Mr. Gupta desired to start a MSME (Micro) unit for manufacturing of spare parts and has invested Rs. 78 lacs in the unit. He subsequently approached Mr. Tiwari , BM of nearby Public sector bank for working capital finance ( for Rs. 60 lacs) to acquire raw materials for his day to day working. On submission of his financial papers / documents , the BM opined that the “Net Working Capital” (NWC) is insufficient to meet the bank’s specification for sanction of the limits as applied for Mr. Gupta (Working as per traditional Method). Hence either Mr Gupta has to infuse more money from long term source or the limit can be sanctioned at lower than what has been asked for. Mr Gupta was perplexed, since he is offering his entire fixed assets as security for the WC limit in addition to the stock /receivables(to be arranged from his own source) that shall be hypothecated to the bank from time to time and could not comprehend the concept of bringing additional funds for margin. He submitted that he has invested money to his maximum capacity in to the business and any amount to be introduced extra shall be at a higher cost and sanction of lower limit shall make him starve for raw material. He somehow could not understand the banker’s approach of forcing him to bring more money instead of their helping him. Finally, he has approached a financial consultant to bail him from the problem. The consultant advised Mr. Gupta to raise some more funds, though at high cost and then negotiated with the Bank and rearranged his financial papers /his request for sanction of limit in such a way that the bank sanctioned the WC limit at original proposed level of Rs. 60 lacs.

The following are the abridged financial papers of Mr. Gupta at the time of submission of original proposal: ( Rs. In lacs)

Financials Swapped by Financial Consultants which were subsequently approved by the bank:

WHAT PROMPTED THE BANK TO SANCTION THE FACILITY IN SECOND CASE?

By raising additional unsecured loan of Rs. 13 lacs , long term sources have been increased to that extent. Bank is satisfied that the same shall be retained on long term basis as per undertaking furnished by the creditors/borrowers before sanctioning the facilities. But Mr Gupta knows that he somehow has to repay the additional amount raised in a short term though presented as long term loans to the bank. This has augmented the margin or NWC for sanction of WC limit.

However it should have been prudent on the part of the bank to sanction a short term loan to meet the margin requirement, and the same can be allowed to be repaid in phased manner from the surpluses generated instead of making him to borrow with a higher cost. More so the borrower has not availed a term loan to acquire his fixed assets, a special treat may be given to such cases, however after confirming the financial viability /cash flow adequacy. Some banks follow the same which is noteworthy.

This leads to the fundamental question of cognizance of the concept of “Net Working Capital” or Margin. As per rule, the NWC or which can also be called as Margin or promoter’s contribution in WC, is arrived either as excess of current assets over current liabilities or Long term sources ( LTS) less long term uses ( LTU- Fixed assets ( FA) and other non Current assets ( NCA) in the system as under:

NWC = CA-CL =  LTS - LTU wherein

LTS = Capital, Reserves /Long term loan/Unsecured loans or other sources not repayable within one year

LTU = Fixed assets + Other Non Current assets .

The bankers want that NWC should come from long term sources and not by raising any short term loans/sources. In other words, it is the borrower’s long term contribution for acquiring the current assets or alternatively termed as liquid surplus. The conviction that NWC is the cushion for the bankers in case of erosion in the security in the current assets is not at all a right approach as security aspect is to be viewed entirely from a different angle. At times, advances are sanctioned even with a nil margin on stocks. In fact, it is a cushion from the borrower’s angle towards exigencies in running day to day business.

As per Tandon committee recommendations, minimum NWC is stipulated to be maintained under the following three methods of lending:

First Method - 25% of the working capital Gap

Second Method -25% of the accepted Current Assets

Third Method -Core Current assets ( CCA) + 25% of the real

Current assets ( RCA)

CCA - are those current assets which are required to be maintained in the system irrespective of having any activity or not.

RCA- is total current assets less core current assets as defined by Tandon Committee.

It is important to remember here that the NWC stipulated or available whichever is higher should be considered by bankers as NWC for deciding the quantum of limits.

Many a times when bankers demand for sufficient NWC for sanction of required WC limits, borrowers depose with the bankers that after the limits are sanctioned, they shall procure the needed margin to draw the bank finance. Here, what they intend is that they shall raise the short term loans to tide over the problem. However, raising short term loan shall not suffice the requisite of the banker and later the borrower may try to inflate the stocks/other current assets to present the NWC as stipulated by the bankers. Hence, while shaping classification of current assets and current liabilities bankers need to examine the individual variables in depth.

It is important that after the banker arrives a level of NWC and sanction certain credit facilities, it should be ensured that once NWC so arrived by bank is not reduced subsequently,

While assessing facilities under the Turnover Method with low NWC, borrower can get higher limits sanctioned than when they have more NWC where the limits are sanctioned at lower levels as can be perceived from following table:

Calculation of WC under Turnover method:

                                                                                                                        Rs in Lacs

Relaxation to this stipulation of agreeing for reduction of the NWC is permitted at times by bankers whenever borrowers use their surplus funds for expansion or the reduction of NWC on account of genuine reasons like loss and erosion in equity etc. but definitely not when there is diversion of funds from system.

MARGIN AND DRAWING POWER:

There are no clear cut norms /guidelines for the banks for stipulation of margin for DP while banks have well defined guidelines for assessment of limits with a specified NWC.

Let us take the case of Mr Gupta who has been sanctioned with a CC hypothecation limit of Rs. 60 lacs. Although the bank sanctioned the limit with an available NWC of Rs. 15 lacs which works out 20% of the WC gap (as per turnover method with an assumed sales level of Rs. 300 lacs and Gross Working Capital of Rs. 75 lacs), the sanction advice stipulated a margin of 25% for drawing power . After completion of the compliance of sanction formalities and when the borrower desires to avail the WC limit , the branch manager demanded a stock statement . Mr Gupta wanted to use his cash and bank balance of Rs. 15 lacs and requested for release of Rs. 60 lacs to procure raw materials of Rs. 75 lacs from supplier. But the bank manager insisted that let Mr Gupta first hypothecate stocks of approximately Rs. 80 lacs , the bank would then be able to release the limit of Rs. 60 lacs ( with margin stipulation of 25% for drawals) as per sanction advice communicated to the borrower. Again, Mr Gupta is perturbed since he felt that when he is sanctioned limits bank has assessed his WC NWC @ 20% of gap i.e; Rs. 15 lacs . Acting upon the advice of his consultant, he again raised short term loan borrowing of Rs. 60 lacs from his friends /other sources at a premium and added his cash on hand of Rs.15 lacs , acquired the stocks of Rs. 75 lacs from the supplier , hypothecated the same to the bank at an inflated rate , drew the Rs. 60 lacs limit and repaid the high cost short term loans. In this process showing all camouflaged transactions. Thus began the deadly “ Mutual Mistrust” between the banker and borrower right from day one and this shall lead to many more misinformed transactions between bank and borrower in future.

The dissimilarity is that bank while considering the limits arrived at a NWC of 20% of the gap but sanctioned a limit with a margin stipulation on stocks of 25%. This aspect if not taken care shall result in complications during the monitoring of the account.

Also it is pertinent to note that while releasing the facilities for the first time banks need to be practical in their approach that instead of demanding the borrower to acquire the stocks first and approach then for limit, they should release the WC , add the borrower contribution /margin ( NWC) and make direct payment to the suppliers. Lines of credit should be suitably realigned to suit this requirement.

The build up of margin should also be closely monitored by banks especially for large borrowers. The surpluses generated are to be retained in the system. Increase in NWC can be perceived by the banker regularly through observance of gradual increase in CA. Banks can monitor this phenomenon by calling monthly/quarterly statements of changes in working capital gap, current liabilities and current assets vis-a-vis change in the short term borrowings and to comprehend how the current assets are financed.

There should not be any hard and fast rule of fixing NWC, it can best summarized as stipulation of minimum desirable margin ( For example under turnover method 20% of the WC requirement) or the available margin whichever is higher. Some banks consider the margin, which is projected as margin requirement while fixation of limit. But giving a practical approach, the NWC which can be reckoned is the NWC available as on date of assessment or at most the NWC that is available as on date of disbursement,  if it can be arrived at. The projected NWC is achievable after the limit is sanctioned with the available NWC and generated surpluses are retained in the system. But governing rule should be that whatever may be the margin decided for sanction of limits, it should be practiced for fixing the drawing power or else problems as in the case of Mr Gupta may arise.

Bankers have to assess the real NWC by correct classification of CA and CL as per their norms/standards. After a level of NWC is arrived, the same should not be allowed to slip normally but any decline or fall should be explainable and justified to the satisfaction of bankers.

The whole concept of understanding the margin is in assessing the contribution of the borrower to finance the current assets. It is always not a good sign to have huge margin or idle inventory in the system but the emphasis is to be on the aspect that better management of current assets for maximum returns.

The theory of arriving at the margin revolves around the assumption that the borrower at all times keeps the records and accounts update/accurate showing the levels of current assets and current liabilities. This is difficult to comprehend in any normal business practice. What is needed a mutual trust between the borrower and banker when the data is called for and scrutinized. Bankers have to arrive at a firm opinion about the levels of margin which is available and which is expected to be achieved with certain assumptions of business levels.