Introduction

In this session, we lean about the concept of working capital and its significance, how banks assess the working capital requirements and the range of facilities they offer to fund the requirement

A business has varied funding requirements. A business can either meet its needs through own sources or Bank debt

 The bank debt can be of two types depending upon the purpose/end use:

• Long Term / Term Financing
• Short Term/ Working Capital Financing

 Classification of WC Financing Products:

1. Cash Credit: A short-term line of credit, running account facility that is used by the borrower as the operating account. Governed by the drawing power.
2. WCDL: It is a short-term loan, the maturity period of which usually ranges from 7 days to 6 months. The loan is disbursed in one tranche and is repayable in a single tranche. A fresh loan may be disbursed within a few days of the repaid loan. Banks have a certainty about the utilisation of the sanctioned limits with fixed date of repayment unlike CC. This also helps bring in a level of discipline in funds management in the borrower.
3. Bill Discounting : Receivables (domestic/export) financing. Once the finished goods are shipped and invoices are drawn up, a borrower draws a bill of exchange (BoE) on the customer. BoE is accepted by the customer to be paid at sight or on an agreed due date. Then the borrower submits the BoE along with documents like the invoice and the transport document to the bank. If the BoE is payable at sight, it is purchased and if there is a credit period offered for payment, it is discounted. The purchased/discounted bill, as an outstanding due from the borrower, gets liquidated on payment as committed by the customer. Self liquidating form of finance.
4. Letter of Credit/ Documentary Credit:  It is a written commitment issued by a bank, guaranteeing payment for goods and services against the seller providing acceptable documentation. The bank assures payment of the value of these documents as long as they are in compliance with the terms and conditions specified in the letter of credit.
5. Bank Guarantee: It is a written assurance in which a bank promises to honour the claim of the beneficiary made within the mentioned period in case the applicant defaults on its obligations to the beneficiary. The bank covers payment only up to the value of the claim and as long as the claim is made before the guarantee expires.

CONCEPT OF WORKING CAPITAL & WORKING CAPITAL CYCLE:

 A business uses its working capital to meet its day-to-day operations. What exactly is working capital? 

It is that portion of the total capital of a business that is invested in the current assets.

Current assets are assets that can be converted into cash within one year. These assets can also be sold, consumed or turned over without disrupting the day-to-day business operations.

It is also called as revolving or circulating capital as the money invested circulates in various forms of current assets in a continued manner.

It is also called ‘Gross Working Capital

 The time taken by a business to convert the current assets into cash is called the WC Cycle. An Operating Cycle is the time between the acquisition of assets for processing and their realization in cash. Where the normal operating cycle cannot be identified, it is assumed to have a duration of 12 months”

HOLDING PERIODS:

Inventory Holding Period:

• Holding period of raw material (RM) in months= Average stock of RM ×12 / RM consumption

Average stock of RM = (Opening balance of RM + Closing stock of RM)/2
Raw material consumption = Opening stock of RM + Purchase of RM - closing stock of RM.

• Holding period of work in progress (WIP) in months= Average stock of WIP×12/ cost of production

Cost of production (COP) = Raw materials consumed + manufacturing expenses + Depreciation, + opening stock of work in process – closing stock of work in process.

•  Holding period of finished goods(FG) in months = Average stock of FG×12 / Cost of sales

Cost of Sales (COGS)= Cost of Production (COP)+ Opening stock of finished goods- Closing stock of finished goods.

 Receivables Holding Period/ Debt Collection Period:

Debt Collection Period (in months)=  Average Receivables Outstanding×12 / Gross Credit Sales

Average Receivable Outstanding = Sundry Debtors + Bills Receivables + Bills Purchased + Discounted by the bank. 

 WORKING CAPITAL GAP

The gross working capital (GWC) is the investment in current assets. What remains after deducting the other current liabilities (OCL) from the WC is the working capital gap (WCG). 

WCG =  Current Assets (CA)- Other Current Liabilities (OCL)

It is this gap that needs to be financed by a business by

• Own sources/NWC
• Bank borrowings (WCDL, CC, OD, CP etc)

A part of the working capital gap (WCG) is funded by the net working capital (NWC) available with a business. 

The NWC is the net surplus of the long-term sources over long-term uses of funds.

NWC = Long Term sources – Long Term uses

=(Equity +Reserves+ Long term debt)- (Fixed assets+Investments)

After factoring the above, if there is a gap left, a business resorts to bank borrowings to fund the gap.

 WORKING CAPITAL ASSESSMENT

Various methods can be used to assess fund-based working capital requirements. These methods differ in the way the working capital requirements are assessed.

 Banks have, however, been advised by RBI to sanction limits after proper appraisal of the genuine working capital requirements of the borrowers keeping in mind their business cycle and short-term credit requirement. Banks need to assess the proposal carefully to correctly estimate the working capital requirement. This assessment could be based on a business’ sales, balance sheet or cash flows

1. NAYAK COMMITTEE /TURNOVER METHOD

 The Turnover method, also called the Nayak Committee Method, is named after Dr. P.R. Nayak, then Deputy Governor of the Reserve Bank of India (RBI), who chaired the committee in 1991. This method was prescribed at a time of credit rationing to encourage bank credit flow to the small sector industries.

This method uses sales projections as a basis for computing the working capital limits. Used for FBWC Limits upto Rs 5 crores for Micro and Small units

• Working capital requirement is considered at 25% of annual projected turnover.
• The borrower should bring in 5% of the turnover as NWC margin. The minimum bank finance should be at 20% of budgeted/projected sales.
• Of the working capital requirement, of which at least four-fifth should be provided by the banking sector, the balance one-fifth representing the borrower's contribution towards margin for the working capital. 
• Banks must satisfy themselves of the reasonableness of the projected annual turnover. Hence, the same should be ‘accepted’.
• This may lead to under-financing if the WC Cycle is more than 3 months (it assumes 4 cycles in a year).

2. TANDON COMMITTEE/MPBF METHOD

This method uses the level of current assets and liabilities to determine the WC requirement. The promoters’ to bring in minimum margin and only the residual gap was to be funded by bank finance. Bank credit should be considered as the last resort after the borrower has exhausted all other sources

Three methods of computation of Maximum Permissible Bank Finance were stated: all recognized that banks should finance only a portion of the WC gap.

WC Gap: Acceptable level of CA-Other CL 

Other CL=CL except Bank Borrowings

Banks collect data in format called Credit Monitoring Arrangement (CMA) forms and review these forms for the:

• Actuals of the past two years
• Estimates for the current year/Projection for the next year

Based on this information, banks decide the amount of funds to be provided to the borrower.

3. CASH BUDGET METHOD

 The cash budget method is the most scientific method among other assessment methods. This method requires a high level of discipline, internal systems and structures to draw up reasonable cash budgets month after month. Banks normally use this method for commodity-based and seasonal businesses. For example, to sanction loans to sugar industry or service industries.

Based on the actual cash inflow and outflow in the past year, the estimated month-wise cash flows for the year ahead are drawn up. These are assessed to determine the fund-based working capital requirement of the borrower.

Banks consider the monthly inflow and outflow of cash, the monthly deficit and cumulative deficit and the limit based on peak deficit to compute the working capital limit when using the cash budget method.

NON-FUND BASED WORKING CAPITAL ASSESSMENT 

• LC ASSESSMENT

 An LC limit for WC purpose enable procurement on raw materials on credit at a relatively lesser cost. Assessment ensures adequacy of limits. Cash flow pattern needs to be analysed to ensure timely pattern. 

• Specify Cash Margin & Maximum Usance period in the Sanction Terms.
• In case there is a variance between Operating Cycle & LC usance , proper justification needs to be given
• Usance period accepted for LC should be compared with the credit period availed (projections), creditors’ period. (Creditors holding is 90 days whereas LC usance is 180 days.. Contradiction)
• Opening LC on sister/group concerns should not be allowed especially in case of domestic LCs.
• Bank’s may stipulate obtention of credit opinion reports of overseas suppliers. 
• Cash flow needs to monitored to ensure that the company shall be able to honour its commitment on the due date
• Track record of borrower/past conduct to be considered while sanctioning LC limit
• Do check if LC creditors are factored while computing DP while allowing FBWC limits to prevent double financing.

 BG ASSESSMENT

The company may need Bank Guarantee limits for various purposes :

• Earnest Money Guarantee: For participating in tenders/bids. Amount various upto 5% of the tender value & is realized within 9 months.
• Mobilization Advance Guarantee: Against the mobilization advance a company receives,, it has to submit a BG to the extent of 10-15% of the value  for a period of 12-24 months.
• Performance Guarantee:  During the course of project execution, a company has to submit BG  of 5-15% of the value of orders at the time of the award of the contract itself. It remains valid throughout the project execution period & may also continue during the Defect Liability Period.
• Retention Guarantee: Post successful execution of the project & obtention of Completion Certificate from the client, company can submit BG and get the retention amount released. This BG is usually  10-15% of the contract value & valid for 12-18 months. 

BG requirement is based on the above needs of the company.