ASSESSMENT OF

WORKING CAPITAL
Venugopal Rajamanuri
FUNDS REQUIREMENT FOR A
BUSINESS / INDUSTRY

A business/Industry, generally, requires funds for
meeting two basic requirements:

I. For acquiring land, building, Plant & Machinery/
equipment, vehicles etc. collectively called
FIXED ASSETS
II. For acquiring stocks and meeting other day-to-day
requirements, collectively called CURRENT
ASSETS

Working capital
Working capital for any manufacturing unit
means the total amount of circulating funds
required for the continuous operations of
the unit on a going basis. The working
capital comprises of:
Working capital (Contd.)
Amount for raw material of various kinds
Amount for stock in process
Amount for all finished goods in stores and in
transit
Amount for Bills receivables or sundry
debtors/trade debtors
Other routine expenses
Advances to suppliers and others
Short term investments/loans to outsiders

Working capital (Contd.)

Inadequate levels of various current assets may
result in under-utilization of capacity and serious
financial difficulties.

Similarly, excessive levels of various current
assets may lead to unproductive use of credit
and unnecessary interest burden on the unit.,
thus the Unit may get a title of an Inefficient Unit.
Working Capital (Contd.)
The advances raised for acquiring fixed assets
are of long term nature called Term Loans
whereas
The funds required for day to day running are
of short term nature are also called Working
Capital
Distinction between Fixed Assets and
Current Assets
Fixed Assets Continue in their original form.
Fixed Assets are tools of business.
Fixed Assets are not meant for sale/turnover.
Fixed assets are utilized for production of saleable
products.
When they become old, they may be replaced by
new assets.
Finance required for acquiring fixed assets
should come from long term sources.

Current assets

Current Assets start with Cash and after going
through various stages get back to Cash.
Current Assets are meant for turnover/sale during
the operating cycle.

Current assets are of short term nature and the
composition keeps on changing.
Finance is required for short term- say for one
operating cycle-thereafter the funds will be
recycled.
Concept of Working Capital.
Working Capital = Funds required for one Trading
or Operating Cycle.
Trading Cycle = Time taken for Cash to go
through different stages before becoming cash
again. That is :
Cash TO Stocks To Receivables To Cash.
Operating Cycle for Manufacturing Industries=
Cash To Raw materials To Semi-finished Goods
To Finished Goods To Receivables To Cash.



Concept of Working Capital.
Gross Working Capital = Total
Current Assets as shown in the balance
sheet

Net Working Capital =
Current Assets less Current Liabilities

Requirement of W/C
DEPENDS ON:
General Nature of business and size of organisation
Manufacturing process/trade cycle
Volume of sales
Credit policy of the unit
Trade terms/purchase terms
Pace of turnover of inventory/receivables
Seasonality
Business cycles
Risk appetite and liquidity & profitability policies
Inflationary trends


MEANS TO FINANCE WORKING
CAPITAL
Credit available on purchases;
Short term Bank borrowing;
Short Term Unsecured loans
Bills payable
Creditors for expenses
Surplus of long term funds over the
long term uses (NWC)
Finance of Current assets (GWC)


Any Questions?

Liabilities Assets
Capital Fixed Assets
Long-term liabilities


Margin/NWC
Liquid Surplus
Current Assets

Working capital limits from
banks

Other Current Liabilities


Finance of Current assets (GWC)
- Negative net working capital


Any Questions?

Liabilities Assets

Capital



Long-term Liabilities


Fixed Assets

Working capital
deficit




Other Current
Liabilities


Current Assets
Assessment of Working Capital
Different Methods

Operating Cycle Method
Projected Balance Sheet Method (PBS)-
Assessed Bank Finance for above Rs.5 crore
limits.
Projected Annual Turnover Method (Nayak
Committee Method) (PAT)( for below Rs.5 crore
limits)
Cash Budget Method for above Rs. 5 crore limits.


Bank s Policy
Based on the report of Kannan
Committee, RBI, had in 1997, given
freedom to Banks to have their own
method of Assessment of Working
Capital limits for all types of
borrowers.


Bank s Policy (contd.)
Accordingly, many banks had decided to
apply Turnover method of Assessment for
assessing the Working Capital requirements
of all borrowers enjoying fund-based working
Capital limits up to and including Rs. 5 crores.
( RBI guidelines of April 1998.)

Bank s Policy (contd.)
In case of accounts of the
consortium, members
generally shall have to fall in
line with the decision of the
leader/consortium.
TURNOVER METHOD FOR SME
PROPOSALS

SME POLICY TO PREVAIL OVER BANKS
CREDIT POLICY
TURNOVER METHOD TO BE USED FOR SME
PROPOSALS
DETAILED CMA DATA NOT TO BE INSISTED
FOR SME PROPOSALS UPTO 500 LACS
CMA data Forms
Form I - Particulars of the existing / proposed limits form the
Banking System
(Limits from all Bank and Financial institutions
as on date of application)
Form II- FORM - II : OPERATING STATEMENT
Form III- ANALYSIS OF BALANCE SHEET
Form IV - COMPARATIVE STATEMENT OF CURRENT ASSETS
& LIABILITIES
Form V- COMPUTATION OF MAXIMUM PERMISSIBLE BANK
FINANCE FOR W.C.
Form VI- FUNDS FLOW STATEMENT
Form VII- Information relating to production such as quantity,
value etc. and estimates for the next 2 years
MPBF METHOD
TONDON COMMITTEE WAS CONSTITUTED IN
1974 TO SUGGEST NEW METHOD OF
LENDING TO REMOVE ENHERENT
DRAWBACK IN THE EXISTING SYSTEM FOR
FINCNCING WORKING CAPITAL
MPBF METHOD
COMMITTEE SUGGESTED THREE
METHODS OF LENDING AND INTRODUCED
THE CONCEPT OF WORKING CAPITAL GAP

WORKING CAPITAL GAP = TOTAL CURRENT
ASSETS CURRENT LIABLITIES OTHER
THAN BANK BORROWINGS
MPBF METHOD
FIRST METHOD OF LENDING

Borrower to contribute at least 25% of
working capital gap

CURRENT RATIO MINIMUM 1.17:1
MPBF METHOD
SECOND METHOD OF LENDING
BORROWER TO CONTRIBUTE AT LEAST 25%
OF THE TOTAL CURRENT ASSETS OUT OF
LONG TERM RESOURCES OF FUNDS

Minimum Current ratio 1.33:1
MPBF METHOD
THIRD METHOD OF LENDING
BORROWER TO CONTRIBUTE ALL CORE
ASSETS PLUS 25% OF THE NON-CORE
CURRENT ASSETS (TO BE IDENTIFIED
FOR EACH INDUSTRY AND FOR EACH UNIT
INDIVIDUALLY)

CURRENT RATIO MINIMUM 1.66:1
3 Methods of Lending - Example
Assume position of CA & CL of an enterprise is as
under:-
Current Assets 1000 (including CCA of 200)
Total C/Liabilities 875
Other C/L 400
Bank Borrowing 475
Current Ratio 1.14
MPBF computed as per different methods of
lending shall be as under:-
3 methods of lending
Ist
method
2
nd

method
3
rd

method
Current Assets
1000 1000 1000
Less current liabilities
other than Bank Borr.
400 400 400
Working Capital Gap
600 600 600
Less core current
assets
- - 200
Less margin
150 250 200
MPBF
450 350 200
Current Ratio
1.18 1.33 1.67
Excess borrowing
25 125 275
MPBF METHOD
CONSIDERING THE NATURE OF OUR
ECONOMY AND THE LIQUIDITY POSITION
OF BORROWERS IN VARIOUS
INDUSTRIES, THE FIRST AND THE
SECOND MOTHODS OF LENDING ONLY
WERE MADE APPLICABLE
Turnover Method
The Trading Cycle/Operating cycle for most of
the businesses was found to be less than or
equal to three months.That is to say that in a
full year, there are four Trade/Operating Cycles
or more.
Once we finance for one full cycle, then the
money will start flowing in a cyclical manner.
The best situation will be to find out the actual
length of the Trading/Operating Cycle, and
accordingly finance them.
There are suitable formula for calculating
Trading/Operating Cycles
Turnover method
Bank has to obtain the Projected sales figure from
the Borrowers.
Based on the past experience, Bank has to study
whether based on past performance of the Unit
and market conditions, the borrower will be able
to achieve the Projected Sales.
This is the most crucial issue in this method of
assessment.
Borrower should convince the Bank about his
plans to achieve the projected sales and Bank
should make an objective evaluation of the plans
and negotiate with the borrower for proper limit.
Parties should not take any unreasonable or
extreme stand based on ego.
Turnover Method
Once the Projected Sales figure is agreed, then the
rest is mere mathematic calculation:
Working capital requirement = 25 % of Projected
Sales (i.e.Total Current Assets)
Margin from borrower = 20% of working capital
requirement i.e. 5% of the projected sales
Minimum Working Capital sanctioned by BANK =
20% of Projected Sales
Current Ratio = 25/20 ie. 1.25


Example of turnover method
Projected Turnover say 300 lacs

Working capital requirement 300 X 25/100= 75 lacs
(25% of projected turnover)

Bank finance for w/c 300 X 20/100 = 60 lacs
(20% of projected turnover or OR
4/5 of w/c requirement) 75 X 4/5 = 60 lacs

Margin money for w/C 300 X 5/100 = 15 lacs
from long term sources OR
( 5 % of projected turnover or
1/5 of working capital
requirement) 075 X 1/5 = 15 lacs
Turnover Method
What is the Control Mechanism?
According to Turnover Method,Bank will sanction
20 % of projected Sales as Fund-based Working
capital Limits;however, for drawing the amount
from the C/c account, the borrower has to have
adequate Drawing Power.
Drawing Power = Value of Paid Stocks less margin
Drawing Limit = sanctioned Limit or Drawing
Power whichever is lower.
Hence, a borrower without sufficient stock of paid
stock will not be able to utilize the limit.
Turnover Method.

Turnover Method assumes that the number of
Operating Cycles is not more than four.
Suppose the number of Operating Cycles is more
than four say six. Then the period of operating
cycle is 2 months and every two months, the
business is getting fresh inflow. However, here
also we will finance min. 20% of projected sales as
the W/C Limit and allow drawings based on stock
statements.
If operating cycles are less than four, then we
have to necessarily sanction higher Working
capital based on the requirements of the
borrowers
Turnover method
Suppose the number of operating cycles is less
than four say 2.Then what to do?
No. of operating cycles 6 4 2
W/C Requirement 16.66% 25% 50%
as a percentage of
Projected Sales
(100/No. of cycles)
Margin 1/5
th
of W/C 3.33 5 10
requirement
W/C limit 13.33% 20% 40%
(as percentage of Projected Sales)
Peak and Non Peak level
assessment of Wg. Capital
In seasonal activities the
working capital limits can be at
different levels for the Peak
season and for the non peak
season


Need for managing Working
Capital
Higher level of Current Assets can help in
maintaining better liquidity but cost of
carrying the stocks will be high.
If level of Current Assets is low, then the
borrower may face liquidity problems and
may default in payment of his creditors
which will affect his credibility in the market.


Treatment of unpaid stock for assessment
of working capital

Turnover method : The value of unpaid stocks
reflected in sundry creditors for purchase of
inventories should be deducted from the stock
statement submitted by the borrower while arriving
at the drawing limit.
Cash budget method : The unpaid stock to the
extent accounted for in the quarterly cash flow
statement must be taken into consideration and
accordingly deducted from the stock statement
while arriving at the drawing limit based on stock
statement submitted by the customer.
Treatment of unpaid stock for assessment
of working capital

MPBF method : While assessing the MPBF,
certain level of creditors for purchase of stocks/
inventories is already factored in and hence should
not be again deducted from the stock statement.
Therefore, out of total value of declared stocks, the
value in excess of the value of creditors taken
into account while computing MPBF/ declared
for the relevant quarter in QIS-I, should be
reduced from the value of stock declared in the
monthly stock statement to arrive at drawing
limit for the corresponding month.

CASH BUDGETING
METHOD
FOR ASSESSMENT
OF
WORKING CAPITAL
Funds Flow:
Based on the movement of funds over a period
of time say one year
Based on the assumption that flow of funds is
homogeneous.
Not possible to identify the period of flow of
specific funds.
It is the exercise of analysis of flow over the
entire period and not localized.
Cash flow analysis
Provides information on whether the flow of
cash /near cash items is on account of
operating /investing /financing activities of the
enterprise.
It provides valuable information on the nature
of earnings during the period under reference.

Contd..
Cash flow analysis (CFA)
However the CFA may not identify
the specific period during which more
cash flows are generated by
operations vis--vis other activities or
otherwise.
CASH BUDGETING
FFA/CFA are tools for wider time frame.
Tool capable of tracking the cash position at
shorter intervals e.g. quarter/ month/week is
called Cash Budgeting
This would help to decide matters of day to
day interest in day-to-day operations e.g.
level of inventory, cash, paying creditors,
meeting expenses etc.
CASH BUDGETING

Cash Budgeting is generally applicable in
case of limits Rs. 5.00 Cr and above.
The option is with the customer.
The choice is with the Bank.
Bank should be sure about the feasibility of
the system at the customers end.

CASH BUDGETING
Proper software, accounting system,
and skilled manpower is must for this
system.
Periodical verification and test checks
are must for the success of the
system.
CASH BUDGETING ANALYSIS
Advantages to the customer:
It gives nature of earning whether from
business, non-business, other sources.
It enables tracking of cash position at
much shorter intervals.
Timely decision for making payments
for inventory, creditors, other
expenses.

CBA- Advantages to the customer:
Useful in making strategy to meet the
shortfall, if anticipated.
Useful in making decision for
investment of surplus funds for a short
period.
CBA-Benefits to the
Bank.

Useful in deciding the level of lending
in the short intervals.
Peak level and non-peak level limits
are easily accessible.
It enables the decision of granting
TOL
It enables to ascertain the level of
funds on due dates of LC,DPG,TOL.
CBA-Benefits to the Bank.

More useful in seasonal activities,
cracker unit, text book publication units,
etc.
Useful in financing of infrastructure units,
tea, rubber, sugarcane, rice milling units
It is emerging as favourite method of
lending.


CBA-Benefits to the Bank.

During peak level we can fix lower
margin and vice versa.
Debtors Turnover and Creditors
Turnover to be calculated and
confirmed from the inflow and outflow of
cash budget figures.
Small deviations may affect the system
substantially

CBA-Benefits to the Bank.

Funds to be withdrawn only after receipt of
actual cash flow of the 2 months back.
In case of wide variation in projections and
actuals, budgeted level to be redrafted.
CBA-Precautions:
Highest level of quarterly cash deficit is the
maximum permissible limit.
Borrower may try for early payments and
delayed receivables to avail higher limits
Monitoring by level of inventory is must.
There should be constant observation and
control on cash flow.
Cash Budget System (Contd.)
Check list of mandatory
information:-
Projected Cash Budget Statement (Annual)
Projected cash flow for next quarter
Quarterly summary of cash book
pertaining to previous quarter- certified by
the CA- (Actual cash Book summary
should be compared with Projected
summary submitted earlier).
MSOD

Thank you.

HAVE A NICE DAY !