WORKING CAPITAL FINANCE
CONCEPT OF WORKING CAPITAL
Working capital is the amount of cash and other current assets a business
has available after all its current liabilities are deducted. It is calculated by
subtracting current liabilities from current assets. Working capital
Is used to fund operations and meet short-term obligations.
Working capital is a daily necessity for businesses, as they require a
regular amount of cash to make routine payments, to pay for unexpected
costs, and purchase basic raw materials used in the production of goods.
Working capital = current assets-current liabilities
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WORKING CAPHAL CYCLE
The needs for working capital vary from industry to industry, and they
can even vary among similar companies. Working Capital Cycle Is the time
It takes to convert current assets and current liabilities (e.g. purchased
stock) Into cash.
The Working Capital Cycle formula is:
Inventory Days+ Receivable Days - Payable Days =Workini Capital Cyde in Days
RAWMA~
------------:::=K IN PROCESS
BOOK DEBT'S ,,_---, FINISHED GOODS
()p(,,ollng Cyci., ~
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W ort.In g Cn~u.l CyclO
The le ngth of this c a s h - to-cash cycle de p e nds on :
(a) the stocks of raw materials required to be held.
(b) the work in process, which in turn depends on the process Involved
In manufacturing/processing to convert the raw materials Into finished
goods.
( c) the stock of finished goods to be carried before they move to the
buyers.
(d) the credit required to be provided to the purchasers.
The longer the working capital cycle, the more is working capital
requirement.
IMPORTANCE OF LIQUIDITY RAnos
► Liquidity refers to how easily or efficiently cash can be obtained to
pay bills and other short-term obligations.
► It helps the company to improve production processes, optimize
Inventory storage, and manage overhead expenses more efficiently.
► It helps understand the availability of cash in a company which
determines the short-term financial position of the company.
► It helps to determine the ability of the company to cover its short-
term obligations.
METHODS OF ASSESSMENT OF BANK FINANCE
H olding Norms Based Me thod o r Operating Cycle Method or
Traditiona l Method
1. Deciding on the Level of Turnover of the Enterprise for
assessment of working capital limits.
2. Assessment of Gross/Total Working Capital: This is the sum
total of the assessment of various components of the working
capital:
(a) Inventory
(b) Receivables/BIiis
(c)Other Current Assets
Sources for Meeting Working Capital Requirem e nt
(a) Own Sources or Net working Capital
(b) Suppliers' Credit:
(c)Other Current Liabilities like advance from customer.
(d) Bank Finance
Calcula tion of Bank f inance
The need for working capital finance from the bank is equal to the
gap between total working capital and the availability of funds
from all the sources except from banks.
The Tandon Committee suggested the following three methods of
lending for determining the permissible level of bank borrowing.
a. First Method of Lending: Under this, the enterprise was
required to bring In NWC of at least 25 per cent of t he
w o rking capital gap (total current assets minus total current
liabilities excluding bank finance) .
b. Second Method of Lending: Under this, the enterprise was
required to bring in NWC of at least 25 pe r cent of t he t otal
cu rren t assets.
c. Third Method of Lending: Under this, the enterprise was
required to bring In, as NWC, 100 per cent o f those current
asset s which are considered 'co re asset s' and at least 25 per
cent of the remaining current assets.
Cash Budget Me thod of Assessm ent
Under this method the estimation of cash inflows and outflows made
by the management over a given period to determine whether the
business has adequate cash & cash equivalents to meet its operating
needs. In case of excess cash outflow, excess is financed by banks.
Projected Turnover Method o f Assessm e nt (Nayak Committee
method)
Under this method, known popularly as Nayak Committee method, of
working capital assessment, it is assumed that the enterprise needs
25% of its annual turnove r as gross working capital, out of which
20% will be provided by the bank and 5% will be brought In as margin
by the enterprise.
Banks are advised by RBI through guidelines, to grant working capital
credit limits to Micro and Small Enterprises (MSEs) computed on the
basis of minimum 20% of t he ir estima ted annua l turnove r whose
credit limit in individual cases is upto Rs. 5 crores.
WORKING CAPITAL FINANCE TO INFORMATION TECHNOLOGY
AND SOFTWARE INDUSTRY
Following the recommendations of the "National Task Force on
Information Technology and Software development", Reserve Bank
has framed guidelines for extending working capital to the said
Industry.
The salient features of these guidelines are:
1. Banks may consider sanction of working capital llmlts based on the
track record of the promoters' group afflllatlon, composition of the
management team and their work experience as well as the
Infrastructure.
2. In the case of the borrowers with working capital limits of up to Rs. 2
crores, assessment may be made at 20 per cent of the projected
turnover. However, in other cases, the banks may consider
assessment of Maximum Permissible Banking Finance on the basis of
the monthly cash budget system. For the borrowers enjoying worki ng
capital limits of Rs. 10 crores and above from the banking system the
guidelines regarding the loan system wou ld be applicable.
3. Banks can stipulate reasonable amount as promoters' contribution
towards margin.
4. Banks may evolve tailor-made follow-up system for such advances.
BILLS/RECEIVABLES FINANCE BY THE BANKS
The terms 'bills purchase',' bills discount', and 'bills negotiation' are
respectively used by the bank for financing against Demand Bills, Usance
BIiis and LC bllls. The seller of goods ( exporter) gets Immediate money
from the bank for the goods sold by him Irrespective of whether It Is a
purchase, discount, or negotiation by the bank according to the nature of
bllls.
Bill discounting Facility allows businesses to sell their unpaid Invoice to
a Bank. In Bill purchase, seller sells the Invoices at a discounted rate.
The money received can be used to fund working capital needs. In Bill
negotiation the bank or financial institution will verify all the documents
before issuing a credit against the invoice amount. It will deduct the
applicable charges from the invoice amount.
GUIDELINES OF RBI FOR OISCOUNTING/REDISCOUNTING OF
BILLS BY BANKS
a. Banks may sanction working capital limits, as also bills limit, to
borrowers after proper appraisal of their credit needs and in
accordance with the loan policy as approved by their Board of
Directors.
b. Banks should open letters of credit (LCs) and
purchase/discount/negotiate bills under LCs only in respect of
genuine commercial and trade transactions of their borrower
constituents who have been sanctioned regular credit facilities by
the banks. (not to non-constituent borrower)
c. BIiis purchased/discounted/negotiated under LC (where the payment
to the beneficiary Is not made 'under reserve') will be treated as
an exposure on the LC issuing bank and not on the borrower. In
the case of negotiations 'under reserve', the exposure should be
treated as on the borrower and risk weight assigned accordingly.
d. Sometimes, a beneficiary of the LC may want to discount the bills
with the LC issuing bank itself. In such cases, banks may discount
bills drawn by beneficiary only if the bank has sanctioned regular
fund-based credit facilities to the beneficiary.
e. Accommodation bills should not be
purchased/discounted/negotiated by banks.
f. Banks should be circumspect while discounting bills drawn by front
finance companies set up by large industrial groups on other group
companies.
g. Bills rediscounts should be restricted to usance bills held by other
banks.
TRADE RECEIVABLES DISCOUNTING SYSTEM (TReDS) (under
Payment & Settlement Systems Act, 2007)
► Micro, Small and Medium Enterprises (MSMEs) play an important
role in the economic fabric of the country. The sector had been
facing constraints in obtaining adequate finance, particularly in
terms of their ability to convert their trade receivables into liquid
funds.
► To address this pan-India issue, setting up of and operating TReDS
was conceptualized. TReDS is an electronic platform for
facilitating the financing / discounting of trade receivables of
Micro, Small and Medium Enterprises (MSMEs) through multiple
financiers.
► These receivables can be due from corporates and other buyers,
including Government Departments and Public Sector Undertakings
(PSUs).
NON FUND BASED WORKING CAPITAL LIMITS
In providing Non-Fund-Based facilities, there is no outlay of funds by the
banks. Therefore, in the balance sheet, these do not appear In the assets
of the bank or the liabilities of the enterprise. However, these appear In
the continge nt liabilities.
Gua ra ntees : Banks issue guarantees on behalf of their customers for
various purposes. The guarantees executed by banks comprise both
performance guarantees and financial guarantees.
A isan
The .. -
Bank guarantee should normally have a maturity of not more than 10
years.
Co- accepta n ce of Bills
A supplier of goods will be more willing to provide credit to the purchaser
(bank's customer), If the bill of exchange drawn by supplier on purchaser
and accepted by purchaser, is also accepted by the bank. Bank's co-
acceptance acts like a guarantee for h er against non payment by
the purchaser.
Guar antees o n Beha lf o f Sh are and St ock Broke rs / Commo dity
Brokers
Banks may issue guarantees on behalf of share and stock brokers in
favour of stock exchanges in lieu of security deposits to the extent It Is
acceptable in the form of bank guarantee as laid down by stock
exchanges. Banks may also issue guarantees In lieu of margin
requirements as per stock exchange regulations. Banks have further
been advised that they should obtain a minimum margin of 50 pe r
cent while issuing such guarantees. A minimum cash margin of 25
per cent (within the above margin of 50 per cent) should be maintained
In respect of such guarantees issued by banks.
Irrevocable Payment Commitments (IPCs)
Banks issuing Irrevocable Payment Commitment (IPCs) to various Stock
Exchange on behalf of Mutual Funds and FIis are advised to adopt the
following risk mitigation measures: Only those custodian banks would be
permitted to Issue IPCs who have a clause In the Agreement with their
clients which gives them an Inalienable right over the securities to be
received as payout In any settlement.
Letters of Credit
A letter of credit is a document sent from a bank or financial institute that
guarantees that a seller will receive a buyer's payment on time and for
the full amount.
Appraisal of LC Limit
An LC Is used for purchase of goods either through Imports or local
purchase. For assessing the LC requirement of an enterprise, we have to
know the following:
(I) Ave rage Amount of Each LC: This Is dependent on the monthly
consumption of goods and the economic order quantity
(ii) Frequency of LC Opening : The number of LCs to be opened In a
year can be calculated by dividing annual consumption by EOQ.
Frequency of opening LCs will be 12 divided by the number of LCs to be
opened in a year.
(Ill) How m a ny LCs will be o utst anding at a particular time: The
time taken for one LC to remain In force depends upon the lead time
(time taken from the date of opening LC to shipment of goods), the
transit time and the usance available to purchaser from the date of
receipt of goods. If the frequency of opening LC is less than this, bank
will have more than one LC outstanding at any point of time.
OTHER ISSUES RELATED TO WORKING CAPITAL FINANCE
Commer cial Paper
► Commercial Paper (CP), an unsecured money market
instrument issued In the form of a promissory note, issued by
highly rated corporate borrowers to diversify their sources of
short-term borrowings.
► Subsequently, primary dealers (POs) and all-India financial
Institutions (Fis) were also permitted to Issue CP to enable them to
meet their short-term funding requirements.
► A company would be eligible to issue CP provided its tangible net
worth Is not less than Rs. 4 crores.
► The minimum credit rating for issuance of CP is 'A3'.
► CP shall be Issued for maturities between a minimum of 7 days
and a maximum of up to one year from the date of issue.
► The borrowal account of the company Is classified as a Standard
Asset by the financing bank/s.
Factoring
Under factoring, the factor not only purchases the book debts/receivables
of the client but may also control the credit given to the buyers and
administer the sales ledger. The purchase of book debts/receivables can
be with recourse or without recourse to the client. If It is without
recourse, the client Is not liable to pay to the factor in case of fallure of
the buyer to pay.
Bank Finance to Factoring Companies
Banks can extend financial assistance to support the factoring business of
Factoring Companies complying with certain criteria. These conditions
Include that the factoring company derives at least 7 5 p er cent of its
income from factoring activity and the receivables purchased/financed,
form at least 75 pe r cent of the assets of the Factoring Company.
Forfaiting
This is similar to factoring but is used only in case of exports and where
the sale is supported by bills of exchange/promissory notes. The financier
discounts the bills and collects the amount of the bill from the buyer on
due dates. Forfaiting is always without recourse to the client.
Therefore, the exporter does not carry the risk of default by the buyer.
Rupee (INR) Denominated trade cr edit
RBI has decided that the resident importer can raise trade credit In
Rupees (INR) within the following framework after entering into a loan
agreement with the overseas lender:
(i) Trade credit can be raised for import of all items ( except gold)
permissible under the extant Foreign Trade Policy
(ii) Trade credit period for import of non-capital goods can be upto
one year from the date of shipment or upto the operating cycle
whichever Is lower.
(iii) Trade credit period for import of capital goods can be upto five
years from the date of shipment
{Iv) No extension can be permitted by the AD Category-I bank beyond
the permissible period
(v) AD Category-I banks can permit trade credit upto USO 20 millions
equivalent per Import transaction
(vi) AD Category-I banks are permitted to give guarantee, Letter of
Undertaking or Letter of Comfort in respect of trade credit for a
maximum period of three years from the date of shipment.
