final project ubi

A PROJECT ON

Case study on working capitalProject Report submitted to

University of Calcutta

Period: 15th June 2016 to 15th August 2016Submitted By:

Name: Jhinuk Roy Roll No.: 93/ECO/151127Year: 1stSemester: 2nd

Department: MSc. (Economics)Under the guidance of

United Bank OF India

11, HemantBasuSarani, Kolkata- 700001

Kolkata, West Bengal

Case Study on Working Capital | 2016

STATEMENT BY THE CANDIDATE

I hereby state the Project Report entitled Case Study on Working Capital has been prepared by me to fulfill the requirements of the internship during the period 15th June 2016 to 15th August 2016.

Dated: 14/08/2016

Jhinuk Roy,(Roll No-93/ECO/151127)

University of Calcutta i


ACKNOWLEDGEMENT I deem it a pleasure to acknowledge my deep sense of gratitude to the officials and staffs of United Bank of India who directed and guided me with their timely advice and constant inspiration, which eased to task the completing of this project report.

I would also like to thank Calcutta University and the HOD of Economics department and all the others faculty members, without whom this project would have been a distant reality.

Finally I must say that no height is ever achieved without some sacrifice made at some end and it is here I owe my special debt to my parents and family members for showing their love throughout this period of time.

Jhinuk Roy.

University of Calcutta ii


ABSTRACT

I student of Calcutta University),pursuing Masters in Economics(M.sc),have undergone summer internship program in United Bank of India .I was assigned to the Credit Department at The United Bank of India, Head Office at Kolkata and has undergone training on Working Capital. This project discusses the theory and practice of working capital and the assessment of working capital. In this project assessment of the factors was done on the basis of a case study which was given to me.This project deals with the loan appraisal methodology of a bank for a proposal received for working capital. Several variables affect the working capital of the companies such as current ratio, debt service coverage ratio, quick ratio, asset coverage ratio, Asset Coverage Ratio etc. These variables were analyzed during the period of study. The factors were compared with the standards as mentioned in the Lending Policy of the bank, on the basis of which it is decided whether the loan will be sanctioned or not. The projected balance sheet and the projected cash flow statement were also assessed.As part of the appraisal process, credit rating is done for the proposal is conducted by the bank itself and approved external agencies. In this study, the important findings and conclusions derived from analyzing the collected data is presented.

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TABLE OF CONTENTS

Statement by the Candidate (i)Acknowledgement (ii)Abstract (iii)List of tables (vi)List of figures (vii)Objective 1Chapter- 1 A Brief Introduction on Bank 2-6

1.1 Introduction 21.2 History 21.3Main Functions of Bank 31.4Secondary Functions 4

Chapter- 2 Evolution of Bank 7-122.1 Structure of the Organized Banking Sector 82.2 Business Segmentation 10

Chapter- 3 Methodology 13-133.1 Limitations of the study 13

Chapter- 4 Discussion 14-354.1 Working Capital 144.2 Sources of Working Capital 174.3Types of Working Capital 184.4Working Capital Management 204.5Working Capital Assessment 234.6Methods for Assessment of Working Capital 244.7Types of Banking 304.8Bank Rating 314.9Types of Securities 334.10Some Common Terms used in Working Capital Assessment 33

Chapter- 5 Case Study 36-545.1 About the Company 35

University of Calcutta Contents


5.2 Gist of Proposal 365.3 Analysis of the Balance Sheet of XYZ Private Limited 375.4Sanction of Working Capital Limits 435.5Credit Rating by Agencies with Purpose of such Rating 435.6Financial Position of the Company as on Close of Financial Years for Last

Three Years 445.7Ratio Analysis 455.8Movement of TNW 465.9Fund Flow Analysis 465.10Computation of ACR for the Working Capital Limit 485.11Assessment of Working Capital 49

5.11.1 Computation of maximum permissible Bank Finance (MPBF) 495.12Loan Policy 525.13 Rationale for Recommendation 53

Chapter- 6 Learning Points 55-716.1 Characteristics of Working Capital 556.2 The Pros & Cons of Working Capital 56

University of Calcutta Contents


LIST OF TABLESTable 1: Sources of Working Capital 17

Table 2: Types of Working Capital 19

Table 3: Balance Sheet of ABC Company Limited 28

Table 4: SMA Sub-categories 33

Table 5: Analysis of the Balance Sheet of XYZ Private Limited 36

Table 6: Sanction of Working Capital Limits 43

Table 7: Credit Rating by Agencies with Purpose of such Rating 43

Table 8: Financial Position of the Company as on Close of Financial Years for Last Three Years 44

Table 9: Ratio Analysis 45

Table 10: Movement of TNW 46

Table 11: Fund Flow Analysis 46

Table 12: Computation of ACR for the Working Capital Limit 48

Table 13: Computation of maximum permissible Bank Finance (MPBF) 49

Table 14: Holding levels for different items of current assets and current liabilities 50

Table 15: Other Current Assets 51

Table 16: Assessment of PC & FBP/FBN Limit 51

Table 17: Benchmark Parameters as per Lending Policy 52

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LIST OF FIGURES

Figure 1Evolution of Banking 7

Figure 2 Structure of Indian Banking System 8

Figure 3 Business Segmentation 10

Figure 4 Operating Cycle in manufacturing firm 15

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OBJECTIVES The main objective of the study is to understand working capital and also the concepts related to working capital. This project has helped me to: To study how bank loans function; To understand the procedures to be followed for availing loan; To know about the lending policy of UBI; To understand the concept of working capital; To understand the various concepts associated with working

capital.

University of Calcutta 1


Chapter 1- A Brief Introduction on Bank

1.1 Introduction:Banking is defined as “Accepting for the purpose of lending and investment, of deposit of money from the public, repayable on demand order or otherwise and withdraw able by cheque, draft or otherwise.”Thus, banking means transacting business with a bank; depositing or withdrawing funds or requesting a loan etc.A bank is a financial institution licensed to receive deposits. This type of bank is referred to as a commercial or retail bank. Some banks also engage in the issuance of new securities to the public. This type of bank is usually referred to as an investment bank. Due to deregulation, a single bank is allowed to do both.A bank that operates as a commercial bank accepts customer deposits in the form of demand deposit accounts, savings accounts, money market accounts and timed accounts such as certificates of deposits (CDs). Banks pay interest to the depositors on some of these accounts.Banks loan the deposited money to borrowers who pay interest to the bank as long as the loan is outstanding. Typical loans include short-term loans, car loans, mortgages, large loans to businesses to fund capital purchases and lines of credit. Some commercial banks also issue credit cards as part of their services.Just like any other business, a bank’s goal is to earn a profit for its owners. It does this by earning more on the interest it charges its borrowers than it loses on the interest it pays to depositors.For example, if in a year, a bank has 100 million in deposits for which it pays 2% to the depositors and then loans that 100 million to borrowers at a rate of 5%, the bank earns a profit of 3% (3 million) for the year.

1.2 History:The development of banking is evaluation in nature. The origin of the word ‘bank’ can be traced back to the German word ‘Banck’ and Italian word ‘Banco’ which means heap of money.Banking is an old concept in India. It was present in ancient Vedic times .There were bankers known as ‘Sheth’ ,’Shah’ ,’Shroff’ or ‘Chettiar’ who were performing the function of bank.

1.3 Main Functions of Bank:Primary Functions:The main functions of banks are accepting deposit and lending loans:

I. Accepting deposits:


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a. Fixed deposits- These deposits mature after a considerable long period like 1 year or more than that the rate of interest is fixed the amount deposited cannot be withdrawn before maturity date.

b. Current A/C deposit- These are mainly maintained by business community to facilitate frequent transaction with big amounts .Generally no rate of interest or very low rate of interest is paid on this account.

c. Saving bank A/C- It is kind of demand deposits which are generally kept by the people for the sake of safety. These facilities are given for small saver and normally a small rate of interest is paid.

d. Recurring deposit A/C- In case of recurring deposit the fixed amount is deposited in a bank every month for a fixed period of time.

II. Lending loans:a. Call/Demand loans- These loans are called back at any time. Normally,

these loans are taken by bill brokers or stock brokers.b. Short term loans- These are sanctioned normally for a period up to 1

year.c. Medium term loans- These are sanctioned normally for the period

varying between 1 and 5 years.

III. Long Term Loans:

These loans are sanctioned for a period of more than 5 years. It includes:

a. Overdraft- The bank grants overdraft facility to its reliable and respectable depositors. It enables companies, firms and businessmen to withdraw amount over and above their actual balance in their current account.

b. Cash Credit- Under this facility, the bank allows the borrower to withdraw cash against certain security.

c. Bills of Exchange- The bank provides funds to their customers by purchasing or discounting bills of exchange. The bank charges commission up to the maturity period of bills.

1.4 Secondary Functions:

The secondary functions of commercial bank can be classified under the following heads.

1. Agency functions2. General utility functions3. Miscellaneous functions



1. Agency Functions- The banks render important services as agent on behalf of their customers in return for a small commission. When banks act as agent, law of agency applies. The agency functions or services of bank are as follows:

a. Collection of Cheques: Commercial banks collect the cheques, bills of exchange, etc, on behalf of their customers. Banks collect local and outstation cheques and bills of exchange through clearing house facilities provided by the central bank.

b. Collection of Income: The commercial banks collect dividends, interest on investment, pension and rent of property due to the customers. When any income is collected by the bank, a credit voucher is sent to the customer for information.

c. Payment of expenses: The banks make payment of insurance premiums, rent, trade subscription, school fee and other obligation of the customers. When any expense is paid by the bank, a debit voucher is sent to the customer for information.

d. Dealer in securities: The banks carry out purchase and sale of securities on behalf of their customers. Banks do it well because they are aware of the market conditions.

e. Acts as trustee: The banks act as trustee to manage trust property as per instructions of property owners. Banks are required to follow the terms and conditions of trust deed.

f. Acts as an agent: Commercial bank sometimes acts as an agent on behalf of its customers at home or abroad in dealing with other banks or financial institutions.

g. Executing standing instructions: Sometimes customer may order his bank to do something on his behalf regarding the conduct of his account. This written order is called standing instruction. The bank being the agent of its customer obeys the standing instructions.

h. Acts as tax consultant: Commercial bank acts as tax consultant to its client. The commercial bank prepares general sales tax return, income tax return, etc. Tiles the same with tax authorities.



2. General Utility Functions- Commercial bank performs different utility functions for their customers. When bank performs utility functions, it does not act as an agent of the customers. The general utility functions are as follows:

a. Provides lockers facilities: Commercial banks provide lockers facilities to its customers for safe custody of Jeweler, shares, securities and other valuables. This has minimized the risk of losing due to theft.

b. Issue of traveler'scheque: Bank issues traveler's cheques to the customers for traveling in and outside the country.

c. Foreign exchange: Commercial banks deal in foreign exchange. This enables the individuals and businessmen to obtain foreign currency in exchange of their home currency. For dealing in foreign exchange, commercial banks have to obtain permission from the central bank.

d. Transfer of money: Commercial banks provide facilities for the transfer of money to any place within and outside the country. The funds are transferred by means of draft, telephonic transfer, electronic transfer etc.

e. Finances foreign trade: A commercial bank finances foreign trade by accepting foreign bills of exchange. Bank also issues letter of credit on behalf of its customers to facilitate foreign trade.

f. Trade information: Commercial banks collect and provide trade information and tender advice to its customers about financial matters. Issues credit cards: Banks issue credit cards to their trustworthy and valued customers. This facilitates the customers to pay for their necessities of life.

g. Purchase PTCs: Commercial banks underwrite or purchase Participation Term Certificate (PTCs), Term Finance Certificates (TFCs). This helps the companies to raise their capital.

h. Financial standing: Commercial banks answer reference letters regarding the financial standing and business reputation of customers. Banks provide this information with great care and utmost secrecy.

3. Miscellaneous Functions-Commercial banks perform the following miscellaneous functions.

a. Collection of utility bills: Commercial banks provide facilities for the collection of utility bills from general public on behalf of government bodies. This facilitates the public to pay utility bills in time.

b. Electronic banking and E-banking:Electronic banking is offering improved services to the customers as follows:

1) ATM Cards 2) Credit Cards and3) Electronic transfer of money





CHAPTER-2 EVOLUTION OF BANK The Indian banking industry has its foundations in the 18th century, and has had a varied evolutionary experience since then. The initial banks in India were primarily traders’ banks engaged only in financing activities. Banking industry in the pre-independence era developed with the Presidency Banks, which were transformed into the Imperial Bank of India and subsequently into the State Bank of India. The initial days of the industry saw a majority private ownership and a highly volatile work environment. Major strides towards public ownership and accountability were made with nationalization in 1969 and 1980 which transformed the face of banking in India. The industry in recent times has recognized the importance of private and foreign players in a competitive scenario and has moved towards greater liberalization.

. Phase I- Pre-Nationalization Phase (prior to 1955) Phase II- Era of Nationalization and Consolidation (1955-1990) Phase III- Introduction of Indian Financial & Banking Sector Reforms and

Partial Liberalization (1990-2004) Phase IV- Period of Increased Liberalization (2004 onwards)

2.1 Structure of the Organized Banking Sector:The organized banking system in India can be classified as given below:



Reserve Bank of India (RBI):

The country had no central bank prior to the establishment of the RBI. The RBI is the supreme monetary and banking authority in the country and controls the banking system in India. It is called the Reserve Bank’ as it keeps the reserves of all commercial banks.

Commercial Banks:

Commercial banks mobilize savings of general public and make them available to large and small industrial and trading units mainly for working capital requirements.Commercial banks in India are largely Indian-public sector and private sector with a few foreign banks. The public sector banks account for more than 92 percent of the entire banking business in India—occupying a dominant position in the commercial banking. The State Bank of India and its 7 associate banks along with another 19 banks are the public sector banks.


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Scheduled and Non-Scheduled Banks:

The scheduled banks are those which are enshrined in the second schedule of the RBI Act, 1934. These banks have a paid-up capital and reserves of an aggregate value of not less than Rs. 5 lakhs, hey have to satisfy the RBI that their affairs are carried out in the interest of their depositors.All commercial banks (Indian and foreign), regional rural banks, and state cooperative banks are scheduled banks. Non- scheduled banks are those which are not included in the second schedule of the RBI Act, 1934. At present these are only three such banks in the country.

Regional Rural Banks:

The Regional Rural Banks (RRBs) the newest form of banks, came into existence in the middle of 1970s (sponsored by individual nationalized commercial banks) with the objective of developing rural economy by providing credit and deposit facilities for agriculture and other productive activities of all kinds in rural areas.The emphasis is on providing such facilities to small and marginal farmers, agricultural laborers, rural artisans and other small entrepreneurs in rural areas.

Cooperative Banks:

Cooperative banks are so-called because they are organized under the provisions of the Cooperative Credit Societies Act of the states. The major beneficiary of the Cooperative Banking is the agricultural sector in particular and the rural sector in general.The cooperative credit institutions operating in the country are mainly of two kinds: agricultural (dominant) and non-agricultural. There are two separate cooperative agencies for the provision of agricultural credit: one for short and medium-term credit, and the other for long-term credit. The former has three tier and federal structure.At the apex is the State Co-operative Bank (SCB) (cooperation being a state subject in India), at the intermediate (district) level are the Central Cooperative Banks (CCBs) and at the village level are Primary Agricultural Credit Societies (PACs).Long-term agriculture credit is provided by the Land Development Banks. The funds of the RBI meant for the agriculture sector actually pass through SCBs and CCBs. Originally based in rural sector, the cooperative credit movement has now spread to urban areas also and there are many urban cooperative banks coming under SCBs.

2.2 Business Segmentation:The entire range of banking operations are segmented into four broad heads- retail bankingbusinesses, wholesale banking businesses, treasury operations



and other banking activities.Banks have dedicated business units and branches for retail banking, wholesale banking(divided again into large corporate, mid corporate) etc.

Treasury Operations:Treasury operations include investments in debt market (sovereign and corporate), equitymarket, mutual funds, derivatives, and trading and forex operations. These functions can beproprietary activities, or can be undertaken on customer’s account. Treasury operations areimportant for managing the funding of the bank.Apart from core banking activities, which comprises primarily of lending, deposit takingfunctions and services; treasury income is a significant component of the earnings of banks.Treasury deals with the entire investment portfolio of banks (categories of HTM, AFS andHFT) and provides a range of products and services that deal primarily with foreignexchange, derivatives and securities.Treasury involves the front office (dealing room), mid office (risk management includingindependent reporting to the asset liability committee) and back office (settlement of dealsexecuted, statutory funds management etc.)Other Banking Businesses:This is considered as a residual category which includes all those businesses of banks that do not fall under any of the aforesaid categories. This category includes para banking activities like hire purchase activities, leasing business, merchant banking, factoring activities etc.Lending:One of the banking activities is lending.Lending Services of Banka. Cash Financeb. Overdraftc. Loans ( Term Finance)d. Purchase and Discounting of Bills



e. Hire- purchase and Leasing FinanceLoans:A loan is a debt provided by an entity (organization or individual) to another entity at aninterest rate, and evidenced by a promissory note which specifies, among other things. , aloan is a debt provided by an entity (organization or individual) to another entity at an interest rate, and evidenced by a note which specifies, among other things, the principal amount, interest rate, and date of repayment. A loan entails the reallocation of the subject asset(s) for a period of time, between the lender and the borrower.Bank Loans often referred to as C & I loans, falls into four main categories which are:1. Transaction Loans: A transaction loan is negotiated for a specific purchase and is tailored to the particular needs of the purchaser. The demandfor these loans from a particular borrower is typicallyepisodic and hence each loan is negotiated separately.2. Working Capital Loans: These loans are used by firms to finance routine day -to-daytransactions. Thus, they are general purpose, short-term borrowings, and are often usedeither to purchase current assets (like inventories) or to repay debts incurred in purchasingcurrent assets.3. Term Loans: These are longer maturity loans used to by fixed assets requiring largeoutlays of capital. Maturities typically run from 3 to 10 years. Repayment is normallyamortized because it comes out of the cash flows generated by the assets financed withthe loan.4. Combinations: Working capital loans often include provisions that permit the conversionof short-term borrowings into term loans at the borrower’s request.



Chapter-3 MethodologyThe methodology includes the following:

Types of study Scope of study Sources of data collection

Types of Study:The UBI has warmly welcomed us to be a in the financial organization and to gain varioustypes of knowledge about how the bank provides credit facilities to the public. In the bankwe get to interact with bankers. As we are in the credit department, they helped us inunderstanding various types of credit facilities that they provide.Scope of the Study:The study deals with the various factors taken into consideration during appraisal of the term loans and financial analysis of the same.Collection of Data:The data is used in this study collected from secondary data sources, i.e. Bank’s lendingpolicy, the bankers, the files in the bank etc.

3.1: Limitations of the study:Although this research was carefully prepared, there may be limitations and short comingsdue to the following reasons:

The duration of the study was quite short. Study was based on secondary sources of data The study is limited only to a single bank Study was based on documents of complex nature which was difficult for

us to understand.



CHAPTER-4 DISCUSSION

4.1 Working Capital:The term working capital means sum of the funds invested at various current assets used in the operating cycle, by the industrial and trading establishments. Operating cycle means the length of time required to convert ‘Non-Cash assets’,(like raw materials(RM),work in process(WIP),finished goods(FG),and receivables)into cash. The appraisal of working capital finance means assessment of gross working capital, net-working capital and working capital gap for assessment of working capital limits for a company.Working capital is calculated as:Working capital=Current asset-Current liabilitiesThe working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as "Net Working Capital".Operating Cycle: The operating cycle is also known as the cash conversion cycle. In the context of a manufacturer the operating cycle has been described as the amount of time that it takes for a manufacturer's cash to be converted into products plus the time it takes for those products to be sold and turned back into cash. In other words, the manufacturer's operating cycle involves:

Paying for the raw materials needed in its products. Paying for the labor and overhead costs needed to convert the raw

materials into products. Holding the finished products in inventory until they are sold. Waiting for the customers' cash payments for the products that have been

sold.



Holding Period: Operating cycle means the length of time required to convert ‘Non-Cash current assets’ like raw material,work- in- process,finished goods and receivables into cash. At each stage of operating cycle i.e. stock of raw material, work- in- process, finished goods a manufacturing unit needs to hold the stock for a length of time in the workplace before dispatching the final products to the customers. The tendency of some manufacturing units holding the current assets (stocks and receivables) beyond the requirement of holding period has the financial implication,as more amount of interest payable on current liabilities for the time taken in converting the current assets into cash.

There are several financial ratios that pertain to working capital:

Liquidity Ratio: A liquidity ratio is an indicator of whether a company’s current assets will be sufficient to meet the company’s obligations when they become due. The liquidity ratios include the current ratio and the acid test or quick ratio. The current ratio and quick ratio are also referred to as solvency ratios. Working capital is an important indicator of liquidity or solvency, even though it is not technically a ratio. Current Ratio: The current ratio is a financial ratio that shows the proportion of current assets to current liabilities. The current ratio is used as an indicator of a company’s liquidity.Quick Ratio: The quick ratio is a financial ratio used to gauge a company’s liquidity. The quick ratio is also known as the acid test ratio. This ratio compares the total amount of cash+ marketable securities+ accounts receivable to the amount of current liabilities. The quick ratio differs from the current ratio in that some current assets are excluded from the quick ratio. The most significant current asset that is excluded is inventory. The reason is that inventory might turn into cash quickly.

Example: Cash 50000Debtors 100000Inventories 150000Current Liabilities 100000Total Current Assets 300000Current Ratio = > 3, 00,000/1, 00,00 = 3: 1Quick Ratio = > 1, 50,000/1, 00,000 = 1.5: 1

Debt-Equity Ratio:Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage, calculated by dividing a company's total liabilities by its stockholders' equity. The D/E ratio indicates how much debt a



company is using to finance its assets relative to the amount of value represented in shareholders' equity.Debt - Equity Ratio = Total Liabilities / Shareholders' Equity

TOL/TNW Ratio:TOL/TNW is a measure of a company’s financial leverage calculated by dividing the total liabilities of the company by the total net worth of the business. Total outside liability is the sum of all the liabilities of the business and total net worth is the sum of share capital and surplus reserves of the company.Asset Coverage Ratio (ACR):The asset coverage ratio is a test that determines a company's ability to cover debt obligations with its assets after all liabilities have been satisfied. When calculating the asset coverage ratio, investors should exercise caution with respect to asset value; using the coverage ratio of the actual liquidation value of assets is significantly less.


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4.2 Sources of Working Capital:Sources of working capital can be spontaneous, short term and long term.Spontaneous Sources of Working Capital Finance: The word ‘spontaneous’ itself explains that this source of working capital is readily or easily available to the business in the normal course of business affairs. The quantum and terms of this credit depend on the industry norms and relationship between buyer and seller. These sources include trade credit allowed by the sundry creditors, credit from employees, and other trade-related credits. The biggest benefit of spontaneous sources as working capital is its effortless raising and insignificant cost compared to traditional ways of financing.Short Term Sources of Working Capital Finance: Short term sources can be further divided into internal and external sources of working capital finance. The short-term internal sources include tax provisions, dividend provisions etc. Short-term external sources include short-term working capital financing from banks such as bank overdrafts, cash credits, trade deposits, bills discounting, short-term loans, inter-corporate loans, commercial paper, etc.Long Term Sources of Working Capital Financing: Long term sources can also be divided into internal and external sources. Long term internal sources of finance are retained profits and provision for depreciation whereas external sources are Share Capital, long-term loan, and debentures.

Spontaneous Sources Short Term Sources Long Term Sources

Internal Sources

External Sources

Internal Sources

External Sources

TradeCredit Tax Provisions

Bank Overdraft

Retained Profits Share Capital

Sundry Creditors

Dividend Provisions

Trade Deposits

Depreciation Provision

Long Term Loans

Bills Payable Public Deposits Debentures

Notes Payable BillsDiscounti

ng Accrued Expenses Short Term

Loans

4.3 Types of Working Capital:Working Capital is divided into various types based balance sheet view and operating cycle view. Balance sheet view divides working capital into gross working capital and net working capital and the operating cycle view divides the working capital into permanent and temporary working capital. Permanent



working capital is further divided into seasonal and special working capital whereas temporary working capital into regular and reserve working capital.Working capital is classified into different types and the classification is based on the following views:

Balance Sheet View:On the basis of Balance Sheet View, types of working capital are described below:Gross Working Capital (GWC): Current assets in the balance sheet of a company are known as gross working capital.

Net Working Capital (NWC): Net working capital is a very frequently used term. There are two ways to understand networking capital. First, one says it is simply the difference between current assets and the current liabilities on the balance sheet of a business. The other understanding discloses little deeper or hidden meaning of the term. As per that, NWC is that part of current assets which are indirectly financed by long-term assets. Compared to gross working capital, net working capital is considered more relevant for effective working capital financing and management.

Operating Cycle View:On the basis of Operating Cycle View, types of working capital are as below: Permanent / Fixed Working Capital: Dealing with current asset and fixed assets is totally different. Determining the financing requirement in the case of fixed assets is simply the cost of the asset. Same is not true for current assets because the value of current assets is constantly changing and it is difficult to accurately forecast that value at any point of time. To simplify the complexity to some extent, on the basis of past trend and experience, we can find a level below which current asset has never gone. The current assets below this level are called permanent or fixed working capital. As an example:

(Rs. in crores)

Types of Working CapitalNet Working

CapitalPermanent / Fixed Working Capital

Temporary / Variable Working Capital Requirement

3000 2500 5002500 2500 02800 2500 3003200 2500 700



In the example, Rs.2500crores is the permanent working capital below which the net working capital has not gone.Regular Working Capital: It is the permanent working capital which is normally required in the normal course of business for the working capital cycle to flow smoothly.

Reserve Working Capital: It is the working capital available over and above the regular working capital. It is kept for contingencies which may arise due to unexpected situations.Temporary / Variable WC: Temporary working capital is easy to understand after getting hold over the permanent working capital. In simple terms, it is the difference between net working capital and permanent working capital. The main characteristic which can be made out of the example is “fluctuation”. The temporary working capital, therefore, cannot be forecasted. In the interest of measurability, this can be further bifurcated as below which can create at least some base to forecast.Seasonal Working Capital: Seasonal working capital is that temporary increase in working capital which is caused due to some relevant season for the business. It is applicable to businesses having the impact of seasons, for example, the manufacturer of sweaters for whom relevant season is the winters. Normally, their working capital requirement would increase in that season due to higher sales in that period and then go down as the collection from debtors is more than sales.Special Working Capital: Special working capital is that rise in the temporary working capital which occurs due to a special event which otherwise normally does not take place. It has no basis to forecast and has rare occurrence normally. For example, a country where Olympic Games are held, all the business requires extra working capital due to a sudden rise in business activity.It was all about the types of working capital. It needs to be managed with several working capital techniques so as to have the effective working capital management.

4.4 Working Capital Management:Each business has its uniqueness and style which decides the nature and the form of working capital it require. An exporter for example will need packing credit limit instead to OD limit in compare to a trader who will ask for OD limit. In view of above and as per industry practices following are the possible forms of the working capital:



I. Fund Based Limits: Fund Base Limit is a limit in which the Company gets the money from bank or financial institution in cash. a. Cash Credit (CC) - To meet working capital requirements of the company the Bank gives the CC limit against the hypothecation of Stock and Debtors. But While deciding the limit, the bank deducts the Trade Creditors also. Further a monthly stock and debtor’s statement need to be submitted with the bank showing the position of the stock and aging of the debtors. Client opens the Cash Credit Account which allows the withdrawal up to the limit sanctioned by the bank. Bank charges the prevailing interest and other bank charges as per norms. This facility is sanctioned for a year and need to review at the closing of the year for renewal subject to the requirement of client. Bank normally asks for the collateral security for securing its hand in case of any default. A regular inspection is conducted on the factory and go downs of the client, to check the stock levels, by the bank officers along with a Stock Audit conducted by a Chartered Accountant on yearly basis. b. Working Capital Term Loan: Some time the borrower fails to bring immediately its own contribution as margin while enjoying the working capital limits. In that case the bank may sanction WCTL which need to be adjusted as soon as possible. It normally carry higher rate of interest in comparison to working capital limit. c. Factoring: The selling of a company’s accounts receivables, at a discount to a factor that then assumes the credit risk of the account debtors and receives cash as the debtors settle their account. There is no need to open the Letter of Credit (LC). There is specialize financial institutions such as SBI Factors, Global Trade Finance, IFCI Factors which gives services of factoring (Domestic as well as International).f. Overdraft (OD): It is a tool to aid cash-flow by a bank providing a reserve of easily accessible money to meet any shortfall in working capital. The facility is usually repayable "on demand" which means whenever the bank demands. Consequently, it is usually shown as a current liability on the balance sheet. It may be secured or unsecured. g. Line of Credit: An arrangement between a financial institution and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement. The advantage of a line of credit over a regular loan is that interest is not usually charged on the part of the line of credit that is unused, and the borrower can draw on the line of credit at any time that it needs to.



h.Packing Credit: PC is available to exporters, for financing purchase, processing, manufacturing or packing of goods prior to shipment. This is basically a loan or advance extended to exporter by the bank on the basis of:

Letter of Credit opened in favor of exporter or in favor of some other person, by an overseas buyer.

A confirmed and irrevocable purchase order for the export of goods from India.

Any other evidence of an order or export from India B. Non-fund Based Limits: The credit facilities given by the banks where actual bank funds are not involved are termed as 'non-fund based facilities' a. Letter of Credit: A standard, commercial letter of credit is a document issued mostly by a financial institution on the request of the buyer in favor of supplier of goods which usually provides an irrevocable payment undertaking. It may be Inland LC or Foreign LC. In this case the buyer bank gives guarantee on behalf of its client to supplier for supplying of material or goods subject to that invoices, bill of lading, shipment documents will come directly to the bank. Bank will mark lien on the goods and will stand as lender/creditor in the books of the client (buyer). The supplier could opt for discounting of LC. In this case he will approach his bankers/agent/factor that wills again approach to the buyer client. The buyer bank will make payment (after deducting the margin) on behalf of its client for a fee. The margin is normally in the range of 10 to 25%, and bank put the money in the form of FDR at prevailing rate till the settlement of the final claim. LC could be at sight LC or usance LC. A 'sight' LC means that payment is made immediately to the beneficiary/seller/exporter upon presentation of the correct documents in the required time frame. A ‘usance/time’ LC will specify when payment will be made at a future date and upon presentation of the required documents.b. Bank Guarantee: In BG the bank guarantees a sum of money to a beneficiary. The sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract. The real estate companies for example normally need to furnish the BG to the Local Bodies or Authorities who sanction and approve the land for commercial/ residential or industrial use. c. Deferred Payment GuaranteeThat is paid a fixed number of days after shipment or presentation of prescribed documents. It is used where a buyer and a seller have close working relationship because, in effect, the seller (beneficiary of the L/C) is financing the purchase by allowing the buyer a grace period for payment. It differs from a



sight draft or time draft in that no drafts are involved but the payment is guaranteed on the stated date. However, there being no draft, the beneficiary party's ability to discount or sell his or her right to payment is restricted.

4.5 Working Capital Assessment:For running any business activity the unit/firm requires mainly two types of assets i.e. Current Assets and Fixed Assets. For financing Fixed Assets we generally sanction Term Loan or Deferred Payment Guarantees (DPG) and for Current Assets, we sanction Cash Credit Limit, Bills Purchase/Discounting and/or Over Draft against Book Debts Limits.Mainly there are three types of Borrowers approaching banks for working capital finance.

Trading Concerns Manufacturing Units (Small/Medium and Large) Service Sector

Incase of manufacturing units, Current Assets comprise Raw Materials, Semi Finished goods, Finished Goods, Receivables, cash etc. these assets go through the operating cycle of the business units and based on operating cycle requirement/quantum for working capital are decided.In case of Trading concerns, Current Assets comprise Stocks, Debtors, receivables and advance paid to supplier of stocks. Where as in service activity, Current Assets comprise, expenses on Wages, Rent, Electricity etc., Working capital or Gross Working Capital means funds required for Current Assets. Current Assets in any unit/firm are funded from mainly three sources:

Trade Creditors. Margin (Net Working Capital) from the party. Bank Finance in the form of Cash Credit, Bills Limit and/or Over

Draft against Book DebtsWith a view to streamlining credit delivery system of commercial banks so as to falling line with the International Practice and uniformity in the Banking system, RBI had appointed several committees in the past. Some of the important committee are-

Daheja Committee in 1968; Tandon Committee in 1975; Chore Committee in 1978 and Nayak Committee in 1993.

As part of Financial Sector Reforms, RBI bestowed operational freedom in the area of credit dispensation upon banks in its monetary and Credit policy for the first Half Year of 1997-98. The prescription in regard to Assessment of Working Capital needs based on the concept of Maximum Permissible Bank Finance (MPBF) enunciated by Tandon.Committee was withdrawn and Banks were advised to evolve an appropriate system for assessing the Working Capital Credit needs of borrowers subject to



observance of prudential guidelines and exposure norms. In tune with liberalized environment the following system is being adopted generally for assessment of Working Capital Requirement of the Borrowers.

4.6: Methods for Assessment of Working Capital:i. Operating Cycle Method.ii. Drawing Power Method. iii. Cash Budget methodTurnover Method.iv. MPBF method /Projected Balance Sheet Method

i.Operating Cycle Method: Meaning of operating cycle:

It begins with acquisition of raw materials and ends with collection of receivables.

Stages:

1) Raw materials (RM/RM consumption)2) Work-in-process (WIP/COP)3) Finished Goods (FG/COS)4) Receivables (Debtors/Credit sales)Less: Creditors (creditors/purchases)

Example of Operating Cycle:Length of operating Cycle:a) Procurement of raw material : 30 daysb) Conversion/process time : 15 daysc) Average time of holding of finished goods: 15 daysd) Average collection period : 30 dayse) Total operating cycle : 90 daysf) Operating cycle in a year : 4g) Total operating expenses per annum : Rs.60 lacsh) Total turnover per annum : Rs.70 lacsi) Working capital requirement : 60/4= 15 lacs

ii.Drawing Power (DP) Method:(For units with small limits)Drawing power is arrived at on the basis of valuation of current assets charged to the bank in the shape of hypothecation and assignment, after deducting the stipulated margin. Illustration:Paid stock – 4 Margin 25% - DP = 3Semi-finished goods – 4 Margin 50% - DP=2



Finished goods -4 Margin 25% - DP = 3Book Debts – 4 Margin 50% - DP = 2Total DP= 10

iii. Cash Budget method:Based on procurement and cash inflow). It is mainly used for Seasonal Industries (Sugar/ Rice Mills/Textiles/Tea/Tobacco/Fertilizers) Contractors & Real Estate Developers, Educational Institutions, etc.

iv.Turnover Method:(Originally suggested by Nayak Committee for SSI units)The WC requirements may be worked out on the basis of Nayak Committee recommendations for working capital limit up to Rs.6 crores from the banking system, on the basis of minimum of 20% of their projected annual turnover for new as well as existing units, beyond which WC be computed on the basis of WC cycle, after fixing stipulated margins, on each component of the WC. In case of borrowers desiring facilities under Nayak Committee recommendations and having a WC cycle of more than 3 months in a year, the WC requirements will be funded after assessing his requirements on the basis of his WC cycle, after fixing proper margins. Example:Applicable for limits up to Rs.6 crores:(a) Projected sales = Rs.10,00,000(b) Working capital requirements: 25% of projected sales i.e. Rs.2,50,000(c) Margin (contribution of Owner) : 5% of projected sales i.e. Rs.50,000(d) Working capital to be funded by bank : Rs.2,00,000

v. Maximum Permissible Bank Finance (MPBF) Method:

In July 1974, the study group headed by Shri. P.I Tandon has framed guidelines for working capital finance by banks. The recommendations made by above study group are known as Tandon Committee recommendations. Out of three methods for assessment of working capital limits proposed by Tandon Committee, RBI has accepted method I and method II, which are explained below: First Method:As per Tandon’s-I method (also called as ‘first method’) of lending the borrower has to arrange 25% of Working Capital Gap as margin.The first method can be explained from the following illustration:Let us take an example of a company which has Total Current Assets (TCA) of Rs.100.00 and Other Current Liabilities(OCL)i.e.(without working capital facilities from the bank) is Rs.20.00.Now we will compute the Maximum Permissible Bank Finance(MPBF) under method-I.



TCA=100 and OCL=20WCG is (TCA-OCL) =100-20=80----------------------Let us call it as (A)25% of WCG =80*25/100=20-----------------Let us call it as (B)( i.e. Minimum Net Working Capital)In this case, Maximum Permissible Bank Finance (MPBF) = (A)-(B) =80-20=60Therefore, MPBF from Bank under first method is Rs. 60 if Total Current Asset is Rs. 100.Current Ratio in first method: Since Total Current Liabilities (including Bank finance) would be Rs.80 against Total Current Assets of Rs. 100,the minimum Current Ratio under method I would be 100:80 i.e. minimum Current Ratio is 1.25:1.

Second Method:Tandon’s-II method: In this method of lending the borrower has to arrange 25% of Total Current Assets (TCA) as margin.Illustration:Let us again take an example of TCA of a company is Rs. 20.00.Now the MPBF is calculated under second method.WCG=CA-CL=100-20=80--------------------------------Let us call it (x)25% of TCA=100*25/100=25------------------------------Let us call it as (y)The MPBF under second method is (x)-(y) =80-25=55MPBF, from Bank under the second method is Rs. 55.When Total Current Assets (TCA) is Rs.100 and working capital gap is 80.• Working capital gap : Current assets – current liabilities (other than bank

borrowings)• Minimum stipulated net working capital= 25% of current assets (excluding

exports receivables)• Actual projected NWC

Current Ratio in second method: Since Total Current Liabilities would be (20+55)=75 against Total Current Assets of Rs.100,the minimum Current Ratio under method-II would be 1.33:1.Under Turnover method, the aggregate fund-based working capital limits are computed on the basis of Minimum 20% of their projected annual turnover. The borrower has to bring the margin of 5% of the annual turnover of such borrowers as margin money.



Projected Balance Sheet Method:

The traditional approach towards projection of working capital requirement of a firm is the ‘Balance Sheet Approach’. Under this method, the working capital requirement of a firm is sought to be determined with reference to the position of current assets and current liabilities deducting the latter from the former.

Balance Sheet of ABC Company Ltd.as on 31.03.2016

(Rs. in crore)2000 2001

Cash and equivalents 4,846 3,922Short-term investments 18,95

227,67

8Total cash and short-term investments 23,79

831,60

0Accounts receivable 3,250 3,671Deferred income taxes 1,708 1,949Other 1,552 2,417Total current assets 30,30

839,63

7Property, Plant and Equipment, Net 1,903 2,309Equity and other investments 17,72

614,14

1Other assets 2,213 3,170Total assets 52,15

059,25

7Accounts payable 1,083 1,188Accrued compensation 557 742Income taxes 558 1,468Unearned revenue 4,816 5,614Other liabilities 2,714 2,120Total current liabilities 9,755 11,13

2Deferred income taxes 1,027 836Common stock and paid-in capital 23,19

528,39

0Retained earnings, accumulated other comprehensive 18,17 18,89



income of 1,527 and 587 3 9Total stockholders' equity 41,36

847,28

9Total liabilities and stockholders' equity 52,15

059,25

7

Formulas & Calculations for the Balance Sheet

Breaking up each balance sheet formula, ratio, or calculation into one of two groups. The first covers those that demonstrate a company's financial strength and liquidity, while the second gives us a glimpse into a company's efficiency in using its asset base to generate earnings

Inventory Turn & Average Age of InventoryAs this company carries no inventory. It is absolutely efficient. Its products are already sold before they are manufactured.

Receivable Turn and Age of ReceivablesAs per income statement of the company, credit sales are not listed as a separate item. Instead, we have to use the less accurate total sales or revenue figure to calculate receivable turn. Take the Rs.25.296 crores in revenues and divide it by the average receivables, Rs.3.4605 crores (3250 + 3671 divided by 2). You will end up with 7.30 turns. To calculate the number of days this translate into, take 365 divided by 7.3. In this case, it is 50 days.

Debt to Equity RatioThis company is debt free. It has no long or short term debt. If you take 0 (the amount of the company's debt) and divide it by the shareholder equity (Rs.47.289 crores) you will get 0. This means that 0% of the company's equity consists of debt; the shareholders own it all.

Final ThoughtsAll of our calculations have shown one thing; the company has virtually no risk of bankruptcy. The company has 3x the cash it needs to survive, no long term debt, no inventory to worry about, and extremely strong current and quick ratios. Its working capital per dollar of sales is 112%, excessive by any standard (especially compared to its competitors. Adobe Software had a ratio of 36%, while Oracle Systems came in at 46.5%).

The ‘Balance Sheet Approach’ to working capital is now criticized on the ground that it does not indicate the exact position of working capital and working capital derived under this approach indicates the status of a firm at a particular point of time and does not reflect the movement of value occurring in the same



during the entire accounting period. Hence, the traditional ‘Balance Sheet Approach’ to project Working Capital requirement of a firm is now replaced by modern approach, viz., ‘Operating Cycle Approach’ or ‘Cash Working Capital Approach’ to Working Capital requirement .Unlike the conventional approach, consistent with the definition, this approach views working capital as a function of the volume of operating expenses. This approach suggests that actual level of working capital requirement of a firm in a period can be appropriately determined with reference to the length of Net Operating Cycle and the operating expenses needed for the period.

4.7Types of Banking:

There are mainly three types of banking arrangements:Sole banking: Sole banking is an arrangement where a borrower avails of finance independently from only one bank, no other banks are involved.

Multiple banking:Multiple banking is an arrangement where a borrower avails of finance independently from more than one bank. Thus, there is no contractual relationship between various bankers. Also, in such arrangements, each banker is free to do his own credit assessment and hold security independent of other bankers. In multiple banking there is a principal lender.

Consortium banking: Under consortium financing, several banks (or financial institutions) finance a borrower with common appraisal, common documentation, joint supervision and follow-up exercises. In consortium banking there is a lead bank.

The practice of multiple banking has increased tremendously during the last years. This is due to the increasing competition and the bankers desire to grow in a short span of time.

4.8 Bank Rating:What is Credit Rating?Credit Rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money – an individual, corporation, state or provincial authority, or sovereign government. Credit assessment and evaluation for companies and governments is 0generally done by a credit rating agency such as Standard & Poor’s, Moody’sorFitch. These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.


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Credit ratings generally reflect a relative ranking of credit risk. For example, an obligor or debt security with a high credit rating is assessed by the credit rating agency to have a lower likelihood of default than an issuer or debt security with a lower credit rating.Credit rating scales, symbols, and definitions may vary among credit rating agencies. Credit ratings typically are expressed on a scale of alpha and/or numeric symbols, and these symbols are defined by the particular credit rating agency issuing those ratings. A typical credit rating scale, as shown in the table below, has a top rating of ‘AAA’ and may have a lowest rating of ‘D’ (indicating default).Some credit rating agencies’ scales distinguish between investment grade and non-investment grade (i.e., “speculative” or “high yield”) ratings and they draw this distinction between the ‘BBB’ and ‘BB’ rating categories (in other words, a rating that is ‘BBB-minus’ or higher is investment grade and a rating that is lower than ‘BBB-minus’ is non-investment grade).

Bank Rating Process:The rating process should guarantee the objectivity and independence of the determination of the rating as well as the supervision of the system itself. In practice, this is ensured by establishing independent rating units and rating committees (sometimes referred to as credit committees) in the bank as well as through the automation of the process. The rating systems should assess all relevant credit risks.Internal Credit Risk Rating:For the first time, banks that meet certain minimum criteria will be able to factor their internal assessment of their credit risk into the regulatory capital allocation process. This supports one of the goals of Basel II, which is to increase the risk sensitivity of the regulatory capital allocation process in the banking industry. Regulators want to encourage banks to continue to improve their internal risk management practices as this should help improve the safety of the entire banking system.External Credit Risk Rating:Banks lacking sufficient data can use external ratings. Ratings by credit rating agencies are often used in the corporate debt markets because of the depth of their issuer and default databases and because their ratings have been tested and confirmed over time. As a result, some banks match their internal risk ratings against external ratings. They also use external ratings to create credit models or to supplement their own default and loss data.Rating Agencies:



SMERA: SMERA Ratings Ltd (SMERA) is a full service credit rating agency exclusively set up for micro, small and medium enterprises (MSME) in India and has grown to rate SME, mid & large corporate . It provides ratings which enable MSME, SMEs, and Corporate to raise bank loans at competitive rates of interest

CRISIL: CRISIL Ratings is India's leading rating agency. It pioneered the concept of credit rating in India in 1987. With a tradition of independence, analytical rigor and innovation, it has a leadership position. They are a full-service rating agency. They rate the entire range of debt instruments: bank loans, certificates of deposit, commercial paper, non-convertible debentures, bank hybrid capital instruments, asset-backed securities, mortgage-backed securities, perpetual bonds, and partial guarantees.


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4.9 Types of Securities:Primary Security: Assets created out of Bank finance.Collateral Security: A form of secondary protection sometimes required by a bank and intended to guarantee a borrower's performance on a debt obligation . The primary security on a substantial business loan is typically the thing that is being financed, such as a factory, company car or shipment, but secondary or collateral security might also be requested by a bank to help assure that the loan will be repaid.

4.10Some Common Terms used in Working Capital Assessment:

SMA – Special Mention Accounts (SMAs) are those standard accounts which exhibit early warning signal and lie in between the Standard and Sub Standard (NPA) category. These accounts require special attention to reverse their downward movement i.e. slippage to NPA. As a corollary, any account classified as NPA should have appeared for some time in the SMA category unless any reason abrupt thereof (like fraud, malfeasance, etc.). Different SMA and their corresponding character are shown below.

SMA Sub-categories

Basis for classification

SMA-0/SMA-NF Non-financial(NF) signals of incipient stressSMA-1 Principal or interest payment overdue between 31-60

daysSMA-2 Principal or interest payment overdue between 61-90

days

While SMA-1 and SMA-2 are of financial character i.e. nonpayment of Principle and interest thereon the other one i.e. SMA-NF is of non-financial character.

MCLR -The Reserve Bank of India has brought a new methodology of setting lending rate by commercial banks under the name Marginal Cost of Funds based Lending Rate (MCLR). It has modified the existing base rate system from April 2016 onwards.

As per the new guidelines by the RBI, banks have to prepare Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark lending rates. Based upon this MCLR, interest rate for different types of customers


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should be fixed in accordance with their riskiness. The base rate will be now determined on the basis of the MCLR calculation. The MCLR should be revised monthly by considering some new factors including the repo rate and other borrowing rates. Specifically the repo rate and other borrowing rates that were not explicitly considered under the base rate system.As per the new guidelines, banks have to set five benchmark rates for different tenure or time periods ranging from overnight (one day) rates to one year. The new methodology uses the marginal cost or latest cost conditions reflected in the interest rate given by the banks for obtaining funds (from deposits and while borrowing from RBI) while setting their lending rate. This means that the interest rate given by a bank for deposits and the repo rate (for obtaining funds from the RBI) are the decisive factors in the calculation of MCLR.

ACR- The asset coverage ratio is a test that determines a company's ability to cover debt obligations with its assets after all liabilities has been satisfied. When calculating the asset coverage ratio, investors should exercise caution with respect to asset value; using the coverage ratio of the actual liquidation value of assets is significantly less.

Companies have two primary ways to raise capital: through debt and through equity. Equity does not need to be paid back if earnings fall, but debt must be paid back no matter what. As a result, banks and investors holding debt want to know that company's earnings are sufficient to cover future debt obligations, but they also want to know what happens if earnings falter. One option, just as it is for the average person, is to start selling assets. The asset coverage ratio tells bankers and investors how many times the company's assets can cover its debts.

The asset coverage ratio is calculated with the following equation:((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) /

Total Debt

If a company wants a loan, it goes to its banker first. The banker then analyzes the company's balance sheet to see if it can afford the loan. In particular, and especially if the company has a poor credit rating, the bank is likely to require the company to provide collateral in the form of assets that can be sold if the company defaults on the loan.

SME- Small and medium enterprises (SMEs) are critical for the economic and social development of emerging markets. They play a major role in creating jobs and generating income for low income people; they foster economic growth, social stability, and contribute to the development of a dynamic private sector.


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Escrow Account- An escrow account is a temporary pass through account held by a third party during the process of a transaction between two parties. This is a temporary account as it operates until the completion of a transaction process, which is implemented after all the conditions between the buyer and the seller are settled.Description: In real estate, the fund flows for the development of the project from any source is kept in the escrow account and the funds utilized for the same are also generated from the escrow account. Even the buyers of the housing units in a project transfer the home price to the escrow account and the amount is not transferred to the seller until the project is completed.Sometimes the construction linked payments are disbursed to the seller from the escrow account so that the builder has sufficient funds for completion of the project. Sellers also benefit from the prioritization mechanism, also called waterfall mechanism, wherein the priority based payments are made to the concerned parties.



CHAPTER-5 CASE STUDY Name of the A/C: XYZPrivateLimited

5.1 About the Company:Incorporated in 1998, XYZ Exports Private Limited is a 100% export oriented unit, engaged into manufacturing and export of gloves and aprons made from leather. The company is mainly promoted by Mr. Ram who has around two decades experience in the similar line of activity. Company mainly exports its products to European Countries and has established contacts with the overseas buyers by regular visit to get orders on a continuous basis. Raw materials required for production are raw hides, finished leather and various types of chemicals. Raw hides are procured from various suppliers situated across the country. The major stages of processing are :- washing by detergent & liming, leashing, reliming, hand fleshing for total cleaning of hairs, wet blue processing bydrums, piling & edging, trimming, shaving, fat liquoring, nailing for sun drying, drum milling. Through all these process, finished leather is produced. These finished leathers are turned into finished goods, i.e., hand gloves & aprons through cutting, stitching, turning, checking and packaging.

5.2 Gist of the Proposal:In the case study, XYZ Exports Private Limited has done review of the account along with reduction in overall limit from Rs.13.89 crore to Rs.13.86 crore by way of continuation of existing PC limit of Rs.8.55 croreat0.25% concession over card rate with CC sub limit of Rs.4.50 crore, FBP/FBD limit of Rs.3.00 Crore at 0.25% concession over card rate, standby limit under gold card facility of Rs.2.31 at 0.25% concession overcard rate under sole banking arrangement,Continuation of existing both way interchangeability from PC to FBP/FBN limit and vice-versa, restricted up to Rs.3.00 crore.



5.3 Analysis of the Balance Sheet of XYZ Private Limited:(Rs. In crore)

Financial Year ended on

31.03.2013

31.03.2014

31.03.2015

31.03.2016

Audited Audited Audited Audited Audited

EQUITY SHARE CAPITAL 0.56 0.56PREFERENCE SHARE CAPITALSECURITY PREMIUMRESERVE & SURPLUS 4.46 4.82DEFERRED TAX LIABILITIES 0.00 -0.02LESS: REVALUATION RESERVELess: INTANGIBLE ASSETSTANGIBLE NET WORTH 0.00 0.00 5.02 5.36 0.00ADJUSTED TNW (net of group investment)NET OWNED FUND 1

TERM LIABILITIES 0.00 0.05 0.05 0.00NET BLOCK (NET OF REV. RES) 0.00 0.49 0.41 0.00NON-CURRENT ASSETS 0.00 0.00 0.11 0.12 0.00CURRENT ASSETS [Other Assets2] 0.00 0.00 17.77 19.43 0.00CURRENT LIABILITIES [Other Liabilities2] 0.00 0.00 13.30 14.55 0.00Total Financial Asset under Management 1

NET WORKING CAPITAL 0.00 0.00 4.47 4.88 0.00DISBURSEMENT 1

GROSS SALES 23.72 20.15NET SALES INTEREST INCOME 1

OTHER OP INCOME 2.61 2.33



GROSS PROFITOTHER INCOME 0.17 0.22PBDIT (excl. Other income) 1.89 1.88PBDIT 2.06 2.10DEPRECIATION 0.09 0.15PBIT 1.97 1.95INTEREST 1.12 1.33PROFIT BEFORE TAX 0.85 0.62PROV. FOR CURRENT TAX 0.26 0.21PROV. FOR DEFERRED TAX -0.02PROFIT AFTER TAX 0.00 0.58 0.42ADD: DEPRECIATION 0.09 0.15ADD: PROV. FOR DEF. TAX -0.02ADD: NON-CASH EXP.LESS: NON-CASH INCOMEGROSS CASH GENERATION 0.67 0.55LESS: DIVIDENDNET CASH GENERATION NON-CURRENT ASSETSINVESTMENT IN ASSOCIATE/GROUPINVESTMENT IN OTHERSRECEIVABLES OVER 6 MONTHSLOANS/ADV TO ASSOCIATE/GROUPLOANS/ADV TO OTHERS 0.11 0.12LONG TERM MARGIN MONEYADV FOR CAPITAL GOODSADV TOWARDS SHARE



INTER CORPORATE DEPOSITSOTHERSTOTAL 0.00 0.00 0.11 0.12 0.00 BLOCK ASSETSGROSS BLOCK (NET OF REV RES) 1.34 1.36LESS ACCUMULATED DEPRECIATION 0.85 0.95OPERATING FIXED ASSETS 0.00 0.00 0.49 0.41 0.00Assets given under Operating Lease 1 0.00CAPITAL WORK IN PROGRESSNET BLOCK (NET OF REV. RES) 0.00 0.00 0.49 0.41 0.00

CURRENT ASSETSInventories 10.18 9.94Trade Receivables 3.25 3.67Cash & Cash Equivalents 1.87 3.43Short Term Loans and Advances 1.50 1.67Other Current Assets 0.97 0.72TOTAL 0.00 0.00 17.77 19.43 0.00 CURRENT LIABILITIESSHORT TERM BORROWING 12.57 13.24TRADE PAYABLES 0.53 1.16CREDITOR FOR EXPENSESADVANCE FROM CUSTOMERSPROVISION FOR TAXESSHORT TERM PROVISIONS 0.07 0.08INSTALMENTS OF



TL/DEB/PREF SHARE,ETC.OTHERS 0.13 0.07TOTAL 0.00 0.00 13.30 14.55 0.00 TERM LIABILITIESOCDNCDBONDSOther Rupee Long Term BorrowingsUnsecured Borrowings from related parties

0.05 0.05

Other Long Term Liabilities & ProvisionsTOTAL 0.00 0.00 0.05 0.05 0.00 INTANGIBLE ASSETSACCUMULATED LOSSMISC. EXP. NOT WRITTEN OFFDEFERRED TAX ASSETSINTANGIBLE FIXED ASSETS (if any)OTHERSTOTAL 0.00 0.00 0.00 0.00 0.00 RATIO ANALYSISTOL/TNW 2.659362

552.723880

6TOL/ Adjusted TNW

DEBT/EQUITY 3 0.71 0.00996016

0.00932836

TOL / NOF 1

Current Ratio 1.33609023

1.33539519

Current Ratio without installment

1.33609023

1.33539519

CRAR 1



GROSS NPA % 1

NET NPA % 1

COLLECTION EFFICIENCY % 1

GROWTH % IN DISBURSEMENT 1

% of Gold Loan in Financial Asset 1

Average Loan to Value % 1

GROWTH % IN NET SALES/REVENUEGROSS PROFIT/NET SALES %INTEREST COVERAGE RATIO 4

NWC/TCA%BANK BORROWING/TCA%OCL (including sundry creditor)/TCA%PBDIT(EXCL OTH INC)/NET SALES%ROACE 5

ROAOCE 6

DSCR 3

PRIORITY OBLIGATION RATIO 4

5.4 Sanction of Working Capital Limits:(Rs. in crore)

ProposedPacking Credit (PC) 8.55(Cash Credit-sub limit of PC) (4.50)FBP/FBD 3.00Standby limit under Gold Card Facility 2.31TOTAL 13.86

5.5 Credit Rating by Agencies with Purpose of such Rating:

Agency Rati Date of Significance of Purpose Valid till



ng Rating Rating

XXX A4+ May 15

Minimal degree of safety regarding timely payment of financial obligations.

ST Bank loan rating

May 2016

Comments:XXX has re-affirmed rating at A4+ for company’s short term bank loan facilities of Rs.13.86 crore which include PC of Rs.8.55 crore, FBP of Rs.3.00 crore and stand by limit under gold card facility of Rs.2.31 crore, indicating minimal degree of safety. The ratings remain constrained by the company’s small scale of operations, working capital intensive business and high leverage (debt equity ratio). The ratings note that the company’s profit margins are susceptible to volatility in raw material prices. The ratings are also constrained by the company’s exposure to geographical concentration risk. However, the ratings are supported by the company’s experienced management and moderate liquidity position. The ratings also draw comfort from the company’s entitlement to export incentives.

5.6 Financial Position of the Company as on Close of Financial Years for Last Three Years:

(Rs. in crore)

31-Mar-14

31-Mar-15

31-Mar-16

31-Mar-17

Audited

Audited

Prov. Estimated

Share Capital 0.56 0.56 0.56 0.56Security Premium -- -- -- --Reserves & Surplus (Excluding rev. reserve)

4.46 4.82 5.23 5.75

Deferred Tax Liability -- (0.02) -- --Tangible Net Worth 5.02 5.36 5.79 6.31Adjusted TNW 5.02 5.36 5.79 6.31Term Liabilities 0.05 0.05 0.05 0.05-Unsecured borrowings 0.05 0.05 0.05 0.05Net Block incl. CWIP 0.49 0.41 0.85 1.14Non-Current Assets 0.11 0.12 0.14 0.14-Loans & advances to others 0.11 0.12 0.14 0.14Current Assets 17.77 19.43 19.74 20.10-Cash & bank balance 1.87 3.43 2.53 2.85-Trade Receivables 3.25 3.67 3.60 3.50



-Inventories 10.18 9.94 10.61 11.00-Short term loans & advances 1.50 1.67 3.00 2.75-Others 0.97 0.72 -- --Current Liabilities 13.30 14.55 14.88 15.01-Bank borrowings 12.57 13.24 13.86 13.86-Creditors 0.53 1.16 0.90 1.00-Provision for taxes 0.07 0.08 0.05 0.05-Current maturities of long term debt

-- -- -- --

-Others 0.13 0.07 0.07 0.10Net Working Capital 4.47 4.88 4.86 5.09Net Sales/ Revenue Income 23.72 20.15 20.00 23.00Other Income (Operational) 2.61 2.33 2.15 2.37Other income(non-operational) 0.17 0.22 -- --PBDIT (excl. non-operational income)

1.89 1.88 1.81 2.06

PBDITA 2.06 2.10 1.81 2.06Depreciation 0.09 0.15 0.10 0.11PBIT 1.97 1.95 1.71 1.95Interest 1.12 1.33 1.04 1.20Profit Before Tax 0.85 0.62 0.67 0.75Provision for Tax 0.27 0.20 0.21 0.18Profit After Tax 0.58 0.42 0.46 0.57Depreciation 0.09 0.15 0.10 0.11Prov. For deferred tax -- (0.02) -- --Gross Cash Generation(Net) 0.67 0.55 0.56 0.68Less: Dividend 0.04 0.04 0.04 --Net Cash Generation 0.63 0.51 0.52 0.68

5.7 Ratio Analysis:

31-Mar-14

31-Mar-15

31-Mar-16

31-Mar-17

Audited Audited Prov. Estimated

TOL/TNW 2.65 2.72 2.54 2.35TOL/ Adjusted TNW 2.65 2.72 2.54 2.35Debt/Equity -- -- -- --Current Ratio 1.34 1.33 1.33 1.34Current Ratio Without Installment

1.34 1.33 1.33 1.34

Growth % in Net Sales/Revenue 43.23% -ve -- 15%PBDIT(Excl Other Inc)/Net Sales%

7.97% 9.33% 9.05% 9.36%

PBT / Sales % 3.58% 3.07% 3.35% 3.41%



PAT / Sales % 2.44% 2.08% 2.30% 2.60%

5.8 Movement of TNW:(Rs. /crore)

31-Mar-15 31-Mar-16 Audited Prov. Opening TNW 5.02 5.36Increase in Share Capital -- --Increase in Security Premium -- --Increase in Share Application -- --Increase in Reserve & Surplus 0.36 0.41Increase in deferred tax liability (0.02) 0.02Closing TNW 5.36 5.79

5.9 Fund Flow Analysis:(Rs. / crore)

31st March 2015 2015

31st March 2015 2016

Inc in TNW 0.34 0.43 Inc in Net Block (0.08 0.44

Inc in Term Liabilities -- -- Inc in non-current assets

0.01 0.02

Total long term sources 0.34 0.43 Total Long term uses

(0.07 0.46

Long Term Deficit 0.03 Long Term Surplus

0.41

Short Term Sources Short Term uses

Cont. from Long Term 0.41 Cont. towards Long Term

0.03

Inc in current liabilities (excl. Bank Borrowings)

0.58 Increase in Current Assets

1.66 0.30

Decrease in current assets Decrease in current liabilities

0.29

Total short term sources 0.99 -- Total Short term uses

1.66 0.62

Short Term Deficit 0.67 0.73

Short Term Surplus

Dec in Bank Borrowings Inc in Bank Borrowings

0.67 0.62



Comments:

Reasons for change in TOL/TNW TOL/Adjusted TNW, D/E, and limit/TNW: - Company’s TNW has been growing consistently over the years. TNW has improved from Rs.5.36 crore in FY 2015 to Rs.5.79 in FY 16 on account of retention of profit into the business. TOL/TNW has improved from 2.72 as on 31.03.2015 to 2.54 as on 31.03.16 on account of more than proportionate increase in TNW compared to outside liabilities. TOL/TNW is well within our benchmark level.

Movement in non-current assets: Non-current assets constitute a small portion of total assets as on 31.03.2016.

Movement in Current Ratio / NWC:-. Company’s liquidity position is satisfactory with current ratio at 1.33 as on 31.03.2016 and above ratio is in compliance with our benchmark level. Even though company’s nature of business is working capital intensive, it has been able to maintain moderate liquidity profile based on its inherent strength in export market. Company has established a long term business relationship with its European customers and payment from customers are received in time, thereby enabling the borrower to maintain a healthy liquidity profile. Based on the above established strength/creditworthiness, our bank has extended gold card facility to the captioned borrower.

Movement in sales/revenue: Company is an export oriented unit and its revenue income mainly consists of income from export operations. Like any other export oriented unit, company’s revenue has remained stagnant during the last two fiscals on account of sluggish global market condition. During FY ended 31.03.2016, company has achieved export turnover of Rs.20.00 croreas per provisional figure. However company’s long standing business relationship with European customers and demand for industrial leather aprons in mines provide cushion against downturn in overseas market.

Profitability: Company’sprofit margins are susceptible to volatility in raw material prices, given that raw materials costs account for 87% of total sales. EBDITA margin has marginally declined from 9.33% as on 31.03.2015 to 9.05% as on 31.03.2016. However PBT and PAT margins have shown improvement on account of savings in depreciation expenses and lower interest outgo. While PBT margin expanded from 3.07% to 3.35%, PAT margin stood at 2.30 % as against last year level of 2.08%.

Status of statutory obligations: No adverse reporting is made by the statutory auditors in its Report for the FY 2014-15 with respect to payment of undisputed statutory obligations.

5.10 Computation of ACR for the Working Capital Limit:(Rs. In crore)

Type Particulars Basic of Val



Valuation uePrimary

Exclusive charge on company’s entire current assets including raw materials, WIP, finished goods and receivables (both present & future)

As per Prov. 2015-16

19.74

Collateral Tangible

Equitable mortgage of office premises As per valuation report dated 11.07.2015

3.41

Intangible

Personal Guarantee of the Directors - -

Total Securities - 23.15

Proposed Loan - 13.86

Asset Coverage Ratio (ACR) 1.67



5.11 Assessment of Working Capital:5.11.1 Computation of maximum permissible Bank Finance (MPBF):

31.03.2014

31.03.2015

31.03.2016

31.03.2017

(AUDITED)

(AUDITED)

(Prov) (Est)

RAW MATERIAL CONSUMPTION-INDIGENOUS

23.63 18.07 17.90 19.80

COST OF PRODUCTION 23.66 20.06 19.65 21.62COST OF SALES 23.67 19.86 19.62 21.52SALES 23.72 20.15 20.00 23.00CURRENT ASSETSRAW MATERIALS-INDIGENOUS

2.72 2.42 2.80 3.00

MONTH CONSUMPTION (1.38) (1.61) (1.88) (1.82)STOCK IN PROCESS 4.58 4.44 4.70 4.80MONTH COST OF PRODUCTION

(2.32) (2.65) (2.87) (2.66)

FINISHED GOODS 2.88 3.08 3.10 3.20MONTH COST OF SALES (1.46) (1.86) (1.73) (1.78)EXPORT RECEIVABLES 3.25 3.67 3.60 3.50MONTH SALES (1.64) (2.18) (1.96) (1.83)OTHERS* 4.34 5.82 5.54 5.60TOTAL (A) 17.77 19.43

19.74 20.10SUNDRY CREDITOR FOR GOODS

0.53 1.160.90 1.00

MONTH PURCHASE (0.51) (0.74) (0.59) (0.60)ADVANCE FROM CUSTOMERS

-- -- -- --

STATUTORY LIABILITIES 0.07 0.08 0.05 0.15OTHERS 0.13 0.07 0.07 --TOTAL (B)

0.73 1.31 1.02 1.15

WORKING CAPITAL GAP (A-B)

17.04 18.12 18.72 18.95

25% OF TOTAL CURRENT ASSETS EXCLUDING EXPORT RECEIVABLES (C)

3.63 3.94 4.03 4.15

ACTUAL/PROJECTED NWC (D)

4.47 4.884.86 5.08



WCG -(C) (E)

13.41 14.18 14.69 14.80

WCG -(D) (F)

12.57 13.24 13.86 13.87

MPBF (MIN. OF E & F) 12.57 13.24 13.86 13.87

While calculating the MPBF, the holding levels for different items of current assets and current liabilities are considered as under:-

(in months)

ParticularsActualAs on

31.03.14

ActualAs on

31.03.15Prov. as on 31.03.16

Estimation for FY 2016-17

Raw materials (Indigenous)

1.38 1.61 1.88 1.82

WIP 2.32 2.65 2.87 2.66Finished goods 1.46 1.86 1.73 1.78

Export Receivables 1.64 2.18 1.96 1.91

Creditors 0.51 0.74 0.59 0.60

The above estimation/projection of holding period appears to be to be realistic considering the past trend.

Other Current Assets include Cash & Bank Balance, Short Term Loans & Advances as under:

(Rs. In crore) Particulars FY 14 FY 15 FY 16 FY 17Short term loans & advances 1.50 1.67 3.00 2.76Cash & bank balance 1.87 3.43 2.54 2.84Others 0.97 0.72 -- --TOTAL 4.34 5.82 5.54 5.60

PC & FBP/FBN Limit has been Assessed as under:-Projected Export Turnover for FY 16-17 Rs.23.00

crore



Usance period 180 daysLimit for usance period (23.00*180/360) Rs.11.50 crorePC and FBP/FBN limit proposed Rs.11.55 crore

Comments:. Renewal of the limit is now recommended at existing level of Rs.11.55 crore. The above limit includes PC of Rs.8.55 crore and FBP/FBN of Rs.3.00 crore. As per estimated financial for 2016-17, export receivables are estimated at Rs.3.50 crore which seems to justify FBP/FBN limit of Rs.3.00 crore. Conduct of the account is satisfactory with timely realization of PC and FBP/FBN liabilities and there are no instances of crystallization of foreign bills.

Continuation of existing CC limit of Rs.4.50 crore as sub limit of PC limit of Rs.8.55 crore:TheCompany is presently enjoying cash credit limit to the tune of Rs.4.50 crore within the overall packing credit limit of Rs.8.55 crore. The company has proposed that though it is a 100% export oriented unit, yet it might need cash credit limit for execution of domestic orders if need arises. Considering the same it has requested for the continuation of the existing cash credit limit of Rs.4.50 crore within the overall packing credit limit, which has been duly recommended by RO as well. Considering company’s satisfactory operation and long standing credit relationship, we recommend for continuation of our existingcash credit limit of Rs.4.50 crore within the overall packing credit limit of Rs.8.55 crore may be considered.

Continuation of Standby limit under Gold Card Facility of Rs.2.31 crore :The company is presently enjoying Gold Card facility of Rs.2.31 crore to meet urgent credit needs arising out of executing sudden orders. Conduct of the account is satisfactory. As per lending Policy of the bank, the exporter shall be sanctioned an additional standby limit not less than 20% of the assessed fund based limit under export credit to facilitate urgent credit needs arising out of executing sudden orders. The export credit limit as earlier assessed is at Rs.11.55 core and 20% of Rs.11.55 crore comes to Rs.2.31 crore, which can be maximum limit under Gold Card Scheme outside MPBF. All credit worthy exporters with good track record including those in the small and medium sector shall be eligible under gold card scheme subject to fulfillment of certain criteria and compliance status with respect to eligibility criteria for availing standby limit under Gold Card facility as per Bank’s Lending Policy.

5.12 Loan Policy:Benchmark parameters as per Lending Policy:-

Parameter As per Lending As per Audited Status of compliance



PolicyFinancials of

31.03.15Credit Risk Rating

Minimum UBICR 3

CR 3 Complied

Promoters’ contribution in the Equity

Minimum 20% 100% Complied

TOL/TNW Maximum 4:1 2.72 CompliedDER Maximum 3:1 -- CompliedCurrent Ratio (without term loan installments)

At least 1.18 (For export credit)

1.33 Complied

ACR

Preferably be 1.33 or more but not less than 1.20

1.67 Complied

Overall limit (FB+NFB) /TNW

Maximum 5 times

2.59 Complied

5.13 Rationale for Recommendation: Company is one of our prestigious clients of overseas branch maintaining a

satisfactory credit relationship with us since 1998, Company has been engaged into manufacturing of leather accessories since

1991 and successfully exporting its products to European countries, Company’s overall financial position is satisfactory with moderate liquidity

profile. The operation and conduct of the account are satisfactory. Exposure is coming under export and MSE segment which is a thrust area of

lending. Exposure is adequately covered by the securities. ECGC coverage is available for export credit limit.

Strengths & Weakness:Strengths:



Experienced management with two decades experience in similar field. Company’s overall financial position is satisfactory. Company is entitled to receive export incentives under schemes proposed by

Ministry of Commerce & Industry, GOI. Our long standing satisfactory business relationship with the company since

1991, The operation and conduct of the account are satisfactory. Company is a gold card holder exporter which indicates its creditworthiness

with good track record as exporter.

Weakness: Company’s profit margins are susceptible to volatility in raw material prices,

given that raw materials costs account for 87% of total sales. Exposure to geographical concentration risk as its business is concentrated in

Europe and decline in demand for leather accessories in the European market.

Company’s small scale of operations limits its bargaining power.



CHAPTER-6 LEARNING POINTS A business requires funds in order for it to be successful in the wide industry of corporations. This will serve as the lifeblood of the company for without it, the business will also be nothing. Aside from serving as fixed assets financing, all business definitely need funds on a regular basis in order for its operations to continue. This will encompass the expenses made for raw material purchases, manufacturing, followed by selling and finally administrating the sold until money is realized. Business transactions are usually made on credit with several days elapsing before the proceeds of the sale will be able to pay for it. Although most of the materials can be bought on credit, any business will still have to pay the employees, meet the expenses for manufacturing and selling such as power, wages, transportation, supplies and communication as well as balance the purchases of the raw materials. Working capital basically means as the financing source needed by the business entities on a regular basis so that needs will be met.

6.1 Characteristics of Working Capital:

Needs that are Short Term: Working capital is being utilized in acquiring current assets which will be converted to cash for a short period only.

Circular Movement: Working capital is being converted to cash constantly which will just be turned as a working capital all over again.

Permanency: Although it is just a kind of short term capital, working capital is needed by a business forever and always.

Fluctuation: Working still fluctuates every now and then even it is something permanent.

Liquidity: It is very liquid for it can be converted as cash any time without losing anything.

Less Risky: Investments in current assets such as working capital comes with less risk for it is just for short term.

No Need for Special Accounting System:Since working capital is a short term asset that will last for a year only, there will be any need for adoption of a special accounting system.



6.2 The Pros & Cons of Working Capital: Positive Working Capital: Positive working capital is the excess of current

assets over current liabilities. In other words, when the net working capital is a positive figure, it is said that the firm has a positive working capital.

Pros:

Fight against Bankruptcy: It is an obvious fact that we should have more dollars in a pocket than the list of expenses we have planned. On the similar lines, from a liquidity and bankruptcy point of view, it is always desirable to have positive working capital. It ensures more incoming dollars than the planning of outgoing dollars.

Grab New Opportunities: A company with positive working capital is better positioned to take advantage of new business opportunities. Since the company has available supplier’s support and the additional funds also which are a prerequisite to encash the new opportunity.

Funds Availability from Banks: Under normal circumstances, banks fund only the working capital gap and not the whole current assets. Working capital gap means net working capital. If the gap between current assets and liabilities is positive, the bank is keen to fund otherwise not. As per banks, the company does not require funds.

Cheaper Financing: If the current assets are financed by the trade credit i.e. current liabilities, by forgoing the discount allowed. The cost of trade creditis normally higher compared to bank finance. It is desirable to take bank finance and avail the trade discount given by the supplier.

Cons: Dependency on Banks: Companies having positive working capital

requires funds from the banks or financial institutions for running the operating cycle of their business. On the contrary, if the company is dependent upon the supplier’s for their business cycle, bank dependency is avoided. It is not necessary that the bank will definitely finance the working capital gap. They may have their own reservations on the same.

Cheaper Financing: If the Cost of Trade Creditis less than the bank finance, it is very obvious that the company will save on the cost of funds i.e. their interest cost and increase its profitability.

Negative Working Capital (NeWC): It is not always bad to have negative working capital. A lot of giant companies with established brands have negative working capital because they are able to bargain very well with their suppliers. They have the muscle power of bulk demand.

Pros:


https://www.efinancemanagement.com/working-capital-financing/cost-of-trade-credit

http://www.efinancemanagement.com/working-capital-financing/cost-of-trade-credit

http://www.efinancemanagement.com/working-capital-financing/cost-of-trade-credit

https://www.efinancemanagement.com/working-capital-financing/net-working-capital


Low Cost of Funding Current Assets: The first thing that would come to our mind is the interest cost of funds if funded by banks. It is because trade credit has no explicit interest cost. The funds are provided by the suppliers and the time limit to pay is also flexible to a great extent. This will depend on a company to company and supplier to supplier.

Cash Richness and Earnings from Investments: Companies having negative working capital may not always have fixed assets financed by current liabilities i.e. suppliers.

Some company may be smart enough who at one side negotiate hard with the suppliers to get credit and on the other side collect money from the customer faster. The money received from the customer is not paid to the supplier but are invested in short-term investments to earn interest. These companies not only save the interest cost of working capital but also earn some interest out of investments.

Must for Some Industries: Take example of companies like Amazon, eBay etc. They purchase goods on credit but sell the goods on cash and their inventory movement is also fast. The shelf life of the product is also not long. For such companies, it is obvious to have negative working capital. On the contrary, if the management is not able to achieve negative working capital, they would be considered inefficient. Similar is the case of retailers who purchase on credit but sell in cash. They also can develop free cash. Telecom companies are famous for having NeWC.



Cons:

Bankruptcy Risk: Companies with negative working capital are using the money of creditor to finance current assets as well as a part of fixed assets. Buying fixed assets with this money can pose some financial trouble anytime. When the payment of accounts payable will be due, the company may fall short of cash and it will be difficult to sell the fixed assets where the money from current liabilities is stuck. This will leadto bankruptcy risk for the company.

Lower Rating Resulting in Higher Interest Rate: Business with NeWC arestruggling to make payment to the creditors and not able to collect money or sellthe lying stock with it. The credit rating of such companies is bound to go down. Lower rating results in higher interest rates charged by the banks.

Growth Opportunities Missed: Negative working capital effectively means no working capital. No growth crop up without money. Without spare working capital, a company is not able to take up any seasonal and special growth opportunities. This is how companies with NeWC misses the growth opportunities.

Investors and Bankers don’t find it worth Investing: Positive working capital is a sign indicating growth and profitability in the business. Also, negative working capital implies over funding by suppliers. In both of the situations, a banker or investor would not find it worth investing in such a company.

Lost Trade Discount: Normally, if a company is having NeWC, it is understood that the accounts payables are not paid on time and that will definitely vanish the trade discount which is only allowed if paid within a certain period of time.

Bad Financial Reputation: Not only does a company having NeWC lose on trade discounts but also lose the financial reputation in the market.

Non-paying and late paying, both are crimes for supplier relationships. Bad financial reputation is a slow poison and it reaches a point when all suppliers in the market stop releasing credit to the company.

Winding up petition by Creditors: When the creditor’s concern changes from late payment to probably no payment, there are good chances that they may file a petition for winding up of the company for the sake of their hard earned money.

Bad Fixed Asset Turnover: Fixed asset turnover ratio indicates that how many sales are generated using the fixed assets of the company. Higher the sales generated using the fixed assets, higher will be the ratio and higher would be the leverage of the using the fixed assets. Without working capital,



it is not possible to push the sales. This leads to inefficient use of the fixed assets also.


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