ASSESSMENT OF WORKING CAPITAL

• What is Working Capital ?

Funds deployed for day-to-day operational requirements of any industry or business is referred to as “Working Capital”.

This essentially goes into the financing of Current Assets of the firm comprising of raw-materials, stock-in-process, finished goods (stock-in-trade) and receivables apart from a reasonable level of cash & bank balance.

All businesses undergo an Operating Cycle. This starts with cash; converted to stocks of raw-materials; undergoes a process of manufacturing/ value-addition is converted to finished products and then to receivables after sale before ending with cash again.

Working capital is for short-term requirements as against Fixed Capital, which is meant for acquisition of fixed assets like land, building, plant, machineries, furniture & fixtures, vehicles etc..

The need for working capital arises to ensure continuity of the business activity. It is required for such day to day operations like purchase and stocking of raw materials, stores and spares, to convert them into finished goods and to store them until sale and generation of cash therefrom.

OPERATING CYCLE

FINISHEDGOODS

FINISHEDGOODS

RAW-MATERIALS

RAW-MATERIALS

CASHCASH

DEBTORSDEBTORSSTOCK-IN-PROCESS

STOCK-IN-PROCESS

CREDITORS

In the context of Balance Sheet, the term “Working Capital” is used in two senses:

“Gross Working Capital” refers to the Total Current Assets.

“Net Working Capital” refers to the difference between “Current Assets” and “Current Liabilities”.

In other words, ‘Net Working Capital’ is that component for financing of current assets that comes from long-term sources.

The “Operating Cycle” comprises of : i. time taken for purchase and storage of raw-

materials (including stores & spares); ii. period for manufacturing/ processing and

converting them to finished goods; iii. storage time for finished goods till sale; iv. period of credit allowed to the customers/

debtors.

The requirement of Working Capital is dependant on the length of this cycle and the fund requirement(s) at each of the above four stages less the credit availed from the suppliers of raw-materials/ inputs.

The estimated requirement/ build-up of Gross Working Capital (Total Current Assets) would resultantly comprise of :

i. Raw-materials (consumption for the holding period);

ii. Stock-in-process (time taken for the production); iii. Finished Goods (for the period of storage before

being sold); & iv. Receivables (for the credit period extended).

Besides the above, there may be some other Current Assets like an acceptable level of Cash and Bank Balance and advance to suppliers etc..

Holding Periods : Raw-materials – (Months’ consumption)Average holding of raw-materials-------------------------------------------------- X 12Raw-materials consumed during the year

Stock-In-Process – (Days’ Cost of Production)

Average holding of S-I-P-------------------------------------------- X 365Cost of Production during the year

Finished Goods – (Months’ Cost of Sales)

Average Stock of Finished Goods------------------------------------------- X 12Cost of Goods Sold during the year

Sundry Debtors – (Months’ Sales)

Average holding of Debtors----------------------------------- X 12Sales during the year

Sundry Creditors – (Months’ Purchases)

Average Creditors Outstanding---------------------------------------- X 12.Total Purchases during the year

The requirement of working capital may be computed accordingly :

Components Period Value (In Rs. Lacs)------------------------ ------------ -------------------------i. Raw-materials ----- Days/Months ---------ii. Stores & Spares ---- Days/Months ---------iii. Stock-In-Process ----- Days/Months ---------iv. Finished Goods ----- Days/Months ---------v. Sundry Debtors ------ Days/Months --------- ----------------- -------------- Total Chargeable Current Assets : -------- Other Current Assets : --------- Total Current Assets : --------- Less Sundry Creditors : --------- -------------- Gross Working Capital : --------- Less Margin : --------- -------------- Working Capital Limit : ---------

ASSESSMENT OF BANK FINANCE FOR WORKING CAPITAL : (DIFFERENT APPROACHES)

. The requirement of working capital for any unit is assessed differently by different banks.

By and large, there are basically 3 approaches for such assessment. They are :

i. Nayak Committee or Projected Annual Turnover Method;

ii. MPBF method of Tandon/ Chore committee; iii. Cash budget method.

NAYAK COMMITTEE (Projected Annual Turnover Method) :

Bank Finance for working capital to be extended to the extent of a minimum of 20 % of the Projected Annual Turnover.

The “Gross Working Capital” has to be estimated at 25% of such projected turnover.

The “Net Working Capital” (NWC) should be a minimum of 5% of turnover, which has to be met out of the Promoters’ contribution/ from long-term sources.

The remaining 20% may be extended by bank(s) as short-term bank borrowing or Working Capital Finance.

The following important points may be reckoned with reference to the above method of financing :

This method assumes an operating/ production cycle of 3 months (4 operating cycles in a year). Hence, Gross Working Capital is estimated at 25% of the projected turnover.

The bank finance should therefore be a minimum of 20% of the projected turnover. In case of longer cycles, the bank finance may be more. However, matching contribution in the form of NWC amounting to 20% of the GWC is to be brought in by the borrower from long-term sources.

In case the projected NWC is more than the minimum stipulated 5%, the same should be reckoned with and the PBF should be scaled down to that extent.

This simplified method of lending for working capital has been adopted by banks for financing working capital requirements of SSIs up to Rs.5.00 Crores and other non-SSI borrowers up to Rs.2.00 Crores.

However, in certain cases banks do also apply the operating cycle or MPBF method for a comparative analysis.

MPBF: 2nd Method of Lending (Tandon/ Chore Committee):

Before attempting this concept of Working Capital finance, let us define the following terminologies :

I. Gross Working Capital = Total Current assetsII. Net Working Capital = Total Current Assets – Total Current Liabilities.

III. Other Current Liabilities (OCL) = Current Liabilities other than bank

borrowings.IV. Working Capital Gap = Total Current Assets – Other Current Liabilities (TCA-OCL).

V. MPBF = Maximum Permissible Bank Finance.

There are three sources of financing the total Current Assets (or Gross Working Capital). They are : Other Current Liabilities (or Creditors and advance from

customers predominantly); Net Working Capital (amount from long-term sources);

and Bank Borrowings as given by MPBF computation.

After the first step of sourcing finance from Trade Creditors, the remainder is called Working Capital Gap.

The second step involves the amount of Net Working Capital (NWC), to be brought in from long-term sources.

Under the the First method, minimum stipulated NWC is 25% of the Working Capital Gap. Whereas, under the 2nd method, the minimum required NWC is higher; i.e., at 25% of Total Current Assets.

After reckoning higher of minimum stipulated NWC or actual NWC, the remainder qualifies as the MPBF (Maximum Permissible Bank Finance).

Since, the minimum warranted NWC under the 2nd method of lending is 25% of the total current assets, it implies a minimum Current Ratio of 1.33.

The steps are shown in the table below under both the methods.

First Method of Lending Second Method of Lending

I. Total Current Assets Total Current Assets

II. Current Liabilities (Other than Bank Borrowings)

Current Liabilities (Other than Bank Borrowings)

III.= ( I – II )

Working Capital Gap Working Capital Gap

IV. Minimum stipulated NWC (25% of III)

Minimum stipulated NWC ( 25% of I )

V. Actual/ Projected NWC Actual/ Projected NWC

VI. Item III - IV Item III - IV

VII. Item III – V Item III – V

VIII. MPBF (Lower of VI or VII) MPBF (Lower of VI or VII)

CMA Forms (to be used/submitted):

Form I ( Particulars of existing and proposed Limits ) Form II ( Operating Statement ) Form III ( Analysis of Balance Sheet ) Form IV ( Comparative Statement of Current Assets &

Current Liabilities) Form V ( Computation of Maximum Permissible Bank

Finance ) Form VI ( Funds Flow Statement ).

Cash Budget Method :

In case of Seasonal industries like sugar, tea etc. or service industries, banks assess the working capital requirements on the basis of cash-budget submitted by the borrowers.

The limit (PBF) is fixed on the basis of peak cumulative short-fall in the projected cash flow.

A simplified example is illustrated below :

Months I II III IV V VI VII VII IX X XI XII

Outflow 25 18 16 20 24 20 10 12 12 10 12 12

Inflow 0 2 4 5 12 8 14 21 34 36 32 34

Shortfall/Excess

-25 -16 -12 -15 -12 -12 +4 +9 +22 +26 +20 +22

Cumulative

-25 -41 -53 -68 -80 -92PLD

-88 -79 -57 -36 -16 +6

SOURCES USES

CURRENTLIABILITIES

FIXED ASSETS & OTHER NON-CURRENT ASSETS

LONG-TERMSOURCES

CURRENTASSETS

NET WORKING CAPITAL