WORKING CAPITAL FINANCEFunds available for a period of one year or less are called short term finance.

In India short term funds are used to finance working capital.

The two most significant ways of working capital financing are TRADE CREDIT & BANK BORROWING.

WORKING CAPITAL FINANCETwo other sources have come up in the recent years and they are : FACTORING & COMMERCIAL PAPER.

TRADE CREDIT : It refers to the credit that a customer gets from suppliers in normal course of trade. This deferral of payments is a short term financing which is called trade credit.

WORKING CAPITAL FINANCEIt is a major source of finance for firms. In India, it contributes to about 1/3rd of the total short term financing. Particularly, small firms are heavily dependant on trade credit as a source of finance since they find it difficult to raise funds from banks or other sources.TRADE CREDIT is also called SPONTANEOUS SOUCRE OF FINANCING.

WORKING CAPITAL FINANCECREDIT TERMS : This refers to the conditions under which the supplier sells on credit to the buyer, and the buyer is required to repay the credit.

A typical way of expressing credit terms is for example : 3/15 net 45. This means 3% discount is available if payment is made within 15 days and if this discount is not availed payment is to be made on or before 45 days.

WORKING CAPITAL FINANCEBENEFITS OF TRADE CREDIT :Easy availability : Unlike other sources of finance, trade credit is relatively easy to obtain.(Except in cases of financially very unsound parties).Flexibility : Trade credit grows with the growth is the firm’s sales. The growth in sales causes growth in the purchases of goods and services, which is automatically financed by trade credit.

WORKING CAPITAL FINANCEBENEFITS OF TRADE CREDIT :Informality : Trade credit is an informal, spontaneous source of finance. It does not require any special negotiations or formal agreements. It does not have the restrictions which are usually part of negotiated sources of finance.At the same time there is something called the cost of trade credit. It is nothing but the cost of foregoing the discount offered.

DECISION MAKING ON TRADE CREDITSuppose Co. “A” has to purchase raw materials worth one lakh and is extended trade credit in the terms of 2/15 net 45.Option A – Pay Rs.98,000/- on the 15th day and save Rs.2000/-.Option B – Pay 100000/- on the 45th day and thereby use the amount of Rs.98,000/- for extra 30 days. This use of funds for 30 days may generate returns more than 2000/-.

OTHER SOURCES OF SPONTANEOUS FINANCE OF WORKING CAPITAL

ACCRUED EXPENSES : Is a liability that a firm has to pay for the services which it has already received. Thus, they represent a spontaneous, interest free source of financing. (Eg. Wages, Salaries, Taxes, Interest etc.)Deffered Income : It represents funds received by the firm for goods or services which it has agreed to supply in the future.(Eg. Advance Payments).

BANK FINANCE OF WORKING CAPITALBanks are the main institutional source of working capital finance in India.The amount approved by the bank for the firm’s working capital is called the CREDIT LIMIT. Credit limit is the maximum funds which a firms can obtain from the bank for use as working capital.

BANK FINANCE OF WORKING CAPITALThe bank considers the firm’s sales, production plans and desirable level of current assets in determining its working capital requirement or the credit limit.

Actually, the banks do not lend 100% of the credit limit. They deduct the Margin money from the loan to keep as security.

FORMS OF BANK FINANCE OVERDRAFT : The borrower is allowed to withdraw funds in excess of his balance in his current account up to a certain specified limit.

The extra amount borrowed is repayable on demand. (???)

The borrower can withdraw and repay funds whenever he desires within the overall stipulations.

Interest is charged on daily balances – on the amount actually withdrawn – subject to minimum charges.

FORMS OF BANK FINANCE CASH CREDIT (CC A/C) : Same as overdraft except for differences given below :

Borrower is not allowed to withdraw the full amount of the limit at once, rather he should borrow periodically as per his requirement and also repay periodically.

There is no commitment charge therefore interest is payable on the amount actually used by the borrower.

Cash credit limits are sanctioned against security of current assets ( Debtors, Stock etc.)

FORMS OF BANK FINANCE PURCHASE OR DISCOUNTING OF BILLS :

A borrower can obtain credit from banks against its bills.

The bank purchases and discounts the bills of the borrower.

The borrower is paid the discounted amount immediately.

The bank collects the full amount on maturity of the bill.

FORMS OF BANK FINANCE LETTER OF CREDIT (LOC) :

Mostly used in case of import transaction.

The bank gives assurance of payment to foreign suppliers in event of non payment by the domestic party.

Generally, provided by banks to financially sound and creditworthy parties.

It is an indirect way of financing.

FORMS OF BANK FINANCE WORKING CAPITAL LOAN :

A borrower may sometimes require funds in excess of the sanctioned credit limits to meet unforeseen contingencies.

Banks provide such accomodation through a “demand loan account” . The borrower is expected to pay high rates of interest in such exceptional cases.

SECURITY REQUIRED IN BANK FINANCE HYPOTHECATION : Under this the borrower is provided working capital finance against the security of movable property (stock, debtors).

The borrower does not transfer the property to the bank physically.

Thus hypothecation is a charge against property where neither ownership nor the possession is passed on to the creditor.

Banks generally grant credit against hypothecation only to first class customers with high integrity.

SECURITY REQUIRED IN BANK FINANCE PLEDGE : Under this arrangement the borrower, is required to physically transfer the possession of the property offered as security to the bank.

(eg. Share certificates, FD certificates, Insurance policy documents etc.)

REGULATIONS OF BANK FINANCE• Banks follow certain norms in granting working capital finance to firms. These norms are

greatly influenced by the recommendations of various committees appointed by the RBI.

• Banks followed the norms suggested by the “Tandon Committee”.

• Further recommendations were made by the “Chore Committee” to strengthen the procedures and norms.

THE TANDON COMMITTEE RECOMMENDATIONS1.Operating Plan : The borrowers should prepare operating plans and on that basis

indicate the amount of working capital finance requirement.

2.Production based financing : The banks should finance only the production based genuine needs of financing.

3.Partial bank financing : The bank should not finance the total requirement of the borrower. Only a reasonable part of it should be financed by the bank.

THE TANDON COMMITTEE RECOMMENDATIONS

4.Reasonable level of Current Assets : The committee further recommends that the borrower should be allowed to maintain current assets specifically debtors and inventories only up to a reasonable level. Flabby, profit making or excessive inventory should not be permitted under any circumstance. However, the bank also visualized the abnormal circumstances such as strikes, power cuts etc. and allowed flexibility to the bankers.

THE TANDON COMMITTEE RECOMMENDATIONS

5.Maximum permissible bank finance (MBFC) :The committee suggested the following three methods of determining the MBFC.

1. The borrower will contribute 25% of the working capital gap, the remaining 75% will be financed from bank borrowings.W.C.Gap = CA-CL excluding bank borowings.(Some analysts define the net working capital in the same manner)

THE TANDON COMMITTEE RECOMMENDATIONS

Maximum permissible bank finance (MBFC) :

2. The borrower will contribute 25% of the total current assets. The remaining of the working capital gap will be financed by the bank.

3. The borrower will contribute 100% of the core assets and 25% of the balance of current assets. The remaining of the working capital gap will be financed.

THE TANDON COMMITTEE RECOMMENDATIONS

Maximum permissible bank finance (MBFC) :

The first two methods were immediately accepted for implementation but the third method was not.

Illustrationmbfc.xlsx

THE TANDON COMMITTEE RECOMMENDATIONS

6. Information System :

The committee recommened for greater flow of information both for operational purposes and for the purpose of supervision and follow up of credit.The statement / information required by the banks are :

THE TANDON COMMITTEE RECOMMENDATIONS

QUARTERLY REQUIREMENTS( ONLY FIRMS HAVING CREDIT LIMIT ON MORE THAN ONE CRORE.)

1. Operating Statement.2. Quarterly Budget.3. Fund flow statement.(Actuals and Projections)

THE TANDON COMMITTEE RECOMMENDATIONS

MONTHLY REQUIREMENTS1. Stock Statement.2. Debtors List.

The Banks were supposed to strictly ensure that the funds lent by the banks were used only for the purposes, for which it was lent.

THE TANDON COMMITTEE RECOMMENDATIONS

CONCLUSION : The Tandon Committee Report was widely debated and criticised both by the borrowers and the banks.

The Bankers found a lot of difficulties in implementation of the recommendations.However, it should be admitted that the report has brought about a perceptible change in the outlook of both borrowers and bankers. The report has helped in bringing a financial discipline in the scheme of bank lending.

THE CHORE COMMITTEE RECOMMENDATIONS

In the year 1979 the RBI constituted a working group to review the system of cash credit under the Chairmanship of Mr.K.B.Chore.

This was basically a follow up of the Tandon Committee.

Major recommendations 1. Reduced dependence on Bank Credit : The borrowers

should contribute more funds to finance their working capital requirements. The idea was to place all borrowers in the 2nd method suggested by the Tandon Committee. In case of difficulties the resort could be taken to WCTL.

2. Credit limits to be separated in to “Peak level” and “Non Peak Level” limits : Credit limits should be assessed and separated in to “Peak level” and “Normal level” for borrowers with credit limits more than 10 lacs. Borrowers should, in advance, inform the requirement of peak level limits. Moreover, any deviation in utilisation beyond 10% tolerance, should be treated as an irregularity. Additional interest of 1% should be charged on adhoc borrowings.

Major recommendations 3. Existing lending system to continue : The

existing system had three types of lending.(a) Cash credit(b) WCTL,(C) Bill discounting.Cash credit system should be replaced by the other two wherever possible.Cash credit accounts of large borrowers to be scrutinized, at least once a year.

Major recommendations 4. Information System : The discipline

regarding submission of quarterly statements should be strictly adhered to, in respect of all borrowers having limits of 50 lacs and above.

COMMERCIAL PAPER A money market instrument in the advanced countries, to raise short term funds.

Introduced in India in 1989 by the RBI on the recommendation of Vaghul Working Group.

In USA , only the highest rated and financially sound companies can issue Commercial papers.

COMMERCIAL PAPER The buyers of C.P’s are Banks, Insurance Companies, Unit trusts and Firms with surplus funds to invest for a short period.

In India, the issue of CP’s is regulated by the RBI.

Only those Companies, which have (a) Net Worth of 10 Crore, (b) MPBF of not less than 25 Crore © Listed in Stock Exchange can issue CP’s.

Size of a single issue should be atleast One Crore and size of each CP should be atleast 25 Lacs. (5 lacs suggested by Vaghul).

COMMERCIAL PAPER Maturity of the CP’s in India runs between 91 to 180 days. In the USA it is 1 to 270 days.

Though the issue of CP’s is regulated by the RBI, still the interest rate is determined by the market.

The interest rate depends on (a) PLR, (b) Maturity, © Credit worthiness (d) and the rating of the CP provided by agencies.

In USA the two main rating agencies are STANDARD & POOR and MOODY.

In India this is done by ICRA ( an agency set up by ICICI & UTI).