AMATYA

Prepared By:

SHRUTI BATRASenior Associate- FinanceAMATYA BUSINESS CONSULTING PRIVATE LIMITED

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WORKING CAPITAL FINANCE

Working Capital refers to that part of the firm’s capital, which is required for financing short term or current assets such as cash marketable securities, debtors and inventories.

Working Capital is also known as Revolving or Circulating Capital or Short-Term Capital.

WORKING CAPITAL CYCLE

This Working Capital Cycle can be explained in the following simple words:

Say, a Company has some amount of cash; this cash will be required for purchasing the raw material, though some raw material may be available on credit basis. The Company also has to spend some amount on labour and factory overheads to convert the raw material in Work-in –progress, and ultimately into finished goods. These finished goods when sold on credit basis gets converted in the form of debtors or receivables. These Sundry Debtors gets converted into cash only after the expiry of the credit period. Thus, there is a cycle in which the originally available cash is converted into cash again only after following the stages of raw material, work-in-progress, finished goods and sundry debtors. Thus, this creates the Working Capital Gap.

Though some part of these current assets may be financed by the current liabilities eg. Creditors or payables. But still the amounts required to be invested in these current assets are always higher than the funds available from current liabilities. This is the precise reason of why the Working Capital requirement arise.

A non-manufacturing trading concern may not require raw material for processing, but it also needs finance for storing goods & providing credit to its customers.

CashRaw

Material

Stock-In-Process

Finished Goods

Sales

Receivables Working Capital

Cycle

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Similarly, a concern engaged in providing services, may not have to keep inventories but it may have to bear day-to-day cash expenses and consumables and also have to provide credit facility to its customers. Thus, all enterprises engaged in manufacturing, trading or providing services require finance for its day-to-day operations, and this finance is called Working Capital Finance.

WORKING CAPITAL MANAGEMENT

Decisions relating to working capital and short term financing are referred to as Working Capital Management. These involve managing the relationship between a firm's short term assets and its  short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

FACTORS TO BE CONSIDERED FOR FORECASTING/ESTIMATION OF WORKING CAPITAL REQUIREMENT

Total costs incurred on materials, wages and overheads.The length of time for which raw materials remain in stores before they are issued to production.The length of the production cycle or WIP, i.e., the time taken for conversion of Raw Material into Finished Goods.The length of the Sales Cycle during which Finished Goods are to be kept waiting for sales.The average period of Credit allowed to customers.The amount of cash required to pay day-to-day expenses of the business.The amount of cash required for advance payments if any.The average period of credit to be allowed by suppliers.Time-lag in the payment of wages and other overheads

WORKING CAPITAL PRODUCTS

Fund based

DomesticCash CreditOverdraft facilityBill DiscountingWorking Capital Term Loan

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ExportPre shipment CreditPost shipment Credit

Non-fund based

Letter of creditBank Guarantee

ASSESSMENT OF WORKING CAPITAL

A unit needs working capital funds mainly to carry current assets required for itsoperations. Inadequate levels of working capital may result in under-utilization of capacity and serious financial difficulties. Similarly excessive levels may lead to unproductive use of credit and unnecessary interest burden on the unit.

Proper assessment of working capital requirement may be done as under-

I. Norms for inventory and receivables:

If the bank credit is to be linked with production requirements, it is necessary to assess the requirements on the basis of certain norms. The ‘study group to frame guidelines to follow-up of bank credit’ (Tandon Study Group) appointed by Reserve Bank of India had suggested the norms for inventory and receivables regarding major industries on the basis of company finance studies made by Reserve Bank process periods in the different industries, discussions with the industry experts and feed-back received on the interim report. The norms suggested by Tandon Study Group are being reviewed from time to time by the Committee of Direction constituted by the Reserve Bank to keep a constant view on working capital requirements. The committee has representatives from a few banks and it generally once in a quarter. It also consults the representatives from industry and trade. It keeps a watch on the various issues relating to working capital requirements and gives various suggestions to suit the changing requirements of the industry and trade.

II. Computation of Maximum Permissible Bank Finance (MPBF):

The Tandon Study group had suggested the following alternatives for working out the maximum permissible bank finance:-

Bank can work out the working capital gap. i. e. total current assets less currentliabilities other than bank borrowings and finance a maximum of 75 per cent of

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the gap; the balance 25% to come out of long-term funds, i.e. owned funds and term borrowings.

Borrower should provide for a minimum of 25 per cent of total current assetsout of long-term funds, i.e. owned funds and long term borrowings. A certainlevel of credit for purchases and other current liabilities inclusive of bankborrowings will not exceed 75 per cent of current assets.

It may be observed from the above that borrower’s contribution from long term funds would be 25 per cent of the working capital gap under the first method of lending and 25 per cent of total current assets under the second method of lending. The above minimum contribution of long-term funds is called minimum stipulated Net Working Capital (NWC) which comes from owned funds and term borrowings.

Mostly second method of lending is followed by the Banks while lending for Working Capital

Format for calculating the MPBF is as follows: S. No.

Particulars Year 1 Year 2 Year3

1. Total Current assets

2. Other Current Liabilities(Other than Bank Borrowings)

3. Working Capital Gap (1-2)

4. Minimum Stipulated NWC(25% Of Total Current Assets)

5. Actual/Projected Net Working Capital (Total Current Assets- Total Current Liabilities)

6. Item 3 minus Item 4

7. Item 3 minus Item5

8. Maximum Permissible Bank Finance(Lower of 6 or 7)

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Bank also considers the followings points while sanctioning the working capital limit to the concern: 1. Turnover size of the concern: The bank normally gives working capital limit upto 20-25

% of the turnover estimated (for the year under review) by the concern.

2. Current ratio should be 1.33: 1. In case of take over case the last three year CR average should be 1.33:1. Some relaxation may be given but subject to approvals from Circle Head or Head Office of bank.

3. Total Outside Liability/ Net Worth Ratio should be in the range of 2-3 times.

4. Term loan Installments payable within the next twelve months time are excluded from current liabilities while calculating MPBF but included while calculating Current Ratio.

5. The Drawing Power (DP) should be equal to or more than the limit applied for. The calculation of same is as follows:

Particulars Year1 Year2 Year3 Year4 MarginRaw Material 25%Other Consumable Spares

25%

Stock-in-process 25%Finished Goods 25%Domestic Receivables 40%Export Receivables 40%Total (A)Less:Creditors 40%Total (B) DP {A-B}

Note: The above margin depends on industry to industry.

Conclusion

Working Capital Financing is a key financing need and challenge for small firms.

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Working capital investment is the lifeblood of a Company. Without it, a firm cannot stay in business. Thus, the first, and most critical, use of working capital is providing the ongoing investment in short-term assets that a company needs to operate.