CREDIT EVALUATION:WORKING CAPITAL FINANCE

Working Capital can be defined as Gross Working Capital & Net Working Capital.Gross Working Capital is investment in Current Assets of the firm e.g. inventories, receivables, marketable securities, Advance Tax paid etc. Current Assets are those assets which normally get converted into cash within a year.Net Working Capital (NWC) refers to the difference between Current Assets and Current liabilities. Current liabilities are those claims of the outsiders which are expected to mature for payment within one year and include, creditors, bills payable, short term bank finance and expenses outstanding. NWC

Is also referred to as Liquid Surplus by the Bankers. It is the amount of surplus funds from long term resources of the firms, which are used to finance the Current Assets of the firm.

LIABILITIESASSETSCapital & Reserves_________________________

Deferred Liabilities

.__________________

Current LiabilitiesFixed Assets

_________________________Misc. & Non C A_________________________Intangible Assets__________________

Current Assets

Working Capital Gap: This is difference between Current Assets and Spontaneous Current Liabilities (i.e. current liabilities other than short term bank finance) and is financed by NWC & short term bank finance.Thus Working Capital required by a unit is Total amount of investment required in its Current Assets, which depends on:(a) The volume of activity (viz. level of operations i.e. production & Sales)(b) The activity carried on viz. mfg.process,product, production programme, materials and marketing mix.

Further, Total Working Capital is finance by:(a) Net Working Capital (Liquid Surplus)(b) Spontaneous Current Liabilities(c) Short Term Bank FinanceOPERATING CYCLE:Any manufacturing cycle is characterised by a cycle of operations consisting of purchase of raw materials Converting these into finished Goods and realising cash by sales of these finished goods. Cash ---Raw material ---Stock in process ---Finished Goods ---- Bills Receivable ---Cash The time that lapses between cash outlay and cash realisation by sale of finished goods and realisation of receivables is known as length of operating cycle.

Thus Gross Working Capital Operating Cycle = Average Raw material storage + AverageConversion Period +Finished Goods Storage Period + Average Receivable PeriodUnit may also avail of credit purchases instead of cash purchases. Thus if we deduct from Gross Working Capital Operating Cycle, Average payment period, it will give us Net operating Cycle.ILLUSTRATION:The following data has been extracted from the books of ABC Ltd.:

PARTICULARS:Amt. in lacs1. Opening balance of:a. Raw material stores and spares3500b. Work-in process60c. Finished Goods650d. Accounts receivable760e. Accounts payable25002. Closing balance of:a. Raw material, stores and spares4100b. Work-in process70

C. Finished Goods1030d. Accounts receivable1160e. Accounts payable30803. Purchases of Raw material & Store107004. Manufacturing expenses11505. Depreciation2506. Customs & Excise duty350007. Selling, administration & Finance expenses45608. Sales55,000

A. Raw material storage period:1. Average stock of raw material= (3500+4100)/2=38002. Annual Consumption of Raw material= Opening stock + Purchases closing stock = 3500+10700-4100= 101003. Average daily consumption of Raw material=10100/360 = 284. Raw material storage period= 3800/28=136 daysAverage conversion or work in process period:1.Average stock of work in process= (60+70)/2=652.Annual cost of production= Opening stock of WIP+

+Consumption of materials+Manufacturing expenses+Depreciation-Closing WIP= 60+10100+1150+250-70 = 114903. Average daily Cost of production=11490/360=31.924. Average Conversion period= 65/31.92= 2 daysC. Finished Goods Storage period:1.Average inventory of Finished goods=(650+1030)/2=8402.Annual cost of sales=Opening stock of FG+Cost of production+Selling,admn.&Financial expenses+Custom and excise duty-Closing stock of FG = 650+11490+4560+35000-1030=506703.Average daily cost of sales=50670/360= 140.75

4.Finished Goods storage period= 840/140.75= 6 daysD. Average Collection period:1. Average Book debts = (760+1160)/2 = 9602. Annual Sales = 55,0003. Average daily sales= 55000/360 =152.784. Average Collection period = 960/152.78 = 6 daysE. Average payment period:1. Average Balance of Trade creditors =(2500+3080)/2= 27902.Annual purchases= 10700

Average daily purchases = 10700/360 = 29.72Average payment period = 2790/29.72 = 94 daysGross WC operating cycle period =136 + 2 + 6 + 6 = 150daysNet WC Operating period = 150 94 = 56 daysTotal AnnualOperating expenses of the Company = 10700+ 1150+ 35000 + 4560 = 51410Total operating cycles on the basis of Gross Working Capital cycle in the year = 360/150 = 2.4Hence Gross Working Capital required = 51410/2.4 = Rs.21421 lacs

Another method to calculate Gross Working Capital requirement:Raw material monthly cost = Annual consumption/12 = 10100/12 = Rs.842Monthly manufacturing expenses = 1390/12 = Rs. 116Monthly Selling, Administration & Finance expenses, Custom & Excise duty= (35000 +4560)/12= Rs.3297Monthly profit = Monthly sales Monthly RM-Monthly mfg.exp Monthly other expenses =(55,000/12)-842-116-3297 = Rs.328

(Rs. In lacs)

InputPeriodRMWIPFGDRS.Total1.RM:In stockIn wipIn FGIn Drs.136d2d6d6d3817

56

168

168

4209

(Rs./lacs)

InputPeriodRMWIPFGDrs.Total2.Mfg exp.In WIPIn FGIn Drs.

1 d6 d6 d

4

23

23

50

3.SellingadmnexIn FGIn Drs.

6 d6 d

660

660

1320

(Rs./lacs)

InputPeriodRMWIPFGDrsTotal4.ProfitIn Drs. 6 d66

66TOTAL:3817608519175645

Manufacturing in WIP are taken as half as they are expected to occur evenly during the total period.Since that there is lot of difference regarding Working Capital required by the above two methods, main distortion has occurred because of high stocking period of RM and Excise & Custom expenses.Traditional method of Assessment of WC:The operating cycle concept serves to identify the areas requiring improvement for the purpose of control and performance review. But, as bankers, we require a more detailed analysis to assess the various components of working capital requirement viz. finance for stocks, bills etc.

Bankers provide Working Capital finance for holding an acceptable level of CA for achieving pre-determined level of production and sales. Quantification of these funds required to be blocked in each of these items of CA at any time and will therefore provide a measure of the Working Capital requirement.Raw Material: Factors affecting stocking Average Consumption, Availability Locally/Outside/ indigenous/imported , lead time, EOQ, Credit/Cash, seasonality etc. (So many months consumption)WIP: Processes i.e. Technology, Processing Time, Number of Products handled, Average quantity of

Each product, Number of shiftsA rough and ready method of computing the requirement of funds is to find out the cost of production for the period of processing, viz.(Raw material consumed per month + expenses per month)x period of processing in months.Finished goods: Stocking depends upon: Firm order/anticipated order, supply terms, minimum quantity that can be dispatched in one lot, Transport availability , inspection, seasonality, variation in demand, Peak level/low level of operations, Marketing arrangement e.g. direct sales to consumers or through wholesale dealers

The requirement of funds against finished goods is expressed as so many months cost of production.Sundry Debtors (Receivables):Sales may be affected (a) against advance payment-No funds blocked up, instead helps in meeting working capital needs (b) Against cash No funds blocked (c) On credit Funds are blocked; extent of credit depends upon Trade practices, market conditions, whether bulk purchase by the buyer, seasonality(rain coats, woolen products), price advantage etc. Even though the amount of sundry debtors according to the units books will be on the sales price, the

Actual amount blocked will be only cost of production of the materials the difference being the units profit margin.The Working Capital requirement against sundry debtors will therefore be computed on the basis of cost of production (whereas the permissible bank finance will be computed on the basis of sale value). The working capital requirement is expressed as so many months cost of production.EXPENSES: It is customary in assessing the working capital requirement of industries to provide for ONE MONTHS EXPENSE(Salaries, admn. Etc.) also. This amount is provided merely as a cushion, to take care of temporary bottlenecks. This amount can be reduced

Or increased depending upon the operating cycle.Credit received: Trade credit received depends upon trade practices in a particular industry and also varies from place to place. Secondly, industry often receive advance payment against orders. The same may be appropriately adjusted while assessing the permissible bank finance.Traditional Method of Working Capital requirement is normally applicable to Industries with Working Capital requirement up to 5 crs.ILLUSTRATION:Name of the Unit: ABC Ltd. (Rs.in 000)Anticipated monthly sales:Rs.100 (Sales to be

Computed at the maximum level of anticipated production during the next 12 months)Cost of production per month: Rs.90 (includes cost of raw material and other manufacturing expenses)Cost of raw material per month : Rs.80

ITEMPeriodWC reqd.Margin %MarginPBFImported RM------Indign RM1 m80252060WIP2 W45251134FG2 W45251134

ItemPeriodWC reqd.Margin %MarginPBFReceivable(S V) 1 m90332367Expenses1 m10100%10-Total:270 75195Less: Advance received40Less: Credit on purchase10WC required220

Sources:Let us say liquid surplus from B/S = 20Limits from Bank =195Total =215Net Deficit (220-215) = 5How the deficit will be met: Deficit have to be met by plough back of profits or unsecured loans. Deficit should be reasonably small, when compared to the WC required.Bank may reduce the PBF in case if liquid surplus available is more than the gap between WC required and PBF calculated.

Projected Annual Turnover method for SSI units (Nayak Committee):As per Nayak Committee Report pertaining to SSI units, minimum working capital requirement for WC limits up to Rs. 5 cr, is 25% of projected annual turnover of the unit; out of which 5% should be brought in by the promoters from liquid surplus and 20% should be financed by the bank.ILLUSTRATION: (Rs.000)Projected annual Turnover 1200 (A)Working Capital requirement(25% of A) 300 (B) Less: Liquid surplus or 5% of A (whichever is higher) say liquidSurplus is Rs.20,000/- 60 (C)Minimum PBF 240

Clarification: RBI instructions to the Banks: In case of limits to SSI units upto Rs.5 cr, assessment should be done both by Turnover method (Nayak Committee) and by Traditional method. The higher of the two should be sanctioned as Working Capital limit by the banks. It should be ensured that the projected annual turnover is reasonable and achievable by the unit. Any projections say beyond 15% of the previous years actual or current years estimates would need closer look.The entire sales proceeds should be routed through Cash-Credit Account.

Sub Limits : The fixing of sub-limits against the stocks, receivables etc. will be decided as warranted.Drawing Power: Drawing power in the account will be regulated as per drawing power arrived at, after providing for the security margin. However, sales data should be obtained every month and compared with the projections.Seasonal Industries:The peculiarity of the particular industry has to be taken into account. In case of seasonal industries, the peak season and off season turnover instead of annual turnover can be separately considered for determining the respective turnover level.

Most of the banks have now extended turnover method for sanctioning WC limits up to Rs.5 cr to other units also apart from SSI units. However, in case of Trade & Services sector, Working Capital limit up to 15% instead of 20%of projected annual turnover is being sanctioned by the banks.TANDON AND CHORE COMMITTEE RECOMMENDATIONS:Tandon committee was appointed by GOI to suggest method of assessing working capital requirement and approach to lending for the industries, since at that time banks resources were scarce. The committee was also asked to devise an information system that would provide periodically, operational data, business forecasts, production plan and

Resultant credit needs of the units. Chore committee which was appointed later, further refined the approach to working capital assessment. The MPBF method is fall out of the recommendations made by Tandon and Chore Committees.Tandon committee also recommended inventory/receivables norms for 22 major industries.Approach to lending: Tandon committee gave 3 methods of assessing the MPBF:(i) MPBF = 0.75 (CA CL)(ii) MPBF = 0.75 (CA) CL(iii) MPBF = 0.75(CA CCA) CLCCA (Core Current Assets) to be financed by LTFTill recent past the banks were required by RBI to use

Tandon committee method II for computing MPBF which gives Current ratio of 1.33. However, banks are now free to use their own policy of calculating MPBF. Also the inventory/receivables norms given by Tandon committee have become redundant and banks now finance these according to acceptable level.ILLUSTRATION:ABC LTD. have CA 200 lacs, SCL 40 lacs and CCA 56 lacs. Calculate MPBF and NWC required under all the 3 methods prescribed by Tandon Committee.Method I MPBF = 0.75 (200 40) = Rs.120 lacs NWC = 200-40-120 = Rs. 40 lacs

Current Ratio = 200/160 = 1.25Method II = MPBF = .75 (200) 40 = Rs.110 lacs NWC = 200-40-110 = 50Current Ratio = 200/150 = 1.33Method-III MPBF = .75 (200 56) -40 = Rs.68 lac NWC = 200-40-68 = Rs.92 lacs Current ratio = 200/108 = 1.85Method I and Method II will always given Current ratio of 1.25 and 1.33 resp. However, in method III CR will depend upon level of CCA; higher the CCA, higher will be CR. But in any case Method III will always give CR higher than method II.

Method of lending : Financing of WC by the banks will be through Cash-Credit (CC), Working Capital Demand Loan (WCDL) and /or bill financing mechanism. In CC limit there will be lot of uncertainty about cash inflows and outflows resorted to by the Company, resulting in uncertainty in interest income of the bank from the facility. To avoid this, RBI introduced a system of loan delivery system for the banks, where Working Capital loans up to Rs.10 crs are extended to the borrowers-a portion as CC Limit, a portion as WCDL and remaining if necessary as bill financing. WCDL has a minimum repayment period of 15 days and can be repaid in instalments or bullet repayment at maturity. WCDL

Can also be rolled over. The disbursement of WCDL is normally based on the projected cash budget statements and Quarterly information/Operating system.Working Capital facilities are renewed annually. Depending on projected operations of the unit, WC limit can be enhanced, reduced or maintained at the same level.In consortium lending CC limits and WCDL/Bill financing limits are share by the consortium banks on pro-rata basis.Ad-hoc limits for short time requirements can also be extended to the borrowers but only after regular limits have been fully utilised by them.

Assessed Bank Finance (ABF)/Projected Balance Sheet (PBS) Method:Normally Applicable to Working Capital Limits above Rs. 5 crThe borrowers total business operations, financial position, management capabilities are analysed in detail to assess the Working Capital requirement and to evaluate the overall risk of the exposure: (a) Analysis of borrowers P&L A/c, B/Sheet, Ratio Analysis, Funds flow etc. for the past periods is done to examine profitability, financial position, financial management etc. in the business (b) Detailed scrutiny and validation of projected income, expenses, Sources and uses of cash are carried out to examine acceptability from the angle of liquidity

Overall gearing, efficiency of operations.The assessment procedure is as follows:Collection of financial information from the borrowerClassification of CA & CLVerification of projected levels of inventory/ receivables/sundry creditorsEvaluation of liquidity in the businessValidation of Bank finance sought.Fixing of sub limits viz C/C, WCDL, Bill finance(i) Current liabilities would also include accrued amounts which are anticipated to cover known obligations e.g.provisions, accrued bonus payment

Taxes etc. In case where specific provisions are not made for these liabilities and will be eventually paid out of General reserves, estimated amounts should be transferred to CL.(ii) Investment in shares and advances to other companies should be excluded from the CA(iii) Advances paid for supplies for a period more than trade practice should be excluded from CA(iv) Progress payments received if shown separately on liability side should be set-off against work-in-progress. Outstanding advance payments received are to be reckoned as CL or otherwise, depending upon whether they are adjustable within a year or not, or later.

(v) Any deposit from the Dealers be treated as Term liability. (vi) Any security deposit/tender deposit made by the Company be treated as NCA .(vii) Advance tax paid should be net-off against provisions.(viii) Provision of disputed excise duty etc. should be classified as CL, unless paid over in instalments beyond a period of 12 months.(Ix) Fixed Deposits with banks investment in MF, CD,CP may be classified as CA. ALL other investments be treated as NCA.

Verification of level of inventory/receivables/sundry creditors:Projected level of above are examined in relation to past trend, inter-firm comparison etc. In case if levels seem to be non realistic, the same be discussed with the borrower and if required revised. Evaluation of liquidity: Bench mark CR is 1.33. But in deserving case, if the proposal is otherwise acceptable and there are genuine reasons for low CR e.g. heavy TL instalments to be paid in next 12 months or large provisions etc. a lower than CR may be acceptable. Sometimes, proposal is sanctioned with a condition that the unit will induct more long term funds to improve CR in a specified period of time.

ILLUSTRATION:ABC Ltd. has applied to the Bank for Working Capital Limit and submitted the projected data to the Bank. Bank analysed the data and after thorough scrutiny, accepted it as follows:

ItemAmt. Rs/crsHolding periodRaw material (Indigenous)38.941.09 mRaw material (imported)20.962.96 mOverall Raw material59.901.39 mStock-in-process28.860.61 mFinished Goods16.080.34 m

Receivables (Domestic)183.643.00 mReceivables (Export)-Other Current Assets52.32Sundry Creditors34.260.79 mOther Current Liabilities20.71Total Current Assets (CA)340.80Spontaneous Current Liabilites (SCL)54.97

Working Capital Gap (WCG) = CA SCL = 340.80-54.97 = 285.83 crWorking Capital Gap will be financed by Net Working Capital (Liquid Surplus) + Working Capital Finance from Bank.Let us say Bank maintains a Current Ratio of 1.33 (Tandon Committee II)1.33 = Current Assets/(Spontaneous CL +Bank finance) =340.80/(54.97 + Bank finance)1.33Bank finance + 73.11 = 340.80 Bank Finance = (340.80 73.11)/1.33 = Rs.201.27 crHence maximum Working Capital finance extended by the Bank will be = Rs.201.27 cr (Say Rs.200 cr)Liquid Surplus = WCG Bank Finance

= 285.83 200 = Rs.85.83 crLet us say existing liquid surplus with the Company i.e. LTF LTU = Rs. 60 crDeficit = 85.83 60 = Rs.25.83 cr. Hence ABC Ltd will arrange long term funds amounting to Rs.25.83 cr. (including plough back of projected profits)Let us say existing liquid surplus is Rs.90 cr. ABC Ltd. will be sanctioned Working Capital Limit equal to = WCG Liquid Surplus = 285.83 90 = Rs.195.83 cr and not Rs.200 cr

Inadequate Working Capital: It may lead to following problems:Cash Discounts: Unit may not be able to avail of available cash discounts.Production facilities: Unit may not be able to take advantage of optimum production facilities because of bulk purchase of raw material etc. This may affect the profitability of the unit which may further affect the liquidity of the unit.Payment of short term liabilities: The same may get affected and the unit may resort to borrowing from outside at higher interest rate, affecting its profitability and good-will in the market.

Inability to meet debt obligations may also result in winding up of the unit.Fixed assets are not efficiently or effectively utilised.Excessive Working Capital: It may lead toOvertrading by the unit which may result in losses.Accumulation of inventories, leading to higher warehousing rent, insurance cost, loss due to theft etc.Higher production, over supply and crash in pricesIdle funds with the unit affecting profitability.Carelessness in cost of production.