Introduction

What is Working Capital?

Apart from financing for investing in fixed assets, every business also requires funds on
a continual basis for carrying on its operations. These include amounts expenses
incurred for purchase of raw material, manufacturing, selling, and administration until
such goods are sold and the monies realized. Business transactions are generally carried
on credit with a number of days elapsing subsequent to the sale being effected for
realization of proceeds1. While part of the raw material maybe purchased by credit, the
business would still need to pay its employees, meet manufacturing & selling expenses
(wages, power, supplies, transportation and communication) and the balance of its raw
material purchases. Working capital refers to the source of financing required to by
businesses on a continual basis for meeting these needs.

Thus the need for working capital arises from the prevalence of credit in business
transactions, need to fund manufacturing and support and to account for the variations
in the supply of raw material and demand for finished goods.

Characteristics of working capital

• It is continually required for a going concern

• However, the quantum of working capital fluctuates depending on the level of
activity
• Working Capital is impacted by numerous transactions on a continual basis

The above characteristics render limit based financing from banks ideal for working
capital financing. This is because the client is charged interest only on the
average outstanding utilized and is saved with the bother of reinvesting short
term surpluses arising out of low working capital utilization at a point in time.
Further since the transactions of the business are generally routed through a current
account with a bank, availing a credit limit from the same bank is really convenient.
Thus, working capital requirements are generally financed through limit based financing
from banks.

Bank Financing for Working Capital

The financing limits are granted based on assessment of the working capital
requirement. The assessment factors include various characteristics such as the nature
of industry, industry norms, actual level of activity for the previous year and the
projected level of activity for the subsequent year to arrive at the working capital
requirement. The bank financing limit is thereafter decided after factoring in margins on
the different types of current assets forming part of the working capital. (Detailed
example provided in the section on Estimation of Working Capital requirements)

The Bank Financing Limit is fixed on an annual basis. However, since such limit is
provided to meet specific requirements, utilizing the limits is subjected to the Drawing
Power, which is decided on a monthly/ quarterly basis.

The effective bank financing is therefore to the extent of the lower of:

• Bank Financing Limit: Determined on an annual basis based on an assessment

of the current year�s projections and the actuals for the previous year.
• Drawing Power: Linked to the quantum of current assets (and current liabilities)
owned by the business with appropriate margins. Fixed on a monthly/ quarterly
basis depending on the submission of Monthly/Quarterly Information System
 returns indicating the position of the stock statement, receivables, Work in
Progress, payables, etc.

Bank Financing (max. permissible) = Bank Financing Limit OR Drawing Power

whichever is less

Procedures to avail working capital financing from banks

Banks exercise extreme caution in lending to first time applicants starting up their
business. A first time applicant would be asked for collateral in the form of land, building
or residential property. This would be in addition to a second charge on the fixed assets
of the enterprise. Sequence of steps to avail working capital

• Application for the working capital

Most of the large commercial banks are moving towards the trend of specialized
SSI branches near the industrial concentrations. The applications for working
capital are generally accepted and processed at these branches.

• List of Documents accompanying the application

The application for working capital would need to have a covering letter
containing a request for sanction of working capital limits. The following
documents would need to be enclosed alongwith:

o Detailed Project Report containing the detailed financials at projected

levels of operations for the next 5 years
o Memorandum and Articles of Association
o Copies of Incorporation documents (relating to formalities with the
Registrar of Companies in case of corporates)
o Statutory approvals obtained/ applied for such as for power, water,
pollution control, environment clearance, clearances from other agencies/
departments with purview over the business.
o Other relevant documents � Letters of intent/ confirmed orders from
prospective buyers.
o Networth statement of promoters.

In case of the larger loans (above Rs. 5 crore in case of most banks), the
projections are generally submitted in the CMA format prescribed by Reserve
Bank of India (earlier mandatory).

• In- Principle Sanction for Working Capital

The timeframe for in-principle sanction depends upon two factors:

o Time taken for submission of necessary documents

o The decision structure at the bank

Most of the large banks have specialized SSI branches at the industrial
 concentrations in the country. These branches are headed by senior executives
often with sanctioning power of Rs. 5-6 crores at the branch. In such instances,
delays for processing the applications at the bank are limited. Infact the stage of
in-principle sanction maybe dispensed with and final sanction accorded on full
appraisal.

In other cases, such processing may take 30-45 days for according In-Principle
Sanction to the project. The newer private sector banks are generally faster in
according such approval. The significance of the in-principle sanction of working
capital is that such sanction is necessary for obtaining term funding from the
financial institutions. While these financial institutions accord sanction to a
industry,

• Appraisal and Final Sanction

The appraisal and final sanction of the request for working capital is based on a
thorough appraisal of the Detailed Project Report (DPR). The traditional banks
generally have specified formats for submission of the DPR. The usual coverage
of the DPR includes:

o Overview of the business

o Background of promoters
o Details of products to be manufactured � manufacturing process and raw
material
o Market overview and competition Sensitivity Analysis � �What if� on
Finished Goods prices, raw material costs and so on
o Detailed financial projections covering the Balance Sheet, Profit and Loss
Account, Funds Flow and the Financial Ratios.

The timeframe for a Final Sanction in cases where all the requirements have
already been submitted by the borrowing unit is 90 days from the submission of
the application.

• Post Sanction Requirements

Post sanction requirements involve completion of documentation creating a

charge in favour of the bank. This could include a charge on assets related to the
business and charge on collateral offered (if any). In case of the assets of the
business already being mortgaged with the term lending institution, a second or
third charge maybe created in favour of the bank.
The financing facilities sanctioned can thereafter be availed by the borrower.

• Monitoring and follow-up

Working capital financing is extended for the current asset build up of a business,
which is linked to its activity level. These assets are mobile (in case of inventory)
and also easily convertible into cash. At best, the banks have a second charge on
the fixed assets of the enterprise and without the power of Seizure (u/s Sec 29 as
available to the state financial institutions) realizing money from the security is
time consuming. Hence, banks pay extremely high importance to the monitoring
and follow-up of the loan.
The system of a current account through which all the transactions are routed acts as an
in-built check on the operations of the borrower. By studying the current account
transactions in detail, the banker is able to make an assessment of the business. In
addition to this, the banks also undertake other forms of monitoring.

These include:

• Stock Statements collected on a monthly basis from the borrower.

• Quarterly Operating Statement giving details of the operations for
the quarter

In addition to these checks, banks often employ methods such as:

• Stock Audit by independent firms of chartered accountants.

This would involve a visit to the storage areas of the borrower, visual inspection
and scrutiny
of the stock statements at the spot. Cross-checking these with the statements
given by the
client would provide a means of check.

• Branch Inspection conducted by the internal audit/ bank staff

In case of larger loans, Consortium meetings where the operations of the unit are jointly
reviewed are also undertaken.

• Review, enhancement of limits and adhoc limits

Review of limits is usually undertaken on an annual basis. In cases where a request

for enhancement of limits is made by the borrower during the course of the year, such a
request is processed based on the stock statements and QoS submitted. In case of
temporary need, an adhoc limit of upto 25% of the
existing limits could be granted on request.
Estimation of Working Capital Requirement

My industry is suffering because of inadequate working capital!

Lack of adequate working capital is often stated as one of the major reasons for sickness
in industry (especially in case of SMEs). The counter arguments from the banks have
been that most firms face problems of inadequate working capital due to credit
indiscipline (diversion of working capital to meet long term requirements or to acquire
other assets). In this context it would be pertinent to understand the method adopted by
banks in computing the working capital requirement of the business and the quantum of
bank financing to be provided by the bank.

What are the main factors considered in the estimation of working capital requirement ?

• The nature of business and sector-wise norms

Factors such as seasonality of raw materials or of demand may require a high

level of inventory being maintained by the company. Similarly, industry norms of
credit allowed to buyers determine the level of debtors of the company in the
normal course of business.

• The level of activity of the business

 Inventories and receivables are normally expressed as a multiple of a day�s
production or sale. Hence, higher the level of activity, higher the quantum of
inventory, receivables and thereby working capital requirement of the business.
So in order to arrive at the working capital requirement of the business for the
year, it is essential to determine the level of production that the business would
achieve. In case of well-established businesses, the previous year�s actuals and
the management projections for the year provide good indicators. The problems
arise mainly in the case of determining the limit for the first time or in the initial
few years of the business. Banks often adopt industry standard norms for
capacity utilization in the initial years.
What are the steps involved in arriving at the level of Working Capital Requirement ?

• Based on the level of activity decided and the unit cost and sales price
projections, the banks calculate at the annual sales and cost of production.
• The quantum of current assets (CA) in the form of Raw Materials, Work-in-
progress, Finished goods and Receivables is estimated as a multiple of the
average daily turnover. The multiple for each of the current assets is determined
generally based on the industry norms.
• The current liabilities (CL) in the form of credit availed by the business from its
creditors or on its manufacturing expenses are deducted from the current assets
(CA) to arrive at the Working Capital Requirement (WCR).

Standard Formulae for determination of Working Capital

The issue of computation of working capital requirement has aroused
considerable debate and attention in this country over the past few decades. A
directed credit approach was adopted by the Reserve Bank of ensuring the flow of
credit to the priority sectors for fulfillment of the growth objectives laid down by
the planners. Consequently, the quantum of bank credit required for achieving
the requisite growth in Industry was to be assessed. Various committees such as
the Tandon Committee and the Chore Committee were constituted and studied
the problem at length.

Norms were fixed regarding the quantum of various current assets for different
industries (as multiples of the average daily output) and the Maximum
Permissible Bank Financing (MPBF) was capped at a certain percentage of the
working capital requirement thus arrived at.

Working Capital assessment on the formula prescribed by the Tandon Committee.

Working Capital Requirement (WCR)= [Current assets i.e. CA (as per industry norms) �
Current Liabilities i.e. CL]
Permissible Bank Financing [PBF} = WCR � Promoter�s Margin Money i.e. PMM (to be
brought in by the promoter)

As per Formula 1: PMM = 25% of [CA � CL] and thereby PBF = 75% of [CA � CL]
As per Formula 2: PMM = 25% of CA and thereby PBF = 75%[CA] � CL

As is apparent Formula 2 requires a higher level of PMM as compared to Formula 1.

Formula 2 is generally adopted in case of bank financing. In cases of sick units where
the promoter is unable to bring in PMM to the extent required under Formula 2, the
difference in PMM between Formulae 1 and 2 may be provided as a Working Capital
Term Loan repayable in installments over a period of time.

Illustrative Example:
Turnover of a manufacturing unit: Rs. 750 lakh p.a (assumed uniform across the year)
Assumed value addition norm: 50% (i.e. cost of raw material = 50% of Realisation)
 Promoter Projections
Current Assets Current Liabilities
- Raw materials Rs. 50 lakh - Payables Rs. 35 lakh
- Work in progress Rs. 25 lakh
- Finished Goods Rs. 60 lakh
- Receivables Rs. 125 lakh

Requirement assessed as per norms applicable for the industry:

Industry Amount as Promoter Applicable

Norm (a) per Norm (b) Projection (c) norm (d)
Current Asset
- Raw material 1 month Rs. 31.25 lakh Rs. 50 lakh Rs. 31.25 lakh
- Work in Progress
(assumed at 50% 10 days Rs. 15.62 lakh Rs. 25 lakh Rs. 15.62 lakh
complete)
- Finished Goods 15 days Rs. 31.25 lakh Rs. 60 lakh Rs. 31.25 lakh
- Receivables Rs. 112.50
1.5 months Rs. 125 lakh Rs. 112.50 lakh
lakh
Rs. 190.62 Rs. 260.0 lakh Rs. 190.62
lakh lakh
Current Liabilities
- Payables 15 days Rs. 18.80 lakh Rs. 35 lakh Rs. 18.80 lakh

Working Capital Rs. 171.82 Rs. 171.82

Rs. 225.0 lakh
Requirement lakh lakh

Notes:

• Assumptions here include: No export turnover, uniform working capital

requirement through out the year
• Industry norms have been specified in the Tandon Committee Report for all
important industry categories
• Raw materials have been valued at cost of raw material (assumed at 50% of
realization)
• Work in progress has been valued at 50% complete basis
• Applicable norm (d) is the more conservative of (b) or (c) from the bank�s point
of view.

Computation of working capital requirement

Working Capital Requirement arrived at therefore is Rs. 171.82 lakh

Formula 1
PMM (Promoter Margin Money) as per formula 1 = 25% of 171.82 lakh = Rs. 42.95 lakh
~ Rs. 43 lakh
Hence, Permissible Bank Finance 1 = Rs. 129 lakh
Formula 2
PMM as per formula 2 = 25% of Rs. 190.6 lakh = Rs. 47.65 lakh
Permissible Bank Financing as per formula 2 = [75% of 190.6 lakh � Rs. 18.8 lakh ] =
Rs. 124.1 lakh

The difference between the 2 methods is Rs. 4.90 lakh (which maybe extended as a
Working Capital Term Loan in case of sick units.

Thus the PMM while being at 25% of the Working Capital requirement1 could actually
translate to as high as Rs. 225 lakh � Rs. 124 lakh i.e. Rs. 101 lakh assuming that the
promoter projections really reflect his genuine need for working capital. It should
however be understood by the entrepreneur that he ought to keep his working capital
requirements to the minimum (whether or not bank financing is available) to ensure that
his interest burden and capital blocked is kept to the minimum.

The following further points maybe worth mentioning here:

• In case of export financing sought by the entrepreneur, the quantum of bank

financing for the Working Capital build up for this purpose would normally be at a
higher percentage
• Within the overall limits, there could be sub-limits for bills financing (in case of
receivables) with the result that such limits might not be fully available to the
business.
• The Bank Financing Limit arrived above is the Overall limit for the year. The
actual quantum of bank financing that could be availed by the unit at a given
point in time depends upon its drawing power based on its periodical returns filed
to the banker.

1
Or at (25% of CA) as per Formula 2

Working Capital and Small Scale Industries

Small scale industries have a distinct set of characteristics such as low bargaining power
leading to problems of receivables and lower credit on purchases, poor financial
strength, high level of variability due to dependence on local factors, etc. Consequently,
it has been rightly argued that the industry norms on different current assets cannot be
adopted.

The PR Nayak Committee that was appointed to devise norms for assessing the working
capital requirement of small-scale industries arrived at simplified norm pegging the
Working Capital bank financing at 20% of the projected annual turnover. However, in
case of units which are non-capital intensive such as hotels, etc. banks often assess
requirements both on the Nayak Committee norms as well as the working cycle norms
and take the lower of the two figures.

Eligibility and Norms for bank financing of SSIs as per Nayak Committee

a. Applicability:

In case of SSIs, with working capital requirement of less than Rs. 5 crores
In case of other industries, with working capital requirement of less than Rs. 1 crore
b. Quantum of Working Capital bank financing:
20% of the projected annual turnover
c. Subject to a Promoter bringing in a margin of:
5% of the projected annual turnover (i.e. 20% of the total fund requirement that has
been estimated at 25% of the projected annual turnover)
Working Capital through Formula � Boon or bane ??
The formula driven computation of working capital requirement have been subjected to
much debate over the past few decades. The advantage of such computation has been
that it removes discretion from the officials of banks (which are largely from the Public
Sector). The uniformity thus reduces the scope for accusation of bias.

However, the strongest argument against the MPBF based lending has been that it does
not take into account the variations arising out of location, relative bargaining of the
enterprise and other reasons, which could vary its need for working capital. Even though
the banker could understand the problem, it was not possible to act on it due to the
norms. Further, the �One Size fits all� theory ensured that banks never needed to
develop credit appraisal skills and lent to all and sundry based on their seeming
adherence to norms on paper.

The method has also been criticized as being more appropriate for the era where credit
was rationed out. Banks today are capable of undertaking better assessment of the
requirements and welcome the idea of offering higher limits (larger exposures) to
established clients if required in order to retain their business in the face of competition
from other banks.

In 1997, the RBI permitted banks to evolve their own norms for assessment of the
Working Capital requirements of their clients.

Cash flow based computation of Working Capital

Cash flow is the most realistic means of assessing the operations of an enterprise.
Drawing up cash flow statements (monthly or quarterly) for the past few years clearly
indicate the seasonal and secular trend in utilization of working capital. The projections
drawn up by the entrepreneur may then be jointly discussed with the banker as modified
in light of the past performance and the banker�s opinions. The peak cash deficit is
ascertained from the cash budgets. The promoter�s share (margin money) for such
requirement maybe mutually arrived at by the banker and the borrower with the balance
requirement forming the Bank financed part of Working Capital.

Cash flow based computation of working capital requirement has been recommended by
the RBI for assessment of working capital requirement permitting the banks to evolve
their own norms for such assessment. The reason for this has been that Cash flow
factors in the past trends, takes into account the company specific factors and is based
on mutual discussion between the banker and the borrower thereby increasing its
acceptability. Also, large companies have adopted cash budgeting systems for managing
their cash flows and hence such a system does not impose additional requirements on
the corporates.

Cash flow system is extremely relevant in case of the seasonal industries to assess the
peak credit requirement and in case of large companies (working capital requirements
above Rs. 10 crores). However the reluctance to provide the cash budgets thereby
revealing additional information to the banks, has led to even larger companies shying
away from Cash Budget method of assessing Working Capital. Consequently Cash
Budget method is currently prevalent mainly in case of seasonal industries, construction
sector as well as other entities whose operations are linked to projects.

Bank financing based on cash budgets works well and is a good step form for the
system.
A big failure in the working capital system hitherto followed by our banks has been that
the Drawing Power (within the PBF limit) is based on post facto stock statements and
these are reset typically on a monthly basis. This means:

• The borrowing unit is putting its money upfront and the Drawing Power is a form
of reimbursement.
• Responsiveness to sudden surges in demand/ seasonality/ other short term boom
conditions is non-existent, putting a burden on the company to finance this at
exorbitant rates from private financiers.
• Finally, a growing company will always be playing �catch-up� and its
Permissible Bank Financing will be lagging its cash requirements by atleast one
year.

Working Capital � The Status Today

 PSU Banks reaffirm faith in MPBF for industry lending and 20% norm for SSI

Though norms for computation of Working Capital have been liberalized, PSU banks
continue to adopt the formula based norms to assess working capital. This is on account
of the affinity that the Public Sector has towards norm based lending which protects

In short, it could be said that in most cases, industries get some credit but not
customized to their requirement!

 Fear of NPAs, enquiries on bad loans and capital adequacy constraints make
banks credit averse
Over the past few years, a combination of circumstances has made banks averse to
taking on additional credit exposure. This is especially so in case of new projects where
the promoter does not have a track record.

o The introduction of globally accepted norms of Asset Classification resulted

in high level of Non-Performing Assets showing up in the books of banks,
which had to be written off affecting profitability and eroding capital.
o The erosion of capital meant that banks were in danger of not meeting the
newly introduced norm of 8% capital adequacy. Not achieving the 8%
norm would affect credibility of the bank and possibility of accessing the
capital markets for equity or debt.
o In a number of public sector banks that faced massive erosion in capital,
enquiries were instituted against officials who sanctioned the bad loans
thereby making bankers more cautious of taking any kind of credit
decisions.

In such circumstances banks increasingly resorted to investing in risk-free government

debt and avoided taking on industrial credit. The problem has been more acute in the
small-scale sector. The sector had witnessed a high level of directed lending in the past
decade most of which turned bad thereby putting off the banks from further credit to the
sector. Even otherwise, the adverse impact of liberalization has been felt more in the
SME sector that among larger industries.

 Increased competition for good client accounts

Over the past few years, banks have been faced with the unenviable task of generating
business while asset quality and facing growing competition in the sector. This has led to
banks competing with each other for securing the business from proven clients (whether
in the large, medium or small scale sector). Apart from providing competitive terms to
the borrower, banks do not hesitate to provide project funding or meeting any other
credit requirement of these clients in order to retain their business.

The younger, aggressive private sector and MNC banks are going after good credit in a
big way. These banks are faster, friendlier and attempt to understand the borrower�s
business and fund requirements, while structuring the transaction. They work through
correspondent branches to extend their reach and pffer customized solutions including
cash management, demand loans against assignment of immediate committed payments
and branches banking and banking through the internet.

An analysis of the assisted units of State Financial Institutions reveals that in most
cases, the proven clients have availed their subsequent loans from banks (most often
PSU banks). Infact it was also seen that all good clients had been visited by more than
one banker offering them better terms of credit. In many cases the existing loans of
these clients to the SFC was prepaid through loans provided by the banks.

Summary
Given the increased focus on credit quality, banks have become increasingly choosy in
providing credit to industry. At the same time, the enhanced profit orientation has meant
that banks are vying with each other to secure business from proven clients. This has
become particularly acute in case of SMEs where availing Working Capital from banks is
no longer a matter of routine. This is especially so in case of first generation
entrepreneurs who lack a track record. Considerable homework displaying commitment
in the project and stable financial position of the promoter is essential for obtaining a
favourable response from bankers.