CONCEPTS OF WORKING CAPITAL AND FACTORS CONSIDERED BY BANK TO DETERMINE THE QUANTUM OF CREDIT THAT CAN BE GRANTED TO A COMPANY

The RBI has introduced the CMA (Credit Management Arrangement) in the year 1988. Under this system, RBI prescribed two sets of format (i) (ii) Assessment of working capital Monitoring through Quarterly Information System (QIS)

Acquiring CMA data is a time taking and a tedious process. Therefore, considering the contribution of SSI to the overall industrial production, employment and also recognizing the need to fillip this sector, a special package of measures was devised by RBI in 1993 to ensure timely and adequate credit to this sector. While doing this the recommendations of the Nayak Committee were taken into account. Lack of adequate working capital is one the biggest problems faced by SSIs. In this context it is pertinent for us to understand the methods adopted by banks to extend credit facilities and the quantum of finance provided by the bank. First, let us understand what working capital is In simple terms, the fund required by the Company for day to day running of its activities is working capital. It is the amount of money required to acquire current assets to run the company at expected levels. Working Capital Finance can be Fund based Inventory Finance Bill Finance

Non Fund based Letter of Credit Bank Guarantee

How can one calculate working capital? Gross working capital (GWC) is Current Assets. Net Working Capital (NWC) is Current Assets minus Current Liabilities.

What does one mean by Current Assets? Assets which are convertible into cash within a period of 12 months are Current Assets. So in the Balance Sheet, the following are current assets: Cash & Bank balances Inventory (Raw material, work in progress and finished goods) Debtors Advances to suppliers Current investments etc

Current liabilities can, therefore, be defined as payables within 12 months. Examples: Trade Creditors Rent Salaries Income tax etc.

Basically it is the amount of current assets which is the working capital. The operating cycle of the business begins with purchase and storage of raw material, conversion into finished goods, sale and collection of receivables, which is converted to cash. Cash to cash is one operating cycle. Therefore, Operating cycle= Raw material purchase & storage period+ duration of work to convert to finished goods+ Finished goods storage period+ debtors collection period- creditors payment period. Various methods were suggested by the Nayak Committee for assessing the working capital requirements of companies. First Method lending: Working Capital gap= Current assets- Current Liabilities The bank can finance up to 75% of the Working Capital (This 75% is called as the Maximum Permissible Bank Finance) and the remaining 25% is to be brought by the Promoter/Company. This method is suggested for small borrowers Second Method: In this method, the promoter would bring in 25% of the Current assets and the bank would provide assistance for 75% of Current assets minus current liabilities. Promoters contribution= 25% of Current Assets MPBF=75% (Current Assets)- Current Liabilities

A third method was also suggested by the committee but it was not adopted by RBI. It is likely that the bank would finance for the lower of the amounts obtained by the two methods. Working Capital for Small Scale Industries: The Committee devised simpler form of calculation for SSIs. It pegged the working capital of an SSI as 20% of the projected annual turnover (MPBF) and required the promoter to bring in 5% of the projected annual turnover as contribution. The Committees method has been criticized as it has ignored various other factors like companys resources, its location, bargaining power etc. and adopted a one size fits all approach. In 1997, RBI has allowed banks to evolve its own method to assess the Working Capital requirement of its clients. The most followed method is the Cash Flow based computation wherein monthly/ quarterly cash statements are drawn to understand clearly the trend of cash utilization. This helps in understanding the amount of cash required by the organization.
Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Opening balance Receipt Payments Cash surplus Cash deficit Closing balance

Some Important ratios that a bank may consider to assess the financial strength of a company. 1. Current ratio Current assets Current Liabilities This ratio measures the Companys ability to pay off its short term liabilities. The greater, the better it is. At the minimum it should be 1. If this ratio is less than 1, it means that the company is not in a position to meet its immediate liabilities also. 2. Quick ratio (Current assets-stock) Current Liabilities It measures the Companys ability to pay off its current liabilities right away. It a more conservative approach when compared to current ratio. Again, the greater it is the better. 3. Debt Equity ratio Long term liabilities Shareholders funds Long term liabilities mean loans or liabilities which are payable in a period exceeding 12 months. Eg: long term loans from banks. Shareholders funds mean Share Capital + Reserves and Surplus This ratio is used to know the financial leverage of a company. If there is high debt in the company, there would be high interest cost which would bring down the profit of the company. However, since interest is a tax deductible component, it is

advisable to have certain amount of debt in the company. The ideal debt equity ratio is 2:1, implying if a Company has Re1 capital, it can borrow up to Rs 2. 4. Inventory Turnover Ratio: Cost of goods sold Average Inventory A ratio indicating how many times companys inventory is converted to sales (read cash). This ratio is compared against inventory standards. The higher it is the better. For example, if the inventory turnover ratio of a company is 15, it means that the company is able to convert its raw material into cash 15 times in a year. A low inventory turnover ratio implies poor sales and lock up of companys funds in stock. 5. Interest Coverage ratio: Earnings before tax & interest Interest expense This ratio determines how easily the company can pay interest on its outstanding debt. The acceptable standard is 6 times. The higher it is the better. 6. Return on equity = Profit after taxes shareholders funds This ratio implies the return available to the shareholders. This again varies from industry to industry. As a norm 15% is considered good. Obviously, the higher it is the better.