Assessment of working capital finance project by noname

EXECUTIVE SUMMERY

It gives me great pleasure to present this project report on working capital finance

at bank of Maharashtra, credit department, head office, Pune. The project was carried out

from 1st June 2007 to 31st July 2007.

The main objective of the project was to study various types of working capital

finance provided by banks. To know details the procedure of assessment of working

capital finance extended by banks.

Wheels of business cannot move without money. Availability of money is being

limited and wants being unlimited. So procurement of fund is one of the important

functions in commercial & non-commercial enterprises and utilizes it for maximization

of business profits.

Business enterprises need funds to meet their different types of requirements,

i. Long-term requirement

ii. Medium-term requirement

iii. Short-term requirement

Working capital requirement is the short-term requirement. Working capital is the

investment needed for carrying out day-to-day operations of the business smoothly. Bank

is one of the important sources of working capital requirement. Bank gives various

facilities to the borrowers.

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In this project I have considered various banking facilities for the working capital

finance to the industries. It covers almost important aspect relating to assessment &

follow up of working capital finance. After discussing the procedure followed by bank,

For assessing working capital requirement case studies have been given with necessary

data in the prescribed forms demonstrate the calculable done by bank to arrive at

maximum permissible bank finance. An inventory & receivables constitute the major

portion of the total working capital requirement.

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Company Profile

The Birth

Registered on 16th Sept 1935 with an authorized capital of Rs 10.00 lakh and

commenced business on 8th Feb 1936.

The Childhood

Known as a common man's bank since inception, its initial help to small units has given

birth too many of today's industrial houses. After nationalization in 1969, the bank

expanded rapidly. It now has 1292 branches (as of 30th September 2005) all over India.

The Bank has the largest network of branches by any Public sector bank in the state of

Maharashtra.

The Adult

The bank has fine tuned its services to cater to the needs of the common man and

incorporated the latest technology in banking offering a variety of services.

Our Philosophy

o Technology with personal touch.

Our Emblem

The Deepmal

o With its many lights rising to greater heights.

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The Pillar

o Our institution- Symbolizing strength.

The 3 M's

Symbolising

• Mobilisation of Money

• Modernisation of Methods and

• Motivation of Staff.

Our Aims

The bank wishes to cater to all types of needs of the entire family, in the whole country.

Its dream is "One Family, One Bank, Maharashtra Bank".

The Autonomy

The Bank attained autonomous status in 1998. It helps in giving more and more services

with simplified procedures without intervention of Government.

Our Social Aspect

The bank excels in Social Banking, overlooking the profit aspect; it has a good share of

Priority sector lending having 46% of its branches in rural areas.

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Other Attributes

Bank is the convener of State level Bankers committee

Bank has signed a MoU with EXIM bank for co-financing of project exports

Bank offers Depository services and Demat facilities in Mumbai.

Bank has captured 97.68% of its total business through computerization.

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OBJECTIVES

To know the various types of working capital finance provided by banks.

To analyze in detail the procedure of assessment of working capital finance

extended by bank.

To apply these procedure at a practical level with the help of case studies.

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RESEARCH METHODOLOGY

This is analytical research area where we analyses information with cause and its

effects relationship. This analysis leads to the simple conclusions of whether to lend

money to the institution for business.

Also if the money is lend then there is reality the norms are not always perfect and

hence it is essential to priorities stringent parameters and secondary parameters.

Research Type Analytical

Source of Data Primary and Secondary

Sample Unit Industries applying for loan

Sample Case studies

Sample Technique Allocation of Case

Analysis Tool used Financial Analysis

Primary Data:

Observation, Discussion with the manager.

The company profile, annual reports have been obtained from BOM.

Secondary Data:

Secondary data relating to the procedure of assessment of working capital finance, old

sanction proposals, RBI guidelines etc. have been sourced from reference books.

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INTRODUCTION TO WORKING CAPITAL

In accounting,” Working capital is the difference between the inflow and outflow of

funds. In other words, it is the net cash inflow. It is defined as the excess of current assets

over current liabilities and provisions. In other words, it is net current assets or net

working capital.

A study of working capital is of major importance to internal and external analysis

because of its close relationship with the day-to-day operations of a business. Working

Capital is the portion of the assets of a business which are used on or related to current

operations, and represented at any one time by the operating cycle of such items as

against receivables, inventories of raw materials, stores, work in process and finished

goods, merchandise, notes or bill receivables and cash.

Working capital comprises current assets which are distinct from other assets. In the first

instance, current assets consist of these assets which are of short duration.

Working capital may be regarded as the life blood of a business. Its effective provision

can do much to ensure the success of a business while its inefficient management can

lead not only to loss of profits but also to the ultimate downfall of what otherwise might

be considered as a promising concern.

The funds required and acquired by a business may be invested to two types of assets:

1. Fixed Assets.

2. Current Assets

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Fixed assets are those which yield the returns in the due course of time. The various

decisions like in which fixed assets funds should be invested and how much should be

invested in the fixed assets etc. are in the form of capital budgeting decisions. This can be

said to be fixed capital management.

Other types of assets are equally important i.e. Current Assets.

These types of assets are required to ensure smooth and fluent business operations and

can be said to be life blood of the business. There are two concepts of working capital —

Gross and Net. Gross working capital refers to gross current assets. Net working capital

refers to the difference between current assets and current liabilities. The term current

assets refers to those assets held by the business which can be converted into cash within

a short period of time of say one year, without reduction in value. The main types of

current assets are stock, receivables and cash. The term current liabilities refer to those

liabilities, which are to be paid off during the course of business, within a short period of

time say one year. They are expected to be paid out of current assets or earnings of the

business. The current liabilities mainly consist of sundry creditors, bill payable, bank

overdraft or cash credit, outstanding expenses etc.

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NEED FOR WORKING CAPITAL

The need of gross working capital or current assets cannot be overemphasized. The object

of any business is to earn profits. The main factor affecting the profits is the magnitude of

sales of the business. But the sales cannot be converted into cash immediately. There is a

time lag between the sale of goods and realization of cash. There is a need of working

capital in the form of current assets to fill up this time lag. Technically, this is called as

operating cycle or working capital cycle, which is the heart of need for working capital.

This working capital cycle can be described in the following words.

If the company has a certain amount of cash, it will be required for purchasing the raw

material though some raw material may be available on credit basis. Then the company

has to spend some amount for labour and factory overheads to convert the raw material in

work in progress, and ultimately finished goods. These finished goods when sold on

credit basis get converted in the form of sundry debtors. Sundry debtors are converted in

cash only after the expiry of credit period. Thus, there is a cycle in which the originally

available cash is converted in the form of cash again but only after following the stages of

raw material, work in progress, finished goods and sundry debtors. Thus, there is a time

gap for the original cash to get converted in form of cash again. Working Capital needs of

company arise to cover the requirement of funds during this time gap, and the quantum of

working capital needs varies as per the length of this time gap.

Thus, some amount of funds is blocked in raw materials, work in progress, finished

goods, sundry debtors and day-to-day requirements. However some part of these current

assets may be financed by the current liabilities also. E.g. some raw material may be

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available on credit basis, all the expenses need not be paid immediately, workers are also

to be paid periodically etc. But still the amounts required to be invested in these current

assets is always higher than the funds available from current liabilities. This is precise

reason why the needs for working capital arise. From the Financial management point of

view, the nature of fixed assets and current assets differ from each other

1. The fixed assets are required to be retained in the business over a period of time and

they yield the returns over their life, whereas the current assets loose their identity over a

short period of time, say one year.

2. In the case of current assets, it is always necessary to strike a proper balance between

the liquidity and profitability principles, which is not the case with fixed assets. E.g. If

the size of current assets is large, it is always beneficial from the liquidity point of view

as it ensures smooth and fluent business operations. Sufficient raw material is always

available to cater to the production needs, sufficient finished goods are available to cater

to any kind of demand of customers, liberal credit period can be offered to the customers

to improve the sales and sufficient cash is available to pay off the creditors and so on.

However, if the investment in current assets is more than what is ideally required, it

affects the profitability, as it may not be able to yield sufficient rate of return on

investment. On the other hand, if the size of current assets is too small, it always involves

the risk of frequent stock out, inability of the company to pay its dues in time etc. As

such, the investment in current assets should be optimum. Hence, it is necessary to

manage the individual components of current assets in a proper way. Thus, working

capital management refers to proper administration of all aspects of current assets and

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current liabilities. Working Capital Management is concerned with the problems arising

out of the attempts to manage current assets, current liabilities and inter-relationship

between them. The intention is not to maximize the investment in working capital nor is

it to minimize the same. The intention is to have optimum investment in working capital.

In other words, it can be said that the aim of working capital management is to have

minimum investment in working capital without affecting the regular and smooth flow of

operations. The level of current assets to be maintained should be sufficient enough to

cover its current liabilities with a reasonable margin of safety. Moreover, the various

sources available for financing working capital requirements should be properly managed

to ensure that they are obtained and utilized in the best possible manner.

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FACTORS AFFECTING WORKING CAPITAL MANAGEMENT

The amount of working capital required depends upon a number of factors which can be

stated as below

Nature of Business:

Some businesses are such, due to their very nature, that their requirement of fixed capital

is more rather than working capital. These businesses sell services and not the

commodities and not the commodities and that too on cash basis. As such, no funds are

blocked in piling inventories and also no funds are blocked in receivables. E.g. Public

utility services like railways, electricity boards, infrastructure oriented projects etc. Their

requirement of working capital is less. On the other hand, there are some business like

trading activity, where the requirement of fixed capital is less but more money is blocked

in inventories and debtors. Their requirement of the working capital is more.

Length of Production Cycle:

In some business like machine tool industry, the time gap between the acquisitions of

raw material till the end of final production of finished product itself is quite high. As

such more amounts may be blocked either in raw materials, or work in progress or

finished goods or even in debtors. Naturally, their needs of working capital are higher.

On the other hand, if the production cycle is shorter, the requirement of working capital is

also less.

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Size and Growth of Business:

In very small companies the working capital requirements are quite high overheads,

higher buying and selling costs etc. As such, the medium sized companies positively have

an edge over the small companies. But if the business starts growing after a certain limit,

the working capital requirements may be adversely affected by the increasing size.

Business I Trade Cycles:

If the company is operating in the period of boom, the working capital requirements may

be more as the company may like to buy more raw material, may increase the production

and sales to take the benefits of favourable markets, due to the increased sales, there may

be more and more amount of funds blocked in stock and debtors etc. Similarly, in case of

depression also, the working capital requirements may be high as the sales in terms of

value and quantity may be reducing, there may be unnecessary piling up of stocks

without getting sold, the receivables may not be recovered in time etc.

Terms of Purchase and Sales:

Sometimes, due to competition or custom, it may be necessary for the company to extend

more and more credit to the customers, as a result of which more and more amounts is

locked up in debtors or bills receivables which increase working capital requirements. On

the other hand, in case of purchases, if credit is offered by the suppliers of goods and

services, a part of working capital requirement may be financed by them, but if it is

necessary to purchase these goods or services on cash basis, the working capital

requirement will be higher.

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Profitability:

The profitability of the business may vary in each and every individual case, which in its

turn may depend upon numerous factors. But high profitability will positively reduce the

strain on working capital requirements of the company, because the profits to the extent

that they are earned in cash may be used to meet the working capital requirements of the

company. However, profitability has to be considered from one more angles so that it can

be considered as one of the ways in which strain on working capital requirements of the

company may be relieved. And these angles are:

Taxation Policy:

How much is required to be paid by the company towards its tax liability?

Dividend Policy:

How much of the profits earned by the company are distributed by way of dividend?

Effect of Inflation on Working Capital Requirement:

The phase of inflation can be identified with the situation of increasing price levels,

increasing demand and increasing supply. As such, the working capital requirements

multiply during the phase of inflation due to increasing cost of production and increasing

level of sales turnover. However, in order to control the increasing demand for working

capital during the period of inflation, the following measures may be applied.

Possibility of using cheaper substitute raw material, without affecting the quality, should

be explored. For this purpose, research activities may be conducted. Attempts should be

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made to reduce the production costs to maximum possible extent. For this purpose, the

techniques like time and motion study, incentive schemes, cost reduction programmes

etc. may be implemented. Attempts should be made to reduce the operating cycle to the

maximum possible extent. Aiming at greater turnover at short intervals will go a long

way to reduce the stress on working capital requirements. Attempts should be made to

reduce the locked up working capital in non-moving or obsolete inventories. A clear-cut

policy should be formulated and followed for timely disposal of non- moving and

obsolete inventories. Similarly, efficient management information system should be

developed to reflect the position of inventory from the various angles. Attempts should be

made to reduce the amount looked up in receivables. Quicker realization of debts will go

a long way to reduce the stress on working capital requirements. Attempts should be

made to make the payments of to creditors in time. This helps the business to build up

good reputation and increases its bargaining power with respect to period of credit of

credit for payment and other conditions.

Attempts should be made to match the projected cash inflows and projected cash

outflows. If they do not match, some of the payments should be postponed or purchases

of certain avoidable items should be deferred. Estimation of Working Capital

Requirements: First of all estimates of all current assets should be made. These current

assets may include stock, debtors. Cash/Bank balance prepaid expenses etc.

Difference between the estimated current assets and current liabilities will represent the

working capital requirements. To this sometime a standard percentage may be added to

take care of the contingencies. This technique is known as Cash Cost technique of

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estimating of working capital requirements. There is another technique available for

estimating working capital requirements also and that is in the form of Balance Sheet

Method. In this the forecast is made of various assets and liabilities, the difference

between assets and liabilities indicating either the surplus or deficiency of cash. There are

various methods available for financing the working capital requirements:

Flied or Permanent or Core Working Capital:

This indicates the amount of minimum working capital, which is required to be

maintained by every business at any point of time, in order to carry on the business on

permanent and uninterrupted basis.

Variable or Temporary Working Capital:

This indicates that amount of working capital required by the business which is over and

above fixed or permanent or core working capital. This need of the working capital may

vary depending upon the fluctuations in demand as a result of changes in production or

sales.

As far as financing of the fixed or permanent needs of working capital are concerned,

these needs should be met out of the long term sources of funds, Own generation of

funds, out of the profits earned, shares or debentures.

As far as financing of the variable or temporary needs of working capital are concerned,

these needs can be met from the various sources:

1. A part of these needs may be financed by way of the credits available from the

suppliers of material or services and of delayed payment of expenses.

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2. A part of these needs may be financed by way of long term sources of funds in the

form of own generation of funds, out of profits earned shares, debentures and other long

term borrowings, public deposits etc.

3. A part of these needs may be financed by way of long term sources of funds in the

form of own generation of funds, out of profits earned, shares, debentures and other long

term borrowing.

4. A major portion of these working capital needs are financed by the Banks. In

financing the working capital needs of the business, the credit obtained from Banks plays

a very important role.

Bank Credit as a Source of Meeting Working Capital Requirements:

While bank credit is considered as a major source of meeting the working capital

requirement of the industry, the banks have to consider the following factors before

meeting their requirements.

A].What should be the amount of working capital assistance?

B].What should be the form in which working capital assistance may be extended?

C].What should be the security that should be obtained for extending the working capital

assistance?

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Amount of Assistance:

To obtain the bank credit for meeting the working capital requirements, the company will

be required to estimate the working capital requirements and will be required to approach

the banks along with the necessary supporting data. On the basis of the estimates

submitted by the company, the bank may decide the amount of assistance which may be

extended, after considering the margin requirements. This margin is to provide the

cushion against the reduction in the value of security. If the company fails to fulfill its

obligations, the bank may be required to realize the security for recovering the dues.

Margin money is meant to take care of the possible reduction in the value of security. The

percentage of margin money may depend upon the credit standing of the company,

fluctuations in the price of security or the directives of Reserve Bank of India from time

to time.

Form of Assistance:

After deciding the amount of overall assistance to be extended to the company, the bank

can disburse the amount in any of the following forms

Non-Fund Based Lending

Fund Based Lending

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Non-Fund Based Lending

In case of Non-Fund Based Lending, the lending bank does not commit any physical

outflow of funds. As such, the funds position of the lending bank remains intact. The

Non-Fund Based Lending can be made by the banks in two forms-

a. Bank Guarantee:

Suppose Company A is the selling company and Company B is the purchasing company.

Company A does not know Company B and as such is concerned whether Company B

will make the payment or not. In such circumstances, D who is the Bank of Company B,

opens the Bank Guarantee in favour of Company A in which it undertakes to make the

payment to Company A if Company B fails to honour its commitment to make the

payment in future. As such, interests of Company A are protected as it is assured to get

the payment, either from Company B or from its Bank D. As such, Bank Guarantee is the

mode which will be found typically in the seller’s market. As far as Bank D is concerned,

while issuing the guarantee in favour of Company A, it does not commit any outflow of

funds. As such, it is a Non-Fund Based Lending for Bank D. If on due date, Bank D is

required to make the payment to Company A due to failure on account of Company B to

make the payment, this Non-Fund Based Lending becomes the Fund Based Lending for

Bank D which can be recovered by Bank D from Company B. For issuing the Bank

Guarantee, Bank D charges the Bank Guarantee Commission from Company B which

gets decided on the basis of two factors-what is the amount of Bank Guarantee and what

is the period of validity of Bank Guarantee. In case of this conventional for of Bank

Guarantee, both company A as well as Company B get benefited as it is able to make the

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credit purchases from Company A without knowing Company A. As such, Bank

Guarantee transactions will be applicable in case of credit transactions.

In some cases, interests of purchasing company are also to be protected. Suppose that

Company A which manufactures capital goods takes some advance from the purchasing

Company B. If Company A fails to fulfill its part of contract to supply the capital goods

to Company B, their needs to be to be some protection available to Company B. In such

circumstances, Bank C which is the banker of Company A opens a Bank Guarantee in

Favour of Company B in which it undertakes that if Company A fails to fulfill its part of

the contract, it will reimburse any losses incurred by Company B due to this non

fulfillment of contractual obligations. Such Bank Guarantee is technically referred to as

performance Bank Guarantee and it ideally found in the buyer’s market.

b. Letter of Credit:

The non-fund based lending in the form of letter of credit is very regularly found in the

international trade. In case the exporter and the importer are unknown to each other.

Under these circumstances, exporter is worried about getting the payment from the

importer and importer is worried as to whether he will get the goods or not. In this case,

the importer applies to his bank in his country to open a letter of credit in favour of the

exporter whereby the importer’s bank undertakes to pay the exporter or accept the bills or

drafts drawn by the exporter on the exporter fulfilling the terms and conditions specified

in the letter of credit.

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Fund Based Lending

In case of Fund Based Lending, the lending bank commits the physical outflow of funds.

As such, the funds position of the lending bank gets affected. The Fund Based Lending

can be made by the banks in the following forms-

Loan: -

In this case, the entire amount of assistance is disbursed at one time only, either in cash or

by transfer to the company’s account. It is a single advance. The loan may be repaid in

instalments, the interests will be charged on outstanding balance.

Overdraft: - In this case, the company is allowed to withdraw in excess of the balance

standing in its Bank account. However, a fixed limit is stipulated by the Bank beyond

which the company will not be able to overdraw the account. Legally, overdraft is a

demand assistance given by the bank i.e. bank can ask for the repayment at any point of

time. However in practice, it is in the form of continuous types of assistance due to

annual renewal of the limit. Interest is payable on the actual amount drawn and is

calculated on daily product basis.

Cash Credit: -

In practice, the operations in cash credit facility are similar to those of overdraft facility

except the fact that the company need not have a formal current account. Here also a

fixed limit is stipulated beyond which the company is not able to withdraw the amount.

Legally, cash credit is a demand facility, but in practice, it is on continuous basis. The

interests is payable on actual amount drawn and is calculated on daily product basis.

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Bills purchased or discounted: -

This form of assistance is comparatively of recent origin. This facility enables the

company to get the immediate payment against the credit bills raised by the company.

The bank holds the bill as a security till the payment is made by the customer. The entire

amount of bill is not paid to the company. The Company gets only the present worth of

the amount of bill, the difference between the face value of the bill and the amount of

assistance being in the form of discount charges. On maturity, bank collects the full

amount of bill from the customer. While granting this facility to the company, the bank

inevitably satisfies itself about the credit worthiness of the customer. A fixed limit is

stipulated in case of the company, beyond which the bills are not purchased or discounted

by the bank.

Working Capital Term Loans: -

To meet the working capital needs of the company, banks may grant the working capital

term loans for a period of 3 to 7 years, payable in yearly or half yearly installments.

Packing Credit: -

This type of assistance may be considered by the bank to take care of specific needs of

the company when it receives some export order. Packing credit is a facility given by the

bank to enable the company to buy the goods to be exported. If the company holds a

confirmed export order placed by the overseas buyer or a letter of credit in its favour, it

can approach the bank for packing credit facility.

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Operating cycle:

The time between purchase of inventory items (raw material or merchandise) and

their conversion into cash is known as operating cycle or working capital cycle. The

longer the period of conversion the longer will be the period of operating cycle. A

standard operating cycle may be for any time period but does not generally exceed a

financial year. Obviously, the shorter the operating cycle larger will be the turnover of the

fund invested for various purposes. The channels of investment are called current assets.

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OPERATING CYCLE

Cash

Purchase of
Receipt from raw material,
debtors components

Creation of Creation of
receivables A/c payable
(Debtors) (Creditors)

Payments to
Sales of creditors
Finished
Goods

Manufacturing
Warehousing operation: wages &
of Finished salaries, fuel,
Goods power, etc

Office, selling,
distribution and
other expenses

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WORKING CAPITAL FINANCE

A manufacturing concern needs finance not only for acquisition of fixed assets

but also for its day-to-day operations. It has to obtain raw materials for processing, pay

wage bills & other manufacturing expenses, store finished goods for marketing & grant

credit to the customers. It may have to pass through the following stages to complete its

operating cycle-

i. Conversion of cash into raw materials – raw material procured on credit, cash

may have to be paid after a certain period.

ii. Conversion of raw materials into stock in process.

iii. Conversion of stock in process into finished goods.

iv. Conversion of finished goods into receivables/debtors or cash.

v. Conversion of receivables/debtors into cash.

A non-manufacturing trading concern may not require raw material for their

processing, but it also needs finance for storing goods & providing credit to its customers.

Similarly a concern engaged in providing services, it may not have to keep inventories

but it may have to provide credit facility to its customers. Thus all enterprises engaged in

manufacturing or trading or providing services require finance for their day-to-day

operations, the amount required to finance day-to-day operation is called working capital

& the assets & liabilities are created during the operating cycle are called current assets &

current liabilities. The total of all the current assets is called gross working capital & the

excess of current assets over current liabilities is called net working capital.

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When entrepreneurs for financing working capital requirements approach the

banks, the bank has to examine the viability of the project before agreeing to provide

working capital for it. Financial institutions & bank while providing term loan finance to

unit for acquisition of fixed assets does a detailed viability study. They have to ensure

that the project will generate sufficient return on the resources invested in it. The viability

of a project depends on technical feasibility, marketability of the products, at a profitable

price, availability of financial resources in time & proper management of the unit. In brief

the project should satisfy the tests of technical, commercial, financial & managerial

feasibility.

Proper co-ordination amongst banks & financial institution is necessary to judge

the viability of a project & to provide working capital at appropriate time without any

delay. If a unit approaches banks only for working capital requirement & no viability

study has been done earlier which is done at the time of providing term loans, a detailed

viability study is necessary before agreeing to provide working capital finance.

In the view of scarcity of bank credit, its increasing demand from various sectors

of economy & its importance in the development of economy, bank should provide

working capital finance according to production requirements. Therefore it is necessary

to make a proper assessment of total requirement of the working capital, which depends

on the nature of the activities of an enterprise & the duration of its operating cycle. It has

to be ensured that the unit will have regular supply of raw material to facilitate

uninterrupted production. The unit should be able to maintain adequate stock of finished

goods for smooth sales operation. The requirement of trade credit, facilities to be given

by the unit to its customers should also be assessed on the basis of practice prevailing in

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the particular industry/trade which assessing above requirements, it should also be

ensured that carrying cost of inventories & duration of credit to customers are minimized.

After assessing the total requirement of working capital, a part of working capital

requirement should be financed for the long term & partly by determining maximum

permissible bank finance.

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ASSESSMENT OF WORKING CAPITAL

A unit needs working capital funds mainly to carry current assets required for its

operations. Proper assessment of funds required for working capital is essential not only

in the interest of the concerned unit but also in the national interest to use the scare credit

according to production requirements. 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 Burdon 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 1: 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

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capital requirements and gives various suggestions to suit the changing requirements of

the industry and trade.

Banks make their own assessment of credit requirements of borrowers based on a total

study of borrowers’ business operations and they can also decide the levels of holding

each item of inventory as also of receivables which in their view would represent a

reasonable built up of current assets for being supported by banks’ finance. Banks may

also consider suitable internal guidelines for accepting the projections made by the

borrowers regarding sundry creditors as sundry creditors are taken as a source of

financing current assets (inventories, receivables, etc.), it is necessary to project them

correctly while calculating need of bank finance for working capital requirements.

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:-

a. Bank can work out the working capital gap. i. e. total current assets less current

liabilities other than bank borrowings and finance a maximum of 75 per cent of

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

borrowings

b. Borrower should provide for a minimum of 25 per cent of total current assets

out of long-term funds, i.e. owned funds and long term borrowings. A certain

level of credit for purchases and other current liabilities inclusive of bank

borrowings will not exceed 75 per cent of current assets.

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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.

Above two method of lending may be illustrated by taking the following example of

a borrower’s financial position, projected as at the end of next year.

Current Liabilities Amt Current Assets Amt

Creditors for purchase 200 Raw materials 380

Other current liabilities 100 Stock in process 40

300 Finished goods 180

Bank borrowing, including bills 400 Receivables, including bills 110

discounted with bankers discounted with bankers

Other current assets 30

700 740

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First method Second method
Total current assets 740 total current assets 740
Less: current liabilities 25% of above from long term
Other than bank borrowings 300 sources 185

Working capital gap 440 555
25% of above from long term less: current liabilities
Sources 110 Other than bank borrowings 300
Maximum permissible bank 330 Maximum permissible bank 255
Finance finance
Excess Bank borrowings 70 Excess Bank borrowings 145
Current ratio 1.17:1 Current ratio 1.33:1

It may be observed from the above that in the first method, the borrower has to

provide a minimum of 25 per cent of working capital gap from ling-term funds and it

gives a minimum current ratio 1.17:1. In the second method, the borrower has to provide

a minimum of 25 per cent of total current assets from long-term funds and gives a

minimum current ratio of 1.33:1.

While estimating the total requirement of long-term funds for new projects,

financial institutions/banks should calculate for working capital on the basis of norms

prescribed for inventory and receivables and by applying the second method of lending.

A project may suffer from shortage of working capital funds if sufficient margin for

working capital is not provided as per the second method of lending while funding new

projects. Proper co-ordination between banks & financial institutions is necessary to

ensure availability of sufficient working capital finance to meet the production

requirement.

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III. Classification of current assets & Current liabilities:

In order to calculate net working capital & maximum permissible bank finance, it is

necessary to have proper classification of various items of current assets & current

liabilities. All illustrative lists of current assets & current liabilities for the purpose of

assessment of working capital are furnished below;

Current assets: -

a. Cash and bank balances

b. Investments

c. Receivables arising out of sales other than deferred receivables (including bills

purchased & discounted by bankers)

d. Installments by deferred receivables due within one year

e. Raw materials & components used in the process of manufactured including

those in transit

f. Stock in process including semi finished goods

g. Finished goods including goods in transit

h. Other consumable spares

i. Advance payment for tax

j. Prepaid expenses

k. Advances for purchases of raw materials, components & consumable stores

l. Payment to be received from contracted sale of fixed assets during the next 12

months

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Current Liabilities:

a. Short-term borrowings (including bills purchased & discounted) from

Banks and ii. Others

b. Unsecured loans

c. Public deposits maturing within one year

d. Sundry creditors (trade) for raw material & consumer stores & spares

e. Interest & other charges accrued but no due for payments

f. Advances/progress payments from customers

g. Deposits from dealers selling agents, etc.

h. Statutory liabilities

Provident fund dues

Provision for taxation

Sales-tax, excise, etc.

Obligation towards workers considered as statutory

i. Miscellaneous current liabilities

Dividends

Liabilities for expenses

Gratuity payable within one year

Any other payments due within one year

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Notes on classification of Current Assets & Current Liabilities:

1. Investment in shares, debenture, etc. and advances to other firms/companies, not

connected with the business of the borrowing firm, should be excluded from

current assets. Similarly investment made in units of Unit Trust of India & other

mutual funds & in associate companies/subsidiaries, as well as investment made

and/or loans extended as inter-corporate deposits should not be included in the

build-up of current assets while assessing maximum permissible bank finance.

2. The borrowers are not expected to make the required contribution of 25 per cent

from long-term sources in respect of export receivables. Therefore, export

receivables may be included in the total current assets for arriving at the

maximum permissible bank finance but the minimum stipulated net working

capital may be reckoned after excluding the quantum of export receivables from

the total current assets.

3. ‘Dead inventory’ i.e. slow moving or obsolete items should not be classified as

current assets.

4. Security deposits/tender deposits given by borrower should be classified as non-

current assets irrespective of whether they mature within the normal operating

cycle of one year or not.

5. Advances/progress payments from customer should be classified as current

liabilities. However, where a part of advances received is required by government

regulations to be invested in certain approved securities, the benefit of netting

may be allowed to the extent of such investment and the balance may be classified

as current liability.

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6. Deposits from dealers, selling agents, etc. received by the borrower may treated as

term liabilities irrespective of their tenure if such deposits are accepted to be

repayable only when the dealership/agency is terminated. The deposits, which do

not fulfill the above condition, should be classified as current liabilities.

7. Disputed liabilities in respect of income tax, excise, custom duty and electricity

charges need not be treated as current liabilities except to the extent of provided

for in the books of the borrower. Where such disputed liabilities are treated as

contingent liabilities for period beyond one year, the borrower should be advised

to make adequate provision so that he may be in a position to meet the liabilities

as & when they accrue.

8. If disputed excise liability has been shown as contingent liability or by way of

notes to the balance sheet, it need not be treated as current liability for calculating

the permissible bank finance unless it has been collected or provided for in the

accounts of borrowers. A certificate from the Statutory Auditors of the borrowers

may be obtained regarding the amount collected from the customers in respect of

disputed excise liability or provision made in the borrowers’ accounts. The

amount of excise duty payable should be treated as current liability for the

purpose of working out the permissible limit of the bank finance strictly on the

basis of the certificate from the borrowers’ Statutory Auditors. The same principle

may also be applied for disputed sales tax dues.

9. In case of other statutory dues, dividends, etc., estimated amount payable within

one year should be shown as current liabilities even if specific provisions have not

been made for their payment.

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10. As per the instructions issued by the Reserve Bank in October, 1993, the entire

term loan investment falling due for payment in the next twelve months need not

be treated as an item of current liabilities for the purpose of arriving at MPBF.

However all overdue term loan should be treated as current liabilities unless the

loan has been rescheduled by the financial institutions/banks. It may be added that

the entire amount of term loan installments payable within the next twelve months

which is kept outside the current liabilities while calculating MPBF. Need not be

taken into account while computing net working capital (NWC). However the

entire amount of term loan installments due within the next twelve months should

continue to be treated as current liability for the purpose of calculating the current

ratio.

IV. Information/Data required for assessment of working capital:

In order to assess the requirements of working capital on the basis of production needs,

it is necessary to get the data from the borrowers regarding their past/projected

production, sales, cost of production, cost of sales, operating profit, etc. in order to

ascertain the financial position of the borrowers & the amount of working capital needs

to be financed by banks, it is necessary to call for the data from the borrowers regarding

their net worth, long term liabilities, current liabilities, fixed assets, current assets, etc.

the Reserve Bank prescribed the forms in 1975 to submit the necessary details

regarding the assessment of working capital under its credit authorization scheme. The

scheme of credit authorization was changed into credit monitoring arrangement in

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1988. The forms used under the credit authorization scheme for submitting necessary

information have also been simplified in 1991 for reporting the credit sanctioned by

banks above the cut-off point to reserve bank under its scheme of credit monitoring

arrangement.

As the traders and merchant exporters who do not have manufacturing activities

are not required to submit the data regarding raw materials, consumable stores, goods-

in-process, power and fuel, etc., a separate set of forms has been designed for traders

and merchant exporters. In view of the peculiar nature of leasing and the hire purchase

concerns, a separate set of forms has also designed for them.

In addition to the information/data in the prescribed forms, bank may also call for

additional information required by them depending on the nature of the borrowers’

activities & their financial position. The data is collected from the borrowers in the

following six forms: -

1. Particulars of the existing/proposed limits from the banking system (form I)

Particulars of the existing credit from the entire banking system as also the term

loan facilities availed of from the term lending institutions/banks are furnished in this

form. Maximum & minimum utilization of the limits during the last 12 months

outstanding balances as on a recent date are also given so that a comparison can be

made with the limits now requested & the limits actually utilized during the last 12

months.

39

2. Operating Statement (Form II)

The data relating to last sales, net sales, cost of raw material, power & fuel, direct

labour, depreciation, selling, general expenses, interest, etc. are furnished in this form.

It also covers information on operating profit & net profit after deducting total

expenditure from total sale proceeds.

3. Analysis of Balance Sheet (Form III)

A complete analysis various items of last year’s balance sheet, current year’s

estimate & following year’s projections is given, in this form. The details of current

liabilities, term liabilities, net worth, current assets, other non-current assets, etc. are

given in this form as per the classification accepted by banks.

4. Comparative statement of current assets & current liabilities (Form IV)

This form gives the details of various items of current assets and current liabilities

as per classification accepted by banks. The figures given in this form should tally

with the figures given in the form III where details of all the liabilities & assets are

given. In case of inventory, receivables and sundry creditors; the holding/levels are

given not only in absolute amount but also in terms of number of month so that a

comparative study may be done with prescribed norms/past trends. They are indicated

in terms of numbers of months in bracket below their amounts.

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5. Computation of Maximum Permissible Bank Finance (Form V)

On the basis of details of current assets & liabilities given in form IV, Maximum

Permissible Bank Finance is calculated in this form to find out credit limits to be

allowed to the borrowers.

6. Fund Flow Statement (Form VI)

In this form, fund flow of long term sources & uses is given to indicate whether

long term funds are sufficient for meeting the long term requirements. In addition to

long term sources and uses, increase/decrease in current assets is also indicated in this

form.

V. Check list for verification of the information/data:

Bank should verify not only the arithmetical accuracy of the data furnished by the

borrowers but also the logic behind various assumptions based on which the projections

have been made. For this purpose, bank officials should hold discussions with the

borrowers on projected sales, level of operations, level of inventory, receivables, etc. if

necessary, a visit to the factory may also be made to have a clear idea of products and

processes.

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ASSESSEMENT OF OTHER LIMITS

LETTER OF CREDIT

The banker examines the proposal of the letter of credit from two angles:

o The cases where letter of credit is required once only

o The cases where letter of credit is required once regularly.

In the second category it is convenient for the banker to fix the separate limit of the letter

of credit.

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ASSESSEMENT OF THE LIMITS UNDER LETTER OF CREDIT-WITH LEAD

TIME

The buyer does not receive the goods immediately on the placement of the order on the

seller. There is always long time log between the order placement and the receipt of the

material. This period is also referred to as the lead-time.

Example: -

If it is assumed that the total raw material requirement is Rs.240lacs per annum and the

normal lead time is 2 months, the buyer will be required to place order so that he has at

least 2 months stock (ignoring safely level). Thus, the total number of order placed would

be 6 per year and the value of per order would be Rs.40 Lacs. This is shown below

Assessment of the limits under LC- with lead-time

Annual requirement of raw material 240 Lacs

Normal lead time 2 months

Value per order (A) 240/6=Rs.40 Lacs

Margin for customer @20%(B) Rs 8 Lacs

Limits under letter of credit (A-B) Rs 32 Lacs

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Assessment of the limits under letter of credit-without lead-time

Annual requirement of raw material 240 lacs

Monthly requirement of raw material 240/12 months =20 lacs

Normal inventory level (1 month) Rs 20 lacs

Value per order (A) Rs 20 lacs

Margin for customer @ 20% (B) Rs 4 lacs

Limits under letter of credit (A-B) Rs 16 lacs

BANK GUARANTEES

There is no standard formula for assessment of bank guarantee limit. The details

pertaining to nature of guarantees, particulars of the contract, period for which the

guarantee is sought and the amount of guarantee to be obtained, this information along

with the view on the creditworthiness of the borrower and relationship with the bank

comprise the major input towards deciding the sanction of limits required by borrower.

Appropriate conditions regarding cash margin and securities have to be laid down to

protect the interest of the bank..

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PROCEDURE FOR WORKING CAPITAL FINANCE

CREDIT SANCTION PROCESS

The revised credit process is introduced with a view of reducing the time lag in the

sanction of credit besides clearly delineating the areas of responsibilities of various

functionaries. As per this the revised process is divide into two components that is Pre

sanctioning and Post sanctioning

In the pre sanctioning it is the only time that the bank can take due assessment and

precautions to make sure that the investments are done for the benefit of the bank. The

post sanctioning is the follow of the payment. Incase the payment defaults then the

account will go into NPA in stages and the bank is then said to scrutinize the said

account.

PRE SANCTION PROCESS: -

Obtain loan application

When a customer required loan he is required to complete application form and submit

the same to the bank also the borrower has to be submit the required information along

with the application form.

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PRE SANCTION
PROCESS

APPRAISAL & SANCTIONING
RECOMMANDATION

ASSESSMENT

The information, which is generally required to be submitted by the borrower along with

the loan application, is under: -

• Audited balance sheets and profit and loss accounts for the previous three year(in

case borrower already in the business)

• Estimated balance sheet for current year.

• Projected balance sheet for next year.

• Profile for promoters/directors, senior management personnel of the company.

• In case the amount of loan required by borrower is 50 lacs and above he should be

submit the CMA Report

46

Examine for preliminary appraisal

RBI guidelines. Policies

Prudential exposure norms and bank lending policy

Industry exposure restriction and related risk factors.

Compliance regarding transfer of borrowers accounts from one bank to

another bank

Government regulation / legislation impact on the industry

Acceptability of the promoter and applicant status with regards to other

unit to industries.

Arrive at the preliminary decision.

Examine/analysis /assessment

Financial statement (in the prescribed forms) refers figure WC cycle & BS

assessment thumb rules.

Financial ratio & Dividend policy.

Depreciation method

Revaluation of fixed assets.

Records of defaults (Tax, dues etc.)

Pending suits having financial implication (Customs, excise etc.)

Qualifications to balance sheet auditors remarks etc.

Trend in sales and profitability and estimates /projection of sales.

Production capacities and utilization: past & projected production

efficiency and cost.

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Estimated working capital gap W.R.T acceptable buildup of

inventory/receivables/other current assets and bank borrowing patterns.

Assess MPBF –determine facilities required

Assess requirement of off balance sheet facilities viz.L/cs,B/gs etc.

Management quality, competence, track records

Company’s structure and system

Market shares of the units under comparison.

Unique feature

Profitability factors

Inventory/Receivable level

Capacity utilization

Capital market perception.

POST SANCTION PROCESS

Supervision and follow up: -

Sanction credit limit of working capital requirement after proper assessment of proposal

is alone not sufficient. Close supervision and follow up are equally essential for safety of

bank credit and to ensure utilization of fund lend. A timely action is possible only close

supervision and followed up by using following techniques.

o Monthly stock statement

o Inspection of stock

o Scrutiny of operation in the account

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o Quarterly/half quarterly statements.

o Under information system

o Annual audited report

POST SANCTION
PROCESS

FOLLOW UP MONITORING &
CONTROL

SUPERVISION

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CREDIT MONITORING ARRANGEMENT

Consequent upon the withdrawal of requirement of prior authorization under the

erstwhile credit authorization scheme (CAS) and introduction of a system of post

sanction scrutiny under credit monitoring arrangement (CMA) the database forms have

been recognized as CMA database. The revised forms for CMA database as drawn up by

the sub-committee of committee of directions have come into use from 1st April 1991.

The existing forms prescribed for specified industries continue to remain in force. With a

view to imparting uniformity to the appraisal system, database from all borrowers

including SSI units enjoying working capital limits of Rs. 50 lacs and more from the

banking system should be obtained.

The revised sets of forms have been separately prescribed for industrial borrowers and

traders/merchant exporters. The details of forms are as under: -

Form 1: - particulars of the existing/proposed limit from the banking system.

Form 2: -Operating statement.

It contains data relating to gross sales, net sales, cost of raw material, power and fuel, etc.

It gives the operating profit and the net profit figures.

Form 3 : - Analysis of balance sheet.

It is complete analysis of various items of last years balance sheet; current years estimate

and following years projection are given in this form.

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Form 4 : - Comparative statement of current asset and liabilities.

Details of various items of current asset and current liabilities are given.

The figures in this form must tally with those in form III.

Form 5: - Computation of maximum permissible bank finance for working capital.

The calculation of MPBF is done in this form to obtain the fund based credit limits to be

granted to the borrower.

Form 6: - Fund flow statement

It provides the details of fund flow from long term sources and uses to indicate weather

they are sufficient to meet the borrowers long term requirements.

CREDIT RATING MODEL

The various risk faced by any company may be broadly classified as follows:

Industry Risk: It covers the industry characteristic, compensation, financial data etc.

Company/ business risk: It considers the market position, operating efficiency of the

company etc.

Project risk: It includes the project cost, project implementation risk, post project

implementation etc.

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Management risk: It covers the track record of the company, their attitude towards risk,

propensity for group transaction, corporate governance etc.

Financial risk: financial risk includes the quality of financial statements, ability of the

company to raise capital, cash flow adequacy etc.

DRAWING POWER OF THE BORROWER

The drawing power that a borrower enjoys at any one point depends on each components

of working capital. The bank for each component, which the borrower must hold as his

contribution to finance working capital, prescribes margins. The drawing power of the

borrower can be best explained with the following illustration

Illustration:

Suppose a borrower has Rs 100.00 lacs as working capital limit sanctioned to him by a

bank.

The security provided by the borrower to the bank is the hypothecation of inventory.

Suppose, the borrower needs to hold an inventory level of say 130 lacs in order to enjoy

Rs 100 lacs as his working capital limit.

The actual level of inventory with the borrower at a point is say 110 lacs.

The inventory margin prescribed by the bank is say 25 %

Therefore with this inventory level, the borrower enjoys only Rs 82.5 lacs as his working

capital limit as against Rs 100 lacs.

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Inventory level (Required) Rs 130 lacs

Drawing power of borrower Rs 100 lacs

Inventory level (Actual) Rs 110 lacs

Margin prescribed by bank 25 %

Drawing power of borrower 110-(0.25× 110) = Rs 82.5 lacs

Suppose, the borrower holds Rs 150 lacs of inventory,

Inventory level (required) Rs 150 lacs

Drawing power of borrower Rs 100 lacs

Inventory level (actual) Rs 150 lacs

Margin prescribed by bank 25 %

Drawing power of borrower 150 − (0.25 × 150) = Rs. 112.2 lacs

Therefore, in this case the borrower would still enjoy Rs 100 lacs as his working capital

limits as against Rs 112.5 lacs.

Therefore, the lower of the two is always considered as the working capital limit or the

drawing power of the borrower sanctioned by the bank.

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SECURITY

Banks need some security from the borrowers against the credit facilities extended to

them to avoid any kind of losses. securities can be created in various ways. Banks

provide credit on the basis of the following modes of security from the borrowers.

Hypothecation: under this mode of security, the banks provide credit to borrowers

against the security of movable property, usually inventory of goods. The goods

hypothecated, however, continue to be in possession of the owner of the goods i.e. the

borrower. The rights of the banks depend upon the terms of the contract between

borrowers and the lender. Although the bank does not have the physical possession of the

goods, it has the legal right to sell the goods to realize the outstanding loans.

Hypothecation facility is normally not available to new borrowers.

Mortgage: It is the transfer f a legal / equitable interest in specific immovable property

for securing the payment of debt. It is the conveyance of interest in the mortgaged

property. This interest terminated as soon as the debt is paid. Mortgages are taken as an

additional security for working capital credit by banks.

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Pledge: The goods which are offered as security, are transferred to the physical

possession of the lender. An essential prerequisite of pledge is that the goods are in the

custody of the bank. Pledge creates some kind of liability for the bank in the sense that

‘Reasonable care’ means care, which a prudent person would take to protect his property.

In case of non-payment by the borrower, the bank has the right to sell the goods.

Lien: The term lien refers to the right of a party to retained goods belonging to other

party until a debt due to him is paid. Lien can be of two types viz. Particular lien i.e. A

right to retain goods until a claim pertaining to these goods are fully paid, and General

lien, Which is applied till all dues of the claimant are paid. Banks usually enjoyed general

lien.

55

BANKING ARRANGEMENTS

Working capital is made available to the borrower under the following arrangements;

CONSORTIUM BANKING ARRANGEMENT:

RBI till 1997 made it obligatory for availing working capital facilities beyond a limit (Rs

500 million in 1997), through the consortium arrangement. The objective of the

arrangement was to jointly meet the financial requirement of big projects by banks and

also share the risks involved in it.

While it consortium arrangement is no longer obligatory, some borrowers continue to

avail working capital finance under this arrangement. The main features of this

arrangement are as follows;

Bank with maximum share of the working capital limits usually takes the role of ‘lead

bank’.

Lead bank, independently or in consultation with other banks, appraise the working

capital requirements of the company.

Banks at the consortium meeting agree on the ratio of sharing the assessed limits.

Lead bank undertakes the joint documentation on behalf of all member banks.

Lead bank organizes collection and dissemination of information regarding conduct of

account by borrower.

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MULTIPLE BANKING ARRANGEMENT

Multiple banking is an open arrangement in which no banks will take the lead role.

Most borrowers are shifting their banking arrangement to multiple banking arrangements.

The major features are –

Borrower needs to approach multiple banks to tie up entire requirement of working

capital.

Banks independently assessed the working capital requirements of the borrower.

Banks, independent of each other, do documentation, monitoring and conduct of the

account

Borrowers deals with all financing banks individually.

SYNDICATION

A syndicated credit is an agreement between two or more lenders to provide a borrower

credit facility using common loan agreement. It is internationally practiced model for

financing credit requirements, wherein banks are free to syndicate the credit limit

irrespective of quantum involved. It is similar to a consortium arrangement in terms of

dispersal of risk but consist of a fixed repayment period.

57

REGULATION OF BANK FINANCE

INTRODUCTION

Bank follows certain norms in granting working capital finance to companies.

These norms have been greatly influenced by the reconditions of various committees

appointed by the RBI from time to time. The norms of working capital finance followed

by banks are mainly based on the recommendation of Tandon committee and chore

committee.

These committees were appointed on the presumption that the existing system of bank

lending of number of weakness industries in India have grown rapidly in the last three

decades as result of which, the industrial system has become vary complex. The banks

role has shifted from trade financing to industrial financing during this period.

However, the banks lending practices and styles have remained the same. Industries

today fail to use bank finance efficiently. Their techniques of managing funds are

unscientific and non-professional. The industries today lack in reducing costs,

optimizing the use of inputs, conserving resources etc.

The weakness of the existing system highlighted by the Dehejia committee in 1968 and

identified by the tondon committee in 1974, are as follows:

It is the borrower who decides how much he would borrow ;the bankers does not decide

how much he would lend and is, therefore, not in a position to do credit planning. The

58

bank credit is treated as the first sources of finance and not as supplementary to other

sources of finance.

The amount of credit is extended is based on the amount of security available and not on

the level of operations of the borrower.

Security does not by itself ensure safety of bank. Funds since all bad sticky advances are

secure advances. Safety essentially lies in the efficient follow up of the industrial

operations of the borrower.

We discuss the following committee’s important finding and recommendations for bank

finance: -

• TANDON COMMITTEE

• CHORE COMMITTEE.

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TANDON COMMITTEE

INTRODUCTION:

The Tandon committee was appointed by the RBI in July 1974 and headed by Shri.

Prakash L. Tandon, the chairman of the Punjab national bank, to suggest guidelines for

rational allocation and optimum use of bank credit taking into consideration the weakness

of the leading system. Bank credit, which had become a scare commodity, strictly

rationed to meet the credit requirement of all the sectors. The larger sector of the industry

needed strict rationing becomes

It was over relying on bank finance and pre empted most of it while the other sectors

were not getting even their due share. Therefore, the method and criterion adopted for

fixing credit ration needed to be standardized so that there is minimum scope for miss-use

or part of the credit uses. The Tandon committee was concern exactly with this problem.

Its report laid down as to how the credit ratio of individual borrowers could be fixed at

imposed certain obligation on them for the efficient use of the credit made available.

The recommendation of the Tandon committee based on the following notions:

The borrower should indicate the demand for credit for which he should draw operating

plans for the ensuring year and supply them to the banker. This would facilitate credit

planning at the banks level and help the banker in evaluating the borrower’s credit needs

in a more realistic manner.

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The banker should finance only the genuine production needs of the borrower. The

borrower maintained reasonable levels inventories and receivables. Efficient management

of resources should therefore be ensured to eliminate slow moving and flabby

inventories.

The working capital needs of borrower cannot entirely finance by the banker. The banker

will finance only a reasonable part of it for the remaining; the borrower should depend on

his own fund. Recommendation of Tandon committee accordingly, the Tandon

committee put forth in the following recommendations

Inventory and receivables norms

The borrower is allowed to hold only a reasonable level of current asset, particularly

inventory and receivable. The committee suggested the maximum level of raw material,

stock in process, finished goods, which corporate in an industry should be to hold.

Only the normal inventory based on a production plan, lead-time of supplies, economic

ordering levels and reasonable factor safety should be financed by the banker.

61

Lending norms:

The banker should finance only a part of the working capital gap; the other part should be

financed by the borrower form long-term sources.

The current asset will be taken on the estimate values or values as per the Tandon

committee norms, whichever is lower.

The current will consist of inventory and receivables, referred as chargeable current

assets (CCA), and other current assets (OCA).

MAXIMUM PERMISSIBLE BANK FINANCE:

The Tandon committee suggested the following three methods of determining the

permissible level of bank borrowings-

The borrower will contribute 25 % of the working capital gap from long term fund i.e

owned fund and term borrowings; the remaining 75 % can be financed from bank

borrowings. This method gives a minimum current ratio of 1:1. This method was

considered suitable only for very small borrowers where the requirement 0 credit was less

than Rs 10 lacs

The borrower will contribute 25 % of the total current assets from long-term funds i.e.

owned funds and term borrowings. A certain level of credit for purchases and other

current liabilities will be available to fund the building up of current assets and the bank

will provide the balance. Consequently, the current liabilities inclusive of bank borrowing

could not exceed 75 % of current assets. This method gives a current ratio of 1.3:1. This

62

method was considered for all borrowers whose credit requirements were more than Rs

10 lacs.

The borrower will contribute 100 % of core current assets, defined at the absolute

minimum level of raw material, processed stock, finished goods and stores, which are in

the pipeline. A minimum level of the 25 % of the balance of the current assets should be

finance from the long term funds and term borrowings. This method covers straightness

the current ratio. The third is the ideal method. Borrowers in the second stage are not

allowed to revert to the first stage. This method applies to all borrowers having credit

limit in excess of Rs.20 lacs from the bank. However this method was not accepted for

implementation.

In some cases, the net working capital was negative or 25 % of the working capital gap.

The new systems allowed this deficiency to be financed in addition to the permissible

bank finance by the bank. This kind of credit facility is called working capital demand

loan, which was to be regulated over a period of time depending on the funds generating

capacity and ability of the borrower.

The working capital demand loan is not allowed to be raised in the subsequent year. For

additional credit in subsequent year, the borrower’s long-term sources were required to

provide 25 % of the additional working capital gap.

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4. Style of credit:

The committee recommended the bifurcation of total credit limit into fixed and

fluctuating parts.

The fixed component is then treated as demand loan for the year representing minimum

level of borrowing, which the borrower expected to use through out the year.

The fluctuating component is taken care of by a demand cash credit. It could be partly

used by way of bills.

The new CC limit should be placed on a quarterly budgeting reporting system.

The interest rate on the loan components should be charged lower than the cash credit

amount. The RBI has stipulated the interest differentiate at 1 %.

The cash credit limits sanctioned (fluctuating) are currently 205 and the loan components

(fixed) are 80 %.

5) INFORMATION SYSTEM:

The committee advocated for grater flow of information from borrower to the bank for

operational purpose and for the purpose of supervision and flow of up credit.

Information should be provided in the following forms:

64

QUARTERLY INFORMATION SYSTEM: FORM:

It should contain the production and sales estimates for the current and next quarter. also,

the current asset current liabilities estimates for the next quarter should be mentioned.

Quarterly information system: Form II:

It should contain the actual production and sales finger during the current year and the

latest completed year. Also, actual current asset and current liabilities for the latest

completed quarter should be mention.

Half year operating statement form IIIA:

Actual operating performance for the half year ended against the estimate should be

mentioned.

Half year fund flow statement: Form IIIB:

It should contain the estimate as well as the actual sources and use of fund for the half

year ended.

Borrowers with a credit limit of more than1 crore are required to supply the quarterly

information.

The bank to follow up and supervise the use of credit should properly use the information

supplied by the borrower.

65

The bank must ensure that the bank credit was used for the purposes for which it is

granted, keeping in view the borrowers operation and environment.

The bank should confirm whether the actual result is in conformity with the expected

results. A+/- 10% variation is considered normal.

The banker should be treated as a partner in the business with whom information should

be shared freely and frankly.

The recommendations of the Tandon committee have been widely debated and criticized.

The bankers have found a difficult to implement the committee’s recommendations.

However, the Tandon committee has brought about a perceptible change in the outlook

and attitude of both the banker and their customers. They have become quite aware in the

matter of making the best use of a scare resource like bank credit. The committee has

help in bringing the financial discipline through a balanced and integrated scheme of

bank lending. Most of banks in India, even today continue to look at the needs of the

corporate in the light of recommendation of the Tandon committee

66

CHORE COMMITTEE

INTRODUCTION

In April 1979, the RBI constituted a working group to review the system of cash credit

under the chairmanship of Mr. K. B. Chore, Chief Officer, DBCOD, RBI. The main

terms of reference for the group were to review the cash credit discipline and relate credit

limit to production.

RECOMMENDATION OF CHORE COMMITTEE: -

Bank credit: -

Borrower should contribute more funds to finance their working capital requirement and

reduce their dependence on bank credit. The committee suggested placing the second

method of lending as explain in the Tandon committee report.

In case the borrower is unable to comply with this requirement immediately, he would be

granted excess borrowing in the form of working capital loan (WCTL).

The WCTL should be paid in seamy annual installments for a period not exceeding 5

years and a higher rate of interest than under the cash credit system would be charged.

This procedure should apply to those borrowers, having working capital requirements of

more than Rs 10 lacs.

67

LEVEL OF CREDIT LIMIT

Bank should appraise and fix separate limits for the “peak level” and normal “non pick

level” credit requirements for all borrowers in excess of Rs. 10 lacs indicating the

relevant periods.

With the sanctioned limits for these two periods, the borrower should indicate in advance

his need for funds during the quarter. Any deviation in utilization of funds Beyond 10%

should be considered irregular and is subject to penalty fix by the RBI (2% p.a. over the

normal rate)

Bank should discourage ad hoc or temporary credit limits. If sanction under exceptional

circumstances the same should be given in the form of a separate demand loan and

additional interest of at least 1% should charged.

Lending system:

The system of three types of lending should continue i.e. cash credit loan and bills

wherever possible; the bank should replace cash credit system by loan and bills.

Bank should scrutinize the cash credit accounts of large borrowers one’s a year.

Bifurcation of cash credit account into demand loan fluctuating cash credit component, as

recommended by the Tandon committee should discontinue.

68

Advances against books debts should be converted to bills wherever possible and at least

50% of cash credit limit utilize for financing purchases of raw material inventory should

also be charged to the bill system.

Information System

The discipline relating to the submission of Quarterly Statements to be obtained from

the borrower should be strictly adhered to in respects of all borrowers having working

capital limits of more than Rs.50 lacs.

If the borrower does not submit report within the prescribed time, he should be penalized

by charging a penal rate of interest, which is 2% p. a. more than the contracted rate.

Banks should insists the public sector undertakings and large borrower to maintained

control accounts in their books to give precise data regarding their dues to the small units

and furnish such data in their quarterly reports.

Other recommendations:

Request for relaxation of inventory norms and for ad hoc increases in limits should be

subjected by banks to close scrutiny and agreed only in exceptional circumstances.

Delays on the part of the banks in sanctioning credit limits should be reduced in cases

where the borrowers cooperate in giving the necessary information about their past

performance and future projection in time.

69

Autonomous institutions on the lines of the discount houses in U.K may be set up to

encourage the bill system of financing and to facilitate all money operations.

There should be a “cell” attached to the chairmen’s office at the central office of each

bank to attend to matters like immediate communication of credit control measures at the

operational level.

The central offices of bank should take a second look at the credit budget as soon as

changes in the credit policy are announced by the RBI and they should revised their plan

of action in the right of new policy and communicate the corrective measures at the

operational levels at the earliest.

Bank should give particular attention to monitor the key branches and critical accounts.

The communication channels and system and procedures with in the banking system

should be toned up so as to ensure that minimum time is taken for collection of

instruments.

70

FINANCIAL RATIOS

CURRENT RATIO=CURRENT ASSET/ CURRENT LIABITIES

Help to measure liquidity and financial strength, indication of availability of current

assets to pay current liabilities. The higher the ratio betters the liquidity position.

Generally it should be at least 1.33.

TOL/TNW=TOL/TANGIABLE NET WORTH

Indicate size of stakes, stability and degree of solvency. Indicates how high the stake of

the creditors is. Indicate what proportion of the company finance is represented by the

tangible net worth. The lower the ratio, greater the solvency. Anything over 5 should be

viewed with concern.

The ratio should be studied at the peak level of operations.

OPERATING PROFIT RATIO=OPERATING PROFIT/NET SALES×100

This ratio indicates operating efficiency. Indication of net margin of profit available on

Rs. 100 sales. Trend for company over a period should be encouraging.

71

DSCR(DEBT SERVICE COVERAGE RATIO)=DEPRICIATION+INTREST ON

TERM LOAN/ INTREST ON TERM LOAN+INSTALLMENT OF TERM LOAN

It indicates the number of times total debt service obligation consisting of interest and

repayment of the principal in installment is covered by the total fund available after taxes.

With the help of this ratio (popularly known as DSCR), we can find out whether the loan

taken for acquisition of fixed assets can be rapid conveniently.

This ratio of 1.5 to 2 considered adequate.

We have already touched upon depreciation as non cash expenditure and since the funds

are available with the enterprise to that extent. It is in order to ask for this sum in

reduction of loan.

INTEREST COVERAGE RATIO=EARNINGS BEFORE TERM LOAN AND

TAXATION / INTEREST ON TERM LOAN

The ratio indicates adequacy of profit to cover interest. Higher the ratio more is the

security to the lender.

72

Analysis & Interpretation of the data

Case studies

Case study 1:

Comparative Balance Sheet and Performance / Financial Indicators:

Abridged Balance sheet

(Rs in lacs)
Liabilities 31.03.04 31.03.05 31.03.06 Assets 31.03.04 31.03.05 31.03.06
Audited Audited Prov. Audited Audited Prov.
Capital 17.53 18.41 84.84 FA 23.15 26.64 150.73
Reserves Depr. 5.85 6.38 21.42
NW 17.53 18.41 84.84 Net Block 17.30 20.26 129.31
TL 12.43 15.98 2.98 Cash & 1.47 0.84 2.51
Bank
Unsec Ln RM
TL from 2.46 81.46 WIP
BOM
TL(car) 1.76 1.88 0.38 FG 12.77 16.53 15.00
Scred Rec- Dom 8.18 12.01 35.13
Bk Borr 9.11 13.08 15.00 Export
OCL 0.09 0.15 OCA 1.19 2.32 2.71
TCL 9.20 13.23 15.00 TCA 23.61 31.70 55.35
Inv
Tot NCA
Acc Loss
Tot.Intang
Ass.
Tot Liab 40.91 51.96 184.66 Tot Ass 40.91 51.96 184.66

31.03.2004 31.03.05 31.03.06
* Net Worth 17.53 18.41 84.84
Less: Revaluation Reserves - - -
Less: Intangible Assets - - -
Tangible Net Worth 17.53 18.41 84.84

73

PERFORMANCE / KEY FINANCIAL INDICATORS: (Rs in Lacs)

Particulars 31.03.04 31.03.05 31.03.06
Net Sales 56.11 95.70 180.00
% Increase / Decrease 71.1% 70.55% 88%
Net Profit After Tax 0.57 0.89 8.62
% to Net Sales 1.01% 0.93% 4.79%
Cash Accruals 6.42 7.28 30.04
TNW excl Revaluation Reserve 17.53 18.41 84.84
TOL / TNW Ratio 1.33 1.82 1.18
NWC 14.41 18.47 40.35
Current Ratio 2.57 2.40 3.69

1. Sales: As partners have been engaged in marketing the new technology to various

users for the initial 2/3 years vigorously and their efforts are started yielding results.

During the year 2005 the firm has obtained approval from BHEL, NTPC, and HAL for

use of its products – DSC & ESC. Agreement with NTPC through BHEL (Haridwar) is

exclusive supply (not to any other companies) for annual turnover of Rs. 250.00 Lacs.

The orders are of repetitive nature. Besides BHEL (Hyd) have also started placing sample

orders. The firm has also been able to secure orders from HAL (Koraptut) for DSC &

ESC.

During the year up to Nov’05 the firm has already done sale of Rs. 100.00 lacs besides

the job work. Orders worth Rs. 150.00 lacs from BHEL (Haridwar) are on hand

scheduled to be completed before March’06. Completion of this of these orders will

enable the firm to achieve a sale of Rs. 250.00 lacs by this year end. This is acceptable.

2. Profit: Hitherto the net profit in terms of sales has been about 1.00%. Against this

backdrop the estimated profitability of 4.79% in the current appears unreasonable. During

discussion it is clarified that as the firm has shifted its focus from mare job work to direct

74

selling the margin will be high. In fact it has set up its own machining plant and has

secured approval from BHEL for the Quality of its own materials.

It used to pay for job works to other companies/firms for the machining purpose. This

payment was to the tune of 25% (appx) of the job work revenue. For the year 2005 as the

job work is being done in-house the expenses are estimated to be hardly 5%. Besides,

margin of direct selling of its materials is better. Moreover with increased sales the

marginal revenue would be proportionately high adding to the increased yield. In view of

the above factors we may accept the profitability estimates made by the firm. In the

coming 7 years the firm has estimated profitability ranging from 8.5% to 12.5%. This

appears to be on the higher side. As the sales are estimated to stabilize at Rs. 312.00 lacs

we may accept the profitability of 4.79% as acceptable for the year 2005. Accordingly the

net profit for the 2nd year would be Rs. 13.70 lacs and then Rs. 14.95 lacs p. a.

3. Cash Accrual: With addition to fixed assets the depreciation shall be high. Thus with

accepted profitability the accrual would be Rs. 30.00 lacs for the year 2005 followed by

Rs. 32.03 lacs, Rs. 30.62 lacs respectively. The position is acceptable.

4. TNW: Up to 2004-05 the TNW has been increasing with retention of profits. In the

year 2005 for the expansion plan the partner have agreed in bring in additional capital of

Rs. 46.00 lacs, Remaining Rs 20.00 lacs from internal accrual. We have discussed the

issue of infusion of capital by partners. It is informed that depending upon the advice of

their auditors they would be either increasing the amount of individual capital and/or

brings in unsecured loans from friends/relatives to be converted to capital over a period

of time. Since the existing work is being carried out from their own sources the branch is

advised to obtain a CA’s certificate certifying the amount investing that will be

75

considered as their contribution. Since the cash accrual for the year 2005 is accepted at

Rs. 30.00 lacs the remaining contribution of Rs. 20.00 lacs from partners appears

reasonable.

5. TOL/TNW: The ratio has been below 2.00 up to 31.03.05 and with proposed capital

infusion the same is estimated to be about 1.18 which is acceptable being well within

benchmark level.

6. NWC & C. R.: Both the parameters have been well above their respective benchmark

levels and are estimated to improve further over the existing levels. It may be mentioned

that even though the firm is increasing its production capacity and consequently sales it

has not requested any additional working capital. During discussion it is gathered that

with direct selling the payment term would be 90 % against supply of materials which

would improve its cash flow and hence there will not be additional requirement of

working capital. However the partners have informed that after the expansion is

completed in March 06 they may approach us for additional working if required at that

point of time.

Thus the overall financial position of the firm is satisfactory.

Assessment of present proposal: -

A. Working capital assessment:

A. Comments on: -

i. Sales projections: Already discussed.

ii. Inventory & receivables: Except the receivables the firm has estimated other current

asset as per past trend and hence acceptable. The holding level of receivables has

been 1.5 month to 1.75 months sales. For the current year it has estimated the same to

76

be 2.33 months. It is clarified that as the firm would be executing Rs 150.00 lacs

worth of orders from BHEL in next 4 months ( At least Rs 80.00 lacs as accepted by

us) there will be concentration of debtors at the year end. Hence the estimates appear

reasonable. Creditors have been nil and are estimated to be nil too.

Against this background PBF is calculated as under.

B. Working of MPBF: -

WORKING OF MAXIMUM PERMISSIBLE BANK FINANCE: (Rs in lacs).

Particulars 31.03.04 31.03.05 31.03.06

Audited Audited Projected

a. Total current assets 23.61 31.70 55.35

b. OCL Excl. short term BB 0.09 0.15 -

c. Working Capital Gap(a-b) 23.52 31.55 55.35

d. Min. Stipulated NWC 5.90 7.93 13.84

(25% of TCA)

e. Actual/Projected NWC 14.41 18.47 40.35

f. Item c-d 17.62 23.62 41.51

g. Item c-e 9.11 13.08 15.00

h. MPBF 9.11 13.08 15.00

i. excess borrowings if any - - -

77

Assessment of working capital finance project by noname

Assessment of working capital finance project by noname

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