Working Capital Finance by Banks Working Capital Finance

Working Capital Finance by Banks

Working Capital Finance • Working Capital is a financial metric which represents operating liquidity available to a business. • The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Working Capital Finance by Banks 2

Sources of Working Capital Finance • There are two most significant short-term sources of finance for workingcapital are 1. Trade credit 2. Bank borrowing Working Capital Finance by Banks 3

• Sources of Working Capital Finance There are two most significant short-term sources of finance for working capital are 1. Trade credit 2. Bank borrowing Working Capital Finance by Banks 4

Trade Credit • Trade Credit : It refers to the credit that a customer gets from suppliers in normal course of trade. This deferral of payments is a short term financing which is called trade credit. • It is a major source of finance for firms. In India, it contributes to about 1/3 rd of the total short term financing. • Particularly, small firms are heavily dependent on trade credit as a source of finance since they find it difficult to raise funds from banks or other sources. • Trade Credit is also called Spontaneous Source of Financing. Working Capital Finance by Banks 5

Credit Terms • Credit Terms : This refers to the conditions under which the supplier sells on credit to the buyer, and the buyer is required to repay the credit. • A typical way of expressing credit terms is for example : 3/15 net 45. This means 3% discount is available if payment is made within 15 days and if this discount is not availed payment is to be made on or before 45 days. Working Capital Finance by Banks 6

ACCRUED EXPENSES AND DEFERRED INCOME Accrued Expenses • Accrued expenses represent a liability that a firm has to pay for the services which it has already received. 1. Accrued Wages and Salaries. 2. Accrued taxes and Interest. Deferred Income • Deferred income represents funds received by the firm for goods and services which it has agreed to supply in future. 1. Advance Payments Working Capital Finance by Banks 7

Working Capital from Bank : It includes the facilities as under: a) Cash Credit and Packing Credit (including Trust Receipts and Working Capital Term Loan) against Pledge / Hypothecation of stock-in-trade and / or standing crops (plantations). b) Discount / Purchase of Inland / Foreign Demand Documentary (DP) Bills and Usance Documentary (DA) Bills under Letters of Credit. c) Overdrafts against approved securities with prescribed margin. d) Discount of Inland Usance DA Bills with Banker’s Co-Acceptance / Guarantee (Under Re-discounting Scheme of IDBI e) Import Loans against imported consignments received under L/Cs opened by our Bank. f) Overdrafts against book debts / Government Supply Bills. g) Discount of Inland / Foreign Usance (DA) bills not covered under L/Cs. h) Advance against Demand Documentary Bills for collection. i) Advance against Warehouse Receipts. j) Advance against un-drawn balance. k) Channel Financing. Major Bank Finance for Working Capital • Overdraft • Cash Credit • Purchase or Discounting of Bills • Letter of Credit • Working Capital Loan Working Capital Finance by Banks 8

Overdraft / adhoc Under this facility, the borrower is allowed to withdraw funds in excess of the balance in his current amount, up to a certain specified limit, during stipulated period. Working Capital Finance by Banks 9

Cash Credit • Meaning: Cash credit is a short-term source of finance. Under cash credit, the bank offers its customer to take a loan up to a certain limit. Cash credit is also known as bank overdraft. • Features of Cash Credit: 1. This loan is given to meet the working capital requirements of a company. 2. It is given against a tangible security. 3. Interest is charged only on the amount of loan taken by the customer and not on the amount of credit sanctioned. Working Capital Finance by Banks 10

Cash Credit • Advantages of Cash Credit: 1. It is an important source of working capital financing. 2. Cash credit can be obtained very easily and quickly. 3. Interest is charged only on the utilized amount. • Disadvantages of Cash Credit: 1. The rate of interest charged by loan on cash credit is very high. 2. Such loan is granted by bank on the basis of company’s turnover, its financial status, value of inventory, etc. So it is difficult for new and financially weak companies to obtain cash credit. 3. For banks, cash credit disturbs their credit planning. Working Capital Finance by Banks 11

Difference between Cash Credit and Overdraft Cash Credit Overdraft It is normally given on security of stock, debtors etc. It is normally given on security of a fixed asset. The maximum amount is calculated as a percentage of sale and stock along with financial statements. For e. g. A bank allowed cash credit unto 80% of stock plus 20% of sales. The maximum amount allowed is calculated mainly on basis of financial statements and security. It should be used for the purpose of business. Can be used for any purpose Balance Sheet, P & L account , VAT reports is required be submitted to bank generally annually or quarterly. Financial statements are generally not required to be resubmitted after approval. Working Capital Finance by Banks 12

Purchase or Discounting of Bills • Under the purchase and discounting bills, a borrower can obtain credit from a bank against its bills. The bank purchases or discounts the borrowers bills. • The amount provided under this agreement is covered within the overall cash credit or overdraft limit. Working Capital Finance by Banks 13

Letter of Credit • Particularly the foreign suppliers, insist that the buyer should ensure that his bank will make the payment if he fails to fulfill its obligation. • This is ensured through a letter of credit agreement. • The bank opens an L/C in favour of a customer to facilitate his purchase of goods. Working Capital Finance by Banks 14

Working Capital Loan • A borrower may sometimes require funds in excess of the sanctioned credit limits to meet unforeseen contingencies. • Banks provide such accommodation through a “demand loan account”. The borrower is expected to pay high rates of interest in such exceptional cases. Working Capital Finance by Banks 15

Security for Bank Finance • Hypothecation • Pledge • Mortgage • Lien Working Capital Finance by Banks 16

Hypothecation • Under this the borrower is provided working capital finance against the security of movable property (stock, debtors). • The borrower does not transfer the property to the bank physically. • Thus hypothecation is a charge against property where neither ownership nor the possession is passed on to the creditor. • Banks generally grant credit against hypothecation only to first class customers with high integrity. Working Capital Finance by Banks 17

Pledge • Under this arrangement the borrower, is required to physically transfer the possession of the property offered as security to the bank to obtain credit. (e. g. Share certificates, Insurance policy documents, etc. ) Working Capital Finance by Banks 18

Mortgage is the transfer of a legal or equitable interest in a specific immovable property for the payment of a debt. Lien means right of the lender to retain property belonging to the borrower till he repays the credit. Working Capital Finance by Banks 19

Regulations of Bank Finance • Banks follow certain norms in granting working capital finance to firms. These norms are greatly influenced by the recommendations of various committees appointed by the RBI. • Banks followed the norms suggested by the “Tandon Committee”. • Further recommendations were made by the “Chore Committee” to strengthen the procedures and norms. Working Capital Finance by Banks 20

The Tandon Committee Regulations 1. Operating Plan : The borrowers should prepare operating plans and on that basis indicate the amount of working capital finance requirement. 2. Production based financing : The bankers should finance only the genuine production needs of borrower. The borrower should maintain reasonable levels of inventory andreceivables. 3. Partial bank financing : The bank should not finance the total requirement of the borrower. Only a reasonable part of it should be financed by the bank. Working Capital Finance by Banks 21

4. Reasonable level of Current Assets : The committee further recommends that the borrower should be allowed to maintain current assets specifically debtors and inventories only up to a reasonable level. Flabby, profit making or excessive inventory should not be permitted under any circumstance. However, the bank also visualized the abnormal circumstances such as strikes, power cuts etc. and allowed flexibility to the bankers. Working Capital Finance by Banks 22

5. Maximum permissible bank finance (MPBF) : The committee suggested the following three methods of determining the MBFC. 1. The borrower will contribute 25% of the working capital gap, the remaining 75% will be financed from bank borrowings. W. C. Gap = CA-CL excluding bank borrowings. (Some analysts define the networking capital in the same manner) 2. The borrower will contribute 25% of the total current assets. The remaining of the working capital gap will be financed by the bank. 3. The borrower will contribute 100% of the core assets and 25% of the balance of current assets. The remaining of the working capital gap will be financed. Working Capital Finance by Banks 23

The Chore Committee Regulations 1. Reduced dependence on Bank Credit : The borrowers should contribute more funds to finance their working capital requirements. The idea was to place all borrowers in the 2 nd method suggested by the Tandon Committee. In case of difficulties the resort could be taken to WCTL. 2. Credit limits to be separated in to “Peak level” and “Non Peak Level” limits : Credit limits should be assessed and separated in to “Peak level” and “Normal level” for borrowers with credit limits more than 10 lacs. Borrowers should, in advance, inform the requirement of peak level limits. Moreover, any deviation in utilization beyond 10% tolerance, should be treated as an irregularity. Additional interest of 1% should be chargedon ad hoc borrowings. Working Capital Finance by Banks 24

The Chore Committee Regulations 4. Existing lending system to continue : The existing system had three types of lending. (a) Cash credit (b) WCTL, (C) Bill discounting. Cash credit system should be replaced by the other two wherever possible. Cash credit accounts of large borrowers to be scrutinized, at least once a year. 5. Information System : The discipline regarding submission of quarterly statements should be strictly adhered to, in respect of all borrowers having limits of 50 lacs and above. Working Capital Finance by Banks 25

Commercial Paper In India, the issue of CP’s is regulated by the RBI. Only those Companies, which have (a) Net Worth of 10 Crores, (b) MPBF of not less than 25 Crores & (c) Listed in Stock Exchange can issue CP’s. Size of a single issue should be at least One Crore and size of each CP should be at least 25 Lacs. (5 lacs suggested by Vaghul). Working Capital Finance by Banks 26

Methods for Assessment of Working Capital Requirements In tune with the liberalized environment, CBI has adopted the following system for assessment of working capital requirements of the borrower. 1. Turnover Method: This method should be used for assessing fund based working capital requirements enjoyed from the banking system upto. Rs. 5. 00 crore. Working Capital Finance by Banks 27

2. Traditional Method: Fund based working capital requirements under this method shall be assessed under Method II for borrowers enjoying fund based working capital limits of above Rs. 5. 00 crore but less than Rs. 50. 00 crore. As per RBI guidelines, Non-Funded limits are also to be a part of MPBF. 3. Cash Budget Method This method would be applicable to borrowers who are i. Falling under Cyclical Industries like Tea, Sugar etc. ii. Borrowers availing Fund Based Working Capital limits of Rs. 50. 00 crore and above from the banking system for Central Bank of India. Working Capital Finance by Banks 28

While considering fresh/ new credit proposals the following Financials shall be kept in view: Ratio Benchmark Current Ratio 1. 33 Current Ratio (Trading) 1. 20 Current Ratio (Seasonal Industry) 1. 00 Current Ratio (NBFC-MFI) 1. 11 TOL/TNW 5: 1 TOL/ATNW 4: 1 TOL/TNW (Trading) 6: 1 TOL/TNW (NBFC/MFI) 8: 1 TOL/TNW (Infrastructure Projects) 7: 1 Debt-Equity TL (other than Infra) 3: 1 Debt-Equity TL (Infra, SEZ & SPVs created for Infra ) 5: 1 Bank Borrowing/TNW 4: 1 DSCR (Avg. ) 1. 5 Interest Coverage Ratio 2. 1 Asset Coverage Ratio (ACR) 1. 5: 1 Fixed Assets Coverage Ratio (FACR) 1. 5: 1 TOL/ TNW + Quasi Equity 4: 1 (Quasi Equity= Unsecured Loans equal to 100% of TNW) Bank allows deviations in the above ratios, if it is properly justified. Powers of deviations in the above ratios falls with various higher authorities committee. Working Capital Finance by Banks 29

Recommended Margins: Approved Securities Minimum Margin (%) 1 FDR held in the name of the borrowers 10 2 Fixed deposits in the name of the third party 25 3 Gilt edged securities viz. , bonds / stocks issued by 25 Central/ State Government/Statutory/quasi-Government Corporation or Body repayment of which is guaranteed by the Central/ State Government (including Post office) 4 National Saving Certificates with accrued value 20 5 Surrender value of Life Insurance Policies issued by LIC 10 of India and other Life Insurance Companies. 6 Kisan Vikas Patra (KVP) with accrued value 25 7 Shares and debentures (on Bank’s approved list – In Dematerialized form 50 8 Stocks of tradable commodities / goods having realizablevalue (RM, SIP, FG) 25 9 Book Debts. - For Book debts Up to 90 days 25 - For Book debts beyond 90 days and up to 180 days 35 10 Plant and Machinery (New) 25 11 Plant and Machinery (Secondhand) 40 (of residual value of second hand machinery). 12 Bills of Exchange with Documents / acceptances Nil 13 Gold Ornaments 40 14 Vehicles 25 15 Furniture / Fixtures 25 16 Consumer durables 25 17 Live Stocks 25 18 Land Buildings / Free Hold Plots 40 19 Land & building forming part of project 25 20 Commodities falling under Selective Credit Control. As directed by. RBI fromtime to time 21 Any other Securities so approved by Central Office. Margin will be notified by Bank Management 22 Stocks of Sugar 25 Working Capital Finance by Banks 30

COMPUTATION OF MPBF ON TURNOVER METHOD Rs. Lacs Last Year’s Audited Year Ending 1 Net Sales Estimates Following for the Year Proj. current year ending 2017 -18 2000 2018 -19 2400 2019 -20 3000 2 25% of Net Sales is WC requirement 500 600 750 3 5% own margin from long term sources 100 120 150 4 MPBF 400 480 600 Working Capital Finance by Banks 31

WHAT IS MSME Definitions of Micro, Small & Medium Enterprises In accordance with the provision of Micro, Small & Medium Enterprises Development (MSMED) Act, 2006 the Micro, Small and Medium Enterprises (MSME) are classified in two Classes: 1. Manufacturing Enterprises 2. Service Enterprises: The limit for investment in plant and machinery / equipment for manufacturing / service enterprises, as notified, are as under Manufacturing Sector Enterprises Investment in plant & machinery Micro Enterprises Does not exceed twenty five lakh rupees Small Enterprises More than twenty five lakh rupees but does not exceed five crore rupees Medium Enterprises More than five crore rupees but does not exceed ten crore rupees Service Sector Enterprises Investment in equipments Micro Enterprises Does not exceed ten lakh rupees: Small Enterprises More than ten lakh rupees but does not exceed two crore rupees Medium Enterprises More than two crore rupees but does not exceed five crore rupees Working Capital Finance by Banks 32

COMPUTATION OF MPBF METHOD I Rs. CRORE PROJECTED YEAR 1 Net Sales 2 Total Current Assets Total Current Liabilities (Other than Bank 3 borrowings) 4 Working Capital Gap( 2 -3) 5 Min. required margin (25% of WCG) 6 Maximum Permissible Bank Finance (4 -5) CURRENT RATIO CA CL C/R Working Capital Finance by Banks 200 100 20 80 20 60 100 80 1. 25 33

COMPUTATION OF MPBF METHOD II Rs. CRORE PROJECTED YEAR 1 Net Sales 2 Total Current Assets Total Current Liabilities (Other than Bank 3 borrowings) 4 Working Capital Gap( 2 -3) Min. required margin (25% of CA 5 excluding export receivables) 6 Maximum Permissible Bank Finance (4 -5) CURRENT RATIO CA CL C/R Working Capital Finance by Banks 200 100 20 80 25 55 100 75 1. 33 34

ISSUES OF WORKING CAPITAL 1. Proper assessment of working capital requirement is very important. Lower working capital loan requirement adversely affects turnover and profitability of the Company. Higher bank working capital loan requirements will increase interest burden to the Company and will entail laziness in recovery from debtors. For bank also higher loan is risky since there are chances of diversion of funds. Working Capital Finance by Banks 35

2. Operating statements and Balance Sheet of the Company is required to be estimated / projected item wise based on past trend, future estimations, market share, competition prevailing etc. 3. Holding period of each item of current assets like Inventory (RM, WIP, FG), debtors, creditors and other expenses to be estimated / projected logically and based on past trend. Working Capital Finance by Banks 36

ROLE OF COST ACCOUTANTS: 1. As a consultant for project finance. Preparing CMA data and working out need based working capital requirements. 2. As a stock auditor i. e. certifying stock and book-debts against which banks have financed working capital requirements. 3. As a concurrent auditor of the bank. 4. Certifying Cost of Project and Means of Finance at each stages of completion of project. 5. Charge certificate and other details of the Company from MCA to Banks. Working Capital Finance by Banks 37