Working Cap Assesment

8/3/2019 Working Cap Assesment

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ASSESSMENT OF WORKING CAPITAL

Any enterprise whether industrial, trading or other acquires two types of assets to run its businessas has already been emphasised time and again. It requires fixed assets which are necessary for

carrying on the production/business such as land and buildings, plant and machinery, furniture

and fixtures etc. For a going concern these assets are of permanent nature and are not to be sold.The other types of assets required for day to day working of a unit are known as current assets

which are floating in nature and keep changing during the course of business. It is these 'currentassets' which are generally referred to as 'working capital'. We are by now already aware of theshort-term nature of these assets which are classified as current assets. It may be noted here thatthere may not be any fixed ratio between the fixed assets and floating assets for different projects

as their requirement would differ depending upon the nature of project. Big industrial projectsmay require substantial investment in fixed assets and also large investment for working capital.The trading units may not require heavy investment in fixed assets while they may be carrying

huge stocks in trade. The service units may hardly require any working capital and all investment

may be blocked in creation of fixed assets.

A set financing pattern is evolved to meet the requirement of a unit for acquisition of fixed assetsand current assets. Fixed assets are to be financed by owned funds and long-term liabilities raised

by a unit while current assets are partly financed by long-term liabilities and partly by currentliabilities and other short-term loans arranged by the unit from the bank. The balance sheet of a

unit under such dispensation may be represented as in next page.

The total current assets with the firm may be taken as gross working capital whereas the net

working capital with the unit may be calculated as under:

Net Working Capital = Current Assets - Current Liabilities

(NWC) (GWC) (including bank borrowings)

This net working capital is also sometimes referred to as 'liquid surplus' with the firm and has

been margin available for working capital requirements of the unit. Financing of working capital

has been the exclusive domain of commercial banks while they also grant term loans for creationof fixed assets either on their own or in consortium with State level/All India financial

institutions. The financial institutions are also now considering sanction of working capital loans.


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The current assets in the example given in the earlier paragraph are financed asunder:

Current Assets = Current liabilities + Working capital limits from banks + Margin from

long-term liabilities

Liabilities Assets

Capital

Fixed Assets

Long-term

liabilities

Margin NWC

Liquid Surplus

Working capital

limits from

banks

Current Assets

Current Liabilities


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(Diagram 1)

This is the normal pattern of financing of current assets. However, a few units may be having a

negative net working capital as shown below :

Liabilities Assets

Capital

Long-term

Liabilities Fixed Assets

Working capital

deficit

Current

Liabilities

Current

Assets


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(Diagram 2)

It is evident from diagram 2 that current liabilities are more than current assets and a part

of short-term funds (current liabilities) have been diverted to finance fixed assets. Notonly that the unit is not able to provide any margin for working capital from its long-termsources, but it is showing a net working capital deficit represented by the bracketed area

in the diagram. This situation may not be considered as satisfactory and the unit isexperiencing liquidity problems and has a current ratio of less than one. It may also bestated here that a large liquid surplus may also not reveal a very encouraging position, asit would mean idle funds or a lower turnover in working capital. It should, therefore, be

the endeavour of every concern to ensure optimum utilisation of all the resources at its

command and have just adequate liquid surplus.

The assessment of working capital may involve two aspects as under

The level of current assets required to be held by any unit which is adequate for its day today functioning, and

The mode of financing of these current assets.

The value of inventory as given in the balance sheet is the position as on a particular day onwhich the balance sheet is drawn and may not be the actual average requirement of the unit. We

will have to, therefore, evaluate the actual consumption pattern to arrive at a correct decision.

OPERATING CYCLE CONCEPT

The day to day business operations of a concern of any nature and, size involves many successivesteps and final working results would depend on the effective combination of all these steps. The

steps in general may include.:

y

Acquisition and storage of raw material and other stores and spares required formanufacture of any product.


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y Actual production process when the raw material is subjected to different processes tobring it to final shape of finished goods.

y Storage of finished goods awaiting sales.

y Sales of finished goods and realisations of sale proceeds.

All these steps put together form an operating cycle which can also be represented

diagramatically as under :

Realisation Cash Raw Material

Stores & Spares

Bills Receivable/Sundry Semi-Finished Goods

Debtors


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SalesFinished Goods

We start from cash to buy raw material etc. and after completing all the steps end up with the

cash. The intervening period required for completion of this entire process is the 'OperatingCycle'. The operating cycle may thus be defined as the intervening period from the time the goodsor services enter the business till their realisation in cash. The study of this operating cycle is

obviously very important as the actual requirement of the unit may be limited to the fundsrequired to complete an operating cycle and the simplest formula for the working capital

requirement may be represented as under:

Total working capital requirement = Total operating expenses expecting during the year

No. of operating cycles in a year

This system of calculation of working capital requirement is not in vogue as it only helps toassess the total requirement of a unit whereas the banks granting working capital limits would be

interested in proper classification of its various components. The concept of operating cycle,however, throws light on various components of working capital required for the unit and these

components may be classified as under:

y Raw material stores and spares consumed in the production process. The unit must havesome stocks of these items for uninterrupted production.

y Manufacturing expenses such as wages, power and fuel etc. to be incurred during the

process of manufacture.

y Stocks of work-in-process/semi finished goods maintained by the unit to complete anoperating cycle.

y Stocks of finished goods awaiting sale. All the finished goods may not be immediatelysold.

y Administrative and selling expenses during this process.

y Bills receivable/debtors for credit sales.


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All or some of these components in varying proportions are required for any business.

CONCEPT OF MARGIN

Margin in relation to working capital has two concepts which need to be clearly understood. The

one concept of providing margin by way of liquid surplus i.e. from long-term liabilities hasalready been explained. It must be clear by now that current assets shall partly be financed bycapital & long-term liabilities for any going concern. This gains importance while fixing overall

limits of working capital by the bank.

The other concept of margin as applicable to working capital limits is related to the value ofsecurity charged to the bank as cover for these limits. Financial accommodation up to 100% ofthe value of goods would not be granted by the banks and they would fix a certain margin on the

value of security which must be provided by the borrower and the balance amount will be

financed by the bank. The percentage of margin fixed on any security is dependent on its nature.

FORMAT FOR ASSESSMENT OF WORKING CAPITAL

In good old days when the banks were mainly adopting security-oriented approach in lending, no

emphasis whatsoever was placed on assessment of limits as the credit decision was mainly basedon the security available to cover the advance. The concept of assessment of working capitalgained currency in early seventies and Reserve Bank of India proposed a scientific method forthis purpose. A format that would be utilised for assessment of working capital was also

prescribed. Various other formats and techniques for assessment have since been developed for

different kinds of projects, the earlier format nevertheless is still in vogue and is made use of inall such cases where a specific method has not been prescribed. The proforma as prescribed by

Reserve Bank of India is reproduced below :

Assessment of Working Capital Requirements

. months raw material requirementsRs.

. Weeks/months' consumable stores and spares Rs.


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. Weeks stocks in process at any one time Rs.

(average period of processing value of raw material

content in stock-in process and manufacturing expenses

for the period of processing to be indicated)

. Months finished goods at cost Rs.

. Weeks/months receivables representing credit sales Rs.

One months' manufacturing and administrative expensesRs.

________________

Total working capital requirement

Less Credit available on purchases and advance payments received .

Rs.

Working capital in business or liquid surplusRs.

________________

Net working capital requirements

Rs. (A)

________________

Permissible Limits

Raw materials Rs.

Less Margin Rs.Rs.

Stock-in-process Rs.

Less Margin Rs.

Rs.


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Finished goods Rs.

Less: Margin Rs.

Rs.

Receivables representing supplies to Govt. Rs.

Less Margin Rs.

Rs.

Receivables representing supplies to sundry parties Rs.

Less Margin Rs.

Rs.

_________________

Total limitsRs. (B)

__________________

Net working capital requirements (A)

Rs.

Permissible limits (B)

Rs.

Deficit, if any (A-B)

Rs.

.

It must, however, be noted that assessment of working capital is always done for future

period, while the financial statements reveal the financial position of a concern as it wasat some point of time in the past. If the calculations are based on the basis of the financial

statements as on some previous date, the results derived may not be workable.Furthermore the newly established units may not provide any financial statements for the

past period. The working capital is always to be assessed on tile basis of projections forthe next year. The first most important point, therefore, is to make as accurate projections

as possible for the next year. The projections submitted to the bank are very criticallyexamined in relation to past performance of the unit, if any, future prospects and market


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for the ultimate product production capacity of the unit and general rate of inflationexpected during the year. The projections given for the next year are, therefore, to be

supported by convincing logic to stand scrutiny in the hands of the banker.

We shall now make an attempt to define various components of working capital as taken in theformat and explain the most acceptable principles involved in calculating them for overall

assessment of working capital.

I . . months raw material requirements :

Every production unit will be required to maintain a minimum level of raw material in stock to

ensure continuous production. The level of stock may differ from unit to unit and inter aliadepends on nature of the raw material, its availability with particular emphasis on lead timeinvolved in procuring it, price level, consumption pattern etc. From the past records, it is possible

to find out the average stocking period of raw material with the following formula :

Average stocking period in months = Average stock of raw material

_____________________________________________

Average monthly consumption of raw material during

the year

where

Average stock of raw material = Opening stock of raw material+ Closing stock of raw

material

______________________________________________

2

Average monthly consumption of


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raw material during the year = Opening stock of raw material + Total purchases of rawmaterial- Closing stock of raw material of raw

material

_________________________________________________________

12

The average stocking period thus arrived may be taken as the requirement of so many months of

raw material for the unit and the estimated value of stocking of raw material required by the unit

can thus be determined on the basis of projected figures.

In case of new units where figures of past performance are not available, storage period may haveto be compared with storage period of such other units for the purpose of these calculations.

II . weeks/months stores and spares

The calculation for requirement of these items may be done in a similar manner as in case of rawmaterials. The average period of stocking required by the unit is generally, done on the basis of

past performance. After determining the average period, the requirement is to be calculated on thebasis of projected figures

III weeks stocks in process

Stocks-in-process is an item representing goods remaining in semi-finished form awaiting certainfurther processing before these can be finally converted to finished goods. The requirement of

blockage of funds in these stocks will depend upon the processing period involved in the

manufacturing. The processing period may differ from unit to unit and in case of new units it mayhave to be compared with existing units of similar nature.

Semi finished goods, however, possess another problem in evaluation. The value representingmanufacturing expenses is added to the cost of raw material to determine the value of stocks in


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process. The value of stocks-in-process is thus related to the 'cost of production which may becalculated as under :

Cost of Production

(i) Raw material consumed

Rs.

(ii) Other spares

Rs.

(iii) Power and fuelRs.

(iv) WagesRs.

(v) Repairs and maintenance

Rs.

(vi) Other manufacturing expenses

Rs.

(vii) Depreciation

Rs.

(viii) Sub-totalRs.

[items (i) to items (vii)]

(ix) Add : Opening stocks in processRs.

(x) Sub-total [item (viii) plus item (ix)]

Rs.

(xi) Deduct : Closing stocks in process

Rs.

(xii) Cost of Production [item (x) minus item (xi)]

Rs.


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The average period of stocking of 'stocks in process' may nom calculated with the following

formula :

Average period of stocking of = Average stock in process

stocks in process in days _____________________________

Daily cost of production

where

Average stock in process= Opening stock in process + Closing stock in process

2

Daily cost of production = Cost of production

365

Average stocking period which may also be taken as average processing period may thus be

calculated from past records. The estimated requirements of the unit under this head may berelated to its projected figures as in case of raw material etc. The calculation will, however, be

based on the basis of cost of production which is the most acceptable principle of valuation of

'stocks-in-process'.

IV . . months finished goods

The stocking period of finished goods may also be different for different types of units and will

mainly depend upon the market conditions. The valuation of finished goods also possess a little problem and most accepted principle is for their valuation in terms of cost of sale which is

calculated as under


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Cost of sale = Opening stock of finished goods + Cost of production- Closing stocks of finishedgoods.

Cost of sale is also equal to net sales minus gross profit.

Average period of stocking of finished goods may be calculated with the help of the followingformula:

Average period of stocking of finished goods in months = Average stock of finished goods

_________________________

Monthly cost of sales during the year

where,

Average stock of finished goods = Opening stock of finished goods +Closing stock of

finished goods

___________________________________________________

2

and

Monthly cost of sales during the year = Cost of sales

___________

12

This period would give an indication as to the average period of stocking of finished goods by the

unit on the basis of its past performance. This average period so found may now be related to the projected figures to find out the estimated requirement under this category. The finished goods

will, however, be related to cost of sales while estimating the requirements.

V . weeks/months receivables representing credit sales:


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All the sales by any unit may not be against cash in which case the unit would not require any

funds to be blocked under this head. A part of the sales might be effected on credit in which casethe outstanding under debtors/bills receivable will form a part of total working capital required by

the unit. The average period of blockage of funds under this head may also likewise be calculatedwith the following formula:

y Average period of credit in months = Average debtors

____________________ x 12

Total credit sales

y Average debtors =Opening balances Closing balance Opening

balance of Closing balance

of debtors + of debtors bills receivable +of bills receivable

_________________________________ +__________________________

2 2

where the figures of credit sales are not separately available, we may take total sales figures in the

denominator for the purpose of above calculation.

After determining the average period of credit sales, the requirement of the unit under this head

may be related to the projected figures.

V1 . One months manufacturing and administrative expenses


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The unit has to meet the running, manufacturing and establishment expenses during the period of

manufacture and necessary provision for funds required for this purpose is necessary. Themonthly average expenditure can be determined by dividing total manufacturing and

administrative expenditure during the last year by 12. Suitable adjustment in the anticipatedexpenditure for the next year may be necessary as per the projected figures.

The total of items No. I to VI is the requirement of the unit for working capital at the gross level.The unit raises resources to meet these requirements from many sources besides the liquid surplusalready available with the unit The resources generally available at the command of the unit may

be as under:

CREDIT AVAILABLE ON PURCHASES

All the goods may not be purchased by any unit against cash and the concern may avail credit forfew purchases. The credit available from the market will reduce the requirement of the unit for

working capital.

Creditors may be treated in the same manner as debtors while determining availability to the unit

under this component. Average period of credit available to the unit may be determined according

to the following formula:

y Average period of credit in months = Average creditors

_______________ x 12

Total credit purchases

y Average creditors =Opening balances Closing balance Opening balance of Closing balance

of creditors + of creditors bills payable +of bills payable


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_________________________________ +__________________________

2 2

Where figures for credit purchases are not separately available, the figure of total purchases may be taken in the denominator for the purpose of the above calculations. After determining the

average number of days for which credit is available, it should be possible to determine theaverage total credit available to the unit by relating it to the projected figures.

ADVANCE PAYMENT RECEIVED

Advance payment for sales may sometimes be received which means that additional funds are

available with the unit there by reducing its working capital requirements. Any such advance payments that are received by the unit must be accounted for while determining the actual

requirement.

LIQUID SURPLUS

The concept of liquid surplus has already been explained and it represents excess of current assets

over current liabilities thereby meaning that some long-term liabilities have already been utilisedby the unit for creation of current assets. This is also one concept of margin being provided by the

unit for working capital as already explained.

Adjustments made in the gross working capital as already calculated for the above three items

will give an idea of net working capital requirements of the unit which may be availed from the

bank-.

The banks may not be willing to finance all the components of working capital which have been

taken into consideration for calculation of gross working capital requirements. The manufacturingand administrative expenses may not be financed by the bank. Banks also stipulate marginrequirements, the other concept of margin, on the value of security of raw materials, semi finished

and finished goods etc. while sanctioning the limits. Banks may be willing to finance sales


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operation by purchasing/discounting bills receivable and may not be very keen to finance 6ookdebts or a very high margin may be stipulated for such advances. The following method is

generally adopted by the banks for fixing limits on various components of working capital :

1. Raw Materials : Credit to the unit is generally available for purchase of raw material and the

same is to be deducted while fixing credit limit against raw material. The margin applicable forraw material is low in comparison to the margin applicable for semi finished and finished goods.

The margin ranging from 15 to 25% may be fixed depending upon the nature of the material andstanding of the unit.

II. Stores and Spares : A small limit is granted against stores and spares and these are generally

included as a part of raw material only for the purpose of calculating the credit limits. If aseparate limit is sanctioned, it will be treated in the same manner as limit against raw materials.

III. Semi-finished goods : Semi-processed goods do not form a good security as its realisable

value cannot be exactly determined. A higher margin upto 40% may be insisted upon by the bankwhile fixing a credit limit against stocks in process.

IV. Finished goods : The margin stipulated on finished goods may generally be higher than the

margin on raw material and may be lower than that stipulated for stocks- in -process.

V. Bills receivable/book debts: Banks generally prefer to grant facilities against bills receivableand a very low or no margin may be stipulated for supplies to Government or other sundry

parties. For finance against book debts margin stipulation may be as high as 50% and only a smalllimit may be permitted.

No bank advance is granted against manufacturing and administrative expenses which are to beborne by the unit itself. We have thus calculated the actual working capital requirements by the

unit and also the limits sanctioned there against by the banks. Different considerations areinvolved while arriving at these figures and it may sometimes be possible that limits sanctioned

by the bank are not adequate and are not equal to the total working capital requirements. The unithas to investigate as to the reasons for such happening and has to take corrective steps, if possible

or to bring in more funds in the business to correct the situation.


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We have made detailed analysis of the balance sheet of a company in Appendix 14.1 given at theend of chapter 14 and will now attempt to assess the working capital of the unit on the basis of

above discussion. It may, however, be mentioned even at the sake of repetition that in actual practice assessment is done on the basis of projected figures of sales for the next year. In this

exercise also we have presumed a uniform increase of about 10% in all the figures for the next

year.

(All figures are taken in Rupeesin lakhs.)

I . raw material requirement:

(Figures available in Schedule H)

y Average stock of = Opening balance of raw material + Closing stock of rawmaterial

raw material ___________________________________________________

= 458.23 +652.77

2

= 555.50

y Average monthly

consumption of raw

material during the year = Opening stock of raw material + Total purchase - Closing

stock of raw material

12

= 458.23 + 3364.63 652.77

12


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= 264.17 per month

y Average stocking period in months = Average stock of raw material

__________________________________

Average monthly consumption of R.M.

= 550.50

264.17

= 2.1 months (app.)

2.1 months is thus the average stocking period for raw material by the unit. Presuming the same

level of production but anticipating a general increase of 10% in all factors of production due toinflation and other such reasons the raw material requirement of the unit will thus be worked out

as under:

2.1 months requirement of raw material

= 2.1 x 290.58 = 610.22

IIweek's/months' stores and spares :

y Average stock of stores and spares = 9.93 +7.85

2

= 17.78

2


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= 8.89

Average monthly consumption figures are not available and the requirement of the unit against

stores and spares may be taken as equivalent to Rs. 10 lacs after providing necessary increase ofabout 10% as already discussed.

III . . weeks stocks in process:

y Cost of production = 3,932.82

y Weekly cost of production = 3,932.82

52

= 75.63

y Average stocks in process = 188.92+215.08

2

= 202

y Average period of process = Average stock in process

Weekly cost of production

= 202 x 52

3932.82

= 2.68 weeks

The requirement of the unit for stock in process after providing the 10% increase over the last

year figures would amount to

2.68weeks stocks in process i.e., cost of production


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= 2.68 x 4326.1

52

= 222.96

IV . months finished goods:

y Cost of sale = Opening stock of finished goods + Cost of production- Closing

stocks of finished goods.

= 385.73 + 3,932.82 - 483.92 = 3,834.63

y Average stocks of finished goods = Opening stock of Finished goods+ Closing stocks of

finished goods

2

= 385.73 + 483.92

2

= 434.82

y Average period of stocking of

finished goods in months = Average stocks of finished goods

Cost of Sales

= 434.82 x 12

3843.63

= 1.36months.

After providing 10% increase under this factor also the requirement of the unit under thiscomponent would be

1.36months' of finished goods i.e., cost of sale = 1.36 x 4,218.09


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12

= 478.05

Vweeks/months bill Receivable representing credit sale

The figures of opening balance of bills receivable/debtors are not given and the figures as per the

balance sheet only is taken to find out the requirement of the unit. The figures of credit sales are

also not separately given and hence figures of total sales are taken for this purpose:

Average period of credit in months = Average Debtors

Sales

= 738.7 12

4832.57

=1.83

The requirement of the unit for bills receivable and debtors will now be computed as under:

1.83 months of bills receivable of sales after providing projected increase of 10 %.

= 1.83 x 5,315.82

12

= 812.56

VI. .. One month's manufacturing and administrative expenses

y

Total operating expenses = 1211.32


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y Expenses for one month = 1211.32

12

= 100.94

y Anticipated expenses in the next you

after providing for 10% increase = 111.00

CREDIT AVAILABLE FOR PURCHASE

Figures of opening balances under creditors are not given and necessary calculations are made onthe same basis as in case of sundry debtors.

y Average period of credit available = Average Creditors x 12

in months Purchases

= 394.85 x 12

3364.63

y Credit available for purchases to the unit = 1.41 month

1.41 months of credit after providing

projected increase of 10% = 1.41 x 3701.09

12


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(Current Assets - Current Liabilities)200.98

(After making adjustment for 10% increase)

____________

Net working capital requirements

(A)1609.48

_____________

Permissible Bank Limits

Raw material 610.22

Less credit available 434.33

175.89

Less margin @ 25% 43.97

____________

131.92

Stock in process 222.96


133.78

Finished goods 478.05


_____________

334.64


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Receivable

Book debts - 412.56

Margin @ 50% 206.28

Bills Receivables - 400

Margin Nil 400.00

_____________

606.28

_______________

Total Limits (B)

1206.62

_____________

Net working capital requirement

1609.48

Permissible bank limits

1206.62

Deficit = 1609.48 - 1206.62

= 402.86

The unit is now faced with a deficit of Rs. 402.86 lacs in working capital and the various optionsavailable to the unit to meet this deficit may be as follows :

y To arrange for additional capital to that extent to wipe off the deficit.

y To arrange for long-term loans/deposits to strengthen the long-term resources of the unit

to provide necessary margin for working capital.


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y To critically examine the level of current assets held by the unit. It may be possible thatthe unit may be able to work with lower inventory and may make some earnest efforts toquickly realise its debtors thereby reducing the level of working capital requirements of

the unit itself.

y To negotiate with the bank to reduce margin requirements so that additional limits are

available thereby reducing the deficit.

A package measure consisting of one or all of these steps is necessary to improve the working

condition of the unit so that it is not starved of the working capital.

The format as suggested by Reserve Bank of India has been the first attempt to assess theworking capital requirement of industrial units on a scientific basis. The format has been dulyamended for smaller units by Puri Committee. The assessment of requirements of borrowers

covered under various segments of priority sectors is done on different consideration and standardforms and procedure have been developed for this purpose.

A new dimension to financing of working capital by banks was given by Reserve Bank of Indiain 1975 by accepting the recommendations of 'Tandon Committee' which were later modified by

Chore Committee. These recommendations were applicable for large advances enjoyingworking capital limits of Rs. 50.00 lacs and above. Reserve Bank of India also prescribed a

standard format for assessment of working capital limits for accounts covered under 'CreditAuthorisation Scheme' later on renamed as, Credit Monitoring Arrangement1. This form has,however, been adopted by many of the banks for assessment of limits for working capital

advances exceeding Rs. 10.00 lacs.

Different forms adopting different techniques are thus in circulation for assessment of working

capital depending upon the size and category of projects as under:

(i) Form for assessment of requirements of SSI units upto credit limits of Rs. 2,00,000/-(including composite loans)

(ii) Form for assessment of requirements of SSI units for credit limits of above Rs. 2,00,000

and upto Rs. 15.00 lacs

(iii) Form for assessment of requirements for units with credit limits above Rs. 15.00 lacs and

upto Rs. 1.00 crore

Comment [M1]: Post-sanction scrutiny und

Credit Monitoring Arrangement has since be

withdrawn by RBI and therefore, banks now

have full operational freedom.


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(iv) Form for assessment of requirements for units with credit limits above Rs. 1.00 crore.

(v) CMA Data form for assessment of requirements for units with credit limits above Rs.

10.00 lacs or as per the cut off point fixed by individual banks.

(vi) Assessment of limits for projects falling under various segments of priority sector.

The format at (v) has been discussed in chapter 17 on New System of Reporting and Loan

System for Delivery of Bank Credit.

It may, however, be added here that assessment of working capital will basically involve all these

factors in all the methods and though this format might have been replaced by other forms, yet itsimportance hardly needs any emphasis as will be proved in subsequent discussions.

Working Cap Assesment

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