Working Capital N.Gopal Deputy General Manager & MoF RBI CAB Pune.

Working Capital

N.GopalDeputy General Manager & MoF

RBI CAB Pune

Working Capital

• Business needs long term and short term funds • Long term funds needed for fixed assets,

permanent assets• Met through Fixed or Permanent Capital or Long

term Debt• Short term funds needed for acquiring short term

assets, meet day to day business expenditure• Met through Temporary capital, circulating capital

or Working Capital

Business requirements

Funds for Business

Long Term

Fixed Capital or Permanent

Capital

Short Term

Working Capital or Temporary or

Circulating Capital

Long Term

Loans

Project Finance

Cash Credit or OD

Short term loans

Banks

Banks

Private Investors

NBFCs

FIs

Banker and Working Capital

• Banker meets both long term and short term needs• Short term finance from banks

– Used for working capital • Procuring short term assets • Meeting short term or day to day expenditure• Financed as Cash Credit, Overdraft, Short Term Working Capital

loan etc• Tenure One year, assessed and renewed annually

Short Term assets and Liabilities

• Current Assets: – Assets which are part of the operating cycle or which

get converted into cash within the operating cycle or within one year

– E.g. inventory (raw and finished), debtors, cash

• Current Liabilities:– Liabilities which are part of the operating cycle or

which need to be paid off within the operating cycle or within one year

– E.g. Sundry creditors, provision for taxes

Current Assets

• Assets which get liquidated in short term (say one year)• As per Companies Act 1956 Current Assets are1. Interest accrued on Investments2. Spares and Spare parts3. Loose tools4. Stock-in-Trade5. Work-in-Progress6. Sundry Debtors – less bad debts7. Cash and Bank Balances8. Loans and advances to subsidiaries 9. Bills of Exchange10. Advances recoverable in cash or receivables11. Balance with customs, port authorities, municipal authorities

Current Assets for Bankers

• Any Asset that gets converted into cash within the “Operating Cycle” or which forms part of the operating cycle is current Asset for bankers

• Logic- Bank finance to be used only for creation of assets which will be sold and reconverted into cash

• Investments in subsidiaries, deposits with customs, electricity boards, municipal authorities, advances to staff etc would not be current assets to bankers

Operating Cycle for Bankers

• Only those assets which are involved in completing the “Operating Cycle or Cash Cycle” or part of it.

Cash

Raw materials

Stock in process

Finished Goods

Sales

Debtors

Current Assets for bankers

1. Cash and Bank Balances2. Short term investments/advances/loans purely connected with the

operating cycle or which helps in completing the cycle 3. Receivables / Sundry Debtors4. Bills purchased and discounted with bank5. Installments receivable on loans falling due within one year6. Inventory- Raw materials, Work-in-Process and Finished goods7. Consumable spares8. Advance payment of tax9. Prepaid Expenses10. Advance for purchase of raw materials, components, stores &&11. Deposits with public bodies refundable within the cycle12. Any money or receivable due within one year

Current Liabilities

• Liabilities payable on demand or within one year• As per companies Act current Liabilities are1. Short term bank borrowings2. Unsecured loans 3. Sundry Creditors and Trade Creditors4. Deposits from public maturing within one year5. Advances and deposits from dealers6. Accrued Interests and Charges7. Provision for taxation8. Dividend payable9. Statutory liabilities 10. Installment of term loans repayable in one year11. Other liabilities and provisions

Current Liabilities for a bankers

• All those liabilities which are part of the Operating Cycle or Cash Cycle – Liabilities which complete the cycle

1. Short term bank borrowings (W.C. loans)2. Unsecured short term loans (12 months)3. Public deposits maturing within 12 months4. Sundry creditors for raw materials, consumables or trade creditors5. Interest and charges accrued but not yet due6. Advance from customers 7. Installment of term loans falling due within one year8. Statutory liabilities- PF dues, provision for taxes, Sales tax dues,

Excise duty etc9. Dividend10. Gratuity 11. Provisions

Working Capital Cycle

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Gross and Net Working Capital

• Gross Working Capital: – All the investment in Current Assets

• Net Working Capital: – Current Assets – Current Liabilities

Liabilities Assets

Capital (Equity +Reserves) Fixed Assets (Plant and Machinery, Land and Building)

Long term Debt (Deferred Liabilities)

Other Non current Assets

CURRENT LIABILITIESCURRENT

ASSETSNWC

Working Capital and sources of finance

Working Capital Requirement (Current Assets)

Source of Finance

1 Raw Material and stores (inventory)

Sundry Creditors or Bank Finance

2. Stock-in-Process Advance payments received or Bank Finance or Liquid Surplus

3. Finished Goods (inventory) Liquid Surplus or Net working Capital or Bank Finance

4. Sundry Debtors Bank Finance short term

5. Cash for expenses Net Working Capital or Liquid Surplus

Valuation of Current Assets

Components of Working Capital or Current Assets

Valuation

1. Stock of Raw Materials Purchase cost of Raw materials

2. Stock of Work in process At cost or market value whichever is lower.

3. Stock of finished goods Cost of production4. Debtors or receivables Cost of Sales or sale

value5. Cash for expenses Actual working

expenses

Methods of Assessing W.C

• Operating Cycle method: Time period from purchase of raw materials, creation of work-in-process, creation of finished goods, holding them till sale, converting them into sundry debtors and realization of debtors and receipt of cash.

• Nayak Committee method or turnover method: Based on the projected sales turnover of the borrower. It is presumed that W.C requirements would be 25% of the projected turnover and the banker would finance 75% to 80% of the same and the borrower to bring in 20%-25%.

• Traditional Method: Assessment based on the current asset level for the level of activity

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Methods of Assessing W.C

• Projected Balance Sheet Method: • The old Committee approach to lending• Cash Budget Method of Assessing working Capital

Operating Cycle Method

Cash

A

Raw materialsB

Stock in process

C

Finished Goods

DSales

EDebtors

F A= Acquisition timeB=Process timeC= Process to Finished Goods

D=Stock of finished goods before saleE= Credit SalesF= Debtors conversion to cash

Operating Cycle

• Operating cycle = Time lapsed from A….F• Working capital= Funds required to complete the cycle from A….F

– E.g. A=20 days B=10 days C= 20 days D= 30 days E=20 days F=20. Cycle = 120 days (i.e. 3 cycles in a year)

– E.g. Sales Rs.1,00,000 per annum– Exp. Rs. 72,000 per annumWCR (for expenses)= 72,000/3 = 24,000/- per cycle

• Working capital requirement would go down if the cycle is increased or if the operating efficiency is increased

• Working capital would be more if the cycle is reduced or if there is operating inefficiency working capital required will be more.

Permissible Bank finance using Operating Cycle

• E.g. Unit ABC has furnished the below mentioned data1. Sales =Rs. 50,000 per month2. Raw Materials =Rs. 12,000 per month3. Wages = Rs. 6,000 per month4. Manufacturing Exp. =Rs. 3,000 per month 5. Operating Cycle

i. Raw materials = Rs. 15 daysii. Stock in process = Rs. 2 daysiii. Finished Goods = Rs. 3 daysiv. Sundry Debtors = Rs. 15 days

Working Capital = Operating Expenses x Operating Cyclei.e. 2+3+4 = Rs.21,000 Cycle = i+ii+iii+iv= 35 daysWC Assessed would be (21,000 x 35)/30= Rs.24500/-

Projected Turnover Method

• Nayak Committee method:– SSI units upto Rs.5.00 crore– Other units upto Rs.1.00 crore– Projected Turnover Method– i.e. 25% of the projected annual turnover to be

reckoned as WC• Borrower to bring in 5% • Bank finance 20%

Projected Turnover

2009 2010 2011 2012 2013

Rs. In Lacs

Annual Sales Turnover

15.00 18.00 20.00 30.00 40.00

Working Capital Requirement 25%

10.00

Margin to be brought in by the borrower 5% of the Annual turnover

2.00

Maximum Permissible bank finance (20%) of the turnover

8.00

Projected Turnover

• Care to be exercised in turnover method.a. Projected turnover is gross turnover inclusive of excise duty etc.b. The other financial strengths of the firm also to be kept in mindc. Margin requirement of at least 5% of the turnover not to be dilutedd. Projected annual turnover to be reasonable, achieved in the past,

achievable in future and realistic in the presente. Reasonableness of projections to be assessed and verified with

returns filed by the borrowerf. Sales achieved till the date of sanction to be obtained from the

borrowerg. Any projection beyond 15% of the previous years actual need

closer attention.

Traditional Method

• It is the sum total of A. Raw Materials required Less Margin XXXB. Work-in-Process Less Margin XXXC. Finished Goods Less Margin XXXD. Sundry Debtors Less Margin XXXE. Miscellaneous expenses (reasonable level) XXX Less: Advance if any received aaa Less: Sundry Creditors aaa aaa Total Working Capital Finance cccThe margin will come from NWC

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The MPBF Methods

METHOD I METHOD II METHOD IIIC.A 200 C.A 200 C.A 200OCL 40 25% of CA 50 Non core CA 56WCG 160 GAP 150 Core CA 14425% of WCG 40 OCL 40 25% of Real CA 36

GAP 108OCL 40

MPBF 120 MPBF 110 MPBF 68

NWC 40 NWC 50 NWC 92C.A 200 C.A 200 C.A 200C.L 160 C.L 150 C.L 108CURRENT RATIO 1.25

CURRENT RATIO 1.33 CURRENT RATIO 1.85

Projected Balance Sheet

• Projected Balance Sheet Method: The level of Current Assets and Current Liabilities are projected and the working capital gap is arrived at. The banker finances 75%-80% of the gap and the balance has to come from NWC (Net Working Capital)

• Balance sheet for the future year is projected• Basis of projection actual audited balance sheet of the

past two- three years

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Cash Budget Method

• Used to assess working capital requirements of contractors

• Used where there cannot be specific hypothecation or where the cash flow is irregular.

• Where the bank wants to keep a close watch on the inflows and outflows of cash of the business

Cash Budget

Particulars March June September December

I Estimated Cash Inflows

Cash Sales

Debtors receipts

. Other receipts

II Estimated cash Outflows

Cash purchases

Cash payment to Creditors

Expenses/Loans Interest

III Opening Cash bal

Cash Budget Method

Particulars March June September December

IV Add/Deduct/Surplus/ Deficit (I - II)

V Closing Cash balance (III – IV)

VI Minimum Level of cash Balance

VII Estimated Excess or Shortfall (V – VI )

Bank Finance on Shortfall less Margin

Ratios to help in assessment

• Current Ratio

• Solvency Ratio

• Quick Ratio or Acid Test Ratio

• Profit to Sales Ratio

• Turnover ratio (Inventory + Receivables)/Net Sales

Liquidity Ratio

Current Assets x 100

Current Liab.

(Quick Ratio or Acid test Ratio)

C.A- Inventory x100

C.L-Bank borrowings

• Whether current assets are enough to cover current liabilities

• Higher ratio could be bad or good

• Lower ratio not necessarily bad

• Whether current liabilities are funding current assets

Solvency Ratio

Total Outside Liabilities Tangible Networth

Total term liabilitiesTangible Networth

or Debt Equity

• Indicates Solvency• Indicates size of

owners stake • Indicates stake of

creditors• Indicates the coverage

of liabilities by the net-worth

• Lower ratio indicates greater solvency

Some ratios explained

• PBIT/Interest (Times)– Interest coverage ratio, explains how many times the

firm earns to cover the interest payable by – Higher ratio means comfortable debt servicing

capacity from cash accruals– A ratio of 3 or 4 is very comfortable.– A ratio of 2 could be risky

• (Inventory + Receivables) / Net Sales– Expressed in days ratio captures turnover time for

major current assets– Higher ratio indicates slower turn over and higher

risk

Turnover Ratio

Annual Sales x 100 Closing Stock

• High ratio indicates good turnover of stock

• Efficient management of sales

• Low ratio indicator of large unsold stock

Other Aspects of Working Capital Assessment

• The non financial aspects of Working capital assessment • Character of the borrower

– Background or brief history of the borrower, nature of activity, expertise available (technical and Managerial)

• Capacity of the borrower– Networth, repayment history, viability of the business activity,

income generating ability of the business, security available for fall back

• Capital of the borrower– What is the owners stake, equity, margin, ability to increase the

margin, source of financing the margin• Credibility of the borrower

– What is the market opinion about the borrower, does he have a track record?

Other Aspects of Working Capital Assessment

• Purpose of the loan– Why does the borrower want a bank loan?, is it a permitted

activity, what asset is being created• Safety of funds lent

– Is there sufficient primary security available, will the collateral back up in the event of default

• Customer rating– A mechanism to assess the riskiness of the borrower and his

venture, to help in having a good risk return trade off, to get adequate price for a risky loan

• Covenants for uncovered risks– Enhanced margins, additional equity, special or specific

stipulations (stock audit, certificate from a Chartered Accountant etc)

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