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Bank Finance for Working Capital

Main Institutional sources of working capital

Banks consider firms sales and production plans and its level of current
assets to determine W.C requirements

The amount approved by bank for the firms working capital is called
Credit limit Means:

The maximum amount of funds which a firm can obtain from the
banking system

Banks may fix separate limits peak level credit requirement non
peak level credit requirement indicating the period for which the
credit limit can be used by the borrower

Banks do not lend 100 per cent of the credit limit they deduct margin
money principle of conservatism to ensure safety

Margin money - The security of banks lending should be maintained


even if its asset value falls by 30 per cent

Forms of Bank Finance

Overdraf

The borrower is allowed to withdraw funds in excess of the


balance in his current account
The overdrawn amount is repayable on demand, it generally
continues for a long period by annual renewal of the limits
It is flexible borrower can withdraw and repay funds whenever
he desires within the overall stipulations
Interest is charged on daily balances on the amount actually
withdrawn subject to some minimum charges

Cash Credit
Similar to the overdraft arrangement
A borrower is allowed to withdraw funds from the bank up to the
sanctioned limit
Not required to borrow the entire sanctioned credit at once
He can draw periodically as per the requirements and repay the
surplus funds to the cash credit account
Interest is payable on the amount actually utilized by the borrower
Limit sanctioned against the security of current assets
Cash credit most flexible arrangement from the borrowers point
of view

Purchase or discounting of bills

- Taking loan against bills


- Satisfies the creditworthiness of drawer
- The borrower is paid the discounted amount of the bill
- Bank collects the full amount on maturity

Bill market scheme

Scheme will facilitate banks to deploy their surpluses or deficits


by rediscounting or selling the bills purchased or discounted by
them
Banks with surplus funds could repurchase or rediscount bills
Banks can sell its bills

Letter of Credit
Suppliers insist that the buyer should ensure that his bank will
make the payment if he fails to honour its obligation
This is ensured by letter of credit (L/C)
A bank opens an L.C in favour of a customer to help him to
purchase goods if the customer does not pay to the supplier
within the credit period; the bank makes payment under the L.C
arrangement.
The risk of supplier is passed on to the bank bank charges the
customer for opening L.C
The facility is extended to the financially sound customers
CC / overdraft facility the L.C arrangement is an indirect
financing the bank will make payment to the supplier

Working Capital Loan

Demand loan - temporary accommodation to meet unforeseen


contingencies
Borrower required to pay a higher rate of interest above the
normal rate of interest on such additional credit

Historical Perspective: Bank Finance

Industrial Structure simple - trade finance efficiently in the


past
Industries grew rapidly in last three decades industrial system
complex shift in banks role trade financing to industrial
financing commercial banks lending practices and style
remained the same
Using of bank funds cash or resource consciousness
unscientific and non professional
A number of companies, yet to learn the methods of reducing
costs, optimizing use of inputs, conserving resources, improving
and developing product
A number of units have become sick and number of such units is
on the increase
Abnormal conditions are the cause of this situation,
mismanagement of resources is far more reason for the present
state of industries

Bank Credit

A scarce resource to be optimally utilized in all circumstances


There are many contenders for bank credit agriculture, small-
scale industry, farmers, common man and many others
Growing demand on bank funds from all sectors industrial
companies have no option but to use bank funds in efficient way

Drawbacks in the then existing Cash Credit System

The practice was to lend to the extent of 75 per cent of the value of
inventory and receivables and the remaining 25 per cent being the
margin

Value of inventory included purchase of materials on credit this


amounted to double financing both from creditors and banks
Bank lending directly related to security in the form of inventory
and receivables irrespective of borrowers operations
When borrower could provide necessary margin the banker
considered his advance as safe and liquid and did not bother
about the way in which the advance was being utilized
The borrowers limit was increased, without much questioning
about his operations whenever the inventory and receivables
levels went up.
The banker never took a closer look into the affairs of the
customer.
The level of advances in a bank was determined not by how much
a banker can lend at a particular point of time but the borrowers
decision to borrow at that time.
In such circumstances, cash credit system makes credit planning
by banks very difficult
The then existing practice in fixing limit was to value inventory at
the market prices due to this reason and credit from creditors a
borrower was able to borrow more than his current assets and
requirements
Then it was possible for the borrower to divert bank funds to
acquire fixed assets, make investments, advances to subsidiaries
and associated concerns