A PROJECT REPORT ON

WORKING CAPITAL FINANCE FROM BANKS

SUBMITED BY

MR. RAHUL LONARE

A Project Report Submitted in

Partial Fulfillment of the Requirement for the

Degree in Master of Commerce

ST. VINCENTS COLLEGE OF COMMERCE

PUNE CAMP -411001

(2011-2012)

1
 CERTIFICATE

This to certify that the Research work incorporated in the report WORKING
CAPITAL FINANCE FROM BANKS is a bonafide work done by MR.RAHUL
LONARE. It was carried out by the candidate under my guidance and supervision.
The materials from other sources have been duly acknowledged by him research
report.

This work is submitted in partial fulfillment of the requirement for the degree
Master of Commerce in the academic year 2011-2012.

Principal Project Guide

Dr.Anil Adsule. Prof. Manoj Vora.

External Examiner

Place:

Date:

2
 STUDENT’S UNDERTAKING

This is to certify that the Research work incorporated in the report WORKING
CAPITAL FINANCE FROM BANKS is a bonafide work done by me, Mr.
RAHUL LONARE. The materials from other sources have been dually
acknowledged by me in my research report.

This work is submitted in partial fulfillment of the requirement for the degree
Master of Commerce in the academic year 2011-2012.

Signature :

Name of the Student :

Exam Seat no :

Date :

3
 Acknowledgement

I express my heartfelt thanks to all the faculty members of ST.VINCENT

COLLEGE OF COMMERCE, PUNE for their assistance and guidance
throughout the years of post graduation.

I hereby acknowledge my profound gratitude to Prof.Manoj Vora for his valuable

guidance. I sincerely thank him for all the efforts he has taken to guide and
encourage me while preparing this project report.

I render my gratitude to my friends especially Miss. Moumita Das and Mr. Dipraj
Sankla who have helped me for successful completion of the project.

Above all, I reveal my indebtedness to my father; Mr. Chandrakant Lonare &

mother, Mrs. Lakshmi Lonare, without their help and co-operation, my studies
would not have been possible. They are the true support for me in completing my
studies.

Place: Pune Signature

Date: Rahul Lonare.

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Sl no. INDEX Page no.

     
1 ACKNOWLEDGEMENT  
  CHAPTER 1 7-14 
2 INTRODUCTION  
3 DEFINITION  
4 NEED FOR WORKING CAPITAL  
5 CONCEPT OF WORKING CAPITAL  
  CHAPTER 2 15-28 
6 TYPES OF WORKING CAPITAL  
7 FACTORS AFFECTING WORKING CAPITAL MANAGEMENT  
  CHAPTER 3 29-43 
8 WORKING CAPITAL FINANCE  
9 ASSESMENT OF WORKING CAPITAL  
10 ASSESSEMENT OF OTHER LIMITS  
11 ASSESSEMENT OF THE LIMITS UNDER LETTER OF CREDIT-WITH LEAD TIME  
  CHAPTER 4 44-54 
12 PROCEDURE FOR WORKING CAPITAL FINANCE  
13 CREDIT SANCTION PROCESS  
14 PRE SANCTION PROCESS  
15 POST SANCTION PROCESS  
16 CREDIT RATING MODEL  
17 DRAWING POWER OF THE BORROWER  
18 SECURITY  
  CHAPTER 5 55-58 
19 BANKING ARRANGEMENTS  
20 CONSORTIUM BANKING ARRANGEMENT:  
21 MULTIPLE BANKING ARRANGEMENT  
22 SYNDICATION  
23 REGULATION OF BANK FINANCE  
CHAPTER 6 59-67
24 TANDON COMMITTEE  
25 CHORE COMMITTEE  
26 MAXIMUM PERMISSIBLE BANK FINANCE:  
27 QUARTERLY INFORMATION SYSTEM: FORM:  
  CHAPTER 7 68-69 
28 FINANCIAL RATIOS  
  CHAPTER 8 70-72 
29 CONCLUSION  
30 SUGGESTION  
31 BIBLIOGRAPHY  

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Chapter 1

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 Introduction of Working Capital

• Working capital typically means the firm’s holding of current or short-term assets such as
cash, receivables, inventory and marketable securities.

• These items are also referred to as circulating capital

• Corporate executives devote a considerable amount of attention to the management of

working capital.

• Every business needs adequate liquid resources in order to maintain day-to-day cash
flow. It needs enough cash to pay wages and salaries as they fall due and to pay creditors
if it is to keep its workforce and ensure its supplies.

• Maintaining adequate working capital is not just important in the short-term. Sufficient
liquidity must be maintained in order to ensure the survival of the business in the long-
term as well.

• Even a profitable business may fail if it does not have adequate cash flow to meet its
liabilities as they fall due.

• Therefore, when businesses make investment decisions they must not only consider the
financial outlay involved with acquiring the new machine or the new building, etc, but
must also take account of the additional current assets that are usually involved with any
expansion of activity.

• Increased production tends to engender a need to hold additional stocks of raw materials
and work in progress. An increased sale usually means that the level of debtors will
increase. A general increase in the firm’s scale of operations tends to imply a need for
greater levels of cash.

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• Working capital management is the device of finance. It is related to manage of current
assets and current liabilities. After learning working capital management, commerce
students can use this tool for fund flow analysis. Working capital is very significant for
paying day to day expenses and long term liabilities. 

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 Definition of Working Capital

Working Capital refers to that part of the firm’s capital, which is required for financing short-
term or current assets such a cash marketable securities, debtors and inventories. Funds thus,
invested in current assets keep revolving fast and are constantly converted into cash and this cash
flow out again in exchange for other current assets. Working Capital is also known as revolving
or circulating capital or short-term capital.

“The net working capital of a business is its current assets less its current liabilities”

Current Assets include:

- Stocks of raw materials

- Work-in-progress
- Finished goods
- Trade debtors
- Prepayments
- Cash balances

Current Liabilities include:

- Trade creditors
- Accruals
- Taxation payable
- Dividends payable
- Short term loans

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 Need for Working Capital

Different industries have different optimum working capital profiles, reflecting their methods of
doing business and what they are selling.

• Businesses with a lot of cash sales and few credit sales should have minimal trade debtors.
Supermarkets are good examples of such businesses;

• Businesses that exist to trade in completed products will only have finished goods in stock.
Compare this with manufacturers who will also have to maintain stocks of raw materials and
work-in-progress.

• Some finished goods, notably foodstuffs, have to be sold within a limited period because of
their perishable nature.

• Larger companies may be able to use their bargaining strength as customers to obtain more
favorable, extended credit terms from suppliers. By contrast, smaller companies, particularly
those that have recently started trading (and do not have a track record of credit worthiness) may
be required to pay their suppliers immediately.

• Some businesses will receive their monies at certain times of the year, although they may incur
expenses throughout the year at a fairly consistent level. This is often known as “seasonality” of
cash flow. For example, travel agents have peak sales in the weeks immediately following
Christmas.

Working capital needs also fluctuate during the year

The amount of funds tied up in working capital would not typically be a constant figure
throughout the year.

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Only in the most unusual of businesses would there be a constant need for working capital
funding. For most businesses there would be weekly fluctuations.

Many businesses operate in industries that have seasonal changes in demand. This means that
sales, stocks, debtors, etc. would be at higher levels at some predictable times of the year than at
others.

In principle, the working capital need can be separated into two parts:

• A fixed part, and

• A fluctuating part

The fixed part is probably defined in amount as the minimum working capital requirement for
the year. It is widely advocated that the firm should be funded in the way shown in the diagram
below:

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The more permanent needs (fixed assets and the fixed element of working capital) should be
financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element
should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and
repaid easily and at short notice.

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 Concept of Working Capital

There are two possible interpretations of working capital concept:

1. Balance sheet concept

2. Operating cycle concept

Balance sheet concept

There are two interpretations of working capital concept under the balance sheet concept.

A. Excess of current assets over current liabilities.

B. Gross or total current assets.

Excess of current assets over current liabilities are called the net capital or net current assets.

Working capital is really what a part of long term finance is locked in used for supporting current
activities.

The balance sheet definition of working capital is meaningful only as an indication of the firm’s
current solvency in repaying its creditors.

When firm speak of shortage of working capital they in fact possibly imply scarcity of cash
resources.

In fund flow analysis an increase in working capital, as conventionally defined, represents

employment or application of funds.

• Operating cycle concept

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 • A company’s operating cycle typically consists of three primary activities:

– Purchasing resources,

– Producing the product and

– Distributing (selling) the product.

These activities create funds flows that are both unsynchronized and uncertain.

It is unsynchronized because cash disbursements (for example, payments for resource

purchases) usually take place before cash receipts (for example collection of receivables).

They are uncertain because future sales and costs, which generate the respective receipts and
disbursements, cannot be forecasted with complete accuracy.

“Circulating capital means current assets of a company that are changed in the ordinary
course of business from one form to another, as for example, from cash to inventories,
inventories to receivables, receivable to cash”

……Genestenbreg

• The firm has to maintain cash balance to pay the bills as they come due.

• In addition, the company must invest in inventories to fill customer orders promptly.

• And finally, the company invests in accounts receivable to extend credit to customers.

• Operating cycle is equal to the length of inventory and receivable conversion periods.

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 Chapter 2

TYPES OF WORKING CAPITAL

Types of Working capital in details as follows:

1) Basic of Concept :
A) Gross Working Capital :
Working capital refers to difference between current asset and current liabilities, working
capital can be further subdivided as gross working capital and net working capital.
Gross Working Capital – Gross working capital refers to the amount which the company has
invested into the current assets; current asset includes cash, stock, debtors or anything
which can be converted into cash within a year.
Cash and short-term assets expected to be converted to cash within a year. Businesses use the
calculation of gross working capital to measure cash flow. Gross working capital does
not account for current liabilities, but is simply the measure of total cash and cash
equivalent on hand. Gross working capital tends not to add much to the business'
assets, but helps keep it running on a day-to-day basis.
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 B) Net Working Capital :
Net working capital refers to the difference between the current assets and current liabilities
of the company, current asset as explained above will be same and current liabilities
include trade creditors, bills payable, outstanding expenses or any debt which
company has to pay within a year.
As one can see from the above that both gross working capital and net working capital are
different because under gross working capital one calculate the amount which the
company has invested into current assets, which implies that current liabilities are
excluded while calculating gross working capital, which is not the case under net
working capital where one calculate the difference between current assets and current
liabilities.

2) Basic of Time :
A) Permanent / Fixed Working capital:

A certain minimum amount of working capital which is required in the business at all
times is known as permanent working capital.

Permanent working capital is a term that is used to identify that portion of working
capital that is expected to generate on a consistent and uninterrupted. This is in contrast to
temporary working capital, which revenue is coming from sources that may or may not
continue. Businesses tend to cultivate and maintain sources of permanent working capital
as the foundation for their continued operation from one year to the next.

The exact criteria used to define what is and is not permanent working capital will vary
slight from one business to the next. A general understanding is that this form of working
capital is often the base level of current assets held by the business, with the balance of
accounts receivable being an example. In some companies that provide services to clients

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 on a mainly contractual basis, revenues generated month to month under the terms of
those contracts may be considered permanent working capital. Any clients who choose to
purchase services on a one-time basis, with no guarantees of repeat business, would be
considered sources of temporary working capital.

B) Temporary/ Variable Working Capital :

Part of working capital for which the requirements change with seasonal changes in
production and sales is known as temporary working capital. The temporary or
varying working capital varies with the volume of operations. It fluctuates with the
scale of operations. This is the additional working capital required from time to time
over and above the permanent or fixed working capital. During seasons, more
production/sales take place resulting in larger working capital needs. The reverse is
true during off-seasons. As seasons vary, temporary working capital requirement
moves up and down. Temporary working capital can be financed through short term
funds like current liabilities. When the level of temporary working capital moves up,
the business might use short-term funds and when the level for temporary working
capital recedes, the business may retire its short-term loans.

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

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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.

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 favorable 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

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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.

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:

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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 made to reduce the production costs to maximum
possible extent. For this purpose, the techniques like time and motion study, incentive schemes,
cost reduction programmers 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 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
20
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.

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.

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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?

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

22
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

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 favor of Company A in which it undertakes to make the payment to Company A if
Company B fails to honor 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 favor 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

23
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 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

Favor 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 favor 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 installments,
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.

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

25
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.

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.

26
 OPERATING CYCLE

Cash

Purchase of raw material, components

Receipt from debtors

Creation of receivables (Debtors) 27 Creation of A/c payable (Creditors)

 Payments to creditors
Sales of Finished Goods

Manufacturing operation: wages & salaries, fuel, power, etc

Warehousing of Finished Goods

Office, selling, distribution and other expenses

CHAPTER 3

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-

28
Conversion of cash into raw materials – raw material procured on credit, cash may have to be
paid after a certain period.

Conversion of raw materials into stock in process.

Conversion of stock in process into finished goods.

Conversion of finished goods into receivables/debtors or cash.

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.

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

29
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 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.

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

30
 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 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,

31
 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.

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.

32
 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

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

33
 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.

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

34
 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 month.

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

35
 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

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

36
 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.

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

37
 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.

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

38
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

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.

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

39
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.

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)

40
 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.

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.

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: -

41
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

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

42
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..

43
 Chapter 4

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. In case 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.

PRE SANCTION PROCESS

44
 APPRAISAL & RECOMMANDATION SANCTIONING

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.
ASSESSMENT
● 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
✔ 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

45
✔ 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.
✔ 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.

46
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
o Quarterly/half quarterly statements.
o Under information system
o Annual audited report

47
 POST SANCTION PROCESS

FOLLOW UP MONITORING & CONTROL

SUPERVISION

48
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 year’s balance sheet; current years estimate and
following year’s projection is given in this form.

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

49
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 whether they are
sufficient to meet the borrower’s 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.

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

50
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.

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,

51
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.

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.

52
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.

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.

53
 Chapter 5

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.

MULTIPLE BANKING ARRANGEMENT

54
 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.

55
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 very complex. The banks role has shifted from trade
financing to industrial financing during this period.

However, the bank’s 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 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.

56
We discuss the following committee’s important finding and recommendations for bank finance:
-

● TANDON COMMITTEE
● CHORE COMMITTEE

57
 Chapter 6

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.

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.

58
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.

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

59
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 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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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.

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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.

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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.

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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.

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.

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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.

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.

65
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.

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 Chapter 7

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.

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.

67
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.

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 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

69
 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

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

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 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 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

71
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 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

72
 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 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 31.03.0 31.03.06

Audited 5 Projected

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 Audited
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 - - -

Chapter 8

Conclusions

⮚ The requirement of working capital finance is ever increasing.

⮚ Loans and advances formed a major portion of the current assets of the firm because of
which the working capital gap is large.

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 ⮚ The bank prefers to use the second method of lending working capital under the MPBF
rather than evolving their own method.
⮚ In most of the cases, hypothecation and/or mortgage are used to create securities for the
banks.
⮚ Bank has their own internal credit rating procedure to rate the clients (Borrowers).
⮚ After doing the assessment of the financial indicators it is up to the judgment of the top
management of the bank to sanction such loan. The very decision could be against the
assessment result.
⮚ If the company is with bank from inception stage then they are given preference, as
credible and loyal party over their financial indicators.
⮚ There is a stiff competition to the nationalized banks from the foreign investors as their
lending rates are much lower than nationalized banks.
⮚ Today the foreign investors are very big threat to business and its existence.
⮚ Bank of Maharashtra has kept a conservative look to banking.

Suggestions

⮚ Closely monitoring and inspecting the activities and stocks of the borrowers from time to
time can avoid the misuse of working capital
⮚ While working out the working capital limits, banks must exclude the loans and advances
from the current assets. The assessment should be done mainly stock and the inventory
level of borrower.
75
 ⮚ Bank must extend working capital finance through non-fund based facilities.
⮚ Another ideal method would be to use LC as the primary source of extending, working
capital clubbed with bill discounting. This would ensure that the credit is put to the right
use by the borrower and repayment is guaranteed to the bank.
⮚ The bank must further secure themselves by holding a second charge on all the fixed
assets of the borrower.
⮚ The time period taken by the banks to sanction the limits should be significantly reduced
to allow the borrowers to make use of the credit when the need is most felt.

Bibliography

Books:

1. HAND BOOK ONWORKING CAPITAL FINANCE

D. P. SARDA, PUBLISHED BY S.J.D. IMPEX, MUMBAI, FOURTH EDITION

2. FINANCIAL MANAGEMENT

76
 R. P. RUSTAGI, GALGOTIA PUBLICATION, NEW DELHI, SECOND EDITION,
2000.

INTERNET SITES:

http://www.banknetindia.com

http://www.indiamarkets.com

http://www.businessfinance.com

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