CHAPTER-VII

FINANCING OF
WORKING CAPITAL
7.1. INTRODUCTION

The object of present chapter is to study the structure of working capital finance

in the selected SSI units of Orissa, with a view to highlight the relative roles played by

different sources of finance in meeting working capital needs of the SSI units. Besides,

attempt has also been made here to evaluate the adequacy or otherwise of the bank

borrowings and contribution of long term funds to finance the working capital requirements

with reference to the norms suggested by the various committees study groups of RBI in

our country in the recent past.

There exists a basic difference in capital structure and the method of financing of

SSIs as against the medium and large scale corporate sector, while in the case of latter,

the choice of the sources of capital, both fixed and variable working capital, is fairly

broad-based, it is very much restricted in the case of SSIs. A large and medium undertaking

can trap a large number of alternatives, besides its internal resources i.e retained earnings

and depreciation reserves. Besides, it can issue shares to the public, float debentures /

bonds, borrow from term lending institutions and can also depend on trade credit. But in

the case of SSIs, most of which are sole proprietorship or partnerships or private limited

companies, the issue of shares or debentures to public and loans from large financial

institutions are all remote and non -existent sources of funds.

The major sources of finance for SSIs include owner’s capital, borrowings from

friends, borrowings from banks, borrowings from relatives and internal resources. The
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availability of there sources of finance to SSI depends on factors like form of organisation,

reputation of owners / partners, stage of operation, size of organization and fiscal policies

of the government.

7.2. INSTITUTIONAL ARRANGEMENT FOR CREDIT FLOW TO THE SSIs

Credit forms the life blood of industry; and one of the perennial problems of

small industry is the easy availability of credit both for fixed assets and for working capital.

Many developing countries have an inadequate banking system; even where it is developed,

it is geared primarily to trading operations and, in some cases, lending to larger industry.

Small industry, inspite of its significant contribution to the country’s total production, gets

a less than proportionate share of the total volume of credit available; this is specially so

outside the metropolitan areas where, till recently, the banking system was hardly present.

Even where it does, the attitude of the bank personnel is based on conventional

banking norms where the approach is security oriented and a ‘collateral’ to cover two or

three times the value of the loan is insisted upon as a guarantee against risk. Further, the

procedural formalities in getting a loan are so cumbersome that small units are often scared

away by the appraisal procedures and the long delays experienced in getting a loan. The

result is that few of them like to deal with a bank; they would rather rely on friends and

relatives or even the money lender (inspite of his exorbitant rate of interest) than the local

bank.

On the other hand, if properly organised, the banking system can be very beneficial

to small industry. Apart from making funds available at reasonable rates of interest (as
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determined by the Reserve Bank of India), banks require financial prudence and discipline

which is vital, even if at times tiresome, to the success of small industry. A bank is also

the first to be able to detect signs of danger in the working of a unit and can therefore

sound an ‘early warning system’ to the owner—who may be blissfully ignorant of the

dangers ahead of ‘approaching sickness’. For this reason, banks can play a useful, even

crucial, role in not only providing credit but, more importantly, in monitoring it.

Apart from credit, fiscal and taxation policies have an important role to play in

the healthy growth of small industry. While undue preference to small industry in exemption

from taxes may not be desirable, it has to be recognised that a uniform tax policy for both

large and small industry may, in practice, be an ‘unintended disadvantage’. It is the wisdom

of fiscal policy makers to balance the disadvantage which small size imposes with a pattern

of rebates and exemptions which can provide suitable incentives to small industry.

Even more important than the formulation of such incentives is to ensure that they

can be easily availed of and, in fact, reach the small units for whom they are intended. All

too often, government policies, (and this is particularly true of fiscal measures) however

well meaning, seem to be lost in a maze of procedures and returns and, coupled with the

proverbial delay in government offices, provide little tangible relief to the small industrialist.

It is necessary to ensure that such policies are worked in a manner as to really benefit the

small-scale sector.

There is also a need to provide incentives for undertaking special programmes

which will benefit the industry in the long run. Programmes like modernisation to improve

the efficiency and productivity of the unit and utilisation of in-house test facilities to obtain
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better quality control are at times costly and therefore, not likely to be taken up by the

small entrepreneur who looks to short-term gains unless encouraged by the special

incentives to undertake them.

The financial system in a country needs to be ‘tuned’ to the needs of the small

industry sector; it has also to mesh with the broad policies of the government so that their

impact is pronounced and visible. This includes also such matters as important policies

where a too liberal attitude may make it difficult for small units against indiscriminate

imports and too rigid an attitude may make it difficult to obtain raw materials and

components which are vital to ensure the good quality of the product. In India credit is

provided to the small sector through:

* State Financial Corporations for fixed capital;

* Commercial Banks for working capital;

* Cooperative Banks provide working capital to industries organised on a

cooperative basis;

* Equity assistance is provided by some of the Small Industry Development

Corporations, SFCs and banks

* The National Small Industry Corporation provides machinery on a hire-purchase

basis;

* The Industrial Development Bank of India (IDBI) and the National Bank for

Agricultural and Rural Development (NABARD) Provide refinance facilities to

the banks and SFCs for lending to small and village industries respectively.
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The Reserve Bank of India has designated that credit to the small scale sector

may be given on a priotiry basis; other priority sectors include agriculture and transport.

IDBI has opened a single window clearance for automatic refinancing of

advances made to small units by SFC and SIDCs. In each district, one bank is designated

as the ‘Lead Bank’ to draw up the credit plans for all the sectors in the district. There is

a District Credit Committee with the District Collector as chairman to ensure adequate

credit flow to all sectors of the economy.

As mentioned earlier, the State Financial Corporations have emerged in recent

years as major lenders of term loans to the small-scale sector. More than 70 per cent of

their sanctions are made to the small sector.

A special scheme for artisans has been in force under which, very small loans (up

to Rs. 50,000) are provided on a ‘composite’ basis for both fixed assets and working

capital. A unique feature of the scheme is that the credit guarantee (normally 75 per cent)

is increased to 90 per cent and there is no ‘penal interest’ on defaulted payments. Interest

is fixed at 11 per cent and repayment is for a period of 7-10 years. A time limit of 30

days is fixed for the disposal of applications.

A Credit Guarantee Scheme has been in force since I960 and placed on a

permanent footing since 1963 under which an automatic guarantee up to 75 per cent is

provided to all advances made to small units by the financial institutions. This enabled the

latter to take risks which they would otherwise have not done, and made credit more

easily available to the small units.

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The scheme was modified in April 1981 and a new agency— Deposit Insurance

and Credit Guarantee Corporation of India— was created to operate the scheme. This

Corporation is a fully owned subsidiary of IDBI. The guaranteed cover varied from 90

per cent in respect of small loans (up to Rs. 5 0,000 to 75 per cent (up to Rs.2 lakhs) and

50 per cent for sums above that amount. The claim liability for an individual borrower is

not to exceed Rs.10 lakhs. In the backward areas, however, credit guarantee is up to 66-

2/3 per cent for amounts above Rs.2 lakhs.

One major demand of small industry for many years has been to establish an

Apex Institution to provide and monitor credit for the small-scale sector. It was felt that

such an institution would .make credit more easily available and apply more meaningful

norms which are now applied across the board for both the large and small sectors.

NABARD was set up in 1980 for funding rural development activities which included a

component for rural industries: IDBI set up a Small Industry Development Fund in 1986

with an initial corpus of Rs.2,500 crores to fund specialised programmes for small industry.

But the working of NABARD has been of limited benefit to small industries since the

focus of its interest is on agriculture and rural development: the SID Fund also does not

substantially increase the total credit made available to the small sector, though it will

enable special programmes to be taken up. The question of setting up an apex financial

agency for the small industry sector (as is the case in Japan, where as many as four such

institutions operate) is still to be resolved. Another problem that has been repeatedly

brought up is to provide for limited liability for partnership—which is the structure for the

majority of small industry units today. The Partnership Act provides only for unlimited
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liability which acts as a disincentive for funds to be invested in any venture. It has, therefore,

been suggested that a modified Partnership Act with limited liability should be formulated

to attract venture capital more easily for small industrial units. At present, such a provision

is available only in the case of cooperatives or joint stock companies.

A basic reform that has been demanded frequently is to simplify the forms and

procedures for obtaining loans from the banks. A high-powered committee appointed in

1977 had recommended various reforms relating to systems and procedures of bank credit

to small-scale industry and the Reserve Bank of India had issued instructions in 1978 to

implement the recommendations of the Committee. These included simplified application

forms and standardisation of forms for all banks. Such forms should be accepted by all

the financing institutes and should also form the basis for reports by the consultancy

organisations. The delays experienced in the disposal of applications also need to he

reduced; a maximum period of 8-9 weeks has been recommended but delays continue to

occur. There is a need for much greater delegation of powers to bank managers so that

unnecessary references to the head office is avoided. Uniformity of margins for working

capital, norms for determining the working capital requirements, and stipulation of collateral

as additional security are matters in which reforms are needed.

Above all, what is needed is a more flexible development approach on the part

of the branch manager to view the problem of small industry with greater empathy and

understanding. The ‘credit worthiness’ of a small entrepreneur consists not in the collateral

he can produce but his own dedication and background and the stake of his career—far

more important than money—in a venture. Unfortunately, progress in this regard has been
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limited and many branch managers continue to exhibit the same rigid attitude in dealing

with small industry as in the past.

This has been primarily responsible for the rapid increase in ‘sick units’ as

estimated by the Reserve Bank of India, which defines a unit-as sick if ‘it has incurred

cash losses for one year and in the judgment of the bank is likely to continue to incur such

losses for the current year as well as the following year and has an imbalance in its financial

structure such as a current ratio of less than 1:1 and worsening debt-equity ratio (total

outside liabilities to the net worth)'. More simply, a sick unit is one which fails to generate

internal surplus on a continuous basis.

A diagnostic sample study conducted in 1985 by the Development Commissioner,

Small Scale Industry, identified the major causes of sickness as :

* Shortage of working capital (inadequate and untimely assistance from the banks)

30 percent

* scarcity of raw materials (22 per cent)

* lack of demand (13 per cent)

* management deficiency (10 per cent)

Another major cause is the delayed payments by the large enterprises which

causes a ‘liquidity crisis’ leading to default and heavy penal interest—creating a vicious

circle from which the small unit finds it difficult to extricate itself. Power cuts experienced

in almost all the States, and which are applied uniformly for all undertakings, is another

contributing factor. Diversion of funds from productive to unproductive uses also creates

problems for the unit.

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In 1985, the Government enacted the Sick Industrial Companies (Special

Provisions) Act to secure timely detection of sick (and potentially sick) units so as to

take preventive or remedial measures. The Act is not applicable to the small or ancillary

industry. Similarly the guidelines issued by the Reserve Bank of India in a Circular dated

5 November 1985 outlines the relief measures that may be taken to rehabilitate sick units

but these are not normally applicable to the sick units in the small sector. These include a

‘package programme’ of relief from the banks, the State and Central Governments, and

the management and labour of the sick unit.

There is, in fact, a need for a comprehensive policy towards prevention of sickness

and the rehabilitation of sick units. In this regard, it is the commercial banks that can play

a useful role in monitoring the ‘health' of the unit and sounding a note of warning well in

advance, since by the time a unit is declared ‘sick' it is too far gone to merit rehabilitation.

Any such programme of rehabilitation must be based on a fair and objective determination

of the potential viability of the unit and whether it would he worthwhile for additional

money to be invested in it. This is so, if the sickness is not due to any intrinsic weakness

in management or technology: in view of the structure of most small units, the ability to

take over the management of the unit for a limited period or inject more capital into it is

not always available.

The District Industries Centre, now functioning in almost every State, needs to

be more actively involved in such a rehabilitation programme as also the state government

agencies such as SKC or SSIDC. The Inter-Institutional Committee set up by the Reserve

Bank of India and the state governments jointly should be empowered to take decisions

as to the worthwhileness of the rehabilitation of a sick unit.

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The Small Industry Development Fund, recently created, may “be utilised

generously to provide assistance in cases which are considered worthwhile. Such

assistance should be in the form of soft loans for modernisation and training; equity capital

may also have to be provided to reduce the debt burden on the unit. The seed capital

scheme, now operated by the SFCs, by which margin money up to 10 per cent of fixed

capital (15 percent in the case of Scheduled Castes and Tribes) is given, may also be

extended by the commercial banks. Bank personnel may be trained at the various Institutes

of entrepreneurship training, to give them a greater awareness of the problems of

entrepreneurs. Collection of data on sick units has to be timely and uptodate.

The system of fiscal incentives provided to small industries maybe reviewed so

that the entrepreneurial spirit is inculcated and risk taking is encouraged, at the same time

providing relief to small units. What is needed is a taxation policy which will restore

initiative, encourage entrepreneurial activity and improve the liquidity position of small

business. While undue protection in favour of small units is not desirable, there are areas

where small industry suffers inequalities or unnecessary disabilities as a result of the present

tax system which need to be corrected. Small-scale industrialists, on their part, need to

he educated that money has a ‘cost’ and that money, made too cheap, distorts the economic

viability of the project leading to wrong investment decisions.

7.3. Conceptual framework of financing for working capital

The working capital management does not end with estimating and forecasting of

working capital requirement, but also includes the financing of this requirement. It is prudent

to bifurcate the total working capital requirement in to permanent and temporary working
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capital .The permanent working capital which is required, irrespective of the fluctuations

in the sales level should be financed by arranging funds from long term sources such as

long term loans and owners capital. However, the temporary working capital requirement

should be financed from short term sources of finance.

Short term financing consists of obligations which are expected to mature within

a period of one year, supports a major portion of current assets. In this chapter we shall

examine (i) the different sources of finance from where the funds on short term basis may

be arranged, and (ii) the banking policy in India in relation to financing of working capital.

7.3.1 SOURCES OF SHORT TERM FINANCE

There are different sources of short term financing. It is essential to consider the

following aspects before selecting a particulars source.

* The financing source selected should have the lowest annual interest cost.

* The impact of source on the credit rating of the firm should be assessed.

* There should be scope for flexibility, so that additional founds, if necessary can be

procured without any difficulty.

* The source should be reliable.

* The source should not impose restrictions on the working of the firms.

Some of the important sources are :

i. Spontaneous sources such as trade credit and accrued expenses.

ii. Commercial papers, and

iii. Bank credit

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7.3.1(a): Spontaneous Sources

These sources result from normal business activities. In the normal course of

business, a firm purchases goods and services for which payment can be made at a later

date. To the extent the payments are delayed, the funds are available to the firm. These

sources are insecured and vary in line with sales level. These are referred as trade liabilities

or current liabilities. Two important such sources are :

★ Trade Credit

The trade credit may be defined as the credit extended in connection with goods

and services purchased for resale. It is the ‘resale which distinguishes trade credit from

other sources. For example, fixed assets maybe purchased on credit, but since these are

to be used in the production process rather than for resale, such credit purchase of fixed

assets is not called the trade credit. The credit extended in connection with the goods

purchased for resale by a retailer or a wholesaler of raw materials used by manufacturer

in producing its products is called the trade credit. Thus, the consumer credit which is the

credit extended to individual customers for purchase of goods for ultimate consumption,

rather than for resale, is also excluded from trade credit. There are two common ways to

extend trade credit:

i) Open Account: The trade credit under open account is usually extended only

after the seller conducts a fairly extensive investigation of the buyer’s standing and

reputation. The open account derives its name from the fact that the buyer does not sign

a formal debt instrument evidencing the amount due. The only evidence the seller has that
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has that credit has been extended is the copy of the invoice that the goods have been

deliverd. When trade credit is arranged, this is all that is done and all that is required to

be done to establish legal evidence of indebtedness.

ii) Bills Payable: In such a case, the buyer will have to give a written promise to pay

the amount of the bill/invoice on demand or at a fixed future date to the seller or the

bearer of the note. The buyer may be required to sign the bills payable in case where (a)

the seller wishes to obtain a formal acknowledgment of the debt, a maturity date, and (b)

the open account have already become the delinquent.

Open account purchases are major sources of unsecured short term financing for

business firm. They include all transactions in which goods are purchased but no formal

bill is signed. Although, the obligations of the purchaser to the supplier may not seem as

legally binding as it would be ifthe supplier had required the buyer to sign the bill, however,

there is no legal difference between the two systems.

The following financial aspects are important regarding trade credit:

★ Credit Terms : The credit terms refer to the set of conditions on which a seller

sells goods and services to the buyer and in particular, on which the buyer has to make

the payment to the seller. These may include

i) The size of the cash discount, if any, from the net invoice price which is given for

making cash payment within a specified period.

ii) The period within which payment must be made, if the cash discount is to be

availed, and
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iii) The maximum period that can elapse before payment of the net invoice price

should be made, if the discount is not taken.

Terms of trade credit usually vary from one industry to another and are specified

on the invoice

Cost of Trade Credit: In view of the cash discount offered by the supplier, the

buying firm has the discretion to use or not to use the trade credit as a source of fund. By

altering its payment period, a firm can expand or contract its account payable. Theoretically,

a firm could reduce payable to zero and use no trade credit at all by paying in cash on the

date of purchase. However, since trade credit is non-interest bearing, it represents a

desirable source of financing. If used beyond certain limits it is not without its costs. The

cost of using trade credit as a source of short term finance depends upon several factors,

the most important being the credit terms upon which the goods are supplied. For the

purpose of measuring the true cost, or the effective annual rate of interest associated with

the use of trade credit as a discretionary source of short term finance, it is necessary to

consider the effects of its use, both, when (i)a firm fails to take its cash discounts but

nevertheless pays within the net period, and ii) a firm fails to take its discount and allows

its payable to become overdue.

These two situations involve an actual cost to the paying debtors. If no cash

discount is offered, then there is no cost for the use of credit during the net period, however

long it maybe. By the same token, if a discount is available and the buyer avails it, there

is also no cost for the use of credit during the discount period. However, if a cash discount

is offered and is not availed, there is an implicit opportunity cost. Say, a firm is offered
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credit terms of 2/10 net 30. It means that the firm has two options : To avail or not to

avail the discount. If the firm opts to avail the discount then it shall pay 98% of the invoice

amount by the end of 10th day of the bill date. The firm in this case has no implicit cost

associated with availing the discount. However, if the firm does not avail the discount

then it can delay the payment by 30days, without any extra cost. Apparently, there is no

explicit cost associated with foregoing the discount, nevertheless, there is an implicit cost.

The discount foregone is the implicit cost.

Stretching Trade Credit: Stretching the trade credit means that the firm delays

the payment to creditors until some time after the credit period. This has the impact of

extending-free credit if cash discount are not offered and of reducing the financing cost if

cash discount are offered and foregone. Stretching the payments is sometimes suggested

as a reasonable strategy for a firm as long as it does not damage its credit rating. Although,

this strategy may be financially attractive, yet it may cause the firm to violate the agreement

it entered into with the supplier. Obviously, a supplier would not look kindly to a customer

who purposely postponed the payments on a regular basis. As a consequence, the firm

may find it increasingly difficult to obtain trade credit on good terms and may be forced

to accept unfavourable credit terms. The suppliers may reduce the firm’s line of credit or

decrease the length of net period or suspend altogether the credit lines. Some suppliers

may not be willing to grant trade credit terms and may offer goods only on cash basis.

The firm may find it necessary to borrow funds in order to purchase raw materials and

other supplies. Stretching the payments can thus, result in affecting the credit position in

the market.
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Management of Trade Credit: The trade credit is a common source of short

term financing, however, the extent to which the trade credit is used as a source varies

widely among firms. In general, manufacturers, retailers and wholesalers make extensive

use of trade credit. There is considerable variation also with respect to firm’s size and

smaller firms generally use trade credit more extensively than large firms. Particularly,

when the monetary policy is tight and credit is difficult to obtain, small firms tend to

increase their reliance on trade credit. Further, large firms are willing to finance their

smaller customers in terms of trade credits, in order to preserve their markets and therefore,

provide financing to smaller firms.

As the trade credit is readily acquired, the buying firm must exercise continuing

care to avoid falling into the habit of using trade credits beyond a particular level. Supplier

firms usually regard the extension of trade credit as a part of overall sales promotion

policy and therefore it is quite easy to get into debts through the use of trade credit. No

doubt, the trade credit is exceedingly useful and valuable for any firm because it can be

obtained, generally, at a time and to the extent it is needed. If the inventory level is to be

increased in order to meet the expected surge in sales volume, the trade credit will

automatically finance a part of the increase.

★ ACCRUED EXPENSES : Another spontaneous source of short term financing

is the accrued expenses or the outstanding expense liabilities. The accrued expenses refer

to the services availed by the firm, but the payment for which has not yet been made. It is

a built-in and an automatic source of finance as most of the services i.e., labor etc., are

paid only at the end of a period. Similarly, taxes are also paid at the end of a particular
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period only. Sales tax is collected by the firm on daily sales but is deposited with the

Government only at the end of a period. The accrued expenses represent an interest free

source of finance. There is no explicit or implicit cost associated with the accrued expenses

and the firm can save liquidity by accruing these expenses.

Employees, in any firm, provide services through out a month at the end of which

they are paid the accumulated wages for the month. The. liability for these expenses accrue

between two pay-days and becomes zero as soon as the payment is made. The longer the

payment period, greater will be the fund availability to the firm during that period. For

example, a firm having a policy of paying to temporary wagers on a weekly basis can

change the payment period to ten days or a fortnight and thereby can increase the funds

available to it and that too for a longer period. Similarly, the sales commission or target

incentives etc., are always payable with a time lag. These provide funds to the firm at no

apparent or explicit cost.

The use of accrued expenses as an interest free source of financing is consistent

with the general philosophy of paying the creditors as late as possible, as long as the firm

does not damage its credit rating. However, in case of setting or changing the payment

period of accrued expenses, the legal provisions must be taken care of. For example,

there is no discreation available in respect of payment of three installments of advance

payment of tax i.e., on 15th September, 15th December and 15th March.

Likewise deferring payments for the services availed, the firm may also receive

advance payment for the goods and services which it has to provide / supply to the customer

in future. In some businesses, customers are often required to maintain a security deposit
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with the supplier, or to pay full or a part of total value with the order. These advance

payment also become a source of finance to a supplier firm, which may pay some nominal

interest on these deposits/advance payments etc.

7.3.1(b): Commercial Papers

Commercial Paper (CP) is an unsecured promissory not issued by a firm to raise

funds for a short period, generally, varying from a few days to a few months. For example,

in India, the maturity period of CP can vary between 90 days to 180 days while in some

other countries, the maturity period may go even up to 270 clays. It is a money market

instrument and generally purchased by commercial banks, money market mutual funds

and other financial institutions desirous to invest their funds for a short period. As the CP

is unsecured, the finns having good credit rating can only issue the CP. The amount raised

by CP is also generally large. Conceptually, CP market is a segment of open market for

the short term funds, however, as compared to customer loan market where the borrowers

negotiate loans terms with banks.

The firm or the dealers in CP sell these to the short term lenders who use it as

interest earning investment of temporary surplus of operating funds. The nature of these

surpluses and motives for buying the CP suggest that all the holders of the CP expect to

be paid in full at maturity. The maturity term of CP is not generally extended. This

expectation on the part of short term lenders requires that the borrowing firm must be (i)

an established and profitable firm, (ii) consistently maintaining a good reputation in the

market, and (iii) having good credit rating. The firm issuing the CP generally has an open

line of credit with a commercial bank to provide a security against the CP. This is to
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provide protection to the lenders in case of borrower firm faces difficulty in redeeming

the CP on the maturity date. Particularly, when the conditions in the money market gets

tight, these lines of credit provide an insurance to the lenders / investors.

V

The commercial papers are issued with a face value but the issue price may be

less than the face value. The difference i.e., the discount on the issue price works as a

return to the lender at the time of maturity, when he gets the refund. In other words, the

borrowing firm gets less at the time of issue but repays the full face value of the CP on

maturity. The discount on issue of CP depends upon the amount involved, maturity period

and the prime lending rates of commercial banks. The main advantage of CP is that the

cost involved is lower than the prime lending rates. In addition to this cost, the borrowing

firm has to bear another cost in the form of placement fees payable to the dealer of CP

who arranges the sale.

Since the CP represents an unsecured borrowing in the money market, the

regulation of CP comes under the purview of the Reserve Bank of India which has issued

guidelines in 1990 on the basis of the recommendations of the Vaghul Working Group.

These guidelines were aimed at:

i) Enabling the highly rated corporate borrowers to diversify their sources of short

term borrowings, and

ii) To provide an additional instrument to the short term investors.

These guidelines have stipulated certain conditions meant primarily to ensure that

only financially strong companies come forward to issue the CP. Subsequently, these
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guidelines have been modified to encourage the issuance of CP. The main features of the

guidelines relating to issue of CP in India may be summarized as follows :

1. CP should be in the form of usance promissory note negotiable by endorsement

and delivery. It can be issued at such discount to the face value as may be decided

by the issuing company. CP is subject to payment of stamp duty.

2 The aggregate amount that can be raised by commercial papers is not restricted any

longer to the company’s cash credit component of the Maximum Permissible Bank

Finance.

3. CP is issued in the denomination of Rs. 5,00,000, but the maximum lot or investment

is Rs. 25,00,000 per investor. The secondary market transactions can be Rs.

5,00,000 or multiples thereof. The total amount proposed to be issued should be

raised within two weeks from the date on which the proposal is taken on record

by the bank.

4. CP should be issued for a minimum period of 30 days (with effect from April 15,

1997 when the monetary policy for 1997 was announced by the RBI) and a

maximum of 6 months. No grace period is allowed for repayment and if the maturity

date falls on a holiday, then it should be paid on the previous working day. Each

issue of CP is treated as a fresh issue.

5. Commercial papers can be issued by a company whose (i) tangible net worth is not

less than Rs. 5 crores, (ii) funds based working capital limit is not less than 4

crores, (iii) shares are listed on a stock exchange, (iv) specified credit rating of P2

is obtained from CRISIL or A2 from ICRA, and (v) the current ratio is 1.33:1:
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The issue expenses consisting of dealers fees, credit rating agency fees and other

relevant expenses should be borne by the issuing company.

CP maybe issued to any person, banks, companies. The issue of CP to NRIs can

only be on a non-repatriable basis and is not transferable.

8. CP can be issued up to 100% of the fund based working capital loan limit. The

working capital limit is reducedpro-tonto on issuance of CP.

Deposits by the issue of CP have been exempted from the provisions of section

58A of the Companies Act, 1956.

Any company proposing to issue CP has to submit an application to the bank

which provides working capital limit to it, along with the credit rating of the firm. The

issue has to be privately placed within two weeks by the company or through a merchant

banker. The initial investor pays the discounted value of the CP to the firm. Thus, CP is

issued only through the bank who has sanctioned the working capital limit to the company.

It is counted as a part of the total working capital limit and it does not increase the

working capital resources of the firm.

From the point of the issuing company, CP provides the following benefits :

a) CP is sold on an unsecured basis and does not contain any restrictive conditions.

b) Maturing CP can be repaid by selling new CP and thus can provide a continuous

source of funds.
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c) Maturity of CP can be tailored to suit the requirement of the issuing firm.

d) CP can be issued as a source of fund even when money market is tight.

e) Generally, the cost of CP to the issuing firm is lower than the cost of commercial

bank loans. However, CP as a source of financing has its own limitations :

i) Only highly credit rating firms can use it. New and moderately rated firm generally

are not in a position to issue CP.

ii) CP can neither be redeemed before maturity nor can be extended beyond maturity.

CP as a source of short term finance for SSIs is unthinkable for the time being for

the SSI units of Orissa.

7.3.1(c) : BANK CREDIT FOR WORKING CAPITAL

Credit facility provided by commercial banks to meet the working capital

requirement has been an important source of short term funds to business firms. In India,

bank credit has been the main institutional source of short term financing requirement.

While the trade credit and accrued expenses are the automatic and spontaneous sources

of finance, the bank credit is a deliberate, negotiated and external source. The bank credit,

in general, is a short term financing say for a year or so. This short term financing to

business firm is regarded as self-liquidating in the sense that the uses to which the borrowing

firm is expected to put the funds are ordinarily expected to generate cash flows adequate

to repay the loan within a year. Further, these loans are called self-liquidating because the

bank’s motive to provide finance is to meet the seasonal demand e.g., to cover the seasonal
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increase in inventories or receivables. In principle, the bank credit is intended to carry

the firm through seasonal peaks in financing need. The amount of credit extended by a

bank may be referred to as a credit limit which denotes the maximum limit of loan which

the firm can avail from the bank. Sometimes, the bank may approve separate limits for

peak season and non-peak season.

Types of Bank Credit: In India, banks may give financial assistance in different

shapes and forms. The usual form of bank credit are as follows:

1. Overdraft: It is the simplest of different forms of bank credit. In this case, the

borrowing firm which already has a current account with the bank is allowed to withdraw

more (up to a specified limit) over and above the balance in the current account. The

amount so over drawn (i.e., borrowed) may be repaid by depositing back in the current

account as and when the firm wants. The firm is not required to seek approval of the bank

authority every time it is overdrawing, but a one time approval may work for a particular

period, say a year. The bank, however, can review and modify the overdraft limit at any

time. The firm has to pay interest at a specified rate only for the period during which the

amount was overdrawn. The bank may also charge a minimum amount per period for

maintaining the over draft limit even if no amount has been over drawn.

2. Cash Credit: The credit facility under the cash credit is similar to the overdraft.

Under the cash credit, a loan limit is sanctioned by the bank and the borrowing firm can

withdraw any amount at any time, within that limit. The interest is charged at the specified

rate on the amount withdrawn and for the relevant period. The bank may or may not

charge any minimum commitment fee. Under the cash credit also, the borrower has the
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option to withdraw or not the amount of loan sanctioned. The amount withdrawn can be

repaid by depositing in the bank account. This will enable the borrowing firm to reduce

the interest burden.

Recently, the Reserve bank of India has issued guidelines which provide that a

firm has to maintain a margin of 25% and cash credit limit may be sanctioned only up to

75% of the cash-purchased inventories and book debts. The over draft limit and the cash

credit limit are considered simultaneously. However, the financing is called cash credit if

it is given against the hypothecation of goods or security of the book debts. The term

over draft may be used when the loan is given against the security of assets other than

inventories and book debts. In both the cases, however, the bank has some or the other

security.

3. Bills Purchased and Bills Discounting : Commercial banks also provide short

term credit by discounting the bill of exchange emerging out of commercial transactions

of sale and purchase. In the normal course of credit sales, the seller of the goods may

draw a bill on the buyer of the goods who accepts the bill and thereby promises to pay

the bill as per terms and conditions mentioned in the bill. However, if the seller wants the

money before the maturity date of the bill, he can get the bill discounted by a bank which

will pay the amount of the bill to the seller after charging some discount. The discount

depends upon the amount of the bill, the maturity period and the prime lending rate

prevailing at that time. The bank represents that bill to the buyer on the due date and gets

the payment. The difference between the amount so received and the amount paid by the

bank in respect of the bill is the income of the bank.

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The bill may be payable on demand or on maturity. When the bill payable on

demand is discounted, it is called bills purchased; and when the bill payable at maturity is

discounted by a bank, it is called bills discounting. In order to popularize and regulate the

bill operations in India, the Reserve Bank of India announced the New Bill Market Scheme

in 1970. The Scheme envisaged the bill discounting as a means of providing short term

financing to various firms as against the cash credit system. The bill discounting is common

only among small size business firm. One of the short coming of the bill discounting system

is that the bank, which discounts that bill, must establish and verify the creditworthiness

of the buyer, which at times, maybe difficult, complicated and time consuming process.

4. Letter of Credit: A letter of credit is a .guarantee provided by the buyer’s

banker to the seller that in case default or failure of the buyer, the bank shall make the

payment to the seller. The responsibility of the buyer is assumed by the bank in case the

latter fails to honour his obligations. The letter of credit issued by the bank may be given

by the buyer to the seller along with the bill of exchange. So, in fact, the letter of credit

becomes a security of the bill and any bank (or the bank or the seller) will have no problem

in discounting the bill.

The letter of credit provides a non-fund based financing as the funds are not

involved in the issue of the letter of credit. It is a contingent liability of the bank and shall

arise only if the buyer fails to pay. However, whenever a letter of credit is issued, the

amount is adjusted against the fund based cash credit limit of the buyer. It may be noted

that in case of letter of credit, the bank provides only a security and undertakes the risk

for the bill period, but the financing is in fact, made by the seller. So, it is an indirect form
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of financing as against the over draft, cash credit and bill discounting where the bank

provides direct financing.

5. Working Capital Term Loan : Generally, the bank while granting working capital

facility to a customer stipulates that a margin of 25% would be required to be provided

by the customer and hence the bank borrowing remains only limited to 75% of the security

offered. In other words, against a security of Rs. 100, the bank gives a loan of up to Rs.

75. The shortfall is generally treated as Working Capital Term Loan (WCTL). This WCTL

is to be repaid in a phased manner varying between a period of two to five years.

6. Funded Interest Term Loan : Sometimes, a company because of it's operations

may not be able to pay the interest charge on its working capital cash credit facility

obtained from a commercial bank. Such accumulation of unserviced interest makes the

cash credit account irregular and in excess of the sanctioned limit. It also prevents the

firm to make further operations in the account. Such unserviced accumulated interest may

be transferred by the bank from cash credit account to Funded Interest Term Loan (FITL).

This will enable the firm to operate its cash credit account. The FITL is considered

separately for repayment.

Security for Bank Credit: The bank credit is generally provided against the security of

one type or the other. Since the bank credit is on a short term basis, the security may be

primarily in the form of liquid assets such as stock, book debts, fixed deposit or other

investment or in some cases immovable properties. The security may be provided in

different forms as follows:

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1. Hypothecation : Hypothecation refers to a situation where a movable property,

generally stock, is given as a security against the loan. The ownership as well as the

physical possession of the goods remain with the borrower. He maybe allowed to even

deal in them. However, in case of default by the borrower, the bank will have the right to

take custody as per the terms and conditions agreed. As per the current practice, the

bank may allow a loan up to 75% of the value of goods, which is taken as the cash

purchased component of the total goods. So, the credit is not allowed against the goods

purchased on credit. For example, a borrower has a total stock of Rs. 9,00,000 in the

godown, and his debtors and creditors are estimated at Rs. 5,00,000 and Rs. 6,00,000

respectively. The value of the stock is taken at Rs. 8,00,000 (i.e., Rs. 9,00,000-Rs.

6,00,000+Rs. 5,00,000) and a loan up to 75% of this value i.e., Rs. 6,00,000 maybe

sanctioned by the bank.

2. Pledge : Pledge is a situation where the goods or property or other investment

being provided as security is to be deposited (physically) with the bank. So, the bank

gets the physical possession of the security under the agreement of loan. This is generally

adopted in case of security provided in the form of investment certificates etc. In case of

repayment of loan, the security is returned to the borrower and, in case of default, the

security may be realized by the bank to recover the loan. During the period of custody,

the bank is supposed to take reasonable care of the goods/security as a pledgee (Pawnee).

3. Mortgage : Mortgage is a situation when an immovable property, say a building

or plant and machinery etc., is provided as a security. In this case, the title to the property,

under an agreement called Mortgage Deed, is transferred to the lender, however, the
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physical possession remains with the borrowers. The borrower who transfers this right is

called the mortgagor while the lender bank is called the mortgagee. In case of repayment

of loan, the title to property reverts to the borrower. However, in case of default, the

lending bank will have the right to sell or otherwise dispose off the asset. For this purpose,

the lender will have to procure the order of the Court of Law. The loan granted against

the mortgage is not self liquidating. The basic shortcoming of the mortgage is the valuation

and marketability of the property mortgage.

4. Lien : The lien refers to a situation when a property or a beneficial right belonging

to another person is retained by a party who is having physical possession of the property,

unless the loan or any other amount due to the latter is paid. The lien may be general,

when the property may be retained for all amounts due or may be particular when the

property is retained for failure to repay a particular debt. The banks like to have a general

lien on the property of the borrowing firm.

7.4. REGULATION OF BANK FINANCE IN INDIA

Bank credit has been an important and inevitable source of short term financing

or working capital finance for most of the business firms. Traditionally, bank credit has

been an easily accessible source of meeting the working capital needs of the borrowing

firms. Convenience in getting the bank credit has been an important factor for the growth

of bank credit in fulfilling the requirement of the industries. However, it also resulted in

distortion of allocation of bank resources in favor of industry. Consequently, the bank

credit has been subject to various rules, regulations and controls. The Reserve Bank of

India has appointed different study groups from time to time to suggest ways and means
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to make the bank credit as an effective instrument of industrialization as well as to ensure

equitable distribution of bank resources. The present section discusses the important

findings and recommendations of the following committees, which in fact have shaped the

flow of bank credit in last three decades in India: i) Dehejia Committee, ii) Tandon

Committee, iii) Chore Committee, iv) Marathe Committee, v) Nayak Committee, vi)

Kannan Committee

DEHEJIA COMMITTEE : A study group under the Chairmanship of V.T.

Dehejia was constituted in 1968 by the National Credit Council to examine the extent to

which credit needs of industry and trade were inflated and to suggest ways and means of

curbing this phenomenon. The Dehejia Committee, inter alia, analyzed (i) the relative

growth rates of short term trade credit and the value of industrial production, (ii) the

relative growth rates of short-term trade credit and inventories with industry and trade,

(iii) the diversion of short-term credit for fixed asset acquisition and for loans and

investments, (iv) the incidence of multiple financing, and (v) the elongation of the credit

period. The major findings of the Dehejia Committee were : (i) Bank credit to industry

grew at a higher rate than the rise in industrial output, (ii) Banks in general, related credit

limits to the security provided by the borrowers without properly assessing their needs

based on projected financial statements, (iii) Short term bank credit was diverted to some

extent for acquiring fixed assets and for other purposes, (iv) The prevailing lending system

facilitated industrial units to rely on short term bank credit to finance non-current assets.

Out the basis of these findings, the principal suggestions made by Dehejia

Committee were as follows:

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a) Credit applications should be appraised on the basis of the financial situation,

current and projected, as reflected in the cash flow analysis and forecasts provided

by the borrowers. Cash credit accounts should be segregated into two components

: (i) the hard core component representing the minimum level of current assets

required for maintaining a given level of production and (ii) the strictly short-term

component representing the fluctuating part of the account.

b) To eliminate multiple financing, a customer should be required to deal with only one

bank. If the credit requirement of a customer is high, a ‘consortium’ arrangement

should be adopted.

c) To check the tendency to seek more-than required credit limit, a commitment

charge should be levied with a provision to impose a minimum interest charge.

d) The Committee recommended that commercial banks, industry and trade should

initiate and develop the practice of issuing usance bills as this would not only impose

financial discipline but also help the borrower to plan his financial commitments.

An adequate growth in the business of bills will facilitate the development of bill

market in India.

e) Adequate attention should be paid to the question of adequacy of the inventories

held by various industry and to minimize the stocks needed by industry. This will

help restraining the demand for bank credit.

Dehejia Committee pointed out the weaknesses of the system of bank credit as

well as gave recommendations to channelize it. However, the recommendations could not
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be implemented and during 1974, the demand for bank credit rose sharply because of

unprecedented inflation. Most of the banks had to freeze the credit limits and a need was

felt to give a closure look at the entire bank credit system. In 1974, the RBI constituted,

the Tandon Committee to frame guidelines for the regulation and provision of bank credit.

TANDON COMMITTEE : A study group under the Chairmanship of Sh. P.L. Tandon

was constituted in 1974 by the Reserve Bank of India to frame the guidelines for the

effective regulation of bank credit and other related aspects. The basic terms of reference

of the Tandon Committee were as follows :

a) To suggest guidelines for commercial banks to follow-up and supervise credit from

the point of view of ensuring proper end-use of funds and keeping a watch on the

safety of the advances.

b) To make recommendations for obtaining periodical forecasts from borrowers of

(i) production plans and (ii) credit needs;

c) To make suggestions for prescribing inventory norms for different industries.

d) To suggest criteria regarding satisfactory capital structure and sound financial basis

in relation to borrowings.

e) To make recommendations as to whether the existing pattern of financing working

capital requirements by cash credit/overdraft system etc. requires to be modified.

On the basis of the findings, the Tandon Committee noted various shortcomings

of the then prevailing cash credit system such as (i) the cash credit system which allows
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the withdrawal of any amount up to a given limit hinders credit planning, (ii) the security

based approach to lending has led to diversion of funds to purchase of fixed assets, and

(iii) the working capital finance should be made available only for a short period, as it has

otherwise, led to accumulation of inventories with the industry. The Tandon Committee

studied the entire system of bank credit and observed that banks should finance only the

genuine production needs of the borrowers who should indicate the likely demand for

credit based on operating plans for the coming period. The borrowers should maintain

only reasonable level of inventory and receivables and that the entire working capital

needs of the industry cannot be met by banks. The Tandon Committee made comprehensive

recommendations regarding the bank lending practices, which can be broadly classified

into four groups such as :

i) Inventory and Receivables Norms : The borrower should be allowed to hold

only a reasonable level of current assets, particularly inventory and receivables. Only the

normal inventory, based on a production plan, lead time of supplies, economic ordering

levels and reasonable factor of safety, should be financed by the banker, profit-making or

excessive inventory should not be permitted under any circumstances. Similarly, the banker

should finance only those receivables which are in line with the practices of the borrower’s

industry. The norms for reasonable level of inventory and receivables are needed to avoid

the undesirable holding and financing of current assets. The norms should also be specified

to bring uniformity in the bank’s approach in assessing the working capital requirements.

The Tandon Committee, in its final report, suggested norms for fifteen industries. Although

the Committee defined norms in the case of fifteen industries only, yet it emphasized, and

rightly so that industries not covered should not be exempt from the discipline of norms.
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It should be noted that the suggestions by the Tandon Committee are not merely meant

for banks to follows in financing the borrower’s working capital needs, rather they represent

the mavimnm limit which should not be exceeded in the normal circumstances.

The Tandon Committee has suggested norms for raw materials, work-in-progress,

finished goods, receivables and bills purchased for different industries. These norms have

been fixed after taking into account (i) company finance studies by the RBI, (ii) process

period in different industries, (iii) discussion with industry and (iv) need for ensuring smooth

production etc. Initially, the norms were intended to be applied to those borrowers with

aggregate credit limit of Rs. 10 lacs or more from the banking system, but were to be

gradually extended to all borrowers.

ii) Lending Norms or Maximum Permissible Bank Finance (MPBF):

The Tandon Committee introduced the concept of MPBF and suggested that bank should

attempt to supplement the borrowers resources in financing the current assets. It has

recommended that a part of current assets should be financed by trade credit and other

current liabilities. The remaining part of the current assets, which is termed by the group

as ‘working capital gap’, should be partly financed by the owner’s funds and long term

borrowings and partly by the short term bank credit. The Tandon Committee has suggested

three alternative methods for working out the MPBF, each successive method reducing

the involvement of short term bank credit to support current assets.

In the first method, the borrower will contribute 25% of the working capital

gap; the remaining 75% can be financed from bank borrowings. This method will give a

minimum current ratio of 1:1.

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In the second method, borrower will contribute 25% of the total current assets.

The remaining of the working capital gap (i.e., the working capital gap/less the borrower’s

contribution) can be bridged from the bank borrowings. This method will give a current

ratio 1.3:1.

In the third method, borrower will contribute 100% of core assets, and 25% of

the balance of current assets. The remaining of the working capital gap can be met from

the borrowings. This method will further strengthen the current ratio.

The Committee recommended the 1st method mainly as a stop-gap method till

borrowers got used to the new approach of lending. The borrowers who are already in

the 2nd stage would not be allowed to revert to the 1st stage. The aim should be to move

forward. The methods for determining the MPBF maybe described as follows :

Method I: MPBF = 0.75(Current Assets - Current Liabilities)

Method II: MPBF = 0.75(Current Assets) - Current Liabilities

Method III: MPBF = 0.75(Current Assets - Core Current Assets) - Current

Liabilities

The Tandon Committee recommended that a beginning should be made by placing

all borrowers on the first method within a year and then moving to the second and third

methods in stages in the light of the assessment of the prevailing circumstances. It also

expressed the view that the third method is ideal as it will provide the largest multiplier of

bank finance. The borrowings in excess of what is permissible under the first method
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should be converted into a working capital term loan and should be repaid over a period

of time. The borrowers should be gradually moved to the third method of calculation of

MPBF. The following example illustrates the three methods of maximum possible bank

finance (MPBF).

Current Assets Rs. in lacs Current Liabilities Rs. in lacs

Raw material 200 Creditors 250
Work-in-progress 100 Other current liabilities 50
Finished goods 200 Bank borrowing 300
Receivables 300 Total 600
Other current assets 5Q

Total 850

The total Core Current Assets (CCA) are Rs. 300 lacs.

The maximum permissible bank finance in the above case under three methods

may be ascertained as follows :

Method I: = .75(CA-CL)
= .75(850-300)
= Rs. 412.50 lacs
Method II: = .75(CA)-CL
= .75(850)-300
= Rs. 337.50 lacs
Method III: = .75(CA-CCA)-CL
= .75(850-300)-300
= Rs. 112.50 lacs

So, it may be noted that the MPBF decreases gradually from the first method to

second method and then to third method. As the firm has already availed the bank loan of

300 lacs, it can still avail a loan of Rs. 112.50 lacs as per the first method; or Rs. 37.50
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lacs as per second method. However, as per the third method, it is eligible to get finance

of Rs. 112.50 lacs only, whereas its present bank borrowings are Rs. 300 lacs.

At the time the new system of lending is introduced, in some cases the net working

capital may be negative while in others it may not be equal to 25% of working capital

gap. The Committee has allowed this deficiency to be financed, in addition to the

permissible bank finance, by banks. It would, however, be regularized over a period of

time depending upon the funds generating capacity and ability of the borrower. This kind

of credit facility has been called working capital term loan. The working capital term loan

is not allowed to be raised in the subsequent years.

iii) Style of Credit: The Tandon Committee also suggested the form of bank financing.

The total MPBF should be bifurcated into the fixed portion and the fluctuating portion.

The fixed portion refers to loan component and represents the minimum level of borrowing

throughout the year. The fluctuating component refers to demand cash credit component

which would take care of the fluctuating needs and required to be reviewed periodically.

Apart from the loan and the cash credit, a part of the total financing requirement should

also be provided byway of bills limit to finance the seller’s receivables. The demand cash

credit component should be charged a slightly higher interest rate than the loan component.

This would provide the borrower an incentive for better planning. The term loan

representing the excess borrowing to be amortized over a period of time, should also

carry a slightly higher rate than the cash credit rate.

iv) Information and Reporting System: Another suggestion of the Tandon Committee

was that there should be a regular flow of information from borrower to the bank. The
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CHORE COMMITTEE : The Reserve Bank of India constituted another

working group under the Chairmanship of Shri K.B. Chore in April 1979, with the terms

of reference to review the cash credit system to promote greater credit discipline and to

make the cash credit system more amenable to rational management of funds by commercial

banks. The recommendations of the Chore Committee may be summarized as follows :

1. System of Credit: The advantages of the existing system of extending credit by

a combination of the three types of lending, viz., cash credit, loan, and bill should

be retained.

2. Bifurcation of Credit Limit: Bifurcation of cash credit limit into a demand loan

portion and a fluctuating cash credit component has not found acceptance either

on the part of the banks or the borrowers. Such bifurcation may not serve the

purpose of better credit planning by narrowing the gap between sanctioned limits

and the extent of utilization thereof.

3. Reduction in Over-dependence on Bank Finance : The need for reducing the

over-dependence of the medium and large borrowers on bank finance for their

production/trading purposes is recognized. The net surplus cash generation of an

established industrial unit should be utilized partly at least for reducing borrowing

for working capital purposes.

4. Increase in Owner’s Contribution : In order to ensure that the borrowers do

enhance their contributions to working capital and to improve their current ratio, it

is necessary to place them under the Second Method of lending recommended by

the Tandon Committee which would give a minimum current ratio of 1.33:1. To
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include the borrowers to repay this loan, it should be charged a higher rate of

interest. The Committee recommended that the additional interest may be fixed at

2% per annum over the rate applicable on the relative cash credit limits.

5. Separation of Normal Non-Peak Level and Peak Level requirements :

While assessing the credit requirement, the bank should appraise and fix separate

limits for the ‘normal non-peak level’ as also for the ‘peak level’ credit

requirements.

6. Temporary Accommodation through Loan : If any ad hoc or temporary

accommodation is required in excess of the sanctioned limit, the additional finance

should be given, through a separate demand loan account or a separate ‘non-

operable’ cash credit account. There should be a stiff penalty for such demand

loan or ‘non-operable’ cash credit portion, at least 2% above the normal rate.

7. Penal Interest: The borrower should be asked to give his quarterly requirement

of funds before the commencement of the quarter on the basis of his budget.

8. Relaxation of norms :Requests for relaxation of inventory norms and for ad

hoc increases in limits should be subjected by banks to close scrutiny and agreed

to only in exceptional circumstances.

9. Bill system : As one of the reasons for the slow growth of the bill system is the

stamp duty on usance bills and difficulty in obtaining the required denominations

of stamps, these questions may have to be taken up with the state governments.
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MARATHE COMMITTEE : The Reserve Rank of India appointed in

November 1982, another study group known as Marathe Committee to review the Credit

Authorization Scheme (CAS) which was in operation since 1965. The CAS was introduced

in 1965 by the RBI to regulate the end use of credit. Under the CAS, all banks were

required to obtain the prior authorization of the RBI for sanctioning credit limits (including

bill discounting) of Rs. 6 crores or more. The Marathe Committee was required to take

an independent view of the CAS. The Committee was of the view that the CAS should

not be looked upon as a mere regulatory measure which is confined to large borrowers.

The basic purpose of the CAS is to ensure orderly credit managements and improve

quality of bank lending so that all borrowings, whether large or small, are in conformity

with the policies and priorities laid down by the central banking authority. If the CAS

scrutiny has to be limited to a certain segment of borrowers, it is only because of

administrative limitations or convenience.

The long time taken in commercial banks in processing application has to be

reduced by suitable organizational changes. The principal recommendation of the Marathe

Committee was to provide incentive to the borrowers to comply with all the requirement

of the CAS and to improve the quality of credit appraisal in the banks. It also

recommended that commercial banks be given discretion to deploy credit in CAS cases

without the prior authorization of RBI, subject to certain conditions.

On the basis of the recommendations of the Marathe Committee, the CAS was

withdrawn with effect from October 10,1988 and was replaced by the Credit Monitoring

Arrangement (CMA), under which the RBI is required to do the post-sanction scrutiny of
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the term loan and working capital loan provided by commercial banks beyond the

prescribed cut-off levels. The banks, under the CMA, have to submit to the RBI, sanctions/

renewals of credit limit beyond Rs. 5 crores for post-sanction scrutiny. In every case, the

banks should indicate whether the minimum level prescribed by the RBI with respect to

financing of credit sales through bills or credit purchases have been attained and if not,

steps taken to fulfill the RBI norms. The banks may also sanction ad hoc limits to

borrowers on merit, for a period not exceeding three months and all such ad hoc sanctions

enjoying working capital limits beyond Rs. 5 crores are to be reported to the RBI within

15 days.

NAYAK COMMITTEE : A committee under the Chairmanship of Shri RR.

Nayak, Deputy Governor, Reserve Bank of India was constituted to examine the adequacy

of institutional credit to Small Scale Industry (SSI) sector and other related aspects.

Considering the contribution of SSI sector to overall industrial production, exports and

employment and also recognizing the need to give a fillip to this sector, a special package

of measures based on the recommendations made by Nayak Committee, were advised

by the RBI in 1983 to ensure adequate and timely credit to this sector. The salient features

of the package are as under :

i) The banks should step up the credit flow to meet the legitimate requirements of the

SSI sector. For this purpose, the banks should draw up annual credit budget for

the SSI sector. Each branch of the bank should prepare an annual budget in respect

of working capital requirements of all SSI before the commencement of the year.

Such budgeting should cover (a) functioning (healthy) units which already have
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the term loan and working capital loan provided by commercial banks beyond the

prescribed cut-off levels. The banks, under the CMA, have to submit to the RBI, sanctions/

renewals of credit limit beyond Rs. 5 crores for post-sanction scrutiny. In every case, the

banks should indicate whether the minimum level prescribed by the RBI with respect to

financing of credit sales through bills or credit purchases have been attained and if not,

steps taken to fulfill the RBI norms. The banks may also sanction ad hoc limits to

borrowers on merit, for a period not exceeding three months and all such ad hoc sanctions

enjoying working capital limits beyond Rs. 5 crores are to be reported to the RBI within

15 days.

NAYAK COMMITTEE : A committee under the Chairmanship of Shri P.R.

Nayak, Deputy Governor, Reserve Bank of India was constituted to examine the adequacy

of institutional credit to Small Scale Industry (SSI) sector and other related aspects.

Considering the contribution of SSI sector to overall industrial production, exports and

employment and also recognizing the need to give a fillip to this sector, a special package

of measures based on the recommendations made by Nayak Committee, were advised

by the RBI in 1983 to ensure adequate and timely credit to this sector. The salient features

of the package are as under :

i) The banks should step up the credit flow to meet the legitimate requirements of the

SSI sector. For this purpose, the banks should draw up annual credit budget for

the SSI sector. Each branch of the bank should prepare an annual budget in respect

of working capital requirements of all SSI before the commencement of the year.

Such budgeting should cover (a) functioning (healthy) units which already have
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borrowing limits with the branch (b) new units and units whose proposals are under

appraisal, and (c) sick units under nursing and also sick units found viable and for

which rehabilitation programs are under preparation.

ii) It is desirable that a single financing agency meets both the requirement of the

working capital and term credit for small scale units. The Single Window Scheme

(SWS) of SIDBI enables the same agency— State Financial Corporation (SFC)

or commercial bank — as the case may be, to provide term loans and working

capital requirement up to Rs. 10 lacs. The banks are advised to adopt this

approach.

iii) It has been decided by the RBI that for requirements of SSI units having aggregate

fond-based working capital credit limits up to Rs. 100 lacs from the banking system,

the norms for inventory and receivables and the first method of lending will not

apply. Instead such units maybe provided working capital limits computed on the

basis of a minimum of 20% of their projected annual turn-over for new as well as

existing units. Subsequently, in February 1994, this system of computing Maximum

Permissible Bank Finance (MPBF) on the basis of annual projected turn-over was

extended to “All Borrowers " enjoying fund based working capital of less than

100 lacs from the banking system. Thus, all the borrowers whether covered under

the definition of SSI or not, availing fund based working capital limits of less than

Rs. 100 lacs, from the banking system are covered under the Nayak Committee

recommendations.
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iv) These units would be required to bring in 5% of their annual projected turnover as

margin money. In other words, 25 % of the output value should be computed as

working capital requirement of which at least four-fifth should be provided by the

bank, the balance one-fifth representing the borrower’s contribution towards margin

for the working capital. The Reserve Bank of India issued from time to time various

clarifications on implementation of Nayak Committee recommendations. The main

clarifications are given here under :

a) The assessment of working capital credit limits should be done both as

per projected turnover basis and the traditional operating cycle method.

b) In terms of guidelines, the working capital requirement is to be assessed at

25% of the projected turnover to be shared between the borrower and bank viz,

borrower contributing 5% of the turnover as Net Working Capital and bank

providing finance at a minimum of 20% of the turnover. The above guidelines were

framed assuming an average production/processing cycle of 3 months (i.e., working

capital would be turned over four times in a year). It is possible that certain industries

may have a production cycle shorter/longer than 3 months. While in the case of a

shorter cycle, the same principles could be applied as it is the intention to make

available at least 20% of turnover by way of bank finance. In case the cycle is

longer, it is expected that the borrower should bring in proportionately higher stake

in relation to his requirement of bank finance. Going by the above principles, at

least l/5th of the working capital requirement should be brought in by way of Net

Working Capital and it should be clearly established.

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c) Since the bank finance is only intended to support need-based requirement of a

borrower; if the available Net Working Capital is more than 5% of the turnover,

the former should be reckoned for assessing the extent of bank finance.

d) Drawls of the limit is to be regulated to the extent of paid up stock. While bank

finance could be assessed at 20% of the annual projected turnover, the actual

drawls should be allowed on the basis of drawing power to be determined by

banks after ensuring that unpaid stocks are excluded.

e) In case of seasonal industries, the peak season and off season turnover, instead

annual turnover, could be separately considered for determining respective 20%

levels.

KANNAN COMMITTEE: The Kannan Committee was the first committee to

have suggested that the prescribed uniform formula for MPBF (as suggested by the Tandon

Committee) should go and the banks should have the sole discretion to determine borrowing

limits of corporates. However, the change from the MPBF system should keep in view

the size of various banks, their delegation system, exposure limit etc. Banks and the

borrowers should be left free to decide the system they adopt for financing working capital.

The main recommendations of the committee are summarised as under:

(i) The Modelities for working capital assessment of the borrower may be left to the

bank who may draw a flexible system under the guidelines of RBI. The following

may be kept in view:

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— For borrowers upto Rs. 25 lacs, assessment may be made on the basis of overall

study of existing and projected business.

— For loans between Rs. 25 lacs and Rs. 500 lacs, the turnover method as suggested

by the Nayak Committee may be followed.

— For loans more than Rs. 500 lacs, the cash budget system should be followed.

However, the above cutoff limits are only indicative.

— Loans limits by various types of facilities may be decided by the bank, (ii) The

system of cash credit should be replaced by a system of loans for working capital.

(iii) The uniform formula for MPBF should be abolished and banks should be given

discretion for determining borrowing limits for corporates.

(iv) The corporate borrowers may be allowed to issue short term debentures for

meeting short term requirements and the banks may subscribe to these debentures.

(v) Borrowers with requirements from Rs. 10 crores to Rs. 20 crores may have a

demand loan component of 75%. For requirements of Rs. 20 crores or more,

working capital by way of demand loans may be allowed to the extent of 100%.

(vi) Margins and holding levels of stocks and receivables as security may be left to the

discretion of the banks.

(vii) Bench mark current ratio of 1.33:1 should be left to the discretion of the banks.

(viii) Periodical statement of stocks, debtors coupled with verification of securities to be

the credit monitoring tool.

(ix) A credit information bureau should be floated independently by banks.

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(x) Banks should be allowed to decide policy norms for issue of commercial papers.

(xi) Borrowers will have to obtain prior approval for investment of funds outside the

business in inter-corporate deposits etc.

(xii) Banks should also try out the syndicate form of lending.

7.5. FINANCING OF WORKING CAPITAL IN SSI OF ORISSA.

In section 7.3 of this Chapter, conceptual analysis of various short term sources

of finance was made. The important sources identified were trade credit, accrued

expenses, commercial papers, and banks. Financing through commercial paper is done in

India by large corporate houses only. Therefore, this source of short term finance is

unknown to the SSI world, we studied.

In this section an attempt has been made to find out the source of finance used by the

selected units. Table 7.1 gives a break-up of current liabilities of selected SSIs of Orissa

from the year 2001-02 to the year 2005-06.

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TABLE 7.1

BREAK-UP WISE CURRENT LIABILITIES OF SELECTED SSIS ORISSA

FROM 2001-02 TO 2005-06

(Rs in nearest lakhs)

Years Current Trade Accrued Bank Others

Liabilities Creditors Expenses Borrowings Borrowings

2001-02 392 68 42 237 45

(17.17) 10.71) (60.46) (11.48)

2002-03 395 69 43 243 40

(17.47) 10.87) (61.52) (10.13)

2003-04 394 63 43 248 50

(15.99) (10.91) (62.95) (12.69)

2004-05 397 58 43 251 46

(14.61) (10.83) (63.22) (11.59)

2005-06 405 61 46 269 21

(15.06) (11.36) (66.42) (5.19)

Average 396.6 63.8 46 249.6 40.4

(16.09) (11.60) (62.93) (10.19)

(Figures in parenthesis are percentage of total current liabilities.)

Table 7.1 reveals that on an average bank borrowings constitute 62.93 of total

current liabilities over the five year period of study. It also reveals that bank borrowings

are the major sources of finance for the selected SSIs. Further, the table also reveals that

the share of bank borrowings is having a rising trend starting from 60.46% in 2001-02,

they went up to 66.42%. The rise in bank borrowings (cash credit and overdrafts) is

primarily due to two reasons viz. raising of additional loan and due to accumulation of

interest arising out of non-payment.

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Trade credits constitute the second important source of short term finance. On an

average trade credits are 16.09% of current liabilities. Except for the year 2002-03, the

trade credits are showing a declining trend. In 2001-02, the trade credits were 17.17%

on the higher side and 14.61% on the lower side in 2004-05. Though the decline is

marginal, it may indicate a lack of confidence by the suppliers. To analyse the extent of

trade credit financing vis-a-vis trade debtors (accounts receivable), Table 7.2 is prepared.

Accrued expenses have shown a minor fluctuation as a percentage of current

liabilities. These are fixed liabilities. The increase in absolute terms is primarily due to

hike in wage rate, increments and allowances.

The selected units have also made private borrowings (grouped under the head of

other borrowings). On an average, they constitute 10.19% of current liabilities. They

have remained between 10 to 11% for all the years of study except 2005-06 which has

shown a huge decline i.e. almost one half of the previous years. The other creditors also

include creditors for tax liabilities.

Table 7.2 depicts the relationship between trade creditors and trade debtors of

the selected units for the entire five year period of study. The trade creditors have been

shown as a parentage of trade debtors.

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TABLE 7.2

SSIs OF ORISSA POSITION OF CREDITORS IN RELATION TO DEBTORS

FROM 2001-02 TO 2005-06

(Rs. In nearest lakhs)

Year Trade Trade Creditors As a

Debtors Creditors Percentage of Debtors

2001-02 146 68 46.58

2002-03 141 69 48.94

2003-04 152 63 41.45

2004-05 135 58 42.96

2005-06 149 61 40.94

Average 144.6 63.8 44.12

From the above table 7.2, it can be observed that on an average for the period

under study the trade creditors are 44.12% of trade debtors. The percentage at a high

was 46.58% in 2001-02 and at a low was 40.94% in 2005-06. It is a matter of great

concern that the small scale units under study are forced to set apart a portion of their

scarce resources to finance their credit sales as the quantum of credit granted to them

stands much smaller in comparison to the quantum of credit allowed by them to their

customers. The gravity of this problem in different industries is highlighted in Table 7.3.
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TABLE 7.3

INDUSTRY WISE TRADE CREDITORS AS A PERCENTAGE OF TRADE

DEBTORS FOR THE SELECTED SSIs OF ORISSA.

(Rs. In nearest lakhs)

INDUSTRY TRADE DEBTORS TRADE CREDITORS CREDITORS AS

PERCENTAGE
OF DEBTORS

Food & Allied 03 02 66.67

Chemicals & 13 05 38.46
Allied
Electrical & 12 07 58.33
Electronics
Engineering 35 12 34.29
& Metal
Forest & 08 04 50.00
Wood based
Glass & 13 07 53.85
Ceramics
Live stock 14 06 42.86
& Leather
Paper & 07 03 42.86
Paper products
Rubber & 07 03 42.86
Plastic products
Textiles 17 07 41.18
Miscellaneous 14 04 28.57
Manufacturing
Repairing 06 01 16.67
& Servicing * i
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The table indicates that in all the 12 industry groups, the quantum of credit received

by small scale sector stands much lower to the quantum of credit allowed by it to its

customers. Outstanding credit as a percentage of outstanding debts, in all the groups

taken together, works out at 40.94%. If the component of creditors for other liabilities is

included, than creditors as a percentage of debtors would have been slightly higher.

Analysing the position in separate industry groups, the “food and Allied based” group has

been the largest beneficiary, having availed credit facilities to the extent of 66.67% of the

debts allowed by it, followed by Electrical & Electronics’ group (58.33%). In Forest &

Wood’ group as well as ‘Glass & Chemicals’ group it is 50% and 53.85% respectively.

For 4 groups it is between 40-42%, for two groups 34 to 39%. The position is worst in

case of‘Repairing and Servicing’ group (16.67%) and ‘Miscellaneous manufacture’ group

(28.57%)

Concomitant with the problem of credit sales to customers, the problem of delayed

payment to small scale industry particularly by the government departments, public sector

undertaking and large scale undertakings in private sector is most pertinent. It has been

revealed by Ramanujam Committee that out of the total receipts on account of credit

sales by SSI units, to medium and large units, about two thirds of the amount has been

received after due date.

SSI units and factoring :

A large number of SSI units is managed by their promoters or persons with technical

orientation, who are not adequately equipped to pay attention to areas of accounting and

working capital management. By and large, they donot have organizational set up or
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expertise in the area of credit management to attend to follow up and recovery of dues

from customers. It is only when they experience liquidity crunch by reasons of delayed

payments or other causes, that those managing such units direct their attention to working

capital management and collection of debts.

The Reserve Bank of India had constituted a study group in January, 1988 to

examine the need and scope of for the introduction of ‘Factoring’ services in India to

help the small scale industries in realizing payments for supply of goods and services.

Fresh guidelines were issued by the RBI in July 1988 for credit assistance to small scale

sector, covering important aspects like timely and adequate sanction of working capital,

coordination between commercial banks and State Financial Corporation for adequate

monitoring of credit assistance to small scale sector.

The group opined, that factoring for SSI units could prove to be mutually beneficial

to both factors and SSI units. Introduction of export factoring will provide an additional

window of facility to the exporters. Even if some extra cost will be involved, exporters

may still prefer export factoring.

In India, factoring services are now being permitted to be operated by State Bank

of India in the Western Region, Punjab National Bank in Northern Region, Allahabad

Bank in the Eastern Region and Canara Bank in the Southern Region. The result of the

scheme is yet to crystallize.

7.6. CONCLUSION

From the foregoing analysis of the patterns of working capital finance to the SSIs,

the following conclusions maybe usefully drawn:

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Although the importance of bank borrowings as a source of working capital finance

remained almost constant over the period, on an assessment of the optimal level

of bank borrowings as per the Tandon Committee norms, it was found with regard

to the selected units that the existing borrowings were much in excess of what the

committee considered as appropriate. This is mostly due to non-payment of

installments and consequent accumulation of borrowings.

Financing through trade credit has proved itself a potential source of finance for

the SSI units. But the units could not utilize the opportunities to their advantage.

Trade creditors were constant and in some years showed a declining trend. The

amount of trade creditors both in absolute terms and percentage was less than

one-half of their receivables. Hence, the units were extending twice the credit to

their customers, then what they themselves were getting from their suppliers.

The use of long term funds for meeting working capital requirements was on the

increase during the period of study.

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REFERENCES :

1. Gitman, Lawrence J., Principle of Managerial Finance, (New York : Harper

and Row Publishers, 1974), p. 159.

2. Ibid.,pA51

3. Walker, E.W.,Essentials of Financial Management, op. cit., p.64.

4. Ibid.,p. 65

5. Vijaya Saradhi, S.P. and Rajeswara Rao, K., 'Working Capital Investment and

Financing in Public Enterprises'. The Management Accountant, Vol. 13, No.5,

May 1978, p. 393.

6. National Council of Applied Economic Research, Structure of Working Capital,

1966 p.27.

7. NCAER, op.cit., p.28.

8. Solomon, Ezra and Pringle, John J., An Introduction to Financial Management,

(New Delhi: Prentice Hall of India Private Limited, 1978), p. 189.

9. Weston, Fred J. and Brigham, Eugene, F., Managerial Finance, (Hinsdale : The

Dryden Press, 1978), p.145

10. Supra p. Also See Dr Braj Kishore, 'Working Capital Policy - A General Frame­

work of analysis : Lok Udyog, Vol XI, No. 11, February 1978, pp. 9-16.