1. Classification of advances.

Ans - The key principle underlying asset classification is its ability to generate
income and record of recovery. An asset, including a leased asset, becomes non-
performing when it ceases to generate income for the bank. In order to ensure a
uniform and consistent approach, objective criteria have been laid down for different
types of facilities offered'. Further, the classification is made borrower-wise and not
facility-wise, ie., if a borrower is enjoying several facilities from the bank and even if
one of those becomes non-performing all facilities of the borrower are classified as
non-performing and need to be subjected to provisioning norms. The norms also
provide flexibility to ensure that banks do not classify accounts as non-performing due
to temporary deficiencies.

An asset becomes NPA when income from it is not received by the bank within a
certain period from the end of the quarter.

The banks have to classify their advances as follows in order to arrive at the amount of
the provision to be made against them, into the following groups

(1) Standard Assets:

Standard assets are those which do not pose any problems and which do not carry
more than normal risk attached to the business. They are non-performing assets
(NPA). No provision is required to be made against them. However, banks have been
asked to make provision at the rate of 0.25% on their standard advances also from the
year ending 31st March, 2000.

(2) Sub-Standard Assets:

Sub-standard assets are those which have been classified as NPA for a period not
exceeding 18 months. In such cases, the security available to the bank is inadequate
and there is a distinct possibility that the bank will suffer some loss, if deficiencies are
not corrected. Provision has to be made at the rate of 10% of the total outstanding
amount of substandard assets. However, in respect of accounts where there are
potential threats of recovery on account of erosion in the value of security or non-
availability of security and existence of other factors, such as frauds committed by
borrowers, it will not be prudent for banks to classify them first as substandard and
then as doubtful after expiry of two years from the date the account has become NPA.
Such accounts should straightaway be classified as doubtful assets, or loss asset, as
appropriate, irrespective of the period for which it has remained as NPA.

(3) Doubtful Assets:

Doubtful assets are those which have remained NPA for a period exceeding 18
months. This period of two years is being reduced to 18 months by 31st March, 2001.
These assets are so weak that their collection or liquidation in full is considered highly
improbable. A loan classified as doubtful has all the weaknesses inherent in the
classified as substandard with the added characteristic that the weaknesses make
collection or liquidation in full, high questionable and improbable, on the basis of
currently known facts, condition and values. In order to arrive at the amount provision
to be made against doubtful assets, the unsecured portions and the secured portions of
these assets have to be considered separately. The unsecured portion has to be fully
provided for, i.e., provision has to be made equal to 100% of the amount by which the
advance is not covered by the realizable value of the security.

(4) Loss Assets:

Loss assets are those where loss has been identified by the bank or internal or external
auditors or RBI inspectors but the amount has not been written off wholly or partly.
These assets are uncollectible and, therefore, they must be written off even though
there may be a remote possibility of recovery of some amount. Provision of 100% of
the outstanding balance should be made.

2. Capital adequacy norms

Ans - Definition: Capital Adequacy Ratio (CAR) is the ratio of a bank's capital in
relation to its risk weighted assets and current liabilities. It is decided by central banks
and bank regulators to prevent commercial banks from taking excess leverage and
becoming insolvent in the process.

Description: It is measured as Capital Adequacy Ratio = (Tier I + Tier II + Tier III

(Capital funds) Risk weighted assets. The risk weighted assets take into account credit
risk, market risk and operational risk.

The Basel IlI norms stipulated a capital to risk weighted assets of 8%.

However, as per RBI norms, Indian scheduled commercial banks are required to
maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a
CAR of 12%.

The capital adequacy ratio is important from the point of view of solvency of the
banks and their protection from untoward events which arise as a result of liquidity
risk as well as the credit risk that banks are exposed to in the normal course of their
business.
The solvency of banks is not a matter that can be left alone to the banking industry.
This is because banks have the savings of the entire economy in their accounts. Hence,
if the banking system were to go bankrupt, the entire economy would collapse within
no time. Also, if the savings of the common people are lost, the government will have
to step in and pay the deposit insurance.

Hence, since the government has a direct stake in the issue, regulatory bodies are
involved in the creation and enforcement of capital ratios. In addition to that capital
ratios are also influenced by international banking institutions.

3. Methods of lending
Ans - Like many other activities of the banks, method and quantum of short-term
finance that can be granted to a corporate was mandated by the Reserve Bank of India
till 1994. This control was exercised on the lines suggested by the recommendations
of a study group headed by Shri Prakash Tandon.

The study group headed by Shri Prakash Tandon, the then Chairman of Punjab
National Bank, was constituted by the RBI in July 1974 with eminent personalities
drawn from leading banks, financial institutions and a wide cross-section of the
Industry with a view to study the entire gamut of Bank's finance for working capital
and suggest ways for optimum utilization of Bank credit. This was the first elaborate
attempt by the central bank to organize the Bank credit. The report of this group is
widely known as Tandon Committee report.

Most banks in India even today continue to look at the needs of the corporates in the
light of methodology recommended by the Group.

As per the recommendations of Tandon Committee, the corporates should be

discouraged from accumulating too much of stocks of current assets and should move
towards very lean inventories and receivable levels. The committee even suggested
the maximum levels of Raw Material, Stock-in-process and Finished Goods which a
corporate operating in an industry should be allowed to accumulate. These levels were
termed as inventory and receivable norms. Depending on the size of credit required,
the funding of these current assets (working capital needs) of the corporates could be
met by one of the following methods:

1. First Method:

MPBF = 75% of (Current assets - Current liabilities other than bank borrowings)

The borrowing firm should provide the remaining 25% from long-term sources. The
minimum current ratio under this method works out to 1: 1.
2. Second Method:

MPBF = (75% of Current assets) - (Current liabilities other than bank borrowings)

The borrowing firm should raise finance to the extent of 25% of current assets from
long-term sources. The minimum current ratio under this method works out to 1.33: 1.

3. Third Method:

MPBF = [75% of (Current assets - Core current assets)] - Current liabilities other than
bank borrowings

The borrower should contribute 100% core current assets and 25% of balance current
assets from long-term sources. A minimum current ratio under this method works out
to above 1.5: 1.

The current ratio will strengthen and reliance on bank finance reduces under these
three methods successively.

Core current assets is permanent component of current assets which are required
throughout the year for a company to run continuously and to stay viable.

4. Short term sources of working capital finance

Ans - Short-term sources of working capital finance are used to finance the day-to-day
operations of a business and are typically repaid within a year. Here are some
common sources of short-term working capital finance:

1. Trade credit: This is an arrangement where a supplier allows the buyer to

purchase goods or services on credit and pay for them at a later date. Trade
credit is often provided for 30, 60, or 90 days.
2. Bank overdraft: A bank overdraft is a short-term loan facility that allows a
business to overdraw its bank account up to an agreed limit. Interest is charged
on the amount overdrawn.
3. Short-term loans: Short-term loans are loans that are repaid within a year. They
can be secured or unsecured and are often used to finance working capital
requirements.
4. Invoice financing: This is a method of financing where a business sells its
outstanding invoices to a third party, who then provides an advance payment.
The third party collects payment from the customer, and the business receives
the remaining amount minus a fee.
 5. Factoring: Factoring is similar to invoice financing, but instead of selling the
invoices, a business sells its accounts receivable to a third party, who then
collects payment from the customers.
6. Commercial paper: Commercial paper is a short-term debt instrument issued by
companies to raise funds. It is typically issued for 30, 60, or 90 days and is
backed by the creditworthiness of the issuer.
7. Bank guarantees: Bank guarantees are a commitment by a bank to pay a
specific amount if the borrower fails to meet its obligations. They are often
used to secure payment obligations and can be used to provide short-term
working capital finance.
8. Cash Credit/Overdrafts Under cash credit/overdraft form/arrangement of bank
finance, the bank specifies a predetermined borrowing/credit limit. The
borrower can draw/borrow up to the stipulated credit/overdraft limit. Within
the specified limit, any number of drawals/drawings are possible to the extent
of his requirements periodically. Similarly, repayments can be made whenever
desired during the period.
9. Loans Under, this arrangement, the entire amount of borrowing is credited to
the current account of the borrower or released, in cash. The borrower has to
pay interest on the total amount. The loans are repayable on demand or in
periodic installments.
10. Bills Purchased/Discounted: Bill Discounting is a discount/fee which a bank
takes from a seller to release funds before the credit period ends. This bill is
then presented to seller's customer and full amount is collected

These short-term sources of working capital finance can provide businesses with the
liquidity they need to meet their day-to-day expenses, pay suppliers, and manage cash
flow.

5. Factors affecting working capital of company

Ans - Several factors can affect the working capital of a company, including:

1. Nature of business: The nature of the business can affect its working capital
requirements. For example, a manufacturing business may require higher levels
of working capital due to the need to purchase raw materials, pay for labor, and
maintain inventory.
2. Sales volume: Sales volume is a critical factor in determining the working
capital requirements of a company. Higher sales volume will increase the need
for working capital to finance increased production and inventory.
3. Seasonality: Businesses that experience seasonal fluctuations in demand will
require higher working capital during peak seasons to finance higher
production and inventory levels.
 4. Credit terms: The credit terms offered to customers can affect the working
capital requirements of a business. Longer credit terms can lead to longer cash
conversion cycles, which can increase the need for working capital.
5. Supplier credit terms: The credit terms offered by suppliers can also affect the
working capital requirements of a business. Longer supplier credit terms can
help to reduce the need for working capital by allowing the business to pay its
suppliers at a later date.
6. Operating efficiency: Efficient management of inventory, receivables, and
payables can help to reduce the working capital requirements of a business.
7. Economic conditions: Economic conditions can affect the availability of credit
and the cost of borrowing, which can impact a company's working capital
requirements.
8. Capital investment: Capital investments, such as the purchase of fixed assets,
can tie up cash and increase the need for working capital to finance day-to-day
operations.
9. Growth Prospects: If a firm is planning on expanding its activities then it will
require more working capital, as it needs to increase the scale of production for
expansion, resulting in the requirement of more inputs, raw materials, etc.,
ultimately increasing the need for more working capital.
10. Level of Competition: If there is competition in the market, then the company
will have to follow a liberal credit policy for supplying goods on time. For this,
it will have to maintain higher inventories, resulting in more working capital
requirements. However, if there is less competition in the market or a company
is in a monopoly position, then it will require less working capital, as it can
dictate its own terms according to its requirements.

These are some of the factors that can affect the working capital requirements of a
company. It is important for businesses to regularly review their working capital
position to ensure that they have sufficient liquidity to meet their operational needs.