Working Capital Assessment

by

CA Rajesh D
rajeshd@sbsandco.com
Date: 16/03/2016
 Source of funds

Banks NBFCs Funds for

Business Banks

Private FIs
Investors

Long Term Short Term

Cash
Long Term
Credit or
Loans
OD

Fixed Capital or Working Capital

Permanent Short
Project or Temporary or
Finance Capital term
Circulating Capital
loans
 Working Capital
Objective:
1. Concept of Working Capital
2. Gross Working Capital , Working capital Gap, Net Working Capital
3. Components of working capital
4. Working capital operating cycle
5. Various methods of working capital assessment viz
i. Turnover method
ii. MPBF method
iii. Cash Budget Method
6. CMA Data.

3 www.sbsandco.com
 Working Capital
Funds required for financing short term assets or current assets such as
cash, debotrs and inventories to enable business/industry to operate at the
expected levels.
Total amount of funds required for the continuous operations of the
business on a going basis.
Therefore it is called operating capital or short-term capital.
Financed as Cash Credit, Overdraft, Short Term Working Capital loan
etc.,
Assessed for one year and renewed annually

4 www.sbsandco.com
 What are Current Assets ?
Assets which are part of the operating cycle or which get converted into
cash within the operating cycle or within one year

1. Spares and Spare parts

2. Loose tools
3. Stock-in-Trade
4. Work-in-Progress
5. Sundry Debtors less bad debts
6. Cash and Bank Balances
7. Loans and advances to subsidiaries
8. Bills of Exchange
9. Advances recoverable in cash or receivables
10. Balance with customs, port authorities, municipal authorities
11. Interest accrued on Investments

5 www.sbsandco.com
 What are Current Liabilities ?
Liabilities which are part of the operating cycle or which need to be paid off
within the operating cycle or within one year

1. Short term bank borrowings

2. Unsecured loans
3. Sundry Creditors and Trade Creditors
4. Deposits from public maturing within one year
5. Advances and deposits from dealers
6. Accrued Interests and Charges
7. Provision for taxation
8. Dividend payable
9. Statutory liabilities
10. Installment of term loans repayable in one year
11. Other liabilities and provisions

6 www.sbsandco.com
 Operating Cycle
Cash

Realization of Raw Materials/

Debtors Stores & Spares

Bills Receivables/ Semi-Finished

Sundry Debtors Goods

Sales Finished Goods

7 www.sbsandco.com
 Operating Cycle
The day to day business operations of a concern of any nature and, size
involves many successive steps and final working results would depend
on the effective combination of all steps.
The steps in general may include the following:
Acquisition and storage of raw material and other stores and spares required
for manufacture of any product.
Actual production process when the raw material is subjected to different
processes to bring it to final shape of finished goods.
Storage of finished goods awaiting sales.
Sales of finished goods and realisations of sale proceeds.

8 www.sbsandco.com
 Operating Cycle
Operating Cycle begins with acquisition of raw materials and ends with
collection of receivables.
Stages:
1) Raw materials (RM/RM consumption)
2) Work-in-process (WIP/COP)
3) Finished Goods (FG/COS)
4) Receivables (Debtors/Credit sales)
Less:
Creditors (creditors/purchases)

9 www.sbsandco.com
 What are Working Capital Sources?

Working Capital Requirement Source of Finance

(Current Assets)

1 Raw Material and stores (inventory) Sundry Creditors or Bank Finance

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

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

Capital or Bank Finance

4. Sundry Debtors Bank Finance short term

5. Cash for expenses Net Working Capital or Liquid
Surplus

10 www.sbsandco.com
 Concepts of Working Capital
GROSS WORKING CAPITAL = CA
These are in the system used/ consumed on a day to day basis.

NET WORKING CAPITAL (NWC) = CA CL

OR
(SHF + TL) (NFA + NCA)

NWC is the entrepreneur's margin available in the system from Long term Funds

Note:
CA=Current Assets, CL=Current Liabilities
SHF=Sha eholde s fu ds, TL=Te Loa
NFA=Net Fixed Assets
NCA=Net Current Assets

NWC should always be more than 1:1

It indicates the margin of safety to short term creditors.

11 www.sbsandco.com
 Length of Operating Cycle

Service Trade Industry

Cash Cash Cash

Receivables Stocks Raw Material
Finished Goods
Receivables
www.sbsandco.com
Semi Finished Goods
12 Receivables
 Factors influencing Working Capital Requirement
Nature of business service/trade/manufacturing.
Seasonality of operations peak/non peak
Production Policy Constant/seasonal
Market conditions- competition/credit terms
Conditions of supply of RM/stores/spares etc.
Quantum of production/Turnover(level of activity)
Operating Cycle
Current Assets to be maintained

13 www.sbsandco.com
 Working Capital Finance
A) Fund Based
Cash Credit
Overdraft
Inventory finance and
Factoring or Bill discounting ( Post Sales Finance).
B) Non Fund Based
Letter of Credit (LC)
Bank Guarantee.

14 www.sbsandco.com
 Assessment Methods
Operating Cycle Method
Service Sector
Traders
Manufacturing Activity.
Drawing Power Method.
Turnover Method
MPBF method (II method of lending) for limits of Rs 6.00 crores and
above
Cash Budget method (for: Based on procurement and cash inflow)
Seasonal Industries (Sugar/ Rice Mills/Textiles/Tea/Tobacco/Fertilizers)
Contractors & Real Estate Developers
Educational Institutions

15 www.sbsandco.com
 Operating Cycle Method
Operating Cycle method: Time period from purchase of raw materials, creation of work-in-process,
creation of finished goods, holding them till sale, converting them into sundry debtors and realization
of debtors and receipt of cash.
Total Working Capital Requirement =

Operating Expenses:
Purchase of Raw Materials & Maintaining
Manufacturing expenses such as wages, power & fuel, etc.
Stock of Work in Progress/ Semi-Finished goods maintained by the unit to complete an operating
cycle.
Stock of Finished goods awaiting sale.
Administrative and selling expenses during this process.
Bills receivable/debtors for credit sales.

16 www.sbsandco.com
 Operating Cycle Method
Length of Operating Cycle
a. Procurement of Raw Material 30 days
b. Conversion / Process time 15 days
c. Average time of holding of FG 15 days
d. Average Collection Period 30 days
e.Operating Cycle (a+b+c+d) 90 days
f. Operating Cycle in a year (365days/e) 4 cycles

17 www.sbsandco.com
 Operating Cycle Method

B. Total Operating Expenses per Rs 60.00 lakhs

Annum

C. Total Turnover per Annum Rs 70.00 lakhs

D. Working Capital Requirement Rs 15 lakhs

= Total Operating Expenses (B)/ No. of operating Cycle (f as
said earlier)

18 www.sbsandco.com
 Drawing Power Method
(for units with small limits)

Particulars Stock value Margin DP

Paid stocks (RM-Creditors) 4 25% 3
Semi Finished goods 4 50% 2
Finished goods 4 25% 3
Book debts 4 50% 2
Total 16 10

19 www.sbsandco.com
 Turnover Method
(Originally suggested by Nayak Committee for SSI Units)

Nayak Committee method or turnover method: Based on the projected sales

turnover of the borrower. It is presumed that W.C requirements would be 25% of
the projected turnover and the banker would finance 75% to 80% of the same and
the borrower to bring in 20%-25%.

Nayak Committee method various industry limits.

SSI units upto Rs.5.00 crore
Other units upto Rs.1.00 crore

20 www.sbsandco.com
 Turnover Method
(Originally suggested by Nayak Committee for SSI Units)

Applicable for limits upto 6 Crores

Item Particulars Scenario 1 Scenario 2 Scenario 3

1 Turnover 1000 1000 1000

2 25% of Turnover 250 250 250

3 Eligible Bank Finance 80% of 2 200 200 200

4 Margin Required at 5% of Turnover 50 50 50

5 Margin (NWC) Actual/ Projected (CA-CL) 150 300 100

6 (2 - 5 ) 100 -50 150

7 Eligible Minimum Bank Finance 100 -50 150

Lower of 3 or 6

21 www.sbsandco.com
 MPBF Method
As per Tandon Committee:
First Method of Lending:
Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank
borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of
the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings.

Second Method of Lending:

Under this method, it was thought that the borrower should provide for a minimum of 25% of total
current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for
purchases and other current liabilities will be available to fund the build up of current assets and the bank
will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could
not exceed 75% of current assets.

Third Method of Lending: Under this method, the borrower's contribution from long term funds will be to
the extent of the entire CORE CURRENT ASSETS, which has been defined by the Study Group as
representing the absolute minimum level of raw materials, process stock, finished goods and stores which
are in the pipeline to ensure continuity of production and a minimum of 25% of the balance current assets
should be financed out of the long term funds plus term borrowings.
(This method was not accepted for implementation and hence is of only academic interest).

22 www.sbsandco.com
 Computation MPBF Method
Example:
(Rs. In Lakhs)

Current Liabilities Amount Current Assets Amount

Creditors for Purchases 100 Raw Materials 200
Other Current Liabilities 50 Stock-In-Process 20
Bank Borrowings including Bills 150 Finished Goods 90
discounted with bankers
Receivables including Bill Discounted 50
with bankers
Other Current Assets 10
Total Current Liabilities 300 Total Current Assets 370

23 www.sbsandco.com
 Computation MPBF Method
(Rs. In Lakhs)

1st Method Amount 2nd Method Amount 3rd Method Amount

Total Current Assets 370 Total Current Assets 370 Total Current Assets 370
Less: Current Liabilities 150 Less: 25% of Current 92 Less: Core Current 95
other than Bank Assets Assets
Borrowings
Working Capital Gap 220 Working Capital Gap 278 Total Real Current 275
assets
Less: 25% of Working 55 Less: Current 150 Less: Other Current 150
Capital Gap Liabilities other than Liabilities
Bank Borrowings
MPBF 165 MPBF 128 Working capital gap 125
MPBF-Borrowings 15 Excess Borrowings 22 Less: 25% of Real 69
Current Assets
Current Ratio 1.17:1 Current Ratio 1.33:1 Current Ratio 1.87
24 www.sbsandco.com
 Justifications of the Performance Projection
(Inventory/Receivable Norms Comparison)
Intra firm Comparison
Comparison of estimates with previous years Actuals.
For New Units
Comparison of estimates with similar units in the area of operation.
Higher projections shall be justified.

Following precautions to be taken care

a. Projected turnover is gross turnover inclusive of excise duty etc.
b. The other financial strengths of the firm also to be kept in mind
c. Margin requirement of at least 5% of the turnover not to be diluted
d. Projected annual turnover to be reasonable, achieved in the past, achievable in future and realistic
in the present
e. Reasonableness of projections to be assessed and verified with returns filed by the borrower
f. Sales achieved till the date of sanction to be obtained from the borrower
g. Any projection beyond 15% of the previous years actual need closer attention

25 www.sbsandco.com
 Important aspects of MPBF Method
Production/Sales estimates
Profitability estimates
Inventory/receivables norms
Build up of Net Working Capital

26 www.sbsandco.com
 Cash Budget
Statement showing forecast of cash receipts, cash payments and net cash balance over a period of time

Months-> 1 2 3 4 5 6 7 8 9 10 11 12

Cash Receipts
Cash Payments
Surplus/deficit
Cash credit OB
Cash credit - CB
Peak deficit is financed and drawings regulated by monthly budgets
27 www.sbsandco.com
 Cash Budget
Advantages:
Suitable for seasonal industries, contractors, software, exporters, etc.
Limitations:
Will not reflect changes in various current assets & liabilities.
Will not give a clue whether a company is earning profit or not.
( Funds Flow Statement is required to detect any diversion of funds ).

28 www.sbsandco.com
 Non-Fund Based Limits
Letter of credit
ILC/FLC
Usance/Sight
Bank Guarantee
Performance
Financial Bid Bonds/Security Deposits/ Mobilisation advance/ retention
money
Deferred Payment Guarantee

29 www.sbsandco.com
 LC Assessment

1 Annual purchase/import FLC/ILC

2 Out of (1) on credit basis
3 Out of (2) on usance LC basis
4 Average of (3) per month
5 Lead time (no. of months)
6 Usance period (no. of months)
7 Usance LC requirement (5+6) X (4)

30 www.sbsandco.com
 Guidelines to be followed
For constituents borrowers with regular sanctioned credit facilities for
genuine transactions.
LCs shall not be opened with clause without recourse to drawer.
Bank Guarantees:
Performance and Financial Guarantees
Purpose / Difference

Security: Cash Margin +Counter Guarantee +Collateral Security

(Immovable / Liquid Security)
Restrictive Clause.

31 www.sbsandco.com
 Financial Ratios
While considering the proposal to the bank to get the credit facilities, banks analyze
the fi a ial st e gth of the o owe s fi a ial a ou ts y usi g atio a alysis.
The following are the ratios:
Current Ratio

Solvency Ratio

Quick Ratio or Acid Test Ratio

Profit to Sales Ratio

Turnover ratio (Inventory + Receivables)/Net Sales

32 www.sbsandco.com
 Financial Ratios
While considering the proposal to the bank to get the credit facilities,
a ks a alyze the fi a ial st e gth of the o owe s fi a ial a ou ts
by using ratio analysis.
The following are the ratios:

Current R =

The u e t atio is used to he k the o owe s a ility of epay e t of de t/
loan when the loan is to be repayable in installments & to know whether
current assets are financed by current liabilities/ long term borrowings.

Debt =

Debt-Equity Ratio is the measure of financial leverage & to know the relative
p opo tio of e titys e uity & de t used i the e titys assets.

33 www.sbsandco.com
 Financial Ratios

= `

It shows the relation between final profits to the sales. It is used to evaluate the
profitability of the business from its primary operations.

Gross Pro =

It shows that to what extent the sale price of the goods can be reduced without
incurring any losses.
+ +
=
+
It is a easu e of o owe s a ility of epay e t of his o ligatio s. The highe it is the
safer for the bank/ lenders.

Interest Coverage Ratio = PBIT /Interest (times) .

Interest coverage ratio explains how many time the firm earns to cover the interest
High ratio means comfortable ratio. 3-4 times is acceptable .

34 www.sbsandco.com
 Security
Hypothecation : Neither ownership nor possession is passed on to the borrower, in the
event of default Bank has legal right to sell the property

Pledge : Possession of the goods passes into the hand of bank as security towards the
debt, interest and other expenses

Lien : right of the lender to retain the property until the debt is repaid.

Mortgage : Transfer of legal or equitable interest in specific immovable property for the
payment of debt.

Charge : Where immovable property of one person is made security for the payment of
o ey to a othe a d the t a sa tio does t a ou t to o tgage. The le de will
charge on the property and all provisions of simple mortgage will apply.

35 www.sbsandco.com
 Non Financial Factors
Character of the borrower
Background or brief history of the borrower, nature of activity, expertise available
(technical and Managerial)
Capacity of the borrower
Networth, repayment history, viability of the business activity, income generating ability
of the business, security available for fall back
Capital of the borrower
What is the owners stake, equity, margin, ability to increase the margin, source of
financing the margin
Credibility of the borrower
What is the market opinion about the borrower, does he have a track record?

36 www.sbsandco.com
 Non Financial Factors
Purpose of the loan
Why does the borrower want a bank loan?, is it a permitted activity, what asset is being
created
Safety of funds lent
Is there sufficient primary security available, will the collateral back up in the event of
default
Customer rating
A mechanism to assess the riskiness of the borrower and his venture, to help in having a
good risk return trade off, to get adequate price for a risky loan
Covenants for uncovered risks
Enhanced margins, additional equity, special or specific stipulations (stock audit,
certificate from a Chartered Accountant etc)

37 www.sbsandco.com
 Data to be obtained
Application.
Financial Statements of Previous years
Estimates/ Projections (with quantitative details)

38 www.sbsandco.com
SBS And Company LLP
Chartered Accountants
6-3-900/6-9, Flat No. 103 & 104, Veeru Castle Thanks for your patient hearing!!!
Durga Nagar Colony,
Panjagutta, Hyderabad - 500 082
Telangana, India.
CA Rajesh D
Our Presence in
Telangana: Hyderabad (HO) PH: XXXXX
Andhra Pradesh: Nellore, Kurnool, TADA (near Sri
City), Vizag rajeshd@sbsandco.com
Karnataka: Bangalore
+91-40-40183366 / +91-40-64584494 / +91-9246883366

Read our monthly e-Journal

www.sbsandco.com/wiki