MODULE-5

FINANCING OF WORKING CAPITAL Prof. R. KANNAN

FINANCING OF WORKING CAPITAL

Cash Raw materials Process stock

Debtors

Finished goods

Working capital cycle Time taken for procurement, manufacturing, selling and collection of receivables. Raw material
f Fixed capital Fixed capital

Products

FINANCING OF WORKING CAPITAL

Working capital comprises - Raw material required to ensure uninterrupted production - Process stock - Finished goods required for uninterrupted sales - Sundry debtors - Consumables (oil, spares) required for maintenance of machines - Cash to meet running expenses
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FINANCING OF WORKING CAPITAL

Working capital requirement depends on a) Availability of inputs (RM stock) b) Demand/supply for the product (FG stock) c) Technology employed (process time) d) Efficiency of inventory control e) Marketing efficiency f) Nature of raw material/product (perishability, cost of storage)
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FINANCING OF WORKING CAPITAL

Sources of financing working capital Margin money through long term sources (Net working capital; Excess of long term liability, equity over fixed assets) Creditors Advance by customers Bank borrowings Usually the margin money is 25% of current assets required to take care of business risks and fall in the value of security.
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FINANCING OF WORKING CAPITAL

Need for proper assessment of working capital Inadequate financing Low capacity utilisation Dependence on unreliable and costly trade credits Difficulty in getting inputs from good sources Inability to offer credit and loss of market share Loss of reputation due to delay in payment Management attention will be in raising finance neglecting operations
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FINANCING OF WORKING CAPITAL

Over financing: Funds diversion to real estate/stock market Breeds inefficiency

Working capital facilities

Pre Sales - Raw materials, process stock, packing and dispatch of product - Risk of not executing order Post Sales - Credit to customers - Risk of debtors not paying - Sale / export through sister companies
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Working capital facilities

Funded Bank advances funds Non-funded facilities Guarantees / Letter of credit Over Financing Funds diversion to real estate/stock market Breeds inefficiency
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FINANCING OF WORKING CAPITAL Core working capital (CWC) Fluctuating working capital (FWC) While in India entire working capital is financed with 25% margin, most other countries CWC is financed by long term sources Now bank credit is based on credit risk and production requirement and not on security alone.
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Holding period of working capital

Raw material As months requirement Process stock/ - As months of production Finished goods Cost of goods sold Receivables - As months of gross sales Spares - As months consumption Gross sales includes all duties (Sales tax, excise) etc. paid before sale proceeds are received Same as cost of goods sold.
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Assessment of working capital

a) Maximum permissible Bank Finance Method (MPBF) b) Turnover Method c) Cash flow Method

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Assessment of working capital

MPBF Method While RBI does not impose any norms for working capital, banks usually follow the norms developed by Tandon Committee. Tandon Committee suggested 3 methods for assessment of working capital. The third method of CWC was rejected by RBI. Usually banks follow second method.
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Assessment of working capital

CA = Current Assets OCL = Other current liabilities (excluding bank borrowings)

First Method: MPBF = (CA-OCL) 25% (CA OCL) Second Method: MPBF = (CA OCL) 25% CA
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Assessment of working capital

Illustration Method (Rs. In lacs)

Current Assets Other Current liabilities Actual Bank borrowings

I 1000 400 475

II 1000 400 475

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Assessment of working capital

Method

Current Assets Less: Other current Liabilities

(Rs. In lacs) I II 1000 1000

400 --------600 400 ---------600
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Assessment of working capital Method (Rs. In lacs)

Margin MPBF Actual borrowings Over borrowings Current ratio Stipulated current Ratio 150 450 475 25 1.14 1.18 250 350 475 125 1.14 1.33

Over borrowings may be segregated as working capital demand loan (WCDL) repayable in instalments over time. Stipulated current ratio always 1.33 in Method II.
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Assessment of working capital

Individual limits for raw materials, process stock, finished goods and receivables are calculated based on holding periods. Adjust advances paid/received, credit received on individual items. Apply margin requirements against working capital to arrive at individual limits to arrive at net MPBF Aggregate working capital limits may be reduced by existing net working capital of the borrower.
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Assessment of working capital

Illustration 2 Gross sales Consumption of raw Materials Power and fuel Labour Other manufacturing cost Depreciation

(Rs. In lacs) 12,000 7680 480 1680 360 600

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Assessment of working capital

Change in closing stock/ Work in process/finished goods (240) Selling and administrative expenses 360 Interest 240 Total cost 11160 Profit before tax 840 Tax 300 Net profit 540

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Assessment of working capital

Total Cost Less: Interest Sales and Administrative Expenses 11160 240

360 -------------Production cost 10560 Production cost / Month 880 Gross sales /Month 1000
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Assessment of working capital

Raw material consumption/ Month 640 Expenses/Month 240 As of last year net working Capital available Rs. 600 lacs Trade credit available 15 days of raw material purchase Rs. 320 lacs Working capital cycle 4 months
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Assessment of working capital

Item Holding period Holding amount Margin Margin Rate amount Bank Financing

Raw Materials Process Stock Finished Goods Receivables Expenses

2 0.5 1.0 0.5 1.0

1280 440 880 500 240 ---------3340 -----------

25% 40% 25% 30% 100%

320 176 220 150 240 ---------1106 ----------

960 264 660 350 0 -------------2234 ---------------

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Assessment of working capital

Total working capital required Less: Net working capital Trade credit available Permissible Bank finance Less: Cash accruals 3340 (600) (320) 2420 220 ----------2200 1140 380
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Cash accruals/year Cash accruals/cycle

Turnover method
For small scale industries borrowing less than Rs.5 crores - Working capital assessed at 25% of turnover - Margin at 5% of turnover - Bank Finance at a minimum of 20% of turnover - Sales Rs.18 crores - Working capital Rs.4.5 crores - Margin Rs.0.9 crores - Bank borrowing Rs.3.6 crores
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Turnover method
For entities of turnover less than Rs.10 lacs no audited accounts are required; only sales tax / incometax returns.

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Cash Budget method

Seasonal Industries like tea have no current assets in the real sense. Segregate the monthly cash flows into operational flows, nonoperational flows such as investments , financing etc. Limits sanctioned as per the peak deficit in the operational flows but the amount is drawn equal to the month to month cash deficit with stipulated margins (usually 25% ). Withdrawals are allowed as per the stock value less creditors plus receivables with stipulated margins. Turnover/working capital is projected based on past working / industry norm.
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Types of Funded facilities

Pre sale finance Overdraft Cash Credit Packing credit Demand loan / line of credit Business card Post sale finance Cheque purcahse Bill purchase Bills discount Bills negotiation
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Overdraft (OD)
A small position A current account in which a certain amount of debit over the balance is allowed Helps temporary mismatch so that cheques issued are not returned for want of balance.

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Cash Credit
Running account which can be overdrawn by the borrower (availing of loan) up to the sanctioned limit and depending upon drawing limit based on security. It has cheque facility. The drawls are secured by inventory. Banks may secure debtors but they prefer bills route for debtors. Sanctioned limit is maximum estimated working capital less than the stipulated margin Drawling limit is the maximum permissible drawls based on stocks less than the stipulated margin. The amount of overdraft is either sanctioned limit or drawing limit whichever is lower.
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Cash Credit
Margins are determined by saleability and asset quality. Raw materials stock have lower margins than process stock. Steel stock will have lower margins than designer clothes. The borrower to submit monthly stock statement for raw materials, process stock and finished goods and statement of book debtors. Theoretically cash credit is a demand facility (i.e. bank can demand repayment at any time. Practically permanent as long as security is available or unless loans are fore closed.

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Cash credit
Interest is computed on the outstanding balance drawn everyday. Helps in managing cash flow for the borrower. No need to invest surplus outside at lower interest with the problem liquidity of investments. Banks face liquidity management problem Borrowing limits are fixed while sanctioning facility. Working capital demand loan Loan repayable in instalments.
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Packing Credit
Concessional finance for exporters Normally 2 to 4% cheaper than cash credit To be repaid within a stipulated period beyond this interest will be as per cash credit. Banks evaluate country and currency risk Exporter to be registered with Director General of Foreign Trade and must have a 10 digit code number He should not be in the caution list of RBI.
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 Currency - Rs. Or freely convertible currencies Period - Time for executing the order Maximum 360 days Rate (Maximum) PLR - 2.5% (Now almost 7% with new fiscal package)
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- LIBOR + 1% (180 days to LIBOR + 3% (Beyond 180 days) Running a/c. Possible against confirmed orders / L/Cs. Paid out of export proceeds Pre-disbursement Requirements: Confirmed order or irrevocable L/C issued by bank or repute If in restricted list of export, export license from DEFT.
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 Maximum amount FOB value of order - Amount required for setting goods reach shipment - Direct payment to suppliers of raw materials if it is possible. Repayment Exporter submits export bills, discounted by bank and credit to packing credit a/c. or out of collections. If order is not executed and repayment is made in rupees, cash credit interest rate will be charged.
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 Advances against duty draw back receivable from Government at packing credit rates after documents proof of receivables. Packing credit applicable for deemed exports.
Post Shipment to fund export receivables In Rs..or convertible currencies
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Repaid from export proceeds Purchase/discounting of export bills Negotiation of export bills Advance against export bills sent for collection. Advance against export incentives receivable (excise/custom refunds).

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Short term working capital loans

Short term loans 1 to 3 months duration Interest rate lower than cash credit Cash credit is to be reduced to the extent of short term working capital loan availed (Double financing)

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Short term working capital loans

Line of Credit Assurance by bank that the company can avail certain quantum of loans upto a limit during next one year. Interest rate decided at the time of drawl. Total of line of credit plus cash credit to be limited to drawing power. Company alternates between line of credit and cash credit depending interest rate.
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Business Cards
Issued for purchase of supplies / inputs without issuing (ICICI Bank, Citi Bank) cheques. As a substitute for cash credit, no interest free credit period is allowed. Sutiable for small business entities. No branch network required.
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Trade Finance (Post sale finance):

For credit sale, lower risk for bankers, as better monitoring possible. Lower interest rates

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Cheque Purchase (Part of Cash Management System): Loan against cheques deposited till clearing Repaid out of cheque realization Interest recovered when advance is given (say 7 days) Unrealised cheques, additional interest debited along with Cheque amount
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Bills Purchase (Contd..)

Bills Discount (Usance Bills) Bills raised by seller (Client) and accepted by the buyer. Usance bill has the date of payment and hence the exact interest is recovered upfront. Hence it is called bills discount. In bills purchase it is an estimated amount.

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Consortium system of credit delivery

Several banks pool together their banking resources and expertise in credit management and provide finance to a single borrower with common appraisal, common documentation and joint supervision and follow up. Each participating bank should share at least 5% of fund based assistance subject to RBI limits and non fund based limit in the same proposition. Entry of any other bank with the consent of consortium only. No bank can leave the consortium before a stipulated date. The borrower not to avail of any credit facility outside consortium.
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Lead Bank
- Appraisal, convening of consortium meetings, completion of documentation, representative of consortium to RBI, advises other members of the consortium on their share of assistance and managing other aspects of consortium like submission of data by borrower, credit delivery.
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Multiple Banking System

- Multiple finance fraud possible against the same pool of assets - Appraisal of credit requirement becomes difficult.

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Syndication
- Large credit exposure and of long term 1) Awarding of mandate to Lead Manager stating terms/conditions of credit to be availed. 2) Preparation of information Memorandum and circulating to other banks. 3) Individual banks collect information, and assess the proposals viability.
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Syndication 4) A syndication meeting is called; issues such as coordination, communication and control within the syndicate is discussed and finalised. The share of each bank is finalised. 5) Participating banks sign loan agreement 6) Lead manager finalises disbursement procedure.
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Commercial Paper (CP)

Unsecured money market instrument issued as promissory note and at a discounted rate. CP market is largely controlled by Fixed Income Money market and Derivatives Association of India Interest on CP is much lower than bank borrowings A company is eligible to issue CP only if

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Commercial Paper (CP)

a) b) c) d) e) f) g) Tangible networth more than Rs.4 crores Has sanctioned working capital limits Is classified as Standard Asset by banks Minimum credit rating P-2 or equivalent Maturity 7 days to one year Minimum investment Rs.5 lacs Appointment of a commercial bank as Issuing and Pay Agent (IPA)
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Commercial paper (CP)

Commercial bank assess the working capital requirements h) When a bank agrees to the role of IPA, it guarantees redemption of CP amount. i) Banks carve out a limit equivalent to CP amount so that redemption could be done and over borrowing is avoided. The bank ensures that issue of CP saves interest but not lead to over borrowings.
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FINANCING OF RECEIVABLES

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Bills Purchase
- Bills are drawn by seller and accepted by the buyer and endorsed in favour of the bank - Bank disburses the amount - Bank sends the bills to the drawee and either accept the bill (in case payment is to be received) or pay
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Bills Purchase (Contd..) Advance against demand bills submitted for collection Recovered when drawee pays The date of payment not fixed Interest is recovered at the time of purchase based on estimation Documents Invoice, Transport documents Bills of exchange, other documents such as Inspection, insurance policy etc. by the buyer and endorsed in favour of the bank.
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Bills discount (Usance Bills):

Bills raised by seller (client) and accepted by the buyer Usance bill has the date of payment and hence the exact interest is recovered upfront. Hence it is called bills discount. In bills purchase it is an estimated amount. Bills are preferred by the bank as the amount may be collected once the amount is received easier monitoring; If not paid, it will be known and collected from the buyer/seller. In case of demand bills, goods cannot be taken delivery unless he pays the bill. Enforcement in a Court of law is easier as bill is a negotiable instrument. Genuineness of transport (lorry / rail) receipts (approved list of IBA)

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Caution in accepting the bills Bills drawn on associate / sister concerns Address of drawee is care of hotel, box or the office of the drawer. The goods covered are totally different from the goods traded by the drawer. The lines of business of drawer and drawee are totally different. Circular transactions continuous bill discounting between associates without product delivery.
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How to design credit facilities Example: 1) Stock Data

Particulars Raw Materials Process Stock Finished goods Receivables Other current assets Rs. Lacs 60 20 50 100 20

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How to design credit facilities 2) Current Liabilities

Particulars Rs. Lacs

Raw Materials
Process Stock

60
20

Finished goods
Receivables Other current assets

50
100 20

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Calculate and design the facilities

1. Total current assets 250

2. Current liabilities excluding bank finance

3. Working capital gap (1-2) 4. Minimum net working capital 5. (3-4)

90
160 62.5 97.5

The limit for borrowings is Rs.97.5 lacs 6. Receivables 100

7. Assume margin at 50%

8. Eligible bank finance for receivables facility)

50
50 (sanctioned as bills
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Margin

Value

Margin

Required finance

Raw materials
Process Stock Finished goods

25%
40% 25%

60
20 50

15
8 12.5

45
12 37.5 94.5

Less: Trade Creditors Finance for Inventory requirement

40.0 54.5

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Rs. lacs
Total overall limit Less: Bills Actual required 97.5 50.0 54.5

Gap
Hence the limits are Bills Cash credit Working capital term loan

7.0
7.0 50.0 47.5 7.0

Working capital repayable in instalments during next 3 years

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Securitisation

Mortgage assets Auto loans Credit cards Trade receivables

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House Loan compay originator

Sale of receivables SPV

Rebundling

PTC-1

PTC-2

PTC-3

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PTC Pass through certificates The collection, follow up, realisation and passing on the receivables to SPV is the responsibility of originator

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Advantages of Securitisation
Improves cashflow position Avoids loss provision Avoids additional capital raising

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Factoring
Factoring - Buying accounts receivables/book debt The institution assess the customers to whom goods are sold, invoices made and bills raised The Institution fixes the credit limit for individual customers and also period of advance Factored receivables are assigned and debtor is instructed to made payments to factor directly. The seller sends the invoice to the factor and factor pays the advance The balance amount net of fees is payable after the customer pays the amount. The credit risk is that of client.
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Forfeiting
Forfeiting agency provides receivables financing without recourse to exporter or his banker Forfeiting agency needs accepted bills of exchange with letter of credit of importers banker Normally forfeiting cost is included in the FOB value of the product Forfeiting agency takes all associated risks such as interest rate risk, currency risk, credit risk and political risk.
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