Working Capital

1. Working Capital N.Gopal Deputy General Manager & MoF RBI CAB Pune

2. Working Capital • Business needs long term and short term funds • Long term funds needed for fixed assets, permanent assets • Met through Fixed or Permanent Capital or Long term Debt • Short term funds needed for acquiring short term assets, meet day to day business expenditure • Met through Temporary capital, circulating capital or Working Capital

3. Business requirements Banks NBFCs Banks Private Investors FIs Long Term Loans Cash Credit or OD Project Finance Short term loans

4. Banker and Working Capital • Banker meets both long term and short term needs • Short term finance from banks • Used for working capital • Procuring short term assets • Meeting short term or day to day expenditure • Financed as Cash Credit, Overdraft, Short Term Working Capital loan etc • Tenure One year, assessed and renewed annually

8. Short Term assets and Liabilities • Current Assets: • Assets which are part of the operating cycle or which get converted into cash within the operating cycle or within one year • E.g. inventory (raw and finished), debtors, cash • 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 • E.g. Sundry creditors, provision for taxes

9. Current Assets • Assets which get liquidated in short term (say one year) • As per Companies Act 1956 Current Assets are • Interest accrued on Investments • Spares and Spare parts • Loose tools • Stock-in-Trade • Work-in-Progress • Sundry Debtors – less bad debts • Cash and Bank Balances • Loans and advances to subsidiaries • Bills of Exchange • Advances recoverable in cash or receivables • Balance with customs, port authorities, municipal authorities

10. Current Assets for Bankers • Any Asset that gets converted into cash within the “Operating Cycle” or which forms part of the operating cycle is current Asset for bankers • Logic- Bank finance to be used only for creation of assets which will be sold and reconverted into cash • Investments in subsidiaries, deposits with customs, electricity boards, municipal authorities, advances to staff etc would not be current assets to bankers

11. Operating Cycle for Bankers • Only those assets which are involved in completing the “Operating Cycle or Cash Cycle” or part of it.

12. Current Assets for bankers • Cash and Bank Balances • Short term investments/advances/loans purely connected with the operating cycle or which helps in completing the cycle • Receivables / Sundry Debtors • Bills purchased and discounted with bank • Installments receivable on loans falling due within one year • Inventory- Raw materials, Work-in-Process and Finished goods • Consumable spares • Advance payment of tax • Prepaid Expenses • Advance for purchase of raw materials, components, stores && • Deposits with public bodies refundable within the cycle • Any money or receivable due within one year

13. Current Liabilities • Liabilities payable on demand or within one year • As per companies Act current Liabilities are • Short term bank borrowings • Unsecured loans • Sundry Creditors and Trade Creditors • Deposits from public maturing within one year • Advances and deposits from dealers • Accrued Interests and Charges • Provision for taxation • Dividend payable • Statutory liabilities • Installment of term loans repayable in one year • Other liabilities and provisions

14. Current Liabilities for a bankers • All those liabilities which are part of the Operating Cycle or Cash Cycle – Liabilities which complete the cycle • Short term bank borrowings (W.C. loans) • Unsecured short term loans (12 months) • Public deposits maturing within 12 months • Sundry creditors for raw materials, consumables or trade creditors • Interest and charges accrued but not yet due • Advance from customers • Installment of term loans falling due within one year • Statutory liabilities- PF dues, provision for taxes, Sales tax dues, Excise duty etc • Dividend • Gratuity • Provisions

15. Working Capital Cycle

16. Gross and Net Working Capital • Gross Working Capital: • All the investment in Current Assets • Net Working Capital: • Current Assets – Current Liabilities NWC

17. Working Capital and sources of finance

18. Valuation of Current Assets

19. Methods of Assessing W.C • 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. • 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%. • Traditional Method: Assessment based on the current asset level for the level of activity

20. Methods of Assessing W.C • Projected Balance Sheet Method: • The old Committee approach to lending • Cash Budget Method of Assessing working Capital

21. Operating Cycle Method D=Stock of finished goods before sale E= Credit Sales F= Debtors conversion to cash A= Acquisition time B=Process time C= Process to Finished Goods

22. Operating Cycle • Operating cycle = Time lapsed from A….F • Working capital= Funds required to complete the cycle from A….F • E.g. A=20 days B=10 days C= 20 days D= 30 days E=20 days F=20. Cycle = 120 days (i.e. 3 cycles in a year) • E.g. Sales Rs.1,00,000 per annum • Exp. Rs. 72,000 per annum WCR (for expenses)= 72,000/3 = 24,000/- per cycle • Working capital requirement would go down if the cycle is increased or if the operating efficiency is increased • Working capital would be more if the cycle is reduced or if there is operating inefficiency working capital required will be more.

23. Permissible Bank finance using Operating Cycle • E.g. Unit ABC has furnished the below mentioned data • Sales =Rs. 50,000 per month • Raw Materials =Rs. 12,000 per month • Wages = Rs. 6,000 per month • Manufacturing Exp. =Rs. 3,000 per month • Operating Cycle • Raw materials = Rs. 15 days • Stock in process = Rs. 2 days • Finished Goods = Rs. 3 days • Sundry Debtors = Rs. 15 days Working Capital = Operating Expenses x Operating Cycle i.e. 2+3+4 = Rs.21,000 Cycle = i+ii+iii+iv=35 days WC Assessed would be (21,000 x 35)/30= Rs.24500/-

24. Projected Turnover Method • Nayak Committee method: • SSI units upto Rs.5.00 crore • Other units upto Rs.1.00 crore • Projected Turnover Method • i.e. 25% of the projected annual turnover to be reckoned as WC • Borrower to bring in 5% • Bank finance 20%

25. Projected Turnover

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

27. Traditional Method • It is the sum total of • Raw Materials required Less Margin XXX • Work-in-Process Less Margin XXX • Finished Goods Less Margin XXX • Sundry Debtors Less Margin XXX • Miscellaneous expenses (reasonable level) XXX Less: Advance if any received aaa Less: Sundry Creditors aaaaaa Total Working Capital Finance ccc The margin will come from NWC

28. The MPBF Methods

29. Projected Balance Sheet • Projected Balance Sheet Method: The level of Current Assets and Current Liabilities are projected and the working capital gap is arrived at. The banker finances 75%-80% of the gap and the balance has to come from NWC (Net Working Capital) • Balance sheet for the future year is projected • Basis of projection actual audited balance sheet of the past two- three years

30. Cash Budget Method • Used to assess working capital requirements of contractors • Used where there cannot be specific hypothecation or where the cash flow is irregular. • Where the bank wants to keep a close watch on the inflows and outflows of cash of the business

31. Cash Budget

32. Cash Budget Method

33. Ratios to help in assessment • Current Ratio • Solvency Ratio • Quick Ratio or Acid Test Ratio • Profit to Sales Ratio • Turnover ratio (Inventory + Receivables)/Net Sales

34. Liquidity Ratio Current Assets x 100 Current Liab. (Quick Ratio or Acid test Ratio) C.A- Inventory x100 C.L-Bank borrowings • Whether current assets are enough to cover current liabilities • Higher ratio could be bad or good • Lower ratio not necessarily bad • Whether current liabilities are funding current assets

35. Solvency Ratio Total Outside Liabilities Tangible Networth Total term liabilities Tangible Networth or Debt Equity • Indicates Solvency • Indicates size of owners stake • Indicates stake of creditors • Indicates the coverage of liabilities by the net-worth • Lower ratio indicates greater solvency

36. Some ratios explained • PBIT/Interest (Times) • Interest coverage ratio, explains how many times the firm earns to cover the interest payable by • Higher ratio means comfortable debt servicing capacity from cash accruals • A ratio of 3 or 4 is very comfortable. • A ratio of 2 could be risky • (Inventory + Receivables) / Net Sales • Expressed in days ratio captures turnover time for major current assets • Higher ratio indicates slower turn over and higher risk

37. Turnover Ratio Annual Sales x 100 Closing Stock • High ratio indicates good turnover of stock • Efficient management of sales • Low ratio indicator of large unsold stock

38. Other Aspects of Working Capital Assessment • The non financial aspects of Working capital assessment • 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?

39. Other Aspects of Working Capital Assessment • 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)

40. THANK YOU