Working Capital
N.Gopal
Deputy General Manager & MoF
RBI CAB Pune
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
Business requirements
Banks
NBFCs
Private
Investors
Long
Term
Loans
Project
Finance
Funds for
Business
Banks
FIs
Long Term
Short Term
Cash
Credit
or OD
Fixed Capital
or Permanent
Capital
Working Capital
or Temporary
or Circulating
Capital
Short
term
loans
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
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
Current Assets
• Assets which get liquidated in short term (say one year)
• As per Companies Act 1956 Current Assets are
1. Interest accrued on Investments
2. Spares and Spare parts
3. Loose tools
4. Stock-in-Trade
5. Work-in-Progress
6. Sundry Debtors – less bad debts
7. Cash and Bank Balances
8. Loans and advances to subsidiaries
9. Bills of Exchange
10. Advances recoverable in cash or receivables
11. Balance with customs, port authorities, municipal authorities
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
Operating Cycle for Bankers
• Only those assets which are involved in completing the
“Operating Cycle or Cash Cycle” or part of it.
Cash
Debtors
Raw
materials
Sales
Stock in
process
Finished
Goods
Current Assets for bankers
1.
2.
Cash and Bank Balances
Short term investments/advances/loans purely connected with the
operating cycle or which helps in completing the cycle
3. Receivables / Sundry Debtors
4. Bills purchased and discounted with bank
5. Installments receivable on loans falling due within one year
6. Inventory- Raw materials, Work-in-Process and Finished goods
7. Consumable spares
8. Advance payment of tax
9. Prepaid Expenses
10. Advance for purchase of raw materials, components, stores &&
11. Deposits with public bodies refundable within the cycle
12. Any money or receivable due within one year
Current Liabilities
• Liabilities payable on demand or within one year
• As per companies Act current Liabilities are
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
Current Liabilities for a bankers
• All those liabilities which are part of the Operating Cycle or
Cash Cycle – Liabilities which complete the cycle
1. Short term bank borrowings (W.C. loans)
2. Unsecured short term loans (12 months)
3. Public deposits maturing within 12 months
4. Sundry creditors for raw materials, consumables or trade
creditors
5. Interest and charges accrued but not yet due
6. Advance from customers
7. Installment of term loans falling due within one year
8. Statutory liabilities- PF dues, provision for taxes, Sales tax dues,
Excise duty etc
9. Dividend
10. Gratuity
11. Provisions
Working Capital Cycle
15
Gross and Net Working Capital
• Gross Working Capital:
– All the investment in Current Assets
• Net Working Capital:
– Current Assets – Current Liabilities
Liabilities
Assets
Capital (Equity +Reserves)
Fixed Assets (Plant and
Machinery, Land and
Building)
Long term Debt (Deferred
Liabilities)
Other Non current Assets
CURRENT
CURRENT LIABILITIES
ASSETS
NWC
Working Capital and sources of finance
Working Capital Requirement
(Current Assets)
Source of Finance
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
Valuation of Current Assets
Components of Working Capital or
Current Assets
Valuation
1.
Stock of Raw Materials
Purchase cost of Raw
materials
2.
Stock of Work in process
At cost or market
value whichever is
lower.
3.
Stock of finished goods
Cost of production
4.
Debtors or receivables
Cost of Sales or sale
value
5.
Cash for expenses
Actual working
expenses
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
19
Methods of Assessing W.C
• Projected Balance Sheet Method:
• The old Committee approach to lending
• Cash Budget Method of Assessing working Capital
Operating Cycle Method
D=Stock of
finished
goods before
sale
E= Credit
Sales
F= Debtors
conversion
to cash
Cash
Raw
materials
Debtors
B
E
Stock in
process
Sales
Finished
Goods
A=
Acquisition
time
B=Process
time
C= Process to
Finished
Goods
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.
Permissible Bank finance using Operating Cycle
•
1.
2.
3.
4.
5.
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
i.
ii.
iii.
iv.
Raw materials
Stock in process
Finished Goods
Sundry Debtors
= Rs. 15 days
= Rs. 2 days
= Rs. 3 days
= 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/-
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%
Projected Turnover
2009
2010
2011
2012
2013
Rs. In
Lacs
Annual Sales
Turnover
15.00
18.00
20.00
30.00
40.00
Working Capital
Requirement 25%
10.00
Margin to be
brought in by the
borrower 5% of
the Annual
turnover
2.00
Maximum
Permissible bank
finance (20%) of
the turnover
8.00
Projected Turnover
• Care to be exercised in turnover method.
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.
Traditional Method
• It is the sum total of
A. Raw Materials required Less Margin
B. Work-in-Process Less Margin
C. Finished Goods Less Margin
D. Sundry Debtors Less Margin
E. Miscellaneous expenses
(reasonable level)
Less: Advance if any received
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Less: Sundry Creditors
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Total Working Capital Finance
The margin will come from NWC
XXX
XXX
XXX
XXX
XXX
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27
The MPBF Methods
METHOD I
METHOD II
C.A
OCL
WCG
25% of WCG
200
40
160
40
C.A
25% of CA
GAP
OCL
MPBF
120 MPBF
NWC
C.A
C.L
CURRENT
RATIO
40 NWC
200 C.A
160 C.L
CURRENT
1.25 RATIO
METHOD III
200
50
150
40
C.A
Non core CA
Core CA
25% of Real CA
GAP
OCL
110 MPBF
200
56
144
36
108
40
68
50 NWC
200 C.A
150 C.L
92
200
108
1.33 CURRENT RATIO
1.85
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
29
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
Cash Budget
Particulars
I
Estimated Cash
Inflows
Cash Sales
Debtors receipts
.
Other receipts
II
Estimated cash
Outflows
Cash purchases
Cash payment to
Creditors
Expenses/Loans
Interest
III
Opening Cash bal
March
June
September
December
Cash Budget Method
Particulars
IV
Add/Deduct/Surplus
/ Deficit (I - II)
V
Closing Cash
balance (III – IV)
VI
Minimum Level of
cash
Balance
VII
Estimated Excess or
Shortfall (V – VI )
Bank Finance on
Shortfall less Margin
March
June
September
December
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
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
Solvency Ratio
Total Outside Liabilities • Indicates Solvency
Tangible Networth
• Indicates size of
owners stake
Total term liabilities • Indicates stake of
creditors
Tangible Networth
• Indicates the coverage
or
of liabilities by the netDebt
worth
Equity
• Lower ratio indicates
greater solvency
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
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
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?
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)
THANK YOU