Working Capital AssessmentCA Rajesh D rajeshd@sbsandco.comDate: 16/03/2016by

Source of fundsLong Term LoansProject FinanceCash Credit or ODShort term loansBanksBanksPrivate InvestorsNBFCsFIs

www.sbsandco.com3Objective: Concept of Working CapitalGross Working Capital , Working capital Gap, Net Working CapitalComponents of working capitalWorking capital operating cycleVarious methods of working capital assessment vizTurnover methodMPBF methodCash Budget MethodCMA Data.

Working Capital

www.sbsandco.com4Funds 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

Working Capital

www.sbsandco.com5Assets which are part of the operating cycle or which get converted into cash within the operating cycle or within one year

Spares and Spare partsLoose toolsStock-in-TradeWork-in-ProgressSundry Debtors less bad debtsCash and Bank BalancesLoans and advances to subsidiaries Bills of ExchangeAdvances recoverable in cash or receivablesBalance with customs, port authorities, municipal authoritiesInterest accrued on Investments

What are Current Assets ?

www.sbsandco.com6Liabilities which are part of the operating cycle or which need to be paid off within the operating cycle or within one year

Short term bank borrowingsUnsecured loans Sundry Creditors and Trade CreditorsDeposits from public maturing within one yearAdvances and deposits from dealersAccrued Interests and ChargesProvision for taxationDividend payableStatutory liabilities Installment of term loans repayable in one yearOther liabilities and provisions

What are Current Liabilities ?

www.sbsandco.com7Operating Cycle

www.sbsandco.com8The 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.

Operating Cycle

www.sbsandco.com9Operating Cycle begins with acquisition of raw materials and ends with collection of receivables.Stages: Raw materials (RM/RM consumption)Work-in-process (WIP/COP)Finished Goods (FG/COS)Receivables (Debtors/Credit sales)Less:Creditors (creditors/purchases)

Operating Cycle

www.sbsandco.com10What are Working Capital Sources?Working Capital Requirement (Current Assets)Source of Finance1Raw Material and stores (inventory)Sundry Creditors or Bank Finance2.Stock-in-ProcessAdvance payments received or Bank Finance or Liquid Surplus3.Finished Goods (inventory)Liquid Surplus or Net working Capital or Bank Finance4.Sundry DebtorsBank Finance short term 5.Cash for expensesNet Working Capital or Liquid Surplus

www.sbsandco.com11GROSS WORKING CAPITAL = CAThese 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 LiabilitiesSHF=Shareholders funds, TL=Term LoanNFA=Net Fixed AssetsNCA=Net Current Assets

NWC should always be more than 1:1 It indicates the margin of safety to short term creditors.

Concepts of Working Capital

www.sbsandco.com12Length of Operating CycleCashCashCashServiceTradeIndustryReceivablesStocksSemi Finished GoodsReceivablesReceivablesFinished GoodsRaw Material

www.sbsandco.com13Nature of business service/trade/manufacturing.Seasonality of operations peak/non peakProduction Policy Constant/seasonalMarket conditions- competition/credit termsConditions of supply of RM/stores/spares etc.Quantum of production/Turnover(level of activity)Operating CycleCurrent Assets to be maintained

Factors influencing Working Capital Requirement

www.sbsandco.com14A) Fund BasedCash CreditOverdraft Inventory finance and Factoring or Bill discounting ( Post Sales Finance).B) Non Fund BasedLetter of Credit (LC)Bank Guarantee.

Working Capital Finance

www.sbsandco.com15Operating Cycle MethodService SectorTradersManufacturing Activity. Drawing Power Method.Turnover MethodMPBF method (II method of lending) for limits of Rs 6.00 crores and aboveCash Budget method (for: Based on procurement and cash inflow)Seasonal Industries (Sugar/ Rice Mills/Textiles/Tea/Tobacco/Fertilizers)Contractors & Real Estate DevelopersEducational Institutions

Assessment Methods

www.sbsandco.com16Operating Cycle Method

www.sbsandco.com17Length of Operating CycleOperating Cycle Methoda. Procurement of Raw Material30 daysb. Conversion / Process time15 daysc. Average time of holding of FG15 daysd. Average Collection Period30 dayse.Operating Cycle (a+b+c+d)90 daysf. Operating Cycle in a year (365days/e)4 cycles

www.sbsandco.com18Operating Cycle MethodB. Total Operating Expenses per Annum Rs 60.00 lakhsC. Total Turnover per AnnumRs 70.00 lakhsD. Working Capital Requirement = Total Operating Expenses (B)/ No. of operating Cycle (f as said earlier)Rs 15 lakhs

www.sbsandco.com19Drawing Power Method(for units with small limits)ParticularsStock valueMargin DPPaid stocks (RM-Creditors) 4 25% 3Semi Finished goods 4 50% 2Finished goods 4 25% 3Book debts 4 50% 2Total 1610

www.sbsandco.com20Turnover 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 croreOther units upto Rs.1.00 crore

www.sbsandco.com21Turnover Method(Originally suggested by Nayak Committee for SSI Units)Applicable for limits upto 6 CroresItemParticularsScenario 1Scenario 2Scenario 31Turnover100010001000225% of Turnover2502502503Eligible Bank Finance 80% of 22002002004Margin Required at 5% of Turnover5050505Margin (NWC) Actual/ Projected (CA-CL)1503001006(2 - 5 )100-501507Eligible Minimum Bank Finance100-50150Lower of 3 or 6

www.sbsandco.com22 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).

www.sbsandco.com23Computation MPBF Method Current LiabilitiesAmountCurrent AssetsAmountCreditors for Purchases100Raw Materials200Other Current Liabilities50Stock-In-Process20Bank Borrowings including Bills discounted with bankers200Finished Goods90Receivables including Bill Discounted with bankers50Other Current Assets10Total Current Liabilities350Total Current Assets370

Example:(Rs. In Lakhs)

www.sbsandco.com24Computation MPBF Method 1st MethodAmount2nd MethodAmount3rd MethodAmountTotal Current Assets370Total Current Assets370Total Current Assets370Less: Current Liabilities other than Bank Borrowings150Less: 25% of Current Assets92Less: Core Current Assets95Working Capital Gap220Working Capital Gap278Total Real Current assets275Less: 25% of Working Capital Gap55Less: Current Liabilities other than Bank Borrowings150Less: Other Current Liabilities150MPBF165MPBF128Working capital gap125Excess -Borrowings35Excess Borrowings72Less: 25% of Real Current Assets(276*25)69MPBF56Current Ratio1.17:1Current Ratio1.33:1Current Ratio1.87

(Rs. In Lakhs)

www.sbsandco.com25(Inventory/Receivable Norms Comparison)Intra firm ComparisonComparison of estimates with previous years Actuals.For New UnitsComparison of estimates with similar units in the area of operation.Higher projections shall be justified.

Following precautions to be taken care Projected turnover is gross turnover inclusive of excise duty etc.The other financial strengths of the firm also to be kept in mindMargin requirement of at least 5% of the turnover not to be dilutedProjected annual turnover to be reasonable, achieved in the past, achievable in future and realistic in the presentReasonableness of projections to be assessed and verified with returns filed by the borrowerSales achieved till the date of sanction to be obtained from the borrowerAny projection beyond 15% of the previous years actual need closer attention

Justifications of the Performance Projection

www.sbsandco.com26Production/Sales estimatesProfitability estimatesInventory/receivables normsBuild up of Net Working Capital

Important aspects of MPBF Method

www.sbsandco.com27Cash Budget Statement showing forecast of cash receipts, cash payments and net cash balance over a period of timeMonths->1 2 3 4 5 6 7 8 9 10 11 12Cash ReceiptsCash PaymentsSurplus/deficitCash credit OBCash credit - CB

Peak deficit is financed and drawings regulated by monthly budgets

www.sbsandco.com28Advantages: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 ).Cash Budget

www.sbsandco.com29Letter of credit ILC/FLCUsance/SightBank Guarantee PerformanceFinancial Bid Bonds/Security Deposits/ Mobilisation advance/ retention money Deferred Payment Guarantee

Non-Fund Based Limits

www.sbsandco.com30LC Assessment1Annual purchase/importFLC/ILC2Out of (1) on credit basis3Out of (2) on usance LC basis4Average of (3) per month5Lead time (no. of months)6Usance period (no. of months)7Usance LC requirement (5+6) X (4)

www.sbsandco.com31For 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 / DifferenceSecurity: Cash Margin +Counter Guarantee +Collateral Security (Immovable / Liquid Security)Restrictive Clause.

Guidelines to be followed

www.sbsandco.com32While considering the proposal to the bank to get the credit facilities, banks analyze the financial strength of the borrowers financial accounts by using ratio analysis.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

Financial Ratios

www.sbsandco.com33Financial Ratios

www.sbsandco.com34Financial Ratios

www.sbsandco.com35Hypothecation : 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 money to another and the transaction doesnt amount to mortgage. The lender will charge on the property and all provisions of simple mortgage will apply. Security

www.sbsandco.com36Character of the borrowerBackground or brief history of the borrower, nature of activity, expertise available (technical and Managerial)Capacity of the borrowerNetworth, repayment history, viability of the business activity, income generating ability of the business, security available for fall backCapital of the borrowerWhat is the owners stake, equity, margin, ability to increase the margin, source of financing the marginCredibility of the borrowerWhat is the market opinion about the borrower, does he have a track record?

Non Financial Factors

www.sbsandco.com37Purpose of the loanWhy does the borrower want a bank loan?, is it a permitted activity, what asset is being createdSafety of funds lentIs there sufficient primary security available, will the collateral back up in the event of default Customer ratingA 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 loanCovenants for uncovered risksEnhanced margins, additional equity, special or specific stipulations (stock audit, certificate from a Chartered Accountant etc)

Non Financial Factors

www.sbsandco.com38Preparation of information memorandum or brief profile of the businessPreparation of CMA (Credit Monitoring Assessment) data consiting of past three years audited information and next three years projected information Filling of Application.Valuation report of the property offered as securityLegal opinion of the property offered as security Depending upon the sanctionging authority the file will be put up for the sanction After the committee/ sanctioning authroity review a sanction letter is releasedOnce we receive the sancti

Process flow

www.sbsandco.com39Once we receive the sanction letter, we need to complete the following documents loan documentation Hypothecation deedMortgage deedBoard Resolution for accepting of the terms and mortgage of the property as security for the loanUpon completion of the above documentation , charge should be created in ROC with this all procedure will be completed. We need to submit the monthly stock statements and submit stock audit report as per the sanction letter terms and conditions.

Process flow

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