Assessment of working capital finance project by noname


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Assessment of working capital finance project by noname

  1. 1. 1
  2. 2. EXECUTIVE SUMMERY It gives me great pleasure to present this project report on working capital financeat bank of Maharashtra, credit department, head office, Pune. The project was carried outfrom 1st June 2007 to 31st July 2007. The main objective of the project was to study various types of working capitalfinance provided by banks. To know details the procedure of assessment of workingcapital finance extended by banks. Wheels of business cannot move without money. Availability of money is beinglimited and wants being unlimited. So procurement of fund is one of the importantfunctions in commercial & non-commercial enterprises and utilizes it for maximizationof business profits.Business enterprises need funds to meet their different types of requirements, i. Long-term requirement ii. Medium-term requirement iii. Short-term requirement Working capital requirement is the short-term requirement. Working capital is theinvestment needed for carrying out day-to-day operations of the business smoothly. Bankis one of the important sources of working capital requirement. Bank gives variousfacilities to the borrowers. 2
  3. 3. In this project I have considered various banking facilities for the working capitalfinance to the industries. It covers almost important aspect relating to assessment &follow up of working capital finance. After discussing the procedure followed by bank,For assessing working capital requirement case studies have been given with necessarydata in the prescribed forms demonstrate the calculable done by bank to arrive atmaximum permissible bank finance. An inventory & receivables constitute the majorportion of the total working capital requirement. 3
  4. 4. Company ProfileThe BirthRegistered on 16th Sept 1935 with an authorized capital of Rs 10.00 lakh andcommenced business on 8th Feb 1936.The ChildhoodKnown as a common mans bank since inception, its initial help to small units has givenbirth too many of todays industrial houses. After nationalization in 1969, the bankexpanded rapidly. It now has 1292 branches (as of 30th September 2005) all over India.The Bank has the largest network of branches by any Public sector bank in the state ofMaharashtra.The AdultThe bank has fine tuned its services to cater to the needs of the common man andincorporated the latest technology in banking offering a variety of services.Our Philosophy o Technology with personal touch.Our EmblemThe Deepmal o With its many lights rising to greater heights. 4
  5. 5. The Pillar o Our institution- Symbolizing strength.The 3 MsSymbolising • Mobilisation of Money • Modernisation of Methods and • Motivation of Staff.Our AimsThe bank wishes to cater to all types of needs of the entire family, in the whole country.Its dream is "One Family, One Bank, Maharashtra Bank".The AutonomyThe Bank attained autonomous status in 1998. It helps in giving more and more serviceswith simplified procedures without intervention of Government.Our Social AspectThe bank excels in Social Banking, overlooking the profit aspect; it has a good share ofPriority sector lending having 46% of its branches in rural areas. 5
  6. 6. Other AttributesBank is the convener of State level Bankers committeeBank has signed a MoU with EXIM bank for co-financing of project exportsBank offers Depository services and Demat facilities in Mumbai.Bank has captured 97.68% of its total business through computerization. 6
  7. 7. OBJECTIVES To know the various types of working capital finance provided by banks. To analyze in detail the procedure of assessment of working capital finance extended by bank. To apply these procedure at a practical level with the help of case studies. 7
  8. 8. RESEARCH METHODOLOGY This is analytical research area where we analyses information with cause and itseffects relationship. This analysis leads to the simple conclusions of whether to lendmoney to the institution for business. Also if the money is lend then there is reality the norms are not always perfect andhence it is essential to priorities stringent parameters and secondary parameters.Research Type AnalyticalSource of Data Primary and SecondarySample Unit Industries applying for loanSample Case studiesSample Technique Allocation of CaseAnalysis Tool used Financial AnalysisPrimary Data: Observation, Discussion with the manager. The company profile, annual reports have been obtained from BOM.Secondary Data:Secondary data relating to the procedure of assessment of working capital finance, oldsanction proposals, RBI guidelines etc. have been sourced from reference books. 8
  9. 9. INTRODUCTION TO WORKING CAPITALIn accounting,” Working capital is the difference between the inflow and outflow offunds. In other words, it is the net cash inflow. It is defined as the excess of current assetsover current liabilities and provisions. In other words, it is net current assets or networking capital.A study of working capital is of major importance to internal and external analysisbecause of its close relationship with the day-to-day operations of a business. WorkingCapital is the portion of the assets of a business which are used on or related to currentoperations, and represented at any one time by the operating cycle of such items asagainst receivables, inventories of raw materials, stores, work in process and finishedgoods, merchandise, notes or bill receivables and cash.Working capital comprises current assets which are distinct from other assets. In the firstinstance, current assets consist of these assets which are of short duration.Working capital may be regarded as the life blood of a business. Its effective provisioncan do much to ensure the success of a business while its inefficient management canlead not only to loss of profits but also to the ultimate downfall of what otherwise mightbe considered as a promising concern.The funds required and acquired by a business may be invested to two types of assets:1. Fixed Assets.2. Current Assets 9
  10. 10. Fixed assets are those which yield the returns in the due course of time. The variousdecisions like in which fixed assets funds should be invested and how much should beinvested in the fixed assets etc. are in the form of capital budgeting decisions. This can besaid to be fixed capital management.Other types of assets are equally important i.e. Current Assets.These types of assets are required to ensure smooth and fluent business operations andcan be said to be life blood of the business. There are two concepts of working capital —Gross and Net. Gross working capital refers to gross current assets. Net working capitalrefers to the difference between current assets and current liabilities. The term currentassets refers to those assets held by the business which can be converted into cash withina short period of time of say one year, without reduction in value. The main types ofcurrent assets are stock, receivables and cash. The term current liabilities refer to thoseliabilities, which are to be paid off during the course of business, within a short period oftime say one year. They are expected to be paid out of current assets or earnings of thebusiness. The current liabilities mainly consist of sundry creditors, bill payable, bankoverdraft or cash credit, outstanding expenses etc. 10
  11. 11. NEED FOR WORKING CAPITALThe need of gross working capital or current assets cannot be overemphasized. The objectof any business is to earn profits. The main factor affecting the profits is the magnitude ofsales of the business. But the sales cannot be converted into cash immediately. There is atime lag between the sale of goods and realization of cash. There is a need of workingcapital in the form of current assets to fill up this time lag. Technically, this is called asoperating cycle or working capital cycle, which is the heart of need for working capital.This working capital cycle can be described in the following words.If the company has a certain amount of cash, it will be required for purchasing the rawmaterial though some raw material may be available on credit basis. Then the companyhas to spend some amount for labour and factory overheads to convert the raw material inwork in progress, and ultimately finished goods. These finished goods when sold oncredit basis get converted in the form of sundry debtors. Sundry debtors are converted incash only after the expiry of credit period. Thus, there is a cycle in which the originallyavailable cash is converted in the form of cash again but only after following the stages ofraw material, work in progress, finished goods and sundry debtors. Thus, there is a timegap for the original cash to get converted in form of cash again. Working Capital needs ofcompany arise to cover the requirement of funds during this time gap, and the quantum ofworking capital needs varies as per the length of this time gap.Thus, some amount of funds is blocked in raw materials, work in progress, finishedgoods, sundry debtors and day-to-day requirements. However some part of these currentassets may be financed by the current liabilities also. E.g. some raw material may be 11
  12. 12. available on credit basis, all the expenses need not be paid immediately, workers are alsoto be paid periodically etc. But still the amounts required to be invested in these currentassets is always higher than the funds available from current liabilities. This is precisereason why the needs for working capital arise. From the Financial management point ofview, the nature of fixed assets and current assets differ from each other1. The fixed assets are required to be retained in the business over a period of time andthey yield the returns over their life, whereas the current assets loose their identity over ashort period of time, say one year.2. In the case of current assets, it is always necessary to strike a proper balance betweenthe liquidity and profitability principles, which is not the case with fixed assets. E.g. Ifthe size of current assets is large, it is always beneficial from the liquidity point of viewas it ensures smooth and fluent business operations. Sufficient raw material is alwaysavailable to cater to the production needs, sufficient finished goods are available to caterto any kind of demand of customers, liberal credit period can be offered to the customersto improve the sales and sufficient cash is available to pay off the creditors and so on.However, if the investment in current assets is more than what is ideally required, itaffects the profitability, as it may not be able to yield sufficient rate of return oninvestment. On the other hand, if the size of current assets is too small, it always involvesthe risk of frequent stock out, inability of the company to pay its dues in time etc. Assuch, the investment in current assets should be optimum. Hence, it is necessary tomanage the individual components of current assets in a proper way. Thus, workingcapital management refers to proper administration of all aspects of current assets and 12
  13. 13. current liabilities. Working Capital Management is concerned with the problems arisingout of the attempts to manage current assets, current liabilities and inter-relationshipbetween them. The intention is not to maximize the investment in working capital nor isit to minimize the same. The intention is to have optimum investment in working capital.In other words, it can be said that the aim of working capital management is to haveminimum investment in working capital without affecting the regular and smooth flow ofoperations. The level of current assets to be maintained should be sufficient enough tocover its current liabilities with a reasonable margin of safety. Moreover, the varioussources available for financing working capital requirements should be properly managedto ensure that they are obtained and utilized in the best possible manner. 13
  14. 14. FACTORS AFFECTING WORKING CAPITAL MANAGEMENTThe amount of working capital required depends upon a number of factors which can bestated as belowNature of Business:Some businesses are such, due to their very nature, that their requirement of fixed capitalis more rather than working capital. These businesses sell services and not thecommodities and not the commodities and that too on cash basis. As such, no funds areblocked in piling inventories and also no funds are blocked in receivables. E.g. Publicutility services like railways, electricity boards, infrastructure oriented projects etc. Theirrequirement of working capital is less. On the other hand, there are some business liketrading activity, where the requirement of fixed capital is less but more money is blockedin inventories and debtors. Their requirement of the working capital is more.Length of Production Cycle:In some business like machine tool industry, the time gap between the acquisitions ofraw material till the end of final production of finished product itself is quite high. Assuch more amounts may be blocked either in raw materials, or work in progress orfinished goods or even in debtors. Naturally, their needs of working capital are higher.On the other hand, if the production cycle is shorter, the requirement of working capital isalso less. 14
  15. 15. Size and Growth of Business:In very small companies the working capital requirements are quite high overheads,higher buying and selling costs etc. As such, the medium sized companies positively havean edge over the small companies. But if the business starts growing after a certain limit,the working capital requirements may be adversely affected by the increasing size.Business I Trade Cycles:If the company is operating in the period of boom, the working capital requirements maybe more as the company may like to buy more raw material, may increase the productionand sales to take the benefits of favourable markets, due to the increased sales, there maybe more and more amount of funds blocked in stock and debtors etc. Similarly, in case ofdepression also, the working capital requirements may be high as the sales in terms ofvalue and quantity may be reducing, there may be unnecessary piling up of stockswithout getting sold, the receivables may not be recovered in time etc.Terms of Purchase and Sales:Sometimes, due to competition or custom, it may be necessary for the company to extendmore and more credit to the customers, as a result of which more and more amounts islocked up in debtors or bills receivables which increase working capital requirements. Onthe other hand, in case of purchases, if credit is offered by the suppliers of goods andservices, a part of working capital requirement may be financed by them, but if it isnecessary to purchase these goods or services on cash basis, the working capitalrequirement will be higher. 15
  16. 16. Profitability:The profitability of the business may vary in each and every individual case, which in itsturn may depend upon numerous factors. But high profitability will positively reduce thestrain on working capital requirements of the company, because the profits to the extentthat they are earned in cash may be used to meet the working capital requirements of thecompany. However, profitability has to be considered from one more angles so that it canbe considered as one of the ways in which strain on working capital requirements of thecompany may be relieved. And these angles are:Taxation Policy:How much is required to be paid by the company towards its tax liability?Dividend Policy:How much of the profits earned by the company are distributed by way of dividend?Effect of Inflation on Working Capital Requirement:The phase of inflation can be identified with the situation of increasing price levels,increasing demand and increasing supply. As such, the working capital requirementsmultiply during the phase of inflation due to increasing cost of production and increasinglevel of sales turnover. However, in order to control the increasing demand for workingcapital during the period of inflation, the following measures may be applied.Possibility of using cheaper substitute raw material, without affecting the quality, shouldbe explored. For this purpose, research activities may be conducted. Attempts should be 16
  17. 17. made to reduce the production costs to maximum possible extent. For this purpose, thetechniques like time and motion study, incentive schemes, cost reduction programmesetc. may be implemented. Attempts should be made to reduce the operating cycle to themaximum possible extent. Aiming at greater turnover at short intervals will go a longway to reduce the stress on working capital requirements. Attempts should be made toreduce the locked up working capital in non-moving or obsolete inventories. A clear-cutpolicy should be formulated and followed for timely disposal of non- moving andobsolete inventories. Similarly, efficient management information system should bedeveloped to reflect the position of inventory from the various angles. Attempts should bemade to reduce the amount looked up in receivables. Quicker realization of debts will goa long way to reduce the stress on working capital requirements. Attempts should bemade to make the payments of to creditors in time. This helps the business to build upgood reputation and increases its bargaining power with respect to period of credit ofcredit for payment and other conditions.Attempts should be made to match the projected cash inflows and projected cashoutflows. If they do not match, some of the payments should be postponed or purchasesof certain avoidable items should be deferred. Estimation of Working CapitalRequirements: First of all estimates of all current assets should be made. These currentassets may include stock, debtors. Cash/Bank balance prepaid expenses etc.Difference between the estimated current assets and current liabilities will represent theworking capital requirements. To this sometime a standard percentage may be added totake care of the contingencies. This technique is known as Cash Cost technique of 17
  18. 18. estimating of working capital requirements. There is another technique available forestimating working capital requirements also and that is in the form of Balance SheetMethod. In this the forecast is made of various assets and liabilities, the differencebetween assets and liabilities indicating either the surplus or deficiency of cash. There arevarious methods available for financing the working capital requirements:Flied or Permanent or Core Working Capital:This indicates the amount of minimum working capital, which is required to bemaintained by every business at any point of time, in order to carry on the business onpermanent and uninterrupted basis.Variable or Temporary Working Capital:This indicates that amount of working capital required by the business which is over andabove fixed or permanent or core working capital. This need of the working capital mayvary depending upon the fluctuations in demand as a result of changes in production orsales.As far as financing of the fixed or permanent needs of working capital are concerned,these needs should be met out of the long term sources of funds, Own generation offunds, out of the profits earned, shares or debentures.As far as financing of the variable or temporary needs of working capital are concerned,these needs can be met from the various sources:1. A part of these needs may be financed by way of the credits available from thesuppliers of material or services and of delayed payment of expenses. 18
  19. 19. 2. A part of these needs may be financed by way of long term sources of funds in theform of own generation of funds, out of profits earned shares, debentures and other longterm borrowings, public deposits etc.3. A part of these needs may be financed by way of long term sources of funds in theform of own generation of funds, out of profits earned, shares, debentures and other longterm borrowing.4. A major portion of these working capital needs are financed by the Banks. Infinancing the working capital needs of the business, the credit obtained from Banks playsa very important role.Bank Credit as a Source of Meeting Working Capital Requirements:While bank credit is considered as a major source of meeting the working capitalrequirement of the industry, the banks have to consider the following factors beforemeeting their requirements.A].What should be the amount of working capital assistance?B].What should be the form in which working capital assistance may be extended?C].What should be the security that should be obtained for extending the working capitalassistance? 19
  20. 20. Amount of Assistance:To obtain the bank credit for meeting the working capital requirements, the company willbe required to estimate the working capital requirements and will be required to approachthe banks along with the necessary supporting data. On the basis of the estimatessubmitted by the company, the bank may decide the amount of assistance which may beextended, after considering the margin requirements. This margin is to provide thecushion against the reduction in the value of security. If the company fails to fulfill itsobligations, the bank may be required to realize the security for recovering the dues.Margin money is meant to take care of the possible reduction in the value of security. Thepercentage of margin money may depend upon the credit standing of the company,fluctuations in the price of security or the directives of Reserve Bank of India from timeto time.Form of Assistance:After deciding the amount of overall assistance to be extended to the company, the bankcan disburse the amount in any of the following formsNon-Fund Based LendingFund Based Lending 20
  21. 21. Non-Fund Based LendingIn case of Non-Fund Based Lending, the lending bank does not commit any physicaloutflow of funds. As such, the funds position of the lending bank remains intact. TheNon-Fund Based Lending can be made by the banks in two forms-a. Bank Guarantee:Suppose Company A is the selling company and Company B is the purchasing company.Company A does not know Company B and as such is concerned whether Company Bwill make the payment or not. In such circumstances, D who is the Bank of Company B,opens the Bank Guarantee in favour of Company A in which it undertakes to make thepayment to Company A if Company B fails to honour its commitment to make thepayment in future. As such, interests of Company A are protected as it is assured to getthe payment, either from Company B or from its Bank D. As such, Bank Guarantee is themode which will be found typically in the seller’s market. As far as Bank D is concerned,while issuing the guarantee in favour of Company A, it does not commit any outflow offunds. As such, it is a Non-Fund Based Lending for Bank D. If on due date, Bank D isrequired to make the payment to Company A due to failure on account of Company B tomake the payment, this Non-Fund Based Lending becomes the Fund Based Lending forBank D which can be recovered by Bank D from Company B. For issuing the BankGuarantee, Bank D charges the Bank Guarantee Commission from Company B whichgets decided on the basis of two factors-what is the amount of Bank Guarantee and whatis the period of validity of Bank Guarantee. In case of this conventional for of BankGuarantee, both company A as well as Company B get benefited as it is able to make the 21
  22. 22. credit purchases from Company A without knowing Company A. As such, BankGuarantee transactions will be applicable in case of credit transactions.In some cases, interests of purchasing company are also to be protected. Suppose thatCompany A which manufactures capital goods takes some advance from the purchasingCompany B. If Company A fails to fulfill its part of contract to supply the capital goodsto Company B, their needs to be to be some protection available to Company B. In suchcircumstances, Bank C which is the banker of Company A opens a Bank Guarantee inFavour of Company B in which it undertakes that if Company A fails to fulfill its part ofthe contract, it will reimburse any losses incurred by Company B due to this nonfulfillment of contractual obligations. Such Bank Guarantee is technically referred to asperformance Bank Guarantee and it ideally found in the buyer’s market.b. Letter of Credit:The non-fund based lending in the form of letter of credit is very regularly found in theinternational trade. In case the exporter and the importer are unknown to each other.Under these circumstances, exporter is worried about getting the payment from theimporter and importer is worried as to whether he will get the goods or not. In this case,the importer applies to his bank in his country to open a letter of credit in favour of theexporter whereby the importer’s bank undertakes to pay the exporter or accept the bills ordrafts drawn by the exporter on the exporter fulfilling the terms and conditions specifiedin the letter of credit. 22
  23. 23. Fund Based LendingIn case of Fund Based Lending, the lending bank commits the physical outflow of funds.As such, the funds position of the lending bank gets affected. The Fund Based Lendingcan be made by the banks in the following forms-Loan: -In this case, the entire amount of assistance is disbursed at one time only, either in cash orby transfer to the company’s account. It is a single advance. The loan may be repaid ininstalments, the interests will be charged on outstanding balance.Overdraft: - In this case, the company is allowed to withdraw in excess of the balancestanding in its Bank account. However, a fixed limit is stipulated by the Bank beyondwhich the company will not be able to overdraw the account. Legally, overdraft is ademand assistance given by the bank i.e. bank can ask for the repayment at any point oftime. However in practice, it is in the form of continuous types of assistance due toannual renewal of the limit. Interest is payable on the actual amount drawn and iscalculated on daily product basis.Cash Credit: -In practice, the operations in cash credit facility are similar to those of overdraft facilityexcept the fact that the company need not have a formal current account. Here also afixed limit is stipulated beyond which the company is not able to withdraw the amount.Legally, cash credit is a demand facility, but in practice, it is on continuous basis. Theinterests is payable on actual amount drawn and is calculated on daily product basis. 23
  24. 24. Bills purchased or discounted: -This form of assistance is comparatively of recent origin. This facility enables thecompany to get the immediate payment against the credit bills raised by the company.The bank holds the bill as a security till the payment is made by the customer. The entireamount of bill is not paid to the company. The Company gets only the present worth ofthe amount of bill, the difference between the face value of the bill and the amount ofassistance being in the form of discount charges. On maturity, bank collects the fullamount of bill from the customer. While granting this facility to the company, the bankinevitably satisfies itself about the credit worthiness of the customer. A fixed limit isstipulated in case of the company, beyond which the bills are not purchased or discountedby the bank.Working Capital Term Loans: -To meet the working capital needs of the company, banks may grant the working capitalterm loans for a period of 3 to 7 years, payable in yearly or half yearly installments.Packing Credit: -This type of assistance may be considered by the bank to take care of specific needs ofthe company when it receives some export order. Packing credit is a facility given by thebank to enable the company to buy the goods to be exported. If the company holds aconfirmed export order placed by the overseas buyer or a letter of credit in its favour, itcan approach the bank for packing credit facility. 24
  25. 25. Operating cycle: The time between purchase of inventory items (raw material or merchandise) andtheir conversion into cash is known as operating cycle or working capital cycle. Thelonger the period of conversion the longer will be the period of operating cycle. Astandard operating cycle may be for any time period but does not generally exceed afinancial year. Obviously, the shorter the operating cycle larger will be the turnover of thefund invested for various purposes. The channels of investment are called current assets. 25
  26. 26. OPERATING CYCLE Cash Purchase of Receipt from raw material, debtors componentsCreation of Creation ofreceivables A/c payable (Debtors) (Creditors) Payments toSales of creditorsFinished Goods Manufacturing Warehousing operation: wages & of Finished salaries, fuel, Goods power, etc Office, selling, distribution and other expenses 26
  27. 27. WORKING CAPITAL FINANCE A manufacturing concern needs finance not only for acquisition of fixed assetsbut also for its day-to-day operations. It has to obtain raw materials for processing, paywage bills & other manufacturing expenses, store finished goods for marketing & grantcredit to the customers. It may have to pass through the following stages to complete itsoperating cycle- i. Conversion of cash into raw materials – raw material procured on credit, cash may have to be paid after a certain period. ii. Conversion of raw materials into stock in process. iii. Conversion of stock in process into finished goods. iv. Conversion of finished goods into receivables/debtors or cash. v. Conversion of receivables/debtors into cash. A non-manufacturing trading concern may not require raw material for theirprocessing, but it also needs finance for storing goods & providing credit to its customers.Similarly a concern engaged in providing services, it may not have to keep inventoriesbut it may have to provide credit facility to its customers. Thus all enterprises engaged inmanufacturing or trading or providing services require finance for their day-to-dayoperations, the amount required to finance day-to-day operation is called working capital& the assets & liabilities are created during the operating cycle are called current assets &current liabilities. The total of all the current assets is called gross working capital & theexcess of current assets over current liabilities is called net working capital. 27
  28. 28. When entrepreneurs for financing working capital requirements approach thebanks, the bank has to examine the viability of the project before agreeing to provideworking capital for it. Financial institutions & bank while providing term loan finance tounit for acquisition of fixed assets does a detailed viability study. They have to ensurethat the project will generate sufficient return on the resources invested in it. The viabilityof a project depends on technical feasibility, marketability of the products, at a profitableprice, availability of financial resources in time & proper management of the unit. In briefthe project should satisfy the tests of technical, commercial, financial & managerialfeasibility. Proper co-ordination amongst banks & financial institution is necessary to judgethe viability of a project & to provide working capital at appropriate time without anydelay. If a unit approaches banks only for working capital requirement & no viabilitystudy has been done earlier which is done at the time of providing term loans, a detailedviability study is necessary before agreeing to provide working capital finance. In the view of scarcity of bank credit, its increasing demand from various sectorsof economy & its importance in the development of economy, bank should provideworking capital finance according to production requirements. Therefore it is necessaryto make a proper assessment of total requirement of the working capital, which dependson the nature of the activities of an enterprise & the duration of its operating cycle. It hasto be ensured that the unit will have regular supply of raw material to facilitateuninterrupted production. The unit should be able to maintain adequate stock of finishedgoods for smooth sales operation. The requirement of trade credit, facilities to be givenby the unit to its customers should also be assessed on the basis of practice prevailing in 28
  29. 29. the particular industry/trade which assessing above requirements, it should also beensured that carrying cost of inventories & duration of credit to customers are minimized.After assessing the total requirement of working capital, a part of working capitalrequirement should be financed for the long term & partly by determining maximumpermissible bank finance. 29
  30. 30. ASSESSMENT OF WORKING CAPITAL A unit needs working capital funds mainly to carry current assets required for its operations. Proper assessment of funds required for working capital is essential not only in the interest of the concerned unit but also in the national interest to use the scare credit according to production requirements. Inadequate levels of working capital may result in under-utilization of capacity and serious financial difficulties. Similarly excessive levels may lead to unproductive use of credit and unnecessary interest Burdon on the unit. Proper assessment of working capital requirement may be done as under-I. Norms for inventory and receivables: If the bank credit is to be linked with production requirements, it is necessary to assess the requirements on the basis of certain norms. The ‘study group to frame guidelines to follow-up of bank credit’ (Tandon Study Group) appointed by Reserve Bank of India had suggested the norms for inventory and receivables regarding 1: major industries on the basis of company finance studies made by Reserve Bank process periods in the different industries, discussions with the industry experts and feed-back received on the interim report. The norms suggested by Tandon Study Group are being reviewed from time to time by the Committee of Direction constituted by the Reserve Bank to keep a constant view on working capital requirements. The committee has representatives from a few banks and it generally once in a quarter. It also consults the representatives from industry and trade. It keeps a watch on the various issues relating to working 30
  31. 31. capital requirements and gives various suggestions to suit the changing requirements of the industry and trade. Banks make their own assessment of credit requirements of borrowers based on a total study of borrowers’ business operations and they can also decide the levels of holding each item of inventory as also of receivables which in their view would represent a reasonable built up of current assets for being supported by banks’ finance. Banks may also consider suitable internal guidelines for accepting the projections made by the borrowers regarding sundry creditors as sundry creditors are taken as a source of financing current assets (inventories, receivables, etc.), it is necessary to project them correctly while calculating need of bank finance for working capital requirements.II. Computation of Maximum Permissible Bank Finance (MPBF): The Tandon Study group had suggested the following alternatives for working out the maximum permissible bank finance:- a. Bank can work out the working capital gap. i. e. total current assets less current liabilities other than bank borrowings 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 b. Borrower should provide for a minimum of 25 per cent of total current assets out of long-term funds, i.e. owned funds and long term borrowings. A certain level of credit for purchases and other current liabilities inclusive of bank borrowings will not exceed 75 per cent of current assets. 31
  32. 32. It may be observed from the above that borrower’s contribution from long termfunds would be 25 per cent of the working capital gap under the first method of lendingand 25 per cent of total current assets under the second method of lending. The aboveminimum contribution of long-term funds is called minimum stipulated Net WorkingCapital (NWC) which comes from owned funds and term borrowings. Above two method of lending may be illustrated by taking the following example ofa borrower’s financial position, projected as at the end of next year. Current Liabilities Amt Current Assets AmtCreditors for purchase 200 Raw materials 380Other current liabilities 100 Stock in process 40 300 Finished goods 180Bank borrowing, including bills 400 Receivables, including bills 110discounted with bankers discounted with bankers Other current assets 30 700 740 32
  33. 33. First method Second methodTotal current assets 740 total current assets 740Less: current liabilities 25% of above from long termOther than bank borrowings 300 sources 185Working capital gap 440 55525% of above from long term less: current liabilitiesSources 110 Other than bank borrowings 300Maximum permissible bank 330 Maximum permissible bank 255Finance financeExcess Bank borrowings 70 Excess Bank borrowings 145Current ratio 1.17:1 Current ratio 1.33:1 It may be observed from the above that in the first method, the borrower has toprovide a minimum of 25 per cent of working capital gap from ling-term funds and itgives a minimum current ratio 1.17:1. In the second method, the borrower has to providea minimum of 25 per cent of total current assets from long-term funds and gives aminimum current ratio of 1.33:1. While estimating the total requirement of long-term funds for new projects,financial institutions/banks should calculate for working capital on the basis of normsprescribed for inventory and receivables and by applying the second method of lending.A project may suffer from shortage of working capital funds if sufficient margin forworking capital is not provided as per the second method of lending while funding newprojects. Proper co-ordination between banks & financial institutions is necessary toensure availability of sufficient working capital finance to meet the productionrequirement. 33
  34. 34. III. Classification of current assets & Current liabilities: In order to calculate net working capital & maximum permissible bank finance, it is necessary to have proper classification of various items of current assets & current liabilities. All illustrative lists of current assets & current liabilities for the purpose of assessment of working capital are furnished below; Current assets: - a. Cash and bank balances b. Investments c. Receivables arising out of sales other than deferred receivables (including bills purchased & discounted by bankers) d. Installments by deferred receivables due within one year e. Raw materials & components used in the process of manufactured including those in transit f. Stock in process including semi finished goods g. Finished goods including goods in transit h. Other consumable spares i. Advance payment for tax j. Prepaid expenses k. Advances for purchases of raw materials, components & consumable stores l. Payment to be received from contracted sale of fixed assets during the next 12 months 34
  35. 35. Current Liabilities: a. Short-term borrowings (including bills purchased & discounted) from Banks and ii. Others b. Unsecured loans c. Public deposits maturing within one year d. Sundry creditors (trade) for raw material & consumer stores & spares e. Interest & other charges accrued but no due for payments f. Advances/progress payments from customers g. Deposits from dealers selling agents, etc. h. Statutory liabilities Provident fund dues Provision for taxation Sales-tax, excise, etc. Obligation towards workers considered as statutory i. Miscellaneous current liabilities Dividends Liabilities for expenses Gratuity payable within one year Any other payments due within one year 35
  36. 36. Notes on classification of Current Assets & Current Liabilities: 1. Investment in shares, debenture, etc. and advances to other firms/companies, not connected with the business of the borrowing firm, should be excluded from current assets. Similarly investment made in units of Unit Trust of India & other mutual funds & in associate companies/subsidiaries, as well as investment made and/or loans extended as inter-corporate deposits should not be included in the build-up of current assets while assessing maximum permissible bank finance. 2. The borrowers are not expected to make the required contribution of 25 per cent from long-term sources in respect of export receivables. Therefore, export receivables may be included in the total current assets for arriving at the maximum permissible bank finance but the minimum stipulated net working capital may be reckoned after excluding the quantum of export receivables from the total current assets. 3. ‘Dead inventory’ i.e. slow moving or obsolete items should not be classified as current assets. 4. Security deposits/tender deposits given by borrower should be classified as non- current assets irrespective of whether they mature within the normal operating cycle of one year or not. 5. Advances/progress payments from customer should be classified as current liabilities. However, where a part of advances received is required by government regulations to be invested in certain approved securities, the benefit of netting may be allowed to the extent of such investment and the balance may be classified as current liability. 36
  37. 37. 6. Deposits from dealers, selling agents, etc. received by the borrower may treated as term liabilities irrespective of their tenure if such deposits are accepted to be repayable only when the dealership/agency is terminated. The deposits, which do not fulfill the above condition, should be classified as current liabilities.7. Disputed liabilities in respect of income tax, excise, custom duty and electricity charges need not be treated as current liabilities except to the extent of provided for in the books of the borrower. Where such disputed liabilities are treated as contingent liabilities for period beyond one year, the borrower should be advised to make adequate provision so that he may be in a position to meet the liabilities as & when they accrue.8. If disputed excise liability has been shown as contingent liability or by way of notes to the balance sheet, it need not be treated as current liability for calculating the permissible bank finance unless it has been collected or provided for in the accounts of borrowers. A certificate from the Statutory Auditors of the borrowers may be obtained regarding the amount collected from the customers in respect of disputed excise liability or provision made in the borrowers’ accounts. The amount of excise duty payable should be treated as current liability for the purpose of working out the permissible limit of the bank finance strictly on the basis of the certificate from the borrowers’ Statutory Auditors. The same principle may also be applied for disputed sales tax dues.9. In case of other statutory dues, dividends, etc., estimated amount payable within one year should be shown as current liabilities even if specific provisions have not been made for their payment. 37
  38. 38. 10. As per the instructions issued by the Reserve Bank in October, 1993, the entire term loan investment falling due for payment in the next twelve months need not be treated as an item of current liabilities for the purpose of arriving at MPBF. However all overdue term loan should be treated as current liabilities unless the loan has been rescheduled by the financial institutions/banks. It may be added that the entire amount of term loan installments payable within the next twelve months which is kept outside the current liabilities while calculating MPBF. Need not be taken into account while computing net working capital (NWC). However the entire amount of term loan installments due within the next twelve months should continue to be treated as current liability for the purpose of calculating the current ratio.IV. Information/Data required for assessment of working capital: In order to assess the requirements of working capital on the basis of production needs, it is necessary to get the data from the borrowers regarding their past/projected production, sales, cost of production, cost of sales, operating profit, etc. in order to ascertain the financial position of the borrowers & the amount of working capital needs to be financed by banks, it is necessary to call for the data from the borrowers regarding their net worth, long term liabilities, current liabilities, fixed assets, current assets, etc. the Reserve Bank prescribed the forms in 1975 to submit the necessary details regarding the assessment of working capital under its credit authorization scheme. The scheme of credit authorization was changed into credit monitoring arrangement in 38
  39. 39. 1988. The forms used under the credit authorization scheme for submitting necessaryinformation have also been simplified in 1991 for reporting the credit sanctioned bybanks above the cut-off point to reserve bank under its scheme of credit monitoringarrangement. As the traders and merchant exporters who do not have manufacturing activitiesare not required to submit the data regarding raw materials, consumable stores, goods-in-process, power and fuel, etc., a separate set of forms has been designed for tradersand merchant exporters. In view of the peculiar nature of leasing and the hire purchaseconcerns, a separate set of forms has also designed for them. In addition to the information/data in the prescribed forms, bank may also call foradditional information required by them depending on the nature of the borrowers’activities & their financial position. The data is collected from the borrowers in thefollowing six forms: - 1. Particulars of the existing/proposed limits from the banking system (form I) Particulars of the existing credit from the entire banking system as also the term loan facilities availed of from the term lending institutions/banks are furnished in this form. Maximum & minimum utilization of the limits during the last 12 months outstanding balances as on a recent date are also given so that a comparison can be made with the limits now requested & the limits actually utilized during the last 12 months. 39
  40. 40. 2. Operating Statement (Form II) The data relating to last sales, net sales, cost of raw material, power & fuel, directlabour, depreciation, selling, general expenses, interest, etc. are furnished in this form.It also covers information on operating profit & net profit after deducting totalexpenditure from total sale proceeds.3. Analysis of Balance Sheet (Form III) A complete analysis various items of last year’s balance sheet, current year’sestimate & following year’s projections is given, in this form. The details of currentliabilities, term liabilities, net worth, current assets, other non-current assets, etc. aregiven in this form as per the classification accepted by banks.4. Comparative statement of current assets & current liabilities (Form IV) This form gives the details of various items of current assets and current liabilitiesas per classification accepted by banks. The figures given in this form should tallywith the figures given in the form III where details of all the liabilities & assets aregiven. In case of inventory, receivables and sundry creditors; the holding/levels aregiven not only in absolute amount but also in terms of number of month so that acomparative study may be done with prescribed norms/past trends. They are indicatedin terms of numbers of months in bracket below their amounts. 40
  41. 41. 5. Computation of Maximum Permissible Bank Finance (Form V) On the basis of details of current assets & liabilities given in form IV, Maximum Permissible Bank Finance is calculated in this form to find out credit limits to be allowed to the borrowers. 6. Fund Flow Statement (Form VI) In this form, fund flow of long term sources & uses is given to indicate whether long term funds are sufficient for meeting the long term requirements. In addition to long term sources and uses, increase/decrease in current assets is also indicated in this form.V. Check list for verification of the information/data: Bank should verify not only the arithmetical accuracy of the data furnished by the borrowers but also the logic behind various assumptions based on which the projections have been made. For this purpose, bank officials should hold discussions with the borrowers on projected sales, level of operations, level of inventory, receivables, etc. if necessary, a visit to the factory may also be made to have a clear idea of products and processes. 41
  42. 42. ASSESSEMENT OF OTHER LIMITSLETTER OF CREDITThe banker examines the proposal of the letter of credit from two angles: o The cases where letter of credit is required once only o The cases where letter of credit is required once regularly.In the second category it is convenient for the banker to fix the separate limit of the letterof credit. 42
  43. 43. ASSESSEMENT OF THE LIMITS UNDER LETTER OF CREDIT-WITH LEADTIMEThe buyer does not receive the goods immediately on the placement of the order on theseller. There is always long time log between the order placement and the receipt of thematerial. This period is also referred to as the lead-time.Example: -If it is assumed that the total raw material requirement is Rs.240lacs per annum and thenormal lead time is 2 months, the buyer will be required to place order so that he has atleast 2 months stock (ignoring safely level). Thus, the total number of order placed wouldbe 6 per year and the value of per order would be Rs.40 Lacs. This is shown belowAssessment of the limits under LC- with lead-timeAnnual requirement of raw material 240 LacsNormal lead time 2 monthsValue per order (A) 240/6=Rs.40 LacsMargin for customer @20%(B) Rs 8 LacsLimits under letter of credit (A-B) Rs 32 Lacs 43
  44. 44. Assessment of the limits under letter of credit-without lead-timeAnnual requirement of raw material 240 lacsMonthly requirement of raw material 240/12 months =20 lacsNormal inventory level (1 month) Rs 20 lacsValue per order (A) Rs 20 lacsMargin for customer @ 20% (B) Rs 4 lacsLimits under letter of credit (A-B) Rs 16 lacsBANK GUARANTEESThere is no standard formula for assessment of bank guarantee limit. The detailspertaining to nature of guarantees, particulars of the contract, period for which theguarantee is sought and the amount of guarantee to be obtained, this information alongwith the view on the creditworthiness of the borrower and relationship with the bankcomprise the major input towards deciding the sanction of limits required by borrower.Appropriate conditions regarding cash margin and securities have to be laid down toprotect the interest of the bank.. 44
  45. 45. PROCEDURE FOR WORKING CAPITAL FINANCECREDIT SANCTION PROCESSThe revised credit process is introduced with a view of reducing the time lag in thesanction of credit besides clearly delineating the areas of responsibilities of variousfunctionaries. As per this the revised process is divide into two components that is Presanctioning and Post sanctioningIn the pre sanctioning it is the only time that the bank can take due assessment andprecautions to make sure that the investments are done for the benefit of the bank. Thepost sanctioning is the follow of the payment. Incase the payment defaults then theaccount will go into NPA in stages and the bank is then said to scrutinize the saidaccount.PRE SANCTION PROCESS: -Obtain loan applicationWhen a customer required loan he is required to complete application form and submitthe same to the bank also the borrower has to be submit the required information alongwith the application form. 45
  46. 46. PRE SANCTION PROCESS APPRAISAL & SANCTIONING RECOMMANDATION ASSESSMENTThe information, which is generally required to be submitted by the borrower along withthe loan application, is under: - • Audited balance sheets and profit and loss accounts for the previous three year(in case borrower already in the business) • Estimated balance sheet for current year. • Projected balance sheet for next year. • Profile for promoters/directors, senior management personnel of the company. • In case the amount of loan required by borrower is 50 lacs and above he should be submit the CMA Report 46
  47. 47. Examine for preliminary appraisalRBI guidelines. PoliciesPrudential exposure norms and bank lending policyIndustry exposure restriction and related risk factors.Compliance regarding transfer of borrowers accounts from one bank toanother bankGovernment regulation / legislation impact on the industryAcceptability of the promoter and applicant status with regards to otherunit to industries.Arrive at the preliminary decision.Examine/analysis /assessmentFinancial statement (in the prescribed forms) refers figure WC cycle & BSassessment thumb rules.Financial ratio & Dividend policy.Depreciation methodRevaluation of fixed assets.Records of defaults (Tax, dues etc.)Pending suits having financial implication (Customs, excise etc.)Qualifications to balance sheet auditors remarks etc.Trend in sales and profitability and estimates /projection of sales.Production capacities and utilization: past & projected productionefficiency and cost. 47
  48. 48. Estimated working capital gap W.R.T acceptable buildup of inventory/receivables/other current assets and bank borrowing patterns. Assess MPBF –determine facilities required Assess requirement of off balance sheet facilities viz.L/cs,B/gs etc. Management quality, competence, track records Company’s structure and system Market shares of the units under comparison. Unique feature Profitability factors Inventory/Receivable level Capacity utilization Capital market perception.POST SANCTION PROCESSSupervision and follow up: -Sanction credit limit of working capital requirement after proper assessment of proposalis alone not sufficient. Close supervision and follow up are equally essential for safety ofbank credit and to ensure utilization of fund lend. A timely action is possible only closesupervision and followed up by using following techniques. o Monthly stock statement o Inspection of stock o Scrutiny of operation in the account 48
  49. 49. o Quarterly/half quarterly statements.o Under information systemo Annual audited report POST SANCTION PROCESS FOLLOW UP MONITORING & CONTROL SUPERVISION 49
  50. 50. CREDIT MONITORING ARRANGEMENTConsequent upon the withdrawal of requirement of prior authorization under theerstwhile credit authorization scheme (CAS) and introduction of a system of postsanction scrutiny under credit monitoring arrangement (CMA) the database forms havebeen recognized as CMA database. The revised forms for CMA database as drawn up bythe sub-committee of committee of directions have come into use from 1st April 1991.The existing forms prescribed for specified industries continue to remain in force. With aview to imparting uniformity to the appraisal system, database from all borrowersincluding SSI units enjoying working capital limits of Rs. 50 lacs and more from thebanking system should be obtained.The revised sets of forms have been separately prescribed for industrial borrowers andtraders/merchant exporters. The details of forms are as under: -Form 1: - particulars of the existing/proposed limit from the banking system.Form 2: -Operating statement.It contains data relating to gross sales, net sales, cost of raw material, power and fuel, etc.It gives the operating profit and the net profit figures.Form 3 : - Analysis of balance sheet.It is complete analysis of various items of last years balance sheet; current years estimateand following years projection are given in this form. 50
  51. 51. Form 4 : - Comparative statement of current asset and liabilities.Details of various items of current asset and current liabilities are given.The figures in this form must tally with those in form III.Form 5: - Computation of maximum permissible bank finance for working capital.The calculation of MPBF is done in this form to obtain the fund based credit limits to begranted to the borrower.Form 6: - Fund flow statementIt provides the details of fund flow from long term sources and uses to indicate weatherthey are sufficient to meet the borrowers long term requirements.CREDIT RATING MODELThe various risk faced by any company may be broadly classified as follows:Industry Risk: It covers the industry characteristic, compensation, financial data etc.Company/ business risk: It considers the market position, operating efficiency of thecompany etc.Project risk: It includes the project cost, project implementation risk, post projectimplementation etc. 51
  52. 52. Management risk: It covers the track record of the company, their attitude towards risk,propensity for group transaction, corporate governance etc.Financial risk: financial risk includes the quality of financial statements, ability of thecompany to raise capital, cash flow adequacy etc.DRAWING POWER OF THE BORROWERThe drawing power that a borrower enjoys at any one point depends on each componentsof working capital. The bank for each component, which the borrower must hold as hiscontribution to finance working capital, prescribes margins. The drawing power of theborrower can be best explained with the following illustrationIllustration:Suppose a borrower has Rs 100.00 lacs as working capital limit sanctioned to him by abank.The security provided by the borrower to the bank is the hypothecation of inventory.Suppose, the borrower needs to hold an inventory level of say 130 lacs in order to enjoyRs 100 lacs as his working capital limit.The actual level of inventory with the borrower at a point is say 110 lacs.The inventory margin prescribed by the bank is say 25 %Therefore with this inventory level, the borrower enjoys only Rs 82.5 lacs as his workingcapital limit as against Rs 100 lacs. 52
  53. 53. Inventory level (Required) Rs 130 lacsDrawing power of borrower Rs 100 lacsInventory level (Actual) Rs 110 lacsMargin prescribed by bank 25 %Drawing power of borrower 110-(0.25× 110) = Rs 82.5 lacsSuppose, the borrower holds Rs 150 lacs of inventory,Inventory level (required) Rs 150 lacsDrawing power of borrower Rs 100 lacsInventory level (actual) Rs 150 lacsMargin prescribed by bank 25 %Drawing power of borrower 150 − (0.25 × 150) = Rs. 112.2 lacsTherefore, in this case the borrower would still enjoy Rs 100 lacs as his working capitallimits as against Rs 112.5 lacs.Therefore, the lower of the two is always considered as the working capital limit or thedrawing power of the borrower sanctioned by the bank. 53
  54. 54. SECURITYBanks need some security from the borrowers against the credit facilities extended tothem to avoid any kind of losses. securities can be created in various ways. Banksprovide credit on the basis of the following modes of security from the borrowers.Hypothecation: under this mode of security, the banks provide credit to borrowersagainst the security of movable property, usually inventory of goods. The goodshypothecated, however, continue to be in possession of the owner of the goods i.e. theborrower. The rights of the banks depend upon the terms of the contract betweenborrowers and the lender. Although the bank does not have the physical possession of thegoods, it has the legal right to sell the goods to realize the outstanding loans.Hypothecation facility is normally not available to new borrowers.Mortgage: It is the transfer f a legal / equitable interest in specific immovable propertyfor securing the payment of debt. It is the conveyance of interest in the mortgagedproperty. This interest terminated as soon as the debt is paid. Mortgages are taken as anadditional security for working capital credit by banks. 54
  55. 55. Pledge: The goods which are offered as security, are transferred to the physicalpossession of the lender. An essential prerequisite of pledge is that the goods are in thecustody of the bank. Pledge creates some kind of liability for the bank in the sense that‘Reasonable care’ means care, which a prudent person would take to protect his property.In case of non-payment by the borrower, the bank has the right to sell the goods.Lien: The term lien refers to the right of a party to retained goods belonging to otherparty until a debt due to him is paid. Lien can be of two types viz. Particular lien i.e. Aright to retain goods until a claim pertaining to these goods are fully paid, and Generallien, Which is applied till all dues of the claimant are paid. Banks usually enjoyed generallien. 55
  56. 56. BANKING ARRANGEMENTSWorking capital is made available to the borrower under the following arrangements;CONSORTIUM BANKING ARRANGEMENT:RBI till 1997 made it obligatory for availing working capital facilities beyond a limit (Rs500 million in 1997), through the consortium arrangement. The objective of thearrangement was to jointly meet the financial requirement of big projects by banks andalso share the risks involved in it.While it consortium arrangement is no longer obligatory, some borrowers continue toavail working capital finance under this arrangement. The main features of thisarrangement are as follows;Bank with maximum share of the working capital limits usually takes the role of ‘leadbank’.Lead bank, independently or in consultation with other banks, appraise the workingcapital requirements of the company.Banks at the consortium meeting agree on the ratio of sharing the assessed limits.Lead bank undertakes the joint documentation on behalf of all member banks.Lead bank organizes collection and dissemination of information regarding conduct ofaccount by borrower. 56
  57. 57. MULTIPLE BANKING ARRANGEMENT Multiple banking is an open arrangement in which no banks will take the lead role.Most borrowers are shifting their banking arrangement to multiple banking arrangements.The major features are –Borrower needs to approach multiple banks to tie up entire requirement of workingcapital.Banks independently assessed the working capital requirements of the borrower.Banks, independent of each other, do documentation, monitoring and conduct of theaccountBorrowers deals with all financing banks individually.SYNDICATIONA syndicated credit is an agreement between two or more lenders to provide a borrowercredit facility using common loan agreement. It is internationally practiced model forfinancing credit requirements, wherein banks are free to syndicate the credit limitirrespective of quantum involved. It is similar to a consortium arrangement in terms ofdispersal of risk but consist of a fixed repayment period. 57
  58. 58. REGULATION OF BANK FINANCEINTRODUCTIONBank follows certain norms in granting working capital finance to companies.These norms have been greatly influenced by the reconditions of various committeesappointed by the RBI from time to time. The norms of working capital finance followedby banks are mainly based on the recommendation of Tandon committee and chorecommittee.These committees were appointed on the presumption that the existing system of banklending of number of weakness industries in India have grown rapidly in the last threedecades as result of which, the industrial system has become vary complex. The banksrole has shifted from trade financing to industrial financing during this period.However, the banks lending practices and styles have remained the same. Industriestoday fail to use bank finance efficiently. Their techniques of managing funds areunscientific and non-professional. The industries today lack in reducing costs,optimizing the use of inputs, conserving resources etc.The weakness of the existing system highlighted by the Dehejia committee in 1968 andidentified by the tondon committee in 1974, are as follows:It is the borrower who decides how much he would borrow ;the bankers does not decidehow much he would lend and is, therefore, not in a position to do credit planning. The 58
  59. 59. bank credit is treated as the first sources of finance and not as supplementary to othersources of finance.The amount of credit is extended is based on the amount of security available and not onthe level of operations of the borrower.Security does not by itself ensure safety of bank. Funds since all bad sticky advances aresecure advances. Safety essentially lies in the efficient follow up of the industrialoperations of the borrower.We discuss the following committee’s important finding and recommendations for bankfinance: - • TANDON COMMITTEE • CHORE COMMITTEE. 59
  60. 60. TANDON COMMITTEEINTRODUCTION:The Tandon committee was appointed by the RBI in July 1974 and headed by Shri.Prakash L. Tandon, the chairman of the Punjab national bank, to suggest guidelines forrational allocation and optimum use of bank credit taking into consideration the weaknessof the leading system. Bank credit, which had become a scare commodity, strictlyrationed to meet the credit requirement of all the sectors. The larger sector of the industryneeded strict rationing becomesIt was over relying on bank finance and pre empted most of it while the other sectorswere not getting even their due share. Therefore, the method and criterion adopted forfixing credit ration needed to be standardized so that there is minimum scope for miss-useor part of the credit uses. The Tandon committee was concern exactly with this problem.Its report laid down as to how the credit ratio of individual borrowers could be fixed atimposed certain obligation on them for the efficient use of the credit made available.The recommendation of the Tandon committee based on the following notions:The borrower should indicate the demand for credit for which he should draw operatingplans for the ensuring year and supply them to the banker. This would facilitate creditplanning at the banks level and help the banker in evaluating the borrower’s credit needsin a more realistic manner. 60
  61. 61. The banker should finance only the genuine production needs of the borrower. Theborrower maintained reasonable levels inventories and receivables. Efficient managementof resources should therefore be ensured to eliminate slow moving and flabbyinventories.The working capital needs of borrower cannot entirely finance by the banker. The bankerwill finance only a reasonable part of it for the remaining; the borrower should depend onhis own fund. Recommendation of Tandon committee accordingly, the Tandoncommittee put forth in the following recommendationsInventory and receivables normsThe borrower is allowed to hold only a reasonable level of current asset, particularlyinventory and receivable. The committee suggested the maximum level of raw material,stock in process, finished goods, which corporate in an industry should be to hold.Only the normal inventory based on a production plan, lead-time of supplies, economicordering levels and reasonable factor safety should be financed by the banker. 61
  62. 62. Lending norms:The banker should finance only a part of the working capital gap; the other part should befinanced by the borrower form long-term sources.The current asset will be taken on the estimate values or values as per the Tandoncommittee norms, whichever is lower.The current will consist of inventory and receivables, referred as chargeable currentassets (CCA), and other current assets (OCA).MAXIMUM PERMISSIBLE BANK FINANCE:The Tandon committee suggested the following three methods of determining thepermissible level of bank borrowings-The borrower will contribute 25 % of the working capital gap from long term fund i.eowned fund and term borrowings; the remaining 75 % can be financed from bankborrowings. This method gives a minimum current ratio of 1:1. This method wasconsidered suitable only for very small borrowers where the requirement 0 credit was lessthan Rs 10 lacsThe borrower will contribute 25 % of the total current assets from long-term funds i.e.owned funds and term borrowings. A certain level of credit for purchases and othercurrent liabilities will be available to fund the building up of current assets and the bankwill provide the balance. Consequently, the current liabilities inclusive of bank borrowingcould not exceed 75 % of current assets. This method gives a current ratio of 1.3:1. This 62
  63. 63. method was considered for all borrowers whose credit requirements were more than Rs10 lacs.The borrower will contribute 100 % of core current assets, defined at the absoluteminimum level of raw material, processed stock, finished goods and stores, which are inthe pipeline. A minimum level of the 25 % of the balance of the current assets should befinance from the long term funds and term borrowings. This method covers straightnessthe current ratio. The third is the ideal method. Borrowers in the second stage are notallowed to revert to the first stage. This method applies to all borrowers having creditlimit in excess of Rs.20 lacs from the bank. However this method was not accepted forimplementation.In some cases, the net working capital was negative or 25 % of the working capital gap.The new systems allowed this deficiency to be financed in addition to the permissiblebank finance by the bank. This kind of credit facility is called working capital demandloan, which was to be regulated over a period of time depending on the funds generatingcapacity and ability of the borrower.The working capital demand loan is not allowed to be raised in the subsequent year. Foradditional credit in subsequent year, the borrower’s long-term sources were required toprovide 25 % of the additional working capital gap. 63
  64. 64. 4. Style of credit:The committee recommended the bifurcation of total credit limit into fixed andfluctuating parts.The fixed component is then treated as demand loan for the year representing minimumlevel of borrowing, which the borrower expected to use through out the year.The fluctuating component is taken care of by a demand cash credit. It could be partlyused by way of bills.The new CC limit should be placed on a quarterly budgeting reporting system.The interest rate on the loan components should be charged lower than the cash creditamount. The RBI has stipulated the interest differentiate at 1 %.The cash credit limits sanctioned (fluctuating) are currently 205 and the loan components(fixed) are 80 %. 5) INFORMATION SYSTEM:The committee advocated for grater flow of information from borrower to the bank foroperational purpose and for the purpose of supervision and flow of up credit.Information should be provided in the following forms: 64
  65. 65. QUARTERLY INFORMATION SYSTEM: FORM:It should contain the production and sales estimates for the current and next quarter. also,the current asset current liabilities estimates for the next quarter should be mentioned.Quarterly information system: Form II:It should contain the actual production and sales finger during the current year and thelatest completed year. Also, actual current asset and current liabilities for the latestcompleted quarter should be mention.Half year operating statement form IIIA:Actual operating performance for the half year ended against the estimate should bementioned.Half year fund flow statement: Form IIIB:It should contain the estimate as well as the actual sources and use of fund for the halfyear ended.Borrowers with a credit limit of more than1 crore are required to supply the quarterlyinformation.The bank to follow up and supervise the use of credit should properly use the informationsupplied by the borrower. 65
  66. 66. The bank must ensure that the bank credit was used for the purposes for which it isgranted, keeping in view the borrowers operation and environment.The bank should confirm whether the actual result is in conformity with the expectedresults. A+/- 10% variation is considered normal.The banker should be treated as a partner in the business with whom information shouldbe shared freely and frankly.The recommendations of the Tandon committee have been widely debated and criticized.The bankers have found a difficult to implement the committee’s recommendations.However, the Tandon committee has brought about a perceptible change in the outlookand attitude of both the banker and their customers. They have become quite aware in thematter of making the best use of a scare resource like bank credit. The committee hashelp in bringing the financial discipline through a balanced and integrated scheme ofbank lending. Most of banks in India, even today continue to look at the needs of thecorporate in the light of recommendation of the Tandon committee 66
  67. 67. CHORE COMMITTEEINTRODUCTIONIn April 1979, the RBI constituted a working group to review the system of cash creditunder the chairmanship of Mr. K. B. Chore, Chief Officer, DBCOD, RBI. The mainterms of reference for the group were to review the cash credit discipline and relate creditlimit to production.RECOMMENDATION OF CHORE COMMITTEE: -Bank credit: -Borrower should contribute more funds to finance their working capital requirement andreduce their dependence on bank credit. The committee suggested placing the secondmethod of lending as explain in the Tandon committee report.In case the borrower is unable to comply with this requirement immediately, he would begranted excess borrowing in the form of working capital loan (WCTL).The WCTL should be paid in seamy annual installments for a period not exceeding 5years and a higher rate of interest than under the cash credit system would be charged.This procedure should apply to those borrowers, having working capital requirements ofmore than Rs 10 lacs. 67
  68. 68. LEVEL OF CREDIT LIMITBank should appraise and fix separate limits for the “peak level” and normal “non picklevel” credit requirements for all borrowers in excess of Rs. 10 lacs indicating therelevant periods.With the sanctioned limits for these two periods, the borrower should indicate in advancehis need for funds during the quarter. Any deviation in utilization of funds Beyond 10%should be considered irregular and is subject to penalty fix by the RBI (2% p.a. over thenormal rate)Bank should discourage ad hoc or temporary credit limits. If sanction under exceptionalcircumstances the same should be given in the form of a separate demand loan andadditional interest of at least 1% should charged.Lending system:The system of three types of lending should continue i.e. cash credit loan and billswherever possible; the bank should replace cash credit system by loan and bills.Bank should scrutinize the cash credit accounts of large borrowers one’s a year.Bifurcation of cash credit account into demand loan fluctuating cash credit component, asrecommended by the Tandon committee should discontinue. 68
  69. 69. Advances against books debts should be converted to bills wherever possible and at least50% of cash credit limit utilize for financing purchases of raw material inventory shouldalso be charged to the bill system.Information SystemThe discipline relating to the submission of Quarterly Statements to be obtained fromthe borrower should be strictly adhered to in respects of all borrowers having workingcapital limits of more than Rs.50 lacs.If the borrower does not submit report within the prescribed time, he should be penalizedby charging a penal rate of interest, which is 2% p. a. more than the contracted rate.Banks should insists the public sector undertakings and large borrower to maintainedcontrol accounts in their books to give precise data regarding their dues to the small unitsand furnish such data in their quarterly reports.Other recommendations:Request for relaxation of inventory norms and for ad hoc increases in limits should besubjected by banks to close scrutiny and agreed only in exceptional circumstances.Delays on the part of the banks in sanctioning credit limits should be reduced in caseswhere the borrowers cooperate in giving the necessary information about their pastperformance and future projection in time. 69
  70. 70. Autonomous institutions on the lines of the discount houses in U.K may be set up toencourage the bill system of financing and to facilitate all money operations.There should be a “cell” attached to the chairmen’s office at the central office of eachbank to attend to matters like immediate communication of credit control measures at theoperational level.The central offices of bank should take a second look at the credit budget as soon aschanges in the credit policy are announced by the RBI and they should revised their planof action in the right of new policy and communicate the corrective measures at theoperational levels at the earliest.Bank should give particular attention to monitor the key branches and critical accounts.The communication channels and system and procedures with in the banking systemshould be toned up so as to ensure that minimum time is taken for collection ofinstruments. 70
  71. 71. FINANCIAL RATIOSCURRENT RATIO=CURRENT ASSET/ CURRENT LIABITIESHelp to measure liquidity and financial strength, indication of availability of currentassets to pay current liabilities. The higher the ratio betters the liquidity position.Generally it should be at least 1.33.TOL/TNW=TOL/TANGIABLE NET WORTHIndicate size of stakes, stability and degree of solvency. Indicates how high the stake ofthe creditors is. Indicate what proportion of the company finance is represented by thetangible net worth. The lower the ratio, greater the solvency. Anything over 5 should beviewed with concern.The ratio should be studied at the peak level of operations.OPERATING PROFIT RATIO=OPERATING PROFIT/NET SALES×100This ratio indicates operating efficiency. Indication of net margin of profit available onRs. 100 sales. Trend for company over a period should be encouraging. 71
  72. 72. DSCR(DEBT SERVICE COVERAGE RATIO)=DEPRICIATION+INTREST ONTERM LOAN/ INTREST ON TERM LOAN+INSTALLMENT OF TERM LOANIt indicates the number of times total debt service obligation consisting of interest andrepayment of the principal in installment is covered by the total fund available after taxes.With the help of this ratio (popularly known as DSCR), we can find out whether the loantaken for acquisition of fixed assets can be rapid conveniently.This ratio of 1.5 to 2 considered adequate.We have already touched upon depreciation as non cash expenditure and since the fundsare available with the enterprise to that extent. It is in order to ask for this sum inreduction of loan.INTEREST COVERAGE RATIO=EARNINGS BEFORE TERM LOAN ANDTAXATION / INTEREST ON TERM LOANThe ratio indicates adequacy of profit to cover interest. Higher the ratio more is thesecurity to the lender. 72
  73. 73. Analysis & Interpretation of the data Case studiesCase study 1:Comparative Balance Sheet and Performance / Financial Indicators: Abridged Balance sheet (Rs in lacs)Liabilities 31.03.04 31.03.05 31.03.06 Assets 31.03.04 31.03.05 31.03.06 Audited Audited Prov. Audited Audited Prov.Capital 17.53 18.41 84.84 FA 23.15 26.64 150.73Reserves Depr. 5.85 6.38 21.42NW 17.53 18.41 84.84 Net Block 17.30 20.26 129.31TL 12.43 15.98 2.98 Cash & 1.47 0.84 2.51 BankUnsec Ln RMTL from 2.46 81.46 WIPBOMTL(car) 1.76 1.88 0.38 FG 12.77 16.53 15.00Scred Rec- Dom 8.18 12.01 35.13Bk Borr 9.11 13.08 15.00 ExportOCL 0.09 0.15 OCA 1.19 2.32 2.71TCL 9.20 13.23 15.00 TCA 23.61 31.70 55.35 Inv Tot NCA Acc Loss Tot.Intang Ass.Tot Liab 40.91 51.96 184.66 Tot Ass 40.91 51.96 184.66 31.03.2004 31.03.05 31.03.06* Net Worth 17.53 18.41 84.84Less: Revaluation Reserves - - -Less: Intangible Assets - - -Tangible Net Worth 17.53 18.41 84.84 73
  74. 74. PERFORMANCE / KEY FINANCIAL INDICATORS: (Rs in Lacs)Particulars 31.03.04 31.03.05 31.03.06Net Sales 56.11 95.70 180.00% Increase / Decrease 71.1% 70.55% 88%Net Profit After Tax 0.57 0.89 8.62% to Net Sales 1.01% 0.93% 4.79%Cash Accruals 6.42 7.28 30.04TNW excl Revaluation Reserve 17.53 18.41 84.84TOL / TNW Ratio 1.33 1.82 1.18NWC 14.41 18.47 40.35Current Ratio 2.57 2.40 3.691. Sales: As partners have been engaged in marketing the new technology to varioususers for the initial 2/3 years vigorously and their efforts are started yielding results.During the year 2005 the firm has obtained approval from BHEL, NTPC, and HAL foruse of its products – DSC & ESC. Agreement with NTPC through BHEL (Haridwar) isexclusive supply (not to any other companies) for annual turnover of Rs. 250.00 Lacs.The orders are of repetitive nature. Besides BHEL (Hyd) have also started placing sampleorders. The firm has also been able to secure orders from HAL (Koraptut) for DSC &ESC.During the year up to Nov’05 the firm has already done sale of Rs. 100.00 lacs besidesthe job work. Orders worth Rs. 150.00 lacs from BHEL (Haridwar) are on handscheduled to be completed before March’06. Completion of this of these orders willenable the firm to achieve a sale of Rs. 250.00 lacs by this year end. This is acceptable.2. Profit: Hitherto the net profit in terms of sales has been about 1.00%. Against thisbackdrop the estimated profitability of 4.79% in the current appears unreasonable. Duringdiscussion it is clarified that as the firm has shifted its focus from mare job work to direct 74
  75. 75. selling the margin will be high. In fact it has set up its own machining plant and hassecured approval from BHEL for the Quality of its own materials.It used to pay for job works to other companies/firms for the machining purpose. Thispayment was to the tune of 25% (appx) of the job work revenue. For the year 2005 as thejob work is being done in-house the expenses are estimated to be hardly 5%. Besides,margin of direct selling of its materials is better. Moreover with increased sales themarginal revenue would be proportionately high adding to the increased yield. In view ofthe above factors we may accept the profitability estimates made by the firm. In thecoming 7 years the firm has estimated profitability ranging from 8.5% to 12.5%. Thisappears to be on the higher side. As the sales are estimated to stabilize at Rs. 312.00 lacswe may accept the profitability of 4.79% as acceptable for the year 2005. Accordingly thenet profit for the 2nd year would be Rs. 13.70 lacs and then Rs. 14.95 lacs p. a.3. Cash Accrual: With addition to fixed assets the depreciation shall be high. Thus withaccepted profitability the accrual would be Rs. 30.00 lacs for the year 2005 followed byRs. 32.03 lacs, Rs. 30.62 lacs respectively. The position is acceptable.4. TNW: Up to 2004-05 the TNW has been increasing with retention of profits. In theyear 2005 for the expansion plan the partner have agreed in bring in additional capital ofRs. 46.00 lacs, Remaining Rs 20.00 lacs from internal accrual. We have discussed theissue of infusion of capital by partners. It is informed that depending upon the advice oftheir auditors they would be either increasing the amount of individual capital and/orbrings in unsecured loans from friends/relatives to be converted to capital over a periodof time. Since the existing work is being carried out from their own sources the branch isadvised to obtain a CA’s certificate certifying the amount investing that will be 75