Assignment of Management of working

capital

Topic : Banker’s appraisal of working capital proposal and restrictions

under loans and advances

SUBMITTED TO:
Dr.kamalpreet kaur (HOD) SUBMITTED BY:
Davinder SINGH
MBA 2nd
ROLL NO: 196212
Banker’s appraisal of working capital proposal and restrictions under
loans and advances
The term working capital means the sum of the funds invested at various current assets used
in the operating cycle, by the industrial and trading establishments. Operating cycle means
the length of time required to convert ‘Non-Cash current assets’, (like raw material (RM),
work in process (WIP), finished goods (FG), and receivables) into cash.
Cash Credit against book
debts/Cheque purchase. Appraisal of working capital finances: A manufacturing unit needs to
purchase raw material, labour and other overheads in the production process. The portion of
current assets which are not financed by current liabilities is known as the working
capital gap
.
The types of loans and advances which  are considered as working capital
finance:

 i.  Cash Credit/ Overdraft against inventories and book debts.

ii.  Demand Loan portion under Loan System for Delivery of Bank Credit (if permissible
working capital finance is  above Rs.10 Crore)

iii. Packing Credit against inventories.

iv. Bills purchased /Discounted (inland & foreign)

v.  Cash Credit against book debts/Cheque purchase.

vi. Working capital term loan (for excess borrowing)

Appraisal of working capital finances:

A manufacturing unit needs to purchase raw material, labour and other overheads in the
production process. The portion of current assets which are not financed by current liabilities
is known as the working capital gap. The working capital gap would be financed either by
own source or from borrowings.
Working capital gap is financed by the contribution from the long-term sources (Known as
Net Working Capital) and bank finance for working capital purpose, wherever necessary.
Therefore, it is important for the bank, to first appraise the gross working capital, net-
working capital and working capital gap for assessment of working capital limits.
The level of limit for each type of facilities will depend upon on the nature of current assets
less suitable margin, within the overall permissible bank finance. RBI, from time to time,
prescribes norms for working capital to be financed by banks. The  financial papers like
Operating statement, Balance-Sheet, and funds flow statements, bankers should examine
whether the borrower is capable of being achieved Bankers have to look into following
consideration for arriving assumptions of future production and sales.

1. Past trends in production/sales

2. The extent of  installed and available production capacities.
3. Availability of raw materials, labour, power supply,etc.
4. Competitive strength of the borrower.
5. Pricing policy of the management
6. Research, renovation, and development
7. Economic factors like demand for the product, import restriction etc.
After being satisfied with the validity of the projection of productions and sales, capacity
utilization, break -even point, economic conditions, cost consciousness, pricing policies etc.,
next steps is to compute following profitability ratios and see how they compare with the past
trends and withthe similar type of units in the same business.

1. Raw materials consumption to cost of production

2. Power and fuel to cost of production
3. Direct labour to cost of production
4. Repairs and Maintenance to cost of production
5. Interest to Net sales
6. Selling, general and administrative expenses to Net Sales
7. Gross profit to net sales
8. Operating profit to Net Sales
9. Net profit before tax to net sales
10. Net Profit after tax to net sales
The above ratios help bankers to assess the ability of the enterprise to earn profit from the
sales,‘Return on Equity’. test of the management’s pricing policy compared to others in the
business, Return on Total Assets, ‘Accounts  Receivable turnover’ etc.
 
5 steps of credit appraisal.

Step 1:   As a first step of appraisal, the work place of prospective borrower to be inspected
by the Manager. From his visit to the factory or business place and residence of the borrower
(in the cases of retail loans), Manager gets first hand idea  of the business environment,
technical, economic and financial viability of the proposition placed before the bank. Further
it helps the Manager to familiarize himself the borrower’s business and attendant trade
practices. The experienced bankers have the knack of measuring and ascertaining the
standing of the borrower, his business capacity, experience in the line of business, managerial
competence actual financial need of the borrower during his visit. He may also notice other
adverse features or drawbacks in the project and may raise the relevant queries with regard to
the project .The Manger has to be alert all the time and has to be diplomatic and tactful in
raising queries. Loans are not sanctioned to any party unless the bank is satisfied with the
replies received from the prospective borrowers.

Step 2: In addition to unit inspection, Bank Manager needs to conduct credit investigation of

the prospective borrower.   Credit investigation means, ascertaining the business reputation
and creditworthiness of the borrower and guarantors. The sources of information available for
credit investigation may be broadly classified as internal and external. Information available
within the bank such as, length of the customer’s association with the bank, past history and
conduct of current account, current or previous borrowing details and rating awarded to the
account, deposit connection, Value and liquidity position of the security offered to the
proposed loan etc. are internal sources of information. Experience with regard to dealings of
the borrower with reference to  co-operation extended in documentation and payment records
of past and present obligations are quite useful in taking credit decisions.

Step 3: Information may be tapped from external sources like meetings with the borrower,
present and past employees of the borrower, from third parties where references are given by
the borrower. Information received during participation in informal and social get together or
market gossip may be counter checked and make the record of it. Reports obtained from other
banks and credit institutions, credit rating agencies, credit investigating entities like Dun and
Bradstreet, CIBIL report on borrower or individuals behind the borrower company and
guarantors to the loan, search report collected from ROC, report from CERSAI are import
sources of credit investigations. News about the borrower or individuals behind Borrower’s
Company published in newspapers and periodicals may alert the bankers..

Step 4: Analysis of financial statements for identifying the financial strength and weakness
of a business establishment. It shows how the capital is distributed, how much of investment
is identified with various accounts. The business trend can be examined by comparisons of
various items in series of balance sheets that show changes in those items either increasing or
decreasing. The successive increase of proportionate receivables to sales indicates that the
company is relaxed period of credit to the customers.

Step 5: Along with appraisal of financial papers, the credit officer of the bank needs
to examine the following non- financial papers while taking credit decisions.

(i).Individuals: In case of employed persons, normally loan will be considered only to

confirmed employees. Employer’s no objection certificate/salary certificates are other
requirements for retail loans. In case of self-employed, IT return for past 2-3 years would be
verified to assess the repayment capacity of the applicant. No due certificate from existing
banker, CIBIL report of the applicant (for a very small loan it is not necessary) will be
verified. Proof of Residence like voter card/Telephone bill, Electricity Bills, Registered lease
deed, Sale agreement etc. will be verified before entertaining borrower’s request for facility.
In case, the applicant is operating his/her account with other banks, SB pass book and
original statement of account is verified.
(ii). Sole Proprietor: Banks examine certified business account statement, Income Tax and
Sales Tax Assessment Orders, VAT turnover statement, orders copy and other related papers.
CIBIL report of the proprietor and the firm will be examined. The property offered as a
security will be inspected and related documents are verified. No due certificate from existing
banker, CIBIL report of the proprietor will be examined. Proof of residence like voter
card/Telephone bill, Electricity Bills, Registered lease deed, Sale agreement etc. will be
verified before entertaining borrower’s request for facility. In case, the applicant is operating
his/her account with other banks, SB pass book and Current account original statement is
verified. Property offered as security will be inspected and title records of security offered are
investigated.
(iii). Partnership firms: Banks examine Partnership Deed, Certified statement of Accounts,
copies of Income Tax assessments, wealth tax Assessment and Sales Tax assessments orders,
VAT turnover statement for the reporting year etc. Reports obtained from CIBIL on partners
and the firm will be verified. No due certificate from existing banker, proof of residence like
voter card/Telephone bill, Electricity Bills, Registered lease deed, Sale agreement etc. will be
verified before entertaining borrower’s request for facility. In case, the applicant is operating
his/her account with other banks, Original statement of account is verified. Property offered
as security will be inspected and title records of security offered are investigated.
(iv).Trust Accounts: Registered Trust Deed, profiles of the Trustees is examined by the bank
before considering the loan proposal. The purpose and provisions to raise loans must be
incorporated in the Trust deed. Financing bank would go through the trust deed to confirm
who are the authorized person/ signatory to the loan documents to be executed. In case, the
applicant is operating his/her account with other banks, Original statement of account is
verified. Copy of Resolution passed CIBIL report of the trustees and the trust and also
property offered as security will be inspected and title records of security offered are
investigated.
(v). HUFs: Bank would first ascertain whether Karta or the Manager (major co-parceners,
authorized by the Karta) of HUF, can create a charge against the joint family property for the
loan availed. Banks should be cautious while considering a credit request from a HUF, as it is
a legal necessity to prove that the loan for which the charge is created, is taken for a purpose
necessary or beneficial to the family. The onus of proving, the purpose for which loan is
taken, lies on the financer. The financer should keep a record that he made reasonable
inquiries and he was satisfied that the loan is availed for the benefit of joint family, CIBIL
report of the Karta and all major co-parceners of the joint family. Original statement of
account is verified. Property offered as security will be inspected and title records of security
offered are investigated.
(v). Clubs, Societies, and Associations: Registered Bye-laws of the Society/Association/club,
Copy of resolution passed in the AGM to authorize managing committee to avail loan and
pledge or mortgage the assets of the club or society or association as a security to the bank.
Profile of Office bearers and CIBIL report on them will be called for. Banks also verify
whether the purpose and provisions to raise loans is incorporated in the bye-laws of the
entities and who are the authorized person/ Signatory to the Documents, Legal Opinion on
creation of charge on assets of the clubs/association/society would be obtained. The property
would be inspected by the bank officials.
(vi).Private Limited and Public Limited Companies: Certificate of Incorporation,
Memorandum of Association, Articles of Association, Certificate for commencement of
Business (for public limited companies), List of Directors, Share Holding pattern, Power of
directors, common seal, Securities for Bank Advances, CIBIL report of the directors and the
company, Search report of the company from the ROC to be verified by the bank to ensure
that there is no prior charge on the assets to be offered to the bank as a security. Profile of
directors of the company and CIBIL report on them will be called for. Banks also verify
whether the purpose and provisions to raise loans is incorporated in the memorandum of the
company and find out is the authorized person/ Signatory to the Documents, Legal Opinion
on creation of charge on assets of the company would be obtained. The property of the
company to be mortgaged to bank and factory and work place of the company should be
inspected by the Bank Manager before evincing interest in credit proposal of the company.
Public Sector Undertakings: The general documents/papers for loans, processed by banks for
Public sector are as in case of PSUs. The bank may explore the possibilities of getting
guarantee from the State or Central Governments for the advance made by the bank.

RESTRICTIONS ON LOANS & ADVANCES

1) Notwithstanding anything to the contrary contained in section 77 of the Companies Act,

1956 (1 of 1956), no banking company shall-
(a) grant any loans or advances on the security of its own shares, or
(b) enter into any commitment for granting any loan or advance to or on behalf of-
(i) any of its Directors,
(ii) any firm in which any of its Directors is interested as Partner, Manager, Employee or
Guarantor, or
(iii) any company (not being a subsidiary of the banking company or a company
registered under section 25 of the Companies Act, 1956 (1 of 1956), or a government
company, of which 15[or the subsidiary or the holding company of which] any of the
Directors of the banking company is a Director, Managing Agent, Manager, Employee or
Guarantor or in which he holds substantial interest, or
(iv) any individual in respect of whom any of its Directors is a partner or guarantor.
(2) Where any loan or advance granted by a banking company is such that a commitment for
granting it could not have been made if clause (b) of sub-section (1) had been in force on the
date on which the loan or advance was made or is granted by a banking company after the
commencement of section 5 of the Banking Laws (Amendment) Act, 1968 (58 of 1968), but
in pursuance of a commitment entered into before such commencement, steps shall be taken
to recover the amounts due to the banking company on account of the loan or advance
together with interest, if any, due thereon within the period stipulated at the time of the grant
of the loan or advance, or where no such period has been stipulated, before the expiry of one
year from the commencement of the said section 5:
that the Reserve Bank may, in any case, on an application in writing made to it by the
banking company in this behalf, extend the period for the recovery of the loan or advance
until such date; not being a date beyond the period of three years from the commencement of
the said section 5, and subject to such terms and conditions, as the Reserve Bank may deem
fit:
that this sub-section shall not apply if and when the Director concerned vacates the office of
the Director of the banking company, whether by death, retirement, resignation or otherwise.
(3) No loan or advance, referred to in sub-section (2), or any part thereof shall be remitted
without the previous approval of the Reserve Bank, and any remission without such approval
shall be void and of on effect.
(4) Where any loan or advance referred to in sub-section (2), payable by any person, has not
been repaid to the banking company within the period specified in that sub-section, then, such
person shall, if he is a Director of such banking company on the date of the expiry of the said
period, be deemed to have vacated his office as such on the said date.
In this section-
(a) "loan or advance" shall not include any transaction which the Reserve Bank may, having
regard to the nature of the transaction, the period within which, and the manner and
circumstances in which, any amount due on account of the transaction is likely to be realized,
the interest of the depositors and other relevant considerations, specify by general or special
order as not being a loan or advance for the purpose of this section;
(b) "Director" includes a member of any board or committee in India constituted by a
banking company for the purpose of managing, or for the purpose of advising it in regard to
the management of, all or any of its affairs.
 (5) If any question arises whether any transaction is a loan or advance for the purposes of this
section, it shall be referred to the Reserve Bank, whose decision thereon shall be final.

LoanProposal:-
Before you begin writing your proposal, there are four things that you need to be able to
clearly address:

1. How much money you need.

2. How your business will use the money.
3. How you will repay the loan.
4. What you will do if your business is unable to repay the loan.

There are many different formats you can use for a loan proposal. You may want to contact
the lender to determine which format is preferred by the lender. Generally, a loan proposal
should include these elements:

 Executive Summary. Begin your proposal with a simple and direct cover letter or
executive summary. Clearly and briefly describe who you are, your business
background, the nature of your business or start-up, and how the loan will be used to
help the company succeed.
 Business Profile. Describe the history of your business and summarize current activity
and results. Describe your market, your customers, and your industry.
 Management Experience. Describe the experience, qualifications, and skills of each
owner and key member of your management team.
 Loan Request. State the amount of money you need and how you determined this
amount. Include quotes for equipment or supplies, for building costs, etc. In short, be
able to answer the question, “Why do you need that amount of money?” Also explain
specifically what the loan will be used for and why it is needed.
 Loan Repayment. Describe the terms you hope to receive (interest rate, term, etc.).
Show how you can meet that repayment schedule based on sales and cash flow
 projections. Keep in mind that loan terms will need to be negotiated with your lender
based on their risk assessment of your business.
 Collateral. Describe collateral you would be willing to pledge as security for the loan.
Every loan program requires at least some collateral that can be sold in case the cash
generated by the small business isn’t sufficient to repay the loan. All loans should
have at least two identifiable sources of repayment. The first source is ordinarily cash
flow generated from profitable operations of the business. The second source is
usually collateral pledged to secure the loan.
 Personal Financial Statements. Include financial statements for all owners with 20
percent or more interest in the business. These statements should not be more than 90
days old. Some lenders may also require tax returns for the previous one to three
years.
 Business Financial Statements. Include complete financial statements (balance
sheet, income statement, and reconciliation of net worth) for the last three years plus a
current interim financial statement (not more than 90 days old). If you are just starting
out, provide a projected balance sheet and income statement.
 Equity Investment. An owner must put some of his/her own money into the business
to get a loan; the amount depends on the type of loan, purpose and terms. Equity can
be built up through retained earnings or by the injection of cash from the owner. Most
lenders want to see that the total liabilities or debt of a business is not more than four
times the amount of equity.
 Projections. Provide projected income and cash flow statements for at least one year
or until positive cash flow can be shown. Be prepared to answer questions about how
you will change operations if you don’t reach your projections.
 Other Items (if applicable)
o Lease (or copies of proposal)
o Franchise agreement
o Purchase agreement
o Articles of Incorporation
o Partnership agreements
o Copies of business licenses and registrations required for you to conduct
business
o Copies of contracts you have with any third parties
Methods of Working capital appraisal:
Banks in India have evolved their own method of lending as they have been given free hand
by the Central Bank (that is RBI) to decide their own lending methods. Normally banks use
the turnover method (which is also called as Nayak Committee norms) for assessment of
working capital limits up to Rs.2 crore (Rs.7.50 Crore for SME). The other two traditional
methods of assessment of working capital limits are MPBF (Maximum Permissible Bank
Finance) or Cash Budget Method depending upon requirements of the customers. The level
of limit for each type of facilities under MPBF method will depend upon on the nature of
current assets less suitable margin, within the overall permissible bank finance. RBI, from
time to time, prescribes norms for working capital to be financed by banks. In July 1974, the
study group headed by Shri. P.L.Tandon, has framed guidelines for working capital finance
by banks. The recommendations made by above study group are known as Tandon
Committee recommendations. Out of three methods for assessment of working capital limits
proposed by Tandon Committee, RBI has accepted method I and method II, which are
explained below.
As per Tandon’s-I method (also called as ‘first method’) of lending the borrower has to
arrange 25% of Working Capital Gap (WCG) as margin.

The first method can be explained from the following illustration.

Let us take an example of a company which has Total Current Assets (TCA) of Rs.100.00
and Other Current Liabilities (OCL) i.e. (without working capital facilities from the bank) is
Rs.20.00. Now we will compute the Maximum Permissible Bank Finance (MPBF) under
method-I.
TCA=100 and OCL=20,

WCG is (TCA-OCL))=100-20=80 ——————————-Let us call it as (A)

25% of WCG           = 80×25÷100= 20————————- Let us call it as (B)

(i.e. Minimum Net Working Capital)

In this case, Maximum Permissible Bank Finance (MPBF) = (A)-(B) = 80-20 = 60

Therefore, MPBF from Bank under the first method is Rs.60 if Total Current Asset is Rs.100
Current Ratio in first method: Since Total Current Liabilities (including Bank finance) would
be Rs.80 against Total Current Assets of Rs.100, the minimum Current Ratio under method–I
would be  100:80 i.e minimum Current Ratio is 1.25:1.
Tandon’s-II method (also called as ‘second method’): In this method of lending the borrower
has to arrange 25% of Total Current Assets (TCA) as margin.
Illustration :

Let us again take an example of TCA of a company is Rs.100.00 and OCL is Rs.20.00 .We
shall now calculate the MPBF under 2nd method.
WCG =CA-CL=100-20 = 80 ————————————————- Let us call it as (x)

25% of TCA=100×25÷100 = 25  ——————————————–Let us call it as (y)

The MBPF under second method is (x)-(y) = 80-25=55

MPBF, from Bank under the second method ,is Rs.55  when Total Current Asset is Rs.100
and working capital gap is 80. 
Current Ratio in second method: Since Total Current Liabilities would be (20+55)=75 against
Total Current Assets of Rs.100, the minimum Current Ratio under method–II would
be  1.33:1
The Chore committee (headed by Shri.K.B.Chore), appointed by RBI in April 1979
recommended that all borrowers except sick units having working capital of Rs.50 lacs and
over from the banking system must be placed under method-II which gives current ratio of
1.33:1. Although the lower cut-off limit for method II is changed from time to time as per
RBI guidance, the benchmark current ratio of 1.33:1 under this method remains unchanged.
Relaxation to this condition is available to export oriented units; products manufactured by
MSME units wherein banks may apply the first method.
Turnover method (Nayak Committee norms)

Under turnover method, the aggregate fund-based working capital limits are computed on the
basis of Minimum of 20% of their projected annual turnover. The borrower has to bring
the margin of 5% of the annual turnover of such borrowers as margin money.
Example:

If projected sales turn-over is                                                                 =           Rs.100, 000.00

Then, working capital gap is 25% of turnover                                     =           Rs.  25000.00

Minimum permissible Bank Finance should be 20% of turnover    =           Rs.  20,000.00
Margin money from the borrower should be 5% of Rs.100000.00 =           Rs.     5000.00

Cash Budget method

The pattern of financing the peak cash deficit(s) is followed for industries dealing in seasonal
products like sugar and tea, construction activities, film industries, order based activities etc.
In the above type of industries, the requirement of finance may be peak during some calendar
months whereas the realizations of sale proceeds take place at a length of time. Therefore,
under Cash budget method, the bank finance is sanctioned based on projected monthly cash
flows estimated by the borrower and approved by the bank. The current ratio for this kind of
facility is normally 1.33: 1 (1.25:1 for MSE) as a benchmark. Some Banks consider lower
ratio on the case-to-case basis depending upon components and quality of current assets and
current liabilities.