Working Capital Finance by Banks

by

Amit Mishra
Working Capital Finance
• Working Capital is a financial metric which
represents operating liquidity available to a
business.
• The goal of working capital management is to
ensure that the firm is able to continue its
operations and that it has sufficient cash flow to
satisfy both maturing short-term debt and
upcoming operational expenses.
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Sources of Working Capital Finance
• There are two most significant short-term
sources of finance for workingcapital are
1. Trade credit
2. Bank borrowing

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• Sources of Working Capital Finance
There are two most significant short-term
sources of finance for working capital are
1. Trade credit
2. Bank borrowing

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Trade Credit
• Trade Credit : It refers to the credit that a customer gets
from suppliers in normal course of trade. This deferral of
payments is a short term financing which is called trade
credit.
• It is a major source of finance for firms. In India, it
contributes to about 1/3rd of the total short term financing.
• Particularly, small firms are heavily dependent on trade
credit as a source of finance since they find it difficult to
raise funds from banks or other sources.
• Trade Credit is also called Spontaneous Source of Financing.

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Credit Terms
• Credit Terms : This refers to the conditions under which
the supplier sells on credit to the buyer, and the buyer is
required to repay the credit.
• A typical way of expressing credit terms is for example :
3/15 net 45. This means 3% discount is available if
payment is made within 15 days and if this discount is
not availed payment is to be made on or before 45 days.

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ACCRUED EXPENSES AND DEFERRED INCOME
Accrued Expenses
• Accrued expenses represent a liability that a firm has to
pay for the services which it has already received.
1. Accrued Wages and Salaries.
2. Accrued taxes and Interest.
Deferred Income
• Deferred income represents funds received by the firm for
goods and services which it has agreed to supply in future.
1. Advance Payments

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Working Capital from Bank : It includes the facilities as under:
a) Cash Credit and Packing Credit (including Trust Receipts and Working Capital Term
Loan) against Pledge / Hypothecation of stock-in-trade and / or standing crops
(plantations). b) Discount / Purchase of Inland / Foreign Demand Documentary
(DP) Bills and Usance Documentary (DA) Bills under Letters of Credit. c) Overdrafts
against approved securities with prescribed margin. d) Discount of Inland Usance
DA Bills with Banker’s Co-Acceptance / Guarantee (Under Re-discounting Scheme
of IDBI e) Import Loans against imported consignments received under L/Cs
opened by our Bank. f) Overdrafts against book debts / Government Supply Bills. g)
Discount of Inland / Foreign Usance (DA) bills not covered under L/Cs. h) Advance
against Demand Documentary Bills for collection. i) Advance against Warehouse
Receipts. j) Advance against un-drawn balance. k) Channel Financing.

Major Bank Finance for Working Capital

• Overdraft
• Cash Credit
• Purchase or Discounting of Bills
• Letter of Credit
• Working Capital Loan

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Overdraft / adhoc
Under this facility, the borrower is allowed to
withdraw funds in excess of the balance in his
current amount, up to a certain specified limit,
during stipulated period .

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Cash Credit
• Meaning:
Cash credit is a short-term source of finance. Under cash credit,
the bank offers its customer to take a loan up to a certain limit.
Cash credit is also known as bank overdraft.
• Features of Cash Credit:
1. This loan is given to meet the working capital requirements of
a company.
2. It is given against a tangible security.
3. Interest is charged only on the amount of loan taken by the
customer and not on the amount of credit sanctioned.

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Cash Credit

• Advantages of Cash Credit:

1. It is an important source of working capital financing.
2. Cash credit can be obtained very easily and quickly.
3. Interest is charged only on the utilized amount.
• Disadvantages of Cash Credit:
1. The rate of interest charged by loan on cash credit is very high.
2. Such loan is granted by bank on the basis of company’s turnover, its
financial status, value of inventory, etc. So it is difficult for new and
financially weak companies to obtain cash credit.
3. For banks, cash credit disturbs their credit planning.

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Difference between Cash Credit and Overdraft
Cash Credit Overdraft
It is normally given on security of It is normally given on security of a
stock, debtors etc. fixed asset.

The maximum amount is calculated as The maximum amount allowed is

a percentage of sale and stock along calculated mainly on basis of financial
with financial statements. statements and security.
For e.g. A bank allowed cash credit
unto 80% of stock plus 20% of sales.

It should be used for the purpose of Can be used for any purpose
business.

Balance Sheet, P & L account , VAT Financial statements are generally not
reports is required be submitted to required to be resubmitted after
bank generally annually or quarterly. approval.

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Purchase or Discounting of Bills
• Under the purchase and discounting bills, a
borrower can obtain credit from a bank
against its bills. The bank purchases or
discounts the borrowers bills.
• The amount provided under this agreement is
covered within the overall cash credit or
overdraft limit.

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Letter of Credit
• Particularly the foreign suppliers, insist that the
buyer should ensure that his bank will make the
payment if he fails to fulfill its obligation.
• This is ensured through a letter of credit
agreement.
• The bank opens an L/C in favour of a customer
to facilitate his purchase of goods.

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Working Capital Loan
• A borrower may sometimes require funds in
excess of the sanctioned credit limits to meet
unforeseen contingencies.
• Banks provide such accommodation through a
“demand loan account”. The borrower is
expected to pay high rates of interest in such
exceptional cases.

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Security for Bank Finance
• Hypothecation
• Pledge
• Mortgage
• Lien

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Hypothecation
• Under this the borrower is provided working capital finance
against the security of movable property (stock, debtors).
• The borrower does not transfer the property to the bank
physically.
• Thus hypothecation is a charge against property where
neither ownership nor the possession is passed on to the
creditor.
• Banks generally grant credit against hypothecation only to
first class customers with high integrity.

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Pledge
• Under this arrangement the borrower, is
required to physically transfer the possession
of the property offered as security to the bank
to obtain credit.
(e.g. Share certificates, Insurance policy
documents, etc.)

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Mortgage
Mortgage is the transfer of a legal or equitable
interest in a specific immovable property for
the payment of a debt.
Lien
Lien means right of the lender to retain property
belonging to the borrower till he repays the
credit.

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Regulations of Bank Finance
• Banks follow certain norms in granting working capital
finance to firms.
These norms are greatly influenced by the
recommendations of various committees appointed by
the RBI.
• Banks followed the norms suggested by the “Tandon
Committee”.
• Further recommendations were made by the “Chore
Committee” to strengthen the procedures and norms.
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The Tandon Committee Regulations
1.Operating Plan : The borrowers should prepare operating
plans and on that basis indicate the amount of working
capital finance requirement.
2.Production based financing : The bankers should finance
only the genuine production needs of borrower. The
borrower should maintain reasonable levels of inventory
andreceivables.
3.Partial bank financing : The bank should not finance the
total requirement of the borrower. Only a reasonable part
of it should be financed by the bank.
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4.Reasonable level of Current Assets : The committee
further recommends that the borrower should be
allowed to maintain current assets specifically
debtors and inventories only up to a reasonable
level. Flabby, profit making or excessive inventory
should not be permitted under any circumstance.
However, the bank also visualized the abnormal
circumstances such as strikes, power cuts etc. and
allowed flexibility to the bankers.

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5.Maximum permissible bank finance (MPBF) :
The committee suggested the following three methods of determining
the MBFC.
1. The borrower will contribute 25% of the working capital gap, the
remaining 75% will be financed from bank borrowings.
W. C. Gap = CA-CL excluding bank borrowings.(Some analysts define
the networking capital in the same manner)
2. The borrower will contribute 25% of the total current assets. The
remaining of the working capital gap will be financed by the bank.
3. The borrower will contribute 100% of the core assets and 25% of
the balance of current assets. The remaining of the working capital
gap will be financed.

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The Chore Committee Regulations
1. Reduced dependence on Bank Credit : The borrowers should contribute
more funds to finance their working capital requirements. The idea was to
place all borrowers in the 2nd method suggested by the Tandon Committee. In
case of difficulties the resort could be taken to WCTL.

2. Credit limits to be separated in to “Peak level” and “Non Peak Level” limits :

Credit limits should be assessed and separated in to “Peak level” and “Normal
level” for borrowers with credit limits more than 10 lacs. Borrowers should, in
advance, inform the requirement of peak level limits. Moreover, any deviation
in utilization beyond 10% tolerance, should be treated as an irregularity.
Additional interest of 1% should be chargedon ad hoc borrowings.

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The Chore Committee Regulations
4. Existing lending system to continue : The existing system had three
types of lending.
(a) Cash credit
(b) WCTL,
(C) Bill discounting.
Cash credit system should be replaced by the other two wherever
possible. Cash credit accounts of large borrowers to be scrutinized,
at least once a year.
5. Information System : The discipline regarding submission of
quarterly statements should be strictly adhered to, in respect of all
borrowers having limits of 50 lacs and above.

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Commercial Paper
In India, the issue of CP’s is regulated by the RBI.
Only those Companies, which have
(a) Net Worth of 10 Crores,
(b) MPBF of not less than 25 Crores &
(c) Listed in Stock Exchange can issue CP’s.
Size of a single issue should be at least One Crore and
size of each CP should be at least 25 Lacs. (5 lacs
suggested by Vaghul).
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Methods for Assessment of Working Capital
Requirements
In tune with the liberalized environment, CBI has
adopted the following system for assessment of
working capital requirements of the borrower.
1. Turnover Method: This method should be used
for assessing fund based working capital
requirements enjoyed from the banking system
uptoRs.5.00 crore.
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2. Traditional Method: Fund based working capital
requirements under this method shall be assessed under
Method II for borrowers enjoying fund based working
capital limits of above Rs.5.00 crore but less than Rs.50.00
crore. As per RBI guidelines, Non-Funded limits are also to
be a part of MPBF.
3. Cash Budget Method This method would be applicable to
borrowers who are i. Falling under Cyclical Industries like
Tea, Sugar etc. ii. Borrowers availing Fund Based Working
Capital limits of Rs.50.00 crore and above from the
banking system for Central Bank of India.

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