Before we discuss the assessment of working capital, let us first understand the meaning and implication of the term “working capital”. “Working Capital” consists of two words “Working “and “Capital ”. As the name suggests, the meaning of working capital is the capital or fund required for
working of the business. It is the fund required for day- to- day operations of the company. So in order to understand the requirement of working capital, we need to understand why we require funds for day- to- day operations.
Day-to-day operations mean purchasing goods and services and processing the same for production of goods and services and then selling the same. As we have discussed in the paper of Financial Management, first the organization has to purchase goods and services, then it processes the same, offer that it sells and then it collects the payment.
Hence, organisation incurs expenses for the first and second stage. However, it collects cash in the fourth stage. So expenses incurred in the first and second stage need to be funded which requires working capital. Let us explain with the help of a simple example of a trading company.
Example
On 12th April 2013, a trader purchases material worth ` 25 lacs. It has incurred expenses on 12th April 2013. It has to make the payment if the supplier is not giving any credit. So if it does not get credit from the market, it requires working capital.
Next, if it sells on 12th April 2013, it gets cash on the same day and from this it can make the payment. So even though a person is purchasing raw material on cash basis and if he sells on cash basis, depending on the time of payment, he may not require working capital. If the customer sells on 15th April 2013 for one month credit, it would get the cash on 15th May 2013 and if it has to make the payment on 12th April 2013, it requires working capital for a longer period.
From the example, it is clear that the working capital requirement arises due to incurring expenses and making the payment on account of expenses before realization of cash from sales. After understanding the meaning of working capital, we shall now bring the definition of working capital.
Gross Working Capital Concept
According to this concept, a company’s investment in total current assets signifies the Working Capital. So, Gross working capital is equal to total current assets.
The Gross Working Capital can be ascertained as follows:
Current assets
(a) Current investments
XXX
(b) Inventories
XXX
(c) Trade receivables
XXX
(d) Cash and cash equivalents
XXX
(e) Short-term loans and advances
XXX
(f) Other current assets Gross Working Capital
Gross Working Capital
XXX
XXX
Net Working Capital Concept
Positive and Negative Working Capital
When current assets exceed current liabilities, a positive Working Capital is created, and when current assets are less than current liabilities, a negative Working capital occurs. The chronic negative working capital situation will lead to closure of business and the enterprise is said to be ‘technically insolvent’.
Factors Determining Working Capital Requirement
There is no set of universally applicable rules to ascertain working capital needs of a business organization. The factors which influence the need level are discussed below:
1. Time span required for conversion of raw materials into finished goods is a block period. The period, in reality, extends a little before and after the WIP. This cycle determines the need for working capital.
2. Credit policy of the business organization includes to whom, when and to what extent credit may be allowed. Amount of money locked-up in account receivables has its impact on working capital.
3. If we look at the balance sheet of any trading organization, we find that major quantum of the resources is deployed on current assets, particularly stock-in-trade. In contrast, service organizations need lesser working capital than trading and financial organizations. So working capital requirement depends on the nature of business.
4. Economic boom or recession etc., have their influence on the transactions and, consequently, on the quantum of working capital required.
5. If demand for a product is seasonal, then also manufacturing operation has to be conducted during the whole year resulting in working capital blockage during off season.
6. Operational level determines working capital demand during a given period. Higher the scale, higher will be the need for working capital.
7. It depends on the policy of the firm at which level of Stock turnover ratio they feel comfortable.
8. Creditworthiness is the precondition for assured accessibility to credit. Accessibility in banks depends on the flow of credit i.e., the level of working capital.
9. In case of newly established concerns, the materials are required to be purchased in cash and the sales are to be made on credit basis. But the established companies can negotiate for credit terms with suppliers and sell the product at shorter credit period to customers. Therefore, it requires less working capital than concerns with lesser business standing.
10. Growth and diversification of business call for larger volume of working fund. Working Capital needs are assessed in advance with reference to business plan.
11. In a buyers’ market i.e. the market with fierce competition, the companies are forced to sell on credit, with liberal credit and collection policies. But if the sellers’ market prevails, quick disposal of
stocks, high percentage of cash sales, strict credit and collection policies etc. reduce the need for working capital.
1. Political stability brings in stability in money market and trading world. Things mostly go smooth. Risk ventures are possible with enhanced need for working capital finance. Similarly, availability of local infrastructural facilities like road, transport, storage and market etc., also influence business and working capital needs.
Assessment of Working Capital from the bank’s point of view
After understanding the fundamental concept of the working capital and the meaning of different terminology of working capital, it is now easy to find out the step by step process of assessment of working capital.
1. Step 1: Understanding the meaning of ‘assessment’: In financial parlance, assessment means determination of quantum. So assessment of working capital means how much working capital is required by the company. When we are talking about the word ‘assessment’ from the bank’s point of view, we mean the amount bank would sanction as working capital limit. Henceforth, we shall talk of assessment from the bank’s point of view only.
2. Step 2: Assessment means future requirement of fund. So assessment would be carried out on the basis of future financials. When we talk about the future we are talking about the current running year (estimate) and the next year (projected). So assessment would be carried out either on the basis of estimated figure or projected figure. However actual is required to find out the present position of the borrower and the validation of the projection.
3. Step 3: Determination of assessment methodology. In India, fund based working capital assessment is carried out by three methods:
a) Turn Over Method
Under this method, the sales are estimated or projected. Based on the projected or estimated sales, 25% of the projected sales is the working capital requirement. The underlying assumption of this method is that working capital cycle of the borrower is 90 days and in a year it would be rotated four times. Accordingly, working capital requirement (not the limit) is 25% of sales. TurnOver method also says that 5% of the sales would be the net working capital. The limit would be 20% of the sales. This is also called Nayek Committee method of assessment of fund based working capital. This is explained with the help of an example:
Example
The actual sales of a company for the FY 2012-13 are ` 150 lacs and the actual bank borrowing for working capital as on March 31, 2013 is 25 lacs. The company has estimated sales of ` 200 lacs for the
FY 2013-14 and the bank has accepted that estimate. Now, the working capital requirement of the company is ` 50 lacs i.e. 25% of ` 200 lacs. The minimum margin money is 5% of sales i.e. ` 10 lacs. We now shall look at the audited (provisional) figure of March 31, 2013. We find that as on March 31, 2013, the current asset is ` 40 lacs and the current liability as on that date is ` 33 lacs, the company is having actual net working capital of ` 7 lacs. The fund- based working capital limit would be ` 40 lacs provided the company brings in additional ` 3 lacs [ ` 10 lacs – ` 7 lacs ]. If the company brings in additional ` 3 lacs, the fundbased working limit would be increased from ` 25 lacs to ` 40 lacs.
(b) Maximum Permissible Bank Finance Method (MPBF)
Under this method, the borrower has to submit the data as per a specified format called Credit Monitoring Arrangement (CMA). As per this format, borrower has to fill up six forms called CMA form.
Form I of CMA forms requires that borrower provide details of the borrowing as on the date of the application.
Form II deals with the P&L.
Form III deals with the balance sheet.
In Form II and Form III, borrower has to provide four years’ data, i.e. last two years’ actual (audited
/provisional), current year estimate and next year’s projections.
While filling up Form II and Form III the borrower needs to adjust certain thing from the audited financials. These are given below:
1. The total sale value has to be segregated into domestic and export sales, with excise to be shown separately in Form II.
2. The consumption of raw material has to be segregated into import and inland part in Form II.
3. With the bank borrowing for working capital, bill discounting amount (which would appear as contingent liability on the borrower’s balance sheet) would be added in the liability side under the head bank borrowing for working capital and in the asset side under the head receivable.
4. The current maturity of term loan would appear under the head current liability.
5. The unsecured loan would appear as term liability if it is payable more than 1 year and if it is not subordinate. In case it is subordinate, it may be treated as quasi- equity.
6. The receivable would have to be shown separately as export and domestic receivable. Receivable of more than 3 months and in some cases more than 6 months would be shown under the head current asset.
7. Loans and advances not related to production i.e. loans and advances to group companies would not be treated as current asset; it would be put under non- current asset.1. Investment would be put under non- current asset.
2. Once Form III has been filled up, forms IV, Form V and Form VI would be automatically generated. Form III is the balance sheet of the borrower.
3. Form IV deals with the current asset and other current liability part. In this form, we have the amount as well as the holding level of Inventory, receivable and creditor.
4. Form V deals with assessment.
5. Form VI deals with the fund flow statement showing the sources and uses of fund.
Rules for making projections
The current asset is projected in a manner so that holding level of inventory, receivable and other current asset should not go up. The other current liability is projected in a manner so that the holding level of the creditor and other current is not going down. In case there is a deviation, it needs to be properly explained.
Once the projection is made, the assessment is carried out mainly by two methods namely Method I and Method II.
Under Method I, the limit has been arrived at by using the following sequence:
1. Estimated Current Asset : ` 100 lacs
2. Estimated Other Current Liability : ` 30 lacs
3. Estimated Working Capital Gap : ` 70 lacs
4. Minimum Net Working Capital (25% of Working Capital Gap) : ` 70 lacs*25% i.e. ` 17.5 lacs
5. Estimated net working capital is ` 18 lacs
6. MPBF is minimum of [ 3-4, or 3-5] i.e. 52 lacs
Under method II, the calculation is carried out in the following sequence:
1. Estimated Current Asset : ` 100 lacs
2. Estimated Other Current Liability : ` 30 lacs
3. Estimated Working Capital Gap : ` 70 lacs
4. Minimum Net Working Capital (25% of Current Asset) : ` 100 lacs*25% i.e. ` 25 lacs
5. Estimated net working capital is ` 25 lacs
1. MPBF is minimum of [ 3-4, or 3-5] i.e. 45 lacs
(b) Cash Budget Method
This is the most complex but most scientific method. In this method, the next two years’ cash budget is forecasted under revenue account and capital account. The revenue deficit amount would be bridged by the capital account surplus and the remaining amount is the fund based limit. In the case of seasonal industry, this is the best method of assessment of fund based working capital. Besides, for construction and software the RBI is advising the banks to follow cash budget method of assessment.
Please note that if the assessment is carried out as per turnover or cash budget method, filling up of CMA form is not required by the borrower. In the case of cash budget, the borrower has to prepare a cash budget for the next 12 months.
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