Working Capital Assessment and Methods

Working capital may be regarded as the life blood of business. Working capital is of major
importance to internal and external analysis because of its close relationship with the current
day-to-day operations of a business. Every business needs funds for two purposes. Long term
funds are required to create production facilities through purchase of fixed assets such as
plants, machineries, lands, buildings etc. and Short term funds are required for the purchase
of raw materials, payment of wages, and other day-to-day expenses.. It is otherwise known as
revolving or circulating capital it is nothing but the difference between current assets and
current liabilities.
Working Capital = Current Asset – Current Liability.
There are 5 components of working capital
1. Cash and Cash Equivalents
2. Accounts Receivable
3. Inventory
4. Accounts Payable
5. Accrued Expenses and Taxes Payable
There are two types of working capital. They are as follows
1. Gross Working Capital:- It is basically the sum of all current assets. There are certain
drawbacks to this type of working capital. They are this working capital emphasizes
more on quantity rather than the quality of the working capital. It also fails to reveal
the true financial position of the firm because every increase of current liabilities will
decrease the gross WC.
2. Net Working Capital:- It is basically the difference of Current Assets and Current
Liabilities.
Operating Cycle

Now the total WC requirement will be

Total Operating Expenses expecting during the year/ No. of Operating Cycles in a year
Sources of working capital
The working capital can be financed by the following sources
1. Owned Fund- This is the portion of long term funds, equity share capital and reserves
& Surplus.
2. Bank Borrowing: - Products like Cash Credit, Bills Discounting.
3. Creditors- Buying on credit from suppliers
Methods of Calculating Working Capital Limits

1. Turnover Method
This method is normally used for issuing credit requirements to Village industries, Micro
Enterprises and Medium enterprises which are having aggregate fund based working capital
limits upto Rs 5 Crores.
 Working Capital Requirement = 25% of Turnover
 Promoter Contribution (Margin) = 5% of Turnover
 Bank Finance = 20% of Turnover
 Proposed by The Nayak Committee
 Used for assessment of working capital needs of small trading companies
 Not appropriate for manufacturing and big trading companies.

2. Cash Budget Method

For all big companies enjoying money central limits of Rs.5 crores and above, a cash budget
may be adopted to appraise their limits. The companies may be asked to submit quarterly
cash budget.

The cash budgets will only contain pure cash transaction and will not reflect the movement of
funds other then cash
The cash budgets may have 4 components.

 Cash flow from business operations

 Cash flow from non- business operations
 Cash flow from capital accounts.
 Cash flow from sundry items.

 Banks were expected to grant working capital limits up to the gap in cash flow from
business operations.
 Cash Inflow –Cash Outflow = Bank Finance in the form of Working Capital
 Cash budget system is mainly used for service sector companies
 Eliminates traditional requirement of Stock and Debtors for assessment

Now as per this method each type of industry has been assigned certain limits of working
capital lending.
 3. MPBF Method
There are 2 methods given by Tandon’s Committee. We will be discussing the second
method.
MPBF Method 2
For corporate with credit requirement of more than Rs.10 lakhs this method is used. In this
method, the borrower finances minimum of 25% of its total current assets out of long term
funds. The rest will be provided by the bank through MPBF. Thus, total current liabilities
inclusive of bank borrowings could not exceed 75% of current assets.
Excess borrowing ( short fall in NWC ) shall be ensured by additional funds to be brought in
by the applicant or by additional bank finance over MPBF.

Some of the important aspects of MPBF method are as follows

 Production/Sales estimates
 Profitability estimates
 Inventory/receivables norms
 Buildup of Net Working Capital

4. Drawing Power Method

Drawing power is the limit up to which a firm or company can withdraw from the working
capital limit sanctioned. Updating drawing power for working capital by the bank is an
important credit monitoring exercise.
Drawing Power is calculated after deducting margin from “Stock Less Creditors + Book
Debts” for the month. Banks have a practice of updating drawing power based on
monthly/quarterly closing stock-book debt and trade creditors’ statement submitted by the
firm/company. In order to understand this better, we need to have a better understanding of
what is “margin” and how DP is calculated.
An important point to note is that “Stock” considered for calculating DP should be insured
stock. Stock not covered under insurance, if considered for drawing power does not reflect
the true drawing power since bank runs a huge risk, in the case of any mishappening.
Drawing Power Sanctioned by Banks. Drawing power is generally a post-sanction credit
monitoring tool. After sanction of limits, it helps the bank in keeping a tab on the
performance of the firm or company to whom the limits are sanctioned. If the debtors become
sticky at any point in time, or if the paid stock shows decreasing trend constantly month on
month, it is an alarm bell for the bank.
Now we will see Bill Finance- Post Sale Finance
DBPs :
Bills of Exchange accompanied with -
1. Invoice
2. Documents of title of the Goods - LRS/RRS
DUBD:
1. Invoice /LRS / RRS – Maximum Tenor 180 days
CUBD:
1. Bill of exchange / Promissory Notes.
2. Eligibility Carved out of MPBF
3. Export Bills: FBP/FUBD
Security – Export Documents drawn against confirmed orders / LCs.