Role of Banks in Working Capital Management PDF

Role of Banks in working capital management
Executive Summery
The project is about role of banks in working capital management to
know that how a bank is plays a major role in the managing the working
capital of their clients (Business firms) to meat their day-to-day
expenditure and other business requirements.
The project also covers various credit facilities given by the banks to its
clients, it functions and different aspects in working capital financing.
The project includes case-study on Icici bank which would help to
understand the concept of working capital financing.
Maintaining of working capital at par level with the efficient and
effective level the bank plays a vital role in that.
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Objectives of the study
♦ The objective of undertaking a project on Role of Banks in Working
Capital Management is to have in-depth knowledge about the Strategy of Banks
to lend the money to the business firms to run the business and mate the day to
day expenses of business firms.
♦ To know about the functions, organizational structure and objective of

Banks lending policies to business firms.
♦ To understand the elements of working Capital and its functions.
♦ To have a broader view on nature of Working Capital which is current
assets & current liabilities and to know what are its components.
♦ To know what are the RBI guidelines formulated for Working Capital
financing.
To know the future scope involved in Working Capital finances & role of
information technology in Working Capital financing.
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Introduction
Working capital management is a significant in financial management
due to the fact that it plays a pivotal (important) role in keeping the
wheels of a business enterprise running. Working capital management is
concerned with short – term financial decisions. Shortage of funds for
working capital has caused many businesses to fail and in many cases,
has retarded their growth. Lack of efficient and effective utilization of
working capital leads to earn low rate of return on capital employed or
even compels to sustain losses. The need for skilled working capital
management has thus become grater in recent years.
A firm invests a part of its permanent capital in fixed assets and keeps a
part of it for working capital I.e., for meeting the day today requirements.
We will hardly find a firm which does not requires any amount of
working capital for its normal operations. The requirement of working
capital varies from firms to firms depending upon the nature of business,
production policy, market conditions, seasonality of operations,
conditions of supply etc. Working capital to a company is like the blood
to human body. It is the most vital ingredient of a business. Working
capital management if carried out effectively, efficiently and consistently,
will assure the health of an organization.
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Definition of Working Capital

Working capital is defined as the excess of current assets over current
liabilities. Current assets are those assets which will be converted into
cash within the current accounting period or within the next year as a
result of the ordinary operations of the business. They are cash or near
cash resources. These include:
• Cash and Bank balances
• Receivables
• Inventory
- Raw materials, stores and spares
- Work-in-progress
- Finished goods
• Prepaid expenses
• Short – term advances
• Temporary investments
The value represented by these assets circulates among several items.
Cash is used to buy raw-materials, to pay wages and to meet other
manufacturing expenses. Finished goods are produced. These are sold,
accounts receivables are created. The collection of accounts receivable
brings cash into the firm. The cycle starts again. This is shown in below
mention diagram.
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Cash
Inventories
Receivables
Current liabilities are the debts of the firms that have to be paid during the
current accounting period or within a year. These include:
• Creditors for goods purchased
• Outstanding expenses i.e., expenses due but not paid
• Short – term borrowings
• Advance received against sales
• Taxes and dividends payable
• Other liabilities maturing within a year.
Working capital is also known as circulating capital, fluctuating capital
and revolving capital. The magnitude and composition keep on
changing continuously in the course of business.
Accounts receivables:
Trade credit creates book debts or accounts receivable. It is used as a
marketing tool to maintain or expends the firm’s sales. A firm’s
investment in accounts receivable depends on volume of credit sales
collection period. The financial manager can influence volume of credit
terms, and collection efforts. Credit standards are criteria to decide to
whom credit sales can be made and how much. If the firm has soft
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standards and sells to almost all customers, its sales may increase but its
costs in the form of bad-debt losses and credit administration will also
increase. Therefore, the firm will have to consider the impact in terms of
increase in profits and increase in costs of a change in credit standards or
any other policy variable. The incremental return which a firm may gain
by changing its credit policy should be compared with the cost of funds
invested in receivables. The firm’s credit policy will be considered
optimum at the point where incremental rate of return equals the cost of
funds. The cost of funds is related to risk; it increases with risk. Thus, the
goal of credit policy is to maximize the shareholders wealth; it is neither
maximization of sales nor minimizations of bad-debt losses.
The conditions for extending credit sales are called credit terms and they
include the credit period and cash discount. Cash discounts are given for
receiving payments before than the normal credit period. All customers
do not pay within the credit period. Therefore, a firm has to make efforts
to collect payments from customers. Collection efforts of the firm aim at
accelerating collections from slow-payers and reducing bad-debt losses.
The firm should in fact thoroughly investigate each account before
extending credit. It should gather information about each customer,
analyze it and then determine the credit limit. Depending on the financial
condition and past experience with a customer, the firm should decide
about its collection tactics and procedures.
There are three methods to monitor receivables. The average collection
period and again schedule are based on aggregate data for showing the
payment patterns, and therefore, do not provide meaning information for
controlling receivables. The third approach which uses disaggregated data
is the collection experience matrix. Receivables outstanding for a period
are related to credit sales of the same period. This approach is better than
the two traditional method of monitoring receivables.
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Inventory Management:
Inventories constitute about 60% (per cent) of current assets of public
limited companies in India. The manufacturing companies hold
inventories in the form of raw materials, work-in-process and finished
goods. There are at last three motives for holding inventories.
1. To facilitate smooth production and sales operation (transaction
motive).
2. To guard against the risk of unpredictable changes in usage rate
and delivery time (precautionary motive).
3. To take advantages of price fluctuations (speculative motive).
Inventories represent investment of a firm’s funds. The objective of the
inventory management should be the maximization of the value of the
firm. The firm should therefore consider:
a. Costs,
b. Return, and
c. Risk factors in establishing its inventory policy.
Two types of costs are involved in the inventory maintenance:
1. Ordering costs: requisition. Placing of order, transportation
receiving, inspecting and storing and clerical and staff services.
Ordering costs are fixed per order. Therefore, they decline as the
order size increases.
2. Carrying costs: warehousing, handling, clerical and staff services,
insurance and taxes. Carrying costs vary with inventory holding.
As order size increases, average inventory holding increases and
therefore, the carrying costs increase.
The firm should minimize the total cost (ordering plus carrying). The
economic order quantity (EOQ) of inventory will occur at a point where
the total cost is minimum.
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Cash Management:
Cash is required to meet a firm’s transactions and precautionary needs. A
firm needs cash to make payments for acquisition of resources and
services for the normal conduct of business. It keeps additional funds to
meet any emergency situation. Some firms any also maintain cash for
taking advantages of speculative changes in prices of input and output.
Management of cash involves three things:
(a) Managing cash flows into and out of the firm,
(b) Managing cash flows within the firms, and
(c) Financing deficit or investing surplus cash and thus, controlling
cash balance at a point of time. It is an important function in
practice because it is difficult to predict cash flows and there is
hardly any synchronization between inflows and outflows.
Firms prepare cash budget to plan for and control cash flows. Cash
budget is generally prepared for short periods such as weekly, monthly,
quarterly, half-yearly or yearly. For making forecasts of cash receipts and
payments, two approaches are used in practice:
i. The receipt and disbursements method, and
ii. The adjusted income method.
The individual items of receipts and payments are identified and
analyzed. Cash inflows could be categorized as:
i. operating
ii. non operating, and
iii. Financial.
Cash outflows could be categorized as:
i. operating
ii. capital expenditure
iii. contractual, and
iv. Discretionary.
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Such categorization helps in determining avoidable or postponable

expenditures. The adjusted income method uses proforma income
statement (profit and loss statement) and balance sheet to work out cash
flows (by deriving proforma cash flow statement). As cash flows are
difficult to predict, a financial manager does not base his forecasts only
on one set of assumptions. He or she considers possible and pessimistic
scenarios can be worked out.
Cash budget will serve its purpose only if the firm can accelerate its
collection and postpone its payments within allowed limits. The main
concerns in collection are:
a. to obtain payment from customers within the credit
period,
b. To minimize the lag between the times a customer pays
the bill and the time cheque etc. are collected.
A number of methods such as concentration banking and lock-box system
can be followed to expedite conversion of an instrument (e.g. cheque,
draft, bills, etc.) into cash. The financial manager should be aware of the
instruments of payments, and choose the most convenient and least costly
mode of receiving payment. Disbursements or payment can be delayed to
solve a firm’s working capital problem. But this involves cost which, in
the long run, may prove to be highly detrimental. Therefore, a firm
should follow the norms of the business.
A firm should hold an optimum balance of cash, and invest any
temporary excess amount in short-term (marketable) securities. In
choosing these securities, the firm must keep in mind safety, maturity and
marketability of its investment.
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Objectives of Working capital management

The basic objectives of working capital management are as follows:
• By optimizing the investment in current assets and by reducing the
level of current liabilities, the company can reduce the locking up
of funds in working capital thereby; it can improve the return on
capital employed in business.
• The second important objective of working capital management is
that the company should always be in a position to meet its current
obligations which should properly be supported by the current
assets available with the firm. But maintaining excess funds in
working capital means locking of funds without return.
• The firm should manage its current assets in such a way that the
marginal return on investment in these assets is not less than the
cost of capital employed to finance the current assets.
Gross and Net Working Capital

Generally the working capital has its significance in two perspectives –
‘Gross working capital’ and ‘Net working capital’, the term ‘Gross
working capital’ refers to the firm’s investment in current assets. The
term ‘Net working capital’ refers to the excess of current assets over
current liabilities. These gross working capital and net working capital
are called Balance sheet approach of working capital.
Permanent and Temporary Working Capital
Considering time as the basis of classification, there are two types of
working capital viz, ‘Permanent’ and ‘Temporary’. Permanent working
capital represent the assets required on continuing basis over the entire
year, whereas temporary working capital represents additional assets
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required at different items during the short term debt financing. For
example, in peak seasons, more raw materials to be purchased, more
manufacturing expenses to be incurred, more funds will be locked in
debtors balance etc. In such times excess requirement of working capital
would be financed from short-term financing sources.
The permanent component current assets which are required through the
year will generally be financed from long term debt and equity. Tendon
committee has referred to this type of working capital as ‘Core Current
Assets’. Core Current Assets are those required by the firm to ensure the
continuity of operations which represents the minimum levels of various
items current assets viz., stock of raw materials, stock of work – in –
progress, stock of finished goods, debtors’ balances, cash and bank etc.
This minimum level of current assets will be financed by the long-term
sources and any fluctuation over the minimum level of current assets will
be financed by the short-term financing. This is shown below. Some time
core current assets are also referred to as ‘hard core working capital’.
Temporarycurrent asset Short term
Financing
Rs.
Permanent current assets
Longterm
+
FixedAssets Equitycapital
0 Times
The management of working capital is concerned with maximizing the

return to shareholders within the accepted risk constraints carried by the
participants in the company. Just as excessive long-term debt puts a
company at risk, so an inordinate quantity of short-term debt also
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increases the risk to a company by straining its solvency. The suppliers of

permanent working capital look for immediate return and the cost of such
financing will also be costlier than the cost of permanent funds for
working capital.
Disadvantages of Insufficient Working Capital

The disadvantages suffered by a company with insufficient working
capital are as follows:
• The company is unable to take advantage of new opportunities or
adopt to changes.
• Trade discounts are lost. A company with ample working capital is
able to finance large stocks and can therefore place large orders.
• Cash discounts are lost. Some companies will try to persuade their
debtors to pay early by offering them a cash discount off the price
owed.
• The advantages of being able to offer a credit line to customers are
foregone.
• Financial reputation is lost result in non-cooperation from trade
creditors in times of difficulty.
• There may be concerted action by creditors and will apply to court
for winding up.
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Operating Cycle Concept

A new concept which is gaining more and more importance in recent
years is the ‘Operating Cycle Concept’ of Working Capital. The
operating cycle refers to the average time elapses between the acquisition
of raw materials and the final cash realisation.
Cash is used to buy raw materials and other stores, so cash is converted
into raw materials and stores inventory. Then the raw materials and stores
are issued to production department. Wages are paid and other expenses
are incurred in the process and work-in-process comes into existence.
Work-in-process becomes finished goods. Finished goods are sold to
customers on credit. In the course of time, these customers pay cash for
the goods purchased by them. ‘Cash’ is retrieved and the cycle is
completed. Thus, operating cycle consists of four stages:
• The raw materials and stores inventory stage
• The work-in-process stage
• The finished goods inventory stage
• The receivable stage
The operating cycle of working capital is shown below:
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Collection of Cash Purchase of

receivables Raw materials
Raw material
Accounts inventory
Receivables
Work-in-process
S ale s Finished
goods Issue of materials of production
and incurring expenses
The operating cycle being with the arrival of the stock, and ends when
the cash is received. The cash cycle beings when cash is paid for
materials, and ends when cash is collected from receivables.
RawMaterial
Purchased
Order Stock Finished Cash
Placed Arrived GoodsSold Receivables
Work-in-processInventoryPeriod AccountsReceivablesPeriod
Time
AccountsPayablePeriod
Invoice CashPaidFor
Received Materials
OperatingCycle
CashCycle
Importance of Operating Cycle Concept
The application of operating cycle concept is mainly useful to ascertain
the requirement of cash working capital to meet the operating expenses of
a going concern. This concept is based on the continuity of the flow of
value in a business operation. This is a important concept because the
longer the operating cycle, the more working capital funds needs.
Management must ensure that this cycle does not become too long. This
concept more precisely measures the working capital fund requirements,
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traces its changes and determines the optimum level of working capital
level of working capital requirements.
Reasons for prolonged Operating Cycle –

The following could be the reasons for longer operating cycle period:
- Purchase of materials in excess / short of requirements
- Buying inferior, defective materials
- Failure to get trade discount, cash discount
- Inability to purchase during seasons
- Defective inventory policy
- Use of protracted manufacturing cycle
- Lack of production planning, coordination and control
- Mismatch between production policy and demand
- Use of outdated machinery, technology
- Poor maintenance and upkeep of plant, equipment and
infrastructural facilities
- Defective credit policy and slack collection policy
- Inability to get credit from suppliers, employees
- Lack of proper monitoring of external environment etc.
How to reduce Operating Cycle?
The aim of every management should be to reduce the length of operating
cycle or the number of operating cycle in a year. Only then the need for
working capital decreases. The following a few remedies may become
handy in contrasting the length of operating cycle period.
♦ Purchase management
The purchase manager owes a responsibility in ensuring availability of
right type of materials in right quantity of right price on right time and
at right place. These six R’s contribute greatly in the improvement of
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length of operating cycle. Further, streamlining of credit from supplier

and inventory policy also help the management.
♦ Production Management
The production manager affects the length of operating cycle by
managing and controlling manufacturing cycle, which is a part of
operating cycle and influences directly. Longer the manufacturing
cycle, longer will be the operating cycle and higher will be the firm’s
working capital requirements. The following measures may be taken:
- Proper maintenance of plant, machinery and other
infrastructural facilities.
- Proper planning and coordination at all levels of activity.
- Up-gradation of manufacturing system, technology.
- Selection of the shortest manufacturing cycle out of
various alternative etc.
♦ Marketing Management
The sale and production policies should be synchronized as far as
possible. Lack of matching increase the operating cycle period.
Production of Qualitative products at lower costs enhances sales of
the firm and reduces finish goods storage period. Effective
advertisement, sales promotion activities, efficient salesmanship, use
of appropriate distribution channel etc., reduces the storage period of
the finished products.
♦ Sound Credit and Collection Policies
Sound credit and collection policies enable the Finance Manager in
minimizing investment in working capital in the form of book debts.
The firm should be discretionary in granting credit them to its
customers. In order to see that the receivables conversion period is
not increased, the firm should follow a rationalized credit policy
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based on the credit standing of customer are other relevant facts. The
firm should be prompt in making collections. Slack collection
policies will tie up funds for long period, increasing length of
operating cycle.
♦ Proper Monitoring of External Environment
The length of operating cycle is equally influenced by external
environment. Abrupt changes in basic conditions would affect the
length of operating cycle. Fluctuation in demand, competitors,
production and sales policies. Government fiscal and monetary
policies, changes on import and export front, price fluctuations, etc.,
should be evaluated carefully by the management to minimize their
adverse impact on the length of operating cycle.
♦ Other Suggestions
The personnel manager by framing should recruitment, selection,
training, placement, promotion, transfer, wages, incentives and
appraisal policies can contract the length of operating cycle. Use of
Human Resources Development technique in the organization
enhances the morale and zeal of employees thereby reduces the length
of operating cycle. Proper maintenance of plant, machinery,
infrastructural facilities, timely replacement, renewals, overhauling
etc., will contribute towards the control of operating cycle.
These measures, if adhered properly, would go a long way in minimizing
not only the length of operating cycle period but also the firm’s working
capital requirements.
Gross and Net Operating Cycle -

In a manufacturing firm, the operating cycle for element of cost, say
direct material, starts with the purchase of materials. Materials are not
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consumed immediately. There involves ‘Raw Materials conversion

period (RCMP)’.
Once materials are issued to production, it again involves time gap
between issue of materials and production of finished product. This time
gap is called as ‘Work-in-process conversion period (WIPCP)’.
Industries produce the output in the expectation of demand or for the
purpose of assembly. Till the demand for finished product materializes,
the product would remain in the store. This period is termed as ‘Finished
goods conversion period (FGCP)’.
The enterprise due to competitive reason and other reasons extended
credit facilities to customers. This time gap between sale and realisation
of cash is known as ‘Book Debt conversion period (BDCP)’.
Business enterprises receive credit in the purchase of raw materials from
the suppliers. This period is called as ‘Payment deferral period (PDP)’.
This payment period reduced the length of operating cycle of business
firm.
The length of operating cycle of manufacturing firm in ‘Direct material’
can be calculated with the help of following formulae.
Gross Operating Cycle = RMCP + WIPCP + FGCP + BDCP
Net Operating Cycle = Gross Operating Cycle – PDP
Or = RMCP + WIPCP + FGCP – PDP
Similar conclusion can also be drawn for other elements of cost i.e., for
Direct wages and overheads. In the case of Direct wages overheads, the
operating cycle starts with the ‘Work-in-progress Conversion Period
(WIPCP)’ as there will be ‘Raw materials Conversion Period (RMCP)’.
The chart below shows the operating cycle for these elements of cost with
hypothetical figures.
Particulars Direct Direct Overheads
Materials Wages
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Raw materials conversion period 2 - -

(RMCP)
Work-in-progress conversion period 3 3 3
(RMPCP) 1 1 1
Finished goods conversion period 2 2 2
8 6 6
(FGCP)
1 ½ -
Book debts conversion period (BDCP)
7 5½ 6
Gross operating cycle
Less : Payment deferral period (PDP)
Net operating cycle
Practical utility of Operating Cycle Concept

The net operating cycle represents the net time gap between investment
of cash and its recovery of sales revenue. If depreciation is excluded from
expenses in the computations of operating cycle, the net operating cycle
also represents the cash conversion cycle. It is the net time interval
between cash collection from sale of product and cash payments for
resources acquired by the firm.
It is the task of Finance Manager the operating cycle effectively and
efficiently. The length of operating cycle is the indicator of operating
management performance. The net operating cycle represents the time
interval for which the firm has to negotiate for working capital from its
Bankers. It enables to determine accurately the amount of working capital
needed for the continuous operation of its activities. The operating cycle
calls for proper monitoring of external environment of the business.
Changes in Government policies like taxation, import restrictions, credit
policy of Central Bank, price trend, technological advancement etc., have
their own impact on the length of operating cycle.
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Role of Banks in Working Capital Management

Banks are the main institutional sources of working capital finance in
India. After trade credit, bank credit is the most important source of
financing working capital requirements of firms in India. A bank
considers a firm’s sales and production plans and the desirable levels of
current assets in determining its working capital requirements. The
amount approved by the bank for the firm’s working capital is called
credit limit. Credit limit is the maximum funds which a firm can obtain
from the banking system. In the case of firms with seasonal business,
banks may fix separate limits for the ‘peak limit’ credit requirement and
‘normal non-peak level’ credit requirement indicating the periods during
which the separate limits will be utilized by the borrower. In practice,
banks do not lend 100 per cent of the credit limit; they deduct margin
money. Margin requirement is based on the principle of conservatism and
is meant to ensure security. If the margin requirement is 30 per cent, bank
will lend only upto 70 per cent of the value of the asset. This implies that
the security of bank’s lending should be maintained even if the asset’s
value falls by 30 per cent.
Till the mid – 1970s the principles of commercial banks lending in India
was predominantly security oriented. It was more or less net worth based,
collateralized financing. Major Banks were nationalized in 1969 and with
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that, approach to lending also changed in 1974, a study group under the
chairmanship of P.L.Tandon was formed to examine the existing methods
of lending and suggest changes. The group submitted its report in August
1975, which came to be popularly known as Tandon committee’s report.
It was a Landmark in the history of bank lending in India. With the
acceptance of major recommendations by RBI a new era of lending being
in India.
Tandon Committee recommendations:
Introduction:-
With the nationalization of major commercial banks in 1969, the
emphasis in bank lending shifted from security to purpose with a bias for
production. The demand for bank credit also registered a phenomenal
growth. While small industries, self-employed and agricultural sectors
and public sector required an increasing share in bank credit, a sizable
share thereof continued to flow into large and medium industries.
Along with increasing demand for bank credit (making it scarce
everyday), there was an ever-increasing inflation calling for control of
bank credit. During 1973-74, inflation touched a level of 31%. Reserve
Bank of India took both monetary and fiscal measures to curb the
inflation.
It was also thought that time was ripe to have a complete review of bank
credit so as to gear it to the development role expected of banks in the
economy. Reserve Bank of India, thus appointed in 1974 a study group
with Sri P.L.Tandon, then chairman, Punjab National Bank as the
chairman. This study group for Framing Guidelines for the following up
of Bank Credit came to be popularly known as the Tandon Committee.
The Reserve Bank of India has accepted the major recommendations and
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banks have to implement them. The major areas covered by the

recommendations are:
Norms for holding inventory and receivables;
Maximum permissible bank finance;
Style of credit; and
Follow up and supervision of credit
Norms for Inventory receivables

The Committee has given itself to the study of those items against which
bank advance is made. In term of the production requirements, the
committee has worked out the level of current assets which each
industrial unit cash hold. These are called the ‘norms’. Norms are the
maximum level of these assets that a unit cab hold. Norms are expressed
in terms in terms of periods for which the assets can be held. The assets
for which norms have been prescribed and the terms in which they are
expressed are given below:
Raw material - So many cost of raw materials consumed
Work-in-Progress - So many month’s cost of production
Finished goods - So many month’s cost of sales
Receivables - So many month’s sales
Norms in the beginning were prescribed for 15 selected industries, which
together accounted for about 50% of the total bank credit to the industry.
Further, they are applicable only to these units have working capital
limits aggregating to Rs. 10 lakhs and above in the entire banking system.
The banks are expected to apply the spirit of the recommendations to
accounts having smaller limits also.
The following factors may be noted while dealing with the norms:
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♦ Norms are the maximum level of current assets that a unit can hold.
They are not the optimum levels. Therefore, if a unit is having
current assets at levels less that the norms, it should continue to
hold at the same level.
♦ Norms have been prescribed separately for 49 different industries.
If few cases, different norms are given for different regions for the
same industry. The norms appropriate to the unit in question should
be applied.
♦ Norms have been prescribed separately for individual current asset.
The unit should satisfy the requirement of norms for individual
component separately. For instance, for pharmaceutical industry,
norms for raw materials and work-in-progress are 2 ¾ months and
½ month respectively. The unit cannot have 2 ¼ months of raw
materials and 1 month of work-in-progress. But in certain cases, a
combined norm for finished goods and receivable is given. In such
cases, the holding of finished goods and receivables can vary
within the overall ceiling prescribed. It should be noted that the
combined norms is 2 ½ months, finished goods can be for 1 month
and receivables for 1 ½ months finished goods and 2 ¼ months
receivable.
♦ No Norms is fixed for export receivables, imported raw materials
and other current assets. For these items, the banker has to go by
the past level of holding.
♦ The level of spares not normally exceeds 5% of the total inventory.
The tendency is to consider spares as current assets only upto the
level of 5% of the total current assets and treat the balance as
miscellaneous assets.
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Maximum Permissible Bank Finance:

The committee has suggested three methods of working out of the
maximum amount that a unit may expect from the bank. The extent of
bank finance will be more in the first method, less in the second method
and the least in third method. The three alternatives may be illustrated by
the following example taken from the report of the committee. The
borrower’s financial position projected as at the end of the next year are
as under.
(Rs. Lakh)
Current Liabilities Current Assets
Creditors for purchases 100 Raw material 200
Other current liabilities 50 Stock in process 20
150
Finished goods 90
Bank borrowings, Receivables, including
50
including discount with bills discounted with 200
bankers bankers 10
Other Current Assets
350 370
As per suggested norms or past practice, whichever is lower in relation to
projected production level for the next year.
(Rs. Lakh)
1st method 2nd method 3rd method
Total Current 370 Total Current 370 Total current 370
assets assets assets
Less: 150 Less: 92 Less: 95
Current 25% of above Core current
liabilities from long- Assets
(other than term sources From long-
long-term term sources
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borrowings) real current

assets
220 278
25% of above
Less: 275
from long-
25% of above 55 Current 150
term sources
form long-term liabilities 69
206
sources (other than
Less:
long-term
Current 150
borrowings)
Liabilities
(other than
bank
borrowings)
MPBF* 165 MPBF* MPBF* 56
128
Working
capital gap 220 220 220
(370-150) 35 72 144
Excess 1.71:1 1.33:1 1.79:1
borrowing
Current ratio
MPBF* = Maximum Permissible Bank Finance.

Initially, all units were placed under method 1. It was expected that over
year the units would progress and could be placed in successive methods.
Accepting the recommendations of Tandon committee, the Reserve Bank
has directed the banks in December 1980 that Method 2 should be applied
for all accounts where the total working capital limit is Rs. 50 lakhs and
above.
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The minimum current ratio under method 1 works out to 1.71:1 and to
1.33:1 under method 2.
Deviation from norms

Norms prescribed by the Tandon committee are not rigid. Deviation from
norms can be allowed for agreed short periods and in situation
satisfactory to the bankers. In the following cases deviation are usually
allowed:
♦ Bunched receipt of raw material including imports.
♦ Power-cuts, strikes and other unavoidable interruptions in the
process of production, transport delays and bottlenecks.
♦ Accumulating of finished goods due to non-availability of shipping
space for exports or other disruptions in sales (but not under
circumstance where sale stimulation is needed through reduction in
prices).
♦ Build –up of stocks of finished goods such as machinery due to
failure (on the part of purchasers for whom those were specifically
manufactured) take delivery.
♦ Need to cover full or substantial requirement of raw materials for
specific export contract of short duration.
Slip Back
A unit whose current ratio is better than the minimum required under the
first method should not be allowed so slip back or worsen it. There were,
however, many representations from industry and Reserve Bank has
allowed the slip back subject the condition that the relaxation does not
result in the contribution of the unit to the working capital gap going
26
below a minimum of 25%. The relaxation is allowed in the following

cases:
- Fro undertaking either an expansion of existing capacity
or for diversification.
- Fro fuller utilization of existing plant capacity.
- For meeting a substantial increase in the unit’s working
capital requirement on account of abnormal price rise.
- For bringing about a reduction in the level of deposits
accepted from the public for complying with statutory
requirements.
- Fro repayment of the installments due; under foreign
currency loans and other term loans.
Style of credit and flow of information:
The recommendation of the Tandon committee with regard to the above
since been modified by the recommendation of the chore committee.
Chore Committee recommendations:

Introduction:-
On reviewing the monetary and credit trends for the busy session of
1978-79, the RBI felt that the extensive use of cash credit system was a
deterrent factor in implementing the credit regulatory measures by the
banks. The Tandon committee had recommended bifurcations of credit
limits into a deemed loan and a fluctuating cash credit component. But
implementation of this recommendation was very slow. The Reserve
Bank, therefore, though that this problem needed a deep study and
decision was taken to entrust the work to a working group. Accordingly a
‘Working Group to review the system of cash credit was constituted in
27
April 1979 under the chairmanship of Sri.K.B.Chore, Chief Officer,

DBCOD, Reserve Bank of India.
Recommendations:
The Committee submitted its final report in August 1979. The major
areas covered by the recommendations are:
♦ Use of different types of advances, cash credit, loan and bills-all
types to continue.
♦ Bifurcation of cash credit limit into demand loan and fluctuating
cash credit portions – not favored because:
1. For seasonal industries the different is too much; for sales
season period the account may be in credit in which case the
loan portion should be nil.
2. For non-seasonal industries the difference is too marrow to
be of any help to the banker.
♦ Separate limits to be granted for peak level and normal non-peak
level credit requirements.
♦ All borrowers (except sick units) with working capital requirement
of Rs. 10 Lakh and above to be placed under second method of
lending recommended by Tandon Committee.
♦ The flow of information from borrower to banks to be simplified.
28
♦ Bank to take up financing a portion of raw material by way of

drawee bills.
Implementation of recommendations:
The recommendations of the committee have been accepted by the RBI
subject to certain modifications. The directives of the RBI on
implementing the recommendations were issued to the banks in
December 1980.
1. Working capital advances of Rs. 10 Lakhs and over (aggregate
working capital advances per borrower)
♦ Banks should review all borrowal accounts to verify the
continued viability and also to assess the need based
character of the advance.
♦ Bifurcation of cash credit accounts into demand loan
component and cash credit portion charging different rates of
interest is withdrawn. If already bifurcated steps should be
taken to abolish the different interest rate with immediate
effect.
2. Working capital advances of Rs. 50 Lakhs and over (aggregate
working capital advance per borrower)
♦ While assessing the credit requirement of borrowers
wherever feasible, the banks should sanction separate limits
for peak level requirement and normal non-peak level
requirements.
♦ Within the limits sanctioned withdrawals from the
account are to be regulated through quarterly statements.
Before the commencement of a quarter the borrower should
indicate his requirements for the quarter by submitting the
quarterly statement (Form I) giving estimates of current
29
assets, current liabilities, bank borrowing, production and

sales. This set operating limit for the quarter.
♦ Ad hoc or temporary limits may be sanctioned in
exceptional cases for predetermined short periods to meet
unforeseen contingencies. Such facilities should be in the
form of a separate demand loan or a non-operable cash credit
account. Except in exceptional cases like natural calamities
and in the case of accounts under nursing programmer banks
are to charge interest at 1% more than the normal rate.
♦ Enhancement of borrowers’ contribution is to be
enforced through placing them under second method of
lending recommended by Tandon committee. According to
this working capital to the extent of at least 25% of the
current assets should be financed by term finance and
contribution from owned funds. This would give a minimum
current ratio of 1.33:1.0.
♦ Discounting bills should be encouraged in place of
cash credit against book debts for financing sales. Wherever
possible existing cash credit against book debts should be
converted into bill limits.
♦ Drawee bill financing should be encouraged for
financing raw material under bill system. Under this, the
seller draws a bill on the buyer. The bank accepts the bill
thus enabling the seller to discount the bill with bank or any
other bank may itself pay the bill amount to the seller. At
least 50% of the cash credit limit against raw materials
sanctioned to manufacturing units should be by way of
drawee bill limits. For example, if the party has been
30
sanctioned a total limit Rs. 200 Lakhs the individual limit

would be as follows:
Cash credit (margin 50%) Rs. 100 Lakhs
Drawee bill discounting Rs. 100 Lakhs
The stock statement may reveal the following particulars:
Stock paid for Rs. 100 Lakhs
Stock received under bill discounting Rs. 75 Lakhs
Unpaid stock Rs. 25 Lakhs
Drawing limits would be determined as under:
Cash credit (Rs. 100 Lakhs less 50% margin) Rs. 50 Lakhs
Bill discounting Rs. 75 Lakhs
When the bill is met by borrower, the stock would be taken under cash
credit. Then it would subject to margin requirements.
Nayak Committee Recommendations:

Considering the contribution of SS! Sector to overall industrial
production, exports and employment and als orecognizing the need to give
a fillip to this sector, RBI has accepted the recommendations of Kayak
committee ("Committee to examine the adequacy of Institutions Credit to
SSI sector and related aspects” headed by Sri. P.R. Nayak). The salient
features of the committee's recommendations are:-
♦ To give preference to village industries, tiny industries and other
small scale units in that order while meeting the credit

requirements of small scale sector.
♦ For the credit requirements of village industries, tiny industries and
other SSI units upto aggregate fund based working capital credit
limits upto Rs. 50 lakhs from the banking system, the norms for
inventory and receivables as also the methods of lending as per
Tandon Committee will not apply. Instead, for such units the
31
working capital limit will be computed at 20% of their projected

annual turn over (for both new as well as existing units). These SSI
units will be required to bring in 5% of their annual turnover as
margin money. In other words, 25% of the output value should be
computed as working capital requirement, of which at least 4/5th
should be provided by Banking Sector, the remaining 1/5th
representing borrower's contribution towards margin money for the
working capital. Branches have to satisfy themselves about the
reasonableness of projected annual turnover of the applicants.
♦ Preparation of annual Budget in respect of Working Capital
requirements of SSI sector on "bottom up" basis.

♦ Sick SSI unit redefined.
♦ Banks are advised to adopt "Single Financing Approach "for

meeting both Term Loan and working capital requirements of SSI sector.
The "Single Window Scheme "(SWS) of SIDBI enables commercial
banks to provide term loans and working capital to SSI units have a
project outlay upto Rs. 20 lakhs and working capital requirement upto
Rs. 10 lakhs.
♦ Banks to set up effective grievance cells to enable SSI borrowers to
approach in case of difficulties.
♦ SSI loan applications should be disposed off within time frame laid
down as follows:
In case of credit upto Rs. 25,000 within 15 days
In all other case 8 to 9 weeks
♦ To help eliminate delay in sanction of limits to SSI units, Banks
should adopt a system of committee approach, in which decisions

are taken by the competent authority after a structured discussion
with the Branch Manager and also the authorities at the intervening
level.
32
♦ Rejection/curtailment of limits by sanctioning authority

should be referred to the next higher authority should be referred to
next higher authority for confirmation.
♦ Branches should not insist on deposit mobilization of
stipulated amounts as a precondition to the sanction of credit.
However, they can enlist the co-operation of these customers for
deposit mobilization.
♦ Branch level officials should have the right aptitude, skills
and orientation with respect of financing SSI sector.
Vaz Committee Recommendations:

The Vaz committee has extended the concept of Nayak committee to all
business enterprises, which also has been accepted and implemented. The
borrower has to bring in a margin of 5% of the projected turnover from
long-term sources as his contribution and 20% would be provided by the
financing bank. Thus, the working capital limits have no relation to the
current assets which is a total departure from Tandon and Chore
Committees.
In arriving at 25% of the projected turnover as the working capital

requirement, the committee has assumed an average of four working
capital cycles in a year. This method of determining the working capital
has understandably made the small entrepreneur happy as he is assured of
a working capital facility from his bankers bearing a direct relationship to
his expected turnover.
Further, he is also able to determine for himself his eligibility for a

working capital limits, but banks, in spite of stiff instructions from the
33
RBI to abide by the new guidelines, still stick to the traditional method.
Bank policy to lend the working capital
The following approaches are generally followed by the banks in

financing working capital needs of the business firms:
♦ Maximum Permissible Bank Finance (MPBF) - Under MPBF
approach, the capital finance limits of a firm at either 75 per cent
of the company’s current assets or the different between 75 per
cent of current assets and non-bank current liabilities. The
inherent concept of the approach is that scarce credit must be
rationed.
Under this method, the minimum acceptable current ratio was
specified, thus fixing the minimum contribution of the corporate
to funding working capital gap. At the same time, the maximum
current assets levels were prescribed through a series of
inventories and receivables norms.
♦ Current Ratio Financing - The liquidity of the
firm is said to be satisfactory if it is able to meet its obligations in
the short - run. The measure of liquidity is the ratio of current
assets to current liabilities. Hence current ratio is used by the
34
bankers in estimating and financing the working capital needs of

the firms. The acceptable current ratio is, therefore, the ratio of
bank funds to own funds. This ratio is fixed through negotiation
between the Corporate and the Banker.
♦ Cash flow Financing - The need for working
capital arises essentially because of uneven and uncertain
nature of cash flows. This is because cash outflows to meet
production expenses do not occur at the same time as cash
proceeds from sales are realised. They are uncertain because
sales and costs are not known in advance. By projecting future
cash receipts and disbursements, the cash budget enables the
corporate to determine its cash needs, and plan their financing
accordingly. Under this approach, bank finance~ based on the
submission of periodic say, quarterly, cash flow statements
that would fit smoothly into a firm’s cash cycle. To determine
the quantum of bank finance, banks must evaluate cash-flow
risks, forcing them to be more involved in day to day
operations of the borrower. Once the bank has appraised the
cash budget, ad hoc requests for more funds will not be
entertained. This will demand sound resource planning&
receivable management, purchase planning and management
of inventory.
35
Different kinds of working capital

financing
The main source of working capital financing, namely, Trade credit,
Bank credit, Factoring and Commercial papers.
TRADE CREDIT:
Trade credit refers to the credit that a customer gets from suppliers of
goods in the normal course of business. In practice, the buying firms do
not have to pay cash immediately for the purchases made. This deferral of
payments is a short-term financing called trade credit. It is major source
of financing for firms. In India, it contributes to about one-third of the
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 in the capital markets.
Trade credit is mostly an informal arrangement, and is granted on an open
account basis. A supplier sends goods to buyer on credit which the buyer
accepts, and thus, in effect, aggress to as a debt: he does not sign any
legal instrument. Once the trade links have been established between
36
routine activities which may be periodically reviewed by the supplier.

Open account trade credit appears as sundry creditors (known as accounts
payable in USA) on the buyer’s balance sheet.
Trade credit may also take the form of bills payable. When the buyer
signs a bill - a negotiable instrument – to obtain trade credit, it appears on
the buyer’s balance sheet as bills payable. The bill has a specified future
date, and is usually used when the supplier is less sure about the buyer’s
willingness and ability to pay, or when the supplier wants cash by
discounting the bill from a bank. A bill is formal acknowledgement of an
obligation to repay the outstanding amount. In USA, promissory notes – a
formal acknowledgement of an obligation with promise to pay on a
specified date – are used an alternative to the open account, and they
appears as note payable in the buyer’s balance sheet.
Credit Terms
Credit terms refer to the conditions under which the supplier sells on
credit to the buyer, and the buyer is required to repay the credit. These
conditions include the due date and the cash discount (if any) given for
prompt payment. Due date (also called net date) is the date by which the
supplier discount is the concession offered to the buyer by the supplier to
encourage him to make payment promptly. The cash discount can be
availed by the buyer if he pays by a certain date which is quite earlier
than the due date. The typical way of expressing credit terms is, for
example, as follows; 3/1.5, net 45’. This implies that a 3 per cent discount
is available if the credit is repaid on the 15th day, and in case the discount
is not taken, the payment is due by the 45th day.
Benefits and Cost of Trade Credit:
As stated earlier, trade credit is normally available to a firm: therefore, it
is a spontaneous source of financing. As the volume of the firm’s
purchase increases, trade credit also expands. Suppose that a firm
37
increases its purchases from Rs.50, 000 per day to Rs. 60,000 per day.
Assume that these purchases are made on credit terms of ‘net 45’, and the
firm makes payment on the 45th day. The average accounts payable
outstanding (trade credit finance) will expand to Rs 27 lakh (Rs. 60,000 x
45) from Rs. 22.50 lakh (Rs. 50,000 x 45).
Advantages of trade credit:
♦ Easy availability: Unlink other sources of finance, trade
credit is relatively easy to obtain. Except in the case of financially
very unsound firms, it is almost automatic and does not require any
negotiations. The easy availability is particularly important to small
firms. Which generally face difficulty in raising funds from the
capital markets.
♦ Flexibility: Flexibility is another advantage of trade credit.
Trade credit grows with the growth in firm’s sales. The expansion
in the firm’s sales causes its purchases of goods and services to
increase which is automatically financed by trade credit. In
contrast, if the firm’s sales contract, purchases will decline and
consequently trade credit will also decline.
♦ Informality: Trade credit is an informal, spontaneous source
of finance. It does not require any negotiation and formal
agreement. It does not have the restrictions which are usually parts
of negotiated sources of finance.
Bank credit: Bank credit is the primary institutional source of working

capital finance in India; in fact, it represents the most important source
of financing of current assets.
Form of Credit:
Working capital finance is provided by banks in five ways:
38
Cash Credit/Overdrafts:
Under cash credits, the bank specifies a predetermined borrowing/ credit
limit. The borrows can draw/borrow up to the stipulated credit/overdraft
limit. Similarly repayments can be made whenever desired during the
period. The interest is determined on the basis of the running
balance/amount actually utilized by the borrower and not on the
sanctioned limit.
Loans:
Under the arrangement the entire amount of borrowing is credited to the
current account of the borrower or the released in cash. The borrower has
to pay interest on the total amount.
Bills purchased/discounted:
The amount made available under this arrangement is covered by the cash
credit and overdraft limit. Before discounting the bill, the bank satisfied
itself about the credit-worthiness of the drawer and the genuineness of the
bill. To popularize the scheme, the discounting banker asks the drawer of
the bill (i.e. seller of goods) to have his bill accepted by the drawee
(buyers) bank before discounting is latter grants acceptance against the
cash credit limit, earlier fixed by it on the basis of the borrowing value of
stocks therefore, the buyer who byes goods on credit cannot use the same
goods as source of obtaining additional bank credit.
Term loans for working capital:
Under this arrangement, banks advance loans for 3-7 years repayable in
yearly or half yearly installments.
Letter of credit:
39
While the other forms of bank credit are direct forms of financing in
which banks provide funds as well as bear risk, letter of credit is an
indirect form of working capital financing and banks assume only the
risk, the credit being provided by the supplier himself.
Mode of Security for Bank credit:

Banks provide credit on the following modes of security:
Hypothecation:
Under this method of security, the banks provide credit to borrowers
against the security of movable property, usually inventory of goods.
Pledge:
Pledge, as mode of security is different from hypothecation in that in the
former, unlike in the latter the goods which are offered as security are
transferred to the physical possession of the lender.
Lien:
The term ‘Lien’ refers to the right of the party to retain goods belonging
to another party until a debt due to him is paid.
Mortgage:
40
It is the transfer of the legal stock equitable interest in specific immovable

property for securing the payment of debts.
Charge:
Where immovable property of one person is, by the act of parties or by
the operation of law, made security for the payment of money to another
and the transaction does not amount to mortgage, the later person is paid
to have a charge on the property and all provisions of simple mortgage
will apply to such a charge.
COMMERCIAL PAPERS:
Meaning:
Commercial paper (CP), an important short term money market
instruments made its debut in India in the beginning of 1990. It was,
while adumbrating the credit policy for the first half of 1989, that the RBI
Governor announced the introduction of CPs, "with a view to enabling
highly rated corporate borrowers to diversifying their sources of short
term borrowing and also providing an additional instrument to investors."
Commercial paper is a short term financial instrument used by
accompany for raising funds from the money markets. Thus, it is a money
market instrument which is issued in the form of unsecured promissory
note in bearer form with a maturity period of one year or even less. The
issue of CP is expected to bring in financial discipline in the working
capital management of an issuer company as it has to ensure its
creditability in the money market by proper utilization of funds to finance
the current or short term transactions and honoring payment of CP on the
maturity date. CP can be issued either through direct placements or
41
through agents like banks, merchant bankers and financial institutions.

CP is freely negotiable by endorsement and delivery.
Advantages
A CP has several advantages for both the issuer and investors. It is a
simple instrument and hardly involves any documentation. It is
additionally flexible in terms of maturities which can be tailored to march
the cash flow of the issuer. Companies which are able to raise funds
through CP's have better financial standing. The CP's are unsecured and
there are no limitations on the end use of funds raised to them.
FACTORING:
Factoring provides resources to finance receivables as well as facilitates

the collection of receivables. Although such services constitute a critical
segment of the financial services scenario in the developed countries,
they appeared in the Indian financial scene only in early nineties as a
result of RBI initiatives. There are two bank sponsored organizations
which provide such services: (i) SBI factors and commercial services ltd.,
and (ii) can bank factors. The first private sector factoring company,
foremost factors ltd. Started operations since the beginning of 1997.
Definition and Mechanism:
Definition: Definition factoring can broadly be defined as an agreement

in which receivables arising out of sale of goods/services are sold by a
firm (client) to the 'factors' (a financial intermediary) as a result of which
the title of the goods/services represented by the said receivables passes
on the factor. Hence forth, the factor becomes responsible for all credit
control, sales accounting and debt collection from the buyers.
42
Mechanism: Credit sales generate the factoring business in the ordinary

course of business dealing. Realisation of credit sales is the main function
of factoring services. Once the sales transaction is completed, the factors
steps into realize the sales. Thus the factor works between the seller and
the buyer and sometimes with the seller’s banks together.
Function of a Factor:
Depending on the type/form of factoring, the main functions of a factor,
in general terms can be classified into following categories:
1. Financing facility trade debts.
2. Maintenance/administration of sales ledger.
3. Collection facility of accounts receivables.
4. Assumption of credit risk/credit control and credit restriction: and

next provision of advisory services.
Cost of Services
It is the factors provide various services at a charge. The charge for

collection and sales ledger administration is in the form of a commission
expressed as value of debt purchase. It is collected up-front/in advance.
The commission for short term financing as advance part-payment is in
the form of interest charged for the period between the date of advance
payment and the date of collection guaranteed payment date. It is also
known as discount charge.
43
Methods for Estimating Working Capital Requirements

There are three methods for estimating the working capital requirements
of a firm:
(i) Percentage of sales method (ii) Regression analysis method (iii)
Operating cycle method.
Percentage of Sales Method - It is a traditional and simple method of
determining the level of working capital and its components. In this
method, working capital is determined on the basis of past experience. if,
over the years, the relationship between sales and working capital is
found to be stable, then this relationship may be taken as a base for
determining the working capital for future.
This method is simple, easy to understand and useful for projecting
relatively short term changes in working capital. However, this
method cannot be recommended for universal application because the
assumption of linear relationship between sales and working capital
may not hold good in all cases.
44
Regression Analysis Method - It is a useful statistical technique

applied for forecasting working capital requirements. It helps in
making working capital requirement projection after establishing the
average relationship between sales and working capital and its
various components in the past year. The method of least squares is
used in this regard.
Operating Cycle Method – In this method the requirement of

working capital is estimating through the operating cycle period. It
varies from firm to firm and industry to industry. If the enterprise is
trading firm than it does not have operating cycle because, they are
directly buying goods from other and selling to others. If the
enterprise is manufacturing firm than their operating cycle depends
on their process of converting raw material into finished goods,
availability of raw material, power, fuel and other required thing to
manufacture.
Individual component approach

Detailed estimation is made using the individual components of the
operating cycle.
45
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 as below:-
♦ Nature of Business:
If we look at the Balance sheet of any trading organization, we find
major parts of the resources are deployed on current assets,
particularly stock-in-trade. Whereas in case of transport organization
major part of funds would be looked up in fixed assets like motor
vehicle, spares and work shed etc. and the working capital component
would be negligible. The service organization or public utilities need
lesser working capital than trading and financial organizations.
Therefore, the requirement of working capital depends upon the nature
of business carried by the organization.
♦ Manufacturing Cycle:
46
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 work-in-progress. This cycle determines the need of
working capital.
♦ Business Cycle Fluctuation:
This is another factor which determines the need level. Barring
exceptional cases, there are variations in the demand for
goods/services handled by any organization. Economic boom or
recession etc., have their influence on the transactions and
consequently on the quantum of working capital required.
♦ Seasonal Variations:
Variation apart, seasonality factor creates production or even storage
problem. Muster and many other oil seeds are Rabi crops. There are to
be purchased in a season o ensure continuous operation of oil plant.
Further there are woolen garments which have demand during winter
only. But manufacturing operation has to be conducted during the
whole year resulting in working capital blockage during off season.
♦ Scale of Operations:
Operational level determines working capital demand during a given
period. Higher the scale, higher will be the need for working capital.
However, pace of sales turnover (Quick or slow) is another factor.
Quick turnover calls for lesser investment in inventory while low
turnover rate necessitates larger investment.
♦ Credit Policy:
Credit policy of the business organization includes to whom, when
and to what extent credit may be allowed. Amount of money locked
47
up in account receivables has its impact on working capital. In

good many cases, account receivables are sterile and sticky and
thereby they have forfeited the right to be classified as current assets.
In view of such situation in ascertaining quick ratio instead of
deducting stock-in-trade we find it worth while to deduct sundry
debtors. The other component is credit policy of the suppliers, their
terms and conditions of credit. Trade credit has its historical presence
in the trading world. Availability of normal credit supplies as well as
trade credit facilities working capital supply and reduce the need for
bank finance.
♦ Accessibility to Credit:
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.
♦ Growth and Diversification of Business:
Growth and diversification of business call for larger volume of
working fund. The need for increased working capital does not follow
the growth of business operations but precedes it. Working capital
need is in fact assessed in advance in reference to the business plan.
♦ Supply Situation:
In easy and stable supply situation, no contingency plan is necessary
and precautionary steps in inventory investment can be avoided. But
in case of supply uncertainties, lead time may be longer necessitating
larger basic inventory, higher carrying cost and working capital need
48
for the purpose. No aggressive approach can gain foothold in such

situation.
♦ Environment Factors:
Political stability in its wake 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 – road, transport, storage and market
etc., influence business and working capital need as well.
Relaxation in Assessment of Working Capital by Banks

In order to provide greater freedom is assessing the working capital
requirements of borrowers, effective from April 15, 1997, all
instructions relating to MPBF were withdrawn. Banks were
instructed to evolve their own method such as turnover method, the
cash budget system, the MPBF system with necessary modifications
or any other system of assessing working capital requirements. The
loan policy in respect of each broad category of industry is, however,
required to be laid down by each bank with the approval of the
respective Board.
49
Ratios for the Working Capital

Working Capital ratio includes the ability of business concern in
meeting its current obligations as well its efficiency in managing its
current assets in generation of sales. These ratios are applied to
evaluate efficiency with the firm manages and utilizes its current
assets. The following three categories of ratios are used for efficient
working capital management.
1. Effective ratios
2. Liquidity ratios
3. Structural health ratios.
Effective ratios:-
Working capital to sales ratio = sales
Working capital
50
Inventory turnover ratio = sales

Inventory
Current Asset turnover ratio = sales
Current Assets
Liquid ratios:-
Current ratio = Current Assets, Loans, Advances
Current liabilities and Provisions
Quick ratio = Current assets, Loans and Advances – Inventories

Current liabilities and Provisions – Bank overdraft
Structural health ratios:-

Total Assets to total net assets = Net Asset
Current Assets
Debtors turnover ratio = Sales
Debtors
Average collection period (in days) = Creditors x 365
Sales
Bad debts to Sales = Creditors x 365
Purchases
51
CASH STUDY
Steel Authority of India Limited.
Balance sheet for the year ended 31.3.2008
(Amounts in crore)
Particulars Sch no. Amount
Sources of funds
Shareholder’s fund
Share capital 1.1 4160.40
Reserves and surplus 1.2 18933.17 23063.57
Loan fund
Secured loans 1.3 925.31
Unsecured loans 1.4 2119.93 3045.24
Deferred tax liability (net) 1568.60
27677.41
Application of funds
Fixed assets 1.5
52
Gross block 30922.73

Less: Deprecation 19351.42
Net block 11571.31
Capital work-in-progress 1.6 2389.55 13960.86
Investments 1.7 538.20
Current assets, loans and advances
Inventories 1.8 6857.23
Sundry debtors 1.9 3048.12
Cash and Bank balance 1.10 13759.44
Other current assets 1.11 273.08
Loans and Advances 1.12 2379.75
26317.62
Less: Current liability & Provisions
Current liability 1.13 6400.92
Provisions 1.14 6797.83
13198.75
Net Current Assets 13118.87
Miscellaneous Expenditure 1.15 59.48
(to the extend of not written off or 27677.41
adjusted)
Profit & Loss Account for the year ended 31.3.2008
(Amount in crore)
Particulars Sch No, Amount
Income
Sales 2.1 45555.34
Less: Excise duty 6046.89 39508.45
Finished products internally 490.81
consumed
Interest earned 2.2 1184.76
Other revenue 2.3 646.27
Provisions no longer required 2.4 60.62
written back
41890.91
Expenditure
53
Accretion (-) to stocks 2.5 -339.30

Raw materials consumed 2.6 13960.14
Purchases of finished / semi- 3.63
finished goods
Employee’s remuneration & 2.7 7919.02
Benefits
Stores & spares consumed 3293.90
Power & fuel 2.8 2825.56
Repairs & Maintenance 2.9 552.15
Freight outward 717.85
Other expenses 2.10 1836.32
Interest & finance charges 2.11 250.94
Deprecation 1235.48
Total 32255.69
Less: Inter Account Adjustments 2.12 1832.22 30423.47
11467.44
Adjustments pertaining to earlier 2.13 1.29
years
11468.73
Profit before tax
Less: Provision for taxation (3931.95)
Profit after tax 7536.78
Transfer to reserves 86.39
Bal b/d from last year 10811.65
Amount for Appropriation 18434.82
Less: Appropriation 2557.16
Balance c/d to balance sheet 18434.82
Efficient ratios:-
W.C to sales ratio = Sales
W.C
= 39508.45
19916.7
= 1.983
54
Inventory turnover ratio = Sales

Inventory
= 39508.45
-339.30
= 39169.15
Current asset turnover ratio = Sales
W.C
= 39508.45
19916.7
= 1.983
Liquid ratios:-
Current ratio = C.A, Loans and Advances
C.L, Provisions – Bank O/D
= 26317.62
13198.75
= 1.993: 1
Quick ratio = Q.A

Q.L
= C.A, Loans and Advances - Inventories

C.L, and Provisions – Bank O/D
= 26317.62 – 6857.23
13198.75 – nil
= 19460.39
13198.45
55
= 1.47:1
Structural health ratios:-
C.A to total net assets = Net assets
C.A
= 27079.73
26317.62
= 1.028
Debtors turnover ratio = Sales
Debtors
= 39508.34
3048.12
= 12.96
Average collection period (in days) = Debtors x 365
Sales
= 3048.12 x365
39508.34
= 1112563.8
39508.34
= 28.16 days
Approx = 28 days
Bad debts to sales = Bad debts
Sales
= 216.69
39508.48
= 0.005
Creditors turnover ratio = Creditors x 365
56
Purchases
= 2981.55
13960.14
= 0.2135
Conclusion
Working capital management is concerned with short term financial

decisions which have been relatively neglected in the literature of finance
shortage of funds for working capital has caused many businesses to fail
and in many cases, has recorded there growth, Lack of efficient and
effective utilization of working capital leads to earn low rate of return on
capital employed or even compels to sustain losses. The need for skilled
57
working capital management has thus become greater in recent years;

every enterprise has to arrange for adequate funds for meeting day-to-day
expenditure apart from investments in fixed assets. Working capital is the
flow of ready funds necessary working of the enterprise. It consists of
funds invested in current assets or those assets which in the ordinary
course of business can be turned into cash within a brief period without
undergoing diminution in value and without disruption of the
organization.
Concept of working capital is difference between current asset and
current liabilities. It is the excess of current asset over current liabilities.
The blood to the business enterprise working capital, if weak, the
business cannot prosper and survive, although there may be a large
investment of fixed assets. Inadequate as well as redundant working
capital is dangerous for the health of industry. In other words “Over and
under working capital is the dangerous for the any business enterprise”.
A company must have working capital adequate to its requirements
neither excessive nor inadequate. While inadequate working capital
adversely affects the business operations and profitability, excessive
working capital keeps idle and earns no profit.
The primary objective of working capital management is to manage the
firm's current assets and current liabilities in such a way that a
satisfactorily level of working capital is maintained. The firm may
become insolvent if it cannot maintain a satisfactory level of working
capital. Working capitals assist in increasing the profitability of the
concern. The working capital position decides the various policies in the
business with receipt to general operations viz., importance of working
capital management.
To manage working capital at par level to meet with the day-to-day
expenditure of the firm, the Banks role is very important as the bank
lends the money to the firm to run the business and day-to-day business
58
activities. In this lending banks lending the advances to the business

firms in various forms. Such as,
Bank credit:-
Cash credit / Bank overdraft
Loans
Bill purchased & discount
Term loan for working capital
Letter of credit discounting
Commercial paper
Factoring
By providing such kind of advances to the business firm, Banks plays the
important role to managing the working capital of the business firm.
59

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Role of Banks in working capital management

Objectives of the study

♦ The objective of undertaking a project on Role of Banks in Working

Capital Management is to have in-depth knowledge about the Strategy of Banks

day expenses of business firms.

♦ To know about the functions, organizational structure and objective of

Definition of Working Capital

Such categorization helps in determining avoidable or postponable

Objectives of Working capital management

Gross and Net Working Capital

The management of working capital is concerned with maximizing the

increases the risk to a company by straining its solvency. The suppliers of

Disadvantages of Insufficient Working Capital

Operating Cycle Concept

Collection of Cash Purchase of

Reasons for prolonged Operating Cycle –

length of operating cycle. Further, streamlining of credit from supplier

Gross and Net Operating Cycle -

consumed immediately. There involves ‘Raw Materials conversion

Raw materials conversion period 2 - -

Practical utility of Operating Cycle Concept

Role of Banks in Working Capital Management

banks have to implement them. The major areas covered by the

Norms for Inventory receivables

Maximum Permissible Bank Finance:

borrowings) real current

MPBF* = Maximum Permissible Bank Finance.

Deviation from norms

below a minimum of 25%. The relaxation is allowed in the following

Chore Committee recommendations:

April 1979 under the chairmanship of Sri.K.B.Chore, Chief Officer,

♦ Bank to take up financing a portion of raw material by way of

assets, current liabilities, bank borrowing, production and

sanctioned a total limit Rs. 200 Lakhs the individual limit

Nayak Committee Recommendations:

small scale units in that order while meeting the credit

working capital limit will be computed at 20% of their projected

requirements of SSI sector on "bottom up" basis.

♦ Banks are advised to adopt "Single Financing Approach "for

should adopt a system of committee approach, in which decisions

♦ Rejection/curtailment of limits by sanctioning authority

Vaz Committee Recommendations:

In arriving at 25% of the projected turnover as the working capital

Further, he is also able to determine for himself his eligibility for a

Bank policy to lend the working capital

The following approaches are generally followed by the banks in

bankers in estimating and financing the working capital needs of

Different kinds of working capital

routine activities which may be periodically reviewed by the supplier.

Bank credit: Bank credit is the primary institutional source of working

Mode of Security for Bank credit:

It is the transfer of the legal stock equitable interest in specific immovable

through agents like banks, merchant bankers and financial institutions.

Factoring provides resources to finance receivables as well as facilitates

Definition and Mechanism:

Definition: Definition factoring can broadly be defined as an agreement

Mechanism: Credit sales generate the factoring business in the ordinary

1. Financing facility trade debts.

2. Maintenance/administration of sales ledger.

3. Collection facility of accounts receivables.

4. Assumption of credit risk/credit control and credit restriction: and

It is the factors provide various services at a charge. The charge for

Methods for Estimating Working Capital Requirements