Working Capital

By

P. Venkat Rao

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Funds required to acquire current assets to enable business/industry

to operate at the expected levels.

What is Working Capital ?

Working Capital

• Business needs long term and short term funds

• Long term funds needed for fixed assets, permanent assets

• Met through Fixed or Permanent Capital or Long term Debt

• Short term funds needed for acquiring short term assets, meet day to day business expenditure

• Met through Temporary capital, circulating capitalor Working Capital

• Banker meets both long term and short term needs

CONCEPTS OF WORKING CAPITAL

GROSS WORKING CAPITAL = CAThese are in the system used/ consumed on a day to

day basis. NET WORKING CAPITAL = CA – CL

OR

(NW + TL) – (FA + MA + IA)NWC (Liquid Surplus) is the entrepreneur's margin available in the system from Long term Funds.WCR = ST Application of Funds

Sources of WC Funds are Short Term as well as Long Term

WC Limits• Cash Credit & OD facilities

• Drawing Power

• ‘Interest only’ facility

• Interest charged on the capital used

• Validity of 12 months; Renewal at existing level or with enhancement or reduction of limit

• Short term, but practically speaking, WC finance is long term !

• Requires closer & greater monitoring

• Project Cost : Margin for Working Capital

• Self-liquidating5

What are Working Capital Sources?

Own funds sundry debtors falls under current assetssundry creditors under current liabilities

Bank borrowings

Sundry Creditors

Advances from customers

Deposits due in a year

Current Assets for Bankers

• Any Asset that gets converted into cash within the “Operating Cycle” or which forms part of the operating cycle is current Asset for bankers

• Logic- Bank finance to be used only for creation of assets which will be sold and reconverted into cash

• Investments in subsidiaries, deposits with customs, electricity boards, municipal authorities, advances to staff etc would not be current assets to bankers

OPERATING CYCLE

Stages:

1) Raw materials (RM/RM consumption)

2) Work-in-process (WIP/COP)cost of production

3) Finished Goods (FG/COS)cost of sales

4) Receivables (Debtors/Credit sales)

Less:

Creditors (creditors/purchases)

…...begins with acquisition of raw materials and ends with collection of receivables.

Operating Cycle for Bankers

• Only those assets which are involved in completing the “Operating Cycle or Cash Cycle” or part of it.

Cash

Raw materials

Stock in process

Finished Goods

Sales

Debtors

Service

Length of Operating Cycle

Receivables

Cash

Trade Industry

CashCash

Stocks

Receivables Receivables

Finished Goods

Semi Finished Goods

Raw Material

WC Assessment Methods

• Operating Cycle Method

• Drawing Power Method

• Turnover Method

• Traditional Method

• Projected B/S Method

• Cash Budget Method

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Operating Cycle Method

Working capital requirement =

Operating expenses p.a.------------------------------------------No. of operating cycles in a year

Operating Cycle Method

A. Length of operating Cycle

a. Procurement of Raw Material 30 days

b. Conversion / Process time 15 days

c. Average time of holding of FG 15 days

d. Average Collection Period 31 days

e. Length of Operating Cycle (a+b+c+d) ….. days

f. No. of Operating Cycles in a year (365days/e)

.…. cycles

…..Operating Cycle Method

•

B. Total Operating Expenses per

Annum

Rs 60 lakhs

C. Total Turnover per Annum Rs 70 lakhs

D. Working Capital Requirement Rs. … lakhs

Drawing Power Method

(for units with small limits)

Particulars Stock value Margin DP

Paid stocks (RM -- Creditors) 4 25% …

Semi Finished goods 4 50% …

Finished goods 4 25% …

Book debts 4 50% …

Total … …

(Rs.in lacs)

Drawing Power Method

(for units with small limits)

Particulars Stock value Margin DP

Paid stocks (RM -- Creditors) 4 25% 3

Semi Finished goods 4 50% 2

Finished goods 4 25% 3

Book debts 4 50% 2

Total 16 10

(Rs.in lacs)

Nayak Committee• Report of the Committee to Examine the Adequacy of

Institutional Credit to SSI Sector(now MSE) and Related Aspects

• MSMED Act 2006

• Enterprises engaged in the manufacture or production, processing or preservation of goods &

• Whose Investment in P & M is:Micro E: upto Rs. 25 LSmall E: > Rs. 25 L & upto Rs. 5 Cr.Medium E: > 5 Cr. & upto Rs. 10 Cr.

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Recommendations• (i) give pref. to village industries, tiny industries

and other small scale units in that order, while meeting the credit requirements of the SSI;

• (ii) grant working capital credit limits to SSI (now MSE) units computed on the basis of minimum 20% of their est. annual turnover whose credit limit in individual cases is upto Rs.2 Cr.[since raised, Rs.5 Cr.]

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DANGERS OF INADEQUATE WORKING CAPITAL

1.It Stagnates Growth

2.Fixed Assets Underutilised

3.Operating Inefficiency Creeps In

4.Difficult To Achieve Targets Of Business ForProduction And Profit

5.Business Reputation At Stake

6.Situation Of Tight Credit Terms

7.Difficult To Meet Payment Commitments

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DANGERS OF EXCESSIVE WORKING CAPITAL

1.Accumulation Of Unnecessary Inventory

2.Risk Of Loss By Theft, And Wastage

3.Makes Management Complacent And Ineffective.

4.Results In Speculative Trend

5.Scope For Diversion Of Funds

6.Indication Of Defective Credit Policy

7.Slack Collection Of Receivable

8.Leads To Higher Incidence Of Bad Debts

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FACTORS INFULENCING WORKING

CAPITAL REQUIREMENT

Nature of business – service/trade/manufacturing.

Seasonality of operations – peak/non peak

Production Policy – Constant/seasonal

Market conditions- competition/credit terms

Conditions of supply of RM/stores/spares etc.

Quantum of production/Turnover(level of activity)

Operating Cycle

Current Assets to be maintained

Projections having direct relevance to Bank Finance

a. Sales

b. Production

c. Cost of production

d. Cost of sales

e. Current assets

f. Current liabilities

g. Net working capital.

The most important area to be looked into is Sales. All other aspects

are directly related to the projected level of sales.

Therefore, determining the projected level of sales is first step in

assessing the working capital needs of a borrower.

Once the level of sales has been determined, the other data can be

easily determined in relation to sales. 22

Projected Turnover depends on

• What is the installed and licensed CAPACITY? Does it haveany idle capacity which can now be utilised?

• Is the unit undertaking any expansion, modernisation ordiversification program? Have any funds been earmarkedfor the same in the projections? Are they going to affectthe quantum of production for the following year and towhat extent? This will be very relevant where the borroweris projecting more than normal rate of growth in respect ofproduction and sales.

• Are essential inputs available to take care of projectedproduction figure?

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Projected Turnover depends on

• What are the present market conditions and terms ofsales? What plans are there to boost sales. Will the sales infuture be on more favorable terms to the buyers? If theperiod of credit is going to be extended is holding ofincreased levels of receivables proposed to be financed?Will it be within the lower of past trends or norms?

• Is the unit proposing to launch an export drive to captureinternational markets?

• Are there any pending orders in hand? What has been theposition in the previous years? Was the unit forced tolaunch any distress sales in the past?

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Working

Capital

Ass

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Turnover Method – Nayak Committee1. Working capital requirement / Gap = 25% of the projected Turnover

2. Promoter’s Contribution (Margin) = 5% of the Turnover

3. Bank Finance = 20% of the Turnover

4. Margin available in system = NWC i.e. CA less CL

5. Higher of NWC or 5% of turnover = Margin

6. Limit permissible = WCG less Margin

7. This method is usually used to assess requirement of small mfg companies(SME) and

no financial documents are taken. Only annual sales considered

8. Projected Sales as per customer is considered, but accept/ validate sales from past

data. Use only audited balance sheet.

• Past performance of 3 years

• Sales growth trend

• Estimation

• Realistic sales

Minimum of above is taken (margin of safety)

NOTE : IF MARGIN AVAILABLE IN SYSTEM IS LOWER THAN 5 % OF TURNOVER, LIMITS IS TOBE FIXED AT 20% OF TURNOVER. HOWEVER, OPERATIONS BE ALLOWED AS PER DRAWINGPOWER AVAILABLE BASING ON PAID UP STOCK. IN OTHER WORDS DP IS RISTRICTED TO 4TIMES OF AVAILABLE NWC AS PER LAST AUDITED BALANCE SHEET

Particulars Rupees Particulars Rupees

To PurchaseTo WagesTo Gross Profit c/d

2000050005000

Sales 30000

30000 30000

To SalariesTo RentTo Depreciation on PlantTo Loss on Sale of FurnitureTo Goodwill Written offTo Net Profit

100010001000

50010005500

By Gross Profit b/dBy Profit on Sale of Building

Book Value 10000Sale Value 15000

5000

5000

10000 10000

31-Mar-16 31-Mar-17Stock 10000 12000Debtors less than 6 months 10000 12000Debtors greater than 6 months 5000 8000

Creditors 5000 7500Bills Receivable 5000 8000Outstanding Expenses 3000 5000Bills Payable 4000 2000

Projected Turnover for FY16-17: 20% growth 26

Turnover Method

• Projected Turnover : 30,000 * 1.2 = 36,000

• Turnover Method:

• Working Capital Requirement:

• 25% of Projected Turnover : 36000 * 25% = 9,000

• Max Bank Funding = 20% of 36000 = 7,200

• Own Contribution = 5% of 36000 = 1,800

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Projected Balance Sheet Method ( for > Rs. 5 Cr.)

Proper examination of performance

• Profitability

• Financial Position

• Financial Management

Scrutiny & Validation of Projections

• Income & Expenses

• Changes in Financial Position

Acceptability of Liquidity, Overall gearing, efficiency of operations

The MPBF Methods (Tandon Committee)

METHOD I METHOD II METHOD III

C.A 200 C.A 200 C.A 200OCL 40 25% of CA 50 Non core CA 56WCG 160 GAP 150 Core CA 14425% of WCG 40 OCL 40 25% of Real CA 36

GAP 108

OCL 40MPBF 120 MPBF 110 MPBF 68

NWC 40 NWC 50 NWC 92C.A 200 C.A 200 C.A 200C.L 160 C.L 150 C.L 108CURRENTRATIO

1.25CURRENTRATIO 1.33 CURRENT RATIO 1.85

Cash Budget Method

• Peak deficit is financed and drawings regulated by monthly budgets.

• Advantages: Suitable for seasonal industries, contractors,

software exporters etc. Limitations: Will not reflect changes in various current assets and

liabilities. Will not give a clue whether a company is earning profit or not.

Funds flow statement is required to detect any diversion of funds.

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•Thank You !

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