MBM Module5 Working Capital Financing

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MODULE-5

FINANCING OF WORKING CAPITAL

Prof. R. KANNAN

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FINANCING OF WORKING CAPITALCash Raw materials Process stock

Debtors Finished goods

Working capital cycle – Time taken for procurement, manufacturing, selling and collection of receivables.

Raw material

ProductsFixed capital fFixed capital

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Working capital comprises- Raw material required to ensure uninterrupted

production- Process stock- Finished goods required for uninterrupted sales- Sundry debtors- Consumables (oil, spares) required for

maintenance of machines- Cash to meet running expenses


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Working capital requirement depends on

a) Availability of inputs (RM stock)

b) Demand/supply for the product (FG stock)

c) Technology employed (process time)

d) Efficiency of inventory control

e) Marketing efficiency

f) Nature of raw material/product (perishability, cost of storage)


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Sources of financing working capital• Margin money through long term sources(Net working capital; Excess of long term liability,

equity over fixed assets)• Creditors• Advance by customers• Bank borrowingsUsually the margin money is 25% of current

assets required to take care of business risks and fall in the value of security.


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Need for proper assessment of working capital Inadequate financing• Low capacity utilisation• Dependence on unreliable and costly trade

credits• Difficulty in getting inputs from good sources• Inability to offer credit and loss of market share • Loss of reputation due to delay in payment• Management attention will be in raising finance

neglecting operations


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• Over financing: Funds diversion to real estate/stock market

• Breeds inefficiency


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Working capital facilities

• Pre Sales- Raw materials, process stock, packing and dispatch of product- Risk of not executing order

• Post Sales- Credit to customers- Risk of debtors not paying- Sale / export through sister companies

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Working capital facilities

• Funded – Bank advances funds

• Non-funded facilities – Guarantees / Letter of credit

Over Financing

• Funds diversion to real estate/stock market

• Breeds inefficiency

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• Core working capital (CWC)• Fluctuating working capital (FWC)• While in India entire working capital is

financed with 25% margin, most other countries CWC is financed by long term sources

• Now bank credit is based on credit risk and production requirement and not on security alone.


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Holding period of working capital

Raw material – As month’s requirement

Process stock/ - As month’s of production

Finished goods – Cost of goods sold

Receivables - As month’s of gross sales

Spares - As month’s consumption• Gross sales – includes all duties (Sales tax,

excise) etc. paid before sale proceeds are received

• Same as cost of goods sold.

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a) Maximum permissible Bank Finance Method (MPBF)

b) Turnover Method

c) Cash flow Method

Assessment of working capital

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MPBF Method

• While RBI does not impose any norms for working capital, banks usually follow the norms developed by Tandon Committee.

• Tandon Committee suggested 3 methods for assessment of working capital. The third method of CWC was rejected by RBI. Usually banks follow second method.


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CA = Current Assets

OCL = Other current liabilities (excluding bank borrowings)

First Method: MPBF = (CA-OCL) – 25% (CA – OCL)

Second Method: MPBF = (CA – OCL) – 25% CA


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Illustration

Method

(Rs. In lacs)

III

Current Assets 1000 1000

Other Current liabilities 400 400

Actual Bank borrowings 475 475


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Method(Rs. In lacs)

I IICurrent Assets 1000 1000Less: Other current Liabilities 400 400

--------- ---------- 600 600


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Margin 150 250MPBF 450 350Actual borrowings 475 475Over borrowings 25 125Current ratio 1.14 1.14Stipulated current Ratio 1.18 1.33

Over borrowings may be segregated as working capital demand loan (WCDL) repayable in instalments over time. Stipulated current ratio always 1.33 in Method II.

Assessment of working capital Method (Rs. In lacs)

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• Individual limits for raw materials, process stock, finished goods and receivables are calculated based on holding periods.

• Adjust advances paid/received, credit received on individual items.

• Apply margin requirements against working capital to arrive at individual limits to arrive at net MPBF

• Aggregate working capital limits may be reduced by existing net working capital of the borrower.

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Illustration 2 (Rs. In lacs)

Gross sales 12,000Consumption of raw Materials 7680Power and fuel 480Labour 1680Other manufacturing cost 360Depreciation 600

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Change in closing stock/

Work in process/finished goods (240)

Selling and administrative expenses 360

Interest 240

Total cost 11160

Profit before tax 840

Tax 300

Net profit 540


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Total Cost 11160Less: Interest 240Sales and Administrative Expenses 360 --------------Production cost 10560Production cost / Month 880Gross sales /Month 1000

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Raw material consumption/Month 640Expenses/Month 240As of last year net workingCapital available Rs. 600 lacsTrade credit available 15 daysof raw material purchase Rs. 320 lacsWorking capital cycle 4 months

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Item Holding Holding Margin Margin Bank period amount Rate amount Financing

Raw Materials 2 1280 25% 320 960ProcessStock 0.5 440 40% 176 264FinishedGoods 1.0 880 25% 220 660Receivables 0.5 500 30% 150 350Expenses 1.0 240 100% 240 0 ---------- ---------- -------------- 3340 1106 2234 ----------- ---------- ---------------

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• Total working capital required 3340Less: Net working capital (600) Trade credit available (320)Permissible Bank finance 2420Less: Cash accruals 220 ----------- 2200Cash accruals/year 1140Cash accruals/cycle 380


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Turnover method

For small scale industries borrowing less than Rs.5 crores

- Working capital assessed at 25% of turnover- Margin at 5% of turnover- Bank Finance at a minimum of 20% of turnover- Sales – Rs.18 crores- Working capital – Rs.4.5 crores- Margin – Rs.0.9 crores- Bank borrowing – Rs.3.6 crores

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For entities of turnover less than Rs.10 lacs – no audited accounts are required; only sales tax / incometax returns.

Turnover method

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Cash Budget method

• Seasonal Industries like tea have no current assets in the real sense.

• Segregate the monthly cash flows into operational flows, nonoperational flows such as investments , financing etc.

• Limits sanctioned as per the peak deficit in the operational flows but the amount is drawn equal to the month to month cash deficit with stipulated margins (usually 25% ). Withdrawals are allowed as per the stock value less creditors plus receivables with stipulated margins.

• Turnover/working capital is projected based on past working / industry norm.

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Types of Funded facilities• Pre sale finance

Overdraft Cash Credit

Packing creditDemand loan / line of creditBusiness card

• Post sale financeCheque purcahseBill purchaseBills discountBills negotiation

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Overdraft (OD)

• A small position

• A current account in which a certain amount of debit over the balance is allowed

• Helps temporary mismatch so that cheques issued are not returned for want of balance.

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Cash Credit

• Running account which can be overdrawn by the borrower (availing of loan) up to the sanctioned limit and depending upon drawing limit based on security. It has cheque facility.

• The drawls are secured by inventory. Banks may secure debtors but they prefer bills route for debtors.

• Sanctioned limit is maximum estimated working capital less than the stipulated margin

• Drawling limit is the maximum permissible drawls based on stocks less than the stipulated margin.

• The amount of overdraft is either sanctioned limit or drawing limit whichever is lower.

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Cash Credit

• Margins are determined by saleability and asset quality.

• Raw materials stock have lower margins than process stock. Steel stock will have lower margins than designer clothes.

• The borrower to submit monthly stock statement for raw materials, process stock and finished goods and statement of book debtors.

• Theoretically cash credit is a demand facility (i.e. bank can demand repayment at any time. Practically permanent as long as security is available or unless loans are fore closed.

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Cash credit

• Interest is computed on the outstanding balance drawn everyday.

• Helps in managing cash flow for the borrower. No need to invest surplus outside at lower interest with the problem liquidity of investments.

• Banks face liquidity management problem• Borrowing limits are fixed while sanctioning

facility. • Working capital demand loan – Loan repayable

in instalments.

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Packing Credit

• Concessional finance for exporters• Normally 2 to 4% cheaper than cash credit• To be repaid within a stipulated period beyond

this interest will be as per cash credit.• Banks evaluate country and currency risk• Exporter to be registered with Director General

of Foreign Trade and must have a 10 digit code number

• He should not be in the caution list of RBI.

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• Currency

- Rs. Or freely convertible currencies

• Period

- Time for executing the order – Maximum 360 days

• Rate

• (Maximum) – PLR - 2.5% (Now almost 7% with new fiscal package)

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- LIBOR + 1% (180 days to LIBOR + 3% (Beyond 180 days)

Running a/c. – Possible – against confirmed orders / L/Cs. Paid out of export proceeds

• Pre-disbursement Requirements: Confirmed order or irrevocable L/C issued by bank or repute

• If in restricted list of export, export license from DEFT.

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• Maximum amount – FOB value of order - Amount required for setting goods reach

shipment - Direct payment to suppliers of raw materials if it is possible.

• Repayment – Exporter submits export bills, discounted by bank and credit to packing credit a/c. or out of collections.

• If order is not executed and repayment is made in rupees, cash credit interest rate will be charged.

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• Advances against duty draw back receivable from Government at packing credit rates after documents proof of receivables.

• Packing credit – applicable for deemed exports.

Post Shipment

• to fund export receivables

• In Rs..or convertible currencies

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• Repaid from export proceeds

• Purchase/discounting of export bills

• Negotiation of export bills

• Advance against export bills sent for collection.

• Advance against export incentives receivable (excise/custom refunds).

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Short term working capital loans

Short term loans

• 1 to 3 months duration

• Interest rate lower than cash credit

• Cash credit is to be reduced to the extent of short term working capital loan availed (Double financing)

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Short term working capital loans

Line of Credit• Assurance by bank that the company can

avail certain quantum of loans upto a limit during next one year.

• Interest rate decided at the time of drawl.• Total of line of credit plus cash credit to be

limited to drawing power.• Company alternates between line of credit

and cash credit depending interest rate.

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Business Cards

• Issued for purchase of supplies / inputs without issuing (ICICI Bank, Citi Bank) cheques.

• As a substitute for cash credit, no interest free credit period is allowed.

• Sutiable for small business entities.

• No branch network required.

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Trade Finance (Post sale finance):

• For credit sale, lower risk for bankers, as better monitoring possible.

• Lower interest rates

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Cheque Purchase (Part of Cash Management System):-

• Loan against cheques deposited till clearing

• Repaid out of cheque realization

• Interest recovered when advance is given (say 7 days)

• Unrealised cheques, additional interest debited along with Cheque amount

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Bills Purchase (Contd..)

Bills Discount (Usance Bills)

• Bills raised by seller (Client) and accepted by the buyer.

• Usance bill has the date of payment and hence the exact interest is recovered upfront. Hence it is called bills discount. In bills purchase it is an estimated amount.

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Consortium system of credit delivery

• Several banks pool together their banking resources and expertise in credit management and provide finance to a single borrower with common appraisal, common documentation and joint supervision and follow up.

• Each participating bank should share at least 5% of fund based assistance subject to RBI limits and non fund based limit in the same proposition.

• Entry of any other bank with the consent of consortium only.

• No bank can leave the consortium before a stipulated date.

• The borrower not to avail of any credit facility outside consortium.

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- Appraisal, convening of consortium meetings, completion of documentation, representative of consortium to RBI, advises other members of the consortium on their share of assistance and managing other aspects of consortium like submission of data by borrower, credit delivery.

Lead Bank

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- Multiple finance fraud possible against the same pool of assets

- Appraisal of credit requirement becomes difficult.

Multiple Banking System

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Syndication

- Large credit exposure and of long term

1) Awarding of mandate to Lead Manager stating terms/conditions of credit to be availed.

2) Preparation of information Memorandum and circulating to other banks.

3) Individual banks collect information, and assess the proposal’s viability.

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4) A syndication meeting is called; issues such as coordination, communication and control within the syndicate is discussed and finalised. The share of each bank is finalised.

5) Participating banks sign loan agreement

6) Lead manager finalises disbursement procedure.

Syndication

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Commercial Paper (CP)

• Unsecured money market instrument issued as promissory note and at a discounted rate.

• CP market is largely controlled by Fixed Income

Money market and Derivatives Association of India

• Interest on CP is much lower than bank borrowings

• A company is eligible to issue CP only if

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Commercial Paper (CP)

a) Tangible networth more than Rs.4 crores

b) Has sanctioned working capital limits

c) Is classified as ‘Standard Asset’ by banks

d) Minimum credit rating P-2 or equivalent

e) Maturity – 7 days to one year

f) Minimum investment Rs.5 lacs

g) Appointment of a commercial bank as Issuing and Pay Agent (IPA)

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Commercial paper (CP)

- Commercial bank assess the working capital requirements

h) When a bank agrees to the role of IPA, it guarantees redemption of CP amount.

i) Banks carve out a limit equivalent to CP amount so that redemption could be done and over borrowing is avoided. The bank ensures that issue of CP saves interest but not lead to over borrowings.

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FINANCING OF RECEIVABLES

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Bills Purchase

- Bills are drawn by seller and accepted by the buyer and endorsed in favour of the bank

- Bank disburses the amount

- Bank sends the bills to the drawee and either accept the bill (in case payment is to be received) or pay

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Bills Purchase (Contd..)

• Advance against demand bills submitted for collection – Recovered when drawee pays

• The date of payment not fixed• Interest is recovered at the time of purchase

based on estimation• Documents – Invoice, Transport documents• Bills of exchange, other documents such as

Inspection, insurance policy etc. by the buyer and endorsed in favour of the bank.

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Bills discount (Usance Bills):

• Bills raised by seller (client) and accepted by the buyer• Usance bill has the date of payment and hence the exact

interest is recovered upfront. Hence it is called bills discount. In bills purchase it is an estimated amount.

• Bills are preferred by the bank as the amount may be collected once the amount is received easier monitoring; If not paid, it will be known and collected from the buyer/seller.

• In case of demand bills, goods cannot be taken delivery unless he pays the bill. Enforcement in a Court of law is easier as bill is a negotiable instrument.

• Genuineness of transport (lorry / rail) receipts (approved list of IBA)

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Caution in accepting the bills

Bills drawn on associate / sister concernsAddress of drawee is care of hotel, box or the

office of the drawer.The goods covered are totally different from the

goods traded by the drawer.The lines of business of drawer and drawee are

totally different.Circular transactions – continuous bill discounting

between associates without product delivery.

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How to design credit facilities

Example: 1) Stock Data

Particulars Rs. Lacs

Raw Materials 60

Process Stock 20

Finished goods 50

Receivables 100

Other current assets 20

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How to design credit facilities

2) Current Liabilities

Particulars Rs. Lacs

Raw Materials 60

Process Stock 20

Finished goods 50

Receivables 100

Other current assets 20

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Calculate and design the facilities

1. Total current assets 250

2. Current liabilities excluding bank finance

90

3. Working capital gap (1-2) 160

4. Minimum net working capital 62.5

5. (3-4) 97.5

The limit for borrowings is Rs.97.5 lacs

6. Receivables 100

7. Assume margin at 50% 50

8. Eligible bank finance for receivables 50 (sanctioned as bills facility)

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Margin Value Margin Required finance

Raw materials

25% 60 15 45

Process Stock

40% 20 8 12

Finished goods

25% 50 12.5 37.5

94.5

Less: Trade Creditors

40.0

Finance for Inventory requirement

54.5

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Rs. lacs

Total overall limit 97.5

Less: Bills 50.0

Actual required 54.5

Gap 7.0

Hence the limits are 7.0

Bills 50.0

Cash credit 47.5

Working capital term loan 7.0

Working capital repayable in instalments during next 3 years

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Securitisation

- Mortgage assets

- Auto loans

- Credit cards

- Trade receivables

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House Loan compayoriginator

S P V

PTC-1 PTC-2 PTC-3

Rebundling

Sale of receivables

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PTC – Pass through certificates

The collection, follow up, realisation and passing on the receivables to SPV is the responsibility of originator

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• Improves cashflow position

• Avoids loss provision

• Avoids additional capital raising

Advantages of Securitisation

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Factoring

• Factoring - Buying accounts receivables/book debt • The institution assess the customers to whom

goods are sold, invoices made and bills raised• The Institution fixes the credit limit for individual

customers and also period of advance• Factored receivables are assigned and debtor is

instructed to made payments to factor directly.• The seller sends the invoice to the factor and factor

pays the advance• The balance amount net of fees is payable after the

customer pays the amount.• The credit risk is that of client.

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Forfeiting

• Forfeiting agency provides receivables financing without recourse to exporter or his banker

• Forfeiting agency needs accepted bills of exchange with letter of credit of importer’s banker

• Normally forfeiting cost is included in the FOB value of the product

• Forfeiting agency takes all associated risks such as interest rate risk, currency risk, credit risk and political risk.

MBM Module5 Working Capital Financing

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