Working capital finance

VIKESH KUMAR
VIKESH KUMARData Analyst
Working Capital Finance
Vikesh Kumar
Working Capital Finance
• Working Capital is a financial metric which represents operating liquidity available
to a business.
The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing
short-term debt and upcoming operational expenses.
Sources of Working Capital Finance
• There are two most significant short-term sources of finance for working
capital are
1. Trade credit
2. Bank borrowing
Trade Credit
• Trade Credit : It refers to the credit that a customer gets from suppliers in
normal course of trade. This deferral of payments is a short term financing
which is called trade credit.
• It is a major source of finance for firms. In India, it contributes to about
1/3rd of the total 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.
• Trade Credit is also called Spontaneous Source of Financing.
Credit Terms
• Credit Terms : This refers to the conditions under which the supplier sells
on credit to the buyer, and the buyer is required to repay the credit.
• A typical way of expressing credit terms is for example : 3/15 net 45. This
means 3% discount is available if payment is made within 15 days and if this
discount is not availed payment is to be made on or before 45 days.
Benefits and Costs of Trade Credit
• Benefits
1. Easy Availability.
2. Flexibility.
3. Informality.
Suppliers sometimes offer cash discount to
buyers for making prompt payment. Buyer
should calculate the cost of foregoing cash
discount to decide whether or not cash
discount should be availed. The following
formula can be used:
Cost of cash discount
ACCRUED EXPENSES AND DEFERRED INCOME
• Accrued Expenses
• Accrued expenses represent a liability that a firm has to pay for the services which it has
already received.
1. Accrued Wages and Salaries.
2. Accrued taxes and Interest.
• Deferred Income
• Deferred income represents funds received by the firm for goods and services which it has
agreed to supply in future.
1. Advance Payments.
Bank Finance for Working Capital
• Overdraft
• Cash Credit
• Purchase or Discounting of Bills
• Letter of Credit
• Working Capital Loan
Overdraft
• Under this facility, the borrower is allowed to withdraw funds in excess of
the balance in his current amount , up to a certain specified limit, during
stipulated period .
Cash Credit
• Meaning:
• Cash credit is a short-term source of finance. Under cash credit, the bank offers its
customer to take a loan up to a certain limit. Cash credit is also known as bank
overdraft.
• Features of Cash Credit:
• 1. This loan is given to meet the working capital requirements of a company.
• 2. It is given against a collateral security.
• 3. Interest is charged only on the amount of loan taken by the customer and not on
the amount of credit sanctioned.
Cash Credit
• Advantages of Cash Credit:
1. It is an important source of working capital financing.
2. Cash credit can be obtained very easily and quickly.
3. Interest is charged only on the utilized amount.
• Disadvantages of Cash Credit:
1. The rate of interest charged by loan on cash credit is very high.
2. Such loan is granted by bank on the basis of company’s turnover, its financial status, value
of inventory, etc. So it is difficult for new and financially weak companies to obtain cash
credit.
3. For banks, cash credit disturbs their credit planning.
Difference between Cash Credit and Overdraft
Cash Credit Overdraft
It is normally given on security of stock, debtors etc. It is normally given on security of a fixed asset.
The maximum amount is calculated as a percentage of
sale and stock along with financial statements.
For e.g. A bank allowed cash credit unto 80% of stock
plus 20% of sales.
The maximum amount allowed is calculated mainly on
basis of financial statements and security.
It should be used for the purpose of business. Can be used for any purpose
Balance Sheet, P & L account , VAT reports is required
be submitted to bank generally annually or quarterly.
Financial statements are generally not required to be
resubmitted after approval.
It doesn’t reduce over time. There is a monthly reduction in amount of overdraft
facility in Dropdown Overdraft (DOD).
Purchase or Discounting of Bills
• Under the purchase and discounting bills, a borrower can obtain credit from
a bank against its bills. The bank purchases or discounts the borrowers bills.
• The amount provided under this agreement is covered within the overall
cash credit or overdraft limit.
Letter of Credit
• Particularly the foreign suppliers, insist that the buyer should ensure that his
bank will make the payment if he fails to fulfill its obligation.
• This is ensured through a letter of credit agreement.
• The bank opens an L/C in favour of a customer to facilitate his purchase of
goods.
Working Capital Loan
• A borrower may sometimes require funds in excess of the sanctioned credit
limits to meet unforeseen contingencies.
• Banks provide such accommodation through a “demand loan account” . The
borrower is expected to pay high rates of interest in such exceptional cases.
Security for Bank Finance
• Hypothecation
• Pledge
• Mortgage
• Lien
Hypothecation
• Under this the borrower is provided working capital finance against the security of movable
property (stock, debtors).
• The borrower does not transfer the property to the bank physically.
• Thus hypothecation is a charge against property where neither ownership nor the possession is
passed on to the creditor.
• Banks generally grant credit against hypothecation only to first class customers with high
integrity.
Pledge
• Under this arrangement the borrower, is required to physically transfer the
possession of the property offered as security to the bank to obtain credit.
• (e.g. Share certificates, FD certificates, Insurance policy documents, etc.)
Mortgage
• Lien means right of the lender to retain property belonging to the borrower
till he repays the credit.
Lien
• Mortgage is the transfer of a legal or equitable interest in a specific
immovable property for the payment of a debt .
Regulations of Bank Finance
• Banks follow certain norms in granting working capital finance to firms.
These norms are greatly influenced by the recommendations of various
committees appointed by the RBI.
• Banks followed the norms suggested by the “Tandon Committee”.
• Further recommendations were made by the “Chore Committee” to
strengthen the procedures and norms.
The Tandon Committee Regulations
1.Operating Plan : The borrowers should prepare operating plans and on that basis indicate the
amount of working capital finance requirement.
2.Production based financing : The bankers should finance only the genuine production needs of
borrower. The borrower should maintain reasonable levels of inventory and
receivables.
3.Partial bank financing : The bank should not finance the total requirement of the borrower. Only
a reasonable part of it should be financed by the bank.
The Tandon Committee Regulations
• 4.Reasonable level of Current Assets : The committee further recommends
that the borrower should be allowed to maintain current assets specifically
debtors and inventories only up to a reasonable level. Flabby, profit making
or excessive inventory should not be permitted under any circumstance.
However, the bank also visualized the abnormal circumstances such as
strikes, power cuts etc. and allowed flexibility to the bankers.
5.Maximum permissible bank finance (MBFC) :
The committee suggested the following three methods of determining the MBFC.
1. The borrower will contribute 25% of the working capital gap, the remaining 75% will
be financed from bank borrowings.
W. C. Gap = CA-CL excluding bank borrowings.(Some analysts define the net
working capital in the same manner)
2. The borrower will contribute 25% of the total current assets. The remaining of the
working capital gap will be financed by the bank.
3. The borrower will contribute 100% of the core assets and 25% of the balance of
current assets. The remaining of the working capital gap will be financed.
The Chore Committee Regulations
1. Reduced dependence on Bank Credit : The borrowers should contribute more funds to
finance their working capital requirements. The idea was to place all borrowers in the 2nd
method suggested by the Tandon Committee. In case of difficulties the resort could be
taken to WCTL.
2. Credit limits to be separated in to “Peak level” and “Non Peak Level” limits :
Credit limits should be assessed and separated in to “Peak level” and “Normal level” for
borrowers with credit limits more than 10 lacs. Borrowers should, in advance, inform the
requirement of peak level limits. Moreover, any deviation in utilization beyond 10%
tolerance, should be treated as an irregularity. Additional interest of 1% should be charged
on ad hoc borrowings.
The Chore Committee Regulations
4. Existing lending system to continue : The existing system had three types of lending.
(a) Cash credit
(b) WCTL,
(C) Bill discounting.
Cash credit system should be replaced by the other two wherever possible.
Cash credit accounts of large borrowers to be scrutinized, at least once a year.
5. Information System : The discipline regarding submission of quarterly statements should
be strictly adhered to, in respect of all borrowers having limits of 50 lacs and above.
Commercial Paper
In India, the issue of CP’s is regulated by the RBI.
Only those Companies, which have
(a) Net Worth of 10 Crores,
(b) MPBF of not less than 25 Crores &
(c) Listed in Stock Exchange can issue CP’s.
Size of a single issue should be at least One Crore and size of each CP should be at least
25 Lacs. (5 lacs suggested by Vaghul).
Commercial Paper
Maturity of the CP’s in India runs between 91 to 180 days. In USA, it is 1 to 270 days.
Though the issue of CP’s is regulated by the RBI, still the interest rate is determined by the market.
The interest rate depends on
(a) PLR,
(b) Maturity,
(c) Credit worthiness and
(d) the rating of the CP provided by agencies.
In USA the two main rating agencies are STANDARD & POOR and MOODY.
In India this is done by ICRA ( an agency set up by ICICI & UTI
THANK YOU
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Working capital finance

  • 2. Working Capital Finance • Working Capital is a financial metric which represents operating liquidity available to a business. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
  • 3. Sources of Working Capital Finance • There are two most significant short-term sources of finance for working capital are 1. Trade credit 2. Bank borrowing
  • 4. Trade Credit • Trade Credit : It refers to the credit that a customer gets from suppliers in normal course of trade. This deferral of payments is a short term financing which is called trade credit. • It is a major source of finance for firms. In India, it contributes to about 1/3rd of the total 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. • Trade Credit is also called Spontaneous Source of Financing.
  • 5. Credit Terms • Credit Terms : This refers to the conditions under which the supplier sells on credit to the buyer, and the buyer is required to repay the credit. • A typical way of expressing credit terms is for example : 3/15 net 45. This means 3% discount is available if payment is made within 15 days and if this discount is not availed payment is to be made on or before 45 days.
  • 6. Benefits and Costs of Trade Credit • Benefits 1. Easy Availability. 2. Flexibility. 3. Informality. Suppliers sometimes offer cash discount to buyers for making prompt payment. Buyer should calculate the cost of foregoing cash discount to decide whether or not cash discount should be availed. The following formula can be used:
  • 7. Cost of cash discount
  • 8. ACCRUED EXPENSES AND DEFERRED INCOME • Accrued Expenses • Accrued expenses represent a liability that a firm has to pay for the services which it has already received. 1. Accrued Wages and Salaries. 2. Accrued taxes and Interest. • Deferred Income • Deferred income represents funds received by the firm for goods and services which it has agreed to supply in future. 1. Advance Payments.
  • 9. Bank Finance for Working Capital • Overdraft • Cash Credit • Purchase or Discounting of Bills • Letter of Credit • Working Capital Loan
  • 10. Overdraft • Under this facility, the borrower is allowed to withdraw funds in excess of the balance in his current amount , up to a certain specified limit, during stipulated period .
  • 11. Cash Credit • Meaning: • Cash credit is a short-term source of finance. Under cash credit, the bank offers its customer to take a loan up to a certain limit. Cash credit is also known as bank overdraft. • Features of Cash Credit: • 1. This loan is given to meet the working capital requirements of a company. • 2. It is given against a collateral security. • 3. Interest is charged only on the amount of loan taken by the customer and not on the amount of credit sanctioned.
  • 12. Cash Credit • Advantages of Cash Credit: 1. It is an important source of working capital financing. 2. Cash credit can be obtained very easily and quickly. 3. Interest is charged only on the utilized amount. • Disadvantages of Cash Credit: 1. The rate of interest charged by loan on cash credit is very high. 2. Such loan is granted by bank on the basis of company’s turnover, its financial status, value of inventory, etc. So it is difficult for new and financially weak companies to obtain cash credit. 3. For banks, cash credit disturbs their credit planning.
  • 13. Difference between Cash Credit and Overdraft Cash Credit Overdraft It is normally given on security of stock, debtors etc. It is normally given on security of a fixed asset. The maximum amount is calculated as a percentage of sale and stock along with financial statements. For e.g. A bank allowed cash credit unto 80% of stock plus 20% of sales. The maximum amount allowed is calculated mainly on basis of financial statements and security. It should be used for the purpose of business. Can be used for any purpose Balance Sheet, P & L account , VAT reports is required be submitted to bank generally annually or quarterly. Financial statements are generally not required to be resubmitted after approval. It doesn’t reduce over time. There is a monthly reduction in amount of overdraft facility in Dropdown Overdraft (DOD).
  • 14. Purchase or Discounting of Bills • Under the purchase and discounting bills, a borrower can obtain credit from a bank against its bills. The bank purchases or discounts the borrowers bills. • The amount provided under this agreement is covered within the overall cash credit or overdraft limit.
  • 15. Letter of Credit • Particularly the foreign suppliers, insist that the buyer should ensure that his bank will make the payment if he fails to fulfill its obligation. • This is ensured through a letter of credit agreement. • The bank opens an L/C in favour of a customer to facilitate his purchase of goods.
  • 16. Working Capital Loan • A borrower may sometimes require funds in excess of the sanctioned credit limits to meet unforeseen contingencies. • Banks provide such accommodation through a “demand loan account” . The borrower is expected to pay high rates of interest in such exceptional cases.
  • 17. Security for Bank Finance • Hypothecation • Pledge • Mortgage • Lien
  • 18. Hypothecation • Under this the borrower is provided working capital finance against the security of movable property (stock, debtors). • The borrower does not transfer the property to the bank physically. • Thus hypothecation is a charge against property where neither ownership nor the possession is passed on to the creditor. • Banks generally grant credit against hypothecation only to first class customers with high integrity.
  • 19. Pledge • Under this arrangement the borrower, is required to physically transfer the possession of the property offered as security to the bank to obtain credit. • (e.g. Share certificates, FD certificates, Insurance policy documents, etc.)
  • 20. Mortgage • Lien means right of the lender to retain property belonging to the borrower till he repays the credit. Lien • Mortgage is the transfer of a legal or equitable interest in a specific immovable property for the payment of a debt .
  • 21. Regulations of Bank Finance • Banks follow certain norms in granting working capital finance to firms. These norms are greatly influenced by the recommendations of various committees appointed by the RBI. • Banks followed the norms suggested by the “Tandon Committee”. • Further recommendations were made by the “Chore Committee” to strengthen the procedures and norms.
  • 22. The Tandon Committee Regulations 1.Operating Plan : The borrowers should prepare operating plans and on that basis indicate the amount of working capital finance requirement. 2.Production based financing : The bankers should finance only the genuine production needs of borrower. The borrower should maintain reasonable levels of inventory and receivables. 3.Partial bank financing : The bank should not finance the total requirement of the borrower. Only a reasonable part of it should be financed by the bank.
  • 23. The Tandon Committee Regulations • 4.Reasonable level of Current Assets : The committee further recommends that the borrower should be allowed to maintain current assets specifically debtors and inventories only up to a reasonable level. Flabby, profit making or excessive inventory should not be permitted under any circumstance. However, the bank also visualized the abnormal circumstances such as strikes, power cuts etc. and allowed flexibility to the bankers.
  • 24. 5.Maximum permissible bank finance (MBFC) : The committee suggested the following three methods of determining the MBFC. 1. The borrower will contribute 25% of the working capital gap, the remaining 75% will be financed from bank borrowings. W. C. Gap = CA-CL excluding bank borrowings.(Some analysts define the net working capital in the same manner) 2. The borrower will contribute 25% of the total current assets. The remaining of the working capital gap will be financed by the bank. 3. The borrower will contribute 100% of the core assets and 25% of the balance of current assets. The remaining of the working capital gap will be financed.
  • 25. The Chore Committee Regulations 1. Reduced dependence on Bank Credit : The borrowers should contribute more funds to finance their working capital requirements. The idea was to place all borrowers in the 2nd method suggested by the Tandon Committee. In case of difficulties the resort could be taken to WCTL. 2. Credit limits to be separated in to “Peak level” and “Non Peak Level” limits : Credit limits should be assessed and separated in to “Peak level” and “Normal level” for borrowers with credit limits more than 10 lacs. Borrowers should, in advance, inform the requirement of peak level limits. Moreover, any deviation in utilization beyond 10% tolerance, should be treated as an irregularity. Additional interest of 1% should be charged on ad hoc borrowings.
  • 26. The Chore Committee Regulations 4. Existing lending system to continue : The existing system had three types of lending. (a) Cash credit (b) WCTL, (C) Bill discounting. Cash credit system should be replaced by the other two wherever possible. Cash credit accounts of large borrowers to be scrutinized, at least once a year. 5. Information System : The discipline regarding submission of quarterly statements should be strictly adhered to, in respect of all borrowers having limits of 50 lacs and above.
  • 27. Commercial Paper In India, the issue of CP’s is regulated by the RBI. Only those Companies, which have (a) Net Worth of 10 Crores, (b) MPBF of not less than 25 Crores & (c) Listed in Stock Exchange can issue CP’s. Size of a single issue should be at least One Crore and size of each CP should be at least 25 Lacs. (5 lacs suggested by Vaghul).
  • 28. Commercial Paper Maturity of the CP’s in India runs between 91 to 180 days. In USA, it is 1 to 270 days. Though the issue of CP’s is regulated by the RBI, still the interest rate is determined by the market. The interest rate depends on (a) PLR, (b) Maturity, (c) Credit worthiness and (d) the rating of the CP provided by agencies. In USA the two main rating agencies are STANDARD & POOR and MOODY. In India this is done by ICRA ( an agency set up by ICICI & UTI