Download Working Capital Finance

Working Capital Finance
By Jignesh Mehta,
B. COM, ACA & LCS.
Mobile No. 9699490918.
Contents
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Definition
Operating cycle of a manufacturing unit
AS – 2 – Valuation of Inventories
Classification of Current Assets and Current Liabilities
CMA data & Do’s and Don’ts
Assessment of working capital requirements
Methods for assessment of WC requirements
Forms of FB and NFB limits
Ratio Analysis and Holding levels of operating cycle items
Cash Flow and Fund Flow Statements
Security Creation and Perfection of security
Credmin documents
Early Warning Signals and Remedial Action.
Definition
 The amount of current assets that is in excess of current liabili
ties. Working capital is frequently used to measure a firm’s
ability to meet current obligations. A high level of working
capital indicates significant liquidity available with the firm.
Operating Cycle of a manufacturing
unit
RM
SFG
Cash
Receivables
FG
AS – 2 :- Valuation of Inventories
 Valuation of Inventories:
Inventories (include RM, WIP and Finished Goods) are valued at cost of
net realisable value whichever is lower.
 Cost of Inventories:The cost of inventories should comprise of:
i. Costs of purchase,
ii. Costs of conversion (direct costs like labour and production
overhead) and
iii. Other costs incurred in bringing the inventories to their present
location and condition.
AS – 2 :- Valuation of Inventories (contd..)
 Net Realisable Value:Inventories are valued on NRV if those inventories are damaged,
if they have become wholly or partially obsolete, or if their
selling prices have declined.
 Methods of Valuation of Inventories:FIFO, WAM and Specific Identification of Project costs.
Classification of CA and CL
• An illustrative list of items of Current Assets and Current Liabilities
is as under: Current Assets:-
I.
II.
III.
IV.
V.
VI.
VII.
Cash and bank balances
Short term Investments
Receivables other than outstanding for more than 6 months
RM, WIP and FG
Other consumable spares
Pre-paid expenses and Advance payment of tax
Advances for purchase of raw-materials, components and
consumable stores
Classification of CA and CL (contd.)
 Current Liabilities:-
I.
Short term borrowings (including bills purchased and
discounted in time)
II. Sundry Creditors for RM & consumable stores and spares
III. Unsecured loans
IV. Public deposits maturing within one year
V. Interest and other charges accrued but not due for payment
VI. Advances/progress payments from customers
VII. Deposits from dealers, selling agents, etc.
VIII. Statutory Liabilities like PF dues, Provision for taxation etc.
IX. Proposed dividend, Outstanding expenses, etc.
CMA data
•
Form Purpose and contents
I
Details of the borrower and the WC credit facilities
existing and required
II
Operating Statement (Profit & Loss account
restructured and reclassified)
III
Assets and Liabilities (Balance Sheet items in the
(A&B) sequence preferred by lending Bankers: Liabilities
(form III A) and Assets (form III B)
IV
Holding period of Current Assets and also Trade
Creditors
V
Computation of MPBF (Maximum Permissible Bank
Finance)
VI
Funds Flow Statement
CMA data - Do’s and Don’ts
• All Short Term / Temporary investments in money market instruments like
Commercial Paper, Certificate of Deposits can be considered as Current
Assets. However, other investments like ICDs (inter Corporate Deposits),
investment in listed Shares & Debentures including investment in
subsidiaries and associates are to be considered as Non-Current Assets.
• Cash margin for Non-Fund Based limits (like LCs / Guarantees) may be
treated as part of current assets for the purpose of MPBF and Current
Ratio. However, such margin held for Deferred Payment Guarantees
should be considered as Non Current Assets.
• Cash required for normal operations of the company only should be
considered as part of current assets. Cash / fixed deposits kept with public
bodies (telephone, power connection, other security deposits, etc), funds
earmarked for any long term purpose, should be classified as noncurrent
assets.
• The borrowers are not expected to make the required contribution of 25
per cent from long-term sources in respect of export receivables.
Therefore, export receivables may be included in the total current assets
for arriving at the maximum permissible bank finance but the minimum
stipulated net working capital may be reckoned after excluding the
quantum of export receivables from the total current assets.
CMA data - Do’s and Don’ts (contd)
• If analyst doubts on the recoverability (within 1 year) of any
current assets, than also it should be treated as non current
assets. Slow moving inventory / obsolete (dead inventory)
should be classified as non current assets.
• Debtors exceeding 6 months though part of working capital
cycle is conservatively treated as non current assets.
• Advances/progress payments from customer should be
classified as current liabilities.
• It may be added that installments of various term liabilities
due within next one year are treated as current liabilities for
calculating current ratio, but are treated as long term source
and part of NWC (long term sources – long term uses) for
MPBF assessment, since the same are not a part of working
capital cycle.
CMA data - Do’s and Don’ts (contd)
• Inter Corporate Deposits (ICDs) taken are to be treated as Current
Liabilities.
• Unsecured loans from promoters not to be included in both TNW as
well as debt provided it is interest free and subordinated to Bank’s
exposure.
• In case of other statutory dues, dividends, etc., estimated amount
payable within one year should be shown as current liabilities.
• Bill purchased / Bills discounted which is shown as contingent
liability in B/S to be added in Bank borrowing. Similar amount to be
added in (domestic and / or exports) receivables as applicable. This
will give the true picture of leverage and receivable holding levels.
• Intangible assets like goodwill, deferred tax assets, etc should be
invariably shown as intangible assets.
Assessment of working capital
requirements
 RBI setup a committee under the chairmanship of Shri P.L. Tandon in
July 1974.
RBI in April 1997 has decided to withdraw the prescription in regard
to assessment of working capital needs based on the concept of MPBF
enunciated by Tandon Study Group.
 Now, the banks can follow MPBF Method, Turnover Method,
Assessed Bank Finance Method, Cash Budget Method or any other
method approved by the boards for assessment of working capital
requirements.
Methods for assessment of WC
requirements
 The various methods for assessment of WC req are as under:Turnover Method (P R Nayak Committee recommendation) :- This method
has been introduced in 1993 by RBI with a view to improve overall credit flow
to the SSI sector.
Applicability:Particulars
Working capital limit upto
Applicable to
MSEs
Upto 5 crs
Manufacturing sector & services sector
Non MSEs
Upto 2 crs
Traders, Merchants, exporters etc. who do not have fixed
operating cycle.
Normally 25% of the estimated gross sales turnover value shall be computed
as working capital requirements, of which 20% shall be provided by the bank
and the balance 5% by way of promoter contribution towards margin money.
Under this method current ratio would be min. 1.25 times.
Methods for assessment of WC
requirements (contd)
 Cash Budget Method:- In the case of specific industries / seasonal
activities such as software export, construction activity, tea and sugar,
normally, the system of assessment based on the cash budget may be
adopted. For Format - Refer pg no. 20 of working Capital Manual.
 MPBF Method:• Working Capital Gap
This represents excess of current assets over current liabilities excluding
bank borrowings. A part of the Current Assets are financed by Current
Liabilities (other than bank borrowings).
• Net Working Capital
NWC indicates the margin or long term sources provided by the borrower
for financing a part of the current assets. Rest part of current assets gets
funded by current liabilities (including Bank Borrowings).
Methods for assessment of WC
requirements (contd)
Tandon committee recommendations for MPBF calculation:Three methods for determining MPBF
• Method 1: MPBF=0.75(CA-CL)
• Method 2: MPBF=0.75(CA)-CL (mostly used)
• Method 3: MPBF=0.75(CA-CCA)-CL, where CA- current asset, CL- current
liabilities, CCA- core current assets (permanent component of working
capital).
Explanation:• Method 1:- Banks can finance upto 75% of WCG and balance should come
from long term sources
• Method 2:- Borrower should provide 25% of total current assets out of
long term funds. Banks will provide balance amount after deducting credit
available for purchases and other current liabilities (other than bank
borrowings)
Methods for assessment of WC
requirements (contd..)
Tandon committee recommendations for MPBF calculation:Current Assets Rs.(in millions)
Raw material
Work in process
Finished goods
Receivables(including bills Discounted)
Other current assets
Current Liabilities
Trade Creditors Other current liabilities Bank borrowings (including Bills discounted)-
18
5
10
2
—
50
—
15
12
3
25
—
40
—
MPBF for Mercury Company Limited as per above methods are:
Method 1: 075(CA-CL) = 0.75(50-15) = Rs.26.25 million
Method 2: 0.75(CA)-CL = 0.75(50)-15 = Rs.22.5 million
Method 3: 0.75(CA-CCA)-CL = 0.75(50-20)-15 = Rs.7.5 million
Forms of FB and NFB limits
Working Capital Finance is extended in different forms based on the
requirement as follows:
I.
Inventory Limits (Pre-Sales) (projected level of the borrower’s operations)
•
•
•
Cash Credit (CC) including WCDL wherever permitted Export Packing Credit (EPC)
Overdraft
Vendor financing
II.
Finance against Receivables (Post-Sales)
•
•
•
Overdraft against Book Debts
Bills Purchased / Discounted/Negotiated
Receivable Buyout
III.
•
•
•
•
Non-Fund based limit (based on genuine needs and capacity of the borrowers)
Letter of Credit (LC)
Trade Credit Bank Guarantee (TCBG)
Bank Guarantee (BG)
Loan Equivalent Risk (LER)
Ratio Analysis and Holding levels of
operating cycle items
Ratio Analysis:- Important ratios are as under:To Examine Financial Ratio
used
Formula
Liquidity
aspects
Current Ratio
CA/CL
Total Liability
vis-à-vis stake
of
shareholders
Gearing Ratio
TOL/TNW,
Where TOL = Long term liabilities + Short term liabilities, &
TNW= Shareholders’ funds viz., Share Capital + Reserves
and Surplus
Servicing
capacity of
Interest
Interest Coverage
Ratio or Interest
Cover
PBDILT/Interest,
where PBDILT = Profit before interest, depreciation, lease
rentals and taxes
Servicing
capacity of
repayment
obligations
Debt Service
Coverage Ratio
(applicable to loans)
Annual Cash Accruals or PBILD/Annual Instalment of TL +
Annual lease rental, where
PBILD = PAT + Depreciation and other non-cash expenses +
Interest on term loan + Annual lease rental)
Ratio Analysis and Holding levels of
operating cycle items (contd..)
 Holding Levels of Inventory:- Helps in fixing working capital requirements:Holding Period (in days)
Formula
RM holding
Stock of RM/ Annual RM consumed * 365
WIP holding
WIP/ Cost of Production * 365
FG holding
Finished Goods/Cost of goods sold * 365
Receivables holding
Receivables/Annual Gross sales * 365
Creditors holding
Creditors/Annual Purchases * 365
where,
RM consumed = Op stock of RM + RM purchased – Cl stock of RM
Cost of Production = RM + Labour + Other direct expenses + Op WIP – Cl WIP
Cost of Goods sold = Sales – Gross Profit
Cash Flow and Fund Flow Statements
 Cash Flow statement (AS – 3 of ICAI):- Helps to take business decision say,
investment in fixed assets, financing through bank borrowings etc. where the
unit needs information on the amount of cash actually held at a particular
point of time.
Cash Flow Statement
Particulars
Amount
Net Cash used in operating activities
xx
Net Cash used in financing activities
xx
Net Cash used in investing activities
xx
Cash generated from all activities
xx
Add:- Opening cash and cash equivalents
xx
Closing cash and cash equivalents
xx
Cash Flow and Fund Flow Statements
(contd..)
 Fund Flow Statement - Historical Perspective:- The importance of funds
flow analysis as a tool for decision-making was recognised by Dehejia
Committee in the late sixties. Subsequently in 1974, Tandon committee put
further emphasis on the concept. The format for Funds Flow was later
incorporated by RBI in CMA format.
 Meaning:- A balance sheet item is known as Fund. The change in position
of an item in the balance sheet is known as flow. Thus, the statement of
changes in financial position is known as “Statement of funds flow” or simply
“Funds flow statement”.
 Rule:- Increase in a liability denotes a Source and Increase in an asset
denotes a Use. On the other hand, decrease in liability is a Use and decrease
in asset is a Source. The box diagram for the same is as under:Increase
Decrease
Liabilities
Source
Use
Assets
Use
Source
Cash Flow and Fund Flow Statements
(contd..)
 Items of Sources:A. Long term Sources:- PAT, Depreciation (added back to profit since it a
notional exp debited to P/L A/c, Increase in share capital/Reserves &
Surplus/Term Liabilities/Debentures, Public Deposits etc, Sale of fixed
asset.
B. Short term sources:- Disposal/Reduction of current assets (e.g.
inventory, receivables), Increase in Current Liabilities like Creditors, bank
borrowings, etc.
 Items of Uses:A. Long term Uses:- Drawings, Increase in share capital/Reserves &
Surplus/Term Liabilities/Debentures, Public Deposits etc.
B. Short term Uses:- Increase in Current Assets like (e.g. inventory,
receivables), Decrease in current liabilities like payment to creditors,
repayment of short term loan, etc.
Security Creation and Perfection of
security
 The security to be created is as under:Type of security
Nature of documentation
Primary Security
Hypothecation of Stock and Bookdebts
Collateral Security
• Equitable mortgage/Regd. Mortgage
of properties
• Pledge of shares/Assignment of
rights
• Personal Guarantees of
directors/Corporate Guarantee of
flagship co.
Security Creation and Perfection of
security (contd..)
 Perfection of Security:Sr.
No.
Forms of security
Perfection Requirement
1.
Indenture of Mortgage
• Filing of Form 8 with ROC
• Registration with relevant Sub-register of Assurances
2.
Equitable
Mortgage/Deposit
Title Deeds
• Filing of Form 8 with ROC
• Registration with relevant Sub-register of Assurances only
in the states of Gujarat and MP
• Notarisation of Directors’ Declaration
of
3.
Hypothecation
•Filing of Form 8 with ROC
4.
Pledge of shares
Physical
•Deposit of share certificate with the pledgee
• POA for voting rights need to be notarised
Dematerialized shares
•Filing under Depository Act/Regulations including filing of
form W (for NSDL) and Pledge Request Form (For CDSL) for
recording pledge of shares
•POA for voting rights need to be notarised
Credmin Documents
 Stock Statements:- Computation of Drawing Power.
1. Inventories
Total inventory (excluding non usable non moving, slow moving stocks)
A
(period to be specified)
2.
LESS; Unpaid stocks, stock under LC
B
Value of paid stock (A – B)
C
LESS: Stipulated margin on stocks as per sanction
D
DP / DL on stocks (C-D)
E
Book-debts
Total amount of inland credit sales (not exceeding the period permitted by the
F
sanctioning authority
LESS; Value of bills (discounted by the Bank/Factors) & advance received against
G
suppliers
Net bills receivables / debtors unfinanced by the Bank / Factors (F-G)
H
LESS: Stipulated margin on book debts as per sanction
I
DP / DL on Book Debts (H-I) or stipulated sub limit under Book Debt whichever lower
J
Credmin Documents (contd..)
 Stock Audit:- Stock Audit mainly involves the counting of physical stock
presenting the specified premises and verifying the same with computed
stock maintained by the company. The main advantages are:• Direct impact on costs and bottom line
• Prevent pilferage and fraud
• Identifies slow moving stock, obsolete stock, dead stock and scrap
• Third party independent opinion, especially for agent warehouses
• Identifies gap in current inventory management process
• Enable accurate valuation of inventory
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•
•
•
Other Credmin documents:QIS (Tandon Committee)/FFR /QMR statements & Quarterly results
Visit/Inspection Report
Consortium Meeting Minutes
Early Warning Signals & Remedial
Action
 Some of the Early Warning Signals which can make an account bad are as
under: Financials:-
1.
2.
3.
4.
5.
6.
Below benchmark Current Ratio, ICR and DSCR.
High gearing ratio or debt burdened company.
Company incurring losses for last financial years.
Receivables stuck up.
Continuous excess borrowings in past audited years as per CMA data
Variation between Actual results v Estimated/Projections by more than
10/20%.
Early Warning Signals & Remedial
Action (contd..)

1.
2.
3.
4.
5.
6.
Operations:Large slow and non-moving items.
RM not available.
Finished goods not sold.
Production disrupted due to natural calamities, strikes, lock-outs, etc.
Payment not made to suppliers in time.
Any other adverse comment(s) made in Stock Audit Report.

1.
2.
3.
4.
5.
Security Creation/Documentation:Adequate securities not created or perfected as per Sanction terms.
Legal Vetting not done.
Land not acquired for creation of mortgage.
Environment clearances not obtained.
Any other pre-disbursement condition not complied with.
Early Warning Signals & Remedial
Action (contd..)

1.
2.
3.
4.
5.
6.
Conduct of the account:A/c reported as SMA 1 or 2 or Critical overdues not cleared.
Low credit summation.
Short term funds utilised for long term purposes.
Frequent cheque returns.
Adhoc TODs granted frequently.
Fall in DP.

1.
2.
3.
4.
5.
Remedial Action:Necessary promoter’s margin is available.
Gearing Ratio is less than 3 times.
All securities are created and perfected and legal vetting is done.
Necessary Credmin documents are in place.
Satisfactory conduct of the account.