Working Capital / OD Limits

Working Capital Limits

Woking Capital Limits (Cash Credits) / OD Limits :-  Advances by Indian Banks, generally take the following three forms, i.e., cash credits, overdrafts and Loans. A cash credit is an arrangement by which a banker allows his customer to borrow money upto a certain limit against the values of his stocks and book debts for his day to day requirements. This is the most favourite mode of borrowing by large commercial and industrial concerns in India, on account of the advantage that a customer need not borrow at once, the whole of the amount he is likely to require, but can draw such amounts as and when required. He can put back any surplus amount which he may find with him for the time being. The banker granting cash credit and overdraft facilities has to estimate the amount of his customers requirements, and in case the actual drawings fall much below his estimate, he may lose interest on the funds remaining ideal.

Overdrafts:-  When a customer  requires temporary accommodations, he may be allowed to overdraw his current account, usually against collateral securities. From the customer's point of view, this arrangement like the cash credit is advantageous as he is required to pay, interest on the amount actually used by him. The essential difference between a cash credit and an overdraft is, that the latter is supposed to be a form of bank credit to be made use of occasionally; whereas the former is used for long terms by commercial and industrial concerns during regular business. In practice, however, this distinction is not always observed and some banks set up regular limits for overdrafts also.

Term Loans:-   Where a loan is granted for a fixed period exceeding one year and is repayable according to a schedule of repayment, as against on demand and at a time, it is known as a "term loan". Where the period exceeds one year but not, say 5 to 7 years, it is commonly known as a medium-term loan; a loan with longer repayment schedule is known as a long-term loan. A term loan is generally granted for fixed capital requirements, although such loans for working capital are not unknown, and are supposed to be repaid out of future earnings of the fixed assets in particular and of the borrower in general. It therefore requires a proper and more sustained appraisal of various factors connected with the proposition than an ordinary commercial demand loan.

Participation Loan or consortium advances:-  Where one single loan is granted by more than one financing agency; it is termed as a participation or consortium loan. Such participation becomes necessary where either the risk involved is too large for one or more of the participating institutions to take individually or there are administrative or other difficulties in servicing and follow up of the loan. Participation loans have been very popular in the USA, mainly due to : (a) the dual banking system prevailing there, (b) the unit banks not having sufficiently large resources, seeking participation with larger city banks, (c) legal restrictions on lending, prohibiting Nationalised banks from lending more than 10 per cent of their paid-up capital and reserves to one single borrower, and (d) the financing of Real estate by banks, involving larger risks. Participation loans are now assuming importance in India. The presence of gigantic banking institutions and other specialized financing agencies on the one hand and existence of a large number of small commercial and co-operative banking units on the other offer ample scope for such participation, particularly in the field of development financing. Participation is also possible among the bigger banks in the case of large advances. 

Apply for Cash credit Limits / Overdraft limits. Visit www.moneimatters.com  or emails us at info@moneimatters.com

Examination of financial Statements to sanction various credit facilities to the borrowers: Whenever a banker advances money to the borrowing entity, the banker demands their balance sheets before an advance to be sanctioned. This is because the study of the balance sheets enables the banker to know the financial position of a potential borrower. It would enable the banker to know whether the money which is to be advanced is likely to be repaid in course of time or not. The study of the balance sheet also reflects the nature of management of the concern whose balance sheets are scrutinized. This is more important because a banker would always like to advance money to concerns which are managed efficiently on the basis of sound principles of company management or financial management. The balance sheet is a statement showing the financial position of a concern as on a particular date. It indicates the debit balances and credit balances on a particular date on the assets side and the liability side of a company. In other words, the balance sheet is a statement showing what the company owns and what it owes to others. It also indicates the source of funds for the company and the use to which the funds are put.

The next question which arises is how the banker should look at a balance sheet especially from the view point of lending money to his potential borrowers. The following important points have to be noted in studying the balance sheet:

1. Normally a banker demands the balance sheets of the concern not for one year but for 3-5 years. This is because the balance sheet of one year may not give a complete and correct picture of the financial affairs of a concern. The year may be exceptionally a good year or a very bad year and therefore it may be difficult to arrive a judgement as regards the financial affairs of a concern. But if the balance sheets of 3/5 years are studied, it would give a trend as to the progress made by the company not only financially but also in other aspects. This would therefore, enables the banker to form a judgement not only in regards to the financial affairs of a company but also in regards to the way in which a company or business is managed.
2. The banker also verify to it that the balance sheets are certified as true and is duly signed by the auditors of the company.
3. The banker also see to it that the balance sheet which are studied are for a full period of 12 months. Otherwise, if a balance sheet is for six months only other balance sheets are for different periods, it would not be possible for a banker to compare the financial position. The comparison of balance sheets gives an idea of a trend in financial affairs over a period of time.
4. It is not sufficient to study only the balance sheet of a company. It would only give a partial picture of the affairs of the company. A balance sheet, therefore has to studied not in isolation, but in relation to other financial statements such as profit and loss account, trading account, income and expenditure account etc. This enables a banker to compare the figures which are relevant in arriving at a decision in considering a proposal for an advance.

A balance sheet can be studied in two ways so far as the lending banker is concerned. It can be studied through ratio analysis, and secondly it can be studied through a funds flow analysis. A ratio is a relationship of one item in the balance sheet to another item and this relationship between two items in the balance sheet can be expressed either as a percentage or as a proportion. The most important ratios which a banker should study in the balance sheet from the point of liquidity are as under:-

• Current ratio:- Current ratio is a ratio between current assets and current liabilities. Current assets are those assets which can be converted into cash within a short period. Current liabilities are the liabilities which fall due for payments for a short period. Current assets includes stock, book debts, cash and investments. Current liabilities are short term bank borrowings, trade creditors, provision for tax etc. Term loan instalments falling due with in one year from the date of balance sheet should also be included in current liabilities. To be specific, current liabilities will includes all sums payable within one year from the date of the balance sheet, including long term liabilities which are payable within the year. The current ratio is obtained by dividing current assets by current liabilities. Thus the ratio is calculated or worked out as:

                                         Current assets

                               -----------------------------

                                       Current Liabilities

An acceptable current ration varies from Industry and business to business for most of the companies current ratio from 1.5 to 2 is acceptable and satisfactory. However, current ration less than one indicate that there are liquidity issues in the firm and the firm must be concerned. Current ratio of above three indicates that management has access cash in hand and they are unable to invest in the properly. This ratio, therefore, is important to a banker since it indicates the liquidity of the borrower. It would not be entirely advisable to depend upon this ration in arriving at a decision to lend money. The ratio may be ideal yet the situation may not be favourable. What is more important is not to depend upon the arithmetic ratio but to go into the quality of assets included as current assets. If the assets are not good, the ratio by itself no meaning. For Example. If there are large stocks, which are not saleable, the situation will not be good even though the ratio may indicate a favourable situation, Similarly the debtors included in the current assets may be large but if they are likely to go bad at the time of realisation, the situation will be precarious though the ratio may indicate a favourable situation. A banker should, therefore, remember that the ratio is only a rough guide in arriving at a decision and he should examine the quality of the assets included in the ratio before taking a final decision. Still, however this current ratio is very important to a lending banker. The ratio should not be too low as it will indicate over trading. A very high ratio is also not a good sign as it indicates idling of funds.

• Acid test or quick ratio - This is also called Liquidity Ratio. This is a part of the current ratio and is calculated by comparing liquid resources, i.e, cash and bank balance, readily saleable securities and book debts with current liabilities. Current liabilities in this case shall not include short-term bank borrowings, i.e, overdraft and cash credit facilities, as although these are payable in a year but these continue to be outstanding from year to year. This ratio is of great importance for banks and financial institutions. A decline in the current ratio and the quick ratio indicates overtrading, which if serious, may land the company in difficulties. If current ratio is good but quick ratio is low it will indicate a dis-proportionately high investment in stock, as the quick assets exclude inventory or closing stock from current assets. The ratio of less than I will be undesirable, a ratio of 2 is ideal. The ratio is worked out as:

Quick assets (Current assets minus Inventory)

Quick Liabilities (Current Liabilities minus Bank borrowings)

• Gross profit to sales ratio – Profits are an important item in the balance-sheet. If the balance-sheet indicates a rising profit from year to year, it is considered to be a good sign. Therefore, a banker should study the gross profit ratio in order to arrive at a decision in respect of the loan proposal. This ratio is calculated by dividing profits before depreciation, taxation and other allocations by the sales during the period, this ratio is generally expressed as a percentage. The banker should study this ratio in the balance-sheet over a period of years and if possible compare the ratio with the ratio of another company engaged in the same line of business. This ratio will also reflect the efficiency or otherwise of management behind the company. Standard ratios worked out for different industries are published in some of the journals and therefore, it is easy for a banker to make an inter-company comparison. The ratio is calculated as:

Gross Profit x 100

Sales

• Debtors ratio - This ratio indicates what part of the sales is on credit basis and what part of sales is on cash basis. This indicates the period of credit which is extended by the borrower to its buyers. For example, if the total sales are Rs. 12 lakh in a year and the debt outstanding at the end of the year are Rs. 1 Lakh, it means that the company concerned grants a credit of one month on an average to its clients. The ratio should not be too high as it means slackness in collection or that a large portion of the sale proceeds are locked up in debtors and the company would thus be short of cash resources to pay its own creditors. This is also called Debt collection Period and is calculated as:

Accounts Receivable (Sundry Debtors and Bills Receivable)

Average Daily credit sales

Or

 Average Monthly Credit sales

It shows the number of day’s sales’ or number of months’ sales that remains uncollected.

Thus if sales during the year is Rs. 3,65,000, or Rs. 1,000 per day, and if the outstanding amounts receivable was Rs. 1,00,000, the debt collection period is 100 days i.e,  Rs. 1,00,000/1,000. There is slackness in collection if the firm allows, say, 60 days credit as instead of 60 days the uncollected debts are for 100 days.

• Net Return Ratio -   This ratio is calculated on the basis of the net profit. It is obtained by dividing the net profit after depreciation but before taxation by the net worth of the company. The net worth of a company consists of Paid-up capital, plus free reserve plus profit minus intangible assets. This ratio indicates the profitability to total own funds employed in business. The net Profit can also be divided by paid-up capital. This would give the profit earning capacity on the share capital employed in business.

This ratio is called Rate of return or Net profit to Capital Employed or, more commonly, Return on Investment (ROI). The most common method of calculating this ratio is:

                           Net Profit before Interest and Tax     x100

               Net Fixed assets+ WorkingCapital     

This ratio judges the overall performance of the concern. A comparison of the ratio for a period of years will show how the concern is utilising the facilities.

• Debtors/ Creditors ratio- This ratio is obtained by dividing debtors by creditors. If the ratio is more than 1, It indicates a satisfactory position. No definite conclusion can be arrived at by a bank on the basis of this ratio.

• Debt/Equity ratio- This ratio indicates the proportion of debt to equity. In other words, it serves to study the relation between borrowed funds and own funds. This is obtained by dividing debt by equity. Debt includes all Debts including current and long-term debts and equity includes share capital and free reserves. As per the earlier view, proportion of debt to equity should be generally one. If the debt exceeds equity the debt/equity ratio will exceed unity and therefore, it indicates an undesirable trend, but now in view of increased dependence on borrowed funds a higher ratio of “2” or “3” may not be undesirable.

       The ratio is calculated as: 

Current and long term Debts

Share Capital and Free Reserves

Commonly, only long term debts are considered for debt equity ratio. But for banks it will be better to take into account total debts. In this case, the ratio may be “2”, indicating that long term and current loans may be twice the shareholder’ funds. However, lower the ratio, more comfortable is the position of creditors or the bank, because it means that they can be called to suffer losses only if the losses are exceptionally heavy.

The normal level of Debt-equity ratio, which the bank have to see is 2:1. The Union Government has, however, announced that this should be relaxed to 4:1 for 35 thrust sectors of industry. This relaxation would be given on case –by-case basis. This measure is expected to encourage additional investment through technological up-gradation in these industries.

• Proprietary ratio. – It is the ratio of funds belonging to proprietors or shareholders to the company. Funds belonging to shareholders means share capital plus reserves and surpluses. Losses, if any, should be deducted. Borrowed funds should not be included. Higher the ratio, better it is for all concerned. The ratio is worked out as:

                                                         Proprietors Funds

                                                              Total assets 

• Solvency ratio.  – This ratio measures the ability of the concern to repay all external debts or outside liabilities out of its own assets on a long term basis. This ratio is obtained by relating Net Tangible Assets to total outside Liabilities:

                                                   Net Tangible Assets

                                                Total outside Liabilities

Net Tangible Assets mean total assets of the concern less all intangible and fictitious assets. Total outside liabilities mean total liabilities of concern other than its net worth. Ideally this ratio should be more than 1. Larger the ratio, better is the solvency of the unit.

• Inventory Turnover ratio. – Inventory means raw materials, stores, stock in process and finished goods. All these items put together are related to cost of goods sold for the year.

                      Cost of Sales = Cost of Production

                                                                Add: Opening stock of-

(i)                  Finished goods and

(ii)                Semi-finished goods.

Less: Closing stock of –

(i)                  Finished goods and

(ii)                Semi-Finished goods.

The cost of production is arrived at by adding all direct cost, viz. raw materials consumed, power and fuel, direct labour, consumable stores, repairs and maintenance to machinery and the other manufacturing expenses.

Cost of sales reflects the ability/production efficiency and as such has an important bearing on the performance of a concern. This ratio is calculated in number of day’s consumption. This ratio is calculated as under:

                                   Inventory x 365

                                Cost of Goods Sold

This shows the inventory held for the numbers of days. The lower the ratio, the more efficient is the inventory management.

The study of these ratios will enable the bankers to decide whether the proposal for an advance should be considered on merit or not if other factors are otherwise favourable. There are many more ratios but they are not of much importance to a banker.

Fund Flow Analysis

The other method of studying a balance-sheet by a lending bankers is through fund flow analysis. The fund flow analysis indicated how the funds are obtained and how they are used through changes in various assets and liabilities. The fund flow statement is also known as “source and application of funds statement”. Sources of funds are derived from:

(1)    Cash inflow from operations.

(2)    Income from investment.

(3)    Sale of fixed assets.

(4)    Contribution of shareholders.

(5)    Decreases in working capital.

(6)    Increases in liabilities.

(7)    Sale of investments.

(8)    Short-term and long-term loans.

Use of funds is equally to cover:

(1)    Operating expenses.

(2)    Repayments of loans and debentures.

(3)    Payment of dividend.

(4)    Increase in working capital.

(5)    Acquisition of fixed assets.

(6)    Purchase of investments.

In this way the lending banker can look at a balance sheet before money is advance to prospective borrowers.

Cash inflow from operations

This shows the cash generated from the business and is arrived at by adding net profit, depreciation and other non-cash charges, e.g., investment allowance, amounts written off, goodwill, patents etc., if any, debited in the profit and loss account. 

Monei Matters has more than 20 years of rich banking experience to get finance and loans  from different banks for their corporate and non corporate clients. Monei Matters has a complete knowledge base and expertise in this field and having back up of ex-bankers, chartered accountants, company secretaries, advocates and other professionals to provide industrys best services to its clients. If you have any query, please do not hesitate to contact us. Please email us at info@moneimatters.com or visit www.moneimatters.com

EXAMINATION OF STATEMENTS BY THE BANKER: GENERAL CONSIDERATIONS

A BANKER BEFORE EMPLOYMENT OF WORKINGCAPITAL FUNDS TO THE POTENTIAL CLIENT NORMALLY MAKES A KEEN EYE ON THE FOLLOWINGS—

The following general hints regarding the analysis of financial statements will, we trust, be found useful: -

• Nature of business:

In the first place the banker normally ascertain the nature of the trade or business—retail, wholesale or manufacturing—of the applicant for loan. This is necessary in order to consider the various items of the statement.

• Recent statement

Secondly, the statement should relate to a fairly recent period as a statement showing the customer’s position in some earlier years may not correctly reflect the true state of affairs at the time the person applies for accommodation. It is also desirable to see that the statement does not refer to a period when merchants, in the particular trade to which the borrower belongs, have their indebtedness at its lowest point. Moreover, the information given in the statement should be verified, as far as possible, by independent inquiries, particularly when the same has not been duly audited by a reliable firm of auditors.

• Differentiation of liquid and other assets

Thirdly, the statements should differentiate between the assets, which are of a liquid nature and those which are more or less fixed. Among the liquid assets may be mentioned cash in hand, cash with bankers, bills receivable, shares and bonds, and merchandise, raw, finished or in the process of manufacture. Similarly, liabilities should be distinguished, as short-term or long-term ones. Among the former are acceptances and amounts due to trade creditors and banks. Lands, buildings, plants and goodwill are some of the principal items of fixed assets, while mortgages and debentures are the chief amongst long-term liabilities.

• Liquid assets to be sufficient to meet short-term liabilities

Fourthly, in examining a statement, the banker must see whether or not the borrower can meet his current or short-term liabilities with the help of his quick or liquid assets. It is necessary to do so, because the continuation of the business may depend largely upon meeting the short-term liabilities as they mature. For instance if a businessman is unable to honour his acceptances, his credit may suffer so much that he may have to close his business, although his fixed assets may be sufficient to meet all his liabilities. Bankers are usually satisfied if the liquid assets and short-term liabilities bear a ratio of at least 2 to 1.

• Difference in the book value and realisable value of assets

Fifthly, it must be borne in mind that the value of the assets given in the statement is ordinarily expressed to show their worth to the trader for use in a going concern. The banker should remember that normally they will fetch much less in case of a good sale,

• Cash

We shall now deal separately with the principal items of the statement and comment upon them. One of the chief items, on the asset side of the statement of a borrower, is the cash in hand and at the bankers. In examining the amount shown as cash in hand the banker should see that it does not include I.O.U.’s of the proprietor or the manager.

• Current assets

Classification of assets into current assets should be strictly as per particular bank and Reserve Bank’s guidelines and it is to be ensured that the other assets are not included under this head while assessing working capital requirements or analysing the balance sheet. They include cash, bank balances, inventories, receivables, amounts due from proprietor, partners, associate concerns or others on current account (not in the nature of long-term advances), advances to suppliers of raw materials, stores, spares and consumables, advance payment of tax, other trade advances, prepaid expenses and the like. Current assets do not include doubtful debts, debts due for more than six months, deferred receivables maturing after one year, investments other than in Government Promissory Notes, deposits of a permanent nature with statutory bodies, advances to suppliers of capital equipment or for acquisition of a capital asset and the like. The composition of current assets requires to be closely examined from the angle of their chargeability as security for Bank's advances, besides ensuring that there is a healthy mix of different components of current assets.

• Bills receivable

As regards bills receivable, the banker should ascertain, whether or not, they are strictly trade bills received from customers, to whom goods have been sold. Taking into consideration the usage of the trade in which the borrower is engaged, the banker should see that they are neither for unduly large amounts, nor for unusually long periods.

• Book debts and accounts receivable

In examining the item of book debts and accounts receivable, the banker has to satisfy himself, whether, having regard to the business done, they are not unduly large, as some of them may not be recoverable. The nature of the debts should be ascertained as to whether there are any big debts that have been outstanding for a long time.

• Stock in trade

As regards the stock, it may not be feasible always to get the inventory made and its value estimated by an independent and reliable value, and, therefore, the bank may generally have to rely upon the borrower’s valuation. However, in such a case, the latter should be required to state that unsaleable and deteriorated goods have not been taken into account and the valuation has been made according to the cost, or the market price, whichever was lower, at the time of the closing of the accounts. Of course, the banker's acceptance of the valuation by the borrower will also depend upon the nature of the business, the relation of the stock to the sales, etc. The banker should also see that the stock carried is not in excess of the requirements of the concern and does not comprise of a large proportion of dead stock.

11.         Stock exchange securities

As regards the stock exchange securities held by the applicant for loan, the banker should try to find out the object with which they are carried as an asset. If the borrower has invested in securities, funds which he cannot profitably use in his own business, his credit position is strengthened, but on the other hand, if the securities happen to be of a speculative nature, the banker should regard them with some suspicion. As the latest market prices of such securities are available without any difficulty, the banker can easily ascertain their market value. However, this does not apply to all kinds of shares and stocks. For instance, the shares of several companies, floated in the last few years, are not easily saleable and the quotations, which appear against them in financial and other papers, being merely nominal, cannot always be relied upon. Moreover, the banker has to see whether the shares, held by the customer, are fully or partly paid-up because in the latter case, they carry a further liability.

12.         Fixed assets

In the case of fixed assets the banker should ascertain whether the land and buildings owned by the borrower are not subject to any incidental charges such as rates, taxes, etc. He has also to satisfy himself that the buildings are in good repairs and adequately insured against fire, deluge, earthquake, riots and civil commotion. He should not only take into account the current value of the property, but should also have due regard to its prospective value. In the case of plant and machinery, the banker has to see that they are in a good condition. He should find out the policy adopted by the applicant regarding the proper provision for the depreciation of such assets, so that, in case the building has to be pulled down, or the plant is to be replaced, there should be either sufficient reserve available for the purpose, or the book values of such assets should be brought down so low as not to affect the position of the concern.

13.         Sundry assets

There may be certain sundry assets such as leaseholds, goodwill, patents, trademarks, etc., whose values should generally be ignored by the banker, as, in the case of a liquidation of the business, they are not likely to fetch any price. It is to be noted that the banker has to take into account the break-up value of fixed and other assets, when considering applications for loans.

14.         Intangible and fictitious assets

Intangible assets are those which carry some value to the concern (but are not tangible) like goodwill, patents, copyrights, trade mark etc. Although in strict commercial terms these items are valuable, for analytical purposes, the banks should not attach any value to these items, as already stated. Fictitious assets include deferred revenue expenditure, share issue expenses, preoperative expenses etc. which are to be written off in due course and the debit balance in Profit and Loss Account. The banks should ignore the value of both intangible and fictitious items and they should be subtracted from the met worth of the concern.

15.         Liabilities

On the liabilities side the banker should first see whether the capital is large enough for the nature and turnover of the business. If the capital is inadequate the business will be hampered. As already stated, it is ordinarily not the function of a bank to supply fixed capital to an industry because commercial banks as far as possible keep their assets in a liquid form.

Acceptances

Secondly, the banker should satisfy himself that all the acceptances are for goods received. In the ordinary course of business, merchants accept bills drawn by persons from whom they purchase goods. If the applicant for accommodation accepts bills, drawn by persons other than those from whom he has purchased goods, or to whom he is indebted, the fact will stand as a point against him. The Bills Payable Register gives the details regarding the names of the drawers, amounts of the bills, and the respective dates of their maturity.

Accounts payable

As book debts or accounts receivable represent goods sold on credit, the item of accounts payable represents goods bought on credit, for which neither payment has been made nor acceptance has been given. This item can be checked by reference to the invoices received. It is desirable that, considering the usage of the trade in which the applicant for accommodation is engaged, these accounts should not be overdue, otherwise, it will clearly betray his inability to pay his debts on due dates. The amount under this heading should not be unreasonably large either. For example, if a concern sells goods worth Rs. 50,000 per month, its purchases should ordinarily be of less than that amount; and, if the credit term in that particular trade is one month, it should not owe more than the amount of its monthly purchases. In case a liberal cash discount is allowed in the trade and is taken advantage of, the amount of such accounts should represent invoices which have not been properly checked, or for which the period allowed for the claiming of discount has not expired. It is also desirable that, if a concern raises money by acceptances and other forms of borrowing, it should not owe large amounts under this heading.

Other liabilities

When the concern applying for a loan its banking with only one banker, the amount and the terms of the credit facilities enjoyed by it will be known to him. Similarly, the concern may owe money for taxes accrued but not paid and for unpaid salaries and wages. Sometimes, these amounts are a source of great anxiety to those responsible for the management of a concern.

Contingent liabilities

These items are indicated by way of a footnote in the balance-sheet as they are not prima facie crystallised liabilities affecting the overall liability position. Hence, very often sufficient attention is not paid to study them carefully. However, a closer look at these items may many a time reveal that they often include liabilities/commitments with serious financial implications, which may have adverse impact later. For example, claims not acknowledged as debts, payment for capital contracts not provided for, etc.

Similarly, issues of far-reaching implications like change in the accounting practices and procedures as also special accounting treatment given to certain transactions are quite often included under this heading or in Notes to Accounts. Each and every special comment should be carefully and critically analysed to understand the implications of the amounts included in the balance-sheet, e.g. liabilities under leasing agreement etc. Particular care should be taken to fully satisfy that the company has made satisfactory arrangements for meeting capital commitments.

16.         Profit and loss account

In addition to the statement of assets and liabilities, the banker should examine carefully the profit and loss accounts for the preceding few years, as they will show, whether or not, the business is a paying one. The banker should not only satisfy himself that all the expenses, chargeable to the profit and loss account, have been deducted before arriving at the figures of net profits, but also that sufficient amounts have been set aside for the depreciation of certain assets such as plant and machinery, buildings, motor cars, furniture, etc., which need replacement after the expiry of certain periods and for the payment of income-tax, etc. He has to take care, to see that the profits shown are real and - not fictitious. The profit and loss account is an important statement as it shows the income and expenditure of a concern during the year. The real protection to the lender is the ability of the concern to perform well and make a reasonable profit and this information will be available only in the profit and loss account. A weak balance-sheet may not necessarily represent a bad credit risk if profitability is good and is improving from year to year. Conversely, a concern with a sound balance-sheet may not be a good credit risk if it is incurring losses consistently.

17.         Working Capital Finance

Working capital requirement.

"Working capital is the capital required for day-to-day requirements of the firm. This is also called “changing” or “circulating” capital. The working capital is required for maintenance of inventories, i.e., stocks of raw materials, work-in-progress and finished goods, for extending credit to customers and for maintaining a cash balance. The total requirement is met partly by the credit that the suppliers of goods and services extend to the firm, the remaining part is to be provided by the firm out of its own internal sources or short term borrowings from banks.

Measurement or assessment of working capital

There are following methods for measuring or assessing the working capital of the concern:

(i) Net working capital— The working capital in this concept means the excess of current assets over current liabilities. The working capital can be measured from the financial data given in the balance-sheet. Sometimes the working capital is classified as Gross Working Capital and Net Working Capital. The former refers to the total of all the current assets and the latter is the difference between the total current assets and total current liabilities. The banker is concerned with the Net WorkingCapital.

(2) Operating or working capital cycle.—The operating or working capital cycle is the length of time between a company’s paying for the materials entering into the stock and receiving the inflow of cash from sales of finished goods. The operating cycle is calculated as under: -

(3) Concept of margin.-The financial accommodation for working capital or the value of the goods is not given for 100% of the value of goods, the banks fix certain margin on the value of the security which must be contributed or provided by the borrower out of his own funds and the balance amount will be financed by the bank. The amount to be financed by the bank after deducting the margin is termed as “permissible limit”. The percentage of margin fixed on the security depends upon the nature of the security. In the early seventies, the Reserve Bank of India proposed a scientific method for assessment of working capital and prescribed a format to be utilised by the banks for assessment of working capital.

18.         Sources of working capital

The working capital required by a concern can be financed from intern external sources. The various sources of working capital are: -

(a) Net gains from operations.—Net profits of the concern or the cash inflow from the operations constitute a potential permanent source of working capital. This is the most desirable source of working capital as it does not burden the business with external

Obligations.

(b) Sale of fixed assets.-This is an occasional and irregular source and the concerns cannot usually depend on this.

(c) Issue of shares.—Funds raised from the sale of shares may be a potential permanent source of working capital funds in addition to the net profit. The share issue may not add to the interest burden like the borrowings from bank but they mean a demand for dividends and sharing the ownership in the business with new investors.

(d) Bank borrowings.-The most widely used source of working capital is the bank loan taken against the hypothecation or pledge of inventory or mortgage of fixed assets. Loans against hypothecation of inventory may be called as short-term, but for all practical purposes they are permanent.

19.         Appraisal of proposals for working capital finance

The appraisal of the proposal is to be done as per the bank’s norms. The information is obtained on the printed forms devised by the banks, therefore the desired information as prescribed is available to the bank. It should however be noted that the assessment of working capital is always done for future period, whereas the financial statements reveal results of the past. In the newly established units the working capital is always to be assessed on the basis of projections for the next years. The most important point, therefore, is to ensure that the projections are as accurate as possible.

In case of the existing units the ratio analysis may be helpful in examining the efficiency with which the working capital is being used in the enterprise. The financial soundness of the enterprise should be seen with the help of the ratios. The various components of the current assets and the liabilities should also be examined under general considerations for analysing the financial statements. The Current Ratio, Quick Ratio and Inventory Turnover Ratio are important in this regard. A workingCapital Statement on the lines of Funds Flow Statement, showing the increase and decrease in the Current Assets and Current Liabilities should be prepared. This will help to analyse changes in the working capital components between two dates. It should be examined that the funds are not being diverted for long-term use.

REQUIREMENT TO HAVE TRANSPARENT GUIDELINES FOR CREDIT DISPENSATION

(a) Primary (Urban) Cooperative Banks (UCBs) are expected to lay down, with the approval of their boards, transparent policies and guidelines for credit dispensation, in respect of each broad category of economic activity, keeping in view the credit exposure norms and various other guidelines issued by the Reserve Bank of India from time to time.

(b) The assessment of working capital requirement of borrowers, other than SSI units, requiring fund based working capital limits up to  1.00 crore and SSI units requiring fund based working capital limits up to & 5.00 crore from the banking system may be made on the basis of their projected annual turnover.

(c) In accordance with these guidelines, the working capital requirement is to be assessed at 25% of the projected turnover to be shared between the borrower and the bank, viz. borrower contributing 5% of the turnover as net working capital (NWC) and bank providing finance at a minimum of 20% of the turnover. Projected turnover may be interpreted as 'Gross Sales' including excise duty.

(d) The banks may, at their discretion, carry out the assessment based on projected turnover basis or the traditional method. If the credit requirement based on traditional production / processing cycle is higher than the one assessed on projected turnover basis, the same may be sanctioned, as borrower must be financed up to the extent of minimum 20 per cent of their projected annual turnover. The projected annual turnover would be estimated on the basis of annual statements of accounts or other documents such as returns filed with sales-tax / revenue authorities. Actual drawals may be allowed on the basis of drawing power to be determined by UCBs after excluding unpaid stocks.

(e) Drawals against the limits should be allowed against the usual safeguards including drawing power and it is to be ensured that the same are used for the purpose intended. Banks will have to ensure regular and timely submission of monthly, statements of stocks, receivables, etc., by the borrowers and also periodical verification of such statements vis-a-vis physical stocks by their

Officials.

(f) In respect of borrowers other than SSI units, requiring working capital limits above Rs. 1 crore and for SSI units requiring fund based working capital limits above & 5 crore, UCBs may determine the working capital requirements according to their perception of the credit needs of borrowers. UCBs may adopt turnover method or cash budgeting method or any other method as considered necessary. However, UCBs may ensure that the book-debt finance does not exceed 75% of the limits sanctioned to borrowers for financing inland credit 3alcs. The remaining 25% of the credit sales may be financed through bills to ensure greater use of bills for financing sales.

- Source: UBDBPD (PCB) McNo.5/1305.0002013-14 dated July 1, 2013.

TERM LOANS

Where a loan is granted for a fixed period exceeding one year and is repayable according to the schedule of repayment, it is known as a “term loan” or “term finance". The period of term loan may extend up to 10 years and in some cases even more than 10 years. Where the period exceeds one year but not, say 5 to 7 years, it is commonly known as a medium-term loan: a loan with longer repayment schedule is known as long term loan. A term loan is generally granted for fixed capital requirements, e.g., investment in plant and equipment or permanent addition to current assets. These may be required for setting up new projects or expansion or modernisation of the plant and equipment.

Concept of Term loan

The expression “term loan” is well understood in banking parlance. The expression implies the grant of loan for a fixed term. It has no relevance with the purpose for which the loan is granted. Where the term for repayment is long, the loan is called “long term loan” and where the term exceeds one year but not, say, 5 to 7 years, it is commonly known as “medium-term loan”. The expression loan is defined as follows: - :

“Loans.—When a Banker makes an advance in a Lump sum the whole of which is withdrawn and is supposed to be repaid generally wholly at one time is called a loan. If the customer repays the same either wholly or partially and wishes to have accommodation subsequently, the latter will be treated as a separate transaction to be entered into if the Bank agrees to do so and subject to such terms as the Bank may like to impose. Thus the Bank does not suffer any loss of interest as a result of carrying excessive cash which is necessary in the case of cash credits and overdrafts. Loan accounts are said to have a lower operating cost than cash credits and overdrafts because of the larger number of operations in the case of the latter as compared to the former and consequently a lower rate of interest on loans appears to be justifiable than in the case of overdrafts and cash credits.

“Term loan-Where a loan is granted for a fixed period exceeding one year and is repayable according to a schedule of repayment, as against on demand and at a time, it is known as a “term loan”. Where the period exceeds one year but not, say 5 to 7 years, it is commonly known as a medium-term loan, a loan with longer repayment schedule is known as long-term loan. A term loan is generally granted for fixed capital requirements, although such loans for working capital are not unknown, and are supposed to be repaid out of future earnings of the fixed assets in particular and of the borrower in general. It, therefore, requires a proper and more sustained appraisal of various factors connected with the proposition than an ordinary commercial demand loan.

Term loan appraisal

Appraisal of term loans depends to a large extent on estimates or forecasts. There are following broad aspects of appraisal:

(1) Technical feasibility. — The examination of this aspect requires a detailed assessment of the goods and services needed for the project, e.g., land, housing, transportation, power, water, raw materials, supplies, fuel etc. The location of the project is highly relevant in technical feasibility and the term-lending institution or bank should pay special attention to the location and other infrastructure needed for the project.

 (2) Economic feasibility.—It should be examined that there is the demand for the additional output or the product.

(3) Managerial competence.— The technical competence, administrative ability, integrity and resourcefulness of the management are also important considerations while appraising the proposal, because repayment prospects largely depend on the managerial competence.

(4) Financial feasibility.— The basic data required for financial analysis is as under:

(a) Cost of the project.

(b) Cost of production and profitability.

(c) Cash-flow estimates during the currency of loan.

(d) Proforma balance-sheets.

* Term-lending institution or the bank has to critically analyse the data obtained from the borrowers and to ensure that: (i) the estimates of the cost of the project fully cover all items of expenditure and are realistic, (ii) the sources of finance contemplated by the sponsors of the project will be adequate and the necessary finance will be available during the period of construction as per the schedule, (iii) what will be the level of production, sales, net earnings, borrowings, etc., and when the project is expected to break-even and start yielding profit, (iv) when the repayment of the term loan will start, considering the cash generations, and (v) the repaying ability of the borrower exists with a reasonable margin of safety.

Security

The term loans are generally fully secured. The term-lending institution has however to examine the loan proposal from the view point of nature and extent of security offered. The security is an important consideration and is necessary adjunct to the financial appraisal, but this cannot substitute the financial appraisal, therefore the greater reliance should not be only on the security.

Cash flow statement

Cash flow statement shows the various sources and applications of funds on the similar lines as in Funds Flow Statement, with the difference that it will begin with the opening balance of bank and cash balances in hand and end with the closing balances at bank and in hand. It is truly a summary of Cash Book. In Funds Flow Statement on the other hand cash and bank balances are included in current assets and met increase or decrease in the working capital is shown in the statement. In Cash Flow Statement, Depreciation and Investment Allowance is shown as a separate source of funds and the payments of interest and taxation are shown separately in the application of funds, the net profit is shown as sources of funds after adding back the interest and taxes.

DIFFERENCE BETWEEN working CAPITAL FINANCE AND TERM LOAN FINANCE

From the discussion of the foregoing pages, following distinguishing features emerge:

i) Purpose-Term loan is given for setting up of new projects or expansion, diversification or modernisation of the existing units. Working capital finance is given to meet out the day-to-day requirements of the concern, e.g., financing the inventories, or extending the credit to the customers. etc.

ii) Period.—Term loan is repayable in instalments over a period of years. Long-termloans are generally repayable as, per the repayment schedule over 8 to 10 years. Repayment starts generally after 2 or 3 year, when the unit starts generating enough cash from its operations. Working capital loan is generally granted for one year although it is renewed every year and is almost a permanent feature. It is however repayable on demand.

iii) Security.—The term loans are secured by a first charge on the immovable and movable properties of the unit. Working capital finance is given against the hypothecation of stock etc.

iv) Convertibility clause.-Term-lending institutions generally keep a convertibility clause in the agreement, which gives them the option to convert part of the loan into equity shares of the borrower. There is no such clause in the working capital finance.

v) Follow-up and supervision.—Term loans require more constant and sustained supervision over the years, because the repayment depends upon the successful execution of the project and cash generations from the operations. In working capital finance it is to be seen that the working capital is being used efficiently and the funds are not being diverted for long-term use.

(vi) Appraisal.—In term loans a detailed and thorough appraisal, is done as to the technical, economic and financial feasibility, as well as managerial competence. The term lending institution has to examine the repaying capacity of the borrower. In the working capital finance however the banks examine the short-term liquidity of the concern.

vii) Source of finance.—Termloans are mainly provided by the term lending institutions and to some extent by banks either on their own or in consortium with such institutions. The termloans granted by banks are also re-financed by the IDBI, therefore, banks do not block their funds in term loans to a large extent. The working capital finance is given generally by banks.

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