Chapter Four Structure of Working Capital

82
4.1 Concepts and Definitions
In order to make the concepts clear and meaningIul, it is necessary to deIine the
meanings and scope oI certain concepts oI working capital used in diIIerent senses Irom
time to time in the literature on Iinancial management. Some oI the concepts like,
working capital, current assets, current liabilities, liquidity and proIitability have been
discussed in this study.

4.1.1 Concept of Working Capital
The capital employed in any business enterprise comprises oI the Iixed capital and the
working capital. In other words, capital can be divided into two main categories- Iixed
capital and working capital. Basically, while the Iormer is required to acquire Iixed
assets, the latter is needed to Iinance current assets. The concepts oI working capital
Gross and Net` are commonly Iound in the literature on Iinance. For the purpose oI
present study, net working capital concept has been adopted. However, gross concept oI
working capital has also been used in appropriate contexts.

4.1.1.1 Concept of Gross Working Capital
Gross working capital is the total oI all current assets, viz., cash, marketable securities,
account receivables, inventory, etc. It is also known as circulating capital or operating
capital, as these assets rotate continuously so long as the Iirm exists. This quantitative
approach Iocuses attention on the levels oI current assets Ior a given activity.

4.1.1.2 Concept of Net Working Capital
The net working capital concept represents the net current assets i.e., excess oI current
assets i.e., excess oI current assets over current liabilities. Alternative deIinition oI net
working capital is as that portion oI a Iirm`s current assets Iinanced with long term
Iunds.
1
Since current liabilities represent sources oI short term Iunds, as long as current
assets exceed the current liabilities, the excess must be Iinanced with long-term sources.
The above deIinition given by Gitman is more useIul Ior the analysis oI trade-oII
between proIitability and risk. Working capital, according to (Guthman and Dougall)
2
is
the excess oI current assets over current liabilities. Accountant`s Hand Book Wixon
3


1
Gitman,L. J., 'Principles oI Managerial Finance, New York: Harper and Row Publishers, 1997, p. 637.

2
Guthman, H.G. and Dougall, H. E., 'Corporate Financial Policy, New York: Prentice-Hall, 1955, p. 387.

3
Wixon, RuIus (ed.), 'Accountants Hand Book, New York: The Ronald Press Company, 1957, p. 254.
Chapter Four Structure of Working Capital
83
completely endorses this view.
The analysis oI the structure oI working capital comprising oI current assets and current
liabilities. The Iormer includes inventories, receivable, cash, marketable securities and
other current assets, while the latter consists oI bank loans, loans other than bank, trade
creditors, provisions and other current liabilities.

4.2 Current Assets
Current assets are those which are used in the conduct oI business operations oI an
enterprise and are maintained Ior short periods oI time. In other words, they are deIined
as those that are expected to be converted into cash within one year. There are basically
Iive major items oI current assets which are brieIly explained in the Iollowing
paragraphs.
Current assets are inclusive oI inventory, marketable securities, trade debtors, cash and
bank balances and other current assets, which are be normally turned into cash within a
short period oI time, Ior instance a year, without undergoing diminution in value and
without disrupting the organization. These are also the assets that Iorm part oI the
circular Ilow` or the operating cycle oI the business.

4.2.1 Inventories
Inventories generally occupy the key position in the structure oI working capital. Not
only huge investment is involved in this segment, but cost oI materials also Iorms a
substantial portion oI the cost oI production in many manuIacturing enterprises. Further,
it signiIicantly contributes towards the maximization oI proIit. It is, thereIore,
absolutely imperative to manage inventories eIIiciency and eIIectively in order to avoid
unnecessary investment in them. An enterprise which neglects the management oI its
inventories may jeopardize its long run proIitability and may even Iail ultimately. As
such, inventories are regarded as grave yard oI business and uncontrolled inventories, as
industrial cancer.
4
In Iact, scientiIic management oI inventories acts as a key to
industrial prosperity.
Inventories can be segregated into Iollowing types:
5



4
Chadda, R.S., 'Inventory Management in India, Bombay: Allied Publishers, 1971, pp. 1-4.

5
Michael Firth, 'Management oI Working Capital, London: The Macmillan Press Ltd., 1976, p.24.

Chapter Four Structure of Working Capital
84
(i) Raw materials stocks: these are held by manuIacturing industries prior to their
being utilized in the production process.
(ii) Work-in-progress: this is the term given to a product which is only part-way
through a manuIacturing process. It consists oI raw materials, labour costs,
subcontracting costs and various manuIacturing costs.
(iii) Finished goods: these are the products that are intended to be sold by the
company to its customers.
Though investment in inventory involves cost, the beneIits Irom holding inventories are
Iairly obvious. Raw materials are held in stock to provide a saIety stock against Iailure
oI supplies and to take advantage oI lower prices because oI bulk purchasing. Work-in-
progress acts as a saIety stock oI raw materials so that production is not interrupted.
Finished goods are held to provide customer service and to allow continuous production
even iI sales are seasonal.
Funds tied up in inventory depend upon the average inventory that would be carried by
a Iirm. The average inventory oI an item is the saIety stock plus halI the order quantity.
The costs associated with holding oI stock are:
(i) Carrying cost;
(ii) Procurement cost, and
(iii) Stock out costs.
The more common items oI inventory carrying cost are storage costs, interest on the
Iunds tied up, insurance, damage, deterioration, pilIerage and obsolescence.
Procurement costs comprise oI cost oI processing purchase order, transportation,
unloading and inspection cost. In other words, not only does this include administrative
paper work in ordering goods but also the physical work involved in it. Running out oI
stock results in losing sales and as a consequence proIits will be lost and may also result
in shut down in Iactory processes in the case oI raw materials which lead to interruption
oI production. ThereIore, optimum level oI inventory shall always be kept in order to
minimize the inventory costs.
In a nutshell, it can be said that the eIIiciency with which the Iirm is managed depends
mostly upon its inventory management. The greater the eIIiciency, the lower the Iunds
tied-up in inventory and greater shall be the improvement in shareholders` wealth, oI
course other things remaining the same.
4.2.2 Marketable Securities
It has become the practice with modern business enterprises to invest a portion oI their
Chapter Four Structure of Working Capital
85
earning in such assets which can easily be converted into cash. Such assets may consist
oI government securities, bonds, debentures and shares which are readily marketable
and may be converted into cash at a short period.

4.2.3 Cash and Bank Balance
Cash is one oI the important components oI current assets and because oI its liquidity it
plays a very signiIicant role in the working oI an enterprise. Cash is the beginning as
well as the end oI the operating cycle oI a manuIacturing concern. Cash is, thus, most
important current asset Ior the operations oI a business. It is the basic input required to
keep the business running continuously and is also the ultimate output expected to be
realized by selling the Iinal product manuIactured by a Iirm.
The cash balance oI a company is a saIety valve or shock absorber protecting the
company against short run Iluctuations in Iunds requirement.
6
The steady and healthy
circulation oI cash throughout the entire business operation is the basis oI business
solvency.
7
A Iirm should, thereIore, maintain suIIicient cash balance, neither more nor
less. While the excess cash may simply remain idle without contributing anything
towards the Iirm`s proIitability, the paucity oI cash may seriously disrupt its
manuIacturing operations. ThereIore, cash Iunction is crucial Ior eIIicient management
oI overall operations oI the Iirm. The planning and control Ior cash policies is the sole
responsibility oI top management. The execution oI these policies and procedures rests
with the Iinancial executive. The role oI Iinancial executive as regards the cash
management is to Iollow sound Iinancial practices which may reduce the number oI
deviations oI actual Ilows Iorm planned cash Ilows. Further, Ior smooth running,
eIIective cash management is oI most importance. ThereIore, Ior the purpose oI
liquidity proIitability should not be sacriIiced and Ior the purpose oI proIitability
liquidity should not be sacriIiced. Hence, a proper balance should be made between
two.
4.2.4 Debtors or Account Receivables
Next to inventories, receivables occupy the prime place in the total oI working capital.
These are short term debts owed to the enterprise, which include oI book accounts,

6
Anthony, R.N., 'Management Accounting Text and Cases, Illinois: Richard D, Irwin, Inc., 1970,
p.430.

7
Howard, B.B. and Upon, M., 'Introduction to Business Finance, New York: McGraw-Hill Book Co.,
Inc., 1953, p. 188.

Chapter Four Structure of Working Capital
86
notes and bills and accrued receivables. They represent all claims held against others Ior
Iurther receipt oI money, goods and services and also cover pre-payments on purchases.
In Iact, the size oI receivables in an enterprise depends very much on the credit and
collection policies. Besides, the quantum oI investment in receivables is also inIluenced
by the practices and customs in the industry. Given the credit terms and collection
policies, the quantum oI outstanding receivables at a point oI time throws considerable
light on the eIIiciency oI receivables management. ThereIore, it is understandable that
Iirms should be vigilant over their credit and collection policies. An enterprise
Iollowing lenient credit policy to outweigh the competition will certainly land in the
crises unless it is strong in collection oI debts. Furthermore, it is the eIIicient
management oI the receivables which eliminates the bad debt losses to the enterprise
and reduces the investment in this component.

4.2.5 Other Current Assets
Other current assets` comprise oI loans and advances, interest accrued, stamps and
stationery, taxes paid in advance, prepaid expenses and deposits with Iinancial
institutions. These include in the total oI current assets in the balance sheets oI the
company.

4.3 Current Liabilities
The investment oI current assets by using short term liabilities also covers working
capital management. In other words, besides current assets, current liabilities also count
in Iraming the structure oI working capital. Current liabilities are those liabilities which
shall be discharged within an accounting year.
The total oI current liabilities includes bank loans, loans other than bank, trade
creditors, provisions and other current liabilities that are normally payable within a
short period oI time, say a year, Irom out oI the current assets or Irom out oI the income
oI the business.

4.3.1 Bank Loans
Banks provide Iinancial assistance through cash credit account Ior the ostensible
purpose oI acquisition oI current assets. Normally, such loans are Ior short periods oI
time and are, thereIore, entered in current liabilities. These loans diIIer Irom bank
overdraIt to the extent that there is Iixed time period Ior the loans. However, in the
Chapter Four Structure of Working Capital
87
present study bank overdraIts are included in bank loans.
4.3.2 Trade Creditors
Trade creditors are created when the Iirm purchases raw materials, stores and goods Ior
resale on credit terms. These purchases on open account` are Ior most Iirms, the largest
single source oI short term Iinancing.
8
However, the extent oI trade credit depends upon
the trade custom, the type oI goods involved and the Iinancial soundness oI the
suppliers and the purchaser.
9


4.3.3 Provisions
They include provision Ior divided and tax as well. The Iinal divided is not oIIicially
declared until the Annual General Body Meeting is conducted and so no cash leaves the
company in respect oI this until possibly six months aIter the year end. Tax dues Ior
payment within a year are usually shown as a current liability.

4.3.4 Other Current Liabilities
Other current liabilities` consist oI unexpired discounts, unclaimed dividends, interest
accrued but not due on loans, outstanding wages and salaries and due Ior gratuity and
superannuation Iunds.

4.4 Liquidity
Liquidity is used in a limited sense in the study to mean short term debt repaying
capacity oI the enterprises. In other words, it is taken as the ability oI the Iirm to meet
the claims oI suppliers oI short term capital used Ior building-up oI current assets.

4.5 Profitability
ProIitability reIers to the ability oI the company in making the proIits in relation to
capital employed, sales and the shareholder`s Iunds.

4.6 Differences between Current Assets and Fixed Assets Management
The separation in treatment oI current and Iixed assets is oIten justiIied on the basis oI

8
Hampton, J. J., 'Financial Decision Making Concepts, Problems and Cases, New Delhi: Prentice Hall
oI India PVT. Ltd., 1996, p.504.

9
Michael Firth, 'Management oI Working Capital, London: The Macmillan Press Ltd., 1976, p. 111.

Chapter Four Structure of Working Capital
88
diIIerences in their nature. Fixed assets are said to be 'lumpy in the sense that they
involve the commitment oI Iunds to a speciIic assets over an extended period oI time,
during which the asset is thought to have limited marketability. In contrast current
assets are oIten viewed as a continuum oI possible investment levels as opposed to
investment in a speciIic Iorm or type liquid assets, receivable or inventory.
10
The
management oI current and Iixed assets diIIers in three important dimensions. Firstly, in
managing Iixed assets, the time Iactor is very important in the sense that the discounting
and compounding aspects oI time element play a crucial role in capital budgeting while
it has less relevance in the management oI current assets. Secondly, the large holding oI
current assets, especially cash, strengthens the Iirm`s liquidity position and reduces risk.
But it also reduces the overall proIitability. Thirdly, though the levels oI Iixed and
current assets maintained depend upon the expected sales, only current assets can be
adjusted with sales Iluctuations in the short run.

4.7 Need for Working Capital Finance
In any business organization, the working capital constitutes a signiIicant portion oI the
total investment. The need Ior working capital to meet the operating needs oI a Iirm
need not be over emphasized. An industrial unit requires working capital Iunds to
perIorm its activities oI production and sale oI its products. Funds are generally needed
to IulIill the Iollowing objectives:
To purchase and stock necessary quantities oI raw materials and stores.
To make advances Ior goods and services.
To meet all incidental expenses related to production.
To carry the Iinished goods till sales are made.
Sometimes sales have to be made on credit basis thus creating receivables
The Iunds would be needed to carry the receivables also as sales do not convert
into cash instantaneously.
4.8 Composition of Working Capital
Following is the list oI current assets:
Current Assets
1) Cash and Bank balances:

10
Van Horne, J.C., 'Financial Management and Policy, New Delhi: Prentice Hall oI India Pvt. Ltd.,
2004, p.437.

Chapter Four Structure of Working Capital
89
a) Cash in hand
b) Cash at Bank
(i) Current accounts
(ii) Deposit accounts
c) Interest accrued on bank balances
2) Marketable securities:
d) Investments in Government or Trust securities
e) Investments in shares, debentures or bonds
3) Sundry Debtors, Loans and Advances:
f) Trade Debtors
g) Bills Receivables
h) Advances to Suppliers, Contractors, etc.
(i) Loans and advances to employees
4) Inventory
j) Raw Materials
k) Work-in-process
l) Finished goods
m) Consumable stores and spares
n) Goods in transit
Current Liabilities
1) Sundry Creditors:
a) Trade Creditors
b) Bills payable
c) Liabilities Ior expenses
2) Loans and Advances:
d) OverdraIt, cash credit, loans Irom banks
e) Sundry loans
f) Fixed deposits
g) Advance and progress payments
h) Interest accrued but not due on loans
3) Provisions:
i) Provision Ior taxation
j) Provision Ior pension, gratuity, etc.
k) Provision Ior dividend
Chapter Four Structure of Working Capital
90
l) Provision Ior contingencies
4) Miscellaneous Current Liabilities:
m) Unclaimed dividends
n) Unclaimed salaries, wages, etc.
o) Employees security deposits
p) Trade deposits Irom stockiest
q) Deposits Irom contractors
r) Share application money
s) Dues to trustees oI Employees Provident Fund

4.9 Classification of Working Capital
The amount oI Iunds required to meet the operational needs varies Irom time to time in
every business. But a certain amount oI assets in the Iorm oI working capital is always
required, iI a business has to carry out its Iunctions eIIiciently. The classiIication oI
working capital is as Iollows.
Figure (4-1) shows classification of working capital,






















A) Permanent of Fixed Working Capital
It is that part oI the capital which is permanently locked up in the circulation oI current
assets and in keeping in motion, e.g., every manuIacturing concern has to maintain
WORKING CAPITAL
Permanent of fixed
working capitaI
WORKING CAPITAL
Permanent of fixed
working capitaI
VariabIe Working
CapitaI
Reserve Margin ReguIar SeasonaI
SpeciaI
Chapter Four Structure of Working Capital
91
stock oI raw materials, work in progress, Iinished products, loose tools and equipments.
It also requires Iunds Ior the payment oI wages and salaries throughout the year.
The permanent working capital can again be subdivided into: (i) Regular working
capital, and (ii) Reserve Margin.
(i) Regular working capital: It is the minimum amount oI liquid capital needed to keep
up the circulation oI the capital Irom cash to inventories to receivables and back again
to cash. This would include a suIIicient cash balance in the bank to discount all bills,
maintain an adequate supply oI raw materials Ior processing, carry a suIIicient stock oI
Iinished goods to give prompt delivery and aIIect the lowest manuIacturing costs.
(ii) Reserve Margin: It is the excess over the need Ior regular working capital that
should be provided Ior contingencies such as:
(a) Rising prices
(b) Business depressions
(c) Strikes, Iires and unexpected severe competition
(d) Special operations such as experiments with products or with methods oI
distribution war contracts, contracts to supply new business, which can be undertaken
only iI suIIicient Iunds are available. In many cases it may be Ior the survival oI a
business.
B) Variable Working Capital
The variable working capital changes with the volume oI business. It may be sub-
divided into: (i) Seasonal and (ii) Special working capital.
(i) Seasonal Working Capital: The capital required to meet the seasonal needs oI
industry is termed as seasonal working capital.
(ii) Special Working Capital: It is that part oI the variable working capital which is
required Ior Iinancing special operations such as implementation oI extensive marketing
campaigns, experiments with products or with methods oI distribution, carrying out oI
special jobs and similar other operations that are beyond the usual business oI buying,
Iabricating and selling.
This distribution between permanent and variable working capital is oI great
signiIicance particularly in arranging the Iinance Ior an enterprise. Regular or Iixed
working capital should be raised in the same way as Iixed capital is procured through
the permanent investment oI the owner or through long-term borrowing. As business
expands, this regular working capital will necessarily expand. II the cash returning Irom
sales includes a large enough proIit to take care oI expending operations and growing
Chapter Four Structure of Working Capital
92
inventories, the necessity oI additional working capital may be provided by the earned
surplus oI the business. Variable needs can, however, be Iinanced out oI short-term
borrowings Irom banks or Irom the public.

4.10 Working Capital as Circulating Capital:
It means money spent in the course oI production and exchange.
Circulating is: moving or Ilowing in a circuit and returning to the same point; as, steam
circulating through the pipes; the circulating thyroid hormones.
Capital is: Money, stock employed in a business.
Working Capital Cycle
Cash Ilows in a cycle into, around and out oI a business. It is the business's liIeblood
and every manager's primary task is to help keep it Ilowing and to use the cash Ilow to
generate proIits. II a business is operating proIitably, then it should, in theory, generate
cash surpluses. II it doesn't generate surpluses, the business will eventually run out oI
cash and expire.
The Iaster a business expands the more cash it will need Ior working capital and
investment. The cheapest and best sources oI cash exist as working capital right within
business. Good management oI working capital will generate cash, will help to improve
proIits and reduce risks. The cost oI providing credit to customers and holding stocks
can represent a substantial proportion oI a Iirm's total proIits.
There are two elements in the business cycle that absorb cash - Inventory (stocks and
work-in-progress) and Receivables (debtors owing you money). The main sources oI
cash are Payables (your creditors) and Equity and Loans. The working capital cycle is
shown in Iigure (4-2).

Chapter Four Structure of Working Capital

93
Each component oI working capital (namely inventory, receivables and payables) has
two dimensions ...TIME ......... and MONEY. When it comes Ior managing working
capital - TIME IS MONEY. II money can be collected to move Iaster around the cycle
(e.g. collect monies Irom debtors more quickly) or reduce the amount oI money tied up
(e.g. reduce inventory levels relative to sales), the business will generate more cash or it
will need to borrow less money to Iund working capital. As a consequence, the cost oI
bank interest can be reduced or additional Iree money would be available to support
additional sales growth or investment. Similarly, iI improved terms can be negotiated
with supplier`s e.g. longer credit or an increased credit limit; would be available to
create Iree Iinance to help Iund Iuture sales.
11


4.11 Importance of Working capital
A developing economy requires not only an increasing volume oI investment in Iixed
assets but also an increasing volume oI working capital. Because oI the scarcity oI
inventible resources, the rate oI growth oI such an economy depends to a signiIicant
extent on the eIIective utilization oI the working capital.
Thus the role oI working capital in industry has two aspects: (a) the optimum rate oI
growth in the volume oI working capital in relation to an increase in the volume oI
output; and (b) the optimum allocation oI the available volume oI working capital into
diIIerent items oI current assets.
An indication oI the eIIective utilization oI working capital is that its requirements Ior
an industry should not increase more than in proportion to the increase in volume oI
output.
Working capital is required Ior current purchases, current expenses, building up
inventories, promoting sales, extending credit Iacilities with the ultimate aim oI
achieving the turnover oI goods and its conversion into cash. Adequacy oI working
capital is a source oI strength and stability to the company. Following are the plus
points oI maintaining adequate working capital.
1) SuIIicient working capital enables the company to pay its bills, to meet the daily
expenses, to make the routine purchases as and when required. Thus the business is kept
going without interruption arising Irom shortage oI Iunds reIlected in scarcity oI
materials, irregular payment oI wages, etc.

11
(www.http://tsunamihelp.blogspot.com).

Chapter Four Structure of Working Capital
94
2) To maintain the solvency oI business and continue production, it is but essential
that a suIIicient amount oI Iunds be made available to purchase raw materials, pay the
wages and salary bills, stock Iinished goods and meet other administrative expenses. A
manuIacturing concern is bound to come into diIIiculties in the absence oI ready cash
available to pay the bills Ior material, direct labour, advertising and distribution
expenses and other costs oI carrying on business.
3) Credit-worthiness oI the company is rated high iI the position oI the working
capital is Iound satisIactory. Credit status depends on the ability to pay and the
promptness with which payments are actually made.
4) A company with sound working capital arrangements, having high-rated credit
standing, is able to procure credit Irom banks on easy or competitive terms.
5) A company having suIIicient Iunds is able to take advantage oI each discount
oIIered by supplies oI raw materials or other merchandise Ior prompt payment.
6) Regular payment oI wages and salaries by a company, with suIIicient working
capital, maintains and enhances morale oI its personnel and thus eIIicient perIormance
is secured.
7) Business oscillations are not uncommon in the liIe oI an undertaking. There is
no credit in obtaining adequate amount oI capital during boom periods, but during
periods oI depression, the demand Ior working capital usually shoots up and only
concerns having ample resources can tide over such circumstances. Thus, the necessity
oI raising cash in periods oI emergency makes it advantageous Ior a company always to
carry a reasonable amount oI surplus cash.
8) In times oI boom, where there is rush oI orders, companies having adequate
working capital can execute the routine, as well as special orders, by purchasing
additional raw materials and employing additional staII.
9) Companies having suIIicient working Iunds can wait Ior better marketing
opportunities by holding up inventories and secure higher price.
10)Continued prosperity and progress oI the undertaking can be maintained by
ample working capital.
Regular payment to staII, prompt payment to creditors, continuous production,
quicker sales, steady rate oI dividend to shareholders, better credit-standing and
enhanced goodwill are well associated with ample working capital.


Chapter Four Structure of Working Capital
95
4.12 Sources of Finance for Working Capital
Short-term Iunds Ior the Iinancing oI working capital requirements may be classiIied as
external and internal. The important sources oI external short-term Iinance are: (a) Bank
Loans, (b) Public deposits and miscellaneous loans, (c) Sundry creditors and other
payables including outstanding Iactor payments, and (d) Taxation provision.
The internal sources oI short-term Iinance are: (a) depreciation Iund and (b) Ploughed
back proIits oI a Iirm.
External sources:
(a) Bank loans: Banks are the traditional institutions, which provide business
concerns with Iunds to Iinance short-term requirements. The conventional method oI
taking bank loans is by means oI unsecured promissory notes, generally Ior 90 to 180
days. The sole security is the general credit oI the borrowing companies. Secured loans
are taken Irom the banks by hypothecation oI inventories. Still another method oI
getting loans Irom banks is by endorsement oI accounts receivables. The establishment
oI overdraIt Iacilities with commercial banks enables business to draw the required
amounts as and when necessary.
The monetary policy directly or indirectly determines the quantity oI money, the
structure oI interest rates and the price and distribution oI bank credit.
Since the beginning oI the second Five Year Plan, the monetary and credit policy oI the
Reserve Bank oI India has been governed by the twin considerations oI assisting a
growing economy and restraining inIlationary pressures. In view oI these
considerations, the Reserve Bank has Iollowed a policy oI "controlled expansion"
which, while aiming at regulating the growth oI demand in the economy as a whole, has
sought at the same time to regulate the Ilow oI resources into the non-priority sectors
and to meet the genuine needs Ior credit oI the priority sectors oI the economy. In order
to achieve the objectives oI controlled expansion, a policy oI general restraint over bank
credit is combined with the application oI selective methods oI credit control.
Normally, the dear monetary policy oI the Reserve Bank should have induced the
industries to turn alternative source. But when the Reserve Bank oI India raises cost oI
credit, other Iinancial institutions also Iollow suit. This result in alternative sources
becoming as dear as bank credit. The net eIIect, thereIore, is that despite the dear money
policy oI the Reserve Bank oI India, the dependence oI these industries on Iinance
through bank loans has remained without appreciable change.
(b) Public deposits and miscellaneous loans: To meet their short-term requirements,
Chapter Four Structure of Working Capital
96
companies resort to taking deposits Irom the public generally Ior a period oI one year.
The rate oI interest on deposits works out to be less than the rate oI interest charged by
other Iinancial institutions. It is easy to procure and the borrower need not go through
the complicated process oI getting the Iinance Irom the Iinancial institutions. Loans are
also taken Irom directors and oIIicers subject to legal regulations. Its importance as a
source oI Iinance has however declined since then because oI the increasing importance
oI bank credit and other sources in Iinancing the needs Ior short-term Iunds.
Miscellaneous loans have remained as an insigniIicant source oI Iinance throughout the
period under study.
(c) Trade credit and other payables: Trade credit serves two purposes: (1) It Iacilitates
sales and is reIerred to as "industrial". (2) It serves as a source oI Iinance and is reIerred
to as "Iinancial".
The trend and signiIicance oI trade credit as a source oI Iinance depends on several
Iactors like the size and rate oI growth oI the company, its Iinancial resources and bank
Iinance. In India, trade credit is not as important as it is in U.S.A., but it has become an
established Ieature oI business transaction. Since trade credit is costlier than bank loans,
it is used as a supplement to bank loans Ior Iinancing short-term requirements. Trade
credit is the credit granted by sellers oI raw materials and goods to manuIacturers and /
or wholesalers. It generally takes the Iorm oI a discount Ior cash payment on delivery
and not Ior Iuture payments; the rate oI discount and the period oI payment may,
however, vary. Other payables reIerred to are accrued wages, salaries, commission and
dividends. These outstanding Iactors oI payments also help to Iinance the current
requirements.
(d) Taxation provisions: Taxes are payable at stated intervals subsequent to the
receipt income on which they are assessed. The companies, thereIore, have the usage oI
such Iunds in the interval obligation Ior payment oI tax is shown in the balance sheet as
accrued tax or as reserve or provision.
Internal Sources:
(a) Ploughed back profits of a firm: These represent the undistributed proIits oI the
business, which is also called as retained earnings. The amount oI retained earnings oI
the business depends upon a number oI Iactors such as the rate oI corporate taxation, the
dividend policy oI the company and the extent oI discriminatory taxation oI dividend as
compared to that oI undistributed proIits. Retained earnings are generally meant Ior
Iinancing expansion and development in an enterprise but to some extent they may also
Chapter Four Structure of Working Capital
97
be used as working capital. The availability oI retained earnings Ior working capital
depends on the extent oI surplus and the company's policy regarding appropriation
thereoI.
(b) Depreciation: It constitutes a part oI the cost oI production and is thereIore, an
item oI expenditure against income. Hence this charge is added to the cost oI the
commodity produced and is recovered in cash in the gross revenue. Since assets are not
replaced then and there, depreciation represents a Iuture cost to replace machinery, as
and when necessary. In the meanwhile, the cash generated as depreciation is utilized as
working capital. The alternative uses Ior which depreciation charges are utilized are Ior
investment in industrial securities outside the business and / or Ior Iuture expansion.

4.13 Factors Affecting Working Capital Requirements
The actual amount Ior working capital requirements cannot be precisely determined
because the size oI working Iunds varies according to the nature and size oI the Iirm,
the character oI their operations, and the rate oI stock turnover.
1. Nature and volume of business: The nature and volume oI business are important
Iactors in deciding the amount oI working capital. Public utility services, as compared
to manuIacturing concerns, require a lesser amount oI working capital because, by their
very nature, they need more Iixed assets and less raw materials. On the other hand,
trading concerns have to invest a large part oI their total Iunds in the purchase oI raw
materials, payment oI wages and salaries, and such other working expenses. Hence a
larger amount oI working capital is required Ior trading institutions. Similarly, basic and
key industries or those engaged in the manuIacture oI producer`s goods usually have
less proportion oI working to Iixed capital than industries producing consumer goods.
2. Size of business unit: It is a signiIicant Iactor Ior determining the proportion oI
working capital to Iixed capital. The bigger the size oI the unit, the more will be the
amount oI working capital required. But it is quite likely that a bigger-sized business
unit may require a larger amount oI Iixed capital than working capital.
3. Time consumed in manufacturing: The longer the period oI manuIacture, the
larger is the inventory required. II the Ilow oI products is quite steady and the value oI
goods in process is large, the working capital will not very much Irom time to time.
4. Need to stockpile raw materials: Those concerns, where there is need to stockpile
raw materials, require larger amount oI working capital. The necessity Ior stockpiling
increases the amount oI Iunds tied up in inventories. In certain lines oI business
Chapter Four Structure of Working Capital
98
stockpiling is necessary. Where work stoppages are Irequent, stockpiling may be
advisable, e.g., public utilities that must have adequate supplies oI coal to assure steady
service, stockpile their inventories oI coal because oI possible coal strikes. Similarly,
where a business uses seasonally grown raw materials, stockpiling may be a common
practice.
5. Need to store finished goods: There are certain businesses wherein it becomes
essential to store Iinished goods, because in the absence oI adequate stock, customers
may return disappointed. Hence such concerns naturally require more working capital.
6. Time -lag between order and delivery: An important inIluence on inventory size
is the time involved between order and delivery oI the goods. When the time element is
uncertain, a larger amount must be invested in raw materials. EIIiciency in handling
inventories and getting prompt deliveries Irom railroads and other transport agencies to
and Irom markets make it possible to carry comparatively low inventories.
7. Turnover of working capital: By Turnover` it means the ratio oI annual gross
sales to average working assets. It is that Iigure which shows how many times the
amount invested in working assets has been traded in or turned over` during a year. As
a principle it may be enunciated that the greater the turnover, the larger the volume oI
business that can be conducted with a given working capital. Demand is the most
important Iactor in determining the rapidity oI turnover.
8. Terms and conditions of purchase and sale: The extent oI credit given and taken
by a concern in its dealings with creditors and debtors may also be considered to assess
the adequacy oI working capital. A business unit, making purchases on credit basis and
selling its Iinished products on cash basis, will require lower amount oI working capital
than a concern having no credit Iacilities and which may Iurther be Iorced to grant
credit to its customers.
9. Conversion of current assets into cash: A company having ample stock oI liquid
current assets will require lesser amount oI working capital because adequate Iunds can
easily be procured by the sale oI current assets and their conversion into cash.
10. Location of the business: The volume oI inventory to be maintained is essentially
inIluenced by the access to the sources oI supplies. The location oI business, thereIore,
assumes great importance, as a Iactor aIIecting the working capital needs. Firms
situated at isolated places have to invest more amounts in current assets to maintain
uninterrupted Ilow oI production than the Iirms occupying positions in central areas
having a network oI transport Iacilities. II there are no proper remittance Iacilities, the
Chapter Four Structure of Working Capital
99
inIlow and outIlow oI cash are aIIected. More working capital may become necessary in
such cases to maintain the given level oI output.
11. Seasonal and special needs of the business: There are certain industries wherein it
becomes essential to purchase the raw materials in large quantities during the season
and utilize them throughout the year. Hence working capital arrangements Ior such
enterprises are seasonally larger and the capital invested in seasonal inventories remains
idle Ior a long time in the process oI conversion into sales and cash.
12. Management policy: The policies Iormulated by the management and the
eIIiciency with which they are implemented aIIect the amount oI working capital oI any
unit. Though constraints are introduced by traditions, customs, government or the
environment, the management generally has a choice. It is the proper exercise oI this
choice, which is the governing Iactor.
13. Business oscillations and working capital: With the prosperity oI business,
management is inclined to spend money Ireely. To conserve its current capital, it must
guard against wasteIul expenditures, unwarranted expansion oI production Iacilities and
introduction oI unnecessary records. It must guard especially against restricted
expansion oI inventories at the height oI an active period.
Periods oI depression are never welcomed by businessmen. The usual characteristics
oI depression periods are:
(i) Small scale unemployment, (ii) less monetary income, (iii) Fall in proIits and (IV)
less production.
The go downs are usually stocked with goods and due to nominal sale, the Iunds oI the
companies remain locked up in the Iorm oI working capital.
Depression is a temporary phenomenon and schemes oI rationalization may soon bring
the stage oI recovery. Under such conditions, there is usually a reconstruction oI the
crippled economy and gradually production and employment show signs oI rise. Hence,
rational management oI working capital is needed.
14. Other factors: Besides all these Iactors, there are certain other Iactors also which
eIIect the requirement oI working capital, e.g.:
Business with a regular gross income in the Iorm oI cash prepayments Ior goods
or services needs relatively small cash working balances.
Close coordination between production and distribution policies is also desirable.
Otherwise, in the absence oI such coordination more working capital may be required.
Chapter Four Structure of Working Capital
100
II the means oI transportation and communication are less developed, more
working capital may be required to store the materials.
An expanding business may also require increase in working capital proportionate
to the rate oI expansion.
A concern that has established substantially good banking connections and enjoys
the conIidence oI commercial bankers may rely on Iinancing temporary expansion oI
current assets with bank loans.

4.14 Working Capital Financing
The investment in raw materials, stock-in-process, Iinished goods, and receivables (the
principal constituents oI current assets) oIten varies a great deal during the course oI the
year. Hence, the Iinancial manager generally spends a good chunk oI his time in Iinding
money to Iinance current assets.
Typically, current assets are supported by a combination oI long-term and short-term
sources oI Iinance. As regards the long-term sources oI Iinance it primarily supports
Iixed assets and secondarily provides the margin money Ior working capital.
An eIIort has been made to discuss the Iollowing sources oI Iinance that are used to
support current assets;
1. Accruals
2. Trade credit capital advance by banks
3. Working Capital advance by various banks
4. Regulation oI bank Iinance
5. Public deposits
6. Inter-corporate deposits
7. Short-term loans Irom Iinancial institutions
8. Factoring

4.14.1 Accruals
The major accrual items are wages and taxes. These are simply what the Iirm owes to
its employees and to the government. Wages are usually paid on a weekly, Iortnightly
basis---between payments, the amounts owed but not yet paid is shown as payable halI-
yearly or annually. In the interim, taxes owed but not paid may be shown as accrued
taxes on the balance sheet.
Chapter Four Structure of Working Capital
101
Accruals very with the level oI activity oI the Iirm. When the activity level expands,
accruals increase and when the activity level contracts accruals decrease. As they
respond more or less automatically to changes in the level oI activity, accruals are
treated as part oI spontaneous Iinancing.
Since no interest is paid by the Iirm on its accruals, they are oIten regarded as a Iree`
source oI Iinancing. However, a closer examination would reveal that this may not be
correct. When the payment cycle is longer, wages may be higher. For example, an
employee earning Rs. 500 per week and receiving weekly payment may ask Ior a
slightly higher compensation iI the payment is made monthly. Likewise when the
payment period is longer, tax authorities may raise the tax rates to some extent. Even
when such adjustments are made, the Iact remains that between established payment
dates accruals do not carry any explicit interest burden.
While accruals are a welcome source oI Iinancing, they are typically not amenable to
control by management. The payment period Ior employees is determined by the
practice in industry and provisions oI law. Similarly, tax payment dates are given by
law and postponement oI payment normally results in penalties.

4.14.2 Trade Credit Capital advance by Banks
Trade credit represents the credit extended by the supplier oI goods and services. It has
been dealt in detail under the need oI external source oI Iinance.

4.14.3 Working Capital Advance by Various Banks
Working capital advance by diIIerent types oI banks represents the most important
source Ior Iinancing current assets. This section discusses the Iollowing aspects oI
source oI Iinance:
Application and Processing
Sanction and Terms and Conditions
Forms oI Bank Finance
Security
Margin Amount
4.14.4 Regulation of Bank Finance in India
Traditionally, industrial borrowers enjoy a relatively easy access to bank Iinance Ior
meeting their working capital needs. Further, the cash credit arrangement, the principal
Chapter Four Structure of Working Capital
102
device through which such Iinance is provided, is quite advantageous Irom the point oI
view oI borrowers. Ready availability oI Iinance in a Iairly convenient Iorm lead to, in
the opinion oI many experienced observers oI the Indian banking scene, over-borrowing
by industry and deprivation oI other sectors. Concerned about such distortion in credit
allocation, the Reserve Bank oI India (RBI)
12
has been trying, particularly Irom the
mid-sixties onwards, to bring a measure oI discipline among industrial borrowers and
redirect to the priority sectors oI the economy. From time to time, the RBI has been
issuing guidelines and directives to the banking sector towards this end. Important
guidelines and directives have stemmed Irom the recommendations oI certain specially
constituted groups entrusted with the task oI examining various aspects oI bank Iinance
to industry. In particular, the Iollowing committees have signiIicantly shaped the
regulation oI bank Iinance Ior working capital in India: the Dahejia Committee, the
Tandon Committee, the Chore Committee, and the Marathe Committee. The key
elements oI regulation are discussed as under;
Norms Ior Inventory and Receivables
Maximum Permissible Bank Finance
Forms oI Assistance
InIormation and Reporting System
Credit Monitoring
The present section discusses the Iollowing committees, which in Iact have shaped in
last three decades in India
13
:

4.14.4.1 Tandon Committee on SSI s
A study group headed by Shri Prakash Tandon, the then Chairman oI Punjab National
Bank, was constituted by the RBI in July 1974 with eminent personalities drawn Irom
leading banks, Iinancial institutions and a wide cross-section oI the industry with a view
to study the entire gamut oI Bank's Iinance Ior working capital and suggest ways Ior
optimum utilization oI Bank credit. This was the Iirst elaborate attempt made by the
central bank to organize the Bank credit. Most banks in India even today continue to

12
Reserve Banak oI India
13
Rustagl.R.P. 'Financial Management, Theory, Concepts and Problems", Galgotia Publishing Company,
Third Revised Edition, 2006, p.753.

Chapter Four Structure of Working Capital
103
look at the needs oI the corporate in the light oI methodology recommended by the
Group. The report oI this group is widely known as Tandon Committee report.
4.14.4.2 Chore Committee on SSI s
The weaknesses in the Cash Credit system have persisted with the non-implementation
oI one oI the crucial recommendations oI the Committee. In the background oI credit
expansion seen in 1977-79 and its ill eIIects on the economy, RBI appointed a working
group to study and suggest i) modiIications in the Cash Credit system to make it
amenable to better management oI Iunds by the Bankers and ii) alternate type oI credit
Iacilities to ensure better credit discipline and develop co- relation between credit and
production. The Group headed by Sh. K.B. Chore oI RBI and has been named as Chore
Committee.
4.14.4.3 Nayak Committee on SSI s
Another group headed by Sh. P.R. Nayak (Nayak Committee) entrusted the job oI
looking into the diIIiculties Iaced by Small Scale Industries due to the sophisticated
nature oI Tandon & Chore Committee recommendations. His report is applicable to
units with credit requirements oI less than Rs.50 lacks.
Considering the contribution oI the SSI sector to the overall industrial production,
exports, employment generation and also recognizing the need to give Iillip to this
sector, a special package oI measures have devised by RBI (during April 1993) to
ensure adequate and timely credit to this sector. While doing so the recommendations oI
the PR Nayak committee were taken into account. Examination oI bank Iinance proIile
oI working capital to the small scale sector by the committee has revealed that this
sector as a whole received a level oI working capital which constitute only 8.1 oI the
its output. The village industries and the smaller tiny industries among them could get
working capital Iinance to the extent oI only about 2.7 oI their output.
14

The recommendations made by Tandon Committee and reinIorced by Chore Committee
were implemented by all Banks and Bank Credit became much more organized.
However, the recommendations were considered as too strict by the industry and there

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Chapter Four Structure of Working Capital
104
has been a continuous clamour Irom the Industry Ior movement Irom mandatory control
to a voluntary market related restraint. With recent liberalization oI economy and
reIorms in the Iinancial sector, RBI has given the Ireedom to the Banks to work out
their own norms Ior inventory and the earlier norms are now to be taken as guidelines
and not a as mandate. In Iact, beginning with the slack season credit policy oI 1997-98,
the RBI has also given Iull Ireedom to all the Banks to devise their own method oI
assessing the short term credit requirements oI their clients and grant lines oI credit
accordingly. Most banks, however, continue to be guided by the principles enunciated
in Tandon Committee report.
15

4.14.4.4 Dehejia Committee on SSI s

A study group under the Chairmanship oI V.T. Dehejia constituted in 1968 by the
National Credit Council to examine the extent to which credit needs oI industry and
trade were inIlated and also to suggest ways and means oI curbing this phenomenon.
The Dehejia Committee, inter alia, analyzed:
(i) The relative growth rates oI short term trade credit and the value oI industrial
production,
(ii) The relative growth rates oI short term trade credit and inventories with industry and
trade,
(iii) The diversion oI short-term credit Ior Iixed asset acquisition and Ior loans and
investments,
(iv) The incidence oI multiple Iinancing, and
(v) The elongation oI the credit period.

4.14.4.5 Marathe Committee on SSI s
The Reserve Bank oI India appointed in November 1982, another study group known as
Marathe Committee to review the Credit Authorization Scheme (CAS)
16
which is in
operation since 1965. The CAS introduced in 1965 by the RBI to regulate the end use oI
credit. Under the CAS, all banks were required to obtain the prior authorization oI the
RBI Ior sanctioning credit limits (including bill discounting) oI Rs. 6 crores or more.

15
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16
Credit Authorization Scheme
Chapter Four Structure of Working Capital
105
The Marathe Committee was required to take an independent view oI the CAS. The
Committee is oI the opinion that the CAS should not be looked upon as a mere
regulatory measure, which is conIined to large borrowers. The basic purpose oI the
CAS is to ensure orderly credit managements and improve quality oI bank lending so
that all borrowing, whether large or small, are in conIormity with the policies and
priorities laid down by the central banking authority. II the CAS scrutiny has to be
limited to a certain segment oI borrowers, it is only because oI administrative
limitations or convenience.
4.14.4.6 Kannan Committee on SSI s

The Kannan Committee the Iirst committee which has suggested that the prescribed
uniIorm Iormula Ior MPBF
17
(as suggested by the Tandon Committee) should go and
the banks should have the sole discretion to determine borrowing limits oI corporate.
However, the change Irom the MPBF system should keep in view the size oI various
banks, their delegation system, exposure limit etc. Banks and the borrowers should be
leIt Iree to decide the system they adopt Ior Iinancing working capital.

4.14.4.7 Estimation of Working Capital Requirement
The industry is suffering because of inadequate working capital!
Lack oI adequate working capital is oIten stated as one oI the major reasons Ior sickness
in industry (especially in case oI SMEs). The counter arguments Irom the banks have
been that most Iirms Iace problems oI inadequate working capital due to credit
indiscipline (diversion oI working capital to meet long term requirements or to acquire
other assets). In this context it would be pertinent to understand the method adopted by
banks in computing the working capital requirement oI the business and the quantum oI
bank Iinancing to be provided by the bank.
The main factors considered in the estimation of working capital requirement
The nature oI business and sector-wise norms

17
Maximum Permissible Bank Financing
Chapter Four Structure of Working Capital
106
Factors such as seasonality oI raw materials or oI demand may require a high level oI
inventory being maintained by the company. Similarly, industry norms oI credit
allowed to buyers determine the level oI debtors oI the company in the normal course oI
business.
The level oI activity oI the business
Inventories and receivables are normally expressed as a multiple oI a day`s production
or sale. Hence, higher the level oI activity, higher the quantum oI inventory, receivables
and thereby higher the working capital requirement oI the business. So in order to arrive
at the working capital requirement oI the business Ior the year, it is essential to
determine the level oI production that the business would achieve. In case oI well-
established businesses, the previous year`s actuals and the management projections Ior
the year provide good indicators. The problems arise mainly in the case oI determining
the limit Ior the Iirst time or in the initial Iew years oI the business. Banks oIten adopt
industry standard norms Ior capacity utilization in the initial years.
The steps involved in arriving at the level of Working Capital Requirement
Based on the level oI activity, the unit cost and sales price projections, the banks
calculate at the annual sales and cost oI production.
The quantum oI Current Assets (CA)
18
in the Iorm oI Raw Materials, Work-in-
progress, Finished goods and Receivables is estimated as a multiple oI the average
daily turnover. The multiple Ior each oI the current assets is determined generally
based on the industry norms.
The Current liabilities (CL)
19
in the Iorm oI credit availed by the business Irom its
creditors or on its manuIacturing expenses are deducted Irom the current assets
(CA) to arrive at the Working Capital Requirement (WCR)
20
.
4.14.4.8 Standard Formulae for determination of Working Capital
The issues oI computation oI working capital requirement have been oI considerable
debate and attract the attention in this country over the past Iew decades. A directed
credit approach has been adopted by the Reserve Bank Ior ensuring the Ilow oI credit to

18
Current Assets
19
Current liabilities
20
Working Capital Requirement
Chapter Four Structure of Working Capital
107
the priority sectors Ior IulIillment oI the objectives oI growth laid down by the planners.
Subsequently, the quantum oI bank credit required Ior achieving the requisite growth in
Industry was to be assessed. Various committees such as the Tandon Committee and the
Chore Committee were constituted and studied the problem at length.
Norms were Iixed regarding the quantum oI various current assets Ior diIIerent
industries (as multiples oI the average daily output) and the Maximum Permissible
Bank Financing (MPBF) capped at a certain percentage oI the working capital
requirement thus arrived at.

4.14.4.9 Approach to lending

The Tandon Committee has suggested three methods oI lending out oI which RBI has
accepted two methods Ior implementation. According to First Method, the borrower can
be allowed maximum bank Iinance upto 75 oI the working capital gap (working
capital gap denotes diIIerence between total current assets required and amount oI
Iinance available in the shape oI current liabilities other than short term bank
borrowings). The balance 25 to be brought by the borrower as surplus oI long term
Iunds over the long term outlay.
As per Second Method oI lending, the contribution oI the borrower has to be 25 oI the
total current assets build-up instead oI working capital gap. (Method oI lending as per
Vaz Committee will now apply to borrowers availing working capital Iund beyond
limits oI Rs. 100 lakh or more only)

Working Capital assessment on the formula prescribed by the Tandon Committee
The Tandon Committee has implemented two methods Ior Working Capital Requirement
(WCR) |Current Assets i.e. CA (as per industry norms) Current Liabilities i.e. CL|
Permissible Bank Financing |PBF} WCR Promoter`s Margin Money i.e. PMM (to be
brought in by the promoter)
As per Formula 1: PMM
21
25 oI |CA CL| and thereby PBF
22
75 oI |CA CL|
As per Formula 2: PMM 25 oI CA and thereby PBF 75 |CA| CL

21
Promoter`s Margin Money
22
Permissible Bank Financing
Chapter Four Structure of Working Capital
108
As is apparent, Iormula 2 requires a higher level oI PMM as compared to Iormula 1.
Formula 2 is generally adopted in case oI bank Iinancing. In cases oI sick units where
the promoter is unable to bring in PMM to the extent required under Iormula 2, the
diIIerence in PMM between Iormulae 1 and 2 may be provided as a Working Capital
term Loan repayable in installments over a period oI time.
4.14.4.10 Norms for inventory and receivables
Norms Ior 15 major industries initially proposed by the committee now have more than
50 disintegrated industry groups. Normally the borrower would not be allowed
deviations Irom norms except in case oI bunched receipt oI raw material, power cuts,
strikes, transport delays, accumulation oI Iinished goods due to non-availability oI
shipping space Ior exports, build up oI Iinished goods stocks due to Iailure on the part
oI purchasers. For those units, which are not covered by the norms, past trends to be
made the basis oI assessment oI working capital. (Discretion given to individual banks
Ior deviations in norms)

Other major recommendations oI the committee were:
No slip back in current ratio, normally.
ClassiIication guidelines Ior Current assets and current liabilities.
IdentiIication oI excess borrowing.
InIormation system, which modiIied by Chore Committee Recommendations.
BiIurcation oI limits into loan and demand component.
All instructions relating to maximum permissible bank Iinance withdrawn by RBI as per
Credit Policy announced on 15.04.1997)
23


4.14.4.11 Working Capital and Small Scale Industries

Small scale industries have a distinct set oI characteristics such as low bargaining power
leading to problems oI receivables and lower credit on purchases, poor Iinancial status,
high level oI variability due to more dependence on local Iactors, etc. Consequently, it
has been rightly argued that the industry norms on diIIerent current assets cannot be
adopted.

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Chapter Four Structure of Working Capital
109
The PR Nayak Committee that has appointed to devise norms Ior assessing the working
capital requirement oI small-scale industries arrived at simpliIied norm pegging the
Working Capital bank Iinancing at 20 oI the projected annual turnover. However, in
case oI units, which are non-capital intensive such as hotels, etc. banks oIten assess
requirements both on the Nayak Committee norms as well as the working cycle norms
and take the lower oI the two Iigures.
Eligibility and Norms for bank financing of SSIs as per Nayak Committee
a. Applicability:
In case oI SSIs, with working capital requirement oI less than Rs. 5 crores
In case oI other industries, with working capital requirement oI less than Rs. 1 crore
b. Quantum of Working Capital bank financing:
20 oI the projected annual turnover
c. Subject to a Promoter bringing in a margin of:
5 oI the projected annual turnover (i.e. 20 oI the total Iund requirement that has
been estimated at 25 oI the projected annual turnover)

Working Capital through Formula - Boon or bane?

The Iormula driven computation oI working capital requirement have been subjected to
too much debate over the past Iew decades. The advantage oI such computation has
been that it removes discretion Irom the oIIicials oI banks (which are largely Irom the
Public Sector). The uniIormity thus reduces the scope Ior bias decision.
However, the strongest argument against the MPBF based lending has been that it does
not take into account the variations arising out oI location, relative bargaining oI the
enterprise and other reasons, which could vary its need Ior working capital. Though the
banker could able to understand the problem, it was not possible to act on it due to the
norms. Further, the 'One Size Iits all theory ensured that banks never needed to
develop credit appraisal skills and lent to all and sundry based on their seeming
adherence to norms on paper.
Chapter Four Structure of Working Capital
110
The method has also been criticized as being more appropriate Ior the era where credit
has been controlled. Banks today are capable oI undertaking better assessment oI the
requirements and welcome the idea oI oIIering higher limits (larger exposures) to
established clients iI required in order to retain their business in the Iace oI competition
Irom other banks.
In 1997, the RBI permitted banks to evolve their own norms Ior assessment oI the
Working Capital requirements oI their clients.
4.14.4.12 Cash flow based computation of Working Capital
Cash Ilow is the most realistic means oI assessing the operations oI an enterprise.
Drawing up cash Ilow statements (monthly or quarterly) Ior the past Iew years clearly
indicate the seasonal and secular trend in utilization oI working capital. The projections
drawn up by the entrepreneur may then be jointly discussed with the banker as modiIied
in light oI the past perIormance and the banker`s opinions. The peak cash deIicit is
ascertained Irom the cash budgets. The promoter`s share (margin money) Ior such
requirement maybe mutually arrived at by the banker and the borrower with the balance
requirement Iorming the Bank Iinanced part oI Working capital.
Cash Ilow based computation oI working capital requirement has been recommended
by the RBI Ior assessment oI working capital requirement permitting the banks to
evolve their own norms Ior such assessment. The reason Ior this has been that Cash
Ilow Iactors in the past trends, takes into account the company speciIic Iactors and is
based on mutual discussion between the banker and the borrower thereby increasing its
acceptability. Also, large companies have adopted cash budgeting systems Ior managing
their cash Ilows and hence such a system does not impose additional requirements on
the corporates.
Cash Ilow system is extremely relevant in case oI the seasonal industries to assess the
peak credit requirement and in case oI large companies (working capital requirements
above Rs. 10 crores). However the reluctance to provide the cash budgets thereby
revealing additional inIormation to the banks, has led to even larger companies shying
away Irom Cash Budget method oI assessing Working Capital. Consequently, Cash
Chapter Four Structure of Working Capital
111
Budget method is currently prevalent mainly in case oI seasonal industries, construction
sector as well as other entities whose operations are linked to projects.
Bank financing based on cash budgets works well and is a good step for the system.
A big Iailure in the working capital system, Iollowed by various banks has been that the
Drawing Power (within the PBF limit) is based on post Iacto stock statements and these
are typically on a monthly basis. This means:
The borrowing unit is putting its money upIront and the Drawing Power is a Iorm oI
reimbursement.
Responsiveness to sudden surges in demand/ seasonality/ other short term boom
conditions is non-existent, putting a burden on the company to Iinance this at exorbitant
rates Irom private Iinanciers.
Finally, a growing company would always be playing 'catch-up and its Permissible
Bank Financing will be lagging its cash requirements by at least one year.
24

4.14.5 Public Deposits
Many Iirms, large and small, have solicited unsecured deposits Irom the public in recent
years, mainly to Iinance their working capital requirements;
i) Cost regulation ii) Evaluation

4.14.6 Inter-Corporate Deposits

A deposit made by one company with another, normally Ior a period up to six months,
is reIerred to as an inter-corporate deposit. Such deposits are usually oI three types:
Call Deposits: A call deposit is withdraw-able by the lender on giving a day`s notice. As
per general practice, however, the lender has to wait Ior at least three days. The interest
rate on such deposits may be higher than general.
Three months Deposits: more popular in practice, these deposits are taken by
borrowers to tide over a short-term cash inadequacy that may be caused by one or more
oI the Iollowing Iactors:

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Chapter Four Structure of Working Capital
112
Disruptions in production, excessive imports oI raw material, tax payment, delay in
collection, dividend payment, and unplanned capital expenditure. The interest rate on
such deposits is around 18 per cent per annum.
Six months Deposits: normally, lending companies do not extend deposits beyond this
time Irame. Such deposits, usually made with Iirst-class borrowers, carry an interest rate
oI around 20 per cent per annum.

4.14.7 Short-Term Loans from Financial Institutions

The LiIe Insurance Corporation oI India, the General Insurance Corporation oI India,
and Unit Trust oI India provide short-term loans to manuIacturing companies with an
excellent track record.

Eligibility
A company to be eligible Ior such loans should satisIy the Iollowing conditions:
It should have declared an annual dividend oI not less than 6 per cent Ior the
past Iive years.
The debt-equity ratio oI the company should not exceed 2:1.
The current ratio oI the company should be at least 1:1.
The average oI the interest cover ratios Ior the past three years should be at least
2:1

Features
The short- term loans provided by Iinancial institutions have the Iollowing Ieatures:
They are totally unsecured and are given on the strength oI a demand
promissory note.
The loan is given Ior a period oI 1 year and can be renewed Ior two consecutive
years, provided the original criteria are satisIied.
AIter a loan is repaid, the company will have to wait Ior at least 6 months beIore
availing oI a Iresh loan.
The loans carry an interest rate oI 18 per cent per annum with a quarterly rest,
which works out to an eIIective rate oI 19.29 per cent per annum. However, there is a
Chapter Four Structure of Working Capital
113
rebate oI 1 per cent Ior prompt payment, in which case the eIIective rate comes down
accordingly.

4.14.8 Factoring
A Iactor is a Iinancial institution, which oIIers services relating to management and
Iinancing oI debts arising Irom credit sales. While Iactoring is well-established in
Western countries, only two Iactors, the SBI Factoring and Commercial Services
Limited and Can bank Factoring Limited, which have been mandated by the Reserve
Bank oI India to operate in the western region and the southern region respectively,
have been set up recently in India. The Punjab National Bank and the Allahabad Bank
have set up Iactoring agencies to serve the northern region and the eastern region,
respectively.

Features of a Factoring Arrangement
The key Ieatures oI a Iactoring arrangement are as Iollows:
The Iactor selects the accounts oI the client that would be handled by it and
establishes, along with the client, the credit limits applicable to the selected accounts.
The Iactor assumes responsibility Ior collecting the debt oI accounts handled by
it. For each account, the Iactory pays to the client at the end oI the credit period or when
the account is collected, whichever comes earlier.
The Iactor advances money to the client against not-yet-collected and not-yet-
due debts. Typically, the amount advanced is 70 to 80 per cent oI the Iace value oI the
debt and carries an interest rate, which may be equal to or marginally higher than the
lending rate oI commercial banks.
Factoring may be on a recourse basis (this means that the credit risk is borne by
the client) or on a non-recourse basis (this means that the credit risk is borne by the
Iactor). Presently, Iactoring in India is done on a recourse basis.
Besides the interest on advances against debt, the Iactor charges a commission,
which may be 1 to 2 per cent oI the Iace value oI the debt Iactored.





Chapter Four Structure of Working Capital
114
The mechanics of factoring are illustrated in figure (4-3),

Evaluation

Factoring oIIers the Iollowing advantages, which makes it quite attractive:
Factoring ensures a deIinite pattern oI cash inIlows Irom credit sales.
Continuous Iactoring may virtually eliminate the need Ior the credit and collection
department.
As against these advantages, the limitations oI Iactoring are:
The cost oI Iactoring tends to be higher than the cost oI other Iorms oI short-term
borrowing.
Factoring oI debt may be perceived as a sign oI Iinancial weakness.
25


25
Prasanna, Chandra. 'Financial Management and Theory and Practice, New Delhi: Tata McGraw-Hill
Publishing Company Limited, 2004, pp. 488-501.