Working capital assessment

working capital requirements

1. Working Capital Assessment CA Rajesh D [email protected] Date: 16/03/2016 b y

2. Source of funds Long Term Loans Project Finance Cash Credit or OD Short term loans Banks Banks Private Investors NBFCs FIs

3. www.sbsandco.com 3 Objective: Concept of Working Capital Gross Working Capital , Working capital Gap, Net Working Capital Components of working capital Working capital operating cycle Various methods of working capital assessment viz Turnover method MPBF method Cash Budget Method CMA Data. Working Capital

4. www.sbsandco.com 4 Funds required for financing short term assets or current assets such as cash, debotrs and inventories to enable business/industry to operate at the expected levels. Total amount of funds required for the continuous operations of the business on a going basis. Therefore it is called operating capital or short-term capital. Financed as Cash Credit, Overdraft, Short Term Working Capital loan etc., Assessed for one year and renewed annually Working Capital

5. www.sbsandco.com 5 Assets which are part of the operating cycle or which get converted into cash within the operating cycle or within one year Spares and Spare parts Loose tools Stock-in-Trade Work-in-Progress Sundry Debtors – less bad debts Cash and Bank Balances Loans and advances to subsidiaries Bills of Exchange Advances recoverable in cash or receivables Balance with customs, port authorities, municipal authorities Interest accrued on Investments What are Current Assets ?

6. www.sbsandco.com 6 Liabilities which are part of the operating cycle or which need to be paid off within the operating cycle or within one year Short term bank borrowings Unsecured loans Sundry Creditors and Trade Creditors Deposits from public maturing within one year Advances and deposits from dealers Accrued Interests and Charges Provision for taxation Dividend payable Statutory liabilities Installment of term loans repayable in one year Other liabilities and provisions What are Current Liabilities ?

7. www.sbsandco.com 7 Operating Cycle

8. www.sbsandco.com 8 The day to day business operations of a concern of any nature and, size involves many successive steps and final working results would depend on the effective combination of all steps. The steps in general may include the following: Acquisition and storage of raw material and other stores and spares required for manufacture of any product. Actual production process when the raw material is subjected to different processes to bring it to final shape of finished goods. Storage of finished goods awaiting sales. Sales of finished goods and realisations of sale proceeds. Operating Cycle

9. www.sbsandco.com 9 Operating Cycle begins with acquisition of raw materials and ends with collection of receivables. Stages: Raw materials (RM/RM consumption) Work-in-process (WIP/COP) Finished Goods (FG/COS) Receivables (Debtors/Credit sales) Less : Creditors (creditors/purchases) Operating Cycle

10. www.sbsandco.com 10 What are Working Capital Sources? Working Capital Requirement (Current Assets) Source of Finance 1 Raw Material and stores (inventory) Sundry Creditors or Bank Finance 2. Stock-in-Process Advance payments received or Bank Finance or Liquid Surplus 3. Finished Goods (inventory) Liquid Surplus or Net working Capital or Bank Finance 4. Sundry Debtors Bank Finance short term 5. Cash for expenses Net Working Capital or Liquid Surplus

11. www.sbsandco.com 11 GROSS WORKING CAPITAL = CA These are in the system used/ consumed on a day to day basis . NET WORKING CAPITAL (NWC) = CA – CL OR (SHF + TL) – (NFA + NCA) NWC is the entrepreneur's margin available in the system from Long term Funds Note: CA=Current Assets, CL=Current Liabilities SHF=Shareholder’s funds, TL=Term Loan NFA=Net Fixed Assets NCA=Net Current Assets NWC should always be more than 1:1 It indicates the margin of safety to short term creditors. Concepts of Working Capital

12. www.sbsandco.com 12 Length of Operating Cycle Cash Cash Cash Service Trade Industry Receivables Stocks Semi Finished Goods Receivables Receivables Finished Goods Raw Material

13. www.sbsandco.com 13 Nature of business – service/trade/manufacturing. Seasonality of operations – peak/non peak Production Policy – Constant/seasonal Market conditions- competition/credit terms Conditions of supply of RM/stores/spares etc. Quantum of production/Turnover(level of activity) Operating Cycle Current Assets to be maintained Factors influencing Working Capital Requirement

14. www.sbsandco.com 14 A) Fund Based Cash Credit Overdraft Inventory finance and Factoring or Bill discounting ( Post Sales Finance). B) Non Fund Based Letter of Credit (LC) Bank Guarantee. Working Capital Finance

15. www.sbsandco.com 15 Operating Cycle Method Service Sector Traders Manufacturing Activity. Drawing Power Method. Turnover Method MPBF method (II method of lending) for limits of Rs 6.00 crores and above Cash Budget method (for: Based on procurement and cash inflow) Seasonal Industries (Sugar/ Rice Mills/Textiles/Tea/Tobacco/Fertilizers) Contractors & Real Estate Developers Educational Institutions Assessment Methods

16. www.sbsandco.com 16 Operating Cycle method: Time period from purchase of raw materials, creation of work-in-process, creation of finished goods, holding them till sale, converting them into sundry debtors and realization of debtors and receipt of cash. Total Working Capital Requirement = Operating Expenses: Purchase of Raw Materials & Maintaining Manufacturing expenses such as wages, power & fuel, etc. Stock of Work in Progress/ Semi-Finished goods maintained by the unit to complete an operating cycle. Stock of Finished goods awaiting sale. Administrative and selling expenses during this process. Bills receivable/debtors for credit sales.   Operating Cycle Method

17. www.sbsandco.com 17 Length of Operating Cycle Operating Cycle Method a. Procurement of Raw Material 30 days b. Conversion / Process time 15 days c. Average time of holding of FG 15 days d. Average Collection Period 30 days e.Operating Cycle ( a+b+c+d ) 90 days f. Operating Cycle in a year (365days/e) 4 cycles

18. www.sbsandco.com 18 Operating Cycle Method B. Total Operating Expenses per Annum Rs 60.00 lakhs C. Total Turnover per Annum Rs 70.00 lakhs D. Working Capital Requirement = Total Operating Expenses (B)/ No. of operating Cycle (f as said earlier) Rs 15 lakhs

19. www.sbsandco.com 19 Drawing Power Method (for units with small limits) Particulars Stock value Margin DP Paid stocks (RM-Creditors) 4 25% 3 Semi Finished goods 4 50% 2 Finished goods 4 25% 3 Book debts 4 50% 2 Total 16 10

20. www.sbsandco.com 20 Turnover Method (Originally suggested by Nayak Committee for SSI Units) Nayak Committee method or turnover method: Based on the projected sales turnover of the borrower. It is presumed that W.C requirements would be 25% of the projected turnover and the banker would finance 75% to 80% of the same and the borrower to bring in 20%-25%. Nayak Committee method various industry limits. SSI units upto Rs.5.00 crore Other units upto Rs.1.00 crore

21. www.sbsandco.com 21 Turnover Method (Originally suggested by Nayak Committee for SSI Units) Applicable for limits upto 6 Crores Item Particulars Scenario 1 Scenario 2 Scenario 3         1 Turnover 1000 1000 1000         2 25% of Turnover 250 250 250         3 Eligible Bank Finance 80% of 2 200 200 200         4 Margin Required at 5% of Turnover 50 50 50         5 Margin (NWC) Actual/ Projected (CA-CL) 150 300 100         6 (2 - 5 ) 100 -50 150         7 Eligible Minimum Bank Finance 100 -50 150   Lower of 3 or 6        

22. www.sbsandco.com 22 MPBF Method As per Tandon Committee: First Method of Lending: Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings. Second Method of Lending: Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. Third Method of Lending:  Under this method, the borrower's contribution from long term funds will be to the extent of the entire CORE CURRENT ASSETS , which has been defined by the Study Group as representing the absolute minimum level of raw materials, process stock, finished goods and stores which are in the pipeline to ensure continuity of production and a minimum of 25% of the balance current assets should be financed out of the long term funds plus term borrowings. (This method was not accepted for implementation and hence is of only academic interest).

23. www.sbsandco.com 23 Computation MPBF Method Current Liabilities Amount Current Assets Amount Creditors for Purchases 100 Raw Materials 200 Other Current Liabilities 50 Stock-In-Process 20 Bank Borrowings including Bills discounted with bankers 200 Finished Goods 90 Receivables including Bill Discounted with bankers 50 Other Current Assets 10 Total Current Liabilities 350 Total Current Assets 370 Example: (Rs. In Lakhs)

24. www.sbsandco.com 24 Computation MPBF Method 1 st Method Amount 2 nd Method Amount 3 rd Method Amount Total Current Assets 370 Total Current Assets 370 Total Current Assets 370 Less: Current Liabilities other than Bank Borrowings 150 Less: 25% of Current Assets 92 Less: Core Current Assets 95 Working Capital Gap 220 Working Capital Gap 278 Total Real Current assets 275 Less: 25% of Working Capital Gap 55 Less: Current Liabilities other than Bank Borrowings 150 Less: Other Current Liabilities 150 MPBF 165 MPBF 128 Working capital gap 125 Excess -Borrowings 35 Excess Borrowings 72 Less: 25% of Real Current Assets(276*25) 69 MPBF 56 Current Ratio 1.17:1 Current Ratio 1.33:1 Current Ratio 1.87 (Rs. In Lakhs)

25. www.sbsandco.com 25 (Inventory/Receivable Norms – Comparison) Intra firm Comparison Comparison of estimates with previous years Actuals. For New Units Comparison of estimates with similar units in the area of operation. Higher projections shall be justified. Following precautions to be taken care Projected turnover is gross turnover inclusive of excise duty etc. The other financial strengths of the firm also to be kept in mind Margin requirement of at least 5% of the turnover not to be diluted Projected annual turnover to be reasonable, achieved in the past , achievable in future and realistic in the present Reasonableness of projections to be assessed and verified with returns filed by the borrower Sales achieved till the date of sanction to be obtained from the borrower Any projection beyond 15% of the previous years actual need closer attention Justifications of the Performance Projection

26. www.sbsandco.com 26 Production/Sales estimates Profitability estimates Inventory/receivables norms Build up of Net Working Capital Important aspects of MPBF Method

27. www.sbsandco.com 27 Cash Budget Statement showing forecast of cash receipts, cash payments and net cash balance over a period of time Months-> 1 2 3 4 5 6 7 8 9 10 11 12 Cash Receipts Cash Payments Surplus/deficit Cash credit – OB Cash credit - CB Peak deficit is financed and drawings regulated by monthly budgets

28. www.sbsandco.com 28 Advantages: Suitable for seasonal industries, contractors, software, exporters, etc. Limitations: Will not reflect changes in various current assets & liabilities. Will not give a clue whether a company is earning profit or not. ( Funds Flow Statement is required to detect any diversion of funds ). Cash Budget

29. www.sbsandco.com 29 Letter of credit ILC/FLC Usance /Sight Bank Guarantee Performance Financial – Bid Bonds/Security Deposits/ Mobilisation advance/ retention money Deferred Payment Guarantee Non-Fund Based Limits

30. www.sbsandco.com 30 LC Assessment 1 Annual purchase/import FLC/ILC 2 Out of (1) on credit basis 3 Out of (2) on usance LC basis 4 Average of (3) per month 5 Lead time (no. of months) 6 Usance period (no. of months) 7 Usance LC requirement (5+6) X (4)

31. www.sbsandco.com 31 For constituents borrowers with regular sanctioned credit facilities for genuine transactions. LCs shall not be opened with clause without recourse to drawer. Bank Guarantees: Performance and Financial Guarantees Purpose / Difference Security: Cash Margin +Counter Guarantee +Collateral Security (Immovable / Liquid Security) Restrictive Clause. Guidelines to be followed

32. www.sbsandco.com 32 While considering the proposal to the bank to get the credit facilities, banks analyze the financial strength of the borrower’s financial accounts by using ratio analysis. The following are the ratios: Current Ratio Solvency Ratio Quick Ratio or Acid Test Ratio Profit to Sales Ratio Turnover ratio (Inventory + Receivables)/Net Sales Financial Ratios

33. www.sbsandco.com 33 While considering the proposal to the bank to get the credit facilities, banks analyze the financial strength of the borrower’s financial accounts by using ratio analysis. The following are the ratios: The current ratio is used to check the borrower’s ability of repayment of debt/ loan when the loan is to be repayable in installments & to know whether current assets are financed by current liabilities/ long term borrowings. Debt-Equity Ratio is the measure of financial leverage & to know the relative proportion of entity’s equity & debt used in the entity’s assets.   Financial Ratios

34. www.sbsandco.com 34 ` It shows the relation between final profits to the sales. It is used to evaluate the profitability of the business from its primary operations. It shows that to what exten t the sale price of the goods can be reduced without incurring any losses. It is a measure of borrower’s ability of repayment of his obligations. The higher it is the safer for the bank/ lenders. Interest Coverage Ratio = PBIT /Interest (times) . Interest coverage ratio explains how many time the firm earns to cover the interest High ratio means comfortable ratio. 3-4 times is acceptable .   Financial Ratios

35. www.sbsandco.com 35 Hypothecation : Neither ownership nor possession is passed on to the borrower, in the event of default Bank has legal right to sell the property Pledge : Possession of the goods passes into the hand of bank as security towards the debt, interest and other expenses Lien : right of the lender to retain the property until the debt is repaid. Mortgage : Transfer of legal or equitable interest in specific immovable property for the payment of debt. Charge : Where immovable property of one person is made security for the payment of money to another and the transaction doesn’t amount to mortgage. The lender will charge on the property and all provisions of simple mortgage will apply. Security

36. www.sbsandco.com 36 Character of the borrower Background or brief history of the borrower, nature of activity, expertise available (technical and Managerial) Capacity of the borrower Networth , repayment history, viability of the business activity, income generating ability of the business, security available for fall back Capital of the borrower What is the owners stake, equity, margin, ability to increase the margin, source of financing the margin Credibility of the borrower What is the market opinion about the borrower, does he have a track record? Non Financial Factors

37. www.sbsandco.com 37 Purpose of the loan Why does the borrower want a bank loan?, is it a permitted activity, what asset is being created Safety of funds lent Is there sufficient primary security available, will the collateral back up in the event of default Customer rating A mechanism to assess the riskiness of the borrower and his venture, to help in having a good risk return trade off, to get adequate price for a risky loan Covenants for uncovered risks Enhanced margins, additional equity, special or specific stipulations (stock audit, certificate from a Chartered Accountant etc ) Non Financial Factors

38. www.sbsandco.com 38 Preparation of information memorandum or brief profile of the business Preparation of CMA (Credit Monitoring Assessment) data consiting of past three years audited information and next three years projected information Filling of Application . Valuation report of the property offered as security Legal opinion of the property offered as security Depending upon the sanctionging authority the file will be put up for the sanction After the committee/ sanctioning authroity review a sanction letter is released Once we receive the sancti Process flow

39. www.sbsandco.com 39 Once we receive the sanction letter, we need to complete the following documents loan documentation Hypothecation deed Mortgage deed Board Resolution for accepting of the terms and mortgage of the property as security for the loan Upon completion of the above documentation , charge should be created in ROC with this all procedure will be completed. We need to submit the monthly stock statements and submit stock audit report as per the sanction letter terms and conditions. Process flow

40. www.sbsandco.com/wiki Read our monthly e-Journal SBS And Company LLP Chartered Accountants 6-3-900/6-9, Flat No. 103 & 104, Veeru Castle  Durga Nagar Colony, Panjagutta,  Hyderabad - 500 082  Telangana, India . Our Presence in Telangana: Hyderabad (HO) Andhra Pradesh: Nellore, Kurnool, TADA (near Sri City), Vizag Karnataka: Bangalore [phone] / [phone] / [phone] CA Rajesh D PH: XXXXX [email protected] Thanks for your patient hearing!!!