working capital financing:-Tandon committee

aktu/ mba 4thsem/ wcm/ unit v

1. Working Capital Financing:-Tandon Committee Dr.ANURAG KUMAR ASSOCIATE PROFESSOR DEPTT. OF MBA, ABES EC GHAZIABAD

2. Regulation of B ank F inance in India BANK credit has been an important and inevitable source of short term financing or working capital finance for most of the business firms. RBI has appointed different study groups from time to time to suggest ways and means to make the bank credit as an effective measurement of industrialization as well as to ensure equitable distribution of bank resources.

3. Committees Important recommendations and directives have stemmed from these groups. Tandon committee. Daheija committee. Chore committee. Marathe committee.

4. Tandon committee The Reserve Bank of India appointed in July 1974 a Study Group, under the Chairmanship of Sri P L Tandon to frame guidelines for the follow-up of bank credit . The practices of most of the banks are still influenced by tandon committee recommendations though financial liberalization occurred in 1990s. .

5. Tandon committee Terms of reference 1. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper end-use of funds and keeping a watch on the safety of advances. 2. To make recommendations for obtaining periodical information that may be obtained by banks from the borrower. 3. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowings.

6. Findings On the basis of the reference given above, the committee studied the existing system of working capital finance provided to industry and identified the following as its major weaknesses. 1 . The banks do not have any credit appraisal or planning. It is the borrower who decides how much he would borrow.   2. The security-based approach to lending has led to division of funds to purchase of fixed assets. 3. Bank credit is treated as the first source of finance rather than being taken as a supplementary to other sources of finance. 4. The working capital finance should be made available only for a short period, as it has otherwise, led to accumulation of inventories with the industry .

7. 5. To make recommendations regarding the sources of financing the minimum working capital requirements 6. To suggest whether the existing patterns of financing working capital requirements by cash credit / overdraft system, etc. are required to be modified, if so, to suggest modifications.

8. Tandon committee Recommendations 1. Maximum permissible bank finance 2. Style of credit 3 Information and reporting syste . .

9. Maximum permissible bank finance (MPBF ) Tandon Committee introduced the concept of MPBF in the working capital finance by banker. The Committee suggested that bank should attempt to supplement the borrowers’ resources in financing the current assets. It has recommended that the current assets first should be financed by trade creditors and other current liabilities. The remaining current assets, which is called working capital gap, should be financed particularly by bankers in the form of bank credit and through long-term borrowings or owner’s funds. In the context of this approach, the committee has suggested three alternative methods for working out the MPBF. Each successive method reduces the involvement of short-term bank credit to finance the current assets.

10. CALCULATION OF OTHER CUURENT LIABILITY AND WORKING CAPITAL GAP Example:= Current assets=50000 Creditors=10000 Bank borrowings=12000 OTHER CURRENT LIABILITY= Current liability – bank borrowings=22000 -12000=10000, CCA= 4000 NOW WORKING CAPITAL GAP =50000-10000=40,000 We should not include bank borrowings BECAUSE we want to know financing of Gross working capital .

11. Tandon committee Maximum permissible bank finance (MPBF ) There are three methods:- METHOD 1: First calculate the working capital gap. The borrower will have to contribute a minimum of 25% of the working capital gap from long-term fund, i.e., equity and/or debt. In other words, the bank will finance a maximum of 75% of the gap and the balance to be met by the borrower. Minimum current ratio, in this case will be 1:1. =75% of (current ASSETS- CURRENT LIABILITIES) .

12. METHOD – 2 ;The borrower will have to provide a minimum of 25% of total current assets out of long-term funds (i.e., owned funds plus term borrowings), balance will be financed by other current liabilities (excluding bank borrowings) first and then by bank credit. Total current liabilities {including bank borrowings) must not exceed 75% of current assets. Minimum current ratio, in this case, at least, will be 1.3: 1 METHOD 2:= ( 75% OFCA)- CL .

13. METHOD 3 METHOD 3: The contribution made by the borrower from long-term funds must be to the extent of the entire ‘core’ current assets and a minimum of 25% of the balance current assets. The balance left, after being reduced by other current liabilities (excluding bank borrowings) if any, will be financed by bank credit. That is, the level of bank borrowings would be reduced in these stages and it will strengthen the current ratio. METHOD 3:=75% OF (CA-CCA)- CL CL= CURRENT LIABILITIES- BANK BORROWINGS CA- current asset, CL- current liabilities, CCA- core current assets (permanent component) i.e. some fixed portion of raw material, WIP, Finished Goods. Are called CCA

14. Method 1 In the first method, 25% of the Working Capital Gap (CA-(CL excluding bank borrowing)) should be contributed by borrower through long-term funds and remaining 75% can be financed from bank borrowings . Th is method will give a minimum current ratio of = CA/ OCL+MPBF= 50000/40000=1.25:1.

15. Method 2 Under this method the borrower should provide 25% of the total current assets through long-term funds and this will give a current ratio of=50000/27500+10000 1.33:1 CURRENT ASSET = 50000 25% OF CURRENT ASSET=50000*25%=12500 FINANCED LONG TERM FUNDS CURRENT LIABILITY (EXCLUDING BANK BORROWING)=10000 Working capital gap=40000(50000-10000) MPBF= =27500 (40000-12500)

16. Third method

17. THIRD METHOD   In this method the borrower should contribute from long-term sources to the extent of core current assets (Fixed Current assets) and 25% of the balance of the current assets. The remaining of the working capital gap can be met from bank borrowings. This method will further strengthen the current ratio. Cuurent ratio = 50000/ 24500+10000=1.44:1

18. Comparison of MPBF Method 1=30000 CR=1.25:1 Method 2=27500 CR=1.33:1 Method 3=24500 CR=1.44:1 MPBF decreases gradually from first method to 2 nd and then to 3 rd method . Method 1 is liberal as compare to Method 2 & 3 Method 2 & 3 is stringent as compare to method 1.

19. 2. Style of credit 3. Information and reporting system

20. Conclusion:- Tandon committee recommended that a beginning should be made by placing all borrowers on the first method with in ayear and then moving to 2 nd & 3 rd method in the light of prevailing circumstances . The borrowers in excess of what is permissible under the first method should be converted into WCTL( working capital term loan ) and should be repaid over a period of time.