Banks are playing a crucial role in national development. By way of extending credit, Banks provide necessary assistance in developing industries and trade, resulting in increased production, employment and profits thereby paving the way for prosperity of the nation with growth in GDP and National Income.
With changing time and economic ecosystem, the pattern of funding to businesses through various assessment methods has also witnessed many changes. Credit assessment methodologies ought to be dynamic in tune with this economic dynamics.
This article is an attempt to present an innovative and flexible way of assessment of working capital needs of a business unit with this transformed economic era especially after Liberalisation, Privatisation and Globalisation (LPG) in 1990’s and with coming up of new refined definitions of Priority sector lending and MSME quite recently in the year 2020. Further, with this COVID pandemic that has adversely affected the business environment, this flexible approach of credit assessment for working capital requirement will definitely find a favourable place.
Working Capital refers to the current assets of an enterprise. The assets representing working capital rapidly converts from one form to another in a short period of time. The quantum of working capital requirements may depend on various factors like operating efficiency, technology employed, level of quality control, demand and supply gap, nature of activity, availability of raw material, labour, power & fuel etc.
With changing business dynamics, different methods of working capital assessment got evolved as per the requirement and demand of industries.
Important FBF is different
Flexible Bank Finance (FBF) method is a re-engineered version of Maximum Permissible Bank Finance (MPBF) Method with borrower friendly approach where the scope of Current Assets is broadened.
Under Flexible Bank Finance (FBF) method a more liberal approach is adopted in working out current assets with changed business scenario and economic ecosystem in our country.
Various Assessment Methods for Working Capital Requirement
The prevalent Working Capital assessment methods are –
- Maximum Permissible Bank Finance (MPBF) Method
- Turnover Method
- Cash Budget Method
A working Group headed by Shri P. L. Tandon was constituted by RBI in July 1974 to suggest methods for effective delivery of industrial credit based on performance and projections of borrower. This committee came out with inventory and receivables norms meaning thereby that borrowing entity should maintain only required level of current assets and move towards leaner inventory and receivables holding period. Concept of Maximum Permissible Bank Finance (MPBF) was enunciated by the committee for assessment of working capital and suggested methods to ensure judicious allocation of bank credit.
Turnover Method was prescribed by Shri. P.R.Nayak and is based on sales cycle of an industry, where bank credit to the borrowers’ margin should be maintained in the range of 80:20 i.e working capital limit shall be computed at 20% of the projected sales turnover accepted by the bank. The most important and basic assumption of this method was the working cycle which was accepted to be of 3 months (90 days).
Cash Budget Method is adopted in case of specific industries/seasonal activities such as Software development, Construction industry, Film industry, Sugar, Fertilizers etc and working capital short term loans. Here, required finance is arrived at from the projected cash flows and not from the projected values of assets and liabilities.
Features of MPBF METHOD
Tandon Committee came up with the findings and recommendations on financing working capital requirements and suggested three approaches (report submitted in year 1975)
- Committee considered bank credit as the source of last resort which should be tapped only after all the internal (promoter’s contribution) and external sourced (Sundry Creditors) of funding working capital requirement at the disposal of enterprise is exhausted. The role of NWC as promoter’s margin towards WC requirement is firmly established in the process.
- In view of the above observations Tandon committee prescribed three alternative methods of WC finance also known as MPBF (Maximum Permissible Bank Finance).
- All three methods recognised that banks would lend only a portion of working capital gap (WCG), which is the value of acceptable level of CA after netting of the other sources of funding WC requirement.
First Method of Lending
Under this method, margin contribution of borrowing enterprise which would be at minimum level of 25% of WCG. Such margin is contributed by NWC of enterprise. This method required current ratio at a minimum level of 1.17:1.
Second Method of Lending
Under this method, borrower contribution is minimum 25% of total current assets requiring current ratio at a minimum level of 1.33:1.
Third Method of Lending
Under this method, borrower’s contribution is to the extent of entire core current assets comprising of absolute minimum level of raw materials, stock in process, finished goods and stores to ensure continuity of production and a minimum of 25% of balance current assets is financed out of the long term funds and term borrowings. This method was not accepted for implementation and is of academic interest only.
Some prescriptions of Tandon Committee in above methods were very stringent and could not find place in Indian business environment, post liberalisation of Indian economy and hence RBI made it optional in 1997, giving greater operational freedom to banks in dispensation of credit.
Hence banks started devising their own way of financing working capital and thus came an innovative method “Flexible Bank Finance Method” which is being used by some banks like Union Bank of India.
Features of Flexible Bank Finance Method
Flexible Bank Finance Method is an extension of permissible Bank Finance (PBF) Method with customer friendly approach in as much as the scope of Current Assets is made broad based and for evaluating projected liquidity, acceptable level of Current Ratio (Current assets/ Current liabilities) is taken at 1.17:1
Flexible Bank Finance (FBF) method shall be applicable as per amount of exposure as under-
- MSE accounts- Above Rs.5.00 Cr
- Non MSE accounts- Above Rs.1.00 Cr
Under FBF method, there is uniformity in classification of current assets and current liabilities as per CMA format.
The assessment of credit requirement of a party shall be made based on the projected study of the borrower’s business operations vis-à-vis the production / processing cycle of the industry. The projected level of inventory and receivables shall be examined in relation to the past trend of unit, market developments and industry trend.
FBF method is based on the assessment of limit as the difference between Working capital gap and Projected Net working capital.
The GAP in required level of resources to maintain the projected level of current assets and the manner in which the current assets are managed need to be examined.
Assessment under Flexible Bank Finance (FBF) method
Firstly, we need to analyse non financial parameters of borrowing entity, like proper due diligence including KYC compliance of borrowers, guarantors, property/ ies offered as security, audit observations and operational aspects (in case of existing accounts).
Alongside, it we need to focus on financial parameters like financial due diligence, sanctity of data and information submitted by the prospective borrower. Assessing authorities now insist upon obtaining financial statements, various certificates etc issued by Chartered Accountants (CA).
For assessment of working capital limit under FBF method, there is need to understand and evaluate three components as under-
- Obtaining financial data in CMA format (Credit Monitoring Arrangement).
- Operating cycle of the business.
- Holding period of current assets and creditors in the business.
CMA format consists of the following 6 parts/forms-
Form-I: Particulars of existing/ proposed limits from the banking system
Form-II: Operating statement
Form-III: Analysis of balance sheet
Form-IV: Comparative statement of Current assets/ Current liabilities
Form-V: Computation of MPBF for working capital
Form-VI: Funds Flow statement
Information provided in Form II, III, IV, and VI serves the detailed financial analysis. Form V shall be used for computation of FBF. In Form-I information relating to working capital and term loan borrowings (existing and proposed) is obtained. Additional information regarding borrowings from Non Bank Finance Companies (NBFC), borrowings from Term Lending Institutions for working capital purpose, Inter Corporate deposits taken, Lease finance availed shall also be collected in Form-I.
How to calculate working capital limit under Flexible Bank Finance method
The quantum of finance is calculated as under-
|1||Total Current Assets (TCA)|
|2||Less||Current Liabilities (other than Bank Borrowings)|
|3||The resultant is Working Capital Gap (WCG)|
|4||Less||Less Actual / Projected Net Working Capital (NWC)|
|5||The resultant is eligible finance (FBF)|
To find out whether there is sufficient margin in the system, the following calculations in % terms are also made immediately after the arrival of Flexible Bank Finance
- NWC (margin) to Total Current Assets (TCA) (%)
- FBF (Limits) to Total Current Assets (TCA) (%)
- Other Current liabilities to TCA (%)
Classification of Current Assets/ Current Liabilities (Form-III)
Under Flexible Bank Finance (FBF) method a more liberal approach has been adopted for classification of current assets and includes the following as part of current assets-
- Margin in the form of cash deposits for LCs (Letter of Credit) and Bank guarantees.
- Fixed deposits with banks and government.
- Temporary investments like
- CP (Commercial paper)
- CD (Certificate of Deposit)
- MMMF (Money Market Mutual Funds), that are made with prior consent of the bank for parking short term funds
Verification of levels of Inventory/ Receivables/ Sundry creditors
The projected level of these is to be examined with reference to the borrower’s specific operational strengths and weaknesses, their need to hold the current assets at projected levels and their ability to absorb costing involved in carrying inventory/ receivables at the projected level.
- Concept of working capital operating cycle
In simple terms, Operating Cycle means the length of time required to convert “Non Cash current assets like raw material, work-in-progress, finished goods and receivables into cash.
III. Holding period/ level
Holding level means the period of a particular current asset or current liability after which it is converted or realized or is paid.
The justification of holding period holds the crucial part of the FBF system of finance.
A business unit needs to hold the stock of raw materials, work-in-progress, finished goods (stock in case of traded goods) for a length of time in the workplace before despatching the final products to the customers.
The holding levels are studied in comparison with the holding levels of similar units in the industry, wherever available. The study of the requirements / holding levels of raw materials, finished goods, stores, stocks in process etc. should be based on the past trend of the concern. The levels of projection to be examined with reference to the borrower’s specific operational strengths and weakness, their need to hold the current assets at the levels projected and their ability to absorb cost of carrying inventory / receivables at the levels proposed.
Normally the holding period is calculated for the following items of current assets and current liabilities for examining the projected level of inventory and receivables and creditors.
Components of current assets
- Raw materials consumed
- Other consumable spares
- Stocks in process
- Finished Goods
- Export Receivables
- Other Receivables
Components of current liabilities
- Creditors for purchases
Calculation of Holding period
Raw Material Holding period:
Holding period of raw material (RM) in months is measured by the Average stock of RM divided by RM consumption multiplied by 12.
- RM Holding Period = Average stock of raw materials *12 / Raw Material Consumption
- Raw material consumption is measured by Opening stock of Raw Material plus Purchase of Raw Material minus Closing stock of raw material.
- Average stock of RM is measured by Opening stock of RM plus Closing stock / 2
Work In Progress Holding period:
Holding period of Wok-in-Progress (WIP) in months is measured by the Average stock of WIP divided by Cost of production (CoP) multiplied by 12.
- WIP Holding Period = Average stock of WIP * 12 / Cost of Production
- Average stock of WIP is measured by Opening balance of WIP plus Closing stock of WIP divided by 2.
- Cost of Production is measured by Raw Material consumed + Manufacturing expenses + Depreciation + Opening stock of WIP – Closing stock of WIP.
Finished Goods Holding period:
Holding period of Finished Goods (FG) in months is measured by the Average stock of FG divided by Cost of Sales (CoS) multiplied by 12.
- Holding period of FG = Average stock of FG x 12 / Cost of sales
- Average stock of FG is measured by Opening balance of FG plus Closing stock of FG divided by 2
- Cost of Sales = Cost of Production + Opening stock of FG – Closing stock of FG.
Receivables Holding period:
Holding period of receivables/ Debt Collection period in months is calculated is measured by Average Receivables Outstanding multiplied by 12 and divided by Gross Credit Sales.
- Debt collection (in months) = Average Receivables Outstanding x 12/ Gross credit sale
- Average receivables outstanding = Sundry debtors + bills receivables inland + bills purchased and discounted by banks inland.
Creditors Holding period:
Creditors’ holding period in months is measured by multiplying Trade Payables by 12 and dividing by Purchase
- Creditors holding period = Trade Payables *12 / Purchase
Monitoring of Working Capital Advance sanctioned under FBF method
It is important that the sanctioned working capital facility is monitored properly and on a continuous basis. Banks have devised certain tools for monitoring of the account.
In order to monitor performance in working capital facilities certain statements need to be scrutinised as under-
- MSOD: Monthly Select Operational Data
- QPR: Quarterly Progress Report
- CA certified Book Debt statements
We need to work in synergy with economic dynamics and we cannot stick to any particular model of working capital assessment. With the changing economic arena worldwide, the businesses in India need to be oriented in that direction. For that, it is pertinent that new models are created for funding business enterprises that should be flexible enough to assimilate ground realities of business, meaning by, Development should be intrinsic in these methods. Flexible Bank Finance method is an effort for that intent. It will pave a way for more liberal approach for development of enterprises in tune with liberalised economy and is worth being implemented across banks and Financial Institutions.