Management of working capital-Estimation and financing - 2 | Management Optional Notes for UPSC PDF Download

Tandon Committee Norms 

• Since the mid-sixties, the issue of financing working capital has been a focal point for both industry and policymakers. The Reserve Bank of India introduced several measures in response, including the Credit Authorization Scheme in November 1965, the formation of the Dahejia Committee in October 1968, the Tandon Committee in July 1974, and the Chore Committee in March 1979. Over time, efforts have been made to streamline credit flow from the banking sector to the industry. The common thread linking the financing of working capital and the recommendations of these committees is the establishment of norms for maintaining various current assets, thereby determining the optimal working capital.
• The Tandon Committee, in particular, pioneered the prescription of norms for holding diverse current asset items. It urged commercial banks to quantify the desirable level of net working capital and the maximum permissible lending. The Committee aimed to identify the "Reasonable level of current assets" as the basis for different lending methods. Essentially, the total of current assets would be based on these norms rather than the actual assets held by undertakings. To this end, the Committee proposed norms for raw materials, work-in-progress, finished goods, and receivables across 15 major industries. These norms delineated the maximum levels of inventories and receivables in each industry type.
• Furthermore, if the holding of any asset exceeded the specified norms, the surplus would be considered excessive and needed to be reduced. Failure to do so would result in the excess being treated as borrowing, subject to penal interest rates. Moreover, excess holdings could not be offset against shortfalls in other current assets, as these norms represented the highest acceptable levels of holdings.
• The list of fifteen industries covered a range including cotton textiles, synthetic textiles, jute, pharmaceuticals, rubber, fertilisers, vanaspati, paper, and engineering. This lending framework persisted with minor adjustments until the early stages of the current decade. However, the underlying philosophy of assessing working capital norms based on industry norms remained unchanged.

Current Banking Policy

• Following a phased liberation program since 1991, the RBI has granted banks full operational freedom in evaluating borrowers' working capital requirements. All directives regarding Maximum Permissible Bank Finance (MPBF) have been rescinded. Instead, a revised method for assessing working capital limits has been introduced. Commercial banks are urged to adopt one of three methods: a) Turnover method b) Eligible working capital limit method c) Cash-flow method.
• Under the 'Turnover method', the working capital needs of borrowers with aggregate fund-based limits up to Rs.2 crore are assessed at a minimum of 25% of their projected annual turnover. Of this, 5% of the annual turnover must be provided by the promoters, leaving the remaining 20% to be financed by banks. This represents a shift away from the previous industry norm approach, where turnover now dictates credit availability, rather than adhering to predetermined norms.
• Alternatively, banks may opt for the 'Cash-flow method' to finance industrial units' working capital needs. This approach involves banks covering any deficits resulting from payments exceeding receipts in a given month. Borrowers are required to furnish monthly cash flow statements and implement control measures to ensure operational smoothness.
• The cash-flow method also discards the industry norm approach, focusing solely on the disparity between receipts and payments. While industrial units must exercise care in preparing cash flow statements, the practical implementation of this method will determine its efficacy.

The RBI has issued revised guidelines on working capital loans to reinforce credit discipline among borrowers and guide banks effectively:

• A 'minimum level' of loan component in fund-based working capital finance is mandated.
• A mandatory 'Credit Conversion Factor (CCF)' is specified for the undrawn portion of cash credit limits or overdraft facilities.
• Large borrowers are redefined as those with fund-based working capital limits of Rs.150 crore and above, up from Rs.100 crore previously.
• As of October 2018, the minimum loan component is set at 40% of the total limit.
• The CCF for large borrowers' unutilized cash credit/overdraft portions is 20% as of April 1, 2019.
• The 'Minimum Loan' component is proposed to increase from 40% to 60% starting April 1, 2019.
• In consortium lending, all lenders mutually agree on ground rules for sharing cash credit and loan components.
• Banks have the freedom to allocate the loan component across different maturity periods based on borrowers' needs.
• Borrowers are prohibited from purchasing assets or making long-term investments with working capital finance.

Revised Guidelines for Working Capital Assessment: A Case Study

In this section, we aim to provide readers with insights into the operational guidelines of one of the nationalized banks.

A. Methodology

The banks follow the following methods as per their policy stance in assessing borrowers' working capital requirements:

• Quantum of requested limits (Rs. in lakh) Method
• Up to Rs.200.00 lakh from the Banking system Turnover Method
• Rs.200.00 lakh and above from the banking system but up to & inclusive of Rs.2000.00 lakh Eligible Working Capital Limit (EWCL) Method
• For limits above Rs.2000.00 lakh, EWCL or Cash Budget Method as decided by the Bank.

TURNOVER METHOD:

For Small Scale Industries (SSI) borrowers seeking fund-based limits up to Rs.200.00 lakh from the banking system, the RBI mandates the following assessment:

• Projected Gross Sales Rs..............
• Working Capital requirements at 25% of A Rs..............
• Margin to be provided by the borrower at 5% of A (Corresponding to a Current ratio of 1.25) or the actual net working capital available, whichever is higher Rs..............
• Eligible Working Capital finance (b–c) Rs..............

For Non-SSI borrowers seeking fund-based limits up to Rs.200.00 lakh from the banking system, the assessment methodology remains the same as for SSI borrowers, except that the minimum margin required from the borrower is 6.25% of the Projected Gross Sales, corresponding to a Current Ratio of 1.33. This can be relaxed to 5% of the Projected Gross Turnover, corresponding to a current ratio of 1.25, subject to other Financial Parameters being satisfactory.

• When determining Eligible Working Capital Finance under the Turnover Method for both SSI and Non-SSI borrowers, if the available Net Working Capital (NWC) is higher than the required minimum, the higher available NWC is considered. Additionally, unpaid stocks exceeding unfinanced eligible receivables are not included in the computation of drawing power. The inventory margin requirement is 20% for SSI borrowers and 20% to 25% for Non-SSI borrowers, depending on the stipulated current ratio.
• If a Non-SSI borrower requests working capital limits higher than what they would be eligible for under the Turnover Method, their requirements can be assessed under the EWCL method, and limits up to their EWCL eligibility may be provided.
• For borrowers seeking fund-based working capital limits less than Rs.10.00 lakh from the Bank, credit facilities are determined holistically, considering factors such as business potential, plans, past dealings, creditworthiness, market standing, collateral availability, and ability to repay.
• Limits assessed through simplified procedures are primarily secured by current assets. Additionally, collateral security of at least 150% of the advance's value is obtained from borrowers assessed through simplified procedures. Zonal Heads have the authority to reduce collateral security coverage, but not below 100% of the advance's value, based on merit.
• For borrowers seeking fund-based limits less than Rs.10.00 lakhs assessed under the Turnover method, the collateral security stipulation mentioned above does not apply, as these borrowers must comply with security cover as per Basic Financial Parameters.
• Working capital limits less than Rs.10.00 lakhs may be extended through short-term loans with a maturity of up to one year. These loans may be repayable in installments (balloon form) or in one lump sum (bullet form) and are available for renewal/rollover at the end of the term, subject to review. Stock statements are required at the end of each calendar quarter, and penal interest is applied to drawings beyond the Drawing Power (DP).

SSI borrowers seeking working capital limits less than Rs.10.00 lakhs are assessed under the Turnover Method but are eligible for short-term loans and/or overdrafts. Short-term loans for SSI borrowers are subject to 0.5% p.a. lower interest (net of tax) than overdrafts, with a minimum of PLR, compared to the interest chargeable on overdrafts.

Eligible Working Capital Limit Method (ewcl):

The EWCL method, which is a more flexible iteration of the former Maximum Permissible Bank Finance (MPBF) Method, will be utilized for borrowers requesting fund-based working capital limits of Rs.200.00 lakhs and above (from the banking system) but up to (and including) Rs.2000.00 lakhs from the Bank, with the assessment conducted as follows:

The treatment and identification of Current Assets and Current Liabilities will remain consistent with the practices observed during the implementation of the MPBF Method. Under this method of assessment, allocating 25% of current assets as margin (NWC) equates to a Current Ratio of 1.33, serving as a benchmark for current ratio evaluation. However, selective relaxation of the current ratio under the EWCL method may be permitted up to 1.1, provided that other fundamental financial parameters meet satisfactory criteria. When determining the current ratio, term loan installments due within the next 12 months will be considered, but they will be excluded as a component of current liabilities in calculating the working capital gap under the EWCL method. Similarly, export receivables will continue to be excluded from current assets when determining the required NWC.

Cash Budget Method

For borrowers seeking fund-based limits above Rs.2000.00 lakhs, the assessment will be conducted using either the Cash Budget Method or the previously discussed EWCL Method, as determined by the Bank. Corporate borrowers with cash budget-driven financial management practices and existing clients of the Bank with consistently strong track records of meeting specified norms and covenants—both financial and performance-related—have the option to undergo assessment using the Cash Budget Method.

The assessment methodology under the Cash Budget Method is as follows:

• Cash Flow from Business Operations:
  • All inflows (receipts)
  • All outflows (payments)
• Cash Flow from Non-business operations:
  • All inflows
  • All outflows
• Cash Flow from Capital Accounts:
  • All inflows
  • All outflows
• Cash Flow from sundry items:
  • All inflows
  • All outflows
• Assessment of bank finance:
  • Cash Gap in business operations {I(ii) – I(i)}
• Less:
• Amount brought/proposed to be brought from other sources i.e., cash surplus under II, III & IV above.
• Net Cash Gap {V(i) – V(ii)}

The Highest (Peak) Cash Gap during the period under assessment is to be extended by way of an eligible working capital limit.

The following prerequisites are recommended for borrowers to be evaluated under the Cash Budget system:

1. Preferably be a company under the Indian Companies Act, listed and quoted at one or more Stock Exchanges in India. However, if the Bank is satisfied with the financial strength, partnership and proprietorship concerns may also be considered under this system. The preference for listed/quoted companies aims to access their published data effectively.
2. Have a database and system for financial planning based on a cash budget.
3. Maintain inventory and receivable management on professional lines, adhering to Stock Audit norms, with store management, shop floor control, and costing norms as per industry standards.

The Cash Budget method will continue to be utilized in seasonal industries like Sugar, Tea, and others, as well as in the construction industry, regardless of the amount of working capital finance sought. Since the requirement for working capital finance is directly linked to production and sales activity levels and the inputs needed to achieve these levels, it is essential to obtain the aforementioned details along with a detailed Cash Budget. While assessing the quantum of finance based on the borrower's cash budget, financial statements and CMA data with fund flows should also be considered to determine the level of business activity for which working capital finance is sought. Additionally, conducting a sensitivity analysis based on variations in major financial assumptions may be necessary for proper risk assessment.

Summary

• Determining the appropriate level of working capital for a business is crucial for its effective management and value maximization, which entails optimal investment across all asset categories. There are three approaches to determining the ideal level of working capital: the industry norm approach, the economic modeling approach, and the strategic choice approach.
• The industry norm approach involves establishing norms based on the nature of operations, with each unit's requirements assessed against these benchmarks. Economic models are utilized to project current asset items and determine an optimal quantity under the economic modeling approach. In contrast, the strategic choice approach advises businesses to develop their unique strategies based on prevailing circumstances, rather than adhering to industry practices.
• In practical terms, the operating cycle concept is commonly employed to assess working capital requirements, considering factors such as the nature of the business, management's risk appetite, growth plans, product policies, stage of the business cycle, terms of trade, and operational efficiency. The methodology proposed by the Tandon Committee holds particular relevance in this regard.
• Against this backdrop, commercial banks establish working capital limits based on their own policy frameworks. Since liberalization, banks have been given more flexibility in setting their norms, within the overarching guidelines provided by the RBI.