A loan that is taken to finance a company’s everyday operations is known as working capital loan. These loans cannot be used to buy long-term assets or investments. Instead, they provide the working capital that fulfils the company’s short-term operational needs. It’s safe to say that working capital loans are simply corporate debts that are used to finance a company’s daily operations.
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How does a Working Capital Loan work?
When a company does not have asset liquidity or enough cash in hand to cover their day-to-day operating expenses, they opt to secure a loan for this purpose. The companies that have high seasonality often rely on working capital loans.
A lot of companies do not have a steady income throughout the year. For example, manufacturing companies have cyclic sales that keep up a correspondence with the requirements of retailers. Manufacturers with this type of seasonal work often need a working capital loan to pay salaries and other operating charges. By the time the company hits its busy season and does not need the finance anymore, the loan is usually repaid.
Methods to Enhance Working Capital
Banks are given authorities by the Central Bank to generate their method of lending for the working capital loans in India. But the methods of third party lenders are comparatively flexible for the best working capital loans. The turnover method is usually used by banks to check working capital limits.
Maximum Permissible Bank Finance or Cash Budget Method is the age-old method for evaluating working capital limits, which depends upon the customer requirement.
The limit for every facility under MPBF (Maximum Permissible Bank Finance) method will depend on the nature of the current. From time to time, norms for working capital are prescribed to the lenders.
A study group, which was headed by Shri. P.L. Tandon, framed guidelines for fast working capital loans in July 1974. Those recommendations are known as Tandon Committee recommendations. Out of three methods proposed by the Tandon Committee, the method I and method II were accepted for appraisal of working capital limits, which are explained below.
Tandon’s First Method
As per Tandon’s ‘first method’ of lending, the borrower must arrange 25% of Working Capital Gap (WCG) as a margin.
The following illustration can explain the ‘first method’-
Let us take an example of any company which has Total Current Assets (TCA) of Rs. 1,000 and Other Current Liabilities (OCL), i.e. (without working capital facilities from the bank) is Rs. 200. Now we will compute the Maximum Permissible Bank Finance (MPBF) under method-I.
TCA=1000 and OCL=200,
WCG is (TCA-OCL)) = 1000 – 200 = 800 —————————— Let us call it as (A)
25% of WCG = 800 × 25 ÷ 100 = 200———————— Let us call it as (B)
(i.e., Minimum Net Working Capital)
In this case, Maximum Permissible Bank Finance (MPBF) = (A)-(B) = 800-200 = 600
Therefore, MPBF from Bank under the first method is Rs.600 if Total Current Asset is Rs.1000
Current Ratio in the first method: Since Total Current Liabilities (including Bank finance) would be Rs.800 against Total Current Assets of Rs.1000, the minimum Current Ratio under method–I would be 1000:800, i.e. minimum Current Ratio is 1.25:1.
This method is also called as ‘second method’). In this method of lending, the borrower has to arrange 25% of Total Current Assets (TCA) as margin.
Illustration: Let us again take an example of the TCA of a company is Rs.1000 and OCL is Rs.200.We shall now calculate the MPBF under 2nd method.
WCG = CA – CL = 1000 – 200 = 800 ———————————————— Let us call it as (x)
25% of TCA = 1000 × 25 ÷ 100 = 250 ——————————————– Let us call it as (y)
The MBPF under second method is (x) – (y) = 800 – 250 = 550
MPBF, from Bank under the second method, is Rs.550 when Total Current Asset is Rs. 1000 and the working capital gap is Rs. 800.
Current Ratio in the second method: Since Total Current Liabilities would be (200 + 550) =750 against Total Current Assets of Rs.1000, the minimum Current Ratio under method–II would be 1.33:1.
The Chore committee which was appointed in April 1979 suggested that all borrowers apart from sick units which have working capital of Rs.50 lakhs and over from the bank system should be positioned under method-II which will give a current ratio of 1.33:1.
As per RBI guidelines, the lower cut-off limit for method II is changed from time to time, but the current benchmark ratio of 1.33:1 should remain unchanged.
Cash Budget Method
Industries dealing in seasonal products like sugar and tea, construction activities, film industries, order based activities, etc. follow the outline of the peak cash deficit. The requirement of finance may be peak during some calendar months in the above-mentioned industries, whereas the realisations of sale proceeds occur in the future.
Therefore, under this method, the bank finance is approved based on projected monthly cash flows estimated by the borrower and agreed by the lender. Some lenders consider a lower ratio on the case-to-case basis depending upon the quality of current assets and components and current liabilities.
Important things to note in the Working Capital Assessment
- In the evaluation of financial statements, lenders examine whether the borrower is capable of achieving the projection made by him.
- Lenders also look into the following factors of future production and sales.
- Production/sales trends in the past,
- The number of available production capacities,
- Accessibility of labour, power supply, raw materials, etc.
- The competitive strength of the borrower,
- Development, research, and renovation,
- Economic factors like import restrictions, demand for the product, etc.
- The profitability ratios are arrived to compare with the past trend and similar types of units in the same business. The profit ratios help lenders to assess the ability of the enterprise to earn profit from the sales, Return on Equity,Return on Total Assets, Accounts Receivable turn-over, and test of the management’s pricing policy compared to others in the business.
- It is essential that limit utilisation is appropriately imitated by transactions and stock statements before taking projection limits in the account. It is important that debits/credits turnover in the balance sheet should match with the full-year period of balance sheet.
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