How to appraise working capital finance?

The term working capital means the sum of the funds invested at various current assets used in the operating cycle, by the industrial and trading establishments. Operating cycle means the length of time required to convert ‘Non-Cash current assets’, (like raw material (RM), work in process (WIP), finished goods (FG), and receivables) into cash.

The types of loans and advances which  are considered as working capital finance:

The following types of loans and advances are considered as working capital finance.

 i.  Cash Credit/ Overdraft against inventories and book debts.

ii.  Demand Loan portion under Loan System for Delivery of Bank Credit (if permissible working capital finance is  above Rs.10 Crore)

iii. Packing Credit against inventories.

iv. Bills purchased /Discounted (inland & foreign)

v.  Cash Credit against book debts/Cheque purchase.

vi. Working capital term loan (for excess borrowing)

Appraisal of working capital finances:

A manufacturing unit needs to purchase raw material, labour and other overheads in the production process. The portion of current assets which are not financed by current liabilities is known as the working capital gap. The working capital gap would be financed either by own source or from borrowings.

Working capital gap is financed by the contribution from the long-term sources (Known as Net Working Capital) and bank finance for working capital purpose, wherever necessary. Therefore, it is important for the bank, to first appraise the gross working capital, net- working capital and working capital gap for assessment of working capital limits.

The level of limit for each type of facilities will depend upon on the nature of current assets less suitable margin, within the overall permissible bank finance. RBI, from time to time, prescribes norms for working capital to be financed by banks. The  financial papers like Operating statement, Balance-Sheet, and funds flow statements, bankers should examine whether the borrower is capable of being achieved Bankers have to look into following consideration for arriving assumptions of future production and sales.

1. Past trends in production/sales
2. The extent of  installed and available production capacities.
3. Availability of raw materials, labour, power supply,etc.
4. Competitive strength of the borrower.
5. Pricing policy of the management
6. Research, renovation, and development
7. Economic factors like demand for the product, import restriction etc.

After being satisfied with the validity of the projection of productions and sales, capacity utilization, break -even point, economic conditions, cost consciousness, pricing policies etc., next steps is to compute following profitability ratios and see how they compare with the past trends and withthe similar type of units in the same business.

1. Raw materials consumption to cost of production
2. Power and fuel to cost of production
3. Direct labour to cost of production
4. Repairs and Maintenance to cost of production
5. Interest to Net sales
6. Selling, general and administrative expenses to Net Sales
7. Gross profit to net sales
8. Operating profit to Net Sales
9. Net profit before tax to net sales
10. Net Profit after tax to net sales

The above ratios help bankers to assess the ability of the enterprise to earn profit from the sales,‘Return on Equity’. test of the management’s pricing policy compared to others in the business, Return on Total Assets, ‘Accounts  Receivable turnover’ etc. 

The time  taken for holding raw materials, work-in-process, finished goods and the collection of receivables is of great interest in evaluating working capital. Let us study how the length of operating period is assessed.

Related articles  in this website (Category: Financial Analysis)

1. 5 Steps of Credit Appraisal
2. Basic ideas on appraisal of working capital limits
3. Computation of working capital limits under Turn-Over method (Nayak Committee Norms)
4. Working capital assessment under cash budget method
5. How the length of operating period (Holding period for stocks and receivables) is measured?
6. The types of loans and advances which are considered as working capital finance
7. Assessment of Non-fund based (LC/LG/DPG/APG) Limits
8. How to appraise term loan proposals?