The methods used for working capital appraisal

(This post explains the definitions of   working capital ,  Operating cycle  and various methods of working capital appraisal viz.  Tandon’s first method, Tandon’s second method,Turnover method or Nayak committee norms, Cash budget method, Chore committee norms,  Maximum permissible bank finance, Minimum permissible bank finance and Important things to note in assessment of working capital assessments)

Definitions of  (a)working capital , (b) Operating cycle :

(a) Working capital means the sum of the funds invested at various current assets used in the operating cycle, by the industrial and trading establishments.

(b) 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.

Methods of Working capital appraisal:

Banks in India have evolved their own method of lending as they have been given free hand by the Central Bank (that is RBI) to decide their own lending methods. Normally banks use the turnover method (which is also called as Nayak Committee norms) for assessment of working capital limits up to Rs.2 crore (Rs.7.50 Crore for SME). The other two traditional methods of assessment of working capital limits are MPBF (Maximum Permissible Bank Finance) or Cash Budget Method depending upon requirements of the customers. The level of limit for each type of facilities under MPBF method 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. In July 1974, the study group headed by Shri. P.L.Tandon, has framed guidelines for working capital finance by banks. The recommendations made by above study group are known as Tandon Committee recommendations. Out of three methods for assessment of working capital limits proposed by Tandon Committee, RBI has accepted method I and method II, which are explained below.

As per Tandon’s-I method (also called as ‘first method’) of lending the borrower has to arrange 25% of Working Capital Gap (WCG) as margin.

The first method can be explained from the following illustration.

Let us take an example of a company which has Total Current Assets (TCA) of Rs.100.00 and Other Current Liabilities (OCL) i.e. (without working capital facilities from the bank) is Rs.20.00. Now we will compute the Maximum Permissible Bank Finance (MPBF) under method-I.

TCA=100 and OCL=20,

WCG is (TCA-OCL))=100-20=80 ——————————-Let us call it as (A)

25% of WCG           = 80×25÷100= 20————————- Let us call it as (B)

(i.e. Minimum Net Working Capital)

In this case, Maximum Permissible Bank Finance (MPBF) = (A)-(B) = 80-20 = 60

Therefore, MPBF from Bank under the first method is Rs.60 if Total Current Asset is Rs.100

Current Ratio in first method: Since Total Current Liabilities (including Bank finance) would be Rs.80 against Total Current Assets of Rs.100, the minimum Current Ratio under method–I would be  100:80 i.e minimum Current Ratio is 1.25:1.

Tandon’s-II method (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 TCA of a company is Rs.100.00 and OCL is Rs.20.00 .We shall now calculate the MPBF under 2^nd method.

WCG =CA-CL=100-20 = 80 ————————————————- Let us call it as (x)

25% of TCA=100×25÷100 = 25  ——————————————–Let us call it as (y)

The MBPF under second method is (x)-(y) = 80-25=55

MPBF, from Bank under the second method ,is Rs.55  when Total Current Asset is Rs.100 and working capital gap is 80. 

Current Ratio in second method: Since Total Current Liabilities would be (20+55)=75 against Total Current Assets of Rs.100, the minimum Current Ratio under method–II would be  1.33:1

The Chore committee (headed by Shri.K.B.Chore), appointed by RBI in April 1979 recommended that all borrowers except sick units having working capital of Rs.50 lacs and over from the banking system must be placed under method-II which gives current ratio of 1.33:1. Although the lower cut-off limit for method II is changed from time to time as per RBI guidance, the benchmark current ratio of 1.33:1 under this method remains unchanged. Relaxation to this condition is available to export oriented units; products manufactured by MSME units wherein banks may apply the first method.

Turnover method (Nayak Committee norms)

Under turnover method, the aggregate fund-based working capital limits are computed on the basis of Minimum of 20% of their projected annual turnover. The borrower has to bring the margin of 5% of the annual turnover of such borrowers as margin money.

Example:

If projected sales turn-over is                                                                 =           Rs.100, 000.00

Then, working capital gap is 25% of turnover                                     =           Rs.  25000.00

Minimum permissible Bank Finance should be 20% of turnover    =           Rs.  20,000.00

Margin money from the borrower should be 5% of Rs.100000.00 =           Rs.     5000.00

Cash Budget method

The pattern of financing the peak cash deficit(s) is followed for industries dealing in seasonal products like sugar and tea, construction activities, film industries, order based activities etc. In the above type of industries, the requirement of finance may be peak during some calendar months whereas the realizations of sale proceeds take place at a length of time. Therefore, under Cash budget method, the bank finance is sanctioned based on projected monthly cash flows estimated by the borrower and approved by the bank. The current ratio for this kind of facility is normally 1.33: 1 (1.25:1 for MSE) as a benchmark. Some Banks consider lower ratio on the case-to-case basis depending upon components and quality of current assets and current liabilities.

Important things to note in assessment of working capital assessment:

1.The time period taken for holding raw materials, work-in-process, finished goods and the collection of receivables is of great interest in evaluating working capital.

2.In the assessment of financial statements  bankers should examine whether the borrower is capable of achieving the projection made by him.

3.Bankers also have to look into following consideration for arriving assumptions of future production and sales. (a)Past trends in production/sales, (b) the extent of installed and available production capacities, (c) Availability of raw materials, labour, power supply, etc., (d) competitive strength of the borrower, (e) Pricing policy of the management, (f)Research, renovation, and development, (g)Economic factors like demand for the product,import restriction etc.,

4.The Profitability ratios  are arrived to compare with the past trend and similar types of units in the same business. The profit ratios help bankers to assess the ability of the enterprise to earn profit from the sales, ‘Return on Equity’, Return on Total Assets, ‘Accounts Receivable turnover, and test of the management’s pricing policy compared to others in the business.

5.It is necessary that limit utilization is properly reflected by transactions, stock statements and turn- over of the sanctioned limits before considering limits based on projections. Total purchase/ sales reflected in balance-sheet should match with the turnover of debits/credits in the current/CC account for the full year (Period of balance sheet). If any disparities are noticed by the appraising officer, enquiries should be made and the reply from the borrower should be convincing. Many a times, transactions routed through some other channel/bank will come to the notice of the bankers through above type of counter verifications.

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?