What Is working capital and How Does It Work?
Working capital finance is business finance to boost the working capital available to a business. For an uninterrupted functioning at a given capacity a firm requires a minimum level of current assets. Working capital & Net working Capital Working capital refers to the amount of total current assets.
Net working capital is calculated by banks as difference between current assets and current liabilities. In other words, net working capital refers to the surplus of long term sources over long term uses.
Working Capital Classification
- Permanent working capital which is minimum amount of current assets necessary for carrying out operations for a period.
- Fluctuating working capital : Additional assets required at different times during an operating period due to cyclic factors.
- Seasonal working capital means requirement for additional current assets due to seasonal natureof the industry.
- Adhoc working capital : Additional funds for meeting the needs arising out of special circumstances e.g. execution of special order, delay in receipt of payment of receivables.
- Working capital term loan: A long term loan given to meet the working capital margin needs of a borrower. The concept was introduced by. Tandon Committee.
Working Capital Terms
- Working Capital = Current assets such as cash, stocks, book-debts, other current assets
- Net Working Capital (NWC) = Current Assets – Current Liabilities (or) Long term sources – Long term uses
- Working Capital Gap = Current assets – Current liabilities
- Working Capital Limit = Bank facilities needed to purchase current assets. These facilities are cash credit, overdraft, bills purchase/discounting, pre-shipment or post-shipment loans etc.
Process for assessment of working capital requirements
Generally there are three methods followed by banks for assessing working capital of a firm i.e.
- Traditional method suggested under Tandon Committee
- Turnover method suggested by Nayak Committee and
- Cash budget method followed in case of seasonal industries.
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Traditional method (Tandon Committee)
As per traditional method (Tandon Committee), the level of working capital is determined both by the length of the operating cycle and the size of the sales.
The method is applicable to working capital limits above Rs.5 lac
- Under Tandon Method 1, minimum stipulated NWC is 25%ofworking capital gap.
- Under Tandon Method 2, minimum stipulated NWC is 25%of total current assets.
Consider a Balance sheet of XYZ Company
Current Liabilities (in Crores)
Cash Credit – 3200
Trade Creditors – 9500
Other Current Liabilities – 2000
Total Current Liabilities – 14700
Current Assets (in Crores)
Cash – 5000
Inventory – 14000
Debtors – 4200
Other Current Assets – 2000
Total Current Assets – 25200
Net Working Capital = CA – CL = 25200 – 14700 = 10500
Working Capital Gap = CA – (CL – BB) = 25200 – (14700 – 3200(CC)) = 25200 – 11500 = 13700
Permissible Bank Finance as per Tandon Committee – Method-I = WCG – 25% of WCG = 13700 – 25% of 13700 = 13700-3425 = 10275
MPBF as per Tandon Committee – Method-II = WCG – 25% of CA = 13700 – 25% of 25200 = 13700 – 6300 = 7400
Turnover Method (Nayak Committee):
It is used where the aggregate fund-based working capital credit limits are upto Rs. 500 lac from the banking system.
- Working capital : Minimum 25% of the projected turnover (or 3 months’s sale).
- Working capital limits : Minimum of 20% of projected annual turnover after satisfying about reasonableness of the projected annual turnover.
- Borrowers’ margin : 5% of projected turnover. If it is higher than 5%, the bank limits can be fixed at a lower level than 20%.
Estimated sale turnover (projected sale) = Rs. 80 Lakhs
Minimum Working Capital @25% estimated sales = Rs. 20 Lakhs
Contribution of borrower@5% = Rs. 4 Lakhs
Minimum Bank credit for working capital @ 20% of projected sales = Rs. 16 Lakhs
Cash Budget method
Under this method, monthly cash inflow and outflow statement is prepared and the highest gap between the two becomes the basis for sanction of credit limit. Banks make use of cash budget method in case of seasonal industries, software development, services sector activities including construction activity,film production etc.
- There should be annual review of the working capital limits of the borrowers invariably.
- The borrowers availing fund based working capital limits of Rs. 50 lac or more (raised to Rs.100 lac wef Jan 1994) to furnish Form I (estimates of ensuing quarter), Form II (actual of previous quarter and Form III (half yearly performance).