CAIIB ABM Unit 28 - Working Capital Finance

Working Capital

The amount of raw materials, work in progress, finished goods, and receivables is called the working capital.

Working Capital Cycle

The normal operations of a business enterprise consist of purchase of raw materials, processing and conversion of raw materials into finished goods, selling these goods on cash/ credit basis, receive cash on sale or end of credit period and again purchase raw materials. This is called working capital cycle.

Method of Assessment of Bank Finance

1. Deciding on the level of Turnover of the Enterprise
2. Assessment of Gross or Total Working Capital : This is the sum total of the assessment of various components of the working capital.

(a) Inventory
(b) Receivables and Bills
(c) Other Current Assets

Sources for Meeting Working Capital Requirement:

(a) Own Sources (N W C)
(b) Suppliers’ Credit
(C) Other Current Liabilities like salaries payable, advances from customers, etc.
(d) Bank Finance

Calculation of Bank Finance

Though banks are now free to formulate their own policies, the methods of lending, mentioned there, still find place in the calculations followed by the banks. The methods are;

(a) First Method of Lending: Under this, the enterprise was required to bring in at least 25 per cent of the working capital gap (total current assets minus total current liabilities excluding bank finance)

(b) Second Method of Lending: Under this, the enterprise was required to bring in at least 25 per cent of the total current assets.

(b) Third Method of Lending: Under this, the enterprise was required to bring in 100 per cent of those current assets which are considered 'core assets' and at least 25 per cent of the remaining current assets.

Bills / Receivables Finance by the Banks

Receivables are part of the current assets of a business enterprise. These arise due to sales on credit basis to the customers. The bank provides finance against these in a fashion similar to that for inventory.

Another method of sales is through Bills of exchange drawn by the seller on the purchaser in the following manner;

(a) If no credit is to be provided to the customer, a demand bill is drawn.

(b) If the credit is to be provided on the sales, a bill of exchange, called usance bill, mentioning the period of payment, is drawn on the purchaser and is accepted by him The outstanding amount is shown in the accounts as 'bills receivables'.

The terms used in bills finance are purchase, discount and negotiation. Normally, 'purchase' is used in case of demand bills, 'discount' in case of usance bills and 'negotiation' in case of bills which are drawn under letters of credit opened by the purchaser's bank.

Guidelines of RBI for Discounting / Rediscounting of Bills by Banks

(a) Banks may sanction working capital limits, as also bills limit, to borrowers after proper appraisal of their credit needs and in accordance with the loan policy as approved by their Board of Directors.

(b) Banks should open letters of credit (L Cs) and purchase / discount / negotiate bills under L Cs only in respect of genuine commercial and trade transactions of their borrower constituents who have been sanctioned regular credit facilities by the banks.

(c) If a beneficiary of the LC wants to discount the bills with the LC issuing bank itself, banks may discount bills drawn by beneficiary only if the bank has sanctioned regular fund-based credit facilities to the beneficiary.

(d) Bills purchased/discounted/negotiated under LC  will be treated as an exposure on the LC issuing bank and not on the borrower.

(e) While purchasing / discounting / negotiating bills under LCs or otherwise, banks should establish genuineness of underlying transactions/documents.

(f) The practice of drawing bills of exchange claused 'without recourse' and issuing letters of credit bearing the legend 'without recourse' should be discouraged because such notations deprive the negotiating bank of the right of recourse it has against the drawer under the NI Act.

(g) Accommodation bills should not be purchased/discounted/negotiated by banks.

(h) Banks should be circumspect while discounting bills drawn by front finance companies set up by large industrial groups on other group companies.

(i) Bills rediscounts should be restricted to usance bills held by other banks.

(j) Banks may exercise their commercial judgment in discounting of bills of the services sector.

Non-Fund-Based Working Capital Limits

1. Guarantees
2. Co-acceptance of Bills
3. Letters of Credit

 

Commercial Paper (CP)

1. Unsecured money market instrument
2. Issued in the form of a promissory note
3. Introduced in India in
4. Cost of borrowing through CP is normally lower compared to other sources of short term finances

Factoring

1. Method of financing the receivables of a business enterprise.
2. The financier is called 'Factor' and can be a financial institution.
3. Banks are not permitted to do this business themselves but they can promote subsidiaries to do this. Under factoring, the factor not only purchases the book debts/receivables of the client, but may also control the credit given to the buyers and administer the sales ledger.
4. The purchase of book debts/receivables can be with recourse or without recourse to the client.
5. If without recourse, the client is not liable to pay to the factor in case of failure of the buyer to pay.

Forfaiting

1. This is similar to factoring but is used only in case of exports and where the sale is supported by bills of exchange/promissory notes.
2. The financier discounts the bills and collects the amount of the bill from the buyer on due dates. Forfaiting is always without recourse to the client. Therefore, the exporter does not carry the risk of default by the buyer.