INSTITUTE OF MANAGMENT STUDIES, DAVV, INDORE

FINANCE AND ADMINISTRATION – SEMESTER IV

CREDIT MANAGEMENT AND RETAIL BANKING

ASSESSMENT OF WORKING CAPITAL FINANCE

 The system for assessment of Working Capital Finance including the concept of Maximum
Permissible Bank Finance (MPBF) is based on the recommendations of ‘Tandon Committee’
and ‘Chore Committee’ set up during the years 1974 and 1979 respectively.
 Consistent with the policy of liberalization, the Reserve Bank of India (RBI) decided to allow full
operational freedom to banks in assessing the working capital requirements of borrowers.
 Even though assessment of loans through MPBF is now not mandatory most of banks are
adopting MPBF system for assessment of loans suggested by 2 nd method of Tondan
committee for all loans sanctioned above Rs. 5 crores.

Why were “Tandon” and “Chore” Committees set up?

 After the nationalization of major banks in 1969, there was a new sense of direction in bank
lending. The task of credit planning became difficult because of the problem of imbalances in
the demand for and supply of funds, which was accentuated by the manner in which the banks
were extending credit under cash credit system of lending.
 Realizing the drawbacks of cash credit system (drawals at the choice of borrower and rolling
over nature), a need was felt to draw out a mechanism for assessment of working capital
finance so that the borrower is induced to plan credit needs and the banker is also enabled to
plan lending on the basis of borrowers’ credit requirements.
Major Factors to Constitution of Tandon Committee were -
- Unprecedented inflation pushing up demand for credit.
- Pressure on banks’ resources leading to ‘credit squeeze’.
- Elements of subjectivity in assessing working capital requirements.
 With the above background, the Reserve Bank of India appointed in July 1974, a Study Group
under the chairmanship of Shri P.L.Tandon to frame guidelines for the assessment of Working
Capital Finance and follow up of bank credit, etc.
 The norms framed by the Tandon Committee were historic necessity at that time. The idea
underlying those moves was to engineer a shift away from a purely security based lending to a
largely need based lending by the banks so as to make more credit available to industry on a
more flexible basis.
 Broadly these recommendations relate to-
- Approach to Lending - MPBF system
- Norms of Inventory and Receivables
- Information System etc.

APPROACH TO LENDING - MPBF SYSTEM

 Banker’s main role as a lender is to supplement the borrower’s resources in carrying a
reasonable level of current assets in relation to the production requirements. These current
assets are carried partly by a certain level of creditors for purchases and other current
liabilities.
  Funds required to carry the remaining current assets may be called the working capital gap
which can be bridged partly out of borrower’s funds and long term borrowing and partly by
bank borrowings.
 In the context of the above approach, the alternatives (popularly known as methods of lending)
for working out the maximum permissible level of bank borrowings were suggested.
First Method of Lending
 Banks can work out the working capital gap, i.e., total current assets less current liabilities
other than bank borrowing and finance a maximum of 75% of the gap; the balance to come out
of long term funds, i.e., own funds and long term borrowings.
Second Method of Lending
 The working capital gap is calculated as mentioned above and the same is financed out of
own/ long term sources and the bank borrowings. The own/ long term sources must be 25% of
the total current assets and the remaining portion of working capital gap will be met by the
borrowings.
 In other words, borrower is to provide for a maximum of 25% of total current assets out of long
term funds. Total current liabilities, inclusive of bank borrowings, will not exceed 75% of current
assets.

Third Method of Lending

 The borrower should provide for entire core current assets and 25% of the current assets over
the core current assets. This method was not accepted.

Deficiencies in the MPBF System

Based on experience, the following deficiencies were observed in the MPBF system:
 Typically, for most companies the MPBF is computed as at a particular date. This may
or may not coincide with the peak working capital requirements of the company. If it does not,
the company generally may run short of funds during peak season when working capital
requirements are maximum. Getting ad-hoc advances from banks, at the time it is needed, is
difficult task.
 The second short-coming is relating to laying down of norms for various industries.
Although, it is desirable that every company should achieve optimum levels of working capital
requirements, this cannot always be the case. Typically, a new company may be required to
stock higher levels of inventory or offer higher credit period, whereby increasing levels of
debtors. Banks should not deny this genuine funds requirement only because it exceeds
certain predetermined levels.
 The methodology for calculating MPBF is such that if a company has availability of
finance for more than 25% of the current assets through long term borrowings, then the whole
amount is netted out while calculating the MPBF. This essentially means that for such
companies, the borrowing limit in terms of MPBF is reduced. And a question is raised ‘Why
should good companies be penalized for this’?
Is there any alternative to MPBF System?
In the liberalization era of today, the flexibility in the matter of assessment of working capital
finance is very much needed. However, a revised system for assessment of working capital limits has
to be evolved which is acceptable to all banks. But many bankers had given the following views in
favour of the existing MPBF system.
 (i) Abolishing the MPBF overnight will be rather dangerous. It is a system that has been with banks
for a long period and cannot be abolished overnight. Several smaller banks rely on larger banks for
their credit appraisal, and if MPBF is done away with, things will be hard for them.
(ii) While the new system of assessment of working capital requirements needs to be more flexible
after taking into consideration the changing form and needs of industry, the time tested Tandon-
Chore formula of arriving at this should not be discarded completely. Since banks do not have an
alternate credit policy at present, any attempt to do away with the existing system would create
chaos.
(iii) The new system, as suggested by the RBI, envisages a changeover, to an assessment based
on cash flows and cash budgets to arrive at the cash gap of borrower. This will require a continuous
flow of information from borrowers on a monthly basis. Given the present level of management
information system in most companies, bankers question the ability and quality of information that
borrowers will be able to provide.
(iv) The RBI has not given any specific time frame for the changeover, but left it to the discretion of
banks. Even while bankers feel that they cannot discard the MPBF concept overnight, they can no
longer be strictly guided by past formulae. They would have to eventually exercise their risk taking
capacities in order to lend. The borrower and his needs will be central in the new scheme of things.
(v) It is doubtful if the inventory norms and MPBF would really disappear in practice. Their ghosts
in some form or another would continue and the banks in India are not going to turn credit decision
into a game without any rules.
(vi) Indian system is now moving a step further from need based lending to lending based on
credit rating or credit worthiness.
(vii) It may be really a wrong step if bankers are once again pressurized to give more money to
corporate under the influence of the industrialists’ lobby.

TURNOVER METHOD
 Acceptance of the recommendations of Nayak Committee suggesting ‘Turnover Method’ for
assessment of fund based working capital limits of less than Rs. 1 crore has since been
increased to Rs. 5 crore by the RBI now.
 Working capital requirements of all the borrowers enjoying aggregate fund based working
capital limits upto Rs.5 crore from the banking system are being assessed on the basis of a
minimum of 25% of their projected annual turnover.
 The banks have to ensure maintenance of minimum margin of 5% of the annual turnover of
such borrowers and remaining 20% has to be financed as working capital limit.
 In other words, 25% of the output value should be computed as working capital requirement, of
which at least four fifth should be provided by banks and balance one fifth should be brought
by way of promoters’ contribution towards margin money.

CASH FLOW METHOD

For better understanding of the assessment of working capital requirement through Cash Flow
Method, a format given below may be used-

Cash Receipts
(a) From Long Term Sources
(i) Equity
(ii) Deposits/Loans from Friends and Relatives
(iii)Inter Corporate Deposits
(iv)Term Loans
 (v) Sale of Fixed assets
(A) Total Cash Receipt from Long Term Sources
(b) From Short Term Sources
(i) Cash Sales
(ii) Realisation of book debts
(iii)Advances from Customers
(iv)Other Income (Non-operational receipts)
(B) Total Cash Receipt from Short Term Sources
(C) Total Cash Receipts (A+B)

Cash Payments
(a) For Long Term Uses
(i) Investments/Fixed Assets, etc.
(ii) Instalments of term Loans
(D) Total Cash Payment for Long Term Uses
(b) For Short Term Uses
(i) Payments to suppliers of raw materials/stores, etc.
(ii) Payments for manufacturing, selling, administrative and general expenses.
(iii)Financial costs
(iv)Advances to suppliers of raw materials
(v) Non-operational payments
(E) Total of Cash Payments for Short-Term uses
(F) TOTAL OF CASH PAYMENTS (D+E)
Monthly deficit (F-C) will be met by Bank Borrowing.
Monthly surplus (C-F) will reduce Bank Borrowing.
This way peak and non-peak level requirements will automatically be taken care of. Initially
payments will be on higher side and the gap will be met by Bank Borrowings.

Prepared by:

Arvind Paranjape, M.Sc. CAIIB

[email protected]
9425067026