NMIMS MUMBAI

Teaching Note
For Case Study on Working
Capital Financing
Submitted By

Amruth Jayaram F025

Surbhi Kaushal F029
Yash Mukhi F038
Jai Singhal F061
Saumya Aggarwal G004
Kshitij Mittal H037
Arunima Sodhani H063
Statement of Relevance

This teaching note accompanies the case study based on ‘Working Capital Financing for a
Manufacturing Company’ submitted by Group 4.

From a teaching point of view this case allows the instructor to explain working capital financing
by using the practical example of a manufacturing company called Northern Forgings Pvt Ltd.
This case highlights the entire process of calculation of the working capital need, internal
appraisal process of a bank and the various regulations and requirements for the same.

Learning Objectives

Important discussion points and lessons emphasized by the case:

 To explain the concept of working capital financing;

 To give an understanding of the various methodologies of working capital finance;
 To understand the intricacies of the CMA format;
 To go through the appraisal process and components of appraisal by the bank;
 To take the decision from the perspective of a banker who needs to balance the bank’s
relationship with the customer and bank regulations simultaneously.

Teaching Notes

Working capital is connected to the liquidity and assets required for the day-to-day operations of
the company. Commonly defined as the difference between the current assets and the current
liabilities, companies often require a huge amount of working capital on a regular basis. There
are two types of working capital:

Gross Working Capital – Defined as the value of Current Assets

Net Working Capital – Current Assets-Current Liabilities

Current assets are those assets which are expected to be sold or consumed through the normal
course of operations of a business either within the current fiscal year or operating cycle
(whichever period is longer). Typically, current assets include cash, cash equivalents, short-term
investments, accounts receivable, stock inventory and the portion of prepaid liabilities.
Current liabilities are all liabilities of the business that need to be settled within the fiscal year or
the operating cycle of a given firm, whichever period is longer. Some examples are sundry
creditors, accounts payable, current portion of long-term debt etc.

The need for working capital arises due to the time lag between production of goods and the
realisation of cash. This lag can be depicted by the operating cycle shown in Figure 1 below:

Figure 1

This is known as the operating cycle or cash conversion cycle which shows the intermediate
steps from the stages of production to the actual receipt of cash. Goods are converted into cash
only after completion of this cycle. The time taken at various stages of this cycle is calculated
using the holding periods for the various components namely: Raw Material Holding Period,
Work in Progress Holding Period, Finished Goods Holding Period and Debtors Collection
Period.

Apart from this by calculating the Creditors Holding Period we can also ascertain the time lag
with which a company pays its creditors. The sum of the rest minus Creditors Holding Period
would give the net operating cycle indicating again the time taken by a company to convert cash
into goods and then back into cash, but this time factoring in creditors as well.

Since, mostly the current liabilities are not sufficient to take care of the liquidity needs to
completing the entire operating cycle for all goods, working capital financing is required to
finance the capital needed to complete the operating cycle.
Working Capital Financing can be done through various types of credit mechanisms but the
most common in the case of a manufacturing company is the Cash Credit Facility and the main
focus of this case study, hence only that will be explained.

The Cash Credit Facility is a type of line of credit under which a customer of a bank is allowed
an advance up to a certain limit by bank to carry on business operations. Through a running
account, drawings within the drawing limit are permissible. This limit is calculated on the basis of
composition of current assets and current liabilities as per the financial statements in the
prescribed format provided to the bank and as decided by due diligence and the appraisal
process conducted by the lender.

The extent of working capital finance that can be granted by a bank is assessed through various
methods as have been elicited by the various committees set up by the government. A brief
description of each committees, its objectives, recommendations and methodology suggested is
as follows:

Tandon Committee

The Reserve Bank of India setup a committee under the chairmanship of Shri P.L. Tandon in
July, 1974 with the following objectives:

 Establishing guidelines for commercial banks to follow up and supervise credit from the
point of view of ensuring proper end use of funds and keeping a watch on the safety of
advances;

 Delineating the type of operational data and other Information that may be obtained by
banks periodically from the borrowers and by the RBI from the leading banks;

 Setting the inventory norms for the different industries, both in the private and public
sectors and indicating the broad criteria under which permitted to deviate from these
norms;

 Defining the resources for financing the minimum working capital requirements;

 Fixing the criteria regarding satisfactory capital structure and sound financial basis in
relation to borrowings;

 If the existing pattern of financing working capital requirements by cash credit/overdraft

system etc., required to be modified, if so, to suggest suitable modifications.

The committee came out with the following recommendations:

 Inventory Norms: The borrower is allowed to hold only a reasonable level of current
assets, particularly inventories and receivables. The committee also suggested the
norms for holding periods for almost fifteen different industries. Subsequently, much of
this list was revised and extended. Only the normal inventory levels based on a
production plan, lead-time of supplies, economic ordering levels and reasonable safety
factors should be financed by the banker.

 Style of Lending: Is suggested that the cash credit limit should be bifurcated into two
components i.e. Minimum level of borrowing required throughout the year should be
 financed by way of a term loan and the demand cash credit to take care for fluctuating
requirements.

 Credit Information Systems: The committee recommended the submission of a

quarterly reporting system based on actual as well as estimations, so that the
requirements of working capital may be estimated on the basis of production needs.

 Follow up, Supervision and Control: The committee suggested that there should be a
proper system of supervision and control.

 Methods of Lending: The committee proposed three methods of lending which come to
be popularly known as the maximum permissible bank finance system of lending, or in
short, MPBF system. The three methods are explained as follows:

Let’s assume a company with Rs.370 cr of Current Assets and Rs. 350 cr of Current
Liabilities (including Rs.200 cr of Bank borrowings). Take Core Current Assets as Rs.92
cr. Calculate the MPBF using each of the three methodologies proposed by the Tandon
Committee.

Methodology 1 Methodology 2 Methodology 3

Current Assets = Rs.370 cr Current Assets = Rs.370 cr Current Assets = Rs.370 cr
Less Less Less Core Current Assets = Rs.92 cr
Current Liabilities other than Bank 25% Long Term Sources = Rs.92 cr (Assuming)
Borrowings = Rs.150 cr
Less 25% Long Term Sources = Rs.
Working Capital Gap = Rs.220 cr Less 92 cr
Less CL other than Bank Borrowings = Less Current Liabilities other than
25% Long Term Sources = Rs.55 cr Rs.150 cr Bank Borrowings = Rs.150 cr

MPBF= Rs.165 cr MPBF = Rs.128 cr MPBF=58.5

Excess Borrowing Excess Borrowings Excess Borrowings

Bank Borrowings – MPBF Bank Borrowings – MPBF Bank Borrowings – MPBF
Rs200 cr – Rs.165 cr = Rs.35 cr Rs200 cr – Rs.128 cr = Rs.72 cr Rs200 cr – Rs.58.5 cr = Rs.141.5 cr

Current Ratio Current Ratio Current Ratio

370/ (165+150) = 1.17 370/ (128+150) = 1.33 370/ (58.5+150) = 1.77

Excess Borrowings in each case are treated as a working capital term loan (WTCL) which has to be
repaid over a period of minimum 5 years.
Chore Committee

Post the implementation of Tandon Committee recommendations, the quality of lending saw
great levels of improvement but the cash credit system was not implemented by several banks,
as they wouldn’t divide the working capital limit into demand loan and cash credit facility. Hence
the RBI appointed a committee in April 1979, headed by Shri KB Chore, to give fresh
recommendations for the cash credit system.

The objective set for the group was to suggest alternative credit facilities to ensure greater credit
discipline and enable banks to relate credit limits to higher output and efficiency.
The following were the major recommendations of the committee:

 Continuance of the existing system: the existing cash credit system shall be continued
with a compulsory periodic review of existing borrowal accounts having working capital limits
of Rs.10 lakhs and above at least once a year.

 No Bifurcation of Cash Credit accounts: RBI’s ruling to bifurcate the cash credit account
into Demand loan component and Cash credit portion and to maintain differential interest
rates be withdrawn with immediate effect.

 Separate level for peak level and non-peak level periods: banks should fix separate
limits for normal and peak level requirements indicating the periods for the two limits, which
can be based on past utilisation.

 Enhancement of Borrower’s Contribution: It was suggested that all borrowers shift to

second method of Tandon Committee to ensure a minimum current ratio of 1.33:1.

 Reducing Over-Dependence on Bank Borrowings: Medium and large borrowers shall

reduce their dependence on bank borrowings for WC purposes by utilising the cash
generated within the unit.

 Sanction of Ad hoc or Temporary Limits: Full discretion has been given to banks to
sanction ad hoc facilities based on commercial judgement and merits of individual case.
Banks are no longer required to charge additional interest of 1 per cent over and above the
normal rate of interest for sanction of ad hoc limits.

 Compulsory Implementation: all the aforementioned recommendations be implemented

compulsorily where borrowers have Working capital limits of Rs.50 lakhs and above from the
banking system. This would progressively apply to all accounts with working capital limit of
Rs.10 lakhs and above.

 Non- submission of QIS statement: The drawings in credit accounts of all borrowers
enjoying total working capital limits of Rs.100 lakhs and above from the entire banking
system are to be regulated by fixing operative limits based upon the data furnished in
'Quarterly Information System' (QIS). Any default in submission of statements under QIS
shall attract penalty and the banks will charge penal interest of at least 1 % per annum for a
 period of one quarter on entire outstanding under various working capital limits sanctioned
to the borrower. The charging of additional penal interest which was hitherto mandatory has
now been left to the discretion of banks.

 Diversion of working capital finance: The funds lent by the banks against working capital
limits are required to be utilised for meeting genuine working capital needs of the borrowers
and cannot be allowed to be diverted for other purpose such as investment in finance
companies, associate companies/subsidiaries, inter-cooperate deposits etc.

 Exception: The instructions under the Ad hoc/Temporary limits and Enhancement of

borrower’s contribution shall not apply to Sick units under nursing programme or where
rehabilitation programme is under active consideration

Nayak Committee

This committee was set up in 1991, headed by Shri P.R Nayak, in order to examine the
adequacy of institutional credit to the SSI sector. The SSI sector plays an important role in
overall industrial production, hence a special package for SSIs was advised by the Nayak
Committee, keeping in mind the lack of proper and verifiable accounting records, increasing
cost of raw material, and locking up of funds due to delay in realisation of sales proceeds from
large, institutional and Government clients.

The major recommendations of the committee were:

 Village Industries and the smaller Tiny Industries with credit limits upto Rs.1 lakh should
have the first claim on the priority sector credit to the SSI

 Bank branches should give priority to those Village Industries and the smaller Tiny
Industries which can use working capital efficiently, having established production
successfully but unable to make further progress for lack of working capital

 The new priority sector credit dispensation, when adopted, should fully provide for the
working capital requirements of all tiny units up to credit limits of Rs.10 lakhs, after first
taking care of the working capital allocation made for village Industries and the smaller Tiny
Industries with credit limits up to Rs.1 lakh. A specific allocation to the larger tiny units
should be made by fixing their proportion of the credit to the total priority sector credit.

 Collateral security and/or third party guarantee should be dispensed with as a rule,
irrespective of the amount of credit involved. Where collateral security is taken, the bank
should return it to the borrower, after a stipulated minimum period, if the unit has been
functioning well and the operations in its various borrowal accounts have been satisfactory.
No applications for advances should be rejected merely for want of collateral security.
 Methods of Calculating Working Capital Requirement under Nayak Committee

The Nayak committee recommended calculation of working capital requirement on the basis of
Projected Annual Turnover (PAT).

Following were the conditions:

 WC requirement is computed at 25% of accepted sales (Projected Annual Turnover)

 Bank finance is 80% of the WC requirement, i.e. 20% of PAT

 The SSI units are required to bring in it at least 5% of PAT as margin money

 If existing Net WC is greater than 5%, it is to be retained

Following is an example to depict the calculation:

A Projected Annual Turnover - 120 lakhs

B WC required 25% of A 30 lakhs
Minimum Margin from
C 5% of A 6 lakhs
borrower
D Minimum Bank Borrowing 80% of B 24 lakhs
E Actual NWC available - 5 lakhs
F Margin Stipulated Higher of C or E 6 lakhs
G Limit Permissible B-F 24 lakhs

Kannan Committee:

The Indian Bank Association (IBA), in 1997, constituted a committee on Assessment of MPBF.
The group was headed by Shri K. Kannan, Chairman and Managing Director of Bank of Baroda.
The committee sought to empower banks with more autonomy in regard to credit policy and
administration as per their individual risks, so that a flexible system may be devised.

The conditions set by Kannan committee were:

 For borrowers with WC requirement upto Rs.25 lakhs, assessment may be made upon an
overall study of existing and projected business

 For WC requirement between Rs.25 lakhs and Rs.5 Cr, Nayak Committee method may be
followed

 For WC requirement more than Rs.5 Cr, Cash Budget Method may be followed
  The above cut off limit is only indicative. Each bank may decide appropriate cut off limit
depending upon size of the Bank and other allied factors.

 Corporate borrowers may be allowed to issue Short Term Working Capital Debentures of 1
to 1-1/2 year maturity. Bank may subscribe to such debentures as working capital
assistance.

The major recommendations of Kannan Committee were:

 The arithmetical rigidities imposed by Tandon Committee and reinforced in the Chore
Committee in the form of MPBF computation should be scrapped.

 The Line of Credit System (LCS) as practiced in many advanced countries should
replace the existing system of assessment/fixation of sub limits within total Working
Capital requirements.

 To shift emphasis from Liquidity Lending (Security Based Lending) to the cash Deficit
Based Lending called Desirable Bank Finance (DBF).

 Borrowers with working capital requirements over Rs.20crores may be granted the
facility 100% by way of loan. Borrowers with working capital requirements over Rs.10
crores but up to Rs.20 crores may have 75% of Loan component and borrowers with
working capital requirements over Rs.5 crores but up to Rs.10 crores may have 60% of
Loan component.

 Loan component wherever stipulated in accordance with the above may be spread over
various maturity base after assessing needs of the borrowers and source of repayment.
Hence loan components may be 3 months, 6 months, 9 months and 12 months tenure
subject to allowing roll over at Bank's discretion.

 Margin and holding level of Stocks, Book Debts etc. as security for working capital
facility may entirely be left to the discretion of the bank. If any Bank so desires, it may
continue to follow Tandon/Chore Committee guidelines.

 Periodical statement of stock, book debts coupled with physical verification of securities,
business site of the borrower should continue to be the basic credit monitoring tool of the
banks. Along with periodical stocks, book debts statement, borrower must mention data
relating to production, sales and other assumptions on which working capital
assessment is made.

 Quarterly Information System (QIS) and Credit Monitoring Arrangement (CMA) may
cease to be a Regulatory requirement. However, individual banks may continue to obtain
QIS statement if they so desire as per their Loan Policy.
 Methods Of Calculating Working Capital Requirement Under Kannan Committee

Operating Cycle Method:

Operating cycle begins with acquisition of raw materials and ends with collection of receivables.

Operating Cycle (in days) =

Raw materials (RM/RM consumption) + Work-in-process (WIP/COP) + Finished Goods
(FG/COS) + Receivables (Debtors/Credit sales) - Creditors (creditors/purchases)

Following is an example to depict the calculation:

A Procurement of raw materials 30 days

B Conversion time 15 days

C Average Inventory holding period 15 days

D Average collection period 30 days

E Average payable period 30 days

F Total operating cycle (A+B+C+D-E) 60 days

G No. of operating cycle per year (360/60) 6

H Total operating expenses per annum Rs.60 lakhs

I Total turnover per annum Rs.70 lakhs

J Working Capital requirement 60/6 = Rs.10 lakhs

Drawing Power Method:

It refers to the extent of finance a borrower can avail at any given point of time. It is arrived at on
the basis of valuation of current assets after deducting the stipulated margin.

Following is an example to depict the calculation:

Less: Margin
A Semi-finished goods 10 lakhs DP= 7.5 lakhs
25%

Less: Margin
B Finished goods 5 lakhs DP= 2.5 lakhs
50%

5 lakhs (10 lakhs- 5 Less: Margin

C Book Debts - Creditors DP= 3 lakhs
lakhs) 40%

D Total Drawing Power (A+B+C) 13 lakhs

Cash Budget Method:

Under the cash flow based lending method, or the cash budget method, bank finance is just
equal to cash deficit which arises when cash receipts fall short of cash payments and is hence
more SME-friendly.

Bank finance is sanctioned in the form of short term loan which may be repaid in suitable
instalments. This is well suited particularly when SME units are dealing in seasonal products /
construction activities / order based activities. The customer is assured of bank finance which is
based on projected cash flows which are estimated by him and approved by the bank. Hence,
the Cash Flow Based Lending method is popular in developed countries.

There are a few drawbacks to this method:

 Heavy reliance on entrepreneur’s estimates of cash flows, which can be easily overstated
 Credit risk is on the higher side due to lack of transparency and verifiability
 Non-availability of stock statement

In order to accommodate for these drawbacks, the end use of funds is ensured through the
monitoring of cash flows i.e. actual cash flows are compared with budgeted cash flows
Following is an example to depict the calculation:

In the above case, the maximum cash deficit is Rs.96 lakhs. This is hence the maximum that
can be drawn from the account. But the firm will be permitted to do so only as per budgeted
cash deficit. Hence in April, the firm can draw up to Rs 32 lakhs only. In July, August and
September, the firm is not allowed to draw any amount since cash inflows are likely to be
greater than cash outflows.
Excess drawing is allowed up to 10% of budgeted cash deficit if need is genuine. It is mandatory
for a borrower to submit a statement of actual cash receipts and cash payments within a week
as soon as the month gets over.
Explanation of the CMA Format

The above methodologies are calculated based on the financial statements as prepared in the
prescribed format i.e. the CMA (Credit Monitoring Arrangement) Format. Here are a few
intricacies of the format.

Notes on classification of Current Assets & Current Liabilities:

1. Investment in shares, debenture, etc. and advances to other firms/companies, not

connected with the business of the borrowing firm, should be excluded from current
assets. Similarly investment made in units of Unit Trust of India & other mutual funds &
in associate companies/subsidiaries, as well as investment made and/or loans extended
as inter-corporate deposits should not be included in the build-up of current assets while
assessing maximum permissible bank finance.
2. The borrowers are not expected to make the required contribution of 25 per cent from
long-term sources in respect of export receivables. Therefore, export receivables may be
included in the total current assets for arriving at the maximum permissible bank finance
but the minimum stipulated net working capital may be reckoned after excluding the
quantum of export receivables from the total current assets.

3. ‘Dead inventory’ i.e. slow moving or obsolete items should not be classified as current
assets.

4. Security deposits/tender deposits given by borrower should be classified as non-current

assets irrespective of whether they mature within the normal operating cycle of one year
or not.

5. Advances/progress payments from customer should be classified as current liabilities.

However, where a part of advances received is required by government regulations to
be invested in certain approved securities, the benefit of netting may be allowed to the
extent of such investment and the balance may be classified as current liability.

6. Deposits from dealers, selling agents, etc. received by the borrower may treated as term
liabilities irrespective of their tenure if such deposits are accepted to be repayable only
when the dealership/agency is terminated. The deposits, which do not fulfill the above
condition, should be classified as current liabilities.

7. Disputed liabilities in respect of income tax, excise, custom duty and electricity charges
need not be treated as current liabilities except to the extent of provided for in the books
of the borrower. Where such disputed liabilities are treated as contingent liabilities for
period beyond one year, the borrower should be advised to make adequate provision so
that he may be in a position to meet the liabilities as & when they accrue.

8. If disputed excise liability has been shown as contingent liability or by way of notes to the
balance sheet, it need not be treated as current liability for calculating the permissible
bank finance unless it has been collected or provided for in the accounts of borrowers. A
certificate from the Statutory Auditors of the borrowers may be obtained regarding the
amount collected from the customers in respect of disputed excise liability or provision
 made in the borrowers’ accounts. The amount of excise duty payable should be treated
as current liability for the purpose of working out the permissible limit of the bank finance
strictly on the basis of the certificate from the borrowers’ Statutory Auditors. The same
principle may also be applied for disputed sales tax dues.

9. In case of other statutory dues, dividends, etc., estimated amount payable within one
year should be shown as current liabilities even if specific provisions have not been
made for their payment.

10. As per the instructions issued by the Reserve Bank in October, 1993, the entire term
loan investment falling due for payment in the next twelve months need not be treated as
an item of current liabilities for the purpose of arriving at MPBF. However all overdue
term loan should be treated as current liabilities unless the loan has been rescheduled
by the financial institutions/banks. It may be added that the entire amount of term loan
installments payable within the next twelve months which is kept outside the current
liabilities while calculating MPBF. Need not be taken into account while computing net
working capital (NWC). However the entire amount of term loan installments due within
the next twelve months should continue to be treated as current liability for the purpose
of calculating the current ratio.

Information/Data required for assessment of working capital:

In order to assess the requirements of working capital on the basis of production needs, it is
necessary to get the data from the borrowers regarding their past/projected production, sales,
cost of production, cost of sales, operating profit, etc. in order to ascertain the financial position
of the borrowers & the amount of working capital needs to be financed by banks, it is necessary
to call for the data from the borrowers regarding their net worth, long term liabilities, current
liabilities, fixed assets, current assets, etc.

The Reserve Bank prescribed the forms in 1975 to submit the necessary details regarding the
assessment of working capital under its credit authorization scheme. The scheme of credit
authorization was changed into credit monitoring arrangement in1988. The forms used under
the credit authorization scheme for submitting necessary information have also been simplified
in 1991 for reporting the credit sanctioned by banks above the cut-off point to reserve bank
under its scheme of credit monitoring arrangement.

In addition to the information/data in the prescribed forms, bank may also call for additional
information required by them depending on the nature of the borrowers’ activities & their
financial position. The data is collected from the borrowers in the following six forms: -

A. Particulars of the existing/proposed limits from the banking system (Form I)

Particulars of the existing credit from the entire banking system as also the term loan
facilities availed of from the term lending institutions/banks are furnished in this form.
Maximum & minimum utilization of the limits during the last 12 months outstanding
balances as on a recent date are also given so that a comparison can be made with the
limits now requested & the limits actually utilized during the last 12months.
 B. Operating Statement (Form II)

The data relating to last sales, net sales, cost of raw material, power & fuel, direct labor,
depreciation, selling, general expenses, interest, etc. are furnished in this form. It also
covers information on operating profit & net profit after deducting total expenditure from
total sale proceeds.

C. Analysis of Balance Sheet (Form III)

A complete analysis of various items of last year’s balance sheet, current year’s estimate
& following year’s projections is given, in this form. The details of current liabilities, term
liabilities, net worth, current assets, other non-current assets, etc. are given in this form
as per the classification accepted by banks.

D. Comparative statement of current assets & current liabilities (Form IV)

This form gives the details of various items of current assets and current liabilities as per
classification accepted by banks. The figures given in this form should tally with the
figures given in the form III where details of all the liabilities & assets are given. In case
of inventory, receivables and sundry creditors; the holding/levels are given not only in
absolute amount but also in terms of number of month so that a comparative study may
be done with prescribed norms/past trends. They are indicated in terms of numbers of
months in bracket below their amounts.

E. Computation of Maximum Permissible Bank Finance (Form V)

On the basis of details of current assets & liabilities given in form IV, Maximum
Permissible Bank Finance is calculated in this form to find out credit limits to be allowed
to the borrowers.

F. Fund Flow Statement (Form VI)

In this form, fund flow of long term sources & uses is given to indicate whether long term
funds are sufficient for meeting the long term requirements. In addition to long term
sources and uses, increase/decrease in current assets is also indicated in this form.

The Appraisal Process by the Bank

Apart from the above stipulated regulations that a banker has to abide by and the correct
calculation of the MPBF to the borrower, there are several other aspects of the appraisal
process for a bank. It is required that comprehensive assessment of the borrower is done to be
able to take the decision of whether credit may or may not be extended by the bank.

A loan officer appraising a borrower for working capital finance would look at the following
features:

1. Previous Relationship with bank: What has been the previous relationship of borrower
with bank, what kind of lending facilities are available to him already, does he pay on time
or not, any defaults etc.
 2. Company Background: A thorough check of the company’s business, the activities it is
involved in, plant/office locations etc.

3. Purpose of Credit Extension: The appraisal can be for several reasons an enhancement
proposal, renewal proposal, ratification or a extending new line of credit altogether etc.
This should be kept in mind whilst making a financing decision.

4. Financial Analysis: This includes looking at the company’s cash flow projections, debt
service capacity, vetting the projected sales and production figures etc. It is an
assessment of the financial position of the firm by looking at both the historical and
projected figures for the company. As a norm, banks usually look at 2 years of historical
data, the current year figures and 2 years of projected/estimated financials.

5. Qualitative Assessment: A check of the character and capabilities of the persons to

whom the loan is to be extended. For a company the promoters will be the ones under
assessment. Determining the quality, breadth and depth of the management team is also
necessary as they are the ones at the helm of operations for a company. Assessing their
ability to implement operational and financial plans.

6. Due diligence: Often to check the validity of the claims of the borrower, lenders may
undertake plant tours, trade checks, interviews with borrower’s competitors, suppliers, etc.

7. Determining Bank’s Ability and Willingness to Lend: The bank also has to keep in
mind the RBI directives on exposure to a borrower such as the prudential exposure norms
as well as its own internal policy on how much can be lent to a single borrower.

Based on the above factors with a combination of the Working capital calculation through an
appropriate methodology and the financial analysis based on the CMA Format, a lender comes
to the decision of to lend or not and if yes, then how much is to be lent.

The lender may structure the credit facility and agreement with the borrower by including the
following components:

1. Amount and Terms of Credit Facility: Describes how much and when the borrower
may borrow, the interest provisions, repayment terms, additional fees etc.

2. Conditions Precedent: Sometimes banks may regulate their interest through certain
conditions such as causing the borrower to maintain a certain level of liquidity, solvency,
provision of some no objection certificate etc. before the credit can be extended.

3. Representations and Warranties: In appraisal the bank relies on certain information

furnished by the borrower and hence, makes assumptions about the borrower’s legal
 status, creditworthiness etc., so this pertains to the financial statements being correct, no
litigation etc.

4. Covenants: Covenants basically entail from the negotiations of the agreement and are
the any particular conditions binding on the borrower for the duration of the agreement
so for e.g. a borrower may be directed to maintain a Current Ratio of 1.5 as long as the
credit facility has been given to him.

5. Events of Default: Defines the rights of the banker in the case of default

6. Charge Creation for Security: If any security is given as collateral what is the right of
the bank, first charge, secondary charge etc.

7. Monitoring of Borrowal Account: Manner of monitoring of the account an credit

extended. For e.g. submission of say monthly stock statements, receivables account etc.

Synopsis of Case

Northern Forgings Pvt. Ltd. is a reputed manufacturer of cold and hot forged steel and
aluminium parts in Northern India. With state of the art in house tool room and self-developed
forging technology NFPL has been serving customers in the Automotive as well as Non-
Automotive industry since its inception. NFPL has a manufacturing unit at Sonepat, Haryana.
Recently the CFO of the company, Mr. Prem Chopra had a meeting with a new client and got a
new order for the company. To meet this new order NFPL would be requiring higher working
capital and thus an increased credit facility from its banker, Dicor Bank. NFPL currently enjoys a
credit facility of 250 Lakh with Dicor bank and Mr Chopra will be meeting the branch manager of
the bank to enhance this limit to 300 Lakh.

Questions and Solutions to the Case

Questions

1) Prepare CMA format for NFPL based on the balance Sheet and Income statement
provided.
2) Calculate the MPBF according to Turnover Method. Does the MPBF calculated through
this method fulfil the needs of NFPL?
3) Calculate the MPBF using Tandon committee Method 2. Does the MPBF fulfil the needs
of NFPL?
4) Calculate the following ratios and comment on them:

a. Growth
b. Profitability
c. Net worth
d. Solvency Ratio
e. Liquidity
 f. Efficiency
g. Working Capital Management

5) Comment on the various aspects of appraisal in this case for the company and decide
whether credit is to be extended or not. If yes, how much is to be issued?

Solutions

1) CMA format for NFPL based on the given balance sheet, income statement and fund
flow statements is presented in an excel sheet (as an attachment to this submission).

2) NFPL has requested for SOD limit of ₹300.00 lakhs which cannot be provided
according to turnover method. The calculations are as follows:

Projected by Accepted by
the party Branch/RO
A) Projected Gross Sales 1350.00 1510.20
B) Working capital requirements at 25% of A 337.50
C) Margin to be provided by the borrower at 67.50
5% / 6.25% of A or Actual NWC available
[whichever is higher]
Eligible Working Capital finance ( B - C ) 270.00

3) The limit of ₹300.00 lakhs under Tandon Committee second method is justified and we
may accept it.

Working Capital gap A 173.76 311.85 430.36 442.24

Minimum stipulated Net 108.07 112.20 129.50 132.51
Working Capital (25% of
CA, excluding Export
receivables) B
Actual/Proj.NWC C -74.68 41.96 130.36 142.24
A–B I 64.89 199.65 300.86 309.73
A–C II 248.44 269.89 300.00 300.00
Eligible Working Capital 64.89 199.65 300.00 300.00
Limit (Lower of I or II)

4) Comments on financials (covering aspects like growth, profitability, solvency, liquidity,

debt service, efficiency, working capital management etc.)

 Growth: Turnover of the company is in increasing trend it has increased to

Rs.1134.71 lacs as on 31/03/2015 in compare to1128.54 as on 2014. The Company
has projected for the year 2016 turnover of Rs.1510.20 lacs it seems that it will be
easily achievable by the company.
  Profitability: Profitability of the company has increased in comparison to the previous
year.

 Net worth: Paid up Capital and Reserve of the party is at Rs.246.73 Lacs as on
31/03/2015 and Rs 234.76 lacs as on 31.03.2014. The net worth of the company is
increased due to ploughing back of profit of the company.

 Solvency Ratio: Solvency ratio at 2.01 is within the prescribed parameters.

 Liquidity: Current Ratio of the company as on 31.03.2015 is 1.10 which is satisfactory

for the manufacturing company.

 Efficiency: Efficiency of the party is on increasing trend due to achievement of

turnover and payment of creditors.

 Working Capital Management: As per provisional balance sheet as on 31.03.215,

Net Working Capital is above the required level of 25% of the Current Asset. Debtors
and Creditors Turnover Ratio is satisfactory. AS per the Provisional Financial
Statement Drawing Power is within the sanctioned limit.

5) Appraisal note is attached additionally to this submission, kindly refer to it to bring out
the salient features of the appraisal process and utilise it to take the case forward.
Credit should be extended to Northern Forgings up till the limit of Rs. 300 lakhs as
calculated under the Second Methodology of Tandon Committee.

Teaching Plan

The instructor should start the discussion with an explanation of the concept of Working Capital
Financing as per the notes provided above. Students are expected to have read the case and
come prepared for the same.
The instructor may follow the explanation with a discussion on the facts of the case and take
opinions prima facie from the children as to whether they would extend credit to the company or
not. This will be followed by the Questions and their solutions to the case utilising the excel
sheets and appraisal note as attached to explain the entire appraisal journey and the
perspective of the banker.

Assuming two sessions devoted to the topic and the case:

Topic Time Allocation

Concept of Working Capital Finance 10 minutes

Various Committees and their Methodologies 60 minutes

CMA Format Explanation 20 minutes

Appraisal Process 20 minutes

Facts of Case and Understanding Context 10 minutes

Preparation of CMA Format for Case using 30 minutes

Excel Sheet provided

Highlighting Various Aspects of Appraisal 20 minutes

using Appraisal Note provided

Conclusion to Case 10 minutes