Any business enterprise whether engaged in manufacturing or purely trading activity, has to have sufficient capital to finance both, its fixed and long term assets, viz. land, building, machineries, etc. and to maintain certain level of short term assets for smooth conduct of day to day business activities/production schedule. Such short term assets which are required for day to day operation are called the current assets.
The amount of current assets required for a smooth conduct of business is dependent on the nature of the activity, availability of the raw materials, level of production, storage capacity and funds available. So the funds/capital actually required to maintain this required level of current assets, is called the gross working capital.
Out of the level of gross working capital, required as above, the borrower raises the necessary funds from many sources, viz. :
- Share Capital
- Retained Profits
- Bank Borrowings
- Trade Creditors
- Advance from Purchasers
Out of the above, credit available in the form of trade creditors and advance from purchasers etc., are sources of finance which are short term in nature and are available as per trade practices and market conditions. The remaining resources are, therefore, to be raised from own capital or through bank borrowing. Such short term credits available to the firm are called current liabilities and the difference of gross working capital and the current liabilities is called the 'Net Working Capital.
In any typical manufacturing unit, the components that constitute the gross working capital or current assets are as under:
- Raw materials
- Consumable stores and spares
- Stock in process
- Finished goods
- Receivables
- Cash and bank balance
Diagrammatically the above can be shown as per exhibit shown below:
(a) The firm requires a total capital of AF to maintain its level of assets comprising of fixed assets = AC and current assets = CF.
(b) The level of current assets CF is partially met by capital raised through current liabilities = EF.
(c) The total current assets is called the gross working capital (CF).
(d) If the borrower has no bank borrowings then the total current assets (CF) - current liabilities (EF) will be called his Net Working capital Gap (CE) required to be bridged.
(e) The borrower is required to raise the resources equivalent to CE from either long term sources or through short term bank borrowings.
(f) Out of this, if he brings in an amount CD, from long term sources, viz. capital, long term debts, etc., the remaining amount DE is the amount required to be financed by the Bank. So the appraisal of working capital finance by the bank requires computing the level of DE in the above diagram. In such a situation CD will be called the net working capital.
The appraisal of bank finance for working capital thus involves the following steps:
(a) Estimation of the Level of Gross Working Capital
(b) Estimation of the Level of Current Liabilities
(c) Computation of Net Working Capital Gap
(d) Computing the share of NWC Gap required to be brought by the borrower as Margin.
(e) Computation of the Level of Bank Finance.
Various methods of lending are adopted by various banks in respect of working capital finance. Our bank shall follow Permissible Bank Finance (PBF) Method for assessing the working capital requirement of the borrowers. It is mentionable that our bank is having a retail lending scheme namely “Business Loan”, wherein fund based working capital finance upto Af.2 Millions may be availed by the borrowers based on their projected sales turn-over and value of their collateral securities.