UNIT 5 Working Capital Financing 

Need and Objectives of Financing of

Working Capital, Short Term credit
The primary objective of working capital management is to ensure smooth operating
cycle of the business. Secondary objectives are to optimize the level of working capital and
minimize the cost of such funds.

The superior objective of financial management is wealth maximization and that can be
gained by profit maximization accompanied with sustainable growth and development. For
sustainable growth and development, the objectives of all the stakeholders including
customers, suppliers, employees, etc should be aligned to the growth of the organization.

This implies that the operating cycle i.e. the cycle starting from the acquisition of raw
material to its conversion to cash should be smooth. It is Objectives of Working Capital
Management not easy; it is as good as circulating 5 balls with two hands without dropping a
single one. If following 6 points can be managed, this operating cycle can be management
well.

 It means raw material should be present on the requirement and it should not be a
cause to stoppages of production.
 All other requirements of production should be in place before time.
 The finished goods should be sold as early as possible once they are produced and
inventoried.
 The accounts receivable should be collected on time.
 Accounts payable should be paid when due without any delay.
 Cash should be available as and when required along with some cushion.

LOWEST WORKING CAPITAL

Working capital here refers to the current assets less current liabilities (net working capital).
It should be optimized because higher working capital means higher interest cost and lower
working capital means a risk of disturbance of operating cycle.

MINIMIZE RATE OF INTEREST OR COST OF CAPITAL

The cost of capital utilized on working capital should be minimized so as to achieve higher
profitability. If the investment in working capital involves bank finance, interest rates should
be negotiated with the bank.
 Cost can be minimized by utilizing long-term funds but in a proper mix. While deciding the
mix of working capital, the fundamental principle of financial management should be kept in
mind that fixed assets and permanent assets should be financed by long term sources of
finance of approximately same maturity and short-term or temporary assets should be
financed by short-term sources of finance.

OPTIMAL RETURN ON CURRENT ASSET INVESTMENT

The return on the investment made in current assets should be more than the weighted
average cost of capital so as to ensure wealth maximization of the owners. In other words,
the rate of return earned due to investment in current assets should be more than the rate
of interest or cost of capital used for financing the current assets.

SHORT TERM CREDIT

Short-term loans are usually extended by financial institutions generally for a period of 1-2
years. These are mostly unsecured, which means you don’t have to pledge a collateral as
security to avail them. Though funds can be extended quickly, the reason why they are
labeled “short-term” is the associated repayment tenor (to be paid off in full within 6-18
months) rather than the speed of funding.

What differentiates such a loan from the other conventional ones in the market is the ease
of availing one. However, there are many short terms loan in India offering you the funds
you need to meet any short-term financial need. Here, we try to cover the ins and outs of
the 5 most popular sources of short-term loans, to help you make an informed decision
when it comes to availing short-term finance.

1. Trade Credit

Possibly one of the most affordable sources of obtaining interest-free funds, you can avail a
trade credit where the lender would give you the time to pay for a purchase without incurring
any additional cost. A trade credit is usually extended for a period of 30 days.

However, you can consider asking for a longer tenor that would easily fit into your plan.

A flexible repayment tenor will allow you to leverage the additional time and funds to finance
other initiatives.

2. Bridge Loans

A bridge loan will help to tide you over till the time you get another loan, usually of a bigger
value, approved. In India, such a loan assumes importance in case of transactions relating
to property. For example, if you want to buy a new house but don’t have sufficient funds
because the old one hasn’t been sold off yet. You might want to wait for the funds to come
through once you get a potential buyer for the old property, but this will have its own
downsides, including the price of the new property shooting up. 
 It is during this waiting time that you can avail a bridge loan, that offers two-pronged
benefits- it helps you with the funds to buy the property while giving you ample time to wait
and get a good deal on the old one.

3. Demand Loans

A demand loan can help you meet any urgent financial obligation. You can pledge your
insurance policies and other savings instruments such as NSCs in lieu of the loan. A certain
percentage of the maturity value on such savings instruments will determine the extent to
which you will be eligible to borrow as the loan amount.

4. Bank overdraft
This is a facility that you can avail on your current account. With an overdraft facility at your
disposal, you will be able to withdraw money despite your account not having sufficient cash
to cover such withdrawals. Essentially, it helps you to borrow money within a sanctioned
overdraft limit.

Much like any other loan, an interest rate (often lower than that on credit cards) is levied on
the outstanding overdraft balance. Having said that be wary of certain additional costs that
might be attached with such a facility, including fees per withdrawal.

5. Personal loans
You can avail a personal loan to meet a variety of needs like home renovation, wedding,
higher education or travel costs. You could also use a personal loan to meet a medical
emergency or consolidate all your existing into one.

Many lenders offer a personal loan on the basis of your income level, employment and
credit history, and perceived capacity to repay. Unlike a home or car loan, a personal loan
isn’t a secured one. This simply means that the lender will not have anything to auction in
case you default on repaying the loan amount. What differentiates a personal loan from all
the above loans is that it gives you a substantial loan amount with flexible tenor to facilitate
repayment.

Mechanism and Cost-Benefit

Analysis Of Alternative Strategies For
Financing Working Capital: Accrued
Wages And Taxes, Accounts Payable,
Trade Credit, Bank Loans,
 Overdrafts, Bill Discounting,
Commercial Papers, Certificates Of
Deposit, Factoring, Secured Term
Loans, etc.
Accrued Wages And Taxes

Accrued wages refers to the amount of liability remaining at the end of a reporting period for
wages that have been earned by hourly employees but not yet paid to them. This liability is
included in the current liabilities section of the balance sheet of a business. Accrued wages
are recorded in order to recognize the entire wage expense that a business has incurred
during a reporting period, not just the amount actually paid.

For example, Mr. Smith is paid $20 per hour. He is paid through the 25th day of the month,
and has worked an additional 32 hours during the 26th through 30th days of the month. This
unpaid amount is $640, which the employer should record as accrued wages as of month-
end. This accrual may be accompanied by an additional entry to accrue for any related
payroll taxes.

The accrued wages entry is a debit to the wages expense account, and a credit to the
accrued wages account. The entry should be reversed at the beginning of the following
reporting period.

Accounts Payable

The accounts payable process or function is immensely important since it involves nearly all
of a company’s payments outside of payroll. The accounts payable process might be
carried out by an accounts payable department in a large corporation, by a small staff in a
medium-sized company, or by a bookkeeper or perhaps the owner in a small business.

Regardless of the company’s size, the mission of accounts payable is to pay only the
company’s bills and invoices that are legitimate and accurate. This means that before
a vendor’s invoice is entered into the accounting records and scheduled for payment, the
invoice must reflect:

 what the company had ordered

 what the company has received
 the proper unit costs, calculations, totals, terms, etc.

To safeguard a company’s cash and other assets, the accounts payable process should
have internal controls. A few reasons for internal controls are to:
 prevent paying a fraudulent invoice
 prevent paying an inaccurate invoice
 prevent paying a vendor invoice twice
 be certain that all vendor invoices are accounted for

Periodically companies should seek professional assistance to improve its internal controls.

The accounts payable process must also be efficient and accurate in order for the
company’s financial statements to be accurate and complete. Because of double-entry
accounting an omission of a vendor invoice will actually cause two accounts to report
incorrect amounts. For example, if a repair expense is not recorded in a timely manner:

1. The liability will be omitted from the balance sheet, and

2. The repair expense will be omitted from the income statement.

If the vendor invoice for a repair is recorded twice, there will be two problems as well:

1. The liabilities will be overstated, and

2. Repairs expense will be overstated.

In other words, without the accounts payable process being up-to-date and well run, the
company’s management and other users of the financial statements will be receiving
inaccurate feedback on the company’s performance and financial position.

A poorly run accounts payable process can also mean missing a discount for paying some
bills early. If vendor invoices are not paid when they become due, supplier relationships
could be strained. This may lead to some vendors demanding cash on delivery. If that were
to occur it could have extreme consequences for a cash-strapped company.

Just as delays in paying bills can cause problems, so could paying bills too soon. If vendor
invoices are paid earlier than necessary, there may not be cash available to pay some other
bills by their due dates.

Trade Credit

Trade credit is an important external source of working capital financing. It is a short-term

credit extended by suppliers of goods and services in the normal course of business, to a
buyer in order to enhance sales. Trade credit arises when a supplier of goods or services
allows customers to pay for goods and services at a later date. Cash is not immediately
paid and deferral of payment represents a source of finance.

Features of Trade Credit:

1. There are no formal legal instruments/acknowledgements of debt.

2. It is an internal arrangement between the buyer and seller.
3. It is a spontaneous source of financing.
4. It is an expensive source of finance, if payment is not made within the discount
period.

Advantages of Trade Credit:

1. It is easy and automatic source of short-term finance.

2. It reduces the capital requirement.
3. It helps the business focus on core activities.
4. It does not require any negotiation or formal agreement.

Disadvantages of Trade Credit:

Like other sources of finance, trade credit is also associated with certain
disadvantages, which are as follows:

1. Trade credit is available only to those companies that have a good track record of
repayment in the past.
2. For a new business, it is very difficult to finance working capital through trade credit.
3. It is very expensive, if payment is not made on the due date.

Bank Loans

Working capital loans are as good as term loan for a short period. These loans may be
repaid in installments or a lump sum at the end. The borrower should take such loans for
financing permanent working capital needs. The cost of interest would not allow using such
loans for temporary working capital.

Overdrafts

Cash credit or bank overdraft is the most useful and appropriate type of working capital
financing extensively used by all small and big businesses. It is a facility offered by
commercial banks whereby the borrower is sanctioned a particular amount which can be
utilized for making his business payments. The borrower has to make sure that he does not
cross the sanctioned limit. The best part is that the interest is charged to the extent the
money is used and not on the sanctioned amount which motivates him to keep depositing
the amount as soon as possible to save on interest cost. Without a doubt, this is a cost-
effective working capital financing.

Bill Discounting

Invoice discounting can be technically defined as the selling of bill to invoice discounting
company before the due date of payment at a value which is less than the invoice amount.
The difference between the bill amount and the amount paid is the fee of the invoice
discounting to the company. The fee will depend on the period left before payment date,
amount and the perceived risk.

The bills or invoices under bill discounting are legally the ‘bill of exchange’. A bill of
exchange is a negotiable instrument which is negotiable mere by endorsing the name. For
 example our currency is an example of bill of exchange. Currency provides value written
over it to the bearer of the instrument. In the case of bill discounting, such bills can be either
payable to the bearer or payable to order. Therefore, after discounting a bill, a bank can
further get the bill discounted from other banks in case of cash flow requirement.

Commercial Papers

Commercial paper is an unsecured, short-term debt instrument issued by a corporation,

typically for the financing of accounts receivable, inventories and meeting short-term
liabilities. Commercial paper is usually issued at a discount from face value and reflects
prevailing market interest rates.

Commercial paper is an unsecured and discounted promissory note issued to finance the
short-term credit needs of large institutional buyers.

Features of Commercial Paper:-

1. The maturity period of commercial paper lies between 15 days to less than 1 year.
2. It is sold at a discount but redeemed at its par value.
3. There is no well-developed secondary market for commercial paper; rather they are
placed with existing investors who intend to hold it till it gets matured.

Commercial Papers have a variety of benefits to both, the issuer as well as the investor.

There are a few important things to note about Commercial Papers, such as their rules,
conditions and requirements.

Certificates Of Deposit

Certificate of Deposit (CD) implies an unsecured, money market negotiable instrument,

issued by the commercial bank or financial institution, either in demat form or as a usance
promissory note, at a discount to face value at market rates, against the amount deposited
by an individual, for a stipulated time.

In finer terms, certificate of deposit is a fixed interest bearing term deposit, which has a fixed
maturity. It limits the access to the funds, until the lock-in period of the investment, i.e. the
depositor cannot withdraw funds, on demand.

Salient Features of Certificate of Deposit

 Eligibility: All scheduled commercial bank, not including regional rural bank and
cooperative bank, are eligible to issue the certificate of deposit. It can be issued by the bank
to individuals, companies, trust, funds, associations, etc. On the non-repatriable basis, it
can be issued to Non-Resident Indians (NRIs) also.
 Maturity period: The CDs are issued by the bank at a discount to face value, at
market-related rates, ranging from 3 months to one year. When a financial institution issues
 CD, the minimum term is one year and maximum three years. In addition to this, no grace
period is allowed for the repayment of CD.
 Denomination: The minimum issue size of a certificate of deposit is Rs. 5,00,000 to
a single investor. Moreover, when the certificate of deposit exceeds Rs. 5,00,000, it should
be in multiples of Rs. 1,00,000. Add to that; there is no ceiling on the total amount of funds
raised through it.
 Transferability: Certificate of deposit existing in physical form can be freely
transferred by way of endorsement and delivery. CDs in dematerialised form can be
transferred, as per the process of other dematerialised securities.
 Reserve requirement: Banks are required to keep CRR and SLR on the issue price
of the certificate of deposit.
 Format: Banks and financial institutions can issue CD in dematerialised form only.
Although the investor, at their discretion, can seek a certificate in traditional form. Moreover,
it attracts stamp duty.
 Discount: Certificate of Deposit is issued at a discount to face value, determined by
the market, which can be front end or rear end discount. The effective rate of discount is
greater than the quoted rate in case of front end discount. On the contrary, in rear end
discount, the CDs yield the quoted rate on the expiry of the specified term.

Banks issue certificate of deposit when the deposit growth is comparatively slow, and credit
demand is high, and there is a tightening trend in the call rate. These are high-cost
liabilities, and banks take recourse of CD’s only when there exist stiff liquidity conditions in
the market.

Factoring

Factoring is an arrangement whereby a business sells all or selected accounts payables to

a third party at a price lower than the realizable value of those accounts. The third party
here is known as the ‘factor’ who provides factoring services to business. The factor would
not only provide financing by purchasing the accounts but also collects the amount from the
debtors. Factoring is of two types – with recourse and without recourse. The credit risk of
nonpayment by the debtor is borne by the business in case of with recourse and it is borne
by the factor in the case of without recourse.

Secured Term Loans

A secured term loan is a loan granted to the business where the borrower then pledges
some form of security or collateral against the loan. Our lenders look at either property
(commercial or residential) or a debtors book as security against a loan. This means that
your business cash flow and profitability is not as important as the underlying security
offered to the lender.  Because there is security, the risk is lower than an unsecured loan
and so the interest rates charged by the lender are normally lower than an unsecured loan. 
Secured loans are normally short medium term loans ranging from 6 months to 5 years
Pattern and Sources of Working
Capital Financing In India With
Reference To Government Policies
Introduction to Working Capital Financing in India:
After determining the level of working capital, there comes the question of financing.

In the present day context the sources of finance for working capital may be
categorised as:

(1) Trade credit.

(2) Bank credit.

(3) Current provisions of non-bank short-term borrowings.

(4) Long-term services comprising equity capital and long-term borrowings.

However; in India the primary sources of financing the working capital are trade credit, and
short-term bank credit, stated to have financed more than ¾ th requirements of working of
Indian industry.

Two other short-term sources of working capital finance are:

(i) Factoring of receivables.

(ii) Commercial papers.

Meaning of Trade Credit:

It refers to the credit extended by the supplier of goods and services in the normal course of
transaction/business/sale of the firm. According to trade practices cash is not paid
immediately for purchases but after an agreed period of time. Thus deferred of payment i.e.,
trade credit represents a service of finance for credit purchases.

There is however no formal/specific negotiation for trade credit. It is an informal

arrangement between the buyer and the seller. There are no legal
instruments/acknowledgements of debt which are granted on an open account basis. Such
credit appears in the records of the buyer of goods as sundry creditors/accounts payable.
 A variant of accounts payable is bills/notes payable. Unlike the open account nature of
accounts payable, bills/notes payable represent documentary evidence of credit purchases
and a formal acknowledgement of obligation to pay for credit purchases on a specified
(maturity) date failing which legal/panel action for recovery will follow.

Note:

A notable feature of bills/notes payable is that they can be rediscounted and the seller does
not necessary have to hold it till maturity to receive payment. However, it creates a legally
enforceable obligation on the buyer of goods to pay on maturity whereas the accounts
payable have more flexible payment obligations. Although most of the trade credit is on an
open account as accounts payable, the suppliers of goods do not extend credit
indiscriminately. Their decisions as well as the quantum is based on the consideration of
factors such as earnings record over a period of time, liquidity position of the firm and post
record of payments.

Advantages:

Trade credit, as a source of short terms/working capital finance, has certain advantages. It
is easily, almost automatically, available. Moreover, it is a flexible and spontaneous source
of finance. The availability and magnitude of trade credit is related to the size of operations
of the firm in terms of sales/purchases.

Example 1:

The requirement of credit purchases to support the existing sales is Rs. 5 lakhs/day. If the
purchases are made on the credit of 30 days. The average outstanding accounts payable/
trade credit (finance) will amount to Rs. 1.5 crores (30 days × 5 lakhs).

The increase in purchases of goods to support higher sales level to Rs. 6 lakhs will imply a
trade credit finance of (30 days × 6 lakhs) = 1.8 crores.

If the credit purchases of goods decline, the availability of trade credit will correspondingly
decline.

Note:

1. Trade credit is also an informal, spontaneous service of finance.

2. Does not require negotiation and formal agreement.
3. Trade credit is free from the restrictions associated with formal/negotiated service of
finance/credit.

Cost:

Trade credit does not involve any explicit interest charge. However, there is an implicit cost
of trade credit. It depends on the credit terms offered by the supplier of goods.
 Suppose, the terms of credit are, 45 days net, the payable amount to the supplier of goods
is the same whether paid on the date of purchase or on the 45th day means trade credit has
no cost or it is cost free.

But, if the credit terms are 2/15, net 45 means there is discount for prompt payment, the
trade credit beyond the discount period has a cost which is equal to –

= [(Discount/1 – Discount)] × 360 days/credit period – discount period)]

Then, explicit interest rate/cost,

= [(0.02/1 – 0.02) × (360/45 – 15)]

= [(0.02/0.98) × (360 – 30)]

= [(0.0204) × (6)]

= 0.024 or 24%

Alternatively, the credit terms, 2/15 net 45, imply that the firm i.e., buyer is entitled to 2%
discount for payment made within 15 days when the entire payment is to be made within 45
days. Since the net amount is due in 45 days, failure to take the discount means paying an
extra 2% for using the money for an additional 30 days. If a firm were to pay 2% for every
30 days period over a year, there will be 12 such periods because 360/30 = 12. This
amounts to an annual interest rate/cost of 24%.

If the terms of credit are 2/10, net 30 the cost of credit works out to 36.4%.

This means:

The smaller the difference between the payment day and the end of the discount period, the
larger is the annual interest/cost of trade credit.

Note:

1. The cost of trade credit is generally very high beyond the discount period. Firms
should avail of the discount on prompt payment. If however, they are unable to avail of
discount, the payment of trade credit should be delayed till the last day of credit (net, period
and beyond without impairing their credit-worthiness.
2. A precondition for obtaining trade credit particularly by a new company is cultivating
good relationship with suppliers of goods and obtaining their confidence by honouring
commitments.
 Bank Credit:

Bank credit is the primary institutional source of working capital finance in India. In fact, it
represents the most important source for financing of current assets.

Working capital is provided by banks in the following ways:

1. Cash credits/overdrafts (limit)

2. Loans
3. Purchase/discount bills
4. Working capital term loans
5. Letter and Credit (LC)

1.Cash Credit/Overdrafts (Limit):

Under cash credit/overdraft form/arrangement of bank finance, the bank specifies a

predetermined borrowing/credit limit. The borrower can draw/ borrow up to the stipulated
credit/over draft limit. Within the specified limit, any number of drawls/drawings is possible
to the extent of his requirements periodically. Similarly, repayments can be made whenever
desired during the period.

The interest is determined on the basis of running balance/amount actually utilized by the
borrower and not on the sanctioned limit. However, a minimum i.e., commitment charge
may be payable on the un-utilised balance irrespective of the level of borrowing for availing
of the facility.

This form of bank financing of working capital is highly attractive to the borrowers
because:

(i) It is flexible in that although borrowed funds are repayable on demand, banks usually do
not recall cash advances/roll them over.

(ii) Borrower has the freedom to draw the amount in advance as and when required while
the interest liability is only on the amount actually outstanding.

However, cash credit/overdraft is inconvenient to the banks and hampers credit planning. It
was the most popular method of bank financing of working capital in India till the early 90s.

Note:

With the emergence of new banking since the mid 90’s, cash credit cannot at present
exceed 20% of the maximum permissible bank finance (MPBF)/credit limit to any borrower.

2. Loans:
 Under this arrangement, the entire amount of borrowing is credited to the current account of
the borrower or released in cash.

The borrower has to pay interest on the total amount. The loans are repayable on demand
or in periodic installments. They can also be renewed from time to time.

As a form of financing, loans imply a financial discipline on the part of borrowers.

Note:

From a modest beginning in the early 90’s, at least 80% of MPBF/credit limit must now be in
the form of loans in India.

3. Bill Purchased/Discounted:

This arrangement is of relatively recent origin in India. With the introduction of the New Bill
Market Scheme in 1970 by RBI, bank credit is being made available through discounting of
usance bills by banks.

The RBI envisaged the progressive used of bills as an instrument of credit as against the
prevailing practice of using the widely-prevalent cash credit arrangement for financing
working capital. The cash credit arrangement gave rise to unhealthy practices. As the
availability of bank credit was unrelated to production needs, borrowers enjoyed facilities in
excess of their legitimate needs. Moreover, it led to double financing.

This was possible because credit was taken from different agencies for financing the same
activity. This was done, for example, by buying goods on credit from suppliers and raising
cash credit by hypothecating the same goods. The bill financing is intended to link credit
with the sale and purchase of goods and thus, eliminate the scope of misuse or diversion of
credit to other purposes.

The amount made available under this arrangement is covered by the cash credit and
overdraft limit. Before discounting the bill, the bank satisfies itself about the credit-
worthiness of the drawer and the genuineness of the bill. To popularise the scheme the
discount rates are fixed at lower rates than those of cash credit, the difference being about
1 – 1.5%.

The discounting banker asks the drawer of the bill i.e., seller of goods to have his bill
accepted by the drawee (buyers) bank before discounting it. The later grants acceptance
against the cash credit limit, earlier fixed by it on the basis of borrowing value of stocks.
Therefore, the buyer who buys goods on credit cannot use the same goods as a source of
obtaining additional bank credit.

The modus operandi of bill finance as a source of working capital financing is that a bill
arises out of a trade sale-purchase transaction on credit. The seller of goods draws the bill
 on the purchaser of goods, payable on demand or after a usance period not exceeding 90
days.

On acceptance of the bill by the purchaser, the seller offers it to the bank for
discount/purchase. On discounting the bill, the bank releases the funds to the seller. The bill
is presented by the bank to the purchaser/acceptor of the bill on due date for payment. The
bills can also be rediscounted with the other bank/RBI. However, this form of financing is
not very popular in the country.

4. Term Loan for Working Capital:

Under this arrangement bank advance loans for 3-7 years repayable in yearly or half-yearly
installments.

In compliance of RBI directions, banks presently grant only a small part of the fund based
working capital facilities to a borrower by the way of running cash credit account, a major
portion is in the form of working capital demand loan.

This arrangement is presently applicable to borrowers having working capital facilities of

Rs.10 crores and above. The minimum period of WCDL which is basically non-operable
account keep on changing. The WCDL is granted for a fixed term on carrying of which it has
to be liquidated renewed or rolled over.

5. Letter of Credit (LC):

While the other forms of bank credit are direct forms of financing in which banks provide
funds as well bear risk, letter of credit is an indirect form of working capital financing and
banks assume only the risk. The credit being provided by the supplier himself.

The purchaser of goods on credit obtains a letter of credit from a bank. The bank
undertakes the responsibility to make payment to the supplier, in case the buyer fails to
meet his obligations.

Thus the modus operandi of letter of credit is that the supplier sells goods on credit/extents
credit/finance to the purchaser, the bank gives a guarantee and bears risk only in case of
default by the purchaser.

Mode of Security:

Banks provide credit on the basis of following modes of security:

1. Hypothecation:

In this mode of security, the banks provide credit to borrowers against the security of
movable property, usually inventory of goods. The goods hypothecated, however, continue
to be in the possession of the owner of these goods, i.e., borrower.
 The rights of the lending bank (hypothecate) depend upon the terms of the contract
between the borrower and the lender. Although the bank does not have physical possession
of the goods, it has the legal right to sell the goods to realise the outstanding loan.
Hypothecation facility is normally not available to new borrower.

1. Pledge:

It is a different mode of security from hypothecation, unlike in the latter; the goods which are
offered as security are transferred to the physical possession of the lender.

An essential perquisite of pledge, therefore, is that the goods are in the custody of the bank.
The borrower who offers the security is called a ‘Pawnon’ or pledger while the bank is called
‘Pawnee’ or pledgee.

The lodging of the goods by the pledger to the pledgee is a kind of bailment. Therefore,
pledge creates some liabilities for the bank. It must take reasonable care of goods pledged
with it. The term reasonable care means care which a prudent person would like to protect
his property. He would be responsible for any loss or damage if he uses the pledged goods
for his own purposes. In case of non-payment of bank loans the bank enjoys the right to sell
the goods.

1. Lien:

The term lien refers to the right of a party to retain goods belonging to another party until a
debt due to him is paid.

Lien can be of following two types:

(i) Particular lien

(ii) General lien

Particular lien is a right to retain goods until a claim pertaining to these goods is fully paid.
General lien is applied till all dues of the claimant are paid.

Note:

Bank usually enjoy general lien.

1. Mortgage:

It is the transfer of a legal/equitable interest in specific immovable property for securing the
payment of debt. The person who parts with the interest in the property is called mortgagor
and the bank in whose favour the transfer takes place is the mortgagee. The instrument of
transfer is called the mortgage deed.
 Mortgage is thus, conveyance of interest in mortgaged property. The mortgage interest in
the property is terminated as soon as the debt is paid. Mortgages are taken as an additional
security for working capital credit by banks.

1. Charge:

Where immovable property of one person is by the act of parties or by the operation of law,
made security for the payment of money to another and the transaction does not amount to
mortgage, the latter person is said to have a charge on the property and all the provisions of
simple mortgage will apply to such a charge.

The provisions are as follows:

(i) A charge is not the transfer of interest in the property through it is security for payment.
But mortgage is a transfer of interest in the property.

(ii) A charge may be created by the act of parties or by the operation of law. But a mortgage
can be created only the act of parties.

(iii) A charge need not be made in writing but a deed must be attested.

(iv) Generally, a charge cannot be enforced against the transferee for consideration without
notice. In a mortgage, the transferee of the mortgaged property can acquire the remaining
interest in the property, if any is left.

Regulation of Bank Finance:

Traditionally bank credit has been an easily assessable source of meeting the working
capital needs of business firms. Indian banks have not been concerning themselves about
the soundness or otherwise of the business carried out or about the actual end use of the
loan. In other words they have been extending credit to industry and trade on the basis of
security. This resulted in a number for distortions in financing of working capital by banks.

Consequently, bank credit has been subjected to various rules, regulations and controls.
The RBI had appointed various committees to ensure equitable distribution of bank
resources to various sectors of economy. These committees suggest ways and means to
make the bank credit an effective instrument of industrialization.

Working Capital Control and Banking

Policy- Deheja Study Group, Chore
Committee, Tandon Committee
The Dahejia Committee:

In September 1969, Dahejia Committee of the RBI pointed out in its reports that in the
financing practice of banks, there was no relationship between the optimum requirements
for production and the bank loan.

The general tendency with business was to take short-term credit from banks and use it for
purposes other than production. The committee also pointed out that banks do not give
proper attention to the financing pattern of their clients. Further, the clients resort to double
financing or multiple financing of stocks.

The Dahejia Committee suggested that the banks should make an appraisal of credit
applications with reference to the total financial situations of the client.

It also suggested that all cash credit accounts should be bifurcated in the following
two:

(i) The hard core which would represent the minimum level of raw material, finished goods
and stores which any industrial concern is required to hold for maintaining certain level of
production.

(ii) The strictly short-term components which should be the fluctuating part of the account.
This part would represent the short-term increases in inventories, tax, dividends and bonus
payments.

The committee also recommended that to determine the hard core elements of cash credit
accounts, norms for inventory levels should be worked out by the chamber of industry or by
the Indian Bank Association.

It can thus be seen that the orientation towards project oriented and need based lending
was first given by the Dahejia Committee. However, in practice the recommendations of the
committee did not have more than a marginal effect on the pattern of bank financing.

Chore Committee

In April 1979, the RBI constituted a committee under the Chairmanship of Shri K.B. Chore
to review the cash credit system of lending in its entirety. The committee submitted its report
in Aug. 1979.

The main recommendations of the Chore Committee as accepted by RBI as follows:

(i) Enhancement of Borrower’s Contribution:

The committee had recommended that the Over dependence on bank credit by medium
and large borrowers should be reduced by requiring them to enhance their contribution
towards working capital.
For this purpose in assessing the permissible bank credit, the borrower should adopt the
second method of lending recommended by the Tandon committee, according to which the
borrowers contribution from own funds and term finance to meet the working capital
requirements should be equal to at least 25% of the total current assets.

This would give a minimum current ratio of 1.33:1. Whenever borrowers are not in a position
to comply with the above requirements, immediately the excess borrowing should be
segregated and treated as working capital loan (WCTL) which could be made repayable in
half yearly installments with the definite period and this period should not exceed 5 years in
any case.

(ii) Compulsory Periodic Review of Cash Credit Limits and Submission of Quarterly
Statements:

The committee recommended that in future cash credit limits of all the borrowers with
working capital limit of Rs. 10 lakhs and over should be reviewed at least once a year
compulsorily to verify the continued viability of the borrowers and to assess the need based
character of credit limits. All the borrowers with working capital limits of Rs. 50 lakhs and
over should submit quarterly statements compulsorily prescribed under the information
system designed by the Tandon Committee.

(iii) No Bifurcation of Cash Credit into Demand Loan of Core Portions and Fluctuating
Cash Credit Components:

The committee recommended that banks should no more bifurcate the cash credit accounts
recommended by Tandon Committee into demand loan components and cash credit
proportions and to maintain a differential interest rate between these two components. In
case where the cash credit accounts have already been bifurcated steps should be taken to
abolish the differential interest rate with immediate effect.

(iv) Separate Limits for Peak and Normal Non-Peak Level Periods:

According to this recommendation, the banks should fix separate limits wherever feasible
for the normal non-peak level as also for the peak level credit requirements indicating the
duration of these periods when the separate limits would be utilized by the borrowers,

(v) Drawal of Funds to be Regulated through Quarterly Statements:

With limits sanctioned for the peak level and non-peak level periods, the borrower should
indicate before the commencement of each quarter the requirements of the funds i.e.,
operating limit during the quarter. Drawings less than or in excess of the operative limit so
fixed (with a tolerance of 10% either way i.e., ± 10%) but not exceeding the sanctioned limit
should be deemed to be an irregularity and appropriate corrective steps should be taken.

Note:
There recommendations of panel interest for deviation beyond the tolerance were not
accepted by RBI.

(vi) Penalty for Default in the Submissions of Quarterly Statements:

For timely submission of quarterly statements, the committee recommended that if a

borrower fails to submit these returns within the prescribed time limit banks may charge
panel interest of 1% per annum on the total outstanding in the period of default in the
submission of quarterly return.

At the same time, the borrower should be given notice that if default persist the account
may be frozen without further notice at the bank’s discretion.

In spite of the levy of penal interest, if default persists, banks should review the positions
and if it is satisfied that a stun action is necessary the operation of the account of such
borrower may be frozen.

If the borrower has accounts with more than one bank, the decision taken by the bank to
freeze the account be intimated to other banks concerned. As soon as advice is received by
the other financing banks, they should ensure that no operations are allowed in such
accounts with them.

(vii) Ad-Hoc or Temporary Limits:

The Committee recommended that a request for ad- hoc or temporary limits to meet
unforeseen contingencies should be considered very carefully and allowed for a
predetermined period through a separate demand loan or non-operatable cash credit
account. Banks are allowed to charge additional interest of 1% per annum on these
recommendations.

(viii) Encouragement for Bill Finance:

(a) Advance against Book Debts:

Generally, sales are financed by banks through purchase, discount of bills. The RBI has
advised banks to replace cash credit against book debts by bill finances. Steps should be
taken for review of such accounts and convert such cash credit limits into bills limit’s
whenever possible.

(B) Drawee Bills:

The Committee has recommended that banks should earmark at least 50% of cash credit
limits against raw material to manufacturing units for drawee bills only.

(c) Payment to Small Units:

With a view to ensure timely payment of the amount due to small suits the committee has
recommended that publics sector undertakings and other large borrowers maintain control
accounts and give precise information in their quarterly statements about dues to small
units. On the basis of such information banks may take such steps as may ensure timely
payments to small units. One such step may be stipulation that a portion of the credit limits
for bills acceptance (drawee bills) will be utilized only for drawee bills of small-scale units.

Besides the above recommendations other recommendation of the course committee

relate to:

(a) Relaxation in inventory norms.

(b) Devising check list of security of data at the operational level.

(c) Reducing delay in sanctioning credit limits.

(d) Taking up of communications system and procedure to ensure minimum time for the
collection to instruments.

(e) Revision of plan of action by Banks in the light of new credit policy announced by the
RBI from time to time and setting up a cell attached to the chairman’s office at the central
office to attend such matters.

(f) Effective continuous monitoring of the credit portfolio of the key branches.

As regards the relative superiority of cash credit loans and bill system of lending, the
committee found that not one system was superior to the other. The group, therefore,
advocated the retention of the existing system of extending credit by a combination of the
three systems of lending.

In brief, the Core committee recommended an amended system of lending, the

adoption of which, would have the following beneficial effects:

(i) The pre dominant share of cash credit is total lending will be reduced.

(ii) Over dependence on bank borrowings will be reduced.

(iii) The ‘gap’ will be reduced.

(iv) Better planning consciousness and discipline among the borrowers will be fostered.

Tandon Committee

In July 1974, the RBI constituted a study group under the chairmanship of Mr. P. L. Tandon.
This study group was asked to give its recommendations on the following:

(i) What constitutes the working capital requirements of the industry and what is the end use
of credit?

(ii) How is the quantum of bank advance to be determined?

(iii) Can norms be evolved of current assets and for debt equity ratio to ensure minimal
dependence on bank finance?

(iv) Can the current manner and state of lending be improved?

(v) Can an adequate planning, assessment and information system be evolved to ensure a
disciplined flow of credit to meet genuine production needs and its proper supervision?

The final recommendations of this committee regarding the approach of the banks towards
the assessment of the working capital requirements of industrial units are very significant.

The major recommendations have been as below:

(i) Banks Finance Essentially for Meeting Working Capital Needs:

Bank credits is essentially intended to finance working capital requirements only, for other
requirements, other sources have to be found.

Even for working capital requirements, same portion of the contribution must come from
source other than bank finance, such as from owner’s own funds, plough back of surpluses
and long-term borrowed funds.

With increased scale of operation and production the owner’s own state in the business
should keep on rising. While it is not practicable to lay down absolute standards of debt
equity ratio, each borrower should take appropriate steps to strengthen his equity base.

(ii) Working Capital Gap:

The study group has emphasised the concept of the working capital gap which represents
the excess of current assets over current liabilities other than bank borrowing.

The maximum permissible bank finance shall be limited to 75% of this working capital gap.
In other words, the balance of 25% will have to be provided by the borrower from equity and
long-term borrowings.

For the purpose of arriving at the working capital gap, the current assets and the current
liabilities will have to be estimated on the basis of the production plan submitted by the
borrower. The level of inventories under raw materials, work-in-progress, finished goods,
consumable stocks and also the level of receivables shall be projected on the norms
prescribed by the study group.

(iii) Norms:

The borrowing requirement of any industrial unit basically depends on the length of the
working capital cycle, from building inventories of raw material to getting the sale proceeds.

If norms of inventory and other current assets are laid down for different industries, the bank
can easily work out the standard working capital required by a unit and sanction the
advance accordingly.

The study group has, therefore prescribed norms for inventory and receivables for 15
industries. The industries covered by the report are cotton and synthetic textile, man-made
fibres, jute, textiles, rubber products, fertilizers, pharmaceuticals, dyes and dyestuffs, basic
industrial chemicals, vegetable and hydrogenated oils, paper, cement, consumer durables,
automobiles and ancillaries, engineering ancillaries and components supplies and
machinery manufacturers. The study group has not suggested any norms for the heavy
engineering industry because each unit in this industry has certain special characteristics.

The norms for the various items are below:

(a) Raw materials – Consumption in terms of months.

(b) Stock-in-progress – Cost of production in terms of months.

(c) Finished goods – Cost of rules in terms of months.

(d) Receivables – Sales in terms of months.

(iv) Three Different Methods of Calculating the Borrowing Limit to Finance the

Working Capital Requirements:

The group views the role of banker only to “supplement the borrower’s resources in carrying
a reasonable level of current assets in relation to his production requirements”.

It proposes three progressive alternatives by which the banks may finance the working
capital requirements of their industrial borrowers.

At the 1st stage the current assets may be worked out as per norms and the current
liabilities (excepting bank borrowings) may be deducted therefrom. This amount would
represent the working capital gap, 25% of which must be financed by the borrowers out of
long-term funds. The maximum permissible bank borrowings would, therefore, be only 75%
of the working capital requirements. Calculated as per the norms laid down regarding,
inventories and receivables.
The committee suggests that as a 1st step, the banks may adopt this method of sanctioning
advances. In case where the banks have already sanctioned advances higher than the
requirements as calculated above, the excess should be converted into a term loan to be
phased out gradually. Thus the committee does not support that the bank should finance
excessive inventory buildup by industrial enterprises.

The 2nd alternative, the borrower will have to provide a minimum of 25% of total current
assets from term funds (as against his providing 25% of working capital gap from long-term
funds in the 1st alterative).

In the 3rd and the ideal method of calculating the borrowing limits, the group makes a
distinction between core current assets and other current assets. Accordingly the total
current assets need to be divided into these two categories.

The borrower should finance the entire core current assets plus minimum of 25% of the
other current assets. The group feels that this classification of current assets and current
liabilities be as per the accepted approach of the bankers.

The recommendations of the committee aim at reducing the reliance of the borrowers on
the bank finance. Implementation of these recommendations would result in a better current
ratio of the industrial borrowers. This would avoid unfortunate stringencies on account of
lack of working capital as those faced by the industrial units in the recent years.

When the government had to enforce a strict credit squeeze in order to fight galloping
inflation. There can be no two opinions on the fact that the industrial units must maintain a
sound current ratio — something which can be achieved only if a good part of working
capital in financed through long-term funds.

(v) Style of Credit:

The group also recommends a change in the style of credit i.e. the manner in which bank
finances is extended to the borrower. It is mentioned that the present credit system of
lending does not provide any controls to the bankers over the levels of advances in cash
credit accounts. This results in a lack of credit planning. Therefore, the total credit limit of
borrower should be bifurcated into two components; the minimum level of borrowing which
the borrower expects to use throughout the year i.e., loan and a demand cash credit which
would take care of his fluctuating requirements.

Both these limits should be reviewed annually. It is recommended that the demand cash
credit should be charged slightly higher interest rate than the loan component, so that the
borrower is motivated to take higher level of fixed component and a smaller limit of cash
credit. This would enable the bankers to forecast the demand for credit more accurately.

(vi) Information System for Banks:

The following points may be noted in this regard:

(a) In order to ensure that the customers do not use the new credit facility in an unplanned
manner the financing should be placed on a quarterly budgeting reporting system for
operational purposes in the prescribed forms.

(b) Actual drawing within the sanctioned limit will be determined by the customer’s inflow
and outflow of funds as reflected in the quarterly funds flow statements and the permissible
level of drawing will be the level as at the end of the previous quarter plus or minus, the
deficit or surplus shown in the funds flow statements.

(c) Variances are bound to arise in any budget of plan. The variances to the extent of say
10% should be permissible and beyond this, the banker and the customer should discuss
the reason.

(d) Since projected funds flow statement would form the basis of determining the line of
credit, the banker would be justified in laying down a condition that any material change,
say beyond 10% of the figure projected earlier, would require his prior approval.

(e) From the quarterly forms the bankers will verify whether the operational results conform
to earlier expectations and whether there is any divergence showing red signals.

(f) In addition to quarterly data, the large borrower should submit a half yearly proforma
balance sheet and profit and loss account within two months from the end of the half year.

(g) Stock statement will be continued to be submitted but these will be improved. The basis
of valuation in the stock statements and the balance sheet should be uniform. The stock
should be reconciled in the stock statement sharing the opening and closing stocks,
quantity-wise and value-wise.

(h) Stock inspection passes problems especially in large industries. In such cases there is
no alternative to depending on financial follow up. Where a banker feels that detailed stocks
verification is called for a regular stock audit may have to be arranged with the assistance of
outside consultants.