Primer on working capital funding

Working capital assistance can be fund-based and non-fund based.



Current assets are those assets in which the entity deals such as cash, stocks and receivables. Similarly, the entity has a liability to pay certain amounts such as dues to suppliers, salaries and wages, rent, electricity, etc. These are termed as current liabilities. Sum total of current assets is gross working capital and the difference between current assets and current liabilities is net working capital.

Banks provide finance to bridge the gap between current assets and current liabilities, known as working capital assistance, which can be fund-based (where funds are released) and non-fund based, where the banker merely extends a comfort level and no cash is released. An entity can avail itself of both the facilities simultaneously.

Commercial banks lend money to traders against the security of stocks and receivables by way of cash credits and bills discounting facilities.

Cash credits (CC) can be permitted against a pledge or hypothecation of stocks. Possession of goods offered as security vests with lender in case of a pledge, and with the borrower in case of hypothecation.

In case of a pledge, the borrower places the goods in the custody of the banker. These goods are lodged in a godown and the key is handed over to the lender.

Therefore, such a cash credit is termed as key cash credit (KCC). This facility is particularly useful where the manufacturer procures raw material in bulk (imported) or of goods of a seasonal nature. The banker releases funds against such goods lodged with them.

Goods are permitted to be drawn from the godown by paying in to the account or replacing the goods of equal value. In certain cases where it takes some time before the finished goods are in a saleable condition, (such as wood products held for seasoning), they can as well be shifted to KCC.

Banks release funds against hypothecation of stocks as well, which is known as Open Cash Credit.

Once the raw materials are released from the go down, they come in to the possession of the manufacturer. Value addition is made and the raw materials transform in to work in progress and finally finished goods. These stocks of raw materials, work in progress and finished goods are offered as security under hypothecation against which the banker releases funds.

The balance available in OCC can be used to pay in to KCC. When goods are removed from the place of the trader, the lender looks for alternative materials or cash deposits. The cycle of drawing goods from KCC and held in OCC is continuous.

BILLS DISCOUNTING

Once the finished goods are sold, they transform into receivables. These receivables can be discounted to maintain the financial equilibrium in CC limits. The bank releases stipulated amounts out of the receivables after setting off the margins.

All these facilities run independent of each other and the limits are sanctioned separately. There cannot be an omnibus limit.

Certain terms used in case of a working capital funding are as under:

Margin: To ensure sense of ownership and responsibility, the institutions insist upon the borrowers to meet a part of the cost of stocks and receivables. Such proportion of investment met by the constituent is termed as Margin;

Drawing power: This refers to the permissible value of stocks that can be funded by the institution. This is the reciprocal of margins. The drawing power of any asset should not be less than the balance outstanding in the account.

For calculation of drawing power, dues to suppliers are to be deducted from the total stocks available. Only paid stocks are to be considered for the purposes of drawing power; and

Limit: This refers to the maximum amount that can be drawn in the CC account. Even if the value of stocks is high, the borrower shall not be permitted to draw more than the sanctioned limit.

Consider that a borrower is sanctioned KCC limit of Rs 2 crore, subject to a margin of 25 per cent on stocks and balances outstanding in KCC is Rs 1.7 crore.

Debtors do not rank for calculation of KCC limits. The entity should have deposited goods of the value of Rs 2.27 crore to warrant the balance in KCC. Out of Rs 2.27 crore, 25 per cent margin to be met by the borrower is Rs 0.57 crore and the balance Rs 1.7 crore is the drawing power, which is funded by the bank.

On the other hand, if goods of the value of Rs 3 crore are held in the godown, the drawing power would be Rs 2.25 crore. But the borrower cannot draw more than the sanctioned limit of Rs 2.00 crore.

(The author is a Hyderabad-based chartered accountant.)

Published on January 30, 2011
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