Working Capital Assessment — Microsoft Excel
In this article, we will walk you through the fantastic journey of learning working capital assessment in accounting and finance perspectives and along with this drive, we also have a glance of understanding how it is important for us and how we can use, why we need this in business financial terms.
Working Capital Assessment
There are various assessments that banks do. Banks assess how much working capital is required by the company.
- MPBF (Maximum Permissible Bank Finance)
- Operating cycle method
- Drawing power method
- Turnover method
- Cash budget method
Maximum Permissible Bank Finance
For companies that require up to ₹10 lakh, banks assess the working capital requirements. Banks finance a maximum of 75% of the required amount and the
balance has come from long term debt.
It has two methods and they calculate the current ratio for this:
Method I
MPBF = 75% of Current Assets – Current Liabilities other than bank borrowings
- Ideal Current Ratio = 1:1
Method II
MPBF = 75% of Current Assets) – Current Liabilities other than bank borrowings.
- Ideal Current Ratio = 1.33:1
Let’s take an example to understand this better
As we can see in the above figure, MPBF in Method I and Method II are 1,200 and 1,100, respectively. It means the banks are liberal in Method 1 and can give more limit in Method I. Current ratios are also 1.25 and 1.33, respectively which are ideal in both
cases.
Operating Cycle Method
We have discussed operating cycle earlier in this section. A bank checks the total number of operating cycles in a year and then decides the limit.
We looked at an operating cycle example in Figure 4.5, so will continue with the same example.
Operating Cycle Day was 67 as per the example.
So, No. of operating cycles in year = 365/67 = 5.45
Let’s assume that operating expenses are 120 lakh in a year, so the values are as shown in figure below.
As we can see in the figure below, we will need Rs. 22.02L in operating cycle method.
Drawing Power Method
Drawing power is the limit upon which every borrower can withdraw the money within the cash credit limit. Total working capital limit is allotted to a customer by the bank, and it is based on the collateral submitted by borrower and credit appraisal
by the bank.
It can be reviewed periodically.
Sanction Limit
The Withdrawal Limit is the maximum amount that can be
withdrawn from a cash credit account, regardless of any increase in the Drawing Power.
Drawing Power
Amount that a borrower can withdraw every month/quarter from the cash credit account based on inventory stock, accounts receivable and accounts
payable.
The margin can be 25% - 40%.
Drawing power is a metric that can vary on a monthly basis, based on changes in inventory, accounts receivable, and accounts payable. It’s important to note that
accounts receivable should be less than 90 days old, as banks typically don’t consider debtors who are more than 90 days delinquent. When calculating drawing power,
the values from Month 1 are used to determine the drawing power for Month 2 and the values from Month 2 are used to calculate drawing power for Month 3 and so on.Drawing power limit cannot more than the sanction limit.
Example
Let’s take the values shown in the figure below.
We will calculate month 2 D.P Limit from the values of Month 1, and Month 3 D.P Limit from the values of Month 2.
As we can see in the above figure, Month 2’s D.P is 60L, whereas Month 3’s D.P is 109.5L. However, the maximum sanction limit is 100L, so we can withdraw a maximum of 100L from our cash credit account but not in Month 2 as its maximum drawing power 60L.
Turnover Method
As the name suggests, it is based on the turnover of a business. This method is used for MSME companies with a maximum turnover of ₹5 crore. The working capital requirement is to be assessed as 25% of the projected turnover; out of this, 5% is
the net working capital, and 20% is bank financing, that is, 20% of total projected turnover is considered MPBF.
Example
- Let projected turnover = 1 crore
- Working Capital Gap = 25% of Project Turnover = 25% of 1 Crore = 25 lakh
- Margin Money (Net Working Capital) = 5% of Projected Turnover = 5 lakh
- MPBF = 20% of Projected Turnover = 20 Lakhs
This method is very simple and it is very useful for small scale industries.
Cash Budget Method
Some companies are dependent on cyclical cash flow due. They get huge cash in one season and might be in cash deficit in one season.
The cash budget method is applicable for cyclical, seasonal industries. For those types of company’s order may come in one season. Unlike other methods, its
working capital limit is based on projected cash flow rather than current assets and current liabilities.
A company must submit its last year’s actual cash flow and 1-year projected cash flow statement. Working capital requirements are sanctioned based on peak cash deficit periods.
Let’s understand this with the help of an example. Let projected cash flow be as shown in the Figure below, we are taking constant closing and opening cash balance in the example as ₹100L.
As we can see in the above figure, the maximum deficit is 70L and the deficit month is October.
So, Working Capital Limit = Peak Deficit = 70L, Withdrawal depends on the sanction limit. Withdrawal depends on the sanction limit.
Conclusion
Finally, we will discussing about working capital assessment and in this journey we will going through lots of interesting and factful concepts. Working capital is the fuel of a business and the mismanagement of working
capital can cause liquidity or even solvency of the company. As accounting and finance professionals, we need to manage working capital better.
