1/7/2016 WORKING CAPITAL MANAGEMENT By CA SANJAY MAJMUDAR RAJKOT BRANCH-WIRC OF ICAI 30 TH MAY, 2015 SANJAY MAJMUDAR & ASSOCIATES

04/21/23

WORKING CAPITALMANAGEMENT

ByCA SANJAY MAJMUDAR

RAJKOT BRANCH-WIRC OF ICAI

30TH MAY, 2015

SANJAY MAJMUDAR & ASSOCIATES

1. PRELIMINARY

• Working Capital is – literally “Life Blood” of Business.

• Analysis of Business failures indicate inadequate /non availability of working capital as a major reason for downfall.

• Proper understanding of working capital management nuances is therefore, of paramount importance, particularly for finance professionals..


2. METHODS OF DETERMINING WORKING CAPITAL

• The generally prevalent methods for working capital assessment are –

• CMA Method – Widely popular for most of the working capital assessments involving turnover in excess of threshold limit usually applicable for manufacturing concerns, trading concerns, contracting business, etc.

• Turnover Method – Typically applied for simple business with turnover up to Rs.6-10 crores (this limit may vary) with thumb rule of the working capital limits required being at the rate of 20% of the turnover.


METHODS OF DETERMINING WORKING CAPITAL Contd…

• Cash Flow Method – Applied where the primary objective is to fund the cash flow deficit for a given business model – for e.g. real estate development projects or short term specific purpose working capital loans, etc.


3. ASCERTAINING WORKING CAPITAL NEEDS : CMA METHOD : BASIC PROCESS

• Understanding the Basic Industry in which the unit operates;

• Understanding the Business Model and strategy of the Enterprise.

• Understanding the basic philosophy of the Enterprise w.r.t. Working Capital Management.

• Analyzing the past performance trends, historical working capital cycles & movements identifying any abnormal factors or “One-Offs”; and normalizing the historical trends.


ASCERTAINING WORKING CAPITAL NEEDS : BASIC PROCESS contd..

• Based on historical trends, as suitably modified by changing business dynamics/parameters, working out realistic and acceptable estimates for the current fiscal year and projections for the next fiscal year.

• Timing of the exercise is very crucial, and can impact the process materially – eg:. Instead of initiating the same in Feb/March; it will be more meaningful if it is initiated in April end, based on latest historical provisional/Audited financials.


4. DETAILED WORKING CAPITAL ASSESSMENT : KEY

PARAMETERS – CMA METHOD • Analysis of working capital movement trends :

Last 12 Months Domestic/Export Sales Last 12 months Inventory & Receivable levels.

(RM/WIP/FG/Domestic receivables/Export Receivables)

• Analysis of the key findings of the latest stock –audit reports/internal inspection reports.

• Perusal of minutes of consortium meetings, so as to determine the mind-set/concerns of the member Banks.


Detailed Working Capital Assessment : Key Parameters contd…

• Perusal of Statutory Audit/Internal Audit/MIS Reports so as to have an idea about inventory movement, identification of slow moving/non-moving/obsolete inventory & sticky receivables not provided for.

• Ageing Analysis of Debtors, - in line with the Business Cycle, and identifying debts which are not recovered and have become disputed /sticky.

• Perusal of last 12 months Bank statements (CC/EPC accounts) to determine the stress areas reflected by frequent overdrawing, ad-hoc limits taken, servicing of interest/repayment obligations, etc.


Detailed Working Capital Assessment : Key Parameters contd…

• Perusal of the external rating of the company together with rating rationale which will give a fairly reasonable overview of the affairs and the concern areas as well as strengths and opportunities available with the enterprise.

• Perusal of existing Terms of sanction, if available, and identifying critical terms with regard to DP eligibility, Margins, pricing, fees & expenses, Commissions & charges, Guarantees & Securities, etc.


5. CERTAIN KEY RATIOS:

Current ratio: Classically computed as current assts divided by current liabilities. Although conventionally, deal level of current ratio is regarded as 1.33, now this is fairly flexible and is basically required to be over 1 with the minimum entry level CR stipulated by RBI at 1.17 for takeover of an account from another bank and CR above 1.25 is generally eligible for good marks for internal/external rating purposes.

CR can be generally lower in export oriented undertakings since export finance is with NIL/lower margins.


CERTAIN KEY RATIOS – contd.

Net working capital: This typically is the difference between total current assets and total current liabilities, representing core working capital which has to be funded by the borrowing entity from long term sources.

Typical sources for NWC would be internal cash generation, equity, long term secured/unsecured loans, long term debentures and preference share capital. A higher NWC denotes strong financial position and vice versa. CR less than one would result into negative NWC – an undesirable situation.



Tangible Net Worth: In ordinary parlance tangible net worth is share capital + reserves less intangibles. However, from a working capital perspective investment outside business made by an enterprise is also deducted from TNW so as to arrive at adjusted TNW.

TOL/TNW: This is the ratio of total outside liabilities to tangible net worth. Total outside liabilities include secured and unsecured loans, trade creditors, creditors for expenses, provisions, etc. If preference share capital is redeemable before a period of 12 years then the same will also be included in TOL. DTL also normally forms part of TOL, however, some banks (very few) are also treating the same as a part of TNW.


Generally the acceptable level of this ratio is that it should be less than 3. It is possible to argue that unsecured loans given by the promoters being subordinate to bank loans should be regarded as quasi equity and accordingly work out the adjusted ratio of TOL/TNW so as to bring it down below the normally accepted benchmark level.

TTL/TNW: This is the ratio of total term liabilities to TNW. It is normally accepted to be in the region of maximum 2 times.



Impact: If the ratios are favourable it has a positive bearing on the internal and external rating. It is again having a direct bearing on the pricing of the loan.

Highly unfavourable ratios would push the rating below the investment grade and it would not be normally feasible to fund such units.



(6) W-CAP COMPONENTS

A. INVENTORIES

Seasonality, identification of peak levels

Commercial usability of slow moving/non-moving inventories.

Goods-in-Transit/with third parties.

Sufficiency of insurance coverage, whether insurance can be avoided?

Uniform margins preferred

In case of imports, terms to be ascertained, i.e. minimum shipment load, L/C requirements, cycle time, etc.

Imports /local purchases against firm export orders are eligible for concessional rates/interest subvention/lower margins.


W-CAP COMPONENTS

B) RECEIVABLES (DOMESTIC)

Debts due in excess of 6 months : Schedule III vis-à-vis Bank’s treatment.

Linkage with Business Cycles-

Margins to be in sync. With Quality of Receivables.

Factor of year end lumpiness to be judged in line with quarterly sales trends.


W-CAP COMPONENTS : contd…

C) EXPORT RECEIVABLES

• Holding levels to be properly determined

• Countries of exports –special dispensation for certain countries like Iran, Pakistan & certain African countries.

• In case of exports against L/Cs special treatment is possible.

• Ranking of Banks opening L/Cs, and L/C terms are critical, otherwise can impact transaction costs/L/C Discounting charges, (eg.: confirmation costs), acceptance conditions, etc.


W-CAP COMPONENTS : contd…

C) EXPORT RECEIVABLES

• ECGC cover charges & costs are relevant-ECGC Cover may not be needed in case of exports through WOs/Marketing JVs; and will not be needed in case of exports against L/Cs.

• Export receivables can be funded at lower rates/Nil Margins- and have a direct impact on the C.R.


W-CAP COMPONENTS : : contd…

D) (OCA) OTHER CURRENT ASSETS

• L/C & B/G Margins (inclusion/exclusion)• Balances with Govt. Authorities (inclusion/exclusion)• DEPB/Export Incentives Receivable- whether qualify for

DP?• Adv. Tax (vis-à-vis Tax Provision)• Advances to Suppliers.

E) (OCL) OTHER CURRENT LIABILITIES

• Current Maturities of LTLs.• Advances from Customers• Trade Creditors/payables for expenses• Short Term unsecured loans• Tax Provisions (vis-à-vis Advance Tax)• Statutory Liabilities


7. STRUCTURING

A. ABF : FBL

• C/C (Hypothecation of inventories/debtors) earmarking against FCNR-B deposits possible.

• WCDL (a portion of C/C at a lower rate)

• EPC/FBP/FBD (standalone or sub-limit of CC)

• PC FC possible.

• Domestic BD (standalone or sub-limit of CC)


STRUCTURING contd..

B. NFB

a) L/C (Site /Usance)

Usance period depends upon trade cycle-normally upto 90-120 days in case of Domestic purchases & 180-270 days in case of import purchases.

Buyer’s credit-BC(sub-limit of L/C to be considered).

Master circular of RBI allows BC for RM/components upto 365 days max.

Has to be in line with Business cycle.

An increasing Trend to assess a combined C/C / L/C limit as C/C limit, and then give L/C sub-limit, so as to reduce risks of devolvement & consequent stress.


b) B.G.

ABG, for enabling to take advance monies as per contractual terms

PBG, for performance guarantees, typically relating to export obligations against duty free imports, performance under contractual terms, EPCG guarantees, Retention Money guarantees, etc.

Guarantees against security deposits like tender deposits, deposits with utility companies for power connection, etc.

Tenor depends upon cycle time and contractual terms.

c) CEL

It is a notional limit, covering margin required to be taken for currency exposures like forward contracts, etc.

It is usually @ 2% of the likely exposure.

STRUCTURING contd..

STRUCTURING contd.

(d) SBLC/Letter of Comfort

Used generally for securing the limits to be granted to overseas subsidiary/JV companies.

(C) Irregularity/NWC Deficit Funding

Devolved portion of L/Cs and DP shortfall can be carved out into WCTL; however this may tantamount to Restructuring.

DP shortfall (resulting into NWC deficit) can be funded through a medium /long term corporate loan, provided sufficient F.A. cover is available.


8. SHARING PATTERN

• Funding upto certain exposure levels (now generally upto Rs.50 crores) is on stand-alone basis.

• For larger exposure, banks insist for either Consortium lending or in some cases, Multiple Banking based lending.

• Typically Consortium Banking preferred, as it ensures better control & Monitoring, higher discipline, sharing of common pool of securities, joint documentation etc.

• A Bank with higher exposure/initial exposure usually acts as a leader of the consortium, and other banks follow the lead bank.


SHARING PATTERN

• However, the flip side of consortium banking is longer time in proposal processing, documentation, problem of managing many banks, higher costs & charges, etc.

• Multiple Banking possible generally in case of distinctly different verticals/ Divisions of an Enterprise, with clearly identifiable income streams, securities & cash flows.


9. Security Structure

a) Primary

First pari passu/exclusive charge on inventories & receivables. Customers’ acceptances of Bills Cash Margins in case of NFB limits. Escrow of specific cash flows First charge on fixed assets in case of corporate loans/SBLCs

b) Collateral

Second charge on fixed assets. Charge on other immovable properties of the

enterprise/promoters Personal /corporate guarantees. Pledge of shares.


10. PRICING

• Linked to External & Internal Rating

• External rating compulsory as per Basel II Guidelines

• Increasing trend for Banks not to take new exposure if external rating is below BBB.

• Equally important is internal rating – most of the models are designed by CRISIL/Mckinsey; and place heavy reliance on achievement of past performance, financial Benchmark ratios; industry, corporate status, promoters & management quality; market information & reports; conduct of account, etc.

• FBL priced at Base rates plus applicable spreads, as per rating. Concessional pricing applicable for EPC/FBP/FBD limits; discounting of sales bills under L/Cs, WCDL limits, etc.


PRICING Contd.

• L/C & B/G opening charges & Commissions depend upon rating, quantum, security, past-performance, etc.

• Banks also charge separately lead Bank fees, proposal processing charges, legal documentation charges, TEV charges, inspection charges, etc.

• Intelligent & careful negotiation is required for ensuring an overall fair & reasonable pricing.

• Concessional pricing possible for MSME/SME sectors.


11. Documentation

• Legal documentation could be a cumbersome, expensive & Time consuming exercise, particularly in consortium accounts.

• As per prevalent stamp duty law in Gujarat, graded duty is levied for Hypothecation & Equitable Mortgages.

• However, for larger advances (in excess of Rs. 10 crores), maximum stamp duty is payable Bank-wise at around Rs. 11.00 lacs for hypo & Rs. 4.00 lacs for E.M.

• Separate fees are to be paid to lawyers for TCR, Documentation etc.


Documentation contd.

• Separate fees are also to be paid to panel valuers for valuation.

• If Terms of sanction are not carefully proposed, multiple duties /costs will be applicable, which can be prohibitively expensive.

• To avoid steep stamp duties in case of large consortiums, there is a trend to have a common security trustee of all Banks for security creation & holding of title documents.


12. Cash Flow Method:

• This method is applicable generally in case of situation where specific cash flow deficit financing requirement exists.

• This is widely used in case of real estate developers – i.e. those developing commercial/ residential projects, townships, etc. For a developer the entire project funding has mainly working capital element but the time period for the project can be much longer say 2 to 5 years depending upon the size and type of the project.


Cash Flow Method cntd.

• The developer will make sales bookings and get periodic advances from the customers as per the terms of allotment.

• At the same time the developer will have to continue constructing the scheme and typically in the initial phases the cost of construction would be higher than the inflows in the form of equity infusion/booking advances from members, thereby creating cash flow deficit.


Cash Flow Method:

• Construction term loan (which is in the nature of working capital loan) is required to be estimated for this deficit funding. It is typically of longer tenor – over one year up to even 5 years and will be repaid as and when the cash surplus arises.

• Cash flow method is also used for certain specific “one off” abnormal items of costs required to be incurred (for e.g. abnormally high purchases or heavy payment of custom duty etc.) which is not envisioned as a part of normal cycle which specifically requires a STL which will be repaid over certain designated period from future cash flows.


CASE STUDY -1.

• ABC Engineering Limited is manufacturing certain engineering products. Its estimated turnover for fiscal 2014-15 is around Rs.500 crores. The main raw material is in the form of special steel sheets and the estimated consumption for FY : 2014-15 is around Rs.350 crores. 70% of the raw material is imported mainly from Japan/China/Korea. Imports are against usance LC with usance period ranging from 180-270 days. Time taken by the suppliers to ship the material is around 30 days after receipt of LC and it takes about 45 days for the material to reach Indian Port. After receipt of the goods at the factory the company takes about 45 days for production. The average holding level of imported inventory is around 1 month. The normal credit offered to the customers is around 2 months.


CASE STUDIES -1 contd..

• What will be the LC limit required by the company? The suppliers can offer a discount of 5 to 7% if the company makes payment against delivery/site LC. Will this be beneficial to the company? How can the company fund the same in a cost effective manner?


•Pipeline Limited are acting as turnkey/EPC contractors in the field of water treatment plants, pipeline laying jobs, etc. As of 01.04.2014 they have unexecuted order book of around Rs.1200 crores. Their target completion and billing for FY 21014-15 is Rs.500 crores. They are also targeting a fresh intake of new orders of around Rs.500 crores in FY 2014-15.

•On an average they take about 2 years for execution of the project. The normal terms of the contract is that around 10% of the contract value is held back as retention money which is released after about 12 months of successful running of the project. Again in general as per the past trend their bid success ratio is about 20%. The bid bond deposit requirement is at the rate of around 2% of the bid amount and it takes about 4 months for the bidding process to be complete

CASE STUDY - 2


• On an average they get about 10% of the contract value as advance and the performance guarantee is also around 10%.

• The opening balance of outstanding bank guarantee is Rs. 60 crores. What would be the fresh bank guarantee limit required for FY 2014-15?.

CASE STUDIES-2 contd..


CASE STUDY-3

• XYZ Cotspin Limited is a major exporter of cotton out of India. Its estimated cotton exports in FY 2014-15 is around Rs.2,000 crores. Almost 90% of these exports take place during the cotton season – which is generally from October till March every year. All exports are against L/Cs from reputed banks. Almost 70% exports are on 90 days’ usance basis and balance 30% exports are on at site basis. The normal documentation/negotiation period is about 15 days. It takes about 10 days for the customers to accept the bills under LCs.

• As per the business cycle, once the LC is received, it takes about 10 days for the company to procure the material, get the quality certification and make it ready for shipment. Please determine the requirement of EPC limit as well as

FBP/FBD limit for FY : 2014-15.


THANK YOU


Documents

1/7/2016 WORKING CAPITAL MANAGEMENT By CA SANJAY MAJMUDAR RAJKOT BRANCH-WIRC OF ICAI 30 TH MAY, 2015 SANJAY MAJMUDAR & ASSOCIATES