Working Capital Finance

Working capital finance refers to credit facilities that fund the day-to-day operational needs of businesses – such as purchasing inventory, paying trade creditors, wages, etc. Unlike term loans which finance long-term investments (machinery, buildings) and are repaid over years, working capital facilities are shorter-term and revolve based on the business cycle. Banks use specific methods to assess the working capital requirement and offer various products like cash credit, overdraft, and bill discounting to meet these needs.

Assessment Methods: Tandon Committee Norms and Nayak Committee

In India, the Reserve Bank of India (RBI) has issued guidelines over time to standardize how banks assess working capital credit limits for businesses. Two important frameworks are the Tandon Committee norms (1975) and the Nayak Committee recommendations (1991) – often called the Turnover method.

Tandon Committee – Maximum Permissible Bank Finance (MPBF)

The Tandon Committee suggested that borrowers should bring a minimum portion of working capital needs from their own funds (or long-term funds), rather than relying entirely on bank credit. It introduced the concept of Maximum Permissible Bank Finance with three methods:

• Method I: The borrower must contribute at least 25% of the Working Capital Gap from long-term funds, and the remaining 75% can be financed by the bank. Working Capital Gap (WCG) is defined as Current Assets minus Current Liabilities (other than bank borrowings). This method ensures a current ratio of about 1.17:1. Essentially, if a company needs ₹100 as net working capital (after using its current liabilities like supplier credit), the bank will at most provide ₹75 and the company must fund ₹25 on its own.
• Method II: The borrower must provide 25% of total Current Assets from long-term funds. This is a stricter norm, resulting in a higher current ratio (~1.33:1). In this case, if total current assets are ₹100, the company’s own contribution is ₹25, and bank finance plus other current liabilities fill the rest. In practice, Method II often yields a lower bank loan amount than Method I for the same situation, thus more safety for the bank.
• Method III: The borrower finances core current assets (the minimum level of inventory & receivables that are permanent) entirely from long-term funds, plus 25% of the remaining current assets. The bank finances the rest of the working capital gap. This method is even more conservative and increases the margin requirements further.

RBI initially mandated banks to move toward these norms. Over time, Method II became the standard for most banks as it provides a better cushion (higher borrower stake) than Method I. The Tandon Committee aimed to discipline working capital finance: ensuring borrowers don’t over-rely on bank credit and maintain reasonable liquidity. It also discouraged banks from financing excessive inventory build-up beyond normative levels. While the rigid MPBF system has been somewhat relaxed in the liberalization era, the underlying principle remains – banks assess working capital needs and require a minimum margin from borrowers’ own funds.

Nayak Committee – Turnover Method

For small and medium enterprises (SMEs), the 1991 Nayak Committee proposed a simpler formula based on sales turnover. According to this Turnover method, a unit’s working capital requirement can be approximated as 25% of its projected annual turnover. Out of this 25%, the borrower is expected to bring one-fifth (which is 5% of turnover) as margin, and the bank may provide four-fifths (which is 20% of turnover) as the working capital limit.

• For example, if a small business forecasts sales of ₹1 crore for next year, total working capital needed is ₹25 lakh; the promoter brings ₹5 lakh and the bank would lend ₹20 lakh. This method is easy to apply and is commonly used for MSME working capital up to ₹5 crore limits (as per RBI guidelines). Banks must still ensure the turnover projection is reasonable (they may check past statements, GST returns, etc.).
• If the traditional method (based on actual current assets-liabilities) shows a higher need, banks can sanction more, but at minimum they should fund 20% of turnover as working capital if the borrower qualifies. The simplicity of this method helps fast-track credit to small units who may not have sophisticated balance sheets.

In practice, banks use a combination of methods. For large corporates, detailed projections and MPBF style assessment are done, while for smaller businesses the turnover method (Nayak) is the norm. The key takeaway is that borrowers must maintain a stake in current assets – they cannot be fully bank-funded. These norms protect banks by ensuring borrowers have “skin in the game” and maintain a healthy liquidity position.

Types of Working Capital Finance

Banks provide several facilities to meet short-term working capital needs of businesses. The most common and exam-relevant forms are Cash Credit, Overdraft, and Bills Discounting. Although all three supply short-term funds, their structure, purpose, and usage differ.

Cash Credit (CC)

Cash credit is the most widely used form of working capital finance for businesses. Under this facility, the bank sanctions a credit limit, and the borrower can withdraw funds up to that limit as required, even if the account has no balance. The account operates as a running account, allowing frequent withdrawals and deposits, provided the outstanding amount does not exceed the sanctioned limit.
Cash credit is generally secured by current assets such as inventory and receivables, which are pledged or hypothecated to the bank. The bank determines drawing power based on stock statements submitted periodically, often allowing a fixed percentage of the value of inventory or receivables. Interest is charged only on the amount actually utilized and is calculated on daily outstanding balances, usually debited monthly.
CC limits are typically sanctioned for one year and are subject to annual review based on the borrower’s financial performance. This facility offers high flexibility to borrowers, as they can use funds according to their needs, while banks benefit from asset-backed security and continuous monitoring of the borrower’s operations.

Overdraft (OD)

An overdraft facility allows an account holder to withdraw more money than the available balance in a deposit account, up to a sanctioned limit. It is commonly linked to current accounts and can be availed by both businesses and individuals for short-term liquidity needs.
Overdrafts may be secured or unsecured. A common secured overdraft is against fixed deposits, where banks typically allow a high percentage of the deposit value as the overdraft limit. Overdrafts may also be granted against other securities or, in some cases, on a clean basis to customers with strong creditworthiness.
Interest is charged only on the overdrawn amount on a daily basis. Some overdrafts have no fixed maturity, especially those linked to fixed deposits, while others are reviewed periodically. Compared to cash credit, overdrafts are more flexible in structure and are often used to manage temporary cash flow mismatches or emergency expenses.

Bills Discounting (Bills Purchase)

Bills discounting is a form of receivables financing. When a business sells goods on credit, payment is often due after a fixed period. Instead of waiting until the due date, the seller can approach the bank to discount the bill or invoice and receive immediate funds.
Under this arrangement, the bank pays the seller the face value of the bill minus a discount representing interest for the remaining credit period. On the due date, the buyer pays the full amount to the bank. If the buyer fails to pay, liability usually falls back on the seller under recourse discounting, unless the arrangement is specifically without recourse.
Bills discounting is secured by the underlying trade transaction and is self-liquidating, as the advance is automatically settled upon payment of the bill. It efficiently converts receivables into cash, improves liquidity, and supports sales growth without creating a long-term loan on the borrower’s balance sheet.

Other Working Capital Finance Methods

Other forms of working capital finance include letters of credit, bank guarantees, working capital demand loans, and commercial paper.