Working Capital Financing Policies (Explained With Diagram)

Working capital financing policy basically deals with the sources and the amount of working capital
that a company should maintain.

A firm is not only concerned about the amount of current assets but also about the proportions of
short-term and long-term sources for financing the current assets. There are several working capital
investment policies a firm may adopt after taking into account the variability of its cash inflows and
outflows and the level of risk.

1. Hedging Policy:

One of the policies by which a firm finances its working capital needs is the hedging policy, also
known as matching policy. This policy works in an arrangement where the current assets of the
business are used perfectly to match the current liabilities.

As per this approach, fixed and permanent current assets are financed through long-term sources
and fluctuating current assets are financed through short-term sources.

This policy is a medium risk proposition and requires a good amount of attention. For example, if a
bank loan is due to be paid after six months, the company will ensure that sufficient amount of cash
will be available to repay the loan on the date of maturity even though it may or may not currently
have sufficient cash.

In case of a growth firm, the amount of fixed assets and permanent current asset go on increasing
with the passage of time but the volume of fluctuating current assets change with the change in
production level. In Figure 8.1, Line A and Line B is upward slopped indicating that they go on
increasing with the passage of time and as per hedging principle they are financed through long-
term sources like equity and long-term debt.

Fluctuating current assets, which are shown by the curved Line C, should be financed through short
term sources.
2. Conservative Policy:

As the name suggests, this policy tries to avoid the risk involved in financing of current assets. Here,
relatively high proportions of long-term sources are to be used for financing current assets. The firm
not only matches the current assets with current liabilities but also keeps some excess amount to
meet any uncertainty.

This is the lowest risk working capital policy and fails to ensure optimum utilization of funds. Hence it
cuts down the expected returns of the shareholders. This policy is illustrated in Figure 8.2. Line A
denotes the fixed assets and Line B denotes the permanent working capital, which is financed
through long-term sources. Certain portion of fluctuating current assets, which is shown by dashed
Line C, is also financed by long-term sources. Under this policy some part of fluctuating current
assets is financed through short-term sources.
3. Aggressive Policy:

Aggressive working capital financing policy is a risky policy that requires maximum amount of invest-
ment in current assets. Fluctuating as well as permanent current assets under this policy will be
financed through short-term debt. In this policy debt is collected on time and payments to the
creditors are made as late as possible.

This policy has been illustrated in Figure 8.3. According to this approach long-term sources are used
to finance the fixed assets, which are shown by Line A; but a portion of permanent current assets,
shown by the dotted Line B, is also financed through long-term sources. The remaining part of
permanent current assets, depicted by Line C, and the entire amount of fluctuating current assets,
shown by the curved Line D, are financed by short-term debt.
4. Highly Aggressive Policy:

This is a highly risky policy for financing the working capital. As per this policy, even some part of
fixed assets is financed through short-term sources. Excessive reliance on short-term sources makes
this policy highly risky.

This policy has been illustrated in Figure 8.4. A major proportion of fixed assets as shown by dotted
Line A are financed through long-term sources and the remaining part of the fixed assets are
financed by short-term sources—shown by Line B. Short-term sources are also used for financing
permanent current assets—Line C; as well as fluctuating current assets as shown by the curved Line

D.
The Tandon Committee Regulations

The Tandon Committee had suggested three methods for determining the maximum permissible
bank finance (MPBF).

In July 1974, the study group headed by Shri. P.L.Tandon, has framed guidelines for working capital
finance by banks. The recommendations made by above study group are known as Tandon
Committee recommendations. Out of three methods for assessment of working capital limits
proposed by Tandon Committee, RBI has accepted method I and method II, which are explained
below.

As per Tandon’s-I method (also called as ‘first method’) of lending the borrower has to arrange 25%
of Working Capital Gap (WCG) as margin and bank can finance maximum 75% of the WCG.

The first method can be explained from the following illustration.

Let us take an example of a company which has Total Current Assets (TCA) of Rs.100.00 and Other
Current Liabilities (OCL) i.e. (without working capital facilities from the bank) is Rs.20.00. Now we will
compute the Maximum Permissible Bank Finance (MPBF) under method-I.

TCA=100 and OCL=20,

WCG (TCA - OCL) = 100 -20 = 80

In this case, Maximum Permissible Bank Finance (MPBF) = 75% of WCG = 80×75% = 60

Total CL = MPBF + OCL = 60 + 20 = 80

CA = 100; WC = CA – CL = 100 – 80 = 20

Current Ratio in first method: Since Total Current Liabilities (including Bank finance) would be Rs.80
against Total Current Assets of Rs.100, the minimum Current Ratio under method–I

would be 100:80 i.e minimum Current Ratio is 1.25:1.

Tandon’s-II method (also called as ‘second method’): In this method of lending the borrower has to
arrange 25% of Total Current Assets (TCA) as margin and MPBF = 75% of TCA - OCL.

Illustration :

Let us again take an example of TCA of a company is Rs.100.00 and OCL is Rs.20.00. We shall now
calculate the MPBF under 2nd method.

The MBPF under second method is 75% of TCA - OCL =75 – 20 = 55 and

MPBF, from Bank under the second method ,is Rs.55 when Total Current Asset is Rs.100.

Current Ratio in second method: Since Total Current Liabilities would be (20+55)=75 against Total
Current Assets of Rs.100, the minimum Current Ratio under method–II would be 1.33:1

The Chore committee (headed by Shri.K.B.Chore), appointed by RBI in April 1979 recommended that
all borrowers except sick units having working capital of Rs.50 lacs and over from the banking system
must be placed under method-II which gives current ratio of 1.33:1. Although the lower cut-off limit
for method II is changed from time to time as per RBI guidance, the benchmark current ratio of
1.33:1 under this method remains unchanged. Relaxation to this condition is available to export
oriented units; products manufactured by MSME units wherein banks may apply the first method.
Tandon’s-III method (also called as ‘third method’): Under this method, Bank will finance only 75%
of Non-Core Current Assets less OCL. Let, Core Current Assets (CCA) = 36

In this method MPBF = 75% of (TCA – CCA) – OCL = 75%*(100 – 36) – 20 = 48 – 20 = 28

Problem 2. CA = 300; CCA = 100; CL = 80; Bank Loan Included in CL = 36.

Solution: OCL = 80 – 36 = 44

Method 1: MPBF=0.75*(CA - OCL)

MPBF = 0.75*(300 – 44) = 256*3/4 =192

Method 2: MPBF=0.75(CA)-OCL

=0.75*300 – 44 = 181

Method 3: MPBF=0.75(CA-CCA)- OCL

=0.75*200 – 44 = 106

CL after taking full MPBF = MPBF + OCL

1. 192 + 44 = 236; CR = 300/236 = 1.27

2. 181 + 44 = 225; CR = 300/225 = 1.33
3. 106 + 44 = 150; CR = 300/150 = 2

What addl. Loan for working capital can be taken by the firm?

1. 192 – 36 =156
2. 181 – 36 = 145
3. 106 – 36 = 70

Partial bank financing : The bank should not finance the total requirement of the borrower. Only a
reasonable part of it should be financed by the bank.

Maximum permissible bank finance (MPBF) :

The committee suggested the following three methods of determining the MBFC.

1. The borrower will contribute 25% of the working capital gap, the remaining 75% will be financed
from bank borrowings.

W. C. Gap = CA-CL excluding bank borrowings.(Some analysts define the networking capital in the
same manner)

2. The borrower will contribute 25% of the total current assets. The remaining of the working capital
gap will be financed by the bank.

3. The borrower will contribute 100% of the core assets and 25% of the balance of current assets.
The remaining of the working capital gap will be financed.

The Chore Committee Regulations

1. Reduced dependence on Bank Credit : The borrowers should contribute more funds to finance
their working capital requirements. The idea was to place all borrowers in the 2 nd method suggested
by the Tandon Committee. In case of difficulties the resort could be taken to WCTL.

The Tandon Committee has suggested three methods of working out the maximum amount that a
unit may expect from the bank, which is termed as ‘maximum permissible bank finance (MPBF)’.

MPBF under three alternatives are ascertained as follows:

1. First Method:

MPBF = 75% of (Current assets – Current liabilities other than bank borrowings)

The borrowing firm should provide the remaining 25% from long-term sources.

The minimum current ratio under this method works out to 1.25: 1. Not True. If OCL is 40% of CA,
MPBF = 45% of CA (75% of WCG) and Current Ratio = 100/85

2. Second Method:

MPBF = (75% of Current assets) – (Current liabilities other than bank borrowings)

The borrowing firm should raise finance to the extent of 25% of current assets from long-term
sources.

The minimum current ratio under this method works out to 1.33: 1.

3. Third Method:

MPBF = [75% of (Current assets – Core current assets)] – Current liabilities other than bank
borrowings

The borrower should contribute 100% core current assets and 25% of balance current assets from
long-term sources.

A minimum current ratio under this method works out to above 1.5: 1. (above 1.33)

The current ratio will strengthen and reliance on bank finance reduces under these three methods
successively.