August 2005
MANAGEMENT

A gainst the backdrop of the macro-economic conditions in Nepal it would be good for the banking system to have a common basis for determining the working capital needs of the borrowers so that a disciplined scenario could prevail upon the banking system. Here is a suggestion:

A banker’s main role, as a lender, will be to supplement the borrower’s resources in carrying a reasonable level of current assets in relation to the production requirements.

Stated differently, we would expect the borrower to hold only a reasonable level of inventory and receivables. The total current assets will be carried partly by a certain level of credit for purchases and other current liabilities. Funds required to carry the remaining current assets may be called the working capital gap that can be bridged partly from the borrower’s owned funds and long-term borrowings and partly by short-term bank borrowings.

In the context of the above approach, there could be three alternatives to work out the maximum permissible level of bank borrowings:

i) Bank can work out the working capital gap, i.e., total current assets minus current liabilities other than bank borrowings and finance a maximum of 75 percent of the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings

ii) Borrower to provide for a minimum of 25 percent of total current assets out of long-term funds, i.e., owned funds plus term borrowings. As a certain level of credit for purchases and other current liabilities will be available to the borrower from the suppliers, the bank should provide the balance. Total current liabilities inclusive of bank borrowings should not exceed 75 percent of current assets.

iii) Same as (ii) above, but excluding core current assets from total current assets on the basis of the theory that core current assets should be financed out of long term funds, i.e., owned funds plus term borrowing.

The three alternatives may be illustrated by taking the examples of a borrower’s financial position, projected as at the end of the next year (see box in the next page).

In case the existing net working capital (i.e. excess of current assets over current liabilities) exceeds 25 percent of the working capital gap (in 1st method) or 25 per cent of total current assets/real current assets (in 2nd and 3rd methods), the contribution from long-term sources will ordinarily be the total extent of the already existing net working capital.

The 1st method would mean the banker financing upto a maximum of 75 percent of the working capital gap of 2,200, i.e., 1,650 and the borrower providing at least 550 out of his long-term funds, i.e., owned funds plus long-term borrowings. This method will give a minimum current ratio of 1:1.

The 2nd method would mean the borrower financing a minimum of 25 percent of total current assets (920) through long-term funds and the gap, i.e., maximum of 1,280 (2,780-1,500), will be provided by the bank. This will give a current ratio of at least 1.3:1.

The 3rd method would mean a further reduction in bank borrowing and strengthening of the current ratio.

It is important to note that in an exercise like this for computing the level of bank finance, the classification of current assets and current liabilities should be made as per the usually accepted approach of bankers and the standard accounting principles. For instance, instalments of term loans payable within 12 months from the date of balance sheet are classified by the banker as current liabilities while it is not so in the balance sheet prepared in accordance with the requirements of the Companies Act. Accordingly we need to be careful about the classification of current assets and liabilities.

Whilst it is felt that the 3rd method is ideal to reach as it will provide the healthiest liquidity for the borrower and the largest multiplier of bank finance; the next best method from this aspect is the second one, followed by the first. However, to avoid hardship to borrowers, it would be logical if a beginning is made with the 1st method of lending. It is necessary to have a time bound programme to make the process effective. It would be not out of place to mention that the Reserve Bank of India had implemented this system very successfully way back in 1976/77.

It is felt that lending up to 75 percent of the working capital gap as in the 1st method is liberal but a view could be taken that this should be considered as the upper limit. The limit of 75 per cent has been suggested as the first step, particularly to facilitate financial structuring of new companies, setting up projects in backward areas and also for flexibility in re-structuring of existing companies with a weak financial base. Over time as more and more borrowers adjust to this credit discipline, they would be building up longer term financing sources in their businesses, which would improve the overall risk profile of the credit exposure of the banking system.

As a logical progression, another point of consideration is as to how to take care of a request for additional credit from a borrower who already has an excess borrowing under any of the above methods. Such a need for additional credit will normally arise with an increase in production activity. We would expect that if the additional fund needs are on a regular basis, the borrower should bring a matching contribution required under the relevant method of lending. He could do this by retained earnings or by raising additional equity or by issuing debentures or by bringing in more funds in any other suitable manner for the purpose. In very exceptional cases, where the borrower is not able to raise the requisite funds immediately in the aforesaid manner, the banks may consider giving a term loan to a reasonable extent provided the cash generation capacity of the borrower is sufficiently strong to take care of the amortisation of the existing term obligations as already stipulated as well as the proposed additional loan within a short period, in a manner acceptable to the bank.

Once the quantum of bank funds to finance a reasonable level of current assets is agreed upon, there is also a need to change the style of extending bank credit. Borrowers enjoying multiple banking facilities need to provide the same information on working capital requirements to all potential lenders, which clearly establishes the maximum permissible bank finance under the norms.

(Mundul is the Chief Executive Officer, Standard Chartered Bank Nepal Ltd. The views in this article are his own and do not necessarily reflect those of his institution.)