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WELINGKAR INSTITUTE OF MANAGEMENT DEVELOPMENT AND RESEARCH

SUMMER PROJECT

ON

PROBLEMS IN ASSESSING
WORKING CAPITAL
FOR MSE

BY

NAME

: SRUTHY GOPAN

COURSE

: MMS-2013-15

SEMESTER

: III

SPECIALIZATION : FINANCE
ROLL NO.

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: 90

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PROBLEMS IN ASSESSING
WORKING CAPITAL
FOR MSE

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ACKNOWLEDGEMENT
Experience is the best teacher and my summer internship period had been enriched by the
experiences of the people I got to work with in IDBI,MSE.
With a sense of great pleasure and satisfaction, I present this project report entitled
PROBLEMS IN ASSESSING WORKING CAPITAL FOR MSE. Completing a task
successfully is never an individual effort; similarly completion of this report is the result of
invaluable support and contribution of many people in direct and indirect manner. In the light of
foregoing, first of all my heartfelt great fullness and thanks goes to Mr. M C SUNIL KUMAR as
the DEPUTY GENERAL MANAGER of IDBI , for giving me an opportunity to work for this
highly esteemed organization and for being a constant source of inspiration and guidance
throughout the project. Without their able support the project would not have seen the light of the
day.
At this juncture, I would also like to thank the entire staff of IDBI. Without their indispensable
cooperation, the project wouldnt have been completed within the stipulated time period.
I would like to thank my mentor Mr SAIRAM SUBRAMANIAN for his earnest advices that
helped make my project more inclusive and exhaustive.
Finally,I would like to thank Professors of Welingkar Institute of Management Development
and Research, who provided guidance in this project.

SRUTHY GOPAN

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EXECUTIVE SUMMARY

In this report the problem we are trying to analyse is the loopholes in assessing the working
capital requirement for the MSE.
MSE s ,previously SSI (small scale industries) are the growth engines of economy.
The prevalent methods of assessments practiced in the banks are discussed .The project is
executed by jointly analyzing both those methods and the inherent features of MSEs. The sector
chosen being MSE hence envisages the discussion of PSL norms prevailing in the banking
industry . The Priority sector lending (PSL),it is the sector which gets directly affected by a lot
of government decisions and those by RBI. Hence the lending policies followed by the banks
will be aligned with those.That angle also forms a part of our project.

The evolution of priority sector lending in india over the years forms the bedrock for the existent
assessment policies in Banking sector.The project brings into purview the flaws addressed
through frequent revisions in the PSL norms and those flaws that remain unaddressed in the
present norms.

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TABLE OF CONTENTS
Sr. No.
1
1.1
1.2
2

Page
6
8

RESEARCH METHODOLOGY
2.1 Objective of Study
2.2 Limitations of the study
2.3 Sources of data

3
3.1
4

Topic
Banking Industry in India
Introduction
Industrial development Bank of India(IDBI)

IMPORTANCE OF
EVOLUTION
INTRODUCTION

PRIORITY

10
10
10
10
SECTOR

LENDING

AND

IMPORTANCE OF MICRO AND SMALL ENTERPRISES(MSEs)


4.1 INTRODUCTION
4.2 MSEs IN INDIA
4.3 ROLE OF BANKS IN MSE FINANCING

5
5.1
5.2
6

WHY WORKING CAPITAL NEEDS MANAGEMENT ?- WCM


IMPORTANCE
METHODS OF ASSESSMENT

ITS 11
11

11
13
15
17
17
21

PROBLEMS FACED BY IDBI AND OTHER BANKS ON ASSESSMENT 28


OF WORKING CAPITAL FOR MSEs
RECOMMENDATIONS/SUGGESTIONS
MODIFICATIONS REQUIRED IN THE SYSTEM

30
30

CONCLUSION

32

BIBLIOGRAPHY & REFERENCES

33

ANNEXURE I:

34

10

ANNEXURE II:

36

10.1

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1.BANKING INDUSTRY IN INDIA


1.1 INTRODUCTION
Banks play a critical role in the economic development of emerging economies such as India.
Banks today are important not just from the point of view of economic growth, but also financial
stability.
In emerging economies, banks are special for three important reasons:
1. They take a leading role in developing other financial intermediaries and markets.
2. Due to the absence of well-developed equity and bond markets, the corporate sector
depends heavily on banks to meet its financing needs.
3. In emerging markets such as India, banks cater to the needs of a vast number of savers
from the household sector, that prefer assured income, liquidity and safety of funds,
because of their inadequate capacity to manage financial risks.

Forms of banking have changed over the years and evolved with the needs of the economy. The
transformation of the banking system has been brought about by deregulation, technological
innovation and globalization. The focus on customers has been changing based on the changing
customer needs and increasing competition. The perspective of Banks towards customers in
various decades can be summarized as below:
Decade
1950-1960
1960-1980
1980-1990
1990-2000
2000 and beyond

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Focus on Customer
Serving the customer
Satisfying the customer
Pleasing the customer
Delighting the customer
Retaining the customer

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PORTERS 5 FORCE MODEL FOR BANKING SECTOR

Threat of New Entrants (HIGH):


o Many financial, even non-financial organizations can easily enter into the banking
industry. For example, an insurance company can easily start offering mortgage
and loan services. Also, when analyzing a regional bank, the possibility of a mega
bank entering into the market poses a real threat. The switching cost in the current
market scenario has become smaller and the returns higher, which is why the
threat of new entrants is high in this industry.
Availability of Substitutes (HIGH):
o There are plenty of substitutes in the banking industry. Banks offer a suite of
services over and above taking deposits and lending money, but whether it is
insurance, mutual funds or fixed income securities, chances are there is a nonbanking financial services company that can offer similar services. On the lending
side of the business, banks are seeing competition rise from unconventional
companies. For example, if car companies are offering 0% financing, customers
will not be approaching banks for Auto loans.

Bargaining Power of Buyers (HIGH):


o Bank industry is a high buyer concentration industry. Millions of people use bank
services, such as deposit money, mortgage, loan, investment, insurance and
currency exchange. Also, with the wide penetration of Internet and technology,
the customer has access to extensive information. One click and the information
about the interest rates offered by all banks on various loans and deposits, is
easily available. Hence, the customers can compare the products and services
offered by Banks and choose the best among them. The customer generally

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compares various banking products and services on the basis of interest rates, be it
taking loans or for term deposits. Even a 0.5% difference in interest rates can
divert customer attention.

Bargaining power of Supplier (LOW):


o Depositors are one of the main capital suppliers of bank, they compare with other
financial products to see whether to draw out capital or not.

1.2

Competitive Rivalry (HIGH):


o The financial services industry has been around for hundreds of years and just
about everyone who needs banking services already has them. Because of this,
banks must attempt to lure clients away from competitor banks. They do this by
offering lower financing, preferred rates and investment services. The banking
sector is in a race to see who can offer both the best and fastest services, but this
also causes banks to experience a lower ROA. They then have an incentive to take
on high-risk projects.

I.D.B.I

Industrial Development Bank of India


Industrial Development bank of India (IDBI) was constituted under Industrial Development bank
of India Act, 1964 as a Development Financial Institution and came into being as on July 01,
1964 vide GoI notification dated June 22, 1964. It was regarded as a Public Financial Institution
in terms of the provisions of Section 4A of the Companies Act, 1956. It continued to serve as a
DFI for 40 years till the year 2004 when it was transformed into a Bank.
Industrial Development Bank of India Limited
In response to the felt need and on commercial prudence, it was decided to transform IDBI into a
Bank. For the purpose, Industrial Development bank (transfer of undertaking and Repeal) Act,
2003 [Repeal Act] was passed repealing the Industrial Development Bank of India Act, 1964. In
terms of the provisions of the Repeal Act, a new company under the name of Industrial
Development Bank of India Limited (IDBI Ltd.) was incorporated as a Govt. Company under the
Companies Act, 1956 on September 27, 2004. Thereafter, the undertaking of IDBI was
transferred to and vested in IDBI Ltd. with effect from the effective date of October 01, 2004. In
terms of the provisions of the Repeal Act, IDBI Ltd. has been functioning as a Bank in addition
to its earlier role of a Financial Institution.

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Merger of IDBI Bank Ltd. with IDBI Ltd.


Towards achieving the faster inorganic growth of the Bank, IDBI Bank Ltd., a wholly owned
subsidiary of IDBI Ltd. was amalgamated with IDBI Ltd. in terms of the provisions of Section
44A of the Banking Regulation Act, 1949 providing for voluntary amalgamation of two banking
companies.
The
merger
became
effective
from
April
02,
2005.

Merger of United Western bank with IDBI Ltd.


The United Western bank Ltd. (UWB), a Satara based private sector bank was placed under
moratorium by RBI. Upon IDBI Ltd. showing interest to take over the said bank towards its
further inorganic growth, RBI and Govt. of India amalgamated UWB with IDBI Ltd. in terms of
the provisions of Section 45 of the Banking Regulation Act, 1949. The merger came into effect
on October 03, 2006.
Change of name of IDBI Ltd. to IDBI Bank Ltd.
In order that the name of the Bank truly reflects the functions it is carrying on, the name of the
Bank was changed to IDBI Bank Limited and the new name became effective from May 07,
2008 upon issue of the Fresh Certificate of Incorporation by Registrar of Companies,
Maharashtra. The Bank has been accordingly functioning in its present name of IDBI Bank
Limited.

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2.

RESEARCH METHODOLOGY

2.1
OBJECTIVE OF STUDY
The objective of the project is to analyse in depth the problems in assessing the working capital
requirement for MSEs.It was quite clear from the beginning that the problems are faced by the
entire banking industry .But the depth and facets of the problems was quite inevitable to be
brought into the picture.Also the inherent flaws prevailing in the system(not only in india but
outside ) is also studied along with to get a more clear picture.
2.2
LIMITATIONS OF THE STUDY
The substantiation of the facts which I got through the files which I came across during my
stint at the bank is impossible because of the extant guidelines of the bank.Because of what I
had to recreate a sample case with hypothetical numbers.Also I had to rely mostly on the oral
interview reports for my primary research.
In performing the comparative study among different banks ,the obstacle faced was their
reluctance to disclose.So the numbers were limited.The banks covered were

2.3

CANARA BANK

INDIAN OVERSEAS BANK

BANK OF BARODA

KARUR VYSYA BANK

SYNDICATE BANK
SOURCES OF DATA

The method adopted is primarily collecting the anecdotes from the managers in IDBI.The nature
of the problems that I have to analyse regarding the assessment is very relevant not only to
IDBI, but also to the entire banking and hence experiences by respective officials of some more
banks were also taken.The modes opted were both questionnaire and oral interview.
The secondary data was collected through Books & magazines, and Websites.

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3.IMPORTANCE OF PRIORITY SECTOR LENDING AND ITS EVOLUTION


3.1 INTRODUCTION
At a meeting of the National Credit Council held in July 1968, it was emphasised that
commercial banks should increase their involvement in the financing of priority sectors, viz.,
agriculture and small scale industries. The description of the priority sectors was later formalised
in 1972 on the basis of the report submitted by the Informal Study Group on Statistics relating to
advances to the Priority Sectors constituted by the Reserve Bank in May 1971. On the basis of
this report, the Reserve Bank prescribed a modified return for reporting priority sector advances
and certain guidelines were issued in this connection indicating the scope of the items to be
included under the various categories of priority sector. Although initially there was no specific
target fixed in respect of priority sector lending, in November 1974 the banks were advised to
raise the share of these sectors in their aggregate advances to the level of 33 1/3 percent by
March 1979.At a meeting of the Union Finance Minister with the Chief Executive Officers of
public sector banks held in March 1980, it was agreed that banks should aim at raising the
proportion of their advances to priority sector to 40 percent by March 1985. Subsequently, on the
basis of the recommendations of the Working Group on the Modalities of Implementation of
Priority Sector Lending and the Twenty Point Economic Programme by Banks (Chairman: Dr.
K. S. Krishnaswamy), all commercial banks were advised to achieve the target of priority sector
lending at 40 percent of aggregate bank advances by 1985..The guidelines were last revised in
the year 2007 based on the recommendations made in September 2005 by the Internal Working
Group of the RBI (Chairman: Shri C. S. Murthy). The Sub-Committee of the Central Board of
the Reserve Bank (Chairman: Shri Y. H. Malegam) constituted to study issues and concerns in
the Micro Finance institutions (MFI) sector, inter alia, had recommended review of the
guidelines on priority sector lending. Accordingly, Reserve Bank of India in August 2011 set up
a Committee to re-examine the existing classification and suggest revised guidelines with regard
to Priority Sector lending classification and related issues (Chairman: M V Nair).
I. Categories under priority sector
(i) Agriculture
(ii) Micro and Small Enterprises
(iii) Education
(iv) Housing
(v) Export Credit & (vi) Others

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II. Targets /Sub-targets for Priority sector


Categories
Total
Sector

Priority

Total agriculture

Micro &
Small
Enterprises
(MSE)

Domestic commercial banks / Foreign banks


with 20 and above branches
40 percent of Adjusted Net Bank Credit [ANBC
defined in sub paragraph (iii) below] or credit
equivalent amount of Off-Balance Sheet
Exposure, whichever is higher.
18 percent of ANBC or credit equivalent
amount of Off-Balance Sheet Exposure,
whichever is higher.
Of this, indirect lending in excess of 4.5% of
ANBC or credit equivalent amount of OffBalance Sheet Exposure, whichever is higher,
will not be reckoned for computing achievement
under 18 percent target. However, all
agricultural loans under the categories 'direct'
and 'indirect' will be reckoned in computing
achievement under the overall priority sector
target of 40 percent of ANBC or credit
equivalent amount of Off-Balance Sheet
Exposure, whichever is higher.

Foreign banks with less than


20 branches
32 percent of ANBC or credit
equivalent amount of OffBalance
Sheet
Exposure,
whichever is higher.
No specific target. Forms part of
total priority sector target.

(i) Advances to micro and small enterprises


sector will be reckoned in computing
achievement under the overall priority sector
target of 40 percent of ANBC or credit
equivalent amount of Off-Balance Sheet
Exposure, whichever is higher.

No specific target. Forms part of


total priority sector target.

40 percent of total advances to micro and


small enterprises sector should go to Micro
(manufacturing) enterprises having investment
in plant and machinery up to Rs.10 lakh and
micro (service) enterprises having investment in
equipment up to Rs. 4 lakh;
(iii) 20 percent of total advances to micro and
small enterprises sector should go to Micro
(manufacturing) enterprises with investment in
plant and machinery above Rs.10 lakh and up to
Rs.25 lakh, and micro (service) enterprises with
investment in equipment above Rs.4 lakh and
up to Rs.10 lakh
Export Credit

Advances to
Weaker Sections

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Export credit is not a separate category. Export


credit to eligible activities under agriculture and
MSE will be reckoned for priority sector
lending under respective categories.
10 percent of ANBC or credit equivalent
amount of Off-Balance Sheet Exposure,
whichever is higher.

No specific target. Forms part of


total priority sector target.

No specific target in the total


priority sector target.

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4 .IMPORTANCE OF MSEs IN PRIORITY SECTOR LENDING


4.1 MSEs in India
Small and Medium Enterprises (MSEs) play a pivotal role in driving the overall industrial and
economic development of a nation. They contribute towards balanced regional development,
economic diversification, and social stability in addition to creating employment and driving
GDP growth. Hence, today, most parts of the world consider nurturing entrepreneurship among
the foremost priorities for overall economic development. The entrepreneurial spirit and
innovative nature of these MSEs have been crucial in driving competitiveness in the
economy.Although MSEs continue to play a crucial role in driving economic development of
countries, development of the MSE sector presents a major and difficult challenge. In this
context, the definition of MSEs varies across economies and it is primarily used for policy
development and implementation, specific to MSEs in respective economies.
The Indian MSE Sector
The Indian government passed the Micro, Small, and Medium Enterprises Development
(MSMED) Act, 2006 to address policy issues affecting MSEs and to extend the coverage and
investment ceiling of the sector. Further, the Act aims to facilitate development of the sector
along with enhancing its competitiveness.
The MSMED Act, 2006, classifies enterprises broadly into: (i) Manufacturing enterprises and (ii)
Services enterprises. The Act further classifies these enterprises into micro, small, and medium
enterprises based on their investment in plant and machinery (for manufacturing enterprises) or
investment in equipment (for services enterprises). The following is the present ceiling on
investment for enterprises to be classified as micro, small, and medium enterprises:

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MSEs play a crucial role of a catalyst in driving growth of the Indian economy by providing vital
linkages to large local and international value chains. As per the Fourth All India Census of
MSE, 2006, there are more than 36 million MSEs in India contributing 45% of industrial output,
40% to Indias exports, and approximately 8% to Indias GDP. MSEs employ more than 80
million people and generate gross output of ` 13,513.8.

The Fourth All India Census of MSME indicates that, of the overall Indian MSME sector,
31.79% of the enterprises are engaged in manufacturing activities, while the remaining 68.21%
are engaged in services.

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Performance of Indian MSME Sector

Source:Ministry of micro ,small and medium enterprises


Indian MSMEs, which constitute more than 95% of the enterprises in India, have grown
significantly, with their gross output growing from 11.5% in FY03 to 15.8% in FY06; from `
3,148.5 bn in FY03 to ` 4978.42 bn in FY06.The gross output of MSME sector is projected to
grow from 6.2% in FY08 to 6.3% in FY11, slightly less than Indias GDP growth during the
same period. During FY12, the gross output of MSME sector is projected to grow at 6.6%,
slightly higher than Indias GDP growth of the same period.The sudden spike in gross output and
market value of fixed assets in FY07 was due to the passing of MSMED Act, 2006,thereby,
changing SSI definition incorporating medium enterprises and enterprises providing services
under the definition. the gross products of the MSMEs is projected to grow at a consistent pace
of over 6% from ` 14,351.79 bn in FY08 to ` 18,434.32 bn in FY12. The market value of fixed
assets of the MSMEs has grown from 4.9% in FY03 to 5.3% in FY06 and is projected to grow
over 6% from FY08 to FY11 and by 7.5% in FY12. Similarly, employment growth rate in
MSMEs projected to grow at an average rate of over 6%. These figures clearly highlight
importance of the MSME sector towards the development of Indian economy.

4.2 ROLE OF BANKS IN MSE FINANCING


Availability of timely and adequate credit is a prerequisite to enable Indian MSEs to expand and
scale their operations. In recent years, while the Indian economy has been growing at over 6%,
the production from micro, small and medium enterprises has been growing at over 11%
between 2002 - 2003 and 2007- 2008 (Ministry of Micro, Small and Medium Enterprises, 2008Summer Internship 2014

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2009). In India, banks are the dominant channel for providing funds to industry. However their
importance in funding smaller rms is even more pronounced since most small and medium
enterprises (MSEs) are not able to access the capital markets for funds. In recent years, governments and policy makers have been giving considerable attention to facilitate the development of
the MSE sector, as a strong and vibrant MSE sector provides a good foundation for
entrepreneurship and innovation in the economy.

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5 WHY WORKING CAPITAL NEEDS MANAGEMENT? - WCM


5.1 IMPORTANCE
For running an industry or a concern, two types of capital are required viz., fixed capital and
working capital. Working capital is the fund invested in current assets and is needed for meeting
day to day expenses.
Current assets represent Gross Working Capital. The excess of current assets over current
liabilities is Net Working Capital. Current assets consists of all stocks including finished goods,
work in progress, raw material, cash, marketable securities, accounts receivables, inventories,
short term investments, etc. These assets can be converted into cash within an accounting year.
Current liabilities represent the total amount of short term debt which must be settled within one
year. They represent creditors, bills payable, bank overdraft, outstanding expenses, short term
loans, etc.
Thus, working capital is the finance required to meet the costs involved during the operating
cycle or business cycle.Working capital is the cash needed to pay for the day to day operations of
the business. In other words, working capital is needed by the business to:

Pay suppliers and other creditors (for raw material purchases)

Pay employees (salary and wages)

Financing the gap between the supply of goods and the receipt of payment thereafter
(trade credit).

In other words, Working Capital Finance is the fund required to meet the cost involved
during the working capital cycle or operating cycle.
Operating Cycle or Working Capital Cycle
Operating cycle is the period involved from the time raw materials are purchased to the time they
are converted into finished goods and the same are finally sold and realized. The need for current
assets arises because of operating cycle. The operating cycle is a continuous process and
therefore the need for current assets is felt constantly. Each and every current asset is nothing but
blockage of funds. Therefore, these current assets need to be financed which is done through
Working Capital Financing.
In manufacturing units, Working capital cycle comprises of purchase of raw materials either in
cash or credit basis, converting raw materials into work in process and then into finished goods
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and transformation of finished goods into book debts / cash.In respect of trading concerns,
operating cycle represents the period involved from the time the goods and services are procured
and the same are sold and realized. The working capital cycle is illustrated as follows:
Trade Cycle for Working Capital

Fixed Portion of Trade Cycle


There is always a minimum level of current assets or working capital which is continuously
required by the firm to carry on its business operations. This minimum level of current assets is
known as permanent or fixed working capital or core current assets. It is permanent in the same
way as the firms fixed assets are. This portion of working capital has to be financed by
permanent sources of funds such as; share capital, reserves, debentures and other forms of long
term borrowings. The extra working capital needed to support the changing production and sales
is called fluctuating or variable or temporary working capital. This has to be financed on short
term basis. The main sources for financing this portion are trade credit, bank credit, factoring and
commercial paper. It is in this context that bank financing assumes significance in the working
capital financing of industrial concerns.
Investment is needed at each stage to finance current assets. The total working capital
requirements for Industrial Units will depend upon the holding period of assets and the operation
of the trade cycle. Thus, the stocking of raw materials may be equivalent to one to three months
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raw materials consumption for most industries.As regards the operating cycle, the duration of
each stage of process cycle is first decided upon having regard to the function it is supposed to
perform. The conversion of raw materials into finished goods depends upon the technical
requirements and manufacturing facilities available. Similarly, the turnover of finished products
and their transformation into book debts, bills or cash could be related to factors like delivery
schedule, business customs and competition. Thus, the working capital cycle of a manufacturing
activity starts with the acquisition of raw materials in cash or credit basis and ends with
realization of finished goods in cash/ book debts.
The cycle is long in some cases and short in others, depending upon the nature of business.
Cycle is fast in consumer goods industries and slow in capital goods industries. Cycle is short in
case of perishables such as food articles, beverages, fruits, fish, eggs, etc. Cycle is long in the
case of tobacco, distilling, timber, steel, etc. Seasonal industries like manufacturers of umbrella,
woollen fabrics, fans, refrigerators, etc., require higher stocks in some months and bare minimum
in remaining months.Companies that have high inventory turnover and do business on a cash
basis (such as a trader) need very little working capital. These types of businesses raise money
quickly, then turn around and plough back that money back into inventory to increase sales.
Since cash is generated so quickly, managements can simply stockpile the proceeds from their
daily sales for a short period of time if a financial crisis arises. Since cash can be raised so
quickly, there is no need to have a large amount of working capital available.
A company that makes heavy machinery is a completely different story. Because these types of
businesses are selling expensive items on a long-term payment basis, they can't raise cash as
quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can
rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it
may be too late). It's easy to see why companies such as this must keep enough working capital
on hand to get through any unforeseen difficulties. During the cycle, funds are blocked in various
stages of current assets, viz., , inventory (consisting of raw materials, stock in process, finished
goods) and receivables.
These require finance, finance involves costs. Quicker the cycle more is the turnover normally
and longer the cycle, the less is the turnover. Stagnation in any area effects turnover and
profitability. Working capital cycle vary from industry to industry depending upon its nature of
business. Factors which affect working capital cycle are:

Policy of the management on production and sales


Inventory management/ Receivables management
Nature of manufacturing activity/process
Policy of extending credit for purchases as well as sales
Government policy

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Type of product
Demand for the products/services and level of competition.

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5.2 METHODS OF ASSESSMENT


Consistent with the policy of liberalization, in April 1997, RBI withdrew the prescription in
regard to assessment of working capital needs, based on MPBF, enunciated by Tandon
Committee. Thus banks are given greater operational freedom for dispensation of credit. Banks
are also free to evolve their own method of assessing working capital requirements of the
borrowers within the prudential guidelines and exposure norms already prescribed.
The level of investment in an operating cycle depends upon changes in:
1) Terms of production and sales other factors remaining constant
2) The price of raw materials
3) Lead time for producing raw materials
4) The pattern of manufacturing expenses
5) The process time
6) Policy of extending credit (both on purchase as well as sales) etc.
Assessment of working capital shall normally based on the following:
1) Production / Processing cycle of the industry
2) Size of the business and quantum of working capital requirements
3) Financial and managerial capability of the borrower and the various parameters relating to
the borrower.
4) Prevailing mandatory instructions of RBI
5) The trade and industry practice prevailing and other objective factors
This chapter explains the framework for assessing working capital requirement. AssesMSEnt of
the Working Capital requirement of a borrower shall generally be made under any one of the
following three methods:
1) Turnover method (P R Nayak Committee recommendation)
2) Maximum Permissible Bank Finance (MPBF) Method (Tandon/Chore Committee
recommendation)
3) Cash flow budget method
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Turnover method
This method has been introduced in 1993 by RBI with a view to improve overall credit flow to
the SSI sector. MSE units having working capital limits of up to Rupees 500 lakh from the
banking system are to be provided working capital finance computed on the basis of 20 percent
of their projected annual turnover. The turnover method shall be applicable on MSE units (new
as well as existing).
Applicability of turnover method:
Particular

Working capital limit upto

Applicable to

MSEs

Upto 5 crs

Manufacturing sector & services sector

Non MSEs

Upto 2 crs

Traders, Merchants, exporters etc.

This system is normally applicable to traders, merchants, exporters who are not having a pre
determined manufacturing / trading cycle. Under the turnover method bank should ensure that
maintenance of minimum margin on the projected annual sales turnover. Normally 25% of the
estimated gross sales turnover value shall be computed as working capital requirements, of
which 20% shall be provided by the bank and the balance 5% by way of promoter contribution
towards margin money. In case of a traders, while bank finance could be assessed at 20% of the
projected turnover, the actual drawals should be allowed on the basis of drawing power
determined after deducting unpaid stocks. Under this method current ratio would be min. 1.25.
Illustration
working capital requirement under the turnover method:
a) Projected accepted annual Gross Sales Turnover

Rs.10.00 lakh

b) Working capital required 25% of the sales

Rs. 2.50 lakh

c) Minimum margin to be provided by the borrower Rs. 0.50 lakh


d) Working capital finance (b-c)

Rs. 2.00 lakh

Monitoring of the working capital finance

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As the working capital requirement are linked to projected turnover, reasonableness of the
projected annual turnover of the applicant company should be analysed by keeping in view of
past performance of the unit, the orders on hand, installed capacity of the units, power,
availability of raw materials and other infrastructural facilities . In respect of a new unit projected
turnover should be analysed with regard to installed capacity, marketability of the products,
performance of the similar unit in the industry, background of the promoters etc.
The projected turnover / output value is the gross sales which include excise duty. The
assessment of working capital credit limits should be done both as per projected turnover basis
and traditional methods based on production/processing cycle (MPBF). If the credit requirement
based on MPBF method is higher than the one assessed on projected turnover basis, the same
may be sanctioned. On the other hand, if the assessed credit requirement is lower than the one
assessed on projected turnover basis, while the credit limit can be sanctioned at 20% of the
projected turnover, drawals may be allowed basing on actual drawing power after excluding
unpaid stocks after obtaining monthly stock statement.
MPBF Method
Before going through the MPBF method of working capital assesMSEnt, we need to understand
two very important concepts of working capital finance as under;
Working Capital Gap
This represents excess of current assets over current liabilities excluding bank borrowings. A
part of the Current Assets are financed by Current Liabilities (other than bank borrowings). The
remaining portion of current assets which requires financing is called as working capital gap.
Banks do not grant advance to the full extent of working capital gap. It is always desirable rule
that the borrower has to finance a part of working capital gap out of either capital or long term
sources called as net working capital (NWC) which reflects his continued commitment to the
business that is necessary for the survival of the unit.
Net Working Capital
NWC indicates the margin or long term sources provided by the borrower for financing a part of
the current assets. Rest part of current assets gets funded by current liabilities (including Bank
Borrowings). For successful operation of a business, Current Assets should be more than the
Current Liabilities. It ensures continuous liquidity (current assets are prone to price fluctuations
and should, therefore, have an in-built margin to absorb changes) and owner's stake in the current
business operations. In other terms, NWC is excess of long term sources available for WC needs
after long term uses. As such, actual NWC is equal to Long Term Sources (LTS) minus Long

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Term Uses (LTU). Net Working Capital changes with the change in level of Long Term Sources
(including profits earned during the year) or Long Term Uses.
Three methods for assessing working capital requirement as per Tandon Committee Norms are:-

Method Quantum of bank finance for working capital


First

75% of working capital gap (Current Assets Current Liabilities). Balance 25% has
to be funded out of long term sources.
This part is also called Net Working Capital (NWC)

Second

NWC should be at least 25% of the total Current assets. Remaining 75% to be first
financed by other current liabilities and the bank may finance the balance
requirement.
Borrower should provide for entire core current assets and 25% of the balance
current assets.

Third

Before the MPBF Method is explained, it is necessary to understand the erstwhile Second
Method of Lending under Tandon Committee Recommendations. Method 2 is the most
commonly adopted tool to assess working capital finance. Under Method II, the borrower should
bring in a minimum margin of 25% of all current assets from owned funds and long term
liabilities, and the balance i.e 75% be financed by the Bank.
The example given below will illustrate this:-

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Current Liabilities

Current Assets

Credit for purchase

30

Other current liabilities

10
40

Bank
borrowings
discounted

including

bill 140
180

Method II
a. Current Assets

Raw materials

100

Stock-in-process

10

Finished goods

50

Receivables
discounted

including

Other current assets

bill 80
10
250

250

Less:
b. Current Liabilities other
Borrowings
c. Working Capital Gap

than Bank 40
210

d. Minimum stipulated net


working 62.50
capital i.e 25% of Current Assets
e. Actual / projected net working capital 70
(total current assets 250 minus
total current liabilities 180 incl.
Bank Borrowings 140)
f. Item c minus d

147.50

g. Item c minus e

140

h. Max. Permissible Bank Finance (Item 140


f or g whichever is lower)
i.

Excess
borrowings 0
(representing shortfall in net working
capital item d minus e)

Cash Flow Budget Method


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In the case of specific industries / seasonal activities such as software export, construction
activity, tea and sugar, normally, the system of assesMSEnt based on the cash budget may be
adopted. Further, in the case of specific industries like tea, wherever for specific reasons, the
borrower opts to avail the Working Capital facility under MPBF system, the same may be
permitted by the respective sanctioning authority after necessary evaluation and justification.
Structure of Cash Flow Statement
The cash flow statement shows the movement of cash and bank balances during a certain period,
the reasons for increase (+) or decrease (-) in the bank borrowings, the level of cash holding
between 2 intervals of time. The cash flow statement is a historical statement that depicts the
flow of cash in the system. A cash budget statement depicts the projected movement of cash and
bank balances at a future period. It shows the expected inflow and outflow of cash and deficit
and surplus in generation of cash. The statement covers most of the details needed for assessment
of the financial needs of the borrower.
Needless to mention that this method of assessment needs to be supplemented with the
following:
1. Need for the projected levels of production (can be justified on the basis of orders on hand /
seasonal availability of the raw material / seasonal demand etc)
2. The projected levels of production should commensurate with the operating capacities of the
unit.
3. Verification of actual level of inventories, creditors and receivables so as to establish the
veracity of projections.
The statement of cash flow is made more meaningful and useful for assessment of working
capital by grouping the cash flows under three heads viz., Operating, Investing and Financing.
The principal cash flows arising out of the above three main groups are described below:
i)

Operating Activities

These activities involve producing and delivering goods and providing services. Cash inflows
from operating activities include receipts from customers for sale of goods and services,
including receipts from collection of debtors. Cash outflows from operating activities include
payments to employees for services, payment to suppliers of goods, payments to Governments
for taxes and duties and services etc.

ii)

Investing Activities

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These activities involve extending and recovering loans and acquiring and disposing of debt and
equity instruments and fixed assets. Cash inflow from investing activities include receipts from
loan collections, receipts from sales of debt and equity instruments of other enterprises and
receipts from sale of fixed assets. Cash outflows from investing activities include disbursements
of loans, payments to acquire debt and equity instruments of other enterprises and payments
(including advances or down payments) to acquire fixed assets.
iii)

Financing Activities

These activities involve obtaining resources from owners and providing them with a return on
and return of their investment, borrowing and repaying amounts borrowed, and obtaining and
paying for other resources obtained from creditors on long term credit. Cash inflows from
financing activities include proceeds from issuing equity instruments, debentures, mortgages,
bills and from other long and short term borrowings. Cash outflows from financing activities are
payments of dividends, repayments of amounts borrowed and principal payments to creditors
who have extended long term credit.
Assessment of the limit under the cash budget system is done by arriving at the deficit between
cash inflow and cash outflow during a period of time. In this method, quantum of finance is
determined by the extent of negative cumulative cash flow position during a particular month.
The indicative format for cash budgeting is in ANNEXURE II.
In the case of seasonal industries / industries having peak/non peak level operations, cash budget
indicating the peak level/non peak level cash flows shall be obtained separately. Based on such
peak level/non peak level cash deficit, peak level limits shall be arrived at.The quantum of bank
finance for working capital to the borrower shall be the peak level of the annual cash deficit
projected as per the projected cash flow statement. However, the working capital limits shall be
in tune with the quarterly cash deficit of the borrower as revealed in the quarterly cash budget.
To ensure sufficient liquidity, the projected balance sheet should reveal the minimum current
ratio acceptable to the bank. It should be ensured that working capital availed by way of cash
deficit is supported by adequate drawing power. Though cash budgeting is adopted, it is still
essential to analyse the liquidity, working capital management, overall leverage and debt
repayment capacity.

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6. PROBLEMS FACED BY IDBI AND OTHER BANKS ON ASSESSMENT OF


WORKING CAPITAL FOR MSEs

Diversion of funds is occasionally noted among many small and medium enterprises:

This may be due to sheer ignorance or due to lack of financial discipline.If such an event is
noted in the past, the natural tendency is to curtail credit exposure to the party irrespective of the
present state of the enterprise or the actual requirements noted.Possibility of diversion of
working capital finance to long term uses ie the Working capital finance which is meant for short
term uses and day to day operations of the firm due to lack of knowledge and financial expertise
,firms use short term capital to purchase long term assets. It will create an asset liability
mismatch and in turn can lead to cash flow crunch. This type of practices can lead to liquidity
crunch in the system.

Information asymmetry:

Difficulty in determining accuracy


a)There are instances when parties under report figures with a view to evade taxes or inflate
certain figures to make the ratios look good. Under such circumstances it is difficult to arrive at a
reasonably accurate credit profile of the party and can result in under financing or rejection of the
proposal.
b)Acceptability of Projected sales and profits
We use Nayak Committe Method for assessing working capital of Small Scale Industries, in
which the eligible working capital limit is calculated as a percentage of total projected sales. So,
in order to avail more working capital finance firms project higher sales and they fall short of
estimates when the actual results come out

Inherent loopholes in the bureaucratic system cause inadvertent delays

Working capital methods existing do not have the scope of include the delays caused due to
pending sanctions from local bodies for instances environmental clearances,power connection
etc.

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Rising pressure of NPAs

Mounting npa levels of many branches have increased the risk averse nature of credit officials.
This results in sanctioning lesser than ideal limits for w.c . Leading to cash strapped enterprises
unable to kick start growth and eventually threatening their very sustainability. Lack of owned
funds in the business, and complete dependency on borrowed funds also add to the conservative
nature of assessing officer

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6.
6.1

RECOMMENDATIONS/SUGGESTIONS

Modifications required in the System

Bureaucratic hurdles: The major revamp is required in the Indian way of redressal of
problems.Despite earning the status of priority sector MSEs struggle for the relevant
sanctions for speedy execution of their project.This in turn causes diversion of the funds
allocated for working capital into other uses .

Solution : A single window clearing system for MSEs in every state can be a solution. States like
Gujarat have already implemented .This ensure right infusion of funds at right time so that
working capital cycle is not affected. The lending technologies employed to lend to the SME
sector in India would thus be influenced by the government policies and the lending
infrastructure prevalent in the country. Lending technology is categorised into two
types:transactions lending that is based on hard quantitative data and relationship lending
which is based on softqualitative information.

Lack of action for increasing awareness: Realizing the importance of the MSME
sector to the Indian economy, both the central and state governments have taken various
initiatives to strengthen and enhance the competitiveness of MSME sector. This is
evident from the subsequent passing of the MSME Development (MSMED) Act in 2006.
Few of the key initiatives include:
National Manufacturing Competitiveness Program (NMCP)
Rajiv Gandhi Udyami Mitra
Credit Guarantee Trust Fund Scheme for Micro and Small Enterprises
Credit Linked Capital Subsidy Scheme (CLCSS)

Solution:But from the interaction I had with the managers of the banks I had surveyed ,I could
discern that the borrowers who are the beneficiary of these plans are many a times unaware of
these steps taken by government.So only through awareness those funds reach the right hands.

Bridging the information asymmetry:

MSEs are more vulnerable to information availability as they lack from large sources of finance
and hence largely in need of bank assistance.
Solution: credit scoring helps to reduce the information asymmetry, particularly with respect to
small firms and hence geographic proximity of the borrower and lender is not crucial to loan
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decisions. Recognising that better credit information can directly increase the amount of
financing for SMEs by reducing the risk and costs arising from information asymmetries, the
Credit Information Bureau of India Limited (CIBIL) has been established as a publice private
partnership to enhance the availability of credit information to member financial institutions.
Also tis estimated that in India, family businesses account for 70% of the total sales and net
profits of the biggest 250 private-sector companies (The Economist, 1996), and almost all
MSME would be family firms. Inter-family relationships and family succession play an important
role in the performance of family firms, and banks would need to take this into account in their
credit decisions. It was also found that family businesses in India where succession takes place
without fights and splits show higher profitability. This would suggest that a credit officer should
also be aware of inter-family relationships as the souring of these relationships could
significantly change the credit risk of the family firm.Hence soft information inclusive ranking
should be introduced in some way.

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7.CONCLUSION
The MSE sector in India, which includes the micro, small and medium enterprises, constitutes an
important part of the economy. However, a major concern for the MSEs is the availability of an
adequate amount of nances. The government has recognised the key role that the MSE segment
plays in creating new enterprises and in providing employment to a large segment of the
population and has adopted several public policy measures to enhance ow of credit to the
sector. One of the prominent measures used to ensure adequate ow of funds to the MSE sector
is through regulation requiring banks to provide at least 40% of loans to targeted areas which
include the micro, small and medium enterprises. Although directed lending would increase the
ow of funds to the MSE sector, studies suggest that MSE rms are credit constrained. One of
the signicant issues in lending to MSEs is the use of both hard data such as nancial
information, as well as soft data such as feedback from vendors and other family members,
which become important inputs towards understanding the credit risk of the business. The
challenge for banks is to bridge the information asymmetry so as to take the appropriate lending
decision so that the good rms are not nancially constrained, and at the same time, cut down on
exposures to bad credit risks.Also the bureaucratic delays adversely affects the working capital
cycle and there is no magical solution to it.So that problem remain out of bound in assesMSEnt.
Measures such as credit scoring for MSEs should improve the quality of nancial information
and enable greater funding for the sector. While it may be too early to conclude that MSE rms
in India are not nancially constrained, the reforms in the nancial sector and the improvement
in the lending infrastructure has certainly improved access to nance for small rms.The banks
as such should keep a balanced view regarding NPAs and should collaboratively deal the risk
averse nature arising out of it.MSE s are indeed the growth engines of our economy and perhaps
our only hope for bridging the CAD in the long term.So it is quite inevitable the sector continue
to be our priority.

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8.BIBLIOGRAPHY & REFERENCES

1. http://www.idbi.co.in/
2. ebsco
I.

Impact of basel ii on lending to MSEs:a regulatory policy assesMSEnt of


Spanish credit register data

II.

Real-time financing: Extending e-invoicing to real-time MSE financing,


Jaap Jan Nienhuis, Mounaim Cortet and Douwe Lycklama

III.

The Reasons and Symptoms of Failure in MSE, Jaroslaw Ropega

IV.

Financing of SME firms in India Interview with Ranjana Kumar,


Former CMD, Indian Bank;Vigilance Commissioner, CVC

3. science direct

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ANNEXURE I

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ANNEXURE II
FORMAT FOR CASH BUDGETING
Particulars / month

Activity Details
Production (quantity)
Sales ( quantity)
Purchases
Cash Flows
(A) Total Cash Inflow ( Sum of 1 to 8)
Cash Sales
Realisation from Debtors
Receipt by way of trade advances
Receipt of interest, dividend, other income
Long term loans raised
Short term loans raised
Sale of assets
Others (Specify)
(B) Total Cash Outflow ( sum of 1 to 16)
Cash purchases
Payment to sundry creditors
Advances to suuppliers
Wages and salaries
Lease rentals

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Manufacturing expenses
Selling and distribution expenses
General administrative expenses
Interest payment
Dividend payment
Capital expenditure
Repayment of Long term loan
Repayment of short term loan
Taxes
Deposits and investments
Others (specify)
(C ) Cash Budget
Total Cash Inflow (A)
Total Cash Outflow (B)
Net cash flow (1-2)
Add Opening cash balance
Cumulative net cash flow Amount to be
financed

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