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: 1.
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.
The current ratio will strengthen and reliance on bank finance reduces under these three methods successively.
Approaches to Bank Financing:
In order to provide greater freedom in assessing the working capital requirements of borrowers, effective from April 15, 1997, all instructions relating to MPBF were withdrawn. Banks were instructed to evolve their own method such as turnover method, the cash budget system, the MPBF system with necessary modifications or any other system of assessing working capital requirements.
The loan policy in respect of each broad category of industry is, however, required to be laid down by each bank with the approval of the respective Board.
The following approaches are generally followed by the banks in financing working capital needs of the business firms:
i. Maximum Permissible Bank Finance (MPBF):
Under MPBF approach, the banks will fix the working capital finance limits of a firm at either 75 per cent of the company’s current assets or the difference between 75% of current assets and non-bank current liabilities. The inherent concept of the approach is that scarce credit must be rationed.
Under this method, the minimum acceptable current ratio was specified, thus fixing the minimum contribution of the corporate to funding working capital gap. At the same time, the maximum current assets levels were prescribed through a series of inventories and receivables norms.
ii. Current Ratio Financing:
The liquidity of the firm is said to be satisfactory if it is able to meet its obligations in the short-run. The measure of liquidity is the ratio of current assets to current liabilities.
Hence current ratio is used by the bankers in estimating and financing the working capital needs of the firms. The acceptable current ratio is, therefore, the ratio of bank funds to own funds. This ratio is fixed through negotiation between the corporate and the banker.
iii. Cash Flow Financing:
The need for working capital arises essentially because of uneven and uncertain nature of cash flows. This is because cash outflows to meet production expenses do not occur at the same time as cash proceeds from sales are realized. They are uncertain because sales and costs are not known in advance.
By projecting future cash receipts and disbursements, the cash budget enables the corporate to determine its cash needs, and plan their financing accordingly. Under this approach, bank finance is based on the submission of periodic say, quarterly, cash flow statements that would fit smoothly into a firms cash cycle.
To determine the quantum of bank finance, banks must evaluate cash-flow risks, forcing them to be more involved in day to day operations of the borrower. Once the bank has appraised the cash budget, ad hoc requests for more funds will not be entertained. This will demand sound resource planning, receivable management, purchase planning and management of inventory.