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# Ascertaining of Capital Requirements

Academic Paper Review   by:LifeLIVE     Original Author: CA S. Sairam

ASCERTAINING THE CAPITAL REQUIREMENTS
Fixed and Working capital assessments are a professional exercise which demands strong knowledge of business operation as well as finance. Working capital is the active portion of the capital for a business. It can be compared to the engine oil for a motor car or the blood of a human body. No wonder why finance is termed as the life blood of business. Regular assessment of the Capital needs is all the more important to keep the business affairs afloat.
For a new business the basic capital requirements are calculated in the below order
1. Profitability assessment i.e. whether the desired profit generation is possible in the venture.
This is a very comprehensive exercise involving estimation of target sales and purchases with a professional market study.
2. Having already arrived at the sales and purchase estimates, we go on to measure the level of debtors and creditors with the data regarding general credit terms prevailing in the industry. We arrive at Debtors as the number of days sales outstanding. For e.g. if the general trade credit is 45 days, the level of debtors is the average expected sales per day multiplied by 45. The same applies to creditors. We also need to compute the level of Inventory. This is a function of the Number of units of a stock to be held to satisfy the customer requirements multiplied the average Cost of production per day. The following numerical example should clear the air,
Sales per month Rs. 30000/- (Average sales per day Rs. 1000)
Purchases per month Rs. 15000/- (Average purchases per day Rs. 500)
Total Cost of Production Rs. 25000/- (Average COP per day Rs. 8334)
Assuming the FG Stock has to maintained for at least a week requirement
If the credit term is 45 days, the debtor amount is (1000*45) Rs. 45000/-; creditor amount is (500*45) Rs. 22500/-. Likewise the FG stock level will be (8334*7) Rs. 58338/-. It may be noted that the relevant factor for Work in Progress is Factory cost (i.e. Prime cost +Factory overheads) and for Raw material is the Purchase Price.
A perfect calculation culminates with inclusion of term loan liabilities payable within one year.
3. Net working capital is Current assets minus Current liabilities. The jargon that we use nowadays is ‘Working capital gap’ which forms the basis for ‘Maximum Permissible Bank Finance’.

• In an ongoing business where there is an accumulated loss, the equity has to be first adjusted for the loss booked till date. This is to calculate the shortage in Promoter margin at any point of time.
• One more significant practical aspect is the components of current assets. In practice, the Banker might also ignore certain non-productive current assets for e.g. Rental Advance paid to accommodate staffs, drinking water deposit etc. Hence while approaching the banker for negotiating short term credit, the finance manager or the Auditor has to get asserted about the components of the current assets and then proceed preparing the CMA (Credit Monitoring Arrangement) data so that he is able to project the current ratio properly.
• In a profitable business, where the Balance sheet contains an item of ‘Deferred Tax asset’ being brought forward business or depreciation loss, a portion of the same can be treated as Current asset for assessment. This emphasis is because the presentation of the balance sheet as per Companies Act 1956 is currently such that the deferred tax items are neither placed as Current assets nor as fixed assets. But thankfully the IFRS balance sheet proposes to eliminate this anomaly by presenting only two classes namely Non Current assets and Current assets. Accordingly the Deferred tax asset can be classified under one of these groups.
Having said these, the Base rate system effective from 1.7.2010 is here to eliminate discretionary lending rates by banks, which means that corporate need not exert too much in making the financial ratios look rosy to bargain for too low interest rates.
The flip side of making a wrong assessment of Working capital is an aftermath in Business. Practically the below consequences have/can arise due to a dearth in Working capital,
• Usage of Term loan funds for paying off suppliers. This breach of covenant has lead to cancellation of the sanction by the Bank since the statutory auditor will not be able to certify the end use of the funds.
• Usage of ECB (External Commercial Borrowing) loans for working capital purposes. This is a very serious punishable offence under FEMA 1999. As per the ECB norms of the RBI, the amount borrowed should not be used for Working capital, real estate and investment in stock market.
• Inability to payback the Import Invoices within 6 months (i.e. time limit allowed under FEMA 1999), which leads to interest obligations with forex impact. This necessitates RBI approval and condonation for the delay.
• Last but not the least, a sub standard Current ratio.
Both the fixed and working capital mentioned above is capable of being measured in quantity and quality. But there is one capital where only quantification is accurately possible but not quality assessment. That is Human capital. Anybody who can decipher a formula will emerge successful in the business venture.
Published: September 09, 2010
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