Until yesterday, the banks were the CFO's sole source of funds for his working capital. No more. A whole new world of quick, and marketable, options has been thrown open to him, and the rationed trickle can be replaced by a range of short- and medium-term debt instruments. BT unveils the CFO's guide to working capital in 2000.

By Gautam Chakravorthy

Working capital Equals Bank Finance. That was the traditional short-term financing formula for generations of CFOs, weaned on a steady diet of financial regulation. With trade credit being the only other source of short-term finance, bank credit reigned supreme as the primary institutional source for working capital funds.

Obtaining that bank finance was a matter of juggling inventories and receivables to meet the intricate norms specified by a series of official committees. This created an inflexible system that was incapable of dealing with business cycles. In fact, in 1996-97, these rigid norms actually shut off the credit tap during an industrial slowdown, further exacerbating the situation. More subtly, this also obviated the need to develop strategies to bridge the working capital gap.

But if corporates could earlier ride through their cash cycles without devising such strategies they can ill-afford to do so now. For, financial deregulation has added, and will continue to add, more variables to the right-hand side of the working capital equation. What are these variables? What financing strategies optimise investments in net working capital? And how will they help redefine short-term financial budgeting to meet the emerging needs of the CFO?

The CFO's Need:
A More Flexible System Of Bank Financing
That Accommodates Variations In Requirements

Inherent in the concept of a maximum Permissible Bank Finance (MPBF) limit was the premise that scarce credit must be rationed. Under the MPBF regime, working capital finance limits for the year were fixed at either 75 per cent of the company's net current assets, or the difference between 75 per cent of the current assets and non-bank current liabilities. This was not as innocuous a formula as it seems.

The minimum acceptable current ratio was specified, thus fixing the minimum contribution of the corporate to funding the working capital gap. At the same time, the maximum current asset levels were prescribed through a series of inventories and receivables norms. Such a rationing mechanism robbed the credit delivery system of the elasticity to cope with even intra-year seasonal fluctuations, let alone full-blown business cycles.

A succession of credit policies did attempt to streamline the system through incremental reforms, but it did not yield much as the notion of the MPBF was left untouched. Finally, the Monetary & Credit Policy for the first half of 1997-98 (M&CP, 97) did away with the MPBF, pitchforking both the banker and the CFO into an era of greater freedom. And greater risk.

THE STRUCTURED SOLUTIONS: Nature--and conservative bankers--abhor a vacuum. Paradoxically, now that the MPBF is no longer mandatory, expect a substantial part of a lumbering banking system to keep on clinging to the safety of the MPBF. But norms can no longer be a substitute for judgement; risk assessment will have to be a key element of any credit-delivery system. Agrees Sanjiv Bhasin, 42, senior manager, Hongkong Bank: "Perceptions of credit risk will now shape working capital finance."

CURRENT RATIO FINANCING. Obviously, the liquidity of the company--that is, its ability to meet its obligations in the short run--will loom large in credit risk appraisals. Since the most common, and convenient, measure of liquidity is the ratio of current assets to current liabilities, future methods of estimating working capital finance will be predicated on the current ratio. Points out R. Sundareshan, 43, senior vice-president, ICICI Bank: "To fund the gap between production and receivables, banks will continue to examine the production cycle and the recovery process."

While this may look suspiciously like the old system, there are vital differences. The acceptable current ratio--and, therefore, the ratio of bank funds to own funds--is now a matter for negotiation between the corporate and the bank. Plus, there will be greater flexibility as to what qualifies as a current asset. For instance, under the MPBF norms, marketable investments were not counted as current assets. Now, corporates can lobby for the inclusion of such investments, thereby lowering the amount to be brought in by the promoters.

CASH-FLOW FINANCING. The need for working capital arises essentially because of the asynchronous, 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 realised. 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. Clearly, bank finance based on the submission of periodic--say, quarterly--cash-flow statements would fit smoothly into a firm's cash cycle.

Cash-flow financing imposes its own brand of discipline. To determine the quantum of bank finance, banks must evaluate cash-flow risks, forcing them to be more involved in the 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, receivables management, purchase planning, and management of inventory.

More subtly, extending working capital finance on the basis of future cash- flows provides a more holistic view of the firm. Avers S.K. Shelgikar, 41, advisor to the Rs 3,000-crore Videocon Group: "Corporates will be funded only on their earning capacity." Agrees V.K. Kaul, 53, the CFO of the Rs 1,068-crore Ranbaxy Laboratories: "Factors such as the state of the industry, the quality, and credibility, of the management, the financial discipline practised, and the track-record will figure in credit appraisal."

Remember, however, that it is not just the company's tangible assets that determine its earning capacity. Increasingly, commercial success in a fiercely-competitive marketplace is predicated by intangibles such as brand equity and know-how. "Placing intangibles, such as brands, on the balance-sheet forces the firm to identify and finance its value-drivers," says Mohandas Pai, 40, director (finance) of the Rs 139.22-crore Infosys Technologies, which recently estimated the value of the Infosys brandname at Rs 178 crore.

The inclusion of intangible assets in the cash- flow calculation will intensify the pressures for unsecured lending. In stark contrast to the lending practices prevalent in the developed markets, working capital finance here has involved the creation of a charge on the underlying assets. But, as S. Narayan Prasad, 43, senior manager (corporate banking), National Bank of Bahrain, cautions: "With the banks' NPAs at 14 per cent of advances, the regulators will frown on unsecured transactions."

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