Understanding Working Capital — A Banker’s View

Day 10 of 30 | Credit Insights Series by Sangeeta Sharma

When entrepreneurs approach banks for working capital limits, they often present one side of the story — their sales. But as credit analysts, we dive deeper into the entire cash operating cycle and balancesheet analysis.

What is Working Capital?

Working Capital = Current Assets — Current Liabilities

• Current Assets: These are assets that can be converted into cash within a year, such as cash itself, accounts receivable (money owed by customers), and inventory.
• Current Liabilities: These are obligations due within a year, including accounts payable (money owed to suppliers), short-term loans, and accrued expenses.

It funds daily business operations — raw material, processing, inventory, and collections.

A positive working capital indicates that a company has enough short-term assets to cover its short-term liabilities. On the other hand, negative working capital is a sign of financial distress.

For a credit analyst, a thorough analysis of working capital provides a window into a company’s operational efficiency and liquidity. It helps us to assess the risk associated with extending credit. A business with a healthy working capital position is seen as more likely to meet its debt obligations, making it a more attractive borrower.

Components We Often Analyze:

1. Inventory Holding Period
2. Receivables Collection Period
3. Payables Credit Period

Working Capital Cycle (CCC):

Cash Conversion Cycle = Inventory Days + Receivable Days — Payable Days

The longer the cycle, the higher the working capital need.

I have discussed it in deep in my Day 8.

Link is here (Day 8)

Banker’s View:

As a credit analyst we check:

• Realistic sales estimates
• Operating expenses trends
• Business seasonality
• Debtor aging report
• GST returns + stock statements
• Turnover vs Limit justification
• Ratios as our bank’s benchmark

Assessment Methods:

1. Turnover Method (20% of projected sales)
2. MPBF (Maximum Permissible Bank Finance)

I will be discussing these two methods in detail in coming days.

Common Red Flags in the Proposal:

• Consistently Negative Working Capital: While some business models (like certain retail or restaurant businesses with cash sales and credit from suppliers) can operate with negative working capital, for most industries, it’s a sign of serious financial trouble.
• A Declining Current or Quick Ratio: A downward trend in these ratios over several periods can indicate deteriorating liquidity and increasing short-term risk.
• A Lengthening Cash Conversion Cycle: This can signal underlying problems with sales, collections, or inventory management. An analyst needs to understand the reasons for the delay.
• Over-reliance on Short-Term Debt: A high proportion of short-term debt to total debt can make a company vulnerable to interest rate fluctuations and refinancing risks.
• Significant Fluctuations in Working Capital: Certain fluctuations in working capital suggests instability in the business operations or poor financial planning.
• High Levels of Old Inventory or Accounts Receivable: A detailed aging report of both inventory and receivables is crucial. A significant amount of old, unsold inventory or long-overdue customer payments will be heavily discounted or even written off by a credit analyst in their assessment.

Pro Tips for Business Owners from Credit Analyst:

1. Accelerate Cash Inflows:

• Invoice promptly and accurately.
• Offer early payment discounts.
• Implement a robust collections process for overdue accounts.
• Consider accepting online or mobile payments for faster processing.

2. Optimize Inventory:

• Implement a just-in-time (JIT) inventory system to minimize holding costs.
• Regularly analyze inventory turnover to identify and clear out slow-moving or obsolete stock.
• Improve demand forecasting to better align inventory levels with sales.

3. Manage Cash Outflows:

• Negotiate favorable payment terms with suppliers.
• Take advantage of early payment discounts from suppliers when it makes financial sense.
• Carefully manage operating expenses and avoid unnecessary cash burn.

How to craft compelling Working Capital Loan Proposal?

When approaching a bank for a working capital loan, a well-prepared proposal is essential. It should not only state the amount needed but also demonstrate a clear understanding of how the funds will be used and how the loan will be repaid. Key elements to include are:

• Executive Summary: A concise overview of your business, the loan request, and the purpose of the financing.
• Business Profile: Details about your company’s history, products or services, market, and management team.
• Financial Statements: Historical and current financial statements (balance sheet, income statement, and cash flow statement).
• Working Capital Analysis: A detailed breakdown of your current working capital position, including key ratios and an explanation of any recent trends.
• Loan Request and Use of Funds: Clearly state the loan amount requested and provide a detailed breakdown of how the funds will be allocated (e.g., to purchase inventory, bridge a seasonal cash flow gap, or support a large contract).
• Repayment Plan: A realistic and detailed plan for how the loan will be repaid, supported by cash flow projections.
• Collateral: A list of assets that can be pledged as security for the loan.

By understanding how bankers/ credit analysts scrutinize working capital, business owners can take proactive steps to strengthen their financial position. This not only improves their day-to-day health of the business but also significantly enhances their ability to secure the financing needs for future growth and success.

Working capital isn’t just a loan — it’s the pulse of your business.

This was Day 10 of my 30-Day Credit Insights Series. Tomorrow, we’ll cover Day 11: Turnover vs Profit — What Matters to a Banker?

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