The basic work of a bank is to accept the surplus and / or investible money from public and lend the same to the needy persons known as Depositors and Borrowers respectively. Before globalization and liberalization or after that, the basic function of a Public Sector Lenders even today remains the same i.e., working capital finance. The working capital finance normally a short term running credit for a maximum period of one year. This quantum of finance is assessed under various methods like Turnover Method, Flexible Bank Finance method etc. Whichever way we assess the quantum of finance, it is basically depends upon two documents. The audited Balance Sheet and P&L account. The projected balance sheet is submitted to the bankers for the purpose of assessing the quantum of finance based on the balance sheet. It is interesting to note at this point that a full years need for working capital of a borrower is based on audited balance sheet which is the snapshot of the business concern as on a particular day. Whichever method we decide the quantum of finance one single element “The Margin” plays a crucial role in finalizing the working capital limits. This entire article is devoted to the clear and unambiguous understanding of the concept of margin.
What is margin ?
Traditionally, when a new officer takes charge the credit department, he is bombarded with technical jargons like “Audited Balance Sheet”, “Turnover”, Projected Sales”, “P&L Account” “Current Assets”, “Current Liabilities” etc. From the day the officer begins the career till the cessation of service one item that is often referred in assessment of working capital limits is the margin. Anyone would have got their first lesson in starting the credit department is first to bifurcate the balance sheet as per the needs of the bankers. The rudimentary lessons are taught in basic segregation of balance sheet into Long Term Sources, Long Term Uses, Short Term Sources and Short Term Uses.
|Long Term Sources|
It can be seen from the above that having split the balance sheet into four segments the difference between the top two or bottom two are always the same.
Thanks to the revised balance sheet introduced to be used from 31st March 2012 which contains more or less the segregation as per banks needs. Owner’s funds and Share Application Money are added as one group, Current and Non Current Liabilities as rest in the liabilities side. The Assets side is simplified into Current and Non Current Assets. Finally the new comer, with the intention not to confuse him at the start of the career, is taught meticulously the concept of margin. He is given the first basic lesson in credit which is margin is nothing but “Current Assets – Current Liabilities = Margin”.
How far it is true?
Strictly speaking as a practical banker, the concept of margin is not that simple to understand. Even learned processing officers used to write that due to increase in the closing stocks the current assets is showing a higher side and margin also increased correspondingly. If you see in depth, the margin has nothing to do with any single item of current assets or current liabilities but it is a result of the excess of long term sources over long term uses. Having brought up with the myth that margin is Current Assets – Current Liabilities if the concept of margin is not made clear to the younger generation who starts the banking career for various reasons with the list of educational qualifications as divergent as Engineering, Arts, Business Administration, Finance, HR, Basic Science. A simple commerce student is sufficient to understand the nuances of balance sheet and various technical terms of working capital finance. It is the general observation that the non commerce student picks up the trends quickly whereas the commerce students tad low due to complacency. It is only the observation exceptions are always there.
Now coming to the core issue what is the correct answer to the question “How margin is calculated in a business concern?” As the balance sheet is bifurcated into two groups in each side with a total of four groups the answer also narrows down to two choices. Either as traditionally taught opinion Current Assets – Current Liabilities or the fact Long Term Sources – Long Term Uses.
It is estimated that majority of senior staff in all public sector banks are retiring on superannuation before the end of 2017 and the consequent vacancies are to be filled up by the inexperienced but smart young probationary officers. How to make the newcomer probationary officer to understand the fact from the opinion is daunting task in the hands of the seniors as the baton has to be passed on before the time runs out.
The youngsters are smart enough to understand any new thing by the blink of an eye so there is no need to teach them traditionally as to How to do it. It is the order of the day to teach them Why to do it. So making them understand the concept is more important than how to do it. With plethora of software and applications the work of how to do it is child’s play for them. So how to make them understand that the margin which is traditionally taught to them as CA-CL is a right answer but not a perfect answer. The perfect answer is the surplus of Long Term Sources over Long Term Uses. It is not that simple to make them understand and believe this basic fact. Then how to make them understand is this purpose of this article. As said earlier it is by telling them why than how to do it.
Let us be practical
Let the youngsters learn in more practical and simple way of observing and asking why than to tell how. When the margin in the system is reduced which is also reflected by reduction in current ratio, all the sanctioning authorities prescribe various terms and conditions to improve the margin in the system. Let us analyze the same one by one.
- Additional Capital to be brought in by the promoters: This is one of the common conditions prescribed by the sanctioning authorities. If additional capital is to be brought in, it depends upon the composition of borrower and that determines the modes of bringing in. In case of Partnership, Individual, Proprietor, LLP, then it is simply bringing in the additional cash. The capital is increased and the corresponding entry in balance sheet Cash on Hand is also increased. In case of companies then the company has to issue additional shares if there is a space available between Authorized Capital and Paid up Capital. Again cash is brought into the system. Capital is one of the main components of Long Term Sources.
- Profit should be ploughed back into the system: This is another standard terms and conditions to improve the margin in the system. The retention of profit is one of the mail sources to build up the capital of the borrower. The higher the percentage of retained profit, more the growth of Reserves and surplus which encompasses surplus from Profit and Loss account. If the profit is entirely withdrawn then the capital remains the same there is no additional infusion of funds. Every business grows till saturation point, and then the diversion of business interest and activities takes place. To meet the growing business needs which results in higher level of current assets, higher margin from the borrower is expected at least in the existing level. Unless the profit is ploughed back in the system which is a natural phenomenon the margin will remain the same. Hence by plough back of profit the margin is increased as it is normally in the form cash.
- Fresh Unsecured Loans to be brought in by the borrower: The capital can be taken back in a simple way in case of borrowers other than companies and by way of declaring dividend in case of companies. The component of loan earns interest for a borrower to the giver for any type of borrower. The same cannot be said if the same is brought in by way of capital. Normally capital is brought in with the intention of starting the business and as such only profit is taken back. As the choice of increasing the margin is left to the borrowers, one such way is to bring additional unsecured loan from friends, relatives and directors. This without an iota of doubt is another element in the Long Term Sources.
- Negative condition with regard to unsecured loans: Many a times, the sanction term stipulates that during the currency of the working capital limits, the unsecured loan should not be withdrawn from the system. Why this condition is stipulated is the borrower can plough back the entire profit into the system, instead of taking a part of the profit, he may withdraw loan which nullifies the effect of plough back of profit. Further withdrawing the unsecured loan is by way of cash which reduces the liquidity and margin available in the system.
- Investments in group companies should be brought back: Coming to the assets side, i..e, Long Term Uses, the investments in group companies and associate concerns are nothing but funds flown out of the system. They form the component of Non Current Assets as per the latest balance sheet pattern. If the investments in the group companies are brought back, naturally it results into funds flow into the system augmenting the cash position of the borrower.
- Recovery efforts for Sundry Debtors to be speeded up: The common understanding is anything which is not current assets automatically goes up to non-current assets. When a sizable portion of non-current assets are reduced, it naturally increases the liquidity by way of additional funds.
- Finished goods more than certain period should be disposed off: Same as above, the finished goods beyond certain period should be disposed either for discount or for cost price so that the money blocked is released. The formation of any non current assets and its reduction always results in addition liquidity for the borrower.
- Non-core assets are to be disposed off: As the name itself suggests, core assets of a borrower is never disposed off unless it is winding up. Whereas the non-core assets by its disposal which in no way affect the normal business and its continuous running, is another important source for increasing the margin.
The above practical examples are not exhaustive but only as major examples repeatedly prescribed by the sanctioning authorities to improve the margin in the system. Now the participants can well understand that to improve the margin in the system, all the terms and conditions stipulated by the sanctioning authorities are revolving around either a component of Long Term Sources or a component of Long Term Uses. Now it will be clear for the youngster to capture this basic nature of how margin is really worked out for a borrower. Having said so much about the Long Term Sources and Long Term Uses which results the margin in the system, it is also pertinent to explain how current assets and current liabilities are related and behave.
The levels of Current Assets and Current Liabilities have no bearing on the margin:
Once the borrower starts running the business unit, he starts the same with the initial corpus of cash on hand. Let us assume that if he buys raw material out of existing cash, then the cash changes its nature from Cash to Inventory. If borrower gets market credit, then to the extent of the value a new item Sundry Creditors is created in the liabilities side and Inventories are created on the assets side. If he converts the raw material into finished goods then it is only intra movement of value within the broad heading Inventory. Supposing if he also avails the bank finance which is nothing but Cash Credit, commonly known as Short Term Bank Borrowings, then it is expected that it is either for releasing the amount blocked in current assets to run the next cycle of production or to create the current assets in case of a new borrower. Every amount of drawing from cash credit account should generate a current asset. Again this is not a strict rule, whether the market credit is costly, then the same can be replaced with bank borrowing which is having cheaper cost compared to the market. Any situation that is happening in the Current Assets and Current Liabilities are either internal movement or intra movement. It is also to be noted that bank borrowing is only against Inventories, Sundry Debtors, etc nor for financing “other current assets”.
Now the concept of margin becomes clearer to the youngsters who donned the role of credit processing officer now and going to become Top Management. The concept of margin due to proper explanation of why than how to do it also enlightens them forever in their career not to mix up the margin with the elements of current assets and current liabilities, though they are starting their career with that teaching “Current Assets – Current Liabilities = Margin”.
About the Author
Assistant General Manager
Union Bank of India, Staff College, Bannerghatta, Bengaluru.