Page 58 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 4: The Financing Mix

In view of the growing demand on bank funds from all sectors, industrial companies have no Notes
option but to use bank funds in the most efficient way. In the past, they misused or mismanaged
the bank funds. Bank credit primarily meant for working capital finance was found to be used
for long-term purposes and to finance subsidiaries and associated companies. Not only this,
cheap credit available from banks has been used to build-up disproportionate stocks of materials
to realise trading profits.
In fact, the misuse of bank funds was made possible by the existing system of bank lending,
based on cash credit system.
The practice was to lend generally to the extent of 75 per cent of the value of inventory and
receivables, the remaining 25 per cent being the margin. The value of inventory included
purchases of materials on credit. Thus, this amounted to double financing – from creditors as
well as banks. Bank lending, under the cash credit system, was directly related to security in the
form of inventory and receivables, irrespective of borrower’s operations. So long as the borrower
continued to provide the required margin, the banker considered his advance to be safe and
liquid, and did not bother about the way in which advance was being utilised. The borrower’s
limit was generally increased, without much questioning about his operations, whenever
inventory and receivable levels went up. The banker never took a closer look into the affairs of
the customer.
One important drawback of the system was that the banker sanctioned a maximum limit within
which the borrower could draw at his will. Under this procedure, the level of advances in a bank
is determined not by how much a banker can lend at a particular point of time but the borrower’s
decision to borrow at that time. Under a tight situation, such a system would put banks to
considerable strain. The cash credit system makes credit planning by banks very difficult.
The existing practice in fixing limit was to value inventory at the market prices for fixing limit.
For this reason and because of the availability of credit from creditors, a borrower was able to
borrow more than his current assets requirements. Accordingly, it was possible for the borrower
to divert banks’ funds to acquire fixed assets, including investment stand make advances to
subsidiaries and associated concerns.
In the early years, bank lending in India was mostly directed to financing of movement of
agricultural produce from the grower to the trader, the task of financing foreign trade being
handled mostly be foreign banks. Advances were sanctioned against the security of stocks
pledged or hypothecated to the banks. Based on English banking practice, the purpose of
commercial bank lending in India has traditionally been seen as the provision of short-term
finance for business.
With the growth of industrialization, the same system of bank lending continued with minor
changes, and the banker saw his function as meeting also the industry’s need for short-term
funds. Working capital finance was made available ostensibly for acquisition of current assets
and as the advances were made available in cash credit accounts, repayable on demand, they
were considered short-term in nature and self-liquidating in character. As industrialization in
India was largely promoted by an earnest of good management, in addition to the security of
the current assets of the borrowing company; security-cum-guarantee advances thus became the
pattern of lending to industry. The security-oriented system tended to favor borrowers with
strong financial resources, irrespective of their economic function.
With the advent of planning for economic development and a growing social awareness of the
role of bank credit in the economy, it was felt that the prevailing commercial bank lending
system had little social control and that it aided concentration of economic power. It was felt too
that system was unresponsive to needs of the weaker sectors of the economy, small industry and
agriculture and concentrated instead on security-cum-guaranteed-oriented lending to large

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