Tandon Committee Report on Working Capital: Norms and Recommendations

In 1974, a study group under the chairmanship of Mr. P. L. Tandon was constituted for framing guidelines for commercial banks for follow-up & supervision of bank credit for ensuring proper end-use of funds. The group submitted its report in August 1975, which came to be popularly known as Tandon Committee Report on Working Capital. Its main recommendations related to norms for inventory and receivables, the approach to lending, style of credit, follow ups & information system.

It was a landmark in the history of bank lending in India. With acceptance of major recommendations by Reserve Bank of India, a new era of lending began in India.

Tandon committee’s recommendations

Breaking away from traditional methods of security oriented lending, the committee enjoyed upon the banks to move towards need based lending. The committee pointed out that the best security of bank loan is a well functioning business enterprise, not the collateral.

Major recommendations of the Tandon committee were as follows:

  1. Assessment of need based credit of the borrower on a rational basis on the basis of their business plans.
  2. Bank credit would only be supplementary to the borrower’s resources and not replace them, i.e. banks would not finance one hundred percent of borrower’s working capital requirement.
  3. Bank should ensure proper end use of bank credit by keeping a closer watch on the borrower’s business, and impose financial discipline on them.
  4. Working capital finance would be available to the borrowers on the basis of industry wise norms (prescribe first by the Tandon Committee and then by Reserve Bank of India) for holding different current assets, viz.
    • Raw materials including stores and others items used in manufacturing process.
    • Stock in Process.
    • Finished goods.
    • Accounts receivables.
  5. Credit would be made available to the borrowers in different components like cash credit; bills purchased and discounted working capital, term loan, etc., depending upon nature of holding of various current assets.
  6. In order to facilitate a close watch under operation of borrowers, bank would require them to submit at regular intervals, data regarding their business and financial operations, for both the past and the future periods.

The Norms

Tandon committee had initially suggested norms for holding various current assets for fifteen different industries. Many of these norms were revised and the least extended to cover almost all major industries of the country.

The norms for holding different current assets were expressed as follows:

  1. Raw materials as so many months’ consumption. They include stores and other items used in the process of manufacture.
  2. Stock-in-process, as so many months’ cost of production.
  3. Finished goods and accounts receivable as so many months’ cost of sales and sales respectively. These figures represent only the average levels. Individual items of finished goods and receivables could be for different periods which could exceed the indicated norms so long as the overall average level of finished goods and receivables does not exceed the amounts as determined in terms of the norm.
  4. Stock of spares was not included in the norms. In financial terms, these were considered to be a small part of total operating expenditure. Banks were expected to assess the requirement of spares on case-by-case basis. However, they should keep a watchful eye if spares exceed 5% of total inventories.

The norms were based on average level of holding of a particular current asset, not on the individual items of a group. For example, if receivables holding norms of an industry was two months and an unit had satisfied this norm, calculated by dividing annual sales with average receivables, then the unit would not be asked to delete some of the accounts receivable, which were being held for more than two months.

The Tandon committee while laying down the norms for holding various current assets made it very clear that it was against any rigidity and straight jacketing. On one hand, the committee said that norms were to be regarded as the outer limits for holding different current assets, but these were not to be considered to be entitlements to hold current assets upto this level. If a borrower had managed with less in the past, he should continue to do so. On the other hand, the committee held that allowance must be made for some flexibility under circumstances justifying a need for re-examination.

The committee itself visualized that there might be deviations of norms in the following circumstances.

  1. Bunched receipt of raw materials including imports.
  2. Interruption of production due to power cuts, strikes or other unavoidable circumstances.
  3. Transport delays or bottlenecks.
  4. Accumulation of finished goods due to non-availability of shipping space for exports or other disruption in sales.
  5. Building up of stocks of finished goods, such as machinery, due to failure on the part of the purchaser for whom these were specifically designed and manufactured.
  6. Need to cover full or substantial requirement of raw materials for specific export contract of short duration.

While allowing the above exceptions, the committee observed that the deviations should be for known and specific circumstances and situation, and allowed only for a limited period to tide over the temporary difficulty of a borrowing unit. Returns to norms would be automatic when conditions return to normal.

Methods of Lending

The lending framework proposed by Tandon Committee dominated commercial bank lending in India for more than 20 years and its continues to do so despite withdrawal of mandatory provision of Reserve Bank of India in 1997.

As indicated before, the essence of Tandon Committee’s recommendations was to finance only portion of borrowers working capital needs not the whole of it. It was thought that gradually, the borrower should depend less on banks to fund its working capital needs. From this point of view the committee three graduated methods of lending, which came to be known as maximum permissible bank finance system or in short MPBF system.

For the purpose of calculating MPBF of a borrowing unit, all the three methods adopted equation:

Working Capital Gap = Gross Current Assets – Accounts Payable

…. as a basis which is translated arithmetically as follows:

Gross Current Assets                 Rs. ………………

Less: Current Liabilities

other than bank borrowings  Rs. ……………….

Working Capital Gap                 Rs. ……………….

First method of lending

The contribution by the borrowing unit is fixed at a minimum of 25% working capital gap from long-term funds. In order to reduce the reliance of the borrowers on bank borrowings by bringing in more internal cash generation for the purpose, it would be necessary to raise the share of the contribution from 25% of the working capital gap to a higher level. The remaining 75% of the working capital gap would be financed by the bank. This method of lending gives a current ratio of only 1:1. This is obviously on the low side.

Second method of lending

In order to ensure that the borrowers do enhance their contributions to working capital and to improve their current ratio, it is necessary to place them under the second method of lending recommended by the Tandon committee which would give a minimum current ratio of 1.33:1. The borrower will have to provide a minimum of 25% of total current assets from long-term funds. However, total liabilities inclusive of bank finance would never exceed 75% of gross current assets. As many of the borrowers may not be immediately in a position to work under the second method of lending, the excess borrowing should be segregated and treated as a working capital term loan which should be made repayable in installments. To induce the borrowers to repay this loan, it should be charged a higher rate of interest. For the present, the group recommends that the additional interest may be fixed at 2% per annum over the rate applicable on the relative cash credit limits. This procedure should be made compulsory for all borrowers (except sick units) having aggregate working capital limits of rs.10 lakhs and over.

Third method of lending

Under the third method, permissible bank finance would be calculated in the same manner as the second method but only after deducting four current assets from the gross current assets.

The borrower’s contribution from long-term funds will be to the extent of the entire core current assets, as defined, and a minimum of 25% of the balance current assets, thus strengthening the current ratio further. This method will provide the largest multiplier of bank finance.

Core portion current assets were presumed to be that permanent level which would generally vary with the level of the operation of the business. For example, in case of stocks of materials the core line goes horizontally below the ordering level so that when stocks are ordered materials are consumed down the ordering level during the lead time and touch the core level, but are not allowed to go down further. This core level provides a safety cushion against any sudden shortage of materials in the market or lengthening of delivery time. This core level is considered to be equivalent to fixed assets and hence, was recommended to be financed from long-term sources.

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]

Leave a Reply

Your email address will not be published. Required fields are marked *


*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>