When it comes to managing working capital needs, businesses, especially in India, often seek financial assistance through banks and financial institutions. One of the methods banks use to calculate and offer this working capital is through Maximum Permissible Bank Finance (MPBF). This approach ensures that businesses do not borrow more than necessary and helps the bank mitigate its lending risks. MPBF is an essential concept for businesses seeking working capital loans to sustain or expand their operations.
This article covers everything you need to know about MPBF, its methods of calculation, its significance, and how businesses can benefit from it.
What is Maximum Permissible Bank Finance (MPBF)?
Maximum Permissible Bank Finance (MPBF) is a method used by banks to determine the maximum amount of working capital finance that can be extended to a company. It is primarily designed for businesses in need of funds to cover their day-to-day operational expenses, including raw materials, inventory, salaries, and other overheads.
The concept of MPBF was introduced by the Tandon Committee in the 1970s to regulate the flow of funds from banks to businesses and ensure that companies do not over-borrow. The approach is focused on maintaining a balance between the company’s internal funds and external borrowing.
Why is MPBF Important for Businesses?
MPBF is crucial for both banks and businesses for several reasons:
- Ensures Adequate Working Capital: MPBF helps businesses maintain adequate working capital to meet short-term obligations and keep the business running smoothly.
- Mitigates Over-Borrowing: MPBF limits the amount a business can borrow, preventing it from falling into a debt trap and encouraging better financial discipline.
- Encourages Optimal Utilization of Funds: It ensures that companies use internal funds efficiently before relying on bank loans.
- Risk Management for Banks: For banks, MPBF helps minimize credit risk by ensuring that companies do not overextend themselves financially, reducing the likelihood of default.
MPBF Calculation: The Tandon Committee Methods
The Tandon Committee suggested three different methods for calculating MPBF. These methods have been adopted by banks to assess working capital requirements for businesses. The choice of the method may depend on the size of the business, its financial stability, and the bank’s lending policies.
Method 1: First Method of Lending
In the First Method of Lending, the bank finances only a portion of the working capital gap, and the rest must be financed through the business’s own resources. This method encourages businesses to rely more on internal funds rather than borrowing excessively from external sources.
- Working Capital Gap (WCG) = Current Assets (CA) – Current Liabilities (CL)
Under the first method, the bank will finance up to 75% of the Working Capital Gap. The business must finance the remaining 25% from its own resources, such as owner’s equity or retained earnings.
For example:
- Current Assets (CA) = ₹10 crores
- Current Liabilities (CL) = ₹4 crores
- Working Capital Gap (WCG) = ₹10 crores – ₹4 crores = ₹6 crores
- Maximum Bank Finance = 75% of ₹6 crores = ₹4.5 crores
- Company’s Contribution = 25% of ₹6 crores = ₹1.5 crores
This method ensures that businesses have a significant stake in managing their own working capital.
Method 2: Second Method of Lending
In the Second Method of Lending, banks take a more conservative approach. Here, the bank’s contribution to the working capital is lower, requiring the company to fund a larger portion of the gap. This method also promotes financial discipline by encouraging businesses to use more of their internal funds.
- Net Working Capital (NWC) = Current Assets (CA) – Current Liabilities (CL) – Core Working Capital (CWC)
In this method, the bank will finance 75% of the core working capital, and the business has to cover the remaining 25% through its own funds.
For example:
- Current Assets = ₹10 crores
- Current Liabilities = ₹4 crores
- Core Working Capital (CWC) = 25% of Current Assets = ₹2.5 crores
- Working Capital Gap = ₹6 crores – ₹2.5 crores = ₹3.5 crores
- Maximum Bank Finance = 75% of ₹3.5 crores = ₹2.625 crores
- Company’s Contribution = 25% of Core Working Capital
This method further reduces the risk for banks by ensuring that businesses rely even more on their internal resources.
Method 3: Third Method of Lending (Not Commonly Used)
The Third Method of Lending is rarely used and offers more flexibility compared to the first two methods. In this method, banks finance a portion of the working capital requirement over and above the core current assets. The method allows for more bank financing than Method 1 and Method 2 but is rarely implemented as it exposes banks to higher risks.
Key Components of MPBF Calculation
To understand MPBF better, it’s essential to break down the major components used in its calculation:
- Current Assets (CA): These are the assets that a company expects to convert into cash or use up within a year, including inventory, accounts receivable, and cash equivalents.
- Current Liabilities (CL): These are obligations the company must pay off within the next year, including accounts payable, short-term loans, and other debts.
- Working Capital Gap (WCG): The difference between current assets and current liabilities, representing the amount of working capital a business needs.
- Core Working Capital (CWC): A portion of current assets that remain permanently invested in the business and are not fluctuating based on operational needs.
- Net Working Capital (NWC): The difference between current assets and current liabilities, reflecting the short-term financial health of the business.
Factors that Influence MPBF for Businesses
While the Tandon Committee’s methods provide a structure for calculating MPBF, several factors can influence how much finance a bank is willing to offer:
- Nature of the Business: Businesses with steady cash flows and lower financial risks may receive a higher MPBF limit compared to businesses with volatile cash flows.
- Business Performance: Profitability, revenue stability, and historical financial performance play a significant role in determining the MPBF amount.
- Collateral Offered: Banks may ask for additional collateral to mitigate risks, even if MPBF traditionally doesn’t require it.
- Banking Relationship: Businesses with strong relationships with their banks, including a history of timely repayments, may get favorable MPBF terms.
- Economic Conditions: During periods of economic downturn, banks may tighten their MPBF criteria to safeguard against defaults.
Advantages of MPBF for Businesses
- Disciplined Borrowing: MPBF helps businesses avoid over-borrowing by capping the maximum permissible finance based on their needs and internal resources.
- Risk Reduction: By encouraging businesses to finance a portion of their working capital needs with internal resources, MPBF reduces the overall risk of over-dependence on loans.
- Ensures Financial Health: The formula-based approach of MPBF helps businesses maintain a balanced financial structure, contributing to long-term sustainability.
- Better Cash Flow Management: With defined limits on working capital loans, businesses are forced to manage their cash flows more efficiently.
Challenges with MPBF
While MPBF offers numerous benefits, it also presents certain challenges for businesses, especially small and medium enterprises (SMEs):
- Limited Flexibility: The fixed percentage contribution required from businesses may strain startups or SMEs with limited internal resources.
- Complex Calculations: The methods of calculating MPBF can be complex for businesses unfamiliar with financial terms, requiring the expertise of financial professionals.
- Stringent Documentation: Banks may require extensive documentation and periodic audits to ensure compliance with MPBF guidelines.
- Potential for Under-Funding: In some cases, MPBF may restrict a business from securing sufficient working capital, which could limit growth opportunities.
How to Apply for MPBF Loans
To apply for working capital finance under MPBF, businesses typically need to follow these steps:
- Prepare Financial Statements: Ensure your business’s financial statements are up-to-date, including balance sheets, income statements, and cash flow statements.
- Analyze Working Capital Requirements: Calculate your working capital needs by assessing your current assets, liabilities, and the working capital gap.
- Consult with the Bank: Approach your bank to discuss the MPBF limits they can offer based on your business’s financial health and requirements.
- Submit Required Documentation: Provide the necessary documents, such as financial statements, business registration, and bank statements, for the MPBF assessment.
- Negotiate Terms: Once the bank has calculated your MPBF, negotiate repayment terms, interest rates, and any collateral requirements if necessary.
Conclusion
Maximum Permissible Bank Finance (MPBF) is an essential tool for businesses in India looking to manage their working capital needs responsibly. It ensures financial discipline, encourages optimal use of internal funds, and reduces over-borrowing risks. For businesses, understanding the MPBF methods and leveraging them can be the key to maintaining healthy financial operations and sustaining growth.
When applying for an MPBF-based loan, it’s crucial to understand the calculation methods, comply with the bank’s documentation requirements, and ensure that your business’s financials are in good shape. With the right approach, MPBF can provide a steady flow of working capital, helping businesses navigate day-to-day challenges and scale effectively.
