The operating cycle
Start with how long money stays locked at each stage. Raw material sits in stores; work in progress sits on the floor; finished goods sit in the warehouse; then the customer takes credit. Against that, the supplier gives credit, which funds part of the cycle for free. What remains is the gap the business has to fund.
- Raw material holding period
- Work in progress period
- Finished goods holding period
- Receivables collection period
- Less: credit period allowed by suppliers
The turnover method
For smaller limits, banks commonly apply the Nayak Committee approach: working capital requirement is taken at 25% of projected annual turnover, of which the borrower contributes 5% of turnover as margin and the bank funds up to 20%. It is deliberately crude — it substitutes a rule of thumb for a detailed cycle analysis, which is why it is confined to limits below the bank's threshold.
MPBF for larger limits
Above that threshold, the working capital gap is computed from actual current assets and current liabilities, and the borrower funds a margin of either the gap or of total current assets depending on the method applied. The holding periods you assumed are now doing real work, so they need to reflect the client's actual trade rather than a template.
Where the computation goes wrong
- Holding periods copied from a template that does not match the trade — a perishable food unit cannot carry 60 days of finished goods.
- Receivables assumed at 30 days when the client's own ledger shows 75.
- Supplier credit assumed generously for a new unit that has no track record and will be asked to pay in advance.
- Working capital computed once and never revised after the turnover projection changed.
Trading units need this most
For a retail or trading business, fixed assets are often trivial and working capital is effectively the entire funding requirement. A report for such a unit that leads with plant and machinery and treats working capital as a residual has been written from the wrong template, and reads that way to the branch.