Working Capital Gap vs. Net Working Capital: Understanding Bank Finance Under the 2nd Method of Lending

Vinu:

Hi Manu. I’m reviewing a working capital proposal, and I often hear about Net Working Capital and Working Capital Gap. I also know that banks sometimes ask the borrower to bring in margin based on a percentage of current assets. Can you explain the difference between Net Working Capital and Working Capital Gap using this context?

Manu:

Absolutely, Vinu. Let me first clarify the two terms:

Working Capital Gap (WCG) is the difference between Current Assets and Current Liabilities excluding bank borrowings.

That is:

WCG = Current Assets – Other Current Liabilities

Let’s say Current Assets are ₹100 lakhs, and Other Current Liabilities (excluding bank borrowings) are ₹40 lakhs.

Then:

WCG = ₹100 – ₹40 = ₹60 lakhs

Now, as per the 2nd Method of Lending (MPBF), the borrower must bring in 25% of Current Assets from long-term sources.

Vinu: So, 25% of ₹100 lakhs means the borrower has to bring in ₹25 lakhs?

Manu:

Exactly. That ₹25 lakhs becomes the Net Working Capital (the borrower’s own contribution). The bank can fund only the balance portion of the Working Capital Gap.

So here’s the breakup:

Current Assets = ₹100 lakhs

Borrower’s Margin (25%) = ₹25 lakhs

Therefore, Bank’s Permissible Finance = ₹100 – ₹40 – ₹25 = ₹35 lakhs

(Or directly: WCG – Margin = ₹60 – ₹25 = ₹35 lakhs)

Vinu: That makes sense. So Net Working Capital is the borrower’s long-term contribution, and the Working Capital Gap is the shortfall before bank finance. And the bank finances only after deducting borrower’s margin.

Manu: Correct. And this method ensures the borrower has sufficient skin in the game and reduces overdependence on bank finance.

Vinu: Got it. So in 2nd Method of Lending, the margin is not on the gap—it’s on total current assets, and then we arrive at eligible bank finance by deducting it from the WCG.

Manu: Exactly, Vinu. That’s the logic behind MPBF – 2nd Method.

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