Calculating Drawing Power in Working Capital and Cash Credit Accounts

India's entrepreneurial ecosystem is expanding at an impressive pace. With over 112,718 recognized startups and 111 unicorns collectively valued at $349.67 billion, businesses across the nation are seeing remarkable growth. 

Yet, managing cash flow effectively is one of the most significant hurdles entrepreneurs face, whether running a startup or an established enterprise. Among the 64 million MSMEs in the country, only 14% have access to credit, highlighting a critical gap in financial support for small businesses. This is where understanding drawing power becomes essential. 

If your business relies on working capital or cash credit accounts, knowing how to calculate your drawing power can make a world of difference.

In this blog, you'll learn everything you need to know about drawing power and how to use it to fuel your business growth.

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What is Drawing Power in Working Capital?

As an entrepreneur, managing business finances can feel like walking on a tightrope. One key factor in ensuring smooth operations is having access to working capital when you need it. Drawing power plays a crucial role here for both borrowers and lenders.

Drawing Power (DP) determines the maximum working capital you can access from a lender. After deducting liabilities such as creditors and margins, it’s based on your company’s current assets, like inventory and receivables.

According to the Reserve Bank of India guidelines, working capital requirements of up to ₹1 crore are assessed at 25% of the projected annual turnover. This allows a business to secure credit from banks to maintain liquidity, helping entrepreneurs manage expenses and cash flow gaps effectively.

For lenders, drawing power is a vital metric that helps assess your business's creditworthiness. For borrowers like you, it ensures that credit is used responsibly while building stronger relationships with lenders.

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Why Drawing Power Fluctuates?

Banks typically provide financing for up to 90 days of inventory and receivables, but they often apply a margin—usually around 25%—to safeguard against potential changes in asset quality and liquidity.

Because of this, your drawing power may fluctuate as your inventory levels shift or as receivables take longer to be collected. This is especially relevant for businesses with extended receivable periods or high inventory turnover rates.

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Understanding Drawing Power and Its Impact on Your Business

Drawing Power (DP) plays a crucial role in determining your borrowing capacity from a lender. Depending on your business's financial position, your drawing power can either indicate room for more credit or a potential liquidity issue. 

Here's a quick breakdown of three common scenarios you might face regarding DP.

1. DP > Loan Balance: More Borrowing Capacity Available

When your drawing power exceeds your loan balance, it shows you have extra borrowing capacity. This is common for businesses with inventory or receivables exceeding 90 days, especially in fast-growing companies. 

Banks typically review these limits semi-annually, and you can explore alternate financing options like NBFCs or private credit funds.

2. DP = Loan Balance: Fully Utilized Borrowing Capacity

If your drawing power equals your loan balance, you've reached your borrowing limit. Any decrease in asset values or increase in liabilities can impact liquidity. It's important to maintain open communication with your lender and consider alternative lenders to support cash flow during growth phases.

3. DP < Loan Balance: Margin Call Risk

When your drawing power falls below your loan balance, you risk a margin call, meaning the lender may request repayment or more equity. To prevent this, focus on improving asset quality by speeding up receivables or selling slow-moving inventory. Early discussions with your lender to adjust loan terms can help avoid liquidity challenges.

Now that you understand the importance of drawing power in managing your working capital, it's time to explore another critical tool for business owners—cash credit accounts. 

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What is a Cash Credit Account and How is it Linked to DP? 

A cash credit account is a short-term loan arrangement banks provide to businesses, allowing them to withdraw money up to a certain limit as needed. This limit is typically determined based on the business's drawing power, calculated by assessing the company's stock, receivables, and creditors. 

Unlike a term loan, which is a lump sum, a cash credit account offers ongoing access to funds, making it ideal for handling day-to-day operational expenses.

The cash credit limit granted by a bank is closely tied to the business’s drawing power. Essentially, the drawing power defines how much money the business can withdraw from the cash credit account. 

For example, if your drawing power is ₹10 lakh, the bank may approve a cash credit limit of ₹10 lakh or slightly lower, depending on other financial assessments.

Who typically uses cash credit accounts?

• Businesses of all sizes, especially SMEs and startups.
• Companies dealing with fluctuating inventory.
• Businesses face inconsistent cash flow due to payment cycles.

Here’s how cash credit accounts are structured. 

The Formula for Calculating Drawing Power

You can use a specific formula to calculate the Drawing Power (DP) for a cash credit account, which takes into account your stock and book debts. This calculation is essential for determining the maximum amount you can withdraw against its working capital limit.  

The general formula to calculate Drawing Power is:

Here’s a quick breakdown:

• Net Value of Stock: The value of your inventory after adjusting for any obsolete or damaged goods.
• Net Value of Debtors: The total amount owed to your business by customers minus any doubtful debts or provisions.

For example, if your stock has a net value of ₹18 lakh and your debtors have a net value of ₹12 lakh, your drawing power would be:

Drawing Power = ₹18 lakh + ₹12 lakh = ₹30 lakh

Understanding your drawing power is essential, but Recur Club can provide additional financial flexibility with structured debt solutions that grow with your business if you're struggling to meet your working capital needs. 

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Real Example of Drawing Power Calculation

Understanding how to calculate drawing power plays a pivotal role in securing the right amount of credit to meet your working capital needs as an entrepreneur. 

In this example, you’ll see the calculation broken down step by step, showing how your stock, creditors, and debtors influence the drawing power and, ultimately, the liquidity of your business.

Dive into a practical example of how this calculation works.

Now, calculate the amount allowed for debtors.

In this example, your drawing power would be ₹5,000, allowing you to access up to that amount in credit based on your stock and debtors after applying the relevant margins. 

This calculation clearly shows how much working capital you can utilize while staying within your limits.

Now that you’ve seen how drawing power is calculated, it’s important to understand one key factor that directly impacts this calculation—margins.

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What Are Margins?

Margins refer to the portion of your assets (such as stock or receivables) that banks deduct from your drawing power calculation. This ensures that the bank retains a buffer, reducing the risk in case of asset devaluation or default. Margins act as a safety net for the bank, allowing them to lend a lower percentage of the total value of your assets.

Now, look at the common margin requirements and how they impact your drawing power. 

1. Owner’s Contribution

As an entrepreneur, part of the financing for your business operations comes from your capital contribution. Margins ensure that you maintain a stake in the risk and don’t rely entirely on borrowed funds.

2. Common Margins

Banks typically apply the following margins:

• 25% for Stock: This means 25% of the total stock value is deducted before calculating the amount eligible for drawing power. For instance, if your stock value is ₹20 lakh, ₹5 lakh would be deducted, leaving ₹15 lakh as part of your drawing power.
  
• 40% for Debtors: In the case of debtors, 40% of the total value is usually subtracted. For ₹10 lahks in debtors, ₹4 lahks would be deducted, allowing only ₹6 lakhs to contribute to your drawing power.
  

3. Variability

These margins are not fixed and can vary depending on bank policies and industry standards. Certain industries have higher or lower margin percentages based on the level of risk involved. It’s crucial to be aware of the specific margins your bank applies to your business.

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RBI Guidelines for Drawing Power 

The Reserve Bank of India (RBI) has established detailed guidelines regarding drawing power to ensure proper financial discipline for borrowers and transparency for lenders. According to these guidelines, banks assess the working capital requirements of businesses, particularly those requiring fund-based working capital limits. 

For micro and small enterprises, this limit extends up to ₹5 crore, and for other borrowers, the cap is ₹1 crore.

Here’s what you need to know about RBI’s approach to drawing power:

• Regular Monitoring: Banks must continuously monitor drawing power, especially in working capital accounts like Cash Credit, to ensure that the business’s financials are consistent with the assets pledged as collateral.
• Asset Classification: If an account is not performing—such as failing to submit stock statements or showing inadequate drawing power for more than three months—it could be classified as a Non-Performing Asset (NPA), triggering stricter financial scrutiny.
• Calculation Methods: Drawing power is determined based on the net value of stock and debtors after considering margins set by the bank. Inaccurate stock or debtor statements can negatively impact the available drawing power and limit access to funds.
• Transparency and Accountability: Businesses must submit regular, accurate financial statements, as outdated or inaccurate data can result in penalties or reduced drawing power.

Adhering to these RBI guidelines can help entrepreneurs maintain healthy financial relationships with their lenders, ensuring uninterrupted access to working capital.

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Why RBI Guidelines Matter for Your Business?

Adhering to the RBI's guidelines for drawing power is crucial for maintaining financial stability and securing continuous access to working capital. These regulations ensure that borrowers and lenders operate transparently and accountable, reducing the risk of financial mismanagement. 

By following these guidelines, businesses can effectively manage their cash flow and avoid disruptions in funding that could otherwise hinder growth.

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Consequences of Non-Compliance

Non-compliance with RBI guidelines can lead to serious repercussions. For example, failure to submit accurate stock or debtor statements on time could result in your account being classified as a Non-Performing Asset (NPA). 

Once classified as an NPA, your access to credit may be limited, triggering stricter scrutiny from banks and making it harder to secure funding in the future. Additionally, non-compliance can damage your relationship with lenders, leading to penalties, increased interest rates, or reduced borrowing limits.

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Frequency of Submission of Drawing Power (DP)

As an entrepreneur, you’re likely juggling multiple financial responsibilities, but keeping track of your Drawing Power (DP) Statement should be a top priority. 

Banks typically require you to submit this statement at the end of each month, detailing your drawing power calculation based on your stock and debtor positions. It's not just about compliance—it's about ensuring your access to funds remains uninterrupted.

Here’s why timely submission matters:

• Stay Within Your Limit: If your actual fund usage exceeds the calculated DP limit, you’ll need to cover the difference quickly. However, if your usage is lower than the limit, you're in the clear.
• Avoid Penalties: Banks give you up to 15 days (sometimes as little as 7) to submit your DP statement, and late submissions often come with penalty charges. Avoiding this hassle is as simple as submitting your statement on time.
• Simplify Your Process: If managing a Cash Credit (CC) limit feels like too much red tape, consider opting for an Overdraft (OD) limit if you have lower working capital needs. This way, you’re exempt from submitting monthly DP statements, giving you one less thing to worry about.
  

In the end, timely submission and accurate calculation of your DP can save you from financial headaches and keep your relationship with the bank running smoothly.

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Benefits of Drawing Power

Drawing power is essential for businesses using working capital or cash credit accounts. It helps you tap into available financial resources, maintain smooth operations, and manage unexpected expenses without hampering your cash flow. 

Check out the benefits of drawing power and how it can be a game-changer for your business’s financial health.

• Optimized Cash Flow: Drawing power helps you tap into working capital without raising funds from external sources, allowing you to manage operational costs smoothly.
• Maximized Credit Utilization: By accurately calculating your DP, you can ensure you’re making the most of the credit available to you, rather than leaving unused funds sitting idle.
• Enhanced Financial Planning: DP offers a clear structure for balancing stock and debtor values, enabling better financial projections and business growth planning.
• Lower Interest Costs: Since DP is tied to your inventory and receivables, it reduces the need for more expensive borrowing options like unsecured loans, thereby reducing interest expenses.
• Flexible Borrowing: DP offers flexibility. You’re only borrowing what you need based on real-time business activity, giving you more control over your debt levels and minimizing financial strain.
• Improved Vendor Relations: Having a predictable and reliable cash flow via DP allows you to pay suppliers on time, strengthening relationships and possibly securing better terms.

Also Read: Introducing Recur Scale: Empowering Startups and SMEs with up to ₹100 Crores in Debt Financing.

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How Can You Use Drawing Power Efficiently?

Drawing power is a crucial financial tool that ensures you have access to the working capital needed to run your business smoothly. But it’s not just about calculating your drawing power. It’s about managing it efficiently. 

Here are some strategies to help you make the most of your drawing power while maintaining a healthy financial profile.

1. Regular Monitoring and Updates

• Frequent Assessments: Review stock and debtor positions regularly to ensure accurate drawing power (DP) calculations. Banks usually update DP monthly or quarterly based on your financial statements.
• Timely Submission: To avoid penalties and maintain a good relationship with the bank, submit DP statements within 15 days of month-end.

2. Optimize Inventory Management

• Insurance Coverage: Ensure all stock used in DP calculations is insured, as uninsured stock doesn’t count, reducing your available credit.
• Inventory Turnover: Aim for higher inventory turnover rates to boost the net value of your stock and enhance your drawing power. Efficient inventory management frees up cash for other business needs.

3. Effective Debtor Management

• Focus on Collecting Receivables: Prioritize collecting receivables that are less than 90 days old, as these directly impact your drawing power. Strong credit control can reduce overdue accounts and improve cash flow.
• Limit Credit Sales: Be cautious when offering credit to customers. Evaluate their creditworthiness to avoid bad debts that could lower your drawing power.

4. Understand Margin Requirements

• Know Your Margins: Familiarize yourself with your bank’s margin percentages (often 25% for stock and 40% for debtors). This helps you calculate your drawing power accurately.
• Adjust Financial Strategies: If margins change, adapt your financial strategies to maintain optimal cash flow.

5. Utilize Temporary Overdrafts Wisely

• Use Temporary Overdrafts (TOD): In cases where drawing power is insufficient, consider using TODs for short-term needs. Keep in mind that TODs often come with higher interest rates.

6. Maintain a Healthy Financial Profile

• Strengthen Financial Health: A strong financial profile can lead to higher sanctioned limits and better margin terms with banks.
  
• Conduct Regular Audits: Regular audits help ensure the accuracy of your financial records and maintain a positive relationship with lenders.

Also Read: Different Types and Sources of Venture Capital. 

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Conclusion 

Mastering drawing power can significantly enhance your business's financial management by providing flexible access to capital, optimizing cash flow, and ensuring smooth operations.

You can maximize your borrowing potential by following RBI guidelines, managing your margins, and staying proactive with your financial health. 

Understanding drawing power and managing your working capital are key steps toward financial stability. But if you're ready to take the next leap in growth, Recur Club offers tailored debt solutions with absolute transparency and zero hidden fees. Join 1500+ customers who trust Recur Club for their financing needs. Get started now.

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FAQS

Q1. What is the difference between Drawing Power and Cash Credit Limit?

Drawing power is the maximum amount a business can withdraw from its cash credit account based on the value of stock and receivables after applying margins. The cash credit limit, on the other hand, is the total limit sanctioned by the bank. 

While the cash credit limit is fixed, the drawing power fluctuates depending on the business's stock levels, receivables, and margin requirements.

Q2. How is drawing power calculated?

Drawing power is calculated using the formula:
Drawing Power = (Net Value of Stock – Creditors) + (Net Value of Debtors – Margins).
Banks typically apply margins of 25% on stock and 40% on debtors, which affects the final amount.

Q3. What happens if my drawing power decreases?

If your drawing power decreases due to lower stock levels or unpaid receivables, the amount you can borrow also reduces. This may limit access to working capital, leading to potential cash flow issues for your business.

Q5. How often should I submit my drawing power statement?

Most banks require businesses to submit their drawing power statement monthly, though some may request it more frequently depending on the account terms and your business's financial activity.

Q6. How often should Drawing Power be recalculated?

Drawing power is typically recalculated every month based on the submission of updated stock and debtor statements. However, depending on the business's financial activity and the bank’s policies, it can be recalculated more frequently in some cases.

Q7. What is the margin in drawing power calculation?

The margin refers to the percentage of stock or debtors that banks deduct while calculating drawing power. Common margins are 25% for stock and 40% for receivables, though these can vary by industry and bank policies.

Q8. Can drawing power be increased?

Yes, drawing power can be increased by improving stock levels, speeding up debt collection, or negotiating lower margins with the bank. Effective financial management can positively impact your drawing power.

Q9. Can Drawing Power change over time?

Yes, drawing power can change over time as it depends on the value of stock, receivables, and the margins applied by the bank. If stock levels decrease, debtors delay payments, or margins change, the available drawing power will be affected accordingly. 

Regular financial assessments ensure that the drawing power reflects the business's current financial position.

Q10. What are the consequences of exceeding drawing power?

Exceeding your drawing power limit can lead to penalties, higher interest rates, or even account classification as a Non-Performing Asset (NPA), affecting your creditworthiness.

Q11. How does the Reserve Bank of India (RBI) regulate drawing power?

The RBI mandates guidelines for banks to monitor drawing power regularly, classify assets, and ensure accurate financial reporting. These guidelines promote financial discipline and transparency between borrowers and lenders.