Financial Management and Strategic Management · Financing of Working Capital

Bank Finance and Trade Credit Costing for CA Inter

Updated 4 October 2026 · Fact-checked

Bank finance is short-term credit from banks such as cash credit, overdraft and bill discounting, limited by Maximum Permissible Bank Finance (MPBF). Trade credit costing finds the annualised cost of skipping a cash discount: [D ÷ (100 − D)] × [365 ÷ (credit period − discount period)]. Compare it with bank interest.

Understand Bank Finance and Trade Credit Costing

Businesses fund working capital in two main ways: credit from suppliers (trade credit) and credit from banks. Both are short-term. The exam asks you to understand the forms, the limits banks apply, and which source is cheaper.

Forms of bank credit. In cash credit, the bank sets a limit and you draw and repay within it as needed; interest is charged on the amount actually used, often with a commitment charge on the unused part. In an overdraft, you draw beyond your current account balance up to a sanctioned limit. In loans, a fixed sum is given and interest is charged on the full amount. In bill discounting/purchasing, the bank pays you the bill value less a discount now and collects from the buyer on the due date. A letter of credit is the bank's undertaking to pay the seller, which lets you buy on credit with comfort to the supplier.

Maximum Permissible Bank Finance (MPBF). The Tandon Committee suggested that a borrower should not rely wholly on the bank. You must fund part of current assets from long-term sources, called net working capital (NWC). It gave three methods. Method I is the baseline: the borrower funds 25% of the working capital gap (current assets less current liabilities other than bank borrowings), and the bank can lend the other 75%. Method II raises the borrower's contribution to 25% of total current assets. Method III raises it further: the borrower funds the whole of the core current assets from long-term sources, plus 25% of the remaining current assets (current assets less core current assets). The bank's share is the MPBF.

The base on which the 25% is taken differs, so the order of steps differs. In Method I, the 25% is taken on the gap (CA − CL), so CL is deducted first and then 75% of the gap is the MPBF. In Methods II and III, the 25% is taken on CA (Method II) or on CA less core current assets (Method III), and CL is then deducted in full from the resulting 75%.

Cost of trade credit. A supplier may offer terms like 2/10 net 30. That means 2% discount if you pay within 10 days, otherwise pay the full amount on day 30. If you skip the discount, you effectively borrow the discounted price for the extra 20 days. The finance cost for those days is the discount you forgo: 2% of the invoice, which is 2/98 of the discounted price you actually borrow. Annualised, this is very expensive, often far above bank interest. So you normally take the discount, even by borrowing from the bank, unless the bank rate is higher than the cost of trade credit.

The decision rule is simple. Compute the annual cost of foregoing the discount. If it is higher than the cost of the alternative finance (such as bank loan), take the discount. If it is lower, pay late on the last day and keep the cash.

Key rules to remember

Cost of foregoing cash discount (simple): Cost = [D ÷ (100 − D)] × [365 ÷ (N − d)] × 100%; D = discount %, N = credit period in days, d = discount period in days. Use 360 days if the question says so.
Cost of foregoing cash discount (compound/effective): Effective cost = [1 + D ÷ (100 − D)]^(365 ÷ (N − d)) − 1; Use only when the question asks for the effective or compounded rate.
MPBF Method I (Tandon): MPBF = 0.75 × (CA − CL), where CL excludes bank borrowing; Working capital gap = CA − CL (excluding bank borrowing). Borrower contributes at least 25% of the gap.
MPBF Method II: MPBF = (0.75 × CA) − CL (CL excluding bank borrowing); Borrower contributes at least 25% of total current assets. The 75% applies to current assets only, and CL is deducted in full. Gives lower bank finance than Method I when CL > 0.
MPBF Method III: MPBF = 0.75 × (CA − Core current assets) − CL (CL excluding bank borrowing); Core current assets are the permanent minimum level of current assets, funded wholly by long-term sources. The borrower therefore contributes the whole of core current assets plus 25% of (CA − core current assets).
Working capital gap: Working capital gap = Current assets − Current liabilities (other than bank borrowings); Starting point for Method I.
Net amount paid on discounting a bill: Proceeds = Bill value − (Bill value × Discount rate × Days ÷ 365); Effective cost = discount ÷ proceeds, annualised.

How to solve Bank Finance and Trade Credit Costing questions

Use this method for any question on trade credit cost, bank finance limits or the choice between them.

1Read the terms carefully and identify D (discount %), d (discount days) and N (credit period days). Note whether the year is 360 or 365 days.
2Compute the cost of foregoing the discount: D ÷ (100 − D) × 365 ÷ (N − d). Write it as a percentage.
3If asked for the effective rate, compound it using the exponent 365 ÷ (N − d).
4Compare with the bank interest rate or other source cost. If the cost of trade credit is higher, take the discount and borrow; otherwise do not.
5For MPBF, list current assets and current liabilities. Exclude bank borrowing from current liabilities.
6Apply the method asked: Method I, II or III. Use the exact 75% and 25% proportions.
7Check that MPBF is not more than the actual requirement and state the borrower's contribution too.
8Write one line of conclusion with the decision and the figure.

Quickest way: Fast path for MCQs and written answers

When to use it: Use when you have under five minutes for a 2-mark MCQ or a short written part.

For discount cost, compute D ÷ (100 − D) first as a decimal, then multiply by 365 ÷ (N − d). Example: 2/10 net 30 gives 0.0204 × 18.25 = 37.2%.
In MCQs, the wrong options usually use D ÷ 100 instead of D ÷ (100 − D), or use N instead of N − d. Eliminate these.
For MPBF, remember the order: Method I gives the highest bank finance, Method III the lowest. Use this to check your answer.
In written answers, show the formula, then substitution, then the percentage, then a decision line. These are the step marks.
Always state the assumption on days in a year (365 unless the question says 360).

Common mistakes in Bank Finance and Trade Credit Costing

Using the credit period N as the denominator instead of N − d.
Students forget that the extra borrowing starts only after the discount period ends.
Fix: Always subtract the discount period. The financing period is the days you gain by not taking the discount.
Dividing the discount by 100 instead of by (100 − D).
It looks natural to use the discount percent on the invoice price.
Fix: The amount you actually borrow is the discounted price, which is 100 − D. Divide by that.
Including bank borrowings in current liabilities when computing MPBF.
Students take the balance sheet total of current liabilities.
Fix: Use only other current liabilities (creditors, provisions, outstanding expenses). Bank borrowing is what you are solving for.
Mixing up the three Tandon methods, especially Method II and Method I formulas.
The 75% and 25% factors appear in all three.
Fix: Method I: MPBF = 75% × (CA − CL). Method II: MPBF = (75% × CA) − CL, with 75% applied to current assets only and CL deducted in full. Method III: MPBF = 75% × (CA − core current assets) − CL.
Taking the discount without comparing it to the bank rate.
Students assume the discount is always better.
Fix: Compare the annual cost of foregoing the discount with the interest rate on borrowing. Decide only after comparing.
Computing bill discount cost on face value instead of proceeds.
The discount is quoted on the face value, so students stop there.
Fix: The cash received is face value less discount. Effective annual cost = discount ÷ proceeds × 365 ÷ days.

Worked examples

Example 1

A supplier offers terms of 2/10, net 45. Your bank charges 18% p.a. on loans. Should you take the cash discount? Use 365 days.

Show the solution

D = 2, d = 10, N = 45. Financing period = 45 − 10 = 35 days.
D ÷ (100 − D) = 2 ÷ 98 = 0.020408.
Annualising factor = 365 ÷ 35 = 10.4286.
Cost of foregoing the discount = 0.020408 × 10.4286 = 0.21283, i.e. 21.28%.
Bank rate is 18%, which is lower than 21.28%.

Answer: The cost of foregoing the discount is about 21.28% p.a. Since the bank loan costs 18%, you should take the discount and borrow from the bank to pay on day 10.

Example 2

A firm has current assets of ₹40,00,000 and current liabilities (other than bank borrowings) of ₹10,00,000. Core current assets are ₹8,00,000. Compute MPBF under the three Tandon methods.

Show the solution

Method I: Working capital gap = 40,00,000 − 10,00,000 = ₹30,00,000. MPBF = 75% × 30,00,000 = ₹22,50,000.
Method II: 75% of current assets = 0.75 × 40,00,000 = ₹30,00,000. MPBF = 30,00,000 − 10,00,000 = ₹20,00,000.
Method III: Current assets less core current assets = 40,00,000 − 8,00,000 = ₹32,00,000. 75% of this = ₹24,00,000. MPBF = 24,00,000 − 10,00,000 = ₹14,00,000.
Check the order: 22,50,000 > 20,00,000 > 14,00,000, so Method I is highest and Method III is lowest.

Answer: MPBF is ₹22,50,000 under Method I, ₹20,00,000 under Method II and ₹14,00,000 under Method III.

Exam tips

Read whether the question says 360 or 365 days. Use the number given and state it.
In a numerical, always end with a decision line comparing the cost of trade credit with the bank rate.
For MPBF, draw a small two-column table of current assets and current liabilities before applying any method.
Check the order of the three Tandon methods as a quick sanity test: bank finance falls from Method I to Method III.
Learn the forms of bank credit with one-line definitions, as short theory questions can be asked on them.

Practice questions from Financing of Working Capital

Bank Finance and Trade Credit Costing in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Bank Finance and Trade Credit Costing: frequently asked questions

What is the formula for the cost of foregoing a cash discount?

It is D ÷ (100 − D) × 365 ÷ (N − d), where D is the discount percent, N the credit period and d the discount period. Express the result as a percentage. The compound version raises (1 + D ÷ (100 − D)) to the power 365 ÷ (N − d) and subtracts 1.

When should I take the cash discount?

Take it when the cost of foregoing it is higher than your cost of borrowing or the return on your surplus cash. If the bank rate is higher than the cost of foregoing the discount, pay on the last day of the credit period instead.

What is the difference between the three Tandon committee methods?

All three make the borrower fund part of the position from long-term sources. Method I needs the borrower to fund 25% of the working capital gap. Method II needs 25% of total current assets. Method III needs the borrower to fund 25% of (current assets less core current assets) plus the core current assets themselves. Under Methods II and III, current liabilities other than bank borrowing are then deducted from the remaining 75% to arrive at MPBF. Bank finance falls from Method I to Method III.

Does MPBF include other current liabilities?

No. MPBF is the bank borrowing only. Other current liabilities, such as creditors and outstanding expenses, are deducted because they already fund part of the current assets, so they are not part of MPBF. In Method I, the 75% applies to the gap after that deduction. In Methods II and III, the 75% applies to current assets (or current assets less core) and the liabilities are then deducted in full.