3882 Study Material Pgdm

Working Capital Management By Praloy Majumder For PGDM Students of IIM Calcutta 10th Batch ( For Class Room Discussion Only)

Table of Contents Section No One

Chapter No

Particulars

Page No

One

Process of Building up of Working Capital Working Capital and Total Balance Sheet Management of Cash and Marketable Securities Management of Inventory Management of Receivable Assessment of Fund Based and Non Fund Based Working Capital Process of Tying Up and Utilisation of Working Capital Finance from Bank Different Corporate Banking Product

7

Two Three Two

Four Five Six

Three

Seven Eight

Appendix 1 Appendix 2

2

20 31 58 73 88 135 148

173 221

Introduction Working Capital Management is an important aspect of financial management of a business entity. Proper working capital management would lead to increased market share by giving proper supply of goods at better price. A company which can manage its working capital properly would be able to reduce its interest cost and in turn lead to reduced price for its product. In a competitive world where price is differentiator for many homogeneous product, the importance of working capital management is paramount. On the other hand , the in efficient working capital management would lead to loss in market and share

and reduced profitability due to increase in financing cost. By

inefficient working capital management , we mean that either working capital is maintained less than the optimum level or more than the optimum level. In case of the first case, the shortage of product in the market would lead to loss of market share and eventually lower profit through lower sales. In the later case, the company’s interest cost would be higher and this will in turn reduce the profitability of the company. This course aims to give you a complete picture of working capital management. The study material is segregated into Three Sections. Section One consists of two chapters . In Chapter One , we should try to visualize the process of building up of working capital. Once, we visualize the process clearly, it would be very easy to develop the concepts. In the Chapter Two , we shall see the working capital in a total balance sheet perspective. In this section, we shall establish linkage between

3

capital budgeting and working capital of a company. After establishing the linkage, we shall define major terminology associated with the working capital finance. Then we shall also discuss the concepts and application of working capital cycle. Section Two of this study material would deal with management of individual components of working capital of an entity. In Three

Chapter

we shall discuss about the management of Cash and

Marketable Securities. During the discussion management of Cash, we shall discuss about the different models of Cash Management Technique to arrive at the optimum level of cash balance. Then we shall also discuss the process of drawing the cash budget of a company with the help of a real life example. Then we shall discuss about various cash management products offered by different banks. This chapter would end after discussing the investment principles and rational for investment in marketable securities. We shall also discuss the different marketable securities available in the Indian Financial Market and their characteristics. Chapter Four would deal with the Inventory Model. Starting from a simple EOQ model, we shall discuss some advanced Inventory Management Models. Chapter Five would discuss the receivable management. Besides the rationale for allowing credit , we shall also discuss the receivable management technique practiced in the industry.

4

Section Three of this material would deal with the way company meets its working capital requirement. Here , we shall discuss about the rational of Banks being the major provider of working capital . In In Chapter

Six, we shall discuss about the assessment of working

capital . Since banks are major source of working capital for a company, a detail analysis of fund based products is required. In this chapter, we shall discuss in detail about the assessment of

working

capital funds from the bank. In Chapter Seven , we shall discuss about the process of tying up of working capital from the bank and also the operational aspect of both fund based and non fund based facilities. In Chapter Eight, we shall discuss about the some of the newer products to meet working capital finance. In this chapter, we shall discuss about Bill Discounting Mechanism, FCNR(B) Loan, MIBOR Linked Debentures, Commercial Papers ,Securitisation Products and Factoring Services in detail .

5

Section One

6

Chapter One Process of Building up of Working Capital Before we proceed in to the micro aspect of working capital management , it would be very much useful if we visualize the process of building up of working capital. For understanding the process, we shall start with small examples as it is always easy to understand with small examples. Subsequently, the same can be extended with the larger examples. Let us assume that a company X has established a factory for production of garments. For establishment of the factory the company purchased land admeasuring 100 cottahs with the value per cottah of land is Rs 25000/- . After the purchase, the company spent Rs 2,00,000/- on stamp duty and registration of the land. The company then constructed factory premises with an investment of Rs 30,00, 000/- ( Rupees Thirty Lacs only) and installed machinery worth Rs 1,50,00,000/- ( Rupees One Crore Fifty Lacs only ) . The company financed this entire capital expenses with both debt and equity in the ratio of 2:1. Before we proceed further, let us draw a balance sheet up to this point. This is a point when the construction of the factory is complete and the factory is ready in all purposes to start production.

7

( All in Rs Lacs) Liability

Asset

Particulars Equity Debt

Amount 69 138

Total Liability

207

Particulars Land Factory Building Plant & Machinery Total Fixed Asset

Amount 27 30 150 207

Figure 1.1 Now for starting of the production , the company requires the following : 1. Raw Materials 2. Consumables 3. Workers and Supervisors 4. Power

Now, we shall introduce the time scale. Suppose at time t=0, the company has hired 20 workers and supervisors with an average salary of Rs 30000/- ( Rupees Thirty Thousand only) per month. The salary would be paid on the last day of the month i.e. at t=30. The company has also purchased Raw Material worth Rs 10,00,000/- ( Rupees Ten Lacs only) at t= 2 day. The company has got electricity connections and the bills during t=1 to 30 days would be paid on t= 45 days . Now we shall draw the balance sheet and P&L on different time scale. Since the purchase is carried out at t= 2 days, on t=2 days, the purchase entry would reflect in the P&L and the Bank/Cash/Credit

8

entry would reflect in the balance sheet. Since the company is new one, it is very difficult to arrange credit for its raw materials. So it needs to put cash in the bank for this raw material amount. So the company deposits Rs 10.00 lacs in bank from its own source. Both the entries would be on the balance sheet. After this entry the balance sheet would look like as follows :

( All in Rs Lacs) Liability Particulars Equity Equity Debt

Total Liability

Asset Amount 69 10 138

217

Particulars Land Factory Building Plant & Machinery

Amount 27 30 150

Total Fixed Asset Cash at Bank Total Asset

207 10 217

Figure 1.2 Now ,we shall write purchase entry in connection with the purchase of Raw Material. The Debit Purchase would be in the P&L Account and the Credit entry would be in Cash and Bank Account. This is shown as below :

Profit & Loss Account

( Rs in lacs) 9

Expense Particulars Amount Purchase of Raw 10 Material t=2 Total 10

Income Particulars By Closing Stock t=2* Total

Amount 10 10

Balance Sheet

( All in Rs Lacs)

Liability Particulars Equity Equity Debt

Asset Amount 69 10 138

Particulars Land Factory Building Plant & Machinery

Amount 27 30 150

Total Fixed Asset Cash at Bank t=2 Raw Material

207 (10-10)=0 10

Total Asset

217

t=2*

Total Liability

217

Figure 1.3 From Figure 1.3, it is clear that the building up of current assets on account of Raw Material purchase is due to closing stock adjustment. Now At t=3, from the stock of Rs 10 lacs raw materials , Rs 1 lacs raw materials is issued for production. Besides, the effort of one entire day of entire work force is used for this production. So the total salary for one day would be Rs 20,000/- . The electricity for one day is , say , Rs 1200/- . Assuming no other cost incurred, the above entries need to be taken care by passing the following entries :

10

For Raw Material , the amount of Rs 1lac would be treated as consumption and the same amount would be reduced from Stock . The salary and power would be debited to P&L and the amount would be outstanding in balance sheet as creditor. This is because these are payable only after the month. There would be closing stock of Work in Progress on account made from the raw material consumed of Rs 1.0 lac. The Entire set of entry is shown below : Profit & Loss Account

( Rs in lacs)

Expense Particulars Amount Purchase of Raw 10 Material t=2 Salary t=3 Electricity t=3 Total

Income

.20 .01 10.21

Particulars By Closing Stock t=2* To Closing Stock t=3 By WIP t=3

Amount 10

Total

10.21

(1) 1.21

Balance Sheet

( All in Rs Lacs)

Liability

Asset

Particulars Equity Equity Debt

Amount 69 10 138

Particulars Land Factory Building Plant & Machinery

Amount 27 30 150

Salary outstanding t=3 Electricity outstanding t=3

.20

Total Fixed Asset Cash at Bank t=2

207 (10-10)=0

Raw Material

10

Raw Material Consumed t=3 WIP t=3 Total Asset

(1)

.01

t=2*

Total Liability

217.21

Figure 1.4 11

1.21 217.21

Now, you see apart from Raw Material Inventory, WIP Inventory has also appeared in the Balance Sheet. Now say t=4, Raw material worth Rs 2 lacs has gone to the production and WIP of the previous day has been converted into the Finished goods. For converting the WIP into Finished goods, the company spends about Rs 5000/- on account of salary and Rs 1000/- on account of electricity. For converting the raw material of Rs 2 lacs issued on t=4, the company spends Rs 15000/on account of salary and Rs 4000/- on account of electricity. At the end of t= 4, all the entries would be as follows : Profit & Loss Account

( Rs in lacs)

Expense Particulars Amount Purchase of Raw 10 Material t=2

Salary t=3 Electricity t=3 Salary for conversion of raw material to WIP t=4 Electricity for conversion of raw material to WIP t=4 Salary for conversion of WIP to Finished Goods Electricity for conversion of WIP to Finished Goods Total

Income

.20 .01 .15

.04

Particulars By Closing Stock t=2* To Closing Stock t=3 To Closing Stock t=4 By WIP t=3 By WIP t=4 To WIP t=4

Amount 10

By Closing Stock of FG t=4

1.27

Total

10.46

(1) (2) 1.21 2.19 (1.21)

.05

.01

10.46

12

Balance Sheet Liability Particulars Amount Equity 69 Equity 10

( All in Rs Lacs) Asset Particulars Land Factory Building Plant & Machinery

Amount 27 30

207

.01

Total Fixed Asset Cash at Bank

(10-10)=0

.15

Raw Material

10

.04

Raw Material Consumed t=3

(1)

.05

Raw Material Consumed t=4

(2)

Debt

138

Salary outstanding t=3 Electricity outstanding t=3 Outstanding Salary for conversion of raw material to WIP t=4 Outstanding Electricity for conversion of raw material to WIP t=4 Outstanding Salary for conversion of WIP to Finished Goods

.20

Outstanding Electricity for conversion of WIP to Finished Goods

.01

t=2

t=2*

150

t=4

WIP

t=3

1.21

t=4

New WIP converted from Raw Material

2.19

WIP converted to Finished Goods t=4

(1.21)

t=4

13

Finished Goods

1.21+.05+.01=1.27

Total Asset

217.46

t=4

Total Liability

217.46

Figure 1.5 In the traditional statement of accounts , lot of entries are reclassified and shown . We see the following statement of accounts at the end of t=3 day : Profit & Loss Account

( Rs in lacs)

Expense Particulars Amount Consumption of 1 Raw Material Salary t=3 .20 t=3 Electricity .01 Total 1.21

Income Particulars By WIP

Amount 1.21

Total

1.21

Balance Sheet

( All in Rs Lacs)

Liability

Asset

Particulars Equity Equity Debt

Amount 69 10 138

Particulars Land Factory Building Plant & Machinery

Amount 27 30 150

Salary outstanding t=3 Electricity outstanding t=3

.20

Total Fixed Asset

207

Raw Material WIP t=3

9 1.21

Total Asset

217.21

Total Liability

.01

217.21

Figure 1.6

14

We also see the following statement of accounts at the end of t=4 Profit & Loss Account

( Rs in lacs)

Expense Particulars Amount Consumption of 3 Raw Material

Salary Electricity Total

Income Particulars Change in WIP

Amount 2.19

Change in Finished Goods

1.27

Total

3.46

.40 .06 3.46

Balance Sheet

( All in Rs Lacs)

Liability

Asset

Particulars Equity Equity Debt

Amount 69 10 138

Salary outstanding Electricity outstanding

Total Liability

Amount 27 30 150

.40

Particulars Land Factory Building Plant & Machinery Total Fixed Asset

.06

Raw Material

7

217.46

WIP Finished Goods Total Asset

2.19 1.27 217.46

207

Figure 1.7 We observe the following : 1) There is no profit element involved up to the finished goods stage. 2) We have not calculated the depreciation. This is to keep the example simpler. The amount of depreciation is reduced from

15

the Fixed Asset of the Balance sheet and the same amount is added in the expenditure side of the Profit and Loss Account. Now , can you tell why we show on the income side of the Profit & Loss Account the incremental figure of WIP and FG stock not the absolute figure ? Why the incremental figure of RM stock is not appearing in the Profit and Loss account as mentioned above? Now if the company incurs an expenditure of Rs 0.20 lacs on account of sales and marketing expenses for this amount of Finished Goods and the Finished Goods is sold at Rs 2.10 lacs and the entire sales is on cash basis the statement of accounts is shown below : Profit & Loss Account

( Rs in lacs)

Expense Particulars Amount Consumption of 3 Raw Material Salary Electricity Selling and Distribution overhead To Profit Transferred to Reserve Total

Income Particulars Change in WIP

Amount 2.19

By Sales

2.10

Total

4.29

.40 .06 .20 .63 4.29

Balance Sheet

( All in Rs Lacs)

Liability

Asset

Particulars Equity Equity Debt

Amount 69 10 138

By Profit

.63

Particulars Land Factory Building Plant & Machinery Total Fixed Asset

16

Amount 27 30 150 207

Salary outstanding Electricity outstanding Selling and Administrative Expenses O/S

Total Liability

.40

Raw Material

7

.06

WIP

2.19

Cash at Bank & Hand Total Asset

2.10

.20

218.29

218.29

Figure 1.8 Now what happens if the entire sales is on credit basis. There is no change in the P&L Statement but in the balance sheet in place of Cash at Bank & Hand , Receivable head will appear. Balance Sheet

( All in Rs Lacs)

Liability

Asset

Particulars Equity Equity Debt

Amount 69 10 138

By Profit Salary outstanding Electricity outstanding Selling and Administrative Expenses O/S Total Liability

Amount 27 30 150

.63 .40

Particulars Land Factory Building Plant & Machinery Total Fixed Asset Raw Material

.06

WIP

2.19

.20

Receivable

2.10

218.29

Total Asset

218.29

Figure 1.9 What is the difference between these two situations?

17

207 7

In the first case the company is having Cash

and it can pay its

liabilities if it wants or it can invest this in investment. In the second case, it has no cash. Now suppose it has to pay the salary , then it has to arrange some cash by borrowing. For example , if the company has to pay the salary of Rs 0.20 lacs immediately , then the company has to borrow from outside this amount and pay the salary. In such case the balance sheet would look like as follows : Balance Sheet

( All in Rs Lacs)

Liability

Asset

Particulars Equity Equity Debt

Amount 69 10 138

Amount 27 30 150

.63 .20

Particulars Land Factory Building Plant & Machinery Total Fixed Asset Raw Material

By Profit Salary outstanding Electricity outstanding Borrowings Selling and Administrative Exp O/S Total Liability

.06

WIP

2.19

0.20 0.20

Receivable

2.10

218.29

Total Asset

218.29

207 7

Figure 1.10 From the above discussion, we get the following key points, which will be useful for remaining portion of this study material: 1) The expenses on the P&L of a company would either appear on the liability side of the balance sheet in case it is not paid immediately or would appear as negative in the bank or cash account in the asset side if it is to be paid immediately.

18

2) The current asset in the form of stock of Raw Material, Work in Progress, Finished Goods, that is appearing in the balance sheet of the company represents the amount of expenses the company incurred but not realized in cash. Similarly, the current asset in the form of Receivable represents the expenses incurred in connection with the sale of the goods plus the profit portion but the amount is not realized . Other composition of the current assets represents the amount paid before the realization of money against which such payment is made. If we sum total the above characteristics of current asset , we can say the following : The Current Asset of the company ( Excluding the Cash and Bank Balances in Demand Deposit, in Term Deposits with an option of the company to withdraw as and when basis) represents the expenses which is incurred by the company and also the payment made by the company

for

both of which the company has not realized the cash. Now the next question is that how the company is meeting these expenses. Some of the expenses are met by the company by deferring the payment . This is achieved through the process of building up the creditor and also the building up of other current liability. The portion of expenses which can not be deferred needs to be paid by resort to borrowing. So the

borrowing

represents

the

portion

of

expenses

represented in the current liability side which is not deferred.

19

Chapter Two Working Capital and Total Balance Sheet In this Chapter, we shall see the relationship of working capital from the perspective of capital budgeting. Besides, we shall also make ourselves aware some of the important terminology used widely in the Working Capital Management. As we are all aware that the process of Capital Budgeting consists of the following steps : 1. Arrival at the Project Cost 2. Selection of Means of Finance 3. Quantum of different types of Means of Finance 4. Arrival at the marginal Weighted Average Cost of Capital ( WACC) 5. Arrival at the incremental cash flow for the duration of the project 6. Arrival at the Net Present Value of the Project 7. Selection/ Rejection of the project. While at the time of arrival at the project cost , a portion of working capital is also taken into account apart from the cost of fixed assets. So the components of project cost is as follows : 1. Total Cost of Fixed Assets 2. A Portion of Current Assets This is shown graphically as below :

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Total Asset

Fixed Asset

T P C O R O T O

S

A J

T

L E C T

Current Asset

Fig 2.1 The means of finance is that portion of Liability side of the balance sheet which finance the project cost. So this is equal to the project cost. This is shown graphically below :

21

Total Liability

Total Asset

Means

Total

Of

Project Long Term

Fixed

Liability

Asset

Current Liability

Current

Finance

Cost

Asset

Fig 2.2 In other words , the means of finance of a project cost represents the long term liability of a company. The composition of long term liability can be any or combination of the following : 1. Equity 2. Reserves 3. Preference Shares 4. Debentures 5. Term Loan

22

The remaining portion of the liability side of the balance sheet consists of Current Liability. Current Liability consists of the following : 1. Bank Borrowing for Fund Based Working Capital 2. Other Current Liabilities : a. Sundry Creditors b. Other other Current Liability c. Provisions Now we shall introduce a very important terminology which is frequently used in finance. This terminology is called “ Margin Money”. What is “Margin Money” ? The answer to the question can be answered only if we complete the above mentioned question. On completion, the full question is : What is Margin Money for Working Capital /Term Loan /Public Issue ? Now the correct answer to the question is the Margin Money is the Money brought in by the entity other than the lender for which margin money is asked for. Fir example, the margin for working capital is the money brought in by the entity other than the lender. In this case, the margin money for working capital is the money brought in by the surplus of long term liability over the long term assets. Similarly, the margin money for the term loan/debenture money

brought

lender/debenture

in

by

holder.

the So

lender the

other

than

the

margin money for

term

is the loan

term loan

/debenture is the money brought in by the equity holder. Similarly, the margin money for Public Issue is the money brought in by those equity holders other than the public. This is also called Promoters Contribution. While arriving at the identification of margin money the following criteria is maintained :

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1. The tenure of maturity of margin money is greater than that of the finance with respect to which margin money is defined. For example, margin money of working capital consists of that portion of liability which has a maturity of more than the current liability. Since the maturity of current liability is one year , the maturity of margin money for working capital is more than one year. 2. Generally , the margin money is superior in the nature of debt characteristics with respect to the finance against which margin money is defined. For example, in the case of margin money for term loan, the margin money should be in the form of equity which is superior than the debt . Now we shall define the margin money for working capital finance. The margin money for working capital finance is also called as Net Working Capital ( NWC). The NWC is explained below: Liability

Asset

LTL

LTA

NWC CA CL

Fig 2.3

24

From the above figure it is quite clear that NWC= LTL-LTA; this is because LTL is the source of fund and LTA is the use of this fund. The difference is the surplus of long term fund after its use for building up of long term assets. This is the money which goes for building up a portion of working capital . So this is margin money by definition of margin money. NWC= LTL- LTA …………………. Eqn 2.1 In a balance sheet , Total Liability = Total Asset ……… Eqn 2.2 Long Term Liability+Current Liability=Long Term Asset+ Current Asset Long Term Liability ( LTL) –Long Term Asset ( LTA)= Current Asset ( CA) – Current Liability ( CL) Putting the value of RHS of Eqn 2.1, we get NWC= CA-CL ……………. Eqn 2.3 But always keep in mind that NWC is the difference between LTL and LTA . The difference between CA and CL is also equal to NWC but it is derived from the definition of NWC. Other important terminology of Working Capital Management : There are some important semantics associated with the working capital management . We shall discuss all these one by one : Current Asset ( CA) : The Current Asset is that portion of asset which is to be realized within a maximum time frame of one year. The typical composition of Current Asset is as follows :

25

1. Raw Material 2. Work In Progress 3. Finished Goods 4. Receivable 5. Other Current Asset 6. Cash & Bank Balances Gross Working Capital ( GWC) :This is equal to Current Asset of the company . Other Current Liability (OCL) : This is the part of current liability other than the bank borrowing for fund based working capital .The composition of OCL is as follows : 1. Sundry Creditors 2. Provisions for Taxation and Dividends 3. Other Other Current Liability Working Capital Gap ( WCG) : This represents that portion of the current assets which is not financed by the Other Current Liability. If we recall the concept build up in the first chapter, this represents the expenses which is not realized and can not be deferred. So WCG = Current Asset ( CA) – Other Current Liability ( OCL)

Operating Cycle ( OC) : As the term Cycle suggests, this represents some thing related to time. Actually this is the time required by a company to realize its cash .As we have already seen in the Chapter I that the Current Asset of a Company represents the expenses incurred but not realized by the company. We have also seen that a portion of the expenses is deferred and this portion represents the other current

26

liability. Putting these two

in the perspective of the definition of

Operating Cycle, we can arrive at the operating cycle provided we convert the time required for such current assets to get converted in to cash. In the balance sheet, the current asset is appearing mainly in the form of Raw Material, Work In Progress , Finished Goods and Receivables. The units of presentation of these current assets are in monetary terms say in rupees. Now in the working capital cycle, we have to convert this into units of time say in days or in months. This is possible only when we replace the unit of money with unit of time. Now, we have to search the accounting statement which represents time and monetary unit. The Profit and Loss statement of a company represents the expenses or income in monetary units over a particular period, generally for 12 months. Now, if we represent the individual item of current assets in terms of expenses and income of Profit and Loss statement , we can convert the representation of individual items of current assets from monetary units to time units. However, one care has to be taken that we use the appropriate expenses

and

income in each stage of current assets. For example , in the case of raw materials only the expenses which can be allocated to the raw materials can be taken for such conversion. So we get the operating cycle with the help of the following methods: Raw Material Cycle ( RM) = Average Raw Material Balance / Raw Material Consumption for the year …( Amnt/(Amnt/time) Work In Process ( WIP) Cycle = Average WIP Balance /( Cost of Production for the Year) Finished Good ( FG) Cycle= Average FG Balance/( Cost of Sales for the Year)

27

Receivable ( R) Cycle = Average Receivable Balance/( Annual Gross Sales for the Year ) Accounts Payable

Cycle ( AP) = Average Creditor Balance /( Annual

Purchase for the Year) OC= RM+WIP+FG+R Cash Cycle (CC) = RM+WIP+FG+R-AP From the above , it can be shown that the cash cycle depends on the inventory , receivable and payable periods. The cash cycle increases as the inventory and receivable periods get longer. It decreases if the company is able to defer payment of payables and thereby lengthen the payables period. Most of the firms are having a positive cash cycle and they thus require financing for inventories and receivables. The longer the cash cycle, the more financing is required .Also, changes in the firm’s cash cycle are often monitored as an early warning measure. The lengthening of a cycle means that the firm is having trouble in moving inventory or collecting on its receivables. The link between a company’s cash cycle and it’s profitability can be easily seen by recalling one of the basic determinants of profitability and growth for a firm is its total asset turnover , which is defined as Sales/Total assets. The higher the ratio is , the greater is the firm’s accounting return on assets, ROA and return on Equity ,ROE. Thus all other things being the same , the shorter the cash cycle is , the lower is firm’s investments in inventories and receivables .As a result , the firm’s total assets are lower, and total turnover is higher.

28

Some Aspects of Short Term Financial Policy : The Short term financial policy that a firm adopts will be reflected in at least two ways: 1. The Size of the Firm’s Investment in Current Assets: This is usually measured relative to the firm’s level of total operating revenues. A flexible, or accommodative, short-term financial policy would maintain a relatively high ratio of current assets to sales. A restrictive policy would involve a low ratio of current assets to sales. 2. The Financing of current assets: This is measured as the proportion of short term debt ( that is , current liabilities ) and long term debt used to finance the current asset. A restrictive short term financial policy means a high proportion of short term debt relative to long term financing and a flexible policy means less short term debt and more long term debt. If we take these two areas together, we see that a firm with a flexible policy would have a relatively large investment in current assets and it would finance its investment with relatively less in short term debt. The net effect of a flexible policy is thus a relatively large level of net working capital.

29

Section Two

30

Chapter Three Management of Cash and Marketable Securities The basic objective in cash management is to keep the investment in cash as low as possible while still keeping the firm operating efficiently and effectively. Besides, the firm must invest temporarily idle cash in short term marketable securities in the financial market. As a group, they have very little default risk , and most are highly marketable. Reason for holding cash : John Maynard Keynes , in his great work

The General Theory of

Employment, Interest and Money , identified three motives for liquidity :the speculative motive, the precautionary motive and the transaction motive. The Speculative and Precautionary Motives : The speculative motive is the need to hold cash in order to be able to take advantage of for example, bargain purchases that might arise, attractive interest rates, and ( in the case of international firms) favorable exchange rate fluctuations. For most firms , reserve borrowing ability and marketable securities can be used to satisfy speculative motives. Thus, there might be a speculative motive for maintaining liquidity, but not

necessarily for

holding cash per se. This is also true to a lesser extent for precautionary motives. The precautionary motive is the need for a safety supply to act as a financial reserve. Once again, there probably ,is a precautionary motive for maintaining liquidity .

31

The Transaction Motive : Cash is needed to satisfy the transaction motive, the need to have cash on hand to pay bills. Transaction related needs come from the normal disbursement and collection activities of the firm. The normal disbursement of cash includes the payment of wages and salaries , trade debts , taxes and dividends. Cash is collected from product sales , the selling of assets, and new financing. The cash inflows ( collections)

and

outflows

(disbursements)

are

not

perfectly

synchronized , and some level of cash holdings is necessary to serve as a buffer. Cost of Holding Cash : When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost. The opportunity cost of excess cash ( held in currency or current accounts in bank) is the interest income that could be earned in the next best use, such as investment in marketable

securities.

However,

the

investment

in

marketable

securities entails another type of costs. The transaction costs covering the transformation between cash to marketable securities and vice versa need to be considered also. Cash Management versus Liquidity Management Before we move on, we should note that it is important to distinguish between true cash management and a more general subject, liquidity management. The distinction between liquidity management and cash management is straightforward. Liquidity management concerns the

32

optimal quantity of liquid assets a firm should have on hand , and it is one particular aspect of current asset management policies. Cash management is much more closely related to optimizing mechanism for collecting and disbursing cash, and it is this subject that we primarily focus on in this chapter. Understanding Float : The difference between the available balance and the ledger balance is called Float and it represents the net effects of checks in the process of clearing. There are two types of floats: 1. Disbursement Float 2. Collection Float Disbursement

Float

:

Checks

written

by

a

firm

generates

disbursement float. For example, A has Rs 1lacs on deposits with bank. On September 1, it buys some raw material and pays with a cheque for Rs 50,000/-. The company’s book balance would

be

immediately reduced by Rs 50,000/- as a result. A’s bank would not find this check until it is presented to A’s bank for payment on say September 4th , .Until the cheque is presented , the firm’s available balance is immediately is greater than

its book balance by Rs

50,000/- . In other words , before September 1, A has zero float .A’s position from September 1 to September 4th is : Disbursement Float = Firm’s available balance –Firm’s book balance = Rs 100000-Rs 50000/- = Rs 50,000/-

33

The company can temporarily invest this amount in marketable securities and earn some interest for this period. Collection Float : The reverse would happen when a cheque is collected by the company. Once it collects the cheque, the same is entered in the bank book maintained with the company.However, it takes some time to deposit the cheque in the bank and during this period the company’s book balance would show more than the original balance in the bank book. This is called collection float. Let us take an example, say on September 1, the company collects a cheque of Rs 30,000/- and on the same day the amount is entered on the book balance . The amount is credited on the 4th September. A’s position during 1st to 4th is : Collection Float = Firm’s available balance –Firm’s book balance = Rs 100000- Rs 130000=- Rs 30000/In general firm’s payment activities generate disbursement float , and its collection activities generate collection float. The net effect, that is the sum of total collection and disbursement float , is the net float. The net float at a point of time is simply the overall difference between firm’s available balance and its book balance. If the net float is positive, then the firm’s disbursement float exceeds its collection float, and its available balance exceeds its book balance. Float Management : Float Management involves controlling the collection and disbursement of cash. The objective in cash collection is to speed up collections and reduce the time customers pay their bills and the time the cash becomes available. The objectives in cash

34

disbursement is to control payments and minimizes the firm’s costs associated with making payments. Total collection or disbursement times can be broken down into three parts : Mailing time : It is the part of the collection and disbursement process during which cheques are trapped in the postal system. Processing delay : It is the time it takes the receiver of cheque to process the payment and deposit it in a bank Available delay : It refers to the time required to clear a cheque through the banking system. Speeding up collections involves reducing one or more of these components. Slowing

up disbursements involve increasing one of

them. Measuring the float : The size of the float depends on both the rupees and the time delay involved.For example, you mail a cheque for Rs 500/- to another place and it takes 5 days to reach the destination( mailing time) and one day for the recipient ( the processing delay) .The recipient’s bank holds out cheques for 3 days ( availability delay) .The total delay is 5+3+1=9 days . In this case, the average daily disbursement float is Rs 500 X9=Rs 4500/- .Assuming 30 days a month, the average daily float is Rs 4500/30=Rs 150/- . We can calculate the float, when there are multiple disbursements or receipts. For example, a company B receives two items each month as follows : Amount

Processing and

35

Total Float

Availability Delay Item I : Rs 5,00,000

X9

=45,00,000/-

Item II : Rs 3,00,000

X5

=15,00,000/-

Total

: Rs 8,00,000

60,00,000/-

The average daily float is equal to : Average

Daily

Float

=

Total

Float/Total

Days

=

60

,00,000/30=2,00,000/So on average there is Rs 2,00,000/- that is uncollected and not available. Cost of the Float : The basic cost of collection float to the firm is simply the opportunity cost of not being able to use the cash. At a minimum, the firm could earn interest on the cash if it were available for investing. The concept of cost

of float can be explained with the help of the

following example: A company A has average daily receipt of Rs 1000/- and a weighted average delay of 3 days. The average daily float is around Rs 3000/-. Suppose that the company can eliminate the float entirely .If it costs Rs 2000/- to eliminate the float should be company go for it?

36

The following figure illustrates the situation for Company A : Day

Beginning

1

2

3

4

5

0

1000

2000

3000

3000

1000

1000

1000

1000

1000

0

0

0

-1000

-1000

1000

2000

3000

3000

3000

Float Cheque Received Cheque Cleared ( cash available) Ending Float Fig 3.1 A starts with a zero float. On a given day, Day 1, A receives and deposits a cheque for Rs 1000/-. The float remains Rs 3000 from day 4. The following figure illustrates what happens if the float is eliminated entirely on some day t in the future.

Day

37

T

T+1

T+2

Beginning Float

3000

0

0

Cheque

1000

1000

1000

-4000

-1000

-1000

0

0

0

Received Cheque Cleared ( cash available) Ending Float

Fig 3.2 After the float is eliminated , daily receipts are still Rs 1000/-. The company collects the same day because the float is eliminated , so daily collections are still Rs 1000/- . As the figure 3.2 shows, the only changes occur in the first day. On that day , A generates an extra cash of Rs 3000/- on day t by eliminating the float. In other words , the Present Value ( PV) of eliminating the float is simply equal to the total float . It cost Rs 2000/- to eliminate the float , then the NPV is Rs 3000/-Rs 2000/- = Rs 1000/- . So the company should do it. Cash Collection and Concentration : From our previous discussion , we know that the collection delays work against the firm. All other things being the same, then, a firm will adopt procedures to speed up collections and thereby decrease the collection times. In addition, even after cash is collected, firms need procedures to funnel, or concentrate , that cash where it can be best used .

Components of Collection Time :

38

Customer

Company

Company

Cash

Mails

Receives

Deposits

Available

Payment

Payment

Payment

Mailing

Processing

Time

Availability

Delay

Delay

Collection Time Fig 3.3 A company can eliminate the Mailing Time and Processing delay to a great extent by availing the Cash Management Services ( CMS) provided by the banks. The availability delay is the delay in clearing process and this can be reduced to a little extent. The

CMS

was

introduced

first

in

India

by

Corporation

Bank.

Subsequently, Citi Bank started the CMS in a big way. Seeing their success, now a days almost all the banks are offering the CMS service. In the CMS , the mailing and processing delay is eliminated to a great extent. Bank’s authorized courier can pick up cheque from a particular location and deposits in its

branches situated at that particular

location. The bank would provide customized report to the company as per agreed format and the fund would be available to the company at

39

any location as desired by the company on the next day of clearance of the cheque. If the cheque is of MICR cheque , then the maximum time required for clearance would be 2 days excluding the collection day. The fund would be available to the company on the 3rd day excluding the collection day. In the case of a high value cheque, the fund would be available would be 2nd day excluding the collection day. Now a days the banks are also providing the web based tracking system by which, a customer gets to know the position of the cheque on a continuous basis. If one looks at the CMS mechanism, one can find out that in the process, the company gets benefited but in the process a bank looses out in the float to an existing customer without CMS facility. The rational being, if a bank can not offer CMS facility, other banks would offer the facility and other bank would build up relationship with the company. There is every possibility that

subsequently, all the other

businesses may be grabbed by the other bank. So

to a bank, CMS

would be the customer retention strategy for an existing customer and for a new customer it is core business acquisition strategy. Managing Cash Disbursement : From the company’s point of view, disbursement float is desirable. To do this, the firm may develop strategies to increase the mail float, processing float and availability float on the checks it writes. However , the tactics for maximizing disbursement float are debatable on both ethical and economic grounds. The discounts may be more beneficial that generation of disbursement

float.

Besides,

there

are

negative

consequence

associated with the stretching the disbursement float beyond a certain point. This can be proved to be costly. Controlling disbursement :

40

We have seen that maximizing disbursement float is probably poor business practice. However, a firm will still wish to tie up as little cash as possible in disbursement .Firms have therefore developed systems for efficiently managing the disbursement process. The general idea in such system is to have no more than the minimum amount necessary to pay cheques on deposit in the bank. Some of the methods for achieving this are discussed below : •

Zero Balance Accounts: With a zero balance account system, the firm , in cooperation with its bank, maintain a master account and a set of sub accounts. When a cheque drawn on one of the sub accounts must be paid, the necessary funds are transferred in from the master account.

•

Controlled

Disbursement

Accounts

:

With

a

controlled

disbursement account system, almost all payments that must be made in a given day are known in the morning .The bank informs the firm of the total, and the firm transfers (usually by wire) the amount needed. Preparation of cash budget: Now, we shall discuss in detail about the process of preparation of cash budget . This will be explained with the help of a simple example .The balance sheet of a company A , as on March 31, 2005 would reveal the following :

41

Liability Serial No

Particulars

Amount ( Rs in lacs)

1

Equity Capital

100

2

Reserves

150

3

Term Loan

150

4

Working Capital Loan

300

5

Creditor For Purchase

100

6

Creditor for Wages

10

7

Creditor for Power

10

8

Creditor for other manufacturing

20

expenses 9

Provision for Taxation

5

10

Provision for Dividend

5

Total

850 Asset

Serial No

Particulars

Amount ( Rs in lacs)

1

Fixed Asset

250

2

Less Depreciation

75

3

Net Fixed Asset

175

4

Investment in Shares

25

5

Investment in Fixed Deposit

35

6

Investment in Group Companies

20

7

Raw Material

75

8

Work in Progress

25

9

Finished Goods

50

10

Receivable

100

11

Other Current Asset

100

12

Loans to Group Companies

75

42

13

Loans to staff

25

14

Advance to supplier

75

15

TDS

25

16

Advance Tax Paid

35

17

Cash and Bank Balance

10

Total

850

The projected Profit and Loss of the company for the first three months is as follows : Sl no

Particulars

April 2005

May 2005

June 2005

1

Sales

150

175

200

2

Other Income

15

20

3

Increase in WIP

2

-

3

4

Increase in FG

5

3

2

Total Income

167

193

225

60

65

75

90

of 60

65

70

of 80

70

85

and 20

20

20

10

15

18

Income

10

Expenses 1

Opening stock of 75 raw material

2

Purchases of Raw 65 Material

3

Closing

Stock

Raw Material Consumption Raw Material 4

Wages Salaries

5

Power & Fuel

43

6

Other

15

20

25

and 10

10

15

Manufacturing expenses 7

Selling Distribution expenses

8

Depreciation

5

5

5

9

Interest

2

5

7

Total Expenses

142

145

175

Profit Before Tax

25

48

50

14

15

18

34

35

Balance Carried to 18

34

35

Provision

for 7

Taxation Profit After Tax the Reserves Fig 3.4 The following data is also available for the company : 1) The realization of sales is as follows : i. The Outstanding receivable as on March 31, 2005 would be realized as follows : 1. 70% would be realized in 30 days 2. 30% would be realized in 60 days ii. The sales realization period of the sales of the financial year 2005-06 would be as follows : 1. 30% of the sales of the month

would be

realized within the month; 50% within the next month and remaining 20% within the next month.

44

iii. The other income is credited at the end of the month. iv. The outstanding creditor for purchase as on March 31, 2005 would be paid as follows : 1. 60% within the next month 2. 30% within the second month 3. 10% within the third month v. The

outstanding

creditor

for

purchase

for

the

financial year will be paid as follows : 1. 30% within the next month 2. 50% within the second month 3. 20% within the third month vi. All the other creditor except the salary would be paid on the next month ; In case of salary it would be paid on the same month except the outstanding as on March 31, 2005 which would be paid on the next month itself. vii. The company pays advance tax in the month of June as per the entire provision . viii. The customer deducts 5% of monthly sales at the time of payment ad TDS for monthly sale of FY 2005-06. ix. The

company

would

liquidate

March

31st

,

Investment level to the tune of 50% in the month of May 2005. x. The company would pay term loan at a monthly installment of Rs 10 each month .

45

xi. The company would purchase fixed asset to the tune of Rs 25 lacs in June by paying the amount in the same month of purchase. Prepare the monthly cash budget for the first quarter of FY 2005-06. It should be mentioned that the alternate for a firm to hold cash is to invest in marketable securities. Without taking into consideration of any

other

constraints,

a

company’s

composition

of

cash

and

marketable securities would be determined by a trade off between interest income earned on marketable securities and transaction cost for conversion from marketable securities to cash and vice versa. If the transaction and inconvenience cost are zero, and the conversion is instantaneous, a firm would hold no cash. When transaction and inconvenience cost is positive, a firm will want to hold cash when expected holding period for investment is not long enough to earn sufficient interest to offset them. Also , if there is some conversion delay, the firm would like to hold some cash. The next question is how much cash a firm should hold ? This is determined by the targeted cash balance. The targeted cash balance is arrived at by taking into consideration of several models. The models vary with the nature of future cash flow of the firm. The future cash flow of the firm can be certain and uncertain. In the case of certain cash flows, Baumol model and Beranack Model is used. In case of uncertainty , depending on the degree of uncertainly, Miller Orr Model and Probabilistic Models are used. All the above mentioned model

assumes certain condition. Before

applying to any of these models, one must check whether appropriate

46

conditions are prevailing or not. Otherwise, the model would give wrong picture. In the case of Baumol, model the key assumption is : Cash Flows are certain with cash is received periodically and cash payment is continuous at a steady rate. The other assumptions are investments yield a fixed rate of return per period of transaction and the transaction cost is constant irrespective of the amount under consideration. The example of such firm is a firm managing rental properties. At the time of receipt of the cash, the cash is kept in an account and then the expenses are paid by drawing down the balance from the same account. If the firm adopts no transaction strategy, we get the following picture :

Cash Balance

Y

t

Fig 3.5

47

Time

If the firm two transaction strategy, the firm would invest one half of the receipt amount in marketable securities and would keep one half of the receipt in cash account. Once the cash account balance would be exhausted, the amount would be replenished by liquidating the marketable securities . This is explained with the help of the following diagram:

Investment Balance

Y/2

Time t/2 Fig 3.6

If the interest earned for period t on investment is i and the transaction cost per transaction is a then the interest income on investment is (1/2)*(1/2)*iY =(1/4)iY Since there are two transaction , the transaction cost is 2a Profit from the transaction is =(1/4)iY-2a If the firm follows the three transactions strategy, then we have the following diagram :

48

Cash Balance

Y/3

Time

t/3

Investment Balance

2/3Y 1/3Y t/3

Fig 3.7

49

Time

If the interest earned for period t on investment is i and the transaction cost per transaction is a then the interest income on the investment is (2/3)(1/3)iY+(1/3)(1/3)iY=(1/3)iY and the cost of the transaction is 3a. Profit from the transaction is (1/3)iY-3a. Whether the two transaction strategy is more profitable than the three transaction strategy depends on the additional interest earned versus additional transaction cost incurred. For n number of transaction interest income would be :[(n-1)/2n]iY and profit is:[(n-1)/2n]iY-na. The optimum no of transaction at which the profit is maximum is given by

n*= (iY/2a)^0.5. The firm would make 1dpeosit and n-1

withdraws from the investment account and the amount of initial deposit would be [(n*-1)/n*]Y and the amount of withdrawal would be (1/n*)Y. The Beranek Model: In this model, the assumption is cash payment is periodic and cash receipt is continuous at a steady rate. The other assumptions of the Baumol model will hold. Here, there would be a number of deposits and a single withdrawal . We can find the same way as mentioned in the Baumol model the optimum no of transactions and profit associated with such optimal transaction. The optimum transaction would be n*= (iY/2a)^0.5 and the firm would make n-1 deposits and 1 withdrawals from the investment account. The amount of periodic investment is (1/n*)Y and the amount of final withdrawal would be [(n*-1)/n*]Y. Till now ,we have discussed the firm’s for which the cash flow is certain. There can be a situation where the cash flow would be

50

uncertain. The degree of uncertainty would vary from random situation to probabilistic situation. In case the net cash flows are uncertain in such a way that net cash flows are distributed normally with mean 0, the standard deviation does not vary over time and there is no correlation of cash flows over time, then the cash flows must follow a Random walk around a zero average net flow. Based on

these assumptions , and using the

advanced mathematical technique of stochastic calculus ,Miller and Orr formulated a profit maximizing strategy based on control limits. Control limits are set up using a formula derived by Miller and Orr. When the firm’s cash balance goes outside upper control limit , investments are made to bring the cash balance back down to the return point. When the firm’s cash balance goes below the lower control limit, disinvestments are made to bring the balance back up to the return point. The formula developed by Miller and Orr is : R=(3aV/4i)1/3 Where V is the variance of daily cash flows,i is the daily interest rate on investments, and a is the transaction cost of investing or disinvesting. If L is the lower control limit ( set by the management ) , the optimum return point is R+L and the optimum upper control limit is 3R+L.

51

Cash Balance

UCL Return Point

LCL

Day Fig 3.8 In the case of uncertainty where one can associate certain probability with the future cash flows , Probabilistic Model would give better results. In this process, end of period cash balances, exclusive of the purchase or sale of marketable securities can be estimated for various cash flows outcome to form a probability distribution .The period should be short , perhaps a few days or no longer than a week .This probabilistic information, together with information about the fixed cost of a transfer between cash and marketable securities and the return on investment in marketable securities, is needed to determine the proper initial balance between cash and marketable securities. For various cash flow outcome, the expected net earnings associated with different initial levels of marketable securities can be determined. The greater the amount of securities held , the greater the probability that some of those securities will have to be sold in order to meet a cash shortfall. The expected net earnings for a particular level of 52

marketable securities is the gross interest earned on the marketable security position, less the expected loss of interest income associated with the sale of those securities. When calculations are undertaken for various possible levels of initial marketable security holdings, one obtains the expected net earnings associated with each level. The optimum level of marketable securities is the level at which expected net earnings are maximized. Factors to be considered for investment in marketable securities : While investing in marketable securities , one needs to know about the Yield and market price of a security. Yield : For understanding the yield on debt instruments , let us first start with the types of debt instruments. There are two types of debt instruments depending on the nature of cash flows associated with such instruments. One is the discounted instrument

and another is

the fixed income instrument. In the case of discounted instrument, the amount is paid in one installment at the time of maturity and issued at a discount to the face value. Example of such type of instrument is Treasury Bill, Commercial Paper ,Certificate of Deposits etc. The yield is calculated by using the simple interest formula. Let us take an example: What would be the issue price of a T Bill of face value of Rs 50 lacs with a maturity of 90 days if the discount rate 5.5% p.a? Issue Price = ( 50,00,000/- /[1+(90*5.5/36500)] = 49,33,099/- . In the case of fixed income instrument, there is a periodic cash flows associated with a coupon amount. Let us take an example. A 6% half yearly coupon of 3 Year Government of India (GOI) Security is having

53

a face value of Rs 10,000/- . The issue date is 1st September 2005. The cash flow associated with this instrument is as follows : Date of Payment

Time from Investment Amount of Payment in Year

1st March 2006

0.5

300

1st Sept 2006

1

300

1st March 2006

1.5

300

1st Sept 2006

2

300

1st March 2006

2.5

300

1st Sept 2006

3

10300 Fig 3.9

If the issue price of the security is Rs 10,000/- then the yield to maturity is 6% p.a. So in a fixed income security, the yield means yield to maturity(YTM). If the issue price is less than Rs 10,000/- , the YTM is more than 6% and if the issue price is more than Rs 10,000/-, the YTM is less than 6%. Different marketable securities vary in yield .The variation in Yield is due to the following reasons : •

Default Risk : This is the risk associated with the default probability of the issuer of the security. Given other factors same, the higher the default risk , the higher should be the YTM. The rating published by a rating agencies in connection with the securities issued by a company , can be considered a fair indicator of the default probability.

•

Marketability : The liquidity of a security depends on how well the concerned security is traded in the market. The higher the

54

marketability, the higher would be the liquidity and lower would be the yield compared to that of other identical securities having lower marketability. •

Length of Time to maturity: For a fixed income security, the length of time to maturity is an important factor and it affects YTM.

•

Coupon Rate : Depending on the coupon rate , the price of a fixed income security can change. As we have already seen that the price of a security changes when there is a change of interest rate. Price fluctuation of a security depends on the level of the coupon rate. The percentage change in bond’s price owing to the change in yield would be smaller if the coupon is higher and vise versa.

•

Taxability : The taxability is also an issue associated with the YTM. The yield would be lower for non taxable securities when compared with taxable securities.

After discussing some of the factors affecting the yield of a security, let us discuss about the characteristics of some of marketable securities available in India. Treasury Bills : Treasury bills ( T bills )is one of the most important money market instrument in any country. Before we discuss about the nature and pricing of T bills , let us discuss the purpose of issuance of treasury bills. In our country, there are two types of budget namely Union Budget and State Budget. In the case of Union Budget, the finance minister submits the budget statement on the last day of February every year for the next financial year. The budget contains two accounts: •

Revenue Account

55

o Income Account o Expenditure Account •

Capital Account o Receipt Account o Disbursement Account

The revenue account deficit is arrived at as follows : Expenditure-Receipt Capital Account receipt has two parts : Market Borrowing and Other Receipt. The Gap between Capital Account Disbursement and Other Receipt is the Gap on the Capital Account. The fiscal deficit is given by Revenue Deficit + Gap on Capital Account. The Market Borrowing is basically to meet the fiscal deficit. The Government resort to market borrowing mainly by issuing securities of maturity more than 1 year and through coupon bearing instrument. During the year, the income is not uniform where as the payment is more or less known with certainty . There is cash flow mismatch between receipt and payment during the year . This mismatch is bridged by issuance of treasury bills. So treasury bills are issued by Central Government to bridge the mismatch of cash flows during the year. Since it is issued by the Central Government, the T bills carry sovereign guarantee and is an indicator of risk free rate. T bills can be issued in 14days, 28days , 91 days, 182 days and 364 days duration. T bills are issued at a discount to face value and is a discounted instrument. T bills are negotiable from next day of its issuance and this increases the liquidity of the instrument. T bills are generally issued in the D mat form .When the purchaser of a T bill is a bank , the

56

transaction is put through

Subsidiary General Ledger ( SGL ) .When the purchaser is a non bank and the purchaser wants T bills in Dematerialised form, the transaction is put through Constituent Subsidiary General Ledger (CSGL) account. T bills can also be issued in Physical Form. Individual, Company, Banks,NRIs and FIIs can invest in T Bills but the usual restriction on debt securities will be applicable for T bill investment for NRIs and FIIs. Commercial Paper : Another short term instrument for investment is Commercial

Paper.Commercial

Paper

is

an

unsecured

usance

promissory note issued by eligible company’s and permitted entities .The duration of commercial paper varies from 7 days to 1 year and the issue is at a discount to face value. The Commercial Paper can be a good investment for company’s for a shorter duration. Bank Fixed Deposit : Bank Fixed Deposit is also an option for investment of short term surplus. The benefit to bank deposit is that it is a fully liquid instrument and can be converted into cash at any point of time. Since bank can offer differential rate and also bank can offer flexible scheme, company can invest in proper fixed deposit scheme to derive the benefit of liquidity and income to a great extent. The underlying principle for investment in marketable securities is that the investment should be risk free and the amount to be determined at the time of investment. However, many companies can invest in marketable

securities

in

such

a

way

to

earn

extra

without

compromising much on the risk front. For such companies, investment in open ended mutual funds, equity market and derivative market can be of option for investment .

57

Chapter Four Management of Inventory By the term inventory, we mean Raw Material, Work In Progress and Finished Goods. Like all other assets , inventory represents a costly investment to the firm. There must be some advantages for carrying inventory which is associated with cost. There are several reasons for carrying inventory of raw materials by a firm. First, having an available stock of raw materials inventory makes production scheduling easier. Second, raw materials inventory is carried out to avoid price changes for these goods. If the firm keeps a stock of raw materials, the firm can purchase these goods when it believes prices are low and can decline to purchase when it believes prices are high. This reduces the firm’s cost . Third, the firm may keep extra raw material inventory to hedge against supply shortage. When prices of raw materials are controlled , there will be times when goods are unavailable at the controlled price. During these times, the firm may draw down its existing inventory to continue production. Finally, the firm may order and keep additional inventories to take advantage of quantity discount. In manufacturing firms, a certain amount of work in progress inventory occurs as products move from one production process to others. A major reason for keeping work in progress beyond minimum level is for buffer production. Buffering is a part of the planning process and allows flexibility and economics that would not otherwise occur. The prime reason for keeping finished good inventory is to provide immediate service. Interlinked with this immediate service, is the issue of uncertainty of demand of the products of the firm. Another reason

58

for keeping the finished goods inventory would be for stabilizing the production. When firms produces several types of products using the same equipment , there are costs and delays in changing from the production of one product to another. The longer are the firm’s production runs, the lower are these transaction ( set up) costs. However, longer production runs result in higher finished goods and work in progress. While carrying the inventory , the firm is incurring costs. These costs are different types and are discussed below : Costs directly proportional to amount of inventory held: Certain costs are directly proportional to the level of inventory carried by the firm. These are usually called “ Carrying cost of inventory” or “Holding cost of inventory”. Examples of these costs are opportunity cost of inventory investment, insurance on the inventory, storage cost of inventory, taxes on inventory investment and so forth. The formula for this type of costs is : Cost =(a)(amount of inventory)……..4.1 Where a is the coefficient representing the sum of all costs that are directly proportional to the level of inventory. Costs not directly proportional to the amount of inventory held: There is also a group of costs that vary with inventory size but not in direct proportion. Examples are spoilage and obsolescence. These cost vary with the length of time that an item is in inventory. The general formula for these costs is : Cost =f ( inventory level) …………4.2 Where f ( inventory level) means that the cost is a function of inventory level while the particular relationship ( linear or not) depends on the type of cost being considered.

59

Costs directly proportional to the Number of Orders : When a firm orders for inventory

there are costs to the ordering, delivery and

payment processes. These costs depend directly on the number of times that orders are placed and received. The formula for this type of cost is : Cost = (c ) ( number of orders) ………..4.3 Where (c ) is the coefficient representing the sum of all the costs of this type. Price per unit of inventory obtained : Due to quantity discounts and economies of scale in production, the price per unit of goods purchased or produced for inventory may vary with the amount ordered. When this occurs, the change in the total cost of the inventory that results can be a major determinant of the most advantageous order quantity. The formula for the total cost of the inventory : Cost =Pq S

………………………4.4

Where Pq is the unit price for the quantity ordered by the firm and S is the yearly usage of the good. Stockout Cost : This cost is the cost associated with the situation of not having adequate inventory. Other Characteristics of Inventory situation : Besides various types of costs involved , there are other characteristics of the situation that vary among types of inventory and must be captured if the decision model

is

to

be

an

accurate

representation

of

the

physical

circumstances .Several of these characteristics are listed below : Lead time : Obtaining inventory usually requires a time lag from the initiation of the process until the inventory starts to arrive.

60

Sources and level of risk : Uncertainties play a significant role in the inventory situation. Uncertainties usually involve lead time and demand levels, but situations where other variables are uncertain also occur.Where there are substantial uncertainties and where the costs of stock out are important , strategies for addressing risk must be formulated. Static versus Dynamic Problems : Inventory problems are usually divided into two types based on the characteristics of the goods involved. In static inventory problems, the goods have a one period life; there is no carry over of goods from one period to the next. In dynamic inventory problems, the goods have value beyond the initial period; they do not loose their value completely over time. Replenishment Rate : Once goods start to be received from a vendor or form the firm’s own production processes, there are differences among goods in the rate at which they are received. This is called replenishment rate. Different Inventory Model : The Basic EOQ Model : The Economic Order Quantity (EOQ) model is presented in most of introductory textbooks in a finance and in management science. First we present the basic version of this model under the assumption that all variables are certain. Subsequently , we present other versions of this model for other inventory situations and present methods for developing safety stock strategies to address risk. The basic EOQ model is simple, but it is applicable only to those inventory situations described by its assumptions , which are : •

There are only two types of costs: costs that are directly proportional to the amount of inventory held and costs that are directly proportional to the number of orders received.

61

•

There may be lead times of any length

•

There is no risk ( risk is modeled separately in determining safety stock strategy)

•

The replenishment rate is finite.

The time pattern of inventory for these assumptions is portrayed in Figure 4.1 The top portion represents relatively large order quantity and the bottom portion represents relatively small order quantity. Inventory Level

QA

Time t Inventory Level

QB Time

Fig 4.1 The top portion represents large inventories but smaller number of orders

while

the

bottom

portions 62

represents

smaller

level

of

inventories but larger number of orders. In the first case, inventory carrying cost is more but ordering cost is less while in the second case, inventory carrying cost is less but ordering cost is more. To decide on the optimum level of Q , we need a mathematical model of the trade offs between the two costs. The average amount of inventory would be (Q+0)/2 or Q/2. The logical way to value this inventory investment is in rupees. If the rupee investment per unit is P and the yearly cost of holding a dollar of inventory ( equal to the sum of all the costs that are directly proportional to inventory level ) is C, then the inventory carrying cost is equal to : Cost =CP(Q/2)

……………….4.5

For any level of order quantity , over an entire year the amount ordered must be sufficient to cover the yearly usage (S).The number of orders required to do this is : Number of Orders =S/Q

……………4.6

If F be cost of ordering , then ordering cost : Ordering Cost =F(S/Q) …………….4.7

Total Cost

(TC) =CP(Q/2)+F(S/Q) ……………..4.8 dTC/dQ= CP/2-F(S/Q2 ) 0= CP/2-F(S/Q2 )

63

Q*=(2FS/CP)0.5 …………….4.9 Where Q* is the optimum ( lowest total cost) ordering strategy .Substituting the figures from the example problem in to this formula , the optimum order quantity is calculated : Q*=(2FS/CP)0.5 Let us take an example. Several variations of this problem would be used for understanding different model of inventory management. A firm purchases 10,000 units of pa particular product per year. The product costs Rs 8/- per unit. The sum of insurance, storage, and the opportunity cost of invested funds is 20 % per year of the average rupee investment in inventory. Each time the firm places an order , it costs Rs 50/- in out of pocket expenses to generate the purchase order , receive goods etc. How much the firm should order each time an order is placed ? Q*=[(2(50)(10000)/(0.20(8))]0.5 = 790.57=791 The Order Point : The order quantity strategy outlined above is very simple to implement. Order 791 units every 28 days .However, rather than using a times ordering approach, it is often advantageous to place orders based on inventory levels. The triggering of orders based on inventory levels is called the order point system. The order point is calculated based on the expected usage during the lead time. If the

64

lead

time

is

7

days , the

usage

during the

lead time

is

(7/360)(10000)=194 units .When the level of inventory reaches 194 units, the firm should place an order for 791 units. The basic EOQ model with order points is easy to understand and to put into practice, but

its

range

is

limited

to

those

situations

described

by

its

assumptions. Other situations require different models to portray their different circumstances. Variation of the basic EOQ Model: We shall discuss two variations of basic EOQ model; the production order quantity model and the EOQ Model with quantity discounts . The Production Order Quantity Model : There are many inventory situations where the increase in the inventory level

during the

replenishment portion of the inventory cycle is not instantaneous. While such situations may occur because of other circumstances ( such as limitations in the ordering firm’s ability to unload materials quickly) , one common circumstance happens when the firm produces its own goods for inventory. This is shown in the following figure : Inventory Level

QA[1-(S/R))]

Time Fig 4.2 65

The primary difference between the basic EOQ model and the model for the finite replenishment case ( also called as POQ model) concerns the maximum inventory that occurs during the inventory cycle, and therefore

the

level

of

holding

costs

of

inventory.

Since

the

replenishment portion of the inventory cycle takes place over time and there is a continual usage of inventory , the maximum inventory that occurs in the POQ model is less than the order quantity. For example, assume a firm makes 500 units of a product for inventory and takes a week to produce these units. Also assume that usage is 20 units per day .Over the seven day week

during which the firm is producing

these goods, 140 units of product will be used. So the net increase in inventory will be 360 units :the 500 units that were added to inventory, less 140 units that were withdrawn from inventory during this week. If the inventory started the week at zero, the inventory after the replenishment will be 360 units , not 500. So a different mathematical model is required. Let R be the replenishment rate, the rate at which items are put into inventory. During the replenishment portion of the inventory cycle, Q items would be received. The length of the replenishment portion of the inventory cycle must then be equal to Q/R. During the replenishment portion of cycle, inventory will be used up at rate S; since this part of the cycle is Q/R in length , the usage over this portion of the cycle will be S(Q/R). Maximum Inventory =Q-S(Q/R)=Q[1-(S/R)] …………4.10 Since the inventory level varies from zero to this maximum in a linear fashion , the average inventory will be one half of the maximum ,or:

66

Average Inventory =Q[1-(S/R)]/2 …………..4.11 Holding Cost =CPQ[1-(S/R)]/2 …………..4.12 The number of order would be same . The total cost : TC= CPQ[1-(S/R)]/2+F(S/Q) …………4.13 Proceeding in the same manner ,we get Q*=(2FS/CP[1-(S/R)])0.5 ……………..4.14 Considering the same problem : A firm purchases 10,000 units of pa particular product per year. The product costs Rs 8/- per unit. The sum of insurance, storage, and the opportunity cost of invested funds is 20 % per year of the average rupee investment in inventory. Each time the firm places an order , it costs Rs 50/- in out of pocket expenses to generate the purchase order , receive goods etc. Assuming a replenishment rate of 40,000 units/year how much the firm should order each time an order is placed ? Q*=[2(50)(10000)/(0.20)(8)(1-(10000/40000)]0.5 =912.87=913 The optimum order quantity is 913 units per order . Quantity Discounts : The prior model deals with cases where the replenishment rate is finite. Let us

67

again return to the basic infinite

replenishment rate situation but now model the circumstance where the cost of acquiring inventory varies with the amount acquired. The most common example of this situation is the existence of quantity discounts . With quantity discounts, the firm’s ordering strategy affects the total cost of material and this effect must be incorporated in the model. So the total cost equation would be :

TC=CPq(Q/2)+F(S/Q)+PqS …………….4.15 To find the optimum order quantity , it would be useful if we could take the derivative of equation with respect to Q, set this equal to 0, and solve for Q*,as before. Unfortunately, the quantity discount policies of most selling firms ( the manner is which Pq varies with Q) are not such that Pq is a continuous function of Q. One alternative approach to the problem is to evaluate the total cost function of various levels of Q via a spread sheet and find out the level at which the cost is minimum. Safety Stock Strategies For Addressing Uncertainty: There are two major uncertain variables in inventory situations: The demand for the goods and the lead time from the order to the arrival of the goods. If neither of these variables is uncertain, the firm can plan perfectly. However, when either or both of these variables is uncertain , there will be times when the firm will not have sufficient goods available , and will then incur stock out costs. To avoid these stock out costs

of inventory, trading off the holding costs of this

68

safety stock against the stock out costs that would result from not maintaining it. Models for the optimum level of safety stocks are developed based on the trade off between stock out costs and the holding costs of the safety stock. Models will be developed for three circumstances regarding uncertainty : 1. Only demand is uncertain 2. Only lead time is uncertain 3. Both lead time and demand are uncertain In all these models , the following assumptions would be made: 1. The firm uses the EOQ/order point system to generate order quantity strategies. 2. If the firm stocks out of the good, it incurs a one time cash cost which is independent of the amount of shortage. 3. Holding costs of the safety stock are a linear function of the amount of safety stock held. 4. The probability distributions of the uncertain variables are normal. Uncertain Demand Levels: Since, most of the firms, sales are uncertain , so is their usage of finished goods, work in progress, and raw materials. To assess the probability of stock out for a given level of safety stock, we need an estimate of the uncertainty in demand. If the firm is using the EOQ/order point system, the relevant uncertainty of demand is the uncertainty of demand during lead time. It is the uncertainty of demand between order and delivery that is relevant in formulating safety stock policy. Let us take an example. In our basic EOQ problem as mentioned before, the optimum ordering strategy was to order 791 units when the level of inventory reached an order point of 194 units, given a lead

69

time of 7 days and yearly demand of 10,000 units. The price was Rs 8/- per unit and the carrying cost of the inventory was 20% per year. Assuming that the yearly demand is uncertain, with a coefficient of variation of 0.10.Assume also that the lead time is certain and that the cost of a stock out is Rs 100.How much safety stock the firm should hold ? Let A be the level of the safety stocks in units. The yearly holding costs of this safety stock will be CPA. Let the probability of stock out during an inventory cycle based on this level of safety stock should be Xa. The expected cost per cycle of stocking out will then be XaK, where K is the cost of the stock out .Since there are S/Q* cycles per year, the expected stock out cost will be XaK(S/Q*), and the cost associated with the safety stock will be : Total Safety Stock Cost = CPA+ XaK(S/Q*)…………4.16 The

optimum can be found more directly by taking the derivative

equation, setting this equal to zero, and solving for the optimum A. The derivative of the above equation is : dTC/dA = CP+(dXa/dA)K(S/Q*) …………4.17 A closed form solution to this equation requires an expression for (dXa/dA). For the normal distribution , this expression is : (dXa/dA)=- [1/(SDd*(2∏)0.5) ]e-(1/2SDd2)A^2 ……..4.18 Where SDd is the standard deviation of demand during the lead time. Substituting this in the above mentioned equation and setting this equal to zero and simplifying , we obtain : A* = [-2 SD2d ln {CPQ* SDd(2Π)0.5/SK}]0.5 …………4.19

70

Inserting the data from the example problem into this equation, the optimum safety stock can be calculated :

A* = [-2 19.42 ln {0.2(8)791(19.4)[2(3.14159)0.5/10000(100)}]0.5 =45.81 So the optimum strategy is to carry a safety stock of 46 units. Since the expected usage during the lead time is 194 units, the firm should place an order for 791 units when the inventory level reaches 240 units. This level of safety stock would result in a Z score of 46/19.41=2.37

and a stock out probability of 0.008894 for each

inventory cycle. Substituting these figure into the equation gives the yearly cost of the optimal safety stock strategy : Total Safety Stock Cost = CPA+ XaK(S/Q*) =0.20(8)(46)+0.008894(100)(10000/791) =Rs 74+Rs 11=Rs 85/- . Uncertainty Lead Times: Firms may also face situations where demand is certain but the lead time between order and the arrival of the inventory is uncertain. Uncertainty lead times often occur when the firm orders materials from a supplier. In such a case, if the firm kept no safety stock, stock out costs would have been incurred. The appropriate model for determining the optimum safety stock with uncertain lead time is essentially the same as that where only demand is uncertain. Let us assume that a firm’s demand for a particular good was 5 units per day for certain, but the lead time from order to delivery was 10 days with a standard deviation of 2 days. This is the same as saying that, units with a standard deviation of 10 units( 2 days times 5 units per day) .If SD1 is the standard distribution of

71

demand during the time form order to receipt due to uncertainty regarding the lead time , the above formula still gives the optimum order quantity , but SD1 is substituted for SDd. Uncertain Demand and Uncertain Lead Times : There are many circumstances where both demand and lead time are uncertain .In such case, both uncertainties must be taken into action in formulating safety stock strategy. Here , the probability distributions of demand and lead time uncertainty must be combined to obtain an estimate of the total uncertainty during the time between placing of the order and its receipt. The formula for the standard deviation of two combined probability distributions is : SDc =(SDa2 + SDb2 +2 SDa SDb CORab )0.5 ………..4.20 Where SDc is the standard deviation of the combined distributions.SDa is the standard deviation of the first distribution, SDb is the standard deviation of the second distribution, and COR

ab

is the correlation

coefficient between the two distributions. First we find out SDc from the above mentioned formula and then we apply the same in the following formula : A* = [-2 SD2cln {CPQ* SDd(2Π)0.5/SK}]0.5

72

…………..4.21

Chapter Five Management of Receivable Accounts receivable management starts when inventory management ends and ends when management of cash begins. It is also known as Credit Management . Credit Management primarily concerns with the following issues : 1. Arrival

at

the

decision

methodologies

for

arriving at the appropriate terms of sales or terms of credit. 2. Arrival of the identification of firms whom to extend credit 3. Monitoring of Accounts Receivable Before we proceed further, let us examine the reason for existence of credit system in business. Prime reasons for existing such system are as follows : 1. Extending credit by a firm can create an opportunity for financial arbitrage. When the seller firm is financially more strong than the buyer firm, the seller firms can extract credit at a favourable term from the bank and then extend credit to the buyer firm .In the process, it charges interest which is more than the interest pays to the bank. Generally any good corporate would be able to avail fund from the banking system at a rate of 12% to 14% p.a. while the minimum amount charges for extending credit is 24% p.a. This provides a clear arbitrage of 12% to 10% p.a.

73

2. Buyers imperfect knowledge about the quality of the product may be another reason fro existence of the credit mechanism. When payment is delayed to some extent, the buyer can inspect and count the goods purchased. 3. Adjustment of sales to take care of temporary fluctuation of demand of products. During the lean season, it can extend the favourable terms of sales to stimulate sales and during the busy season, it can put more stringent conditions for sale. The typical sequence of events when a firm grants credit is as follows : 1. The credit sale is made; 2. The customer sends a cheque to the firm; 3. The firm deposits the cheque; 4. The firm’s account is credited for the amount of the cheque; This is explained with the help of the following diagram : Credit Sale Made

Customer mails cheque

Firm Deposit Bank Credits Cheque in Bank Firm account

Cash Collection

Accounts Receivable

74

Fig 5.1 It can be viewed from the above that one of the factors influencing the receivables period is float.Thus one way to reduce the receivable period is to speed up the check mailing, processing and clearing. Terms of Sales : The terms of a sale are made up of three distinct elements : 1. The period for which credit is granted (the credit period); 2. The Cash discount and the discount period; 3. The type of credit instrument; Within an industry, the terms of sale are usually fairly standard, but these terms vary quite a bit across industries. The Basic Form : The easiest way to understand the terms of sale is to consider an example. For bulk purchase of an item , terms of 2/10, net 60 days are commonly given by a seller. This means that

the

customer has to pay in 60 days from the invoice date to pay the full amount. But if payment is made within 10 days, a 2 percent cash discount can be taken. Let us consider a buyer who places an order for Rs 1000/- and assume that the terms of the sale are 2/10, net 60. The buyer has the option of paying Rs 1000 (1-0.02)=Rs 980/- in 10 days , or paying the full Rs 1000/- in 60 days. If the terms of sale are stated as just net 30, then the customer has 30 days from the invoice date to pay Rs 1000/- and no discount is offered for early payment.

75

The Credit Period : The credit period is the basic length of time for which credit is granted.The credit period varies widely from industry to industry, but it is almost always between 30 and 120 days. If a cash discount is offered, then the credit period has two components :the net credit period and cash discount period. The net credit period id the length of time the customer has to pay. The cash discount period is the period during which the cash discount is available. With 2/10, net 30, the net credit period is 30 days and the cash discount period is 10 days. Invoice date : The invoice date is the beginning of the credit period. For individual items, by convention, the invoice date is usually the shipping date or the billing date, not the date that the buyer receives the goods or the bill. Many other arrangements also exist. For example, the terms of sale might be ROG, for receipts of goods. In this case, the credit period starts when the customer receives the order. This might be used when the customer is at a remote location. With EOM dating, all sales made during a particular month are assumed to be made at the end of the month. This is useful when a buyer makes purchase through out the month, but the seller only bills once a month. Length of the credit period : Several factors influence the length of the credit period. Two important factors are the buyer’s inventory period and operating cycle. All else equal , the shorter these are, the shorter the credit period will be. The operating cycle has two components : the inventory period and the receivable period. The buyer’s inventory period is the time it takes the buyer to acquire inventory , process it and sell it. The buyer’s receivable period is the time it then takes the buyer to collect on the sale. The credit period the seller offers is effectively the buyer’s payable period. By extending credit, the seller

76

finance a portions of buyer’s operating cycle and thereby shortens the buyer’s cash cycle. If seller’s credit periods exceeds the buyer’s inventory period, then the seller is not only financing the buyer’s inventory purchase, but part of the buyer’s receivable as well. If the seller’s credit period

is more than the buyer’s operating cycle, then

the seller is effectively providing financing for aspects of its customer’s business beyond the immediate purchase and sale of its merchandise. There are other factors that influence the credit period. Among the most important are : •

Perishability

and

collateral

value

:Perishable

items

have

relatively high turn over and low collateral value. So credit period extended would be shorter for such goods. •

Consumer Demand : Products that are well established generally have more rapid turn over

and relatively lower credit period

than the newer products. •

Cost , Profitability and Standardization :Relatively less expensive items goods tend to have shorter credit periods. The same is true for relatively standardized goods and raw materials. These all tend to have lower markups and higher turnover rates, both of which lead to shorter credit periods.

•

Credit Risk : The greater the credit risk of the buyer , the shorter the credit period is likely to be granted.

•

Size of the account: If an account is small, the credit period may be shorter because small account costs more to manage, and the customers are less important.

•

Competition: When the seller is in a highly competitive market, longer credit periods may be offered as a way of attracting customers.

77

Cash Discounts : The cash discounts are often part of the terms of sale. When a cash discount is offered, the credit is essentially free during the discount period .The buyer only pays for the credit after the discount period is over. With 2/10, net 30, a rational buyer either pays in 10 days

or pays in 30 days. By giving up the

discount, the buyer effectively gets 30-10=20 days’ credit. Another reason for cash discounts is that they are a way of charging higher prices to customers that have had credit extended to them. In this sense, a cash discount is a convenient way of charging for the credit granted to customers. Cost of Credit : In the previous example, it might seem that the discounts are rather small. With 2/10, net 30, for example early payment gets the buyer a 2 percent discount. We can find out the interest rate that the buyer is effectively paying for the trade credit. Suppose the order is for Rs 1000/- .The buyer can pay Rs 980/- in 10 days or wait for another 20 days and pay Rs 1000/-.It is obvious that the buyer is effectively borrowing Rs 980/- for 20 days and pays Rs 20/- in interest on the loan. The interest rate work out to be Rs 20/ Rs980=2.0408% but for the period of 20 days . So the effective annual rate EAR is : EAR=1.02040818.25 -1=44.6% The Average Collection Period (ACP) : The investment in accounts receivable for any firm depends on the amount of credit sales and average collection period (ACP). If a firm’s average collection period,ACP, is 30 days , then at any given time, there will be 30 days’ worth of sales outstanding. If credit sales run Rs 1000/- per day , the firm’s accounts receivable will then be equal to 30daysX Rs 1000/- per day =Rs 30000/- . So Accounts Receivable =Average Daily sales X ACP

78

A cash discount encourages customers to pay early, it will shorten the receivable period and , all other things being equal ,reduce the firm’s investment in receivables. For example, a firm currently has terms of net 30 and an average collection period ACP , of 30 days.If it offers 2/10, net 30, then perhaps 50 percent of its customers will pay in 10 days. The remaining customers will still take an advantage of 30 days to pay. The ACP would be : New ACP=0.50X10days +0.50X 30days =20days Credit Instruments : The credit instrument is the basic evidence of indebtedness. Most trade credit is offered on open account. This means the only formal instruments of credit is the invoice, which is sent with the shipments of goods and which the customer signs as evidence that the goods have been received. In certain cases, the buyers needs to accept a bills of exchange for taking delivery of goods. The same bills of exchange can be used by the seller to raise fund immediately from the banks. Analyzing the Credit Policy : We shall now take a closed look at the factors that influence the decision to grant credit. Granting credit makes sense only if the financial results from such decision is positive. The important dimensions of a firm’s credit policy are : •

Credit Standards

•

Credit Period

•

Cash Discount

•

Collection Effort

Credit Standards : In general, liberal credit standards tend to push sales up by attracting more customers. This, is however, accompanied

79

by a higher incidence of bad debts loss, a larger investment in receivables, and a higher cost of collection. Stiff credit standards have opposite effects. The effect of relaxing the credit standards on profit may be estimated by using the formula : ∆ P=∆S(1-V)-k∆I-bn∆S …………….5.1 ∆ P= Change in Profit ∆S= Increase in sales V = Ration of variable costs to sales k= cost of capital ∆I= increase in receivable investment bn =bad debt loss ration on new sales On the right hand side of eqn 5.1, the first term measures the increase in gross profit, the second terms, k∆I, measures the opportunity cost of additional funds locked in receivables , and the third term, bn∆S, represents the increase in bad debt. Credit Period : The credit period refers to the length of time customers are allowed to pay for their purchases. It generally varies from 15 days to 60 days. When a firm des not extend any credit , the credit period would obviously be zero. If a firm allows 30 days of credit, with no discount to induce early payments, its credit terms are stated as “net 30”.Lengthening of the credit period pushes sales up by inducing existing

customers

to

purchase

more

and

attracting

additional

customers. This is, however, accompanied by a larger investment in receivable and a higher incidence of bad debt loss. Since the effects of lengthening the credit period are similar to that of relaxing the credit standard, we may estimate the effects on profit of change in credit

80

period by using the same formula of 5.1. Here we put the value of ∆I as follows : ∆I =(ACPN-ACP0)[S0/360]+V (ACPN) [∆S/360 ]………….5.2 ∆I= increase in investment ACPN

=new

average

collection

period

(

after

lengthening the credit period) ACP0=old average collection period V

=ratio of variable cost to sales

∆S = increase in sales On the right hand side of eqn 5.2, the first terms represents the incremental investment in receivables associated with existing sales and the second term represents the investments in receivables arising from the incremental sales. It may be noted that the incremental investment in receivables arising from existing sales is based on the value of sales, whereas the investment in receivable arising from new sales is based on the variable costs associated with new sales. The difference exists because the firm would have collected the full sale price on the old receivable earlier in the absence of the credit policy change, whereas it invests only the variable costs associated with new receivables. Cash Discount : Firm generally offer cash discounts to induce customers to make prompt payments. The percentage discount and the period during which it is available are reflected in the credit terms. As mentioned earlier , credit terms of 2/10, net 30 mean

81

that a discount of 2 percent is offered if the payment is made by the tenth day, otherwise full payment is due by the 30th day. Liberalizing the cash discount policy mean that the discount percentage is increased and/or the discounts period is lengthened. Such an action tends to enhance sales , reduce the average collection period, and increase the cost of discount. The effect of such an action on gross profit may be estimated by the following formula : ∆ P=∆S(1-V)+k∆I-∆DIS …………….5.3 ∆ P= Change in Profit ∆S= Increase in sales V = Ration of variable costs to sales k= cost of capital ∆I= savings in receivable investment ∆DIS = increase in discount cost Where ∆I =(ACP0 -ACPN)[S0/360]-V(ACPN) [∆S/360 ]………….5.4 and ∆DIS = pn(S0+∆S )dn – p0S0d0 …………..5.5 pn =proportion of discount sales after liberalizing the discount terms S0 =sales before liberalizing the discount terms ∆S = increase in sales as a result of liberalizing the discount terms dn = new discount percentage p0=proportion of discount sales before liberalizing the discount terms d0 = old discount percentage

82

Collection effort : The collection programme of the firm, aimed at timely collection of receivables, may consist of the following: •

Monitoring the state of receivables

•

Despatch of letters to customers whose due date is approaching

•

Telegraphic and telephone advice to customers around the due date.

•

Threat of legal action to overdue accounts

•

Legal action against overdue accounts

A rigorous collection programme tends to decrease sales, shorten the average collection period, reduce bad debt percentage, and increase the collection expense. A lax collection programme , on the other hand , would push sales up, lengthen the average collection period, increase in bad debt percentage, and perhaps reduce the collection expenses. The effect of decreasing the rigour of collection programme on profit may be estimated as follows: ∆ P=∆S(1-V)-k∆I-∆BD …………….5.6 where ∆BD= increase in bad debt cost. Here ∆I =(ACPN-ACP0)S0/360]+(ACPN) [∆S/360 ]………….5.7 and ∆BD = b0(S0+∆S )dn – b0S0 …………..5.8 Credit Evaluation : Before granting credit to a prospective customer the firm must verify about the creditworthiness of the customer. In judging the credit worthiness of the customer, the three basic factors Character ,Capacity and Collateral are considered. There are several ways one can find these three factors. Some of them are :

83

•

Analysis of Financial Statement

•

Obtaining bank reference

•

Analysis of firm’s experience

•

Numerical credit rating

Analysis of

Financial Statement : Financial statements contain a

wealth of information about the customer’s financial conditions and performance. The following ratios would be helpful to achieve this purpose : •

Current Ratio

•

Acid Test Ratio

•

Debt Equity Ratio

•

EBIT-total asset Ratio

•

Return on Equity

Obtaining Bank Reference : The banker of the prospective client may be another source of information about its financial condition. This information may be obtained indirectly through the bank of the credit granting firm to ensure a higher degree of candidness. Analysis of Firm’s experience: Consulting one’s own experience is very important. If the firm has had previous dealings with the customer, then it can check from its past track record. But in case, the customer is being approached fro the first time the impression of the company’s salesman about the integrity of the customer is important. Numerical

Credit

Scoring

:

Under

this

system,

a

customer’s

creditworthiness may be captures in a numerical credit index

based

on several factors. The credit index is simply a weighted sum of factors which ostensibly have a bearing on credit worthiness.

84

Collection Policy: Collection Policy is the final element in credit policy. Collection policy

involves monitoring receivables to spot trouble and

obtaining payment on past due accounts. Monitoring Receivables : To keep the track of payments by customers, most firms will monitor outstanding accounts. First of all, a firm will normally keep track of its average collection period, ACP, through time. If a firm is in a seasonal business, the ACP will fluctuate during the year, but unexpected increase in the ACP are a cause for concern. Either customers in general are taking longer to pay, or some percentage of accounts receivable is seriously overdue. The aging schedule is a second basic tools for monitoring receivable. To prepare one, the credit department classifies accounts by age. Let us take an example where the firm has Rs 1,00,000/- in receivable. Some of these accounts are only a few days old, but others have been outstanding for quite some time. The following is the break up of receivable as per age : Aging Schedule Age of accounts

Amount ( Rs )

Percentage of Total Value of Accounts Receivable

0-10 days

50000

50%

11-60 days

25000

25%

61-80 days

20000

20%

Over 80 days

5000

5%

10000

100%

Fig 5.2

85

If this firm has a credit period of 60 days, then 25% of its accounts are late. Collection Effort: A firm usually goes through the following sequence of procedures for customers whose payments are overdue : 1. It sends out a delinquency letter informing the customer of the past due status of the account; 2. It makes a telephone call to the customer; 3. It employs a collection agency; 4. It takes legal action against the customer.

86

Section Three

87

Chapter Six Assessment of Fund Based and Non Fund Based Working Capital By Fund Based ( FB) working capital facility, we mean products of banks through which bank provides fund for meeting working capital requirement of the company . If we recall the concept of building up of working capital discussed in the chapter one , we find that current assets represents the expenses which is incurred but not realized. We have also said that part of the expenses can be deferred and this constitutes the other current liability ( OCL).The expenses which can not be deferred would be paid from borrowings. We have also seen in Chapter two, that a part of the expenses are paid from Net Working Capital ( NWC) and the remaining part of expenses would met from borrowing of the banking system. We have also discussed the reason for bank’s being the major provider of working capital facilities in our country. So Fund Based ( FB) working capital represents that portion of current liability which is going to build up that portion of current assets which are not financed by OCL and NWC. After defining the FB working capital products, we shall now discuss about the entire process of availing the Fund Based Working Capital facility of bank. The sequence of availing the facility from bank is as follows: 1. Company assess its working capital requirement ; 2. After assessment, the company decides the type of banking; 3. Company initiates the process of tying up of fund from banking system; 4. Company avails the fund from the baking system; 5. In the next year, company follows the same process;

88

Assessment of Working Capital Requirement :

The working capital facility of a company consists of two types of facilities : 1. Fund Based Working Capital Facility 2. Non Fund Based Working Capital Facility While the detail discussion on Non Fund Based facility would be done in the next chapter, in this chapter we shall discuss the fund based facility. Though the final assessment of fund based facility is carried out by the lender, the process starts from company’s end. If company is aware of the process of assessment of working capital , it would be able to sanction its working capital as per its requirement. Assessment is defined as the process by which one can determine the maximum amount of fund can be availed from institutional lender to meets a company’s working capital requirement. So assessment of working capital for a corporate means the process of arriving at the maximum quantum of working capital requirement of a corporate for a particular period.

Assessment of Fund Based Working Capital In India, Fund Based working capital is carried out with the help of any of the three following processes : 1. Maximum Permissible Bank Finance ( MPBF) Process 2. Cash Budget Process 3. Turn Over Process

89

MPBF Process : Under this method , the assessment of fund based working capital is carried out by taking into account figures from Balance Sheet as on a particular date. Before going into detail, let us make one concept very clear. Since a company is carrying out assessment , it is trying to ascertain funds required in the future. The past financials would indicate the company’s achieved performance and also validates the future financials. But the assessment is carried out on the basis of future financials. When we talk about the future, there are two years. One is the current running year and another is the next coming year. While the figures for the first one is called Estimate , the later one is called the Projections. For example, a corporate carrying out the assessment as on May 1,2005, the company has two choices. If it follows the assessment based on estimates, it will take financial data for the FY 2005-06 and Balance Sheet data as on March 31,2006. If it follows the assessment based on projections, it would use the datas for the FY 2006-07 and also Balance Sheet Data as on March 31,2007. Now coming back to MPBF process, under this process FB working capital requirement would be carried out in any of the following three methods: 1. Method I 2. Method II 3. Method III In all the above three methods, all the figures are taken from the balance sheets. The figures are either from “Estimates” or from “Projections” but not from both. While arriving at the assessment figure of Fund Based Working Capital requirement under MPBF method, company needs to submit data in a specified format. This form is called as “Credit Monitoring Arrangement or CMA” forms. CMA

90

form consists of 6 separate forms representing different types of figures taken from Profit & Loss and Balance Sheet of the company .The following tabular representation would make it clear the content and implications of these 6 forms : Form No

Content of Form

Justification

I

Total Existing Borrowing of

The proposed lender

the company as on the

would decide to take a

date of application

fresh exposure depending on the existing leverage and future cash out flows from the existing borrowing of the company

II

Profit and Loss Accounts

Detail analysis of Profit & Loss account of the company.Since the funding for working capital is predominantly for meeting the expenses incurred but not recovered in connection with the production of goods and services, major analysis is carried out for expenses associated with the productions.

III

Analysis of Entire Balance

91

Detail Balance Sheet

Sheet of the company

Analysis of the company is carried out. Here some adjustment is made to incorporate the effect of certain off balance items and also the immediate effect of cash out flows

IV

Analysis of Current Assets

As we have already seen,

and Other Current Liability

Working Capital Finance is mainly to take care of Current Assets and Other Current Liability. Form IV aims to carry out detail analysis of Current Assets and Other Current Liabilities in terms of months of holding and other parameters

V

Assessment of Fund Based

This calculated the MPBF

Working Capital

depending on the methods followed.

VI

Fund Flow Analysis

This explains detail calculation of sources and uses of long term funds and the utilization of NWC towards individual current assets.

Figure 6.1

92

Form I: Form I contains the existing borrowing of the company. This includes all types of borrowing namely Term Loan, Debenture, Unsecured Loan and also Lease Finance. It must contain data as on the application date .This information would help the proposed lender to take a decision whether it should lend depending on the leverage of the

company,

repayment

capacity

towards

already

existing

commitment of the company. Form II : This form and Form III contain the financial data for 4 years. These contain actual data for last 2 years , estimates for the current financial year and projections for the next financial year.For example, a company applying for Fund Based Working Capital under MPBF methodon July 1,2005, should give the following 4 sets of data in Form II & III: 1. Actual Data ( Audited Figure) for the financial year ended March 31,2004 and March 31,2005. 2. Estimates Data for the financial year ending March 31,2006. 3. Projections Data for the Financial year ending March 31,2007. For III is actually representation of Profit & Loss figure of the company with a special emphasis on the cost associated with the production of goods and services. Form III : This form comprises of data taken from the Balance Sheet of a company.If one analyse the format of Form III, one can find out the following : Form III starts with the Current Liability . In this form , current liability is segregated into 2 parts. The first part consists of Bank Borrowing for working capital and the second part consists of Other Current Liability ( OCL) .The Term Liability ( TL) is presented and the total outside liability is arrived at. Then comes the Own Capital .It starts with Equity

93

and then figures representing reserves and other equity type of instruments are taken in to account. The total of Out Side Liability ( Term Liability + Current Liability) and Owned Fund represents the Total Liability of the company . The Asset Side of the Form III starts with Current Assets. Then comes Gross Fixed Asset , depreciation and Net Fixed Asset. Then the figures representing the Non Current Assets ( NCA) are incorporated. Then, Intangible assets if any is also taken in to account. Taking all these together ( Current Asset+ Net Fixed Asset +Non Current Asset + Intangible Asset) , one arrives at the Total Asset figure of the company. There are some adjustments required to fill up Form III of CMA form. To understand these adjustments in Form III of CMA form ,let us take the example of the following : Balance sheet of X Limited as on March 31,2005 All amount in Rs Lacs Sources of Fund : Schedule

Amount

Share Capital

1

100

Reserves

2

250

Secured Loans

3

125

Total Source of Fund Uses of Fund :

Schedule

Fixed Asset

4 94

475 Amount 200

Less Depreciation

50

Net Fixed Asset

150

Investment

5

100

Current Assets ,Loans and Advances

285

Current Assets

225

Raw Material

6

70

Work In Progress

7

20

Finished Goods

8

30

Receivable

9

100

Cash at Bank

10

5

Loans and Advances

11

60

Loan to Group Companies

20

Loan to Staff

10

Other Advance

10

Tax Deduct at Source

5

Advance Tax Paid

15

Less Current Liability and Provision

60

Current Liability

12

Sundry Creditors

30

Advance from Customers Provision

Net

40 10

13

20

Provision for Taxation

15

Provision for Dividend

5 Current

Asset

225 Total Uses of Fund

95

475

Notes on Contingent Liabilities : a. Bill discounted from Bank Rs 15 lacs. Further Information from Schedules are Available as follows : Schedule

Description 2

3

Amount ( Rs in lacs)

Reserves

250

Revaluation Reserves

20

Free Reserves

230

Secured Loan

125

Term Loan

50

( The term Loan to be paid in 5 yearly installment of Rs 10 lacs each ) Cash Credit for

75

Working Capital 5

Investment

100

Fixed Deposit in Bank

50

Investment in Group

30

Companies Investment in Quoted

20

Shares 9

Receivable

100

Outstanding for more

25

than 180 days Outstanding for up to than 180 days

96

75

Figure 6.2 In the actual accounts of a company, we get details of each schedule. In this section, we have made only those schedules which are required for adjustment of figures in filling Form III of CMA form. 1) The First adjustment is the bill discounted amount. When a company sells on credit the following entry is passed : Dr Receivable Cr Sales There is no cash flow associated with this entry. To improve the cash flow the company can sell a part of its credit sales after drawing bill of exchange. So the receivable can be segregated into two groups : a. Accounts Receivable : This is simple credit and there is no bills of exchange. This is also called as Open Account Sales. b. Bills Receivable : In this type of credit sales , apart from documents required under Open Account Sales , additional document Exchange

in

the

also

form

of

Bills

accompanies

of the

document. The buyer once accepts the bills of exchanges would be liable to pay the bills of exchange. Some additional protection under legal statute is available for the Drawer of Bills of Exchange since

97

Bills

of

Exchange

is

a

negotiable

instrument. To improve the cash flow, the company discounts the bills of exchange to bank. When the bill is discounted , the following entry would appear in the balance sheet of the company : Dr . Bank Cr Receivable But the amount outstanding under bills discounted will appear as the contingent liabilities in the balance sheets of the company. Now, when one company fills up the Form III, this amount is added both on the liability side and also on the asset side. In the liability side, it is added under the head Bank Borrowing for working capital under Current Liability and in the asset side this amount is added with the receivable figure appearing on the balance sheet. The amount of Rs 15 lacs would be added with the Cash Credit For Working Capital head in the current liability portion of Form III and Rs 15 lacs would be added to the Receivable on the asset side of Form III under the head Receivable. The Second Adjustment : The secured loan consists of Term Loan and Cash Credit for Working Capital .We shall first segregate the two. From schedule we get the following : Term Loan : Rs 50 lacs Cash Credit : Rs 75 lacs After this, the term loan needs to be segregated further into two parts. One part must mention the installment to be paid within one year and the other part must contain installment to be paid after one year. From the description of the schedule, we can segregate the term loan portion as follows as on March 31,2005 :

98

Installment payable within 1 year : Rs 10 lacs Installment payable more than 1 year : Rs 40 lacs Now while filing up the Current Liability portion of Form III, this installment of term loan payable within 1 year would be filled up in the current liability and the installment of Term Loan to be payable after 1 year would appear on the term liability . So after adjustment of Bill Discounting , the total bank borrowing in the Form III would be Rs (75+15)=Rs 90 lacs . Third Adjustment : Here , the adjustment for Tax would be carried out. The Tax on the Profit of a business entity is calculated as per the Income Tax Act ,1961. At the beginning of the year , the company projects a certain profit as per the Calculation under Income Tax Act 1961 and determines its tax. Let us take an example that during FY 2005-06, the income tax calculated by the company is Rs 12 lacs. The total amount of tax to be paid by the company during the Financial Year 2005-06 would be Rs 12 lacs. However, in certain services provided by a company, as per Income Tax Act,1961 the receiver of service would have to deduct tax on the payment at source ( TDS) and the same is deposited by the service receiving company, against which Form 16A is issued by the service receiving company. The company also makes an assessment of this TDS. The net amount i.e. the estimated Tax Amount minus the TDS amount would be the amount in cash to be deposited by the company to the exchequer. The company needs to pay this net amount in Quarterly installment as specified under IT Act ,1961

under the head Advance Tax Paid. So

99

whenever there would be payment of tax on account of Advance Tax Paid, the following entry is passed : Dr . Advance Tax Paid Cr

Bank A/C

Similarly when TDS is calculated on the service , the following entry is passed : At the time of booking income while providing service on credit , Dr Receivable say Rs 10 /Cr Income

Rs 10/-

Now at the time of payment by the customer, it would deduct TDS , if applicable. If the TDS percentage is 10% on bills value , then the following entry would be passed

in the books of selling company

during the time of payment by the customer of selling company . Dr Bank

Rs

9/-

Dr TDS

Rs

1/-

Cr Receivable

Rs 10/-

At the end of the year , say on April 15,2006, the company calculates the actual profit under IT Act,1961 for the FY 2005-06 and the entire amount is provided in the P&L account .The following book entry is passed : Dr

Profit & Loss Account for provision for taxation

Cr Balance sheet account under the head current liability and provision Any difference between the Tax Paid ( advance tax paid +TDS) and the provision for taxation would be paid in the bank .

100

So the head TDS and Advance Tax Paid

in the Assets side of the

balance sheet would contain the amount of Tax paid by the company and the head provision for taxation in the Current Liability side of the balance sheet would contain the amount of tax required to be paid by the company. The company would not be able to know the exact position in respect to the actual tax payment position unless the assessment is carried out the department. Till the time assessment is over for a particular year , the corresponding amounts would carry on both sides of the balance sheet. Generally, it takes more than 1 year for getting the assessment of a FY . This is because the last date for submission of Tax Return for a company is October 31st of a particular year. So the tax return to be filled by a company for the financial year ended

March31,2005 is on October 31st ,2005. Generally the

assessment would be carried out by September 2006 and during that time the advance tax paid ,TDS amount and Provision For Taxation for the FY 2005-06 would appear on the balance sheet. So at any point of time , the figures in Advance Tax Paid, TDS account and provision for taxation would contain these figures for more than 1 financial year . Now in the above mentioned example the following segregation is available : Advance Tax Paid : Rs 15 lacs TDS

Rs

5 lacs

Provision for Taxation : Rs 15 lacs Rs in lacs Particulars Advance

FY 2003-04 Tax 6

FY 2004-05

Total

9

15

Paid TDS Provision

1.75 for 7

3.25 8

101

5 15

Taxation Fig 6.3 While filling up the form III , the net of figure ( i.e. the net of figure of Tax Paid , in the form of TDS and Advance Tax Paid and Provision for Taxation is permitted). In the above mentioned example, only Rs 5 would appear on the asset side as TDS because Advance Tax Paid and Provision for taxation cancels out each other. Fourth Adjustment : In the asset side of the Form III, the investments are first classified in terms of maturity. Besides maturity , the purpose of this investment would also be analysed for its classification under Current Asset

in Form III. In the above mentioned example , the

following break up is available : Fixed Deposit in Bank : Rs 50 lacs Investment in Group Companies : Rs 30 lacs Investment in quoted shares : Rs 20 lacs While arriving at the fund based working capital limit, the classification of current assets would be such that the bank finance would be made available for those current assets which are related to production. In the case of a manufacturing company, its main activity is the manufacturing of goods . Assuming the above mentioned company is a manufacturing company . the investment in the form of Group companies and quoted shares would not be classified as current asset even though the maturity is less than 1 year. So under Form III, the fixed deposit in bank amounting to Rs 50 lacs would be included in the current asset. Fifth Adjustment : In the asset side of Form III, next adjustment is made for receivable. In the case of receivable also, bank would also

102

classify those receivable whose maturity is up to 90 days in case of private debtors and in case of government debtors it is 180 days. Any receivable having a maturity of more than this would be classified as non current assets. Assuming the all the debtors outstanding up to 180 days is also outstanding up to 90 days, the classification of receivable would be as follows : Receivable to be classified as Current Asset : Rs 75 lacs Receivable to be classified as Non Current Asset : Rs 25 lacs Sixth Adjustment : In the asset side of Form III, next adjustment would be under the head of Loans and Advances. Under this head an amount of Rs 20 lacs is given to group company .Applying the same logic as mentioned above, the amount of Rs 20 lacs would not be included in the current asset . So after all these adjustment the current asset as per Form III would be as follows : Category

of Particulars

Amount

head in Form III

appearing

Amount Appear in in Form III

Balance Sheet Current Assets : Fixed

Deposits Fixed

Deposits 50

in Bank

kept in Bank

Receivable

Receivable to

90

up 100

days

PVT)

and

days

(

(

180 Govt)

would

be

classified

as

103

50 90

Current Asset in Form

III

and

receivable under

Bill

Discounting Scheme

would

be added to the receivable Loans Advances

and Loans given to 40

20

Group Company would appear in Non

Current

Asset TDS

and 20

Advance

Tax

5

would appear as net basis after adjustment with Provision

for

Taxation Fig 6.4 Seventh Adjustment : This adjustment would be on account of Fixed Asset revaluation . If the reserve contains any revaluation reserve , the same would be deducted from the reserve of the liability side of form III and the same amount would also be reduced from the Fixed Asset side of Form III. So in the liability side of Form III, the reserve amount would be Rs 230 lacs and in the asset side of Form III, the Fixed Asset amount would be Rs 180 lacs.

104

After all the adjustment , the Form III would contain the following : Category

of Particulars

Amount

head in Form III

appearing

in Appearing

Balance Sheet

in Form III

( Rs lacs)

( Rs lacs)

Bank Borrowing Bill discounted portion 75 For

Amount

90

Working would also be added

Capital Other

Current

Liability Sundry Creditor

All types of Sundry 30

30

creditors is included Advance Customer

from All

types

associated 10

10

with regular operation of the company

are

included Term installment

Loan As on the date of the balance

sheet,

the

payable within 1 term loan outstanding year

would be segregated into

two

parts

one

consisting installment within

1

installment

o payable year

and

payable

more than 1 year ;

105

10

installment

payable

within 1 year would appear here Provision

for Depending on the net 15

Taxation

off

figure

,

either

provision for taxation or advance tax would appear in Form III Provision

for This would appear in 5

Dividend Total

5

Form III Current

135

145

Liability Term Liability Term Loan

Term Loan installment 50 payable

beyond

40

1

year would appear in the Form III Total

Term

50

40

185

185

capital 100

100

Liability Total

Outside

Liability Equity Capital

All

Equity

would appear here in Form III Reserves

Revaluation would

be

reserve 250

230

excluded

from reserve in Form III Total

Owned

330

106

330

Fund Total Liability

Category

of Particulars

head in Form III

535

515

Amount

Amount

appearing

in Appearing

Balance Sheet

in Form III

( Rs lacs)

( Rs lacs)

Current Assets Fixed Deposit in Payable within 1 year 50 Bank

would be classified

Raw Material Work

50

In

70

70

20

20

30

30

Progress Finished Goods Receivable

Receivable include

should 100 the

bill

discounting

figure

appearing

as

contingent

liability

;Receivable

should

contain receivable

90

only up

to

maturity of 90 days for pvt and 180 days for govt Loans Advances

and Loans and advances 40 to Group companies would be included in

107

20

non current asset Loans

and Advance Tax and TDS 20

Advances

5

would appear as net off

figure

with

provision for taxation Cash and Bank

5

5

335

290

The figure would be 150

130

Balance Total

Current

asset Fixed Asset Net Fixed Asset

reduced

by

the

revaluation figure Other

Non

Current Asset Investment

Investment

not 50

50

related to production would

be

included

here even though the maturity

period

investment

is

of less

than 1 year Receivable

Receivable

of

more

25

than 3 moths ( Pvt) and

more

than

6

months ( govt) Loans

Loans given to group

20

company Total

Non

50

108

95

Current Asset Total Asset

535

515

Fig 6.5 Form IV : Form IV gives more analytical picture of current assets and other current liability. In the case of current assets , the form gives the holding level of Raw Material , Working in Progress , Finished Goods and Receivable. The Raw material holding is expressed in terms of month of consumption, work in progress in terms of months of cost of production, finished goods in terms of months of cost of sales and receivable in terms of months of gross sales. The other current asset will also appear in the form IV in absolute figure. In the other current liability section , the creditor for trade is expressed in terms of months of purchase of material . The other other current liability would appear as the absolute figure . Form V : This form calculates the quantum of working capital requirement under MPBF method. A quick comparison of two methods i.e. Method I and Method II would reveal the difference of the two assessment : Method I 1

Current Asset Current Asset

Method II Current Asset

( CA) 2 3

Other Current Other Current

Other Current

Liability (OCL)

Liability

Liability

Working

1-2

1-2

25% of ( WCG)

25% of CA

Capital Gap ( WCG) 4

Minimum

109

NWC 5

Estimated

Estimated/Projected Estimated/Projected

/Projected Net Net working capital

Net working capital

working capital 6

Maximum

Min of [(3-4) or (3- Min of [(3-4) or (3-

Permissible

5)]

Bank

5)]

Finance

( MPBF) Fig 6.6 An analytical view of the above stipulates : •

Up to the arrival of WCG both the method is same.

•

The method varies only in the context of minimum NWC requirement. In the case of Ist method, the minimum NWC is 25% on WCG while in the case of II nd method, the minimum NWC is 25% of CA.So stipulation of minimum NWC is more in case of II nd method compared to that of Ist method.

•

Due to the above factor, MPBF is always more for 1st Method than 2nd Method.

Form VI : Form VI gives the details of sources of NWC. It also gives the utilization details of NWC towards building up of

individual

component of Current Assets. Important points for arriving at the assessment of fund based working capital under MPBF method : •

The holding level of Raw Material, Work in Progress, Finished Goods and Receivable should not go up from that of last two years actual in the estimates and projections figure. If there is an increase, suitable justification would be required.

110

•

The percentage of other current asset as a percentage of total current asset should not go up in the estimate and projection figure when compared with last two years actual.

•

The holding level of creditor should not go down in the estimates and projection figure.

•

The percentage of other other current liability

with respect to

total other current liability should not go down. •

The Current Ratio should not go down in the estimates and projection.If there is any fall in current ratio , very convincing explanation should be given.

•

The leverage ratio i.e. TOL/TNW should not increase beyond a certain point.

•

The detail long term sources should be disclosed in detail.

•

The sales estimates and projection should be commensurate with the industry growth.

At the time of assessment , the above mentioned rules are followed. After discussing in detail the fund based worked capital assessment under MPBF method, it is clear that this method arrives at the requirement of Working Capital by taking all the figures from Balance Sheet as on a particular date. If the assessment is carried out based on the estimates figure then the figures from as on the last day of the estimates year is taken for carrying out the assessment of the fund based working capital limit. Another important aspect of MPBF method is that the last two years figures should be in the audited form. Since the company has to submit its audited figures to a large number of statutory bodies, the company coincides its account closing in such a manner that most of the compliances are met from the same accounts. This is the reason why most of the companies are closing their accounts as on the March 31, of every year. If the company’s

111

business does not reflect any seasonality, there is no problem with this as the accounts of all the time of the year would reflect the uniform patterns. However, if the business of company has marked seasonality then there is a problem. If the company’s business season is such that the peak business operation takes place at a time which is not coinciding with the accounts closing date, the company’s accounts would not be able to capture the true requirement of working capital. Please recollect the concepts we develop in the first chapter. Current Assets represents the expenses which is incurred but not realized. If the business cycle of a company has seasonality and the peak business cycle is not coinciding with the accounting years, then the current asset as on the balance sheet date would not represent the true expenses which is incurred but not realized. Since the expenses would be more during the peak business cycle compared to that of other time , the current asset level would be more during the peak business cycle. So if the assessment would carry out as per MPBF method, it would only take the figures from balance sheet as on the audited accounts date. But there can be a point in between two account closing date which represents the peak business cycle and the current asset at that point of time would reflect the true representation of the maximum current asset of the company for the entire financial year. So MPBF method of assessment would be leading to inadequate fund based working capital

for seasonal industry. For seasonal

industry , the fund based working capital requirement needs to be assessed through a separate methodology i.e.called Cash Budget Method. As we have already seen that the requirement of fund based working capital is due to bridge the timing match between the expenses towards production of goods and /or service incurred and money

112

realized from the sale of the same goods and /or service. While the expenses is associated with the outflow of cash where as the realization from the products/services would be inflow of cash. Moreover, the long term surplus would represents components of NWC of the company . So in the cash budget method, the next twelve months monthly cash flow is drawn as per the following format : Revenue Account: Since working capital represents the expenses incurred for the revenue account , the inflows and outflows of the revenue account are plotted in each month. The heads under which inflows and outflows are put represents the heads that will appear against current assets and liabilities. For example, the current asset consists of Raw Material ,SIP and Finished Goods. Only when the sales are made and money is realized one receives cash in the revenue account. So the Inflow of revenue account would be the realization of receivable. Where as for selling the finished goods one needs to purchase raw material and convert into finished goods through different stages of production. While at the time of purchase of raw material , the company can purchase it in cash or in credit. If it purchase in cash then there would be immediate cash out flow and if it purchases in credit the creditor payment would capture this cash flow after some time. Now after purchase of raw materials there are other manufacturing expenses in the form of electricity, salary and wages for production and other manufacturing expenses. Expenses are plotted against these heads on monthly heads. Then after the finished goods stages are reached, there are selling and distribution expenses .These expenses are plotted monthly wise . After the selling and distribution expenses there are finance charges or interest expenses. The interest expenses are divided into two groups ,interest on working capital

113

finance

and interest on long term liabilities. However, both the

interest would come in the revenue account ( others wise debt trap like situation will arise) . Now the tax payment would take place and also

dividend payment would take

place. Both this would be

incorporated in the cash out flow. So the cash outflow on a monthly basis for the revenue account would contain the following : For

the Month 30th April

31st May

Ending Inflow : Inflow

from

Cash Sales Realization

of

Receivable Other Income Total Inflow of Revenue Account Outflow: Purchase of Raw Materials

in

Cash Payment

of

creditors

on

account

of

purchase of raw materials

on

credit Payment

of

Power and Fuel

114

30th June

for

Production

of goods Payment Wages

of and

Salaries Payment

on

account

of

Other Manufacturing Expenses Payment

on

account

of

salary and other establishment cost for selling and distribution expenses Payment

on

account

of

selling

and

distribution expenses Payment

of

account

of

Interest expenses Payment

on

account

of

Taxes

115

Payment

on

account

of

Dividends Total Outflow on Revenue Account Revenue Account Surplus/Deficit Fig 6.7 In the Capital Account we can have the following inflows : Inflows on account of induction of fresh equity capital Inflows on account of fresh term liability in the form of term loan and debenture Inflows on account of unsecured loan In the capital account we can have the following outflows : Outflows on account of purchase of fixed assets Outflows on account of investments in financial assets Outflows on account of repayment of term liability Outflows on account of repayment of unsecured loan. So the capital account cash flow is drawn as below : For

the Month 30th April

31st May

Ending

116

30th June

Inflow : Inflow

from

Induction

of

Equity Capital Inflow

from

Fresh

Term

Loan Inflow

from

Fresh Debenture Inflow

from

Unsecured Loan Total Inflow on Capital Account Outflow Purchase

of

Fixed Asset Repayment

of

Term Loan Investment Repayment

of

Unsecured Loan Total Outflow on account

of

Capital Account Capital Account Surplus/Deficit

117

We get the total cash requirement by combining the above two : For

the Month 30th April

31st May

30th June

Maximum

Maximum

Ending Surplus/Deficit in

Revenue

Account Surplus/Deficit in

Capital

Account Overall Surplus/Deficit Opening

Cash

balance Closing

Cash

Balance Maximum Amount

of Amount

of Amount

of

Drawal Allowed Drawal Allowed Drawal Allowed in this Month

in this Month

in this Month

Fig 6.8 The Closing cash balance reflects the cumulative deficit of the company for the coming year. The maximum limit would be peak deficit . If you see , in the cash budget method the seasonality of business cycle is taken care off as the outflows and inflows of cash in each month is taken into the account for arriving at the fund based working capital limit. Actually, the cash budget method of assessment is more scientific method of assessment of working capital and this can also be extended to non-seasonal industry.

118

However, in India, even today most of the bankers follow the MPBF method of assessment for working capital finance. This is due to the fact that for all non-seasonal industry, MPBF being the method practiced for a quite long period of time. So bankers are comfortable with this method of assessment. Since the number of seasonal industries was significantly less compared to that of normal industry, bankers carried out more number of assessments under MPBF method compared to that of cash budget method. Accordingly, bankers have developed expertise over the years on MPBF methodology. This is the reason why MPBF methods are still popular with the bankers. Besides this , MPBF method is also a security based lending system because MPBF is calculated by taking figures directly from the Balance Sheet. Since the balance sheet contains figure of assets and liability and since a company can offer security its assets only , the amount arrived under MPBF is based directly on security of the company. Accordingly, it is called as security based lending system. In the case of cash budget system, the company needs to submit the actual cash budget vis a vis the statement given at the time of assessment and any negative deviation needs to be explained properly. Even though this method is scientific and takes care of each month working capital requirement more accurately, this method also requires collation of figures more frequently and company needs to have a strong MIS in place. Many corporations may not be having this kind of system in place. These are the reasons why even today, MPBF method is the most popular method of fund based working capital finance. There is another method for assessment of fund-based working capital for a company. This method is called as Turn Over Method. This

119

method is applied for small business houses. The assumption of this method is very simple. The working capital cycle is 3 months i.e. the sales are rotated four times a year. The total working capital requirement is 25 % of the projected sales. Out of this total requirement, at least 5% is to be brought in from long term sources. So the remaining 20% would be minimum amount of fund based working capital to be given to a company. This method is called Turn Over Method and very simple to assess.This is mainly followed for fund based working capital limit of up to Rs 200 lacs. All the above methods are for assessment of fund based working capital for domestic credit.However, for export credit the basis of assessment remains the same, however the process of availing the credit is different. This is due to the fact that the government gives certain incentives for promoting export in the form of concessional interest cost. While providing such incentive, the government must also draw some mechanism so that the fund which is given for export is not misused. Generally the working capital for export is segregated in to two parts. They are : 1) Pre Shipment Credit 2) Post Shipment Credit Pre Shipment Credit : As the name suggests, this is the working capital given up to the point of shipment. The amount of fund based working capital given for pre shipment credit should cover all the expenses till the shipment stage. This facility is also known as Packing Credit . As mentioned earlier, the packing credit is the fund based working capital facility given by the bank to meet the expenses

120

incurred till the shipment stage . The following expenses are incurred by an exporter till the shipment stage : 1) Expenses incurred for purchase of raw material 2) Expenses incurred for conversion of raw material to finished goods 3) Expenses incurred for ware housing of finished goods 4) Expenses incurred for putting the goods on board. As mentioned earlier, the total assessment is carried out in the same manner as the assessment for the domestic working capital and the required NWC of 25% of the current assets is to be brought in by the company. Since the fund is disbursed under concessional interest rate, there should be some mechanism that the fund is going for the export purpose. So any packing credit is disbursed against either LC or confirmed order and the disbursing bank make an endorsement on the LC or Export order so that the company can not avail the export packing credit against the same order from bank. Moreover, the fund under packing credit needs to be repaid from the post shipment credit and for this purpose bank maintains a diary of shipment .If it is liquidated from the domestic sources, a penal interest rate well above the market is imposed. This prevents the company to misuse the packing credit for domestic purpose. After the goods is put on board of ship, the bank provides a post shipment credit to the company. The post shipment credit is provided on the cost of the goods plus Insurance plus freight . This is popularly known as CIF value. For promoting export, apart from the concessional interest , the bank do not insists for any margin on Post Shipment

121

Credit. The entire amount which is disbursed against post shipment credit would be credited to the pre shipment account and the pre shipment

credit is closed. So when the bank disburses the packing

credit his main concern is the shipment of the goods. Since once the shipment takes place, the packing credit is liquidated. In the case of post shipment credit , the risk of the bank increases .This is because in the pre shipment stage , the bank has the finished goods as the security in the post shipment stage the bank is having only receivable which a piece of paper only. To reduce the risk of any delinquency, bank insists on the following : 1) Generally bank asks for Letter of Credit for Post Shipment Credit 2) When LC is not available, banks gets credit rating of the overseas buyer from the reputed agencies like Dun and Broad Street . 3) Bank also insists for Export Credit Guarantee Commission ( ECGC) coverage for Post Shipment Finance. This is an insurance coverage for counter party risks. 4) Bank does not provide the Post Shipment Finance for exporting to countries where there are significant country risk involved. After the post shipment finance is disbursed, the same precaution to be taken so that the purpose of concessional interest is not defeated. The post shipment finance is to be realized only from the Realisation of export proceeds and the export proceeds to be realized in all cases ( except the case of capital goods export) within 180 days.If it is not realized within 180 days , details to be given to RBI and the writing off of export receivable requires fulfillment of many formalities. These formalities would act as deterrent for reaping unscrupulous benefits of concessional interest rate.

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Assessment of Non Fund Based Limit After discussing in detail the fund based worked capital assessment ,we shall now discuss in detail about the Non Fund Based assessment. As we have seen in the previous chapter that, fund based working capital facility is required to meet the expenses incurred but can not be deferred and also for the payment made for the continuance of the regular operation procedure. We have also seen that a part of the expenses can be met by deferring the payment arising on account of such expenses. Moreover, a company can take advances from the customer, in time. All these consist of Other Current Liability .Non Fund Based facility is used by a company for building up of Other Current Liability. Non Fund Based facility is the facility provided by bank to a company without involvement of any immediate involvement of fund. The examples of Non Fund Based facility is Letter of Credit ( LC) and Bank Guarantee ( BG). A Non Fund Based Facility consists of the following characteristics : 1. At the time of providing the facility , issuer of Non Fund Based facility would not disburse any fund. Generally banks are the provider of Non Fund Based facility. Banks can issue LC and BG on behalf of its customer and at the time of issuance there is no fund involved. This would help bank to increase the business without involvement of fund. If one analyses the balance sheet of Financial Intermediaries, majority of the fund generated by such intermediaries are from the depositors. This is reflected in the high gearing ration of the financial intermediaries. Since high

123

leverage ratio is associated with a significant in crease in risk of the concerned entity, the question can be asked why such high leverage is permitted for financial intermediaries and how the risk associated with such high leveraged intermediaries are addressed ? The answer to the first question lies in the role of the financial intermediaries. The role of financial intermediaries is to act as a channel for funds from the saving unit to the investment unit. To channelise this fund, financial intermediaries should be permitted to accept deposits from the savings unit and naturally it would lead to high leverage ration. While permitting the financial intermediaries to accept deposits , the

risk

associated

with

such

highly

leveraged

entity

is

addressed by the following mechanism: 1. There is a supervisor which issues licenses. Generally the Central

Bank

of

the

Country

does

this

supervisory

function. 2. The

Supervisor

imposes

certain

risk

management

measures in terms of capital adequacy and prudential norms so that financial intermediaries can not cross the limit of approved risk level. Coming back to the issues of Non Fund Based facilities. As we have already discussed , for this type of facility the financial intermediary need not to part fund .So a financial intermediary can generate significant income by resorting to non fund based business. This would basically help the financial intermediary to earn income without the risk of asset liability mismatch and interest rate risk on the liability and asset side. So the non fund

124

based facility is beneficial to both financial intermediaries and the company. However , another important characteristics of Non Fund Based facility is that in the case the customer on behalf of whom the intermediary issues this facility does not keep its commitment ( this process is called devolvement ) , the financial intermediary would pay the amount. So incase of devolvement , the non fund based facility is converted in to fund based facility. Letter of Credit : This is one of the most popular Non Fund Based products prevalent in the world market. Whenever, one company sells goods to another , the first company is called the seller and the second company is called the buyer. The seller needs to establish a mechanism so that it get paid after the delivery of goods while at the other hand, the buyer needs to establish a mechanism so that it gets the goods it has asked for. The situation can arise when seller sales goods and the buyer does not pay. The other side of the story is that the buyer pays but it does not receive goods as per the requirement. To address the concerns of both the party, LC mechanism can be resorted to .

125

The total work flow of LC is shown below: 8

Issuing Bank/ Opening Bank

2

3

9

10

Negotiating Bank

11

Advising Bank/ Confirming Bank

6

7

4

Applicant / Buyer /Draweee

5 1

Beneficiary /Seller/Draw er

Fig 6.9 Steps No

Activity

Chronological Step of Transaction

1

2

3

The Buyer and Seller finalized the terms

This is the

of sale. The Buyer sends the Purchase

first step of a

Order to the seller .The Seller then sends

trade

the Invoice.

transaction .

The Buyer goes to its bank and applies for

This is the

a Letter of Credit as per the terms of

Second Step

purchase for opening of Letter of Credit

of the

from a sanctioned letter of credit limit.

transaction .

The Buyer’s bank also known as applicant

This is the 3rd

bank/issuing bank opens a letter of credit

steps of the

and the same letter of credit is send to

transaction .

126

the seller through a bank which is known to the seller. The Issuing bank sends the LC to another bank familiar to the beneficiary. This bank is called the Advising Bank. 4

The advising bank advises the LC to the

This is step

seller. Sometimes, the seller also requires

four of the

some more assurance as it can rely solely

transaction.

on the issuing bank .In that case, the advising bank needs to add confirmation to the LC and the advising bank is called as Confirming bank. 5

The seller ships the goods to the buyer.

The start of

Till now all the process are of

this process

chronological order. Though the start of

is fifth steps

the process is after stage 4, the

of the

completion of the process can be later

transaction

than the subsequent stages.

.However the completion can be after step 9.

6

7

The seller submits the documents to a

This is 6th

bank called negotiating bank along with

Step of the

the LC.

transaction .

The Negotiating bank scrutinize the

This 7th Step

documents and if the document is in

of the

order, it disburses the payment to the

transaction.

seller. 8

The Negotiating bank sends the document

127

This is 8th

to the Issuing Bank .

step of the transaction .

9

The Issuing Bank sends the document to

This is 9th

the applicant for acceptance or rejections

step of the

if any. The buyer accepts the documents

transaction.

and returns the accepted document to the Issuing Bank.On receipt of the accepted document, the issuing bank informs the negotiating bank and then release the transport documents so that the buyer can release the goods. Completion of step 5 10

The goods which is shipped at the

This is 10th

beginning of the step 5 is released by the

step of the

buyer .

transaction .

The buyer pays to the issuing bank on

This is the

due date i.e. at the end of the credit

11th step of

period.

the transaction.

11

The issuing bank pays to the negotiating

This the 12th

bank.

and final step of the transaction.

Fig 6.10 If we analyse the utility of the LC, it is basically a credit enhancing mechanism. In case the buyer does not pay, the issuing bank would pay provided the beneficiary complies with the terms and conditions of the LC. So from the seller’s point of view the payment is assured once it complies with the terms and conditions of LC. Now here comes a very important aspect of LC.LC says that it deals with the documents

128

not with goods. From the above

chronological steps, it is clear that

the buyer will be able to accept the documents before it can see the goods. Then the question is how does buyer ensure that the goods supplied is the goods it asked for. Here lies the expertise of LC opening.

The

buyer

must

stipulate

documents and terms and

conditions which will force the seller to ship the correct goods. Special care should be taken at the time of opening the LC by the buyer. Similarly one can see that the negotiating bank pays in chronological stage 7th of the transaction while it gets paid in chronological stage 12th of the transaction. Now the question arises , how negotiating bank confirms that the seller fulfils all the terms and conditions of the LC. It may happen that for negotiating bank certain terms and conditions are accepted but the same may not be accepted by the issuing bank. Since the ultimate fund would be remitted by the issuing bank , the fulfillment of terms and conditions as accepted by the negotiating bank should also be accepted by the issuing bank. To avoid any confusion and disputes between negotiating and issuing bank, an uniform procedure is adopted by all the banks in the world. This procedure is called as Uniform Conduct and Procedure for Documentary Credit ( UCPDC) version 500.This is framed by International Chamber of Commerce ( ICC) .UCPDC 500 contains 49 clauses which describes the mode of operation of the entire LC mechanism. The details of all the sections of UCPDC 500 is given in the study material. Before we proceed with the operational aspect of the LC, let us first know that how the LC limit is assessed .By now, we know the specific requirement of LC. It is basically used to purchase material on credit. In other words, LC is required to build up a portion of Other Current

129

Liability .To be precise LC is used to build up Sundry Creditor ( Trade). A company wants to purchase material on Credit without giving any LC. The reason

being , with LC there are two aspects of the

transaction : 1. Payment to be made on due date by the customer without fail. Since Bank is giving the LC, in case of non payment to the bank by the customer on due date, the issuing bank would pay from itself to the negotiating bank. This would reduce the credit rating of the company in the books of the Issuing Bank. In the case of simple credit, the company can delay the payment to the supplier without loosing too much credibility . 2. When LC is opened , certain charges need to be paid to the banks concerned. So, there is an additional cost for purchase under LC. A company would always try to purchase material on Credit without LC. Only when the company can not purchase without LC , generally then only it will agree to give LC to the supplier. The First Step of the LC assessment process is the arrival of the percentage of purchase with LC. From the past experience , the percentage of total purchase under LC is arrived at. The total purchase figure is obtained as below : If the assessment is carried out on the basis of estimates, then the estimated purchase figure is found out as follows : Serial No

Particulars

Source

1

The Consumption of Raw Material and Form II

130

spares for the year under estimation 2

The Opening stock of Raw Material Form III and

Spares

for

the

year

under

estimation i.e. the closing stock of Raw Material and Spares as on the previous year . 3

The Closing stock of Raw Material and Form III Spares for the Year under estimation

4

Total Purchase

4= (2+3-1)

5

Out of the above purchase percentage Y=x% of 4 of purchase under LC Fig 6.11

Depending on the payment period

enjoyed by the applicant of the

LC,LC can be of two types. These are: •

Sight LC

•

Usance LC

Sight LC : In this LC , the payment is made on sight of the document. Whenever, the document is seen by the applicant, the applicant would pay the amount under LC. Actually 7 days are given to pay the LC. Effectively the buyer does not get any credit except the 7days period from the sight of the documents under LC. Usance LC : Under this

LC , the payment is made after a certain

period from a specified date. The specified date can be date of a document mentioned under LC. This period is called usance period. The applicant enjoys credit for this period. The weighted Average Usance Period ( AUP) under LC is arrived at by using historical data. Besides this , there is a time taken to process the

131

entire LC operation. This is called the Lead Time ( LT). The LC period (LP) consists of AUP plus LT. The number of times an LC is rotated is equal to =365/LP The total LC requirement is (Y /365)*LP Once the limit has been assessed by the bank , the bank issues a sanction letter for LC. Bank Guarantee : Bank Guarantee (BG) is another Non Fund Based facility provided by Financial Intermediary. Like any other non fund based facility , BG is also required to build up other non current liability. Specially it is required to build up that portion of non current liability for which advance is taken from a client. This can be explained with the help of an example : Suppose the Kolkata Metropolitan

Development Authority (KMDA)

decides to construct a Bridge. It asks for bid from prospective construction companies ( civil contractors) . After the successful bidding ,KMDA selects one contractor say A for the job .Since the construction job is of very high volume in nature, KMDA would provide advance for mobilization of the job. This is called the mobilization advance. Now, KMDA also wants some kind of mechanism so that after taking the money A should fulfill its responsibility . KMDA would ask a Bank Guarantee to be submitted by A . A would approach its banker X to issue a Guarantee on its behalf to KMDA . The Banker would issue a Bank Guarantee . In a bank guarantee there are following parties : 1. The Applicant : Here the company A on whose behalf bank issues bank guarantee. 2. The Beneficiary : Here KMDA for whose favour the Bank Guarantee is issued.

132

3. The Issuing Bank : The Bank which is guaranteeing the payment in case of non performance of the applicant . Here X is the issuing bank. We have seen that in both the case of LC and BG, these are creditenhancing mechanism. In both the cases, the interest of beneficiary is protected

and in both the cases banks are giving assurances to the

beneficiary. Then where are the differences ? 1. The First difference is the trigger which causes the payment in these two types of instruments. In the case of LC, the Issuing Bank pays to the negotiating bank only if the terms and conditions mentioned against LC is fulfilled. So the payment of LC is triggered only because of performance of the beneficiary. But in case of Bank Guarantee, the payment is triggered only when the applicant does nor perform. So incase of Bank Guarantee , the payment is made only in case of non performance of the applicant. 2. In the case of LC , most of the times payment is made.In case of BG only few times the payment is made. After understanding the guarantee instruments, now we shall discuss the different types of guarantee before proceeding forward for assessment of the guarantee requirement of a corporate. There are mainly two types of Bank Guarantee .They are : 1. Financial Bank Guarantee : When a bank gives the guarantee for financial performance of its client ( which is also applicant of the guarantee ) , it is called the financial guarantee. Generally the guarantee issued for securing Mobilisation Advance, Security Deposit are Financial Guarantee. 2. Performance Bank Guarantee : When a bank gives guarantee for physical performance of its client ( which is also applicant of the

133

guarantee ) , it is called Performance Guarantee. Generally it is given to release the retention money kept by the beneficiary for the defect liability period. Assessment of Bank Guarantee : The assessment process of Bank Guarantee is as follows : •

The company arrives at the opening bank guarantee at the start of the year under consideration . (A)

•

It classifies the guarantee into Performance and Financial Guarantee (A1 +A2 )

•

It calculates the requirement of fresh guarantee during the period under consideration in terms of Performance Guarantee and Financial Guarantee. ( B1 +B2)

•

It calculates the guarantee to be returned during the year under consideration . ( C1 +C2)

•

Then the guarantee limit is arrived at by using the formula D=( (A1 + B1 - C1) + (A2 + B2 – C2 )

The first one reflects the limit for Performance Guarantee and the Second one reflects the limit for Financial Guarantee.

134

Chapter Seven Process of Tying up and utilization of Working Capital Finance from Bank After discussing in detail the worked capital assessment both the Fund Based and Non Fund Based facility ,we shall now discuss in detail about the

entire process of tying up and use of

working capital

assessment from banks. The process of tying up of working capital consists of the following stages : •

Determination quantum of working capital requirement. With the help of the process mentioned in previous chapters, a company , now, can decide the requirement of working capital both fund based and non fund based.

•

Once the quantum is decided, then the company needs to take a decision about the type of banking arrangements. There are three types of Banking Arrangements .These are : o Sole banking Arrangement : When the entire working capital facility is taken from a single bank it is called sole banking arrangement .If the working capital requirement is not very large , a company would prefer sole banking arrangement. o Consortium Banking Arrangement : When the working capital requirement is large, a single bank may not be willing to lend such large amount .In that case , the company must go for a banking arrangement where more than one bank is involved. One type of banking where more than one bank is involved is called Consortium banking arrangement. Under this method, a bank assumes the role of a leader and the bank is called Lead Bank.Lead 135

bank assesses the limit and then informs other bank about the limit. The other banks joins an association and this is called as Consortium. Once the leader assess the limit it informs the other member bank and other member banks carry out its own assessment and inform the

lead bank

about the share they are taking . Once this is formalized , a meeting called consortium meeting is called and the process for disbursement of fund takes place. o Multiple Banking : When the requirement of working capital is large, more than one banking would be involved. In this case, apart from the consortium banking , multiple banking arrangement is also possible. Under multiple banking arrangement , the limit is assessed by individual banks and individual banks take exposure. The benefit of multiple banking is that in case of consortium banking there is lot of rigidity from the point of view of the company. In case there is more requirement of working capital and even though other member banks wants to disburse their share , they can not do anything unless the lead bank approves the limit. This cause some delay which can hamper the business of a company. In case of multiple banking , such problem is not there. Once the company decides the type of banking then it selects the bank by keeping in mind the following criteria: •

The First Criteria for selection of Bank is the time the bank is supposed to take to sanction the limit and make it available to the company. It again depends on the organization structure of banks. In banks, the sanctioning power is delegated at different level. The

136

degree

of

delegation

is

different

in

different

banks.For some banks , Scale IV officer can sanction a working capital limit of Rs 3 crores where as for another bank same Scale IV officer can sanction a working capital limit of Rs 1.25 crores. So depending on the delegation power and company’s requirement company selects bank. •

After this, the next important criteria is the cost of the facility.For fund based working capital facility , interest rate is the charge the company pays to the bank. In the case of non fund based working capital facility , commission is the charge the company pays to the bank.In today’s context , different banks charge different interest for the same borrower. The borrower would apply to the banks where the total cost is lowest.

•

After this the security issue needs to be taken into account. Generally, all the working capital assistance are in the form of secured loan. Whenever a company borrows from other , the amount would appear in the liability side of the balance sheet. The liability can be

secured liability and unsecured

liability. In the case of secured liability, the liability is backed by security. The security can be created only on the Asset. In case of non payment of liability , secured liability holder can enforce the security for which it is holding charge and can realize cash after liquidation of such securities. Security can be created by any of the three processes:

137

•

Lien : Under this process, security is created on financial asset. The name of the liability holder is marked on the face of the financial instrument as lien. Under this system, the ownership is with the borrower where as the possession is with the lender. The security is created on financial assets.

•

Pledge : Under this process , security is created on both financial and physical assets. In the case of Pledge, the ownership is with the borrower where as the possession is with the lender. The lender can keep the assets in its own premises or in other premises.

•

Hypothecation : Under this process, security is created on physical assets. In the case of hypothecation,

both

the

possession

and

ownership is with the borrower. For creation of hypothecation, charge needs to be created for limited company. •

Mortgage : For immovable property, mortgage is created. In the case of mortgage, the possession and ownership is with the borrower. But mortgage is created on the immovable property where as the hypothecation is created on movable physical assets.

A comparison of all these four process are given below :

138

A comparison of the above mentioned four charge making process is shown below : Name Process

Lien

of Ownership of the Asset

Possession

Type

of Governing

of the Asset

Asset

on Statute

During

the During

tenure

of tenure

the which of charge

the loan

the loan

Borrower

Lender;

is

created At Financial

Indian

the Lender’s Asset

Contract Act

premises Pledge

Borrower

Lender;At

Both

Indian

the Lender’s Financial premises or Asset any

Contract Act and

other Movable

place under Physical the custody Asset of lender Hypothecation Borrower

Borrower

Movable

Indian

Physical

Contract Act

Asset Mortgage

Borrower

Borrower

Immovable

Transfer

Physical

Immovable

Asset

Properties Act

Fig 7.1

139

of

Depending on the nature of security to be offered to the lender , the borrower can decide on the types of charges to be created and the same is mentioned in the application form.

While deciding a particular bank, another important aspect to be taken is the issue of collateral security. Many bank insists for collateral security. Security can be classified into two types. These are : •

Primary Security : A Primary Security with respect to a particular type of finance is defined as the security which is created out of that finance. For example, when working capital is provided , current assets are build up from the working capital . In this case, the current asset is called as Primary security.

•

Collateral Security : A collateral security with respect to a particular type of finance is defined as the security on which charge is created even though the security is not created from the sad finance. For example,

in case a charge on the fixed

asset of a company for working capital loan is created, the collateral security is the fixed asset. After deciding all these factors, a company submits the application to bank(s) for working capital facility. While submitting the application form , the following documents are given : •

Filled up Application Form as per the Bank’s Own Format

•

Memorandum and Article of Association

•

Certificate of Incorporation

•

Copy of Board Resolution

•

Last three years audited accounts along with Directors Report

•

Filled Up CMA Forms/Cash Budget for next 12/18 months

140

•

Detail assumption of estimates and projections.

The Bank then processes the application forms .Depending on the banks degree of delegation power, efficiency level and business target , it usually takes 7 days to 60 months to sanction a fresh working capital limit. Each bank has specified process note ( a copy of the same is provided along with this material ) and the same note is signed by two officials. One official recommends and another official sanction the limit. In the present decentralized structure most of the banks have adopted the following structures : 1. Large Corporate Accounts : Under this category, financially very sound companies are selected .For handling these companies, in all the major cities of the country, dedicated branches are opened and the same branch can directly deal with Head Office for sanctioning of proposal. 2. Other Corporate Accounts : Other Corporate accounts follow three tier structure: a. Branch Level Sanction : For Fund Based and Non Fund Based limit up to a particular amount, branch level sanction is given. Individual branch can sanction limit and sends the proposal to the superior office for ratification. b. Zonal Level Sanction : Above the branch, Zonal Office is situated. The loan sanctioned in Zonal Office would be ratified in the head office.

141

c. Head Office Level Sanction: Generally, the head office consists of General Manager, Executive Director, Managing Director ,Chairman, Committee of Directors, Board of Directors. Each of these authorities is having sanctioning power and the sanction of loan by all these authorities are ratified by the immediate higher authority. Once the loan is sanctioned , the bank would inform the customer through a letter called Sanction Letter. Some times it is also called as Credit Arrangement Letter. A Credit Arrangement Letter would contain the following : Name of Customer : Name of the Facility Sanctioned : e.g.Fund Based Working Capital Type of Facility Sanctioned : e.g. Cash Credit Limit Sanctioned : Interest Rate : % Interest rate with reference to PLR or any other rate. Mode of charging of interest i.e. either quarterly or monthly should be mentioned . Security : The sanction letter would describe in details about the security to be offered against the facility. The security can be Primary Security and /or Collateral Security. The charge can be First Charge or Second Charge. Similarly , the security can be on exclusive basis or on pari passu basis. After discussing in detail

142

about the Primary Security and collateral security , we shall now discuss about the First Charge and Second Charge. An asset can be given security to a lender on the basis of first charge or the same asset can be given security to a lender on the basis of second charge. In the case of a first charge holder, the lender would get the first priority on the value realized from the liquidation of the asset. Let us take an example .A lender provides a working capital loan of Rs 25 lacs against a first charge on current assets of the company values at Rs 32 lacs. In the case of liquidation of the company, the lender on liquidation of the current assets would get Rs 32 lacs and it would first appropriate Rs 25 lacs and the remaining Rs 7 lacs would go to the second charge holder if any. Generally, the working capital banker would take the first charge on current assets and second charge on fixed assets . The term lender on the other hand take first charge on fixed assets and second charge on current assets of the company .The purpose of taking second charge of a company is to increase its security coverage. Now the first charge can be on the basis of exclusive charge or can be on pari passu basis. In the case of exclusive charge , a lender gets the

entire realization obtained from the liquidation

of the asset. However , when the credit facility is significantly large, more than one bank is involved .For example, a company has been sanctioned a working capital limit of Rs 50 crores and the total amount of working capital facility would be provided by say 4 banks each providing Rs 12.50 crores . Since all the banks are lending against the same current assets of the company , the charge is created on pari passu basis. Now if the value of the security is say Rs 60 crores, in case the charge is created on pari

143

passu basis, each bank are entitled to get Rs 15 crores each from the realization of the current assets of the company. In many cases, Personal Guarantee of the promoter is stipulated. In other cases, the corporate guarantee of another company is stipulated. Margin : The margin is stipulated against different types of assets. Generally a margin of 25% is stipulated on Inventory and slightly higher margin is stipulated on Receivable. After the security the negative covenant is stipulated by the lender in the sanctioned letter. After the sanctioned letter is received by the company , it needs to accepts the letter in a board meeting. A board meeting is convened and in that meeting the letter is accepted and persons are authorized to accept the terms and conditions of the sanctioned letter. Once the letter is accepted by the company, the company would then execute the documents with the lender. Generally,

the

following documents are executed with the lender : •

Credit facility agreement executed between the lender and borrower

•

Deed

of

lien/pledge/hypothecation

executed

by

the

borrower •

Documents executing the mortgage of a property by the borrower.

•

Personal

Guarantee

Bond

concerned.

144

executed

by

the

person

•

Corporate Guarantee Bond executed by the company concerned.

Once the document is executed, the charge is created by the company. The next step is that the charge is to be registered with the Registrar of Companies at the office where the registered office of the company is situated. The charge is registered by depositing specific form namely Form 8 and Form 13 duly executed by the lender and borrower to the ROC within 30 days from the date of executing of relevant documents. While filing the charge with ROC, it is important to mention that any prior charge holder must cede the charge and only then the charge can be created by any subsequent lender. Once the charge is created the lender is ready to disburse the fund. Before disbursement of the fund the lender asks for a stock statement to calculate the drawing power. Stock statement is a statement showing details of the assets in terms of name , age, quantity and value of assets for which margin is stipulated as well as security is created. The drawing power is arrived at after deducting the margin from the value of the assets mentioned in the stock statement. After arriving at the drawing power, the lender make disbursement. Monitoring of Accounts : After disbursement the lender needs to monitor the company’s performance. The lender should develop adequate mechanism so that any delinquency sign is captured early enough so that rectification measures can be initiated and any loss arising out of such delinquency can be minimized. A lender can develop the following monitoring system :

145

•

Routine Submission of Statement: If we recollect , the sanction of working capital facilities is based on either estimates /projection method/Cash

Budget

figure taken for either MPBF method.

In

both

the

cases,

borrower’s performance against this estimates /projection is to be monitored. For monitoring at periodic interval, the lender stipulates the following statements : o Monthly Statement : This consists of mainly position of securities at the end of every month . Besides, the monthly cash flow statement is stipulated for limit assessed under Cash Budget mythology. The last date of submission of this statement is 7th days of succeeding month. After receiving the statement, the lender analyses the statement vis a vis the estimates made based on which the limit is assessed . o Quarterly statement : This statement contains the security position at the end of the quarter and estimates for the next quarter. The first statement is to be submitted within 6 weeks after the end of the concerning quarter

and the second statement is to

be submitted before the start of the quarter for which the projections to be made. o Half yearly statement : This statement contains the Profit and Loss of the company on half yearly basis and the related fund flow statement .The entire fund flow statement is segregated in such a way that the operational fund, investment fund and fund is found out clearly .

146

financing

o Annual statement : Generally working capital facility is sanctioned for 1 year. After the expiry of 1 year, the company needs to submit the renewal data which contains all the documents submitted during the sanction of the original proposal. Once received by the bank, the entire process is again repeated for renewal of the facility.

147

Chapter Eight Different Corporate Banking Product After discussing in detail about the entire methods of tying up of working capital limit from the banking system , we shall now discus about the products by this fund based working capital can be raised by a company. Starting from 1991, the financial liberalization has opened up newer vistas in terms of availability of newer products. The development of a reasonably structured money market, the gradual liberalization of the money ,debt and foreign exchange market contributed to the development a large number of newer products for meeting the working capital requirement of company. A company can meet its fund based working capital requirement mainly through : •

Loan Product

•

Investment Product

Loan Product : In the case of a loan product , the fund is provided by the bank in the form of loans and advances. The loans and advances are classified as Loans and advances in the balance sheet of the bank .The loans and advances are not traded in the market and the value of the loan and advances would remain same. The typical loan products are : •

Overdraft

•

Cash Credit

•

Bill Discounting

•

FCNR ( B ) Loans

148

Overdraft : Overdraft is the facility by which an entity gets loan over and above the value of the security. This can be explained with the help of the following example : A company is having a fixed deposit of Rs 5 lacs maturing on 15th September 2005.The fixed deposit was made on 15th September 2004 and the interest rate was 6.5% p.a. payable at quarterly rest. Now , on September 1st, the company requires a fund of Rs 5 lacs . The company has two options : Option I : The company closes the fixed deposits prematurely and in the process , it looses 1% interest. If the company exercise this option, it will earn interest to the tune of Rs 27032/-. Option II: The company can take a loan for 15 days against the fixed deposit and continue with the deposit itself. The interest rate on loan of fixed deposit would be 1% higher than the interest rate of fixed deposit. In this case, the company pays 7.5% interest on Rs 5 lacs for 15 days . The company in this process would earn Rs 31760/- on its investment. So in many cases, it is beneficial to avail an overdraft over the fixed deposit amount . This facility is called the over draft. This is also a very popular retail banking product. Cash Credit : This is the most popular mode of loan product for funding the fund based working capital requirement of

a company.

Once the fund based limit has been assessed by the bank and the limit is in place after fulfilling all the steps , the fund is made available through the cash credit product. The accounts operates like a typical current account. At the time of first disbursement, the drawing power is fixed from the stock statement and the company is allowed to operate within this limit till the next month when a monthly stock

149

statement would be submitted by the company. The company would be able to draw fund up to the drawing power of the company for the month. The company can deposit and withdraw the fund as many times as it wants .The company would pay interest only on the outstanding amount on a daily product basis and the interest is charged on monthly rests. This is explained with the help of the following example : A company has been sanctioned a fund based working capital limit of Rs 200 lacs and interest rate is PLR +2% p.a, payable at quarterly rests.The present PLR of the company is 11% . The company avails this facility through a cash credit route. The stock statement submitted on 1st of September 2005, stipulates that the drawing power would be Rs 190 lacs. The transaction of the company is as follows : ( Rs in lacs) Date

Particulars

Withdrawal

Deposit

3.9.05

To Electricity 15

15

5.9.05

To Salary

60

6.9.05

To

45

Raw 100

Balance

160

Material Supplier 10.9.05

To

Other 30

190

creditor 11.9.05

By

Sales

30

160

Proceeds 12.9.05

To purchase

25

185

16.9.05

By Sales

50

135

30.9.05

By Sales

80

55

150

Fig 8.1 Since the drawing power of the company is Rs 190 lacs the balance can not exceed Rs 190 lacs. The company can withdraw and deposit

as many times as possible

provided the balance is within Rs 190 lacs. In the above mentioned example, the company withdraws 5 times in a month and deposits 3 times in a month. This is one of major advantage of the cash credit system enjoys by the corporate. The cash management responsibility is shifted to the bank. The bank has to block the entire Rs 190 lacs for this account throughout this month though the company has only drawn this amount once i.e. on 10.9.05. If we define the idle fund from this account is the difference in amount between the drawing power and the amount availed and the opportunity cost is 7.00% p.a the total opportunity cost is calculated below : ( Rs in lacs) Date

DP

Balance

Idle Fund

Period

Cost

(days) 1.9.05

190

190

2

0.073

3.9.05

190

15

175

2

0.067

5.9.05

190

60

130

1

0.025

6.9.05

190

160

30

4

0.023

10.9.05

190

190

-

1

0.00

11.9.05

190

160

30

1

0.005

12.9.05

190

185

5

4

0.004

16.9.05

190

135

55

14

0.147

151

30.9.05

190

55

135

1

0.025

Total

30

0.369

In the case of cash credit facility , the bank looses this amount due to idle fund. If the limit is substantially large, the idle fund cost is considerably higher. To help the banks to overcome this , RBI stipulated a loan delivery mechanism for all the fund based working capital limit of Rs 10 crores and above. Under this system, 80% of the fund based working capital would be disbursed through a product called Working Capital Demand Loan ( WCDL)

where the

repayment is to be specified by the borrower at the time of availing the disbursement. The maximum tenure of WCDL is 1 year and minimum tenure can be 7 days. The remaining 20% of limit can be availed through the normal cash credit route. In the case of WCDL, the cash management lies with the bank .

Bill Discounting : Once the assessment of the fund based working capital limit is carried out , the company can avail this fund based working capital amount either through a single product under loan component or through a combination of different product under loan component or through a combination of different products under loan and investment component. Bill discounting is a product where a part of the receivable can be financed. Once the assessment of the company is carried out,

a

portion of the assessed limit representing part of the receivable can be financed through bill discounting mode. When a company sales goods on credit, receivable is generated in the books of accounts of the company. This receivable is of two types :

152

•

Open Account sales : Under this process only sales invoice and other sales related documents are drawn by the seller.

•

Bills Receivable : Under this process, not only all the documents associated with the open account sales are drawn but also a Bills of Exchange is drawn. A typical Bills of Exchange would look like as follows :

Bills of Exchange Rs ______________/-

Date:

Please Pay ________________ ( Payee) or Order a sum of Rs

-

(Rupees ________________only ) on 90 days ( Credit Period) from the date of this document. ---------------------------( Name & Address of Drawee)

--------------------------( Name & Address of Drawer)

Fig 8.2 A close scrutiny of the above mentioned bills of exchange would reveal the following : •

It is an order given by the drawer of the bill of exchange to the drawee to pay to a party after certain days. Here the drawer is generally

the

seller

and

the

drawee

is

generally

the

purchaser. The payee is the bank from whom the seller gets the credit under bill discounting scheme.

153

•

Under normal circumstances, the seller would get the payment after 90 days from the buyer.This is the credit period extended by the seller to the buyer. This is also called the usance period of bills of exchange.

•

To improve the cash flow, the seller can get the fund from the Payee, immediately on submission of bills of exchange to a bank .The bank would send it for acceptance to the drawee and drawee accepts the bills of exchange to pay on due date.

•

On receipt of acceptance from the drawee, the bank would pay to the drawer immediately.

•

On due date the bank would collect the money from the drawee. Since the bill of exchange is a negotiable instrument, protection under Negotiable Instrument Act is available to the payee. In many cases , the credit enhancement of bills of exchange can be increased with the help of a LC.

Now a days, this method of financing became very much popular for Small and Medium Enterprise (SME) financing. Many large company outsourced their production facility to SMEs. These SMEs may not be financially strong enough to attract very competitive interest rate from the bank. The bank enters into arrangement where the large company which is the buyer of goods of SME would accept the Bills of Exchange drawn by the SME and in that case the exposure is shifted on the Large Company. Under this mechanism , SME can get very finer interest rate. FCNR(B) Loan: This is one of the most popular methods of working capital finance for last couple of years. If you go through the accounts of any large corporate , you will find the presence of this product.

154

Before going to the benefits of the product, we shall first discuss about the product itself. Foreign Currency Non Resident ( Bank) is the name of a deposit scheme operated by Indian bank to collect deposits from Non Resident Indians and Overseas Corporate Bodies ( OCB). These deposits are collected in United States Dollars (USD), Japanese Yen (JPY),Euro ,Great Britain Pounds (GBP),Canadian Dollar and Australian Dollar. The deposit can be taken for a minimum period of 12 months and maximum period of 36 months. The interest and principal is to be paid in foreign currency. When a bank accepts FCNR(B) deposits, it accepts deposits in these foreign currencies. The Indian bank has the following options before it : 1. It keeps the deposit in the dollar form and invest in overseas bank account. The benefit of this mechanism is that the bank has fully hedged the currency conversion risk and the counter party risk is nil. The drawback of this mechanism is that in this process, the earning is substantially lower. 2. After accepting the deposits, the bank converts this foreign currency in to the domestic currency. Subsequently , it lends the domestic currency to the Indian company and earns domestic interest rate. On due date of payment of interest and principal ,bank converts the Indian currency into foreign currency as it has to pay back to the depositor both interest and principal in foreign currency. The benefit of this mechanism is that the earning to the bank is more .However, the drawback is that the bank incurs a foreign exchange risk. 3. There can be another process by which some of the benefits from both the alternative can be retained. Such process would lead to the development of the product called FCNR(B) loan. In the case of FCNR(B) loan, bank can lend to Indian corporate in

155

foreign currency held by the bank under FCNR(B) deposit .The benefit to the bank is that without incurring the conversion risk( as mentioned under drawback in option 2), the bank can earn more as the Indian corporate would pay more compared to that of the foreign bank ( as mentioned in option 1 above). The benefit to the corporate is that it can derive the interest rate benefit between two countries. With strong foreign exchange reserves over the period of last couple of years, the short term stability on rupee dollar exchange rate would help the corporate to hedge the currency risk completely. This can be explained with the help of the following example : •

A company is having a credit rating of AA from a bank. The Bank gives fund at PLR plus 0.50 % to a AA rated customer. The company enjoys a fund

working capital limit of Rs 10

crores from the bank. The PLR of the bank is 11.00%. The company , if avails this loan through WCDL and CC route, the interest rate would be 11.50%. The company can substitute about Rs 435 lacs i.e. USD 1 million through FCNR(B) loan from the bank. Since it is a foreign currency loan, the interest rate would be linked to London Inter Bank Offer Rate (LIBOR). Suppose the company gets LIBOR +2% on the loan for 6 months. With a very strong foreign exchange reserve, the 6 months Rs dollar premium is actually very low say 2% p.a. The six months LIBOR is about 1.75% p.a. With a total hedge, the all inclusive cost of the company is 5.75% p.a. compared to 11.50% p.a. in the rupee loan. So the company benefits substantially in reducing the cost.

156

•

But there are some restriction in the use of FCNR(B) loan.This loan can only be used for financing the working capital requirement .The corporate must have a sanctioned working capital limit. This loan can not be used for any speculative purpose. After discussing the FCNR(B) loan , it would be better that we discuss something about the External Commercial Borrowing ( ECB) and compare this two facilities.

Like FCNR(B) loan, a company can also take a foreign currency loan under External Commercial Borrowing (ECB) and Trade Credit ( TC) scheme. The similarity of all the three schemes are that these are routes by which an Indian company can raise debt in foreign currency. ECB : A company can raise foreign currency loan under the scheme ECB. The ECB can be raised either through Automatic Approval Route or after obtaining permission of Government and RBI. Under the automatic approval route the following need to be fulfilled : •

ECB up to USD 20 million with minimum average maturity of 3 years

•

ECB between USD 20 million with minimum average maturity of 5 years.

•

Maximum ECB to be raised during a financial year is USD 500 million.

157

•

Maximum Interest to be paid between three to five years maturity is LIBOR+200 basis point and the same for more than five years maturity is LIBOR+350 basis point.

•

ECB can be used only for project finance but can not be used for working capital finance. Trade Credit (TC) : The trade credit refers to the credit extended by the overseas supplier, banks and financial institution

for original maturity of less than 3 years. TC

can take in the form of buyers credit or supplier credit. In the case of suppliers’ credit, it relates to credit for import in to India by overseas supplier, while buyers’ credit refers to the loan for payment of imports into India arranged

by

the

importer

for

a

bank

or

financial

institutions outside India for a maturity of less than 3 year . This is for import of capital goods. The comparison of all the three facilities are given below: FCNR(B) Loan Tenure Purpose

Maximum

TC

ECB

1 Maximum

3 Minimum 3 year

year

year

Meeting

Import of goods For Investment

Working Capital ( Requirement

all

goods in Real Sector,

including capital For goods)

acquisition

.Part abroad

can be meeting working capital requirment. Interest Rate

No restriction

Ceiling

158

is Ceiling

is

prescribed Source of Fund

Allready existing

prescribed

Fresh Liability in Fresh Liability in NRI Balance

of Balance

Liability in the Payment form

of

Payment

of

FCNR(B) deposit Permission

No

permission Information

is required. No needs information

to

to submitted

Information be needs

to

be

submitted

be submitted. Fig 8.3 In the case of a loan product, the interest rate is linked to the PLR of the lending bank. For loan product in foreign currency like FCNR(B) loan, the interest rate is linked to LIBOR. The PLR or Prime Lending Rate of the company is the reference rate for lending under loans and advances. This rate does not change frequently .The rate is arrived at by taking into the account the deposit rate and the other overhead cost. Since the deposit rate of a bank does not change very frequently , the PLR of the bank does not change very frequently. Let us take an example. A company has been sanctioned a cash credit limit of Rs 250 lacs at a rate of PLR+1.00%. If the PLR is 11% p.a. the company needs to pay interest on the drawing till Rs 250 lacs at an interest rate of 12%

till it enjoys the facility or till the PLR is changed

whichever is earlier. So company’s interest liability is fixed for a longer period. This

kind of situation may lead to the loss if a soft

interest rate regime prevails in the economy.

159

The company can take advantage of more prevalent interest rate if it is

resorted

to

borrowing

through

investment

product.

The

characteristic of investment product is that the interest rate is linked to money market interest rate. Since the money market interest rate keeps changing on the daily basis, the company can take the advantage of recent changes of the money market interest rate in the investment product. Another characteristics of investment product is that all the products are rated by an external agencies. Since the product is rated by an external agencies, the decision taking capacity of the bank is much faster compared to that of loan product. In Indian market, generally investment products are used to replace the traditional loan product for availing the interest rate benefit. In all the cases, the company is having a

sanctioned working capital limit

from a bank. The company uses the investment product to substitute the loan product within the sanctioned limit to take advantage of the interest rate. The following investment products are widely used in India for funding the working capital requirement of a company: •

Commercial Paper (CP)

•

Mumbai Inter Bank Offer Rate ( MIBOR) linked debenture

•

Non Convertible Debenture.

Commercial Paper ( CP) : CP is an unsecured money market instrument issued in the form of a promissory note by corporation of high repute to diversify their source of short term borrowing and to provide an additional instruments to investors. Subsequently , Primary Dealers and Financial Institutions are also permitted to issue CP.

160

•

Who Can Issue a CP ? A company, Primary Dealer and All India Financial Institutions can issue CP. In the case of a company the following criteria needs to be fulfilled : o The TNW of the company as per latest audited balance sheet should not be less than Rs 4crores; o The Company has been sanctioned a working capital limit by Banks and /or all India Financial Institutions o The Borrowal Account is classified as Standard assets by the bank/Fis.

In the case of Primary Dealer and All India Financial Institutions , RBI permits them to issue CP to meet their short term funding requirement within an umbrella limit specified by the RBI . •

Rating Criteria : All eligible participants shall obtain the credit rating

for

issuance

of

commercial

paper

from

ICRA,CRISIL,CARE,FITCH Ratings India Pvt Limited or any other credit rating agencies as prescribed by RBI from time to time. The minimum credit rating should be P2 of CRISIL or equivalent of other rating agencies . The issuer of CP should ensure that the rating is valid at the time of issuance . •

Maturity : The CP can be issued for a minimum maturity of 7 days to maximum maturity of 1year .Under no circumstances, the maturity date of CP should not go beyond the date

up to

which the rating is valid. •

Denominations : CP can be issued in denominations of Rs 5 lacs or multiples thereof.

•

Limits and the amount of issue of CP: CP can be issued as a “Stand Alone ” product. The aggregate amount of CP from an issuer ( company)

shall be within the limit as approved by its

Board of Directors or the Quantum indicated by the credit rating

161

agencies for the specified rating, whichever is lower. An FI can issue CP up to the umbrella limit fixed by RBI i.e. issue of CP along with other instrument viz. term money borrowings, tem deposits ,Certificate of Deposits

and Inter Corporate Deposits

should not exceed 100 percent of its net owned fund, as per the latest audited balance sheet. •

Issue and Paying Agency : By now, we have seen the issuer of Cp needs to fulfill a number of requirement. To verify that the issuer has fulfilled all the requirement, an independent agencies should certify to that extent to the investor. Issue and Paying Agencies (IPA) would play that role. Only schedule commercial banks can act as a IPA.

•

Investment in CP : CP may be issued to and held by an Individual, Banks, Fis, NRIs and also FIIs .However, investment by FIIs would be within the limits set for their investments by SEBI.

•

Mode of Issuance : CP can be issued in Physical Mode or in Dematerialized Mode through any of the depositories approved by and registered with SEBI.CP can be issued at a discount to face value as may be decided by the issuer.

•

Payment of CP : The initial investor would pay the discounted value of the CP by means of a crossed account payee cheque to the account of the issuer through IPA. On maturity of CP, when the CP is held in physical form, the holder of instrument would present the instrument to the issuer through IPA. However, when the CP is held in demat form, the holder of CP will have to get it redeemed through depository and receive payment from the IPA.

162

•

Stand by facility : In view of CP being a “Stand Alone ” product, it would not be obligatory for bank and Fis to issue stand by facility to the issuer of CP. However , banks and Fis have the flexibility to provide for a CP issue, credit enhancement by way of stand by assistance/credit,back stop facility etc based on their commercial judgment, subject to the prudential norms as applicable and with specific approval of their board. Non

bank

entities

including

corporates

may

also

provide

unconditional and irrevocable guarantee for credit enhancement for CP issue provided: 1. The issuer fulfills the eligibility criteria prescribed for issuance of CP; 2. The guarantor has a credit rating at least one notch higher than the issuer given by an approved rating agencies; 3. The offer documents for CP properly discloses the net worth of the guarantor company, the names of the companies to which the guarantor has issued similar guarantees, the extent of the guarantees offered by the guarantor company, and the conditions under which the guarantee would be invoked. •

Procedure for Issuance : Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investor its financial positions as per the standard market practice. After the exchange of deal confirmation between the investor and the issuer, the issuing company shall issue physical certificates to the investor or arrange for

crediting

the CP to the investor’s account with the depository. Investor shall be given a copy of IPA certificate to the effect that the

163

issuer has a valid agreement with the IPA and the documents are in order. When a company raises the fund through CP , it will pay discount rate which is depended on the money market rate at the date of issuance. For example, a company wants to raise Rs 5 crores through CP ( having a rating of P1+) for 90 days on 1st September 2005, the discount rate to be paid on the CP would depend on the call money rate or MIBOR rate prevailing on 1st September 2005.This discount rate is fixed for the company for the entire tenure of 90 days from 1st September 2005. For example if the call money rate is 5% p.a. and a P1+ CP would attract a discount rate of 0.75% above the MIBOR rate , then the discount rate to be paid by the company would be 5.75% p.a. for 90 days from 1st September 2005.Now if the call money rate goes down to 4.75% on September 15th 2005 , if the company could have raised the fund at that point of time at an interest rate of 5.50% p.a. for 90 days. The benefits of daily movement of interest rate would be possible in the case of MIBOR linked debentures. Under this instruments, a company can raise working capital where the interest rate is compounded on a daily basis based on the closing MIBOR rate prevailing at the close of each day. Factoring Services : In the international transaction factoring of receivable is also a very important corporate banking product. In most of the international trade transactions, besides the normal credit risks, it involves additional concepts of country and therefore a sovereign risks comes into play. Sovereign risks in international business is usually of three broad categories : •

Transaction Risk : It is linked to specific transaction that involves a specific amount within a specific time

164

frame, such as an export sales on six months draft terms; •

Translation Risk: It stems form the obligation of multinational companies to translate foreign currency assets and liabilities into the parent company’s accounting currency regularly , a process that can give rise to book keeping gains and losses

•

Economic

Risk

encompasses

: all

In

the

changes

broadest in

a

sense

,

it

company’s

international operating environment that generate, real economic gains or losses. Export credit is quite distinct from the domestic counterpart is several respects. The principal characteristics of export credit which distinguish it from the domestic sales are as follows: •

Longer time scales for delivery , funds transfer and credit period;

•

Extra time and distance require terms which provide a security for the risks perceived;

•

The expectation of local credit terms for each market

•

Competition from other countries having different money costs and government policies;

•

The use of international standard terminology.

This feeling of insecurity and risks involved in international transactions has, therefore, resulted in various methods of payment system, the most secure of these being the Advance Payment or Cash with Order ( CWO) .The other two prevalent methods of receiving payments are through the mechanism of Bills of Exchange and Documentary Credit. In both these methods, the banking system is the channel through which the

165

transactions are normally carried out. Though advantageous to the sellers, secured to a certain extent , except the concept of clean bills of exchange ( here shipping documents are not enclosed) , usually in a competitive environment, debtors are not inclined to open letters of credit because of the cost and time involved. Further, the entire mechanism of operations through letter of credit is gradually loosing its impact through out world primarily on account of what is known as Doctrine of Strict Compliance. The seriousness of the problems is evident from a survey conducted in United Kingdom which revealed that more than 50 percent of documents failed to comply with the terms of letter of credit in first presentation to the banks. In view of the constraints of the existing systems, open account transactions are also coming into existence in larger numbers than in the past. Under this system, there is direct arrangement between the exporter and the importer to complete the deal including the payment within a predetermined future date usually between 60 days and 90 days from the date of invoice. The goods and the shipping documents are sent directly to the importer enabling him to take delivery of goods. The essential features of open account transaction are listed as follows : 1. Complete confidence in the credit standing not only of the debtors but also of his country so that proceeds of the goods can be realized within the agreed period. 2. An efficient sales ledger administration often in multi currencies coupled with credit control mechanism involving sound knowledge of trade practices, law and knowledge of the importer’s country.

166

3. Sufficient liquidity source to grant competitive credit terms to the importer. In such situation , export factoring can play a

very important

role not only in providing finance but also in providing a service package to exporters. Export factoring can broadly be defined as an agreement in which export receivables arising out of sale of goods/services are sold to the factor, as a result of which title to the goods/services represented by the said receivable passes on to the factor. Henceforth, the factor becomes responsible for all credit control, sales accounting and debt collection from the importers. Advantages of International Factoring : The distinct advantages of a factoring transaction over other methods of finance/facilities provided to an exporter can be summarized as follows : 1. Immediate finance up to a certain percentage ( say 75-80 percent) of the eligible export receivable. This prepayment facility s available without a letter of credit –simply on the strength of the invoice(s) representing the shipment of goods. 2. Credit checking of all the prospective debtors in importing countries ,through own databases o the export factor or by taking assistance from his counterpart(s) in importing countries known as import factor or established credit rating agencies. 3. Maintenance of entire sales ledger of the exporter including undertaking asset management functions. Constant liaison is maintained with the debtors in importing countries and collections are affected in a diplomatic but efficient

167

manner,

ensuring

faster

payment

and

safeguarding

financial costs. 4. According bad debt protection up to full extent ( 100 percent) on all approved sales to agreed debtors ensuring total predictability of cash flows . 5. Undertaking cover operations to minimize potential losses arising from possible exchange rate fluctuations. 6. Efficient and fast communication system through letters, telex, telephone or in person in the buyer’s language and in line with the national business practices. 7. Consultancy services in areas relating to special conditions and regulations as applicable to the importing countries. Types of International Factoring : The most important form of factoring is two factor system. Two Factor System : The

transaction

companies

is

based

on

operation

of

two

factoring

in two different countries involving in all, four

parties :Exporter, Importer, Export Factor in exporter’s country and import factor in importer’s country. The mechanics of operation in this arrangement works out as follows : 1. The exporter approaches the export factor with relevant information which, inter alia, may include a) Type of business,b) Names and addresses of the debtors in various

importing countires,c)Annual expected export

turnover to each country ,d) Number of invoices/credit notes per country,e)Payments terms and f) Line of credit required for each debtor.

168

2. Based on the information furnished , the export factor would contact his counterpart( import factor) in different countries to assess the creditworthiness of the various debtors. 3. The import factor makes a preliminary assessment as to his ability to give credit cover to the principal debtors. 4. Based on the positive response of the import factor, the factoring agreement is signed between the exporter and export factor. 5. Goods are sent by the exporter to the importer along with the original invoice which includes an assignment clause stipulating that the payment must be made to the import factor. Simultaneously, two copies of the invoice along with notifications of the debt are sent to the export factor. At this stage, prepayment up to an agreed per cent ( say 75-80 percent) of the invoice(s) is made to the exporter by the export factor. 6. A copy of the invoice is sent by the export factor to his counterpart, that is the import factor. Henceforth , the responsibilities relating to book keeping and collection of debts remain vested with the import factor. 7. Having collected the debts, the proceeds are remitted by the import factor to his counterpart, that is export factor. In case of payments are not received from any of the debtor(s) at the end of the previously agreed period on account of financial inability of the debtor concerned, the import factor has to pay the amount of the bill to his export counterpart from his own funds. However, this obligation will not apply in case of any dispute regarding

169

quality ,quantity, terms and conditions of supply etc. If any dispute arises, the same has to be settled between the parties concerned through the good offices of the factoring companies , otherwise legal action may have to be initiated by the import factor based on the instructions of the exporter/export factor. 8. On receipt of the proceeds of the debts realized, the retention held (say 15-20 percent) is released to the exporter. The entire factoring fee is debited to the exporter’s account and the export factor remits the mutually agreed commission to his importing counter part. This, the export factor undertakes the exporter risk whereas the importer risk is taken care of by the import factor. The main functions of the export factor relate to : •

Assessment of the financial strength of the exporter

•

Prepayment to the exporter after proper documentation and regular audit and post sanction control

•

Follow up with the import factor

•

Sharing of commission with the import factor

The import factor is primarily engaged in the areas of : •

Maintaining books of exporter in respect of sales to the debtors of his country

•

Collection of debts from the importers and remitting proceeds of the same to the export factor

•

Providing credit protection in case of financial inability on part of any of the debtors.

The two factor systems is by all means the best mode of providing the most effective factoring facilities to a prospective

170

exporter. However, the system is also fraught with certain basic disadvantages, i.e. delay in operations like credit decision, remittance of fund, etc, due to involvement of many parties.

171

Appendix

172

Appendix 1

UCPDC 500 A. General Provisions and Definition Article 1: Application of UCP The Uniform Customs and Practice for Documentary Credits, 1993 Revision, ICC Publication N0. 500, shall apply to all Documentary Credits (including to the extent to which they may be applicable, Standby Letter(s) of Credit) where they are incorporated into the text of the Credit. They are binding on all parties thereto, unless otherwise expressly stipulated in the Credit. Article 2 : Meaning of Credit For the purposes of these Articles, the expressions 'Documentary 'Credit(s)' and 'Standby Letter(s) of Credit (hereinafter referred to as 'Credit(s)'), mean any arrangement, however named or described, whereby a bank (the 'Issuing Bank') acting at the request and on the instruction of a customer (the 'Applicant') or on its own behalf,

173

i. is to make a payment to or to the order of a third party (the ' Beneficiary'), or is to accept and pay bills of exchange (Draft(s)) drawn by the Beneficiary, or ii. authorises another bank to effect such payment, or to accept and pay such bills of exchange (Draft(s)), or iii. authorises another bank to negotiate, against

stipulated

document(s),

provided

that

the

terms

and

conditions of the Credit are complied with. For the purposes of these Articles, branches of a bank in different countries are considered another bank. Article 3 Credits v Contracts a. Credits, by their nature, are separate transactions from the sales of other contract(s) on which they may be based and banks are in no way concerned with or bound by such contract(s), even if any reference whatsoever to such contract(s) is included in the Credit. Consequently, the undertaking of a bank to pay, accept and pay Draft(s) or negotiate and/or to fulfil any other obligation under the Credit, is not subject to claims or defences by the Applicant resulting from his relationships with the Issuing Bank or the Beneficiary. b. A Beneficiary can in no case avail himself of the contractual relationships existing between the banks or between the Applicant and the Issuing Bank.

174

Article 4 Documents v. Goods/ Services/ Performances In Credit operations all parties concerned deal with documents, and not with goods, services and/or other performances to which the documents may relate. Article 5 Instructions to Issue/Amend Credits a. Instructions for the issuance of a Credit, the Credit itself, instructions for an amendment thereto, and the amendment itself, must be complete and precise. In order to guard against confusion and misunderstanding, banks should discourage any attempt: i. to include excessive detail in the Credit or in any amendment thereto; ii. to give instructions to issue, advise or confirm a Credit by reference to a Credit previously issued (similar Credit) where such previous Credit

has

been

subject

to

accepted

amendment(s),

and/or

unaccepted amendment(s). b. All instructions for the issuance of a Credit and the Credit itself and, where applicable, all instructions for an amendment thereto and the amendment itself, must state precisely the document(s) against which payment, acceptance or negotiation is to be made.

175

Forms and Notification of Credits Article 6 Revocable v Irrevocable Credits a. A Credit may be either: i. revocable, or ii. irrevocable. b The Credit, therefore, should clearly indicate whether it is revocable or irrevocable. c In the absence of such indication the Credit shall be deemed to be irrevocable. Article 7 Advising Bank's Liability a. A Credit may be advised to a Beneficiary through another bank (the 'Advising Bank') without engagement on the part of the Advising Bank, but that bank, if it elects to advise the Credit, shall take reasonable care to check the apparent authenticity of the Credit which it advises. If the bank elects not to advise the Credit, it must so inform the Issuing Bank without delay. b. If the Advising Bank cannot establish such apparent authenticity it must inform, without delay, the bank from which the instructions appear to have been received that it has been unable to establish the

176

authenticity of the Credit and if it elects nonetheless to advise the Credit it must inform the Beneficiary that it has not been able to establish the authenticity of the Credit. Article 8 Revocation of a Credit a. A revocable Credit may be amended or cancelled by the Issuing Bank at any moment and without prior notice to the Beneficiary. b. However, the Issuing Bank must: i. reimburse another bank with which a revocable Credit has been made available for sight payment, acceptance or negotiation - for any payment, acceptance or negotiation made by such bank - prior to receipt by it of notice of amendment or cancellation, against documents which appear on their face to be in compliance with the terms and conditions of the Credit; ii. reimburse another bank with which a revocable Credit has been made available for deferred payment, if such a bank has, prior to receipt by it of notice of amendment or cancellation, taken up documents which appear on their face to be in compliance with the terms and conditions of the Credit. Article 9 Liability of Issuing and Confirming Banks a. An irrevocable Credit constitutes a definite undertaking of the Issuing Bank, provided that the stipulated documents are presented to the Nominated Bank or to the Issuing Bank and that the terms and conditions of the Credit are complied with: i. if the Credit provides for sight payment - to pay at sight;

177

ii. if the Credit provides for deferred payment - to pay on the maturity date(s) determinable in accordance with the stipulations of the Credit; iii. if the Credit provides for acceptance: a. by the Issuing Bank - to accept Draft(s) drawn by the Beneficiary on the Issuing Bank and pay them at maturity, or b. by another drawee bank - to accept and pay at maturity Draft(s) drawn by the Beneficiary on the Issuing Bank in the event the drawee bank stipulated in the Credit does not accept Draft(s) drawn on it, or to pay Draft(s) accepted but not paid by such drawee bank at maturity; iv. if the Credit provides for negotiation - to pay without recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit. A Credit should not be issued available by Draft(s) on the Applicant. If the Credit nevertheless calls for Draft(s) on the Applicant, banks will consider such Draft(s) as an additional document(s). b. A confirmation of an irrevocable Credit by another bank (the "Confirming Bank") upon the authorisation or request of the Issuing Bank, constitutes a definite undertaking of the Confirming Bank, in addition to that of the Issuing Bank, provided that the stipulated documents are presented to the Confirming Bank or to any other Nominated Bank and that the terms and conditions of the Credit are complied with: i. if the Credit provides for sight payment - to pay at sight; ii. if the Credit provides for deferred payment - to pay on the maturity date(s) determinable in accordance with the stipulations of the Credit; iii. if the Credit provides for acceptance:

178

a. by the Confirming Bank - to accept Draft(s) drawn by the Beneficiary on the Confirming Bank and pay them at maturity, or b. by another drawee bank - to accept and pay at maturity Draft(s) drawn by the Beneficiary on the Confirming Bank, in the event the drawee bank stipulated in the Credit does not accept Draft(s) drawn on it, or to pay Draft(s) accepted but not paid by such drawee bank at maturity; iv. if the Credit provides for negotiation - to negotiate without recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit. A Credit should not be issued available by Draft(s) on the Applicant. If the Credit nevertheless calls for Draft(s) on the Applicant, banks will consider such Draft(s) as an additional document(s). c. i. If another bank is authorised or requested by the Issuing Bank to add its confirmation to a Credit but is not prepared to do so, it must so inform the Issuing Bank without delay. ii. Unless the Issuing Bank specifies otherwise in its authorisation or request to add confirmation, the Advising Bank may advise the Credit to the Beneficiary without adding its confirmation. d. i. Except as otherwise provided by Article 48, an irrevocable Credit can neither be amended nor cancelled without the agreement of the Issuing Bank, the Confirming Bank, if any, and the Beneficiary. ii. The Issuing Bank shall be irrevocably bound by an amendment(s) issued by it from the time of the issuance of such amendment(s). A Confirming Bank may extend its confirmation to an amendment and shall be irrevocably bound as of the time of its advice of the amendment. A Confirming Bank may, however, choose to advise an

179

amendment to the Beneficiary without extending its confirmation and, if so, must inform the Issuing Bank and the Beneficiary without delay. iii. The terms of the original Credit (or a Credit incorporating previously accepted amendment(s)) will remain in force for the Beneficiary until the Beneficiary communicates his acceptance of the amendment to the bank that advised such amendment. The Beneficiary should give notification of acceptance or rejection of amendment(s). If the Beneficiary fails to give such notification, the tender of documents to the Nominated Bank or Issuing Bank, that conform to the Credit and to not yet accepted amendment(s), will be deemed to be notification of acceptance by the Beneficiary of such amendment(s) and as of that moment the Credit will be amended iv. Partial acceptance of amendments contained in one and the same advice of amendment is not allowed and consequently will not be given any effect. Article 10 Types of Credit a. All credits must clearly indicate whether they are available by sight payment, by deferred payment, by acceptance or by negotiation. b. i. Unless the Credit stipulates that it is available only with the Issuing Bank, all Credits must nominate the bank (the 'Nominated Bank') which is authorised to pay, to incur a deferred payment undertaking, to accept Draft(s) or to negotiate. In a freely negotiable Credit, any bank is a Nominated Bank. Presentation of documents must be made to the Issuing Bank or the Confirming Bank, if any, or any other Nominated Bank.

180

ii.

Negotiation

means

the

giving

of

value

for

Draft(s) and/or

document(s) by the bank authorised to negotiate. Mere examination of the

documents without giving of value

does not constitute a

negotiation. c. Unless the Nominated Bank is the Confirming Bank, nomination by the Issuing Bank does not constitute any undertaking by the Nominated Bank to pay, to incur a deferred payment undertaking, to accept Draft(s), or to negotiate. Except where expressly agreed to by the Nominated Bank and so communicated to the Beneficiary, the Nominated Bank's receipt of and/or examination and/or forwarding of the documents does not make that bank liable to pay, to incur a deferred payment undertaking, to accept Draft(s) or to negotiate. d. By nominating another bank, or by allowing for negotiation by any bank, or by authorising or requesting another bank to add its confirmation, the Issuing Bank authorises such bank to pay, accept Draft(s) or negotiate as the case may be, against documents which appear on their face to be compliance with the terms and conditions of the Credit and undertakes to reimburse such bank in accordance with the provisions of these Articles. Article 11 Teletransmitted and Pre-Advised Credits a. i. When an Issuing Bank instructs an Advising Bank by an authenticated teletransmission to advise a Credit or an amendment to a Credit, the teletransmission will be deemed to be the operative Credit

instrument

or

the

operative

amendment,

and

no

mail

confirmation should be sent. Should a mail confirmation nevertheless

181

be sent, it will have no effect and the Advising Bank will have no obligation to check such mail confirmation against the operative Credit instrument or the operative amendment received by teletransmission. ii. If the teletransmission states 'full details to follow' (or words of similar effect) or states that the mail confirmation is to be the operative Credit instrument or the operative amendment, then the teletransmission will not be deemed to be the operative Credit instrument or the operative amendment. The Issuing Bank must forward the operative Credit instrument or the operative amendment to such Advising Bank without delay. b. If a bank uses the services of an Advising Bank to have the Credit advised to the Beneficiary, it must also use the services of the same bank for advising an amendment(s). c. A preliminary advice of the issuance or amendment of an irrevocable Credit (pre-advice), shall only be given by an Issuing Bank if such bank is prepared to issue the operative Credit instrument or the operative amendment thereto. Unless otherwise stated in such preliminary advice by the Issuing Bank, an Issuing Bank having given such pre-advice shall be irrevocably committed to issue or amend the Credit, in terms not inconsistent with the pre-advice, without delay. Article 12 Incomplete or Unclear Instructions If incomplete or unclear instructions are received to advise, confirm or amend a Credit, the bank requested to act on such instructions may give preliminary notification to the Beneficiary for information only and without responsibility. This preliminary notification should state clearly

182

that the notification is provided for information only and without the responsibility of the Advising Bank. In any event, the Advising Bank must inform the Issuing Bank of the action taken and request it to provide the necessary information The Issuing Bank must provide the necessary information without delay. The Credit will be advised, confirmed or amended, only when complete and clear instructions have been received and if the Advising Bank is then prepared to act on the instructions. Liabilities and Responsibilities Article 13 Standard for Examination of Documents a. Banks must examine all document stipulated in the Credit with reasonable care, to ascertain whether or not they appear, on their face, to be in compliance with the terms and conditions of the Credit. Compliance of the stipulated documents on their face with the terms and conditions of the Credit, shall be determined by international standard banking practice as reflected in these Articles. Documents which appear on their face to be inconsistent with one another will be considered as not appearing on their face to be in compliance with the terms and conditions of the Credit Documents not stipulated in the Credit will not be examined by banks. If they receive such documents, they shall return them to the presenter or pass them on without responsibility.

183

b. The Issuing Bank, the Confirming Bank, if any, or a Nominated Bank acting on their behalf shall each have a reasonable time, not to exceed seven banking days following the day of receipt of the documents, to examine the documents and determine whether to take up or refuse the documents and to inform the party from which it received the documents accordingly. c. If a Credit contains conditions without stating the document(s) to be presented in compliance therewith, banks will deem such conditions as not stated and will disregard them. Article 14 Discrepant Documents and Notice a. When the Issuing Bank authorises another bank to pay, incur a deferred payment undertaking, accept Draft(s), or negotiate against documents which appear on their face to be in compliance with the terms and conditions of the Credit, the Issuing Bank and the Confirming Bank, if any, are bound: i. to reimburse the Nominated Bank which has paid, incurred a deferred payment undertaking, accepted Draft(s), or negotiated, ii. to take up the documents. b. Upon receipt of the documents the Issuing Bank and/or Confirming Bank, if any, or a Nominated Bank acting on their behalf, must determine on the basis of the documents alone whether or not they

184

appear on their face to be in compliance with the terms and conditions of the Credit. If the documents appear on their face not to be in compliance with the terms and conditions of the Credit, such banks may refuse to take up the documents. c. If the Issuing Bank determines that the documents appear on their face not to be in compliance with the terms and conditions of the Credit, it may in its sole judgement approach the Applicant for a waiver of the discrepancy(ies). This does not, however, extend the period mentioned in sub-Article 13 (b). d. i. If the Issuing Bank and/or Confirming Bank, if any, or a Nominated Bank acting on their behalf, decides to refuse the documents, it must give notice to that effect by telecommunication or, if that is not possible, by other expeditious means, without delay but no later than the close of the seventh banking day following the day of receipt of the documents. Such notice shall be given to the bank from which it received the documents, or to the Beneficiary, if it received the documents directly from him ii. Such notice must state all discrepancies in respect of which the bank refuses the documents and must also state whether it is holding the documents at the disposal of, or is returning them to, the presenter. iii. The Issuing Bank and/or Confirming Bank, if any, shall then be entitled to claim from the remitting bank refund, with interest, of any reimbursement which has been made to that bank.

185

e. If the Issuing Bank and/or Confirming bank, if any, fails to act in accordance with the provisions of this Article and/or fails to hold the documents at the disposal of, or return them to, the presenter, the Issuing Bank and/or confirming bank, if any, shall be precluded from claiming that the documents are not in compliance with the terms and conditions of the Credit. f. If the remitting bank draws the attention of the Issuing Bank and/or Confirming Bank, if any, to any discrepancy(ies) in the document(s) or advises such banks that it has paid, incurred a deferred payment undertaking, accepted Draft(s) or negotiated under reserve or against an indemnity in respect of such discrepancy(ies), the Issuing Bank and/or confirming Bank, if any, shall not be thereby relieved from any of their obligations under any provision of this Article. Such reserve or indemnity concerns only the relations between the remitting bank and the party towards whom the reserve was made, or from whom, or on whose behalf, the indemnity was obtained. Article 15 Disclaimer on Effectiveness of Documents Banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document(s), or for the general and/or particular conditions stipulated in the document(s) or superimposed thereon; nor do they assume any liability or responsibility for the description, quantity, weight, quality, condition,

packing,

delivery,

value

or

existence

of

the

goods

represented by any document(s), or for the good faith or acts and/or

186

omissions, solvency, performance or standing of the consignors, the carriers, the forwarders, the consignees or the insurers of the goods, or any other person whomsoever. Article 16 Disclaimer on the Transmission of Messages Banks assume no liability or responsibility for the consequences arising out of delay and/or loss on transit of any message(s), letter(s) or document(s), or for delay, mutilation or other error(s) arising in the transmission of any telecommunication. Banks assume no liability or responsibility for errors in translation and/or interpretation of technical terms, and reserve the right to transmit Credit terms without translating them. Article 17 Force Majeure Banks assume no liability or responsibility for the consequences arising out of the interruption of their business by Acts of God, riots, civil commotions, insurrections, wars or any other causes beyond their control, or by any strikes or lockouts. Unless specifically authorised, banks will not, upon resumption of their business, pay, incur a deferred payment undertaking, accept Draft(s) or negotiate under Credits which expired during such interruption of their business.

187

Article 18 Disclaimer for Acts of an Instructed Party a. Banks utilising the services of another bank or other banks for the purpose of giving effect to the instructions of the Applicant do so for the account and at the risk of such Applicant. b. Banks assume no liability or responsibility should the instructions they transmit not to be carried out, even if they have themselves taken the initiative in the choice of such other bank(s) c. i. A party instructing another party to perform services is liable for any charges, including commissions, fees, costs or expenses incurred by the instructed party in connection with its instructions. ii. Where a Credit stipulates that such charges are for the account of a party other than the instructing party, and charges cannot be collected, the instructing party remains ultimately liable for the payment thereof. d. The Applicant shall be bound by and liable to indemnify the banks against all obligations and responsibilities imposed by foreign laws and usages. Article 19 Bank-to-Bank Reimbursement Arrangements a. If an issuing Bank intends that the reimbursement to which a paying, accepting or negotiating bank is entitled, shall be obtained by such bank (the "Claiming Bank"), claiming on another party (the "Reimbursing Bank"), it shall provide such Reimbursing Bank in good

188

time with the proper instructions or authorisation to honour such reimbursement claims b. Issuing Banks shall not require a Claiming Bank to supply a certificate of compliance with the terms and conditions of the Credit to the Reimbursing Bank. c. An Issuing Bank shall not be relieved from any of its obligations to provide reimbursement if and when reimbursement is not received by the Claiming Bank from the Reimbursing Bank. d. The Issuing Bank shall be responsible to the Claiming Bank for any loss of interest if reimbursement is not provided by the Reimbursing Bank on first demand, or as otherwise specified in the Credit, or mutually agreed, as the case may be. e. The Reimbursing Bank's charges should be for the account of the Issuing Bank. However, in cases where the charges are for the account of another party, it is the responsibility of the Issuing Bank to so indicate in the original Credit and in the reimbursement authorisation. In cases where the Reimbursing Bank's charges are for the account of another party they shall be collected from the Claiming Bank when the Credit is drawn under. In cases where the Credit is not drawn under, the Reimbursing Bank's charges remain the obligation of the Issuing Bank.

Documents Article 20 Ambiguity as to the Issuers of Documents

189

a. Terms such as "first class", "well known", "qualified", "independent", "official", "competent", "local", and the like, shall not be used to describe the issuers of any document(s) to be presented under a Credit. If such terms are incorporated in the Credit, banks will accept the relative document(s) as presented, provided that it appears on its face to be in compliance with the other terms and conditions of the Credit and not to have been issued by the Beneficiary. b. Unless otherwise stipulated in the Credit, banks will also accept as an original document(s), a document(s) produced or appearing to have been produced: i. by reprographic, automated or computerised systems; ii. as carbon copies; provided that it is marked as original and, where necessary, appears to be signed. A document may be signed by handwriting, by facsimile signature, by perforated

signature,

by

stamp,

by

symbol,

or

by

any

other

mechanical or electronic method of authentication. c. i. Unless otherwise stipulated in the Credit, banks will accept as a copy(ies), a document(s) either labelled copy or not marked as an original - copy(ies) need not be signed ii. Credits that require multiple document(s) such as "duplicate", "two fold", "two copies" and the like, will be satisfied by the presentation of one original and the remaining number in copies except where the document itself indicates otherwise d. Unless otherwise stipulated in the Credit, a condition under a Credit calling for a document to be authenticated, validated, legalised, visaed, certified or indicating a similar requirement, will be satisfied by any signature, mark, stamp or label on such document that on its face appears to satisfy the above condition.

190

Article 21 Unspecified Issuers or Contents of Documents When

documents

other

than

transport

documents,

insurance

documents and commercial invoices are called for, the Credit should stipulate by whom such documents are to be issued and their wording or data content. If the Credit does not so stipulate, banks will accept such documents as presented, provided that their data content is not inconsistent with any other stipulated document presented. Article 22 Issuance Date of Documents v Credit Date Unless otherwise stipulated in the Credit, banks will accept a document bearing a date of issuance prior to that of the Credit, subject to such document being presented within the time limits set out in the Credit and in these Articles.

Article 23 Marine/Ocean Bill of Lading

191

a. If a Credit calls for a bill of lading covering a port-to-port shipment, banks will, unless otherwise stipulated in the Credit, accept a document, however named, which: i. appears on its face to indicate the name of the carrier and to have been signed or otherwise authenticated by: -the carrier or a named agent for or on behalf of the carrier, or -the master or a named agent for or on behalf of the master. Any signature or authentication of the carrier or master must be identified as carrier or master, as the case may be. An agent signing or authenticating for the carrier or master must also indicate the name and the capacity of the party, i.e. carrier or master, on whose behalf that agent is acting, and ii. indicates that the goods have been loaded on board, or shipped on a named vessel. Loading on board or shipment on a named vessel may be indicated by pre-printed wording on the bill of lading that the goods have been loaded on board a named vessel or shipped on a named vessel, in which case the date of issuance of the bill of lading will be deemed to be the date of loading on board and the date of shipment. In all other cases loading on board a named vessel must be evidenced by a notation on the bill of lading which gives the date on which the goods have been loaded on board, in which case the date of the on board notation will be deemed to be the date of shipment. If the bill of lading contains the indication 'intended vessel', or similar qualification in relation to the vessel, loading on board a named vessel must be evidenced by an on board notation on the bill of lading which, in addition to the date on which the goods have been loaded on board, also includes the name of the vessel on which the goods have been

192

loaded, even if they have been loaded on the vessel named as the 'intended vessel'. If the bill of lading indicates a place of receipt or taking in charge different from the port of loading, the on board notation must also include the port of loading stipulated in the Credit and the name of the vessel on which the goods have been loaded, even if they have been loaded on the vessel named in the bill of lading. This provision also applies whenever loading on board the vessel is indicated by preprinted wording on the bill of lading, and iii. indicates the port of loading and the port of discharge stipulated in the Credit, notwithstanding that it: (a) indicates a place of taking in charge different from the port of loading,and/or a place of final destination different from the port of discharge, and/or (b) contains the indication 'intended' or similar qualification in relation to the port of loading and/or port of discharge, as long as the document also states the ports of loading and/or discharge stipulated in the Credit, and iv. consists of a sole original bill of lading or, if issued in more than one original, the full set as so issued, and v. appears to contain all of the terms and conditions of carriage, or some of such terms and conditions by reference to a source or document other than the bill of lading (short form/blank back bill of lading); banks will not examine the contents of such terms and conditions,

193

and vi. contains no indication that it is subject to a charter party and/or no indication that the carrying vessel is propelled by sail only, and vii. in all other respects meets the stipulations of the Credit. b. For the purpose of this Article, transhipment means unloading and reloading from one vessel to another vessel during the course of ocean carriage from the port of loading to the port of discharge stipulated in the Credit. c. Unless transhipment is prohibited by the terms of the Credit, banks will accept a bill of lading which indicates that the goods will be transhipped, provided that the entire ocean carriage is covered by one and the same bill of lading. d. Even if the Credit prohibits transhipment, banks will accept a bill of lading which: i. indicates that transhipment will take place as long as the relevant cargo is shipped in Container(s), Trailer(s) and/or 'LASH' barge(s) as evidenced by the bill of lading provided that the entire ocean carriage is covered by one and the same bill of lading, and/or ii. incorporates clauses stating that the carrier reserves the right to tranship. Article 24 Non-Negotiable Sea Waybill

194

a. If a Credit calls for a non-negotiable sea waybill covering a port-toport shipment, banks will, unless otherwise stipulated in the Credit, accept a document, however named, which: i. appears on its face to indicate the name of the carrier and to have been signed or otherwise authenticated by: -the carrier or a named agent for or on behalf of the carrier, or -the master or a named agent for or on behalf of the master. Any signature or authentication of the carrier or master must be identified as carrier or master, as the case may be. An agent signing or authenticating for the carrier or master must also indicate the name and the capacity of the party, i.e. carrier or master, on whose behalf that agent is acting, and, ii. indicates that the goods have been loaded on board, or shipped on a named vessel. Loading on board or shipment on a named vessel may be indicated by pre-printed wording on the non-negotiable sea waybill that the goods have been loaded on board a named vessel or shipped on a named vessel, in which case the date of issuance of the non-negotiable sea waybill will be deemed to be the date of loading on board and the date of shipment. In all other cases loading on board a named vessel must be evidenced by a notation on the non-negotiable sea waybill which gives the date on which the goods have been loaded on board, in which case the date of the on board notation will be deemed to be the date of shipment. If the non-negotiable sea waybill contains the indication 'intended vessel', or similar qualification in relation to the vessel, loading on board a named vessel must be evidenced by an on board notation on the non-negotiable sea waybill which, in addition to the date on which

195

the goods have been loaded on board, includes the name of the vessel on which the goods have been loaded, even if they have been loaded on the vessel named as the 'intended vessel'. If the non-negotiable sea waybill indicates a place of receipt or taking in charge different from the port of loading, the on board notation must also include the port of loading, stipulated in the Credit and the name of the vessel on which the goods have been loaded, even if they have been loaded on a vessel named in the non-negotiable sea waybill. This provision also applies whenever loading on board the vessel is indicated by pre-printed wording on the non-negotiable sea waybill, and, iii. indicates the port of loading and the port of discharge stipulated in the Credit, notwithstanding that it: (a) indicates a place of taking in charge different from the port of loading, and/or a place of final destination different from the port of discharge, and/or (b) contains the indication 'intended' or similar qualification in relation to the port of loading and/or port of discharge, as long as the document also states the ports of loading and/or discharge stipulated in the Credit, and, iv. consists of a sole original non-negotiable sea waybill, or if issued in more than one original, the full set as so issued, and, v. appears to contain all of the terms and conditions of carriage, or some of such terms and conditions by reference to a source or document other than the non-negotiable sea waybill (short form/blank

196

back non-negotiable sea waybill); banks will not examine the contents of such terms and conditions, and, vi. contains no indication that it is subject to a charter party and/or no indication that the carrying vessel is propelled by sail only, and, vii. in all other respects meets the stipulations of the Credit. b. For the purpose of this Article, transhipment means unloading and reloading from one vessel to another vessel during the course of ocean carriage from the port of loading to the port of discharge stipulated in the Credit. c. Unless transhipment is prohibited by terms of the Credit, banks will accept a non-negotiable sea waybill which indicates that the goods will be transhipped, provided that the entire ocean carriage is covered by one and the same non-negotiable sea waybill. d. Even if the Credit prohibits transhipment, banks will accept a nonnegotiable sea waybill which: i. indicates that transhipment will take place as long as the relevant cargo is shipped in Container(s), Trailer(s) and/or 'LASH' barge(s) as evidenced by the non-negotiable sea waybill, provided that the entire ocean carriage is covered by one and the same non-negotiable sea waybill, and/or ii. incorporates clauses stating that the carrier reserves the right to tranship. Article 25

197

Charter Party Bill of Lading a. If a Credit calls for or permits a charter party bill of lading, banks will, unless otherwise stipulated in the Credit, accept a document, however named, which: i. contains any indication that it is subject to a charter party, and ii. appears on its face to have been signed or otherwise authenticated by: -the master or a named agent for or on behalf of the master, or -the owner or a named agent for or on behalf of the owner. Any signature or authentication of the master or owner must be identified as master or owner as the case may be. An agent signing or authenticating for the master or owner must also indicate the name and the capacity of the party, i.e. master or owner, on whose behalf that agent is acting, and iii. does or does not indicate the name of the carrier, and iv. indicates that the goods have been loaded on board or shipped on a named vessel. Loading on board or shipment on a named vessel may be indicated by pre-printed wording on the bill of lading that the goods have been loaded on board a named vessel or shipped on a named vessel, in which case the date of issuance of the bill of lading will be deemed to be the date of loading on board and the date of shipment. In all other cases loading on board or shipment on a named vessel must be evidenced by a notation on the bill of lading which gives the date on which the goods have been loaded on board, in which case the

198

date of the on board notation will be deemed to be the date of shipment, and v. indicates the port of loading and the port of discharge stipulated in the Credit, and vi. consists of a sole original bill of lading or, if issued in more than one original, the full set as so issued, and vii. contains no indication that the carrying vessel is propelled by sail only, and viii. in all other respects meets the stipulations of the Credit. b. Even if the Credit requires the presentation of a charter party contract in connection with a charter party bill of lading, banks will not examine such charter party contract, but will pass it on without responsibility on their part. Article 26 Multimodal Transport Document a. If a Credit calls for a transport document covering at least two different modes of transport (multimodal transport), banks will, unless otherwise stipulated in the Credit, accept a document, however named, which: i. appears on its face to indicate the name of the carrier or multimodal transport operator and to have been signed or otherwise authenticated by:

199

-the carrier or multimodal transport operator or a named agent for or on behalf of the carrier or multimodal transport operator, or -the master or a named agent for or on behalf of the master. Any signature or authentication of the carrier, multimodal transport operator or master must be identified as carrier, multimodal transport operator or master, as the case may be. An agent signing or authenticating for the carrier, multimodal transport operator or master must also indicate the name and the capacity of the party, i.e. carrier, multimodal transport operator or master, on whose behalf that agent is acting, and ii. indicates that the goods have been dispatched, taken in charge or loaded on board. Dispatch, taking in charge or loading on board may be indicated by wording to that effect on the multimodal transport document and the date of issuance will be deemed to be the date of dispatch, taking in charge or loading on board and the date of shipment. However, if the document indicates, by stamp or otherwise, a date of dispatch, taking in charge or loading on board, such date will be deemed to be the date of shipment, and iii. (a) indicates that the place of taking in charge stipulated in the Credit which may be different from the port, airport or place of loading, and the place of final destination stipulated in the Credit which may be different from the port, airport or place of discharge, and/or (b) contains the indication 'intended' or similar qualification in relation to the vessel and/or port of loading and/or port of discharge, and

200

iv. consists of a sole original multimodal transport document or, if issued in more than one original, the full set as so issued, and v. appears to contain all the terms and conditions of carriage, or some of such terms and conditions by reference to a source or document other than the multimodal transport document (short form/blank back multimodal transport document); banks will not examine the contents of such terms and conditions, and vi. contains no indication that it is subject to a charter party and/or no indication that the carrying vessel is propelled by sail only, and vii. in all other respects meets the stipulation of the Credit. b. Even if the Credit prohibits transhipment, banks will accept a multimodal transport document which indicates that transhipment will or may take place, provided that the entire carriage is covered by one and the same multimodal transport document. Article 27 Air Transport Document a. If a Credit calls for an air transport document, banks will, unless otherwise stipulated in the Credit, accept a document, however named, which: i. appears on its face to indicate the name of the carrier and to have been signed or otherwise authenticated by: -the carrier, or -a named agent for or on behalf of the carrier.

201

Any signature or authentication of the carrier must be identified as carrier. An agent signing or authenticating for the carrier must also indicate the name and the capacity of the party, i.e. carrier, on whose behalf that agent is acting, and ii. indicates that the goods have been accepted for carriage, and iii. where the Credit calls for an actual date of dispatch, indicates a specific notation of such date, the date of dispatch so indicated on the air transport document will be deemed to be the date of shipment. For the purpose of this Article, the information appearing in the box on the air transport document (marked 'For Carrier Use Only' or similar expression) relative to the flight number and date will not be considered as a specific notation of such date of dispatch. In all other cases, the date of issuance of the air transport document will be deemed to be the date of shipment, and iv. indicates the airport of departure and the airport of destination stipulated in the Credit, and v. appears to be the original for consignor/shipper even if the Credit stipulates a full set of originals, or similar expressions, and vi. appears to contain all of the terms and conditions of carriage, or some of such terms and conditions, by reference to a source or document other than the air transport document; banks will not examine the contents of such terms and conditions, and vii. in all other respects meets the stipulations of the Credit.

202

b. For this purpose of this article, transhipment means unloading and reloading from one aircraft to another aircraft during the course of carriage from the airport of departure to the airport of destination stipulated in the Credit. c. Even if the Credit prohibits transhipment, banks will accept an air transport document which indicates that transhipment will or may take place, provided that the entire carriage is covered by one and the same air transport document. Article 28 Road, Rail or Inland Waterway Transport Documents. a. If a Credit calls for a road, rail, or inland waterway transport document, banks will, unless otherwise stipulated in the Credit, accept a document of the type called for, however named, which: i. appears on its face to indicate name of the carrier and to have been signed or otherwise authenticated by the carrier or a named agent for or on behalf of the carrier and/or to bear a reception stamp or other indication of receipt by the carrier or a named agent for or on behalf of the carrier. Any signature, authentication, reception stamp or other indication of receipt of the carrier, must be identified on its face as that of the carrier. An agent signing or authenticating for the carrier, must also indicate the name and the capacity of the party, i.e. carrier, on whose behalf that agent is acting, and ii. indicates that the goods have been received for shipment, dispatch or carriage or wording to this effect. The date of issuance will be

203

deemed to be the date of shipment unless the transport document contains a reception stamp, in which case the date of the reception stamp will be deemed to be the date of shipment, and iii. indicates the place of shipment and the place of destination stipulated in the Credit, and iv. in all other respects meets the stipulations of the Credit. b. In the absence of any indication on the transport document as to the numbers issued, banks will accept the transport document(s) presented as constituting a full set. Banks will accept as original(s) the transport document(s) whether marked as original(s) or not. c. For the purpose of this Article, transhipment means unloading and reloading from one means of conveyance to another means of conveyance, in different modes of transport, during the course of carriage from the place of shipment to the place of destination stipulated in the Credit. d. Even if the Credit prohibits transhipment, banks will accept a road, rail or inland waterway transport document which indicates that transhipment will or may take place, provided that the entire carriage is covered by one and the same transport document and within the same mode of transport. Article 29 Courier and Post Receipts a. If a Credit calls for a post receipt or certificate of posting, banks will, unless otherwise stipulated in the Credit, accept a post receipt or certificate of posting which:

204

i. appears on its face to have been stamped or otherwise authenticated and dated in the place from which the Credit stipulates the goods are to be shipped or dispatched and such date will be deemed to be the date of shipment or dispatch, and ii. in all other respects meets the stipulations of the Credit b. If a Credit calls for a document issued by a courier or expedited delivery service evidencing receipt of the goods for delivery, banks will, unless otherwise stipulated in the Credit, accept a document, however named, which i. appears on its face to indicate the name of the courier/service, and to have been stamped, signed or otherwise authenticated by such named courier/service, (unless the Credit specifically calls for a document issued by a named Courier/Service, banks will accept a document issued by any Courier/Service), and ii. indicates a date of pick-up or of receipt or wording to this effect, such date being deemed to be the date of shipment or dispatch, and iii. in all other respects meets the stipulations of the Credit Documents Article 30 Transport Documents issued by Freight Forwarders

205

Unless otherwise authorised in the Credit, banks will only accept a transport document issued by a freight forwarder if it appears on its face to indicate: i. the name of the freight forwarder as a carrier or multimodal transport operator and to have been signed or otherwise authenticated by the freight forwarder as carrier or multimodal transport operator, or ii. the name of the carrier or multimodal transport operator and to have been signed or otherwise authenticated by the freight forwarder as a named agent for or on behalf of the carrier or multimodal transport operator. Article 31 "On deck", "Shipper's Load and Count", Name of Consignor Unless otherwise stipulated in the Credit, banks will accept a transport document which: i. does not indicate, in the case of carriage by sea or by more than one means of conveyance including carriage by sea, that the goods are or will be loaded on deck. Nevertheless, banks will accept a transport document which contains a provision that the goods may be carried on deck, provided that it does not specifically state that they are or will be loaded on deck, and/or ii. bears a clause on the face thereof such as 'shipper's 'load and count' or 'said by shipper to contain' or words of similar effect, and/or

206

iii. indicates as the consignor of the goods a party other than the Beneficiary of the Credit. Article 32 Clean Transport Documents a. A clean transport document is one which bears no clause or notation which expressly declares a defective condition of the goods and/or the packaging. b. Banks will not accept transport documents bearing such clauses or notations unless the Credit expressly stipulates the clauses or notations which may be accepted. c. Banks will regard a requirement in a Credit for a transport document to bear the clause 'clean on board' as compiled with if such transport document meets the requirement of this Article and of Articles 23, 24, 25, 26, 27, 28, or 30. Article 33 Freight Payable/Prepaid Transport Documents a. Unless otherwise stipulated in the Credit, or inconsistent with any of the documents presented under the Credit, banks will accept transport documents stating that freight or transportation charges (hereafter referred to as 'freight') have still to be paid. b. If a credit stipulates that the transport document has to indicate that freight has been paid or prepaid, banks will accept a transport document on which words clearly indicating payment or prepayment of

207

freight appear by stamp or otherwise, or on which payment or prepayment of freight is indicated by other means. If the Credit requires courier charges to be paid or prepaid banks will also accept a transport document issued by a courier or expedited delivery service evidencing that courier charges are for the account of a party other than the consignee. c. The words 'freight prepayable' or 'freight to be prepaid' or words of similar effect, if appearing on transport documents, will not be accepted as constituting evidence of the payment of freight. d. Banks will accept transport documents bearing reference by stamp or otherwise to costs additional to the freight, such as costs of, or disbursements incurred in connectoin with, loading, unloading or similar operations, unless the conditions of the Credit specifically prohibit such reference. Article 34 Article 34 UCP 500 Insurance Documents a. Insurance documents must appear on their face to be issued and signed by insurance companies or underwriters or their agents. b. If the insurance document indicates that it has been issued in more than one original, all the originals must be presented unless otherwise authorised in the Credit. c. Cover notes issued by brokers will not be accepted, unless specifically authorised in the Credit. d. Unless otherwise stipulated in the Credit, banks will accept an insurance certificate or a declaration under an open cover pre-signed

208

by insurance companies or underwriters or their agents. If a Credit specifically calls for an insurance certificate or a declaration under an open cover, banks will accept, in lieu thereof, an insurance policy. e. Unless otherwise stipulated in the Credit, or unless it appears from the insurance document that the cover is effective at the latest from the date of loading on board or dispatch or taking in charge of the goods, banks will not accept an insurance document which bears a date of issuance later than the date of loading on board or dispatch or taking in charge as indicated in such transport document f. i. Unless otherwise stipulated in the Credit, the insurance document must be expressed in the same currency as the credit. ii. Unless otherwise stipulated in the Credit, the minimum amount for which the insurance document must indicate the insurance cover to have been effected is the CIF (cost, insurance and freight(...'named port of destination')) or CIP (carriage and insurance paid to (...'named place of destination')) value of the goods, as the case may be, plus 10%, but only when the CIF or CIP value can be determined from the documents on their face. Otherwise, banks will accept as such minimum amount 110% of the amount for which payment, acceptance or negotiation is requested under the Credit, or 110% of the gross amount of the invoice, whichever is the greater Article 35 Type of Insurance Cover a. Credits should stipulate the type of insurance required and, if any, the additional risks which are to be covered. Imprecise terms such as "usual risks" or "customary risks" shall not be used; if they are used,

209

banks

will

accept

insurance

documents

as

presented,

without

responsibility for any risks not being covered. b. Failing specific stipulations in the Credit, banks will accept insurance documents as presented, without responsibility for any risks not being covered. c. Unless otherwise stipulated in the Credit, banks will accept an insurance document which indicates that the cover is subject to a franchise or an excess (deductible). Article 36 All Risks Insurance Cover Where a Credit stipulates 'insurance against all risks', banks will accept an insurance document which contains any 'all risk's notations or clause, whether or not bearing the heading 'all risks', even if the insurance document indicates that certain risks are excluded, without responsibility for any risk(s) not being covered. Article 37 Commercial Invoices a. Unless otherwise stipulated in the Credit, commercial invoices: i. must appear on their face to be issued by the Beneficiary named in the Credit (except as provided in Article 48), and ii. must be made out in the name of the Applicant, (except as provided in sub-Article 48 (h)),

210

and iii. need not be signed b. Unless otherwise stipulated in the Credit, banks may refuse commercial invoices issued for amounts in excess of the amount permitted by the Credit. Nevertheless, if a bank authorised to pay, incur a deferred payment undertaking, accept Draft(s), or negotiate under a Credit accepts such invoices, its decision will be binding upon all parties, provided that such bank has not paid, incurred a deferred payment undertaking, accepted Draft(s) or negotiated for an amount in excess of that permitted by the Credit. c. The description of the goods in the commercial invoice must correspond with the description in the Credit. In all other documents, the goods may be described in general terms not inconsistent with the description of the goods in the Credit. Article 38 Other Documents If a Credit calls for an attestation or certification of weight in the case of transport other than by sea, banks will accept a weight stamp or declaration of weight which appears to have been superimposed on the transport document by the carrier or his agent unless the Credit specifically stipulates that the attestation or certification of weight must be by means of a separate document. Miscellaneous Provisions

211

Article 39 Allowances In Credit Amount, Quantity and Unit Price a. The words "about", "approximately", "circa" or similar expressions used in connection with the amount of the Credit or the quantity or the unit price stated in the Credit are to be construed as allowing a difference not to exceed 10% more or 10% less than the amount or the quantity or the unit price to which they refer. b. Unless a Credit stipulates that the quantity of the goods specified must not be exceeded or reduced, a tolerance of 5% more or 5% less will be permissible, always provided that the amount of the drawings does not exceed the amount of the Credit. This tolerance does not apply when the Credit stipulates the quantity in terms of a stated number of packing units or individual items. c.

Unless

a

Credit

which

prohibits

partial

shipment

stipulates

otherwise, or unless sub-Article (b) above is applicable, a tolerance of 5% less in the amount of the drawing will be permissible, provided that if the Credit stipulates the quantity of the goods, such quantity of goods is shipped in full, and if the Credit stipulates a unit price, such price is not reduced. This provision does not apply when expressions referred to in sub-Article (a) above are used in the Credit. Article 40 Partial Shipments/Drawings a. Partial drawings and/or shipments are allowed, unless the Credit stipulates otherwise.

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b. Transport documents which appear on their face to indicate that shipment has been made on the same means of conveyance and for the same journey, provided they indicate the same destination, will not be regarded as covering partial shipments, even if the transport documents indicate different dates of shipment and/or different ports of loading, places of taking in charge, or despatch. c. Shipments made by post or by courier will not be regarded as partial shipments if the post receipts or certificates of posting or courier's receipts or dispatch notes appear to have been stamped, signed or otherwise authenticated in the place from which the Credit stipulates the goods are to be despatched, and on the same date. Article 41 Instalment Shipments/Drawings If drawings and/or shipments by instalments within given periods are stipulated in the Credit and any instalment is not drawn and/or shipped within the period allowed for that instalment, the Credit ceases to be available for that and any subsequent instalments, unless otherwise stipulated in the Credit. Article 42 Expiry Date and Place for Presentation of Documents a. All Credits must stipulate an expiry date and a place for presentation of documents for payment, acceptance, or with the exception of freely negotiable Credits, a place for presentation of

213

documents for negotiation. An expiry date stipulated for payment, acceptance or negotiation will be construed to express an expiry date for presentation of documents b. Except as provided in sub-Article 44(a), documents must be presented on or before such expiry date. c. If an Issuing Bank states that the Credit is to be available "for one month", "for six months" or the like, but does not specify the date from which the time is to run, the date of issuance of the Credit by the Issuing Bank will be deemed to be the first day from which such time is to run. Banks should discourage indication of the expiry date of the Credit in this manner. Article 43 Limitation on the Expiry Date a. In addition to stipulating an expiry date for presentation of documents, every Credit which calls for a transport document(s) should also stipulate a specified period of time after the date of shipment during which presentation must be made in compliance with the terms and conditions of the Credit. If no such period of time is stipulated, banks will not accept documents presented to them later than 21 days after the date of shipment. In any event, however, documents must be presented not later than the expiry date of the Credit b. In cases in which sub-Article 40(b) applies, the date of shipment will be considered to be the latest shipment date on any of the transport documents presented.

214

Article 44 Extension of Expiry Date a. If the expiry date of the Credit and/or the last day of the period of time for presentation of documents stipulated by the Credit or applicable by virtue of Article 43 falls on a day on which the bank to which presentation has to be made is closed for reasons other than those referred to in Article 17, the stipulated expiry date and/or the last day of the period of time after the date of shipment for presentation of documents, as the case may be, shall be extended to the first following day on which such bank is open. b. The latest date for shipment shall not be extended by reason of the extension of the expiry date and/or the period of time after the date of shipment for presentation of documents in accordance with sub-Article (a) above. If no such latest date for shipment is stipulated in the Credit or amendments thereto, banks will not accept transport documents indicating a date of shipment later than the expiry date stipulated in the Credit or amendments thereto. c. The bank to which presentation is made on such first following business day must provide a statement that the documents were presented within the time limits extended in accordance with subArticle 44 (a) of the Uniform Customs and Practice for Documentary Credits, 1993 Revision, ICC Publication No. 500. Article 45

215

Hours of Presentation Banks are under no obligation to accept presentation of documents outside their banking hours. Article 46 General Expressions as to Dates for Shipment a. Unless otherwise stipulated in the Credit, the expression "shipment" used in stipulating an earliest and/or a latest date for shipment will be understood to include expressions such as, "loading on board", "dispatch", "accepted for carriage", "date of post receipt", "date of pick-up", and the like, and in the case of a Credit calling for a multimodal transport document the expression "taking in charge". b. Expressions such as "prompt", "immediately", "as soon as possible", and the like should not be used. If they are used banks will disregard them. c. If the expression "on or about" or similar expressions are used, banks will interpret them as a stipulation that shipment is to be made during the period from five days before to five days after the specified date, both end days included. Article 47 Date Terminology for Periods of Shipment

216

a. The words "to", "until", "till", "from", and words of similar import applying to any date or period in the Credit referring to shipment will be understood to include the date mentioned. b. The word "after" will be understood to exclude the date mentioned. c. The terms "first half", "second half", of a month shall be construed respectively as the 1st to the 15th, and the 16th to the last day of such month, all dates inclusive. d. The terms "beginning", "middle", or "end" of a month shall be construed respectively as the 1st to the 10th, the 11th to the 20th, and the 21st to the last day of such month, all dates inclusive. Transferable Credit Article 48 Transferable Credit a. A transferable Credit is a Credit under which the Beneficiary (First Beneficiary) may request the bank authorised to pay, incur a deferred payment undertaking, accept or negotiate (the "Transferring Bank"), or in the case of a freely negotiable Credit, the bank specifically authorised in the Credit as a Transferring Bank, to make the Credit available in whole or in part to one or more other Beneficiary(ies) (Second Beneficiary(ies)). b. A Credit can be transferred only if it is expressly designated as "transferable" by the Issuing Bank. Terms such as "divisible", "fractionable", "assignable", and "transmissible" do not render the Credit transferable. If such terms are used they shall be disregarded.

217

c. The Transferring Bank shall be under no obligation to effect such transfer except to the extent and in the manner expressly consented to by such bank. d. At the time of making a request for transfer and prior to transfer of the

Credit,

the

First

Beneficiary

must

irrevocably

instruct

the

Transferring Bank whether or not he retains the right to refuse to allow the

Transferring

Bank

to

advise

amendments

to

the

Second

Beneficiary(ies). If the Transferring Bank consents to the transfer under these conditions, it must, at the time of transfer, advise the Second Beneficiary(ies) of the First Beneficiary's instructions regarding amendments. e. If a Credit is transferred to more than one Second Beneficiary(ies), refusal of an amendment by one or more Second Beneficiary(ies) does not invalidate the acceptance(s) by the other Second Beneficiary(ies) with respect to whom the Credit will be amended accordingly. With respect to the Second Beneficiary(ies) who rejected the amendment, the Credit will remain unamended. f.

Transferring

Bank

charges

in

respect

of

transfers

including

commissions, fees, costs or expenses are payable by the First Beneficiary, unless otherwise agreed. If the Transferring Bank agrees to transfer the Credit it shall be under no obligation to effect the transfer until such charges are paid. g. Unless otherwise stated in the Credit, a transferable Credit can be transferred once only. Consequently, the Credit cannot be transferred at the request of the Second Beneficiary to any subsequent Third Beneficiary. For the purpose of this Article, a retransfer to the First Beneficiary does not constitute a prohibited transfer. Fractions of a transferable Credit (not exceeding in the aggregate the amount of the Credit) can be transferred separately, provided partial

218

shipments/drawings are not prohibited, and the aggregate of such transfers will be considered as constituting only one transfer of the Credit. h. The Credit can be transferred only on the terms and conditions specified in the original Credit, with the exception of: -the amount of the Credit, -any unit price stated therein, -the expiry date, -the last date for presentation of documents in accordance with Article 43, -the period for shipment, any or all of which may be reduced or curtailed. The percentage for which insurance cover must be effected may be increased in such a way as to provide the amount of cover stipulated in the original Credit, or these Articles. In addition, the name of the First Beneficiary can be substituted for that of the Applicant, but if the name of the Applicant is specially required by the original Credit to appear in any document(s) other than the invoice, such requirement must be fulfilled. i. The First Beneficiary has the right to substitute his own invoice(s) (and Draft(s)) for those of the Second Beneficiary(ies), for amounts not in excess of the original amount stipulated in the Credit and for the original unit prices if stipulated in the Credit, and upon such substitution of invoice(s) (and Draft(s)) the First Beneficiary can draw under the Credit for the difference, if any, between his invoice(s) and the Second Beneficiary's(ies) invoice(s). When a Credit has been transferred and the First Beneficiary is to supply his own invoice(s) (and Draft(s)) in exchange for the Second Beneficiary's(ies) invoice(s) (and Draft(s)) but fails to do so on first

219

demand, the Transferring Bank has the right to deliver to the Issuing Bank the documents received under the transferred Credit, including the Second Beneficiary's(ies) invoice(s) (and Draft(s)) without further responsibility to the first Beneficiary. j. The First Beneficiary may request that payment or negotiation be effected to the Second Beneficiary(ies) at the place to which the Credit has been transferred up to and including the expiry date of the Credit, unless the original Credit expressly states that it may not be made available for payment or negotiation at a place other than that stipulated in the Credit. This is without prejudice to the First Beneficiary's right to substitute subsequently his own invoice(s) (and Draft(s)) for those of the Second Beneficiary(ies) and to claim any difference due to him. Assignment of Proceeds

Article 49 Assignment of Proceeds The fact that a Credit is not stated to be transferable shall not affect the Beneficiary's right to assign any proceeds to which he may be, or may become, entitled under such Credit, in accordance with the provisions of the applicable law. This Article relates only to the assignment of proceeds and not to the assignment of the right to perform under the Credit itself.

220

Appendix 2

Powers Branch

Zone

: :

PROCESS NOTE Note No. Credit Rating – Existing Proposed Asset Classification

:

Subject : Proposal received at the Branch: HO: Clarifications received on:

dt. : : :

ZO:

I.PARTICULARS OF THE BORROWER: 1

Name of the borrower : Address – Office : Plant : 2 Constitution : 3 Date of incorporation : 4 Line of Activity : 5 Dealings with our : bank since 6 Chief Executive : 7 Group : 8 Sector : 9 Income earned in the : Rs. Lacs Account (from ………. to ……….) 10 Details of existing and proposed limits with bank: (Rs.in lacs) Sanction Reference: FACILITY EXISTIN O/S AS DP/OD PROPOS RATE OF ED G ON INTEREST LIMIT ………… LIMIT EXISTIN PROPOSE …. G D

221

Total – FB NFB Grand Total Exposure: (Rs.in lacs) Ceilings as per RBI norms

*Constitution wise ceiling as per our bank policy

**Our bank’s exposure Existing Proposed

To the unit To the group * Ceilings as applicable to ……………………… ** Term Loan Outstandings + 100% of Fund Based Working Capital Limit or Outstandings, whichever is higher + 50% of Non Fund Based Limit or Outstandings, whichever is higher. 11 Banking arrangement : Sole/Multiple/Consortium Leader (in case of consortium) : Our Bank share : Other member banks : 12 Details of credit facilities : with other banks/FIs as on ……….. (Rs.in Name of bank/ Working Institution Capital Fund Based Limit O/S

13 Compliance with HO/RBI guidelines

lacs) Working Capital Non Fund Based Limit

:

14. a. Primary Security: b. Collateral Security – Existing/Proposed:

222

O/S

Term Credit Limit

O/S

15.Guarantors: Name

Net worth (Rs.in lacs)

16.FINANCIAL INDICATORS : (Rs. in lacs) Performance/ Financial indicators

31.3…...

31.3……

Audited

Audited

31.3…...

31.3……

Audited

Audited

31.3…… Audited

30.9………. Provisional

Net sales Other Income Profit before tax Profit after tax Depreciation Cash generation Paid up capital Tangible Net Worth Fixed Assets Term Liabilities Investments Performance/ Financial indicators Current Assets Current Liabilities Net Working Capital Current Ratio TOL/TNW Debt equity ratio Interest Coverage ratio Net profit/Net sales (%) Dividend Paid (%) Dividend/Net profit

223

31.3…… Audited

30.9………. Provisional

(%) EPS Detailed analysis of financial statements for the last 3 years is enclosed as Annexure-III. Brief Comments:

II. OWNERSHIP AND MANAGEMENT: 1. Names of the Directors S.No Name Designation

MANAGEMENT:

224

(Indicate names of key personnel looking after areas like Technical, Financial, Marketing, Management etc. and their past experience.)

2.

Chief Executive

:

Since When ?

:

Capital Structure: 3.

4.

Authorised Capital Paid up capital (as on )

: Rs. : Rs.

Whether Listed Company If Listed, Face value of share Market quotation High (during last 52 weeks) Low

: : Rs.

Lacs. Lacs.

: Rs. : Rs. : Rs.

- Latest 5A Share holding pattern: Particulars Number of shares held

Face value of share holding (Rs.in lacs)

Percentage share holding

Promoters Associates Public Financial Institutions Others Total 5B. Names of top 10 share holders: (as on Particulars Number of shares Held

225

) Face value of

share holdi ng (Rs.in lacs)

Quality of management

:

6.

Whether the Company/Firm 7. has suitable cost accounting system? III. BRIEF HISTORY:

:

Technical Aspects: Line of activity: Division

Line of activity

Date of commencement of commercial production

Products manufactured: Products

Capacity Installed Present Operating

Licensed

226

Marketing arrangements:

Major developments, if any, that have taken place in the company:

Areas of strength and weakness Strengths: Weaknesses: Future outlook of the company:

IV. ASSESSMENT OF TERM LOAN/DPG (Fill up Annexure-V if there 227

is a request for term loan/DPG):

V. ASSESSMENT OF WORKING CAPITAL REQUIREMENTS: PROJECTIONS FOR THE ENSUING YEAR/NEXT YEAR: The actual production/sales for the last 2 years and estimation/projection for the ensuing year/next year. Year

Actuals/ Estimates

Production Quantity

Sales Quantity

Sales Value (Rs.in lacs)

Actuals Actuals Estimates Projections Present actual monthly production/sales during current year : (upto date of submission of application)

Achievability of estimated/projected production/sales:

228

Detailed operating statements for achievable level of production/sales is enclosed as Annexure-IV . Gist of the same is as follows: (Rs. in lacs) (Actuals)

(Estimate )

(Projection)

Installed Capacity Production (Quantity) Capacity Utilisation Gross Sales Net Sales Raw material consumption - Imported - Domestic Cost of Production Cost of Sales Operative Profit Net Profit before tax Assessment of Working Capital requirements: Turnover (Rs.in lacs)

Method:

(where Actuals

applicable) Estimates

A. Turnover B. 20% of (A) C. Margin Required at 5% of (A) D. Margin (NWC) E. Surplus/Shortfall (C-D) F. Eligible Minimum Bank Finance (20% of A or 4 times of C) G. Bank Borrowings H. Difference (F-G) Second Method of Lending: (Rs. in Lacs) Norms as per

(Actuals

229

(Estimate

(projectio

Peak

last sanction

)

s)

(A)Position of current assets Raw materials - Imports - Domestic (Months consumption) Consumable stores (months consumption) Stock in process (Months cost of prod) Finished goods (Months cost of Sales) Receivables – Export (months sales) Domestic (months sales) Other Current Assets Total (A) (B) Position of Current Liabilities other than Bank Borrowings Creditors for purchase of RM, stores/spares (months purchases) Adv. from Customers Statutory liabilities Other current liabilities Total (B) (C) Working

230

ns)

Period

Capital Gap ( A-B) (D) Minimum stipulated NWC (25% of CA excl. Export receivables) (E) Actual/Projected NWC (F) Item C Minus Item D (G) Item C Minus Item E (H) Eligible Credit (Item F or G whichever is lower) (I) Excess Borrowings representing shortfall in NWC (D-E) Comments on the levels of current assets projected: (a)

Raw material:

(b)

Stores and Spares:

(c) Semi-finished goods: (d)

Finished goods:

(e)

Receivables:

(f) Other Current assets:

Comments on current liabilities projected: (a) Creditors for purchases: 231

(b) Advances from customers: (c) Other current liabilities: Build up of Net Working Capital (NWC) : (Rs. in Lacs)

Actuals

Estimates

Projection

Actual NWC at beginning of the year ADD: Retained Profit for the year (Net Profit after tax and dividend) Depreciation Additional Long Term Funds: Increase in Capital Increase in Deposits Increase in Term Loans Others SUB TOTAL LESS: Long Term Uses: Reduction in Deposits Reduction in Term Liabilities Increase in Fixed Assets Others SUB TOTAL NWC as at the end of the Year

Bifurcation of MPBF (between inventory and bills): (In respect of borrowers enjoying working capital limits of Rs.10.00 crores and above from the banking system, separate Sub Limits have to be specified for meeting payment obligations of the borrower in respect of purchases from SSI units)

232

Non Fund based limits: a) Letters of credit limit: Existing: Applied : Assessment of sight LC

Sight

Usance

:

Total

FOR FLC

FOR ILC

1.Annual Purchase/Import : 2.Out of the above on : sight on LC basis : 3.Average of (2) p.m. : 4.Lead time (in terms of : months) 5.Sight LC requirement : (3) * (4) Assessment of Usance LC

:

FOR FLC

1.Annual Purchase/Import : 2.Out of the (1) on credit : basis : 3.Out of the (2) on : usance LC basis : 4.Average of (3) p.m. : 5.Lead time (in terms of : months) 6.Usance period (-do-) : 7.Usance LC requirement : (5 + 6) * (4) b) Guarantees Limit : Existing: Applied : Assessment: GEARING RATIO (wherever applicable):

233

FOR ILC

VI. SHARING OF FUND BASED AND NON-FUND BASED CREDIT LIMITS IN CASE OF CONSORTIUM: (Rs. in lacs) Name of the Bank

Shar e (%)

Fund Based

Shar e (%)

Inventor Bills y

Non Fund Based LC

BG

Other s

Total VII. OTHER LIABILITIES OF THE COMPANY/DIRECTORS/PARTNERS TO THE BANK:

VIII. PARTICULARS OF DEALING WITH OUR BANK: (Rs.in lacs) Name of concern/ Activity

Facility

Limit

ASSOCIATE/GROUP

Outstan - dings on …………

Overdues

CONCERNS

Credit Rating

Sanct. Authority

(furnish financial indicators of associate/group concerns separately) IX.PARTICULARS OF ASSOCIATE/GROUP CONCERNS DEALING WITH OTHER BANKS: (Rs.in lacs) Name of concern

Name of the Bank

Facility

Limit

234

Outstandin gs

Overdue s

on……………

(furnish financial indicators of associate/group concerns separately) X. WHETHER THE COMPANY/PROMOTERS/ASSOCIATE COMPANIES ARE FIGURING IN (1) THE LIST OF DEFAULTERS AND (2) EXPORTERS'CAUTION LIST CIRCULATED BY RBI AND/OR (3) ECGC SPECIFIC APPROVAL LIST, IF SO, FURNISH DETAILS:

XI. BRANCH VIEWS AND RECOMMENDATIONS:

Branch recommended for sanction of the following credit limits: ---------------------------------------------------------------------------------------------------------------Facility Limit ROI Margin Primary Security (Rs.in lacs) Existing Proposed Existing Proposed ---------------------------------------------------------------------------------------------------------------

--------------------------------------------------------------------------------------------------------------Collateral Security – Existing/Proposed :

235

Guarantors:

XII. ZONAL OFFICE VIEWS AND RECOMMENDATIONS:

XIII. HEAD OFFICE VIEWS AND RECOMMENDATIONS:

CREDIT RISK ASSESSMENT OF THE BORROWAL ACCOUNT 236

(attach Credit Rating Sheet in case CRAS is not applicable) Name of borrower : Reference Year : (A) INDUSTRY & MANAGEMENT RISK FACTORS: PARAMETER Group reputation Management succession Market share/ Brand Image Dividend record Retention of profits Competition Future prospects Industry Cycle Dealing with bank Integrity Total Crosses Multiplying factor Marks obtained Maximum Marks

COLUMN-A Most reputed Excellent

COLUMN-B Reputed

COLUMN-C No affiliation

Good

Satisfactory

Excellent

Good

Satisfactory

Excellent Excellent

Good Good

Satisfactory Satisfactory

Less Excellent Upswing

Medium Good Downswing

Long (10 yrs plus) Reliable

Medium (3 yrs plus)

Heavy Satisfactory Unpredictabl e Others (below 3 yrs) Not reliable

Reported reliable 1. 5

15 Marks scored .0

237

1 . 0

0.5

(B) FINANCIAL RISK FACTORS: a) Net Sales/contract receipts/gross receipts (Rs.in lacs) Reference Year Sales Projection (X) Actual Sales

(Y)

Achievement (Y/X*100)

b) Profitability (Rs.in lacs) Previou Indicator s Year

Above 85% Above 75% & upto 85% Above 50% & upto 75% 50% & below

Parameter Referen ce Year

Net sales (X) Operating Profit /loss (Y) Profitability Ratio (Y/X*100)

c) Solvency (Rs.in lacs) Previou Indicator s Year

Parameter

Satisfactory – No slippage Satisfactory – with slippage Satisfactory Positive-below satisfactory Negative ratio

Parameter Referen ce Year

Tangible Net worth (TNW) Total Outside liabilities (TOL) TOL/TNW

238

2 and below – No slippage 2 and below with slippage Above 2 to 3

Mark s 10 8

Cro ss

6 0

Mark s 15

Cro ss

12 8 4 0

Mark s 10 8 6

Above 3 to 4

4

Above 4 to 5 Above 5

2 0

Cro ss

d) Liquidity Previou s Year

Parameter

Indicator Minimum stipulated current ratio

Actual Current Ratio

Referenc 1.33 or above e Year without slippage 1.33 or above with slippage 1.25 to below 1.33 1.20 to below 1.25 1.15 to below 1.20 Below 1.15

e) Interest Coverage Previou s Year

3.00

Indicator

Parameter Referen ce Year

Minimum desired Interest coverage

3.00

Actual Interest Coverage

Above 3 – No slippage Above 2 to 3 – No slippage Above 1.5 to 2 with or Without slippage > 1.25 to 1.50 1.25 and below

Mark s 10

Cro ss

8 6 4 2 0

Mark s 5

Cro ss

4 3 2 0

( C ) OPERATIONAL EXPERIENCE: PARAMETER Submission of stock statements Submission of QIS Repayment of interest & instal.

COLUMN - A Most regular

COLUMN - B Regular with delay

COLUMN – C Irregular/no n submission

Most regular Prompt on due date

Regular with delay Paid with delay

Compliance with sanction terms

Complied promptly

Complied with delay

Irregular/no n submission Irregular /non payment Not complied

239

Total No. of crosses Multiplying factor Marks obtained Maximum marks

5

3

1

20 Marks scored

(D) VALUE OF THE ACCOUNT : PARAMETER Average float/ credit balance Deposit support from self/friends/asso ciates Non interest income Collateral security (as % of limits) Transaction cost Total No. of crosses Multiplying factor Marks obtained Maximum marks

COLUMN - A Substantial >25% of limit Substantial >25% of limit

COLUMN - B Moderate >10% to 25% Moderate >10% to 25%

COLUMN - C Nominal <=10%

High- >25% of int. income Above 50%

Moderate >10% to 25% 25% to 50%

Low <=10%

Low

Moderate

High

3

Nominal <=10%

Below 25%

2

1

15 Marks scored

(E) SUMMARY OF MARKS FOR VARIOUS PARAMETERS: Parameter

Maximum Marks 15

(A) Industry and Management Risk

240

Marks secured

Percent age

(B) Financial Risk (C) Operational Experience (D) Value of the account Total

50 20 15 100

(F) APPLICABLE RATE OF INTEREST: Marks secured

Grade

Applicable Spread

Above 95% >90 to 95%

CRA Ratin g A+++ A++

Prime Excellent

>80 to 90%

A+

Very good

>70 to 80%

A

Good

>60 to 70%

B

60% & below

C

Satisfactor y Average

Nil 1.25% 1.75% 2.00% 2.50% 2.75% 3.25% 3.50% 3.75% 4.00%

Cros s

Interest applicable

to to to to

Justification for finer rate, if recommended:

Present CRA Rating Rate of Interest

Proposed

Date:

Date:

Officer

Recommending Authority

241

242