Assessing Fund Based and Non Fund Based Credits

Working Capital Concepts

Business entities engaged in manufacturing or service activities typically require two types of assets to carry
on their business activities: fixed assets and trading assets. These businesses require funds to acquire fixed
assets such as land or buildings, machinery, equipment, or vehicles, depending upon the nature of the activity.
Fixed assets have a long life, and are used to produce goods and extend services. Trading assets (see examples
below) support the operating cycle.

 Examples of fixed assets:

o Equipment, such as X-ray and ECG machines for a hospital
o A bus for a transport operator
o A photocopier for a printing/copying company
o Plant and machinery for a PVC pipe manufacturer
 Example of trading assets:
o Medicine and other consumable items for a hospital
o Fuel for the transport operator’s bus
o Televisions and other electronic items for a TV showroom
o Stock of PVC granules for a PVC pipe manufacturer

Business entities also need funds to carry on day-to-day business activities such as producing goods and
providing services, as well as to meet the expenses such as wages, salaries, and power. The funds required to
meet the day-to-day needs of a business enterprise are called working capital (WC).

In this lesson, you will learn the importance of working capital, the terminology of the working capital
assessment, and the impact of the various components of a working capital assessment.
At the end of this lesson, you should be able to:
 Explain the concepts and terminology of working capital assessment.
 Discuss the impact of working capital cycle, current assets, current liabilities, other current
liabilities, working capital gap, margin, and net working capital in working capital assessment.
 Differentiate between fund-based and non-fund-based working capital funding.

What You Need to Know

Business entities need adequate and continuously available funds to meet their business requirements and
achieve their goals. In other words, these entities need to maintain sufficient working capital to run their
businesses. The amount of working capital should neither be excess nor deficit. Excess working capital would
result in idle funds and may also add to the cost of funds, whereas inadequate working capital would disrupt
production activities and, in turn, adversely impact business levels.
In previous lessons, you learned about the concept and importance of the operating cycle. The operating cycle
is a relatively short cycle that reflects and encompasses the day-to-day activities of a business enterprise.
These activities typically include:
 Buying, managing, and paying for inventory
 Converting inventory into goods for sale
 Selling goods and collecting payments from customers
The components of the operating cycle in manufacturing units consist of:
At each stage of the operating cycle, funds are invested. The aggregate amount invested in the various
components of the operating cycle constitutes the working capital of a business enterprise. Because of the
tight connection between the working capital and operating cycle, the operating cycle is also referred to as the
“working capital cycle” or the cash-to-cash
cash cycle.
The Terminology of the Working Capital Assessment
Assessment–

The various terms for the components use

usedd in a working capital assessment are explained in the table below.
These components will enable a lender to determine the working capital requirements of a business
enterprise.
Impact of the Components of the Operating Cycle on Working Capital Needs–

The assessment of working capital is primarily an approximation of the holding levels of the components of
current assets. Outlined below is the impact of holding levels on the working capital assessment:
 1. Raw material: The holding level depends on the logistics, seasonality of the available raw
material, the volume of business, and trade terms. The reasonableness of the holding
levels is to be analysed in comparison with similar units in the same line of activity.
2. Stock in Progress: The holding period (for manufacturing units) depends upon the
processing period involved. While assessing the working capital requirements of a unit,
one has to understand the processing period involved in the activity.
3. Finished Goods: The holding period depends upon the level of sales, nature of the product,
trade terms, logistics, and seasonality. While assessing the working capital requirements of
a unit, one has to find out whether the holding period of finished goods are in line with
similar units in the same line of activity.
4. Sundry Debtors or Trade Receivables: The holding period depends upon the terms of sale.
While assessing the working capital requirement of a unit, one has to find out whether the
holding period of sundry debtors is in line with industry trends and reasons for any
variations.
5. Other Current Assets: Consists of advances made to suppliers, fixed deposits with banks,
margins on LCs and BGs. They are not a major part of current assets and holding period
analysis may not be relevant. However, these items should be reasonable within the line of
activity.

Other Current Liabilities (OCL)

The sources available to a business enterprise to meet its working capital requirement have been explained
earlier in this lesson. OCL is one of the funding sources.

OCL consists of sundry creditors, provisions, and expenses payable. OCL is arrived at by excluding short-term
bank borrowings from total current liabilities, and helps to determine the working capital gap in a working
capital assessment.

The holding period of trade creditors/payables depends upon purchase volumes and trade terms. The
reasonableness of the holding period should be analysed when assessing the working capital requirement of a
business entity.

To sum up, the holding period of current assets and other current liabilities are the critical factors in the
assessment of working capital. As a lender, you need to discern the reasonableness and acceptability of the
holding levels. Any variation from the acceptable holding levels would result in either excess or deficit working
capital assessment.
Difference Between Fund-Based and Non-Fund-Based Working Capital Facilities–

Every business activity is unique, which will determine the nature and form of working capital it requires.
  An exporter, for example, will need a packing credit overdraft, while an importer will need
a letter of credit followed by a cash credit facility.
 A contractor engaged in civil works requires a bank guarantee to participate in tenders,
and when awarded a contract, may be in need of fund fund-based
based facilities.
The above examples indicate the need for providing fund
fund-based and non-fund-basedbased facilities. The key
differences between fund-based
based and non
non-fund-based
based working capital facilities are listed here:

What You Need to Do

To understand how efficiently
fficiently a business’s operations are managed, you should evaluate its operating cycle
and its components. This means you should determine what the day day-to-day
day operations look like, who the key
suppliers and customers are, and what the typical trading term termss are. The following guidelines will help you do
this effectively.
 Identify the working capital (operating) cycle and the changes in it compared to the previous year
and the reasons for the changes.
 Identify reasons for variations in the holding levels.
 Findind out whether the net working capital available with the unit meets the margin requirements
of the bank policy guidelines.
 Identify which part of the working capital cycle requires non non-fund-based
based and/or fund-based
fund
facilities.

How This is Useful

Analysis
sis of the working capital (operating) cycle provides vital insight for lenders in the assessment of working
capital. Lenders should therefore view any significant change in the length of the working capital cycle and
understand its impact on the working capital
apital assessment.
M/S. Auto Components, who are engaged in manufacturing and supplying customised auto spare parts to TVS
Motor Company, request an enhancement of their cash credit facility. The proprietor of the M/S. Auto
Components mentions that the contract with TVS has been renewed for another five years, with an increase in
the order value. The unit has submitted their audited financial statements, which reflect improving sales year
on year. Their balance sheet shows the following.

The knowledge you have acquired in this lesson will help you arrive at the gross working capital, working
capital gap, and net working capital of the unit, and analyse the impact of these components on the working
capital requirement.

Questions You Should Ask

As a lender, you will need insight into the working capital cycle, and to analyse the factors that impact the
working capital assessment. The following questions will help you with your insight analysis.
Question 1
Select to flip
Have I understood the working capital (operating) cycle of the unit? Who are their key suppliers and what are
the payment terms?
Question 2
What is the normal working capital cycle in the industry for a given product line, and how does the unit
compare to that?
 Question 3
Have I analysed the reasons for variations in the normal working capital cycle and gauged the impact on the
working capital?
Question 4
Have I discussed what portion of the working capital cap the unit is able to mobilise from their own sources?

Fund-Based Working Capital Assessment.

In the previous lesson, you learned about the importance of working capital to a business entity. You also
als
learned about the components of the operating cycle and their relevance to the working capital assessment.

As a lender, you will encounter businesses engaged in either manufacturing or trading. You should understand
the business model for both types of business
usiness activities, as well as the operating cycle and the factors that
affect it. With this knowledge, you will be able to choose the right approach and adopt the best method to
assess the working capital needs of either type of business enterprise.

In this
is lesson, we discuss the various methods used by banks to assess the working capital needs of business
entities.
At the end of this lesson, you should be able to:
 Explain the rationale behind the various assessment methods used to calculate fund-based
fund
working
king capital requirement.
 Describe the different methods used to assess fund
fund-based
based working capital needs.
 Explain the key differences between the working capital assessment methods.
 Explain the concept of drawing power and its importance in assessing working
work capital needs.

What You Need to Know

Determining the amount of bank finance a business needs to achieve its targets is critical to the success of the
business.

During the 1970s, bank lending was more security oriented than purpose oriented. This outlook
out resulted in
credit flowing to only a few business activities and diversion of funds to speculative activities. Credit for other
economically viable activities was unavailable.

In an effort to ensure that businesses had access to need

need-based credit, RBI took measures to shift the
preference from security-oriented
oriented to purpose
purpose-oriented
oriented lending. RBI formed various committees to analyse the
business models and operating cycle of different types of businesses and the challenges they faced in
obtaining bank credit.
dit. Thus, it was able to recommend appropriate methods to assess working capital needs.
As a credit professional, you should understand and be able to apply those methods to different business
activities requiring a working capital facility.

In recent years,
rs, RBI has allowed banks to adopt their own methods for assessing the working capital
requirements of their customers. However, most banks follow the methods recommended by RBI, with
guidance from their own loan policy document.
In this lesson, we providee an overview of the different methods used to assess working capital requirements.

Methods of Working Capital Assessment

What You Need to Know, continued.

There are three main methods of assessing working capital requirements:

1. Projected Turnover Method

2. Cash Budget Method
3. Projected Financial Method (Balance Sheet Method)
Projected Turnover Method–

The projected turnover method is the method suggested by RBI for small business enterprises (SMEs) whose
working capital needs do not exceed Rs.5.00 Crs. This method was recommended by the P. R. Nayak
committee.

The committee made the following observations:

 Smaller SME units do not always maintain proper books of accounts.

 Detailed analysis of the financial statements of such a business may not be feasible.
 Smaller
maller businesses may have limited sources to draw on for their margin.
Based on these observations, the committee recommended a simplified method of reckoning sales as the
basis on which the working capital requirement of small SME units is assessed.

Thee committee took into consideration that, under normal circumstances, most SME units rotate their
working capital four times in a year in an effort to achieve their projected sales turnover. They recommended
that the owner’s contribution be at least 5% of the projected turnover, and bank financing at least 20%.
Cash Budget Method–

For business entities engaged in non-seasonal

seasonal activities such as construction, film production, or software
development, the level of activity and cash flows are typically uniform throughout the year. Those engaged in
seasonal activities, on the other hand, have two distinct features in the cash flows: peak season and non-peak
non
season.

Example
A business that manufactures sweaters and other woolen garments must produce the products throughout
the year and hold the finished goods until winter, when market demand picks up. The peak season is the
period during which the finished goods are rapidly accumulating in preparation for sales. The non-peak season
begins when the sales and cash in-flows commence.

With seasonal businesses, the operating cycle varies, cash flows are uneven, and business activity has both
peak and non-peak periods. Such seasonality of operations results in a variety of working capital needs. With
these businesses, the cash budget method is the best method to determine the working capital required to
meet both peak and non-peak needs.
Projected Financial Method (Projected Balance Sheet Method)–

Banks generally follow the projected financial method to assess the needs of SMEs requiring fund-based
working capital of above Rs.5 Crs. and a combination of working capital facilities. High-value working capital
facilities of this nature require a holistic understanding of the company’s past track record, trends, and
projections. The projected financial method provides a working capital assessment at the comprehensive level
required for such large customers.

The projected financial method of working capital assessment is based on recommendations of the Tandon
Committee.

The committee suggested that the working capital assessment should be based on the following factors:

1. The level of current assets that must be maintained to achieve the current year estimates
and projected sales for the following year.
2. The period of credit available on purchases.
3. The working capital gap – that is, the amount needed from net working capital (NWC) and
bank finance to meet working capital needs.
4. The amount of NWC available.
5. The maximum permissible bank finance (also referred to simply as permissible bank
finance).
The Tandon Committee recommended three methods of assessment, of which two methods were accepted
by RBI for implementation by the banks. The difference between the two methods of working capital
assessment is as follows:

 Method 1: Minimum NWC is 25% of the company’s working capital gap

 Method 2: Minimum NWC is 25% of the company’s total current assets
The decision to use either method is left to individual banks. However, most banks continue to apply one or
both methods, depending on the nature of the business.

The credit monitoring arrangement (CMA) is a tool used with these methods to arrive at the permissible level
of bank finance. In the following topic, you will learn about the CMA and its usefulness in working capital
assessments.

Credit Monitoring Arrangement

What You Need to Know, continued.
In 1988, RBI introduced the Credit Monitoring Arrangement (CMA) based on recommendations of the Tandon
Committee for working capital assessment. The CMA forms were designed based on the Committee’s
Com
suggested formats.
Under CMA, banks are required to report to RBI for post
post-sanction
sanction scrutiny any sanction or renewal of credit
limits for facilities with the following limits:
 Rs.10 Crs. and above in the case of funded working capital facilities, whether new or subject to
renewal.
 Rs. 5 Crs. and above in the case of term loans

CMA Data

What You Need to Know, continued.

CMA Data is a statement showing a systematic analysis of the working capital needs of the borrower. The
purpose of this statement is to determine how funds are used. The analysis generally includes two years of
audited financial statements, current estimates, and next
next-year
year projections for the business enterprise.

The main objectives of CMA data are as follows:

 To enforce financial discipline on larger borrowers, where necessary, based on uniform

principles of lending.
 Where a SME unit is financed by more than one bank, to ensure that the business’s
proposal is assessed in light of information available from all the banks.
 To improvee the techniques banks use for credit appraisal, including their follow-up
follow system.

CMA consists of 6 forms, as described in the table below.

RBI allows banks to adopt their own methods and tools to assess the credit facilities. However, most banks
continue to use the CMA forms because they facilitate critical analysis and interpretation of the financial
statements.
With the amendment to the Companies Act, the financial statements of most companies now follow a similar
structure to that of the CMA forms.

Methods of Working Capital Assessment

The table below outlines the differences between the various methods of working capital assessment to help
you decide on the method best applied to different loan proposals.

The method of assessment you adopt should be appropriate to the nature of the SME’s activities. Your bank’s
policy should provide guidelines regarding the best method to use.

Drawing Power and Its Importance

What You Need to Know, continued.

The appropriate method of working capital assessment for a particular business should help you to arrive at a
credit limit for that business, to which extent the company may draw to meet its operating cycle
requirements. The ability of the business to draw funds to the maximum limit is linked to the level of inventory
and trade receivables position. In any business activity, the level of inventory and trade receivables is not
static but dynamic.

As a lender, you must regularly monitor the fund-based working capital loan account to ensure that the
outstanding balance is fully covered with the inventory and receivables after keeping the stipulated margin.
The tool used to regulate the account is called Drawing Power (DP).
Drawing power is an important concept as applied to fund-based working capital facilities such as a Cash
Credit (CC) facility. It is defined as the ceiling up to which a company can draw from the sanctioned working
capital limit. Updating the DP for working capital is an important credit monitoring exercise.
How to Calculate Drawing Power–

The business enterprise must submit a statement detailing the movement and position of inventory, trade
receivables, and sundry creditors at monthly intervals or at intervals stipulated in the facility’s sanction letter.
As the lender, you must update the DP based on the monthly or quarterly stock and trade receivable
statement submitted by the business enterprise. Based on that statement, the DP is calculated as follows:

Example of Drawing Power Calculation–

M/S Auto Expo Enterprises has been approved for a cash credit limit of Rs.75.00 lacs against inventory and
trade receivables. The margin stipulated is 25% of Inventory and 30% of trade receivables. The loan sanction
letters also stipulate that the business must submit the inventory and trade receivable statements every
month.

Trade receivables beyond 180 days must be excluded when calculating drawing power.

The business has submitted the inventory and trade receivable statement for the month, with details as
follows:
Drawing power calculation:

Drawing power = Lesser of A or B = Rs. 75.00 Lacs

In short, DP helps not only to ensure that the working capital loan outstanding is fully secured by the inventory
and receivables available with stipulated margin; it also helps to ensure that the operations in the account
reflect the true state and activity level of the business enterprise

What You Need to Do

When a working capital loan proposal is received:
 Find out the nature of business activity.
 Decide on the appropriate method of assessment, in line with bank policy guidelines.
 Determine how the NWC was arrived at.
On receipt of the stock and trade receivable statement from the business:
  Check the movement and position of inventory and trade receivables to calculate DP.
 Determine whether the outst
outstanding
anding balance in the working capital account is within the DP.
How This is Useful

You received the loan proposals from different business entities for the working capital facility.

 M/S Quality Concretes is engaged in the manufacture of customised railwayrailw sleeper cars. It
requests a working capital facility of Rs. 60.00 lacs. The financial data provided by the
business indicate that it has achieved sales turnover of Rs. 2.50 Crs. during the previous
year and estimates a sale turnover of Rs. 3.00 Crs. dur
during
ing the current year.
 Construction (India) Ltd, which is engaged in the construction of 20 small studio flats,
requests a working capital facility of Rs. 2.50 Crs. The promoter clarifies that the business
has received advance money of 20% of the value of tthe he flat from the prospective buyers.
The balance portion will be received when construction is complete.
 Ashok Castings (p) Ltd, which manufactures industrial and ornamental iron castings,
requests enhancement of their cash credit limit from Rs. 4.00 Crs. to Rs. 6.00 Crs. The
business has been engaged in the same line of activity since 2014.

This lesson should help you to identify the appropriate method to assess the working capital requirements of
each of these business entities.
Questions You Should Ask

In this lesson you learned about the various methods used to assess working capital and situations in which
each method is applicable. In using these methods, you should consider all relevant aspects for assessment,
with a particular focus on the followinging key points:
Question 1
Select to flip
Which approach should I use if working capital finance is not adequate (i.e
(i.e.,
., less than of 20% of the projected
turnover) to meet the working capital needs of the business enterprise?
Question 2
Where business activity is seasonal, does the business require the building up of raw materials or finished
goods such that peak season affects its cash flows?
Question 3
Are the financial projections in line with past performance trends of the business enterprise?
Question 4
What are the key reasons for any divergence between past trends and projections?
Question 5
Have I developed the skill
ill to relate the movement of inventory and trade receivables to the activity level?
 The Maximum Permissible Bank Finance Method
Intro

In the 1970s, bank lending was more security

security-oriented than purpose-oriented.
oriented. There was no uniformity of
approach in the assessment of credit facilities. The assessment of working capital facilities was not linked to
the level of a business’s activity.

Therefore, in July 1974, RBI set up a working group, the Tandon Committee, to streamline the flow of credit.
The Committee recommended three methods of working capital assessment and introduced the concept of
Maximum Permissible Bank Finance (MPBF), also referred to as Assessed Bank Finance (ABF) or Permissible
Bank Finance (PBF). We will use “PBF” in this lesson. The RBI acce
accepted
pted two of the Tandon Committee’s
recommended methods to assess PBF.

In this lesson, we shall learn how the PBF is arrived at and the impact of Net Working Capital (NWC) on the
total working capital.
At the end of this lesson, you should be able to:
 Identify
ify the two methods of PBF calculation.
 Explain how to calculate other current liabilities, current assets, buildup of NWC, and working capital gap.
 Describe how to calculate the PBF with methods I and II.

What You Need to Know

The RBI allows banks to adopt

dopt any suitable method of Working Capital assessment. Lenders are guided by
their internal SME loan policy guidelines on which method they should use.

The Permissible Bank Finance (PBF) method of Working Capital assessment is generally applied in case of
o loan
proposals of Rs. 5.00 Crores and above.
When employing the PBF method, a lender should confirm:
 Whether the unit is capable of achieving the projected sales
 If the estimated/projected holding levels of the components of current assets are in line with
wi the current level
of activity and past trends
 Whether the unit is capable of bringing in the minimum margin as per bank policy guidelines
 If other sources are available to the unit to meet its working capital requirement
Assessment of Working Capital Limit by the PBF Method

In the previous lesson, we learned about Credit Monitoring Arrangement (CMA) formats. The PBF methods
use the CMA data to assess working capital. CMA data (Forms IV and V), discussed in the previous lesson, will
facilitate your assessment
ment of the working capital requirement under the PBF method.

The PBF method of working capital assessment is linked to the working capital gap (WCG) less margin. You
learned in the previous lesson that the Tandon Committee recommended 25 percent of the WCG WC as Net
Working Capital (NWC) under the first method, and 25 percent of total current assets under the second
method. The following examples illustrate the assessment of working capital under both methods.
As can be seen in the examples, the NWC under Method I is lower than Method II. Consequently, the PBF is
higher under method I than the one under method II. Your bank’s policy will provide guidelines on the method
to be applied for different categories of SME units.

Assessment of PBF under Method I of the Tandon Committee Recommendations–

Assessment of PBF under Method II of the Tandon Committee Recommendations–

The Key Components of the Operating Cycle Affecting the WC Assessment Under the PBF Method–

Lenders need insight into the operating cycle (working capital cycle / cash-to-cash cycle) when assessing the
working capital requirements of a business enterprise. Analysing past trends in sales, holding levels, and Net
Working Capital will enable the lender to discuss with the management of the business enterprise:
  Their strategies to achieve the estimated/projected sales in light of the business environment and
market conditions that may affect the achievement of the estimates/projections as submitted by the
unit
 The reasons for variance (if any) in the holding levels
 Their plans to build up the required NWC
And to decide on the reasonableness and acceptability of the estimates/projections.

Methods of Fund-Based Working Capital Assessment.pdf 62.1 KB

What You Need to Do
Having understood the PBF method of working capit
capitalal assessment, the following points will guide you as you
process the proposal.
 Find out the past trends in performance and the holding levels of current assets and other current
liabilities.
 Determine the reasonableness and acceptability of the current y year
ear estimates and projections.
 Identify the factors that resulted in increased working capital gap.
 Find out the sources for the incremental NWC required.
 Decide on the method (Method
Method I or IIII)) to be adopted as per policy guidelines.

How This is Useful

M/S. Ashok Foundries, engaged in manufacturing auto components for two-wheelers,wheelers, are presently using
fund-based
based working capital limits (cash credit) of Rs. 5.00 crores. They are seeking enhancement of the facility
to Rs. 6.00 crores. The unit submitted audited financial statements for the past two years along with current
year estimates and projections.

During discussions with the partners, you learn that:

 M/S. Ashok Foundries has signed a five

five-year
year contract with a client for the supply of customised auto
components, which would increase the sales by 15 percent.
 The creditt period to the new client would be 75 days as against 60 days to the existing clients.

The key performance and financial indicators are as below (Rs. in lacs)
The topics in this lesson will help you:

 Identify the trends in past financial performance.

 Establish linkage between past trends and estimates/projections.
 Identify the reasons for the increase in working capital gap
 Identify the buildup of NWC.
 Establish whether the justifications on holding levels given by the unit are reasonable.
 Assess the PBF.
 Questions You Should Ask

 Having understood Methods I and II of the PBF calculation, your credit assessment will be
comprehensive if you carefully analyse the answers to the questions below:
  Question 1
 Select to flip
 Has the unit planned the buildup of NWC in anticipation of increased working capital requirement?
 Question 2
 What are the key factors that may impact the projected performance of the unit?
 Question 3
 What are the technology trends in this line of business?

The Cash Budget Method

In lesson 2 (Fund-based Working Capital Assessment), you were given an overview of the Cash Budget method
for assessing industries whose business is cyclical, and whose working capital requirement is therefore not
steady through the year. In this lesson, you will learn in detail how this method is used to assess the working
capital requirement.
At the end of this lesson, you should be able to:
 Explain the Cash Budget method of the working capital assessment.
 Calculate peak and non-peak level deficits.
 Assess the working capital requirement under the Cash Budget method.
 Describe how drawings are regulated.

What You Need to Know

In short, a Cash Budget is a forecast of receipts and payments drawn at short intervals, e.g., half-yearly,
quarterly, and monthly. The cash budget method of assessment is most suitable for businesses whose
activities are seasonal and cash flow is not uniform throughout the year. From the projected inflows and
outflows, the cash deficit, and therefore the working capital requirement, can be calculated.
A proper application of the cash budget method will also help a lender decide the level for short-term
financing. The lender will be able to determine whether the outstanding balance in a short-term credit facility
is adequately covered by the value of the current assets charged to the bank.

The Components of the Cash Budget

What You Need to Know, continued.

In seasonal industries such as sugar, tea, and construction, the requirement for working capital finance may
peak during the calendar months before sales are realised, followed by a reduced requirement and a period
when no facility is required. Under the cash budget method of working capital assessment, the working capital
finance need is based on projected monthly cash flows estimated by the borrower and the bank. The
projected cash inflows and outflows are classified as operational and non-operational, as follows:
Only cash flows from operating activities are considered for assessing working capital finance. The working
capital limits sanctioned will be equal to the peak deficit, but the amount allowed to be drawn will be equal to
the month-to-month deficit.
Example of Monthly Cash Budget–

This monthly cash budget shows projections over five months.

The peak deficit is Rs. 50 lacs. The working capital finance will be Rs. 50 lacs. The drawing power will
correspond to the deficit each month. In the above example, in May, the drawing power will peak at 50 lacs,
and in August, it will be zero.

The loan is monitored by using the budgeted drawing levels at the end of the respective months as
benchmarks. However, where such credit facilities are covered by primary security such as inventory holdings
or receivables, it will be necessary to compute the value of those chargeable assets at the end of each month.
This would ensure that at any point of time, the balance in the loan account is always covered by the value of
the primary security, less the margin. In other words, sufficient drawing power will be available to support the
outstanding balance.
Typical Uses of the Cash Budget Method

What You Need to Know, continued.

The list below shows typical uses of the cash budget method for assessing working capital requirements. Note
that this list is illustrative and not exhaustive.

Financing seasonal business activities: Activities that depend on agriculture are generally seasonal in nature,

as are firecracker manufacturing, printing, and textbook publication. Credit decisions for these activities are

taken on the basis of cash budgets prepared. Credit limits are fixed at a higher level during peak activity

periods and may be fixed at lower levels during non-peak periods.

Construction activities: These require the application of realistic cash budgeting in order to determine the

level of projected cash requirements at specified intervals. The amount and periodicity of repayment may also

be determined by those projections.

Request for a short-term loan: Often business enterprises request a short-term loan for the execution of

contracts. The loan would be for a period of 3 to 6 months, with full repayment on completion of the contract.

Opening a Letter of Credit (LC): Letters of credit must be honoured when the bills are presented to the issuing

banker for payment. Before issuing the LC, the bank has to ensure that the client’s liquidity position is

comfortable and that the balance in the client’s account is sufficient to pay the bills against the LC when they

are received. Note that as per RBI guidelines, obtaining the cash flow statement is mandatory for opening an

LC.

The RBI has laid down specific guidelines for employing the cash budget method to finance agro-based

seasonal activities such as sugar and tea manufacturing/processing, as well as software development

activities. Activities such as coffee, rubber, cardamom, and rice milling may also be financed following these

guidelines to a large extent.

In cases where the procurement of inventory or the build
build-up
up of receivables occur, drawings are regulated as
per the budget by fixing the drawing power (DP) based on a chargeable current asset such as inventory or
receivables, and stipulating a suitable mar
margin.
gin. The actual cash flows must match the budget at determined
intervals.
Note: With the RBI making Performance
Performance-Based
Based Financing (PBF) optional for banks and opening the door to
adopt suitable new methods of financing, the cash budget method is fast emergin
emergingg as a favorite lending
option. Since lenders obtain actual cash flows for the budgeted period, it is possible to monitor the end use of
funds, which is of great comfort. In the near future, banks may employ the cash budget method of working
capital assessment
ment more frequently than other methods.

Assessment of Fund-Based Working Capital.pdf

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What You Need to Do

Now that you have learned the details of the cash budget method, following the actions below will enhance
your assessment capability:
 Ascertain the business’s operati
operating cycle and periodicity of receipts/payments.
 Verify the cash flow statement and ensure it is drawn as per the entity’s business profile.
 Establish the achievable level of sales by referring to past actuals and projected estimates on a
quarterly/monthly basis.
 Check and analyse time periods for sales realisation, purchase payments, wages paid, and so
forth.
 Estimate the purchase and holding level of inventory during peak and non-peak
non periods and
compare them with past levels.
 Decide and arrive at the Net Working Capital (owner’s margin and assess the working capital
needs).
 Regulate drawings according to the budget and liquidity position.

How This is Useful

M/S Agarwal Cotton Yarn Pvt. Ltd. is a yarn manufacturing unit situated in Delhi. They plan to procure
pr good
cotton from the Maharashtra Cotton Growers Federation during the Kharif season, and store and use it for
production during the rest of the year.

The company has approached you for sanction of a working capital limit of Rs. 2.50 crores (comprising
(comprisi both a
fund-based
based facility of Rs. 2.00 crores and a non
non-fund-based
based facility of Rs. 0.50 lacs for a LC and a BG).
The knowledge you have acquired in this lesson will enable you to:
 Identify the appropriate method of assessment.
  Ascertain the deficit gapss in the cash flow so that the working capital requirement is properly
assessed.
 Monitor the assessed working capital limits. Withdrawals thereon can be effectively monitored by
way of the benchmarks established by the budgeted drawing levels at the end of the respective
months.
 Regulate the drawings and follow up for liquidation of the drawings.

Questions You Should Ask

As you assess units for a cash budget analysis of working capital, it will be helpful to ask:
Question 1
Select to flip
What is the operating cycle of the business? How seasonal is the operating cycle?
Question 2
What are the peak and non-peak levels of the working capital requirement?
Question 3
What is the working capital requirement? How will the drawing be monitored?
Question 4
How will I verify the estimated cash budget submitted by the entity if they do not have an MIS (management
information system) in place?
Question 5
How do I regulate the cash flows if there is a divergence in the actuals and budgeted cash flow?
Question 6
How can I ensure that the required margin for the need
need-based
based assessed limit is available in the system, and
monitor the margin
argin while the drawing changes regularly?

The Turnover Method

Introduction

In a previous lesson, we introduced the working capital assessment under the projected turnover method.
There are many small, family-run
run enterprises that are unable to maintain fo
formal
rmal books of accounts. The
reason may be inadequate exposure to accounting practices and small business size.

Unable to get timely and adequate credit from formal lending institutions, these small entrepreneurs are
forced to approach private money lenders and borrow at high cost. To bring these firms under the banking
umbrella, a simplified method has been developed to assess their limited working capital needs.
At the end of this lesson, you should be able to:
 Explain the turnover method of working capita
capital assessment
 Assess the working capital limit based on the working capital requirement, as well as stipulated
margin and available margin
What You Need to Know

The Turnover method is used to assess the working capital requirements of SME units up to Rs. 5 crores.
Under this method, 25% of the projected turnover is considered as a gross working capital requirement of the
enterprise. The bank must judge that projected turnover is reasonable and acceptable.

The P. R. Nayak Committee recommends that the borroborrower

wer contribute at least 5% of this amount as margin,
and 20% is considered permissible bank finance (PBF). Because of the Nayak Committee recommendations,
the Turnover method is also referred to as Nayak Committee norms.
In considering the proposal under thehe Turnover method, the following factors must be analysed:
 The minimum working capital requirement is 25% of what is deemed an acceptable level of sales.
 The assumed working capital cycle is 3 months under this method. If the operating cycle is more
than 3 months, then the working capital requirement is assessed using the maximum permissible
bank finance (MPBF) method.
 The borrower must bring in 5% of the projected sales (turnover) as margin from available net
working capital (NWC). If the available NWC iiss more than the minimum required (5%), then that
larger amount must be considered.
 Key financial ratios must be at the benchmark ratios stipulated in the bank’s internal credit policy.
Key ratios include, for example, the NWC ratio, the current ratio, and the debt-to-equity
debt ratio.
The following example clearly illustrates the concept of the turnover method.
Example of Turnover Method for Assessment of Working Capital Requirement
Requirement–

M/S Hindustan Saw Mill Private Limited is an SME enterprise in the business o off timber processing for the last
five years. The following table shows the sales figures of the business for the last three years. Projected
turnover is also shown.

Given this information, it is clear that the past growth rate in sales is around 20%. The projected growth rate is
in tune with the past trend, though it is higher at 24%. The lending banker discusses the underlying reasons for
the increase in projected turnover with the firm’s management. After due consideration, and having done its
due diligence,
iligence, the lender accepts the projected turnover.
Example of Calculating Eligible Working Capital
Capital–

Note that the most important step in this method of assessment is determining whether the projected sales
amount is realistic.
After the projected sales level is determined, the eligible working capital is calculated as follows:

Assessment of working capital under turnover method.

M/S Hindustan Saw Mill Private Limited

Case Study: Owner Margin

What You Need to Know, continued.

In many cases, the business unit can bring in more than the 5% stipulated NWC. Because the bank provides
need-based finance to the entity, in such cases, they deduct the available NWC and finance the balance.

The following case study illustrates the treatment to be given when the available margin is either less or more
than the required minimum margin of 5%.
M/S A and B Company has approached you for working capital finance for the coming year and have
submitted their financial statements. The company had achieved a sales turnover of Rs. 250 lacs last year, and
Rs. 360 lacs the current year. They have estimated the sales turnover in the coming year at Rs. 500 lacs. They
have also submitted order copies substantiating the likelihood that they will achieve their sales targets in the
coming year.
Balance sheet of M/S AB Company as on 31.03.2017–

The table below shows the outstanding balances in the balance sheet of M/S AB & Company as on 31/03/20XX
(the current year) after classifying the current assets and current liabilities.
Calculating
culating PBF Using the Turnover Method of Lending
Lending–

In this case, the 5% minimum recommended by the P. R. Nayak Committee for the turnover method is Rs. 25
lacs. However, the business has Rs. 42.75 lacs of NWC available. Therefore, the PBF is only Rs. 82.75
82 lacs
(eligible working capital less NWC), rather than 100 Rs. lacs (eligible working capital less 5%).

In cases where the available NWC is less than 5% Rs. 25 lacs, the company will be required to bring in the
balance before availing the limit.

What You Need to Do

Having learned about the turnover method of lending, you should know how to respond when a potential SME
borrower approaches the bank seeking working capital finance. The following actions should help you handle
the proposal properly and serve
erve the customer well:
 Verify whether the working capital limit sought from the banking system is within Rs. 5 crores.
 Analyse the existing financial statements of the entity to ensure that its financial health is
satisfactory.
 Determine whether the opera operating
ting cycle of the activity is within 90 days or more.
If so, adopt the MPBF method.
 Review the sales figures the business expects to achieve within the next 12 months, that is, the
amount for which it is seeking the facility.
 Determine whether the projecte
projected d sales are reasonable and whether the business is capable of
achieving its target in light of past performance.

How This is Useful

The bank receives the following SME proposal from an existing customer:

M/S Bright Metals Private Limited is a SME enter

enterprise
prise engaged in the manufacture of stainless steel utensils.

This customer has been dealing with the bank for the past 10 years. They now wish to expand their business
and have approached the bank for a working capital facility. The company is prepared to
t bring in the 5%
margin through their own sources. They achieved a turnover of 8 crores last year and expect to achieve a
turnover of Rs. 10 crores this year.

The company is seeking working capital to the extent of Rs. 2 crores, with which they plan to grow
gr the
business. How will you handle this proposal?
With the knowledge from this lesson, you should able to:
 Determine the method of lending to be adopted.
 Establish whether the company can achieve its projected turnover (i.e., whether the projection is
reasonable).
 Find out whether the company has the capacity to bring in the margin required.
 Calculate the requirement by adopting the turnover method.

 Questions You Should Ask


 As a responsible credit professional, you should ask the following questions tthat
hat may help address the
challenges:
 Question 1
 Select to flip
 Can the business show its past performance levels in the absence of formal books of accounts?
  Question 2
 Does the unit have the necessary infrastructure to achieve the projected turnover?
Question 3

 Does the business show incremental growth in NWC towards the projected turnover?
 Question 4
 How many times will the operating cycle rotate in a year?
 Question 5
 Which units in my branch can benefit if we adopt this method of lending?
 Question 6
 Which industries in my command area can I bring under this method of lending?
Working Capital for Export Trade

Introduction

In the previous lessons, you learned about the methods of financing domestic trade.

Credit and finance are crucial for a business enterprise, whether it is engaged in domestic or international
business. Export finance is short-term in nature, and takes the form of working capital finance.
Export business enterprises engaged in international business require working capital finance to meet various
needs:
 To procure raw materials as per importers’ requirements and to cover production-related
expenditures.
 To finance the cost of shipping, duties and freight, and insurance, most of which are incurred
before export revenue is realized.
 To support the credit period required from the time a shipment leaves the port until the importer
makes the repayment. Ocean transit (shipping), for example, can sometimes take several weeks to
reach the import destination.
At the end of this lesson, you should be able to:
 Recognise the Working Capital Finance needs of exporters
 Explain methods of assessment for financing Pre-shipment exports
 Explain methods of assessment for financing Post-shipment exports
What You Need To Know

Export finance consists of pre-shipment finance and post-shipment finance, with a number of different
facilities.

Pre-shipment Finance:

 Packing Credit Loan (PCL) or Export Packing Credit (EPC), extended in INR
 Packing Credit in Foreign Currency (PCFC), extended in foreign currency such as USD, GBP,
EUR.

Post-shipment Finance:

 Foreign Documentary Bills Purchased/Negotiated (FBP)

 Foreign Usance Bills Purchased/Negotiated (FUBP)
 Post-shipment in Foreign Currency (PSCFC)/Export Bills Re-discounted (EBR)
  Advance against Bills for Collection (ABC)
 Advance against Duty Draw Back/Export incentives.
Detailed descriptions of the financing requirements post dis
dispatch
patch of goods are presented in the document
below.

Key Features of Pre-shipment Finance Packing Credit (INR) and Export Packing Credit.pdf
974 KB

Appraisal of Packing Credit Limits

What You Need to Know, continued.

As with general credit extended to other types of borrowers, the appraisal of working capital for a packing
credit facility uses the holding level concept. The main difference is only with respect to the margin, which is
normally set lower than for general credit, at around 10 to 15 percent.
The Amount of Finance–

Consideration of a packing credit facility is always need-based.. To assess the export finance need, the Reserve
Bank of India has suggested that banks may follow any of the three methods for assessing the overall credit
credi
requirement discussed in the earlier lessons: Maximum Permissible Bank Finance (MPBF) method , Cash
budget method , Turnover method.

However, while considering need-based

based finance, the following aspects are to be taken into account:

 Export packing credi

creditt limits are assessed as a part of overall credit requirements, with clear
justification for the limits under consideration.
 If an exporter has both a domestic and an export business, it will be necessary to ensure
that the export credit facility matches tthe
he past and projected export volume of sales.
 It is also neccessary to assess the general conduct of the account and the utilisation of
credit limits. Generally, export credit limits are sanctioned as sub
sub-limits
limits of the whole limits
sanctioned.

When a borrower
rrower has both a domestic and an export business, it is often necessary to permit inter-
inter
changeability between domestic and export credit limits. Likewise, the exporter may seek inter-changeability
inter
between pre-shipment and post-shipment
shipment finance. These cons
considerations
iderations must be factored into the
assessment. When a business is healthy, a lender may consider relaxations with respect to networking capital
and the current ratio. The period of credit will depend on the manufacturing/trade cycle. However, this period
should not exceed 180 days.
Assessment of Export Packing Credit–

Example of an Assessment of Export Packing Credit

Post-shipment Finance

What You Need to Know, continued.

Export trade finance is short-term finance that is self-liquidating in nature. Pre-shipment finance always has to
be followed by post-shipment finance.

Post-shipment finance is defined as any loan or advance granted or any other credit provided by a bank to an
exporter of goods/services from India from the date of shipment /rendering of services to the date of
realization of the export proceeds. Post-shipment finance can be availed in rupees or foreign currency. Post-
finance/credit is generally provided in the form of:

 Export bills purchased and discounted/negotiation

 Advances against bills for collection
 Advances against duty draw-back receivables from the Government
 Advances against undrawn balances on export bills

Features of Post-shipment Finance – Packing Credit (Rupee and Foreign Currency).pdf

624 KB

Assessment of Post-shipment Credit Facility: Bills Discounting Limits (NON-LC )–

In our assessment of the export packing credit above, we arrived at the amount of Rs. 10.80 crores and Rs.
12.00 crores for post-shipment credit.

Since post-shipment follows pre-shipment, the overall export credit will be Rs. 12.00 crores, within which Rs.
10.80 crores will be pre-shipment (sub-limit).
(Image 1)

Most banks consider post-shipment credit under LC as exposure not on the party but on the bank, and bills
negotiated are outside the limits.

Image 1
Bank Guidelines for Export Credit–

It is important to understand that while assessing a proposal for export credit, the bank has an obligation to
adhere to the following guidelines:

 Exchange control regulations: detailed in the Foreign Excha

Exchange
nge Management Act (FEMA)
 Trade control regulations: Import/Export guidelines implemented through the Director General of
Foreign Trade (DGFT)
 RBI directives issued by the Exchange Control Department
 Export Credit Guarantee Corporation (ECGC) guidelines ccovering risk
 Foreign Exchange Dealers Association of India (FEDAI) guidelines regarding charges, commissions, and
the like
 International Chamber of Commerce (ICC) Uniform Customs and Practices on Documentary Credit
(UCPDC) and International Commercial TerTerms (Incoterms®)
A good understanding of the above items will help you structure export credit transactions effectively and
within the approved norms and guidelines for such credits.

What You Need to Do

When you meet with export-oriented

oriented SME clients, yo
you will need to do the following:

 Enquire and understand:

1. The business operating model, including the important details and terms of sales.
2. The overall end-to-end
end operating cycle (working capital/cash
capital/cash-to-cash
cash cycle), and the
production steps and shipping d details.
 Assess and evaluate:
1. The overall transaction risks, and identify the applicable product offering that best meets
the client’s needs as well as mitigates risk.
 2. Amount of financing required at each stage, and the liquidation mechanism.
 Structure:
1. The pre-shipment
shipment facilities so they are liquidated to post
post-shipment
shipment facilities with the bank.
2. The repayment so that the importers’ payments are the main source for liquidating the
post-shipment
shipment stage.
In addition, having understood various types of credit fac
facilities
ilities that can be made available to an exporter, you
can:

 Ascertain:
1. Whether the party has an importer
importer-exporter code (IEC).
2. Whether the exported commodity is on the banned list/negative list of the import-export
import
policy.
3. Whether the exports are against aann LC or confirmed orders, and what are the terms of
supply.
 Discuss and explore:
1. The possibility of extending PCFC/EBR to the exporter.
 Confirm:
1. That an insurance cover been obtained from the ECGC by the exporter.
2. That the credit is covered under the WTPC
WTPCG G (Whole Turnover Packing credit
Guarantee)/WTPSG (Whole Turnover Post Shipment Guarantee).
How This is Useful

M/S ABC Private Ltd. is a leading garment manufacturer and exporter, and a customer of yours for the past
two years. The company’s main busines
business is supplying their ready-made
made garments to well-known
well companies in
Abu Dhabi, Europe, and the USA. Last year they achieved a total turnover of Rs. 15.00 crores (both domestic
and exports). The company is anticipating a turnover of Rs. 18.00 crores in the coming year. Nearly 80 percent
of the turnover is from exports.

Presently, the company has working capital facilities of Rs. 3.00 crores, with a sub
sub-limit
limit for exports of 2.50
crores, divided into a pre-shipment
shipment facility of of 1.00 crores and a post
post-shipmentt credit limit of Rs. 1.50
crores.

They are seeking an overall credit facility of Rs. 4.00 crores, with a sub
sub-limit
limit for exports of Rs. 3.50 crores,
divided into a pre-shipment
shipment facility of Rs.1.50 crores and a post
post-shipment
shipment facility of Rs. 2.00 crores.

The company approaches your bank with an export order of USD $100,000 CIF (Cost, Insurance and Freight) to
supply ready-made
made garments to Brands in Abu Dhabi, to be executed within a month. The freight and
insurance is marked at 15 percent in the said contract
contract.
As per the terms of the sanction, your bank allows:
 Pre-shipment
shipment finance at a margin of 25 percent on FOB (Free on Board) value of the contract
 Interest for pre-shipment
shipment finance at the stipulated rate

The company is expecting the rupee to weaken against the USD, and hence requests that 25 percent of the
value of the contract be held in an Exchange Earners’ Foreign Currency (EEFC) account.
As per government guidelines, the company is eligible for a 2 percent Duty Drawback, which is certified by the
customs authorities. The company is seeking finance to complete the contract.

M/S ABC Private Ltd. exports the garments under the terms of the contract and submits documents covering
the full shipment against the aforesaid contract for USD $100,000. The Bill is d drawn
rawn with a 90 days usance
period. They request that the bills be purchased against the limit available.
Having understood this lesson, at the Pre
Pre-shipment stage, you will be able to:
 Assess the Working Capital Limit of Rs. 4.00 crores, including the Expor
Exportt Credit of Rs. 3.50 crores.
 Disburse either a Packing Credit in rupees or a Packing Credit in foreign currency (PCFC) available
at an internationally competitive rate.
 Calculate the FOB value or the cost of procurement, whichever is lower. The amount of the
PCL/PCFC granted shall be the FOB value minus the margin.
 Ensure that this transaction is covered under comprehensive insurance obtained by the exporter.
 Ensure that the advance to be covered is under a WTPCG (whole turnover packing credit
guarantee) of the bank.
At the Post-shipment stage,, you will be able to:
 Disburse a post-shipment
shipment facility in the form of a foreign bills purchased account (FBD), or under
an EBR scheme if sanctioned as a PCFC (after deducting the EEFC, if any) and the PCL/PCFC
granted
ed earlier to the company is closed.
 Ensure that the post-shipment
shipment credit is covered under a WTPSG.
 On realisation of the bills by credit to the nostro account, adjust the post
post-shipment
shipment extended
under FBD/EBR.
 Offer the company an advance against Duty Draw Drawback
back at a concessional rate.

You will be also able to advise the company that they can convert the value held in the EEFC account by the
end of the month, and take advantage of expected depreciation.
The options to the company available for the USD $100,00
$100,000 contract:
 Avail a PCL in rupees at the prepre-shipment
shipment stage, to be closed by availing an Advance Against Bills
for Collection (AABC) at the post
post-shipment
shipment stage to take advantage of the depreciation in the
value of rupee, if any, at the time of receipt of p
payment for the post-shipment
shipment facility.
 Avail a PCFC/EBR to avoid fluctuations in exchange rates (lenders’ conservative approach prefers
this option).
 Questions You Should Ask


 As a responsible credit official, getting answers to the following questions wi
willll enhance your capacity to
serve the customer better.
 Question 1
 Select to flip
 Have you ascertained the risk prof
profile
ile of the countries where the supplies are made?
Question 2

 What precautions are to be taken where the supplies are being shipped to a country where the risk is
high?
 Question 3
  What precautions should I put in place in case the exporter avails a PCL and the export does not take
place?
 Question 4
 How am I to handle the foreign bills discounted in not-paid?
 Question 5
 Is ECGC cover available and is a specific buyer policy needed?

Assessment of Term Loans

Introduction

The primary reason for any asset creation is its ability to generate revenue. If a loan is used finance such asset
creation, the returns generated by the investment will be the primary source of repayment.

A typical business activity starts with an investment in fixed assets such as a plant, machinery, or equipment.
Such investments are called capital investments, and they enable businesses to manufacture or trade in
products or deliver services to customers. Capital investments require long-term financing, as they generally
require a large cash outlay. Their capacity to generate cash flow over their economic life is usually measured in
years, and is subject to fluctuation.

Since the amount of a capital investment is generally large, businesses will use a combination of funding. Term
loans offered by banks enable businesses to finance such asset creation.

Because capital investments are long term in nature, they carry higher risks. Credit underwriters must
evaluate term loan proposals in light of these risks.
At the end of this lesson, you should be able to:
 Explain the need for term finance
 Explain NPV, IRR, FACR, DSCR, and BEP
 Assess a proposal for a term loan
 Explain different repayment methods and structured repayment schedules
What You Need to Know

A Term Loan (or term finance) is a fund-based facility for the purpose of acquiring capital assets through
activities such as the purchase of plant and machinery, for example, or the construction of a warehouse. The
loan is repayable in installments out of future cash flow (profits) as per a pre-determined repayment schedule
during the economic life of the asset financed.
As a credit underwriter, you understand that the economic life of the asset will deteriorate on account of its
continuous use, and that the bank loan has to be recovered within the economic life of the asset. Therefore,
when assessing term loan proposals, it is essential to analyse the expected cash flow and the factors that may
affect it over the term of the loan.
Example–

To help them increase their production capacity, M/S Belgaum Hydraulics plans to add one more lathe
machine, at the cost of Rs. 15.00 lacs. The proprietor of the unit, Mr. Raghunath, has made an advance
payment of Rs. 5.00 lacs to the suppliers, and is requesting credit support of Rs. 10.00 lacs.

The Bank agrees to provide a term loan of Rs. 10.00 lacs towards the purchase of the lathe machine. The
additional machinery will facilitate increased sales. The additional income generated will repay the loan in
installments over a period of time.
As you assess the proposal
oposal outlined in the above scenario, you will want to know, among other things, the
lead time from the installation of the machinery to the commencement of commercial production, the
projected economic life of the asset, and its capacity to generate inco
income
me to service the loan. The technical and
economic viability reports (TEV reports) provide detailed information in this regard.

In addition to the TEV reports, it is equally important to assess the promoter’s credibility and analyse the
business’s key financial
ncial indicators. It will be prudent for you to evaluate the following to ensure an objective
credit decision:

 Is the cash inflow (revenue) more than cash outflow (investment)?

 What is the rate of return on the investment?
 What is the minimum level of capacapacity utilisation to cover costs?
 If debt is used to finance, will the revenue generated cover loan obligations?
 What factors affect business and revenue generation?
 What is the security value in comparison to the loan amount?
Financial tools such as net present
resent value (NPV), internal rate of return (IRR) , break
break-even
even point (BEP), debt
service coverage ratio (DSCR) and fixed asset coverage ratio (FACR) help determine the required inputs. While
each of these tools answers the specific questions posed above, w when
hen applied simultaneously, they enable
credit underwriters with clear insights on the viability of the capital investment.

What You Need to Know, continued.

As a lender, you need to find out:

 Whether the present value of future cash flows are higher than the capital investment
made
 Whether it is viable to fund the project and provide term loan
 What is the economic value added to the unit by the proposed capital investment

Net present value (NPV) is the simplest of the tools to identify the economic viab
viability
ility of a capital investment.
A typical capital investment will require a cash outflow at the time of investment and generate a series of cash
inflows over its economic life. While the outflow is immediate and in the present, the inflows are all in the
future.
uture. Hence, to compare present outflow and future inflows, a discounting factor is used on the inflows. A
project is economically viable only when the present value of all future cash inflows is greater than the present
outflow. A positive NPV indicates economic viability.

Example–

Srinivas Enterprises – Capital Investment in Plant and Machinery

 Initial Capital Investment in Fixed Assets = Rs. 20,000

 Estimated Life of the Asset = 5 years
 Residual Value = Rs. 1,000
Is the cash inflow (revenue) more than cash outflow (investment)?
A positive NPV indicates that the revenue of the project is higher than the investment.

Internal Rate of Return (IRR)

What You Need to Know, continued.

What is the rate of return on the investment?

The internal rate of return (IRR) is a rate at which the present value of cash inflows and present value of cash
outflows are equal in a given period. This is a reflection of the returns generated by the investment.

A project will be unable to repay loan obligations if the returns are lower than the interest charged. The IRR
will also provide insights to the level of involvement by the business. Typically projects with low returns lose
business interest and eventually turn bad.
Because the IRR helps us identify the returns generated by the investment, comparing the IRR with interest
rate of the loan will provide insight into the repayment capacity of the investment. If the IRR is greater than
the interest rate, the project is acceptable.
Example–

An investment (in fixed assets) of Rs. 100 yields cash inflows of Rs. 25 at the end of every year for the next five
years.

Situation 1: Taking into the projected Even cash flows per year at Rs. 25 for the next 5 years.
Situation 2: Taking into the projected Even cash flows per year at Rs. 30 for the next 5 years.
Situation 3: Taking into the projected Un-even cash flows for the next 5 years.

Observations: It can be observed from the above situations, the investment of Rs.100 in the first case is not
viable as the NPV is negative and IRR is less than the discounted rate. In the second and third situations, the
investment is viable as the NPV is positive with IRR at 15% and 14% respectively higher than the discounted
rate. The discount rate is taken at 10% in all the three situations. Between the situations (2) and (3), situation
No. 2 is more viable and acceptable.

Break-Even Point (BEP)

What You Need to Know, continued.

The break-even point (BEP) is the level of operations where there is no net loss or profit.

 Expenses = Revenues
 Profit = Sales − Total Cost

The BEP is important from two perspectives. First, to understand the minimum level of operations required to
meet costs and second, the time taken to achieve this.

The Total Cost is a combination of the variable costs and fixed costs that the unit has to recover to break even
at the earliest point.

Examples of Variable Costs: Raw materials consumed, labour charges. These expenses have a direct
relationship with the level of activity.
Examples of Fixed Costs (FC): Rent, salaries, administrative expenses. These do not vary with the level of
production.

The margin of safety is defined as the excess of actual sales over break-even sales. It is used to help estimate:

 The impact of any deterioration in actual sales on the profits of the unit
 Whether the unit is able to operate above the BEP in spite of deterioration in the sales
levels.
The higher the actual sales above the break-even sales, the better the margin of safety.
Calculation of the Break-Even Point–

BEP in units = Fixed Cost ÷ Contribution per unit

 BEP in Rupees = BEP in units × sales price per unit.

 BEP in capacity = No. of units at BEP ÷ Total Capacity × 100
 Contribution = Sales – Variable Cost
 Margin of safety = Actual sales – BEP sales, expressed in percentage
Note: A business can generate profits to repay its term loan installments only when it operates above the
break-even point. The business has to generate adequate profits, which should be more than the Term Loan
repayment obligations (interest and principal amount).
Example–

Tasty Foods, a popular restaurant manufacturing and selling pizzas, has approached the bank for a term loan
and has provided the following details during discussions.

The unit is selling pizzas at Rs. 40.00 per pizza.

We see that Tasty Foods is able to recover its variable cost of Rs. 25 per pizza. The excess of Rs. 15 (Rs. 40
minus Rs. 25) is the contribution in units available to meet fixed costs.

How many pizzas does Tasty Foods need to sell to recover its fixed costs and operate at the break-even point?
Debt Service Coverage Ratio (DSCR)

What You Need to Know, continued.

In term finance, we also need to find out whether the Term Loan repayment obligations are sufficiently
covered by the profits, and determine the borrower’s ability to repay the interest and principal amount.

Debt Service Coverage Ratio (DSCR) will help measure the ability of a borrower to meet its repayment
obligations. DSCR ratio acts as a guide to determine the period of loan and arrive at an appropriate repayment
schedule. This ratio indicates whether the profits projected are adequate to service the interest burden and
installments of the loan.

Important Points to Note–

  DSCR has to be worked out for the project on a stand-alone basis, as well as for the
business as a whole, taking into account the existing term loan obligations and the
proposed term loan obligations.
 Depreciation is added back as it is a notional/non-cash expenditure and there is no outflow
of cash.
 DSCR has to be worked for each year and average DSCR for the entire period of the loan.
The rationale for DSCR Analysis–

The rationale for a DSCR analysis is to ensure that a business will be able to honour its repayment obligations
based on both the stand-alone DSCR for each year and the average DSCR.

It must be noted that DSCR is only one of the indicators, and it needs to be analysed along with other tools to
ensure the economic viability and feasibility of the activity.

Generally, if the projected DSCR for the unit is above the benchmark DSCR of 1.5:1, it indicates that a business
can generate adequate income to service the interest and installment obligations of the proposed term loan.
The actual cash flow can vary from the repayment ability indicated by the DSCR for a number of reasons,
including various changes in the operating cycle. The lender has to analyse the cash flows in addition to the
DSCR to align the repayment structure.
Example–

The repayment of installments could be monthly, quarterly, half-yearly, and/or yearly, based on the cash
flows.

Sensitivity Analysis

What You Need to Know, continued.

A term loan is for a longer period of time, and a business will always be subject to changes in the market
environment. Hence, the viability of the business activity is also to be tested against the market changes
anticipated and their impact on:
  Sales
 Production costs
 Revenue generation

A sensitivity analysis evaluates the impact of changes on business conditions over the projected performance
and profitability of the project, as any adverse movement will impact repayment of the loan.
Example–

Fixed Assets Coverage Ratio (FACR)

What You Need to Know, continued.

The Fixed Assets Coverage Ratio (FACR) indicates the extent of fixed assets available to long-term borrowed
funds.

From a credit risk management perspective, the depreciated value of the capital assets financed by the bank
must always be higher than the term loan outstanding.

Example–
We can see that the term loan is fully covered by the written-down value (WDV) of the assets, financed with a
sufficient margin ranging from 0.33 (highest) to 0.28 (lowest).

As a lender, in addition to analysing the FACR, you need to know the other factors that may affect the value of
the security, and therefore the recovery of the loan.

Assessment of Term Loan Proposals

What You Need to Know, continued.

Having understood the various tools used in a term loan assessment and their utility, the next step is
understanding how to assess a term loan application of an SME unit.
The term loan appraisal comprises the following components:
 Appraisal of the borrower, which must provide insight on the honesty and integrity of the
borrower, the market standing of the enterprise, and managerial competence. Sources could
include CIBIL reports, trade circle enquiries, the conduct of existing loan accounts, external rating
agency reports, and the RBI defaulters list.
 Appraisal of the project covers technical, commercial, and financial appraisal of the project.
 Technical feasibility study covers analysis of the technology involved in the project, the
requirement and availability of resources, the environmental impact, and necessary government
licenses. You will assess:
 Whether the machinery is available locally and/or imported
 If the machinery is imported, the impact of changes in foreign currency rates on the costs
 Details of the suppliers
 Project implementation plan
o Expected date of trial production and commercial production
o Alternate action plans in case of any unexpected cost over-run or time over-run
 Commercial viability study covers analysis of the line of business activity, demand and supply,
competition, business strategy and sustainability.
 Financial appraisal covers
 Analysis of past financial performance and impact of proposed capital investment
o Key financial indicators like Debt Equity ratio and TOL/TNW ratio
 Reasonability of estimates and projections
o Comparison of key financial indicators with the benchmark financial indicators of
the loan policy
o If deviations are there, whether the same is reasonable and in line with the industry
trends
o Expected plan of action of the management for improvement in the financial
indicators and time frame.
 Cost of project – Sources of finance, Owners contribution

Analysis of NPV, IRR, BEP, DSCR, Sensitivity analysis & FACR

Repayment Methods

What You Need to Know, continued.

The repayment method for a term loan must be structured appropriately, otherwise a business may find it
difficult to service their loan installments, and the value of the loan asset will deteriorate.

The repayment program depends upon the frequency of income generation and adequacy of income to cover
both interest and installment obligations. Some income generating activities are continuous throughout the
year while other activities may generate income incrementally, but not continuously, after a specific period.
The repayment method depends upon the frequency and pattern of income generation. For example, an SME
unit engaged in transport services will generate income on a daily and/or monthly basis, whereas an SME
entrepreneur engaged in a civil contract business generally generates income at the end of the contract
and/or at frequent intervals, but not on daily basis. The following is a summary of the various repayment
methods:
 Equated monthly installments (EMI): Where the repayment includes principal and interest
equally distributed over the repayment period. EMI is generally applied for non-business loans
such as housing and educational loans.
 Principal Equally Distributed (PED): Where the interest is a part of a business’s expenditures. The
principal loan repayment is equally distributed over the repayment period and the liability to the
bank is reduced. PED is generally applied for business loans, and payments made at monthly
intervals when the income generation is continuous and consistent.
 Balloon repayment method: Where the amount of the repayment installments are increased
incrementally at regular intervals. This method is generally applied for business activities where
the income generation is expected to increase at regular intervals.
Example: M/S All Well Pvt. Ltd is presently operating at 50 percent of installed capacity and is expected to
operate at a growth of 10 percent a year. We can observe that the production levels are reflecting an
incremental increase at a year-on-year basis, and the profits are also expected to be in line with these levels.
We can therefore adopt the balloon repayment method.
 Bullet repayment method: Where full repayment is made in a single installment as the income is
expected in bulk at the end of a particular period.

Example: M/S Road Repairs Pvt. Ltd. is executing a stretch of road construction within the next 12
months. In this case, the company will receive payment only on completion of the contract at the
end of 12 months, so we can stipulate the bullet repayment method for the loan.
Note: In the case of a balloon repayment, there will be a gradual and incremental repayment, whereas for a
bullet repayment, the repayment will be in one lump sum on the due date, and there will be no prior
installment payment other than interest servicing.

Structuring a Repayment Schedule

What You Need to Know, continued.

As explained above, the repayment method depends upon the type of activity. The borrower has to be
informed about the repayment schedule, installment amount, and due date. A lender will consult the
repayment schedule to follow up the recovery of installments and take necessary measures if there is any
delay and/or default in repayments.
Generally, the terms of the loan will allow a “repayment holiday” or moratorium period to cover the period to
install the machinery, run a trial production, and commence commercial production. This will ensure that the
business can generate profits as per their projections and ccommence
ommence repayment of the term loan.
Example Structure of a Repayment Schedule
A term loan to an SME manufacturing unit of Rs. 4,80,000 has been approved. The loan is repayable in 48
monthly installments of Rs. 10,000 per month, with repayment to commence from December. The method of
repayment is principal equally distributed (PED), as the business is expected to generate continuous and
consistent income. The repayment structure is shown in the table below.

What You Need to Do

Term loans are generally secured

ecured by an asset and have a longer tenure. The key challenge in a term loan
assessment is to determine the capacity of the asset created to generate adequate cash flows. Since the cash
flows are spread over the economic life of the asset, it is prudent ffor
or the lender to focus on the following.

 Find out
 Whether the proposed machinery is a replacement and/or an addition to the existing
machinery
 What, in the case of a replacement, the improvement in production capacity would be and
how much costs will be re
reduced
 What, in the case of new machinery, is the incremental business and income expected
 The cost of the proposed machinery and the sources of margin
 The competitive pricing for the proposed new machinery
 Whether the proposal complies with the loan pol policy guidelines
 Details of the suppliers and their expertise in providing post
post-sales
sales services
 Whether the unit has the skilled labour to operate the machinery
 The economic life of the proposed machinery
 The installed capacity and the expected capacity utiutilisation
  Whether the market is generally conducive to the management’s plans?
 Discuss
 The availability of a sufficient power supply and the availability of necessary approvals
 Alternate arrangements to ensure continuous production in the case of power failuresfai
 Continuous availability of raw materials and alternate arrangements
 Details of new customers and ready orders on on-hand
 Decide
 Whether the cash accruals justify the proposed capital investment made
 Whether the management has the necessary capacity a and
nd business acumen to encash the
market opportunity
 If, in the case of the projected DSCR, the IRR is not in line with policy guidelines, what are
the alternate solutions
 The amount of the loan, the repayment method, and the structure of the repayment
schedule
 Whether the existing working capital is adequate, or if there is a need for additional
working capital. If there is such a need, discern the sources of the company’s margin
contribution for the additional working capital.

How This is Useful

M/S Vinay
nay Concrete Poles Enterprises is a partnership firm engaged in manufacturing electrical poles. They
have long-term
term contracts with various state governments and presently hold the following facilities with our
branch:

 Cash credit facility of Rs. 50.00 lacs

 Term facility of Rs. 150.00 lacs.

The firm participated in the tenders called by South

South-Western
Western Railways, and has succeeded in the bid. They
have been allotted the tender to manufacture cement concrete railway sleepers, and the contract is valid for
the next five years. This contract will improve their sales by 15 percent and will increase profits.

They are planning to install additional machinery to execute the orders. The cost of the machinery is Rs.
200.00 lacs. They have obtained a proforma invoice aand
nd have made an advance payment of Rs. 25.00 lacs to
the suppliers of machinery. Mr. Shekhar, one of the firm’s partners, has submitted the audited financial
statements for the previous two years along with current year estimates and projections for the next
ne five
years. Mr. Shekhar has requested early processing of the loan approval.

With the knowledge from this lesson, you are now able to:

 Link your analysis of financial indicators to the term loan assessment

 Analyse the capital investment decision based on the NPV, IRR, BEP and DSCR
 Decide on the loan amount and repayment method
 Structure the repayment program
Questions You Should Ask

When assessing a typical term loan, in addition to your assessment of financial indicators, you must also
analyse the possible impact of external factors on cash flows. Answers to the questions below will enable you
to make a more informed credit decision.
Question 1
Select to flip
Am I convinced about the projected sales and other financial indicators of the unit?
Question 2
What are the industry trends that could impact performance and revenue generation?
Question 3
Will the firm require
quire additional working capital? What are the sources of their margin contribution?
Question 4
Are there any government subsidies available to the unit?
Question 5
Are there any government schemes to manage credit risk?

Letter of Credit
Introduction

Business
ness transactions often involve both domestic and overseas trade, which could involve the purchase of
raw material, the purchase of capital goods such as machinery and equipment, or the sale of finished goods.

While the availability of cash acts as a lubr

lubricant
icant for the smooth functioning of such trade, businesses must use
the available cash prudently, and so also use credit facilities from suppliers of goods and services.

Because buyers and sellers do not necessarily know each other, the trust deficit betwbetween
een the buyer and the
supplier limits the extension of credit facilities from suppliers. Such limitations compel an enterprise to use
cash that could otherwise have been put to alternate use. Hence, businesses are challenged to transact or
make advance payments
ments or extend credit facilities to enable trade.

While non-fund-basedbased facilities do not involve cash outflows for the bank or the business in the normal course
of operations, they involve risks in the event of devolvement/invocation. Hence, banks need to t assess such
facilities in light of risks from devolvement/invocation.

In this lesson, we will discuss the assessment process for a Letter of Credit (LC), the risks involved, and the
specific laws governing LC facilities.
At the end of this lesson, you should
hould be able to:
 Explain non-fund-based
based facilities
 Identify the need for a Letter of Credit facility
 Assess the Letter of Credit limit under normal and seasonal business activities
 List the various articles of the Uniform Customs and Practice for Documen
Documentarytary Credits (UCP 600)
 Identify the various risks involved in the execution of a Letter of Credit
What You Need to Know
When banks act primarily as underwriters, committing funds to a seller on the due date, such facilities are
referred to as non-fund-based
ed facilities as the customer’s business requirements are taken care of while there
is no immediate outflow of funds from the bank. There are a number of different non
non-fund
fund-based facilities:

 Letter of Credit (LC)

A letter of credit (LC) is a written commit
commitment
ment issued by a bank on behalf of an importer. The LC provides
assurance to the Beneficiary that payment will be made.

 Bank Guarantees (BG)

A Bank Guarantee is an assurance from a bank that the liabilities of the principal to the Beneficiary will be met
in
n the event of failure to fulfill contractual obligations.

 Deferred Payment Guarantees (DPG)

A Deferred Payment Guarantee is generally issued for the purchase of capital goods such as high-value
high
machinery. The vendor agrees to installment payments for the value of the machinery, subject to a
commitment from a bank assuring payment of the installments on the due date in case of default by the
purchaser. A DPG acts a substitute for a term loan, and all the credit risk applicable to a term loan assessment
has to be analysed in detail when issuing a DPG.
This lesson focuses on the Letter of Credit.

Letter of Credit Facility

What You Need to Know, continued.

A letter of credit (LC), also known as a Documentary Credit, is a written commitment issued by a bank on the
request of an importer confirming that payment will be made to the Beneficiary (the supplier) provided that
the terms and conditions stated in the LC have been met as evidenced by the presentation of specified
documents.

A Letter of Credit (LC) facility

ity has the following features:

 Assures payment to suppliers subject to the fulfillment of the terms of the LC

 Facilitates suppliers to discount the bills under LC with their bankers
  Allows better management of the working capital cycle
 The buyer is assured
red of documents and delivery of goods as per the terms of LC
Parties to a Letter of Credit–

Types of Letter of Credit–

Banks issue different types of letters of credit, which in turn depend upon the trade agreement and payment
terms between the buyer and d seller. An overview of the different types of LCs issued by banks is listed below.
Assessment of Letter of Credit Limit (Normal and Seasonal Business Activities)

What You Need to Know, continued.

Business entities may need a letter of credit as a one-time measure and/or on a recurring basis. The request
for an LC could be either for the purchase of raw materials and/or fixed assets such as equipment and
machinery. Where the request for an LC is on a regular basis, such as for the import or purchase of raw
materials to ensure continuity of the working capital cycle, a bank will usually approve a regular LC limit for a
period of one year.

The conduct and utilisation of the LC limit is monitored regularly. The basic information required for an
assessment of an LC is:

A. Approximate value of the annual purchases under an LC

B. Lead time from opening of the LC to the shipment/loading of goods

C. Transit period from the shipment of goods until the goods reach the buyer’s factory
D. Credit period or usance period, if any, allowed by the suppliers
The sum of B + C + D is called the purchase cycle. The purchase cycle begins with the placement of the
purchase order by the buyers and ends with the payment of the bills under the LC.
Example–

M/S Auto India – an SME customer, provided the following information with their request for a regular LC
limit. The unit procures raw materials from both the domestic and international market. The payment terms
for an inland LC are on a documents against acceptance (DA) basis, and for imports, the payment terms are on
a documents against payment (DP) basis.

The shipment and loading period is seven days. The transit period is eight days for domestic purchases and 23
days for imports. The credit period allowed by the exporter supplier is 60 days from the date of shipment.
Annual purchases under the LC are Rs. 300.00 lacs (domestic purchases, Rs. 100.00 lacs and imports from
Germany, Rs. 200.00 lacs).

The letter of credit limit for M/S Auto India is assessed as below:

(Letter of Credit Limit = Annual Purchases Under LC x Purchase Cycle /365)

The LC Limit would be in force for a period of two months from August to September, with due dates as per
the terms of the LC.

The LC limit may be requested to meet domestic purchases and/or imports. When issuing LCs, credit
underwriters must identify the reasons for the LC requirements and ensure that:

 In the case of inland LCs, the LC is not requested for transactions from sister concerns
(inter-firm purchases)
 The LC period is within the normal operating cycle, and that specific reasons are stated for
any request when the usance period is outside the normal operating cycle. Suitable
adjustments are to be made when arriving at the DP.
 The integrity of the exporter is assessed in exceptional cases, such as if the imports are for
the first time from a new supplier (in this regard, external agency support, such as a D&B
report, could be useful).
Assessment of LC Limit for Seasonal Activities–
In the case of seasonal activities, raw materials are available only during a particular season, so the unit has to
stock sufficient quantities to ensure continuous production throughout the year. As such, the assessment of
the LC limit is slightly different than for regular activities.

The basic information required would be the same as detailed in the table above. However, as the availability
of raw materials is seasonal, the following details must also be taken into account when assessing the LC limit.

 The season or period during which the raw materials are available
 The quantity required by the unit to ensure production throughout the year
 The credit period allowed by the suppliers and the transit period.

Various Articles of Uniform Customs and Practices (UCP 600)

What You Need to Know, continued.

A letter of credit transaction involves various parties spread across different geographical regions and
countries. The parties operate under different legal systems and jurisdictions. Therefore, the settlement of any
dispute arising out of any terms and conditions of the LC may be too complex to proceed through the normal
legal channels. Against this backdrop, the ICC (International Chamber of Commerce), which was established in
1919 with the primary objective of facilitating the flow of international trade, has codified and published a
common set of rules applicable to documentary credits in order to:

 Alleviate the confusion caused by individual countries’ national rules on letter of credit
transactions
 Create a set of contractual rules that would establish uniformity in the letter of credit
transactions
 Establish commonality of the trade terms and protect the interest of all the parties to the
letter of credit transactions.
The document codifying the rules applicable to documentary credits is known as the Uniform Customs and
Practices for Documentary Credits (UCP). Most of the trading countries have subscribed to this ICC document
and the UCP rules are valid in these countries. It is important to note that UCP is neither an international
convention, nor a law. Presently UCP 600 is in effect. UCP 600 contains 39 articles.
Important Articles of the UCP 600–

A few important articles of the UCP 600 are listed below:

The Major Risk Factors in LC Operations

What You Need to Know, continued.

As discussed in this lesson, a letter of credit is useful to both the buyer and seller of goods to take care of their
business needs. However, there are certain inherent risks in LC operations, as the issuing bank/opening bank is
committed to making payment to the supplier (the Beneficiary of the LC). Understanding the risk factors in LC
operations will enable an SME lender to take a prudent decision while providing these facilities and mitigating
the inherent risks. The major risk factors in LC operations (from the point of view of the issuing bank) are:
 Political risk: Factors beyond the control of the importer and or exporter may affect the payment
(non-payment risk to the exporter) and/or delivery of the goods (non-delivery risk to the
importer). Examples of such political risk include civil wars, politically motivated disturbances,
restrictions by the government on foreign currency transfers, and trade bans. The issuing bank
may not be able to honour its commitment in these circumstances.
 Fraud: Fraud risk in international trade is comparatively higher than in domestic trade. The
volume of trade is generally larger than domestic trade and it is difficult to compensate the loss
that may occur on account of fraudulent trade transactions. Examples of fraud risk include
fictitious shipments, forged documents, and goods shipped other than the goods described in the
LC.
  Payment risk – Insolvency risk of the Applicant to the LC: If there is an adverse change in the
financial position of the Applicant to the LC, the issuing bank may not be able to recover the LC
amount that has already been paid to the Beneficiary of the LC.
 Rejection of the import documents by the Applicant: Applicant refuses to accept the documents
under the LC on account of a dispute between the buyer and the suppsupplier.
 Non-payment
payment of the LC on the due date: Willful default by the Applicant to the LC in payment of
the LC bills on the due date.

What You Need to Do

A letter of credit allows a unit to procure raw materials at the supply stage of the operating cycle. Cash is
realised at the collection stage, at the end of the cycle. As a lender, you will need to ensure that the cash flows
and LC payment obligations are aligned. You will need to take the following actions to ensure an objective
assessment of the letter of credit facility.
 Discern the need for the letter of credit (LC) and analyse the operating cycle.
 Understand the LC terms and discuss any of the onerous clauses in the LC.
 Find out the previous track record of the Applicant and if there have been any defaults.
de
 Ensure the Applicant is capable of bringing in the margin, and verify the sources of the margin.
 Analyse the cash flow statement, the factors that may affect the cash flow, and the preparedness
of the unit to address these factors.
 The risks involved ed and the risk mitigants thereon.
 Arrive at the LC limit.
 Underwrite the exposure as if the LC was to be drawn.
 Be familiar with the UCP 600 guidelines for LC transactions.
 Diarise the due dates and follow
follow-up on payments.

How This is Useful

Mr. Satish, a partner of M/S Auto India Pvt. Ltd, and one of your valued customers, has a cash credit limit of
Rs. 50.00 lacs and a term loan of Rs. 25.00 lacs. He informs you that M/S Auto has signed an agreement with
Motors India Ltd. to supply spare parts for the next five years. In this regard, they need to import certain
customised components on a regular basis, and the suppliers in Germany have agreed to supply the goods
against an LC, with a payment period of 60 days.
The above scenario illustrates the need for an LC limit and how it would be beneficial to a business. From the
knowledge you have gained in this lesson, you know what details you will have to obtain in order to assess the
LC limit. You also know which UCP articles are applicable to the LC terms for these imports. You also know the
steps you will have to take to ensure that M/S Auto can pay their bills on the due date.

Questions You Should Ask

Now that you understand the process for assessing an LC, as you proceed with an assessment, is also
important
tant to consider the following questions:
Question 1
Select to flip
What is the arrangement made for payment (retir(retirement)
ement) of the bills under LCs. Are funded facilities available?
Question 2
If the LC was drawn, how would the borrower repay the bank?
Question 3
How well does the buyer manage currency risk?
Question 4
What is the likely action plan in the event of devolv
devolvement?
Question 5
What fallback or alternate funding options are available for any unforeseen disturbance in cash flows?
Question 6
Are there any other business obligations bunching up with the maturity of the LC?

Bank Guarantee
Introduction

In the previous
us lesson, you learned about the various types of non
non-fund-based
based credit facilities offered by
banks. In this lesson, we focus specifically on bank guarantees (BGs).

Business entities frequently enter into commercial transactions with other businesses. The relationship
between the businesses may be a buyerbuyer-seller, principal-agent, or contractee-contractor
contractor arrangement. In a
buyer-seller
seller relationship, a letter of credit is commonly used to minimise the risk of non-payment
non to the seller.
However, letters of credit
dit are less appropriate when nonnon-performance is a risk.

In the case of principal-agent

agent and contractee
contractee-contractor relationships, non-performance
performance is a major risk for the
principal and the contractee respectively.

In such arrangements, one contracting part

party seeks to mitigate the risk of non-payment,
payment, whereas the other
wants protection against non-performance.
performance. Thus, they look for an intermediary to protect the interest of both
parties on mutually acceptable terms. Banks meet this need by extending BGs.
At the end of this lesson, you should be able to:
 Explain the need for bank guarantees
 Explain types of bank guarantees
 Assess the bank guarantee limit
 Identify the various risks in bank guarantee operations

What You Need to Know

A bank guarantee (BG) is a financial

ncial instrument issued by a bank to assure a third party of payment for or
performance of an obligation.
There are three parties to a BG:
 Applicant (the agent or contractor)
 Beneficiary (the principal or contractee)
 Issuing bank (the applicant’s bank)
The
he role of the issuing bank is to compensate the beneficiary for any losses incurred as a result of default or
delay by the other party to the contract.

Key Benefits of a Bank Guarantee–

 A BG allows the applicant to meet its contractual obligations to a supplier or vendor, while
having the comfort of cash held in its name on deposit with the bank.
 The deposit funds held as security attract prevailing credit interest rates on the full amount
of the deposit. Interest earned is paid to the applicant’s nominated
nated transaction account.
 For the beneficiary (the supplier or vendor) it provides assurance of payment if they make
a written demand to the bank on the guarantee. There is no need for them to hold or
manage individual bonds from their customers.
Uses of Bank Guarantees–

 Participation in tenders (e.g., tenders for large government projects)

 Participation in contracts requiring a guarantee of performance of obligations (e.g., a
contracts for construction of roads)
 Participation in contracts requiring that mmargins
argins be maintained (e.g., stock exchange and
broker contracts)
 Purchase of goods on credit.
Features of a Bank Guarantee–

The amount guaranteed is specific

The guarantee has a definite expiry date
The guarantee contract has no onerous clauses
A standard indemnity clause restricts the bank’s liability to the guarantee amount.
Example: Importance of Bank Guarantees
Guarantees–

The following example shows how a BG works and illustrates its importance to both parties in a contract.

National Highways Authority of India (NHAI) is calling for tenders to maintain the nationally owned highway
between Jaipur and Delhi. NHAI stipulates that a security deposit of Rs. 10.00 lacs (known as an earnest money
deposit, or EMD) must be made by any applicant wishing to participate in the tender.
The EMD is required to guard against situations where the entity awarded the contract rejects, delays
commencement of, or abandons the work under contract, or otherwise brings costs or losses to NHAI.

NHAI also provides for submission of a BG by participating business entities as an alternative to a security
deposit. The provision for a BG allows the business enterprises to participate in the tenders without blocking
their funds.
Types of Bank Guarantees

What You Need to Know, continued.

Bank guarantees are broadly classified into two categories:

 Financial Guarantees
o Financial guarantees are direct credit substitutes whereby a bank irrevocably
undertakes to guarantee the payment of a contractual financial obligation. This
type of guarantee assures the payment of money to the beneficiary in case of
default or incomplete payment by the applicant according to the terms of the
contract.

 Performance Guarantees
o A performance guarantee provides assurance of compensation for any loss suffered
by the beneficiary in the event of inadequate or delayed performance or of non-
performance of a contractual obligation by the applicant. It is important to note
that the bank does not agree to perform the contract; it merely commits to paying
the guaranteed amount to the beneficiary if the applicant fails to perform the
contract.

Example:
A contractor has been allotted a contract for a government road construction project. The government
authorities ask for a guarantee that the work will be executed according to the terms of the contract. The
contractor approaches the bank for the issue of a performance guarantee, under which bank agrees to
compensate the beneficiary (i.e., the government) for any loss suffered in case the construction company
delays or does not complete the project as agreed.

Several types of bank guarantees that fall within the two categories are described below.
Assessment of a Bank Guarantee (BG) Limit

What You Need to Know, continued.

To assess the limit on a BG, the following information is required:
 The number and value of tenders the business is expected to participate in
 The value of contracts on hand
 The type of BG required
 The terms and conditions of the BG
 The expiry date of any existing BG
 Whether renewal of a BG already issued is required

The particulars of a BG limit assessment are described below. In the case of a first-time assessment, items A,
F, and G are not applicable.
Example: Bank Guarantee Limit Assessment

What You Need to Know, continued.

M/S Vibrant Electronics Bangalore is engaged in the manufacture of electronic components and are supplying
to Indian Railways. The business has been dealing with the bank since 2012.

The company currently has the following facilities.

Mr. Vikram, a partner of the firm, mentioned that the central government has called for tenders for the supply
of electronic components for various undertakings. These tenders involve several departments and will be
recurring in nature. Mr. Vikram requested a regular BG limit to allow for regular participation in these tenders.
The following details are available to you:

 The company will participate, on average, in 50 tenders a year, with each tender valued at Rs. 10
lacs.
 They anticipate that at least 10 Tenders will be allotted to them – a success rate of 20%.
 The EMD put up as security on each tender will be 10%.
 Eligible for an advance payment of 15% of the contract value if a suitable Bank Guarantee is
furnished at 100% of the advance payment.
 The government authorities will hold back 5% of the bill amount on delivery for a period of one
year or will release the full amount against the bank guarantee for the retention amount.
 Mr. Vikram further mentioned that they may request cancellation of a few BGs amounting to Rs.
50 lacs during the year.
 They may also request renewal of a few BGs amounting to Rs. 25 lacs
Thus, the BG limit assessment is as follows:
Operational Aspects of BG
What You Need to Know, continued.

Bank guarantees must comply with the following operational rules:

 The guarantee must be issued on bank’s standard security documents.
 The documentation process must be completed for the entire BG limit.
 The bank must obtain a counter guarantee from the applicant for the entire BG limit approved.
 If the applicant is a company, the registration charges must be completed with the registrar of
companies.
 The margin money deposit must be marked “lien”.
 The guarantee contract should not contain any onerous clauses.
 Indicate the expiry date of BGs and ensure the timely return of the original BG by the beneficiary.
 Any claim must be settled without delay and followed up with the applicant for recovery.
Risks Involved in BG Operations–

A BG is an irrevocable undertaking by the issuing bank to the beneficiary. Any default by the applicant will
result in a claim by the beneficiary and an outflow of funds from the Bank. Therefore, credit risk is a key
concern, and the company must be analysed for such risks before setting up a BG limit.

The risk involved in BG operations are summarised as follows:

 In case of any claim or invocation, they must pay the guaranteed amount to the
beneficiary without delay or recourse.
  Any delay or failure in executing an obligation according to the terms of the contract, may
result in the beneficiary lodging a claim or invokin
invoking the BG.
 The applicant may be unable to make good the amount claimed by the beneficiary to the
BG.
 Disputes may arise between the applicant and the beneficiary, and the bank may be made
a party to the dispute.
Invocation of a BG–

Bank guarantees are invoked

ed under the following circumstances:

A bid bond guarantee is invoked if the applicant fails to accept the contract awarded in a
bid.
 An advance money guarantee is invoked if the applicant fails to begin the work contracted
for or fails to maintain the re
required time schedules.
 A retention money guarantee is invoked if, after completing the contract in full or in
stages, and where bills have been submitted and settled by the authorities, it turns out at a
later date that quality specifications were not comp
compiled
iled in the execution of the contract.
 A performance guarantee is invoked if the applicant delays or does not complete the work
contracted for within the required time frame, or does not adhere to standards of
performance of sufficient quality.
What You Need to Do

You have now learned how BGs facilitate businesses in the execution of contracts. While issuing BGs, the
lender must understand that, though a BG is a non non-fund-based
based facility, there could be situations where the
applicant to the BG may default in executing the contract. Such a situation could result in the BG converting to
a fund-based exposure for the lender.
You can safeguard the lender’s interest by considering the following aspects in respect to the applicant:
 Whether the applicant is techn
technically competent to execute the contract
 Whether the applicant is capable of bringing in margin and the sources of that margin
 The previous experience of the applicant in the execution of similar contracts
In processing such proposals, you must:
 Identify the
he factors that may adversely affect the applicant to execute the contract.
 Determine how the business is prepared to overcome such adverse factors.
 Before setting up the limit, discuss the expected level of improvement in the business volumes.
 Identify the
he collateral security the business could offer towards the BG limit.
Identify the risks involved in issuing a BG.
 Discuss whether the business requires any fundfund-based
based facilities to finance the underlying
contracts.
Finally, you must:
 Identify the type of BG facility to issue and the appropriate limit.
 Identify the options available to mitigate risk.
 Identify the means of recovery in case of invocation.
  Assess acceptability, marketability, and enforceability of the collateral security offered.
How This is Useful

Mr. Ashok is a partner of M/S Ashok Dall Mills, a company engaged in the processing of pulses and other food
grains. The company presently has a fund
fund-based
based credit facility. Mr. Ashok mentions that the defence ministry
of the Government of India hass called for tenders for the supply of pulses to their centres across the country.
The proposed contract is for a period of two years, and the tender value is 10 Crs. per annum.
Mr. Ashok further mentioned that:
 They are soon expecting similar tenders botbothh from other government departments and from non- non
government entities. They foresee a good business opportunity.
 They are planning to participate in these tenders and supply the products.

Mr. Ashok requests a regular BG limit in addition to the present cash credit limit of Rs. 1.00 Crs.
As you learned in this lesson, to process Mr. Ashok’s request of a BG, you need to consider the following
factors:
 Purpose and type of BG required
 Whether the purpose of the BG complies with policy guidelines of your bank.
 The method used to assess the BG Limit
 The risks involved if BGs are issued
 Whether any collateral security is needed
 The sources of cash margin
 Whether the BG to be issued contains any onerous clauses and, if so, how to protect bank’s
interests
 Questions You Should Ask


 Having learnt the process of assessing BG limits, you may come across situations where a business may
ask for BGs of longer tenure to cover different purposes or varied terms of contract. In such situations,
you must understand the terms of contract and adhere to both internal (your bank’s) and RBI
guidelines for BG transactions.
 To facilitate the issuance of BGs that meet those guidelines, you should ask the following questions:
Question 1
 Select to flip
 Does the BG tenure conform to the RBI guidelines for BGs?
Question 2

 Is the performance guarantee in conformity with the line of activity of the app
applicant?
licant?
 Question 3
 Is the BG amount in line with the value and terms of the contract?
 Question 4
 In the event the guarantee is invoked, how will the borrower repay the bank?
Buyers’ Credit
Introduction

Business entities who import materials for their busi

business
ness activities use a letter of credit (LC) facility offered by
banks. These LCs are established based on the terms of sale between the buyer and the overseas supplier. The
payment terms are predetermined and are agreed upon either on a demand or usance basis. ba LCs have a
definite due date and the buyer has to arrange for payment of the LC on the due date.

There are situations where a buyer may desire an extension of the credit period. Typically, domestic banks
also offer fund-based
based facilities to meet LC co
commitments.
mmitments. However, a business will typically look for cheaper
alternatives to meet their LC commitments.

Buyers’ credit is a fund-based

based loan facility offered by an overseas bank to help an importer meet their LC
commitments arising from overseas trades. TThe he key feature here is that the importers (buyers) themselves
initiate requests for loan facilities from the overseas bank. The overseas bank extends the credit to the buyer,
and hence the name, “Buyers’ Credit”.

In this lesson we shall learn about buyers’ credit, the need for buyers’ credit and its impact, and how to
distinguish between buyers’ credit and suppliers’ credit.
At the end of this lesson, you should be able to:
 Describe the concept of buyers’ credit.
 Explain the process to arrange buyers’ credi
credit.
 Recognise the impact of buyers’ credit.
 Distinguish between buyers’ credit and suppliers’ credit
What You Need to Know
The Concept of Buyers’ Credit

Buyers’ credit refers to the funds arranged by an importer from an overseas bank to meet their commitment
commitme
under an LC, against a letter of comfort or letter of undertaking (LOC or LOU) issued by the importer’s bank
(the LC issuing bank).
The following table will help you understand the concept of buyers’ credit. Under buyers’ credit, an extension
of the credit
edit period beyond the LC due date is mutually agreed upon between the parties to the buyers’ credit.
It must be noted that the extension must be within the RBI guidelines on buyers’ credit.
Key Points of RBI Guidelines on Buyers’ Credit–

An importer requesting buyers’ credit should consult the RBI guidelines on buyers’ credit. An overview of
these guidelines is provided below.

Maximum maturity period of the loan

 Up to one year for non-capital goods

 Up to three years for capital goods.

The period of credit is linked to the operating cycle and/or the trade transaction.

 Authorised dealers are permitted to approve buyers’ credit up to a maximum of USD $20
M or equivalent per import transaction.
 The bank has to report all the trade credits or buyers’ credit transactions to the RBI at
monthly intervals.
 Goods imported under the transaction should be permissible under the Foreign Trade
Policy implemented by the DGFT.
 The cost of buyers’ credit is normally quoted as “3M L + 350 bps” where 3M is three
months and L stands for Libor. Libor depends upon the period of credit. All the costs
have to be borne by the importer.

Impact of Buyers’ Credit

What You Need to Know, continued.

 Importer’s Perspective
  Extended payment period on buyers’ credit from the o overseas
verseas lending bank
 Cost efficient
 Improved price-negotiating
negotiating capacity with the suppliers (payment to suppliers made on a
DP basis and by availing buyers’ credit).
 LC Issuing Bank’s Perspective:
 Buyers’ credit results in extended commitment period
 Contingent
gent liability shifts from the LC due date to letter of comfort (LOC) under bank
guarantee (BG).
 Drawing power is to be factored.
 Suppliers’ Credit
 What You Need to Know, continued.
 Credit arranged by the supplier of goods (exporter) to the importer is ca called
lled “suppliers’ credit”.
 An example of suppliers’ credit is the usance period allowed by the suppliers.
 Distinguishing Between Buyers’ Credit and Suppliers’ Credit

What You Need to Do

When an importer requests buyers’ credit, you will need to:

 Ascertain
tain the purpose and cost benefits.
 Analyse the cash flows to ensure payment on the due date.
 Arrange for forwarding contracts.
 Ensure compliance with RBI guidelines.
 Report the buyers’ credit transaction to the RBI.
 Monitor and follow up of payment on the due date.

How This is Useful

M/S Arihant Fabrics,, engaged in manufacturing rich cotton ready

ready-made
made garments, presently has both funds-
funds
based and non-fund-based
based facilities to the extent of Rs. 5.00 crores. They are planning to import rich cotton
thread from
om Egypt, where the suppliers, M/S Egypt Cotton Inc., have agreed to supply the materials against
payment (DP basis) under an LC.

The liquidity position of M/S Arihant Fabrics does not permit making payment of the bills on a sight basis. Mr.
Prashant, the promoter/director of M/S Arihant Fabrics,, has approached the bank for an alternate financial
solution.

Now that you understand buyers’ credit, as explained in this lesson, you will be able to offer a solution to M/S
Arihant Fabrics. The solution will comprise:
rise:

a) Opening of an LC
b) Arranging buyers’ credit

Questions You Should Ask

Buyers’ credit results in an extension of the credit period to the importer and of the bank’s liability thereon.
When issuing a buyers’ credit, the lender should discern the reasons behind the request for the buyers’ credit
and its impact. The following questions will facilitate the processing of such requests.
Question 1
Select to flip
Is the importer requesting a buyers’ credit facility due to liquidity challenges?
Question 2
Are there any cost benefits to the importer by availing buyers’ credit?
Question 3
Do cash flows match the LC/ buyers’
uyers’ credit commitments?
Question 4
What is the currency fluctuation expected during the buyers’ credit period?
Question 5
What is the impact of buyers’ credit on the working capital cycle?
Question 6
What is the effect on contingent liability?

Interchangeability of Fund-Based and Non

Non-Fund-Based Facilities

Introduction

In the previous lessons, you learned about various fund fund-based (FB) and non-fund-based
based (NFB) working capital
facilities and how to assess their limits. In this lesson, we explore the topi
topicc further to learn about a concept
called interchangeability.

For example, business entity has a cash credit facility and a letter of credit (LC) facility for its manufacturing
activity. Owing to the sudden supply of products to a one
one-time buyer, for which h the buyer paid cash, the
business is able to replenish funds in the cash credit facility with the deposit of the sale proceeds.
At the same time, the business requires raw materials for further production immediately, so it asks to
procure those materials using the LC. However, its LC limit is fully utilised, and the payments under the LC are
not yet due. Any further opening of the LC would result in the business exceeding its approved limit.
Nevertheless, the bank has the option to open the LC by earmarking an unused portion of the cash credit limit
as a one-time measure.

This arrangement is called interchangeability of the facilities and is a normal practice in the banks.

In this lesson, you will learn in detail about the interchangeability of fund-based (FB) and non-fund-based
(NFB) working capital facilities.
At the end of this lesson, you should be able to:
 Differentiate between assessment of FB and NFB working capital limits.
 Distinguish the method used to assess FB working capital limits from that used to assess NFB
limits.
 Explain how to assess the required owner’s margin.
 Explain the link and interchangeability of FB and NFB limits
What You Need to Know

In the previous lessons, you learned about the various methods used to assess fund-based, working capital
facilities, including the turnover method, the cash budget method, and the projected balance sheet method.
The core objectives of all these methods are to provide need-based facilities and to avoid both underfinancing
and excess financing.

You also learned about the non-fund-based facilities, including letters of credit and bank guarantees (BGs),
and their usefulness to business entities.

The following information should help you to differentiate between fund-based and non-fund-based working
capital facilities when assessing their feasibility.
Components for Assessment of Working Capital Facilities

Non-fund-based facilities fill only the raw materials component of the working capital cycle. In contrast, fund-
based facilities cover all components, including inventory (i.e., raw materials, stock in progress, and finished
goods), trade receivables, and sundry creditors.

 The fund-based working capital facilities are extended towards both pre-sale and post-sale
needs of the business, such as procurement of the raw materials and production of goods
and receivables.
 The non-fund-based working capital facilities are mainly extended towards the pre-sale
needs of the business, such as the purchase of raw materials and participation in tenders.
An understanding of these concepts should help you to recommend the proper mix of financing solutions to
clients and also to better manage credit risk.

Assessing of the Owner’s Margin

What You Need to Know, continued.

The need for and importance of owner’s margin was explained in the lessons on working capital and term loan
assessments. Remember that margin must derive from long-term resources – that is, equity – to protect the
bank from deterioration in the value of current assets and to ensure that the owner’s interest in the business
is protected.
In the case of FB facilities, the margin amount is the owner’s contribution in chargeable current assets,
including raw materials, semi-finished
finished goods, finished goods, and trade receivables.

Generally, the margin is around 25% of paid inventory and 30% of trade receivables.. The drawings in FB
working capital facilities such as cash credit are permitted to the following extent (whichever amount is
lower):

 The approved limit, or

 The total value of paid inventory and ttrade
rade receivables, less margin stipulated

Note that raw materials procured under a usance LC must be treated as unpaid stocks when calculating
(arriving at) drawing power.

Example

Cash credit limit approved = Rs. 5.00 lacs

Total value of current assets = 8.00

00 lacs (Inventory of 4.00 lacs and sundry debtors of Rs. 4.00 lacs)

Unpaid stocks under a usance LC = Rs 2.00 lacs

Margin stipulated 25% on inventory and 30% of trade receivables

Under both LCs and BGs, the margin amount is generally in the form of liquliquid
id securities, such as a fixed
deposit, that must be deposited up front at the time the facility issued.
Margin amount in the form a fixed deposit is appropriated at the time of payment or devolvement of the LC or
invocation of the BG. The purpose of margi
marginn is to safeguard against any deterioration in the value of the goods
procured under the LC.

The Link Between FB and NFB Limits

What You Need to Know, continued.

The operating cycle of a business progresses as follows:

Given the above information, you can understand the importance of the link between NFB and FB facilities.

Interchangeability Between FB And NFB Facilities

What You Need to Know, continued.

The operating cycle of a business entity may have variations due to such events as changes in the terms of
supply or execution of bulk orders. In such situations, the business may request interchangeability of the
various working capital facilities within the overall approved limits.
Example 1–

The following facilities have been approved to M/S Premier Apparels:

1. Cash credit limit of Rs. 50.00 lacs

2. LC limit of Rs. 100.00 lacs
The business has fully utilised the LC facility, and the cash credit facility has been used to the extent of 30.00
Lacs.

1. The promoter of the business mentions that he has signed a sale agreement with a new
client and received bulk orders to be delivered within a month’s time.
2. The promoter also mentions that he must import a specific type of raw material to execute
this bulk order, and that this material must come from a different supplier against an LC.
3. The promoter asks to open the LC for Rs. 20.00 lacs to execute the bulk order.

To support the business, the LC for Rs. 20.00 Lacs could be opened by earmarking the unused portion of the
cash credit limit to the extent of Rs. 20.00 Lacs (the LC amount). This arrangement would meet the
commitment of the LC. The cash credit limit would be restored to its original limit once the commitment under
the LC is met, and the LC liability would be reduced to the original limit of Rs. 100.00 Lacs.

Example 2–

M/S Red Mahal Basmati Rice is engaged in the processing and exporting of basmati rice to Dubai, Singapore,
and other Middle East countries. The business has the following credit facilities:

A partner of the firm, Mr. Raghuveer, mentions that they have received an additional order from an existing
client because of the festive season. The production has been completed by procuring raw materials from the
regular suppliers on extended payment terms, and the goods are ready for dispatch. Mr. Raghuveer asks to
have the export bills discounted to Rs. 8.00 Lacs.

To support the business, the export bills could be discounted by earmarking the unused portion of the packing
credit limit to the extent of Rs. 8.00 Lacs. This arrangement would also ensure that the total bank’s exposure
to the business remains within the overall approved limits.

Notice that the proposed interchange is between the packing credit and the post-shipment credit (FUBP). If
approved, the packing credit limit will be restored to the original level on realisation of any of the export bills
already discounted. Furthermore, the post-shipment credit (FUBP) liability will be reduced to the regular limit
of Rs. 25.00 Lacs.

This is how the interchangeability of facilities operates. You can observe that the overall exposure to the
business, even after the interchange facilities, remains the same and within the overall approved limits.

What You Need to Do

In today’s changing business environment, businesses commonly desire flexibility of credit facilities to allow
for optimal use. Lenders must therefore be prepared to deal with requests from their clients for
interchangeability of the facilities.
In processing such requests , you must:
 Know the need for NFB facilities and the effectiveness of providing FB facilities.
 Analyse the need for interchangeability of the facilities, as well as the risks involved.
 Decide on the additional terms and conditions required for interchangeability of facilities.
 Decide on the margin amount required.
 Do not allow interchangeability between term loans and working capital facilities.
How This is Useful

M/S Premier Apparels presently enjoys both FB and NFB facilities. The partners of the business have received
additional orders from Dubai and other Middle East countries to supply rich cotton apparels.

The present position of the various facilities approved to the unit is as follows (Rs. in lacs):
The business requests interchangeability of the unused portion of the packing credit with the FUBD.
The concepts learned in this lesson should help you to understand:
 The method used to assess working capital
 The link between FB and NFB facilities
 The common need for interchangeability of FB and NFB facilities
 Importance of margin or owner’s contribution

Questions You Should Ask

When permitting interchangeability of credit facilities, the lender must analyse the purpose and suitability of
the particular interchange and the risks involved. Monitoring is necessary to ensure that the exposure is within
overall approved limits.
The following questions should help in processing such requests:
Question 1
Select to flip
Have I analysed the FB and NFB facilities made available to the business to determine whether they mutually
supplement each other?
Question 2
Have I analysed the risk factors involved in permitting an interchange of the facilities?
Question 3
Rather than permitting an interchange, is it better to recommend enhancement of the facility itself?
Question 4
Have I thought of alternative solutions in case the business requests interchangeability routinely?
Question 5
Can I earmark the unused portion of the FB facility as margin towards the NFB facility?