3882 study material pgdm

Working Capital Management

By

Praloy Majumder

For

PGDM Students of IIM Calcutta

10th Batch

( For Class Room Discussion Only)

2

Table of Contents

Section No

Chapter No Particulars Page No

One Process of Building up of Working Capital

7 One

Two Working Capital and Total Balance Sheet

20

Three Management of Cash and Marketable Securities

31

Four Management of Inventory 58

Two Five Management of

Receivable 73

Six Assessment of Fund Based and Non Fund

Based Working Capital

88

Seven Process of Tying Up and Utilisation of Working

Capital Finance from Bank

135

Three

Eight Different Corporate Banking Product

148

Appendix 1 173 Appendix 2 221

3

Introduction

Working Capital Management is an important aspect of financial

management of a business entity. Proper working capital management

would lead to increased market share by giving proper supply of goods

at better price. A company which can manage its working capital

properly would be able to reduce its interest cost and in turn lead to

reduced price for its product. In a competitive world where price is

differentiator for many homogeneous product, the importance of

working capital management is paramount. On the other hand , the in

efficient working capital management would lead to loss in market and

share and reduced profitability due to increase in financing cost. By

inefficient working capital management , we mean that either working

capital is maintained less than the optimum level or more than the

optimum level. In case of the first case, the shortage of product in the

market would lead to loss of market share and eventually lower profit

through lower sales. In the later case, the company�s interest cost

would be higher and this will in turn reduce the profitability of the

company.

This course aims to give you a complete picture of working capital

management. The study material is segregated into Three Sections.

Section One consists of two chapters . In Chapter One , we should

try to visualize the process of building up of working capital. Once, we

visualize the process clearly, it would be very easy to develop the

concepts.

In the Chapter Two , we shall see the working capital in a total balance

sheet perspective. In this section, we shall establish linkage between

4

capital budgeting and working capital of a company. After establishing

the linkage, we shall define major terminology associated with the

working capital finance. Then we shall also discuss the concepts and

application of working capital cycle.

Section Two of this study material would deal with management of

individual components of working capital of an entity. In Chapter

Three we shall discuss about the management of Cash and

Marketable Securities. During the discussion management of Cash, we

shall discuss about the different models of Cash Management

Technique to arrive at the optimum level of cash balance. Then we

shall also discuss the process of drawing the cash budget of a

company with the help of a real life example. Then we shall discuss

about various cash management products offered by different banks.

This chapter would end after discussing the investment principles and

rational for investment in marketable securities. We shall also discuss

the different marketable securities available in the Indian Financial

Market and their characteristics.

Chapter Four would deal with the Inventory Model. Starting from a

simple EOQ model, we shall discuss some advanced Inventory

Management Models.

Chapter Five would discuss the receivable management. Besides the

rationale for allowing credit , we shall also discuss the receivable

management technique practiced in the industry.

5

Section Three of this material would deal with the way company

meets its working capital requirement. Here , we shall discuss about

the rational of Banks being the major provider of working capital . In

In Chapter Six, we shall discuss about the assessment of working

capital . Since banks are major source of working capital for a

company, a detail analysis of fund based products is required. In this

chapter, we shall discuss in detail about the assessment of working

capital funds from the bank.

In Chapter Seven , we shall discuss about the process of tying up of

working capital from the bank and also the operational aspect of both

fund based and non fund based facilities.

In Chapter Eight, we shall discuss about the some of the newer

products to meet working capital finance. In this chapter, we shall

discuss about Bill Discounting Mechanism, FCNR(B) Loan, MIBOR

Linked Debentures, Commercial Papers ,Securitisation Products and

Factoring Services in detail .

6

Section One

7

Chapter One

Process of Building up of Working Capital

Before we proceed in to the micro aspect of working capital

management , it would be very much useful if we visualize the process

of building up of working capital. For understanding the process, we

shall start with small examples as it is always easy to understand with

small examples. Subsequently, the same can be extended with the

larger examples.

Let us assume that a company X has established a factory for

production of garments. For establishment of the factory the company

purchased land admeasuring 100 cottahs with the value per cottah of

land is Rs 25000/- . After the purchase, the company spent Rs

2,00,000/- on stamp duty and registration of the land. The company

then constructed factory premises with an investment of Rs 30,00,

000/- ( Rupees Thirty Lacs only) and installed machinery worth Rs

1,50,00,000/- ( Rupees One Crore Fifty Lacs only ) . The company

financed this entire capital expenses with both debt and equity in the

ratio of 2:1.

Before we proceed further, let us draw a balance sheet up to this

point. This is a point when the construction of the factory is complete

and the factory is ready in all purposes to start production.

8

( All in Rs Lacs)

Liability Asset Particulars Amount Particulars Amount

Equity 69 Land 27 Debt 138 Factory Building 30

Plant & Machinery

150

Total Liability 207 Total Fixed Asset

207

Figure 1.1 Now for starting of the production , the company requires the following

:

1. Raw Materials

2. Consumables

3. Workers and Supervisors

4. Power

Now, we shall introduce the time scale. Suppose at time t=0, the

company has hired 20 workers and supervisors with an average salary

of Rs 30000/- ( Rupees Thirty Thousand only) per month. The salary

would be paid on the last day of the month i.e. at t=30. The company

has also purchased Raw Material worth Rs 10,00,000/- ( Rupees Ten

Lacs only) at t= 2 day. The company has got electricity connections

and the bills during t=1 to 30 days would be paid on t= 45 days .

Now we shall draw the balance sheet and P&L on different time scale.

Since the purchase is carried out at t= 2 days, on t=2 days, the

purchase entry would reflect in the P&L and the Bank/Cash/Credit

9

entry would reflect in the balance sheet. Since the company is new

one, it is very difficult to arrange credit for its raw materials. So it

needs to put cash in the bank for this raw material amount. So the

company deposits Rs 10.00 lacs in bank from its own source. Both the

entries would be on the balance sheet. After this entry the balance

sheet would look like as follows :

( All in Rs Lacs)


Equity 69 Land 27 Equity 10 Factory Building 30 Debt 138 Plant &

Machinery 150

Total Fixed

Asset 207

Cash at Bank 10 Total Liability 217 Total Asset 217

Figure 1.2 Now ,we shall write purchase entry in connection with the purchase of

Raw Material. The Debit Purchase would be in the P&L Account and the

Credit entry would be in Cash and Bank Account. This is shown as

below :

Profit & Loss Account ( Rs in lacs)

10

Expense Income

Particulars Amount Particulars Amount Purchase of Raw

Material t=2 10 By Closing

Stock t=2* 10

Total 10 Total 10 Balance Sheet ( All in Rs Lacs)



Machinery 150

Total Fixed

Asset 207

Cash at Bank t=2 (10-10)=0 Raw Material

t=2* 10

Total Liability 217 Total Asset 217

Figure 1.3 From Figure 1.3, it is clear that the building up of current assets on

account of Raw Material purchase is due to closing stock adjustment.

Now At t=3, from the stock of Rs 10 lacs raw materials , Rs 1 lacs raw

materials is issued for production. Besides, the effort of one entire day

of entire work force is used for this production. So the total salary for

one day would be Rs 20,000/- . The electricity for one day is , say ,

Rs 1200/- . Assuming no other cost incurred, the above entries need

to be taken care by passing the following entries :

11

For Raw Material , the amount of Rs 1lac would be treated as

consumption and the same amount would be reduced from Stock . The

salary and power would be debited to P&L and the amount would be

outstanding in balance sheet as creditor. This is because these are

payable only after the month. There would be closing stock of Work in

Progress on account made from the raw material consumed of Rs 1.0

lac. The Entire set of entry is shown below :


Expense Income Particulars Amount Particulars Amount

Purchase of Raw Material t=2

10 By Closing Stock t=2*

10

To Closing Stock t=3

(1)

Salary t=3 .20 By WIP t=3 1.21 Electricity t=3 .01

Total 10.21 Total 10.21 Balance Sheet ( All in Rs Lacs)



Machinery 150

Salary

outstanding t=3 .20 Total Fixed

Asset 207

Electricity outstanding t=3

.01 Cash at Bank t=2 (10-10)=0

Raw Material t=2*

10

Raw Material Consumed t=3

(1)

WIP t=3 1.21 Total Liability 217.21 Total Asset 217.21

Figure 1.4

12

Now, you see apart from Raw Material Inventory, WIP Inventory has

also appeared in the Balance Sheet. Now say t=4, Raw material worth

Rs 2 lacs has gone to the production and WIP of the previous day has

been converted into the Finished goods. For converting the WIP into

Finished goods, the company spends about Rs 5000/- on account of

salary and Rs 1000/- on account of electricity. For converting the raw

material of Rs 2 lacs issued on t=4, the company spends Rs 15000/-

on account of salary and Rs 4000/- on account of electricity. At the

end of t= 4, all the entries would be as follows :



Purchase of Raw Material t=2

10 By Closing Stock t=2*

10


(1)


(2)

Salary t=3 .20 By WIP t=3 1.21 Electricity t=3 .01 By WIP t=4 2.19

Salary for conversion of

raw material to WIP t=4

.15 To WIP t=4 (1.21)

Electricity for conversion of


.04 By Closing Stock of FG t=4

1.27

Salary for conversion of

WIP to Finished Goods

.05

Electricity for conversion of


.01

Total 10.46 Total 10.46

13

Balance Sheet ( All in Rs Lacs) Liability Asset

Particulars Amount Particulars Amount Equity 69 Land 27 Equity 10 Factory

Building 30

Debt 138 Plant & Machinery

150

Salary


Asset 207


.01 Cash at Bank t=2

(10-10)=0

Outstanding Salary for

conversion of raw material to

WIP t=4

.15 Raw Material t=2*

10

Outstanding Electricity for conversion of


.04 Raw Material Consumed t=3

(1)

Outstanding Salary for

conversion of WIP to

Finished Goods t=4

.05 Raw Material Consumed t=4

(2)

Outstanding Electricity for conversion of


t=4

.01 WIP t=3 1.21

New WIP converted from Raw Material

t=4

2.19

WIP converted to Finished Goods t=4

(1.21)

14

Finished Goods t=4

1.21+.05+.01=1.27

Total Liability 217.46 Total Asset 217.46

Figure 1.5

In the traditional statement of accounts , lot of entries are reclassified

and shown . We see the following statement of accounts at the end of

t=3 day :



Consumption of Raw Material

1 By WIP 1.21

Salary t=3 .20 Electricity t=3 .01




Machinery 150

Salary


Asset 207


.01

Raw Material 9 WIP t=3 1.21


Figure 1.6

15

We also see the following statement of accounts at the end of t=4 Profit & Loss Account ( Rs in lacs)



3 Change in WIP 2.19

Change in Finished Goods

1.27

Salary .40 Electricity .06




Machinery 150

Salary outstanding

.40 Total Fixed Asset 207

Electricity outstanding

.06 Raw Material 7

WIP 2.19 Finished Goods 1.27


Figure 1.7

We observe the following :

1) There is no profit element involved up to the finished

goods stage.

2) We have not calculated the depreciation. This is to keep the

example simpler. The amount of depreciation is reduced from

16

the Fixed Asset of the Balance sheet and the same amount is

added in the expenditure side of the Profit and Loss Account.

Now , can you tell why we show on the income side of the Profit & Loss

Account the incremental figure of WIP and FG stock not the absolute

figure ?

Why the incremental figure of RM stock is not appearing in the Profit

and Loss account as mentioned above?

Now if the company incurs an expenditure of Rs 0.20 lacs on account

of sales and marketing expenses for this amount of Finished Goods

and the Finished Goods is sold at Rs 2.10 lacs and the entire sales is

on cash basis the statement of accounts is shown below :




3 Change in WIP 2.19

By Sales 2.10 Salary .40

Electricity .06 Selling and Distribution overhead

.20

To Profit Transferred to

Reserve

.63




Machinery 150

By Profit .63 Total Fixed Asset 207

17

Salary outstanding

.40 Raw Material 7


.06 WIP 2.19

Selling and Administrative Expenses O/S

.20

Cash at Bank & Hand

2.10


Figure 1.8 Now what happens if the entire sales is on credit basis. There is no

change in the P&L Statement but in the balance sheet in place of Cash

at Bank & Hand , Receivable head will appear.

Balance Sheet ( All in Rs Lacs)



Machinery 150

By Profit .63 Total Fixed Asset 207 Salary

outstanding .40 Raw Material 7


.06 WIP 2.19

Selling and Administrative Expenses O/S

.20 Receivable 2.10


Figure 1.9

What is the difference between these two situations?

18

In the first case the company is having Cash and it can pay its

liabilities if it wants or it can invest this in investment. In the second

case, it has no cash. Now suppose it has to pay the salary , then it

has to arrange some cash by borrowing. For example , if the company

has to pay the salary of Rs 0.20 lacs immediately , then the company

has to borrow from outside this amount and pay the salary. In such

case the balance sheet would look like as follows :

Balance Sheet ( All in Rs Lacs)



Machinery 150

By Profit .63 Total Fixed Asset 207 Salary

outstanding .20 Raw Material 7


.06 WIP 2.19

Borrowings 0.20 Receivable 2.10 Selling and

Administrative Exp O/S

0.20


Figure 1.10 From the above discussion, we get the following key points, which will

be useful for remaining portion of this study material:

1) The expenses on the P&L of a company would either

appear on the liability side of the balance sheet in case it

is not paid immediately or would appear as negative in

the bank or cash account in the asset side if it is to be

paid immediately.

19

2) The current asset in the form of stock of Raw Material, Work

in Progress, Finished Goods, that is appearing in the

balance sheet of the company represents the amount of

expenses the company incurred but not realized in cash.

Similarly, the current asset in the form of Receivable

represents the expenses incurred in connection with the

sale of the goods plus the profit portion but the amount is

not realized . Other composition of the current assets

represents the amount paid before the realization of

money against which such payment is made. If we sum

total the above characteristics of current asset , we can say the

following :

The Current Asset of the company ( Excluding the Cash

and Bank Balances in Demand Deposit, in Term Deposits

with an option of the company to withdraw as and when

basis) represents the expenses which is incurred by the

company and also the payment made by the company for

both of which the company has not realized the cash.

Now the next question is that how the company is meeting these

expenses. Some of the expenses are met by the company

by deferring the payment . This is achieved through the

process of building up the creditor and also the building

up of other current liability. The portion of expenses which

can not be deferred needs to be paid by resort to borrowing. So

the borrowing represents the portion of expenses

represented in the current liability side which is not

deferred.

20

Chapter Two

Working Capital and Total Balance Sheet

In this Chapter, we shall see the relationship of working capital from

the perspective of capital budgeting. Besides, we shall also make

ourselves aware some of the important terminology used widely in the

Working Capital Management.

As we are all aware that the process of Capital Budgeting consists of

the following steps :

1. Arrival at the Project Cost

2. Selection of Means of Finance

3. Quantum of different types of Means of Finance

4. Arrival at the marginal Weighted Average Cost of Capital (

WACC)

5. Arrival at the incremental cash flow for the duration of the

project

6. Arrival at the Net Present Value of the Project

7. Selection/ Rejection of the project.

While at the time of arrival at the project cost , a portion of working

capital is also taken into account apart from the cost of fixed assets.

So the components of project cost is as follows :

1. Total Cost of Fixed Assets

2. A Portion of Current Assets

This is shown graphically as below :

21

T P C O R O

T O S

A J T

L E

C

T

Fig 2.1

The means of finance is that portion of Liability side of the balance

sheet which finance the project cost. So this is equal to the project

cost. This is shown graphically below :

Total Asset

Fixed Asset

Current Asset

22

Means Total

Of Project

Finance Cost

Fig 2.2

In other words , the means of finance of a project cost represents the

long term liability of a company. The composition of long term liability

can be any or combination of the following :

1. Equity

2. Reserves

3. Preference Shares

4. Debentures

5. Term Loan

Total Liability Total Asset

Fixed

Asset

Long Term

Liability

Current Liability

Current

Asset

23

The remaining portion of the liability side of the balance sheet consists

of Current Liability. Current Liability consists of the following :

1. Bank Borrowing for Fund Based Working Capital

2. Other Current Liabilities :

a. Sundry Creditors

b. Other other Current Liability

c. Provisions

Now we shall introduce a very important terminology which is

frequently used in finance. This terminology is called � Margin Money�.

What is �Margin Money� ?

The answer to the question can be answered only if we complete the

above mentioned question. On completion, the full question is :

What is Margin Money for Working Capital /Term Loan /Public Issue ?

Now the correct answer to the question is the Margin Money is the

Money brought in by the entity other than the lender for which margin

money is asked for. Fir example, the margin for working capital is the

money brought in by the entity other than the lender. In this case, the

margin money for working capital is the money brought in by the

surplus of long term liability over the long term assets.

Similarly, the margin money for the term loan/debenture is the

money brought in by the lender other than the term loan

lender/debenture holder. So the margin money for term loan

/debenture is the money brought in by the equity holder.

Similarly, the margin money for Public Issue is the money brought in

by those equity holders other than the public. This is also called

Promoters Contribution.

While arriving at the identification of margin money the following

criteria is maintained :

24

1. The tenure of maturity of margin money is greater than that of

the finance with respect to which margin money is defined. For

example, margin money of working capital consists of that

portion of liability which has a maturity of more than the current

liability. Since the maturity of current liability is one year , the

maturity of margin money for working capital is more than one

year.

2. Generally , the margin money is superior in the nature of debt

characteristics with respect to the finance against which margin

money is defined. For example, in the case of margin money for

term loan, the margin money should be in the form of equity

which is superior than the debt .

Now we shall define the margin money for working capital finance. The

margin money for working capital finance is also called as Net Working

Capital ( NWC). The NWC is explained below:

LTL

CL

Fig 2.3

Liability Asset

LTA

NWC

CA

25

From the above figure it is quite clear that NWC= LTL-LTA; this is

because LTL is the source of fund and LTA is the use of this fund. The

difference is the surplus of long term fund after its use for building up

of long term assets. This is the money which goes for building up a

portion of working capital . So this is margin money by definition of

margin money.

NWC= LTL- LTA ��. Eqn 2.1

In a balance sheet ,

Total Liability = Total Asset �� Eqn 2.2

Long Term Liability+Current Liability=Long Term Asset+ Current Asset

Long Term Liability ( LTL) �Long Term Asset ( LTA)= Current Asset (

CA) � Current Liability ( CL)

Putting the value of RHS of Eqn 2.1, we get

NWC= CA-CL ��. Eqn 2.3

But always keep in mind that NWC is the difference between LTL and

LTA . The difference between CA and CL is also equal to NWC but it is

derived from the definition of NWC.

Other important terminology of Working Capital Management :

There are some important semantics associated with the working

capital management . We shall discuss all these one by one :

Current Asset ( CA) : The Current Asset is that portion of asset which

is to be realized within a maximum time frame of one year. The typical

composition of Current Asset is as follows :

26

1. Raw Material

2. Work In Progress

3. Finished Goods

4. Receivable

5. Other Current Asset

6. Cash & Bank Balances

Gross Working Capital ( GWC) :This is equal to Current Asset of the

company .

Other Current Liability (OCL) : This is the part of current liability other

than the bank borrowing for fund based working capital .The

composition of OCL is as follows :

1. Sundry Creditors

2. Provisions for Taxation and Dividends

3. Other Other Current Liability

Working Capital Gap ( WCG) : This represents that portion of the

current assets which is not financed by the Other Current Liability. If

we recall the concept build up in the first chapter, this represents the

expenses which is not realized and can not be deferred. So

WCG = Current Asset ( CA) � Other Current Liability ( OCL)

Operating Cycle ( OC) : As the term Cycle suggests, this represents

some thing related to time. Actually this is the time required by a

company to realize its cash .As we have already seen in the Chapter I

that the Current Asset of a Company represents the expenses incurred

but not realized by the company. We have also seen that a portion of

the expenses is deferred and this portion represents the other current

27

liability. Putting these two in the perspective of the definition of

Operating Cycle, we can arrive at the operating cycle provided we

convert the time required for such current assets to get converted in

to cash. In the balance sheet, the current asset is appearing mainly in

the form of Raw Material, Work In Progress , Finished Goods and

Receivables. The units of presentation of these current assets are in

monetary terms say in rupees. Now in the working capital cycle, we

have to convert this into units of time say in days or in months. This is

possible only when we replace the unit of money with unit of time.

Now, we have to search the accounting statement which represents

time and monetary unit. The Profit and Loss statement of a company

represents the expenses or income in monetary units over a particular

period, generally for 12 months. Now, if we represent the individual

item of current assets in terms of expenses and income of Profit and

Loss statement , we can convert the representation of individual items

of current assets from monetary units to time units. However, one

care has to be taken that we use the appropriate expenses and

income in each stage of current assets. For example , in the case of

raw materials only the expenses which can be allocated to the raw

materials can be taken for such conversion. So we get the operating

cycle with the help of the following methods:

Raw Material Cycle ( RM) = Average Raw Material Balance / Raw

Material Consumption for the year �( Amnt/(Amnt/time)

Work In Process ( WIP) Cycle = Average WIP Balance /( Cost of

Production for the Year)

Finished Good ( FG) Cycle= Average FG Balance/( Cost of Sales for the

Year)

28

Receivable ( R) Cycle = Average Receivable Balance/( Annual Gross

Sales for the Year )

Accounts Payable Cycle ( AP) = Average Creditor Balance /( Annual

Purchase for the Year)

OC= RM+WIP+FG+R

Cash Cycle (CC) = RM+WIP+FG+R-AP

From the above , it can be shown that the cash cycle depends on the

inventory , receivable and payable periods. The cash cycle increases as

the inventory and receivable periods get longer. It decreases if the

company is able to defer payment of payables and thereby lengthen

the payables period.

Most of the firms are having a positive cash cycle and they thus

require financing for inventories and receivables. The longer the cash

cycle, the more financing is required .Also, changes in the firm�s cash

cycle are often monitored as an early warning measure. The

lengthening of a cycle means that the firm is having trouble in moving

inventory or collecting on its receivables.

The link between a company�s cash cycle and it�s profitability can be

easily seen by recalling one of the basic determinants of profitability

and growth for a firm is its total asset turnover , which is defined as

Sales/Total assets. The higher the ratio is , the greater is the firm�s

accounting return on assets, ROA and return on Equity ,ROE. Thus all

other things being the same , the shorter the cash cycle is , the lower

is firm�s investments in inventories and receivables .As a result , the

firm�s total assets are lower, and total turnover is higher.

29

Some Aspects of Short Term Financial Policy :

The Short term financial policy that a firm adopts will be reflected in at

least two ways:

1. The Size of the Firm�s Investment in Current Assets: This is

usually measured relative to the firm�s level of total operating

revenues. A flexible, or accommodative, short-term financial

policy would maintain a relatively high ratio of current assets to

sales. A restrictive policy would involve a low ratio of current

assets to sales.

2. The Financing of current assets: This is measured as the

proportion of short term debt ( that is , current liabilities ) and

long term debt used to finance the current asset. A restrictive

short term financial policy means a high proportion of short term

debt relative to long term financing and a flexible policy means

less short term debt and more long term debt.

If we take these two areas together, we see that a firm with a flexible

policy would have a relatively large investment in current assets and it

would finance its investment with relatively less in short term debt.

The net effect of a flexible policy is thus a relatively large level of net

working capital.

30

Section Two

31

Chapter Three

Management of Cash and Marketable Securities

The basic objective in cash management is to keep the investment in

cash as low as possible while still keeping the firm operating efficiently

and effectively. Besides, the firm must invest temporarily idle cash in

short term marketable securities in the financial market. As a group,

they have very little default risk , and most are highly marketable.

Reason for holding cash :

John Maynard Keynes , in his great work The General Theory of

Employment, Interest and Money , identified three motives for liquidity

:the speculative motive, the precautionary motive and the transaction

motive.

The Speculative and Precautionary Motives :

The speculative motive is the need to hold cash in order to be able to

take advantage of for example, bargain purchases that might arise,

attractive interest rates, and ( in the case of international firms)

favorable exchange rate fluctuations.

For most firms , reserve borrowing ability and marketable securities

can be used to satisfy speculative motives. Thus, there might be a

speculative motive for maintaining liquidity, but not necessarily for

holding cash per se.

This is also true to a lesser extent for precautionary motives. The

precautionary motive is the need for a safety supply to act as a

financial reserve. Once again, there probably ,is a precautionary

motive for maintaining liquidity .

32

The Transaction Motive :

Cash is needed to satisfy the transaction motive, the need to have

cash on hand to pay bills. Transaction related needs come from the

normal disbursement and collection activities of the firm. The normal

disbursement of cash includes the payment of wages and salaries ,

trade debts , taxes and dividends. Cash is collected from product sales

, the selling of assets, and new financing. The cash inflows (

collections) and outflows (disbursements) are not perfectly

synchronized , and some level of cash holdings is necessary to serve

as a buffer.

Cost of Holding Cash :

When a firm holds cash in excess of some necessary minimum, it

incurs an opportunity cost. The opportunity cost of excess cash ( held

in currency or current accounts in bank) is the interest income that

could be earned in the next best use, such as investment in

marketable securities. However, the investment in marketable

securities entails another type of costs. The transaction costs covering

the transformation between cash to marketable securities and vice

versa need to be considered also.

Cash Management versus Liquidity Management

Before we move on, we should note that it is important to distinguish

between true cash management and a more general subject, liquidity

management. The distinction between liquidity management and cash

management is straightforward. Liquidity management concerns the

33

optimal quantity of liquid assets a firm should have on hand , and it is

one particular aspect of current asset management policies. Cash

management is much more closely related to optimizing mechanism

for collecting and disbursing cash, and it is this subject that we

primarily focus on in this chapter.

Understanding Float :

The difference between the available balance and the ledger balance is

called Float and it represents the net effects of checks in the process

of clearing.

There are two types of floats:

1. Disbursement Float

2. Collection Float

Disbursement Float : Checks written by a firm generates

disbursement float. For example, A has Rs 1lacs on deposits with

bank. On September 1, it buys some raw material and pays with a

cheque for Rs 50,000/-. The company�s book balance would be

immediately reduced by Rs 50,000/- as a result. A�s bank would not

find this check until it is presented to A�s bank for payment on say

September 4th , .Until the cheque is presented , the firm�s available

balance is immediately is greater than its book balance by Rs

50,000/- . In other words , before September 1, A has zero float .A�s

position from September 1 to September 4th is :

Disbursement Float = Firm�s available balance �Firm�s book balance

= Rs 100000-Rs 50000/- = Rs 50,000/-

34

The company can temporarily invest this amount in marketable

securities and earn some interest for this period.

Collection Float : The reverse would happen when a cheque is

collected by the company. Once it collects the cheque, the same is

entered in the bank book maintained with the company.However, it

takes some time to deposit the cheque in the bank and during this

period the company�s book balance would show more than the

original balance in the bank book. This is called collection float. Let us

take an example, say on September 1, the company collects a cheque

of Rs 30,000/- and on the same day the amount is entered on the

book balance . The amount is credited on the 4th September. A�s

position during 1st to 4th is :

Collection Float = Firm�s available balance �Firm�s book balance

= Rs 100000- Rs 130000=- Rs 30000/-

In general firm�s payment activities generate disbursement float , and

its collection activities generate collection float. The net effect, that is

the sum of total collection and disbursement float , is the net float.

The net float at a point of time is simply the overall difference

between firm�s available balance and its book balance. If the net float

is positive, then the firm�s disbursement float exceeds its collection

float, and its available balance exceeds its book balance.

Float Management : Float Management involves controlling the

collection and disbursement of cash. The objective in cash collection is

to speed up collections and reduce the time customers pay their bills

and the time the cash becomes available. The objectives in cash

35

disbursement is to control payments and minimizes the firm�s costs

associated with making payments.

Total collection or disbursement times can be broken down into three

parts :

Mailing time : It is the part of the collection and disbursement process

during which cheques are trapped in the postal system.

Processing delay : It is the time it takes the receiver of cheque to

process the payment and deposit it in a bank

Available delay : It refers to the time required to clear a cheque

through the banking system.

Speeding up collections involves reducing one or more of these

components. Slowing up disbursements involve increasing one of

them.

Measuring the float : The size of the float depends on both the rupees

and the time delay involved.For example, you mail a cheque for Rs

500/- to another place and it takes 5 days to reach the destination(

mailing time) and one day for the recipient ( the processing delay)

.The recipient�s bank holds out cheques for 3 days ( availability delay)

.The total delay is 5+3+1=9 days .

In this case, the average daily disbursement float is Rs 500 X9=Rs

4500/- .Assuming 30 days a month, the average daily float is Rs

4500/30=Rs 150/- .

We can calculate the float, when there are multiple disbursements or

receipts. For example, a company B receives two items each month

as follows :

Amount Processing and Total Float

36

Availability Delay

Item I : Rs 5,00,000 X9 =45,00,000/-

Item II : Rs 3,00,000 X5 =15,00,000/-

Total : Rs 8,00,000 60,00,000/-

The average daily float is equal to :

Average Daily Float = Total Float/Total Days = 60

,00,000/30=2,00,000/-

So on average there is Rs 2,00,000/- that is uncollected and not

available.

Cost of the Float :

The basic cost of collection float to the firm is simply the opportunity

cost of not being able to use the cash. At a minimum, the firm could

earn interest on the cash if it were available for investing.

The concept of cost of float can be explained with the help of the

following example:

A company A has average daily receipt of Rs 1000/- and a weighted

average delay of 3 days. The average daily float is around Rs 3000/-.

Suppose that the company can eliminate the float entirely .If it costs

Rs 2000/- to eliminate the float should be company go for it?

37

The following figure illustrates the situation for Company A :

Day

1 2 3 4 5

Beginning

Float

0 1000 2000 3000 3000

Cheque

Received

1000 1000 1000 1000 1000

Cheque

Cleared

( cash

available)

0 0 0 -1000 -1000

Ending

Float

1000 2000 3000 3000 3000

Fig 3.1

A starts with a zero float. On a given day, Day 1, A receives and

deposits a cheque for Rs 1000/-. The float remains Rs 3000 from day

4. The following figure illustrates what happens if the float is

eliminated entirely on some day t in the future.

Day

38

T T+1 T+2

Beginning Float 3000 0 0

Cheque

Received

1000 1000 1000

Cheque Cleared

( cash available)

-4000 -1000 -1000

Ending Float 0 0 0

Fig 3.2

After the float is eliminated , daily receipts are still Rs 1000/-. The

company collects the same day because the float is eliminated , so

daily collections are still Rs 1000/- . As the figure 3.2 shows, the only

changes occur in the first day. On that day , A generates an extra cash

of Rs 3000/- on day t by eliminating the float. In other words , the

Present Value ( PV) of eliminating the float is simply equal to the total

float . It cost Rs 2000/- to eliminate the float , then the NPV is Rs

3000/-Rs 2000/- = Rs 1000/- . So the company should do it.

Cash Collection and Concentration :

From our previous discussion , we know that the collection delays work

against the firm. All other things being the same, then, a firm will

adopt procedures to speed up collections and thereby decrease the

collection times. In addition, even after cash is collected, firms need

procedures to funnel, or concentrate , that cash where it can be best

used .

Components of Collection Time :

39

Customer Company Company Cash

Mails Receives Deposits Available

Payment Payment Payment

Mailing Processing Availability

Time Delay Delay

Collection Time

Fig 3.3

A company can eliminate the Mailing Time and Processing delay to a

great extent by availing the Cash Management Services ( CMS)

provided by the banks. The availability delay is the delay in clearing

process and this can be reduced to a little extent.

The CMS was introduced first in India by Corporation Bank.

Subsequently, Citi Bank started the CMS in a big way. Seeing their

success, now a days almost all the banks are offering the CMS service.

In the CMS , the mailing and processing delay is eliminated to a great

extent. Bank�s authorized courier can pick up cheque from a particular

location and deposits in its branches situated at that particular

location. The bank would provide customized report to the company as

per agreed format and the fund would be available to the company at

40

any location as desired by the company on the next day of clearance

of the cheque. If the cheque is of MICR cheque , then the maximum

time required for clearance would be 2 days excluding the collection

day. The fund would be available to the company on the 3rd day

excluding the collection day. In the case of a high value cheque, the

fund would be available would be 2nd day excluding the collection day.

Now a days the banks are also providing the web based tracking

system by which, a customer gets to know the position of the cheque

on a continuous basis.

If one looks at the CMS mechanism, one can find out that in the

process, the company gets benefited but in the process a bank looses

out in the float to an existing customer without CMS facility. The

rational being, if a bank can not offer CMS facility, other banks would

offer the facility and other bank would build up relationship with the

company. There is every possibility that subsequently, all the other

businesses may be grabbed by the other bank. So to a bank, CMS

would be the customer retention strategy for an existing customer and

for a new customer it is core business acquisition strategy.

Managing Cash Disbursement : From the company�s point of view,

disbursement float is desirable. To do this, the firm may develop

strategies to increase the mail float, processing float and availability

float on the checks it writes. However , the tactics for maximizing

disbursement float are debatable on both ethical and economic

grounds. The discounts may be more beneficial that generation of

disbursement float. Besides, there are negative consequence

associated with the stretching the disbursement float beyond a certain

point. This can be proved to be costly.

Controlling disbursement :

41

We have seen that maximizing disbursement float is probably poor

business practice. However, a firm will still wish to tie up as little cash

as possible in disbursement .Firms have therefore developed systems

for efficiently managing the disbursement process. The general idea in

such system is to have no more than the minimum amount necessary

to pay cheques on deposit in the bank. Some of the methods for

achieving this are discussed below :

• Zero Balance Accounts: With a zero balance account system, the

firm , in cooperation with its bank, maintain a master account

and a set of sub accounts. When a cheque drawn on one of the

sub accounts must be paid, the necessary funds are transferred

in from the master account.

• Controlled Disbursement Accounts : With a controlled

disbursement account system, almost all payments that must be

made in a given day are known in the morning .The bank

informs the firm of the total, and the firm transfers (usually by

wire) the amount needed.

Preparation of cash budget:

Now, we shall discuss in detail about the process of preparation of

cash budget . This will be explained with the help of a simple example

.The balance sheet of a company A , as on March 31, 2005 would

reveal the following :

42

Liability

Serial No Particulars Amount ( Rs in lacs)

1 Equity Capital 100

2 Reserves 150

3 Term Loan 150

4 Working Capital Loan 300

5 Creditor For Purchase 100

6 Creditor for Wages 10

7 Creditor for Power 10

8 Creditor for other manufacturing

expenses

20

9 Provision for Taxation 5

10 Provision for Dividend 5

Total 850

Asset

Serial No Particulars Amount ( Rs in lacs)

1 Fixed Asset 250

2 Less Depreciation 75

3 Net Fixed Asset 175

4 Investment in Shares 25

5 Investment in Fixed Deposit 35

6 Investment in Group Companies 20

7 Raw Material 75

8 Work in Progress 25

9 Finished Goods 50

10 Receivable 100

11 Other Current Asset 100

12 Loans to Group Companies 75

43

13 Loans to staff 25

14 Advance to supplier 75

15 TDS 25

16 Advance Tax Paid 35

17 Cash and Bank Balance 10

Total 850

The projected Profit and Loss of the company for the first three

months is as follows :

Sl no Particulars April 2005 May 2005 June 2005

Income

1 Sales 150 175 200

2 Other Income 10 15 20

3 Increase in WIP 2 - 3

4 Increase in FG 5 3 2

Total Income 167 193 225

Expenses

1 Opening stock of

raw material

75 60 65

2 Purchases of Raw

Material

65 75 90

3 Closing Stock of

Raw Material

60 65 70

Consumption of

Raw Material

80 70 85

4 Wages and

Salaries

20 20 20

5 Power & Fuel 10 15 18

44

6 Other

Manufacturing

expenses

15 20 25

7 Selling and

Distribution

expenses

10 10 15

8 Depreciation 5 5 5

9 Interest 2 5 7

Total Expenses 142 145 175

Profit Before Tax 25 48 50

Provision for

Taxation

7 14 15

Profit After Tax 18 34 35

Balance Carried to

the Reserves

18 34 35

Fig 3.4

The following data is also available for the company :

1) The realization of sales is as follows :

i. The Outstanding receivable as on March 31, 2005

would be realized as follows :

1. 70% would be realized in 30 days

2. 30% would be realized in 60 days

ii. The sales realization period of the sales of the

financial year 2005-06 would be as follows :

1. 30% of the sales of the month would be

realized within the month; 50% within the next

month and remaining 20% within the next

month.

45

iii. The other income is credited at the end of the

month.

iv. The outstanding creditor for purchase as on March

31, 2005 would be paid as follows :

1. 60% within the next month

2. 30% within the second month

3. 10% within the third month

v. The outstanding creditor for purchase for the

financial year will be paid as follows :

1. 30% within the next month

2. 50% within the second month

3. 20% within the third month

vi. All the other creditor except the salary would be paid

on the next month ; In case of salary it would be

paid on the same month except the outstanding as

on March 31, 2005 which would be paid on the next

month itself.

vii. The company pays advance tax in the month of June

as per the entire provision .

viii. The customer deducts 5% of monthly sales at the

time of payment ad TDS for monthly sale of FY

2005-06.

ix. The company would liquidate March 31st ,

Investment level to the tune of 50% in the month of

May 2005.

x. The company would pay term loan at a monthly

installment of Rs 10 each month .

46

xi. The company would purchase fixed asset to the tune

of Rs 25 lacs in June by paying the amount in the

same month of purchase.

Prepare the monthly cash budget for the first quarter of FY

2005-06.

It should be mentioned that the alternate for a firm to hold cash is to

invest in marketable securities. Without taking into consideration of

any other constraints, a company�s composition of cash and

marketable securities would be determined by a trade off between

interest income earned on marketable securities and transaction cost

for conversion from marketable securities to cash and vice versa. If

the transaction and inconvenience cost are zero, and the conversion is

instantaneous, a firm would hold no cash. When transaction and

inconvenience cost is positive, a firm will want to hold cash when

expected holding period for investment is not long enough to earn

sufficient interest to offset them. Also , if there is some conversion

delay, the firm would like to hold some cash.

The next question is how much cash a firm should hold ? This is

determined by the targeted cash balance. The targeted cash balance is

arrived at by taking into consideration of several models. The models

vary with the nature of future cash flow of the firm.

The future cash flow of the firm can be certain and uncertain. In the

case of certain cash flows, Baumol model and Beranack Model is

used. In case of uncertainty , depending on the degree of uncertainly,

Miller Orr Model and Probabilistic Models are used.

All the above mentioned model assumes certain condition. Before

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

47

conditions are prevailing or not. Otherwise, the model would give

wrong picture. In the case of Baumol, model the key assumption is :

Cash Flows are certain with cash is received periodically and cash

payment is continuous at a steady rate. The other assumptions are

investments yield a fixed rate of return per period of transaction and

the transaction cost is constant irrespective of the amount under

consideration. The example of such firm is a firm managing rental

properties.

At the time of receipt of the cash, the cash is kept in an account and

then the expenses are paid by drawing down the balance from the

same account. If the firm adopts no transaction strategy, we get the

following picture :

Cash Balance Y Time

t Fig 3.5

48

If the firm two transaction strategy, the firm would invest one half of

the receipt amount in marketable securities and would keep one half of

the receipt in cash account. Once the cash account balance would be

exhausted, the amount would be replenished by liquidating the

marketable securities . This is explained with the help of the following

diagram:

Investment Balance Y/2 Time t/2 Fig 3.6 If the interest earned for period t on investment is i and the

transaction cost per transaction is a then the interest income on

investment is (1/2)*(1/2)*iY =(1/4)iY

Since there are two transaction , the transaction cost is 2a

Profit from the transaction is =(1/4)iY-2a

If the firm follows the three transactions strategy, then we have the

following diagram :

49

Cash Balance Y/3 t/3 Time Investment Balance 2/3Y

1/3Y Time t/3

Fig 3.7

50

If the interest earned for period t on investment is i and the

transaction cost per transaction is a then the interest income on the

investment is (2/3)(1/3)iY+(1/3)(1/3)iY=(1/3)iY and the cost of the

transaction is 3a. Profit from the transaction is (1/3)iY-3a.

Whether the two transaction strategy is more profitable than the three

transaction strategy depends on the additional interest earned versus

additional transaction cost incurred. For n number of transaction

interest income would be :[(n-1)/2n]iY and profit is:[(n-1)/2n]iY-na.

The optimum no of transaction at which the profit is maximum is given

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

withdraws from the investment account and the amount of initial

deposit would be [(n*-1)/n*]Y and the amount of withdrawal would be

(1/n*)Y.

The Beranek Model: In this model, the assumption is cash payment is

periodic and cash receipt is continuous at a steady rate. The other

assumptions of the Baumol model will hold. Here, there would be a

number of deposits and a single withdrawal . We can find the same

way as mentioned in the Baumol model the optimum no of

transactions and profit associated with such optimal transaction. The

optimum transaction would be n*= (iY/2a)^0.5 and the firm would

make n-1 deposits and 1 withdrawals from the investment account.

The amount of periodic investment is (1/n*)Y and the amount of final

withdrawal would be [(n*-1)/n*]Y.

Till now ,we have discussed the firm�s for which the cash flow is

certain. There can be a situation where the cash flow would be

51

uncertain. The degree of uncertainty would vary from random situation

to probabilistic situation.

In case the net cash flows are uncertain in such a way that net cash

flows are distributed normally with mean 0, the standard deviation

does not vary over time and there is no correlation of cash flows over

time, then the cash flows must follow a Random walk around a zero

average net flow. Based on these assumptions , and using the

advanced mathematical technique of stochastic calculus ,Miller and Orr

formulated a profit maximizing strategy based on control limits.

Control limits are set up using a formula derived by Miller and Orr.

When the firm�s cash balance goes outside upper control limit ,

investments are made to bring the cash balance back down to the

return point. When the firm�s cash balance goes below the lower

control limit, disinvestments are made to bring the balance back up to

the return point. The formula developed by Miller and Orr is :

R=(3aV/4i)1/3

Where V is the variance of daily cash flows,i is the daily interest rate

on investments, and a is the transaction cost of investing or

disinvesting. If L is the lower control limit ( set by the management ) ,

the optimum return point is R+L and the optimum upper control limit

is 3R+L.

52

Cash Balance

UCL

Return Point

LCL Day

Fig 3.8

In the case of uncertainty where one can associate certain probability

with the future cash flows , Probabilistic Model would give better

results. In this process, end of period cash balances, exclusive of the

purchase or sale of marketable securities can be estimated for various

cash flows outcome to form a probability distribution .The period

should be short , perhaps a few days or no longer than a week .This

probabilistic information, together with information about the fixed

cost of a transfer between cash and marketable securities and the

return on investment in marketable securities, is needed to determine

the proper initial balance between cash and marketable securities.

For various cash flow outcome, the expected net earnings associated

with different initial levels of marketable securities can be determined.

The greater the amount of securities held , the greater the probability

that some of those securities will have to be sold in order to meet a

cash shortfall. The expected net earnings for a particular level of

53

marketable securities is the gross interest earned on the marketable

security position, less the expected loss of interest income associated

with the sale of those securities. When calculations are undertaken for

various possible levels of initial marketable security holdings, one

obtains the expected net earnings associated with each level. The

optimum level of marketable securities is the level at which expected

net earnings are maximized.

Factors to be considered for investment in marketable securities :

While investing in marketable securities , one needs to know about the

Yield and market price of a security.

Yield : For understanding the yield on debt instruments , let us first

start with the types of debt instruments. There are two types of debt

instruments depending on the nature of cash flows associated with

such instruments. One is the discounted instrument and another is

the fixed income instrument. In the case of discounted instrument, the

amount is paid in one installment at the time of maturity and issued at

a discount to the face value. Example of such type of instrument is

Treasury Bill, Commercial Paper ,Certificate of Deposits etc. The yield

is calculated by using the simple interest formula. Let us take an

example: What would be the issue price of a T Bill of face value of Rs

50 lacs with a maturity of 90 days if the discount rate 5.5% p.a?

Issue Price = ( 50,00,000/- /[1+(90*5.5/36500)]

= 49,33,099/- .

In the case of fixed income instrument, there is a periodic cash flows

associated with a coupon amount. Let us take an example. A 6% half

yearly coupon of 3 Year Government of India (GOI) Security is having

54

a face value of Rs 10,000/- . The issue date is 1st September 2005.

The cash flow associated with this instrument is as follows :

Date of Payment Time from Investment

in Year

Amount of Payment

1st March 2006 0.5 300

1st Sept 2006 1 300

1st March 2006 1.5 300

1st Sept 2006 2 300

1st March 2006 2.5 300

1st Sept 2006 3 10300

Fig 3.9

If the issue price of the security is Rs 10,000/- then the yield to

maturity is 6% p.a. So in a fixed income security, the yield means

yield to maturity(YTM). If the issue price is less than Rs 10,000/- , the

YTM is more than 6% and if the issue price is more than Rs 10,000/-,

the YTM is less than 6%.

Different marketable securities vary in yield .The variation in Yield is

due to the following reasons :

• Default Risk : This is the risk associated with the default

probability of the issuer of the security. Given other factors

same, the higher the default risk , the higher should be the

YTM. The rating published by a rating agencies in connection

with the securities issued by a company , can be considered a

fair indicator of the default probability.

• Marketability : The liquidity of a security depends on how well

the concerned security is traded in the market. The higher the

55

marketability, the higher would be the liquidity and lower would

be the yield compared to that of other identical securities

having lower marketability.

• Length of Time to maturity: For a fixed income security, the

length of time to maturity is an important factor and it affects

YTM.

• Coupon Rate : Depending on the coupon rate , the price of a

fixed income security can change. As we have already seen that

the price of a security changes when there is a change of

interest rate. Price fluctuation of a security depends on the level

of the coupon rate. The percentage change in bond�s price

owing to the change in yield would be smaller if the coupon is

higher and vise versa.

• Taxability : The taxability is also an issue associated with the

YTM. The yield would be lower for non taxable securities when

compared with taxable securities.

After discussing some of the factors affecting the yield of a security, let

us discuss about the characteristics of some of marketable securities

available in India.

Treasury Bills : Treasury bills ( T bills )is one of the most important

money market instrument in any country. Before we discuss about the

nature and pricing of T bills , let us discuss the purpose of issuance of

treasury bills.

In our country, there are two types of budget namely Union Budget

and State Budget. In the case of Union Budget, the finance minister

submits the budget statement on the last day of February every year

for the next financial year. The budget contains two accounts:

• Revenue Account

56

o Income Account

o Expenditure Account

• Capital Account

o Receipt Account

o Disbursement Account

The revenue account deficit is arrived at as follows :

Expenditure-Receipt

Capital Account receipt has two parts : Market Borrowing and Other

Receipt. The Gap between Capital Account Disbursement and Other

Receipt is the Gap on the Capital Account. The fiscal deficit is given by

Revenue Deficit + Gap on Capital Account. The Market Borrowing is

basically to meet the fiscal deficit. The Government resort to market

borrowing mainly by issuing securities of maturity more than 1 year

and through coupon bearing instrument. During the year, the income

is not uniform where as the payment is more or less known with

certainty . There is cash flow mismatch between receipt and payment

during the year . This mismatch is bridged by issuance of treasury

bills. So treasury bills are issued by Central Government to bridge the

mismatch of cash flows during the year. Since it is issued by the

Central Government, the T bills carry sovereign guarantee and is an

indicator of risk free rate. T bills can be issued in 14days, 28days , 91

days, 182 days and 364 days duration. T bills are issued at a discount

to face value and is a discounted instrument. T bills are negotiable

from next day of its issuance and this increases the liquidity of the

instrument. T bills are generally issued in the D mat form .When the

purchaser of a T bill is a bank , the transaction is put through

57

Subsidiary General Ledger ( SGL ) .When the purchaser is a non bank

and the purchaser wants T bills in Dematerialised form, the transaction

is put through Constituent Subsidiary General Ledger (CSGL) account.

T bills can also be issued in Physical Form. Individual, Company,

Banks,NRIs and FIIs can invest in T Bills but the usual restriction on

debt securities will be applicable for T bill investment for NRIs and

FIIs.

Commercial Paper : Another short term instrument for investment is

Commercial Paper.Commercial Paper is an unsecured usance

promissory note issued by eligible company�s and permitted entities

.The duration of commercial paper varies from 7 days to 1 year and

the issue is at a discount to face value. The Commercial Paper can be

a good investment for company�s for a shorter duration.

Bank Fixed Deposit : Bank Fixed Deposit is also an option for

investment of short term surplus. The benefit to bank deposit is that it

is a fully liquid instrument and can be converted into cash at any point

of time. Since bank can offer differential rate and also bank can offer

flexible scheme, company can invest in proper fixed deposit scheme to

derive the benefit of liquidity and income to a great extent.

The underlying principle for investment in marketable securities is that

the investment should be risk free and the amount to be determined

at the time of investment. However, many companies can invest in

marketable securities in such a way to earn extra without

compromising much on the risk front. For such companies, investment

in open ended mutual funds, equity market and derivative market can

be of option for investment .

58

Chapter Four

Management of Inventory

By the term inventory, we mean Raw Material, Work In Progress and

Finished Goods. Like all other assets , inventory represents a costly

investment to the firm. There must be some advantages for carrying

inventory which is associated with cost.

There are several reasons for carrying inventory of raw materials by a

firm. First, having an available stock of raw materials inventory makes

production scheduling easier. Second, raw materials inventory is

carried out to avoid price changes for these goods. If the firm keeps a

stock of raw materials, the firm can purchase these goods when it

believes prices are low and can decline to purchase when it believes

prices are high. This reduces the firm�s cost . Third, the firm may keep

extra raw material inventory to hedge against supply shortage. When

prices of raw materials are controlled , there will be times when goods

are unavailable at the controlled price. During these times, the firm

may draw down its existing inventory to continue production. Finally,

the firm may order and keep additional inventories to take advantage

of quantity discount.

In manufacturing firms, a certain amount of work in progress

inventory occurs as products move from one production process to

others. A major reason for keeping work in progress beyond minimum

level is for buffer production. Buffering is a part of the planning

process and allows flexibility and economics that would not otherwise

occur.

The prime reason for keeping finished good inventory is to provide

immediate service. Interlinked with this immediate service, is the issue

of uncertainty of demand of the products of the firm. Another reason

59

for keeping the finished goods inventory would be for stabilizing the

production. When firms produces several types of products using the

same equipment , there are costs and delays in changing from the

production of one product to another. The longer are the firm�s

production runs, the lower are these transaction ( set up) costs.

However, longer production runs result in higher finished goods and

work in progress.

While carrying the inventory , the firm is incurring costs. These costs

are different types and are discussed below :

Costs directly proportional to amount of inventory held: Certain costs

are directly proportional to the level of inventory carried by the firm.

These are usually called � Carrying cost of inventory� or �Holding cost

of inventory�. Examples of these costs are opportunity cost of

inventory investment, insurance on the inventory, storage cost of

inventory, taxes on inventory investment and so forth. The formula for

this type of costs is :

Cost =(a)(amount of inventory)��..4.1

Where a is the coefficient representing the sum of all costs that are

directly proportional to the level of inventory.

Costs not directly proportional to the amount of inventory held: There

is also a group of costs that vary with inventory size but not in direct

proportion. Examples are spoilage and obsolescence. These cost vary

with the length of time that an item is in inventory. The general

formula for these costs is :

Cost =f ( inventory level) ��4.2

Where f ( inventory level) means that the cost is a function of

inventory level while the particular relationship ( linear or not)

depends on the type of cost being considered.

60

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

orders for inventory there are costs to the ordering, delivery and

payment processes. These costs depend directly on the number of

times that orders are placed and received. The formula for this type of

cost is :

Cost = (c ) ( number of orders) ��..4.3

Where (c ) is the coefficient representing the sum of all the costs of

this type.

Price per unit of inventory obtained : Due to quantity discounts and

economies of scale in production, the price per unit of goods

purchased or produced for inventory may vary with the amount

ordered. When this occurs, the change in the total cost of the

inventory that results can be a major determinant of the most

advantageous order quantity. The formula for the total cost of the

inventory :

Cost =Pq S ��4.4

Where Pq is the unit price for the quantity ordered by the firm and S is

the yearly usage of the good.

Stockout Cost : This cost is the cost associated with the situation of

not having adequate inventory.

Other Characteristics of Inventory situation : Besides various types of

costs involved , there are other characteristics of the situation that

vary among types of inventory and must be captured if the decision

model is to be an accurate representation of the physical

circumstances .Several of these characteristics are listed below :

Lead time : Obtaining inventory usually requires a time lag from the

initiation of the process until the inventory starts to arrive.

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Sources and level of risk : Uncertainties play a significant role in the

inventory situation. Uncertainties usually involve lead time and

demand levels, but situations where other variables are uncertain also

occur.Where there are substantial uncertainties and where the costs of

stock out are important , strategies for addressing risk must be

formulated.

Static versus Dynamic Problems : Inventory problems are usually

divided into two types based on the characteristics of the goods

involved. In static inventory problems, the goods have a one period

life; there is no carry over of goods from one period to the next. In

dynamic inventory problems, the goods have value beyond the initial

period; they do not loose their value completely over time.

Replenishment Rate : Once goods start to be received from a vendor

or form the firm�s own production processes, there are differences

among goods in the rate at which they are received. This is called

replenishment rate.

Different Inventory Model :

The Basic EOQ Model :

The Economic Order Quantity (EOQ) model is presented in most of

introductory textbooks in a finance and in management science. First

we present the basic version of this model under the assumption that

all variables are certain. Subsequently , we present other versions of

this model for other inventory situations and present methods for

developing safety stock strategies to address risk. The basic EOQ

model is simple, but it is applicable only to those inventory situations

described by its assumptions , which are :

• There are only two types of costs: costs that are directly

proportional to the amount of inventory held and costs that are

directly proportional to the number of orders received.

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• There may be lead times of any length

• There is no risk ( risk is modeled separately in determining

safety stock strategy)

• The replenishment rate is finite.

The time pattern of inventory for these assumptions is portrayed in

Figure 4.1 The top portion represents relatively large order quantity

and the bottom portion represents relatively small order quantity.

Inventory Level

QA

Time t Inventory Level QB

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

orders while the bottom portions represents smaller level of

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inventories but larger number of orders. In the first case, inventory

carrying cost is more but ordering cost is less while in the second case,

inventory carrying cost is less but ordering cost is more. To decide on

the optimum level of Q , we need a mathematical model of the trade

offs between the two costs.

The average amount of inventory would be (Q+0)/2 or Q/2.

The logical way to value this inventory investment is in rupees. If the

rupee investment per unit is P and the yearly cost of holding a dollar of

inventory ( equal to the sum of all the costs that are directly

proportional to inventory level ) is C, then the inventory carrying cost

is equal to :

Cost =CP(Q/2) ��.4.5

For any level of order quantity , over an entire year the amount

ordered must be sufficient to cover the yearly usage (S).The number

of orders required to do this is :

Number of Orders =S/Q ��4.6

If F be cost of ordering , then ordering cost :

Ordering Cost =F(S/Q) ��.4.7

Total Cost (TC) =CP(Q/2)+F(S/Q) ��..4.8

dTC/dQ= CP/2-F(S/Q2 )

0= CP/2-F(S/Q2 )

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Q*=(2FS/CP)0.5 ��.4.9

Where Q* is the optimum ( lowest total cost) ordering strategy

.Substituting the figures from the example problem in to this formula ,

the optimum order quantity is calculated :

Q*=(2FS/CP)0.5

Let us take an example. Several variations of this problem would be

used for understanding different model of inventory management.

A firm purchases 10,000 units of pa particular product per year. The

product costs Rs 8/- per unit. The sum of insurance, storage, and the

opportunity cost of invested funds is 20 % per year of the average

rupee investment in inventory. Each time the firm places an order , it

costs Rs 50/- in out of pocket expenses to generate the purchase

order , receive goods etc. How much the firm should order each time

an order is placed ?

Q*=[(2(50)(10000)/(0.20(8))]0.5

= 790.57=791

The Order Point : The order quantity strategy outlined above is very

simple to implement. Order 791 units every 28 days .However, rather

than using a times ordering approach, it is often advantageous to

place orders based on inventory levels. The triggering of orders based

on inventory levels is called the order point system. The order point is

calculated based on the expected usage during the lead time. If the

65

lead time is 7 days , the usage during the lead time is

(7/360)(10000)=194 units .When the level of inventory reaches 194

units, the firm should place an order for 791 units. The basic EOQ

model with order points is easy to understand and to put into practice,

but its range is limited to those situations described by its

assumptions. Other situations require different models to portray their

different circumstances.

Variation of the basic EOQ Model:

We shall discuss two variations of basic EOQ model; the production

order quantity model and the EOQ Model with quantity discounts .

The Production Order Quantity Model : There are many inventory

situations where the increase in the inventory level during the

replenishment portion of the inventory cycle is not instantaneous.

While such situations may occur because of other circumstances ( such

as limitations in the ordering firm�s ability to unload materials quickly)

, one common circumstance happens when the firm produces its own

goods for inventory. This is shown in the following figure :

Inventory Level QA[1-(S/R))] Time Fig 4.2

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The primary difference between the basic EOQ model and the model

for the finite replenishment case ( also called as POQ model) concerns

the maximum inventory that occurs during the inventory cycle, and

therefore the level of holding costs of inventory. Since the

replenishment portion of the inventory cycle takes place over time and

there is a continual usage of inventory , the maximum inventory that

occurs in the POQ model is less than the order quantity. For example,

assume a firm makes 500 units of a product for inventory and takes a

week to produce these units. Also assume that usage is 20 units per

day .Over the seven day week during which the firm is producing

these goods, 140 units of product will be used. So the net increase in

inventory will be 360 units :the 500 units that were added to

inventory, less 140 units that were withdrawn from inventory during

this week. If the inventory started the week at zero, the inventory

after the replenishment will be 360 units , not 500.

So a different mathematical model is required. Let R be the

replenishment rate, the rate at which items are put into inventory.

During the replenishment portion of the inventory cycle, Q items would

be received. The length of the replenishment portion of the inventory

cycle must then be equal to Q/R. During the replenishment portion of

cycle, inventory will be used up at rate S; since this part of the cycle is

Q/R in length , the usage over this portion of the cycle will be S(Q/R).

Maximum Inventory =Q-S(Q/R)=Q[1-(S/R)] ��4.10

Since the inventory level varies from zero to this maximum in a linear

fashion , the average inventory will be one half of the maximum ,or:

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Average Inventory =Q[1-(S/R)]/2 ��..4.11

Holding Cost =CPQ[1-(S/R)]/2 ��..4.12

The number of order would be same . The total cost :

TC= CPQ[1-(S/R)]/2+F(S/Q) ��4.13

Proceeding in the same manner ,we get

Q*=(2FS/CP[1-(S/R)])0.5 ��..4.14

Considering the same problem : A firm purchases 10,000 units of pa

particular product per year. The product costs Rs 8/- per unit. The sum

of insurance, storage, and the opportunity cost of invested funds is 20

% per year of the average rupee investment in inventory. Each time

the firm places an order , it costs Rs 50/- in out of pocket expenses to

generate the purchase order , receive goods etc. Assuming a

replenishment rate of 40,000 units/year how much the firm should

order each time an order is placed ?

Q*=[2(50)(10000)/(0.20)(8)(1-(10000/40000)]0.5

=912.87=913

The optimum order quantity is 913 units per order .

Quantity Discounts : The prior model deals with cases where the

replenishment rate is finite. Let us again return to the basic infinite

68

replenishment rate situation but now model the circumstance where

the cost of acquiring inventory varies with the amount acquired. The

most common example of this situation is the existence of quantity

discounts . With quantity discounts, the firm�s ordering strategy affects

the total cost of material and this effect must be incorporated in the

model. So the total cost equation would be :

TC=CPq(Q/2)+F(S/Q)+PqS ��.4.15

To find the optimum order quantity , it would be useful if we could

take the derivative of equation with respect to Q, set this equal to 0,

and solve for Q*,as before. Unfortunately, the quantity discount

policies of most selling firms ( the manner is which Pq varies with Q)

are not such that Pq is a continuous function of Q. One alternative

approach to the problem is to evaluate the total cost function of

various levels of Q via a spread sheet and find out the level at which

the cost is minimum.

Safety Stock Strategies For Addressing Uncertainty:

There are two major uncertain variables in inventory situations: The

demand for the goods and the lead time from the order to the arrival

of the goods. If neither of these variables is uncertain, the firm can

plan perfectly. However, when either or both of these variables is

uncertain , there will be times when the firm will not have sufficient

goods available , and will then incur stock out costs. To avoid these

stock out costs of inventory, trading off the holding costs of this

69

safety stock against the stock out costs that would result from not

maintaining it.

Models for the optimum level of safety stocks are developed based on

the trade off between stock out costs and the holding costs of the

safety stock. Models will be developed for three circumstances

regarding uncertainty :

1. Only demand is uncertain

2. Only lead time is uncertain

3. Both lead time and demand are uncertain

In all these models , the following assumptions would be made:

1. The firm uses the EOQ/order point system to generate order

quantity strategies.

2. If the firm stocks out of the good, it incurs a one time cash cost

which is independent of the amount of shortage.

3. Holding costs of the safety stock are a linear function of the

amount of safety stock held.

4. The probability distributions of the uncertain variables are

normal.

Uncertain Demand Levels: Since, most of the firms, sales are

uncertain , so is their usage of finished goods, work in progress, and

raw materials. To assess the probability of stock out for a given level

of safety stock, we need an estimate of the uncertainty in demand. If

the firm is using the EOQ/order point system, the relevant uncertainty

of demand is the uncertainty of demand during lead time. It is the

uncertainty of demand between order and delivery that is relevant in

formulating safety stock policy.

Let us take an example. In our basic EOQ problem as mentioned

before, the optimum ordering strategy was to order 791 units when

the level of inventory reached an order point of 194 units, given a lead

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time of 7 days and yearly demand of 10,000 units. The price was Rs

8/- per unit and the carrying cost of the inventory was 20% per year.

Assuming that the yearly demand is uncertain, with a coefficient of

variation of 0.10.Assume also that the lead time is certain and that the

cost of a stock out is Rs 100.How much safety stock the firm should

hold ?

Let A be the level of the safety stocks in units. The yearly holding costs

of this safety stock will be CPA. Let the probability of stock out during

an inventory cycle based on this level of safety stock should be Xa. The

expected cost per cycle of stocking out will then be XaK, where K is the

cost of the stock out .Since there are S/Q* cycles per year, the

expected stock out cost will be XaK(S/Q*), and the cost associated

with the safety stock will be :

Total Safety Stock Cost = CPA+ XaK(S/Q*)��4.16

The optimum can be found more directly by taking the derivative

equation, setting this equal to zero, and solving for the optimum A.

The derivative of the above equation is :

dTC/dA = CP+(dXa/dA)K(S/Q*) ��4.17

A closed form solution to this equation requires an expression for

(dXa/dA). For the normal distribution , this expression is :

(dXa/dA)=- [1/(SDd*(2∏)0.5) ]e-(1/2SDd2)A^2 ��..4.18

Where SDd is the standard deviation of demand during the lead time.

Substituting this in the above mentioned equation and setting this

equal to zero and simplifying , we obtain :

A* = [-2 SD2d ln {CPQ* SDd(2Π)0.5/SK}]0.5 ��4.19

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Inserting the data from the example problem into this equation, the

optimum safety stock can be calculated :

A* = [-2 19.42 ln {0.2(8)791(19.4)[2(3.14159)0.5/10000(100)}]0.5 =45.81 So the optimum strategy is to carry a safety stock of 46 units. Since

the expected usage during the lead time is 194 units, the firm should

place an order for 791 units when the inventory level reaches 240

units. This level of safety stock would result in a Z score of

46/19.41=2.37 and a stock out probability of 0.008894 for each

inventory cycle. Substituting these figure into the equation gives the

yearly cost of the optimal safety stock strategy :

Total Safety Stock Cost = CPA+ XaK(S/Q*)

=0.20(8)(46)+0.008894(100)(10000/791)

=Rs 74+Rs 11=Rs 85/- .

Uncertainty Lead Times: Firms may also face situations where demand

is certain but the lead time between order and the arrival of the

inventory is uncertain. Uncertainty lead times often occur when the

firm orders materials from a supplier. In such a case, if the firm kept

no safety stock, stock out costs would have been incurred.

The appropriate model for determining the optimum safety stock with

uncertain lead time is essentially the same as that where only demand

is uncertain. Let us assume that a firm�s demand for a particular good

was 5 units per day for certain, but the lead time from order to

delivery was 10 days with a standard deviation of 2 days. This is the

same as saying that, units with a standard deviation of 10 units( 2

days times 5 units per day) .If SD1 is the standard distribution of

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demand during the time form order to receipt due to uncertainty

regarding the lead time , the above formula still gives the optimum

order quantity , but SD1 is substituted for SDd.

Uncertain Demand and Uncertain Lead Times : There are many

circumstances where both demand and lead time are uncertain .In

such case, both uncertainties must be taken into action in formulating

safety stock strategy. Here , the probability distributions of demand

and lead time uncertainty must be combined to obtain an estimate of

the total uncertainty during the time between placing of the order and

its receipt. The formula for the standard deviation of two combined

probability distributions is :

SDc =(SDa2 + SDb

2 +2 SDa SDb CORab )0.5 ��..4.20

Where SDc is the standard deviation of the combined distributions.SDa

is the standard deviation of the first distribution, SDb is the standard

deviation of the second distribution, and COR ab is the correlation

coefficient between the two distributions. First we find out SDc from

the above mentioned formula and then we apply the same in the

following formula :

A* = [-2 SD2cln {CPQ* SDd(2Π)0.5/SK}]0.5 ��..4.21

73

Chapter Five

Management of Receivable

Accounts receivable management starts when inventory management

ends and ends when management of cash begins. It is also known as

Credit Management . Credit Management primarily concerns with the

following issues :

1. Arrival at the decision methodologies for

arriving at the appropriate terms of sales or

terms of credit.

2. Arrival of the identification of firms whom to

extend credit

3. Monitoring of Accounts Receivable

Before we proceed further, let us examine the reason for existence of

credit system in business. Prime reasons for existing such system are

as follows :

1. Extending credit by a firm can create an opportunity

for financial arbitrage. When the seller firm is

financially more strong than the buyer firm, the

seller firms can extract credit at a favourable term

from the bank and then extend credit to the buyer

firm .In the process, it charges interest which is

more than the interest pays to the bank. Generally

any good corporate would be able to avail fund from

the banking system at a rate of 12% to 14% p.a.

while the minimum amount charges for extending

credit is 24% p.a. This provides a clear arbitrage of

12% to 10% p.a.

74

2. Buyers imperfect knowledge about the quality of the

product may be another reason fro existence of the

credit mechanism. When payment is delayed to

some extent, the buyer can inspect and count the

goods purchased.

3. Adjustment of sales to take care of temporary

fluctuation of demand of products. During the lean

season, it can extend the favourable terms of sales

to stimulate sales and during the busy season, it can

put more stringent conditions for sale.

The typical sequence of events when a firm grants credit is as

follows :

1. The credit sale is made;

2. The customer sends a cheque to the firm;

3. The firm deposits the cheque;

4. The firm�s account is credited for the amount of the

cheque;

This is explained with the help of the following diagram :

Credit Customer Firm Deposit Bank Credits Sale mails cheque Cheque in Bank Firm account Made

Cash Collection

Accounts Receivable

75

Fig 5.1 It can be viewed from the above that one of the factors influencing the

receivables period is float.Thus one way to reduce the receivable

period is to speed up the check mailing, processing and clearing.

Terms of Sales : The terms of a sale are made up of three distinct

elements :

1. The period for which credit is granted (the

credit period);

2. The Cash discount and the discount period;

3. The type of credit instrument;

Within an industry, the terms of sale are usually fairly standard, but

these terms vary quite a bit across industries.

The Basic Form : The easiest way to understand the terms of sale is to

consider an example. For bulk purchase of an item , terms of 2/10, net

60 days are commonly given by a seller. This means that the

customer has to pay in 60 days from the invoice date to pay the full

amount. But if payment is made within 10 days, a 2 percent cash

discount can be taken.

Let us consider a buyer who places an order for Rs 1000/- and assume

that the terms of the sale are 2/10, net 60. The buyer has the option

of paying Rs 1000 (1-0.02)=Rs 980/- in 10 days , or paying the full Rs

1000/- in 60 days. If the terms of sale are stated as just net 30, then

the customer has 30 days from the invoice date to pay Rs 1000/- and

no discount is offered for early payment.

76

The Credit Period : The credit period is the basic length of time for

which credit is granted.The credit period varies widely from industry to

industry, but it is almost always between 30 and 120 days. If a cash

discount is offered, then the credit period has two components :the

net credit period and cash discount period. The net credit period id the

length of time the customer has to pay. The cash discount period is

the period during which the cash discount is available. With 2/10, net

30, the net credit period is 30 days and the cash discount period is 10

days.

Invoice date : The invoice date is the beginning of the credit period.

For individual items, by convention, the invoice date is usually the

shipping date or the billing date, not the date that the buyer receives

the goods or the bill. Many other arrangements also exist. For

example, the terms of sale might be ROG, for receipts of goods. In this

case, the credit period starts when the customer receives the order.

This might be used when the customer is at a remote location. With

EOM dating, all sales made during a particular month are assumed to

be made at the end of the month. This is useful when a buyer makes

purchase through out the month, but the seller only bills once a

month.

Length of the credit period : Several factors influence the length of the

credit period. Two important factors are the buyer�s inventory period

and operating cycle. All else equal , the shorter these are, the shorter

the credit period will be. The operating cycle has two components : the

inventory period and the receivable period. The buyer�s inventory

period is the time it takes the buyer to acquire inventory , process it

and sell it. The buyer�s receivable period is the time it then takes the

buyer to collect on the sale. The credit period the seller offers is

effectively the buyer�s payable period. By extending credit, the seller

77

finance a portions of buyer�s operating cycle and thereby shortens the

buyer�s cash cycle. If seller�s credit periods exceeds the buyer�s

inventory period, then the seller is not only financing the buyer�s

inventory purchase, but part of the buyer�s receivable as well. If the

seller�s credit period is more than the buyer�s operating cycle, then

the seller is effectively providing financing for aspects of its customer�s

business beyond the immediate purchase and sale of its merchandise.

There are other factors that influence the credit period. Among the

most important are :

• Perishability and collateral value :Perishable items have

relatively high turn over and low collateral value. So credit

period extended would be shorter for such goods.

• Consumer Demand : Products that are well established generally

have more rapid turn over and relatively lower credit period

than the newer products.

• Cost , Profitability and Standardization :Relatively less expensive

items goods tend to have shorter credit periods. The same is

true for relatively standardized goods and raw materials. These

all tend to have lower markups and higher turnover rates, both

of which lead to shorter credit periods.

• Credit Risk : The greater the credit risk of the buyer , the shorter

the credit period is likely to be granted.

• Size of the account: If an account is small, the credit period may

be shorter because small account costs more to manage, and

the customers are less important.

• Competition: When the seller is in a highly competitive market,

longer credit periods may be offered as a way of attracting

customers.

78

Cash Discounts : The cash discounts are often part of the terms of

sale. When a cash discount is offered, the credit is essentially free

during the discount period .The buyer only pays for the credit after

the discount period is over. With 2/10, net 30, a rational buyer

either pays in 10 days or pays in 30 days. By giving up the

discount, the buyer effectively gets 30-10=20 days� credit.

Another reason for cash discounts is that they are a way of

charging higher prices to customers that have had credit extended

to them. In this sense, a cash discount is a convenient way of

charging for the credit granted to customers.

Cost of Credit : In the previous example, it might seem that the

discounts are rather small. With 2/10, net 30, for example early

payment gets the buyer a 2 percent discount. We can find out the

interest rate that the buyer is effectively paying for the trade credit.

Suppose the order is for Rs 1000/- .The buyer can pay Rs 980/- in

10 days or wait for another 20 days and pay Rs 1000/-.It is obvious

that the buyer is effectively borrowing Rs 980/- for 20 days and

pays Rs 20/- in interest on the loan. The interest rate work out to

be Rs 20/ Rs980=2.0408% but for the period of 20 days . So the

effective annual rate EAR is :

EAR=1.02040818.25 -1=44.6%

The Average Collection Period (ACP) : The investment in accounts

receivable for any firm depends on the amount of credit sales and

average collection period (ACP). If a firm�s average collection

period,ACP, is 30 days , then at any given time, there will be 30

days� worth of sales outstanding. If credit sales run Rs 1000/- per

day , the firm�s accounts receivable will then be equal to 30daysX

Rs 1000/- per day =Rs 30000/- . So

Accounts Receivable =Average Daily sales X ACP

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A cash discount encourages customers to pay early, it will shorten

the receivable period and , all other things being equal ,reduce the

firm�s investment in receivables. For example, a firm currently has

terms of net 30 and an average collection period ACP , of 30 days.If

it offers 2/10, net 30, then perhaps 50 percent of its customers will

pay in 10 days. The remaining customers will still take an

advantage of 30 days to pay. The ACP would be :

New ACP=0.50X10days +0.50X 30days =20days

Credit Instruments : The credit instrument is the basic evidence of

indebtedness. Most trade credit is offered on open account. This

means the only formal instruments of credit is the invoice, which is

sent with the shipments of goods and which the customer signs as

evidence that the goods have been received. In certain cases, the

buyers needs to accept a bills of exchange for taking delivery of

goods. The same bills of exchange can be used by the seller to raise

fund immediately from the banks.

Analyzing the Credit Policy :

We shall now take a closed look at the factors that influence the

decision to grant credit. Granting credit makes sense only if the

financial results from such decision is positive. The important

dimensions of a firm�s credit policy are :

• Credit Standards

• Credit Period

• Cash Discount

• Collection Effort

Credit Standards : In general, liberal credit standards tend to push

sales up by attracting more customers. This, is however, accompanied

80

by a higher incidence of bad debts loss, a larger investment in

receivables, and a higher cost of collection. Stiff credit standards have

opposite effects. The effect of relaxing the credit standards on profit

may be estimated by using the formula :

∆ P=∆S(1-V)-k∆I-bn∆S ��.5.1

∆ P= Change in Profit

∆S= Increase in sales

V = Ration of variable costs to sales

k= cost of capital

∆I= increase in receivable investment

bn =bad debt loss ration on new sales

On the right hand side of eqn 5.1, the first term measures the increase

in gross profit, the second terms, k∆I, measures the opportunity cost

of additional funds locked in receivables , and the third term, bn∆S,

represents the increase in bad debt.

Credit Period : The credit period refers to the length of time customers

are allowed to pay for their purchases. It generally varies from 15

days to 60 days. When a firm des not extend any credit , the credit

period would obviously be zero. If a firm allows 30 days of credit, with

no discount to induce early payments, its credit terms are stated as

�net 30�.Lengthening of the credit period pushes sales up by inducing

existing customers to purchase more and attracting additional

customers. This is, however, accompanied by a larger investment in

receivable and a higher incidence of bad debt loss. Since the effects of

lengthening the credit period are similar to that of relaxing the credit

standard, we may estimate the effects on profit of change in credit

81

period by using the same formula of 5.1. Here we put the value of ∆I

as follows :

∆I =(ACPN-ACP0)[S0/360]+V (ACPN) [∆S/360 ]��.5.2

∆I= increase in investment

ACPN =new average collection period ( after

lengthening the credit period)

ACP0=old average collection period

V =ratio of variable cost to sales

∆S = increase in sales

On the right hand side of eqn 5.2, the first terms represents the

incremental investment in receivables associated with existing sales

and the second term represents the investments in receivables

arising from the incremental sales. It may be noted that the

incremental investment in receivables arising from existing sales is

based on the value of sales, whereas the investment in receivable

arising from new sales is based on the variable costs associated

with new sales. The difference exists because the firm would have

collected the full sale price on the old receivable earlier in the

absence of the credit policy change, whereas it invests only the

variable costs associated with new receivables.

Cash Discount : Firm generally offer cash discounts to induce

customers to make prompt payments. The percentage discount and

the period during which it is available are reflected in the credit

terms. As mentioned earlier , credit terms of 2/10, net 30 mean

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that a discount of 2 percent is offered if the payment is made by

the tenth day, otherwise full payment is due by the 30th day.

Liberalizing the cash discount policy mean that the discount

percentage is increased and/or the discounts period is lengthened.

Such an action tends to enhance sales , reduce the average

collection period, and increase the cost of discount. The effect of

such an action on gross profit may be estimated by the following

formula :

∆ P=∆S(1-V)+k∆I-∆DIS ��.5.3

∆ P= Change in Profit

∆S= Increase in sales

V = Ration of variable costs to sales

k= cost of capital

∆I= savings in receivable investment

∆DIS = increase in discount cost

Where

∆I =(ACP0 -ACPN)[S0/360]-V(ACPN) [∆S/360 ]��.5.4

and

∆DIS = pn(S0+∆S )dn � p0S0d0 ��..5.5

pn =proportion of discount sales after liberalizing the discount terms

S0 =sales before liberalizing the discount terms

∆S = increase in sales as a result of liberalizing the discount terms

dn = new discount percentage

p0=proportion of discount sales before liberalizing the discount terms

d0 = old discount percentage

83

Collection effort : The collection programme of the firm, aimed at

timely collection of receivables, may consist of the following:

• Monitoring the state of receivables

• Despatch of letters to customers whose due date is

approaching

• Telegraphic and telephone advice to customers around the

due date.

• Threat of legal action to overdue accounts

• Legal action against overdue accounts

A rigorous collection programme tends to decrease sales, shorten the

average collection period, reduce bad debt percentage, and increase

the collection expense. A lax collection programme , on the other hand

, would push sales up, lengthen the average collection period, increase

in bad debt percentage, and perhaps reduce the collection expenses.

The effect of decreasing the rigour of collection programme on

profit may be estimated as follows:

∆ P=∆S(1-V)-k∆I-∆BD ��.5.6

where ∆BD= increase in bad debt cost.

Here ∆I =(ACPN-ACP0)S0/360]+(ACPN) [∆S/360 ]��.5.7

and

∆BD = b0(S0+∆S )dn � b0S0 ��..5.8

Credit Evaluation : Before granting credit to a prospective customer

the firm must verify about the creditworthiness of the customer. In

judging the credit worthiness of the customer, the three basic factors

Character ,Capacity and Collateral are considered. There are several

ways one can find these three factors. Some of them are :

84

• Analysis of Financial Statement

• Obtaining bank reference

• Analysis of firm�s experience

• Numerical credit rating

Analysis of Financial Statement : Financial statements contain a

wealth of information about the customer�s financial conditions and

performance. The following ratios would be helpful to achieve this

purpose :

• Current Ratio

• Acid Test Ratio

• Debt Equity Ratio

• EBIT-total asset Ratio

• Return on Equity

Obtaining Bank Reference : The banker of the prospective client may

be another source of information about its financial condition. This

information may be obtained indirectly through the bank of the credit

granting firm to ensure a higher degree of candidness.

Analysis of Firm�s experience: Consulting one�s own experience is very

important. If the firm has had previous dealings with the customer,

then it can check from its past track record. But in case, the customer

is being approached fro the first time the impression of the company�s

salesman about the integrity of the customer is important.

Numerical Credit Scoring : Under this system, a customer�s

creditworthiness may be captures in a numerical credit index based

on several factors. The credit index is simply a weighted sum of factors

which ostensibly have a bearing on credit worthiness.

85

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

Collection policy involves monitoring receivables to spot trouble and

obtaining payment on past due accounts.

Monitoring Receivables : To keep the track of payments by customers,

most firms will monitor outstanding accounts. First of all, a firm will

normally keep track of its average collection period, ACP, through

time. If a firm is in a seasonal business, the ACP will fluctuate during

the year, but unexpected increase in the ACP are a cause for concern.

Either customers in general are taking longer to pay, or some

percentage of accounts receivable is seriously overdue.

The aging schedule is a second basic tools for monitoring receivable.

To prepare one, the credit department classifies accounts by age. Let

us take an example where the firm has Rs 1,00,000/- in receivable.

Some of these accounts are only a few days old, but others have been

outstanding for quite some time. The following is the break up of

receivable as per age :

Aging Schedule

Age of accounts Amount ( Rs ) Percentage of Total

Value of Accounts

Receivable

0-10 days 50000 50%

11-60 days 25000 25%

61-80 days 20000 20%

Over 80 days 5000 5%

10000 100%

Fig 5.2

86

If this firm has a credit period of 60 days, then 25% of its accounts are

late.

Collection Effort:

A firm usually goes through the following sequence of procedures for

customers whose payments are overdue :

1. It sends out a delinquency letter informing the customer of the

past due status of the account;

2. It makes a telephone call to the customer;

3. It employs a collection agency;

4. It takes legal action against the customer.

87

Section Three

88

Chapter Six

Assessment of Fund Based and Non Fund Based Working Capital

By Fund Based ( FB) working capital facility, we mean products of

banks through which bank provides fund for meeting working capital

requirement of the company . If we recall the concept of building up of

working capital discussed in the chapter one , we find that current

assets represents the expenses which is incurred but not realized. We

have also said that part of the expenses can be deferred and this

constitutes the other current liability ( OCL).The expenses which can

not be deferred would be paid from borrowings. We have also seen in

Chapter two, that a part of the expenses are paid from Net Working

Capital ( NWC) and the remaining part of expenses would met from

borrowing of the banking system. We have also discussed the reason

for bank�s being the major provider of working capital facilities in our

country. So Fund Based ( FB) working capital represents that portion

of current liability which is going to build up that portion of current

assets which are not financed by OCL and NWC.

After defining the FB working capital products, we shall now discuss about

the entire process of availing the Fund Based Working Capital facility of bank.

The sequence of availing the facility from bank is as follows:

1. Company assess its working capital requirement ;

2. After assessment, the company decides the type of banking;

3. Company initiates the process of tying up of fund from banking

system;

4. Company avails the fund from the baking system;

5. In the next year, company follows the same process;

89

Assessment of Working Capital Requirement :

The working capital facility of a company consists of two types of

facilities :

1. Fund Based Working Capital Facility

2. Non Fund Based Working Capital Facility

While the detail discussion on Non Fund Based facility would be done

in the next chapter, in this chapter we shall discuss the fund based

facility.

Though the final assessment of fund based facility is carried out by the

lender, the process starts from company�s end. If company is aware of

the process of assessment of working capital , it would be able to

sanction its working capital as per its requirement.

Assessment is defined as the process by which one can determine the

maximum amount of fund can be availed from institutional lender to

meets a company�s working capital requirement. So assessment of

working capital for a corporate means the process of arriving at the

maximum quantum of working capital requirement of a corporate for a

particular period.

Assessment of Fund Based Working Capital

In India, Fund Based working capital is carried out with the help of any

of the three following processes :

1. Maximum Permissible Bank Finance ( MPBF) Process

2. Cash Budget Process

3. Turn Over Process

90

MPBF Process : Under this method , the assessment of fund based

working capital is carried out by taking into account figures from

Balance Sheet as on a particular date. Before going into detail, let us

make one concept very clear. Since a company is carrying out

assessment , it is trying to ascertain funds required in the future. The

past financials would indicate the company�s achieved performance

and also validates the future financials. But the assessment is carried

out on the basis of future financials.

When we talk about the future, there are two years. One is the current

running year and another is the next coming year. While the figures

for the first one is called Estimate , the later one is called the

Projections. For example, a corporate carrying out the assessment as

on May 1,2005, the company has two choices. If it follows the

assessment based on estimates, it will take financial data for the FY

2005-06 and Balance Sheet data as on March 31,2006. If it follows the

assessment based on projections, it would use the datas for the FY

2006-07 and also Balance Sheet Data as on March 31,2007.

Now coming back to MPBF process, under this process FB working

capital requirement would be carried out in any of the following three

methods:

1. Method I

2. Method II

3. Method III

In all the above three methods, all the figures are taken from the

balance sheets. The figures are either from �Estimates� or from

�Projections� but not from both. While arriving at the assessment

figure of Fund Based Working Capital requirement under MPBF

method, company needs to submit data in a specified format. This

form is called as �Credit Monitoring Arrangement or CMA� forms. CMA

91

form consists of 6 separate forms representing different types of

figures taken from Profit & Loss and Balance Sheet of the company

.The following tabular representation would make it clear the content

and implications of these 6 forms :

Form No Content of Form Justification

I Total Existing Borrowing of

the company as on the

date of application

The proposed lender

would decide to take a

fresh exposure depending

on the existing leverage

and future cash out flows

from the existing

borrowing of the

company

II Profit and Loss Accounts Detail analysis of Profit &

Loss account of the

company.Since the

funding for working

capital is predominantly

for meeting the expenses

incurred but not

recovered in connection

with the production of

goods and services,

major analysis is carried

out for expenses

associated with the

productions.

III Analysis of Entire Balance Detail Balance Sheet

92

Sheet of the company Analysis of the company

is carried out. Here some

adjustment is made to

incorporate the effect of

certain off balance items

and also the immediate

effect of cash out flows

IV Analysis of Current Assets

and Other Current Liability

As we have already seen,

Working Capital Finance

is mainly to take care of

Current Assets and Other

Current Liability. Form IV

aims to carry out detail

analysis of Current

Assets and Other Current

Liabilities in terms of

months of holding and

other parameters

V Assessment of Fund Based

Working Capital

This calculated the MPBF

depending on the

methods followed.

VI Fund Flow Analysis This explains detail

calculation of sources and

uses of long term funds

and the utilization of

NWC towards individual

current assets.

Figure 6.1

93

Form I: Form I contains the existing borrowing of the company. This

includes all types of borrowing namely Term Loan, Debenture,

Unsecured Loan and also Lease Finance. It must contain data as on

the application date .This information would help the proposed lender

to take a decision whether it should lend depending on the leverage of

the company, repayment capacity towards already existing

commitment of the company.

Form II : This form and Form III contain the financial data for 4 years.

These contain actual data for last 2 years , estimates for the current

financial year and projections for the next financial year.For example,

a company applying for Fund Based Working Capital under MPBF

methodon July 1,2005, should give the following 4 sets of data in Form

II & III:

1. Actual Data ( Audited Figure) for the financial year ended March

31,2004 and March 31,2005.

2. Estimates Data for the financial year ending March 31,2006.

3. Projections Data for the Financial year ending March 31,2007.

For III is actually representation of Profit & Loss figure of the company

with a special emphasis on the cost associated with the production of

goods and services.

Form III : This form comprises of data taken from the Balance Sheet

of a company.If one analyse the format of Form III, one can find out

the following :

Form III starts with the Current Liability . In this form , current liability

is segregated into 2 parts. The first part consists of Bank Borrowing for

working capital and the second part consists of Other Current Liability

( OCL) .The Term Liability ( TL) is presented and the total outside

liability is arrived at. Then comes the Own Capital .It starts with Equity

94

and then figures representing reserves and other equity type of

instruments are taken in to account. The total of Out Side Liability (

Term Liability + Current Liability) and Owned Fund represents the

Total Liability of the company .

The Asset Side of the Form III starts with Current Assets. Then comes

Gross Fixed Asset , depreciation and Net Fixed Asset. Then the figures

representing the Non Current Assets ( NCA) are incorporated. Then,

Intangible assets if any is also taken in to account. Taking all these

together ( Current Asset+ Net Fixed Asset +Non Current Asset +

Intangible Asset) , one arrives at the Total Asset figure of the

company.

There are some adjustments required to fill up Form III of CMA form.

To understand these adjustments in Form III of CMA form ,let us take

the example of the following :

Balance sheet of X Limited as on March 31,2005

All amount in Rs Lacs

Sources of Fund :

Schedule Amount

Share Capital 1 100

Reserves 2 250

Secured Loans 3 125

Total Source of Fund 475

Uses of Fund : Schedule Amount

Fixed Asset 4 200

95

Less Depreciation 50

Net Fixed Asset 150

Investment 5 100

Current Assets ,Loans and Advances 285

Current Assets 225

Raw Material 6 70

Work In Progress 7 20

Finished Goods 8 30

Receivable 9 100

Cash at Bank 10 5

Loans and Advances 11 60

Loan to Group Companies 20

Loan to Staff 10

Other Advance 10

Tax Deduct at Source 5

Advance Tax Paid 15

Less Current Liability and Provision 60

Current Liability 12 40

Sundry Creditors 30

Advance from Customers 10

Provision 13 20

Provision for Taxation 15

Provision for Dividend 5

Net Current Asset

225

Total Uses of Fund 475

96

Notes on Contingent Liabilities :

a. Bill discounted from Bank Rs 15 lacs.

Further Information from Schedules are Available as follows :

Schedule Description Amount ( Rs in lacs)

2 Reserves 250

Revaluation Reserves 20

Free Reserves 230

3 Secured Loan 125

Term Loan

( The term Loan to be

paid in 5 yearly

installment of Rs 10

lacs each )

50

Cash Credit for

Working Capital

75

5 Investment 100

Fixed Deposit in Bank 50

Investment in Group

Companies

30

Investment in Quoted

Shares

20

9 Receivable 100

Outstanding for more

than 180 days

25

Outstanding for up to

than 180 days

75

97

Figure 6.2

In the actual accounts of a company, we get details of each schedule.

In this section, we have made only those schedules which are required

for adjustment of figures in filling Form III of CMA form.

1) The First adjustment is the bill discounted amount. When a

company sells on credit the following entry is passed :

Dr Receivable

Cr Sales

There is no cash flow associated with this entry. To improve the

cash flow the company can sell a part of its credit sales after

drawing bill of exchange. So the receivable can be segregated

into two groups :

a. Accounts Receivable : This is simple

credit and there is no bills of exchange.

This is also called as Open Account Sales.

b. Bills Receivable : In this type of credit

sales , apart from documents required

under Open Account Sales , additional

document in the form of Bills of

Exchange also accompanies the

document. The buyer once accepts the

bills of exchanges would be liable to pay

the bills of exchange. Some additional

protection under legal statute is available

for the Drawer of Bills of Exchange since

98

Bills of Exchange is a negotiable

instrument.

To improve the cash flow, the company discounts the bills of

exchange to bank. When the bill is discounted , the following entry

would appear in the balance sheet of the company :

Dr . Bank

Cr Receivable

But the amount outstanding under bills discounted will appear as the

contingent liabilities in the balance sheets of the company. Now, when

one company fills up the Form III, this amount is added both on the

liability side and also on the asset side. In the liability side, it is added

under the head Bank Borrowing for working capital under Current

Liability and in the asset side this amount is added with the receivable

figure appearing on the balance sheet.

The amount of Rs 15 lacs would be added with the Cash Credit For

Working Capital head in the current liability portion of Form III and Rs

15 lacs would be added to the Receivable on the asset side of Form III

under the head Receivable.

The Second Adjustment : The secured loan consists of Term Loan and

Cash Credit for Working Capital .We shall first segregate the two. From

schedule we get the following :

Term Loan : Rs 50 lacs

Cash Credit : Rs 75 lacs

After this, the term loan needs to be segregated further into two parts.

One part must mention the installment to be paid within one year and

the other part must contain installment to be paid after one year. From

the description of the schedule, we can segregate the term loan

portion as follows as on March 31,2005 :

99

Installment payable within 1 year : Rs 10 lacs

Installment payable more than 1 year : Rs 40 lacs

Now while filing up the Current Liability portion of Form III, this

installment of term loan payable within 1 year would be filled up in the

current liability and the installment of Term Loan to be payable after 1

year would appear on the term liability .

So after adjustment of Bill Discounting , the total bank borrowing in

the Form III would be Rs (75+15)=Rs 90 lacs .

Third Adjustment : Here , the adjustment for Tax would be carried out.

The Tax on the Profit of a business entity is calculated as per the

Income Tax Act ,1961. At the beginning of the year , the company

projects a certain profit as per the Calculation under Income Tax Act

1961 and determines its tax. Let us take an example that during FY

2005-06, the income tax calculated by the company is Rs 12 lacs. The

total amount of tax to be paid by the company during the Financial

Year 2005-06 would be Rs 12 lacs. However, in certain services

provided by a company, as per Income Tax Act,1961 the receiver of

service would have to deduct tax on the payment at source ( TDS)

and the same is deposited by the service receiving company, against

which Form 16A is issued by the service receiving company. The

company also makes an assessment of this TDS. The net amount i.e.

the estimated Tax Amount minus the TDS amount would be the

amount in cash to be deposited by the company to the exchequer. The

company needs to pay this net amount in Quarterly installment as

specified under IT Act ,1961 under the head Advance Tax Paid. So

100

whenever there would be payment of tax on account of Advance Tax

Paid, the following entry is passed :

Dr . Advance Tax Paid

Cr Bank A/C

Similarly when TDS is calculated on the service , the following entry is

passed :

At the time of booking income while providing service on credit ,

Dr Receivable say Rs 10 /-

Cr Income Rs 10/-

Now at the time of payment by the customer, it would deduct TDS , if

applicable. If the TDS percentage is 10% on bills value , then the

following entry would be passed in the books of selling company

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

Dr Bank Rs 9/-

Dr TDS Rs 1/-

Cr Receivable Rs 10/-

At the end of the year , say on April 15,2006, the company calculates

the actual profit under IT Act,1961 for the FY 2005-06 and the entire

amount is provided in the P&L account .The following book entry is

passed :

Dr Profit & Loss Account for provision for taxation

Cr Balance sheet account under the head current liability

and provision

Any difference between the Tax Paid ( advance tax paid +TDS) and

the provision for taxation would be paid in the bank .

101

So the head TDS and Advance Tax Paid in the Assets side of the

balance sheet would contain the amount of Tax paid by the company

and the head provision for taxation in the Current Liability side of the

balance sheet would contain the amount of tax required to be paid by

the company. The company would not be able to know the exact

position in respect to the actual tax payment position unless the

assessment is carried out the department. Till the time assessment is

over for a particular year , the corresponding amounts would carry on

both sides of the balance sheet. Generally, it takes more than 1 year

for getting the assessment of a FY . This is because the last date for

submission of Tax Return for a company is October 31st of a particular

year. So the tax return to be filled by a company for the financial year

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

assessment would be carried out by September 2006 and during that

time the advance tax paid ,TDS amount and Provision For Taxation for

the FY 2005-06 would appear on the balance sheet. So at any point of

time , the figures in Advance Tax Paid, TDS account and provision for

taxation would contain these figures for more than 1 financial year .

Now in the above mentioned example the following segregation is

available :

Advance Tax Paid : Rs 15 lacs

TDS Rs 5 lacs

Provision for Taxation : Rs 15 lacs

Rs in lacs

Particulars FY 2003-04 FY 2004-05 Total

Advance Tax

Paid

6 9 15

TDS 1.75 3.25 5

Provision for 7 8 15

102

Taxation

Fig 6.3

While filling up the form III , the net of figure ( i.e. the net of figure of

Tax Paid , in the form of TDS and Advance Tax Paid and Provision for

Taxation is permitted). In the above mentioned example, only Rs 5

would appear on the asset side as TDS because Advance Tax Paid and

Provision for taxation cancels out each other.

Fourth Adjustment : In the asset side of the Form III, the investments

are first classified in terms of maturity. Besides maturity , the purpose

of this investment would also be analysed for its classification under

Current Asset in Form III. In the above mentioned example , the

following break up is available :

Fixed Deposit in Bank : Rs 50 lacs

Investment in Group Companies : Rs 30 lacs

Investment in quoted shares : Rs 20 lacs

While arriving at the fund based working capital limit, the classification

of current assets would be such that the bank finance would be made

available for those current assets which are related to production. In

the case of a manufacturing company, its main activity is the

manufacturing of goods . Assuming the above mentioned company is a

manufacturing company . the investment in the form of Group

companies and quoted shares would not be classified as current asset

even though the maturity is less than 1 year. So under Form III, the

fixed deposit in bank amounting to Rs 50 lacs would be included in the

current asset.

Fifth Adjustment : In the asset side of Form III, next adjustment is

made for receivable. In the case of receivable also, bank would also

103

classify those receivable whose maturity is up to 90 days in case of

private debtors and in case of government debtors it is 180 days. Any

receivable having a maturity of more than this would be classified as

non current assets. Assuming the all the debtors outstanding up to

180 days is also outstanding up to 90 days, the classification of

receivable would be as follows :

Receivable to be classified as Current Asset : Rs 75 lacs

Receivable to be classified as Non Current Asset : Rs 25

lacs

Sixth Adjustment : In the asset side of Form III, next adjustment

would be under the head of Loans and Advances. Under this head an

amount of Rs 20 lacs is given to group company .Applying the same

logic as mentioned above, the amount of Rs 20 lacs would not be

included in the current asset . So after all these adjustment the

current asset as per Form III would be as follows :

Category of

head in Form III

Particulars Amount

appearing in

Balance Sheet

Amount Appear

in Form III

Current Assets :

Fixed Deposits

in Bank

Fixed Deposits

kept in Bank

50 50

Receivable Receivable up

to 90 days (

PVT) and 180

days ( Govt)

would be

classified as

100 90

104

Current Asset in

Form III and

receivable

under Bill

Discounting

Scheme would

be added to the

receivable

Loans and

Advances

Loans given to

Group Company

would appear in

Non Current

Asset

40 20

TDS and

Advance Tax

would appear as

net basis after

adjustment with

Provision for

Taxation

20 5

Fig 6.4

Seventh Adjustment : This adjustment would be on account of Fixed

Asset revaluation . If the reserve contains any revaluation reserve ,

the same would be deducted from the reserve of the liability side of

form III and the same amount would also be reduced from the Fixed

Asset side of Form III. So in the liability side of Form III, the reserve

amount would be Rs 230 lacs and in the asset side of Form III, the

Fixed Asset amount would be Rs 180 lacs.

105

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

Category of

head in Form III

Particulars Amount

appearing in

Balance Sheet

( Rs lacs)

Amount

Appearing

in Form III

( Rs lacs)

Bank Borrowing

For Working

Capital

Bill discounted portion

would also be added

75 90

Other Current

Liability

Sundry Creditor All types of Sundry

creditors is included

30 30

Advance from

Customer

All types associated

with regular operation

of the company are

included

10 10

Term Loan

installment

payable within 1

year

As on the date of the

balance sheet, the

term loan outstanding

would be segregated

into two parts one

consisting o

installment payable

within 1 year and

installment payable

more than 1 year ;

10

106

installment payable

within 1 year would

appear here

Provision for

Taxation

Depending on the net

off figure , either

provision for taxation

or advance tax would

appear in Form III

15

Provision for

Dividend

This would appear in

Form III

5 5

Total Current

Liability

135 145

Term Liability

Term Loan Term Loan installment

payable beyond 1

year would appear in

the Form III

50 40

Total Term

Liability

50 40

Total Outside

Liability

185 185

Equity Capital All Equity capital

would appear here in

Form III

100 100

Reserves Revaluation reserve

would be excluded

from reserve in Form

III

250 230

Total Owned 330 330

107

Fund

Total Liability 535 515

Category of

head in Form III

Particulars Amount

appearing in

Balance Sheet

( Rs lacs)

Amount

Appearing

in Form III

( Rs lacs)

Current Assets

Fixed Deposit in

Bank

Payable within 1 year

would be classified

50 50

Raw Material 70 70

Work In

Progress

20 20

Finished Goods 30 30

Receivable Receivable should

include the bill

discounting figure

appearing as

contingent liability

;Receivable should

contain only

receivable up to

maturity of 90 days

for pvt and 180 days

for govt

100 90

Loans and

Advances

Loans and advances

to Group companies

would be included in

40 20

108

non current asset

Loans and

Advances

Advance Tax and TDS

would appear as net

off figure with

provision for taxation

20 5

Cash and Bank

Balance

5 5

Total Current

asset

335 290

Fixed Asset

Net Fixed Asset The figure would be

reduced by the

revaluation figure

150 130

Other Non

Current Asset

Investment Investment not

related to production

would be included

here even though the

maturity period of

investment is less

than 1 year

50 50

Receivable Receivable of more

than 3 moths ( Pvt)

and more than 6

months ( govt)

25

Loans Loans given to group

company

20

Total Non 50 95

109

Current Asset

Total Asset 535 515

Fig 6.5

Form IV : Form IV gives more analytical picture of current assets and

other current liability. In the case of current assets , the form gives

the holding level of Raw Material , Working in Progress , Finished

Goods and Receivable. The Raw material holding is expressed in terms

of month of consumption, work in progress in terms of months of cost

of production, finished goods in terms of months of cost of sales and

receivable in terms of months of gross sales. The other current asset

will also appear in the form IV in absolute figure.

In the other current liability section , the creditor for trade is

expressed in terms of months of purchase of material . The other other

current liability would appear as the absolute figure .

Form V : This form calculates the quantum of working capital

requirement under MPBF method. A quick comparison of two methods

i.e. Method I and Method II would reveal the difference of the two

assessment :

Method I Method II

1 Current Asset

( CA)

Current Asset Current Asset

2 Other Current

Liability (OCL)

Other Current

Liability

Other Current

Liability

3 Working

Capital Gap (

WCG)

1-2 1-2

4 Minimum 25% of ( WCG) 25% of CA

110

NWC

5 Estimated

/Projected Net

working

capital

Estimated/Projected

Net working capital

Estimated/Projected

Net working capital

6 Maximum

Permissible

Bank Finance

( MPBF)

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

5)]

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

5)]

Fig 6.6

An analytical view of the above stipulates :

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

• The method varies only in the context of minimum NWC

requirement. In the case of Ist method, the minimum NWC is

25% on WCG while in the case of II nd method, the minimum

NWC is 25% of CA.So stipulation of minimum NWC is more in

case of II nd method compared to that of Ist method.

• Due to the above factor, MPBF is always more for 1st Method

than 2nd Method.

Form VI : Form VI gives the details of sources of NWC. It also gives

the utilization details of NWC towards building up of individual

component of Current Assets.

Important points for arriving at the assessment of fund based working

capital under MPBF method :

• The holding level of Raw Material, Work in Progress, Finished

Goods and Receivable should not go up from that of last two

years actual in the estimates and projections figure. If there is

an increase, suitable justification would be required.

111

• The percentage of other current asset as a percentage of total

current asset should not go up in the estimate and projection

figure when compared with last two years actual.

• The holding level of creditor should not go down in the estimates

and projection figure.

• The percentage of other other current liability with respect to

total other current liability should not go down.

• The Current Ratio should not go down in the estimates and

projection.If there is any fall in current ratio , very convincing

explanation should be given.

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

certain point.

• The detail long term sources should be disclosed in detail.

• The sales estimates and projection should be commensurate

with the industry growth.

At the time of assessment , the above mentioned rules are followed.

After discussing in detail the fund based worked capital assessment

under MPBF method, it is clear that this method arrives at the

requirement of Working Capital by taking all the figures from Balance

Sheet as on a particular date. If the assessment is carried out based

on the estimates figure then the figures from as on the last day of the

estimates year is taken for carrying out the assessment of the fund

based working capital limit. Another important aspect of MPBF method

is that the last two years figures should be in the audited form. Since

the company has to submit its audited figures to a large number of

statutory bodies, the company coincides its account closing in such a

manner that most of the compliances are met from the same

accounts. This is the reason why most of the companies are closing

their accounts as on the March 31, of every year. If the company�s

112

business does not reflect any seasonality, there is no problem with this

as the accounts of all the time of the year would reflect the uniform

patterns. However, if the business of company has marked seasonality

then there is a problem. If the company�s business season is such that

the peak business operation takes place at a time which is not

coinciding with the accounts closing date, the company�s accounts

would not be able to capture the true requirement of working capital.

Please recollect the concepts we develop in the first chapter. Current

Assets represents the expenses which is incurred but not realized. If

the business cycle of a company has seasonality and the peak

business cycle is not coinciding with the accounting years, then the

current asset as on the balance sheet date would not represent the

true expenses which is incurred but not realized. Since the expenses

would be more during the peak business cycle compared to that of

other time , the current asset level would be more during the peak

business cycle. So if the assessment would carry out as per MPBF

method, it would only take the figures from balance sheet as on the

audited accounts date. But there can be a point in between two

account closing date which represents the peak business cycle and the

current asset at that point of time would reflect the true representation

of the maximum current asset of the company for the entire financial

year. So MPBF method of assessment would be leading to inadequate

fund based working capital for seasonal industry. For seasonal

industry , the fund based working capital requirement needs to be

assessed through a separate methodology i.e.called Cash Budget

Method.

As we have already seen that the requirement of fund based working

capital is due to bridge the timing match between the expenses

towards production of goods and /or service incurred and money

113

realized from the sale of the same goods and /or service. While the

expenses is associated with the outflow of cash where as the

realization from the products/services would be inflow of cash.

Moreover, the long term surplus would represents components of NWC

of the company . So in the cash budget method, the next twelve

months monthly cash flow is drawn as per the following format :

Revenue Account: Since working capital represents the expenses

incurred for the revenue account , the inflows and outflows of the

revenue account are plotted in each month. The heads under which

inflows and outflows are put represents the heads that will appear

against current assets and liabilities. For example, the current asset

consists of Raw Material ,SIP and Finished Goods. Only when the sales

are made and money is realized one receives cash in the revenue

account. So the Inflow of revenue account would be the realization of

receivable. Where as for selling the finished goods one needs to

purchase raw material and convert into finished goods through

different stages of production. While at the time of purchase of raw

material , the company can purchase it in cash or in credit. If it

purchase in cash then there would be immediate cash out flow and if it

purchases in credit the creditor payment would capture this cash flow

after some time. Now after purchase of raw materials there are other

manufacturing expenses in the form of electricity, salary and wages for

production and other manufacturing expenses. Expenses are plotted

against these heads on monthly heads. Then after the finished goods

stages are reached, there are selling and distribution expenses .These

expenses are plotted monthly wise . After the selling and distribution

expenses there are finance charges or interest expenses. The interest

expenses are divided into two groups ,interest on working capital

114

finance and interest on long term liabilities. However, both the

interest would come in the revenue account ( others wise debt trap

like situation will arise) . Now the tax payment would take place and

also dividend payment would take place. Both this would be

incorporated in the cash out flow. So the cash outflow on a monthly

basis for the revenue account would contain the following :

For the Month

Ending

30th April 31st May 30th June

Inflow :

Inflow from

Cash Sales

Realization of

Receivable

Other Income

Total Inflow of

Revenue

Account

Outflow:

Purchase of Raw

Materials in

Cash

Payment of

creditors on

account of

purchase of raw

materials on

credit

Payment of

Power and Fuel

115

for Production

of goods

Payment of

Wages and

Salaries

Payment on

account of

Other

Manufacturing

Expenses

Payment on

account of

salary and other

establishment

cost for selling

and distribution

expenses

Payment on

account of

selling and

distribution

expenses

Payment of

account of

Interest

expenses

Payment on

account of

Taxes

116

Payment on

account of

Dividends

Total Outflow on

Revenue

Account

Revenue

Account

Surplus/Deficit

Fig 6.7

In the Capital Account we can have the following inflows :

Inflows on account of induction of fresh equity capital

Inflows on account of fresh term liability in the form of term loan and

debenture

Inflows on account of unsecured loan

In the capital account we can have the following outflows :

Outflows on account of purchase of fixed assets

Outflows on account of investments in financial assets

Outflows on account of repayment of term liability

Outflows on account of repayment of unsecured loan.

So the capital account cash flow is drawn as below :

For the Month

Ending


117

Inflow :

Inflow from

Induction of

Equity Capital

Inflow from

Fresh Term

Loan

Inflow from

Fresh

Debenture

Inflow from

Unsecured Loan

Total Inflow on

Capital Account

Outflow

Purchase of

Fixed Asset

Repayment of

Term Loan

Investment

Repayment of

Unsecured Loan

Total Outflow on

account of

Capital Account

Capital Account

Surplus/Deficit

118

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

For the Month

Ending


Surplus/Deficit

in Revenue

Account

Surplus/Deficit

in Capital

Account

Overall

Surplus/Deficit

Opening Cash

balance

Closing Cash

Balance

Maximum

Amount of

Drawal Allowed

in this Month

Maximum

Amount of

Drawal Allowed

in this Month

Maximum

Amount of

Drawal Allowed

in this Month

Fig 6.8

The Closing cash balance reflects the cumulative deficit of the

company for the coming year. The maximum limit would be peak

deficit . If you see , in the cash budget method the seasonality of

business cycle is taken care off as the outflows and inflows of cash in

each month is taken into the account for arriving at the fund based

working capital limit. Actually, the cash budget method of assessment

is more scientific method of assessment of working capital and this can

also be extended to non-seasonal industry.

119

However, in India, even today most of the bankers follow the MPBF

method of assessment for working capital finance. This is due to the

fact that for all non-seasonal industry, MPBF being the method

practiced for a quite long period of time. So bankers are comfortable

with this method of assessment. Since the number of seasonal

industries was significantly less compared to that of normal industry,

bankers carried out more number of assessments under MPBF method

compared to that of cash budget method. Accordingly, bankers have

developed expertise over the years on MPBF methodology. This is the

reason why MPBF methods are still popular with the bankers. Besides

this , MPBF method is also a security based lending system because

MPBF is calculated by taking figures directly from the Balance Sheet.

Since the balance sheet contains figure of assets and liability and since

a company can offer security its assets only , the amount arrived

under MPBF is based directly on security of the company. Accordingly,

it is called as security based lending system.

In the case of cash budget system, the company needs to submit the

actual cash budget vis a vis the statement given at the time of

assessment and any negative deviation needs to be explained

properly. Even though this method is scientific and takes care of each

month working capital requirement more accurately, this method also

requires collation of figures more frequently and company needs to

have a strong MIS in place. Many corporations may not be having this

kind of system in place. These are the reasons why even today, MPBF

method is the most popular method of fund based working capital

finance.

There is another method for assessment of fund-based working capital

for a company. This method is called as Turn Over Method. This

120

method is applied for small business houses. The assumption of this

method is very simple. The working capital cycle is 3 months i.e. the

sales are rotated four times a year. The total working capital

requirement is 25 % of the projected sales. Out of this total

requirement, at least 5% is to be brought in from long term sources.

So the remaining 20% would be minimum amount of fund based

working capital to be given to a company. This method is called Turn

Over Method and very simple to assess.This is mainly followed for fund

based working capital limit of up to Rs 200 lacs.

All the above methods are for assessment of fund based working

capital for domestic credit.However, for export credit the basis of

assessment remains the same, however the process of availing the

credit is different. This is due to the fact that the government gives

certain incentives for promoting export in the form of concessional

interest cost. While providing such incentive, the government must

also draw some mechanism so that the fund which is given for export

is not misused. Generally the working capital for export is segregated

in to two parts. They are :

1) Pre Shipment Credit

2) Post Shipment Credit

Pre Shipment Credit : As the name suggests, this is the working

capital given up to the point of shipment. The amount of fund based

working capital given for pre shipment credit should cover all the

expenses till the shipment stage. This facility is also known as Packing

Credit . As mentioned earlier, the packing credit is the fund based

working capital facility given by the bank to meet the expenses

121

incurred till the shipment stage . The following expenses are incurred

by an exporter till the shipment stage :

1) Expenses incurred for purchase of raw material

2) Expenses incurred for conversion of raw material to finished

goods

3) Expenses incurred for ware housing of finished goods

4) Expenses incurred for putting the goods on board.

As mentioned earlier, the total assessment is carried out in the same

manner as the assessment for the domestic working capital and the

required NWC of 25% of the current assets is to be brought in by the

company.

Since the fund is disbursed under concessional interest rate, there

should be some mechanism that the fund is going for the export

purpose. So any packing credit is disbursed against either LC or

confirmed order and the disbursing bank make an endorsement on the

LC or Export order so that the company can not avail the export

packing credit against the same order from bank. Moreover, the fund

under packing credit needs to be repaid from the post shipment credit

and for this purpose bank maintains a diary of shipment .If it is

liquidated from the domestic sources, a penal interest rate well above

the market is imposed. This prevents the company to misuse the

packing credit for domestic purpose.

After the goods is put on board of ship, the bank provides a post

shipment credit to the company. The post shipment credit is provided

on the cost of the goods plus Insurance plus freight . This is popularly

known as CIF value. For promoting export, apart from the concessional

interest , the bank do not insists for any margin on Post Shipment

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Credit. The entire amount which is disbursed against post shipment

credit would be credited to the pre shipment account and the pre

shipment credit is closed. So when the bank disburses the packing

credit his main concern is the shipment of the goods. Since once the

shipment takes place, the packing credit is liquidated. In the case of

post shipment credit , the risk of the bank increases .This is because in

the pre shipment stage , the bank has the finished goods as the

security in the post shipment stage the bank is having only receivable

which a piece of paper only. To reduce the risk of any delinquency,

bank insists on the following :

1) Generally bank asks for Letter of Credit for Post Shipment Credit

2) When LC is not available, banks gets credit rating of the

overseas buyer from the reputed agencies like Dun and Broad

Street .

3) Bank also insists for Export Credit Guarantee Commission (

ECGC) coverage for Post Shipment Finance. This is an insurance

coverage for counter party risks.

4) Bank does not provide the Post Shipment Finance for exporting

to countries where there are significant country risk involved.

After the post shipment finance is disbursed, the same precaution to

be taken so that the purpose of concessional interest is not defeated.

The post shipment finance is to be realized only from the Realisation of

export proceeds and the export proceeds to be realized in all cases (

except the case of capital goods export) within 180 days.If it is not

realized within 180 days , details to be given to RBI and the writing off

of export receivable requires fulfillment of many formalities. These

formalities would act as deterrent for reaping unscrupulous benefits of

concessional interest rate.

123

Assessment of Non Fund Based Limit

After discussing in detail the fund based worked capital assessment

,we shall now discuss in detail about the Non Fund Based assessment.

As we have seen in the previous chapter that, fund based working

capital facility is required to meet the expenses incurred but can not

be deferred and also for the payment made for the continuance of the

regular operation procedure. We have also seen that a part of the

expenses can be met by deferring the payment arising on account of

such expenses. Moreover, a company can take advances from the

customer, in time. All these consist of Other Current Liability .Non

Fund Based facility is used by a company for building up of Other

Current Liability.

Non Fund Based facility is the facility provided by bank to a company

without involvement of any immediate involvement of fund. The

examples of Non Fund Based facility is Letter of Credit ( LC) and Bank

Guarantee ( BG). A Non Fund Based Facility consists of the following

characteristics :

1. At the time of providing the facility , issuer of Non Fund Based

facility would not disburse any fund. Generally banks are the

provider of Non Fund Based facility. Banks can issue LC and BG

on behalf of its customer and at the time of issuance there is no

fund involved. This would help bank to increase the business

without involvement of fund. If one analyses the balance sheet

of Financial Intermediaries, majority of the fund generated by

such intermediaries are from the depositors. This is reflected in

the high gearing ration of the financial intermediaries. Since high

124

leverage ratio is associated with a significant in crease in risk of

the concerned entity, the question can be asked why such high

leverage is permitted for financial intermediaries and how the

risk associated with such high leveraged intermediaries are

addressed ?

The answer to the first question lies in the role of the financial

intermediaries. The role of financial intermediaries is to act as a

channel for funds from the saving unit to the investment unit.

To channelise this fund, financial intermediaries should be

permitted to accept deposits from the savings unit and naturally

it would lead to high leverage ration.

While permitting the financial intermediaries to accept deposits ,

the risk associated with such highly leveraged entity is

addressed by the following mechanism:

1. There is a supervisor which issues licenses. Generally the

Central Bank of the Country does this supervisory

function.

2. The Supervisor imposes certain risk management

measures in terms of capital adequacy and prudential

norms so that financial intermediaries can not cross the

limit of approved risk level.

Coming back to the issues of Non Fund Based facilities. As we

have already discussed , for this type of facility the financial

intermediary need not to part fund .So a financial intermediary

can generate significant income by resorting to non fund based

business. This would basically help the financial intermediary to

earn income without the risk of asset liability mismatch and

interest rate risk on the liability and asset side. So the non fund

125

based facility is beneficial to both financial intermediaries and

the company.

However , another important characteristics of Non Fund Based

facility is that in the case the customer on behalf of whom the

intermediary issues this facility does not keep its commitment (

this process is called devolvement ) , the financial intermediary

would pay the amount. So incase of devolvement , the non fund

based facility is converted in to fund based facility.

Letter of Credit : This is one of the most popular Non Fund Based products

prevalent in the world market. Whenever, one company sells

goods to another , the first company is called the seller and the

second company is called the buyer. The seller needs to

establish a mechanism so that it get paid after the delivery of

goods while at the other hand, the buyer needs to establish a

mechanism so that it gets the goods it has asked for. The

situation can arise when seller sales goods and the buyer does

not pay. The other side of the story is that the buyer pays but it

does not receive goods as per the requirement. To address the

concerns of both the party, LC mechanism can be resorted to .

The total work flow of LC is shown below:

8

3 11

St

g

Negotiating Bank

Issuing Bank/ OpeninBank

2 9 10 6 7

eps No

1 The Buyer and

of sale. The B

Order to the se

t

2 The Buyer goes

a Letter of Cr

purchase for o

from a sanctio

3 The Buyer�s ban

bank/issuing ba

and the same

Applicant / Buyer /Draweee

g

Advising Bank/ ConfirminBank

126

4

5

1

Fig 6.9

Activity Chronological

Step of

Transaction

Seller finalized the terms

uyer sends the Purchase

ller .The Seller then sends

he Invoice.

This is the

first step of a

trade

transaction .

to its bank and applies for

edit as per the terms of

pening of Letter of Credit

ned letter of credit limit.

This is the

Second Step

of the

transaction .

k also known as applicant

nk opens a letter of credit

letter of credit is send to

This is the 3rd

steps of the

transaction .

Beneficiary /Seller/Drawer

127

the seller through a bank which is known

to the seller. The Issuing bank sends the

LC to another bank familiar to the

beneficiary. This bank is called the

Advising Bank.

4 The advising bank advises the LC to the

seller. Sometimes, the seller also requires

some more assurance as it can rely solely

on the issuing bank .In that case, the

advising bank needs to add confirmation

to the LC and the advising bank is called

as Confirming bank.

This is step

four of the

transaction.

5 The seller ships the goods to the buyer.

Till now all the process are of

chronological order. Though the start of

the process is after stage 4, the

completion of the process can be later

than the subsequent stages.

The start of

this process

is fifth steps

of the

transaction

.However the

completion

can be after

step 9.

6 The seller submits the documents to a

bank called negotiating bank along with

the LC.

This is 6th

Step of the

transaction .

7 The Negotiating bank scrutinize the

documents and if the document is in

order, it disburses the payment to the

seller.

This 7th Step

of the

transaction.

8 The Negotiating bank sends the document This is 8th

128

to the Issuing Bank . step of the

transaction .

9 The Issuing Bank sends the document to

the applicant for acceptance or rejections

if any. The buyer accepts the documents

and returns the accepted document to the

Issuing Bank.On receipt of the accepted

document, the issuing bank informs the

negotiating bank and then release the

transport documents so that the buyer

can release the goods.

This is 9th

step of the

transaction.

Completion

of step 5

The goods which is shipped at the

beginning of the step 5 is released by the

buyer .

This is 10th

step of the

transaction .

10 The buyer pays to the issuing bank on

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

period.

This is the

11th step of

the

transaction.

11 The issuing bank pays to the negotiating

bank.

This the 12th

and final step

of the

transaction.

Fig 6.10 If we analyse the utility of the LC, it is basically a credit enhancing

mechanism. In case the buyer does not pay, the issuing bank would

pay provided the beneficiary complies with the terms and conditions of

the LC. So from the seller�s point of view the payment is assured once

it complies with the terms and conditions of LC. Now here comes a

very important aspect of LC.LC says that it deals with the documents

129

not with goods. From the above chronological steps, it is clear that

the buyer will be able to accept the documents before it can see the

goods. Then the question is how does buyer ensure that the goods

supplied is the goods it asked for. Here lies the expertise of LC

opening. The buyer must stipulate documents and terms and

conditions which will force the seller to ship the correct goods. Special

care should be taken at the time of opening the LC by the buyer.

Similarly one can see that the negotiating bank pays in chronological

stage 7th of the transaction while it gets paid in chronological stage

12th of the transaction. Now the question arises , how negotiating bank

confirms that the seller fulfils all the terms and conditions of the LC. It

may happen that for negotiating bank certain terms and conditions are

accepted but the same may not be accepted by the issuing bank. Since

the ultimate fund would be remitted by the issuing bank , the

fulfillment of terms and conditions as accepted by the negotiating bank

should also be accepted by the issuing bank. To avoid any confusion

and disputes between negotiating and issuing bank, an uniform

procedure is adopted by all the banks in the world. This procedure is

called as Uniform Conduct and Procedure for Documentary Credit (

UCPDC) version 500.This is framed by International Chamber of

Commerce ( ICC) .UCPDC 500 contains 49 clauses which describes the

mode of operation of the entire LC mechanism. The details of all the

sections of UCPDC 500 is given in the study material.

Before we proceed with the operational aspect of the LC, let us first

know that how the LC limit is assessed .By now, we know the specific

requirement of LC. It is basically used to purchase material on credit.

In other words, LC is required to build up a portion of Other Current

130

Liability .To be precise LC is used to build up Sundry Creditor ( Trade).

A company wants to purchase material on Credit without giving any

LC. The reason being , with LC there are two aspects of the

transaction :

1. Payment to be made on due date by the customer without fail.

Since Bank is giving the LC, in case of non payment to the bank

by the customer on due date, the issuing bank would pay from

itself to the negotiating bank. This would reduce the credit rating

of the company in the books of the Issuing Bank. In the case of

simple credit, the company can delay the payment to the

supplier without loosing too much credibility .

2. When LC is opened , certain charges need to be paid to the

banks concerned. So, there is an additional cost for purchase

under LC.

A company would always try to purchase material on Credit without

LC. Only when the company can not purchase without LC , generally

then only it will agree to give LC to the supplier.

The First Step of the LC assessment process is the arrival of the

percentage of purchase with LC. From the past experience , the

percentage of total purchase under LC is arrived at. The total purchase

figure is obtained as below :

If the assessment is carried out on the basis of estimates, then the

estimated purchase figure is found out as follows :

Serial No Particulars Source

1 The Consumption of Raw Material and Form II

131

spares for the year under estimation

2 The Opening stock of Raw Material

and Spares for the year under

estimation i.e. the closing stock of

Raw Material and Spares as on the

previous year .

Form III

3 The Closing stock of Raw Material and

Spares for the Year under estimation

Form III

4 Total Purchase 4= (2+3-1)

5 Out of the above purchase percentage

of purchase under LC

Y=x% of 4

Fig 6.11

Depending on the payment period enjoyed by the applicant of the

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

• Sight LC

• Usance LC

Sight LC : In this LC , the payment is made on sight of the document.

Whenever, the document is seen by the applicant, the applicant would

pay the amount under LC. Actually 7 days are given to pay the LC.

Effectively the buyer does not get any credit except the 7days period

from the sight of the documents under LC.

Usance LC : Under this LC , the payment is made after a certain

period from a specified date. The specified date can be date of a

document mentioned under LC. This period is called usance period.

The applicant enjoys credit for this period.

The weighted Average Usance Period ( AUP) under LC is arrived at by

using historical data. Besides this , there is a time taken to process the

132

entire LC operation. This is called the Lead Time ( LT). The LC period

(LP) consists of AUP plus LT.

The number of times an LC is rotated is equal to =365/LP

The total LC requirement is (Y /365)*LP

Once the limit has been assessed by the bank , the bank issues a

sanction letter for LC.

Bank Guarantee :

Bank Guarantee (BG) is another Non Fund Based facility provided by

Financial Intermediary. Like any other non fund based facility , BG is

also required to build up other non current liability. Specially it is

required to build up that portion of non current liability for which

advance is taken from a client. This can be explained with the help of

an example :

Suppose the Kolkata Metropolitan Development Authority (KMDA)

decides to construct a Bridge. It asks for bid from prospective

construction companies ( civil contractors) . After the successful

bidding ,KMDA selects one contractor say A for the job .Since the

construction job is of very high volume in nature, KMDA would provide

advance for mobilization of the job. This is called the mobilization

advance. Now, KMDA also wants some kind of mechanism so that after

taking the money A should fulfill its responsibility . KMDA would ask a

Bank Guarantee to be submitted by A . A would approach its banker X

to issue a Guarantee on its behalf to KMDA . The Banker would issue a

Bank Guarantee . In a bank guarantee there are following parties :

1. The Applicant : Here the company A on whose behalf bank

issues bank guarantee.

2. The Beneficiary : Here KMDA for whose favour the Bank

Guarantee is issued.

133

3. The Issuing Bank : The Bank which is guaranteeing the payment

in case of non performance of the applicant . Here X is the

issuing bank.

We have seen that in both the case of LC and BG, these are credit-

enhancing mechanism. In both the cases, the interest of beneficiary is

protected and in both the cases banks are giving assurances to the

beneficiary. Then where are the differences ?

1. The First difference is the trigger which causes the payment in

these two types of instruments. In the case of LC, the Issuing

Bank pays to the negotiating bank only if the terms and

conditions mentioned against LC is fulfilled. So the payment of

LC is triggered only because of performance of the beneficiary.

But in case of Bank Guarantee, the payment is triggered only

when the applicant does nor perform. So incase of Bank

Guarantee , the payment is made only in case of non

performance of the applicant.

2. In the case of LC , most of the times payment is made.In case of

BG only few times the payment is made.

After understanding the guarantee instruments, now we shall discuss

the different types of guarantee before proceeding forward for

assessment of the guarantee requirement of a corporate. There are

mainly two types of Bank Guarantee .They are :

1. Financial Bank Guarantee : When a bank gives the guarantee for

financial performance of its client ( which is also applicant of the

guarantee ) , it is called the financial guarantee. Generally the

guarantee issued for securing Mobilisation Advance, Security

Deposit are Financial Guarantee.

2. Performance Bank Guarantee : When a bank gives guarantee for

physical performance of its client ( which is also applicant of the

134

guarantee ) , it is called Performance Guarantee. Generally it is

given to release the retention money kept by the beneficiary for

the defect liability period.

Assessment of Bank Guarantee :

The assessment process of Bank Guarantee is as follows :

• The company arrives at the opening bank guarantee at the start

of the year under consideration . (A)

• It classifies the guarantee into Performance and Financial

Guarantee (A1 +A2 )

• It calculates the requirement of fresh guarantee during the

period under consideration in terms of Performance Guarantee

and Financial Guarantee. ( B1 +B2)

• It calculates the guarantee to be returned during the year under

consideration . ( C1 +C2)

• Then the guarantee limit is arrived at by using the formula D=(

(A1 + B1 - C1) + (A2 + B2 � C2 )

The first one reflects the limit for Performance Guarantee and the

Second one reflects the limit for Financial Guarantee.

135

Chapter Seven

Process of Tying up and utilization of Working Capital

Finance from Bank

After discussing in detail the worked capital assessment both the Fund

Based and Non Fund Based facility ,we shall now discuss in detail

about the entire process of tying up and use of working capital

assessment from banks. The process of tying up of working capital

consists of the following stages :

• Determination quantum of working capital requirement. With the

help of the process mentioned in previous chapters, a company ,

now, can decide the requirement of working capital both fund

based and non fund based.

• Once the quantum is decided, then the company needs to take a

decision about the type of banking arrangements. There are

three types of Banking Arrangements .These are :

o Sole banking Arrangement : When the entire working

capital facility is taken from a single bank it is called sole

banking arrangement .If the working capital requirement is

not very large , a company would prefer sole banking

arrangement.

o Consortium Banking Arrangement : When the working

capital requirement is large, a single bank may not be

willing to lend such large amount .In that case , the

company must go for a banking arrangement where more

than one bank is involved. One type of banking where

more than one bank is involved is called Consortium

banking arrangement. Under this method, a bank assumes

the role of a leader and the bank is called Lead Bank.Lead

136

bank assesses the limit and then informs other bank about

the limit. The other banks joins an association and this is

called as Consortium. Once the leader assess the limit it

informs the other member bank and other member banks

carry out its own assessment and inform the lead bank

about the share they are taking . Once this is formalized ,

a meeting called consortium meeting is called and the

process for disbursement of fund takes place.

o Multiple Banking : When the requirement of working

capital is large, more than one banking would be involved.

In this case, apart from the consortium banking , multiple

banking arrangement is also possible. Under multiple

banking arrangement , the limit is assessed by individual

banks and individual banks take exposure. The benefit of

multiple banking is that in case of consortium banking

there is lot of rigidity from the point of view of the

company. In case there is more requirement of working

capital and even though other member banks wants to

disburse their share , they can not do anything unless the

lead bank approves the limit. This cause some delay which

can hamper the business of a company. In case of multiple

banking , such problem is not there.

Once the company decides the type of banking then it selects the

bank by keeping in mind the following criteria:

• The First Criteria for selection of Bank is the time the

bank is supposed to take to sanction the limit and

make it available to the company. It again depends

on the organization structure of banks. In banks, the

sanctioning power is delegated at different level. The

137

degree of delegation is different in different

banks.For some banks , Scale IV officer can sanction

a working capital limit of Rs 3 crores where as for

another bank same Scale IV officer can sanction a

working capital limit of Rs 1.25 crores. So depending

on the delegation power and company�s requirement

company selects bank.

• After this, the next important criteria is the cost of

the facility.For fund based working capital facility ,

interest rate is the charge the company pays to the

bank. In the case of non fund based working capital

facility , commission is the charge the company pays

to the bank.In today�s context , different banks

charge different interest for the same borrower. The

borrower would apply to the banks where the total

cost is lowest.

• After this the security issue needs to be taken into

account. Generally, all the working capital assistance

are in the form of secured loan. Whenever a

company borrows from other , the amount would

appear in the liability side of the balance sheet. The

liability can be secured liability and unsecured

liability. In the case of secured liability, the liability is

backed by security. The security can be created only

on the Asset. In case of non payment of liability ,

secured liability holder can enforce the security for

which it is holding charge and can realize cash after

liquidation of such securities. Security can be created

by any of the three processes:

138

• Lien : Under this process, security is created

on financial asset. The name of the liability

holder is marked on the face of the financial

instrument as lien. Under this system, the

ownership is with the borrower where as the

possession is with the lender. The security is

created on financial assets.

• Pledge : Under this process , security is

created on both financial and physical assets.

In the case of Pledge, the ownership is with

the borrower where as the possession is with

the lender. The lender can keep the assets in

its own premises or in other premises.

• Hypothecation : Under this process, security is

created on physical assets. In the case of

hypothecation, both the possession and

ownership is with the borrower. For creation of

hypothecation, charge needs to be created for

limited company.

• Mortgage : For immovable property, mortgage

is created. In the case of mortgage, the

possession and ownership is with the borrower.

But mortgage is created on the immovable

property where as the hypothecation is created

on movable physical assets.

A comparison of all these four process are given below :

139

A comparison of the above mentioned four charge making process is

shown below :

Name of

Process

Ownership

of the Asset

During the

tenure of

the loan

Possession

of the Asset

During the

tenure of

the loan

Type of

Asset on

which

charge is

created

Governing

Statute

Lien Borrower Lender; At

the Lender�s

premises

Financial

Asset

Indian

Contract Act

Pledge Borrower Lender;At

the Lender�s

premises or

any other

place under

the custody

of lender

Both

Financial

Asset and

Movable

Physical

Asset

Indian

Contract Act

Hypothecation Borrower Borrower Movable

Physical

Asset

Indian

Contract Act

Mortgage Borrower Borrower Immovable

Physical

Asset

Transfer of

Immovable

Properties

Act

Fig 7.1

140

Depending on the nature of security to be offered to the lender , the

borrower can decide on the types of charges to be created and the

same is mentioned in the application form.

While deciding a particular bank, another important aspect to be taken

is the issue of collateral security. Many bank insists for collateral

security. Security can be classified into two types. These are :

• Primary Security : A Primary Security with respect to a particular

type of finance is defined as the security which is created out of

that finance. For example, when working capital is provided ,

current assets are build up from the working capital . In this

case, the current asset is called as Primary security.

• Collateral Security : A collateral security with respect to a

particular type of finance is defined as the security on which

charge is created even though the security is not created from

the sad finance. For example, in case a charge on the fixed

asset of a company for working capital loan is created, the

collateral security is the fixed asset.

After deciding all these factors, a company submits the application to

bank(s) for working capital facility. While submitting the application

form , the following documents are given :

• Filled up Application Form as per the Bank�s Own Format

• Memorandum and Article of Association

• Certificate of Incorporation

• Copy of Board Resolution

• Last three years audited accounts along with Directors Report

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

141

• Detail assumption of estimates and projections.

The Bank then processes the application forms .Depending on the

banks degree of delegation power, efficiency level and business target

, it usually takes 7 days to 60 months to sanction a fresh working

capital limit.

Each bank has specified process note ( a copy of the same is provided

along with this material ) and the same note is signed by two officials.

One official recommends and another official sanction the limit. In the

present decentralized structure most of the banks have adopted the

following structures :

1. Large Corporate Accounts : Under this category, financially very

sound companies are selected .For handling these companies, in

all the major cities of the country, dedicated branches are

opened and the same branch can directly deal with Head Office

for sanctioning of proposal.

2. Other Corporate Accounts : Other Corporate accounts follow

three tier structure:

a. Branch Level Sanction : For Fund Based and Non Fund

Based limit up to a particular amount, branch level

sanction is given. Individual branch can sanction limit and

sends the proposal to the superior office for ratification.

b. Zonal Level Sanction : Above the branch, Zonal Office is

situated. The loan sanctioned in Zonal Office would be

ratified in the head office.

142

c. Head Office Level Sanction: Generally, the head office

consists of General Manager, Executive Director, Managing

Director ,Chairman, Committee of Directors, Board of

Directors. Each of these authorities is having sanctioning

power and the sanction of loan by all these authorities are

ratified by the immediate higher authority.

Once the loan is sanctioned , the bank would inform the

customer through a letter called Sanction Letter. Some times it

is also called as Credit Arrangement Letter.

A Credit Arrangement Letter would contain the following :

Name of Customer :

Name of the Facility Sanctioned : e.g.Fund Based Working

Capital

Type of Facility Sanctioned : e.g. Cash Credit

Limit Sanctioned :

Interest Rate : % Interest rate with reference to PLR or any

other rate. Mode of charging of interest i.e. either quarterly or

monthly should be mentioned .

Security : The sanction letter would describe in details about the

security to be offered against the facility. The security can be

Primary Security and /or Collateral Security. The charge can be

First Charge or Second Charge. Similarly , the security can be on

exclusive basis or on pari passu basis. After discussing in detail

143

about the Primary Security and collateral security , we shall now

discuss about the First Charge and Second Charge. An asset can

be given security to a lender on the basis of first charge or the

same asset can be given security to a lender on the basis of

second charge. In the case of a first charge holder, the lender

would get the first priority on the value realized from the

liquidation of the asset. Let us take an example .A lender

provides a working capital loan of Rs 25 lacs against a first

charge on current assets of the company values at Rs 32 lacs. In

the case of liquidation of the company, the lender on liquidation

of the current assets would get Rs 32 lacs and it would first

appropriate Rs 25 lacs and the remaining Rs 7 lacs would go to

the second charge holder if any. Generally, the working capital

banker would take the first charge on current assets and second

charge on fixed assets . The term lender on the other hand take

first charge on fixed assets and second charge on current assets

of the company .The purpose of taking second charge of a

company is to increase its security coverage.

Now the first charge can be on the basis of exclusive charge or

can be on pari passu basis. In the case of exclusive charge , a

lender gets the entire realization obtained from the liquidation

of the asset. However , when the credit facility is significantly

large, more than one bank is involved .For example, a company

has been sanctioned a working capital limit of Rs 50 crores and

the total amount of working capital facility would be provided by

say 4 banks each providing Rs 12.50 crores . Since all the banks

are lending against the same current assets of the company ,

the charge is created on pari passu basis. Now if the value of the

security is say Rs 60 crores, in case the charge is created on pari

144

passu basis, each bank are entitled to get Rs 15 crores each

from the realization of the current assets of the company.

In many cases, Personal Guarantee of the promoter is stipulated.

In other cases, the corporate guarantee of another company is

stipulated.

Margin : The margin is stipulated against different types of

assets. Generally a margin of 25% is stipulated on Inventory and

slightly higher margin is stipulated on Receivable.

After the security the negative covenant is stipulated by the

lender in the sanctioned letter.

After the sanctioned letter is received by the company , it needs

to accepts the letter in a board meeting. A board meeting is

convened and in that meeting the letter is accepted and persons

are authorized to accept the terms and conditions of the

sanctioned letter.

Once the letter is accepted by the company, the company would

then execute the documents with the lender. Generally, the

following documents are executed with the lender :

• Credit facility agreement executed between the lender and

borrower

• Deed of lien/pledge/hypothecation executed by the

borrower

• Documents executing the mortgage of a property by the

borrower.

• Personal Guarantee Bond executed by the person

concerned.

145

• Corporate Guarantee Bond executed by the company

concerned.

Once the document is executed, the charge is created by the

company. The next step is that the charge is to be registered

with the Registrar of Companies at the office where the

registered office of the company is situated. The charge is

registered by depositing specific form namely Form 8 and Form

13 duly executed by the lender and borrower to the ROC within

30 days from the date of executing of relevant documents. While

filing the charge with ROC, it is important to mention that any

prior charge holder must cede the charge and only then the

charge can be created by any subsequent lender.

Once the charge is created the lender is ready to disburse the

fund. Before disbursement of the fund the lender asks for a stock

statement to calculate the drawing power. Stock statement is a

statement showing details of the assets in terms of name , age,

quantity and value of assets for which margin is stipulated as

well as security is created. The drawing power is arrived at after

deducting the margin from the value of the assets mentioned in

the stock statement. After arriving at the drawing power, the

lender make disbursement.

Monitoring of Accounts :

After disbursement the lender needs to monitor the company�s

performance. The lender should develop adequate mechanism so

that any delinquency sign is captured early enough so that

rectification measures can be initiated and any loss arising out of

such delinquency can be minimized. A lender can develop the

following monitoring system :

146

• Routine Submission of Statement: If we recollect , the

sanction of working capital facilities is based on either

estimates /projection figure taken for either MPBF

method/Cash Budget method. In both the cases,

borrower�s performance against this estimates /projection

is to be monitored. For monitoring at periodic interval, the

lender stipulates the following statements :

o Monthly Statement : This consists of mainly position

of securities at the end of every month . Besides, the

monthly cash flow statement is stipulated for limit

assessed under Cash Budget mythology. The last

date of submission of this statement is 7th days of

succeeding month. After receiving the statement, the

lender analyses the statement vis a vis the estimates

made based on which the limit is assessed .

o Quarterly statement : This statement contains the

security position at the end of the quarter and

estimates for the next quarter. The first statement is

to be submitted within 6 weeks after the end of the

concerning quarter and the second statement is to

be submitted before the start of the quarter for

which the projections to be made.

o Half yearly statement : This statement contains the

Profit and Loss of the company on half yearly basis

and the related fund flow statement .The entire fund

flow statement is segregated in such a way that the

operational fund, investment fund and financing

fund is found out clearly .

147

o Annual statement : Generally working capital facility

is sanctioned for 1 year. After the expiry of 1 year,

the company needs to submit the renewal data

which contains all the documents submitted during

the sanction of the original proposal. Once received

by the bank, the entire process is again repeated for

renewal of the facility.

148

Chapter Eight

Different Corporate Banking Product

After discussing in detail about the entire methods of tying up of

working capital limit from the banking system , we shall now discus

about the products by this fund based working capital can be raised by

a company. Starting from 1991, the financial liberalization has opened

up newer vistas in terms of availability of newer products. The

development of a reasonably structured money market, the gradual

liberalization of the money ,debt and foreign exchange market

contributed to the development a large number of newer products for

meeting the working capital requirement of company.

A company can meet its fund based working capital requirement

mainly through :

• Loan Product

• Investment Product

Loan Product : In the case of a loan product , the fund is provided by

the bank in the form of loans and advances. The loans and advances

are classified as Loans and advances in the balance sheet of the bank

.The loans and advances are not traded in the market and the value of

the loan and advances would remain same. The typical loan products

are :

• Overdraft

• Cash Credit

• Bill Discounting

• FCNR ( B ) Loans

149

Overdraft : Overdraft is the facility by which an entity gets loan over

and above the value of the security. This can be explained with the

help of the following example :

A company is having a fixed deposit of Rs 5 lacs maturing on 15th

September 2005.The fixed deposit was made on 15th September 2004

and the interest rate was 6.5% p.a. payable at quarterly rest. Now ,

on September 1st, the company requires a fund of Rs 5 lacs . The

company has two options :

Option I : The company closes the fixed deposits prematurely and in

the process , it looses 1% interest. If the company exercise this

option, it will earn interest to the tune of Rs 27032/-.

Option II: The company can take a loan for 15 days against the fixed

deposit and continue with the deposit itself. The interest rate on loan

of fixed deposit would be 1% higher than the interest rate of fixed

deposit. In this case, the company pays 7.5% interest on Rs 5 lacs for

15 days . The company in this process would earn Rs 31760/- on its

investment.

So in many cases, it is beneficial to avail an overdraft over the fixed

deposit amount . This facility is called the over draft. This is also a

very popular retail banking product.

Cash Credit : This is the most popular mode of loan product for

funding the fund based working capital requirement of a company.

Once the fund based limit has been assessed by the bank and the limit

is in place after fulfilling all the steps , the fund is made available

through the cash credit product. The accounts operates like a typical

current account. At the time of first disbursement, the drawing power

is fixed from the stock statement and the company is allowed to

operate within this limit till the next month when a monthly stock

150

statement would be submitted by the company. The company would

be able to draw fund up to the drawing power of the company for the

month. The company can deposit and withdraw the fund as many

times as it wants .The company would pay interest only on the

outstanding amount on a daily product basis and the interest is

charged on monthly rests. This is explained with the help of the

following example :

A company has been sanctioned a fund based working capital limit of

Rs 200 lacs and interest rate is PLR +2% p.a, payable at quarterly

rests.The present PLR of the company is 11% . The company avails

this facility through a cash credit route. The stock statement submitted

on 1st of September 2005, stipulates that the drawing power would be

Rs 190 lacs. The transaction of the company is as follows :

( Rs in lacs)

Date Particulars Withdrawal Deposit Balance

3.9.05 To Electricity 15 15

5.9.05 To Salary 45 60

6.9.05 To Raw

Material

Supplier

100 160

10.9.05 To Other

creditor

30 190

11.9.05 By Sales

Proceeds

30 160

12.9.05 To purchase 25 185

16.9.05 By Sales 50 135

30.9.05 By Sales 80 55

151

Fig 8.1

Since the drawing power of the company is Rs 190 lacs the balance

can not exceed Rs 190 lacs.

The company can withdraw and deposit as many times as possible

provided the balance is within Rs 190 lacs. In the above mentioned

example, the company withdraws 5 times in a month and deposits 3

times in a month. This is one of major advantage of the cash credit

system enjoys by the corporate. The cash management responsibility

is shifted to the bank. The bank has to block the entire Rs 190 lacs for

this account throughout this month though the company has only

drawn this amount once i.e. on 10.9.05.

If we define the idle fund from this account is the difference in amount

between the drawing power and the amount availed and the

opportunity cost is 7.00% p.a the total opportunity cost is calculated

below :

( Rs in lacs)

Date DP Balance Idle Fund Period

(days)

Cost

1.9.05 190 190 2 0.073

3.9.05 190 15 175 2 0.067

5.9.05 190 60 130 1 0.025

6.9.05 190 160 30 4 0.023

10.9.05 190 190 - 1 0.00

11.9.05 190 160 30 1 0.005

12.9.05 190 185 5 4 0.004

16.9.05 190 135 55 14 0.147

152

30.9.05 190 55 135 1 0.025

Total 30 0.369

In the case of cash credit facility , the bank looses this amount due to

idle fund. If the limit is substantially large, the idle fund cost is

considerably higher. To help the banks to overcome this , RBI

stipulated a loan delivery mechanism for all the fund based working

capital limit of Rs 10 crores and above. Under this system, 80% of the

fund based working capital would be disbursed through a product

called Working Capital Demand Loan ( WCDL) where the

repayment is to be specified by the borrower at the time of availing

the disbursement. The maximum tenure of WCDL is 1 year and

minimum tenure can be 7 days. The remaining 20% of limit can be

availed through the normal cash credit route. In the case of WCDL, the

cash management lies with the bank .

Bill Discounting : Once the assessment of the fund based working

capital limit is carried out , the company can avail this fund based

working capital amount either through a single product under loan

component or through a combination of different product under loan

component or through a combination of different products under loan

and investment component.

Bill discounting is a product where a part of the receivable can be

financed. Once the assessment of the company is carried out, a

portion of the assessed limit representing part of the receivable can

be financed through bill discounting mode.

When a company sales goods on credit, receivable is generated in the

books of accounts of the company. This receivable is of two types :

153

• Open Account sales : Under this process only sales invoice and

other sales related documents are drawn by the seller.

• Bills Receivable : Under this process, not only all the documents

associated with the open account sales are drawn but also a Bills

of Exchange is drawn. A typical Bills of Exchange would look like

as follows :

Fig 8.2

A close scrutiny of the above mentioned bills of exchange would reveal

the following :

• It is an order given by the drawer of the bill of exchange to the

drawee to pay to a party after certain days. Here the drawer is

generally the seller and the drawee is generally the

purchaser. The payee is the bank from whom the seller gets

the credit under bill discounting scheme.

Bills of Exchange

Rs ______________/- Date: Please Pay ________________ ( Payee) or Order a sum of Rs - (Rupees ________________only ) on 90 days ( Credit Period) from the date of this document. ---------------------------- --------------------------- ( Name & Address of ( Name & Address of Drawee) Drawer)

154

• Under normal circumstances, the seller would get the payment

after 90 days from the buyer.This is the credit period extended

by the seller to the buyer. This is also called the usance period

of bills of exchange.

• To improve the cash flow, the seller can get the fund from the

Payee, immediately on submission of bills of exchange to a bank

.The bank would send it for acceptance to the drawee and

drawee accepts the bills of exchange to pay on due date.

• On receipt of acceptance from the drawee, the bank would pay

to the drawer immediately.

• On due date the bank would collect the money from the drawee.

Since the bill of exchange is a negotiable instrument, protection

under Negotiable Instrument Act is available to the payee. In

many cases , the credit enhancement of bills of exchange can be

increased with the help of a LC.

Now a days, this method of financing became very much popular for

Small and Medium Enterprise (SME) financing. Many large company

outsourced their production facility to SMEs. These SMEs may not be

financially strong enough to attract very competitive interest rate from

the bank. The bank enters into arrangement where the large company

which is the buyer of goods of SME would accept the Bills of Exchange

drawn by the SME and in that case the exposure is shifted on the

Large Company. Under this mechanism , SME can get very finer

interest rate.

FCNR(B) Loan: This is one of the most popular methods of working

capital finance for last couple of years. If you go through the accounts

of any large corporate , you will find the presence of this product.

155

Before going to the benefits of the product, we shall first discuss about

the product itself. Foreign Currency Non Resident ( Bank) is the name

of a deposit scheme operated by Indian bank to collect deposits from

Non Resident Indians and Overseas Corporate Bodies ( OCB). These

deposits are collected in United States Dollars (USD), Japanese Yen

(JPY),Euro ,Great Britain Pounds (GBP),Canadian Dollar and Australian

Dollar. The deposit can be taken for a minimum period of 12 months

and maximum period of 36 months. The interest and principal is to be

paid in foreign currency. When a bank accepts FCNR(B) deposits, it

accepts deposits in these foreign currencies. The Indian bank has the

following options before it :

1. It keeps the deposit in the dollar form and invest in overseas

bank account. The benefit of this mechanism is that the bank

has fully hedged the currency conversion risk and the counter

party risk is nil. The drawback of this mechanism is that in this

process, the earning is substantially lower.

2. After accepting the deposits, the bank converts this foreign

currency in to the domestic currency. Subsequently , it lends

the domestic currency to the Indian company and earns

domestic interest rate. On due date of payment of interest and

principal ,bank converts the Indian currency into foreign

currency as it has to pay back to the depositor both interest and

principal in foreign currency. The benefit of this mechanism is

that the earning to the bank is more .However, the drawback is

that the bank incurs a foreign exchange risk.

3. There can be another process by which some of the benefits

from both the alternative can be retained. Such process would

lead to the development of the product called FCNR(B) loan. In

the case of FCNR(B) loan, bank can lend to Indian corporate in

156

foreign currency held by the bank under FCNR(B) deposit .The

benefit to the bank is that without incurring the conversion risk(

as mentioned under drawback in option 2), the bank can earn

more as the Indian corporate would pay more compared to that

of the foreign bank ( as mentioned in option 1 above).

The benefit to the corporate is that it can derive the

interest rate benefit between two countries. With strong

foreign exchange reserves over the period of last couple

of years, the short term stability on rupee dollar exchange

rate would help the corporate to hedge the currency risk

completely. This can be explained with the help of the

following example :

• A company is having a credit rating of AA from a bank. The

Bank gives fund at PLR plus 0.50 % to a AA rated customer.

The company enjoys a fund working capital limit of Rs 10

crores from the bank. The PLR of the bank is 11.00%. The

company , if avails this loan through WCDL and CC route, the

interest rate would be 11.50%. The company can substitute

about Rs 435 lacs i.e. USD 1 million through FCNR(B) loan from

the bank. Since it is a foreign currency loan, the interest rate

would be linked to London Inter Bank Offer Rate (LIBOR).

Suppose the company gets LIBOR +2% on the loan for 6

months. With a very strong foreign exchange reserve, the 6

months Rs dollar premium is actually very low say 2% p.a. The

six months LIBOR is about 1.75% p.a. With a total hedge, the

all inclusive cost of the company is 5.75% p.a. compared to

11.50% p.a. in the rupee loan. So the company benefits

substantially in reducing the cost.

157

• But there are some restriction in the use of FCNR(B) loan.This

loan can only be used for financing the working capital

requirement .The corporate must have a sanctioned working

capital limit. This loan can not be used for any speculative

purpose.

After discussing the FCNR(B) loan , it would be better that

we discuss something about the External Commercial

Borrowing ( ECB) and compare this two facilities.

Like FCNR(B) loan, a company can also take a foreign currency loan

under External Commercial Borrowing (ECB) and Trade Credit ( TC)

scheme. The similarity of all the three schemes are that these are

routes by which an Indian company can raise debt in foreign

currency.

ECB : A company can raise foreign currency loan under the scheme

ECB. The ECB can be raised either through Automatic Approval Route

or after obtaining permission of Government and RBI. Under the

automatic approval route the following need to be fulfilled :

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

years

• ECB between USD 20 million with minimum average maturity of

5 years.

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

million.

158

• Maximum Interest to be paid between three to five years

maturity is LIBOR+200 basis point and the same for more than

five years maturity is LIBOR+350 basis point.

• ECB can be used only for project finance but can not be used for

working capital finance.

Trade Credit (TC) : The trade credit refers to the credit

extended by the overseas supplier, banks and financial

institution for original maturity of less than 3 years. TC

can take in the form of buyers credit or supplier credit. In

the case of suppliers’ credit, it relates to credit for import

in to India by overseas supplier, while buyers’ credit

refers to the loan for payment of imports into India

arranged by the importer for a bank or financial

institutions outside India for a maturity of less than 3

year . This is for import of capital goods.

The comparison of all the three facilities are given below:

FCNR(B) Loan TC ECB

Tenure Maximum 1

year

Maximum 3

year

Minimum 3 year

Purpose Meeting

Working Capital

Requirement

Import of goods

( all goods

including capital

goods) .Part

can be meeting

working capital

requirment.

For Investment

in Real Sector,

For acquisition

abroad

Interest Rate No restriction Ceiling is Ceiling is

159

prescribed prescribed

Source of Fund Allready

existing NRI

Liability in the

form of

FCNR(B)

deposit

Fresh Liability in

Balance of

Payment

Fresh Liability in

Balance of

Payment

Permission No permission

is required. No

information to

be submitted.

Information

needs to be

submitted

Information

needs to be

submitted

Fig 8.3

In the case of a loan product, the interest rate is linked to the PLR of

the lending bank. For loan product in foreign currency like FCNR(B)

loan, the interest rate is linked to LIBOR. The PLR or Prime Lending

Rate of the company is the reference rate for lending under loans and

advances. This rate does not change frequently .The rate is arrived at

by taking into the account the deposit rate and the other overhead

cost. Since the deposit rate of a bank does not change very frequently

, the PLR of the bank does not change very frequently. Let us take an

example. A company has been sanctioned a cash credit limit of Rs

250 lacs at a rate of PLR+1.00%. If the PLR is 11% p.a. the company

needs to pay interest on the drawing till Rs 250 lacs at an interest

rate of 12% till it enjoys the facility or till the PLR is changed

whichever is earlier. So company�s interest liability is fixed for a

longer period. This kind of situation may lead to the loss if a soft

interest rate regime prevails in the economy.

160

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

is resorted to borrowing through investment product. The

characteristic of investment product is that the interest rate is linked

to money market interest rate. Since the money market interest rate

keeps changing on the daily basis, the company can take the

advantage of recent changes of the money market interest rate in the

investment product.

Another characteristics of investment product is that all the products

are rated by an external agencies. Since the product is rated by an

external agencies, the decision taking capacity of the bank is much

faster compared to that of loan product.

In Indian market, generally investment products are used to replace

the traditional loan product for availing the interest rate benefit. In all

the cases, the company is having a sanctioned working capital limit

from a bank. The company uses the investment product to substitute

the loan product within the sanctioned limit to take advantage of the

interest rate.

The following investment products are widely used in India for funding

the working capital requirement of a company:

• Commercial Paper (CP)

• Mumbai Inter Bank Offer Rate ( MIBOR) linked

debenture

• Non Convertible Debenture.

Commercial Paper ( CP) : CP is an unsecured money market

instrument issued in the form of a promissory note by corporation of

high repute to diversify their source of short term borrowing and to

provide an additional instruments to investors. Subsequently , Primary

Dealers and Financial Institutions are also permitted to issue CP.

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• Who Can Issue a CP ? A company, Primary Dealer and All India

Financial Institutions can issue CP. In the case of a company the

following criteria needs to be fulfilled :

o The TNW of the company as per latest audited balance

sheet should not be less than Rs 4crores;

o The Company has been sanctioned a working capital limit

by Banks and /or all India Financial Institutions

o The Borrowal Account is classified as Standard assets by

the bank/Fis.

In the case of Primary Dealer and All India Financial Institutions , RBI

permits them to issue CP to meet their short term funding

requirement within an umbrella limit specified by the RBI .

• Rating Criteria : All eligible participants shall obtain the credit

rating for issuance of commercial paper from

ICRA,CRISIL,CARE,FITCH Ratings India Pvt Limited or any other

credit rating agencies as prescribed by RBI from time to time.

The minimum credit rating should be P2 of CRISIL or equivalent

of other rating agencies . The issuer of CP should ensure that the

rating is valid at the time of issuance .

• Maturity : The CP can be issued for a minimum maturity of 7

days to maximum maturity of 1year .Under no circumstances,

the maturity date of CP should not go beyond the date up to

which the rating is valid.

• Denominations : CP can be issued in denominations of Rs 5 lacs

or multiples thereof.

• Limits and the amount of issue of CP: CP can be issued as a

�Stand Alone � product. The aggregate amount of CP from an

issuer ( company) shall be within the limit as approved by its

Board of Directors or the Quantum indicated by the credit rating

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agencies for the specified rating, whichever is lower. An FI can

issue CP up to the umbrella limit fixed by RBI i.e. issue of CP

along with other instrument viz. term money borrowings, tem

deposits ,Certificate of Deposits and Inter Corporate Deposits

should not exceed 100 percent of its net owned fund, as per the

latest audited balance sheet.

• Issue and Paying Agency : By now, we have seen the issuer of

Cp needs to fulfill a number of requirement. To verify that the

issuer has fulfilled all the requirement, an independent agencies

should certify to that extent to the investor. Issue and Paying

Agencies (IPA) would play that role. Only schedule commercial

banks can act as a IPA.

• Investment in CP : CP may be issued to and held by an

Individual, Banks, Fis, NRIs and also FIIs .However, investment

by FIIs would be within the limits set for their investments by

SEBI.

• Mode of Issuance : CP can be issued in Physical Mode or in

Dematerialized Mode through any of the depositories approved

by and registered with SEBI.CP can be issued at a discount to

face value as may be decided by the issuer.

• Payment of CP : The initial investor would pay the discounted

value of the CP by means of a crossed account payee cheque to

the account of the issuer through IPA. On maturity of CP, when

the CP is held in physical form, the holder of instrument would

present the instrument to the issuer through IPA. However,

when the CP is held in demat form, the holder of CP will have to

get it redeemed through depository and receive payment from

the IPA.

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• Stand by facility : In view of CP being a �Stand Alone � product,

it would not be obligatory for bank and Fis to issue stand by

facility to the issuer of CP. However , banks and Fis have the

flexibility to provide for a CP issue, credit enhancement by way

of stand by assistance/credit,back stop facility etc based on their

commercial judgment, subject to the prudential norms as

applicable and with specific approval of their board.

Non bank entities including corporates may also provide

unconditional and irrevocable guarantee for credit enhancement

for CP issue provided:

1. The issuer fulfills the eligibility criteria prescribed for

issuance of CP;

2. The guarantor has a credit rating at least one notch higher

than the issuer given by an approved rating agencies;

3. The offer documents for CP properly discloses the net

worth of the guarantor company, the names of the

companies to which the guarantor has issued similar

guarantees, the extent of the guarantees offered by the

guarantor company, and the conditions under which the

guarantee would be invoked.

• Procedure for Issuance : Every issuer must appoint an IPA for

issuance of CP. The issuer should disclose to the potential

investor its financial positions as per the standard market

practice. After the exchange of deal confirmation between the

investor and the issuer, the issuing company shall issue

physical certificates to the investor or arrange for crediting

the CP to the investor�s account with the depository. Investor

shall be given a copy of IPA certificate to the effect that the

164

issuer has a valid agreement with the IPA and the documents

are in order.

When a company raises the fund through CP , it will pay discount

rate which is depended on the money market rate at the date of

issuance. For example, a company wants to raise Rs 5 crores

through CP ( having a rating of P1+) for 90 days on 1st September

2005, the discount rate to be paid on the CP would depend on the

call money rate or MIBOR rate prevailing on 1st September

2005.This discount rate is fixed for the company for the entire

tenure of 90 days from 1st September 2005. For example if the call

money rate is 5% p.a. and a P1+ CP would attract a discount rate

of 0.75% above the MIBOR rate , then the discount rate to be paid

by the company would be 5.75% p.a. for 90 days from 1st

September 2005.Now if the call money rate goes down to 4.75%

on September 15th 2005 , if the company could have raised the

fund at that point of time at an interest rate of 5.50% p.a. for 90

days. The benefits of daily movement of interest rate would be

possible in the case of MIBOR linked debentures. Under this

instruments, a company can raise working capital where the

interest rate is compounded on a daily basis based on the closing

MIBOR rate prevailing at the close of each day.

Factoring Services : In the international transaction factoring of

receivable is also a very important corporate banking product. In

most of the international trade transactions, besides the normal

credit risks, it involves additional concepts of country and therefore

a sovereign risks comes into play. Sovereign risks in international

business is usually of three broad categories :

• Transaction Risk : It is linked to specific transaction

that involves a specific amount within a specific time

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frame, such as an export sales on six months draft

terms;

• Translation Risk: It stems form the obligation of

multinational companies to translate foreign currency

assets and liabilities into the parent company�s

accounting currency regularly , a process that can

give rise to book keeping gains and losses

• Economic Risk : In the broadest sense , it

encompasses all changes in a company�s

international operating environment that generate,

real economic gains or losses.

Export credit is quite distinct from the domestic counterpart is

several respects. The principal characteristics of export credit

which distinguish it from the domestic sales are as follows:

• Longer time scales for delivery , funds transfer and credit

period;

• Extra time and distance require terms which provide a

security for the risks perceived;

• The expectation of local credit terms for each market

• Competition from other countries having different money

costs and government policies;

• The use of international standard terminology.

This feeling of insecurity and risks involved in international

transactions has, therefore, resulted in various methods of

payment system, the most secure of these being the Advance

Payment or Cash with Order ( CWO) .The other two prevalent

methods of receiving payments are through the mechanism of

Bills of Exchange and Documentary Credit. In both these

methods, the banking system is the channel through which the

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transactions are normally carried out. Though advantageous to

the sellers, secured to a certain extent , except the concept of

clean bills of exchange ( here shipping documents are not

enclosed) , usually in a competitive environment, debtors are not

inclined to open letters of credit because of the cost and time

involved. Further, the entire mechanism of operations through

letter of credit is gradually loosing its impact through out world

primarily on account of what is known as Doctrine of Strict

Compliance. The seriousness of the problems is evident from a

survey conducted in United Kingdom which revealed that more

than 50 percent of documents failed to comply with the terms of

letter of credit in first presentation to the banks.

In view of the constraints of the existing systems, open account

transactions are also coming into existence in larger numbers

than in the past. Under this system, there is direct arrangement

between the exporter and the importer to complete the deal

including the payment within a predetermined future date

usually between 60 days and 90 days from the date of invoice.

The goods and the shipping documents are sent directly to the

importer enabling him to take delivery of goods. The essential

features of open account transaction are listed as follows :

1. Complete confidence in the credit standing not only of the

debtors but also of his country so that proceeds of the

goods can be realized within the agreed period.

2. An efficient sales ledger administration often in multi

currencies coupled with credit control mechanism involving

sound knowledge of trade practices, law and knowledge of

the importer�s country.

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3. Sufficient liquidity source to grant competitive credit terms

to the importer.

In such situation , export factoring can play a very important

role not only in providing finance but also in providing a service

package to exporters. Export factoring can broadly be defined as

an agreement in which export receivables arising out of sale of

goods/services are sold to the factor, as a result of which title to

the goods/services represented by the said receivable passes on

to the factor. Henceforth, the factor becomes responsible for all

credit control, sales accounting and debt collection from the

importers.

Advantages of International Factoring :

The distinct advantages of a factoring transaction over other

methods of finance/facilities provided to an exporter can be

summarized as follows :

1. Immediate finance up to a certain percentage ( say 75-80

percent) of the eligible export receivable. This prepayment

facility s available without a letter of credit �simply on the

strength of the invoice(s) representing the shipment of

goods.

2. Credit checking of all the prospective debtors in importing

countries ,through own databases o the export factor or by

taking assistance from his counterpart(s) in importing

countries known as import factor or established credit

rating agencies.

3. Maintenance of entire sales ledger of the exporter including

undertaking asset management functions. Constant liaison

is maintained with the debtors in importing countries and

collections are affected in a diplomatic but efficient

168

manner, ensuring faster payment and safeguarding

financial costs.

4. According bad debt protection up to full extent ( 100

percent) on all approved sales to agreed debtors ensuring

total predictability of cash flows .

5. Undertaking cover operations to minimize potential losses

arising from possible exchange rate fluctuations.

6. Efficient and fast communication system through letters,

telex, telephone or in person in the buyer�s language and

in line with the national business practices.

7. Consultancy services in areas relating to special conditions

and regulations as applicable to the importing countries.

Types of International Factoring : The most important form of factoring is two factor system.

Two Factor System :

The transaction is based on operation of two factoring

companies in two different countries involving in all, four

parties :Exporter, Importer, Export Factor in exporter�s country

and import factor in importer�s country.

The mechanics of operation in this arrangement works out as

follows :

1. The exporter approaches the export factor with relevant

information which, inter alia, may include a) Type of

business,b) Names and addresses of the debtors in

various importing countires,c)Annual expected export

turnover to each country ,d) Number of invoices/credit

notes per country,e)Payments terms and f) Line of credit

required for each debtor.

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2. Based on the information furnished , the export factor

would contact his counterpart( import factor) in different

countries to assess the creditworthiness of the various

debtors.

3. The import factor makes a preliminary assessment as to

his ability to give credit cover to the principal debtors.

4. Based on the positive response of the import factor, the

factoring agreement is signed between the exporter and

export factor.

5. Goods are sent by the exporter to the importer along with

the original invoice which includes an assignment clause

stipulating that the payment must be made to the import

factor. Simultaneously, two copies of the invoice along

with notifications of the debt are sent to the export factor.

At this stage, prepayment up to an agreed per cent ( say

75-80 percent) of the invoice(s) is made to the exporter

by the export factor.

6. A copy of the invoice is sent by the export factor to his

counterpart, that is the import factor. Henceforth , the

responsibilities relating to book keeping and collection of

debts remain vested with the import factor.

7. Having collected the debts, the proceeds are remitted by

the import factor to his counterpart, that is export factor.

In case of payments are not received from any of the

debtor(s) at the end of the previously agreed period on

account of financial inability of the debtor concerned, the

import factor has to pay the amount of the bill to his

export counterpart from his own funds. However, this

obligation will not apply in case of any dispute regarding

170

quality ,quantity, terms and conditions of supply etc. If

any dispute arises, the same has to be settled between

the parties concerned through the good offices of the

factoring companies , otherwise legal action may have to

be initiated by the import factor based on the instructions

of the exporter/export factor.

8. On receipt of the proceeds of the debts realized, the

retention held (say 15-20 percent) is released to the

exporter. The entire factoring fee is debited to the

exporter�s account and the export factor remits the

mutually agreed commission to his importing counter

part.

This, the export factor undertakes the exporter risk whereas the

importer risk is taken care of by the import factor.

The main functions of the export factor relate to :

• Assessment of the financial strength of the exporter

• Prepayment to the exporter after proper documentation

and regular audit and post sanction control

• Follow up with the import factor

• Sharing of commission with the import factor

The import factor is primarily engaged in the areas of :

• Maintaining books of exporter in respect of sales to the

debtors of his country

• Collection of debts from the importers and remitting

proceeds of the same to the export factor

• Providing credit protection in case of financial inability on

part of any of the debtors.

The two factor systems is by all means the best mode of

providing the most effective factoring facilities to a prospective

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exporter. However, the system is also fraught with certain basic

disadvantages, i.e. delay in operations like credit decision,

remittance of fund, etc, due to involvement of many parties.

172

Appendix

173

Appendix 1

UCPDC 500

A. General Provisions and Definition

Article 1:

Application of UCP

The Uniform Customs and Practice for Documentary Credits, 1993

Revision, ICC Publication N0. 500, shall apply to all Documentary

Credits (including to the extent to which they may be applicable,

Standby Letter(s) of Credit) where they are incorporated into the text

of the Credit. They are binding on all parties thereto, unless otherwise

expressly stipulated in the Credit.

Article 2 :

Meaning of Credit

For the purposes of these Articles, the expressions 'Documentary

'Credit(s)' and 'Standby Letter(s) of Credit (hereinafter referred to as

'Credit(s)'), mean any arrangement, however named or described,

whereby a bank (the 'Issuing Bank') acting at the request and on the

instruction of a customer (the 'Applicant') or on its own behalf,

174

i. is to make a payment to or to the order of a third party (the '

Beneficiary'), or is to accept and pay bills of exchange (Draft(s)) drawn

by the Beneficiary,

or

ii. authorises another bank to effect such payment, or to accept and

pay such bills of exchange (Draft(s)),

or

iii. authorises another bank to negotiate,

against stipulated document(s), provided that the terms and

conditions of the Credit are complied with.

For the purposes of these Articles, branches of a bank in different

countries are considered another bank.

Article 3

Credits v Contracts

a. Credits, by their nature, are separate transactions from the sales of

other contract(s) on which they may be based and banks are in no

way concerned with or bound by such contract(s), even if any

reference whatsoever to such contract(s) is included in the Credit.

Consequently, the undertaking of a bank to pay, accept and pay

Draft(s) or negotiate and/or to fulfil any other obligation under the

Credit, is not subject to claims or defences by the Applicant resulting

from his relationships with the Issuing Bank or the Beneficiary.

b. A Beneficiary can in no case avail himself of the contractual

relationships existing between the banks or between the Applicant and

the Issuing Bank.

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Article 4

Documents v. Goods/ Services/ Performances

In Credit operations all parties concerned deal with documents, and

not with goods, services and/or other performances to which the

documents may relate.

Article 5

Instructions to Issue/Amend Credits

a. Instructions for the issuance of a Credit, the Credit itself,

instructions for an amendment thereto, and the amendment itself,

must be complete and precise.

In order to guard against confusion and misunderstanding, banks

should discourage any attempt:

i. to include excessive detail in the Credit or in any amendment

thereto;

ii. to give instructions to issue, advise or confirm a Credit by reference

to a Credit previously issued (similar Credit) where such previous

Credit has been subject to accepted amendment(s), and/or

unaccepted amendment(s).

b. All instructions for the issuance of a Credit and the Credit itself and,

where applicable, all instructions for an amendment thereto and the

amendment itself, must state precisely the document(s) against which

payment, acceptance or negotiation is to be made.

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Forms and Notification of Credits

Article 6

Revocable v Irrevocable Credits

a. A Credit may be either:

i. revocable,

or

ii. irrevocable.

b The Credit, therefore, should clearly indicate whether it is revocable

or irrevocable.

c In the absence of such indication the Credit shall be deemed to be

irrevocable.

Article 7

Advising Bank's Liability

a. A Credit may be advised to a Beneficiary through another bank (the

'Advising Bank') without engagement on the part of the Advising Bank,

but that bank, if it elects to advise the Credit, shall take reasonable

care to check the apparent authenticity of the Credit which it advises.

If the bank elects not to advise the Credit, it must so inform the

Issuing Bank without delay.

b. If the Advising Bank cannot establish such apparent authenticity it

must inform, without delay, the bank from which the instructions

appear to have been received that it has been unable to establish the

177

authenticity of the Credit and if it elects nonetheless to advise the

Credit it must inform the Beneficiary that it has not been able to

establish the authenticity of the Credit.

Article 8

Revocation of a Credit

a. A revocable Credit may be amended or cancelled by the Issuing

Bank at any moment and without prior notice to the Beneficiary.

b. However, the Issuing Bank must:

i. reimburse another bank with which a revocable Credit has been

made available for sight payment, acceptance or negotiation - for any

payment, acceptance or negotiation made by such bank - prior to

receipt by it of notice of amendment or cancellation, against

documents which appear on their face to be in compliance with the

terms and conditions of the Credit;

ii. reimburse another bank with which a revocable Credit has been

made available for deferred payment, if such a bank has, prior to

receipt by it of notice of amendment or cancellation, taken up


terms and conditions of the Credit.

Article 9

Liability of Issuing and Confirming Banks

a. An irrevocable Credit constitutes a definite undertaking of the

Issuing Bank, provided that the stipulated documents are presented to

the Nominated Bank or to the Issuing Bank and that the terms and

conditions of the Credit are complied with:

i. if the Credit provides for sight payment - to pay at sight;

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ii. if the Credit provides for deferred payment - to pay on the maturity

date(s) determinable in accordance with the stipulations of the Credit;

iii. if the Credit provides for acceptance:

a. by the Issuing Bank - to accept Draft(s) drawn by the Beneficiary on

the Issuing Bank and pay them at maturity,

or

b. by another drawee bank - to accept and pay at maturity Draft(s)

drawn by the Beneficiary on the Issuing Bank in the event the drawee

bank stipulated in the Credit does not accept Draft(s) drawn on it, or

to pay Draft(s) accepted but not paid by such drawee bank at

maturity;

iv. if the Credit provides for negotiation - to pay without recourse to

drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary

and/or document(s) presented under the Credit. A Credit should not

be issued available by Draft(s) on the Applicant. If the Credit

nevertheless calls for Draft(s) on the Applicant, banks will consider

such Draft(s) as an additional document(s).

b. A confirmation of an irrevocable Credit by another bank (the

"Confirming Bank") upon the authorisation or request of the Issuing

Bank, constitutes a definite undertaking of the Confirming Bank, in

addition to that of the Issuing Bank, provided that the stipulated

documents are presented to the Confirming Bank or to any other

Nominated Bank and that the terms and conditions of the Credit are

complied with:

i. if the Credit provides for sight payment - to pay at sight;

ii. if the Credit provides for deferred payment - to pay on the maturity

date(s) determinable in accordance with the stipulations of the Credit;

iii. if the Credit provides for acceptance:

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a. by the Confirming Bank - to accept Draft(s) drawn by the

Beneficiary on the Confirming Bank and pay them at maturity,

or

b. by another drawee bank - to accept and pay at maturity Draft(s)

drawn by the Beneficiary on the Confirming Bank, in the event the

drawee bank stipulated in the Credit does not accept Draft(s) drawn

on it, or to pay Draft(s) accepted but not paid by such drawee bank at

maturity;

iv. if the Credit provides for negotiation - to negotiate without recourse

to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary

and/or document(s) presented under the Credit. A Credit should not

be issued available by Draft(s) on the Applicant. If the Credit

nevertheless calls for Draft(s) on the Applicant, banks will consider

such Draft(s) as an additional document(s).

c. i. If another bank is authorised or requested by the Issuing Bank to

add its confirmation to a Credit but is not prepared to do so, it must so

inform the Issuing Bank without delay.

ii. Unless the Issuing Bank specifies otherwise in its authorisation or

request to add confirmation, the Advising Bank may advise the Credit

to the Beneficiary without adding its confirmation.

d. i. Except as otherwise provided by Article 48, an irrevocable Credit

can neither be amended nor cancelled without the agreement of the

Issuing Bank, the Confirming Bank, if any, and the Beneficiary.

ii. The Issuing Bank shall be irrevocably bound by an amendment(s)

issued by it from the time of the issuance of such amendment(s). A

Confirming Bank may extend its confirmation to an amendment and

shall be irrevocably bound as of the time of its advice of the

amendment. A Confirming Bank may, however, choose to advise an

180

amendment to the Beneficiary without extending its confirmation and,

if so, must inform the Issuing Bank and the Beneficiary without delay.

iii. The terms of the original Credit (or a Credit incorporating previously

accepted amendment(s)) will remain in force for the Beneficiary until

the Beneficiary communicates his acceptance of the amendment to the

bank that advised such amendment. The Beneficiary should give

notification of acceptance or rejection of amendment(s). If the

Beneficiary fails to give such notification, the tender of documents to

the Nominated Bank or Issuing Bank, that conform to the Credit and to

not yet accepted amendment(s), will be deemed to be notification of

acceptance by the Beneficiary of such amendment(s) and as of that

moment the Credit will be amended

iv. Partial acceptance of amendments contained in one and the same

advice of amendment is not allowed and consequently will not be given

any effect.

Article 10

Types of Credit

a. All credits must clearly indicate whether they are available by sight

payment, by deferred payment, by acceptance or by negotiation.

b. i. Unless the Credit stipulates that it is available only with the

Issuing Bank, all Credits must nominate the bank (the 'Nominated

Bank') which is authorised to pay, to incur a deferred payment

undertaking, to accept Draft(s) or to negotiate. In a freely negotiable

Credit, any bank is a Nominated Bank.

Presentation of documents must be made to the Issuing Bank or the

Confirming Bank, if any, or any other Nominated Bank.

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ii. Negotiation means the giving of value for Draft(s) and/or

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

the documents without giving of value does not constitute a

negotiation.

c. Unless the Nominated Bank is the Confirming Bank, nomination by

the Issuing Bank does not constitute any undertaking by the

Nominated Bank to pay, to incur a deferred payment undertaking, to

accept Draft(s), or to negotiate. Except where expressly agreed to by

the Nominated Bank and so communicated to the Beneficiary, the

Nominated Bank's receipt of and/or examination and/or forwarding of

the documents does not make that bank liable to pay, to incur a

deferred payment undertaking, to accept Draft(s) or to negotiate.

d. By nominating another bank, or by allowing for negotiation by any

bank, or by authorising or requesting another bank to add its

confirmation, the Issuing Bank authorises such bank to pay, accept

Draft(s) or negotiate as the case may be, against documents which

appear on their face to be compliance with the terms and conditions of

the Credit and undertakes to reimburse such bank in accordance with

the provisions of these Articles.

Article 11

Teletransmitted and Pre-Advised Credits

a. i. When an Issuing Bank instructs an Advising Bank by an

authenticated teletransmission to advise a Credit or an amendment to

a Credit, the teletransmission will be deemed to be the operative

Credit instrument or the operative amendment, and no mail

confirmation should be sent. Should a mail confirmation nevertheless

182

be sent, it will have no effect and the Advising Bank will have no

obligation to check such mail confirmation against the operative Credit

instrument or the operative amendment received by teletransmission.

ii. If the teletransmission states 'full details to follow' (or words of

similar effect) or states that the mail confirmation is to be the

operative Credit instrument or the operative amendment, then the

teletransmission will not be deemed to be the operative Credit

instrument or the operative amendment. The Issuing Bank must

forward the operative Credit instrument or the operative amendment

to such Advising Bank without delay.

b. If a bank uses the services of an Advising Bank to have the Credit

advised to the Beneficiary, it must also use the services of the same

bank for advising an amendment(s).

c. A preliminary advice of the issuance or amendment of an irrevocable

Credit (pre-advice), shall only be given by an Issuing Bank if such

bank is prepared to issue the operative Credit instrument or the

operative amendment thereto. Unless otherwise stated in such

preliminary advice by the Issuing Bank, an Issuing Bank having given

such pre-advice shall be irrevocably committed to issue or amend the

Credit, in terms not inconsistent with the pre-advice, without delay.

Article 12

Incomplete or Unclear Instructions

If incomplete or unclear instructions are received to advise, confirm or

amend a Credit, the bank requested to act on such instructions may

give preliminary notification to the Beneficiary for information only and

without responsibility. This preliminary notification should state clearly

183

that the notification is provided for information only and without the

responsibility of the Advising Bank. In any event, the Advising Bank

must inform the Issuing Bank of the action taken and request it to

provide the necessary information

The Issuing Bank must provide the necessary information without

delay. The Credit will be advised, confirmed or amended, only when

complete and clear instructions have been received and if the Advising

Bank is then prepared to act on the instructions.

Liabilities and Responsibilities

Article 13

Standard for Examination of Documents

a. Banks must examine all document stipulated in the Credit with

reasonable care, to ascertain whether or not they appear, on their

face, to be in compliance with the terms and conditions of the Credit.

Compliance of the stipulated documents on their face with the terms

and conditions of the Credit, shall be determined by international

standard banking practice as reflected in these Articles. Documents

which appear on their face to be inconsistent with one another will be

considered as not appearing on their face to be in compliance with the

terms and conditions of the Credit

Documents not stipulated in the Credit will not be examined by banks.

If they receive such documents, they shall return them to the

presenter or pass them on without responsibility.

184

b. The Issuing Bank, the Confirming Bank, if any, or a Nominated Bank

acting on their behalf shall each have a reasonable time, not to exceed

seven banking days following the day of receipt of the documents, to

examine the documents and determine whether to take up or refuse

the documents and to inform the party from which it received the

documents accordingly.

c. If a Credit contains conditions without stating the document(s) to be

presented in compliance therewith, banks will deem such conditions as

not stated and will disregard them.

Article 14

Discrepant Documents and Notice

a. When the Issuing Bank authorises another bank to pay, incur a

deferred payment undertaking, accept Draft(s), or negotiate against


terms and conditions of the Credit, the Issuing Bank and the

Confirming Bank, if any, are bound:

i. to reimburse the Nominated Bank which has paid, incurred a

deferred payment undertaking, accepted Draft(s), or negotiated,

ii. to take up the documents.

b. Upon receipt of the documents the Issuing Bank and/or Confirming

Bank, if any, or a Nominated Bank acting on their behalf, must

determine on the basis of the documents alone whether or not they

185

appear on their face to be in compliance with the terms and conditions

of the Credit. If the documents appear on their face not to be in

compliance with the terms and conditions of the Credit, such banks

may refuse to take up the documents.

c. If the Issuing Bank determines that the documents appear on their

face not to be in compliance with the terms and conditions of the

Credit, it may in its sole judgement approach the Applicant for a

waiver of the discrepancy(ies). This does not, however, extend the

period mentioned in sub-Article 13 (b).

d. i. If the Issuing Bank and/or Confirming Bank, if any, or a

Nominated Bank acting on their behalf, decides to refuse the

documents, it must give notice to that effect by telecommunication or,

if that is not possible, by other expeditious means, without delay but

no later than the close of the seventh banking day following the day of

receipt of the documents. Such notice shall be given to the bank from

which it received the documents, or to the Beneficiary, if it received

the documents directly from him

ii. Such notice must state all discrepancies in respect of which the

bank refuses the documents and must also state whether it is holding

the documents at the disposal of, or is returning them to, the

presenter.

iii. The Issuing Bank and/or Confirming Bank, if any, shall then be

entitled to claim from the remitting bank refund, with interest, of any

reimbursement which has been made to that bank.

186

e. If the Issuing Bank and/or Confirming bank, if any, fails to act in

accordance with the provisions of this Article and/or fails to hold the

documents at the disposal of, or return them to, the presenter, the

Issuing Bank and/or confirming bank, if any, shall be precluded from

claiming that the documents are not in compliance with the terms and

conditions of the Credit.

f. If the remitting bank draws the attention of the Issuing Bank and/or

Confirming Bank, if any, to any discrepancy(ies) in the document(s) or

advises such banks that it has paid, incurred a deferred payment

undertaking, accepted Draft(s) or negotiated under reserve or against

an indemnity in respect of such discrepancy(ies), the Issuing Bank

and/or confirming Bank, if any, shall not be thereby relieved from any

of their obligations under any provision of this Article. Such reserve or

indemnity concerns only the relations between the remitting bank and

the party towards whom the reserve was made, or from whom, or on

whose behalf, the indemnity was obtained.

Article 15

Disclaimer on Effectiveness of Documents

Banks assume no liability or responsibility for the form, sufficiency,

accuracy, genuineness, falsification or legal effect of any document(s),

or for the general and/or particular conditions stipulated in the

document(s) or superimposed thereon; nor do they assume any

liability or responsibility for the description, quantity, weight, quality,

condition, packing, delivery, value or existence of the goods

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

187

omissions, solvency, performance or standing of the consignors, the

carriers, the forwarders, the consignees or the insurers of the goods,

or any other person whomsoever.

Article 16

Disclaimer on the Transmission of Messages

Banks assume no liability or responsibility for the consequences arising

out of delay and/or loss on transit of any message(s), letter(s) or

document(s), or for delay, mutilation or other error(s) arising in the

transmission of any telecommunication. Banks assume no liability or

responsibility for errors in translation and/or interpretation of technical

terms, and reserve the right to transmit Credit terms without

translating them.

Article 17

Force Majeure

Banks assume no liability or responsibility for the consequences arising

out of the interruption of their business by Acts of God, riots, civil

commotions, insurrections, wars or any other causes beyond their

control, or by any strikes or lockouts. Unless specifically authorised,

banks will not, upon resumption of their business, pay, incur a

deferred payment undertaking, accept Draft(s) or negotiate under

Credits which expired during such interruption of their business.

188

Article 18

Disclaimer for Acts of an Instructed Party

a. Banks utilising the services of another bank or other banks for the

purpose of giving effect to the instructions of the Applicant do so for

the account and at the risk of such Applicant.

b. Banks assume no liability or responsibility should the instructions

they transmit not to be carried out, even if they have themselves

taken the initiative in the choice of such other bank(s)

c. i. A party instructing another party to perform services is liable for

any charges, including commissions, fees, costs or expenses incurred

by the instructed party in connection with its instructions.

ii. Where a Credit stipulates that such charges are for the account of a

party other than the instructing party, and charges cannot be

collected, the instructing party remains ultimately liable for the

payment thereof.

d. The Applicant shall be bound by and liable to indemnify the banks

against all obligations and responsibilities imposed by foreign laws and

usages.

Article 19

Bank-to-Bank Reimbursement Arrangements

a. If an issuing Bank intends that the reimbursement to which a

paying, accepting or negotiating bank is entitled, shall be obtained by

such bank (the "Claiming Bank"), claiming on another party (the

"Reimbursing Bank"), it shall provide such Reimbursing Bank in good

189

time with the proper instructions or authorisation to honour such

reimbursement claims

b. Issuing Banks shall not require a Claiming Bank to supply a

certificate of compliance with the terms and conditions of the Credit to

the Reimbursing Bank.

c. An Issuing Bank shall not be relieved from any of its obligations to

provide reimbursement if and when reimbursement is not received by

the Claiming Bank from the Reimbursing Bank.

d. The Issuing Bank shall be responsible to the Claiming Bank for any

loss of interest if reimbursement is not provided by the Reimbursing

Bank on first demand, or as otherwise specified in the Credit, or

mutually agreed, as the case may be.

e. The Reimbursing Bank's charges should be for the account of the

Issuing Bank. However, in cases where the charges are for the account

of another party, it is the responsibility of the Issuing Bank to so

indicate in the original Credit and in the reimbursement authorisation.

In cases where the Reimbursing Bank's charges are for the account of

another party they shall be collected from the Claiming Bank when the

Credit is drawn under. In cases where the Credit is not drawn under,

the Reimbursing Bank's charges remain the obligation of the Issuing

Bank.

Documents

Article 20

Ambiguity as to the Issuers of Documents

190

a. Terms such as "first class", "well known", "qualified", "independent",

"official", "competent", "local", and the like, shall not be used to

describe the issuers of any document(s) to be presented under a

Credit. If such terms are incorporated in the Credit, banks will accept

the relative document(s) as presented, provided that it appears on its

face to be in compliance with the other terms and conditions of the

Credit and not to have been issued by the Beneficiary.

b. Unless otherwise stipulated in the Credit, banks will also accept as

an original document(s), a document(s) produced or appearing to have

been produced:

i. by reprographic, automated or computerised systems;

ii. as carbon copies;

provided that it is marked as original and, where necessary, appears

to be signed.

A document may be signed by handwriting, by facsimile signature, by

perforated signature, by stamp, by symbol, or by any other

mechanical or electronic method of authentication.

c. i. Unless otherwise stipulated in the Credit, banks will accept as a

copy(ies), a document(s) either labelled copy or not marked as an

original - copy(ies) need not be signed

ii. Credits that require multiple document(s) such as "duplicate", "two

fold", "two copies" and the like, will be satisfied by the presentation of

one original and the remaining number in copies except where the

document itself indicates otherwise

d. Unless otherwise stipulated in the Credit, a condition under a Credit

calling for a document to be authenticated, validated, legalised,

visaed, certified or indicating a similar requirement, will be satisfied by

any signature, mark, stamp or label on such document that on its face

appears to satisfy the above condition.

191

Article 21

Unspecified Issuers or Contents of Documents

When documents other than transport documents, insurance

documents and commercial invoices are called for, the Credit should

stipulate by whom such documents are to be issued and their wording

or data content. If the Credit does not so stipulate, banks will accept

such documents as presented, provided that their data content is not

inconsistent with any other stipulated document presented.

Article 22

Issuance Date of Documents v Credit Date

Unless otherwise stipulated in the Credit, banks will accept a document

bearing a date of issuance prior to that of the Credit, subject to such

document being presented within the time limits set out in the Credit

and in these Articles.

Article 23

Marine/Ocean Bill of Lading

192

a. If a Credit calls for a bill of lading covering a port-to-port shipment,

banks will, unless otherwise stipulated in the Credit, accept a

document, however named, which:

i. appears on its face to indicate the name of the carrier and to have

been signed or otherwise authenticated by:

-the carrier or a named agent for or on behalf of the carrier, or

-the master or a named agent for or on behalf of the master.

Any signature or authentication of the carrier or master must be

identified as carrier or master, as the case may be. An agent signing

or authenticating for the carrier or master must also indicate the name

and the capacity of the party, i.e. carrier or master, on whose behalf

that agent is acting,

and

ii. indicates that the goods have been loaded on board, or shipped on a

named vessel.

Loading on board or shipment on a named vessel may be indicated by

pre-printed wording on the bill of lading that the goods have been

loaded on board a named vessel or shipped on a named vessel, in

which case the date of issuance of the bill of lading will be deemed to

be the date of loading on board and the date of shipment.

In all other cases loading on board a named vessel must be evidenced

by a notation on the bill of lading which gives the date on which the

goods have been loaded on board, in which case the date of the on

board notation will be deemed to be the date of shipment.

If the bill of lading contains the indication 'intended vessel', or similar

qualification in relation to the vessel, loading on board a named vessel

must be evidenced by an on board notation on the bill of lading which,

in addition to the date on which the goods have been loaded on board,

also includes the name of the vessel on which the goods have been

193

loaded, even if they have been loaded on the vessel named as the

'intended vessel'.

If the bill of lading indicates a place of receipt or taking in charge

different from the port of loading, the on board notation must also

include the port of loading stipulated in the Credit and the name of the

vessel on which the goods have been loaded, even if they have been

loaded on the vessel named in the bill of lading. This provision also

applies whenever loading on board the vessel is indicated by pre-

printed wording on the bill of lading,

and

iii. indicates the port of loading and the port of discharge stipulated in

the Credit, notwithstanding that it:

(a) indicates a place of taking in charge different from the port of

loading,and/or a place of final destination different from the port of

discharge,

and/or

(b) contains the indication 'intended' or similar qualification in relation

to the port of loading and/or port of discharge, as long as the

document also states the ports of loading and/or discharge stipulated

in the Credit,

and

iv. consists of a sole original bill of lading or, if issued in more than one

original, the full set as so issued,

and

v. appears to contain all of the terms and conditions of carriage, or

some of such terms and conditions by reference to a source or

document other than the bill of lading (short form/blank back bill of

lading); banks will not examine the contents of such terms and

conditions,

194

and

vi. contains no indication that it is subject to a charter party and/or no

indication that the carrying vessel is propelled by sail only,

and

vii. in all other respects meets the stipulations of the Credit.

b. For the purpose of this Article, transhipment means unloading and

reloading from one vessel to another vessel during the course of ocean

carriage from the port of loading to the port of discharge stipulated in

the Credit.

c. Unless transhipment is prohibited by the terms of the Credit, banks

will accept a bill of lading which indicates that the goods will be

transhipped, provided that the entire ocean carriage is covered by one

and the same bill of lading.

d. Even if the Credit prohibits transhipment, banks will accept a bill of

lading which:

i. indicates that transhipment will take place as long as the relevant

cargo is shipped in Container(s), Trailer(s) and/or 'LASH' barge(s) as

evidenced by the bill of lading provided that the entire ocean carriage

is covered by one and the same bill of lading,

and/or

ii. incorporates clauses stating that the carrier reserves the right to

tranship.

Article 24

Non-Negotiable Sea Waybill

195

a. If a Credit calls for a non-negotiable sea waybill covering a port-to-

port shipment, banks will, unless otherwise stipulated in the Credit,

accept a document, however named, which:



-the carrier or a named agent for or on behalf of the carrier, or


Any signature or authentication of the carrier or master must be

identified as carrier or master, as the case may be. An agent signing

or authenticating for the carrier or master must also indicate the name

and the capacity of the party, i.e. carrier or master, on whose behalf


and,

ii. indicates that the goods have been loaded on board, or shipped on a

named vessel.


pre-printed wording on the non-negotiable sea waybill that the goods

have been loaded on board a named vessel or shipped on a named

vessel, in which case the date of issuance of the non-negotiable sea

waybill will be deemed to be the date of loading on board and the date

of shipment.

In all other cases loading on board a named vessel must be evidenced

by a notation on the non-negotiable sea waybill which gives the date

on which the goods have been loaded on board, in which case the date

of the on board notation will be deemed to be the date of shipment.

If the non-negotiable sea waybill contains the indication 'intended

vessel', or similar qualification in relation to the vessel, loading on

board a named vessel must be evidenced by an on board notation on

the non-negotiable sea waybill which, in addition to the date on which

196

the goods have been loaded on board, includes the name of the vessel

on which the goods have been loaded, even if they have been loaded

on the vessel named as the 'intended vessel'.

If the non-negotiable sea waybill indicates a place of receipt or taking

in charge different from the port of loading, the on board notation

must also include the port of loading, stipulated in the Credit and the

name of the vessel on which the goods have been loaded, even if they

have been loaded on a vessel named in the non-negotiable sea

waybill. This provision also applies whenever loading on board the

vessel is indicated by pre-printed wording on the non-negotiable sea

waybill,

and,

iii. indicates the port of loading and the port of discharge stipulated in

the Credit, notwithstanding that it:

(a) indicates a place of taking in charge different from the port of

loading, and/or a place of final destination different from the port of

discharge,

and/or


to the port of loading and/or port of discharge, as long as the

document also states the ports of loading and/or discharge stipulated

in the Credit,

and,

iv. consists of a sole original non-negotiable sea waybill, or if issued in

more than one original, the full set as so issued,

and,

v. appears to contain all of the terms and conditions of carriage, or

some of such terms and conditions by reference to a source or

document other than the non-negotiable sea waybill (short form/blank

197

back non-negotiable sea waybill); banks will not examine the contents

of such terms and conditions,

and,



and,


b. For the purpose of this Article, transhipment means unloading and

reloading from one vessel to another vessel during the course of ocean

carriage from the port of loading to the port of discharge stipulated in

the Credit.

c. Unless transhipment is prohibited by terms of the Credit, banks will

accept a non-negotiable sea waybill which indicates that the goods will

be transhipped, provided that the entire ocean carriage is covered by

one and the same non-negotiable sea waybill.

d. Even if the Credit prohibits transhipment, banks will accept a non-

negotiable sea waybill which:

i. indicates that transhipment will take place as long as the relevant

cargo is shipped in Container(s), Trailer(s) and/or 'LASH' barge(s) as

evidenced by the non-negotiable sea waybill, provided that the entire

ocean carriage is covered by one and the same non-negotiable sea

waybill,

and/or

ii. incorporates clauses stating that the carrier reserves the right to

tranship.

Article 25

198

Charter Party Bill of Lading

a. If a Credit calls for or permits a charter party bill of lading, banks

will, unless otherwise stipulated in the Credit, accept a document,

however named, which:

i. contains any indication that it is subject to a charter party,

and

ii. appears on its face to have been signed or otherwise authenticated

by:

-the master or a named agent for or on behalf of the master, or

-the owner or a named agent for or on behalf of the owner.

Any signature or authentication of the master or owner must be

identified as master or owner as the case may be. An agent signing or

authenticating for the master or owner must also indicate the name

and the capacity of the party, i.e. master or owner, on whose behalf


and

iii. does or does not indicate the name of the carrier,

and

iv. indicates that the goods have been loaded on board or shipped on a

named vessel.


pre-printed wording on the bill of lading that the goods have been

loaded on board a named vessel or shipped on a named vessel, in

which case the date of issuance of the bill of lading will be deemed to

be the date of loading on board and the date of shipment.

In all other cases loading on board or shipment on a named vessel

must be evidenced by a notation on the bill of lading which gives the

date on which the goods have been loaded on board, in which case the

199

date of the on board notation will be deemed to be the date of

shipment,

and

v. indicates the port of loading and the port of discharge stipulated in

the Credit,

and

vi. consists of a sole original bill of lading or, if issued in more than one

original, the full set as so issued,

and

vii. contains no indication that the carrying vessel is propelled by sail

only,

and

viii. in all other respects meets the stipulations of the Credit.

b. Even if the Credit requires the presentation of a charter party

contract in connection with a charter party bill of lading, banks will not

examine such charter party contract, but will pass it on without

responsibility on their part.

Article 26

Multimodal Transport Document

a. If a Credit calls for a transport document covering at least two

different modes of transport (multimodal transport), banks will, unless

otherwise stipulated in the Credit, accept a document, however

named, which:

i. appears on its face to indicate the name of the carrier or multimodal

transport operator and to have been signed or otherwise authenticated

by:

200

-the carrier or multimodal transport operator or a named agent for or

on behalf of the carrier or multimodal transport operator, or


Any signature or authentication of the carrier, multimodal transport

operator or master must be identified as carrier, multimodal transport

operator or master, as the case may be. An agent signing or

authenticating for the carrier, multimodal transport operator or master

must also indicate the name and the capacity of the party, i.e. carrier,

multimodal transport operator or master, on whose behalf that agent

is acting,

and

ii. indicates that the goods have been dispatched, taken in charge or

loaded on board.

Dispatch, taking in charge or loading on board may be indicated by

wording to that effect on the multimodal transport document and the

date of issuance will be deemed to be the date of dispatch, taking in

charge or loading on board and the date of shipment. However, if the

document indicates, by stamp or otherwise, a date of dispatch, taking

in charge or loading on board, such date will be deemed to be the date

of shipment,

and

iii. (a) indicates that the place of taking in charge stipulated in the

Credit which may be different from the port, airport or place of

loading, and the place of final destination stipulated in the Credit which

may be different from the port, airport or place of discharge,

and/or


to the vessel and/or port of loading and/or port of discharge,

and

201

iv. consists of a sole original multimodal transport document or, if

issued in more than one original, the full set as so issued,

and

v. appears to contain all the terms and conditions of carriage, or some

of such terms and conditions by reference to a source or document

other than the multimodal transport document (short form/blank back

multimodal transport document); banks will not examine the contents

of such terms and conditions,

and



and

vii. in all other respects meets the stipulation of the Credit.

b. Even if the Credit prohibits transhipment, banks will accept a

multimodal transport document which indicates that transhipment will

or may take place, provided that the entire carriage is covered by one

and the same multimodal transport document.

Article 27

Air Transport Document

a. If a Credit calls for an air transport document, banks will, unless

otherwise stipulated in the Credit, accept a document, however

named, which:



-the carrier, or

-a named agent for or on behalf of the carrier.

202

Any signature or authentication of the carrier must be identified as

carrier. An agent signing or authenticating for the carrier must also

indicate the name and the capacity of the party, i.e. carrier, on whose

behalf that agent is acting,

and

ii. indicates that the goods have been accepted for carriage,

and

iii. where the Credit calls for an actual date of dispatch, indicates a

specific notation of such date, the date of dispatch so indicated on the

air transport document will be deemed to be the date of shipment.

For the purpose of this Article, the information appearing in the box on

the air transport document (marked 'For Carrier Use Only' or similar

expression) relative to the flight number and date will not be

considered as a specific notation of such date of dispatch.

In all other cases, the date of issuance of the air transport document

will be deemed to be the date of shipment,

and

iv. indicates the airport of departure and the airport of destination

stipulated in the Credit,

and

v. appears to be the original for consignor/shipper even if the Credit

stipulates a full set of originals, or similar expressions,

and

vi. appears to contain all of the terms and conditions of carriage, or

some of such terms and conditions, by reference to a source or

document other than the air transport document; banks will not

examine the contents of such terms and conditions,

and


203

b. For this purpose of this article, transhipment means unloading and

reloading from one aircraft to another aircraft during the course of

carriage from the airport of departure to the airport of destination

stipulated in the Credit.

c. Even if the Credit prohibits transhipment, banks will accept an air

transport document which indicates that transhipment will or may take

place, provided that the entire carriage is covered by one and the

same air transport document.

Article 28

Road, Rail or Inland Waterway Transport Documents.

a. If a Credit calls for a road, rail, or inland waterway transport

document, banks will, unless otherwise stipulated in the Credit, accept

a document of the type called for, however named, which:

i. appears on its face to indicate name of the carrier and to have been

signed or otherwise authenticated by the carrier or a named agent for

or on behalf of the carrier and/or to bear a reception stamp or other

indication of receipt by the carrier or a named agent for or on behalf of

the carrier.

Any signature, authentication, reception stamp or other indication of

receipt of the carrier, must be identified on its face as that of the

carrier. An agent signing or authenticating for the carrier, must also

indicate the name and the capacity of the party, i.e. carrier, on whose

behalf that agent is acting,

and

ii. indicates that the goods have been received for shipment, dispatch

or carriage or wording to this effect. The date of issuance will be

204

deemed to be the date of shipment unless the transport document

contains a reception stamp, in which case the date of the reception

stamp will be deemed to be the date of shipment,

and

iii. indicates the place of shipment and the place of destination

stipulated in the Credit,

and

iv. in all other respects meets the stipulations of the Credit.

b. In the absence of any indication on the transport document as to

the numbers issued, banks will accept the transport document(s)

presented as constituting a full set. Banks will accept as original(s) the

transport document(s) whether marked as original(s) or not.

c. For the purpose of this Article, transhipment means unloading and

reloading from one means of conveyance to another means of

conveyance, in different modes of transport, during the course of

carriage from the place of shipment to the place of destination


d. Even if the Credit prohibits transhipment, banks will accept a road,

rail or inland waterway transport document which indicates that

transhipment will or may take place, provided that the entire carriage

is covered by one and the same transport document and within the

same mode of transport.

Article 29

Courier and Post Receipts

a. If a Credit calls for a post receipt or certificate of posting, banks will,

unless otherwise stipulated in the Credit, accept a post receipt or

certificate of posting which:

205

i. appears on its face to have been stamped or otherwise authenticated

and dated in the place from which the Credit stipulates the goods are

to be shipped or dispatched and such date will be deemed to be the

date of shipment or dispatch,

and

ii. in all other respects meets the stipulations of the Credit

b. If a Credit calls for a document issued by a courier or expedited

delivery service evidencing receipt of the goods for delivery, banks

will, unless otherwise stipulated in the Credit, accept a document,

however named, which

i. appears on its face to indicate the name of the courier/service, and

to have been stamped, signed or otherwise authenticated by such

named courier/service, (unless the Credit specifically calls for a

document issued by a named Courier/Service, banks will accept a

document issued by any Courier/Service),

and

ii. indicates a date of pick-up or of receipt or wording to this effect,

such date being deemed to be the date of shipment or dispatch,

and

iii. in all other respects meets the stipulations of the Credit

Documents

Article 30

Transport Documents issued by Freight Forwarders

206

Unless otherwise authorised in the Credit, banks will only accept a

transport document issued by a freight forwarder if it appears on its

face to indicate:

i. the name of the freight forwarder as a carrier or multimodal

transport operator and to have been signed or otherwise authenticated

by the freight forwarder as carrier or multimodal transport operator,

or

ii. the name of the carrier or multimodal transport operator and to

have been signed or otherwise authenticated by the freight forwarder

as a named agent for or on behalf of the carrier or multimodal

transport operator.

Article 31

"On deck", "Shipper's Load and Count", Name of Consignor

Unless otherwise stipulated in the Credit, banks will accept a transport

document which:

i. does not indicate, in the case of carriage by sea or by more than one

means of conveyance including carriage by sea, that the goods are or

will be loaded on deck. Nevertheless, banks will accept a transport

document which contains a provision that the goods may be carried on

deck, provided that it does not specifically state that they are or will be

loaded on deck,

and/or

ii. bears a clause on the face thereof such as 'shipper's 'load and

count' or 'said by shipper to contain' or words of similar effect,

and/or

207

iii. indicates as the consignor of the goods a party other than the

Beneficiary of the Credit.

Article 32

Clean Transport Documents

a. A clean transport document is one which bears no clause or notation

which expressly declares a defective condition of the goods and/or the

packaging.

b. Banks will not accept transport documents bearing such clauses or

notations unless the Credit expressly stipulates the clauses or

notations which may be accepted.

c. Banks will regard a requirement in a Credit for a transport document

to bear the clause 'clean on board' as compiled with if such transport

document meets the requirement of this Article and of Articles 23, 24,

25, 26, 27, 28, or 30.

Article 33

Freight Payable/Prepaid Transport Documents

a. Unless otherwise stipulated in the Credit, or inconsistent with any of

the documents presented under the Credit, banks will accept transport

documents stating that freight or transportation charges (hereafter

referred to as 'freight') have still to be paid.

b. If a credit stipulates that the transport document has to indicate

that freight has been paid or prepaid, banks will accept a transport

document on which words clearly indicating payment or prepayment of

208

freight appear by stamp or otherwise, or on which payment or

prepayment of freight is indicated by other means. If the Credit

requires courier charges to be paid or prepaid banks will also accept a

transport document issued by a courier or expedited delivery service

evidencing that courier charges are for the account of a party other

than the consignee.

c. The words 'freight prepayable' or 'freight to be prepaid' or words of

similar effect, if appearing on transport documents, will not be

accepted as constituting evidence of the payment of freight.

d. Banks will accept transport documents bearing reference by stamp

or otherwise to costs additional to the freight, such as costs of, or

disbursements incurred in connectoin with, loading, unloading or

similar operations, unless the conditions of the Credit specifically

prohibit such reference.

Article 34

Article 34 UCP 500

Insurance Documents

a. Insurance documents must appear on their face to be issued and

signed by insurance companies or underwriters or their agents.

b. If the insurance document indicates that it has been issued in more

than one original, all the originals must be presented unless otherwise

authorised in the Credit.

c. Cover notes issued by brokers will not be accepted, unless

specifically authorised in the Credit.

d. Unless otherwise stipulated in the Credit, banks will accept an

insurance certificate or a declaration under an open cover pre-signed

209

by insurance companies or underwriters or their agents. If a Credit

specifically calls for an insurance certificate or a declaration under an

open cover, banks will accept, in lieu thereof, an insurance policy.

e. Unless otherwise stipulated in the Credit, or unless it appears from

the insurance document that the cover is effective at the latest from

the date of loading on board or dispatch or taking in charge of the

goods, banks will not accept an insurance document which bears a

date of issuance later than the date of loading on board or dispatch or

taking in charge as indicated in such transport document

f. i. Unless otherwise stipulated in the Credit, the insurance document

must be expressed in the same currency as the credit.

ii. Unless otherwise stipulated in the Credit, the minimum amount for

which the insurance document must indicate the insurance cover to

have been effected is the CIF (cost, insurance and freight(...'named

port of destination')) or CIP (carriage and insurance paid to (...'named

place of destination')) value of the goods, as the case may be, plus

10%, but only when the CIF or CIP value can be determined from the

documents on their face. Otherwise, banks will accept as such

minimum amount 110% of the amount for which payment, acceptance

or negotiation is requested under the Credit, or 110% of the gross

amount of the invoice, whichever is the greater

Article 35

Type of Insurance Cover

a. Credits should stipulate the type of insurance required and, if any,

the additional risks which are to be covered. Imprecise terms such as

"usual risks" or "customary risks" shall not be used; if they are used,

210

banks will accept insurance documents as presented, without

responsibility for any risks not being covered.

b. Failing specific stipulations in the Credit, banks will accept insurance

documents as presented, without responsibility for any risks not being

covered.

c. Unless otherwise stipulated in the Credit, banks will accept an

insurance document which indicates that the cover is subject to a

franchise or an excess (deductible).

Article 36

All Risks Insurance Cover

Where a Credit stipulates 'insurance against all risks', banks will accept

an insurance document which contains any 'all risk's notations or

clause, whether or not bearing the heading 'all risks', even if the

insurance document indicates that certain risks are excluded, without

responsibility for any risk(s) not being covered.

Article 37

Commercial Invoices

a. Unless otherwise stipulated in the Credit, commercial invoices:

i. must appear on their face to be issued by the Beneficiary named in

the Credit (except as provided in Article 48),

and

ii. must be made out in the name of the Applicant, (except as provided

in sub-Article 48 (h)),

211

and

iii. need not be signed

b. Unless otherwise stipulated in the Credit, banks may refuse

commercial invoices issued for amounts in excess of the amount

permitted by the Credit. Nevertheless, if a bank authorised to pay,

incur a deferred payment undertaking, accept Draft(s), or negotiate

under a Credit accepts such invoices, its decision will be binding upon

all parties, provided that such bank has not paid, incurred a deferred

payment undertaking, accepted Draft(s) or negotiated for an amount

in excess of that permitted by the Credit.

c. The description of the goods in the commercial invoice must

correspond with the description in the Credit. In all other documents,

the goods may be described in general terms not inconsistent with the

description of the goods in the Credit.

Article 38

Other Documents

If a Credit calls for an attestation or certification of weight in the case

of transport other than by sea, banks will accept a weight stamp or

declaration of weight which appears to have been superimposed on the

transport document by the carrier or his agent unless the Credit

specifically stipulates that the attestation or certification of weight

must be by means of a separate document.

Miscellaneous Provisions

212

Article 39

Allowances In Credit Amount, Quantity and Unit Price

a. The words "about", "approximately", "circa" or similar expressions

used in connection with the amount of the Credit or the quantity or the

unit price stated in the Credit are to be construed as allowing a

difference not to exceed 10% more or 10% less than the amount or

the quantity or the unit price to which they refer.

b. Unless a Credit stipulates that the quantity of the goods specified

must not be exceeded or reduced, a tolerance of 5% more or 5% less

will be permissible, always provided that the amount of the drawings

does not exceed the amount of the Credit. This tolerance does not

apply when the Credit stipulates the quantity in terms of a stated

number of packing units or individual items.

c. Unless a Credit which prohibits partial shipment stipulates

otherwise, or unless sub-Article (b) above is applicable, a tolerance of

5% less in the amount of the drawing will be permissible, provided

that if the Credit stipulates the quantity of the goods, such quantity of

goods is shipped in full, and if the Credit stipulates a unit price, such

price is not reduced. This provision does not apply when expressions

referred to in sub-Article (a) above are used in the Credit.

Article 40

Partial Shipments/Drawings

a. Partial drawings and/or shipments are allowed, unless the Credit

stipulates otherwise.

213

b. Transport documents which appear on their face to indicate that

shipment has been made on the same means of conveyance and for

the same journey, provided they indicate the same destination, will

not be regarded as covering partial shipments, even if the transport

documents indicate different dates of shipment and/or different ports

of loading, places of taking in charge, or despatch.

c. Shipments made by post or by courier will not be regarded as partial

shipments if the post receipts or certificates of posting or courier's

receipts or dispatch notes appear to have been stamped, signed or

otherwise authenticated in the place from which the Credit stipulates

the goods are to be despatched, and on the same date.

Article 41

Instalment Shipments/Drawings

If drawings and/or shipments by instalments within given periods are

stipulated in the Credit and any instalment is not drawn and/or

shipped within the period allowed for that instalment, the Credit

ceases to be available for that and any subsequent instalments, unless

otherwise stipulated in the Credit.

Article 42

Expiry Date and Place for Presentation of Documents

a. All Credits must stipulate an expiry date and a place for

presentation of documents for payment, acceptance, or with the

exception of freely negotiable Credits, a place for presentation of

214

documents for negotiation. An expiry date stipulated for payment,

acceptance or negotiation will be construed to express an expiry date

for presentation of documents

b. Except as provided in sub-Article 44(a), documents must be

presented on or before such expiry date.

c. If an Issuing Bank states that the Credit is to be available "for one

month", "for six months" or the like, but does not specify the date

from which the time is to run, the date of issuance of the Credit by the

Issuing Bank will be deemed to be the first day from which such time

is to run. Banks should discourage indication of the expiry date of the

Credit in this manner.

Article 43

Limitation on the Expiry Date

a. In addition to stipulating an expiry date for presentation of

documents, every Credit which calls for a transport document(s)

should also stipulate a specified period of time after the date of

shipment during which presentation must be made in compliance with

the terms and conditions of the Credit. If no such period of time is

stipulated, banks will not accept documents presented to them later

than 21 days after the date of shipment. In any event, however,

documents must be presented not later than the expiry date of the

Credit

b. In cases in which sub-Article 40(b) applies, the date of shipment will

be considered to be the latest shipment date on any of the transport

documents presented.

215

Article 44

Extension of Expiry Date

a. If the expiry date of the Credit and/or the last day of the period of

time for presentation of documents stipulated by the Credit or

applicable by virtue of Article 43 falls on a day on which the bank to

which presentation has to be made is closed for reasons other than

those referred to in Article 17, the stipulated expiry date and/or the

last day of the period of time after the date of shipment for

presentation of documents, as the case may be, shall be extended to

the first following day on which such bank is open.

b. The latest date for shipment shall not be extended by reason of the

extension of the expiry date and/or the period of time after the date of

shipment for presentation of documents in accordance with sub-Article

(a) above. If no such latest date for shipment is stipulated in the

Credit or amendments thereto, banks will not accept transport

documents indicating a date of shipment later than the expiry date

stipulated in the Credit or amendments thereto.

c. The bank to which presentation is made on such first following

business day must provide a statement that the documents were

presented within the time limits extended in accordance with sub-

Article 44 (a) of the Uniform Customs and Practice for Documentary

Credits, 1993 Revision, ICC Publication No. 500.

Article 45

216

Hours of Presentation

Banks are under no obligation to accept presentation of documents

outside their banking hours.

Article 46

General Expressions as to Dates for Shipment

a. Unless otherwise stipulated in the Credit, the expression "shipment"

used in stipulating an earliest and/or a latest date for shipment will be

understood to include expressions such as, "loading on board",

"dispatch", "accepted for carriage", "date of post receipt", "date of

pick-up", and the like, and in the case of a Credit calling for a

multimodal transport document the expression "taking in charge".

b. Expressions such as "prompt", "immediately", "as soon as possible",

and the like should not be used. If they are used banks will disregard

them.

c. If the expression "on or about" or similar expressions are used,

banks will interpret them as a stipulation that shipment is to be made

during the period from five days before to five days after the specified

date, both end days included.

Article 47

Date Terminology for Periods of Shipment

217

a. The words "to", "until", "till", "from", and words of similar import

applying to any date or period in the Credit referring to shipment will

be understood to include the date mentioned.

b. The word "after" will be understood to exclude the date mentioned.

c. The terms "first half", "second half", of a month shall be construed

respectively as the 1st to the 15th, and the 16th to the last day of

such month, all dates inclusive.

d. The terms "beginning", "middle", or "end" of a month shall be

construed respectively as the 1st to the 10th, the 11th to the 20th,

and the 21st to the last day of such month, all dates inclusive.

Transferable Credit

Article 48

Transferable Credit

a. A transferable Credit is a Credit under which the Beneficiary (First

Beneficiary) may request the bank authorised to pay, incur a deferred

payment undertaking, accept or negotiate (the "Transferring Bank"),

or in the case of a freely negotiable Credit, the bank specifically

authorised in the Credit as a Transferring Bank, to make the Credit

available in whole or in part to one or more other Beneficiary(ies)

(Second Beneficiary(ies)).

b. A Credit can be transferred only if it is expressly designated as

"transferable" by the Issuing Bank. Terms such as "divisible",

"fractionable", "assignable", and "transmissible" do not render the

Credit transferable. If such terms are used they shall be disregarded.

218

c. The Transferring Bank shall be under no obligation to effect such

transfer except to the extent and in the manner expressly consented

to by such bank.

d. At the time of making a request for transfer and prior to transfer of

the Credit, the First Beneficiary must irrevocably instruct the

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

the Transferring Bank to advise amendments to the Second

Beneficiary(ies). If the Transferring Bank consents to the transfer

under these conditions, it must, at the time of transfer, advise the

Second Beneficiary(ies) of the First Beneficiary's instructions regarding

amendments.

e. If a Credit is transferred to more than one Second Beneficiary(ies),

refusal of an amendment by one or more Second Beneficiary(ies) does

not invalidate the acceptance(s) by the other Second Beneficiary(ies)

with respect to whom the Credit will be amended accordingly. With

respect to the Second Beneficiary(ies) who rejected the amendment,

the Credit will remain unamended.

f. Transferring Bank charges in respect of transfers including

commissions, fees, costs or expenses are payable by the First

Beneficiary, unless otherwise agreed. If the Transferring Bank agrees

to transfer the Credit it shall be under no obligation to effect the

transfer until such charges are paid.

g. Unless otherwise stated in the Credit, a transferable Credit can be

transferred once only. Consequently, the Credit cannot be transferred

at the request of the Second Beneficiary to any subsequent Third

Beneficiary. For the purpose of this Article, a retransfer to the First

Beneficiary does not constitute a prohibited transfer.

Fractions of a transferable Credit (not exceeding in the aggregate the

amount of the Credit) can be transferred separately, provided partial

219

shipments/drawings are not prohibited, and the aggregate of such

transfers will be considered as constituting only one transfer of the

Credit.

h. The Credit can be transferred only on the terms and conditions

specified in the original Credit, with the exception of:

-the amount of the Credit,

-any unit price stated therein,

-the expiry date,

-the last date for presentation of documents in accordance with Article

43,

-the period for shipment,

any or all of which may be reduced or curtailed.

The percentage for which insurance cover must be effected may be

increased in such a way as to provide the amount of cover stipulated

in the original Credit, or these Articles.

In addition, the name of the First Beneficiary can be substituted for

that of the Applicant, but if the name of the Applicant is specially

required by the original Credit to appear in any document(s) other

than the invoice, such requirement must be fulfilled.

i. The First Beneficiary has the right to substitute his own invoice(s)

(and Draft(s)) for those of the Second Beneficiary(ies), for amounts

not in excess of the original amount stipulated in the Credit and for the

original unit prices if stipulated in the Credit, and upon such

substitution of invoice(s) (and Draft(s)) the First Beneficiary can draw

under the Credit for the difference, if any, between his invoice(s) and

the Second Beneficiary's(ies) invoice(s).

When a Credit has been transferred and the First Beneficiary is to

supply his own invoice(s) (and Draft(s)) in exchange for the Second

Beneficiary's(ies) invoice(s) (and Draft(s)) but fails to do so on first

220

demand, the Transferring Bank has the right to deliver to the Issuing

Bank the documents received under the transferred Credit, including

the Second Beneficiary's(ies) invoice(s) (and Draft(s)) without further

responsibility to the first Beneficiary.

j. The First Beneficiary may request that payment or negotiation be

effected to the Second Beneficiary(ies) at the place to which the Credit

has been transferred up to and including the expiry date of the Credit,

unless the original Credit expressly states that it may not be made

available for payment or negotiation at a place other than that


This is without prejudice to the First Beneficiary's right to substitute

subsequently his own invoice(s) (and Draft(s)) for those of the Second

Beneficiary(ies) and to claim any difference due to him.

Assignment of Proceeds

Article 49

Assignment of Proceeds

The fact that a Credit is not stated to be transferable shall not affect

the Beneficiary's right to assign any proceeds to which he may be, or

may become, entitled under such Credit, in accordance with the

provisions of the applicable law. This Article relates only to the

assignment of proceeds and not to the assignment of the right to

perform under the Credit itself.

221

Appendix 2

PROCESS NOTE Powers : Note No. dt. Branch : Credit Rating �

Existing Proposed

: :

Zone : Asset Classification

:

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

I.PARTICULARS OF THE BORROWER: 1 Name of the borrower : Address � Office : Plant : 2 Constitution : 3 Date of incorporation : 4 Line of Activity : 5 Dealings with our

bank since :

6 Chief Executive : 7 Group : 8 Sector : 9 Income earned in the

Account : Rs. Lacs

(from ��. to ��.) 10 Details of existing and proposed limits with bank:

(Rs.in lacs) Sanction Reference:

RATE OF INTEREST

FACILITY EXISTING

LIMIT

O/S AS ON

…………….

DP/OD PROPOSED

LIMIT EXISTING

PROPOSED

222

Total � FB NFB Grand Total

Exposure: (Rs.in lacs)

**Our bank�s exposure

Ceilings as per RBI norms

*Constitution wise ceiling as per our

bank policy Existing Proposed To the unit To the group * Ceilings as applicable to �� ** Term Loan Outstandings + 100% of Fund Based Working Capital Limit or Outstandings, whichever is higher + 50% of Non Fund Based Limit or Outstandings, whichever is higher. 11 Banking arrangement : Sole/Multiple/Consortium Leader (in case of consortium) :

Our Bank share : Other member banks :

12 Details of credit facilities with other banks/FIs as on ��..

: (Rs.in lacs)

Name of bank/ Institution

Working Capital

Fund Based

Working Capital Non Fund Based

Term Credit

Limit O/S Limit O/S Limit O/S

13 Compliance with

HO/RBI guidelines :

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

223

15.Guarantors:

Name Net worth (Rs.in lacs)

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

31.3�...

Audited

31.3��

Audited

31.3�� Audited

30.9��.

Provisional Net sales Other Income Profit before tax Profit after tax Depreciation Cash generation Paid up capital Tangible Net Worth Fixed Assets Term Liabilities Investments Performance/ Financial indicators

31.3�...

Audited

31.3��

Audited

31.3�� Audited

30.9��.

Provisional Current Assets Current Liabilities Net Working Capital Current Ratio TOL/TNW Debt equity ratio Interest Coverage ratio Net profit/Net sales (%)

Dividend Paid (%) Dividend/Net profit

224

(%) EPS Detailed analysis of financial statements for the last 3 years is enclosed as Annexure-III. Brief Comments: II. OWNERSHIP AND MANAGEMENT: 1. Names of the Directors

S.No Name Designation

MANAGEMENT:

225

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

past experience.)

2.

Chief Executive :

Since When ? : 3.

Capital Structure:

Authorised Capital : Rs. Lacs. Paid up capital (as on

) : Rs. Lacs.

4. Whether Listed Company : If Listed, Face value of

share : Rs.

Market quotation - High (during last 52 weeks) - Low - Latest

: : :

Rs. Rs. Rs.

5A Share holding pattern: Particulars Number of

shares held Face value of share holding

(Rs.in lacs)

Percentage share

holding

Promoters Associates Public Financial Institutions Others Total

5B. Names of top 10 share holders: (as on ) Particulars Number of

shares Held

Face value of

226

share holding

(Rs.in lacs)

6.

Quality of management

:

7.

Whether the Company/Firm has suitable cost accounting system?

:

III. BRIEF HISTORY: Technical Aspects: Line of activity: Division Line of activity Date of commencement of

commercial production

Products manufactured: Capacity Products Licensed Installed Present Operating

227

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

Areas of strength and weakness

Strengths: Weaknesses:

Future outlook of the company:

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

228

is a request for term loan/DPG): V. ASSESSMENT OF WORKING CAPITAL REQUIREMENTS: PROJECTIONS FOR THE ENSUING YEAR/NEXT YEAR: The actual production/sales for the last 2 years and estimation/projection for the ensuing year/next year. Year Actuals/

Estimates Production Quantity

Sales Quantity

Sales Value

(Rs.in lacs) Actuals Actuals Estimates Projections

Present actual monthly production/sales during current year : (upto date of submission of application) Achievability of estimated/projected production/sales:

229

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

(Actuals) (Estimate )

(Projection)

Installed Capacity Production (Quantity) Capacity Utilisation Gross Sales Net Sales Raw material consumption - Imported - Domestic

Cost of Production Cost of Sales Operative Profit Net Profit before tax Assessment of Working Capital requirements: Turnover Method: (where applicable) (Rs.in lacs) Actuals Estimates A. Turnover B. 20% of (A) C. Margin Required at 5% of (A)

D. Margin (NWC) E. Surplus/Shortfall (C-D) F. Eligible Minimum Bank Finance (20% of A or 4 times of C)

G. Bank Borrowings H. Difference (F-G) Second Method of Lending: (Rs. in Lacs) Norms

as per (Actuals

(Estimate

(projectio

Peak

230

last sanction

) s) ns) Period

(A)Position of current assets

Raw materials - Imports - Domestic (Months consumption)

Consumable stores (months consumption)

Stock in process (Months cost of prod)

Finished goods (Months cost of Sales)

Receivables � Export (months sales) Domestic (months sales)

Other Current Assets

Total (A) (B) Position of Current Liabilities other than Bank Borrowings

Creditors for purchase of RM, stores/spares (months purchases)

Adv. from Customers

Statutory liabilities Other current liabilities

Total (B) (C) Working

231

Capital Gap ( A-B) (D) Minimum stipulated NWC (25% of CA excl. Export receivables)

(E) Actual/Projected NWC

(F) Item C Minus Item D

(G) Item C Minus Item E

(H) Eligible Credit (Item F or G whichever is lower)

(I) Excess Borrowings representing shortfall in NWC (D-E)

Comments on the levels of current assets projected:

(a) Raw material: (b) Stores and Spares:

(c) Semi-finished goods:

(d) Finished goods:

(e) Receivables:

(f) Other Current assets:

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

232

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

Actuals

Estimates

Projection

Actual NWC at beginning of the

year

ADD: Retained Profit for the year (Net Profit after tax and dividend)

Depreciation Additional Long Term Funds:

Increase in Capital Increase in Deposits Increase in Term Loans Others SUB TOTAL LESS: Long Term Uses: Reduction in Deposits Reduction in Term Liabilities

Increase in Fixed Assets Others SUB TOTAL NWC as at the end of the Year Bifurcation of MPBF (between inventory and bills): (In respect of borrowers enjoying working capital limits of Rs.10.00 crores and above from the banking system, separate Sub Limits have to be specified for meeting payment obligations of the borrower in respect of purchases from SSI units)

233

Non Fund based limits: a) Letters of credit limit: Sight Usance Total Existing: Applied : Assessment of sight LC : FOR FLC FOR ILC 1.Annual Purchase/Import : 2.Out of the above on : sight on LC basis : 3.Average of (2) p.m. : 4.Lead time (in terms of : months) 5.Sight LC requirement : (3) * (4) Assessment of Usance LC : FOR FLC FOR ILC 1.Annual Purchase/Import : 2.Out of the (1) on credit : basis : 3.Out of the (2) on : usance LC basis : 4.Average of (3) p.m. : 5.Lead time (in terms of : months) 6.Usance period (-do-) : 7.Usance LC requirement : (5 + 6) * (4) b) Guarantees Limit : Existing: Applied : Assessment: GEARING RATIO (wherever applicable):

234

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

Share (%)

Fund Based Share

(%)

Non Fund Based

Inventory

Bills LC BG Others

Total

VII. OTHER LIABILITIES OF THE COMPANY/DIRECTORS/PARTNERS TO THE BANK: VIII. PARTICULARS OF ASSOCIATE/GROUP CONCERNS DEALING WITH OUR BANK: (Rs.in lacs) Name of concern/ Activity

Facility Limit Outstan- dings on ��

Over-dues

Credit Rating

Sanct. Autho-rity

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

Name of the Bank

Facility Limit

Outstandings

Overdues

235

on��

(furnish financial indicators of associate/group concerns separately) X. WHETHER THE COMPANY/PROMOTERS/ASSOCIATE COMPANIES ARE FIGURING IN (1) THE LIST OF DEFAULTERS AND (2) EXPORTERS'CAUTION LIST CIRCULATED BY RBI AND/OR (3) ECGC SPECIFIC APPROVAL LIST, IF SO, FURNISH DETAILS: XI. BRANCH VIEWS AND RECOMMENDATIONS: Branch recommended for sanction of the following credit limits: ----------------------------------------------------------------------------------------------------------------- Facility Limit ROI Margin Primary Security (Rs.in lacs) Existing Proposed Existing Proposed ---------------------------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------------- Collateral Security � Existing/Proposed :

236

Guarantors: XII. ZONAL OFFICE VIEWS AND RECOMMENDATIONS: XIII. HEAD OFFICE VIEWS AND RECOMMENDATIONS:

CREDIT RISK ASSESSMENT OF THE BORROWAL ACCOUNT

237

(attach Credit Rating Sheet in case CRAS is not applicable) Name of borrower : Reference Year : (A) INDUSTRY & MANAGEMENT RISK FACTORS: PARAMETER COLUMN-A COLUMN-B COLUMN-C Group reputation Most

reputed Reputed No affiliation

Management succession

Excellent Good Satisfactory

Market share/ Brand Image


Dividend record Excellent Good Satisfactory Retention of profits


Competition Less Medium Heavy Future prospects Excellent Good Satisfactory Industry Cycle Upswing Downswing Unpredictabl

e

Dealing with bank

Long (10 yrs plus)

Medium (3 yrs plus)

Others (below 3 yrs)

Integrity Reliable Reported reliable

Not reliable

Total Crosses Multiplying factor 1.

5 1

.0

0.5

Marks obtained Maximum Marks 15

.0 Marks scored

238

(B) FINANCIAL RISK FACTORS: a) Net Sales/contract receipts/gross receipts (Rs.in lacs)

Parameter Marks

Cross

Reference Year Above 85% 10 Sales Projection (X) Above 75% &

upto 85% 8

Actual Sales (Y) Above 50% & upto 75%

6

Achievement (Y/X*100) 50% & below 0 b) Profitability (Rs.in lacs)

Parameter Marks

Cross

Previous Year

Indicator Reference Year

Satisfactory � No slippage

15

Satisfactory �with slippage

12

Net sales (X) Satisfactory 8 Operating Profit /loss

(Y)

Positive-below satisfactory

4

Profitability Ratio (Y/X*100)

Negative ratio 0

c) Solvency (Rs.in lacs)

Parameter Marks

Cross

Previous Year


2 and below � No slippage

10

2 and below -with slippage

8

Tangible Net worth (TNW)

Above 2 to 3 6

Total Outside liabilities (TOL)

Above 3 to 4 4

TOL/TNW Above 4 to 5 2 Above 5 0

239

d) Liquidity Parameter Mark

s Cross

Previous Year


1.33 or above without slippage

10

Minimum stipulated current ratio

1.33 or above - with slippage

8

1.25 to below 1.33

6

Actual Current Ratio 1.20 to below 1.25

4

1.15 to below 1.20

2

Below 1.15 0 e) Interest Coverage Parameter Mark

s Cross

Previous Year


Above 3 � No slippage

5

Above 2 to 3 � No slippage

4

3.00

Minimum desired Interest coverage

3.00

Above 1.5 to 2 with or Without slippage

3

> 1.25 to 1.50 2 Actual Interest

Coverage 1.25 and below 0

( C ) OPERATIONAL EXPERIENCE: PARAMETER COLUMN - A COLUMN - B COLUMN – C Submission of stock statements

Most regular Regular with delay

Irregular/non submission

Submission of QIS

Most regular Regular with delay

Irregular/non submission

Repayment of interest & instal.

Prompt on due date

Paid with delay

Irregular /non payment

Compliance with sanction terms

Complied promptly

Complied with delay

Not complied

240

Total No. of crosses

Multiplying factor

5 3 1

Marks obtained Maximum marks 20 Marks scored (D) VALUE OF THE ACCOUNT : PARAMETER COLUMN - A COLUMN - B COLUMN - C Average float/ credit balance

Substantial >25% of limit

Moderate >10% to 25%

Nominal <=10%

Deposit support from self/friends/associates

Substantial >25% of limit


Nominal <=10%

Non interest income

High- >25% of int. income


Low <=10%

Collateral security (as % of limits)

Above 50% 25% to 50% Below 25%

Transaction cost Low Moderate High Total No. of crosses

Multiplying factor

3 2 1

Marks obtained Maximum marks 15 Marks scored (E) SUMMARY OF MARKS FOR VARIOUS PARAMETERS: Parameter Maximum

Marks Marks secured

Percentage

(A) Industry and Management Risk

15

241

(B) Financial Risk 50 (C) Operational Experience 20 (D) Value of the account 15 Total 100 (F) APPLICABLE RATE OF INTEREST: Marks secured

CRA Rating

Grade Applicable Spread

Cross

Interest applicable

Above 95% A+++ Prime Nil >90 to 95% A++ Excellent 1.25% to

1.75%

>80 to 90% A+ Very good 2.00% to 2.50%

>70 to 80% A Good 2.75% to 3.25%

>60 to 70% B Satisfactory

3.50% to 3.75%

60% & below C Average 4.00%

Justification for finer rate, if recommended:

Present

Proposed

CRA Rating

Rate of Interest

Date: Officer

Date: Recommending Authority