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Financing can be for working capital ( for ongoing business expenditure ) or term loans (for capital expenditure). Working capital credit can further be segregated into fund based and non-fund based. The terms Fund based limits and Non fund based limits are used in connection with working capital requirements of a Company.
Fund based limits include those where actual funds are proposed to be given. Cash Credit or overdrafts are the common examples of Fund-based Working Capital Credit Limits. Packing credit or pre-shipment credit is an example of such Limits where credit is extended to the exporters for purchasing raw materials/goods, processing and packaging for eventual export sale. However the borrower has to submit an irrevocable letter of credit and/or a confirmed export order for availing of Pre-Shipment Credit. Advance at pre-shipment stage is to be adjusted by submitting export bills. Once the export bills are negotiated/purchased/discounted, pre-shipment credit shall extinguish and post-shipment credit would commence. Non Fund based limits include those arrangements where the fund is not actually provided to the borrower for use. These are commercial documents guaranteeing payment by the bank to the beneficiary, who is usually the seller of merchandise, against the underlying transaction.
Under Fund based the following facilities are commonly used : –
Cash credit: Cash credit refers to a system of financing where a borrower is provided a credit limit, which could be utilized by him for the purpose of running day-to-day business. The limits are decided based on his overall cash requirement of the business. The calculation is based on the total operating cycle and gap between payment to be received and to be made. Cash credit is used mostly for inland trade.
Overdraft/Line-of-credit: overdraft allows you to draw funds beyond the available limit of your bank account. The maximum amount you can overdraw is your line of credit. The terms and amount depend on the relationship you have with your banker and his/her assessment of your credit worthiness. Overdrafts are flexible and simple to operate. You pay interest only on the amount you have overdrawn. Overdrafts are flexible and simple to operate. You pay interest only on the amount you have overdrawn
Packing credit or pre-shipment credit is an example of such Limits where credit is extended to the exporters for purchasing raw materials/goods, processing and packaging for eventual export sale. However the borrower has to submit an irrevocable letter of credit and/or a confirmed export order for availing of Pre-Shipment Credit. Advance at pre-shipment stage is to be adjusted by submitting export bills. Once the export bills are negotiated/purchased/discounted, pre-shipment credit shall extinguish and post-shipment credit would commence.
Post shipment credit is provided after shipment of consignment and is adjustable usually on realization of export bills. Such facilities are allowed by way of Foreign bills Negotiation/Purchase/Discounting facilities(FDBP/FUDBP)2 or may be backed by irrevocable Letters of Credit or might even have sub limits against confirmed export orders or against book debts.
Under Non fund based limits the following are the commonly used arrangements:
A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a line of credit, the sum is only paid if the applicant, on whose behalf the guarantee has been issued, does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to non-performance by the other party in a contract. A bank guarantee might be used when a buyer obtains goods from a seller then runs into cash flow difficulties and can’t pay the seller. The bank would pay an agreed-upon sum [as mentioned in the guarantee bond] to the seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay the purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure for the opposing party in a commercial transaction.
Deferred payment guarantee: Typically in case of equipment financing, the manufacturer (by itself/through a financing tie-up) offers credit to the buyers of its equipment at attractive terms to generate additional demand for its products. The Deferred Payment Guarantee (DPG) is a bank facility where the bank it extends a guarantee to the equipment manufacturer on behalf of its client that the financing extended by the manufacturer (by himself or through its preferred financier would be repaid as per the terms agreed upon.
Commercial Letter of Credit: Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. There are basically two types: commercial and standby. The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism.
A commercial letter of credit is a contractual agreement between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank’s customer as the payee.
Elements of a Letter of Credit
1. A payment undertaking given by a bank (issuing bank)
2. On behalf of a buyer (applicant)
3. To pay a seller (beneficiary) for a given amount of money
4. On presentation of specified documents representing the supply of goods
5. Within specified time limits
6. Documents must conform to terms and conditions set out in the letter of credit 7. Documents to be presented at a specified place
Beneficiary The beneficiary is entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the customer and beneficiary. The issuing bank’s obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the bank.
Issuing Bank The issuing bank’s liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft. The issuing banks’ role is to provide a guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due and to examine the documents, and only pay if these documents comply with the terms and conditions set out in the letter of credit.
Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill and an insurance document; but there are many others. Letters of credit deal in documents, not goods.
Advising Bank An advising bank, usually a foreign correspondent bank of the issuing bank will advise the beneficiary. Generally, the beneficiary would want to use a local bank to insure that the letter of credit is valid. In addition, the advising bank would be responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.
Confirming Bank The correspondent bank may confirm the letter of credit for the beneficiary. At the request of the issuing bank, the correspondent obligates itself to insure payment under the letter of credit. The confirming bank would not confirm the credit until it evaluated the country and bank where the letter of credit originates. The confirming bank is usually the advising bank.
The following steps outline how a L/C arrangement works :
A. Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment.
B. Buyer applies to his bank for a letter of credit in favor of the seller.
C. Buyer’s bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary).
D. Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary).
E. Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company.
F. Seller presents the required documents to the advising or confirming bank to be processed for payment.
G. Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit.
H. If the documents are correct, the advising or confirming bank will claim the funds by:
I. Debiting the account of the issuing bank.
J. Waiting until the issuing bank remits, after receiving the documents.
K. Reimburse on another bank as required in the credit.
L. Advising or confirming bank will forward the documents to the issuing bank.
M. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer’s account.
N. Issuing bank then forwards the documents to the buyer.
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed freely from one party to another almost in the same way as money. To be negotiable, the letter of credit must include an unconditional promise to pay, on demand or at a definite time. The nominated bank becomes a holder in due course. Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. A revocable letter of credit cannot be confirmed. Once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honored, the letter of credit cannot be revoked
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. A revocable letter of credit cannot be confirmed. Once the documents have been presented and meet the terms and conditions in the letter of credit, and the draft is honored, the letter of credit cannot be revoked
The standby letter of credit serves a different function than the commercial letter of credit. The commercial letter of credit is the primary payment mechanism for a transaction. The standby letter of credit serves as a secondary payment mechanism. A bank will issue a standby letter of credit on behalf of a customer to provide assurances of his ability to perform under the terms of a contract between the beneficiary. The parties involved with the transaction do not expect that the letter of credit will ever be drawn upon. When making payment for product on behalf of its customer, the issuing bank must verify that all documents and drafts conform precisely to the terms and conditions of the letter of credit. Although the credit can require an array of documents, the most common documents that must accompany the draft include:
Commercial Invoice – The billing for the goods and services. It includes a description of merchandise, price, FOB origin, and name and address of buyer and seller.
Bill of Lading- A document evidencing the receipt of goods for shipment and issued by a freight carrier engaged in the business of forwarding or transporting goods.
Warranty of Title -A warranty given by a seller to a buyer of goods that states that the title being conveyed is good and that the transfer is rightful.
There are also structures products used for financing .Some structured products are –
Factoring: It is a structured working capital finance solution that includes finance against the client’s domestic or export receivables, collection of receivables on due date, credit protection and credit advisory services. It allows the client to convert the accounts receivables to cash thereby releasing the cash generation potential of the business.
Commercial Paper: (CP) is an unsecured money market instrument issued in the form of a promissory note. Can be issued by corporates, Primary Dealers and the all-India financial institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by the Reserve Bank of India are eligible to issue CP. Term loans on the other hand are taken for expenses of a capital nature i.e. benefits from which are to be reaped on a long term basis. Term loans are taken for buying machinery, land or for setting up new projects.
PROCESSING MSME CREDIT APPLICATIONS.
On receiving an application first one must check the track record of the borrower if the borrower is an existing unit. In addition to this the track record/credentials of the proprietor/partners/owner is to be determined as their activities have a significant impact on the performance of the organization. One has to look out for the intrinsic quality of the business, the market condition and future prospects, quality of its dealings with vendors, other financial institutions, buyers and creditors for a some period in the past. This may help in bringing out irregularities which would not be evident otherwise. These then can be sought to be clarified by the applicant by asking them to provide necessary clarifications with documentary evidence or by site visits wherever necessary.
The first step of actual appraisal includes inputting the data provided in the Profit and Loss a/c and the balance sheet as per the audited, provisional/expected and projected p/l and balance sheet into an Excel sheet called the CMA3 data sheet. CMA data is a tool used by bankers to assess the requirements of working capital.It is divided into six parts namely:-
Form I Particulars of existing and proposed limits.
Form II Operating statement.
Form III Analysis of balance sheet.
Form IV Comparative statement of current assets and liabilities.
Form V Computation of maximum permissible bank finance ( MBPF )4
Form VI Fund flow statement.
3 Credit Monitoring Arrangement 4 As per the Projected Balance sheet method also known as the traditional method
Here based on the judgment of the ‘banker’ the various heads of income and expenses and assets/liabilities are filled in. Necessary adjustments are also made. For example terms loans are generally shown as term liabilities in balance sheets but in the CMA data sheet the installments (principal & interest) to be paid within the coming year are to be shown as current liabilities. In case the borrower has only term loans from the bank concerned then one has to find out the repayment obligations, from the system, to be paid within the next 12 months and then classify it under current liabilities and the adjusted term loan figure to appear under term liabilities. If this would not have been done the Current ratio would have showed a better figure thus proving to be misleading. Thus such necessary checks have to be made so as to check the authenticity of the data especially in case of the projected/estimated financial statements which being unaudited can be erroneous and all further calculations are dependent on these projected figures. One needs to check the validity of expected performance figures and also check whether the company has been more or less meeting these obligations without much negative variation. On correct completion of the FORMS II & III of the CMA5 data sheet we automatically get the Comparative statement of current assets & liabilities in FORM IV , the working capital assessment and computation of Eligible Bank finance in FORM V and the FUNDS FLOW statement in FORM VI .
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