3882 Study Material PGDM
-
Upload
api-3806925 -
Category
Documents
-
view
960 -
download
0
Transcript of 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)
Liability Asset Particulars Amount Particulars Amount
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)
Liability Asset Particulars Amount Particulars Amount
Equity 69 Land 27 Equity 10 Factory Building 30 Debt 138 Plant &
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 :
Profit & Loss Account ( Rs in lacs)
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)
Liability Asset Particulars Amount Particulars Amount
Equity 69 Land 27 Equity 10 Factory Building 30 Debt 138 Plant &
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 :
Profit & Loss Account ( Rs in lacs)
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)
To Closing Stock t=4
(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
raw material to WIP t=4
.04 By Closing Stock of FG t=4
1.27
Salary for conversion of
WIP to Finished Goods
.05
Electricity for conversion of
WIP to Finished Goods
.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
outstanding t=3 .20 Total Fixed
Asset 207
Electricity outstanding t=3
.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
raw material to WIP t=4
.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
WIP to Finished Goods
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 :
Profit & Loss Account ( Rs in lacs)
Expense Income Particulars Amount Particulars Amount
Consumption of Raw Material
1 By WIP 1.21
Salary t=3 .20 Electricity t=3 .01
Total 1.21 Total 1.21 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
outstanding t=3 .20 Total Fixed
Asset 207
Electricity outstanding t=3
.01
Raw Material 9 WIP t=3 1.21
Total Liability 217.21 Total Asset 217.21
Figure 1.6
15
We also see the following statement of accounts at the end of t=4 Profit & Loss Account ( Rs in lacs)
Expense Income Particulars Amount Particulars Amount
Consumption of Raw Material
3 Change in WIP 2.19
Change in Finished Goods
1.27
Salary .40 Electricity .06
Total 3.46 Total 3.46 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 outstanding
.40 Total Fixed Asset 207
Electricity outstanding
.06 Raw Material 7
WIP 2.19 Finished Goods 1.27
Total Liability 217.46 Total Asset 217.46
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 :
Profit & Loss Account ( Rs in lacs)
Expense Income Particulars Amount Particulars Amount
Consumption of Raw Material
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
Total 4.29 Total 4.29 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
By Profit .63 Total Fixed Asset 207
17
Salary outstanding
.40 Raw Material 7
Electricity outstanding
.06 WIP 2.19
Selling and Administrative Expenses O/S
.20
Cash at Bank & Hand
2.10
Total Liability 218.29 Total Asset 218.29
Figure 1.8 Now what happens if the entire sales is on credit basis. There is no
change in the P&L Statement but in the balance sheet in place of Cash
at Bank & Hand , Receivable head will appear.
Balance Sheet ( All in Rs Lacs)
Liability Asset Particulars Amount Particulars Amount
Equity 69 Land 27 Equity 10 Factory Building 30 Debt 138 Plant &
Machinery 150
By Profit .63 Total Fixed Asset 207 Salary
outstanding .40 Raw Material 7
Electricity outstanding
.06 WIP 2.19
Selling and Administrative Expenses O/S
.20 Receivable 2.10
Total Liability 218.29 Total Asset 218.29
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)
Liability Asset Particulars Amount Particulars Amount
Equity 69 Land 27 Equity 10 Factory Building 30 Debt 138 Plant &
Machinery 150
By Profit .63 Total Fixed Asset 207 Salary
outstanding .20 Raw Material 7
Electricity outstanding
.06 WIP 2.19
Borrowings 0.20 Receivable 2.10 Selling and
Administrative Exp O/S
0.20
Total Liability 218.29 Total Asset 218.29
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.
61
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.
62
• 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
63
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 )
64
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
66
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:
67
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
70
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
71
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
72
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
79
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
82
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
30th April 31st May 30th June
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
30th April 31st May 30th June
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
122
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.
161
• 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
162
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.
163
• 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
165
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
166
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.
167
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.
169
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
171
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.
175
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.
176
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
documents which appear on their face to be in compliance with the
terms and conditions of the Credit.
Article 9
Liability of Issuing and Confirming Banks
a. An irrevocable Credit constitutes a definite undertaking of the
Issuing Bank, provided that the stipulated documents are presented to
the Nominated Bank or to the Issuing Bank and that the terms and
conditions of the Credit are complied with:
i. if the Credit provides for sight payment - to pay at sight;
178
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:
179
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.
181
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
documents which appear on their face to be in compliance with the
terms and conditions of the Credit, the Issuing Bank and the
Confirming Bank, if any, are bound:
i. to reimburse the Nominated Bank which has paid, incurred a
deferred payment undertaking, accepted Draft(s), or negotiated,
ii. to take up the documents.
b. Upon receipt of the documents the Issuing Bank and/or Confirming
Bank, if any, or a Nominated Bank acting on their behalf, must
determine on the basis of the documents alone whether or not they
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:
i. appears on its face to indicate the name of the carrier and to have
been signed or otherwise authenticated by:
-the carrier or a named agent for or on behalf of the carrier, or
-the master or a named agent for or on behalf of the master.
Any signature or authentication of the carrier or master must be
identified as carrier or master, as the case may be. An agent signing
or authenticating for the carrier or master must also indicate the name
and the capacity of the party, i.e. carrier or master, on whose behalf
that agent is acting,
and,
ii. indicates that the goods have been loaded on board, or shipped on a
named vessel.
Loading on board or shipment on a named vessel may be indicated by
pre-printed wording on the non-negotiable sea waybill that the goods
have been loaded on board a named vessel or shipped on a named
vessel, in which case the date of issuance of the non-negotiable sea
waybill will be deemed to be the date of loading on board and the date
of shipment.
In all other cases loading on board a named vessel must be evidenced
by a notation on the non-negotiable sea waybill which gives the date
on which the goods have been loaded on board, in which case the date
of the on board notation will be deemed to be the date of shipment.
If the non-negotiable sea waybill contains the indication 'intended
vessel', or similar qualification in relation to the vessel, loading on
board a named vessel must be evidenced by an on board notation on
the non-negotiable sea waybill which, in addition to the date on which
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
(b) contains the indication 'intended' or similar qualification in relation
to the port of loading and/or port of discharge, as long as the
document also states the ports of loading and/or discharge stipulated
in the Credit,
and,
iv. consists of a sole original non-negotiable sea waybill, or if issued in
more than one original, the full set as so issued,
and,
v. appears to contain all of the terms and conditions of carriage, or
some of such terms and conditions by reference to a source or
document other than the non-negotiable sea waybill (short form/blank
197
back non-negotiable sea waybill); banks will not examine the contents
of such terms and conditions,
and,
vi. contains no indication that it is subject to a charter party and/or no
indication that the carrying vessel is propelled by sail only,
and,
vii. in all other respects meets the stipulations of the Credit.
b. For the purpose of this Article, transhipment means unloading and
reloading from one vessel to another vessel during the course of ocean
carriage from the port of loading to the port of discharge stipulated in
the Credit.
c. Unless transhipment is prohibited by terms of the Credit, banks will
accept a non-negotiable sea waybill which indicates that the goods will
be transhipped, provided that the entire ocean carriage is covered by
one and the same non-negotiable sea waybill.
d. Even if the Credit prohibits transhipment, banks will accept a 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
that agent is acting,
and
iii. does or does not indicate the name of the carrier,
and
iv. indicates that the goods have been loaded on board or shipped on a
named vessel.
Loading on board or shipment on a named vessel may be indicated by
pre-printed wording on the bill of lading that the goods have been
loaded on board a named vessel or shipped on a named vessel, in
which case the date of issuance of the bill of lading will be deemed to
be the date of loading on board and the date of shipment.
In all other cases loading on board or shipment on a named vessel
must be evidenced by a notation on the bill of lading which gives the
date on which the goods have been loaded on board, in which case the
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
-the master or a named agent for or on behalf of the master.
Any signature or authentication of the carrier, multimodal transport
operator or master must be identified as carrier, multimodal transport
operator or master, as the case may be. An agent signing or
authenticating for the carrier, multimodal transport operator or master
must also indicate the name and the capacity of the party, i.e. carrier,
multimodal transport operator or master, on whose behalf that agent
is acting,
and
ii. indicates that the goods have been dispatched, taken in charge or
loaded on board.
Dispatch, taking in charge or loading on board may be indicated by
wording to that effect on the multimodal transport document and the
date of issuance will be deemed to be the date of dispatch, taking in
charge or loading on board and the date of shipment. However, if the
document indicates, by stamp or otherwise, a date of dispatch, taking
in charge or loading on board, such date will be deemed to be the date
of shipment,
and
iii. (a) indicates that the place of taking in charge stipulated in the
Credit which may be different from the port, airport or place of
loading, and the place of final destination stipulated in the Credit which
may be different from the port, airport or place of discharge,
and/or
(b) contains the indication 'intended' or similar qualification in relation
to the vessel and/or port of loading and/or port of discharge,
and
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
vi. contains no indication that it is subject to a charter party and/or no
indication that the carrying vessel is propelled by sail only,
and
vii. in all other respects meets the stipulation of the Credit.
b. Even if the Credit prohibits transhipment, banks will accept a
multimodal transport document which indicates that transhipment will
or may take place, provided that the entire carriage is covered by one
and the same multimodal transport document.
Article 27
Air Transport Document
a. If a Credit calls for an air transport document, banks will, unless
otherwise stipulated in the Credit, accept a document, however
named, which:
i. appears on its face to indicate the name of the carrier and to have
been signed or otherwise authenticated by:
-the carrier, or
-a named agent for or on behalf of the carrier.
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
vii. in all other respects meets the stipulations of the Credit.
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
stipulated in the Credit.
d. Even if the Credit prohibits transhipment, banks will accept a road,
rail or inland waterway transport document which indicates that
transhipment will or may take place, provided that the entire carriage
is covered by one and the same transport document and within the
same mode of transport.
Article 29
Courier and Post Receipts
a. If a Credit calls for a post receipt or certificate of posting, banks will,
unless otherwise stipulated in the Credit, accept a post receipt or
certificate of posting which:
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
stipulated in the Credit.
This is without prejudice to the First Beneficiary's right to substitute
subsequently his own invoice(s) (and Draft(s)) for those of the Second
Beneficiary(ies) and to claim any difference due to him.
Assignment of Proceeds
Article 49
Assignment of Proceeds
The fact that a Credit is not stated to be transferable shall not affect
the Beneficiary's right to assign any proceeds to which he may be, or
may become, entitled under such Credit, in accordance with the
provisions of the applicable law. This Article relates only to the
assignment of proceeds and not to the assignment of the right to
perform under the Credit itself.
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
Excellent Good Satisfactory
Dividend record Excellent Good Satisfactory Retention of profits
Excellent Good Satisfactory
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
Indicator Reference 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
Indicator Reference 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
Indicator Reference 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
Moderate >10% to 25%
Nominal <=10%
Non interest income
High- >25% of int. income
Moderate >10% to 25%
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
242