Financing Working Capital Needs

FINANCING WORKING CAPITAL NEEDSUNIT 9

Bank Credit : Principles and Practices 5

UNIT 10Bank Credit : Methods of Assessment and Appraisal 27

UNIT 11

Other Sources of Short Term Finance 44

3Block

Indira GandhiNational Open UniversitySchool of Management Studies

MS-41Working Capital

Management

Course Preparation Team

Unit Writers1. Dr. Kanaka Durgaube, R. M. College of Social Work, Hyderabad2. Dr. B .V. Jagadish, R. M. College of Social Work , Hyderabad3. Mr. Vedanshu Tripathi, JNU New Delhi4. Mr. Sanjay Bhattacharya, BSSS, Bhopal5. Mr. Joseph Varghese, Consultant, IGNOU, New Delhi

Content Editor Language Editor Block EditorProf. K.K. Jacob Dr. Bodh Prakash Prof. Gracious Thomas,Udaipur, Rajasthan. University of Delhi IGNOU, New Delhi

Programme Cooodinator Course Coordinators Unit TransformationProf. Gracious Thomas Prof. Gracious Thomas Mr. Joseph VargheseIGNOU Dr. R P. Singh Consultant, IGNOUNew Delhi Dr. Annu J. Thomas Secretarial Assistance

Mr. Balwant Singh, IGNOUMs. Maya Kumari, IGNOU

ProductionMr. K. N. MohananSection Officer (Publication)SOCE

April, 2004

ã Indira Gandhi National Open University, 2004

ISBN-81-

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Prof. H.P. Dikshit Prof. S. C. GargVice Chancellor, IGNOU Pro-Vice Chancellor, IGNOU

Expert CommitteeProf. P. K. GandhiJamia Millia IslamiaNew Delhi

Dr. D.K. Lal DasR.M. College of SocialWork, Hyderabad

Dr. P.D. MathewIndian Social InstituteNew Delhi

Dr. Alex VadakumthalaCBCI Centre, New Delhi

Prof. Gracious ThomasIGNOU, New Delhi

Prof. A. P. Barnabas (Retd.)IIPA, New Delhi

Prof. K.K. MukhopathyayaUniversity of DelhiNew Delhi

Prof. A.R. KhanIGNOU, New Delhi

Dr. R.P. SinghIGNOU, New Delhi

Dr. Richa ChaudharyDr. B. R.Ambedkar CollegeUniversity of DelhiNew Delhi

Prof. Prabha ChawlaIGNOU, New Delhi

Dr. Ranjana SehgalIndore School of SocialWork, Indore

Dr. Rama V. BaruJNU, New Delhi

Dr. Jerry ThomasDon Bosco, Guwahati

Prof. Surendra SinghVice ChancellorM.G. Kashi VidyapithVaranasi

Prof. A.B. Bose (Retd.)SOCE, IGNOUNew Delhi

BLOCK 3 : FINANCING WORKINGCAPITAL NEEDS

The previous Block has focused on the management of the components of workingcapital. Prudent management implies management of every constituent in the mostefficient manner. Units 5-8 of Block 2 provide the reader with such understandingand also guide him through the relevent techniques that need to be employed forbetter management of working capital. In the present Block, the focus will be mainlyon the sources of financing working capital requirement of companies.

After estimating the funds needed for Working Capital purposes of a firm, the nexttask is to decide the sources from which such funds are to be raised. As alreadynoted, Gross Working Capital denotes the total amount of funds which are requiredfor investment in current assets. A part of such assets is financed through TradeCredit which is an autonomous source of finance. Rest of the current assets arefinanced through other sources both short term and long term. The permanentportion of the Working Capital always remains blocked up in business and hencemust be financed from long term sources like share capital, debentures and termloans . This is the reason why a part of the permanent Working Capital is included inthe cost of the project as margin money for Working Capital and is raised from longterm sources.

In Unit 9 we shall study the basic concepts and practices relating to borrowings frombanks, as they prevail in India. In Unit 10 we shall learn the methods of assessmentof Working Capital needs which are adopted by banks in India and other relatedmethods. The concluding unit of this Block (Unit-11) studies other sources of financ-ing Working Capital needs of a firm.

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Financing WorkingCapital Needs

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UNIT 9 BANK CREDIT - PRINCIPLES ANDPRACTICES

Objectives

The objectives of this unit are to explain:

· The basic principles of sound lending

· The style of Credit — their merits and demerits

· The types of security required and the modes of creating charge, and

· The methods of credit investigation

Structure

9.1 Introduction

9.2 Principles of Bank Lending

9.3 Style of Credit

9.4 Classification of Advances According to Security

9.5 Modes of Creating Charge Over Assets

9.6 Secured Advances

9.7 Purchase & Discounting of Bills

9.8 Non Fund Based Facilities

9.9 Credit Worthiness of Borrowers

9.10 Summary

9.11 Key Words

9.12 Self Assestment Questions

9.13 Further Readings

Appendix : Observations of RBI on working capital cycles and Demand for bankcredit

9.1 INTRODUCTION

Bank credit constitutes one of the major sources of Working Capital for trade andindustry. With the growth of banking institutions and the phenomenal rise in theirdeposit resources, their importance as the suppliers of Working Capital hassignificantly increased. Of the total gross bank credit outstanding as at the end ofAugust 22, 2003, of Rs.6,63,122 crore, Rs.2,78,408 crore is advanced to industry. Thisworks out to around 41.98 percent. More particularly, there has been significant risein the credit towards industry in the recent past. In this unit, first we shall examinethe basic principles of bank credit, followed by a detailed account of the varioustypes of credit facilities offered by banks and the securities required by them.

9.2 PRINCIPLES OF BANK LENDING

While granting loans and advances commercial banks follow the three cardinalprinciples of lending. These are the principles of safety, liquidity and profitability,which have been explained below:

1) Principle of Safety : The most important principle of lending is to ensure thesafety of the funds lent. It means that the borrower repays the amount of theloan with interest as per the loan contract. The ability to repay the loan dependsupon the borrower’s capacity to pay as well as his willingness to repay. Toensure the former, the banker depends upon his tangible assets and the viabilityof his business to earn profits. Borrower’s willingness depends upon his honestyand character. Banker, therefore, takes into account both the above mentioned

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aspects to determine the credit - worthiness of the borrower and to ensuresafety of the funds lent.

2) Principle of Liquidity : Banks mobilize funds through deposits which arerepayable on demand or over short to medium periods. The banker thereforelends his funds for short period and for Working Capital purposes. These loansare largely repayable on demand and are granted on the basis of securitieswhich are easily marketable so that he may realise his dues by selling thesecurities.

3) Principle of Profitability: Banks are profit earning institutions. They lend theirfunds to earn income out of which they pay interest to depositors, incuroperational expenses and earn profit for distribution to owners. They chargedifferent rates of interest according to the risk involved in lending funds tovarious borrowers. However, they do not have to sacrifice safety or liquidity forthe sake of higher profitability.

Following the above principles banks pursue the practice of diversifying risk byspreading advances over a reasonably wide area, distributed amongst a good numberof customers belonging to different trades and industries. Loans are not granted forspeculative and unproductive purposes

9.3 STYLE OF CREDIT

Commercial banks provide finance for working capital purposes through a variety ofmethods. The main systems or style of credit, prevalent in India are depicted in thefollowing diagram.

Bank Credit

Loans and advances Discounting of bills

Overdrafts Cash Credit Loans

Short term Medium & Bridge Composite PersonalLoans Long term loans loans loans

loans

The terms and conditions, the rights and privileges of the borrower and the bankerdiffer in each case. We shall discuss below these methods of granting bank credit.

9.3.1 Overdrafts

This facility is allowed to the current account holders for a short period. Under thisfacility, the current account holder is permitted by the banker to draw from hisaccount more than what stands to his credit. The excess amount drawn by him isdeemed as an advance taken from the bank. Interest on the exact amount

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overdrawn by the account-holder is charged for the period of actual utilisation. Thebanker may grant such an advance either on the basis of collateral security or on thepersonal security of the borrower. Overdraft facility is granted by a bank on anapplication made by the borrower. He is also required to sign a promissory note.Therefore, the customer is allowed the amount, upto the sanctioned limit of overdraftas and when he needs it. He is permitted to repay the loan as per his convenienceand ability to do so.

9.3.2 Cash Credit System

Cash Credit System accounts for the major portion of bank credit in India. Thesalient features of this system are as follows:

1) Under this system, the banker prescribes a limit, called the Cash Credit limit,upto which the customer- borrower is permitted to borrow against the securityof tangible assets or guarantees.

2) The banker fixes the Cash Credit limit after considering various aspects of theworking of the borrowing concern i.e production, sales ,inventory levels, pastutilisation of such limit, etc.

3) The borrower is permitted to withdraw from his Cash Credit account, amount asand when he needs them. Surplus funds with him are allowed to be depositedwith the banker any time. The Cash Credit account is thus a running account,wherein withdrawals and deposits may be made frequently any number of times.

4) As the borrower withdraws from Cash Credit account he is required to providesecurity of tangible assets. A charge is created on the movable assets of theborrower in favour of the banker.

5) When the borrower repays the borrowed amount in full or in part, security isreleased to him in the same proportion in which the amount is refunded.

6) The banker charges interest on the actual amount utilised by him and for theactual period of utilisation.

7) Though the advance made under Cash Credit System is repayable on demandand there is no specific date of repayment, in practice the advance is rolled overa period of time i.e. the debit balance is hardly fully wiped out and the loancontinues from one period to another.

8) Under this system, the banker keeps adequate cash balance to meet thedemand of his customers as and when it arises, but interest is charged on theactual amount of loan availed of. Thus, to neutralize the loss caused to thebanker, the latter imposes a commitment charge at a normal rate of 1% or so, onthe unutilised portion of the cash credit limit.

Merits of Cash Credit System

The Cash Credit System has the following merits:

1) The borrower need not keep surplus funds idle with himself. He can deposit thesurplus funds with the banker, reduce his debit balance, and thus minimise theinterest burden. On the other hand he can withdraw funds at any time to meethis needs.

2) Banks maintain one account for all transactions of a customer. As documentsare required only once in a year the costs of repetitive documentation is avoided.

Demerits of Cash Credit System

The Cash Credit System, on the other hand, suffers from the following demerits:

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1) Cash Credit limits are prescribed only once in a year and hence they are fixedkeeping in view the maximum amount that can be required within a year.Consequently, a portion remains unutilised for part of the year during which bankfunds remain unemployed.

2) The banker remains unable to verify the end use of funds borrowed by thecustomer. Such funds may be diverted to unapproved purposes.

3) The banker remains unable to plan the utilisation of his funds as the level ofadvances depends upon the borrower’s decision to borrow at any time.

4) As the volume of cash transactions increases significantly under the cashcredit system as against the loan system, the cost of handling cash, honouringcheques, taking and giving delivery of securities increases the transactions costof banks.

5) As there is only commitment charge of 1% or less, there will be a tendency onthe part of companies to negotiate for a higher limit.

9.3.3 Loan System

Under the loan system, a definite amount is lent at a time for a specific period and adefinite purpose. It is withdrawn by the borrower once and interest is payable for theentire period for which it is granted. It may be repayable in instalments or in lumpsum. If the borrower needs funds again , or wants to renew an existing loan, a freshproposal is placed before the banker. The banker will make a fresh decisiondepending upon the availability of cash resources. Even if the full loan amount is notutilised the borrower has to pay the full interest.

Advantages of the Loan System

The loan system has the following advantages over the Cash Credit System:

1) This system imposes greater financial discipline on the borrowers, as they arebound to repay the entire loan or its instalments on the due date/ dates fixed inadvance.

2) At the time of granting a new loan or renewing an existing loan, the bankerreviews the loan account. Thus unsatisfactory loan accounts may bediscontinued at his discretion.

3) As the banker is entitled to charge interest on the entire amount of loan, hisincome from interest is higher and his profitability also increases because oflower transaction cost.

Short Term Loans

Short term loans are granted by banks to meet the Working Capital requirements ofthe borrowers. Such loans are usually granted for a period upto one year and aresecured by the tangible movable assets of the borrowers like goods and commodities,shares, debentures etc. Such goods and securities are pledged or hypothecated withthe banker.

As we shall study in the next unit. Reserve Bank of India has exercised compulsionon banks since 1995 to grant 80% of the bank credit permissible to borrowers withcredit of Rs 10 crore or more in the form of short term loans which may be forvarious maturities. Reserve Bank has also permitted the banks to roll over suchloans i.e. to renew the loan for another period at the expiry of the period of the firstloan.

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Medium and Long Term Loans

Such loans are generally called ‘Term Loans’ and are granted by banks with AllIndia Financial institutions like Industrial Development Bank of India, IndustrialFinance Corporation of India, Industrial Credit and Investment Corporation of IndiaLtd. Term loans are granted for medium and long terms, generally above 3 yearsand are meant for purchase of capital assets for the establishment of new units andfor expansion or diversification of an existing unit . At the time of setting up of a newindustrial unit, term loans constitute a part of the project finance which theentrepreneurs are required to raise from different sources. These loans are usuallysecured by the tangible assets like land, building, plant and machinery etc. In October1997 Reserve Bank of India permitted the banks to announce separate primelending rate for term loans of 3 years and above. In April 1999 Reserve bank ofIndia also permitted the banks to offer fixed rate loans for project financing. ReserveBank of India has encouraged the banks to lend for project finance as well. InSeptember, 1997 ceiling on the quantum of the term loans granted by banksindividually or in consortia/syndicate for a single project was abolished. Banks nowhave the discretion to sanction term loans to all projects within the overall ceiling ofthe prudential exposure norms prescribed by Reserve bank. ( Fully discussed in thenext unit). The period of term loans will also be decided by banks themselves.

Though term loans are meant for meeting the project cost but as project costincludes margin for Working Capital , a part of term loans essentially goes to meetthe needs of Working Capital.

Bridge Loans

Bridge loans are in fact short term loans which are granted to industrial undertakingsto enable them to meet their urgent and essential needs. Such loans are grantedunder the following circumstances:

1) When a term loan has been sanctioned by banks and/ or financial institutions, butits actual disbursement will take time as necessary formalities are yet to becompleted.

2) When the company is taking necessary steps to raise the funds from the Capitalmarket by issue of equities/debt instruments.

Bridge loans are provided by banks or by the financial institutions which havegranted term loans. Such loans are automatically repaid out of the amount of termloan when it is disbursed or out of the funds raised from the Capital Market.

Reserve Bank of India has allowed the banks to grant such loans within the ceilingof 5% of incremental deposits of the previous year prescribed for individual banks’investment in Shares/ Convertible debentures. Bridge loans may be granted for amaximum period of one year.

Composite Loans

Composite loans are those loans which are granted for both, investment in capitalassets as well as for working capital purposes. Such loans are usually granted tosmall borrowers, such as artisans, farmers, small industries etc. Under thecomposite loan scheme, both term loans and Working Capital are provided througha single window. The limit for composite loans has recently (in Feb., 2000) beenincreased from Rs. 5 lakhs to Rs.10 lakhs for small borrowers.

Personal Loans

These loans are granted by banks to individuals specially the salary-earners andothers with regular income, to purchase consumer durable goods like refrigerators,

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T.Vs., cars etc. Personal loans are also granted for purchase/construction of houses.Generally the amount of loans is fixed as a multiple of the borrower’s income and arepayment schedule is prepared as per his capacity to save.

Activity 9.1

1) What do you understand by Margin money for Working Capital? How is itfinanced?

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2) Explain three important demerits of the Cash Credit System

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3) What do you understand by Term Loans? For what purposes are they grantedby banks? What is Reserve Bank’s directive to banks in this regard?

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4) What is meant by Bridge Loan? What is the necessity for granting such loans.

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5) Elucidate the principles of Bank lending.

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9.4 CLASSIFICATION OF ADVANCES ACCORDINGTO SECURITY

Banks attach great importance to the safety of the funds, lent as loans andadvances. For this purpose, they ask the borrowers to create a charge on theirtangible assets in their favour. In some cases, the banks secure their interest byasking for a guarantee given by a third party. Besides the tangible assets or aguarantee, banks rely upon the personal security of the borrower and grant loans

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which are called unsecured advances’ or ‘clean loans’. In the balance sheet, banksclassify advances as follows:

Advances

Secured by Covered by UnsecuredTangible Assets Bank /Govt. Guarantees

Secured Advances

According to Banking Regulation Act 1949, a secured loan or advance means “aloan or advance made on the security of assets, the market value of which is not atany time less than the amount of such loan or advances”. An unsecured loan oradvance means a loan or advance not so secured.

The main features of a secured loan are:

1) The advance is made on the basis of security of tangible assets like goods andcommodities, life insurance policies, corporate and government securities etc.

2) A charge is created on such security in favour of the banker.

3) The market value of such security is not less than the amount of loan. If theformer is less than the latter, it becomes a partly secured loan.

Unsecured Advances

Unsecured advances are granted without asking the borrower to create a charge onhis assets in favour of the banker. In such cases the security happens to be thepersonal obligation of the borrower regarding repayment of the loan. Such loans aregranted to parties enjoying high reputation and sound financial position.

The legal status of the banker in case of a secured advance is that of a securedcreditor. He possesses absolute right to recover his dues from the borrower out ofthe sale proceeds of the assets over which a charge is created in his favour. In caseof an unsecured advance, a banker remains an unsecured creditor and stand at parwith other unsecured creditors of the borrower, if the latter defaults.

Guaranteed Advances

The banker often safeguards his interest by asking the borrower to provide aguarantee by a third party may be an individual, a bank or Government. Accordingto the Indian Contract Act, 1872, a contract of guarantee is defined as “a contract toperform the promise or discharge the liability of third person is case of hisdefault”. The person who undertakes this obligation to discharge the liability ofanother person is called the guarantor or the surety. Thus a guaranted advance is, infact, also an unsecured advance i.e. without any specific charge being created onany asset, in favour of the banker. A guarantee carries a personal security of twopersons i.e. the principal debtor and the surety to perform the promise of theprincipal debtor. If the latter fails to fulfill his promise, liability of the surety arisesimmediately and automatically. The surety therefore, must be a reliable personconsidered good for the amount for which he has stood as surety. The guaranteegiven by banks, financial institutions and the government are therefore consideredvaluable.

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Financing WorkingCapital Needs 9.5 MODES OF CREATING CHARGE OVER

ASSETS

As we have noted above, in case of secured advance, a charge is created over anasset of the borrower in favour of the lender. By creation of charge it is meant thatthe banker gets certain rights in the tangible assets of the borrower. The borrowerstill remains the owner of the asset, but the banker gets the right of realizing his duesout of the sale proceeds of the asset. Thus banker’s interest is safeguarded.

There are several methods of creating charge over the borrower’s assets as shownbelow:

Modes of Creating charge

Pledge Hypothecation Mortgage Lien Assignment

9.5.1 Pledge

Pledge is the most popular method of creating charge over the movable assets.Indian Contract Act, 1872, defines pledge as ‘bailment of goods as security ofpayment of a debt or performance of a promise”. The person who offers thesecurity is called the pledger and the person to whom the goods are entrusted iscalled the ‘pledgee’ . Thus bailment of goods is the essence of a pledge. IndianContract Act defines bailment as “delivery of goods from one person to another forsome purpose upon the contract that the goods be returned back when the purpose isaccomplished or otherwise disposed of according to the instructions of the bailor”.

Thus when the borrower pledges his goods with the banker, he delivers the goods tothe banker to be retained by him as security for the amount of the loan. Delivery ofgoods may be either (i) physical delivery or (ii) constructive or symbolic delivery.The latter does not involve physical delivery of the goods. The handing over of thekeys of the godown storing the goods, or even handing over the documents of the titleto goods like warehouse receipts, duly endorsed in favour of the banker amounts toconstructive delivery.

It is also essential that the banker must return the same goods to the borrower afterhe repays the amount of loan along with interest and other charges. The pledgee(banker) is entitled to certain rights, which are conferred upon him by the IndianContract Act. The foremost right is that he can retain the goods pledged for thepayment of debt and interest and other charges payable by the borrower. In case thepledger defaults, the pledgee has the right to sell the goods after giving pledgerreasonable notice of sale or to file a suit for the amount due from him.

9.5.2 Hypothecation

Hypothecation is another method of creating charge over the movable assets of theborrower. It is preferred in circumstances in which transfer of possession oversuch assets is either inconvenient or is impracticable. For example, if the borrowerwants to borrow on the security of raw materials or goods in process, which are to beconverted into finished products, transfer of possession is not possible/practicablebecause his business will be impeded in case of such transfer. Similarly a transporterneeds the vehicle for plying on the road and hence cannot give its possession to thebanker for taking a loan. In such circumstances a charge is created by way ofhypothecation.

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Under hypothecation, neither ownership nor possession over the asset is transferredto the creditor. Only an equitable charge is created in favour of the banker. Theasset remains in the possession of the borrower who promises to give possessionthereof to the banker, whenever the latter requires him to do so. The charge ofhypothecation is thus converted into that of a pledge. The banker enjoys the rightsand powers of a pledgee. The borrower uses the asset in any manner he likes, viz hemay take out the stock, sell it and replenish it by a new one. Thus a charge iscreated on the movable asset of the borrower. The borrower is deemed to holdpossession over the goods as an agent of the creditor. To enforce the security, thebanker should take possession of the hypothecated asset on his own or through thecourt.

9.5.3 Mortgage

A charge on immovable property like land & building is created by means of amortgage. Transfer of Property Act 1882 defines mortgage as” the transfer of aninterest in specific immovable property for the purpose of securing the paymentof money, advanced or to be advanced by way of loan, an existing or futuredebt or the performance of an engagement which give rise to a pecuniaryliability”. The transferor is called the ‘mortgagor’ and the transferee ‘mortgagee’.

The owner transfers some of the rights of ownership to the mortgagee and retainsthe remaining with himself. The object of transfer of interest in the property mustbe to secure a loan or to ensure the performance of an engagement which results inmonetary obligation. It is not necessary that actual possession of the property bepassed on to the mortgagee. The mortgagee, however, gets the right to recover theamount of the loan out of the sale proceeds of the mortgaged property. Themortgagor gets back the interest in the mortgaged property on repayment of theamount of the loan along with interest and other charges.

Kinds of Mortgages

Though Transfer of Property Act specifies seven kinds of mortgages, but from thepoint of view of transfer of title to the mortgaged property, mortgages are dividedinto-

a) Legal mortgages and

b) Equitable mortgages

In case of Legal Mortgage, the mortgagor transfers legal title to the property infavour of the mortgagee by executing the Mortgage deed. When the mortgagemoney is repaid, the legal title to the mortgaged property is re-transferred to themortgagor. Thus in this type of mortgage expenses are incurred in the form of stampduty and registration charges.

In case of an equitable mortgage the mortgagor hands over the documents of title tothe property to the mortgagee and thus creates an equitable interest of the mortgageein the mortgaged property. The legal title to the property is not passed on to themortgagee but the mortgagor undertakes through a Memorandum of Deposit toexecute a legal mortgage in case he fails to pay the mortgaged money. In suchsituation the mortgagee is empowered to apply to the court to convert the equitablemortgage into legal mortgage.

Equitable Mortgage has several advantages over Legal Mortgage. It is notnecessary to register the Memorandum of Deposit or the covering letter sent alongwith the Documents of title. Actual handing over by a borrower to the lender ofdocuments of title to immovable property with the intention to constitute them assecurity is sufficient. As registration is not mandatory, information regardingmortgage remains confidential and the mortgagor’s reputation is not affected. When

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the debt is repaid documents are returned back to the borrower, who may re-depositthe same for taking another loan against the same documents. But the banker shouldbe very careful in retaining the documents in his possession, because if the equitablemortgagee is negligent or mis-represents to another person, who advances money onthe security of the mortgaged property, the right of the latter will have first priority.

9.5.4 Assignment

The borrower may provide security to the banker by assigning any of his rights,properties or debts to the banker. The transferor is called the ‘assignor’ and thetransferee the ‘assignee’. The borrowers generally assign the actionable claims tothe banker under section 130 of the Transfer of Property Act 1882. Actionable claimis defined as a claim to any debt, other than a debt secured by mortgage ofimmovable property or by hypothecation or pledge of movable property or to anybeneficial interest in movable property not in the possession of the claimant.

A borrower may assign to the banker(i)the book debts, (ii) money due from agovernment department or semi-government organisation and (iii)life insurancepolicies.

Assignment may be either a legal assignment or an equitable assignment. In case oflegal assignment, there is absolute transfer of actionable claim which must be inwriting. The debtor of the assignor is informed about the assignment. In theabsence of the above the assignment is called equitable assignment.

9.5.5 Lien

The Indian Contract Act confers upon the banker the right of general lien. Thebanker is empowered to retain all securities of the customer, in respect of the generalbalance due from him. The banker gets the right to retain the securities handed overto him in his capacity as a banker till his dues are paid by the borrower. It is deemedas implied pledge.

Activity 9.2

1) Distinguish between a secured advance and a guaranteed advance.

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2) Distinguish between pledge and hypothecation. Which provides better securityto the banker and why?

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3) What do you understand by Equitable Mortgage? What are its advantagesvis-a-vis legal mortgage?

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9.6 SECURED ADVANCES

Secured advances account for significant portion of total advances granted by banks.As we have seen, in case of secured advances, a charge is created on the assets ofthe borrowers in favour of the banker, which enables him to realise his dues out ofthe sale proceeds of the assets. Banks grant advances against a variety of assets asshown below:

Securities for Advances

Goods & Documents Real Estates Book SupplyCommodities Debts Bills

Documents of Stock Exchange Life Insurance Fixed DepositTitle to goods Securities Policies Receipts

Let us first study the general principle of secured advances:

1) Marketability of Securities: The banker grants advances on the basis of thosesecurities which are easily marketable without loss of time and money, becausein case of non-payment by the borrower, the banker shall have to dispose off thesecurity to realise his dues.

2) Adequacy of Margin : Banker also maintains a difference between the valueof the security and the amount lent. This is called ‘ margin’. Suppose a bankergrants a loan of Rs. 100 /- on the security valued at Rs. 200/- the differencebetween the two (i.e. Rs. 200 - Rs. 100 = Rs. 100) is called margin. Margin isnecessary to safeguard the interest of the banker as the market value of thesecurity may fall in future and /or interest and other charges become payable bythe borrower , thus increasing the liability of the borrower towards the banker.Different margins are prescribed in case of different securities.

3) Documentation: Banker also requires the borrower to execute the necessarydocuments e.g. Agreement of pledge, Mortgage Deed, Promissory notes etc. tosafeguard his interest.

Goods and Commodities

Bulk of the advances granted by banks are secured by goods and commodities, rawmaterial and finished goods etc., which constitute the stock-in-trade of businesshouses. However, agricultural commodities are likely to deteriorate in quality over aperiod of time. Hence banks grant short term loans only against such commodities .The problem of valuation of stock pledged with the bank is not a difficult one, asdaily quotations are easily available. Banker usually prefers those commodities whichhave steady demand and a wider market. Such goods are required to be insuredagainst fire and other risks. Such goods either pledged or hypothecated to the bankerare released to the borrower in proportion to the amount of loan repaid.

Agro-based commodities such as foodgrains, sugar, pulses, oilseeds, cotton aresensitive to the market forces of demand and supply and prices. As our country hasfaced seasonal shortages in several of these commodities, the reserve bank of Indiaunder the authority vested in it by the Banking Regulation Act, issues directivesknown as Selective Credit Control (SCC) to scheduled commercial banks during thecommencement of each busy season which is, in practical terms, the commencementof the Kharif or the Rabi season each year. In order to ensure that speculation in

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these sensitive commodities does not take place, the Reserve Bank of India in itsbusy season policy issues direction to control the credit for commodities by:

i) Fixing an overall ceiling for credit to sensitive commodities for each bank aswhole. For example, total credit against these commodities in a particular yearmay be restricted to 80% of the previous year’s level;

ii) Fixing margins and rates of interest that can be levied by banks in their creditagainst the selected commodities; and

iii) Banning the flow of bank credit towards financing one or more of these selectedcommodities.

Each bank takes into consideration the RBI’s policy on selective credit control whiledetermining its own credit policy. The Head Offices of banks advise their brancheson the terms and conditions applicable to SCC commodities.

Documents of Title to Goods

These documents represent actual goods in the possession of some other person.Hence they are proof of possession or control over the goods. For example,warehouse receipts, railway receipts, Bill of lading etc. are documents of title togoods. When the owner of goods represented by these documents wants to take aloan from the banker, he endorses such documents in favour of the banker anddelivers them to him. The banker is thus entitled to receive the delivery of suchgoods, if the advance is not repaid. However, there remains the risk of forgery insuch documents and dishonesty on the part of the borrower.

Stock Exchange Securities

Stock Exchange Securities comprise of the securities issued by the Central and Stategovernments, semi-govt. orgaisations, like Port Trust & Improvement Trust, Sharesand Debentures of companies and Units of the Mutual Funds listed on the StockExchanges. The Govt. securities are accepted by banks because of their easyliquidity, stability in prices, regular accrual of income and easy transferability.

In case of corporate securities banks prefer debentures of companies vis-à-vis sharesbecause the debenture holder generally happens to be secured creditor and there is acontractual obligation on the company to pay interest thereon regularly. Amongst theshares, banks prefer preference shares, because of the preferential rights enjoyedby the preference shareholders over equity shareholders. Banks accept equityshares of those companies which they approve after thorough screening andexamination of all aspects of their working. A charge over such securities is createdin favour of the banker.

Reserve Bank of India has permitted the banks to grant advances against shares toindividuals upto Rs. 20 lakhs w.e.f. April 29, 1998 if the advances are secured bydematerialized Securities. The minimum margin against such dematerialized shareswas also reduced to 25%. Advances can also be granted to investment companies,shares & stock brokers, after making a careful assessment of their requirements.

Life Insurance Policies

A life insurance policy is considered a suitable security by a banker as repayment ofloan is ensured to the banker either at the time policy matures or at the time of deathof the insured. Moreover, the policy has a surrender value which is paid by theinsurance company, if the policy is discontinued after a minimum period has lapsed.The policy can be legally assigned to the banker and the assignment may beregistered in the books of the insurance company. Banks prefer endowment policiesas compared to the whole life policies and insist that the premium is paid regularlyby the insured.

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Fixed Deposit Receipts

A Fixed Deposit Receipt issued by the same bank is the safest security for grantingan advance because the receipt represent a debt due from the banker to thecustomer. At the time of taking a loan against fixed deposit receipt the depositorhands over the receipt to the banker duly discharged, along with a memorandum ofpledge. The banker is thus authorised by the depositor to appropriate the amount ofthe FDR towards the repayment of loan taken from the banker.

Real Estate

Real Estate i.e. immovable property like land and building are generally not regardedsuitable security for granting loans for working capital. It is difficult to ascertain thatthe legal title of the owner is free from any encumbrance. Moreover, their valuationis a difficult task and they are not readily realizable assets. Preparation of mortgagedeed and its registration takes time and is expensive also. Real Estates are,therefore, taken as security for term loans only.

Book Debts

Sometimes the debts which the borrower has to realise from his debtors are assignedto the banker in order to secure a loan taken from the banker. Such debts have eitherbecome due or will accure due in the near future. The assignor must execute aninstrument in writing for this purpose, clearly expressing his intention to pass on hisinterest in the debt to the assigner (banker). He may also pass an order to his debtorto pay the assigned debt to the banker.

Supply Bills

Banks also grant advance on the security of supply bills. These bills are offered assecurity by persons who supply goods, articles or materials to various Govt.departments, semi-govt. bodies and companies, and by the contractors who undertakegovt. contract work. After the goods are supplied by the suppliers to the govt.department and he obtains an inspection note or Receipted Challan from the Deptt.,he prepares a bill for the goods supplied and gives it to the bank for collection andseeks an advance against such supply bills. Such bills are paid by the purchaser atthe expiry of the stipulated period.

Security for bank credit could be in the form of a direct security or an indirectsecurity. Direct security includes the stocks and receivables of the customers onwhich a charge is created by the bank through various security documents. If in theview of the bank, the primary or direct security is not considered adequate or is risk-prone, that is, subject to heavy fluctuations in prices, quality etc., the bank mayrequire additional security either from the customer or from a third party onbehalf of the customer. The additional security so obtained is known as Indirect or“Collateral Security”. The term collateral means running parallel or together andcollateral security is an additional and separate security for repayment of moneyborrowed.

In case the customer is unable to provide additional security when required by thebank, he may be required to provide collateral security from a third party. Thecommon form of the third party collateral security is a guarantee given by a personon behalf of the customer to the bank. The third party collateral security in turn maybe unsecured or secured. For example, where the guarantor has executed a guaran-tee agreement only, The collateral security is unsecured. However, if he lodges alongwith the guarantee agreement, security such as title deeds to his property creatingmortgage by deposit of title deeds with the bank, a secured collateral security iscreated.

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Financing WorkingCapital Needs 9.7 PURCHASE AND DISCOUNTING OF BILLS

Purchase and discounting of bills of exchange is another way banks provide credit tobusiness entities. Bills of exchange and promissory notes are negotiable instrumentswhich arise out of commercial transactions both in inland trade and foreign trade andenable the debtors to discharge their obligations towards their creditors.

On the basis of maturity period , bills are classified into (i) demand bills and (ii)usance bills. When a bill is payable ‘at sight’ ‘on demand’ or on presentment, it iscalled a demand bill. If it matures for payment after a certain period of time say30,60,90 days , after date or sight, it is called a usance bill. No stamp duty is requiredin case of demand bills and on usance bills, if they (i) arise out of the bona fidecommercial transactions , (ii) are payable not more than 3 months after date or sightand (iii) are drawn on or made by or in favour of a commercial or cooperative bank.

When the drawer of a bill encloses with the bill documents of title to goods, such asthe railway receipt or motor transport receipt, to be delivered to the drawee , suchbills are called documentary bills. When no such documents are attached the bill iscalled a clean bill. In case of documentary bills, the documents may be delivered onaccepting the bill or on making its payment. In the former case it is calledDocuments against Acceptance (D/A) basis, and in the latter case Documentsagainst Payment (D/P) basis. In case of a clean bill, the relevant documents of titleto goods are sent directly to the drawee.

Procedure for Discounting of Bills

When the seller of the goods draws a bill of exchange on the buyer (debtor), he hastwo options to deal with the bill.

a) to send the bill to a bank for collection, or

b) to sell it to, or discount it with, a bank

When the bill is sent to the bank for collection the banker acts as the agent of thedrawer and makes its payment to him only on the realisation of the bill from thedrawee. The banker sends it to its branch at the drawee’s place, which presents itbefore the drawee, collects the amount and remits it to the collecting banker, whocredits the same to the drawer’s account. In case of collection of bills, the bank actsas an agent of the drawer of the bill and does not lend his funds by giving creditbefore actual realisation of the bill.

The business of purchasing and discounting of bills differs from that of collection ofbills. In case of purchase/discounting of bills, the bank credits the amount of the billto the drawer’s account before its actual realisation from the drawee. The bankerthus lends his own funds to the drawer of the bill. Bills purchased or discounted aretherefore, shown under the head ‘ Loans and Advances’ in the Balance Sheet of abank.

The practice adopted in case of demand bills is known as purchase of bills. Asdemand bills are payable on demand, and there is no maturity, the banker is entitled todemand its payment immediately on its presentation before the drawee. Thus themoney credited to the drawer’s account, after deducting charges/discount, is realisedby the banker within a few days.

In case of a usance bill maturing after a period of time generally 30,60,or 90 days,therefore, banker discounts the bill i.e. credits the amount of the bill, less the amountof discount, to the drawer’s account. Thereafter, the bill is sent to the bank’s branchat the drawee’s place which presents it to the drawee for acceptance. Documentsof title to goods, if enclosed with the bills, are released to him on accepting the bill.

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The bill is thereafter retained by the banker till maturity, when it is presented to theacceptor of the bill for payment.

Advantages of Discounting of Bills

A banker derives the following advantages by discounting the bills of exchange:

1) Safety of funds lent

Though the banker does not get charge over any tangible asset of the borrower incase of discounting of bills, his interest is safeguarded by the fact that the bills ofexchange contains signatures of two parties—the drawer and the drawee(acceptor)— who are responsible to make payment of the bill. If the acceptor failsto make payment of the bill the banker can claim the whole amount from hiscustomer, the drawer of the bill. The banker can debit the customer’s account andrecover the money on the due date. The banker is able to recover the amount as hediscounts the bills drawn by parties of standing and good reputation.

2) Certainty of payment

Every usance bill matures on a certain date. Three days of grace are allowed to theacceptor to make payment. Thus, the amount lent to the customer by discounting thebills is definitely recovered by the banker on its due date. The banker knows the dateof payment of the bills and hence can plan the utilisation of his funds well inadvance and with profit.

3) Facility of re-discounting of bills

The banker can augment his funds, if need arises, by re-discounting the bills, alreadydiscounted by him, with the Reserve Bank of India, other banks and financialinstitutions and the Discount and Finance House of India Ltd. Reserve Bank ofIndia can also grant loans to the banks on the basis of the bills held by them.

4) Stability in the value of bills

The value of the bills remains fixed and unchanged while the value of all other goods,commodities and securities fluctuate over period of time.

5) Profitability

In case of discounting of bills, the amount of interest (called discount) is deducted inadvance from the amount of the bill. Hence the effective yield is higher than loansand advances where interest is payable quarterly/half yearly.

Derivative Usance Promissory Notes

As noted above, banks may re-discount the discounted bills of exchange with otherbanks and financial institutions. For this purpose, under the normal procedure, thebills are endorsed in favour of the re-discounting bank /institution and delivered to it.At the time of maturity reverse process is required.

To simplify the procedure of re-discounting, Reserve Bank of India has dispensedwith the necessity of physical lodgment of the discounted bills. Instead, banks arepermitted, on the basis of such discounted bills, to prepare derivative usancepromissory notes for suitable amounts like Rs. 5 lakh or Rs. 10 lakh and for suitablematurities like 60 days or 90 days. These derivative usance promissory notes are re-discounted with the re-discounting bank or institution. The essential condition is thatthe derivative promissory note should be backed by unencumbered bills of exchangeof atleast equal value till the date of maturity. In the meanwhile, any maturing bill

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may be replaced by another bill for equal amount. No stamp duty is required on suchderivative usuance promissory notes.

Compulsion on the Use of Bills

To encourage the use of bills of exchange by corporate borrowers, the Reserve Bankof India had directed the commercial banks to advice their corporate borrowers tofinance their domestic credit purchases from small scale industrial units as well asfrom others at least to the extent of 25 percent by way of acceptance of bills drawnupon them by their suppliers. This was to be stipulated as a condition for sanctioningworking capital credit limits. Banks were also authorized to charge an additionalinterest from those borrowers who did not comply with this requirements in anyquarter. In October 1999 Reserve bank of India permitted the banks to chargeinterest rate on discounting of bills without reference to Prime Lending Rate. Theyare now free to offer competitive rate of interest on the bill discounting facility. Theabove-mentioned compulsion was also withdrawn.

Revised Guidelines of RBI on Discounting of Bills

· Banks may sanction working capital limits as also bills limits to borrowers afterproper appraisal of their credit needs and in accordance with the loan policy asapproved by their Board of Directors.

· Banks are required to open letters of credit (LCs) and purchase /discount/negotiate bills under LCs only in respect of genuine commercial and tradetransactions of their borrower constituents who have been sanctioned regularcredit facilities by them.

· For the purpose of credit exposure, bills purchased discounted/negotiated underLCs or otherwise would be reckoned as exposure on the bank’s borrowerconstituent. Accordingly, the exposure should attract a risk-weight appropriate tothe borrower constituent (viz.,100 per cent for firms, individuals, corporates) forcapital adequacy purposes.

· Banks have been permitted to exercise their commercial judgment in discountingof bills of services sector. Banks would need to ensure that actual services arerendered and accommodation bills are not discounted. Services sector bills shouldnot be eligible for rediscounting.

Bank Credit Through Debt Instruments

During recent years, banks have resorted to granting large credit to the corporatesector and the public sector undertakings by investing in their debt instruments likebonds, debentures and commercial paper. Banks find excess liquidity with them inthe midst of low off take of credit, by the corporate sector. Taking advantage of sucha situation, companies prefer to raise funds by way of private placement of theirbonds, debentures and commercial paper. During 1998-99 roughly Rs. 35, 000 crorewas raised from debt instruments only through private placements. Most of thiswas subscribed by the banks. Their outstanding investment in debt paper was Rs.41,458 crore as at the end March, 1999 as against Rs. 28,378 crore a year earlier.Investment in C.P.s stood at Rs. 4,033 crore at the end of March 1999. Thuscorporates have been able to raise funds from the investors (including banks) atrates lower than the prime lending rates of banks.

Moreover, investment in debt instruments is not reckoned as bank credit and hencedoes not entail bank’s obligation to grant advances to priority sectors based thereon.Further, the relaxation granted by Reserve Bank of India in April 1997 to the banks toinvest in the bonds and debentures of private corporate sector without any limit, hasalso contributed to the greater flow of bank credit through debt instruments.

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9.8 NON FUND BASED FACILITIES

The credit facilities explained above are fund based facilities wherein funds areprovided to the borrower for meeting their working capital needs. Banks also providenon-fund based facilities to the customers. Such facilities include ( i ) letters of creditand (ii) bank guarantees. Under these facilities, banks do not immediately providecredit to the customers, but take upon themselves the liability to make payment incase the borrower defaults in making payment or performing the promise undertakenby him.

Letter of Credit

A letter of Credit(L/C) is a written undertaking given by a bank on behalf of itscustomer, who is a buyer , to the seller of goods, promising to pay a certain sum ofmoney provided the seller complies with the terms and conditions given in the L/C. ALetter of Credit is generally required when the seller of goods and services dealswith unknown parties or otherwise feels the necessity to safeguard his interest.Under such circumstances, he asks the buyer to arrange a letter of credit from hisbanker. The banker issuing the L/C commits to make payment of the amountmentioned therein to the seller of the goods, provided the latter supplies the specifiedgoods within the specified period and comply with other terms and conditions.

Thus by issuing Letter of Credit on behalf of their customers, banks help them inbuying goods on credit from sellers who are quite unknown to them. The bankerissuing L/C undertakes an unconditional obligation upon himself, and charge a feefor the same. L/Cs may be revocable or irrevocable. In the latter case, theundertaking given by the banker cannot be revoked or withdrawn.

Bank Guarantee

Banks issue guarantees to third parties on behalf of their customers. Theseguarantees are classified into (i) Financial guarantee, and (ii) Performanceguarantee. In case of the financial guarantees, the banker guarantees the repaymentof money on default by the customer or the payment of money when the customerpurchases the capital goods on deferred payment basis.

A bank guarantee which guarantees the satisfactory performance of an act, saycompletion of a construction work undertaken by the customer, failing which the bankwill make good the loss suffered by the beneficiary is known as a performanceguarantee.

9.9 CREDIT WORTHINESS OF BORROWERS

The business of granting advances is a risky one. It is more risky specially in case ofunsecured advances. The safety of the advance depends upon the honesty andintegrity of the borrower, apart from the worth of his tangible assets. The bankerhas, therefore, to investigate into the borrower’s ability to pay as well as hiswillingness to pay the debt taken. Such an exercise is called credit investigation.Its aim is to determine the amount for which a person is considered creditworthy.Credit worthiness is judged by a banker on the basis of borrower’s ( i ) character, (ii)capacity and (iii) capital.

1) Character includes a number of personal characteristics of a person e.g hishonesty, integrity, promptness in fulfilling his promises and repaying the dues,sense of responsibility, reputation and goodwill enjoyed by him. A person havingall these qualities, without any doubt in the minds of others , possesses, anexcellent character and hence his creditworthiness is considered high.

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2) Capacity If the borrower possesses necessary technical skill, managerial abilityand experience to run a particular business or industry, success of such anenterprise is taken for granted except in some unforeseen circumstances, Such aperson is considered creditworthy by the banker.

3) Capital The borrower is also expected to have financial stake in the business,because in case the business fails, the banker will be able to realise his moneyout of the capital put in by the borrower. It is a sound principle of finance thatdebt must be supported by sufficient equity.

The relative importance of the above factors differs from banker to banker and fromborrower to borrower. Banks are granting advances to technically qualified andexperienced entrepreneurs but they are required to put in a small amount as their owncapital. Reserve Bank of India has recently directed the banks to dispense with thecollateral requirement for loans upto Rs. 1 lakh. This limit has recently been furtherincreased to Rs. 5 lakh for the tiny sector.

Determination of credit worthiness of a borrower has become now a more scientificexercise. Special institutions like rating companies such as CRISIL, ICRA, CARE,have come on to the field and each of them has developed a methodology of its own.

This was discussed in earlier Block under Receivables Management in more detail.

Activity 9.3

1) Why do banks prefer Govt. and semi-govt. securities vis-à-vis CorporateSecurities for granting credit? Amongst the Corporate Securities why do theyprefer debt instruments?

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2) What are the advantages of discounting of bills to the banks? Is it compulsoryfor corporate borrowers to use bills of Exchange?

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3) What do you understand by credit-worthiness of a borrower? What factors aretaken into account by the banker to determine credit-worthiness?

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9.10 SUMMARY

In this unit we have discussed the basic concepts, principles and practices of bankcredit as a source of working capital. Various forms in which bank credit is grantedviz. Overdrafts, loans, cash credit and discounting of bills etc. are discussed withtheir merits and demerits. Different types of loans, and their classification on thebasis of security and guarantee have been explained. After explaining the variousmodes of creating charge over the borrower’s assets, we have discussed merits and

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demerits of different types of securities taken by banks. Purchase and discounting ofbills as a method of granting credit has been duly explained. Concept of creditworthiness of the borrower has been clarified. In the end, the two important non-fund based facilities such as letter of credit and guarantee given by banks have beenexplained.

9.11 KEY WORDS

Overdrafts : This is a facility allowed to a current account holder for a shortperiod. Under this facility, the account holder is allowed to draw from his accountmore than what stands to his credit, either on the personal security of the borrower oron the basis of collateral security.

Cash Credit System: This is a method of granting credit by banks. Under thismethod the bank prescribes a limit, called the Cash Credit limit, upto which thecustomer is permitted to borrow against the security of tangible assets or guarantee.The borrower may withdraw from the account as and when he needs money.Surplus funds with him may be deposited with the banker any time. Thus, it isrunning a/c with the banker, wherein withdrawals and deposits may be madefrequently in any number of times.

Loan: Under the Loan System of granting credit a definite amount is lent for aspecified period.

Bridge Loan: Bridge Loan is a short term loan which is usually granted to industrialundertakings to enable them to meet their urgent needs. It is granted when a termloan has already been sanctioned by a bank/financial institution, but its disbursementtakes some time or when the company is taking steps to raise funds for the capitalmarket. It is a type of interim finance.

Composite Loan: Those loans that are granted for both investment in capital assetsand for working capital purposes, are called composite loans.

Secured Loans: A secured loan is a loan made on the security of any tangible assetof the borrower. It means that a charge or right is created on the assets of theborrower in favour of the lender. The value of the security must be equal to theamount of the loan. If the former is less than the latter, it is called partly securedloan. An advance without such security is called unsecured advance. In case ofsecured loan the lender gets the right to realise his dues from the sale proceeds of thesecurity, if the borrower defaults.

Pledge: Pledge is a method of creating a charge over the movable assets of theborrower in favour of the lender. Under the pledge , the movable assets of theborrower are delivered to the banker as a security, which he will return back to theborrower, after he repays the amount due from him in respect of principal andinterest.

Hypothecation: It is another method of creating charge over the movable assets.Under hypothecation the possession over such assets is not transferred to thebanker. Only an equitable charge is created in favour of banker. The assets remainin the possession of the borrower, who promises to give possession of the same to thebanker , whenever he is requested to do so.

Mortgage: It is a method of creating charge over the immovable property like landand building. Under Mortgage the borrower transfers some of the rights ofownership to the banker (or mortgagee) and retains the remaining rights withhimself. The objective is to secure a loan taken from the banker. Actual possessionover the property is not passed on to the mortgage in all cases.

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Equitable Mortgage: In this type of mortgage the mortgagor hands over thedocuments of title to the property to the mortgagee and thus an equitable interest ofthe mortgagee is created in the property. If the mortgagor fails to repay the amountof the loan, he may be asked to execute a legal mortgage in favour of the lender.

Assignment: It is a method whereby the borrower provides security to the bankerby assigning (transferring or parting with) any of his rights, properties or debts to thebanker.

Lien: Lien is the right of the banker to retain all securities of the customer, until thegeneral balance due from him is not repaid.

Documents of title to goods: These are the documents which represent the goodsin the possession of some other person. For example a warehouse receipt or arailway receipt. By endorsing such documents in favour of the banker, the borrowerentitles the banker to take delivery of the goods from the warehouse or railway, if hedoes not repay the advance.

Credit worthiness: Creditworthiness indicates the quality of the borrower. Itdenotes the amount for which a borrower is considered worthy for borrowing from abank. It depends upon his ability and willingness and is judged on the basis ofcharacter, capacity and capital of the borrower.

9.12 SELF ASSESMENT QUESTIONS

1. Why does a bank as a general rule not lend on long term basis ?

2. What are the common securities against which a bank may lend for workingcapital purposes ? Can a bank extend an unsecured loan or advance ?

3. Does a bank need to be satisfied about the creditworthiness of a customerbefore extending non – fund facilities to him ? If so why ? Would a bankguarantee issued in favour of Customs Authorities guaranteeing payment ofcustoms duty be classified as a performance or financial one ?

4. What are the different types of ventures that a bank can finance ? Does itinclude a handcart operator selling vegetables ?

5. Discuss the different ways by which banks provide credit to business entities?

9.13 FURTHER READINGS

1. Tannan’s Banking Law and Practice (19th Edition)

2. P. N. Varshney- Banking Law & Practice

3. P. N. Varshney- Indian Financial System and Commercial Banking.

4. S. Srinivasan 1999; Cash and Working Capital Management, Vikas Publishinghouse, New Delhi.

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Appendix

Observation of RBI on Working Capital Cycles and Demand for Bank Credit

Working capital is critical for daily management of cash flows to settle bills, wagesand other variable costs. The working capital cycle is the period of time whichelapses between the point at which cash begins to be expended on the production ofa product and the collection of cash from sale of the product to its customers.Typically, the cycle begins with the injection of cash which is utillised for makingpayments to the suppliers of raw materials, workers, etc. Between each stage of thisworking capital cycle, there is a time lag. The amplitude of the working capital cycledepends on the type of activity. In general, careful management of working capital isvital for any firm, particularly where the gestation lag between the productionprocess and realisation of the receivables is substantial in a situation when the firmhas incurred all expenditure associated with production but has not realised the valueof its product, it is imperative that the firm manages its cash flow carefully to stayliquid and operational.

Working capital requirements can be financed from both internally generated re-sources (selling current assets) and externally acquired alternatives (borrowing orsecuring current assets). Mostly firms borrow on the strength of their current assetsand the major sources of funds include trade credits, accruals, short-term bank loans,collateral papers, commercial papers and factoring accounts receivable. In a bank-based financial system, the loan from the bank by a corporate takes form of line ofcredit or overdraft. This is an arrangement between the bank and its customers withrespect to the maximum amount of unsecured credit the bank will permit the bor-rower firm. Besides this arrangement, there are other forms of short-term financingby raising resources directly from the market through issue of commercial paper.

In the Indian context, a major part of the working capital requirements are met bybank credit. Typically, periods of spurt in industrial activity are associated with surgesin non-food bank credit, albeit, with some lag. These lags are more prolonged in aproduction based business rather than in service providing firms. Commercial paper(CP)has emerged as an important source of funding working capital needs; howeverit is restricted to a few large companies with triple-A corporate ratings and does notenjoy wider market acceptability. Thus, bank credit in the form of cash credit (CC)and working capital demand loan (WCDL)continues to remain the principal source ofworking capital requirements. An analysis of the data for large borrowers showedthat working capital credit which constituted nearly 65 per cent of the total bankcredit in mid-1990s, came down to nearly 55 per cent in 2002.

The CC arrangement in India is a unique system, which is highly advantageous to theborrowers as the task of cash managment of the borrowers is passed on to thelending banks. Since the borrowers are free to draw from the cash credit account atany time depending on their cash requirements, it results in uncertainty in the utilisa-tion of the cash credit limit. As such, banks are required to maintain large cash/liquidassets or resort to borrowal from the call money market to meet the sudden demandfor withdrawal by the borrowers. In April 1995, under the 'Loan System' of deliveryof bank credit, the CC component was restricted to a maximum of 75 percent of theMaximum Permissible Borrowerd Fund (MPBF) in respect of cases where theMPBF was up to 20 crore, with a view to bringing about an element of discipline inutlisation of bank credit by large borrowers and for gaining better control over theflow of credit. The 'Loan System' aimed at minimising the risk of cash and liquiditymanagement on the part of the banking system caused by the volatile movement inthe CC component of working capital. It was extended in phases to cover largenumber of borrowers with the percentage of the loan component (WCDL) beinggradually increased. In October 1997 the minimum level of the loan component was

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prescribed at 80 percent in respect of borrowers with working captial credit limit ofRs.10 crore and above. In view of the improved environment of short-term invest-ment opportunities available to both corporates and banks and the banks having put inplace suitable risk management systems for covering liquidity and interest rate risks,banks were allowed to increase the CC component beyond 20 percent in October2001. Banks are expected to appropriately price each of the two components ofworking capital finance, taking into account the impact of such decisions on their cashand liquidity management.

Source: RBI's Annual Report, 2002-2003.

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UNIT 10 BANK CREDIT - METHODS OFASSESSMENT AND APPRAISAL

Objectives

The objectives of this unit are:

· To explain the methods permitted by Reserve Bank of India for banks to assessthe credit needs of the large borrowers.

· To explain the Maximum Permissible Bank Finance Method as evolved on thebasis of Tandon Committee and Chore Study Group’s Reports and thealternatives suggested by the Reserve Bank.

· To describe the system of compulsory loan component in bank credit, asenforced by the Reserve Bank of India.

· To discuss present system of interest rates, and

· To discuss the methodology of financing large borrowers by banks

Structure

10.1 Introduction

10.2 Brief Historical Background

10.3 Maximum Permissible Bank Finance System

10.4 The Turnover Method

10.5 The Cash Budget Method

10.6 Compulsory Loan Component in Bank Credit

10.7 Interest Rates on Bank Advances

10.8 Tax on Bank Interest

10.9 Prudential Norms for Exposure Limits

10.10 Consortium Advances

10.11 Syndication of Credit

10.12 Summary

10.13 Key Words

10.14 Self Assessment Questions


10.1 INTRODUCTION

In Unit 9, we have studied the principles of bank lending, the style of credit and thesecurities taken by a banker from his customers. The basic task before the bankerremains how to assess the needs of a customer for bank credit, particularly formeeting working capital needs. The need for bank credit depends upon a borrower’soperating cycle i.e the period between the time of payment for purchase of rawmaterial and the time sale proceeds are realised in cash. In addition, it also dependsupon the level of inventories held by the borrowers in different forms-raw materials,semi-manufactured goods and the finished goods. The credit terms offered by theborrower to his customers and the collection efforts made by him also affect theworking capital needs. In short, a careful assessment of all these aspects is requiredto be made by the banker to assess the working capital requirements of a customer.

10.2 BRIEF HISTORICAL BACKGROUND

In India, traditionally the Cash Credit System has been in vogue for a very long timeand to a larger extent. There are two main defects in this system. First, the level of

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advances in a bank is determined not by how much a banker can lend at a particularpoint of time but by the borrower’s decision to borrow at that time.

Secondly, the Cash Credit advances, though repayable on demand by the banker, aregenerally rolled over and thus never fall below a certain level during the course of ayear. Thus the business concerns employ bank funds on a quasi-permanent basis.

Realising these drawbacks in the Cash Credit System, Reserve Bank of Indiaappointed a study group, under the chairmanship of Shri P.L. Tandon to frameguidelines for the follow up of bank credit. Accepting the recommendations ofTandon Study Group, Reserve Bank of India advised the banks in 1975 to follow areformed system of Cash Credit, which is known as ‘ Maximum Permissible BankFinance System’. In 1980, necessary modifications were made in the above in thelight of the recommendations of another working group known as ‘ChoreCommittee’. The Maximum Permissible Bank Finance System (MPBF) wassubstantially liberalized in 1993. Ultimately, in April 1997, the MPBF System wasmade optional to the banks. Reserve Bank of India has permitted the banks tofollow any of the following methods for assessing the working capital requirements ofthe borrower:

1) The Turnover Method for small borrowers, already enforced, may be continuedfor this category of borrowers,

2) The Cash Budget System may be followed by banks for large borrowers whoprepare Cash Budget,

3) The existing Maximum Permissible Bank Finance System, may be retained , ifnecessary, with modifications.

4) Any other system.

Thus sufficient operational flexibility has been given to the banks in their efforts toassess working capital needs. But, on the other hand, compulsion has been enforcedon banks to introduce a compulsory loan component in bank credit and exposurenorms have been prescribed. In case of large borrowers flexibility is allowed to formconsortium or to go for syndication.

10.3 MAXIMUM PERMISSIBLE BANK FINANCESYSTEM

As noted in the previous section, the Maximum Permissible Bank Finance Systemwas introduced in India in 1975. Initially, it was made obligatory for all borrowerswith credit limits of Rs. 10 lakh and above. The Tandon Committee, while suggestingthis system, made a significant attempt towards modernising the methodology ofcredit appraisal. The Chore Committee, strengthened the System further. In thewake of liberalisation policy, the MPBF System was substantially liberalised in theyear 1993. In April 1997, it ceased to be mandatory and banks were permitted toadopt this system with modification, if any, or to adopt any other system of creditappraisal. As the MPBF System is still relevant in India, we shall study its salientfeatures as modified /amended in 1993.

1) Norms for Inventories and Receivables

The main thrust of this system is on assessing the credit needs of a borrower on thebasis of holding of current assets, as per the prescribed norms. Initially, theCommittee suggested norms for holding various current assets for 15 industries.Later on, almost all industries were covered. The norms were prescribed for variouscurrent assets as follows:

1) For raw materials expressed as so many months’ consumption. Raw materialsinclude store and other items used in the process of manufacture.

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2) For stock-in-process, expressed as so many months’ cost of production

3) For finished goods, expressed as so many months’ cost of sales,

4) For receivables, expressed as so many months’ sales.

These norms were to be treated as the maximum quantity of current assets to be heldby a borrower. If a borrower had managed with less quantity in the past, he shouldcontinue to do so. The norms were for the average level of holding of a particularcurrent asset and not for a particular item of a current asset. For most of theindustries a combined norm was prescribed for finished goods and receivables.

The objective of laying down the norms of inventories was to ensure that banksassess the credit needs of a borrower on the basis of reasonable level of inventoriesheld as per the norms. Thus the credit granted was intended to be need- based.However, the Reserve Bank permitted the banks to deviate from the norms inspecified circumstances.

In 1993, Reserve bank of India provided more flexibility to the banks in this regard.Banks were permitted to make their own assessment of credit requirements ofborrowers based on their own study of the borrowers’ business operations i.e takinginto account the production/processing cycle of the industry as well as the financialand other relevant parameters of the borrowers. Banks are now allowed to decidethe levels of holding of each item of inventory and receivables, which in their viewwould represent a reasonable build up of current assets for being supported by bankfinance.

Reserve Bank of India now does not prescribe norms for each item of inventory andreceivables. Its role is now confined to advising the overall levels of inventories andreceivables of different industries for the guidance of the banks. The above guidelineswere made applicable to all borrowers enjoying aggregate fund-based workingcapital limit of Rs. 2 crore and above from the banking system. (instead of Rs. 10lakhs earlier) All borrowers enjoying aggregate fund based credit limits of up to Rs.2 crore from the banking system were exempted from the above guidelines. Theirworking capital needs are now assessed on the basis of projected Turnover Method(which has been explained in a subsequent section in this unit) which was earlierapplicable to village and tiny industries and other small scale industries enjoying fund-based working capital limits up to Rs. 50 lakhs.

2) Methods of Lending

The MPBF system permits the banks to finance only a portion of the borrowers’working capital requirements from bank credit. The borrower is expected to dependless and less on banks to finance his working capital needs. The Tandon Committeesuggested the following three methods of lending for determining the permissible levelof bank borrowing. It is to be noted that each successive method is intended toincrease progressively the involvement of long term funds comprising borrower’sowned funds and term borrowings to support current assets. The three methods oflending are as follows:

First Method of Lending: Under this method, banks have to work out the workingcapital gap by deducting current liabilities other than bank borrowings from thecurrent assets. Bank can provide a maximum credit upto 75 percent of workingcapital gap. The balance is to be met by the own funds of the borrower and termloans.

Second Method of Lending: Under this method, the borrower has to provide for aminimum of 25 percent of the total current assets out of long term funds i.e. ownfunds plus term borrowings. After deducting current liabilities other than bankborrowings from the rest of the current assets, the balance of current assets are to be

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financed through bank borrowings. Thus the total current liabilities inclusive of bankborrowing will not exceed 75 percent of current assets.

Third method of Lending: This is the same as the second method except onedifference. The core current assets, i.e. the permanent current assets which shouldbe financed from long term funds are deducted from the total current assets. Of thebalance of current assets, 25% are financed from long term sources and the rest outof current liabilities including bank borrowings.

It is to be noted that the first method gives a minimum current ratio 1.17:1, while thesecond method gives 1.3:1 and the third method 1.79:1

You can understand well calculation of the maximum permissible bank finance underthe three methods of lending from the following illustration:

Projected Balance sheet of a borrower is as follows:

Current liabilities Current Assets

Creditors for purchases 100 Raw material 200

Other Current liabilities 50 Stock-in process 20————

150 Finalised 90————

Bank borrowings 200 Receivables

(including bills discounted) (including bills discounted) 50

Other current assets 10—— ———

350 370——- ———

1st Method 2nd Method 3rd Method

Total Current Assets 370 Total Current Assets 370 Total Current Assets 370Less Current liabilities 25% of above from Less Core Current AssetOther than bank long term sources 92 (assumed) financedBorrowings 150 from long term sources 95Working CapitalGap 220 278 Rest of Current Assets 27525% of the above Less Current liabilitiesfrom long term other than bank 25% of above fromsources 55 borrowing 150 long term sources 69

206Less Current liabilitiesother than bankborrowings 150

Maximum bank Maximum bankBorrowing borrowing Maximum bankPermissible 165 permissible 128 borrowing permissible 56Actual bank Actual bankBorrowings 200 borrowings 200 Actual bank borrowing 200Excess borrowings 35 Excess borrowing 72 Excess borrowing 144Current Ratio 1.17:1 Current Ratio 1.33:1 Current Ratio 1.79:1

You will note that the current ratio is higher in case of Method II as against Method I,and still higher in case of Method III as against Method II.

Till 1993, Reserve Bank of India required the banks to follow the first method oflending in case of borrowers enjoying fund-based working capital limits of Rs. 10lakh and above and upto Rs. 50 lakh. For borrowers with high fund-based workingcapital limits method II was to be applied.

In 1993, Method II was made applicable to all borrowers with aggregate fund basedworking capital limits above Rs. 2 crore from the banking system. Borrowers with

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credit limit upto Rs. 2 crore were to be sanctioned credit limits according to ProjectedTurnover Method (discussed ahead)

The following credit facilities have been exempted from the application of SecondMethod of lending:

a) Borrowing units engaged in export activities.

b) Additional credit needs of exporters arising out of firm orders/confirmed lettersof credit.

c) Borrowing units marketing/trading exclusively the products and merchandisemanufactured by village, tiny & small scale industrial units will be subject to 1st

Method provided dues are settled by them within 30 days of supply.

d) Sick/weak units under rehabilitation.

3) Style of Credit

On the recommendation of the Tandon Committee, the Reserve Bank of Indiaprescribed at the time of introduction of MPBF System that banks should bifurcateaccommodation into (1) loan comprising the minimum level of borrowing which theborrower expects to use throughout the year and (2) a demand cash credit tomeet the fluctuating requirements of credit. A slightly higher rate of interest ondemand Cash Credit component than for loan component was also suggested.Reserve Bank of India directed the banks that the interest rate on demand CashCredit should be higher by one percent over the rate of interest on the loancomponent.

The above directive was withdrawn by Reserve Bank of India in 1980. Subsequentlyin 1995 Reserve Bank of India introduced a compulsory loan component in thedelivery of bank credit (which has been discussed in a subsequent section in thisunit).

Peak Level and Non Peak Level Limits

The Chore Committee suggested significant modification in the MPBF System, whichwere enforced by the Reserve Bank of India in December 1980. Hitherto creditlimits were sanctioned on the basis of peak level requirements of the borrowers, buta portion of the same remained unutilized during the non-peak season. The MPBFSystem was, therefore, modified so as to require the banks to fix credit limits for thenormal peak level and non-peak level requirements of the borrower separately.These limits are to be fixed on the basis of the utilisation of such limits in the past.The period during which they have to be utilised is also required to be specified.Seasonal limits are required to be fixed in case of all agro-based industries andconsumer goods industries having seasonal demand. For other industries only onelimit is to be fixed.

Withdrawal of Funds

After the peak level and non- peak level credit limits are sanctioned by the banks asstated above, the borrower is required to indicate, before the commencement of eachquarter, his expected requirements of funds in that quarter. Such requirements arecalled the ‘operating limits’. Borrower is expected to withdraw funds from thebanks as per his requirements within the operating limit in that quarter subject to atolerance of 10% either way. Banks also require the borrower to submit monthlystock statements to determine his drawing power within the operating limit. Hencethe actual amount availed of as bank credit will be the operating limit or the drawingpower, whichever is lower. If a borrower draws more than or less than thesetolerance limits, it must be considered as an irregularity in the account. In such

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situation banks should take necessary corrective steps to avoid the repetition of suchirregularity in future.

Submission of Quarterly Statements

Each borrower enjoying fund-based working capital limit of Rs. 2 crore or more isrequired to submit to the banker the following two quarterly statements:

1) Statement giving estimates of production, sales, stock position and currentliabilities. (This statement is to be submitted in the week preceding thecommencement of the quarter to which it relates).

2) Statement showing actual performance in the quarter. This statement is to besubmitted within six weeks from the end of the quarter. In addition to these, theborrowers are also required to submit half yearly operating statement and fundsflow statement, along with a half yearly balance sheet within 2 months from theclose of the half year.

Reserve Bank of India has also prescribed penalties for non-submission of the abovestatements within the prescribed period as follows:

1) banks are permitted to invariably charge penal interest of at least 1 percent perannum for a period of one quarter on the outstandings under various workingcapital limits sanctioned to a borrower.

2) If the default is of a serious nature or persists for two consecutive quarters,banks may consider charging a rate of interest higher than the normal lendingrate determined for a borrower on his entire outstanding, under the workingcapital limits sanctioned, until such time as the position relating to timelysubmission of various statements is regularised.

3) In case of continuous/persisting defaults, banks may further consider freezingthe operations in the account after giving due notice to the borrower.

4) Sick units which remain closed, and borrowers affected by political disturbances,riots, natural calamities are excluded from the requirements of submission ofstatements.

Commitment Charge

Banks are permitted to levy a minimum commitment charge of 1 percent per annumon the unutilised portion of the working capital limits, subject to tolerance level of 15percent of such limits. This is applicable incase of borrowing units with aggregatefund-based working capital credit limits of Rs. 1 crore and above from the bankingsystem. The commitment charge will be exclusive of overall ceiling of 2 percent ofpenal additional interest, as stipulated by the Reserve Bank of India.

The commitment charge will not apply to-

a) Drawing in excess of the operating limit

b) Working Capital limits sanctioned to sick/weak units

c) Limits sanctioned for export credit as well as against export incentives

d) Inland Bill limit

e) Credit limit granted to commercial banks, financial institutions and cooperativebanks.

Ad-hoc Credit Limits

Since 1993 banks are permitted to decide the quantum as also period of any ad-hoccredit facilities based on their commercial judgement and merits of individual cases.Banks will also have the discretion to decide about charging of interest forsanctioning ad-hoc credit limits.

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Activity 10.1

1. As per Tandon Committee, the norms for stocks and receivables have beenas:

a) Raw material as so many months’ - - - - - - - - - -

b) Stock in process as so many months’ - - - - - - - - - -

c) Finished goods as so many months’ - - - - - - - - - -

d) Receivables as so many months’ - - - - - - - - - -

2. Under the First Method of Lending the MPBF is equal to……….percent of…….whereas under the Second Method it is …………of…………….

3. Give details of the two Quarterly Statements required to be submitted underMPBF Method?

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

4) Work out the MPBF under three methods taking a live example.

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

10.4 THE TURNOVER METHOD

The Turnover Method of assessing working capital needs was introduced by ReserveBank of India in 1991 in case of village and tiny industries and other small scaleindustries having aggregate fund-based working capital credit limits up to Rs. 50 lakhfrom the banking system. In 1993 it was extended to non-small scale industriesborrowers also, having aggregate credit limit upto Rs. 1 crore. Later, banks wereadvised to follow this method for small borrowers with credit limit up to Rs. 4 crore incase of small industries and up to Rs. 2 corer in case of other borrowers. In thebudget of 1999-2000 this limit has been raised to Rs. 5 crore in case of small scaleindustries.

The turnover method ensures adequate and timely flow of credit to the borrowers.Under this method, norms of inventory and receivables and the first method oflending are not applicable to the borrower. On the other hand, credit needs of theborrower are assessed on the basis of their projected annual turnover(PAR), whichmeans projected gross scales inclusive of the excise duty. The following are thesteps to be followed under this method:

1) First, the projected sales of the borrower for the whole year are assessed. Theprojection should be justified, reasonable, achievable and falling in line with thepast trend in the industry concerned. It can be ascertained by scrutinizingannual statement of accounts, various returns filed, orders on hand and theinstalled capacity of the unit, etc.

2) Banks should work out working capital requirements at a minimum level of25% of the accepted turnover, assuming an average production/processing cycleof 3 months.

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3) Borrower should contribute 5% of the turnover as his margin or as Net WorkingCapital

4) The remaining 20% of the turnover should be considered as the workingcapital credit limits by the bank. If the borrower is having margin, greater than5% of the turnover, the same is to be considered for arriving at the credit limits,which can be scaled down below 20% of the turnover. Hence the word‘minimum’ is intended for the working capital gap and not for the limits to besanctioned. The facilities intended under this method should be need-based andnot based on eligibility. Assessment under this method is done as shown in thetable below:

ASSESSMENT OF WORKING CAPITAL BY TURNOVER METHOD

Rs.

a) Total projected sales ——

b) 25% of projected sales (i.e of a) ——

c) Margin at 5% of turnover ——

d) Limit 20% of ‘a’ a ——

e) Margin available in System (NWC) ——

f) Higher of ‘c’ or e (margin) ——

g) Credit Limit Permissible (b-f) ——-

Evaluation: The Turnover Method is a simple method of assessing the workingcapital requirements. But the assessment does not take into account the funds flowof the borrower with the result that the working capital limits may remainunderutilized in case of borrower with regular and sufficient cash flows. Funds maybe diverted to some other uses if not required in the business.

10.5 THE CASH BUDGET METHOD

As already noted, the Reserve Bank of India has permitted the banks to choose CashBudget Method, as one of the alternatives to MPBF method, in case of largeborrowers. This method endeavors to assess the credit requirements of a borroweron the basis of his projected cash inflows and outflows during a specific period oftime.

One of the important drawbacks of MPBF method is that the working capital limit islimited to the accepted level of current assets, and not much significance is attachedto the cash flows of the borrowers. Sometimes the receivables remain unrealizedfor longer period of time or inventories are accumulated for a longer period due topeculiar nature of demand. Thus the borrowers face the liquidity problem which isturn affects their production as need-based working capital limits taking into accounttheir cash flows, are not made available to them.

Under the Cash Budget Method, the entire funds requirements of a borrower aretaken into account. Payments which are not inevitable and which may be incurredupon the availability of funds are not included. For example, payment of dividends,unrelated investments, diversion for creation of fixed assets for forward/backwardintegration are excluded from the total outflows. The Cash budget method thus helpsin arriving at need-based working capital limits. Thus this method avoidsaccumulation of larger current assets than actual requirements, diversion of fundsbecause of availability of surplus funds and also prevents sickness of the businessunits due to inadequate working capital funds. As the current assets are taken asprime security for working capital limits, banks can restrict their exposure to theextent of availability of the security.

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The calculation of eligible bank finance under Cash Budget System is shown in thechart below:

On the basis of the Cash Projections, quarterly Working Capital limits may be fixed.For monitoring of the utilisation of credit limits, the bank may call for data periodicallyi.e monthly, quarterly or half yearly, in addition to the balance sheet. If in a quarterexcess finance has been availed of, explanation may be called from the borrowerand a penal interest may be charged on the excess amount for the entire previousquarter to enforce financial discipline.

CALCULATION OF ELIGIBLE BANK FINANCE UNDER CASHBUDGET METHOD

Quarterly Projections

I II III IV

1) Consumption of raw materials, consumable stores and spares,

2) Factory salaries and wages

3) Other manufacturing expenses (excluding Depreciation)

Sub total

Add opening stock —————-

Less closing stock —————-

_______Sub total–––––––

Add

1) Administrative and selling expenses Other overheads

2) Interest

3) Tax/Statutory dues payable

4) Repayment of Deposits/Debentures/Instalment of term loans.

5) Margin required for letters of credit/Bank guarantees

6) Others:

a) Advances for RM/Stores & spares etc.

b) Deposit with Govt. Departments

c) Loans to employees

d) Payment to Trade Creditors

e) L.C. Payment

f) Contingencies

7) Outstanding Receivables

Total Fund Required Grand Total (A)

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Sources of Funds

(Other than bank finance) Quarterly Projection

I II III IV

1) Cash sales

2) Realisation from Receivables(Previous Receivables plus credit sales)minus outstanding Receivables)

3) Unsecured/Corporate loans taken

4) Public Deposits

5) Credit Purchases of Raw materialsConsumable stores and spares

6) Advances received from customers

7) Deposit from Dealers/selling agents

8) Incentives

1) Sales Tax

2) Export

3) Subsidy

4) Other Deferred payments

9) Other Incomes

a) Interest, commission

b) Sale of Scrap Assets

Total Funds Available Grand Total (B)

c.) Working Capital Gap (A-B)

d.) Minimum Margin

(25% of Working Capital Gap)

e) Net Working Capital

(Long term sources less Long Term uses)

f) Maximum Eligible Bank Finance

(c-d) or (c-e) whichever is less

Activity 10.2

1. Under the Turnover Method of assessing Working Capital needs, the credit limitsare fixed at ..................... percent of....................

2. What types of payments are excluded from total Outflows under the CashBudget Method?

........................................................................................................................

........................................................................................................................

........................................................................................................................

........................................................................................................................

........................................................................................................................

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3. How is maximum eligible bank finance determined under the Cash BudgetMethod?

........................................................................................................................

........................................................................................................................

........................................................................................................................

........................................................................................................................

10.6 COMPULSORY LOAN COMPONENT IN BANKCREDIT

In April 1995, Reserve Bank of India introduced a reform of far reaching significancein the delivery system of bank credit. Reserve Bank introduced a compulsory loancomponent in the credit granted by banks to large borrowers and issued guidelines tothe banks in this regard . The salient features of these guidelines as amended uptodate are as follows:

1) Initially in April 1995, the loan component was made compulsory in case ofborrowers with maximum permissible bank finance of Rs. 20 crore and above.In April 1996 it was extended to all borrowers with MPBF of Rs. 10 crore andabove. Since October 1997 the loan component for all borrowers having MPBFof Rs. 10 crore and above has been uniformly prescribed at 80 percent ofMPBF. The cash credit portion has consequently been reduced to 20 percent. Itis mandatory for banks/ consortia/syndicate to restrict the cash credit componentas specified above.

2) For borrowers with working capital credit limits of less than Rs. 10 crore, theReserve Bank of India has permitted the banks to settle with their customers thelevels of loan and cash credit components. Such borrowers may like to avail ofbank credit in the form of loans because of lower rate of interest applicable onloan component.

3) Reserve Bank has also permitted the banks to identify the business activitieswhich may be exempted from the loan system of delivery of bank credit on theground that such business activities are cyclical and seasonal in nature or haveinherent volatility and hence application of loan component may createdifficulties.

4) The minimum period of the loan for working capital purposes is to be fixed bybanks in consultation with the borrowers. Banks are also permitted to split theloan component according to the needs of the borrowers with different maturitiesfor each segments and allow roll over of loans.

5) banks are permitted to fix their prime lending rate and spread over the primelending rate separately for loan component and cash credit component.

6) Reserve Bank of India has permitted that a borrower can avail of the loancomponent for working capital purpose , at more than the specified level of80% of MPBF. In such cases the cash credit component shall stand reduced. Aborrower can also draw the loan component first.

7) An ad hoc limit may be sanctioned only after the borrower has fully utilised thecash credit and the loan components.

8) In case of consortium/syndicate, member banks should share the cash creditcomponent and the loan component on a pro rata basis depending upon theirindividual share in MPBF.

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9) Bill limit for inland bills should be carved out of the loan component.

10) The Reserve Bank has allowed the banks to permit the borrowers to invest theirshort term/temporary surplus in short term money market instruments likecommercial paper, certificate of deposits and in term deposits with banks.

11) Export credit limit (both post-shipment and pre-shipment) are to be excludedfrom MPBF for the purpose of bifurcation of credit limits into loan and cashcredit components.

12) The loan component would be applicable to borrowal accounts classified asstandard and sub-standard.

The basic objective behind the bifurcation of credit limits into loan component andCash Credit component is to bring about discipline in the utilisation of bank creditand to gain better control over the flow of credit. As you already know, there is nofinancial discipline on the borrower in case of cash credit system —he may borrowany amount within the operating limit at any time and may repay the same as per hischoice and convenience. The banker, therefore, remains unable to plan theutilisation of his resources in advance and his earnings are affected, as he earnsinterest on the actual amount utilised by the borrower. By introducing a compulsoryloan component which now accounts for the major part of bank credit, banks canensure that their resources are utilised for the full period of the loan and thus theirearnings are enhanced. Such a system will also compel the borrowers to resort toplanning in utilizing the funds.

10.7 INTEREST RATES ON BANK ADVANCES

Interest rates charged by banks on their advances were, to a great extent regulatedby the Reserve Bank of India for over two decades (1971-1991). The NarasimhamCommittee 1991 recommended deregulation of interest rates on advances in a phasedmanner. Accepting its recommendation, Reserve Bank of India abolished theminimum lending rate on advances of Rs. 2 lakh in October 1994 and asked thebanks to fix their own prime lending rate which will be their minimum lending rate.Concessional interest rate of 12% was prescribed for advances upto Rs. 25,000 anda higher rate of 13.5% was prescribed for advances over Rs. 25,000 and upto Rs. 2lakh. In October 1996, Reserve Bank of India asked the banks to announce themaximum spread over the Prime Lending rate for all advances other than theconsumer credit. Banks have also been permitted to prescribe different PrimeLending Rates for the loan component and the cash credit component in order toencourage the borrowers to prefer the loan component because of lower spread.

Banks were allowed to fix their Prime Lending Rates and spread after taking intoconsideration their cost of funds, transaction cost and minimum spread.

In April 1998, Reserve Bank further extended the process of deregulation bypermitting the banks to charge interest on advances below Rs. 2 lakh at a rate notexceeding their Prime Lending Rate, which is available to the best borrowers of thebank concerned.

The lending rates of banks are at present completely deregulated. Banks prescribetheir own Prime Lending Rate for their best borrowers and a spread thereon. ThePrime Lending Rate happens to be the maximum rate for borrowers up to Rs. 2 lakheach, whereas it is the minimum rate for all other borrowers. Since October 1997banks have been permitted by the Reserve Bank of India to prescribe their PrimeLending Rate for term loans of 3 years and above. In April 1999 banks have beengranted further freedom to operate different Prime Lending Rates for differentmaturities. Banks are also permitted to offer fixed rate loans for project finance.

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Though the Reserve bank has granted freedom to the commercial banks to prescribetheir own Prime Leading Rates, the changes in the Bank Rate announced by theReserve Bank of India from time to time do exert their influence on the bank’sdecisions on their Prime Lending Rates. For instance, the reduction of Bank Rate byReserve Bank of India by one percentage point from 9% to 8% effective March 1,1999 was immediately followed by similar reduction in the Prime Lending Rate ofState bank of India and all other commercial banks. The Reserve Bank of India hasthus made the bank rate a reference rate for other interest rates.

10.8 TAX ON BANK INTEREST

The Government of India re-introduced interest tax on income from interest accuringto the financial institutions with effect from October 1, 1991 and has withdrawn it inthe budget for 2000-2001. Interest Tax was payable on gross interest income ofbanks and credit institutions like cooperative societies engaged in the business ofbanking (excluding cooperative societies providing credit facilities to farmers andvillage artisans), public financial institutions, state financial corporations and financecompanies.

Interest Tax was charged @ 2% on the gross amount of interest earned by banks,including the commitment charges and discount on promissory notes and bills ofexchange. Interest earned on Cash Reserves maintained with Reserve Bank ofIndia, discount on Treasury bills and interest on loans to other credit institutions wasnot included in the income from interest for this purpose. Banks were permitted tore-imburse themselves by making necessary adjustments in the interest charges.Hence the real burden of this tax was borne by the borrowers themselves as creditbecame costlier to them by the amount of interest tax.

10.9 PRUDENTIAL NORMS FOR EXPOSURE LIMITS

Credit requirements of large business houses are invariably large. Banks follow thepolicy of diversifying their risks by spreading their lending over different borrowerswho are engaged in different types of trades and industries, in order to minimise theirrisks. They do not commit large resources to a single borrower or a group ofborrowers for better risk management. Reserve Bank of India has laid downprudential norms for banks, for exposure to a single borrower or group of borrowersas follows:

1) The overall exposure to a single borrower shall not exceed 20% of the networth of the bank. The exposure ceiling has been reduced from 25% to 20%effective April 1,2000. In case it exceeds 20% of capital funds as onOctober 31, 1999, banks are expected to reduce it to 20% by end of October2001, and

2) The overall exposure to a group of borrowers shall not exceed 50% of the networth of the bank.

For determining exposure to a single borrower/ group, credit facilities will include thefollowing:

a) Advances by way of loans, cash credit, overdrafts

b) Bill purchased/discounted

c) Investment in debentures,

d) Guarantees, letters of credit, co-acceptances, underwriting etc.

e) Investment in Commercial Paper

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The non-fund based facilities shall be counted @ 50% of sanctioned limit and addedto total fund based limits.

While the Reserve Bank of India has granted flexibility to the banks to assess thecredit requirements of the borrowers as already noted, the above prudential normsare to be invariably complied by the banks.

10.10 CONSORTIUM ADVANCES

Credit needs of large borrowers may be met by banks in any of the following ways:

a) By sole bank

b) By multiple banks

c) On consortium basis

d) On syndication basis

Sole banking i.e lending by a single bank to a large borrower, subject to theresources available with it and limited to the exposure limits imposed by theReserve Bank of India. When the credit requirements of a borrower are beyond thecapacity of a single bank, the borrower may resort to multiple banking i.e borrowingfrom a number of banks simultaneously and independent of each other, underseparate loan agreements with each of them. Securities are charged to themseparately.

Consortium lending, also called joint financing or participation financing, is alsoundertaken by a number of banks but against a common security which remainscharged to all the banks for the total advance. Usually, in case of consortium lendingone of the banks acts as a consortium leader and takes a leading part in theprocessing of the loan proposal, its documentation, recovery etc. The participatingbanks enter into an agreement setting out the terms and conditions of suchparticipation arrangement.

Reserve Bank Directives

Consortium lending by banks in India commenced in 1974 when Reserve Bank ofIndia issued guidelines to the banks in this regard. In 1978 formation of consortiumwas made obligatory where the aggregate credit limits sanctioned to a singleborrower amounted to Rs. 5 crore or more. In October 1993, this threshold limit forformation of consortium was raised to Rs. 50 crore and the guidelines were alsosuitably revised.

Following the policy of liberalisation and deregulation in the financial sector, theReserve Bank of India decided in October 1996, that whenever a consortium isformed either on a voluntary basis or on obligatory basis, the ground rules of theconsortium arrangement would be framed by the participating banks in theconsortium. These rules may relate to the following:

i) Number of participating banks

ii) Minimum share of each bank

iii) Entry into/exit from a consortium

iv) Sanction of additional/ad hoc limit in emergency situation/contingencies by leadbank/other banks

v) The fee to be charged by the lead bank for the services rendered by it

vi) Grant of any facility to the borrower by a non-member bank

vii) Deciding time frame for sanctions/ renewals.

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In April 1997, Reserve Bank of India withdrew the mandatory requirements onformation of consortium for working capital requirements under multiple bankingarrangement. Reserve bank has advised the banks to evolve an appropriatemechanism for adoption of a sole bank/multiple bank/consortium or syndicationapproach by framing necessary ground rules on operational basis. While the aforesaidflexibility has been granted to the banks, they are required not to exceed the singleborrower/group exposure limits laid down by the Reserve Bank. Banks have beenadvised to ensure to have an effective system for appraisal, flow of information onthe borrower among the participating banks, commonality in approach and sharing oflending resources, under the single window concept. Banks have also been permittedto adopt the syndication route, if the arrangement suits the borrower and the financingbanks.

10.11 SYNDICATION OF CREDIT

As you have noted in the previous section, Reserve Bank of India has permitted thebanks to adopt syndication route to provide credit in lieu of consortium advance. Asyndicated credit differs from consortium advance in certain aspects. The salientfeatures of a syndicated credit are as follows:

1) It is an agreement between two or more banks to provide a borrower a creditfacility using common loan documentation.

2) The prospective borrower gives a mandate to a bank, commonly referred to a‘Lead Manager, to arrange credit on his behalf. The mandate gives thecommercial terms of the credit and the prerogatives of the mandated bank inresolving contentious issues in the course of the transaction.

3) The mandated bank prepares an Information Memorandum about the borrowerin consultation with the latter and distributes the same amongst the prospectivelenders, inviting them to participate in the credit.

4) On the basis of the Information Memorandum each bank makes its ownindependent economic and financial evaluation of the borrower. It may collectadditional information from other sources also.

5) Thereafter, a meeting of the participating banks is convened by the mandatedbank to discuss the syndication strategy relating to coordination, communicationand control within the syndication process and to finalise the deal timings,charges for management, cost of credit, share of each participating bank in thecredit etc.

6) A loan agreement is signed by all the participating banks

7) The borrower is required to give prior notice to the Lead Manager or his agentfor drawing the loan amount so that the latter may tie up disbursement with theother lending banks.

8) Under the system, the borrower has the freedom in terms of competitive pricing.Discipline is also imposed through a fixed repayment period under syndicatedcredit.

Activity 10.3

1) Fill in the blanks:

a) Loan Component has now been made compulsory for Credit limits of Rs....................... crore and above.

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b) Prime lending rate is the............................. rate for borrower uptoRs......................

c) Interest tax was not charged on income from interest earned by bankson.............................

2) State whether it is true or false:

a) Formation of Consortium of banks for working capital requirement is nowmandatory?

b) Investment in Commercial paper is excluded for the purpose of exposurelimits.

c) Under the Syndication of Credit the borrower gives mandate to a bank toarrange credit on his behalf.

10.12 SUMMARY

In this unit we have dealt with the methods followed by banks for assessing the creditneeds of their borrowers for Working Capital. We have explained in detail the up-dated version of the Maximum Permissible Bank Finance System (MPBF System)as it prevailed as a mandatory prescription for banks till 1997. Since then they arepermitted to follow the alternative methods also. The Turnover Method and theCash Budget Method, as suggested by the Reserve Bank have been explained.

This unit also deals with the measures introduced by Reserve Bank of India todiscipline the big borrowers and to reduce the risks of the lending bankers.Compulsory bifurcation of credit limits into loans and Cash Credit and introduction ofPrudential Norms for Exposure limits have been duly explained. Banks have alsobeen granted flexibility in forming consortium and syndicate to finance the creditneeds of big borrowers. The unit explains in detail these new dimensions in grantingbank credit.

10.13 KEY WORDS

Maximum Permissible Bank Finance System: This system of assessing theworking capital needs was introduced by Reserve Bank of India in 1975. In thismethod the norms for holding the main types of current assets for differentindustries have been laid down. On the basis of such norms, the working capitalgap is estimated. A portion of this gap is required to be met by owned funds andlong term sources and the rest may be provided by banks. This forms the maximumlimit on bank finance permissible.

Turnover Method: This method of assessing the working capital needs has beenintroduced for small borrowers upto Rs. 5 crore. Under this method, the projectedannual turnover inclusive of the excise duty are assessed. Working Capitalrequirements are worked out at a minimum level of 25% of the accepted turnover.Banks, are permitted to provide 20% of turnover as working capital limits.

Cash Budget Method: This method of assessing working capital needs has beensuggested for those large borrowers who prepare Cash Budget. Under this method,the credit requirements of a borrower are assessed on the basis of his projected cashinflows and outflows during a specific period of time.

Prudential Norms for Exposure Limits: In case of large borrowers, creditrequirements are also large and lending large funds is not without risks. Hence toensure that banks do not commit large resources to a single borrower or a group ofborrowers. Reserve Bank of India has prescribed the limits upto which they maylend to them. These exposure limits are linked to the net worth of the bankconcerned.

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Consortium Advances:When the credit needs of a large borrower are met by anumber of banks together, it is called consortium lending. Under it, a commonsecurity remains charged to all the banks for the total advance. One of the banksacts as consortium leader and takes a leading part in the processing of the loanproposal, its documentation, recovery etc. Participating banks enter into anagreement amongst themselves.

Syndication of Loans: It is also a method of financing large borrowers. Under itthe borrower gives a mandate to a bank to arrange credit on his behalf. Themandated bank distributes an Information Memorandum about the borrower amongstprospective lenders, inviting them to participate. A loan agreement is signed by allthe participating banks. The borrower gives notice to lead Manager for drawing theamount so that the latter may tie up disbursement with other lending banks.

Commitment Charge: It is a charge at a nominal rate, say ½% or 1%, which thebanks impose on the unutilized portion of Cash Credit Limit.

10.14 SELF ASSESSMENT QUESTIONS

1. Why has the Reserve Bank of India made it compulsory for the banks tointroduce loan component in the credit granted to big borrowers?

2. What do you understand by Prime Lending Rate ? How is it determined? Arebanks free to determine more than one Prime Lending Rate? How is the spreadover Prime Lending Rate determined?

3. What do you understand by Prudential Norms for Exposure Limits? Why havethey been prescribed by Reserve Bank of India?

4. What do you understand by Consortium Lending? How does it differ fromsyndication of loans?

5. Explain how can the permissible bank finance be assessed under the SecondMethod of Lending. How does it differ from the First Method of Lending?

6. What do you understand by operating limits? How is it determined?

7. Explain how the credit needs of a borrower are assessed under the TurnoverMethod?

8. What are the advantages of Cash Budget Method of assessing working capitalneeds.


1) V.K. Bhalla, 2003, Working Capital Management Anmol Publications Pvt. Ltd.,New Delhi.

2) P.N. Varshney, 1999, “Banking Law &Practice “, Sultan Chand & Sons, NewDelhi.

3) Hrishikes Bhattacharya, 1998, “Banking Strategy, Credit Appraisal andLending Decisions” Oxford University Press.

4) Reserve Bank of India - Report of the Working Group to Review the Systemof Cash Credit. (Chairman: K.B. Chore) 1979.

5) Reserve Bank of India, - Report of the Study group to frame Guidelines forFollow-up of Bank credit (Chairman: Prakash Tandon), 1975

6) “How to Borrow from Financial and Banking Institutions” A NabhiPublication.

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Financing WorkingCapital Needs UNIT 11 OTHER SOURCES OF SHORT

TERM FINANCE

Objectives

The objectives of this Unit are:

· To discuss the sources of short term finance, other than bank credit and tradecredit, to meet the working capital needs, and

· To highlight the framework of rules and regulations prescribed by the authoritiesregarding these non-bank sources of finance.

Structure

11.1 Introduction

11.2 Public Deposits

11.3 Commercial Paper

11.4 Inter-Corporate Loans

11.5 Bonds and Debentures

11.6 Factoring of Receivables

11.7 Summary

11.8 Key Words

11.9 Self Assessment Questions


11.1 INTRODUCTION

Trade credit and commercial bank credit have been two important sources offunds for financing working capital needs of companies in India, apart from the longterm source like equity shares. However, more stringent credit policies followed bybanks, tightening financial discipline imposed by them, and their higher cost, led thecompanies to go in for new and innovative sources of finance. As the new equitiesmarket has remained in a subdued condition and investor interest in the equities hasalmost vanished during recent years, corporates have raised larger resourcesthrough debt instruments, some of them being for as short a period as 18 months.The situation has turned bouyant for corporates during 2002 and after for any type offinance.

Raising short term and medium term debt by inviting and accepting deposits from theinvesting public has become an established practice with a large number ofcompanies both in the private and public sectors. This is the outcome of the processof dis-intermediation that is taking place in Indian economy. Similarly, issuance ofCommercial Paper by high net-worth Corporates enables them to raise short-termfunds directly from the investors at cheaper rates as compared to bank credit. Inpractice, however, commercial banks have been the major investors in CommercialPaper in India, implying thereby that bank credit flows to the corporate sectorthrough the route of CPs. Inter-Corporate loans and investments enable the cashrich corporations to lend their surplus resources to those who need them for theirworking capital purpose. Factoring of receivables is a relatively recent innovationwhich enables the corporates to convert their receivables into liquidity within ashort period of time. In this unit we shall discuss the salient features of varioussources of non-bank finance and the regulatory framework evolved in respect ofthem.

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11.2 PUBLIC DEPOSITS

Public deposits are unsecured deposits accepted by companies for specific periodsand at specific rates of interest. These deposits have acquired prominence as asource of finance for the companies, as it is more convenient and cheaper to mobiliseshort term finance through such deposits. Public deposits provide a fine example ofdis-intermediation, as the borrower directly accepts the deposits from the lenders, ofcourse with the help of brokers.

In India, acceptance of deposits from the public is regulated by sections 58A and58B of the Companies Act 1956, and the Companies (Acceptance of Deposits)Rules, 1975. The above sections were inserted in the Companies Act in 1974 withthe objective to safeguard the interests of the depositors. The regulatory frameworkin this regard is contained in the Companies Act and the Rules. Their importantprovisions are stated below:

Sections 58A (1) empowers the Central Government, in consultation with theReserve Bank of India , to prescribe the limits up to which, the manner in which andthe conditions subject to which deposits may be invited or accepted by a companyeither from the public or from its members. Such deposits are to be invited inaccordance with the rules made under this section and after insertion of anadvertisement issued by the company.

Section 58 (2) (c) which was inserted with effect from March 1, 1997 prohibits acompany which is in default in the repayment of any deposit or part thereof or anyinterest thereupon, from accepting any further deposit.

Categories of Deposits and Statutory limits

Rule 3 lays down that the period for which such deposits may be accepted by acompany should not be less than 3 months and not more than 36 months from thedate of acceptance or renewal of deposit. Companies are not permitted to acceptdeposits repayable on demand or on notice. Deposits accepted by companies aredivided into the following two categories and separate limits have been prescribed foreach of them:

i) Deposits received from specified sources:

Deposits against unsecured debentures

Deposits from shareholders

Deposits guaranteed by directors

The maximum limit upto which such deposits are allowed is 10% of the aggregatepaid up share capital and free reserves.

ii) Deposit received from the general public:

This category of deposits may be accepted to the extent of 25% of the aggregatepaid up capital and free reserves of the company.

For government companies, there is only one single limit of 35% of paid up capitaland free reserves for all such deposits.

Companies are, however, permitted to accept or renew deposit from depositorsfalling in category (i) above for periods below 6 months but not less than 3 monthsfor the purpose of meeting any short term requirements of funds provided suchdeposits do not exceed 10% of the aggregate of paid up share capital and freereserves of the company.

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Maintenance of Liquid Assets

Every company accepting public deposit is required to deposit or invest before 30th

April of each year, an amount which shall not be less than 15% of the amount of itsdeposits which will mature during the next financial year ending 31st March in anyone or more of the following:

a) in a current or other deposit account with any scheduled bank, free from chargeor lien,

b) in unencumbered securities of the central or state governments,

c) in unencumbered securities in which Trust funds may be invested under theIndian Trust Act, 1882; or

d) in unencumbered bonds issued by Housing Development Finance CorporationLtd.

The securities referred to in clauses (b) or (c) shall be reckoned at their marketvalue. The amount deposited or invested as aforesaid shall not be utilised for anyother purpose than the repayment of deposits maturing during the year.

Rates of Interest and Brokerage

The Rules prescribe the maximum rate of interest payable on such deposits. Atpresent companies are allowed to pay interest not exceeding 15% per annum atrates which shall not be shorter than monthly rests.

Companies are permitted to pay brokerage to any broker at the rate of 1% of thedeposits for a period of upto 1 year, 1½ % for a period more than 1 year but upto 2years and 2% for a period exceeding 2 years. Such payment shall be on one timebasis.

Advertisement

Every company intending to invite or accept deposits from the public must issue anadvertisement for that purpose in a leading English newspaper and in one vernacularnewspaper circulating in the state in which the registered office of the company issituated.

The advertisement must be issued on the authority and in the name of the Board ofDirectors of the company. The advertisement must contain the conditions subject towhich deposits shall be accepted by the company and the date on which the Boardof Directors has approved the text of the advertisement. In addition, theadvertisement must contain the following information, namely:

a) Name of the company,

b) The date of incorporation of the company,

c) The business carried on by the company and its subsidiaries with the details ofbranches of units, if any,

d) Brief particulars of the management of the company

e) Names, addresses and occupations of the directors,

f) Profits of the company, before and after making provision for tax, for the threefinancial years immediately preceding the date of advertisement,

g) Dividends declared by the company in respect of the said years.

h) A summarised financial position of the company as in the two audited balancesheets immediately preceding the date of advertisement in the prescribed form,

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i) The amount which the company can raise by way of deposits under these rulesand the aggregate of deposits actually held on the last day of the immediatelypreceding financial year.

j) A statement to the effect that on the day of the advertisement, the company hasno overdue deposits, other than the unclaimed deposits, or a statement showingthe amount of such overdue deposits, as the case may be, and

k) A declaration as prescribed under the Rules.

The advertisement shall be valid until the expiry of six months from the date ofclosure of the financial year in which it is issued or until the date on which thebalance sheet is laid before the company at its general meeting, or where AnnualGeneral Meeting for any year has not been held, the latest day on which that meetingshould have been held as per the Companies Act, whichever is earlier. A freshadvertisement is required to be made in each succeeding financial year.

Before issuing an advertisement, a copy of such advertisement shall have to bedelivered to the Registrar for registration. Such advertisement should be signed bythe majority of the Directors of the company or their duly authorised agents.

The above provision regarding mandatory publication of an advertisement isnecessary in case the company invites public deposits. But if the company intends toaccept deposits without inviting the same, it is not required to issue an advertisementbut a statement in lieu of such advertisement shall have to be delivered to theRegistrar for registration, before accepting deposits. The contents of the statementand its validity period shall be the same as in the case of an advertisement.

Procedure for Accepting Deposits

Every company intending to accept public deposits is required to supply to theinvestors forms, which shall be accompanied by a statement by the companycontaining all the particulars specified for advertisements. The application must alsocontain a declaration by the depositor stating that the amount is not being depositedout of the funds acquired by him by borrowing or accepting deposits from any otherperson.

On accepting a deposit or renewing an existing deposit, every company shall furnishto the depositor or his agent a receipt for the amount received by the company withina period of eight weeks from the date of receipt of money or realisation of cheques.The receipt must be signed by an officer of the company duly authorised by it. Thecompany shall not have the right to alter to the disadvantage of the depositor, theterms and conditions of the deposit after it is accepted.

Register of Deposits

Every company accepting deposits is required to keep as its registered office one ormore registers in which the following particulars about each depositor are to beentered:

a) Name and address of the depositors,

b) Date and amount of each deposit

c) Duration of the deposit and the date on which each deposit is repayable

d) Rate of interest

e) Date or dates on which payment of interest will be made.

f) Any other particulars relating to the deposit.

These registers shall be preserved by the company in good order for a period of not

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less than eight years from the end of the financial year in which the latest entry ismade in the Register.

Repayment of Deposits

Deposits are accepted by companies for specified period say 12 months, 18 months,24 months, etc. Companies prescribe different rates of interest for deposits fordifferent periods. Other terms and conditions are also prescribed by the companiesand interest is paid at the stipulated rate at the time of maturity of the deposit.

But, if a depositor desires repayment of the deposit, before the period stipulated in theReceipt, companies are permitted to do so, but interest is to be paid at a lower rate.Rules prescribe that if a company makes repayment of a deposit after the expiry of aperiod of six months from the date of such deposit, but before the expiry of the periodfor which such deposit was accepted by the company, the rate of interest payable bythe company shall be determined by reducing one percent from the rate which thecompany would have paid had the deposit been accepted for the period for which thedeposit had run.

The rules also provide that if a company permits a depositor to renew the deposit,before the expiry of the period for which such deposit was accepted by the company,for availing of benefit of higher rate of interest, the company shall pay interest tosuch depositor at higher rate, if

a) such deposit is renewed for a period longer than the unexpired period of thedeposit, and

b) the rate of interest as stipulated at the time of acceptance or renewal of adeposit is reduced by one percent for the expired period of the deposit and is paidor adjusted or recovered.

The Rules also stipulate that if the period for which the deposit had run contains anypart of a year, then if such part is less than six months, it shall be excluded and if partis six months or more, it shall be reckoned as one year.

Return of Deposits

Every company accepting deposits is required to file with the Registrar every yearbefore 30th June, a return in the prescribed form and giving information as on 31st

March of the year. It should be duly certified by the auditor of the company. A copyof the same shall also be filed with the Reserve Bank of India.

Penalties

Sub-section 9 and 10 of section 58 A, which were inserted with effect from 1st

September 1989, provide a machinery for repayment of deposits on maturity and alsoprescribes penalties for defaulting companies. According to sub-section (9), if acompany fails to repay any deposit or part thereof in accordance with the terms andconditions of such deposit, the Company Law Board may, if it is satisfied, direct thecompany to make repayment of such deposit forthwith or within such time or subjectto such conditions as may be specified in its order. The Company Law Board mayissue such order on its own or on the application of the depositor and shall give areasonable opportunity of being heard to the company and to other concernedpersons.

Sub-section 10 prescribes penalty for non-compliance with the above order of theBoard. Whoever fails to comply with its order shall be punishable with imprisonmentwhich may extend to 3 years and shall also be liable to a fine of not less than Rs. 50for every day during which such non-compliance continues.

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The above rule shall not apply to those categories of amounts which may be specifiedin consultation with Reserve Bank of India.

Section 58 A (6) stipulates penalties for accepting deposits in excess of the specifiedlimits. Where a company accepts deposits in excess of the limits prescribed or incontravention of the manner or condition prescribed, the company shall bepunishable:

a) Where such contravention relates to the acceptance of any deposit, with finewhich shall not be less than an amount equal to the amount of the depositaccepted,

b) Where such contravention relates to the invitation of any deposit, with fine whichmay extend to Rs. 1 lakh, but not less than Rs. 5000.

Every officer of the company who is in default shall be punishable with imprisonmentfor a term which may extend to 5 years and shall also be liable to fine.

Deduction of Tax At Source

According to section 194 A of the Income Tax Act, 1961, the companies acceptingpublic deposits are required to deduct income tax at source at the prescribed rates ifthe aggregate interest paid or credited during a financial year exceeds Rs. 5000.This limit has been recently (May 2000) raised from Rs. 2500 to Rs. 5000.

Public Deposits with Companies in India

Public Deposits constitute an important source of working capital for corporates inIndia. According to the data published by the Reserve Bank of India, the totalamount of Public deposits with the companies as at the end of March 1997 was Rs.357, 153 crores, out of which 62.7% was held by the Non-finance companies andthe rest by finance companies and other Non-banking Companies.

Companies attract deposits because of higher rates of interest vis-à-vis the banks.One year coupon rate of leading manufacturing companies at present ranges from11% to 15% . Moreover, most of the companies provide incentive ranging from 0.25to 1% to the depositors. For the guidance of the depositors the fixed deposits of thecompanies are rated also by the Credit Rating agencies and the credit ratings arepublished by the companies to solicit deposits. The rate of interest varies with thecredit rating assigned to it. Higher credit rating carries lower rate of interest andvice-versa.

Public deposits with the companies are unsecured deposits and do not carry the coverof deposit insurance while bank deposits are insured by Deposit Insurance and CreditGuarantee Corporation of India to the extent of Rs. 1 lakh in each account. Manycompanies default in the repayment of the deposits along with interest. In manycases, the District Consumers Disputes Redressal Fora have penalised thecompanies for not paying their depositors’ money. The Fora have held thecompanies guilty for deficiency of service and maintained that a depositor was aconsumer within the meaning of the Consumer Protection Act., 1986 Nevertheless,reputed companies do attract deposits from the public, because of their soundfinancial position and reputation.

Activity 11.1


a) A company which ………………………………………………….. isprohibited from accepting any further deposit.

b) The maximum period for which a company may accept deposit is………….months.

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c) The advertisement for deposit must give the profits of the company anddividends declared during…………………………………financial yearsimmediately preceding the date of advertisement.

2) Can a company repay a deposit before the period stipulated in the Receipt?Will the depositor suffer in such a case?

.................................................................................................................

.................................................................................................................

.................................................................................................................

.................................................................................................................

3) What penalty is imposed on the company if it accepts deposit in excess ofthe prescribed limits?

.................................................................................................................

.................................................................................................................

.................................................................................................................

.................................................................................................................

11.3 COMMERCIAL PAPER

Commercial paper (C.P) is another source of raising short term funds by highly ratedcorporate borrowers for working capital purposes. A commercial paper at the sametime provides an opportunity to cash rich investors to park their short term funds.The Reserve Bank of India permitted companies to issue Commercial paper in 1989and issued guidelines entitled “Non banking Companies (Acceptance of Depositsthrough Commercial Paper) Directions 1989,” to regulate the issuance of C.Ps. Theguidelines have been significantly relaxed and modified from time to time. The salientfeatures of these guidelines (as amended to date) are as follows:

Eligibility to Issue CPs

Companies (except the banking companies) which fulfil the following requirementsare permitted to issue CPs in the money market:

i) The minimum tangible net worth of the company is Rs. 4 crore as per the latestaudited balance sheet.

ii) The company has fund-based working capital limits of not less than Rs. 4 crore.

iii) The shares of the company are listed at one or more stock exchanges. Closelyheld companies whose shares are not listed on any stock exchange are alsopermitted to issue CPs provided all other conditions are fulfilled.

iv) The company has obtained minimum credit rating from a Credit rating agencyi.e. CP2 from Credit Rating Information Services of India Ltd., A2 fromInvestment Information & Credit Rating Agency or PR2 from Credit Analysisand Research.

Terms of Commercial Paper

The Commercial paper may be issued by the companies on the following terms andconditions:

a) The minimum period of maturity should be 15 days (It was reduced from 30 dayseffective May 25, 1998) and the maximum period less than one year.

b) The minimum amount for which a CP is to be issued to a single investor in theprimary market should be Rs. 25 lakh and thereafter in multiple of Rs. 5 lakh.

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c) CPs are to be issued in the form of usance promissory notes which are freelytransferable by endorsement and delivery.

d) CPs are to be issued at a discount to face value. The rate of discount is freelydetermined by the issuing company and the investors.

e) The issuing company shall bear the dealers fee, rating agencies fee, and othercharges. Stamp duty shall also be applicable on CPs.

f) CPs may be issued to any person, corporate body incorporated in India, or evenunincorporated bodies. CPs may be issued to Non-resident Indians only on non-repatriation basis and such CPs shall not be transferable.

g) The issue of CP will not be underwritten or co-accepted by any individual orinstitution.

h) There will be no grace period for payment. The holder of the CP shall presentthe instrument for payment to the issuing company.

Ceiling on the amount of issue of Commercial Paper

The amount for which the companies issue Commercial Paper is to be carved out ofthe fund based working capital limit enjoyed by the company with its banker. Themaximum amount that can be raised through issue of commercial paper is equal to100 percent of the fund based working capital limit. The latter is reduced pro-tantoon the issuance of CP by the company. Effective October 19, 1996 the amount ofCP is permitted to be adjusted out of the loans or cash credit or both as per thearrangement between the issuer of the CP and the concerned bank.

Standby facility withdrawn

As stated above, the amount of CP is carved out of the borrower’s working capitallimit. Till October 1994 commercial banks were permitted to provide standby facilityto the issuers of CPs. It ensured the borrowers to draw on their cash credit limit incase there was no roll-over of CP. Thus the repayment of the CP was ensuredautomatically.

In October 1994 Reserve bank of India prohibited the banks to grant such stand-by-facility. Accordingly, banks reduce the cash credit limit when CP is issued. Ifsubsequently, the issuer requires a higher cash credit limit, he shall have to approachthe bank for a fresh assessment of his requirement for the enhancement of creditlimit. Banks do not automatically restore the limit and consider the sanction of higherlimit afresh. In November 1997, Reserve Bank of India permitted the banks todecide the manner in which restoration of working capital limit is to be done onrepayment of the CP if the corporate requests for restoration of such limit.

Procedure for Issuing Commercial Paper

1) The company which intends to issue CP should submit an application in theprescribed form to its bankers or leader of the consortium of banks, togetherwith a certificate from an approved credit rating agency. The rating should notbe more than 2 months old.

2) The banker will scrutinize the proposal and if it finds the proposal satisfying alleligibility criteria and conditions, shall take the proposal on record.

3) Thereafter, the company will make arrangement for privately placing the issuewithin a period of 2 weeks.

4) Within 3 days of the completion of the issue, the company shall advice theReserve Bank through its bankers the amount actually raised through CP.

5) The investors shall pay the discounted value of the CP through a cheque to theaccount of the issuing company with the banker.

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6) Thereafter, the fund-based working capital limit of the company will be reducedcorrespondingly.

Commercial Paper in India

The Vagul Committee suggested the introduction of commercial paper in India toenable the high worth corporates to raise short term funds cheaper as compared tobank credit. On the other hand, the investors in CPs were expected to earn a betterreturn because of the absence of intermediaries between them and the borrowers.As the issuer bears the cost of issuing the CPs, his total cost is higher by 1% point orso over the discount rate on the CPs issued by him.

Commercial paper is being issued by corporates in India for about a decade now.During this period the quantum of outstanding CPs has gradually increased. Till May1997 the outstanding amount of CPs remained below the level of Rs. 1000 crore andthe rate of discount ranged above 11%. But since May 1997 the outstanding amounthas gradually increased and the discount rate remained much below 10%. Duringthe year 1998, Rs. 5249 crore were raised during the first fortnight of January 1998and again in the second fortnight of August 1998 when discount rate ranged between8.5 and 11%. Since May 1998, the level of outstanding CPs has gradually risen andhas touched the mark of Rs. 11153 crore in December 1998. Discount rate touchedthe low range of 8.5 to 9% during this period. By the end of July 31, 2003, theoutstanding CPs stood at Rs.7,557 crore and the typical effective rates of discountvaried between 4.99% to 8.25%. Thus the corporates find the CP route far cheaperthan normal bank credit.

Banks continue to be the major investors in CPs as they find CPs of top-ratedcompanies very attractive, because of the excess liquidity situation they are presentlyplaced in. As on February 28, 1999, the outstanding investment by scheduledcommercial banks in CP amounted to Rs. 5367 crore with an effective discount ratein the range of 10.2% to 13%. Outstanding investments in CPs steadily increased toRs. 7658 crore as on September 30.1999 due to easy liquidity.

The Reserve Bank of India has issued revised draft guidelines on July 6,2000 for theissuance of commercial paper. The important changes proposed were:

i) Corporates are permitted to issue CP upto 50% of their working capital (fund-based) under the automatic route, i.e. without prior clearance from the banks.

ii) CPs can be issued for wide range of maturities from 15 days to 1 year and canbe in denominations of Rs. 5 lakh or multiple there of.

iii) Financial Institutions may also issue CPs.

iv) Foreign instutional investors may invest in CPs. Within 30% limit set for theirinvestments in debt instruments

v) Credit rating again will decide the period of validity of the issue.

11.4 INTER-CORPORATE LOANS

Short term finance for working capital requirements of a company may be raisedthrough accepting inter-corporate loans or deposits. Some companies, which mayhave surplus idle cash due to seasonal nature of their operations or otherwise wouldlike to lend such resources for such period when they are not needed by them. Onthe other hand, some other companies face financial stringency and need cashresources to meet their immediate liquidity needs. The former lend their surplusresources to the latter through brokers, who charge for their services. Inter-corporate loans facilitate such lending and borrowings for short periods of time. Therate of interest and other terms and conditions of such loans are determined by

53

negotiations between the lending and borrowing companies. The prevailing marketconditions do exert their influence on the determination of interest rates.

Statutory Provisions Prior to January 1999

The Inter-corporate loans were, till recently, governed by the provisions of section370 of the Companies Act, 1956 and the Rules framed thereunder. This sectionprovided that no company shall (a) make any loan to or (b) give any guarantee orprovide any security in connection with a loan given to any body corporate unlesssuch loan or guarantee has been previously authorised by a special resolution of thelending company. But such special resolution was not required in case of loansmade to other bodies corporate not under the same management as the lendingcompany where the aggregate of such loans did not exceed thirty percent of theaggregate of the subscribed capital of the lending company and its free reserves.’

Further the aggregate of the loans made by the lending company to all other bodiescorporate shall not, except with the prior approval of the Central Government,exceed.

a) Thirty percent of the aggregate of the subscribed capital of the lending companyand its free reserves, where all such other bodies are not under the samemanagement as the lending company.

b) Thirty percent of the aggregate of the subscribed capital of the lending companyand its free reserves, where all such corporates are under the same managementas the lending company.

Section 372 of the Companies Act laid down the limits for investment by a companyin the shares of another body corporate. Rules framed thereunder laid down that theBoard of Directors of a company shall be entitled to invest in the shares of anyother body corporate upto thirty percent of the subscribed equity share capital or theaggregate of the paid up equity and preference share capital of such other bodycorporate whichever is less. Permission of the Central Government was alsorequired in case the investment made by the Board of Directors in all other bodiescorporate exceed thirty percent of the aggregate of the subscribed capital andreserves of the investing company.

Present Statutory Provisions

After the promulgation of Companies (Amendment) Ordinance 1999 in January 1999the provisions of sections 370 and 372 were made ineffective and instead a newsection 372A was inserted to govern both inter-corporate loans and investments.According to the new section 372 A, a company shall, directly or indirectly.

a) make any loan to any other body corporate,

b) give any guarantee, or provide security in connection with a loan made by anyother person to any body corporate, and

c) acquire, by way of subscription, purchase or otherwise, the securities of anyother body corporate upto 60% of its paid up capital and free reserves or 100%of the free reserves, whichever is more.

The loan, investment, guarantee or security can be given to any company irrespectiveof whether it is subsidiary company or otherwise. If the aggregate of all such loansand investments exceed the above limit the company would have to secure thepermission of shareholders through a special resolution which should specify theparticulars of the company in which investment is to be made or loan, security orguarantee is proposed to be given. It should also specify the purpose of theinvestment, loan, security or guarantee and the specific sources of funding. Theresolution should be passed at the meeting of the Board with the consent of all

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directors present at the meeting and the prior approval of the public financialinstitutions where any term loan is subsisting, is obtained. But no prior approval ofthe public financial institution is necessary , if there is no default in payment of loaninstalment or repayment of interest thereon as per the terms and conditions of theloan.

The above provisions of Section 372 A will not apply to any loan made by a Holdingcompany to its wholly owned subsidiary or any guarantee given by the former inrespect of loan made to the latter or acquisition of securities of the subsidiary by theholding company. Section 372 A Shall not apply to any loan, guarantee or investmentmade by a banking company, an insurance company or a housing finance company ora company whose principal business is the acquisition of shares, stocks, debenturesetc or which has the object of financing industrial enterprises or of providing infrastructural facilities.

The loan to any body corporate shall be made at a rate of interest not lower than theBank rate. A company which has defaulted in complying with the provisions of thesection 58A of the Companies Act, 1956 shall not be permitted to make inter-corporate loans and investment till such default continues.

Companies making inter- corporate loans/ investment are required to keep a Registershowing the prescribed details of such loans/investments/guarantees. Such Registershall be open for inspection and extracts may be taken therefrom. The provision ofthe new section are not applicable to loans made by banking, insurance/housingfinance/investment company and a private company, unless it is subsidiary of a publiccompany.

If a default is made in complying with the provisions of section 372A, the companyand every officer of the company who is in default shall be punishable withimprovement upto 2 years or with fine upto Rs. 50,000/-.

Activity 11.2


a) The minimum period of maturity of CP. should be ………………..days

b) The CP must have………………………. Rating from Credit RatingInformation Services Ltd.

c) The loans by a company to another company shall carry a rate of interestwhich is not less than .....................................

2) Explain what do you understand by Standby facility?

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3) Provision of Section 372 A are not applicable to certain companies. Specifythem.

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11.5 BONDS AND DEBENTURES

Bonds and debentures are another form of raising debt for augmenting funds for longterm purposes as well as for working capital. It has gained popularity during recentyears because of the depressed conditions in the new equities market and thepermission given to the banks to invest their funds in such bonds and debentures.These debentures may be fully convertible, partly convertible, or non-convertible intoequity shares.

The salient points of the Guidelines issued by Securities and Exchange Board ofIndia (SEBI) in this regard are as follows:

1) Issue of fully convertible debentures having a conversion period more than 36months will not be permissible unless conversion is made optional with “put” and“call” options.

2) Compulsory credit rating is required, if conversion of fully convertible debenturesis made after 18 months.

3) Premium amount on conversion, and time of conversion in stages, if any, shall bepredetermined and stated in the prospectus. The rate of interest shall be freelydetermined by the issuer.

4) Companies issuing debentures with maturity upto 18 months are not required toappoint Debentures Trustees or to create Debentures Redemption Reserves. Inother cases the names of debentures trustee must be stated in the prospectus.The trust deed must be executed within 6 months of the closure of the issue.

5) Any conversion in part or whole of the debentures will be optional at the handsof the debenture holders, if the conversion takes places at or after 18 monthsfrom the date of allotment but before 36 months.

6) In case of Non-Convertible Debentures and Partly convertible debentures, creditrating is compulsory if maturity exceeds 18 months.

7) Premium amount at the time of conversion of Partly convertible debentures shallbe pre-determined and stated in the Prospectus. It must also state theredemption amount, period of maturity, yield on redemption for Non-convertible/Partly Convertible Debentures.

8) The discount on the non-convertible portion of the Partly convertible debentures,in case they are traded and procedure for their purchase on spot trading basis,must be disclosed in the propectus.

9) In case, the non-convertible portions of partly Convertible Debentures or Non-Convertible Debentures are to be rolled over without change in the interest rate,a compulsory option should be given to those debenture holders who want towithdraw and encash their debentures. Positive consent of the debentureholders must be obtained for all-over.

10) Before the rollover, fresh credit rating shall be obtained within a period of sixmonths prior to the due date of redemption and must be communicated to thedebenture holders before the rollover. Fresh Trust Deed must be made in caseof rollover.

11) The letter of information regarding rollover shall be vetted by SEBI.

12) The disclosure relating to raising of debenture will contain amongst other things

a) The existing and future equity and long term debt ratio,

b) Servicing behaviour of existing debentures,

c) Payment of interest due on due dates on term loans and debentures

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d) Certificate from a financial institution or bankers about their no objection for asecond or pari passu charge being created in favour of the trustees to theproposed debenture issue.

13) Companies which issue debt instruments through an offer document can issuethe same without submitting the prospectus or letter of offer for vetting to SEBIor obtaining an acknowledgement card from SEBI in respect of the said issue,provided the:

a) Company’s securities are already listed on any stock exchange

b) Company has obtained atleast an ‘adequately safe’ credit rating for itsissue of debt instrument from a credit rating agency.

c) The debt instrument is not convertible, is not issued along with any othersecurity or, without any warrant with an option to convert into equityshares.

14) In such cases a category I Merchant bank shall be appointed to manage theissue and to submit the offer document to SEBI. The Merchant banker acting asLead Manager should ensure that the document for the issue of debt instrumentcontains the required disclosure and gives a true, correct and fair view of thestate of affairs of the company. The merchant banker will also submit a duediligence certificate to SEBI.

15) The debentures of a company can be listed at a Stock Exchange, even if itsequity shares are not listed.

16) The trustees to the Debenture issue shall have the power to protect the interestof debenture holders. They can appoint a nominee director on the Board of thecompany in consultation with institutional debenture holders.

17) The lead bank will monitor the utilisation of funds raised through debentures forworking capital purposes. In case the debentures are issued for capitalinvestment purpose, this task of monitoring will be performed by lead Institution/Investment Institution.

18) In case of debentures for working capital, institutional debenture holders andtrustees should obtain a certificate from the company’s auditors regardingutilisation of funds at the end of each accounting year.

19) Company should not issue debentures for acquisition of shares or for providingloans to any company belonging to the same group. This restriction does notapply to the issue of fully convertible debentures provided conversion is allowedwithin a period of 18 months.

20) Companies are required to file with SEBI certificate from their bankers that theassets on which security is to be created are free from any encumbrances andnecessary permission to mortgage the assets have been obtained or a Noobjection from the financial institutions/ banks for a second or pari passu chargehas been obtained, where the assets are encumbered.

11.6 FACTORING OF RECEIVABLES

Factoring of receivables is another source of raising working capital by a businessentity. Factoring is an agreement under which the receivables arising out of the saleof goods/services are sold by a firm(called the client) to the factor (a financialintermediary). The factor thereafter becomes responsible for the collection of thereceivables. In case of credit sale, the purchaser promises to pay the sale proceedsafter a period of time. The seller has to wait for that period for realising his claimsfrom the buyer. His cash cycle is thus prolonged and he needs larger workingcapital. Factoring of receivables is a device to sell the receivables to a factor, whopays the whole or a major part of dues from the buyer immediately to the seller,

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thereby reducing his cash cycle and the requirements of working capital. The factorrealises the amount from the buyers on the due date.

Factoring is of recent origin in India. Government of India notified factoring as apermissible activity for the banks in July 1990. They have been permitted to set upseparate subsidiaries for this purpose or invest in the factoring companies jointly withother banks. Two factoring companies have been set up by banks jointly with SmallIndustries Development Bank of India. SBI Factors and Commercial Services Ltd.has been promoted by State Bank of India, Union, Bank of India and the SmallIndustries Development Bank of India. Canbank Factors Ltd. is another factoringcompany promoted jointly by Canara Bank, Andhra Bank and SIDBI. TheForemost Factors Ltd. is the first private sector company which has commenced itsoperations in 1997.

With Recourse and Without Recourse Factoring

Factoring business may be undertaken on ‘with recourse’ or ‘without recourse’basis. Under with recourse factoring, the factor has recourse to the client if thereceivable purchased turn out to be irrecoverable. In other words, the credit risk isborne by the client and not the factor. The factor is entitled to recover the amountfrom the client the amount paid in advance, interest for the period and any otherexpenses incurred by him.

In case of, without recourse factoring, the factor does not possess the above right ofrecourse. He has to bear the loss arising out of non-payment of dues by the buyer.The factor, therefore, charges higher commission for bearing this credit risk.

Mechanism of Factoring

1) An agreement is entered into between the seller and the factor for renderingfactoring services.

2) After selling the goods to the buyer, the seller sends copy of invoice, deliverychallen, instructions to make payment to the factor, to the buyer and also to thefactor.

3) The factor makes payment of 80% or more of the amount of receivable to theseller.

4) The seller should also execute a deed of assignment in favour of the factor toenable him to recover amount from the buyer.

5) The seller should also obtain a letter of waiver from the banker in favour of thefactor, if the bank has charge over the asset sold to the buyer.

6) The seller should give a letter of confirmation that all conditions of the saletransactions have been completed.

7) The seller should also confirm in writing that all payments receivable from thedebtor are free from any encumbrances, charge, right of set off or counter claimfrom another person, etc.

8) The facility of factoring in India is available to all forms of business organisationsin manufacturing, service and trading. Sole proprietary concerns, partnershipfirms and companies can avail of the services of factors, but a ceiling on thecredit which they can avail of in terms of the value of the invoice to bepurchased is generally fixed for each client in medium and small scale sectors.Generally the period for which receivables are factored ranges between 30 and90 days.

9) The factor evaluates the client on the basis of various criteria e.g. level ofreceivables turnover, the quality of receivables, growth in sales, etc. The factorcharges a service fee and a discount. The service fee is charged in advance anddepends upon the invoice value for different categories of clients. It rangesbetween 0.5-.2% of the invoice value.

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Moreover, the factor also charges a discount on the pre-payment made to the client.It is payable in arrears and is generally linked to the bank lending rate. In case ofhigh worth clients, the discount rate is presently one percent point lower than the ratecharged under the cash credit system.

The cost of funds under, without recourse, factoring is much higher than, withrecourse, factoring due to the credit risk borne by the factor. However, the servicefee and discount charge depends upon the cost of funds and the operational cost.

Activity 11.3


a) Credit Rating is compulsory if the fully convertible debentures are convertibleafter................... months.

b) The names of Debenture Trustees must be disclosed in ..........................

c) In case of ‘with recourse factoring’, the loss arising out of non-payment ofthe dues by the buyer is borne by........................

2) State the conditions under which it is not necessary for a company to issue debtinstruments without submitting proposals or letter of offer to SEBI.

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3) Explain the mechanism of factoring of receivables.

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11.7 SUMMARY

In this unit, we have discussed various sources of short term funds, other than bankcredit and trade credit which are used by business and industrial houses in India tofinance their working capital needs. The unit covers public deposits, commercialpaper, inter-corporate loans, bonds and debentures and factoring of receivables. Thestatutory framework, along with rules and regulations concerning these sources havebeen explained in detail. Relative significance of these sources has also beenexplained by citing relevant facts and figures. Though these sources are deemed asnon-bank sources of finance, involvement of commercial banks in providing suchfinance is evident, specially in case of commercial paper, bonds and debentures andfactoring of receivables.

11.8 KEY WORDS

Public Deposits: Public deposits are deposits of money accepted by companies inIndia from the public for specified period ranging between 3 months and 36 months.These deposit are accepted within the limit and subject to terms prescribed underCompanies( Acceptance of Deposits) Rule , 1975.

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Commercial Paper: Commercial paper is an unsecured instrument through whichhigh net worth corporates borrow funds from any person, corporate orunincorporated body. It is issued in the form of usance promissory note; which isfreely transferable by endorsement and delivery. Its minimum period of maturityshould be 15 days and maximum period less then a year, It is issued at a discountto face value.

Inter-Corporate Loans : These are loans made by a company to another company,whether its own subsidiary or otherwise. These loans and investments in thesecurities of another company should be upto the limits specified in section 372 A ofthe Companies Act.

Convertible Bonds: These are bonds issued by the companies to the investors,which are convertible either fully or partly into the equity shares of the companywithin a specified period of time at the option of the investor.

Put and Call Options: The debt instruments like bonds and debentures are issuedfor a fixed period of time-i.e. they are redeemable at the expiry of a fixed periodsay 5 or 7 years. But sometimes the issuer includes the ‘put’ or/and ‘call’ optionsin the terms of issue. ‘Put’ option means that the investor may, if he so desires askfor the redemption of the bond after a specified period is over but before the periodof maturity. If the issuer reserves this right to himself to redeem the bond after aspecific minimum period but before the date of maturity, such right is called ‘call’option.

Credit Rating: Credit Rating is an opinion expressed by a Credit Rating Agencyabout the ability of the issuer of a debt instrument to make timely payment ofprincipal and interest thereon. It is expressed in alphabetical symbols. All types ofdebt instruments may be rated. Rating is given for each instrument and not for theissuer as such.

Factoring of Receivables: Factoring is an agreement under which the receivablesarising out of the sale of goods/services are sold by a firm (called the client) to thefactor (a financial intermediary), who becomes responsible for the collection of thereceivable on the due date.

With Recourse and without Recourse Factoring : When the factor bears theloss arising out of non-payment of the dues by the buyer, it is called without recoursefactoring. In case of ‘With Recourse Factoring’ he can recover the loss from theclient (seller).

11.9 SELF ASSESSMENT QUESTIONS

1) State the two broad categories of deposits which non-banking companies canaccept to meet their working capital needs.

2) State the existing guidelines regarding maintenance of liquid assets prescribed fora company accepting deposits from the public.

3) What remedy is available to the depositor, if the company fails to repay thedeposit as per the terms and conditions of the deposit?

4) Describe the eligibility conditions prescribed for issuing the Commercial Paper.

5) Describe five important terms and conditions for issuing Commercial Paper.

6) Why are banks major investors in Commercial Paper?

7) Explain the provisions of newly inserted section 372 A regarding inter-corporateloans and investments.

8) Describe the guidelines issued by SEBI for the conversion of debentures intoequity.

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9) What do you understand by factoring? Discuss With Recourse and WithoutRecourse factoring.

10) Write a short note on ‘company deposits’ as a source of working capital financefor industry in India.

11) As the ceiling on the issue of the Commercial Paper has been removed and thebanks are the major investors in CPs, do you think that CPs will replace bankcredit all together? Give reasons.


1) Reserve Bank of India: Report of the study group on Examining theIntroduction of factoring Services in India. ( chairman: E.S. Kalyanasundaram)

2) Reserve Bank of India: Repon of the working Group on Money Market.(Chairman: N. Vaghul).

3) Jain A. P.: Company Deposit: Law and Procedure. Chapters 1,2,3.

4) Taxman’s Companies Act with SEBI Rules/Regulations and Guidelines, 1998.

MS-41Working Capital

Management

Indira Gandhi National Open UniversitySchool of Management Studies

3FINANCING WORKING CAPITAL NEEDS

Financing Working Capital Needs

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