Annexure A

Credit appraisal for working capital finance

A PROJECT REPORT Under the guidance of Sri Debabrata Chakraborty, Manager Indian overseas Bank, Chowringhee Branch

Submitted by

Mitali Bagchi Roll No 520933922

A REPORT SUBMITTED IN PARTIAL FULFILLMENT FOR THE AWARD OF THE DEGREE OF MBA PROGRAMME IN FINANCE

November 2010

Annexure B

I hereby declare that the project report entitled Credit appraisal for

working capital finance is submitted in partial fulfillment of the

requirement for the degree of Master of Business Administration in Finance under Sikkim Manipal University, India, is my original work and not submitted for the award of any other degree, diploma, fellowship, or any other similar title or prizes.

Place: Kolkata Date:

(Mitali Bagchi) Roll No 520933922

Annexure C
A PROJECT REPORT ON

Credit appraisal for working capital finance

SUBMITTED BY MITALI BAGCHI ROLL NO 520933922

Is approved and is acceptable in quality and form.

Internal Examiner
(Name, Qualification and Designation)

External Examiners
(Name, Qualification)

Chapter No.

Particulars Acknowledgement Bonafide Certificate Executive Summary Methodology and sources of data

Page No 6. 7. 8. 9. 13-14 15-17. 18. 19. 20-28. 29. 30. 31. 32-38. 39. 40-43. 44. 45. 46. 47-49. 50. 51. 52-53. 54 55. 56. 57. 57-59. 60-61. 62 63 66-68 69 -93 94-95 Page no 96-98 99

1.
1.1 1.2 1.3 1.4

Introduction Banking Sector in India An Overview of Indian Overseas Bank Rationale for Study Objective

2. 3.

Banks Loans and Advances Working Capital Management 3.1 Introduction 3.2 Need of Working Capital Management 3.3 Gross Working Capital and Net Working Capital 3.4 Concepts 3.5 Types of Working Capital 3.6 Determinants of Working Capital 3.7 Working Capital Cycle 3.8 Working Capital financing 3.9 Working Capital Products 3.10 Various methods of Working Capital Assessment Credit Appraisal and Monitoring: Common Issues 4.1 What is Credit Appraisal 4.2 Data to be obtained for Credit Appraisal 4.3 Credit Monitoring: Common Issues 4.3.1 Additional requirements in case of Loan is granted to Company 4.3.2 Additional requirements in case of Loan is granted to Firm 4.4 Principles of Lending 4.5 Principles of BASEL II Accord 4.5.1 Basel II consists of three pillars 4.5.2 PD Dynamics 4.6 Financial Analysis of Lending 4.6.1 Steps involved in Financial Analysis of Lending 4.7 Clarification with regard to Classification of Working Capital limits Case Study Conclusion and Recommendation 6.1 Comments on financial performance of the company Particulars 6.2 Gist of Recommendations 4

4.

5. 6.

Chapter No. 6.

Appendices Bibliography

Acknowledgement
The project report submitted in partial fulfillment of MBA Programme in Finance is a golden opportunity for learning and self-development. I consider myself very lucky and honored to have many distinguished personalities to lead and guide me in completion of this project. 5

My grateful thanks to Mr. DEBABRATA CHAKRABARTY, CREDIT MANAGER, INDIAN OVERSEAS BANK, CHOWRINGHEE branch who in spite of being immensely busy with his duties, provided me the essential information and extended his best support providing me an insight into various issues pertaining to the case mentioned in the report. His sincere support and consistent guidance led to the completion of the project. My humble gratitude to Mr. K PARTHASARATHY, CHIEF MANAGER, INDIAN OVERSEAS BANK, CHOWRINGHEE branch for giving me ample scope to continue my project work inside the branch. Mr. PRABIR KUMAR ROY, CHIEF MANAGER, IOB, REGIONAL OFFICE, KOLKATA (1) arranged all the facilities to make the process very easier to me. I choose this moment to acknowledge his contribution gratefully. I am highly indebted to Prof. SUJIT DUTTA and Prof. RANJAN DAS GUPTA for their mentorship and valuable suggestions that gave an entirely new dimension to the project under consideration. Their guidance gave immense confidence and encouragement that helped me to put in my best. In this opportunity I would like to thank my brother who has helped and encouraged me to complete the Project work smoothly. Last but not the least I am very grateful to my parents, husband and son for providing me all sorts of cooperation, encouragement and inspiration.

Bonafide Certificate:

BONAFIDE CERTIFICATE
Certified that this project report titled Credit appraisal for Working Capital Finance is the bonafide work of Smt Mitali Bagchi Roll No 520933922, a student of MBA Finance of Sikkim Manipal University who carried out the project work under my supervision during the period 21/06/2010 to 20/08/2010. I wish her all round success in her professional career.

(P K Roy)
Chief Manager Indian Overseas Bank Regional Office Kolkata I

(Debabrata Chakraborty)
Manager Indian Overseas Bank Chowringhee Branch

EXECUTIVE SUMMARY
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Almost all of the industrial enterprises whether they are into manufacturing trading or service sector need bank finance in order to run the businesses. So everyone approaches the bank at the same point of time for business loan whether it is for running day to day business or for setting up a new project. A banker approaches the proposal and then decides whether to lend the money or not. This report gives a clear understanding with what goes behind the credit appraisal of the proposal. Chennai based Indian Overseas Bank is one of the nationalized banks in India, that has a substantive history since 1937. The bank not only deals in retail banking providing utility services to its customers but has also expanded its area of operation in multidimensional services like merchant banking, agribusiness consultancy and e-banking. It recently registered a core profit of Rs.1325 crores in the financial year March08-March09. The report deals with the lending procedures followed by Indian Overseas Bank. It explains different types of loans and advances offered by banks. It gives an insight of the steps involved in lending process. Working capital financing is discussed in the report. Calculation of maximum permissible bank finance is shown with example. Common issues related to credit appraisal is discussed in detail. This report also deals with principles of lending and principles of BASEL II ACCORD.

The most important part of the study includes case analysis of Working Capital Assessment/Appraisal of a partnership firm M/s XXX Co. ( Name of the firm changed ) which is a trading concern dealing in Indian manufactured foreign liquor (IMFL).
This explains the significance of study of key financial indicators, study of debt service coverage ratio, in a precise manner. The present status of the project shown by the study of balance sheets sand other financial details furnished by the borrower and the bank. Financial ratios, past performance and projected future performance, study of cash flow statement and collateral security are helpful to the bank while taking lending decision. Finally, conclusion and recommendation as per the analysis during the training period winds up the report.

METHODOLOGY AND SOURCES OF DATA

The proposed methodology for fulfilling the objectives of the project is as follows: The study of guidelines laid by the Reserve Bank of India and the governing authorities of Indian Overseas Bank to be adhered to (pertaining to advances) as published in the journals issued by these authorities from time to time. The secondary data is deduced from the books of accounts maintained by the bank (without disclosure of any personal details of the borrower). The data from the official books as maintained by the bank, reference books, newsletters published by financial institutions and websites have been utilized for the analytical study of advances made by bank. The methodology includes a detailed study of the data collected from the bank, pre and post requisites of lending, calculation of interest on loans and equated monthly installments and documentation of the same. The observation of advances sanctioned by the bank in the past few years that resulted successful lending constitutes the most substantial part of the project work. It also involves active participation in banking transactions and internal functioning of the Advances Department of the branch. An elaborate study of loans and advances granted by the branch and analysis of the same has been the most significant component of the project. Information mentioned in the cases are deduced from the books of accounts as maintained by the bank branch, the figures and facts given being realistic in nature. Finally, identification of the problems associated with advances by bank and the solution of the same with certain recommendations is to be provided after analyzing certain loans (stated as illustrations in the project) to help the advances department of the bank.

Table 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16.

Serial No. Abbreviation Narration 1. CBS Core Banking Solution 2. ISO Indian Standard Organization No. Narration 3. IMFL Indian Manufactured Foreign Liquor Page No: 4. SCB levels Scheduled Commercial Banks Key Ratio 64 5. ICRA Facilities International Credit Rating Agency Nature of 69 6. FOREX Foreign Exchange Guarantors and their Networth 70 7. IPO Initial Public Offer Collateral Securities details 8. VISA Visa International Service Association 70 9. NRI Non Resident Indian Securities 71 10. ROE Return on Equity FORM I 73 11. WIP Work in Process 74 -76 12. FORM II NFS National Financial Switch A/C) 77 -79 13. FORM III(P & L Fixed Deposit Receipt FDR 14. FORM III(B/S) Earnings per share EPS 79 - 81 15. DSCR Debt Service Coverage Ratio FORM IV(B/S) Accounts Receivable 82 - 83 16. AR 84 - 85 17. Comparison SME Small Medium Enterprise 18. FORM V(B/S) MPBF Maximum Permission Banks Finance 86 - 87 19. FORM VI(B/S) Credit Monitoring Analysis CMA 88 - 89 20. NWC Net Working Capital Financial Indicators 90 21. NSC National savings Certificate 91 22. Financial Position LIC Life Insurance Corporation 23. Sanction of enhancement cum renewal of limits 93 KVP Kishan Vikas Patra 24. IBA Indian Bank Association 25. CIBIL Credit Information Burea India Limited 26. CC Cash Credit 27. ROC Registrars of Companies 28. HO Head Office 29. LGD Loss Given default 30. EAD Exposure at Default 31. MCR Minimum Capital Requirement 32. RWA Risk Weighted Assets 33. PD Probability of Default 34. EL Expected Loss 35. SWOT Strength,Weakness,Opportunity & Threat 36. CLB Company Law Board 37. DPG Deferred Payment Guarantee 38. WCG Working Capital Gap 39. TNW Tangible Net Worth 40. TOL Total of Liabilities

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Figure No Narration Fig 1 IOB Fig 2 Working Capital Fig 3 Working Capital Cycle Fig 4 Cash Operating Cycle Fig 5 Credit Appraisal Fig 6 BASEL II

Page No 14 38 43 44 49 56

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Chapter 1. INTRODUCTION 1.1BANKING SECTOR IN INDIA Banking in India originated in the last decades of the 18th century. The first bank in India, though conservative, was established in 1786. From 1786 till today, the journey of Indian Banking System can be segregated into three distinct phases. They are as mentioned below: Early phase from 1786 to 1969 of Indian Banks Phase from Nationalization of Indian Banks and up to 1991, prior to Indian banking sector Reforms. New phase of Indian Banking System with the advent of Indian Financial & Banking Sector Reform after 1991. Currently, India has 88 scheduled commercial banks (SCBs) - 27 public sector banks (that is with the government of India holding a stake), 31 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 38 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, public sector bank holds over 75% of the total asset of the banking industry, with the private and foreign bank holding 18.2% and 6.5% respectively. 12

Currently (2007) banking in India is generally fairly mature in terms of supply, product,range and reach even though reach in rural India still remains a challenge for private sector .In terms of capital adequacy and quality of assets, Indian banks are considered to have clean, strong and transparent balance sheet relative to other banks in comparable economies in its region. The Reserve Bank of India is an autonomous body, with minimal pressure from the government. The stated policy of the bank on the Indian rupee is to manage volatility but without any fixed exchange rate and this has mostly been true.

With the growth in the Indian economy expected to be strong for quite some time, especially in its services sector -the demand for banking services, especially retail banking mortgages and investment services are expected to be strong. Without a sound and effective banking system in India it cannot have a healthy economy. The banking system of India should not only be hassle free but it should be able to meet new challenges posed by the technology and any other external and internal factor. Indian Banking market is growing at an astonishing rate, with assets expected to reach US$1 trillion by 2010. An expanding economy, middle class and technological innovations are all contributing to this growth. The countrys middle class accounts for over 330 million people. In correlation with the growth of the economy, rising income levels, increased standard of living and affordability of banking products are promising factors of continued expansion. For the past three decades India's banking system has several outstanding achievements to its credit. The most striking is its extensive reach. It is no longer confined to only metropolitans or cosmopolitans in India.

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1.2 AN OVERVIEW OF INDIAN OVERSEAS BANK

Fig 1.IOB VISION Their vision is to emerge as one of the most competitive banks in the industry. INDIAN OVERSEAS BANK (IOB) enjoys pride of place as the premier institution among the public sector banks in the country. Indian Overseas Bank was rated as one of Fortune 2000 companies last year with gross profits of nearly $295 million. Headquartered in Chennai Tamil Nadu, Indian Overseas Bank has nearly 1500 branches and 250 extension counters with more than 24,000 employees all across India and overseas. IOB was founded in 1937 before World War II. Shri M Ct M Chidambaram Chettiar, the founder, was a man of remarkable foresight and vision who focussed on overseas banking and foreign exchange business as the primary activities that the bank would concern itself with. IOB commenced operations on Feb 10, 1937. IOB started up simultaneously at three branches, one each in Karaikudi, Chennai and Rangoon. It then quickly opened a branch in Penang and another in Singapore. Indian Overseas Bank (IOB or the Bank) 14

provides various banking services, including saving bank, current accounts, credit facilities and other services. The Bank's services also include personal banking services, non-residential Indian (NRI) accounts, corporate banking services, foreign exchange reserves (FOREX) collections services, agri business consultancy and e-banking services. IOB was the first bank to venture into consumer credit, as it introduced the popular Personal Loan scheme. In 1964, the Bank started computerization in the areas of inter-branch reconciliation and provident fund accounts. Indian Overseas Bank was one of the 14 major banks which were nationalized in 1969. After nationalization, the Bank emphasized on opening its branches in rural parts of India. In 1979, IOB opened a Foreign Currency Banking Unit in the free trade zone in Colombo. It offers internet banking and is one of the banks that the Government Of India has approved for online payment of taxes. In the year 2000, Indian Overseas Band undertook an initial public offering (IPO) that brought the government's share in the bank's equity down to 75%. The equity shares of IOB are listed in the Madras Stock Exchange (Regional), Bombay Stock Exchange, and National Stock Exchange of India Ltd., Mumbai. Since its inception, IOB has absorbed various banks including the latest Bharat Overseas Bank in 2007. Indian Overseas Bank offers investment options like Mutual Funds and Shares. It provides a wide range of consumer and commercial banking services, including Savings Account, Current Account, Depositary Services, VISA Cards, Credit Cards, Debit Cards, Online Banking, Any Branch Banking, Home Loans, NRI Account, Agricultural Loans, Payment of Bills / Taxes, Provident Fund Scheme, Forex Collection Services, Retail Loans, etc. Indian Overseas Bank has an ISO certified in-house Information Technology department, which has developed the software that 2018 branches use to provide online banking to customers; the bank has achieved 100% networking status as well as 100% CBS status of branches with a total number of 2018 CBS branchs and Extension Counters. IOB also has a network of about 771 ATMs all over India and IOB's International VISA Debit Card is accepted at all ATMs belonging to the Cash Tree and NFS networks During fiscal 2009, the Bank launched an rural development project aiming at total village development called IOB-Sampoorna in Kuthambakkam and Padur villages in Tiruvallur District, Kameshwaram village in Nagapattinam District, Dhaliyur village in Coimbotore District and Innambur village in Thanjavur, Tamil Nadu. In 2009, IOB took over Shree Suvarna Sahakari Bank, which was founded in 1969 and had its head office in Pune. In 2001 it acquired the 15

Mumbai-based Adarsha Janata Sahakari Bank, which gave it a branch in Mumbai. Shree Suvarna Sahakari Bank has been in administration since 2006. It has nine branches in Pune, two in Mumbai and one in Shirpur. The total employee strength is estimated to be little over 100. During the fiscal year ended March 31, 2010 (fiscal 2010), IOB had 13 establishments abroad, consisting of six branches (two branches in Hong Kong and one each in Singapore, South Korea, Sri Lanka and Bangkok), four representative offices, two remittance centers and one extension counter.

1.3 RATIONALE FOR THE STUDY

Offering credit is an operation fraught with risk. Before offering credit to an organization, its financial health must be analyzed. Credit should be disbursed only after ascertaining satisfactory financial performance. Based on the financial health of an organization, banks assign credit ratings. These credit ratings are used to fix the interest rate and quantum of installment. This study aims to analyze steps involved in credit appraisal .After analyzing credit health, the credit rating is determined. On the basis of credit rating, the interest rate guidelines circular is consulted to fix a price for the credit facilities i.e. determine the interest rate. This study aims to analyze the credit health of organizations that approach Indian overseas bank for credit facilities. After analyzing credit health, the credit rating is determined. On the basis of credit rating, the interest rate guidelines circular is consulted to fix a price for the credit facilities i.e. determine the interest rate. Companies present audited balance sheets of the current and previous years. These are used to determine the financial health, turnover trends and rise and fall of profitability. Then credit rating is done.

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The financial health and credit rating are theoretical methods for determining the right interest rate. However, in practice, banks consider other factors such as history with client, market reputation and future benefits with clients. Thus, a difference exists between theory and practice.

1.4 OBJECTIVE
1. Understand the principles of good lending, including relevant law and codes of practice such as Treating Customers Fairly, Responsible Lending and The Banking Code. Provide an outline of the principles of credit scoring. 2. Understand the nature of different types of borrowers (personal customers, sole traders, partnerships and, limited companies and the lending services that may be of benefit to them. 3. Analyse the borrowing requirements of personal and commercial customers (including the interpretation of financial statements). 4. Understand and apply the features and benefits of the whole range of lending products and services to each customer type and lending situation. 5. Understand the implications and application of the lending cycle, from the lending decision, through lending and control, management of early warning signals to the recovery of debts. 6. Apply the principles of security including land and property, life policies, stocks and shares, guarantees and debentures incorporating fixed and floating charges.

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Chapter 2. BANK LOANS AND ADVANCES Bank is a lawful organization, which accepts deposits that can be withdrawn on demand. It also lends money to individuals and business houses that need it. Banks also render many other useful services like collection of bills, payment of foreign bills, safe-keeping of jewellery and other valuable items, certifying the credit-worthiness of business, and so on. Commercial banks accept deposits and also lend money to the people who require it for various purposes. Lending of funds to traders, businessmen and industrial enterprises is one of the important activities of commercial banks. The major part of the deposits received by banks is lent out, and a large part of their income is earned from interest on such lending. There is a considerable difference between the rate of interest which the commercial bank grants on deposits, and the rate they charge on loans and advances. It is this difference which constitutes the main source of bank earnings. Operation and expansion of business and commercial activities depend a great deal on the availability of loans/advances from commercial banks. 2. a. Meaning of Loans and Advances The term loan refers to the amount borrowed by one person from another. The amount is in the nature of loan and refers to the sum paid to the borrower. Thus from the view point of borrower, it is borrowing and from the view point of bank, it is lending. Loan may be regarded as credit granted where the money is disbursed and its recovery is made on a later date. It is a debt for the borrower. While granting loans, credit is given for a definite purpose and for a predetermined 18

period. Interest is charged on the loan at agreed rate and intervals of payment. Advance on the other hand, is a credit facility granted by the bank. Banks grant advances largely for short-term purposes, such as purchase of goods traded in and meeting other short-term trading liabilities. There is a sense of debt in loan, whereas an advance is a facility being availed of by the borrower. However, like loans, advances are also to be repaid. Thus a credit facility- repayable in instalments over a period is termed as loan while a credit facility repayable within one year may be known as advances. However, in the present lesson these two terms are used interchangeably.

2.b. Utility of Loans and Advances Loans and advances granted by commercial banks are highly beneficial to individuals, firms, companies and industrial concerns. The growth and diversification of business activities are effected to a large extent through bank financing. Loans and advances granted by banks help in meeting short-term and long term financial needs of business enterprises. We can discuss the role played by banks in the business world by way of loans and advances as follows: 1. Loans and advances can be arranged from banks in keeping with the flexibility in business operations. Traders may borrow money for day to day financial needs availing of the facility of cash credit, bank overdraft and discounting of bills. The amount raised as loan may be repaid within a short period to suit the convenience of the borrower. Thus business may be run efficiently with borrowed funds from banks for financing its working capital requirements. 2. Loans and advances are utilized for making payment of current liabilities, wage and salaries of employees, and also the tax liability of business. 3. Loans and advances from banks are found to be economical for traders and businessmen, because banks charge a reasonable rate of interest on such loans/advances. For loans from money lenders, the rate of interest charged is very high. The interest charged by commercial banks is regulated by the Reserve Bank of India. 4. Banks generally do not interfere with the use, management and control of the borrowed money. But it takes care to ensure that the money lent is used only for business purposes.

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5. Bank loans and advances are found to be convenient as far as its repayment is concerned. This facilitates planning for future and timely repayment of loans. Otherwise business activities would have come to a halt. 6. Loans and advances by banks generally carry element of secrecy with it. Banks are dutybound to maintain secrecy of their transactions with the customers. This enhances peoples faith in the banking system.

2. c. Borrowing Rate and Lending Rate People make their funds available to the banks by depositing their savings in various types of accounts. In other words, bank funds mainly consist of deposits from the public, though banks may also borrow money from other institutions and the Reserve Bank of India. Banks, thus mobilizes funds through its deposits. On public deposits the banks pay interest at and the rate of interest vary according to the type of deposit. The borrowing rate refers to the rate of interest paid by a bank on its deposits. The rates which the banks allow depend upon the nature of deposit account and the period for which the deposit is made with the bank. No interest is generally paid on current account deposits. The rate is relatively lower on savings account deposits. Higher rates ranging from 6% to 12% per annum are paid on fixed deposit accounts according to the period of deposit. Banks also borrow from other institutions as well as from the Reserve Bank of India. When the Reserve Bank of India lends money to commercial banks, the rate of interest it charges for lending is known as Bank Rate. The rate at which commercial banks make funds available to people is known as Lending-rate. The lending rates also vary depending upon the nature of loans and advances. The rates also vary according to the purpose in view. For example if the loan is sanctioned for the purpose of activities for the development of backward areas, the rate of interest is relatively lower as against loans and advances for commercial/business purposes. Similarly for smaller amounts of loan the 20

rate of interest is higher as compared to larger amounts. Again lending rates for consumer durables, e.g. loans for purchase of two-wheelers, cars, refrigerators, etc. are relatively higher than for commercial borrowings. However, the Reserve Bank of India from time to time announces changes in the interest-rate structure to regulate the lending of fund by banks. Different rates of interest are prescribed for various categories of advances, such as advances to agriculture, small scale industries, road transport, etc. Graded rates of interest are prescribed for backward areas. Lower rate is normally charged from agencies selling food-grains at fixed price through Govt. approved outlets. Lastly, lower rate of interest is charged for loans granted to persons belonging to weaker sections of the society. 2. d.Lending of Money Commercial banks lend money in four different ways: (a) direct loans, (b) cash credit, (c) overdraft, and (d) discounting of bills. These are briefly discussed below: (a) Loans Loan is the amount borrowed from bank. The nature of borrowing is that the money is disbursed and recovery is made in installments. While lending money by way of loan, credit is given for a definite purpose and for a pre-determined period. Depending upon the purpose and period of loan, each bank has its own procedure for granting loan. However the bank is at liberty to grant the loan requested or refuse it depending upon its own cash position and lending policy. There are two types of loan available from banks: Demand loan Term loan (a) A Demand Loan is a loan which is repayable on demand by the bank. In other words, it is repayable at short-notice. The entire amount of demand loan is disbursed at one time and the borrower has to pay interest on it. The borrower can repay the loan either in lump sum (one time) or as agreed with the bank. For example, if it is so agreed the amount of loan may be repaid in suitable installments. Such loans are normally granted by banks against security. The security may include materials or goods in stock, shares of companies or any other asset. Demand loans are raised normally for 21

working capital purposes, like purchase of raw materials, making payment of short-term liabilities. (b) Term Loans: Medium and long-term loans are called term loans. Term loans are granted for more than a year and repayment of such loans is spread over a longer period. The repayment is generally made in suitable installments of a fixed amount. Term loan is required for the purpose of starting a new business activity, renovation, modernization, expansion/ extension of existing units, purchase of plant and machinery, purchase of land for setting up of a factory, construction of factory building or purchase of other immovable assets. These loans are generally secured against the mortgage of land, plant and machinery, building and the like.

(b) Cash credit Cash credit is a flexible system of lending under which the borrower has the option to withdraw the funds as and when required and to the extent of his needs. Under this arrangement the banker specifies a limit of loan for the customer (known as cash credit limit) up to which the customer is allowed to draw. The cash credit limit is based on the borrowers need and as agreed with the bank. Against the limit of cash credit, the borrower is permitted to withdraw as and when he needs money subject to the limit sanctioned. It is normally sanctioned for a period of one year and secured by the security of some tangible assets or personal guarantee. If the account is running satisfactorily, the limit of cash credit may be renewed by the bank at the end of year. The interest is calculated and charged to the customers account. Cash credit, is one of the types of bank lending against security by way of pledge or / hypothetifcation of goods. Pledge means bailment of goods as security for payment of debt. Its primary purpose is to put the goods pledged in the possession of the lender. It ensures recovery of loan in case of failure of the borrower to repay the borrowed amount. In Hypothetication, goods remain in the possession of the borrower, who binds himself under the agreement to give possession of goods to the banker whenever the banker requires him to do so. So Hypothetication is a device to create a charge over the asset under circumstances in which transfer of possession is either inconvenient or impracticable. (c) Overdraft

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Overdraft facility is more or less similar to cash credit facility. Overdraft facility is the result of an agreement with the bank by which a current account holder is allowed to draw over and above the credit balance in his/her account. It is a short-period facility. This facility is made available to current account holders who operate their account through cheque. The customer is permitted to withdraw the amount of overdraft allowed as and when he/she needs it and to repay it through deposits in the account as and when it is convenient to him/her. Overdraft facility is generally granted by a bank on the basis of a written request by the customer. Sometimes the bank also insists on either a promissory note from the borrower or personal security of the borrower to ensure safety of amount withdrawn by the customer. The interest rate on overdraft is higher than is charged on loan. The following are some of the benefits of cash credits and overdraft :(i) Cash credit and overdraft allow flexibility of borrowing, which depends upon the need of the borrower. (ii) There is no necessity of providing security and documentation again and again for borrowing funds. (iii) This mode of borrowing is simple and elastic and meets the short term financial needs of the business. (d) Discounting of Bills Apart from sanctioning loans and advances, discounting of bills of exchange by bank is another way of making funds available to the customers. Bills of exchange are negotiable instruments, which enable debtors to discharge their obligations to the creditors. Such Bills of exchange arise out of commercial transactions both in inland trade and foreign trade. When the seller of goods has to realize his dues from the buyer at a distant place immediately or after the lapse of the agreed period of time, the bill of exchange facilitates this task with the help of the banking institution. Banks invest a good percentage of their funds in discounting bills of exchange. These bills may be payable on demand or after a stated period. In discounting a bill, the bank pays the amount to the customer in advance, i.e. before the due date. For this purpose, the bank charges discount on the bill at a specified rate. The bill so 23

discounted , is retained by the bank till its due date and is presented to the drawee on the date of maturity. In case the bill is dishonoured on due date the amount due on bill together with interest and other charges is debited by the bank to the customers account.

Term Loans Medium and long-term loans are generally known as term loans. These loans are granted for more than 15 months. In case of medium term loan, the period ranges from 15 months to less than 5 years. Medium term loans are generally granted for heavy repairs, expansion of existing units, modernization /renovation etc. Such loans are sanctioned against the security of immovable assets. The normal rate of interest ranges between 12% to 18% depending upon the period, purpose, nature and amount of the loan. Though banks may grant long-term loans, they avoid granting loan for more than 5 years. 2.e. Nature and Security of Loans To ensure the safety of funds lent, the first and most important factor considered by a bank is the capacity of borrowers to repay the amount of loan , The bank therefore, relies primarily on the character, capacity and financial soundness of the borrower. But the bank can hardly afford to take any risk in this regard and hence it also has the security of tangible assets owned by the borrower. In case the borrower fails to repay the loan, the bank can recover the amount by attaching the assets. It can sell the assets offered as security and realize the amount. Thus from the viewpoint of security of loans, we can divide the loans into two categories: (a) secured, and (b) unsecured. Unsecured loans are those loans, which are not covered by the security of tangible assets. Such loans are granted to firms/institutions against the personal security of the owner, manager or director. On the other hand Secured loans are those which are granted against the security of tangible assets, like stock in trade and immovable property. Thus, while granting loan against the security 24

of some assets, a charge is created over the assets of the borrower in favour of the bank. This enables the bank to recover the dues from the customer out of the sale proceeds of the assets in case the borrower fails to repay the loan.

There are various types of securities which may be offered against loans granted, but all of those are not acceptable to the banks. The types of securities generally accepted by the bank are the following: Tangible assets such as plant and machinery, motor-van, etc. Documents of title to goods, like Railway Receipt (R/R), Bills of exchange, etc. a) Financial Securities (Shares and Debentures) b) Life-Insurance Policy c) Real estates (Land, building, etc). d) Fixed Deposit Receipt (FDR) e )Gold ornaments, Jewellery etc. 2.f. Procedure of granting Cash Credit, Overdraft and Discounting Bills We have studied in this lesson that banks provide financial assistance to its customers in the form of loans, advances, cash credit, overdraft and through the discounting of bills. The procedure of applying for and sanction of loans and advances differs from bank to bank. However, the steps which are generally to be taken in all cases are as follows: (I) Filling up of loan application form Each bank has separate loan application forms for different categories of borrowers. When you want to borrow money from a bank, you will have to fill up a loan application form available with the bank free of cost. The loan application form contains different columns to be filled in by the applicant. It includes all information required about the borrower, purpose of loan, nature of facility (cash-credit, overdraft etc) required, period of repayment, nature of security offered, and the financial status of the borrower. 25

A running business limit may be required to furnish additional information in respect of : Assets and liabilities Profit and loss for the last 2 to 3 years. The names and addresses of three persons (which may include borrowers, suppliers, customers and bankers) for reference purposes. (ii) Submission of form along with relevant documents The loan application form duly filled in should be submitted to the bank along with the relevant documents. (iii) Sanctioning of loan The bank scrutinizes the documents submitted and determines the credit worthiness of the applicant. If it is found to be feasible, the loan is sanctioned. If the loan is for Rs 5000 or less, normally the Branch Manager himself can take the decision and sanction the loan. In case the amount of loan is more than Rs 5000, the application is considered at regional, zonal or head office level, depending on the amount of loan. (iv) Executing the Agreement When the loan is sanctioned by the bank and the borrower is informed about it, he will have to execute an agreement with the bank regarding terms and condition for the amount of loan raised. (v) Arrangement of Security for Loan The borrower will now arrange for security against the loan. These securities may be immovable properties, shares, debentures, fixed deposit receipts, and other documents, like, Kisan Vikas Patra, National Savings Certificate, as per agreement. When the borrower completes all the formalities, he is allowed to get the amount of loan/advance/ over draft as sanctioned by the bank. In case of discounting of bills, the bank credits the amount of bill to the customers account before the realization of the bill and thus, makes available the fund. In case, the bill is dishonored 26

on due date, the amount due on the bill together with interest and other charges are payable by the party whose bill is discounted.

Chapter 3. WORKING CAPITAL MANAGEMENT 3.1.Introduction Working capital management is concerned with the problems arise in attempting to manage the current assets, the current liabilities and the inter relationship that exist between them. The term current assets refers to those assets which in ordinary course of business can be, or, will be, turned in to cash within one year without undergoing a diminution in value and without disrupting the operation of the firm. The major current assets are cash, marketable securities, account receivable and inventory. Current liabilities ware those liabilities which intended at their inception to be paid in ordinary course of business, within a year, out of the current assets or earnings of the concern. The basic current liabilities are account payable, bill payable, bank over-draft, and outstanding expenses. The goal of working capital management is to manage the firms current assets and current liabilities in such way that the satisfactory level of working capital is mentioned. The current should be large enough to cover its current liabilities in order to ensure a reasonable margin of the safety. Definition:1. According to Guttmann & Dougall Excess of current assets over current liabilities. 1. According to Park & Gladson The excess of current assets of a business (i.e. cash, accounts receivables, inventories) over current items owned to employees and others (such as salaries & wages payable, accounts payable, taxes owned to government).

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3.2) Need of working capital management The need for working capital gross or current assets cannot be over emphasized. As already observed, the objective of financial decision-making is to maximize the shareholders wealth. To achieve this, it is necessary to generate sufficient profits can be earned will naturally depend upon the magnitude of the sales among other things but sales cannot convert into cash. There is a need for working capital in the form of current assets to deal with the problem arising out of lack of immediate realization of cash against goods sold. Therefore sufficient working capital is necessary to sustain sales activity. Technically this refers to operating or cash cycle. If the company has certain amount of cash, it will be required for purchasing the raw material may be available on credit basis. Then the company has to spend some amount for labour and factory overhead to convert the raw material in work in progress, and ultimately finished goods. These finished goods convert in to sales on credit basis in the form of sundry debtors. Sundry debtors are converting into cash after expiry of credit period. Thus some amount of cash is blocked in raw materials, WIP, finished goods, and sundry debtors and day to day cash requirements. However some part of current assets may be financed by the current liabilities also. The amount required to be invested in this current assets is always higher than the funds available from current liabilities. This is the precise reason why the needs for working capital arise.

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3.3. Gross working capital and Net working capital There are two concepts of working capital management 1. Gross working capital Gross working capital refers to the firms investment in current assets. Current assets are the assets which can be convert in to cash within year includes cash, short-term securities, debtors, bills receivable and inventory. 2. Net working capital Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors, bills payable and outstanding expenses. Net working capital can be positive or negative. Efficient working capital management requires that firms should operate with some amount of net working capital, the exact amount varying from firm to firm and depending, among other things; on the nature of industries net working capital is necessary because the cash outflows and inflows do not coincide. The cash outflows resulting from payment of current liabilities are relatively predictable. The cash inflow are however difficult to predict. The more predictable the cash inflows are, the less net working capital will be required. The concept of working capital was, first evolved by Karl Marx. Marx used the term variable capital means outlays for payrolls advanced to workers before the completion of work. He compared this with constant capital which according to him is nothing but dead labour. This variable capital is nothing This variable capital is nothing but wage fund which remains blocked in terms of financial management, in work-in-process along with other operating expenses until it is released through sale of finished goods. Although Marx did not mentioned that workers also gave credit to the firm by accepting periodical payment of wages which funded a portioned of W.I.P, the concept of working capital, as we understand today was embedded in his variable capital.

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3.4.CONCEPTS Gross working capital referred to as working capital, means the total current assets. Net working capital can be explained in two ways : The difference between the current assets and current liabilities. The portion of current assets which is financed with long term funds.

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CALCULATION OF FINANCIAL RATIOS

Ratio analysis is a powerful tool of financial

analysis. In financial analysis, a ratio is used as a benchmark for evaluating the financial position and performance of the firm. A ratio in itself has no meaning. It should be compared with some standard. Standards of comparison may consist of: A)Past ratios B)Competitors ratios C)Industry ratios D)Projected ratios A)Liquidity Ratio B)Degree of financial leverage of debt C)Profitability C)Efficiency D)Value

The most frequently used ratios by bank and financial analysts are:

The task of financial manager in managing working capital efficiently is to ensure requisite liquidity in the operations of the enterprise. The liquidity of a business firm is measured by its ability to satisfy short-term obligations as they become due. The two basic measures of a frrms overall liquidity are

Current Ratio Liquid ratio CURRENT RATIO

The current ratio is the ratio of total current assets to total liabilities. It is calculated by dividing current assets by current liabilities. CURRENT ASSETS CURRENT RATIO = ---------------------------------CURRENT LIABILITIES

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Current assets include cash and bank balances marketable securities Inventory of raw materials Semi-finished goods or work-in-progress Finished goods Debtors net of provision for bad and doubtful debts Bills receivables Prepaid expenses The current liabilities are defined as liabilities which are short-term maturing obligations to be met, as originally contemplated, within a tear, consist of Trade creditors Bills payable Working capital credit by banks Provision for taxation Dividends payable Outstanding expenses The current ratio of a measures its short term liquidity, that is, its ability to meet short-term obligations. The higher the current ratio, the larger is the amount of rupees available per rupee of current liability, the more is the firms ability to meet current obligations and the greater is the safety of funds of short-term creditors. The firm should maintain sufficient/ requisite amount of current assets which should be larger than current liabilities so that the firm would be assured of being able to pay its current maturing debts as and when it becomes due. The current ratio measures the size of the short-term liquidity buffer. A satisfactory current ratio would enable a firm to meet its obligations. Ideal current ratio should be 1.33.

LIQUID RATIO:
The acid test ratio provides a check on the liquidity position of a firm. The quick ratio or the acid test ratio is a more rigorous and penetrating test of the liquidity position of a position. The acidtest ratio is a measure of liquidity designed to overcome the shortcomings of the current ratio. 32

It is often referred to as quick ratio because it is a measurement of a firms ability to convert its liabilities. Thus, it is a measure of quick or acid liquidity. The acid test ratio is the ratio between quick current assets and current liabilities and is calculated by dividing the quick assets and current liabilities. QUICK ASSETS LIQUID RATIO= ---------------------------------------CURRENT LIABILITIES The term quick assets refers to current assets which can be converted into cash immediately or at a short notice without diminution of value. Quick asset includes Cash and Bank balances Short-term marketable securities Debtors/ receivables And it excludes Prepaid Expenses Inventory. The reason of excluding inventory is that it is not easily and readily convertible into cash. Prepaid expenses by their very nature are not available to pay off current debts. Current liabilities exclude the bank borrowings. So, the ratio can be written as QUICK ASSET PREPAID EXPENSES INVENTORIES LIQUID RATIO= ------------------------------------------------------------------------------------------CURRENT LIABILITIES BANK BORROWINGS Generally, an acid-test ratio of 1:1 is considered satisfactory as a firm can easily meet all current claims.

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ANALYZING DEBT: Debt ratios show the extent to which a firm is relying on debt to finance its investments and operations, and how well it can manage the debt obligation, i.e. repayment of principal and periodic interest. If the company is unable to pay its debt, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and allows it to exploit business opportunities and grow. Note that total debt includes short-term debt (bank advances + the current portion of long-term debt) and long-term debt (bonds, leases, notes payable) 1. Leverage Ratios Debt to Equity Ratio = Total Debt / Total Equity This shows the firms degree of leverage or its reliance on external debt for financing. Debt to Assets Ratio = Total Debt / Total assets In general, with either of the above ratios, the lower the ratio, the more conservative (and probably safer) the company is. However, if a company is not using debt, it may be foregoing investment and growth opportunities. This is a question that can be answered only by further company and industry research. Interest Coverage (or Times Interest Earned) Ratio = Earnings before Interest and Taxes / Annual Interest Expense This shows the firms ability to cover fixed interest charges (on both short-term and long-term debt) with current earnings. The margin of safety that is acceptable varies within and across industries, and also depends on the revenue generation history of a firm (especially the consistency of earnings from period to period and year to year). Cash Flow Coverage = Net Cash Flow / Annual Interest Expense Net cash flow = Net Income is either subtracted from or added to non-cash items, as applicable (e.g. -equity income + minority interest in earnings of subsidiary + deferred income taxes + depreciation + depletion + amortization expenses) Since depreciation is usually the largest non-cash item in most companies, analysts often approximate Net cash flow as being equivalent to Net Income + Depreciation.

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Cash flow is a critical variable in assessing a company. If a company is showing high profits but has poor cash flow, one should investigate further before passing a favorable opinion on the company. Analysts prefer ratio #3 to ratio #2. ANALYZING PROFITABILITY: Profitability is a relative term. It is hard to say what percentage of profits represents a profitable firm, as profits depend on factors such as the position of the company and its products on the competitive life cycle (for example profits will be lower in the initial years when investment is high), on competitive conditions in the industry, and on borrowing costs. For decision-making, bank is mainly concerned with the present value of expected future profits. Past or current profits are important only as they help us to ascertain future profits, by identifying historical and forecasted trends of profits and sales. Net Profit Margin = Profit after taxes / Sales Return on Assets (ROA) = Profit after taxes / Total Assets Return on Equity (ROE) =Profit after taxes / Shareholders Equity (book value) Earnings per Common share (EPS) = (Profits after taxes - Preferred Dividend) / (# of common shares outstanding) Payout Ratio = Cash Dividends / Net Income. ANALYZING EFFECIENY: These ratios reflect how well the firms assets are being managed. The inventory ratio shows how fast the inventory is being produced and sold. Inventory Turnover = Cost of Goods Sold / Average Inventory This ratio shows how quickly the inventory is being turned over (or sold) to generate sales. A higher ratio implies the firm is more efficient in managing inventories by minimizing the investment in inventories. Thus a ratio of 12 would mean that the inventory turns over 12 times, or the average inventory is sold in a month. Total Assets Turnover = Sales / Average Total Assets This ratio shows how much sales the firm is generating for every dollar of investment in assets. The higher the ratio, the better is the performance of the bank. Accounts Receivable Turnover = Annual Credit Sales / Average Receivables Average Collection period = Average Accounts Receivable / (Total Sales / 365) 35

The last two ratios show the firms efficiency in collecting cash from its credit sales. While a low ratio is good, it could also mean that the firm is being very strict in its credit policy, which may not attract customers. Days in Inventory = Days in a year / Inventory turnover This is referred to as the shelf-life i.e. how quickly the manufactured product is sold off the shelf. Thus days in Inventory and inventory turnover ratios are related. VALUE RATIOS: Value ratios show the embedded value in stocks, and are used by investors as a screening device before making investments. 1. Price to Earnings Ratio (P/E) = Current Market Price per Share / After-tax Earnings per Share 2. Dividend Yield = Annual Dividends per Share / Current Market Price per Share DEBT SERVICE COVERAGE RATIO: The debt service coverage ratio (DSCR) is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition or covenant. Breaching a DSCR covenant can, in some circumstances, be an act of default. In general, it is calculated by: Net Operating Income/Total Debt Services A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1 say 0.95 would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income.

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3.5) Type of working capital The operating cycle creates the need for current assets (working capital).However the need does not come to an end after the cycle is completed to explain this continuing need of current assets a destination should be drawn between permanent and temporary working capital. 1) Permanent working capital The need for current assets arises, as already observed, because of the cash cycle. To carry on business certain minimum level of working capital is necessary on continues and uninterrupted basis. For all practical purpose, this requirement will have to be met permanent as with other fixed assets. This requirement refers to as permanent or fixed working capital 2) Temporary working capital Any amount over and above the permanent level of working capital is temporary, fluctuating or variable, working capital. This portion of the required working capital is needed to meet fluctuation in demand consequent upon changes in production and sales as result of seasonal changes

Fig 2. Working Capital Graph shows that the permanent level is fairly castanet; while temporary working capital is fluctuating in the case of an expanding firm the permanent working capital line may not be horizontal. This may be because of changes in demand for permanent current assets might be increasing to support a rising level of activity.

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3.6 Determinants of working capital The amount of working capital is depends upon a following factors 1. Nature of business Some businesses are such, due to their very nature, that their requirement of fixed capital is more rather than working capital. These businesses sell services and not the commodities and that too on cash basis. As such, no founds are blocked in piling inventories and also no funds are blocked in receivables. E.g.public utility services like railways, infrastructure oriented project etc. there requirement of working capital is less. On the other hand, there are some businesses like trading activity, where requirement of fixed capital is less but more money is blocked in inventories and debtors. 2. Length of production cycle In some business like machine tools industry, the time gap between the acquisition of raw material till the end of final production of finished products itself is quite high. As such amount may be blocked either in raw material or work in progress or finished goods or even in debtors. Naturally there need of working capital is high. 3. Size and growth of business In very small company the working capital requirement is quit high due to high overhead, higher buying and selling cost etc. as such medium size business positively has edge over the small companies. But if the business start growing after certain limit, the working capital requirements may adversely affect by the increasing size. 4. Business/ Trade cycle If the company is the operating in the time of boom, the working capital requirement may be more as the company may like to buy more raw material, may increase the production and sales to take the benefit of favorable market, due to increase in the sales, there may more and more amount of funds blocked in stock and debtors etc. similarly in the case of depressions also, working capital may be high as the sales terms of value and quantity may be reducing, there may be unnecessary piling up of stack without getting sold, the receivable may not be recovered in time etc.

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5. Terms of purchase and sales Some time due to competition or custom, it may be necessary for the company to extend more and more credit to customers, as result which more and more amount is locked up in debtors or bills receivables which increase the working capital requirement. On the other hand, in the case of purchase, if the credit is offered by suppliers of goods and services, a part of working capital requirement may be financed by them, but it is necessary to purchase on cash basis, the working capital requirement will be higher. 6. Profitability The profitability of the business may be vary in each and every individual case, which is in turn its depend on numerous factors, but high profitability will positively reduce the strain on working capital requirement of the company, because the profits to the extent that they earned in cash may be used to meet the working capital requirement of the company. 7) Operating efficiency If the business is carried on more efficiently, it can operate in profits which may reduce the strain on working capital; it may ensure proper utilization of existing resources by eliminating the waste and improved coordination etc. 8)Production policy The quantum of working capital is also determined by production policy. In the case of certain lines of business, the demand for products is seasonal, that is, they are purchased during the certain months of the year. 9) Credit policy The credit policy relating to sales and purchases also affects the working capital. The credit policy influences the requirement of working capital in two ways: Through credit terms granted by the firm to its customers/ buyers of goods Credit terms available to the firm from its creditors.

The credit terms granted to customers have a bearing on the magnitude of working capital by determining the level of book debts. The credit sales result in higher book debts (receivables). Higher book debts mean more working capital. On the other hand, if liberal credit terms are available from the suppliers of goods (trade creditors), the need for working capital is less.

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10) Growth and Expansion As a company grows, it is logical to expect that a larger amount of working capital is required. It is, of course, difficult to determine precisely the relationship between the growth in the volume of business of a company and the increase in its working capital. But it is true that growth industries require more working capital than those that are static. 11) Vagaries in the availability of Raw Material The availability of certain raw materials on a continuous basis without interruption would sometimes affect the requirement of working capital. There may be some materials which cannot be procured easily either because of their sources are few or they are irregular. To sustain smooth production, therefore, the firm might be compelled to purchase and stock them far in excess of genuine production needs. This will result in an excessive inventory of such materials. This will lead to a relatively high level of working capital. 12) Profit level The level of profits earned differ from enterprise to enterprise. In general, the nature of the product, hold on the market, quality of management and monopoly power would determine the profit earned by a firm. Higher profit margin would improve the prospects of generating more internal funds thereby contributing to the working capital pool. The net profit is a source of working capital to the extent that it has been earned in cash. The cash profit can be found by adjusting non-cash items such as depreciation, outstanding expenses and losses written off, in the net profit. But in practice, cash is used for augmenting stock, book debts, and fixed assets. The availability of internal funds for working capital requirements is determined not merely by the profit margin but also by the manner of appropriating profits. 13) Level of taxes The first appropriation out of profits is payment or provision for tax. The amount of taxes to be paid is determined by the prevailing tax regulations. Tax liability is, in a sense, short-term liability payable in cash. An adequate provision for tax payment is, therefore, an important aspect of working capital planning. If tax liability increases, it leads to an increase in the requirement of working capital and vice versa. 14) Dividend policy Another appropriation of profits which has a bearing on working capital is dividend payment. The payment of dividend consumes cash resources and, thereby, affects the working capital to that extent. If any firm does not pay dividend but retains the profits, working capital increases. In planning working capital requirements, therefore, a basic question to be decided is whether profits will be retained or paid out to shareholders.

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15) Depreciation policy Depreciation policy also exerts an influence on the quantum of working capital. Depreciation charges do not involve any cash outflows. The effect of depreciation policy on working capital is indirect. 16) Price level changes Changes in the price level also affect the requirements of working capital. Rising prices necessitate the use of more funds for maintaining an existing level of activity. For the same level of current assets, higher cash layouts are required. The effect of rising prices is that a higher amount of working capital is required. In the case of companies which can raise their prices proportionately, there is no serious problem regarding working capital. To conclude, the level of working capital is determined by a wide variety of factors which are partly internal to the firm and partly external (environmental) to it. Efficient working capital management requires efficient planning and a constant review of the needs of an appropriate working capita strategy.

3.7. WORKING CAPITAL CYCLE

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AR converted to cash

Cash

Collect Account receivable Sales Order Deliver goods/services

Cash to inventory Goods/services converted to accounts receivable Fig 3. Working Capital Cycle Produces goods/services

3.8. WORKING CAPITAL FINANCING

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Working Capital is financed by following sources: OWNED FUNDS A portion of long term funds, equity share capital and reserves & surplus is utilized to fund working capital BANK BORROWINGS Various bank products like cash credit, packing credit, bills discounting etc. CREDITORS

FUNDING THE CASH OPERATING CYCLE

Raw Materials

W-I-P

Finished Good

Debtors

Trade Payables

Bank Borrowings

+ LongTermfunds

Fig 4. Cash operating Cycle

3.9. WORKING CPITAL PRODUCTS Working Capital Products are broadly classified under three categories: 43

 FUND BASED NON FUND BASED STRUCTURED PRODUCT 1)FUND BASED A)Domestic

Cash Credit Over Draft Facility Bill finance Documentary Clean

B) Export

Pre-shipment Postshipment

2) NON FUND BASED Letter of Credit Bank guarantee

3) STRUCTURED PRODUCT Commercial Papers Buyersand Suppliers Credit Corporate Loan Securitisation 44

Factoring Forfeiting

3.10.VARIOUS METHODS OF WORKING CAPITAL ASSESSMENT: Like many other activities of the banks, method and quantum of short-term finance that can be granted to a corporate was mandated by the Reserve Bank of India till 1994.

NAYAK COMMITTEE METHOD

With freedom given to the banks in evolving their own method of lending, generally the banks evolved their lending policy accordingly to which borrowers with working capital limits upto Rs. 2crores (Rs. 7.5 crore for SME borrowers) which will be assessed as per Nayak Commiittee Recommendations ( TURNOVER METHOD). The calculation of bank finance under this method is as follows:
1. Estimated Sales Turnover as on current year 2. 25% of the Estimated Turnover as on current year 3. 5% of the Estimated Turnover as on current year 4. Available net working capital in the past financial year 5. 2 3 6. 2 4

XXXX Lacs XXX Lacs XXX Lacs XXX Lacs XXX Lacs XXX Lacs XXX Lacs

7. Maximum Permissible Bank Finance (5 or 6 whichever is lower)

MPBF-II METHOD
Borrowers enjoying working capital limits of Rs. 2 crore and above (Rs. 7.5 crore and above for SME borrowers) and upto Rs. 10 crores, will be assessed as per the entirely traditional method of arriving at Maximum Permissible Bank Finance (MPBF) calling for the CMA data.
1. Total Current Assets 2. Current Liabilities (other than bank borrowings) 3. Working Capital Gap

XXXX Lacs XXX Lacs XXX Lacs 45

4. Min. stipulated net working capital- 25% of total current assets

other than export receivables

5. Actual / projected net Working capital 6. Item 3 minus item 4

XXX Lacs XXX Lacs XXX Lacs XXX Lacs XXX Lacs XXX Lacs

7. Item 3 minus item 5 8. Maximum permissible by bank finance (item 6 or 7 whichever is lower)
9. Excess borrowings, if any representing short fall in NWC (4-5)

Excess borrowing (short fall in NWC) shall be ensured by additional funds to be brought in by the applicant or by additional bank finance over MPBF. Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the buildup of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets specially inventory. Generally, bankers are stipulating 50% margin on book debts and in case of valued debtors they are lowering the margin to the tune of 40% to 30% on case to case basis. Important Aspects of MPBF method Production/Sales estimates Profitability estimates Inventory/receivables norms Build up of Net Working Capital

CMA data is a tool used by the bankers to assess the requirement of working capital. It is divided into six parts as follows: Form-I Particulars of Existing & Proposed Limits Form-II Operating Statement Form-III Analysis of Balance Sheet Form-IV Comparative Statement of Current Assets & Current Liabilities Form-V Computation of Maximum Permissible Bank Finance (MPBF) Form-VI Funds Flow Statement 46

Limitations: Represents position on a particular date Not tuned to Peak Time Assessment Not applicable for service industries In practice may differ with Drawing Power

CASH-BUDGET METHOD
In this method credit appraisal is entirely done by total inflows and outflows of the firm/ company during peak season and slack season throughout the year. This method is applicable for: Seasonal industries (sugar/ rice/ mills/ textiles/ tea/ tobacco/ fertilizers) Contractors Real Estate Developers Software Exporters Borrowers enjoying working capital limits of Rs. 10 crores and above option has been given to the borrower to be assessed as per the Cash Budget Method. For industries like the mentioned above where in the pattern of financing the peak cash deficit(s) is followed all along, the existing system of assessment under the Cash Budget Method is followed.

Limitations:
Will not reflect changes in various current assets and current liabilities. It does not give any clue whether a company is earning profit or not.
Funds flow statement is required to detect any diversion of funds. But this method

does not include Funds flow statement.

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Chapter 4
CREDIT APPRAISAL AND MONITORING: COMMON ISSUES 4.1. WHAT IS CREDIT APPRAISAL? Credit appraisal is a process to ascertain the risks associated with the extension of the credit facility. It is generally carried by the financial institutions which are involved in providing financial funding to its customer. Credit risk is a risk related to non-payment of the credit obtained by the customers of a bank. Thus, it is necessary to appraise the credibility of the customer in order to mitigate the credit risk. Proper evaluation of the customers is performed which measures the financial condition and the ability of the customer to repay back the loan in future. Generally, the credit facilities are extended against the security for which the credit limit is being sanctioned, known as PRIME SECURITY. Apart from that, financial institutions take some other securities like fixed deposits, NSCs, LICs, KVPs, immovable properties, to be considered as COLLATERAL SECURITY for the credit limits sanctioned by them. But even though the loans are backed by collateral, financial institutions are normally interested in the actual loan amount to be repaid along with the interest.

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Fig 5. Credit Appraisal

4.2. DATA TO BE OBTAINED FOR CREDIT ASSESSMENT: Loan application of the credit facilities. A profile of the firm/ company. Financial Statements of previous years. Estimates/ projections (with quantitative details) Asset liability statement of the borrowers/ guarantors. Supporting details of the financials including income tax return, stock/ book debt statements etc.

Apart from that bankers are to obtain the market reports of the proposed borrower as also credit opinion from other banks/ financial institutions, if any, as per INDIAN BANKS ASSOCIATION (IBA) approved format. In spite of that due to latest technological improvements bankers are viewing any default of payments towards credit obligations from other financial institutions through online CIBIL System.

49

4.3. CREDIT MONITORING: Common Issues Caution needs to be exercised when loan is to be sanctioned to a party who operates in rented premises and leave & license agreement period is less than repayment period of the loan. Specific enquiry should be made for approaching IOB and whether loan application has been simultaneously submitted to other banks. Apart from obtaining usual credit report from existing bankers, it is also necessary to find out from other sources about the borrowers operation with that banker as it is quite likely for any banker to give normal report if they do not wish to retain account. Bank should prepare S (Strength) W (Weakness) O (Opportunity) T (Threat) analysis in case of advances of say Rs. 15 Lacs & above. Whenever borrower submits IT Return then it should be ensured that it has been filed every year rather all a time or in a short span of few months. It is obvious from such so-called compliance that IT Return has been filed just to meet the stipulation for processing of loan application. Loan should not be granted on the basis of income affidavit submitted by borrower. Reasons for not filing IT Return should be enquired. Net worth of secureties should be ascertained to confirm that he has the capacity to pay the loan in case of default by borrower. Bank should stipulate the condition that unsecured loans should not be withdrawn till currency of Bank Loan. Bank should stipulate the condition that expansion plans would be executed only after consulting bank. Bank should stipulate the condition that Key personnel appointment will be approved / confirmed 50

by Bank. Collateral security should be taken to the extent possible. e.g. Residential flat, LIC, Shares, NSC, KVP etc. More so when effective/economical life of the asset hypothecated is less than repayment period of loan. Banks nameplate should be given to borrower and his acknowledgement should be taken, followed by his letter confirming the affixing the nameplate. Bank should stipulate that borrower should submit Monthly Information as per the format stipulated by Bank. Undertaking to deal exclusively with our bank is obtained and borrower blindly executes the same. In fact we are aware that borrower is operating with other banks. In such case, in case he cannot close the account with other banks as the same may be required for ST, Excise etc. then we should specifically give permission & bank statements should be obtained monthly of such accounts .Otherwise account closure certificate should be obtained Disbursement should be directly made to Builder, Vendor etc. depending on type of loan. In case the same is to be reimbursed to borrower, then stamped receipt, bills, installation report, inspection report, insurance policy, valuation report etc. should be available on record. Post dated cheques (payable fortnightly) should be taken from large borrowers (New) as well as from existing borrowers not repaying the loan regularly Insurance policy of adequate sum should be taken covering the appropriate risks such as Fire, Burglary etc. Security documents should be verified periodically to confirm with entries in Security Register. Valuation report should be obtained say once in three years of security offered such as Land, Machinery, Gala, Flat, and Vehicle etc. Accounts, Audit report, I.T.Return etc. of Borrower, Directors, Partners and Guarantors should be obtained in November every year. Assets & Liabilities statement of Borrower, Directors, Partners and Guarantors should be obtained every year. Term Loans should be reviewed every year. Caution is called for whenever lump sum payment is arranged by borrower to regularize the loan account. 51

Bank should avoid the temptation of ever greening / window dressing the CC / Loan account Recovery notice should be sent whenever overdue is noticed.

4.3.1 Additional requirements in case of Loan is granted to Company: Search Report of ROC records should be obtained in case loan is proposed to be given / Company Secretarial Compliance Report should also be obtained in case loan has Board resolution for making loan application to a Bank should also be obtained along with Board resolution for acceptance of terms & conditions of sanctions and for execution of given to Pvt. Or Public ltd. Company. been given to Pvt. Or Public ltd. Company. Loan application. documents should be kept on record. The said resolution should be typed on Companys letterhead and authenticated by chairman of the meeting and not by any director.

Common seal of the company should be affixed on all documents executed by the Form 8 & Form 13 should be filed with ROC within 30 days of loan documentation. Bank should stipulate the condition that dividend should not be declared without Promoters contribution should be brought in the form of Capital. Contribution, then borrower should be requested to enhance authorized Capital List of shareholders & their relationship with the promoters /management of the company Details of Shareholding should be obtained. Copies of various forms filed with ROC should be obtained such Annual Audited 52

company.

approval of Bank. If Authorized capital is not adequate to accommodate promoters capital clause immediately. should be ascertained.

Accounts, Annual Return, Allotment of Shares, Agreements, Resolutions etc. should be obtained.

4.3.2 Additional requirements in case of Loan is granted to Firm:

Certified true copy of Partnership Deed should be obtained. Original deed should also be Partnership deed should be referred to confirm as to whether firm could do banking Partnership should be registered with Registrar of Firms. Relevant registration

referred to confirm the Xerox copy. operations with Co-operative bank and how bank account will be operated? certificate and other papers filed should be kept on record. Bank should stipulate condition that says 25 % profit & Salary due to partner should be retained in the business
REGISTERS

HO should prescribe the format of various loan registers to be maintained by HO should arrange to print these registers or procure them on behalf of branches to Security register (computer) should be up dated regularly.

branches. ensure uniformity.

53

4.4. PRINCIPLES OF LENDING

According to general principles of lending, all mortgage originators should act in "good faith and with fair dealings" in any transaction. A reliable customer forms the basis of a successful lending. The following principles act as the foundation of a judicious lending: Safety of funds ensures that the bank, although being a profit generating unit, continues to build and retain the trust of the public at large. Security accepted from the borrower as an alternative for recovery of advances in case of default must be of significant value. Purpose or the objective of advances should remain in favor of nations security. It should not be anti- social or illegal. Profitability and yield on advances should be in line with the banks objective, so the advances made must be successful. Liquidity of advances made by the bank indicates its ability to meet its deposit liabilities, so the advances made should be adequately liquid. Integrity of borrower is very vital to consider the loan proposal envisaged by him for further sanction. Adequacy of bank finance is of prime importance for a borrower to accomplish his project so both under and over financing should be avoided by the bank. Timely availability of funds to the borrowers helps the bank grow in the current scenario.

54

These principles strengthen the bank finance eventually leading to safe advances.

4.5 PRINCIPLES OF BASEL II ACCORD 4.5.1 Basel II consists of three pillars

Fig 6. Basel II PILLAR 1 It sets principles for minimum capital requirements to cover both credit and operational risks. Capital requirement is a guarantee amount against unexpected losses. It is taken as equity in banks accounts. To determine minimum capital requirements, a bank can either use external sources or an internal rating base approach. There are three fundamental components to calculate the minimum capital requirement according to Basel II. 55

a) Probability of Default (PD): It is the likelihood that an applicant will default in one year time period. b) Loss Given Default (LGD): It is the proportion of the exposure that will be lost if the applicant defaults. c)Exposure at Default (EAD): The nominal value of loan granted. The minimum capital requirement (MCR) estimation is shown in with respect to Basel II: MCR = 0.08*RW*EAD = 0.08 RWA Here RW is the risk weight calculated by using PD, LGD and remaining maturity of exposure. It has specific formulas for each asset type. RWA is the risk weighted asset. EL = PD*EAD*LGD MCL=EAD*LGD*PD-b*EL Where EL is the expected loss and b is the proportion of expected loss of loan covered by minimum capital requirement. PILLAR 2 It defines principles for supervisors to review assessments to ensure adequate capital. The rating system and risk management activities are checked by supervisors. Supervisors review process, to be sure that banks have adequate and valid techniques for capital requirements. Accurate and valid techniques lead to better credit risk management for the banks. Banks are expected to manage their internal capital assessments. According to Basel Committee, there is a relation between capital required and banks risk. Banks should have a process for assessing overall capital adequacy in relation to their risk profile. Supervisors are responsible for the review and evaluation of the assessment procedure. When supervisors think the validity of the rating process is not adequate, they can take appropriate actions. They can take early stage actions to prevent capitals from falling below the minimum levels required to support the risk characteristic. PILLAR 3 56

It sets principles about banks disclosure of information concerning their risk. Its purpose is to maintain the market discipline by completing pillar 1 and pillar 2. The Basel Committee encourages market discipline by developing sets of disclosure requirements. According to the new accord, banks should have a disclosure policy and implement a process to evaluate the appropriateness of the disclosure. For each separate risk areas banks must describe their risk management objectives and policies.

57

4.5.2 PD Dynamics Probability of default is one of the challenging factors that should be estimated while determining the minimum capital requirement. New Accord has sets principles in estimating PD. According to Basel II, there are two definitions of default: a) The bank considers that the obligor is unlikely to pay its credit. There are four main indicators that bank considers the obligor is unlikely to pat the obligation: The bank puts the obligation on an non-accrued stratus The bank sells the credit obligation at a material credit related economic Loss. The bank consents to a distressed restriction of credit obligation. The obligor sought or has been placed in bankruptcy. b) The obligor past due more than 90 days on credit obligation to the bank. Banks should have a rating system of its obligor with at least 7 grades having meaningful distribution of exposure. One of the grades should be for no defaulted obligor and one for defaulted only. For each grade there should be one PD estimate common for all individuals in that grade. It is called as pooled PD. There are three approaches to estimate pooled PD. a) Historical experience approach: In this approach, PD for the grade is estimated by using the historical observed data default frequencies. In other words, the proportion of defaulted obligers in a specific grade is taken as pooled PD. b)Statistical Model Approach In that approach, firstly predictive statistical models are used to estimate default probabilities of obligors. Then, for each grade the mean or median of PDs are taken as pooled PD. c)External Mapping Approach

58

In this approach, firstly a mapping procedure is established to link internal ratings to external ratings. The pooled PD of external rating is assigned to internal rating by means the mapping established before. Basel II allows the banks to use simple averages of one year default rates while estimating pooled PD. While establishing the internal rating process, the historical data should be at least 5 years, and the data used to build the model should be representative of the population. Where only limiting data are available or there are limitations of assumptions of the techniques, banks should add the margins of conservatism in their PD estimates to avoid over optimism. The margin of conservatism is determined according to the error rates of estimates depending on the satisfactory of the models. There should be only one primary technique used to estimate PD, the other methods can be used just for comparison. Therefore, the best model should be taken as the primary model representing the data. After the estimation of PDs, the rating classes are needed to be built. The banks are allowed to use the scale of external institutions. In the PD estimation process, just building the model is not enough supervisors need to know not only the application also the validity of the estimates. Banks should guarantee to the supervisor that the estimates are accurate and robust and the model has good predictive power. For this purpose, a validation process should be built. The scoring models are built by using a subset of available information. While determining the variables relevant for the estimation of PD, banks should use human judgment. Human judgment is also needed when evaluating and combining the results.

59

4.6 FINANCIAL ANALYSIS OF LENDING Financial analysis is the systematic examination and interpretation of financial data to evaluate the past performance of a business, its present conditions and its future prospects. It refers to an assessment of the viability, stability and profitability of a business, sub-business or a project. Essentially, financial analysis moves from a preliminary investigation of the client to an in depth examination of operating performance, as interpreted from historical and projected financial statements. With financial analysis, the advances manager assesses the financial performance of the company to arrive at a conclusion about the future prospects of the loan repayment.

60

4.6.1 FINANCIAL ANALYSIS ASSESSES THE FIRMS: 1. Profitability - its ability to earn income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on the income statement, which reports on the company's results of operations; 2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term; 3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations; 4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of income statement and balance sheet, as well as other financial and non-financial indicators.

61

4.6.2 STEPS INVOLVED IN FINANCIAL ANALYSIS OF LENDING Step1: Companys financial statement for at least 3 to 5 years is acquired. The financial statement must include the following: Balance sheets Income statements Shareholders equity statement Cash flow statements Step 2: A quick scanning of all the statements is done to look for large movements in specific terms from one year to the next. If there is something suspicious, relevant research about the company is done from the information available to find out the reason. Notes accompanying the financial statements are also reviewed for additional information that may be significant to analysis. Step 3: This stage calls for an exhaustive scrutiny of the balance sheet. While examining, the advances manager looks for the large changes in overall components of companys assets and liabilities of equity. For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? Has the portion of debt grown rapidly, to reflect a new financial strategy? Step 4: This level relates to an assessment of the income statement as furnished by the client. The advances manager looks for the trends overtime. Graphs and growth of the following entries over the past several years are calculated. 1. Revenue (sales) 2. Net income (profit, earnings) For each key expense components on the income statement, percentage of sales of each year is calculated. For example, percentage of cost of goods sold over sales, general and administrative 62

expenses over sales and development over sales are computed. Favorable and unfavorable trends are highlighted. Manager determines whether the spending trends support the companys strategies. Step 5: The very phase pertains to an evaluation of the cash flow statement. It gives information about the cash inflows and outflows from operations, financing and investing. While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors really care about. Step 6: Calculation of financial ratios- Discussed in Chapter 3.

KEY RATIO LEVELS PARTICULARS LOW RISK Current Ratio TOL/TNW Interest Coverage PAT/SALES% Inventory (No. of > 1.40 <2.00 >3.50 >10.00 <60 MEDIUMRISK 1.20-1.40 2.00-3.50 2.00-3.50 4.00-10.00 60-90 45-90 1.25-1.75 1.25-2.00 Table 1: Key ratio levels HIGH RISK <1.20 <3.50 <2.00 <4.00 >90.00 >90.00 >1.75 <1.25

days Debtors (No. of days <45 Debt Equity Ratio <1.25 DSCR (For TL) >2.00

63

4.7 CLARIFICATION WITH REGARD TO ASSESSMENT OF WORKING CAPITAL LIMITS

64

Issues raised by banks 1

Clarification 2

A Whether banks should sanction working capital The assessment of working capital credit limits limits on the basis of a minimum of 20 percent of should be done both as per projected turnover the projected annual turn over /output value or method and traditional method . If credit whether it is intended that banks should also requirement based on production/processing arrive at the requirement based on the traditional cycle is higher than the one assessed on project approach of production /processing cycle and turn over basis ,the same may be sanctioned as there after decide the quantum of need based RBI guidelines stipulate bank finance at finance.If the traditional approach is followed minimum of 20% of the projected turnover.On ,the working capital finance arrived at could be the other hand of it the assessed credit either more than or less than .In case it is less requirement is lower than the one assessed on than 20%,whether bank should still give 20% ? projected turn over basis,while the credit limit can be sanctioned at 20% of the projected turn over ,actual drawals may be allowed on the basis of drawing power to be determined by the banks after excluding unpaid stocks. In case of selective credit control commodities the drawing power should be determined as indicated in the RBI directives. B Whether projected turnover/output value basis The projected turnover/output value ,may be gross sale interpreted as gross sale which will include excise duty also. C Whether 5% promoters stake (Net Working In terms of extant guidelines the working Capital) should be reckoned with reference to the capital requirement is to be assessed at 25% of projected turnover with reference to working projeted turnover to be shared between the capital arrived at based on production and process borrower and bank viz. borrower contributing cycle ? 5% of the turnover as NWC and bank providing finance at a minimum of 20% of the turn over .The above guideline were framed assuming the average production cycle of 3 months .It is possible that certain industries may have production cycle of shorter/longer 3 months.While in the case of shorter cycle ,the same principal could be applied as it the 65 intention to make available atleast 20% of turnover by way of bank finance. In case the cycle is longer ,it is expected that the borrower

66

Chapter 5.
A CASE STUDY While undergoing my project work under the guidance of Indian Overseas Bank authority, I have been assigned to do the Working Capital Assessment/Appraisal of a partnership firm M/s XXX Co. ( Name of the firm changed ) which is a trading concern dealing in Indian manufactured foreign liquor (IMFL). BACKGROUND OF THE FIRM XXX Co. is a partnership firm promoted by Mrs. A, Mr. B and Mr. C. They belong to the same family. Mrs. A is the mother of Mr. B and Mr. C. The unit being established on 09/09/2001 started wholesale dealership trading in Indian manufactured foreign liquor and beer since 2003. XXX Co., opened their account with INDIAN OVERSEAS BANK since 09-01-2003. At first they availed a cash credit facility of Rs. 35 Lacs on 08-04-2003, after then it had enhanced to the tune of Rs. 95 Lacs on 20-09-2004. So long they used to avail the same credit facility without further enhancement. This limit expired on 31-07-2009. Earlier in this nature of business a sizeable quantum of credit could be obtained from the manufacturers/ stockists, but as per recent trend almost all the payments are to be made in advance to get the stocks due to shortage of supply and huge demand of the product resulting in stiff competition amongst the wholesale dealers. Sales are going on increasing over the years. In this year, they got an offer of stockistship of BEER under the brand name of KINGFISHER STRONG and KINGFISHER PREMIUM product of eminent UB GROUP which has already gain a lions share in the field of BEER market. It is expected that with the intervention of this lucrative branded BEER market, their sales turnover would increase by leaps and bounds. For this, they need further Working Capital. In this year they appealed the bank to enhance the existing credit limit of Rs. 95 Lacs to the tune of Rs. 200 Lacs. The business is sound and progressing. Partners are creditworthy, well experienced and enjoying goodwill in the market. In this trade, the manufacturer fix the price of the product and allow a certain percentage of discount to the wholesaler. The wholesaler keep a portion of the discount with them and pass the remaining discount to the retailer. The retailer sells the product at the predetermined price. The 67

discount allowed by the manufacturer to them as Stockiest/ Dealers/ Wholesalers is a lump sum profit, but the same is shown as other income in the balance sheet. Conduct of the account for full financial year from 01-04-2008 to 31-03-2009 (Rs. In crores) Nature of facility Cash Credit From 01-04-2009 to 14-08-2009 Limit 0.95 0.95 Max. Min. O/s O/s 0.97 0.97 0.84 0.88 Turn over 6.58 2.19 Average Income Utilization Earned 97.26% 96.23% 0.14 0.04 Interest serviced Upto 31-03-2009 31-07-2009

Table 2: Nature of Facility

SWOT ANALYSIS OF THE FIRM: STRENGTH: WEAKNESS: OPPORTUNITY: THREAT: Good Entrepreneurship, Knowledge and Experience Advance payment to the stockists for getting the stock, on the contrary sizeable receivables from the retailers. Good location of the shop establishment and possibility of getting stockistship of renowned beer of UB group. Competitors.

68

SUBJECTS PRESENT REQUEST XXX Co. requested for Renewal cum Enhancement of cash credit limit of Rs. 95.00 Lacs to the tune of Rs. 200.00 Lacs. They submitted all the required data which is very much necessary for the approval of the request. The details are as follows: Table 3: Guarantors and their net worth NAME Mrs. A Mr. B Mr. C Mr. D AGE 59 38 37 62 ADDRESS WORTH (in crores) 1.78 1.16 1.13 0.10 AS ON 10/08/2009 -do-do-do-

Table 4:COLLATERAL SECURITY DETAILS (in crores) Nature of Security Market Value Forced Sale Value Proposed Valuation Other details/percentage of security cover

Date & Name of Approved Valuer Existing F.D.-0.10 LIC-0.03 NSC-0.02 Cash Credit Flat-0.42 Shop cum Godown-0.85 Total-1.42 Proposed F.D-0.11 LIC-0.04 NSC-0.02 Flat-0.56 Shop cum Godown-1.03 Total-1.76 F.D-0.11 LIC-0.04 NSC-0.02 Dated Flat-0.48 20/08/2009. Shop cum Godown-0.88 Total-1.53 AAA & Consultants Collateral security coverage is 76.50% with the total exposure of the cash credit limit of 200 lacs

69

INSURANCE
Table 5: Securities Prime Securities Stocks Collateral Securities Building Value of the Securities 1.30 0.92 Insured Value 1.50 1.13 (in crore) Valid Upto 23/11/2010 22/11/2010

** As per stock statement submitted by the firm to the bank, it has been observed that on an average they are keeping stocks to the tune of Rs. 1.20 Rs. 1.30 crores in their godown. Hence, keeping some margin they have made insurance on stock valued at Rs. 1.50 crores. ** Though the value of the Flat and godown kept with the bank as collateral security stands at Rs. 0.92 crores but the valuation has been done two years ago. Keeping in view towards the escalation of immovable properties valuation, they have made insurance on building to the extent of Rs. 1.13 crores. They have done so because if the securities are being insured at undervalue, the insurance company will not compensate the actual value of the securities in case of any untoward incidence would take place.

VALUE OF THE CUSTOMER 70

In the year 2008-2009, average balance stands @97.26% of the existing limit and the same stands @96.63% on & from 01.04.2009 to 14.08.2009. fixed deposits are being held at card rates i.e., the normal rate of interest on deposits to various types of customers approved by the competent bank authority. We are hopeful for bringing few other low cost and no cost accounts through the subject(s).

CMA FORMAT
The basic foundation of all banks' appraisal of the needs of creditors is the level of current assets. The classification of assets and balance sheet analysis, therefore, assumes a lot of importance. RBI has mandated a certain way of analyzing the balance sheets. The requirements of this breakup of assets and liabilities differs slightly from that mandated by the Company Law Board (CLB). The analysis of balance sheet in CMA data is said to give a more detailed and accurate picture of the affairs of a corporate. The corporates are required by all banks to analyse their balance sheet in this specific format called CMA data format and submit to banks. While most qualified accountants working with the firms are aware of the method of classification in this format, professional help is also available in the form of Chartered Accountants, Financial Analysts for this analysis. All the data available in the Balance Sheet give by the XXX Co. are extracted and put it in the CMA format for the required analysis.

ASSESSMENT OF WORKING CAPITAL REQUIREMENTS FORM-I 71

Particulars of the existing/proposed limits from the banking system. (Limits from all Banks and Financial Institutions s on the date of application) Table 6: FORM1

(AMOUNT- Rs. IN LACS)

SL NAME OF THE BANK/ NO. FINANCIAL INSTITUTIO N NATURE OF THE FACILITY EXISTING LIMITS EXTENT TO WHICH LIMITS WERE UTILIZED DURING THE LAST 12 MONTHS MAX. MIN. BALANCE O/S AS ON 20-08-2009 LIMITS NOW QUEST ED

Indian Overseas Bank, Chow ringhee branch

Cash credit

95

97

84

93

200

ASSESSMENT OF WORKING CAPITAL FORM- II 72

Table 7:FORM II As per Profit and Loss accounts /estimates for the year ended /ending LAST THREE YEARS ACCOUNT CURRENT FOLLOWI (AS PER AUDITED ACCOUNTS) YEAR NG YEAR ESTIMATES PROJECTI 31-03-2006 31-03-2007 31-03-2008 ON 31-03-2009 31-03-2010 1.GROSS INCOME i. SALES (NET OR RETURNS) a) Domestic sales 692.56 b) Export sales c) Sub-total [a +b] 692.56 d) Percentage rise [+] or fall [-]in sales turnover as compared to previous year (%) ii. OTHER INCOME a) Duty drawback b) Cash assistant/ 29.74 discount c) Other assistance d) Sub-total [a +b +c] iii. Total [i]+[ii] 722.30 2.COST OF SALES i. Purchases 401.91 ii. Other trading expenses [ carriage onward. Commn & brokerage on purchase] iii. Sub-total [ i + ii] iv. Add: opening stock v. Sub-total [ iii + iv] vi. Less : closing stock vii. Sub-total [v-vi] 3.69 405.60 171.62 577.22 44.05 533.17 483.96 483.96 -30.12 540.34 540.34 11.65 622.60 622.60 15.22 1134.00 1134.00 82.14

21.26

11.03

13.49

24.78

505.22 470.75 0.00 470.75 44.05 514.80 53.41 461.39

551.37 518.18 0.00 518.18 53.41 571.49 74.34 497.25

636.09 586.20 0.00 586.20 74.34 660.54 73.86 586.68

1158.78 1167.44 0.00 1167.44 73.86 1241.30 164.00 1077.30

73

3. SELLING GENERAL & ADMINISTRATIVE EXPENSES 175.66 (including Bonus payments) 4. OPERATING PROFIT [interest & depreciation] 13.47 [1 (iii) 2 (vii) - 3] 5. INTEREST 6. DEPRECIATION 7.OPERATING PROFIT [after interest / depreciation] -0.62 [ 4- 5- 6] 8. i] Add: Other non operating-income a) Interest on FRD b) Interest on loan/ Income Tax Refund c) Others (lifting charges) d) Sub-total (income) ii] less: Other nonoperating expenses. a) Preliminary expenses b) Interest on Partners Capital A/C c) Partners Remuneration d) Sub-total (expenses) 3.46 0.00 5.94 5.94 12.45 1.64

21.11

24.85

23.23

32.76

22.72 11.80 1.64

29.27 13.36 1.40

26.18 13.46 1.19

48.72 26.00 1.04

9.28

14.51

11.53

21.68

0.84 0.44 1.28

0.00 0.39 0.39

0.00 0.00 0.00

0.00 0.00 0.00

1.90 1.56

1.61 3.50 5.11 74

5.24 3.54 8.78

4.71 3.50 8.21

4.92 9.00 13.92

iii] Net of other nonoperating income / expenses 2.48 [ net of 8 (i) & 8 ( ii )] 9. PROFIT BEFORE TAX / LOSS 1.86 [ 7+8( iii )] 10. PROVISION FOR TAXES 1.83 11.NET PROFIT / LOSS (9- 10) 12. a) Equity dividend paid** b) Dividend rate 13. RETAINED PROFIT (11-12) 14. RETAINED PROFIT / NET POFIT (%) (13-11) 0.03 100% 0.01 100% 0.04 100% 0.03 0.01 0.04 -1.06 -0.48 5.44 6.08 4.38 8.24 5.45 6.12 3.32 7.76 -3.83 -8.39 -8.21 -13.92

** In case of firms, drawings made during the year by projectors / partners.

75

LIABILITIES

ASSESSMENT OF CAPITAL Table 8:FORM- III(P& L A/C) As per Profit and loss accounts actual / estimates for the year ended / ending

76

LAST THREE YEARS ACCOUNT ( as per audited accounts)

CURRENT YEAR ESTIMAT ES

FOLLOWI NG YEAR PROJECTI ON

31-03-2006 31-03-2007 31-03-2008 1. Short term borrowings from banks ( including Bill purchased, discounted & excess borrowings placed on repayment basis) a) From applicant bank 93.10 b) From other bank c) ( of which BP & BD ) SUB-TOTAL ( A ) 2. Short term borrowing from others 3. Sundry creditors ( trade ) ( months purchases) 4. Advance payments from customers / deposits from dealers 5. Provisions for taxation 6. Dividend payable 7. Other statutory Liabilities ( due within one year) 0.07 8. Deposits / debentures / installments under term loans / DPGs, etc. (due within one year) 9. Other current liabilities & provisions (due within one year) ( specially major terms) (sundry Expenses + other Finance) SUB-TOTAL ( B ) 5.92 56.18 5.69 67.34 7.06 96.23 0.07 0.13 49.76 0.43 61.46 0.12 89.02 0.02 95.71 97.93

31-03-2009 31-03-2010

94.60

200.00

93.10

95.71

97.93

94.60

200.00

66.16 0.00

60.37 0.00

0.00

0.00

7.90 74.06

8.65 69.02

10. TOTAL CURRENT LIABILITIES 11. Debentures ( not maturing within one year )

149.28

77 163.05

194.16

168.66

269.02

Table 9:FORM-III(B/S)

As per balance sheet as at

LAST THREE YEARS ACCOUNT (AS PER AUDITED ACCOUNTS) CURRENT ASSETS 31-03-2006 31-03-2007 31-03-2008 31-03-2009 31-03-2010 1. Cash and bank balances 22.21 2. Investments [ other than long term investments] i. Government & other Trustee Securities ii. Fixed Deposits with banks including Interest accrued 3. i. Receivables other than deferred 7 exports 60.46 [ including bills purchased & discounted by bankers] [Months export sales] ii. Export receivables [ including bills purchased / discounted by bankers] [ months export sales] 4. Installments of deferred receivables (due within one year) 5. Stocks-in trade ( months cost of sales) 6. Advances to suppliers of merchandise & deposits 7. Advance payment of taxes 8. Other current assets [ specify major items] 29.67 27.55 78 26.10 24.83 28.03 98.99 119.48 112.32 159.84 19.83 13.96 7.40 8.00 CURRENT YEAR ESTIMAT ES FOLLOWI NG YEAR PROJECTI ON

Loan and Advances 9. TOTAL CURRENT ASSETS 156.39 [ TOTAL OF 26 TO 33] 199.78 233.88 218.41 359.87

10. Fixed Assets 11. Depreciation 12. NET BLOCK [ 35 36 ] 13. Investments / book debts/ advances/ deposits , which are not current assets i. a) investments in subsidiary companies / at liabilities b) Others ii. advances to suppliers of capital Goods & contractors. deferred receivables

11.73 1.64 10.09

10.48 1.64 8.84

9.39 1.40 7.99

8.27 1.19 7.08

7.48 1.04 6.44

iii.

[ maturity exceeding one year] iv. security deposits / tender deposits v. others / Debtor over 6 months 14. Obsolete stocks 15. Other non-current assets 16. TOTAL OTHER NON CURRENT

0.08

0.08

0.08

1.14

1.62

0.08 79

0.08

0.08

1.14

1.62

ASSETS ( total of 38 to 40) 17. Assets ( patents, goodwill, preliminary expenses, bad/doubtful debts not provided for ,etc) 18. TOTAL ASSETS ( total of 34, 37, 41 & 42 ) 19. TANGIBLE NET WORTH ( 24-42 ) 20. NET WORKING CAPITAL 8.74 {[ 17+24] [37+41+42]} TO TALLY WITH [ 34 - 10] 1.05 1.23 1.20 1.29 1.34 36.74 39.72 49.75 90.85 166.56 13.43 208.71 43.69 241.95 47.68 226.63 57.97 367.93 98.91

21. CURRENT RATIO [ 34/10]

22. TOTAL OUTSIDE

LIABILITIES/ TANGIBLE NW WORTH [ 18/44 ]

11.40

3.78

4.07

2.91

2.72

ASSESSMENT OF WORKING CAPITAL

Table 10:FORM-IV(B/S) LAST THREE YEARS ACTUALS ( AS PER AUDITED ACCOUNTS) As per balance sheet as at CURRENT FOLLOWI YEAR NG YEAR ESTIMATE PROJECTI S ON 31-03-2009 31-03-2006 31-03-2007 31-03-2008 31-03-2010

80

A. CURRENT ASSETS 1. Stocks- in-trade 44.05 [ months cost of sales ] 2. Receivables other than export and deferred receivables ( including bills purchased and discounted by bankers) ( months domestic sales) 3. Export receivables ( including bills purchased and discounted by bankers) ( months domestic sales) 4. Advances to suppliers of merchandise 5. Other current assets ( including cash and bank balances & deferred receivables due within one year) ( specially major items) (Loan and Advances) 6. TOTAL CURRENT ASSETS 156.39 ( to agree with item 34 in Form-III ) 199.78 233.88 218.41 359.87 51.88 47.38 40.06 32.23 36.03 60.46 98.99 119.48 112.32 159.84 53.41 74.34 73.86 164.00

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COMPARATIVE STATEMENT OF CURRENT ASSETS AND CURRENT LIABILITIES

As per balance sheet as at Table 11:Comparision LAST THREE YEARS ACTUALS CURRENT YEAR ESTIMAT ( AS PER AUDITED ACCOUNTS) ES FOLLOWI NG YEAR PROJECTI ON

31-03-2006 31-03-2007 31-03-2008 31-03-2009 31-03-2010

B. CURRENT LIABILITIES 82

( other than bank borrowings for working capital) 7. Sundry Creditors ( Trade) ( Months Purchases) 49.76 61.46 89.02 66.16 60.37

8. Advance payments from customer / deposits from dealers 9. Statutory Liabilities

0.43

0.12

0.02

0.00

0.00

0.07

0.07

0.13

0.00

0.00

10. Other current liabilities ( specially major items such as short time borrowings, unsecured loans dividend payable , installments of TL, DPG , public deposits, debentures , etc.)

5.92

5.69

7.06

7.90

8.65

11. TOTAL ( To agree with sub-total BForm-III) 56.18 67.34 96.23 74.06 69.02

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COMPUTATION OF MAXIMUM PERMISSIBLE BY BANK [FINANCE FOR WORKING CAPITAL] Table 12:FORM-V(B/S)
LAST THREE YEARS ACTUALS ( AS PER AUDITED ACCOUNTS) As per balance sheet as at CURRENT FOLLOWI YEAR NG YEAR ESTIMAT PROJECIO ES N

31-03-2006 31-03-2007 31-03-2008 31-03-2009 31-03-2010 1. Total current assets (34 Form III) 2. Current liabilities ( 2 to 9 Form III) 156.39 56.18 84 199.78 67.34 233.88 96.23 218.41 74.06 359.87 69.02

( other than bank borrowings) 3. Working capital gap 100.21 ( WCG) ( 1-2 ) 4. Min. stipulated net working capital- 25% of total current assets other than export receivables ( as at 28(ii) of form III ) 5. Actual / projected net Working capital (45 in form III) 6. Item 3 minus item 4 7. Item 3 minus item 5 8. Maximum permissible by bank finance ( item 6 or 7 whichever is lower) 9. Excess borrowings, if any representing short fall in NWC (4-5) 39.10 49.95 58.47 54.60 89.97 132.44 137.65 144.35 290.85

8.74 61.11 91.47

36.74 82.49 95.70

39.72 79.18 97.92

49.75 89.75 94.60

90.85 200.88 200.00

61.11

82.49

79.18

89.75

200.88

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Table 13: FORM VI (B/S)

FUNDS FLOW STATEMENT

LAST TWO YEARS ACTUALS ( as per audited balance sheet) 31-03-2007 31-03-2008 1. SOURCES a) Net profit 0.01 ( after tax) b) Depreciation c) Increase in capital 1.64 30.26 0.04 1.40 3.99 1.19 10.29 1.04 40.94 As per balance sheet as at CURRENT FOLLOWI YEAR NG YEAR ESTIMAT PROJECTI ES ON 31-03-2009 31-03-2010

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d) Increase in term liabilities

( including Public Deposits) e) Decrease in I. Fixed assets II. Other NonCurrent assets f) Others g) TOTAL 2. USES a) Net Loss 1.06 b) Decrease in term liabilities 1.88 ( including Public deposits) c) Increase in I. Fixed assets II. Other NonCurrent assets d) Dividend payments e) Others f) TOTAL 3. Long term Surplus (+)/ deficit (-) 4. 5. 6. 7. ( 1-2) Increase / Decrease in current assets Increase / Decrease in current Liabilities other than bank borrowings Increase / decrease in working capital gap Net surplus (+) / deficit (-) 2.27 29.64 43.39 11.16 32.23 -2.59 2.59 2.41 3.02 34.10 28.89 5.21 -2.19 2.19 1.45 10.03 -15.47 -22.17 6.70 3.33 -3.33 0.88 41.10 141.46 -5.04 146.50 -105.4 105.4 1.86 0.11 0.00 0.48 31.91 5.43 11.48 41.98

0.39

0.55

0.28

0.40

(Difference of 3 & 6) 8. Increase / decrease in bank borrowings

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INCREASE / DEFICIT IN NET SALES

-208.6

56.38

82.26

511.4

BRIEF FINANCIAL INDICATORS OF SUBJECT COMPANY:

(Rs. In crores)

Table 14: Financial Indicators Year Ending Audit Status Net Sales 2006-2007 Audited 4.84 2007-2008 Audited 5.40 0.29 0.0004 2008-2009 Provisional 6.23 0.26 -0.0106 2009-2010 Estimated 11.34 0.49 -0.0048

Operating 0.23 Profit Net Profit After 0.0001 Tax

88

Cash 0.04 Generation Net Working 0.37 Capital Current Ratio TNW TOL/TNW 1.23 0.44 3.78

0.05 0.40

0.08 0.50

0.14 0.91

1.20 0.48 4.07 0.00 0.09 0.00

1.29 0.60 2.91 0.00 0.08 0.00

1.34 0.99 2.72 0.00 0.07 0.00

Term 0.05 Liability/TNW Gross Fixed 0.10 Assets Term Loan 0.02

N.B. : Net Profit After Tax in each year have been depicted very less as per the above charge. This is so that the subjects have debited the items like Interest in Partners Capital, Partners Remuneration etc. in their Profit and Loss account.

A BRIDGED FINANCIAL POSITION: (Rs. In crores) Table 15: Financial Position Year ending Audit Status LIABILITIESCapital and 89 2006-2007 Audited 2007-2008 Audited 2008-2009 Provisional 2009-2010 Estimated

Reserves 0.44 Long Term 002 Liabilities TOTAL LIABILITIES 2.09 ASSETSFixed Assets Non-Current Assets 0.09 0.48 0.00 0.58 0.00 0.99 0.00

2.42

2.27

3.68

0.08

0.07

0.06

0.00

0.00

0.00

0.00

Current Assets Intangible Assets TOTAL ASSETS

2.00 0.00

2.34 0.00

2.20 0.00

3.62 0.00

2.09

2.42

2.27

3.68

Chapter 6. 90

CONCLUSION AND RECOMMENDATION 6.1 COMMENTS ON FIANCIALS/PERFORMANCE OF THE COMPANY (conclusion)

SALES: Comments on achievements of sales vis--vis estimates given in the past,

current year sales achieved till previous month, feasibility of achieving sales estimated/ projected.

PROFITS: comments on trend in profitability and feasibility of achieving estimates/

projections

TANGIBLE NET WORTH (TNW): comments of trend and feasibility of

achieving the estimates / projections.

TOL/TNW: comments on acceptability of key ratios and other negative features. CR/ NWC: comments on large amounts held under Non-Current Assets, other
Current Assets, other Current Liabilities with break up details must be furnished with justification thereof.

Sales are going on increasing over the years. In this year they got an offer of stockistship of BEER under the brand name KINGFISHER STRONG and KINGFISHER PREMIUM product of eminent UB GROUP which has already gain a lions share in the field of BEER market. It is expected that with the intervention of this lucrative branded BEER market, their sales turnover would increase by leaps and bounds. So far in this financial year, their turnover as per financial year 2009 stands at Rs. 218.69 lacs upto JULY 2009 with induction of further Working Capital and ensuing festive season and winter season, we can presume that estimated sales target of Rs. 1134.00 lacs in the financial year 2009-2010 would be achieved within rest period of 8months.

Operating Profit of the firm are going on increasing over the years. Net Profit After Tax in each year have been depicted very less as per the above charge. This is so that the subjects have debited the items like Interest in Partners Capital, Partners Remuneration etc. in their Profit and Loss account.

TNW is also going on increasing over the years due to fresh induction of capital as also retained profit which includes partners remuneration, interest on capital and capital and share of profit.

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 TOL/TNW IS 2.91 & 2.72 in the financial year 2008-09 & 2009-10 respective acceptable

especially in this time of business where much working capital is needed to run the show. Current Ratio is gradually improving over the years and stands well within the benchmark level ie 1.32 in the estimated in the increasing order over the years.

In a word, sales, Net profit, TNW and NWC are in the increasing order.

6.2GIST OF RECOMMENDATIONS:

Based on the aforementioned facts and figure, Partners Goodwill, creditworthiness and good entrepreneurship, financials of the company, progressing trend of the business, working capital need, overall security aspects and guarantee offered, we may consider favorably to enhance the existing cash credit limit of Rs. 95 Lacs to the tune of Rs. 200 Lacs. We recommend sanction of the same.
Table 16: SANCTION OF FOLLOWING ENHANCEMENT cum RENEWAL OF LIMITS

( IN CRORES) Nature of limit/ facility Cash Credit Working Capital purpose Existing limit 0.95 Revised limit 2.00 (+)/ (-) +1.05 25% on stock Margin Interest% applicable rate BLPR +2.25% i.e. Interest % proposed BLPR +2.25% i.e. at present @14.25%

and 40% at present on book- @14.75% debts TERMS AND CONDITIONS OF SANCTION 1. A processing charge of Rs 33,600/- only is to be paid to the bank.

2. All sale transactions must be rooted through the cash credit account with the bank. 3. The firm is to deal exclusively with the bank for departmental stores with the bank. 4. Hypothecation board must be displayed in the shop/ godown. 92

5. Stocks and land & Buildings are to ensured in full value with the respective bank clause 6. Bank officials must have an access in the shop/ godown and all immovable properties for the purpose of inspection as on when required.
7. Stock statements as on last date of each month must be submitted to the bank with the

10th day f the following month filing which 2% penal interest will be levied. 8. All the other norms/guidelines as applicable for finance as per banks book of instructions, manual of documentation and circulars issued by RBI/Central Office from time to time should be complied with. ** The entire working capital credit assessment of the aforementioned appraisal has been done from one of the files of Indian Overseas Bank, Chowringhee branch and the name of the firm being changed where the sanction has been based on the then current year estimates as on 20092010.

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After study and analysis of working capital I would like to recommend the following: 1. Company should raise funds through short term sources for short term requirement of funds, which comparatively economical as compare to long term funds. 2. Company should take control on debtors collection period which is major part of current assets. 3. Company has to take control on cash balance because cash is non earning assets and increasing cost of funds. 4. Company should reduce the inventory holding period with use of zero inventory concepts.

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APPENDICES
Bibliography Books Referred 1. I. M. Pandey - Financial Management - Vikas Publishing House Pvt. Ltd. - Ninth Edition 2. M.Y. Khan and P.K. Jain-Financial management Vikas Publishing house ltd., New Delhi. 3. K.V. Smith- management of Working Capital- Mc-Grow-Hill New York 4. Satish Imandar- Principles of Financial Management-Everest Publishing House Websites References 1. www.jains.com 2. www.google.co.in 3. www.workingcapitalmanagement.com 4. www.wikipedia.com All the data regarding the subject of the case study are supplied by the bank. Images are collected from google images.

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