Final BBM Financial management

` ` ` ` `

` `

Background : Banks oversold the credit and there was no exchange of the information between the banks and the customer The cash credit limit was sanctioned by the banks but was not reviewed by the banks for 2 to 3 years 1969- nationalization of banks New policy new approach credit agency based on the development potential rather than on security only, to assist the weaker sections of the society and later to lend to public sector But this prevailing system of cash credit also came under severe criticism This system level of the advances by the bank was determined not by the banker to lend but by the borrowers decisions to borrow at that time --- difficult for the bank Changes --- borrower would plan his credit needs and the banker would be able to plan, having knowing the borrowers credit requirements A committee was appointed by the RBI in July 1974 under the chairmanship of Sri. P.L. Tandon.

1.

2.

3.

4.

5.

6.

To suggest guidelines for the commercial banks to follow up and supervise the credit from the point of view of ensuring proper end use of the funds and keeping a watch on the safety of advances To suggest the type of operational data and other information that may be obtained by banks periodically from the borrowers and the RBI from the lending banks To make suggestions to make inventory norms for different industries both in the private and public sector and indicate the broad criteria for deviating from these norms To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to the borrowing To make recommendations regarding resources for financing the minimum working capital requirements To suggest whether the existing pattern of financing working capital requirements by cash credit/ overdraft requires to be modified, if so, to suggest suitable modifications

i.

ii. iii.

iv.

It is the borrower who decides how much he would borrow who decides how much he would borrow. The banker cannot do any credit planning since he does not decide hoe much he would lend Bank credit is treated as the first source of finance Bank credit is extended on the amount of security available and not according to the level of operations of the borrower There is a wrong notion that security by itself ensures the safety of bank funds. As a matter of fact, safety essentially lies in efficient follow up of the industrial operations of the borrower

  

A proper financial discipline has to be observed by the borrower. He should supply banker with the information regarding his operational plans well in advance. The banker must carry realistic appraisal of such plans The main function of the bank as a lender is to supplement the borrowers resources to carry an acceptable level of current assets. This has two implications: The level of current assets must be based on the reasonable and based on norms and A part of funds requirement for carrying out current assets must be found from long term funds The bank should know the end use of the bank credit so that it is used only for the purposes for which it I made available

` Inventory

and receivables

norms

` Lending

norms

Norms for 15 industries --1. Cotton and synthetic textiles 2. Man made fiber 3. Jute textile 4. Rubber products 5. Fertilizers 6. Pharmaceuticals 7. Dye 8. Dyestuffs 9. Basic industrial chemicals 10. Vegetable and hydrogenated oils 11. Paper 12. Cement 13. Engineering 14. Manufacturers 15. Other capital equipment suppliers

The norms proposed represent the maximum level for holding inventories and receivables. Raw materials including stores and other items used in the process of manufacture Stocks in process Finished goods Receivables and bills discounted and purchased

` `

The norms work according to the time element If borrower has managed with a less investment in the above items as compared to norms in the past he should continue to do

The bankers role as a lender is only to supplement the borrower resources and not meet his entire working capital needs. 3 alternatives methods for working out the maximum permissible level of the bank borrowings. Each successive methods reduces the involvement of short term bank credit to finance the current assets.

Method I. The borrower should bring in 25% of the net working capital (current assets current liabilities excluding bank borrowing) from its owned and long-term liabilities.

Method II. The borrower should finance 25% of all current assets from owned funds and long-term liabilities and the balance he financed by the bank. Method III. The hard core current assets i.e., the current assets which are permanently required by the unit for its functioning must be exclusively financed by the borrower. The borrower should also provide 25% of the remaining current assets and only the balance will be financed by the bank.

Total CA required by the borrower as per the norms Current liabilities

20000

5000

Working capital gap (20000 5000) Less 25% from long term sources Maximum permissible borrowings

5000 3750 11250

Current assets as per norms Less 25% to be provided from long term funds

20000 5000 15000

Less current liabilities other than bank borrowings Maximum permissible bank borrowings

5000 10000

Current assets as per norms Less core current assets

20000 2000 18000

Less 25 % to be provided from long term funds

4500 13500

Less current liabilities Maximum permissible bank borrowings

5000 8500

It instructed the commercial banks in 1976 to put all the borrowers having aggregate credit limits from banking systems in excess of Rs10 lakhs, under the first method of lending.

The third important aspect of Group's recommendations related to the style of credit. Recommendations in this regard have four basic ingredients as under:

(i) Financing inventories which is already in excess of stipulated norms. (ii) Treatment to be given to borrowings in excess of maximum permissible bank finance. (iii) New structure of cash credit facility. (iv) Financing the sales receivables.

Financing Inventories in Excess of Stipulated Norms/broad indicators accepted by the banks The banks would not normally extend any credit facilities against inventories in excess of norms and the units might be granted a short time say 2 months to 6 months to liquidate those excess stocks. This will result in the unit holding inventories as per the broad indicators accepted by the banks.

Treatment to be given to the excess borrowings All units would first of all be brought to conform to first method of lending. However, no slip back would be permitted if any unit is already on the 2nd method. The unit is progressively to be moved from 1st method to 2nd method. The borrowings in excess of theadjusted by the unit by arranging funds from long-term sources by way of additional capital etc. In cases where it is not possible for the unit to arrange for funds for liquidating the excess borrowings, the bank may consider to amortise these dues by granting a short-term working capital loan. The repayment of working capital loan may be fixed according to the cash generating and capital raising capacity of the unit. To induce the units for early adjustment of working capital loan, it was suggested that a higher interest may be charged on the loan component as compared to the interest on normal working capital limits. The units were required to bring in matching permitted bank finance should normally be funds from their long-term sources at the time of enhancement in their working capital limits.

New Structure of Cash Credit Facility Cash credit limit is considered a short-term facility payable on demand. But in practice it is rarely so. A part of facility, being the minimum requirement at all times, is used almost permanently. It was, therefore, suggested that this part representing permanent requirement of the unit may be sanctioned as a loan and the balance amount of limit may be permitted as cash credit facility. The total cash credit facility is thus to be bifurcated in two parts - a loan component representing fixed requirement and running account facility representing the fluctuating requirement of the unit. It was further provided that the loan component may be charged a rate of interest which is lower by 1 % than that charged on the fluctuating component. This provision was considered necessary to induce the borrowers to have proper financial planning to envisage the level of borrowing for their fixed requirements. This aspect has not been strictly implemented so far and has finally been dropped. A new system of bifurcation of MPBF into cash credit component and loan component has been introduced w.e.f. April, 95.

Financing the Sales Receivables It was suggested that the sales may be financed through the medium of bills instead of granting running limits against debtors. Monitoring of credit facilities granted as purchase/discount of bills is far easier and the seller is also aware of the due date for realisation of his dues which is not possible in case of finance against book debts. The Group further suggested that banks should endeavour to grant credit facilities to the purchasers as far as possible and seller should be paid immediately after sale. This type of financing can also be arranged through the medium of bills and is popularly known as 'Drawee Bill Scheme. The seller will be paid immediately on presentation of the bill and the liability against these bills will be on account of the buyer as part of his working capital limits. On due date the bills will be paid to the bank by the buyer. This mechanism was considered better as it not only ensures end use of funds but also imposes a discipline in respect of payments for purchases. The Group, however, did not give any specific recommendations in the matter and left it to concerned banks for implementation of the scheme.

` `

A copy of the audited balance sheet and profit and loss account at the end of each year A copy of the projected profit and loss account, balance sheet and a fund flow statement as at the end of the next year within three months of the end of the year Quarterly budget and performance data along with the quarterly funds flow statement within two weeks of the commencement of the quarter Monthly stock statement Half yearly proforma balance sheet and profit and loss account within 60 days of the end of the half year.

The quality of lending improved considerably but the cash credit system continued to pose few difficulties. Bifurcation of working capital limit in two parts as demand loan and a fluctuating cash credit component, as suggested by Tandon Group, was not done by many banks. It was, therefore, considered necessary by Reserve Bank to review the system of cash credit in all its aspects and for this purpose a 'Working Group' headed by Sh. K. B. Chore was appointed in 1979. The terms of reference to the 'Group' were as follows: To review the operation of cash credit system in recent years, particularly with reference to the gap between sanctioned credit limits and the extent of their utilisation

In the light of the review, to suggest: (a) modifications in the system with a view to making the system more amenable to rational management of funds by commercial banks, and/or (b) alternative types of credit facilities, which would ensure greater credit discipline and also enable banks to relate credit limits to increases in output or other productive activities, and To make recommendations on any other related matter as the 'Group' may consider germane to the subject. The 'Group' gave its recommendations in 1979. Important recommendations which are accepted by Reserve Bank and have a direct bearing on credit limits of the borrowers are discussed below.

No Structural Change Continuation of Cash Credit, Loan and Bills Facilities No structural changes in the lending system are considered necessary and working capital credit limits are to be sanctioned as a combination of cash credit, loans and bills facilities as hitherto. However, a directional change is necessary and the cash credit limit is to be supplemented by loan and bill facility, wherever possible

Review of Borrowal Accounts All borrowal accounts enjoying total working capital credit limits of Rs.10 lacs and above from the entire banking system must be reviewed at least once in a year. The review is necessary not only to ensure the continued viability of the borrower but also to assess the need based requirement for credit limits. Bifurcation of Cash Credit Limit The scheme of bifurcating the cash credit limit in two parts as demand loan and variable cash credit portion as recommended by 'Tandon Group' and accepted by Reserve Bank is scrapped as it did not find any acceptance either at borrower's level or at bank's level. The scheme was basically suggested to enable the banks to have proper credit planning. The objective is now desired to be achieved by streamlining and strengthening the information system. All borrowers enjoying working capital credit limits of Rs.100 lacs and above from the entire banking system are now required to submit the following statements indicating in advance at the commencement of each quarter the requirements of funds during that quarter:

Estimates for the ensuing quarter: This statement is to be submitted in Form 1 in the week preceding the commencement of the quarter to which the statement relates. It gives the level of current assets and current liabilities as are estimated for the ensuing quarter on the basis of which operating limits will be fixed by the banks. The discipline on the borrowers will be exercised on the strength of this operating statement. As from April 1991, the Performa of this form has been revised. Separate proformae have since been prescribed for traders/merchant exporters and manufacturers (Appendix 16.1 & 16.11).

Performance during the previous quarter: This statement is to be submitted in Form 11 (Appendix 16.111 & IV) within 6 weeks from the close of the quarter to which the statement relates. In fact Form I submitted by the borrower for the ensuing quarter is to be followed by Form H after the end of that quarter. Form I gives the estimates whereas Form II gives the actual during the quarter. By making comparisons between these statements the quality of credit planning by the borrower and his efficiency to translate his plans into actual production can be effectively ascertained. New forms effective from April 1991 have been prescribed by Reserve Bank. Separate proformae for (a) traders and merchant exporters and (b) manufacturers have been given. The revised formats are given as Appendix 16 111 & 16 IV. Half Yearly Operating and Funds Flow Statements- Form III. The form III has since been bifurcated effective from I st April, 1991 as under Form IIIA -Half yearly operating statement Form IIIB - Half yearly Funds Flow Statement These statements are to be submitted within two months from the close of half year to which they relate. Separate proformae have been prescribed for traders/merchant exporters and for manufacturers. For proformae, refer to Appendices 16.V to 16.VIII.

` `

` ` ` ` ` `

Application of 2nd Method of Lending The permitted level of inventories with various groups of industries is to be determined as per the system determined by individual banks as per broad indicators accepted by them. However, the borrowers have to enhance their contributions in the working capital and for this purpose all the borrowal accounts with working capital limits of Rs.100 lacs and above from the entire banking system are to be placed under the second method of lending as recommended by 'Tandon Group'. Under the second method the borrowers have to contribute a minimum of 25% of total current assets from long-term sources ensuring a minimum current ratio of 1.33 : 1. Exemptions from 2nd method of lending now permitted have already been discussed earlier. Working Capital Term Loan A few borrowers on being placed on 2nd method of lending may not be able to bring in the additional contributions immediately. The banks may sanction 'Working Capital Term Loan' (WCTL) which may be placed on liquidation basis within a maximum time of 5 years. The method to be adopted for segregating excess borrowings on this account would be the same as already discussed under 'Tandon Group'. Higher interest at a rate which may be 1% more than the normal rate charged on cash credit a/c may be charged on WCTL to induce the borrowers for its early adjustment. Charging of higher rate has however, been left at the discretion of the bank.

'Peak Level' and 'Normal Non-Peak Level' Limit Separate appraisal and fixation of credit limits for 'peak level' and normal 'non-peak level' must be necessary and the periods during which the separate limits will be in operation must also be specified. The past trend in utilisation of limits by the borrower must be taken into consideration at the time of fixing up these limits. 'Peak Level' requirements are relevant not only for seasonal agro based industries but assume importance even in industries producing consumer goods like fans, refrigerators, woollens etc. Demand of funds may also be created due to purchase of raw material in lot, payment of tax, bonus to staff, dividend etc. at a particular point of time. All these factors are required to be taken into cognisance while fixing 'peak level' And 'normal non-peak level' credit limits. Adhoc or Temporary Limits Bank have now been given full discretion to sanction ad hoc facilities based on commercial judgement and merits of individual case. The rate of interest and others terms and conditions including period of ad hoc/temporary limits will be as per the discretion of concerned bank. It will no longer be mandatory for the banks to charge additional interest of 1 per cent over and above the normal rate of interest for sanction of ad hoc limits.

Fixation of Operative Limits The operative limits will be fixed by the banks within the overall sanctioned limits on the basis of quarterly Information submitted by the borrower in Form I as already discussed before the commencement of a quarter. This statement will form the basis of quarterly review of the account and fixing of operative limits and should virtually set the level of drawings in the account in that quarter subject to a tolerance of 10% on either way. Any excess/under utilisation of operative limit beyond the tolerance level should be taken as an irregularity revealing defective planning by the borrower and calling for some corrective measures to avoid recurrence of such irregularities in future. The concept of 'operative limit' is desired to be set up on a more formal basis and it is compulsory for all borrowers enjoying working capital credit limits of Rs.100 lacs and above to submit the quarterly operating statements before the commencement of the quarter. If a borrower does not submit these statements within the prescribed time limits, the banks shall charge penal interest of one per cent per annum on the total outstanding for the period of default in submission of statements. The penalty is to be followed by a notice to the borrower to freeze the account if the default persists. Even in consortium accounts, the operations in cash credit accounts of the borrower may be frozen. If the quarterly operative returns are not submitted. No additional limits will be sanctioned to such defaulting borrowers. The borrowers are, therefore, required to make necessary arrangements for timely compilation and submission of quarterly statements to the bank. The charging of penal interest on default/delay in submission of statements under QIS which was mandatory for banks has now been left at the discretion of the banks who have to make suitable policy in this regard.

Cash Credit Limits against Book Debts Sales are financed either by allowing purchase/discount facilities of drawn by the seller or simply as cash credit facility against book debts. The facility of cash credit against book debts is to be discouraged and such limits are to be converted to bill purchase/discount facilities wherever possible. For all borrowers enjoying aggregate fund based working capital limits of Rs.5 crores and more from the banking system a minimum of 25% of the limits sanctioned to such borrowers for financing inland credit sales must be in the shape of bill purchase/discount facilities. Banks are required to charge interest at 2 percentage points above the relevant cash credit interest rate on the portion of book- debt finance which is in excess of the prescribed norm of 75 per cent of the limits sanctioned to such borrowers for financing inland credit sales. The additional interest prescribed is in addition to the overall ceiling of 2 per cent of penal interest charged for other irregularities. The provision relating to charging of additional interest of 2% for non-compliance with bill culture as above has since been withdrawn by Reserve Bank.

Drawee Bill Scheme It has been recommended by 'Tandon Committee' as well that a part of cash credit facility for purchase of raw material should be allowed by the banks under 'Drawee Bill Scheme'. This concept has been put on a formal basis and it is now recommended that 25% of the cash credit limit against raw materials to manufacturing unit must be allowed by drawee bills only. It would be interesting to clearly understand the mechanism of 'drawee bills' and also the method suggested for fixation of limits and drawing power under this system.

` `

The drawee bill scheme may operate under two different methods as under: Acceptance system: The seller may draw a bill on the bank of the buyer who shall accept it under an arrangement with the buyer. The seller can discount the bill with his banker. Seller's bank would obtain payment of the bill from the buyer's bank on due date. The buyer's bank will maintain a separate liability account on behalf of the buyer to keep record of all bills accepted by the bank on its behalf. On due date the buyer's bank will debit the bill amount in the cash credit account of the buyer. Bill discounting system: Under this system the buyer's bank will himself discount the bills drawn by the seller and will keep the liability in a separate account against the buyer. On due date the amount will be debited in the account of the buyer. Under both the above systems the seller gets the payment immediately after supply of goods. The liability for acceptance/discount of bills is held in a separate account by the bank (buyer's) on account of the buyer under the scheme and the bill amount is eventually debited to buyer's account on due date.

` `

` ` `

Under this method borrower is entitled for a higher D. P. but will have to provide the margin of 25% on the due date of the bill when it is debited to the account otherwise the cash credit account will become irregular at the time of debit. While announcing the Monetary and Credit Policy. for the Second Half of 1997-98, Reserve Bank has reiterated that 25 per cent of inland credit purchases of the borrowers should be through bills drawn on them by the sellers. This mandatory provision will come into effect from 1st January, 1998. The most notable contributions from, 'Chore Committee' can be summed up as under: Application of 2nd method of lending to all borrowal accounts enjoying working capital credit limits of Rs.50 lacs and above from the entire banking system. The limit has now been raised to Rs.100 lacs. Scrapping of the scheme of bifurcation of cash credit limit into two parts as demand loan and fluctuating cash credit account. Formalisation of the system of operative limit and strengthening of submission of quarterly information by the borrowers. A new direction to implementation of 'Drawee Bill Scheme' by making it compulsory to allocate 25% of the cash credit limit against raw materials to be utilized by way of drawee bills. These methods have not only brought in better financial planning by the banks but have also helped the borrowers to have a planned and budgeted approach to their production and operating schedules.