Final MRP End Review Report

8/18/2019 Final MRP End Review Report

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Management Research Project

End Review Report

On

A comparative study on Credit analysis process

followed by select Private Banks, Public

Banks and NBFCs

Submitted to: Submitted by:

Prof. Devang Patel Khyati Shah(221)

Nikunjsinh Sodha (241)

(March 2016)


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Table of Content

PageNo.

Section-1 Industry Analysis 61.i Introduction to the Industry 61.ii Brief Evolution and Growth in the

Industry43

1.iii Major Trends in Credit Industry 471.iv Major Players of the Banking Industry 481.v Comparison of Market Shares of Major

Players49

1.vi Challenges faced by Indian BankingIndustry

51

1.vii Technological Changes in the BankingIndustry

51

1.viii Non-Performing Assets(NPA) 561.ix Application of the Industry Tools 581.ix.1 SWOT Analysis 581.ix.2 BCG Matrix 671.ix.3 Snake Diagram 721.ix.4 Porter Five Force Model 751.ix.5 PEST Analysis 751.ix.6 Value Chain Analysis 771.ix.7 Strategic Group Mapping 81

Section- 2 Research Methodology 83

2.i Literature Review 832.ii Scope 852.iii Research Plan 852.iv Interviews 862.v Analysis and Learning from Interview 892.vi Research Limitation 912.vii Bibliography 922.viii Discussion Guide 93

2.ix Conclusion 94


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PREFACE

This report is completed as a partial requirement of our FinalProject, which is compulsory for every student of Xcellon

Institute-School of Business. We got the opportunity to learn,

Credit Analysis Process of Public, Private and NBFCs. To get

the idea of Credit Analysis Process and relevant mechanism

we had to work the Credit Department of the banks. For this

report we had to collect all information from different written

Documents, banks and NBFCs officers, and well as from bankweb site. In this report we tried to cover up a clear overview of

various banks, our three months research experience and our

main report part credit appraisal month’s research experience

and our main report part credit analysis process of various

banks and NBFCs.

This report is divided into some portion where we have tried to

portray the banks and NBFCs overall picture. Also try to make

some my own observation and recommendation in this part.

Then we also talked about my main project topic. Our project

topic is Credit Analysis Process of Public, Private and NBFCs.

Here we have explained all the process regarding credit

analysis system of different banks and NBFCs. Credit Analysis

is the part of lending procedure. The procedure starts when

borrowers come to any branch and seeking for loan and

continues until the clients adjust to total loan. Here we have

focused on different until the client’s procedure to assess the

credit appraisal process. We showed it in a sequential flow

chart. We also find out some problem related with the credit

analysis process and try to give some possible

recommendations.


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ACKNOWLEDGEMENT

This satisfaction and joy that accompanies the successfulcompletion of a task is incomplete without mentioning name of

the person who extended his help and support in making it a

success. We are greatly indebted to Prof. Devang Patel, our

Project Guide for devoting his valuable time ad efforts towards

our project. We thank him for being a constant source of

knowledge, inspiration and help during this project of making

project.

Khyati Shah(M00221)

Nikunjsinh Sodha(M00241)


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EXECUTIVE SUMMARY

Technology has become a part of all walks of life and across all business sectors, and even

more so in banking. There has been massive use of technology across many areas of

banking business in India, both from the asset and the liability side of a bank’s balancesheet. Delivery channels have immensely increased the choices offered to the customer to

conduct transactions with ease and convenience. Various wholesale and retail payment

and settlement systems have enabled faster means of moving the money to settle funds

among banks and customers, facilitating improved turnover of commercial and financial

transactions. Banks have been taking up new projects like data warehousing, customer

relationship management and financial inclusion initiatives to further innovate and

strategies for the future and to widen the reach of banking.

The dependence on technology is such that the banking business cannot be thought of in

isolation without technology; such has been the spread of technology footprints across the

Indian commercial banking landscape. Developments in IT have also brought along a whole

set of challenges to deal with. The dependence on technology has led to various challenges

and issues like frequent changes or obsolescence, multiplicity and complexity of systems,

different types of controls for different types of technologies/systems, proper alignment with

business objectives and legal/regulatory requirements, dependence on vendors due to

outsourcing of IT services, vendor related concentration risk, segregation of duties, external

threats leading to cyber frauds/crime, higher impact due to intentional or unintentional acts

of internal employees, new social engineering techniques employed to acquire confidential

credentials, need for governance processes to adequately manage technology and

information security, need for appreciation of cyber laws and their impact and to ensure

continuity of business processes in the event of major exigencies.

Technology risks not only have a direct impact on a bank as operational risks but can also

exacerbate other risks like credit risks and market risks. Given the increasing reliance of

customers on electronic delivery channels to conduct transactions, any security related

issues have the potential to undermine public confidence in the use of e-banking channels

and lead to reputation risks to the banks. Inadequate technology implementation can also

induce strategic risk in terms of strategic decision making based on inaccurate

data/information. Compliance risk is also an outcome in the event of non-adherence to any

regulatory or legal requirements arising out of the use of IT. These issues ultimately have

the Report of the Working Group on Electronic Banking Page.


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SECTION 1 – INDUSTRY ANALYSIS

1. i Introduction to the Industry

Industry scenario of the Indian banking IndustryThe growth in the Indian Banking Industry has been more qualitative than

quantitative and it is expected to remain the same in the coming years. Based on the

projections made in the "India Vision 2020" prepared by the Planning Commission

and the Draft 10th Plan, the report forecasts that the pace of expansion in the

balance-sheets of banks is likely to decelerate. The total assets of phone banking,

ATMs. As far as foreign banks are concerned they are likely to succeed in the Indian

Banking Industry all scheduled commercial banks by end-March 2010 is estimated at

Rs 40, 90,000 crores.

That will comprise about 65 per cent of GDP at current market prices as compared

to 67 per cent in 2002-03. Bank assets are expected to grow at an annual

composite rate of 13.4 per cent during the rest of the decade as against the growth

rate of 16.7 per cent that existed between 1994-95 and 2002-03. It is expected that

there will be large additions to the capital base and reserves on the liability side.

The Indian Banking industry, which is governed by the Banking Regulation Act of

India, 1949 can be broadly classified into two major categories, non scheduled

banks and scheduled banks. Scheduled banks comprise commercial banks and the

co-operative banks. In terms of ownership, commercial banks can be furthergrouped into nationalized banks, the State Bank of India and its group banks,

regional rural banks and private sector banks (the old/ new domestic and foreign).

These banks have over 67,000 branches spread across the country. The Public

Sector Banks (PSBs), which are the base of the Banking sector in India account for

more than 78 per cent of the total banking industry assets. Unfortunately they are

burdened with excessive Non Performing assets (NPAs), massive manpower and

lack of modern technology. On the other hand the Private Sector Banks are making

tremendous progress. They are leaders in Internet banking, mobile banking.


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Structure of Banking Industry

Business Segmentation


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Product and Services

Introduction of Bank Credit

The last year financial crises have become the main cause for recession which was started

in 2006 from US and was spread across the world. The world economy has been majorly

affected from the crisis. The securities in stock exchange have fallen down drasticallywhich has become the root cause of bankruptcy of many financial institutions and

individuals. The root cause of the economic and financial crisis is credit default of big

companies and individuals which has badly impacted the world economy. So in the present

scenario analyzing one’s credit worthiness has become very important for any financial

institution before providing any form of credit facility so that such situation doesn’t arise in

near future again.

Analysis of the credit worthiness of the borrowers is known as Credit Appraisal. In order tounderstand the credit appraisal system followed by the banks this project has been conducted.The project has analyzed the credit appraisal procedure with special reference to PunjabNational Bank which includes knowing about the different credit facilities provided by the banksto its customers, how a loan proposal is being made, what are the formalities that is to besatisfied and most importantly knowing about the various credit appraisal techniques whichare different for each type of credit facility.

Before going further it is necessary to understand the need and basic framework of the

project. Therefore this chapter provides an introduction to the topic, objective of the project,

reasons for selecting the project and the basic structure and framework how the project

proceeds. In order to understand the importance of the topic selected an introduction to the

overview of the commercial bank, its functions, and present trends and growth in bank credit

are required and it is covered in this chapter.

About Banks and Credit Analysis Process followed by them


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Commercial banks and its objectives

A commercial bank is a type of financial intermediary that provides checking

accounts, savings accounts, and money market accounts and that accepts time

deposits. Some use the term "commercial bank" to refer to a bank or a division of abank primarily dealing with deposits and loans from corporations or large businesses.

This is what people normally call a "bank". The term "commercial" was used to

distinguish it from an investment bank.

Commercial banks are the oldest, biggest and fastest growing financial intermediaries

in India. They are also the most important depositories of public savings and the most

important disbursers of finance. Commercial banking in India is a unique banking

system, the like of which exists nowhere in the world. The truth of this statement

becomes clear as one studies the philosophy and approaches that have contributed to

the evolution of banking policy, programmers and operations in India.

The banking system in India works under constraints that go with social control and

public ownership. The public ownership of banks has been achieved in three stages:

1995, july 1969 and April, 1980. Not only the public sector banks but also the private

sector and foreign banks are required to meet the targets in respect of sectoral

deployment of credit, regional distribution of branches, and regional credit deposit

ratios. The operations of banks have been determined by lead bank scheme,

Differential Rate of interest scheme, Credit authorization scheme, inventory norms and

lending systems prescribed by the authorities, the formulation of credit plans, and

service area approach.

Commercial Banks in India have a special role in India. The privileged role of thebanks is the result of their unique features. The liabilities of Bank are money andtherefore they are important part of the payment mechanism of any country. For afinancial system to mobilize and allocate savings of the country successfully andproductively and to facilitate day-to-day transactions there must be a class of financialinstitutions that the public views are as safe and convenient outlets for its savings.The structure and working of the banking system are integral to a country’s financialstability and economic growth. It has been rightly claimed that the diversification anddevelopment of Indian Economy are in no small measure due to the active role bankshave played financing economic activities of different sectors.

Ma jor objectives of commercial bank Balancing profitability with liquidity management

•As any other business concern, Banks also aim to make profit •but besides that they also need to maintain liquidity beacuse of the nature of

their liabilities.

Management of Reserves

•Banks are expected to hold a part of their deposits in form of ready cash which isknown as CASH RESERVES.

•Central bank decides the reserve ratio known as the CRR.

Creation of Credit

Bank Credit


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The borrowing capacity provided to an individual by the banking system, in the form ofcredit or a loan is known as a bank credit. The total bank credit the individual has is thesum of the borrowing capacity each lender bank provides to the individual.

The operating paradigms of the banking industry in general and credit dispensation

in particular have gone through a major upheaval.

Lending rates have fallen sharply.

Traditional growth and earning such as corporate credit has been either slow ornot profitable as before.

Banks moving into retail finance, interest rate on the once attractive retail loans alsostarted coming down.

Credit risks has went up and new types risks are surfaced

Types of credit-

Bank in India provide mainly short term credit for financing working capital needs although,

as will be seen subsequently, their term loans have increased over the years. The various

types of advances provide by them are:

(a) Term Loans,

(b) Cash credit,

(c) Overdrafts,

(d) Demand Loans,

(e) Purchase and discounting of commercial bills, and,

(f) Installment or hire purchase credit.

Volume of Credit

Commercial banks are a major source of finance to industry and commerce. Outstanding

bank credit has gone on increasing from Rs 727 crore in 1951 to Rs 19,124 crore in 1978, to

Rs 69,713 crore in 1986, Rs 1,01,453 crore in 1989-90 , Rs 2,82,702 crore in 1997 and to

Rs 6,09,053 crore in 2002. Banks have introduced many innovative schemes for the

disbursement of credit. Among such schemes are village adoption, agriculture development

branches and equity fund for small units. Recently, most of the banks have introduced

attractive education loan schemes for pursuing studies at home or abroad. They have

introduced attractive educational loan schemes for pursuing studies at home or abroad.They have moved in the direction of bridging certain defects or gaps in their policies, such

as giving too much credit to large scale industrial units and commerce and giving too little

credit to agriculture, small industries and so on.

The Public Sector Banks are still the leading lenders though growth has declinedcompared to previous quarter. The credit growth rate has dipped sharply in foreign andprivate banks compared to previous quarter. In all, the credit growth has slipped in thisquarter

Credit (YOY Growth)


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March 28 2008 March 27

2009

Public Sector Banks 22.5 20.4

The rates have gone down compared to previous quarter when it was seen that there wasno changes in loan rates in private and foreign banks. But then compared to rate cutsdone by RBI, they still need to go lower.

Table 16: Reduction in Deposit and Lending Rates

(October 2008 – April 2009*)

(Basis points)

Bank Group Deposit Rates Lending Rates (BPLR)

Public Sector Banks 125-225 125-250

Private Sector Banks 75-200 100-125

Five Major Foreign Banks 100-200 0-100

Change BPLR Oct – 13 Mar – 14 Apr – 15 (from Oct to

Apr)

Public Sector Banks 13.75-

11.50-14.00 11.50-13.50 125-225 14.75

Private Sector Banks

13.75-

12.75-16.75 12.50-16.75 100-125 17.75

Five Major Foreign 14.25-

14.25-15.75 14.25-15.75 0-100 Banks 16.75

Sector-wise credit points credit has increased to agriculture, industry and real estate

whereas has declined to NBFCs and Housing. A bank group wise sectoral allocation is also

given which suggests private banks have increases exposure to agriculture and real estate

but has declined to industry. Public sector banks have increased allocation to industry and

real estate. There is a more detailed analysis in the macroeconomic report released before

the monetary policy.


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As on As on

Sector February February 15,

27

% share Variations % share Variations

in total (per cent) in total (per cent)

Agriculture 9.2 16.4 13 21.5

Industry 45.2 25.9 52.5 25.8

Real Estate 3.1 26.7 8.5 61.4

Housing 7.3 12 4.7 7.5

NBFCs 5.7 48.6 6.6 41.7

Overall Credit 100 22 100 19.5

To sum up, the credit conditions seems to have worsened after January 2013. The rateshave declined but lending has not really picked up. However, the question still remains – whether credit decline is because banks are not lending (supply) or

Because people/corporate are not borrowing (lack of demand). It is usually seen that all

financial variables as lead indicators say if credit growth (along with other fin indicators) is

picking, actual growth will also rise. However, it is actually seen the relation is far from

clear. In fact, the financial indicators hardly help predict any change in business cycle. Most

rise in good times and fall in bad times. Most financial indicators failed to predict this globalfinancial crisis and kept rising making everyone all the more complacent.


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Procedure for providing Bank Credit- Banks offers different types of credit facilities to the eligible borrowers. For this, thereare several procedures, controls and guidelines laid out. Credit Appraisal, Sanctions,Monitoring and Asset Recovery Management comprise the entire gamut of activitiesin the lending process of a bank which are clearly shown as below:

Credit

Appraisal

Sanctions

Monitoring & Asset

RecoveryManagement

Source- Self constructed

From the above chart we can see that Credit Appraisal is the core and the basic functionof a bank before providing loan to any person/company, etc. It is the most important aspect

of the lending procedure and therefore it is discussed in detail as below.

Credit Appraisal

Meaning

The process by which a lender appraises the creditworthiness of the prospective borrower

is known as Credit Appraisal. This normally involves appraising the borrower’s payment

history and establishing the quality and sustainability of his income. The lender satisfies

himself of the good intentions of the borrower, usually through an interview.

The credit requirement must be assessed by all Indian Financial Institutions or


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specialised institution set up for this purpose.

Wherever financing of infrastructure project is taken up under a consortium /syndication arrangement – bank’s exposure shall not exceed 25%

Bank may also take up financing infrastructure project independently / exclusively in respect ofborrowers /promoters of repute with excellent past record in project implementation.

In such cases due diligence on the inability of the projects are well defined andassessed. State government guarantee may not be taken as a substitute for satisfactorycredit appraisal.

The important thing to remember is not to be overwhelmed by marketing or profit centre reasons

to book a loan but to take a balanced view when booking a loan, taking into account the risk

reward aspects. Generally everyone becomes optimistic during the upswing of the business

cycle, but tend to forget to see how the borrower will be during the downturn, which is a short-

sighted approach. Furthermore greater emphasis is given on financials, which are usuallyoutdated; this is further exacerbated by the fact that a descriptive approach is usually taken,

rather than an analytical approach, to the credit. Thus a forward looking approach should also be

adopted, since the loan will be repaid primarily from future cash flows, not historic performance;

however both can be used as good repayment indicators.

Credit philosophy

“To achieve credit expansion required for sustaining

the profitability of the bank and emphasis on quality assets, profitable

relationships and prudent growth.”

Credit Policy

Bank follows following broad policy imperatives:-

Reduction in dependence upon short term corporate loans, especially unsecuredexposures.

Aiming to achieve more sanctions at levels closer to the customer.

Changing the mix of the portfolio in favor of better diffused and higher yielding credit.

Building competencies in credit management through training & promotion of selfdirected learning.

Objectives of credit policy

A balanced growth of credit portfolio, which does not compromise safety.

Adoption of a forward looking and market responsive approach for moving into profitablenew areas on lending which emerge, within the pre determined exposure ceilings.

Sound risk management practices to identify measure, monitor and control risks.

Maximize interest yields from credit portfolio through a judicious management ofvarying spreads of loan assets based upon their size, credit rating and tenure.


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Leverage on strong relationships with existing long-standing clients to source a bulk ofnew business by addressing their requirements comprehensively.

Ensure due compliance of various regulatory norms including CAR, income recognition

and asset classification

Accomplish balanced development of credit to various sectors and geographical regions.

Achieve growth of credit to priority sectors / subsectors and continue to surpass thetargets stipulated by reserve bank of India.

Using of pricing as a tool of competitive advantage ensuring however that earningsare protected.

Objectives in Credit

To maintain healthy balance between-

Credit volumes

Earnings

Asset quality

within the framework of regulatory prescriptions, corporate goals and bank’ssocial responsibilities.

Introduction to loans

Loans are advances for fixed amounts repayable on demand or in instalment. They arenormally made in lump sums and interest is paid on the entire amount. The borrowercannot draw funds beyond the amount sanctioned.

A key function of the Bank is deploying funds for income-yielding assets. A major part ofBank’s assets are the loans and advances portfolio and investments in approved securities.

Loans & Advances refer to long-term and short-term credit facilities to various types of

borrowers and non-fund facilities like Bank Guarantees, Letters of Credit, Letters of

Solvency etc. Bill facilities represent structured commitments which are negotiable claims

having a market by way of negotiable instruments. Thus, Banks extend credit facilities by

way of fund-based long-term and short-term loans and advances as also by way of non-fundfacilities.


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Classification of Loans and Process of Loans:

Loans/Advances Loans/Advances

Fund Based Non-Fund Based

Retail Loan Bank Guarantee

Cash Credit Post shipment Finance

Export Finance Letter of Credit

Bill Discounting Pre-shipment Finance

Term Loan

Bank provides credit in various forms. These are broadly classified into two categories-

Fund based and Non –Fund Based. Fund based refers to the type of credit where cash is

directly involved i.e. where bank provides money to the seeker in anticipation of getting it

back. Where as in a Non-fund Based, Bank doesn’t pay cash directly but gives assurance

or takes guarantee on behalf of its customer to pay if they fail to do so. In case on Fund

Based there are different categories of loans which are discussed as follows

RETAIL LOANS

Retail banking in India is not a new phenomenon. It has always been prevalent in Indiain various forms. For the last few years it has become synonymous with mainstreambanking for many banks.

The typical products offered in the Indian retail banking segment are:-

Housing loans

Consumer loans for purchase of durables

Auto loans

Educational loans


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Credit Cost.

Personal loans

Retail loan is the practice of loaning money to individuals rather than institutions. Retail

lending is done by banks, credit unions, and savings and loan associations. Theseinstitutions make loans for automobile purchases, home purchases, medical care, home

repair, vacations, and other consumer uses. Retail lending has taken a prominent role in the

lending activities of banks, as the availability of credit and the number of products offered for

retail lending have grown. The amounts loaned through retail lending are usually smaller

than those loaned to businesses. Retail lending may take the form of instalment loans,

which must be paid off little by little over the course of years, or non-instalment loans, which

are paid off in one lump sum.

These loans are marketed under attractive brand names to differentiate the products

offered by different banks. As the Report on Trend and Progress of India, 2007-08 has

shown that the loan values of these retail lending typically range between Rs.20, 000 toRs.100 lakh. The loans are generally for duration of five to seven years with housing loans

granted for a longer duration of 15 years. Credit card is another rapidly growing sub-

segment of this product group. In recent past retail lending has turned out to be a key profit

driver for banks with retail portfolio. The overall impairment of the retail loan portfolio

worked out much less then the Gross NPA ratio for the entire loan portfolio. Within the retail

segment, the housing loans had the least gross asset impairment. In fact, retailing make

ample business sense in the banking sector.

Basic reasons that have contributed to the retail growth in India are-

First, economic prosperity and the consequent increase in purchasing power has given a

fillip to a consumer boom. Note that during the 10 years after 1992, India's economy grew

at an average rate of 6.8 percent and continues to grow at the almost the same rate – not

many countries in the world match this performance.

Second, changing consumer demographics indicate vast potential for growth in

consumption both qualitatively and quantitatively. India is one of the countries having

highest proportion (70%) of the population below 35 years of age (young population). The

BRIC report of the Goldman-Sachs, which predicted a bright future for Brazil, Russia, India

and China, mentioned Indian demographic advantage as an important positive factor for

India.

Third, technological factors played a major role. Convenience banking in the form of debit

cards, internet and phone-banking, anywhere and anytime banking has attracted many

new customers into the banking field. Technological innovations relating to increasing use

of credit / debit cards, ATMs, direct debits and phone banking has contributed to the growth

of retail banking in India.

Fourth, the Treasury income of the banks, which had strengthened the bottom lines of

banks for the past few years, has been on the decline during the last two years. In such a

scenario, retail business provides a good vehicle of profit maximisation. Considering the fact

that retail’s share in impaired assets is far lower than the overall bank loans and advances,retail loans have put comparatively less provisioning burden on banks apart from

diversifying their income streams.


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Fifth, decline in interest rates have also contributed to the growth of retail creditby generating the demand for such credit. According to K V Kamath, the changing demographic profile and a downwardtrend of the interest rates will propel retail credit in India."There is a huge retailcredit opportunity that is surfacing. Banks have low penetration in this segmentcurrently. But it is the one area that is providing the momentum in the bankingbusiness now,” India has among the lowest penetration of retail loans in Asia.Though the sector has been growing at around 15 per cent, there is still a hugeopportunity to tap into.

Middle and -high-income homes in India has increased to 2.57 crore (25.7 million). Interest

rates on retail loans have been dropping rapidly too. For instance residential mortgages

slumped by 7 per cent over the last four years."The entry of a number of banks in India in

the last few years has helped provide increased coverage and a number of new products

in the market," says Kamath.

WORKING CAPITAL / CASH CREDIT

Cash credit is a short-term cash loan to a company. A bank provides this type of funding,

but only after the required security is given to secure the loan. Once a security for

repayment has been given, the business that receives the loan can continuously draw from

the bank up to a certain specified amount. The bank provides certain amount to the

company for its day to day working keeping certain margin in hand.

Term Loans

A bank loan to a company, with a fixed maturity and often featuring amortization of

principal. If this loan is in the form of a line of credit, the funds are drawn down shortly afterthe agreement is signed. Otherwise, the borrower usually uses the funds from the loan soon

after they become available. Bank term loans are very a common kind of lending.

Term loans are the basic vanilla commercial loan. They typically carry fixed interest rates,and monthly or quarterly repayment schedules and include a set maturity date. Bankerstend to classify term loans into two categories:

Intermediate-term loans: Usually running less than three years, these loans are generally

repaid in monthly instalments (sometimes with balloon payments) from a business's cash

flow. According to the American Bankers Association, repayment is often tied directly to

the useful life of the asset being financed.

Long-term loans: These loans are commonly set for more than three years. Most are

between three and 10 years, and some run for as long as 20 years. Long-term loans are

collateralized by a business's assets and typically require quarterly or monthly payments

derived from profits or cash flow. These loans usually carry wording that limits the amount

of additional financial commitments the business may take on (including other debts but

also dividends or principals' salaries), and they sometimes require that a certain amount of

profit be set-aside to repay the loan.

Appropriate For: Established small businesses that can leverage sound financial statementsand substantial down payments to minimize monthly payments and total loan costs.


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Repayment is typically linked in some way to the item financed. Term loans require

collateral and a relatively rigorous approval process but can help reduce risk by minimizing

costs. Before deciding to finance equipment, borrowers should be sure they can they make

full use of ownership-related benefits, such as depreciation, and should compare the cost

with that leasing.

Supply: Abundant but highly differentiated. The degree of financial strength required toreceive loan approval can vary tremendously from bank to bank, depending on the levelof risk the bank is willing to take on.

Bill Discounting

While discounting a bill, the Bank buys the bill (i.e. Bill of Exchange or Promissory Note)

before it is due and credits the value of the bill after a discount charge to the customer's

account. The transaction is practically an advance against the security of the bill and the

discount represents the interest on the advance from the date of purchase of the bill until it

is due for payment.

Bills of exchange- A bill of exchange or "draft" is a written order by the drawer to the drawee

to pay money to the payee. A common type of bill of exchange is the cheque (check in

American English), defined as a bill of exchange drawn on a banker and payable on

demand. Bills of exchange are used primarily in international trade, and are written orders

by one person to his bank to pay the bearer a specific sum on a specific date. Prior to the

advent of paper currency, bills of exchange were a common means of exchange. They are

not used as often today.

A bill of exchange is an unconditional order in writing addressed by one person to another,

signed by the person giving it, requiring the person to whom it is addressed to pay on demand

or at fixed or determinable future time a sum certain in money to order or to bearer. It is

essentially an order made by one person to another to pay money to a third person.

A bill of exchange requires in its inception three parties--the drawer, the drawee, andthe payee.

The person who draws the bill is called the drawer. He gives the order to pay money to third

party. The party upon whom the bill is drawn id called the drawee. He is the person to

whom the bill is addressed and who is ordered to pay. He becomes an acceptor when he

indicates his willingness to pay the bill. The party in whose favor the bill is drawn or is

payable is called the payee.

Promissory Note- A promissory note is a written promise by the maker to pay money to the

payee. Bank note is frequently transferred as a promissory note, a promissory note made

by a bank and payable to bearer on demand. A maker of a promissory note promises to

unconditionally pay the payee (beneficiary) a specific amount on a specified date.

A promissory note is an unconditional promise to pay a specific amount to bearer or tothe order of a named person, on demand or on a specified date. A negotiable promissory note is unconditional promise in writing made by one person toanother, signed by the maker, engaging to pay on demand, or at fixed or determinable

future time, sum certain in money to order or to bearer


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Export Finance

This type of a credit facility is provided to exporters who export their goods to differentplaces. It is divided into two parts- pre-shipment finance and post-shipment finance.

Pre Shipment Finance is issued by a financial institution when the seller want the paymentof the goods before shipment.

Post Shipment Finance is a kind of loan provided by a financial institution to an exporter or

seller against a shipment that has already been made. This type of export finance is granted

from the date of extending the credit after shipment of the goods to the realization date of

the exporter proceeds. Exporters don’t wait for the importer to deposit the funds.

Non Fund Based loans generate income for the bank without committing the funds ofthe bank. Bank generates substantial income under this head. There are two types ofcredit under this category which are discussed as follows:-

Bank Guarantee

A bank guarantee is a written contract given by a bank on the behalf of a customer. By

issuing this guarantee, a bank takes responsibility for payment of a sum of money in case,

if it is not paid by the customer on whose behalf the guarantee has been issued. In return,

a bank gets some commission for issuing the guarantee.

Any one can apply for a bank guarantee, if his or her company has obligations towards a third

party for which funds need to be blocked in order to guarantee that his or her company fulfils its

obligations (for example carrying out certain works, payment of a debt, etc.).

In case of any changes or cancellation during the transaction process, a bankguarantee remains valid until the customer dully releases the bank from its liability.

In the situations, where a customer fails to pay the money, the bank must pay theamount within three working days. This payment can also be refused by the bank, if theclaim is found to be unlawful.

Letter of Credit

A standard, commercial letter of credit is a document issued mostly by a financialinstitution, used primarily in trade finance, which usually provides an irrevocable paymentundertaking.

The LC can also be the source of payment for traction, meaning that redeeming the letter of

credit will pay an exporter. Letters of credit are used primarily in international trade

transactions of significant value, for deals between a supplier in one country and a

customer in another. They are also used in the land development process to ensure that

approved

public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a

letter of credit are usually a beneficiary who is to receive the money, the issuing bank ofwhom the applicant is a client, and the advising bank of whom the beneficiary is a client.


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Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior

agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing

a transaction, letters of credit incorporate functions common to giros and Traveler's

cheques. Typically, the documents a beneficiary has to present in order to receive payment

include a commercial invoice, bill of lading, and documents proving the shipment were

insured against loss or damage in transit. However, the list and form of documents is opento imagination and negotiation and might contain requirements to present documents issued

by a neutral third party evidencing the quality of the goods shipped, or their place of origin.

Building Up of a Proposal.

Gathering Credit Information An appraisal of a proposal begins with the gathering of adequate background knowledge

about borrower’s character and credit worthiness. In the concept of appraisal, much

reliance is placed on the credentials of the borrower. Therefore, there is a necessity for

evaluation of the borrower in regard to his standing in the business, means and

respectability. The result of the elaborate scrutiny concerning all these aspects is required

to be put into a precise credit report which helps in taking decision on a credit proposal.

Each individual case has to be examined in the light of its own circumstances and judgment

exercised on issues enumerated above and a final decision has to be arrived at on the

basis of scrutiny of all the issues.

Information by definition is that data which is relevant and meaningful for making decisions.

An information system is an aid to the decision making, carrying out and altering decisions.

All information required by the banker in the pre-sanction period should become part of a

system. It should flow into the information system from various sources, such as the

borrower, bank’s own record, environment etc. A significant basis of banker -borrowerrelationship is governed by the information which flows between the two parties. After

ascertaining the credit needs of the borrower, the banker looks towards information about

his borrower’s credit worthiness. He seeks out the credit information etc. from his co -

bankers, other borrowers and market information.

Various Sources of Credit Information

Information regarding character, honesty, and financial position has to be discreetlygathered from following sources:

The borrower: the bank should develop as much credit information as possible during the

initial interview with the borrower/partners of firm/ directors of company/ proposed

guarantor /co-obligator and principal officials of firms/company, nature of its business, past

and expected profitability, the degree of competition that the firm/company faces and

whether or not it has had or anticipated any difficulty etc.

Information regarding its principal officers should be collected during such interview.

Borrower’s financial statements: for lending decisions, financial information is asignificant part of the total information system. It is derived basically from borrowers:

Trading and profit and loss statement

Balance sheet


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Cash and fund flow statements

Banks own records: If he is an existing borrower, bank’s own records are a rich source of

additional information. Operations in the borrower’s account and other dealings at the bank

level in regard to collections, discounting/retirement of bills etc. often useful clues toborrower’s operating and financial transactions. A review of the previous year’s operations

in the account and assessments of borrowers’ financial statements relating to that period

will provide a rich source of information about the borrower.

Opinions: Bank should compile opinions on their borrowers. They should contain full and

reliable records of the character, estimated means and business activities of all firms and

individuals who are under any form of liability to the bank, whether as direct borrowers or

as co-obligators. Full particulars of parties immovable properties where they are situated,

whether they are free from encumbrance and in the case of land, acreage should be

recorded together with fair estimates of their value. As far as possible written statements of

their properties should be taken in evaluating properties owned by parties jointly withothers and as a rule such properties should be disregarded in arriving at the net means.

From other banks: in respect of fresh proposals, enquiries with local banks should be

made before entertaining the proposal to avoid multiple financing without our full

knowledge. In case of new customer having dealings with other banks, confidential opinion

of his banker has to be obtained.

Income tax assessment order- Income tax assessment orders agricultural income tax

assessment orders give an insight into the borrower’s account and the extent to which it is

profitable. Comments thereon by the income tax office shall indicate the shortcomings

(lacunae) in the business. In the case of estate owners agricultural tax assessment orders

to be obtained to arrive at parties credit worthiness.

Sales tax assessment orders: Sales tax assessment orders will reveal the turnover in

business and when read with trading/ manufacturing and profit & loss account, it may

be possible to have a fair assessment of tendencies in trade i.e., whether over-trading

or carefully trading within recourses at command or trading entirely on the borrowed

funds.

Wealth tax assessment orders: wealth tax assessment order will indicate the net worth ofindividuals and reveals the liquid source available to bring the required margin money forthe venture.

Market sources: Constant touch with the market will help to have first hand informationabout the gains or losses in particular business transactions of the borrowers.

Property statements: The property statement of borrower will give an idea of his worth,liabilities and his income from real estate’s (immovable properties).

Municipal property registers: reference to municipal property registers will give an idea ofbuilding owned within the municipality, Rental Values and house tax payable. It may be

noted that the said registers are open for reference to all persons.

Other external sources: other external sources, if any, like stock exchange directory,


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business periodicals/magazines/journals etc.

Requirement as per Constitution of Borrower:

Following Requirements as per constitution of borrower should be collected for proposalsemanating from-

Partnership:

Copy of partnership deed

Copy of certificate of registration of firm (if registered)

Company :

Memorandum and articles of association

Certificate of incorporation

Certificate of commencement of business

Search report indicating subsisting charges on the assets of the company.

Board resolution for borrowings, creation on the assets of the company and execution of thedocuments.

Cooperative societies

Bylaws

Permission from registrar for the borrowings, creation of charge on the assets of the societyand execution of documents.

Trusts

Trust deed

Resolution for the borrowings and execution of documents.

Industrial units :

Project report with cash flow, fund flow statements etc.

Industrial licenses/SSI registration certificate.

License from local authority, compliance of legal requirements or conditions asapplicable and clearance from regulatory bodies.


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Financial Appraisal

On receipt of a loan application the banker begins the process of financial appraisal. Thefirst thing done is to analyze the financial statements. Therefore, an understanding of thesefinancial statements is important for the appraiser.

Once balance sheet is taken for analysis the following items are checked up:

Fixed assets: To find out any revaluation of fixed assets done by the company toimprove their net worth.

The schedules of the fixed assets should be checked up.

Study notes on accounts and comments of auditors should be checked.

Schedule for reserve should be studied

Any change in the accounting procedure of depreciation should be checked

Current assets: to find out whether the assets stated are really liquid or not.

The schedules under current liabilities and current assets to ascertain any obsolete orslow moving raw material or finished good and old debtors or receivables should bechecked

The auditor’s report should be read and understood properly.

The claims lodged against receivables must be studied

The receivables due from sister/associate concerns must be studied.

Other Current Assets: Their reasonableness and their need to maintain them forthe business.

Various components of other current assets and if the same is more than 5% -10%,

ascertain the nature and need for maintaining such amount ; any assets which is not used

in the into day business activity shall be removed and proper treatment is to be madeaccordingly.

Bank guarantee or letter of credit margin shall be shown as non- current assets.

Contingent liabilities: To find out any unrecognized liabilities or losses if any.

The CDD/DBD other bills discounted liability, if any ,is reported in the auditor’s report ,

then increase the bank borrowing to the extent liability was not taken in the balance sheetand also increases the debits/receivables to that extent.

Term liabilities: To find out whether the liabilities are long term or short term, and itsneeds and regularity


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This shall be decreasing year after year; if it has increased, then the reason for the sameis to be looked into (may be irregular or new term loan availed for expansion etc.)

The term liabilities with repayment of the same and the amount payable during the yearshall be deducted from the term liabilities as current liabilities for finding out liquidity position

of the company should be checked.

Stocks:

The stock statements and QIS forms to find the authenticity of the figures reportedunder stock/receivables.

Change in the valuation of the stock/finished goods, if any, is to be verified to find outits effect on the profitability of the company.

Intangible assets :

Any abnormal increase in this figure shall be studied to find out the reasons for thesame; this may be due to take over by others also.

Accounting Norms:

Any change in the accounting norms from the past shall be studied to find out thereasons for the same; its effect on the net profit, net worth of the company is to beascertained.

Balance Sheet Analysis

Comments on the performance of the unit vis-à-vis last year sales-

Increased in last year sales are always good; if the net profit also hasincreased correspondingly the performance can be noted as satisfactory.

If the sales has come down or the net profit has also come down then the reason has to beascertained. If the unit earned at least cash profit then the position may be considered assatisfactory.

If the NP to N/sales is positive, that is sufficient for accepting as satisfactory; but as per thecredit rating chart maximum marks are assigned if the borrower achieves 8% aspercentage of net profit/net sales.

Return on investment or Return on equity may also be used to find out the return oncapital invested.

Long term Strength of a company is calculated based on the level of the net worth of thecompany /promoters stake/loans from close relatives-

If the net worth has increased due to infusion of fresh capital or plough back of profit, it canbe termed as satisfactory; even increase of loan from friends & relatives is a good sign.


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If the net worth is decreasing, reason may due to net loss or diversion; true reason needs tobe ascertained.

If the D/E ratio is less than 2:1 the same is good; further if the TOL/TNW is less than 5:1then the unit’s solvency is noted to be satisfactory. The ratio indicates that borrower has

not borrowed much and the outside debts within a reasonable limit.

Liquidity position of the party-Current ratio

If the current ratio is increasing and nearer to 1.5 and above then we can note the position issatisfactory.

Expected Current ratio is 1.22:1 and above; if the ratio is less than 1.22:1 then thepromoter’s margin (Net working capital) towards Working Capital may not be sufficient to cover the working capital limit; care shall be taken to ensure that sufficient Networking capital for the working capital enjoyed is available.

When the Current ratio is poor and the Net working capital is not sufficient to cover theexisting limit, no further term loan shall be sanctioned and the party is to be advised notto take up any fresh investment in fixed assets.

Quality of current assets :

The current assets holding period must be less than 3 months for traders and the 5months for the industries depending upon the type of industry ;holding level more than theabove needs proper justification.

It should be ensured that the current assets turnover is at least more than four times in

a year.

Contingent liability:

The effect of this liability on the net worth of the company; if it’s effect is less than 5-10 %

of the net worth of the company ,the same may be noted; but if it threatens the existenceof the company then the position needs serious analysis.

Diversion from the business needs to be viewed carefully.

Reduction in Net working capital position( below the required level) when the unit hasearned cash profit and clearing of term loan installments when the unit is making cash lossneeds to be viewed seriously.

Reduction in the net worth of the firm (when they have shown net profit needsfurther probing.

Movement of Credit Proposal

With reference to Bank the movements of credit proposals are studied carefully andthe detailed process is discussed as follows:

The movement of credit proposals follows a pre-defined path which has been structured

in keeping with the risk management principle that the credit granting process shouldinvolve multiple credit approvers who should subject the proposals to credit approvals at


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various stages accordingly.

Credit Appraisal Techniques

Credit appraisal techniques act as tool for the credit portfolio managers to take right

decisions. It is the first and the prime most function performed by the Credit Appraisal Cellbefore providing any sort loans or advances. The appraisal technique for each type of loan

is separate from each other. Each type of loan whether secured or unsecured has to be

analyzed in a different way. The different techniques of credit analysis or credit appraisal are

discussed as under:

Process of Credit appraisal for Term Loans

Term loans- Loans which are repayable in not less than 36 months are referred to as term

loans. In the interest of sound risk management practices, banks monitor the percentage of

Term loans in their credit portfolio with a view to keeping the term loan component within a

pre-determined percentage.

Requirements to be obtained with the proposal:

a) Copies of project report

b) Where loan is on participation basis, a copy of the appraisal note of the lead institution /bank should be obtained.

c) Scrutiny of proposals

The scope of the project:

Background of promoters

Government consents

The technical appraisal

Cost of the project

Sources of finance

The schedule of implementation

The financial projections and profitability

Cash flow statements

Calculation of debt service coverage ratio (DSCR)


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Breakeven analysis

d) Disbursement

e) Follow up (post sanction)

Assessment :

For assessment purposes the forms prescribed are used and debt equity ratio,

average DSCR, BEP, pay back period, etc. are taken into consideration. The following

minimum financial parameters are required to be satisfied for a Term loan proposal to

merit consideration:

Not more than 2.33:1(1.7:1 may be accepted in

The case of real estate sector and generally forDebt Equity Ratio

different type of industry different level of DER is acceptable.)

Not less than 1.5to 2 (ratio lower than this is to be looked into)

Average DSCR

Ratios for appraising term loans:

Debt equity ratio: long term debt

Tangible net worth

Average DSCR : Net profit + Depreciation + interest on TL

Term loan installment + interest on TL

Breakeven point : Fixed cost_______

Sales-Variable cost (contribution)

It should be noted that the banks generally consider only term loans repayable within 5 to 7yrs. Term loans with maturity beyond 7 yrs are normally not experienced exceptinfrastructure loans.

Debt Equity Ratio:

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the companyis using to finance its asset


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Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financialstatements as well as companies'.

A high debt/equity ratio generally means that a company has been aggressive in financing

its growth with debt. This can result in volatile earnings as a result of the additional interest

expense. If a lot of debt is used to finance increased operations (high debt to equity), the

company could potentially generate more earnings than it would have without this outside

financing. If this were to increase earnings by a greater amount than the debt cost (interest),

then the shareholders benefit as more earnings are being spread among the same amount

of shareholders. However, the cost of this debt financing may outweigh the return that the

company generates on the debt through investment and business activities and become too

much for the company to handle. This can lead to bankruptcy, which would leave

shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For

example for large projects (with project cost Rs. 100 crore and above) in Power, acceptable

level of DER is 2.33:1, in Iron and Steel Industry 2.25:1 , in Infrastructure and CapitalIntensive projects 2:1 and in Real Estate, level of DER is 1.75:1. The CH, GM, ED and CMD

have powers to further relax.

Debt Service Coverag Ratio (DSCR):

The ultimate purpose of project appraisal is to ascertain the viability of a project which has

a direct bearing on the repayment of the instalments under the proposed term loan /

deferred payment guarantee. While the repayment program will depend upon the

profitability of a project, the quantum of annual instalments has to be related to the size of

the annual cash flows. The repayment schedule should, therefore, be fixed after

ascertaining the annual servicing by the debt service coverage ratio.

The debt service coverage ratio is the core test ratio in project financing. This ratio indicates

the degree of viability of a project and influences in fixing the repayment period, and the

quantum of annual instalments. For the purpose of this ratio , “debt” means maturing term

obligations viz. instalments payable during a year under all the term loans/ deferred

payment guarantees and ‘service’ means cash accruals (service) available to cover the

maturing obligation (debt) during each year.

The debt service coverage ratio indicates the ability of the firm to generate cash accruals

for repayment of installment and interest. For example, a DSCR of 3:1 indicates that for

each Re.1/-long term debt including interest to be paid the business generates cash

accrual of Rs.3/- to be utilized for repayment of debt. The difference between the accruals

and debt is known as margin of safety (Rs.2/- in this case).

The ratio of 1.5 to 2 is considered reasonable. Ratio lower than this should be further looked

into. A very high ratio may indicate the need for lower moratorium period/repayment of loan

in a shorter schedule. This ratio provides a measure of the ability of an enterprise to service

its debts i.e. `interest' and `principal repayment' besides indicating the margin of safety. The

ratio may vary from industry to industry but has to be viewed with circumspection when it is

less than 1.5.


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BREAK EVEN POINT OR COST VOLUME PROFIT (CVP) ANALYSIS:

A. The breakeven point is calculated to note the level of production at which the unit neither

earns profit nor incur loss. BEP is the level of operations (in terms of sales or production or

capacity utilization) at which total revenues are equal to total operating costs (fixed and

variable) or, in other words, the operating profit is equal zero. He firm starts earningoperating profits only after the break-even is reached. At BEP, “contribution” exactly equals

the “fixed costs.

B. The formula for calculating the break-even point for each year is as under:

Total fixed cost/Contribution

C. Certain items of the cost that are to be incurred by the unit irrespective of the level of

production are called as fixed cost. The same includes depreciation, repairs and

maintenance, interest, certain portion of salaries, rent, insurance, selling expenses other

than variable items and administrative expenses

D. The variable cost changes with the levels of production. It includes cost of raw materials,direct wages and other items, which are apportion able to unit of production.

E. The breakeven point is generally expressed in terms of percentage of capacity utilization

Break even analysis is generally expressed in terms of percentage of capacity utilisation.

The CVP analysis provides answers to such questions as: level of operations needed to

avoid loss, level of sales required to achieve targeted profit, effect of product mix on

profits, impact of expansion, most and least profitable products etc. Break-even analysis

is the most widely used form of the CVP analysis.

Break-even analysis is one of the most useful techniques of profit planning and controlling.

The break-even analysis can help in making vital decisions relating to fixation of selling price

make or buy decision, maximizing production of the item giving higher contribution etc.

Further, the break-even analysis can help in understanding the impact of important cost

factors, such as, power, raw material, labor, etc. and optimizing product-mix to improve

project profitability.

It is a useful method for considering also the risk implications of alternative actions. From

one alternative a firm may expect higher profit and also a higher break-even point, while

another alternative may produce comparatively lower profit but at a lower break-even point.

The firm has to weigh the probability (riskiness) of reaching the break-even in the first case

before choosing that alternative. Generally, the preferred alternative would be where the

break-even will be reached earlier.


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Caution:

Relationship between revenue, variable costs and volume may not be linear.

It is not always easy to have a clean separation of costs into fixed and variable components.

Fixed costs may be ‘stepped’ – not fixed over all volumes.

Complexity involved in using BEP analysis in multi-product businesses

Illustration:

Assumed:

Normal year production 75 lakh units (93.75% of installed

capacity)

Fixed Costs Rs. 13.71 lakh

Variable Costs Rs. 13.35 lakh

Sales realization Rs. 41.25 lakh

Contribution

Rs. 27.90 lakh

BEP (production) : (Fixed cost / Contribution)* 75 lakh = 36.85 lakh units

BEP (capacity utilization): (Fixed cost / Contribution)* 93.75 = 46.07%

BEP (sales) : (Fixed cost / Contribution)* Rs. 41.25 lakh = Rs. 20.27 lakh

Sensitivity Analysis

Projects do not always run to plan. Costs and benefits estimated at an early stage of a

project may indicate a profitable project, but this profit could be eroded by an increase in

costs or a decrease in the value of the benefits (the revenue). Sensitivity Analysis involves

changing input variable estimates from an original set of estimates (called the base case)

and determine their impact on a project’s measured results, such as NPV (or IRR) from

investor’s viewpoint, or DSCR from banker’s point of view.


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The Sensitivity Analysis helps in arriving at profitability of the project wherein critical or

sensitive elements are identified which are assigned different values and the values

assigned are both optimistic and pessimistic such as increasing or reducing the sale

price/sale volume, increasing or reducing the cost of inputs etc. and then the project

viability is ascertained.

The critical variables can then be thoroughly examined by generally selecting thepessimistic options so as to make possible improvements in the project and make itoperational on viable lines even in the adverse circumstances.

In the absence of any defined factors and its values for carrying out the sensitivity analysis,

a common 5% sensitivity factor on sale price/cost price of major raw materials is to be

applied in appraisals of all the projects irrespective of the industry. However, 10% sensitivity

factor may be applied in highly volatile industries by assessing the expected volatility in sale

price/ cost price of major raw materials in future on case to case basis.

Process of Credit Appraisal for providing Cash Credit / Working Capital Limits

Working capital for any unit means the total amount of circulating funds required for meeting

day to day requirements of the unit. For proper working a manufacturing unit needs a

specific level of current assets such as raw material, stock in process, finished goods,

receivables and other current assets such as cash in hand/ bank and advances etc. So the

working capital means the funds invested in current assets. The trading units need the

working capital for storing the goods and allowing credit to its customers.

Gross Working Capital and Net Working capital

Gross working capital means the total funds required for financing the total current assets.

Net Working capital means the difference the current assets and liabilities. In other words ,

net working capital denotes the portion of gross working capital contributed from long term

sources. As per practice of Indian banks net working capital should normally be 25% of total

current assets which will give a current ratio of 1.33 to the unit. When net working capital is

negative, it implies that the short term funds have been diverted / used for long term uses

and the unit is facing a liquidity crunch. Such situation may also arise due to losses. In such

a situation, the need of the hour is for raising long term sources. A unit needs working capital

because the production, sales and realizations are not simultaneous. The unit needs cash to

purchase the raw material and pay expenses as there may not be perfect matching between

cash inflows and outflows. The stock of raw material is kept to ensure the uninterrupted andsmooth production. It may also be required to cover the situations of shortages etc.

Factors affecting the requirement of working capital:

Nature of activity: Manufacturing units need more working capital as compared totrading and service units.


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The length of operating cycle: More the length of operating cycle, more the requirement ofworking capital. lengthy the process of manufacture, more the need of working capital dueto increase of length of working capital cycle

Market trend: The market trend of allowing credit to customers also varies from industryto industry and city to city. More the credit allowed to customers, more the need ofworking capital.

Availability of raw materials: When the availability of raw material is assured andcomfortable, lower stock maintenance is required. When there is expectation of shortageor expectation of rise in prices, more amounts is blocked in raw materials.

Location of the unit: When the unit is located near the source of raw material, lowerstock maintenance is required.

Type of customers: When there are regular customers, low stock of finished productsis needed. When the sales are to be made to walk- in customers, more level of stock offinished products is required.

Seasonality Factor: When the raw material required is available in a particular season, the

stock for whole of year is to be purchased in the particular season. E.g. Sugarcane, Cotton,

Paddy etc. Similarly the woollen products and products required in a particular season such

as ACs, for keeping the production running, higher level of finished stocks have to be kept.

Role of Banker:

The unit should have sufficient amount of working capital. A portion of it is to be financedfrom long term sources called the liquid surplus or net working capital (NWC). The remaining

is normally financed by the bank in the form of working capital limits. Excess maintenance of

working capital may result in idle resources and high interest cost whereas less amount of

working capital may mean disruption in the working. So both the situations are to be

avoided. That is why the technique of calculation of right amount of working capital assumes

significance. For financing of working capital, a banker should be able to calculate right

amount of working capital needed by the unit being financed. It shall mean right amount of

financing which will result in higher profitability for the unit and safety of funds of the bank.

Parameters for various stages in computation of working capital:

Stage Time Value

i Raw Material Holding period value of RM consumed

during the period

ii SIP Time taken in RM + Mfg.Exp. during the

converting the period (Cost of


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RM into FG production)

iii FG Holding period of R.M + Mfg. Exp. +Adm

FG before being overheads for the

sold period (Cost of sales)

iv Receivables Credit allowed RM+ Mfg. Exp. + Adm.

to buyer Exp.+ Profit for the period

(sales)

The assessment of working capital requirement of business unit has been engaging theattention of the Govt., RBI and a series of committees were set up to suggestappropriate modalities of financing working capital as under.

TANDON COMMITTEE RECOMMENDATIONS

Realising the absence of a proper control system in the flow of bank credit for working

capital, RBI constituted a working group “Tandon Committee’ in July 1974 under thechairmanship of Shri P.L. Tandon. The main task of the group was:

To suggest guidelines to commercial banks to follow up and supervise credit from the viewof ensuring proper end use of the funds and keeping a watch on the safety of the advances.

To suggest as to what constitutes the working capital requirements of industry andto suggest the sources for financing the minimum working capital requirements.

To suggest the maximum level of bank finance and the method to compute the same.

To make recommendations as to whether the existing pattern of financing working capital

requirements by cash credit or overdraft etc. requires to be modified. If so, to suggestsuitable modifications.

The group submitted its final report during December 1975. The recommendations of thisCommittee are summarised below:


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Norms for Inventory and Receivables

With a view to curbing speculative and hoarding tendencies, the Committee fixed norms

(in terms of the weeks/month consumption) in respect inventory and receivables which

industrial units may hold. The norms were fixed for 15 major industries and indicate the

maximum permissible limits for inventory holding. Deviations from norms not allowed formeeting unforeseen situations.

Approach to Lending.

The three methods of lending as suggested by the committee are:

First Method: 75% of Working Capital Gap (Total Current Assets – Other Current liabilities)

Second Method: 75% Total Current Assets – Other Current liabilities

Third Method: 75% [(Total Current Assets – Core Current Assets) – Other Current liabilities)

Third method of lending was not accepted by RBI and hence rejected.

(iii) Style of Credit.

Tandon Committee suggested that instead of making available entire limit by way of cashcredit it may be bifurcated into demand loan and cash credit component (modified by ChoreCommittee).

(iv) Quarterly Follow-up and Supervision

Tandon Committee suggested quarterly forms under the information system madeapplicable to borrowers with working capital credit of Rs. 1 crore and over from thebanking system. These forms aim at ensuring proper end-use of credit.

CHORE COMMITTEE RECOMMENDATIONS

In April 1979, a working group under the chairmanship of Sh K.B.Chore was constituted toreview the system of cash credit. The committee submitted the report in Dec 1980. The

lending discipline, as enunciated by Tandon Committee, has been streamlined by certain

recommendations made by Chore Committee. The gist of these recommendations is as

follows:


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(a) Annual Review

All working capital credit limits of Rs. 50 lacs and above from the banking system should bereviewed at least once a year. These reviews are intended to ensure that the limits are need-based and continue to be viable propositions.

(b) Information System

The scope of the quarterly information system originally envisaged by the study group toframe guidelines for follow-up of bank credit has been enlarged bringing into its ambit allborrowers having credit limits of Rs. 50 lacs and over from the banking system.

Presently this limit of Rs. 50 lac has been raised to Rs. 1 Crore.

(c) Withdrawal of bifurcation of cash credit

The recommendation of the Tandon Study Group to bifurcate cash credit accountsinto demand loan and cash credit components has been withdrawn.

(d) Separate limit for peak level and non-peak level

A recommendation that will induce a greater degree of credit planning pertains to the

separate 'Peak-level' and `non-peak level' credit limits, wherever considered feasible. The

period during which these limits will be utilised will now be indicated in the bank's adviceconveying sanction of credit. This recommendation is based on the pronounced seasonal

trends in agriculture-based industries, (such as tea. coffee, sugar, jute, vegetable oils, etc.),

and in the case of some consumer industries such as those manufacturing fans,

refrigerators etc. One of the major determinants of borrower's peak-level and non-peak level

credit limits will be their availment during the corresponding period in the past. Borrower in

whose cases there are no pronounced seasonal trends, may be sanctioned only one limit as

peak-level and non-peak level concepts will not be relevant in such cases.

(e) Determination of Quarterly Operative limits

Before the commencement of each quarter, the borrowers will now be required to indicate

limits sanctioned for their requirements of funds during the ensuing quarter. This will be

termed as the operative limit for the relevant quarter. The operative limit indicated by the

borrower would virtually set the level of drawing in that quarter subject to tolerances of

10% either way. Hence forth, excess-utilisation or under- utilisation of the operative limit,

beyond the tolerance level referred to above would be considered as an irregularity in the

account. This will be treated as an indication of defective credit planning by the borrower.


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Dialogue with the borrower will be initiated to set right the position in regard to defectivecredit planning and to ensure that such instances are avoided in future.

(f) Penalty for delayed or non submission of returns

Non-submission of returns, within the prescribed time limit, will henceforth entail penal of 2%per annum on the total outstanding for the period of default in the submission of returns.

Simultaneously, a notice would be issued to the borrower stating that if the default persists it

would be open to the bank to freeze the account without further notice to the borrower. lf the

default persists despite imposition of penal interest and the bank is satisfied that deterrent

action is warranted, the operations in the account may be frozen on the basis of the notice

issued to the borrower.

(g) Adhoc or temporary limits

The working group has conceded that in exceptional cases, ad-hoc or temporary limits couldbe sanctioned to borrowers through demand loan or non-operatable cash credit accounts.

On those limits, banks are required to charge additional 1% interest per annum over the

normal rate. However, in certain cases like natural calamities it would be the discretion of the

bank to charge interest of 1% per annum.

(h) Switching over to Second Method of lending

A major recommendation of the working group relates to switching over the borrowers from

the first to the second method of lending. Recognising that in some cases this may not be

possible immediately, Reserve Bank has stipulated that in such cases, the excess

borrowings are to be segregated and treated as WCTL (Working Capital Term Loan),which should be made repayable in half-yearly instalments within a definite period but not

exceeding five years in any case.

(i) Encouragement of Bills system

To encourage bills systems of financing purchase of raw material inventory, the Working

Group has recommended that banks should extend at least 50% of the cash credit limit

against raw materials to manufacturing units, whether in the public or private sector, by

way of drawee bills only.

Present Status:

The concept of MPBF was the cornerstone of financing which had emerged as a result ofrecommendation of Tandon and Chore. However RBI has now abolished the guidelines for


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MPBF and advised the banks to draw the guidelines for credit dispensation. Our bank is stillfollowing MPBF system. However the relaxations on case to cases are being allowed.

NAYAK COMMITTEE RECOMMENDATIONS

To give a comprehensive and straight line method for the assessment of working capital

requirement of the borrowers, RBI constituted a working group under the chairmanship of

Sh P.R.Nayak. The study group gave its recommendations in March 1993. In April, 1993,

RBI implemented the recommendations of Nayak Committee for assessing the credit

requirements of village industries, tiny industries and other SSI units . Initially the

recommendations were for SSI units only but now other units have also been covered.

Presently units covered under these guidelines are those having aggregate fund-based

working capital credit limits less than Rs.200 lacs for other than SSI and Rs. 500 lacs for

SSI from the banking system.

It has been advised not to apply the norms for inventory and receivables as also theMethods of Lending. Instead such units be provided working capital limits computed on thebasis of a minimum of 20% of their Projected Annual Turn-Over (PATO) for new as well asexisting units. Their working capital requirement be assessed at a minimum of 25% of theirProjected Annual Turn-Over (PATO) assessed on realistic basis for new as well as existing

units. Out of this, at least 4/5th(20% of their PATO) be provided by the bank and the

borrower should contribute 1/5th of this estimated working capital requirement (5% of PATO)

as margin money of working capital.

- In case the margin with the party is more than 5% , PBF may be adjustedaccordingly.

- The 20% limit is the minimum. As a temporary relief measure for SME Units, RBI

has allowed banks to finance upto 25% under stimulus package. The same shall be

reviewed after 30.6.09. However if the working capital cycle is longer than 3 months, higher

limit may be fixed. If the working capital cycle is less than 3 months, the limit may be fixed

@ 20 % of turnover but actual withdrawal should be allowed only on the basis of actual D.P.

However lower limit can be sanctioned if requested in writing by the borrower.

LENDING DISCIPLINE - QUARTERLY MONITORING SYSTEM (QMS)

Consequent to operational freedom granted by RBI in regard to submission of statementsunder QIS/Monthly Cash Budget System prescribed under CMA, Bank reviewed the sameand submission of QIS was replaced with Quarterly Monitoring System (QMS)


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The QMS discipline is to be enforced on all borrowers enjoying working capital limits of Rs.1crore and over from the banking system, irrespective of whether they are exporters orotherwise.

In case the limits have been sanctioned on the basis of Naik Committtee, QMS forms and

CMA data need not be submitted.

The forms for QMS and time period for submission are as under.

Form- 1 To be submitted within 6 weeks from the close of quarter to which it relates

Form-11 To be submitted within 2 months from the close of Half Year to which itrelates.

QMS form I gives us the quarterly data of production and sales and quarterly levels ofcurrent assets and current liabilities.

QMS form II gives us half yearly profitability statement and fund flow statements.

By comparing with the projections as given in CMA, we can see whether the performance isgoing on as projected.

QIS I:

QIS I which was earlier discontinued has been reintroduced and is to be submittedin addition to QMS I and QMS II.

- For all borrowed accounts availing fund based working capital credit limits of Rs.5

crore & above from our bank, Quarterly Information System (QIS) Form-I may be obtained

for fixing up of quarterly operative limits in addition to the QMS Forms. The QIS Form-I is to

be submitted in the week preceding the commencement of the quarter to which it relates.

- Non adherence to the operative limits will attract penal interest.

COMMITMENT CHARGES

To discourage the borrowers from non-availment of credit already provided to them by

banking institutions and to indirectly help the banks in their Asset Management, RBI has

permitted bank to charge penalty on unavailed portion of sanctioned limit known as a

commitment charge. It is applicable to the working capital limits of Rs.5 crore or above and

charged @ 1% per annum with a tolerance limit of 15% based upon the limit sanctioned.


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The unutilized part of the limit is found out by calculating the average utilization during the

quarter. While calculating the average utilization, overdrawn portion or excess portion is not

taken into consideration. If the average utilization is less than 85% than commitment

charges is levied on the entire unavailed position.

Commitment charge is not applicable in case of export unit and sick unit.

PENAL INTEREST

In order to instil a sense of credit discipline among the borrowers, RBI has permitted banksto levy penal intt. over and above the sanctioned rate of interest in case of non complianceof various terms and conditions

The broad areas of non compliance where bank charges penal interest are:

Default in repayment of loans

Irregularity in cash credit account

Non submission of stock statements and other financial data

Default in adhering to borrowing covenants

Non payment of bills

Excess borrowings arising out of excess current assets

Non submission of information under Quarterly Monitoring System

EXEMPTION FROM PENAL INTEREST

All advances up to 25000/-

Sick unit under rehabilitation

Sick unit remained closed

Advance against deposits/LIC policy/Govt. securities/Gold & Jewellery where the drawingsare within available value of security

Account transferred to Protested category


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RATE OF PENAL INTEREST

2% above the sanctioned rate where irregularity and default and non-compliance ofterms and co