Credit Mgt. - WEBILT - Deck

MBA - Banking and Finance
A WORK INTEGRATED LEARNING PROGRAM

TA L E N T | T E C H N O L O GY | T R A N S F O R M AT IO N
Credit Management
Unit 1 – Credit Management

Unit Description
Bank credit contributes to national income. Four factors go into the production of all goods and services. They are:
• Land
• Labor
• Capital
• Organization (Entrepreneur)
The entrepreneur needs funds in the form of capital and borrowings to mobilize the other factors of production.
It is here that the banks play a critical role by helping the entrepreneur
with funds in the form of bank credit. To extend this support, banks look
for entrepreneurs with ability to bring all other factors of production
together in a proper mix with a plan to earn profit after remunerating all
product factors including bank which provides the borrowed capital.
In this unit, let us identify the purpose and means to deploy banks funds,
importance of regulatory compliance, types of borrowers, credit facilities
and government support.
Unit Objectives
At the end of this unit, you will be able to:

• Identify the purpose and means to deploy bank funds in a safe and productive manner
• Explain the importance of regulatory compliance by the bank/borrower
• Identify different types of borrowers and applicable securities
• Explain the various credit facilities offered by banks
• Identify the government support extended to MSME
Credit Cycle
Credit Cycle
A loan cycle can be defined as a sequential order of various phases of lending, starting with screening of a customer,
receiving loan application, sanction, disbursement, monitoring and collection or recovery.
1
Screening of
Customer 2
7 Application
Recovery
CreditCycle
Credit Cycle 3
Appraisal
6
Monitoring &
Supervision 4
5
Disbursement of Approval/Sanction
Loan
How are Customers Screened?
Screening starts with sourcing of a customer: Screening of right kind of customer starts with proper identification
at sourcing stage itself.
• Own marketing teams, Filed Officers, Relationship Managers
• Referrals and social media in sourcing
• Sourcing support from government agencies
• Large value propositions sourced through arrangement between banks
Identification/sourcing of potential borrowers is followed by screening because it is very important for a lender to filter
the right quality of clients to the next stage of credit approval process. This is known as Screening or Due Diligence or
Credit Investigation. Inadequate screening results in higher rejection at a later stage.
Following are the important check points for screening of the prospective borrowers:
• Unit Visit, Interview, Business Activity and Utility Bill Payments, Details of Business and Existing Banking
Arrangements, Security, Succession Plans etc.,
Application
After screening the prospect in all respects to find the suitability in terms of bank’s internal guidelines as
well as regulatory guidelines the following documents/papers shall be obtained:
• A formal application in the bank’s prescribed format as per the category of borrower
• Proprietorship letter/Partnership deed/Trust deed/Society bye-laws/memorandum and Articles of Association as the case may
be to establish the legal constitution
• Know Your Customer (KYC) documents like Photo identity card (Aaadhar Card or Pass port or Driving license) along with PAN
card ((Xerox copies only) of the proprietor/Partners/Directors as the case may be
• Audited Financial Statements (Profit & Loss Account, Balance sheet, Funds Flow and cash flow, Credit Monitoring
Arrangement (CMA) data wherever applicable for the past 3 years along with the current year’s estimates and profitability
projections for the next 2 years
• Details of securities/collateral securities
• Net-worth statement of the proprietor/partners/directors etc.,
• Credit Investigation Report (CIR) of the applicant/firm/company etc.,
• Latest Income Tax/wealth tax returns/ GST assessment etc.,
• SSI registration certificate, if applicable
Appraisal
• Verification of report from Credit Information Bureau (India) Limited (CIBIL) and RBI defaulters’ database before
embarking on appraisal.
• Banks have their loan policy guidelines which will be dynamic in nature and spell out very clearly the aspects of
lending to be followed.
• Banks while appraising the loan proposals should bear in mind the RBI guideline that banks should approve only
need based finance without linking to the value of collateral security.
• Banks arrive at the need based working capital limits based on one of the following methods:
o Working Capital Gap (WCG) method
o Cash Budget Method
o Projected Turnover Method (as per P. R. Nayak Committee recommendations)
Sanction / Approval
• Banks, depending upon the size of its operations, geographical spread and skill set of the officials, vest different
levels of sanctioning powers at various levels of the hierarchy.
• Bank officials whom the approval powers are vested in are expected to exercise the powers with diligence,
judiciousness and integrity.
• Approving authorities are not expected to be associated with approval of proposals that involve friends &
relatives. In such instances, the loan proposals are referred to a higher approving authority.
• After careful appraisal by following all the guidelines of the bank, credit facilities will be sanctioned if found
suitable and communicated to the borrower for their acceptance by means of a sanction letter in duplicate.
• The applicant should carefully go through the sanction letter conditions and acknowledge and return the duplicate
copy of the sanction letter for having agreed with the sanction terms and conditions.
Documentation/Disbursement - Monitoring and Supervision
• Documentation: To have a proper evidence of lending of funds to the borrower with many conditions and to avoid
unnecessary litigation in future, banks obtain suitable documents from all the concerned parties with proper
stamp duty as per the law.
• Disbursement: Banks ensure that not only the sanction but disbursement also is need based. Banks supervise
disbursement to make sure that all the assets are created as per the proposal and disbursals are approved and
released within the time schedule to enable the unit to start operations as planned.
• Banks lend funds on the basis of the plans and projections submitted by the borrower. Unless monitored
regularly, there is every chance that actuals vary from the projections and finally project may not reach the
desired goal which will result in loss of funds or diversion of funds for unintended purposes.
• It is critical to supervise the physical progress of the business units besides monitoring the utilization of the loan
amounts.
Recovery
• The amounts lent are expected to be paid back as per the terms of repayment stipulated in the sanction letter.
• Banks are required to collect their dues as quickly as possible for fear that the income may not be consistent in
future and uncollected dues left with the borrowers may be diverted to other purposes.
• In case the borrower is unable to repay principal or interest for the genuine reasons, banks reschedule
repayments or provide additional funds to nurse back the units to normal health and recover the loan.
• In case of willful default by the borrower, banks use various recovery tools such as invoking legal action in the
court of law and measures under “Securitization and Reconstruction of Financial Assets and Enforcement of
Securities Interest” Act (SARFAESI) to take possession of the assets and sell them to recover the loan.
Principles of Lending
Principles of Lending
• Banks mobilize funds from the public by way of deposits and borrowings from the market for the purpose of lending
and investment. Banks have to pay interest on the deposits with certain exceptions and on the borrowings as per
agreed terms.
• Banks deploy these resources either by lending and or by investing in approved debt and market instruments.
• Therefore, while lending, Banks need to keep in mind the following aspects:
• Safety of funds
• Asset and Liability management
• Profitability
• Purpose
• Security
• Risk spread
5 C’s of CREDIT
In Practice: To check if the Collateral is acceptable use MASTDAY

acronym
1. Character
Acceptability of collateral security can be checked with “‘MASTDAY”
acronym
2. Capacity
• M - Marketability
3. Capital • A - Ascertain ability of its title, value, quantity and quality
• S - Stability of value
4. Collateral • T - Transferability of title
• D - Durability (not perishable)
5. Conditions • A - Absence of contingent liability
• Y - Yield
Mandatory Compliance
Mandatory Compliances required while taking Credit decisions:
KYC compliance: Banks have to follow all the Know Your Customer
guidelines scrupulously for all the borrowers.
These guidelines include Customer Acceptance Policy, Customer
Identification, Due diligence and reporting.
• Aadhar Card
• Election Card
• Driving License
• Passport
• PAN Card
to identify and understand your customer.
Due Diligence
Purpose and Process of Customer Due Diligence (CDD)
Purpose of Customer Due Diligence:

• to assist in making the right lending decisions
• to ascertain borrower credentials from a financial and credit behavior perspective.
• to ensure the validity of borrower information.
Process of Customer Due Diligence:

The most common types of verification /analysis are as follows:
1. Analyzing Bank statement transactions
2. Credit Bureau checks
3. Verification for validity of business and borrower information:
4. Analyzing Tax (IT/WT/GST) returns for understanding trends
Bank Statement Analysis
Bank statements and Overdraft statements provide an excellent window on the health of the business.
Detailed analysis of operating bank statements and overdraft accounts is one of the most critical tools as it
provides the lender a deeper understanding of the borrower’s financial health and credit behavior.
What analysis of bank statement/ OD statements, can tell us:

• Cash flow trends (monthly fluctuations, average balances, cash volatility and turnover etc.)
• Transactional/ Payment behavior signals to look for:
• Cheques issued by the customer getting returned due to shortage of funds
• Cheques deposited into the customer account by 3rd parties getting returned
• Loan repayment history records (regular EMI outflows and repayment track record)
• Depositing of large sums of cash or round sums
• Cheques issued in favor of parties unrelated to the business
• Huge turnover (sum of total credits) in the account disproportionate to the sales turnover
• Poor swing in the account (difference between maximum and minimum balance)
Credit Bureau Analysis
There are six main Credit Bureaus in India registered under SEBI, namely:
• TransUnion Credit Information Bureau (India) Limited (or CIBIL)
• Credit Rating Information Services of India Limited (CRISIL)
• Equifax
• ICRA (formerly known as Investment Information and Credit Rating Agency of India Limited)
• CRIF High Mark
• Experian
Of these, Trans Union CIBIL is extensively used by banks and other lenders. The section below gives salient details of
how CIBIL works to illustrate the functioning of credit information bureaus
Trans Union CIBIL
• Purpose: Credit bureau reports offer an effective way of evaluating the past credit behavior and repayment
track record of a small business both at a business and individual level. Most banks use CIBIL reports to track
the repayment history of the borrowers before underwriting credit risk. This information should be analyzed for
all key owners/partners/promoter directors/managers.
• Members of the CIBIL: All leading banks, financial institutions, non-banking financial companies and housing
finance companies
• Types of reports: Credit reports are in the form of:
o Commercial credit report: in case the borrowing entity is a company/ non-individual
o Personal credit report: credit report of an Individual who is the owner or main Owners of the company.
• Source of information: Credit bureaus collect factual information from various sources (banks, credit card
companies, collection agencies, blacklisted databases and various government agencies) about the
commercial borrowers/ individuals.
Verification for validity of business/ borrower information and the acceptability of the offered property as security
Searches in the Data

Personal Discussion / Residential / Property
Site/Office Visits Bases of RBI and Other
Tele Verification Verification
Online Resources
Company Search / Google Search / Defaulters /

Negative Database Search
Analysing Trends revealed by Tax (IT/WT/GST) Returns
Analysis and verification of IT/WT/GST returns reveal some of the aspects which are not disclosed or wrongly declared
by the loan applicant.
Some of the trends that can be uncovered from these returns are:
• Whether the income declared by the business firm in the IT return is consistent with the income as per the profit and
loss account
• What are the various sources of income declared by the borrower as per IT return and whether these details are
furnished to the lending institution in the application?
• Whether returns are regularly submitted to IT and the other authorities and tax assessment be completed for the
past years?
• Are there any IT dues pending payment? Are there any disputed claims from IT department?
• Whether the return copies submitted to the lending institution are genuine? This should be got verified by
independent agencies who for a fee visit to the concerned offices, compare with the originals and certify.
Pre-sanction Inspection
Banks conduct pre sanction inspection of the business premises and the properties offered as security besides visiting the residence
of borrower and the guarantor. This inspection is necessary for the following reasons:
• To verify the information provided by the borrower in the credit proposal is true? Or are there any factual errors?
• Further bank may know some more information during the unit inspection which may not be possible to obtain in the application.
• Banks conduct pre-sanction inspection of the unit/factory through their own offices or in some cases, where projects are
complicated; the pre-sanction inspection is done through some well-known outside agency. Example: Any lock out declared by
the management in the recent past, labor unrest, maintenance of proper records, observation of regulatory stipulations, break
down of important machinery etc.,
• To check whether the address given by the borrower is correct or not? The mentioned activity is actually carried out or not? The
property offered as security really exists or not?
• To verify whether the properties are having good marketability? Any deviations in the construction vis-à-vis the plan approved by
Government authorities?
Ministry of corporate affairs (MCA21) web page, search report in case of companies would provide details about performance of the
company.
RBI Prudential Exposure Norms
Purpose: The following are the important prudential norms (as of July 2018 – These norms are
updated from time to time through Master Circulars made available on RBI’s
A bank’s exposures to its website):
counterparties (borrowers for the • Bank’s exposure to a single borrower and a borrower group was restricted to 15
purpose of our discussion) may percent and 40 percent of the bank’s capital funds respectively.
result in concentration of its assets • Credit exposure to a single borrower may exceed the exposure norm of 15 percent of the
bank's capital funds by an additional 5 percent (i.e. up to 20 percent) provided the additional
to a single counterparty or a group credit exposure is on account of extension of credit to infrastructure projects.
of connected counterparties. As a • Credit exposure to borrowers belonging to a group may exceed the exposure norm of 40
first step to address the percent of the bank's capital funds by an additional 10 percent (i.e., up to 50 percent),
concentration risk, the Reserve provided the additional credit exposure is on account of extension of credit to infrastructure
Bank, in March 1989, fixed limits projects.
on bank exposures to an individual • Banks may, in exceptional circumstances, with the approval of their Boards, consider
enhancement of the exposure to a borrower (single as well as group) up to a further 5
business concern and to business
percent of capital funds subject to the borrower consenting to the banks making appropriate
concerns of a group. RBI’s disclosures in their Annual Reports.
prudential exposure norms have • The above exposure limits will also be applicable to lending under consortium arrangements
evolved since then.
Types of Borrowers
Types of Borrowers
All the banking transactions create contracts between the bank and the customers and the law of the land applies to
those transactions, creating rights and obligations depending upon on the type of customers involved.
The following are the types of Borrowers:

• Individual
• Sole Proprietary Concerns
• Partnership Firms
• Co-operative Societies and Trusts
• Limited Liability Partnerships
• Companies – Private and Public Limited Companies
Documents to be obtained
While processing loan applications of companies, as a matter of preliminary check (due diligence), banks obtain the
following documents:
Proprietorship:
Individuals:
1. PAN card
1. PAN card
2. Aaadhar card
2. Aaadhar card
3. IT/WT returns
3. IT/WT returns
4. Photos
4. Photos
5. Latest electricity bill/water bill/Telephone bill
5. Latest electricity bill/water bill/Telephone bill
6. Statement of assets and liabilities
7. A letter of proprietorship
8. GST registration
Co-operative Societies:
Partnerships
1. Certificate of registration of the society with the Registrar of
All partners’ co-op societies
1. PAN card 2. Society bye-laws
2. Aaadhar card 3. NOC from Registrar of co-op society to borrow funds from
3. IT/WT returns banks
4. Photos 4. KYC documents of individual principal office bearers of the
society who are signing the loan documents
5. Driving license/voter card/pass port
5. Resolution passed by the members permitting the society to
borrow from banks
7. Firm’s Partnership deed (Registered)
8. Firm’s GST registration
Companies:
Trusts:
1. MOA (memorandum of Association) to verify as to whether the
1. A trust is an agreement between parties, activity being financed matches with the activity or purpose as
whereby one party holds an asset for the benefit defined in the MOA.
of another party.
2. Articles of Association to verify the borrowing powers of the board.
2. Trusts are registered under Indian Trusts Act,
1882 3. Certificate of incorporation
3. There can be minimum two members in a Trust 4. Certificate of commencement of business ( For Public Limited
companies only)
4. Trust Deed is the key document of reference for
the Trust 5. Board resolution covering (i) the authority to borrow (ii) The amount
of loan (ii) the bank/s from which to raise the loan and or borrow
5. A Trust can be either registered or unregistered and (iii) The authorized signatories to sign/execute the loan
6. The board of management of trust contains documents (iv)Creation of security charge towards the bank loan.
trustees who manage the affairs of the Trust.
Types of Credit Facilities
Types of Credit Facilities
Based on whether the lending bank commits the physical outflow of funds
• Fund based (where there is physical outflow of funds from the bank end)
• Non-fund based (where the credit facility offered by the bank does not result in immediate physical outflow of funds)
Further the credit facilities can be sub-categorized as under:

A. Based on whether the loan is covered by any collaterals/security
• Secured facilities (where the credit is partially or fully secured by Primary /collateral security)
• Unsecured Facility (where the facility is not covered by any primary/collateral security)
B. Based on the Tenor of the Credit Facility
• Short Term – Facilities typically under one-year tenor or up to 3 years
• Medium Term – Facilities between 3- 7 years
• Long Term - >7 years
C. Based on the purpose or business requirements:
• To meet the routine business needs – Working capital
• To acquire fixed assets like plant and machinery, equipment’s - Term Loan
Characteristics of Retail Lending
• All small ticket loans

• Cater to large number of customers
• Diversified portfolio
• Target customers are generally individuals or small business firms
• Standardized products and appraisal. Not much of customization
• Loan processing is generally centralized
• Decision process is fast and objective
• Mostly templated lending
• Interest rates are highly competitive
• Risks are well diversified
• Volumes are low
• Portfolio level risk management
Characteristics of Wholesale banking:
• Low volume of large transactions
• Focused on few corporate customers
• Mostly products are customized
• Long-drawn decision process which is both objective and subjective
• Concentrated risks
• Few number of accounts, segmentation is not so large
• Account level risk management

Types of Securities
Types of Securities
Assets created out of bank finance are available as security for the loan. In case of certain loans, banks also obtain
additional security as a safety measure.
• The securities available to the bank could be broadly classified under two categories:
• Primary Security - The assets created out of bank finance are called primary security. The value of the primary
security must be higher than the loan balance outstanding so that the security covers the loan with adequate
margin.
• Collateral Security - additional security other than primary is called as collateral security. Banks obtain
additional securities as a cushion to guard against default in repayment and or inadequate coverage of the
primary security to the loan. Collateral security enhances the comfort for lending.
Different Modes of Security Charge Creation
• Hypothecation
• Pledge
• Mortgage
• Lien
• Assignment
MSME Financing
MSME Financing - Introduction
The Micro Small and Medium Enterprise (MSME) sector play an important role in India's economy. They are major
sources of entrepreneurial skills, innovations and employment.
The key highlights of MSME sector contribution to the Indian economy are given hereunder:
• MSMEs account for about 45% of India’s manufacturing output
• MSMEs account for about 40% of India’s total exports
• The sector is estimated to employ about 73 million people in more than 31 million units spread across the country
• MSMEs manufacture more than 6,000 products ranging from traditional to high tech items
• However, both the MSME sector and Banks have challenges.

Challenges Faced by MSME Sector
• Lack of availability of adequate and timely credit
• High cost of credit
• Collateral requirements
• Limited access to equity capital
• Procurement of raw material at a competitive cost
• Problems of storage, designing, packaging and product display
• Lack of access to global markets and poor marketing capabilities
• Inadequate infrastructure facilities including power, water, roads
• Lack of access to modern technology
• Lack of skilled manpower for manufacturing, services and marketing
• Multiplicity of labor laws and complicated procedures associated with compliance with such laws
Definition of MSME as per MSMED Act 2006
• The business activities have been classified under two broad heads:
• Manufacturing - Manufacturing Enterprises: Enterprises engaged in the manufacturing or production,
processing or preservation of goods
• Service Enterprises: Shall include small road and water transport operators, small businesses, professional
and self-employed persons, retail traders and all other service enterprises.
• Further, the business activities engaged either in manufacturing and or services are sub-classified under three
heads as:
• Micro
• Small
• Medium
• The subcategorization of the activities is linked to the original investment in plant and machinery in case of
manufacturing enterprises and original investment in equipment in case of service enterprises. It must be noted
that the investment in land and building is excluded for the purpose of MSME classification. The following table
provides more information on the classification of MSME segment:
Definitions of MSME as per MSMED Act 2006
The classification of micro or small or medium enterprises is based on the investment in plant and machinery or equipment's.
As per MSMED Act 2006, the criteria for classification of Micro, Small and Medium enterprises are:
OLD Classification
Enterprises
Category
Micro Small Medium
Manufacturing units with Original Above Rs 25 Lakh to Rs 5.0 Above Rs 5 Crore to Rs 10

Up to Rs 25 Lakh
Investments in plant and machinery Crore Crore
Service Enterprises with Original Above Rs 10 Lakh to Rs 2.0 Above Rs 2 Crore to Rs 5.0
Up to Rs 10 Lakh
investment in Equipment's Crore Crore
Definitions of MSME as per MSMED Act 2006
The Revised classification takes into account both the Investment in Plant and Machinery as well as Turnover.
New Classification
Investment in plant and machinery or

Classification And Turnover (excluding export turnover)
equipment
Micro enterprises Not exceeding Rs. 1 crore and Not exceeding Rs. 5 crore
Small enterprises Not exceeding Rs. 10 crore and Not exceeding Rs. 50 crore
Medium enterprises Not exceeding Rs. 20 crore and Not exceeding Rs. 100 crore
Major initiatives to ensure adequate Credit
• MSME Loan policy
• Specialized MSME loan processing Centers
• MSME Clusters and Care Centers
• Simplified loan applications and documentation
• Customized MSME Loan products
• Competitive loan pricing and processing charges
• Prime Minister’s Mudra Yojana Scheme though which loan up to Rs.10 lakhs per unit is provided by banks and NBFCs
• Simplified loan application forms are introduced
• All loan applications should be acknowledged in writing
• Loan applications to be disposed-off or processed within a definite time frame
• To provide working capital limits to Micro & Small Enterprises (Manufacturing) on the basis of minimum of 20% of projected
turnover.
• It should also be ensured that sanctioned loans are disbursed within 2 working days from the date of compliance of all terms and
conditions of sanction/documentation.
• Penal provisions have been in place to take care of delayed payments by the corporates.
CGTMSE (Credit Guarantee Fund Trust for Micro and Small Enterprises)
• The lenders should give importance to project viability and secure the credit facility purely on the primary security of the assets
financed.
• The lender availing guarantee facility proactively extends composite credit to the borrowers so that the borrowers obtain both
term loan and working capital facilities from a single agency.
• In the event of an MSE unit, which availed collateral free credit facilities, fails to discharge its liabilities to the lender, the
Guarantee Trust would make good the loss incurred by the lender up to a certain percentage of the credit facility.
• The following provisions are subject to change from time to time and can be accessed from the updated guidelines hosted online
by Government of India:
o The eligibility for CGTMSE cover,
o Extent of cover available
o Guarantee fee
Summary
Summary
Here is the recap of what you have learnt in this unit.
• Credit cycle involves sourcing and screening of the borrowers, appraisal, sanction, disbursement, supervision &
monitoring and recovery.
• Due diligence or Credit Investigation is a key aspect of credit management to avoid bad loan booking.
• A visit to the business unit of the borrower reveals more information than that of the application and other
documents.
• A check with CIBIL and RBI defaulters’ list is a pre-requisite for loan sanction.
• Legal Documentation is necessary to evidence existence of debt. Banks do not disburse loans until and unless the
legal documentation is complete in all respects.
• A good loan not properly monitored may turn out to be a bad loan in course of time while a well monitored bad
asset has chances of turning out to be a good loan. In other words, loan monitoring is a critical component of
Credit
Summary
• Banks should keep these accepts in mind while entertaining credit proposals: Safety of funds, Asset and Liability
management, Profitability, Purpose, Security, Risk spread.
• 5Cs in credit management are: Character, Capital, Capacity, Collateral and Conditions.
• Capacity and Willingness to pay are the two most important parameters that should be established by a loan
appraise beyond doubt before underwriting.
• A pre-sanction visit to the borrower’s place of residence and business reveal more things which are not disclosed
in the loan application.
• Post sanction monitoring and supervision is necessary to ensure that the loan amount is utilised for the purpose it
is sanctioned and the operations of the borrower’s business are happening as per the projections
• All mandatory compliances should be taken care while entertaining credit proposals to ensure safety of bank’s
funds.
• Extra care should be taken while entertaining takeover proposals.

THANK
YOU
Credit Management
Unit 2
–
Financial Statement Analysis, Interpretation and Decision Making
Unit Description
Promoters, owners, shareholders, investors, financiers, lenders, bankers, creditors, suppliers, employees, tax
authorities or any other individual or group of persons connected with a particular business concern are interested
to find answers to certain fundamental questions such as:
• What is the financial standing of the business entity as on a particular day?
• How did the business perform over a long period particularly in the recent past?
• Are their financial and other interests safe?
In order to find answers to those important and logical questions, one has to lay
hands on certain financial statements of the business concern.
Unit Objectives

• Identify the importance of balance sheet and profit & loss account in the financial statement
analysis
• Explain how operating statement and cash flow statement are used in the financial statement
analysis
• Explain QIS analysis
• Explain ratio analysis and its importance
• Use financial benchmarks and spread sheets
• Breakdown CMA data for analysis
Financial Statement
Financial Statement
Financial Statements are summarized statements of accounting data produced at the end of an accounting process by
an enterprise through which it communicates accounting information to the internal & external users.
The term financial statement refers to TWO documents namely:

1. Balance sheet with schedules
2. Profit and Loss account with schedules
The audited financial statements also include Directors’ report, Auditors’ report, Cash flow statement and Funds Flow Statement.
Financial statement analysis is the process of reviewing and evaluating a company's financial statements, thereby
gaining an understanding of the financial health of the company and enabling more effective decision making.
The primary function of a lending banker is to evaluate the credit worthiness and credit requirements of a business or
industrial enterprise. Financial statements play an important part in performing this function.
Balance Sheet
• It is a statement of assets (properties owned) and liabilities (amount owed) of the business as on that date,
revealing the financial position of a business concern. It can also be stated as a statement of sources and
application(uses) of funds.
Objectives:
• To understand the nature of assets and liabilities in a balance sheet and their proper classification
• To understand the business performance
• To make meaningful decisions by the management, investors, creditors and debtors
Schedule VI (revised) of Companies act 2013 prescribes a format for classification of various assets and liabilities of a balance
sheet. It is mandatory to present the balance sheet in the same format and classification by all the companies in India.
Reclassification of Assets and Liabilities - RBI Guidelines
The first and foremost step in the analysis of balance sheet is re-classification of assets and liabilities of balance sheet in line with
the RBI guidelines for the bankers.
This re-classification is required to be done for the following reasons:
• The liabilities are grouped on the basis of security and liquidity. The liability side of a company balance sheet format of 1956
consists of i)Share Capital ii) Reserves & Surplus iii) Secured Loans iv)Unsecured Loans v)Current Liabilities and Provisions.
• The objective of a banker in analyzing the balance sheet is to find out the current liabilities (which are payable in less than one
year) and to compare them with the current assets (which are converted into cash within a year) to ensure that all the current
liabilities are backed by adequate current assets. This purpose cannot be served by classify the liabilities into Secured and
Unsecured Loans as done in the old format.
• This reclassification of current assets and current liabilities is also necessary to decide how much working capital is required
for a business concern (the total of all current assets) and the Working Capital Gap (Current Assets-Current Liabilities
excluding bank finance) to be financed by the banks.
• In order to bring a uniform practice among the banking industry in the matter of classifying the current assets and current
liabilities, the Reserve Bank has suggested a classification which is followed by all banks in India.
Balance Sheet Analysis
It is carried out in four steps:

• Classification: Assets and Liabilities and income & expenditure into standard headings as under:
o Liabilities: Net-worth – Term Liabilities-Current Liabilities and Provisions
o Assets: Current Assets- Non--Fixed Assets- Current Assets-Non-Current Assets-Intangible Assets
• Grouping: Grouping of all the items of balance-sheet under the various standard heads as mentioned in (1) above
• Ratio computation: Establishing inter relationship between and amongst various groups.
• Interpretation: Interpretation of the ratios to enable the readers to understand about the financial position of the
business concern.
The re-classified balance-sheet format as per RBI guidelines for bankers is furnished in the annexure-3
Understanding each item of Balance Sheet
• Liabilities - These are the sources of funds to acquire various assets necessary for business operations.
• Net-Worth - The sum of capital and reserves of a firm/company
• Long-term Liabilities – These are loans borrowed by the business on a long term basis. Generally, repayable
after one year from the date of balance sheet.
• Current Liabilities – Liabilities which are repayable within 12 months from the date of the balance sheet.
Generally, loans and overdrafts intended for working capital purpose are current liabilities.
• Assets are those which are acquired by a business firm or a company out of its liabilities. Hence assets are
application of funds.
• Fixed Assets are those assets which are used for more than one accounting period. These are the assets not
meant for sale or for conversion into cash.
Understanding each item of Balance Sheet
• These assets are neither Current Assets nor Fixed Assets and are not converted into cash during normal
business cycle. These are not productive assets unlike current assets and fixed assets but they are necessary to
run the business. Hence, business concerns ensure that only minimum level of funds is invested in non-current
assets.
• Current Assets are those assets which are capable of being converted into cash or cash equivalent with in one
operating cycle or with in a maximum period of 12 months from the date of balance sheet.
• These assets might have been acquired after spending a good amount of money. In case of well-run enterprise,
value of these assets is enormous.
• Fictitious assets are not assets actually, they are expenses and losses shown on asset side of the Balance sheet.
They are neither tangible nor intangible Factitious assets are those assets which couldn’t be written off during the
current accounting period.
Profit and Loss Account
Profit and Loss Account
It is a statement of income and expenditure during a specific period of time. Income is shown on the right hand side
or on top and expenditure is shown on the left hand side or at the bottom. The resultant profit or loss is transferred to
Balance Sheet. P&L account is divided into three parts.
o Trading and manufacturing account
o P&L account showing net profit after charging administrative, financial and selling expenses
o P&L appropriation account.
Objective:
• Analysis of Operating Data
• Significance of profit earned at Different levels of Manufacturing and Trading activities
• Profitability Ratios as indicators of Business Efficiency
• Importance of Ratio Analysis and its significance in making credit decisions
• Various formulae used in ratio calculation
P & L Terms Explained
• Net Sales = Gross Sales (Total Sales) minus Excise duty
• Raw Materials Consumed = (Opening stock of raw material + Purchases during the year) – Closing stock of raw
material at the end of the year
• Cost of Production (CoP) = Raw Material Consumed + Manufacturing expenses including depreciation +
Opening stock in process – Closing stock in process.
• Cost of Sales (CoS) = Cost of Production + Opening stock of finished goods-Closing stock of finished goods
• Gross Profit (GP) = Net Sales - Cost of sales
• Operating Profit (OP)`= Gross Profit (GP)-Operating Expenses
• Net Profit (NP) = Operating Profit + Non-Operating Income-Non Operating Expenses

Ratio Analysis and its Significance
• Once the balance sheet and profit and loss account are presented in
the prescribed form, it is necessary to ‘read” or interpret them and
draw meaningful conclusions.
• For this purpose, some well tested tools are available. The two most
important tools available are:
o Ratio Analysis
o Funds Flow and Cash Flow Statements
Ratio Analysis
Ratio Analysis is the process of determining and interpreting numerical relationship based on financial statements. It is the
technique of interpretation of financial statements with the help of accounting ratios derived from the balance sheet and profit and
loss account.
Importance / Significance of Ratio Analysis:
• Current Ratio and Quick Ratio help in assessing the short term solvency/liquidity of a firm
• Profitability ratios help in evaluating the operating performance of a business firm.
• Ratios show the degree of efficiency in managing various resources of the firm
• Capital structure ratios help is understanding the long term solvency
• One of the most important reasons to use ratio analysis is that it helps in understanding the business risk of the firm.
Limitations of the Ratio Analysis:
• Ratio analysis is based on historical data and as such sometimes it is difficult to predict future developments in the
business
• The firm can make some year-end changes to their financial statements, to improve their ratios. Then the ratios end up
being nothing but window dressing.
• Ratios ignore the price level changes due to inflation.
Important Ratio
1. Current Ratio = Current Assets / Current Liabilities.
2. Debt Equity Ratio = Long Term Debt/Tangible Net-worth
3. TOL / TNW ratio= Total Out-side Liabilities / Tangible Net Worth
4. Capital Gearing Ratio = (Total outside liabilities + Total Non-fund Based Limits) / (Tangible Net Worth- Non-
Current Assets)
5. DSCR = (PAT+ Depreciation+ Interest on Term Loans)/ (Interest on Term Loans + Instalments on Term
loans)
6. Net Working Capital (NWC) = Long Term Sources of Funds-Long Term Application of Funds. Or Total
Current Assets (TCA)-Total Current Liabilities (TCL)
Important Ratio
7. Gross Profit Ratio (GP Ratio) = Gross Profit / Net sales (Gross Profit = Net Sales - Cost of Sales)
8. Net Profit Ratio (N.P ratio) = Profit After Tax (PAT) / Net Sales
9. Interest Service Coverage Ratio (ISCR) = Operating Income (EBDIT) / Interest obligation
10. Debtors Days or Receivable Days = Average Debtors x 365 / Gross Sales
11. Creditors Days or Account Payable Days = Average Creditors x 365/Purchases

Window Dressing of Balance sheet
In accounting parlance, window dressing of the balance sheet is the technique by which financial statement is made to
reveal a better picture than the actual position. By manipulating certain items of balance-sheet and profit and loss
account, the business concerns make their balance-sheets appear rosy. Some of the examples of window-dressing are
given hereunder:
• Postpone paying suppliers, so that the period-end cash balance appears higher than it should be.
• High debtor levels are perceived as a negative feature since indicates that the debtors collection is poor and the
company’s liquidity is under stress. Therefore, the company gives heavy discounts at the year end and realize the
debtors.
• If the cheques issued to the suppliers are accounted, sometimes the cash balance may turn negative. Companies
do not like to show negative cash balances in their balance sheet as it creates a negative impression to the readers.
Hence, either they hold issue of cheques to the suppliers or they do not account for it even if they issue.
• Over valuing of closing stock of raw material, work-in-process and finished goods result in inflated gross profits. A
loss making concern can paint a better picture by resorting to over valuation of stocks
Fund Flow Statement
Fund Flow Statement
It is a statement of the Sources and Application of funds. It reveals as to how a business concern has got funds
for its business and how the funds have been spent or utilized.
Hence, the funds flow statement is also called “where got, where gone” statement.
Funds flow statement is nothing but a statement of movement of funds to and from the company’s cash box.
Thus, the sources include increase in owner’s equity capital, increase in loans/debt and sale of assets.
Applications or Uses include purchase of assets, repayment of debts, investments in other business activities,
redemption of bonds/debentures, reduction in owner’s equity etc.
Types of Sources and Application of Funds
Long-term Source of Funds: Those funds which remain with the company for more than 12 months from the
balance sheet date. E.g. Equity Capital, Long term loans (repayable over >12 months), long term debentures and
bonds.
Short-term Source of Funds: are those funds which remain with the business for a period not exceeding 12 months
and they should be paid back to the lenders in 12 months’ time. E.g. All current liabilities (bank borrowings for working
capital purpose, trade creditors, provisions and outstanding expenses etc.) are short term source of funds.
Long-term use of Funds: Those funds which are utilized for acquisition of the assets which remain with the company
for a long period (>12 months) and used for repayment of long term liabilities E.g. Acquisition of fixed assets, Non-
current assets like investments, security deposits, repayment of term liabilities etc.
Short-term use of Funds: Those sources which are utilized for acquiring all current assets like inventories,
receivables, cash and bank balances, prepaid expenses etc. Besides that funds utilized for repayment of current
liabilities also is a short term use of funds.
Fund Flow Statement
Requirements to compile or prepare a funds flow statement:
• Consecutive balance sheets for two or more years
• Consecutive Profit and Loss statements for two or more years.
Funds flow is one of the statements under Credit Monitoring Arrangement (CMA) under Form-VI. The CMA excel
format automatically captures the data from Operating statement (Form-II) and balance sheet (Form-III) for completing
Form-VI.
Cash Flow Statement
Cash Flow Statement
Cash flow Statement Analysis:

• The cash flow analysis refers to the examination or analysis of the different inflows of the cash to the company
and the outflows of the cash from the company during the period under consideration from the different
activities which include operating activities, investing activities and financing activities.
• Cash flow from Operating Activities (Operating Cash Flow)
o The Operating Cash Flow (OCF) is the net cash generated from or cash used for the main business
activity. In other words, the net amount of cash coming in (inflow) or going out (outflow) from the day to
day business operations of an entity is called Cash Flow from Operations.
o Basically it is the operating income plus non-cash items such as depreciation added back.
o Cash flow from operations is an important measurement because it tells the analyst about the viability of
an entities business operations. In the long run, cash flow from operations must be positive in order for an
entity to be solvent and provide for the normal outflows from investing and finance activities.
Cash Flow Statement
• Cash Flow from Investing Activities (Investing Cash-flow)

o Cash flow from investing activities would include the outflow of cash for long term assets such as land,
buildings, equipment, etc., and the inflows from the sale of assets, businesses, securities, etc. Most cash
flow investing activities are cash out flows because most entities make long term investments for
operations and future growth.
• Cash flow from Financing Activities (Financing Cash-flow)
o Cash flow from financing activities includes the cash out flow by way of interest and principal payments
towards loans, bonds, debentures etc. and dividend payments to equity investors. Cash inflows arise from
fresh loans, issuance of bonds/debentures or issuance of equity or preference shares. Most cash flows
from financing activities are cash outflows since most entities only issue bonds and stocks occasionally.
Credit Monitoring Arrangement (CMA)
Credit Monitoring Arrangement (CMA)
During 1988, Reserve Bank of India, introduced 'Credit Monitoring Arrangement' (CMA). The CMA forms were
designed based on the suggested formats of Tandon Committee recommendations on working capital
assessment.
In the past, banks were required to report any sanction/ renewal of credit limits of
(a) Rs.10 Crs and above in case of Working capital facilities (funded) – New and/or renewal.
(b) Rs. 5 Crs and above in case of term loans to in the CMA format to the RBI for post sanction scrutiny.
CMA Forms
CMA consists of 6 forms as detailed here under:

Form No. Particulars Purpose
To know:
Details of various credit facilities being • Present credit facilities and the proposed facilities.
FORM I enjoyed with different banks and • Details of Fund and Non-fund based limits
Financial Institutions • The extent of usage of the present facilities and current outstanding balance.
Recast of Trading, Profit, and Loss statement for a comparative analysis of the operating
FORM II Operating Statement performance.
Balance sheet
FORM III (FORM III L- Liabilities, FORM III A - Recast of Balance sheet items for a comparative analysis of the financial position
Assets)
Holding period of Current Assets and Comparative analysis of the holding period of current assets & current liabilities.
FORM IV
Current Liabilities
Computation of P B F (Permissible Computation of Permissible Bank Finance taking into account the various items of current
FORM V assets, current liabilities and Working Capital Gap (WCG).
Bank Finance)
To know the sources of funds (long term and short term) and how they are deployed. Whether
FORM VI Funds Flow Statement long term surplus is available to provide margin (NWC) for working capital? Whether there is
any diversion of short-term funds?
Quarterly Information System (QIS) – Financial Follow-up Report (FFR) I & II
Purpose:
• Banks sanction credit facilities basing on the projections and promises given by the borrowers in the CMA data. If
banks wait up to the end of the financial year to know whether the given projection of production and sales have
materialized, it may be too late for any corrective action required to be taken.
• Hence, banks obtain periodical performance reports from the borrowers basing on the limits sanctioned to them.
QIS- FFR I AND II are such reports which enable the bank to understand whether the actual performance of the
business is in tandem with the projected performance.
Who should submit FFR-I & II?

All the borrowers (manufacturing or trading and Exporters) who are enjoying working capital limits of Rs.6 crores and
above from banking system are required to submit FFR-I for each quarter and II once in a half year. The data is to be
submitted for each line of activity/unit separately as also for company as a whole.
Contents
FFR-I
• Quarter-wise estimates of production and sales
• Quarter-wise actuals of production and sales
• Quarter-wise actuals vs estimates of current assets and liabilities at the end of the quarter
FFR-II
• Half yearly Profit & Loss Statement
• Half yearly Funds Flow Statement
Periodicity of Submission:
• FFR-IA, I B&C are to be submitted within 6 weeks from the close of the quarter.
• FFR-II is to be submitted within 8 weeks from the close of the half year
Summary
Summary
• Financial Statements are summarized statements of accounting data produced at the end of an accounting
process by an enterprise through which it communicates accounting information to the internal & external users.
• Financial statement analysis is the process of reviewing and evaluating a company's financial statements (such as
the balance sheet or profit and loss statement), thereby gaining an understanding of the financial health of the
company and enabling more effective decision making.
• A balance sheet shows the financial position of a business concern as on a particular date. It is a statement of
assets (properties owned) and liabilities (amount owed) of the business as on that date.
• A profit and loss account It is a statement of income and expenditure during a specific period of time. Income is
shown on the right hand side or on top and expenditure is shown on the left hand side or at the bottom. The
resultant profit or loss is transferred to Balance Sheet.
• The sum of capital and reserves of a firm/company is known as its “Net-worth”. Net-worth represents
owners’/promoters’ own funds in the business. Net worth is a measure of financial health or soundness of the
business.
Summary
• Ratio Analysis is the process of determining and interpreting numerical relationship based on financial statements.
It is the technique of interpretation of financial statements with the help of accounting ratios derived from the
balance sheet and profit and loss account.
• Window dressing of the balance sheet is the technique by which financial statement is made to reveal a better
picture than the actual position. By manipulating certain items of balance-sheet and profit and loss account, the
business concerns make their balance-sheets appear rosy.
• Funds Flow Statement is a statement of the Sources and Application of funds. It reveals as to how a business
concern has got funds for its business and how the funds have been spent or utilised. Hence, the funds flow
statement is also called “where got, where gone” statement.
• Long term source of funds: are those funds which remain with the company for more than 12 months from the
balance sheet date. E.g. Equity Capital, Long term loans (repayable over >12 months), long term debentures and
bonds.
• The cash flow analysis refers to the examination or analysis of the different inflows of the cash to the company and
the outflows of the cash from the company during the period under consideration from the different activities which
include operating activities, investing activities and financing activities.
THANK
YOU
Credit Management
Unit 3
–
Credit Delivery System
Unit Description
Credit Management broadly comprises 3 important functions namely:
1. Credit Assessment
2. Credit Delivery
3. Credit Monitoring and Supervision
In this unit, we will study

a) different methods of assessing working capital limits
b) Credit delivery methods and
c) Monitoring and Supervision of credit.
Unit Objectives

• Identify the methods of assessing Maximum Permissible Bank Finance (MPBF) as per Tandon Committee
Recommendations
• Explain the Cash Budget Method of assessing need based working capital finance suggested by Kannan
Committee
• Explain the Credit Delivery System - Working Capital Demand Loan(WCDL) recommended by Jelani Committee
• Identify the different types of banking arrangements - Sole banking - Multiple banking - Consortium banking -
Syndication
Credit Assessment
Tandon Committee Recommendations
A study group under the chairmanship of Shri P.L. Tandon, the then chairman of PNB was constituted in 1974 by the
RBI in order to frame guidelines for bank credit.
The major operative recommendations of the Tandon Committee are applicable to all borrowers enjoying Working
Capital Limits (Fund based) in excess of Rs.10 lakhs from the banking system.
The committee suggested certain norms for bank lending which are as follows:
• The borrowers are allowed to keep reasonable level of current assets particularly inventory and debtors
depending upon their production plan, lead time of supplies and economic order quantities. Bank shall finance
only the reasonable levels of current assets.
• Bank finance to borrowers in the form of working capital should not be made available for profit making or to keep
excess inventory. Similarly the bank should finance the bills receivable, which are in line with the practices of the
borrower’s industry.
Tandon Committee Recommendations
• The norms of inventory and receivables have been worked out according to the time element. The level of the
raw materials to be held is expressed as so many months of total consumption in the year. The work-in-progress
level is determined as so many months of cost of production, the finished goods and bills receivable limits are
determined by cost of sales and sales respectively.
• No norms spares have been suggested. However, it was suggested that he maximum holding for spares should
not exceed 5% of total permissible inventory or actual consumption during last 12 months, whichever is lower.
Banks generally permit 9 months holding for indigenous spares and 12 months consumption for imported
spares.
• These norms are not entitlement to a borrower. If actuals are less than the norms suggested by the committee,
banks continue to accept the actual levels only for the assessment of working capital. The Tandon Committee
has suggested norms of inventory and receivables for fifteen industries.
Maximum Permissible Bank Finance (MPBF)
Tandon Committee introduced the concept of MPBF in the working capital finance by bankers. The Committee
suggested that bank should attempt to supplement the borrowers’ resources in financing the current assets.
It has recommended that the current assets (working capital) first should be financed by trade creditors and other
current liabilities.
The remaining current assets, which is called working capital gap, should be financed particularly by
a) bankers in the form of bank credit and
b) owner’s margin.
In the context of this approach, the committee has suggested three alternative methods for working out the MPBF.
Each successive method reduces the involvement of short-term bank credit to finance the current assets.
First Method of Assessment
Steps Involved:
Step 1: Compute total current assets required to hold for a particular level of production and sales by adopting holding
level norms as suggested by the committee in respect of inventory and receivables.
Step 2: Compute current liabilities (other than bank borrowing for working capital) based on trade credit available in
the market.
Step 3: Workout Working Capital Gap by deducting current liabilities excluding bank borrowing from current assets
WCG = Current Assets – Current Liabilities (excluding bank borrowing)
Step 4: Reduce 25% of the Working Capital Gap from WCG which should be contributed by borrower by way of his
margin from long-term funds and remaining 75% can be financed by way of bank borrowings.
This method will give a minimum current ratio of 1.17:1.
Second Method
• Steps 1 to 3 are same as first method.
• Step 4: Borrower should provide 25% of the total current assets as his margin instead of 25% of WCG by way of
long-term funds. This will give a current ratio of 1.33:1.
Example:
The first two methods of lending are illustrated by taking the following example of the borrowers’ financial position projected as at
the end of the next year.
Current Liabilities Current Assets
Trade creditors 100 Raw Materials 200
Other current liabilities 50 Stock-in process 20
Bank Borrowings 222 Finished Goods 90
Receivables (Sundry Debtors) 50
Other current assets 12
Total Current Liabilities 372 Total Current Assets 372
Example of first and second method
As per First Method As per Second Method

Total Current Assets 370 Total Current Assets (TCA) 372
Less : Current Liabilities other than bank borrowings 150 Less : margin : 25% of TCA 93
Working Capital Gap (WCG) 220 Less : Current Liabilities 150
Less : margin 25% of WCG 55
Maximum Permissible Bank Finance 165 Maximum Permissible Bank Finance 129
Excess Borrowing = (222-165) 57 Excess Borrowings (222-129) 93
Current Ratio = CA/CL = 370/315 = 1.17 Current Ratio = CA/CL=370/279 1.33
It may be observed from the above example that the required margin to be brought in by the borrower
under first method of lending is 25% of WCG while under second method the margin requirement is 25% of
total current assets, which is more.
The detailed assessment of working capital as per I method and II method have been dealt with in
Unit-4 (Working Capital Assessment).
Turnover Method of Assessing Working Capital (P. R. Nayak Committee)
The method of assessment of working capital limits up to Rs.2 crore (Rs.7.50 Crore for SME) assessed
under turn over method is called limits assessed under Nayak Committee Norms.
Under turnover method, the aggregate fund based working capital limits are computed on the basis of
Minimum of 20% of their projected annual turnover. The borrower has to bring margin of 5% of the annual
turn-over as margin money.
If Projected sales turn-over 200

Then, working capital requirement is 25% of turnover ( 3 months requirement) 50
Minimum permissible Bank Finance should be 20% of turnover 40
Margin money from the borrower should be 5% of 200 10
Reserve Bank’s Direction:

As per the RBI direction, all the borrowers whose working capital requirements are up to Rs.2 crores, a minimum of 20% of their
annual turnover shall be provided as bank finance. This conforms to 3 months operating cycle. If any borrower has higher than 3
months operating cycle, the need based finance may be considered based on their current assets and current liabilities build-up.
Kannan Committee Recommendations (Cash Budget Method)
In view of the ongoing liberalization in the financial sector, the Indian Banks Association (IBA) constituted a committee
headed by Shri K. Kannan, Chairman and Managing Director of Bank of Baroda to examine all the aspects of working
capital finance including assessment of maximum permissible bank finance (MPBF).The Committee submitted its report
on 25th February, 1997.
Recommendations accepted:
• Assessment of working capital finance based on the concept of MPBF, as recommended by Tandon Committee, has
been withdrawn. The banks have been given full freedom to evolve an appropriate system for assessing working
capital needs of the borrowers within the guidelines and norms already prescribed by Reserve Bank of India.
• The turnover method may continue to be used as a tool to assess the requirements of small borrowers. For SME
(Small and Medium Enterprises) this method of assessment has been extended up to total credit limits of Rs 5 crores.
• Banks may now adopt Cash Budgeting System for assessing the working capital finance in respect of large
borrowers.
• The banks have also been allowed to retain the present method of MPBF with necessary modification or any other
system as they deem fit.
After the assessment of the working capital finance to be provided by the bank (MPBF method/Cash budget
method/Turn-over method as the case may be), the MPBF will be bifurcated into Inventory finance and sales finance
in the ratio of inventory: receivables and then it is to be decided – in consultation with the borrower – as to how the
bifurcated limits will be availed of by the borrower.
Depending upon the nature of the business activity and the operating cycle prevalent in the particular industry, the
following modes of delivery of credit are commonly adopted in India.
• Inventory Finance
• Bill Finance / Bill System of Financing
• Bridge Loan
Inventory Finance - Overdraft/Cash Credit
• The inventory limit carved out of total MPBF is made available in the form of a running account called
“Overdraft/Cash Credit” account.
• The maximum withdrawals from the CC account at any point of time should not exceed the inventory limit.
However, the withdrawals from the CC account are subject to availability of Drawing Power (DP).
• The DP is calculated by the bank on a monthly basis over the amount of various items of inventory available with
the borrower.
The following is the projected position of current assets and current liabilities at the time of assessment of
working capital limit.
Current Liabilities Amount (Rs. in lakhs) Current Assets Amount (Rs.in lakhs)
Trade Creditors 100 Inventory 200
BB for WC 300 Receivables 300
TCL 400 TCA 500

The MPBF of Rs.300 lakhs may be bifurcated in the same ratio of inventory and receivables i.e. in 2:3
Inventory limit = 300 * 2/5 = Rs.120 lakhs
Receivable limit = 300 * 3/5 = Rs.180 lakhs
Style of Credit:
• The inventory limit of Rs.120 lakhs will be made available to the borrower in the form of Cash Credit account
which is a running account.
• The receivable limit of Rs.180 lakhs will be released in the form of Bill Discounting
Drawing Power (DP):
The inventory and receivables keep changing depending upon the production and sales. Hence, bank obtains a
statement of stock and receivables every month from the borrower to know the stock and receivable position.
Based on the stock levels, the drawing power will be fixed as under:
Say in a particular month the stock is Rs.170 lakhs and against which outstanding trade credit is Rs.70 lakhs. Then
the D.P is computed as under:
Inventory 170
Less: trade credit 70
Paid stock 100
Less: margin 25% 25
Drawing Power 75
Though the sanctioned CC limit is Rs.120 lakhs, since the D.P is available only to the extent of Rs.75 lakhs, the
drawings in the CC account will be restricted to Rs.75 lakhs only.
Thus sanctioned limit or the D.P whichever is lower will be permitted to draw for that month.
Repayment / Renewal / Rollover of Loan Component Banks will have the discretion to stipulate repayment of the
WCDLs in instalments or by way of a bullet repayment. Banks may consider rollover of the WCDLs at the request of
the borrower.
Bill Finance/Bill System of Financing
It is basically financing of credit sales of the business concern. Every business unit sells a portion of its product/s
on cash basis and some part of its product/s on credit basis which is a common practice in the business parlance.
The seller may extend 30 to 90 days or more days of credit to his buyer depending upon the business practice,
demand for the product, buyer’s credit worthiness etc.
In this transaction, seller’s working capital funds are blocked for the credit period and are not available for further
production of the finished goods. Here the need for bank finance against the amount blocked in credit sales arises.
Seller (drawer) draws a bill of exchange on the buyer (drawee) directing him to pay the amount specified in the
bill to him or to a certain person (payee) or to the bearer of the bill.
The Section 5 of the Negotiable Instrument act (NI act) 1881 defines bill of exchange as under:
“A bill of exchange is an instrument in writing containing an unconditional order, signed by the maker, directing a
certain person to pay a certain sum of money to, or to the order of, a certain person or to the bearer of the
instrument.”
Types of Bill of Exchange
• Clean Bill of Exchange

• Documentary Bill of Exchange
• Sight Bill of Exchange
• Usance Bill of Exchange
• DP Bill (Delivery Against Payment)
• DA Bill (Delivery Against Acceptance)
• Bill Drawn under Letter of Credit or LC Bill
Types of Advance Against Bills
Bills finance is short term and self- liquidating finance in nature. Demand Bills are purchased and Usance bills
are discounted and the bills drawn under Letter of Credit (LC may be on sight draft or usance draft) are
negotiated by the banks.
• Purchase of clean/documentary demand bills
• Discounting of clean/documentary usance bills
• Advance against supply bills
• Advance against bills sent on collection

Advantages of Bill Finance
To Borrowers: To Banks:
• It unlocks the working capital stuck • Self-liquidating Advance against bills is self-liquidating in
up in credit sales and thereby nature. The advance stands automatically liquidated from the
improves cash flow position. payment received from the customer – Buyer.
• Secured Finance against the documentary bill is a secured
• It encourages the business finance in the case of demand documentary bills whereas it is
enterprise to sell goods on credit un-secured in case of Usance documentary bills.
and thereby the turnover increases.
• High yielding In case of bill finance, as interest is recovered in
• Bankers prefer to extend bill finance advance it gives a better yield compared to loans with the
to inventory finance with much ease. same rate of interest and it results in fee-based income like
• No need to offer collateral security if exchange/commission.
the bills are backed by a letter of • End-Use Verification In Bill finance, it is easy to verify the end
credit or drawn on big corporates. user and monitor while in cash credit monitoring is a
continuous process.
Bridge Loan
Commercial banks often grant bridge loans to the business enterprises to temporarily bridge the financial gap between
granting of loans by other banks and financial institutions and actual disbursement by them.
The gap arises due to the time taken for completion of documentation and other formalities between the borrower and
the financial institution. Bridge loans are also sanctioned by commercial banks to meet the time-gap between the
closure of a public issue of equity or other shares by a company and actual availability of funds after completing all the
formalities as required by the capital market regulatory authorities.
Availing of a bridge loan often becomes essential during the period of project implementation when the delay in
procuring the plant and machinery and incurring other capital expenditure will result in time and cost overrun.
The bridge loan helps the project work to continue without any hindrance or stoppage for lack of fund. After the funds
are available to the business enterprise, the bridge loan is repaid. Banks have to exercise caution in granting bridge
loans as unless a proper tie-up with the incoming funds is made, the repayment may pose a problem.
Loan System for delivery of bank credit (Working Capital Demand Loan)
In respect of borrowers having aggregate fund based working capital limit of Rs.150 crores and above from the
banking system, a minimum level of ‘loan component’ of 60 percent is effective from April 1, 2019.This loan component
will be designated as “Working Capital Demand Loan (WCDL). Drawings in excess of the minimum ‘loan component’
threshold may be allowed in the form of cash credit facility.
Working Example for Bifurcation of Working Capital Limits
(₹ in crores)
Sanctioned Aggregate Fund based Working 60 % of column 2 is to be
S. No. Current Outstanding
Capital Limit drawn as WCL
(1) (2) (3) (4)
WCL - ₹78
Scenario 1 ₹210 ₹78
CC - Nil
WCL - ₹126
CC - ₹44
WCL - ₹126
CC - ₹34
WCL - ₹126
CC - ₹74
WCL - ₹126
CC - ₹79
Credit Monitoring and Supervision
Credit Monitoring and Supervision
Credit Monitoring and Supervision can be defined as a review of loan account on an going basis keeping a
continuous watch/vigil over the functioning of a borrower’s business to ensure that business operations conform to
the various assumptions made at the time of sanction of the credit facilities.
Based on recommendations of a committee set up in 1979 under the chairmanship of Shri K.B Chore , the RBI
issued the following guidelines:
1. Annual Review of Accounts: All scheduled banks are required to review the accounts of their borrowers
having working capital limits of Rs.10 lakhs and above at least once in a year. If the borrower’s limit
exceeds Rs.50 lakhs (later revised to Rs.100 lakhs), they are required to submit the Quarterly Information
System (QIS).
2. Peak level and Non peak level limits: Banks may fix separate credit limits for the borrowers according to
the normal peak level and non-peak level business activity as far as possible which are to be selected on
the basis of past performances of the borrowers and the utilization of such limits. At the same time, the
period for which the borrowings are to be utilized is to be specified.
3. Withdrawal and Utilization of funds: It is expected that borrower must withdraw funds from bank within
the operating limit in that particular quarter subject to a tolerance limit of 10% either way. After the
completion of the quarter, borrower has to submit the actual utilization of funds in QIS-2.
Quarterly Information System (QIS)
Objective: Obtaining information from the borrowers to ensure that the projections/assumptions submitted by the
borrower at the time of assessment of credit limits continue to hold good in relation to actual level of borrower’s
operations (production and sales). It is also essential to follow-up proper end use of funds lent.
Operation of QIS: The QIS system envisages flow of information from borrowers to banks on a quarterly basis in the
following 3 forms:
1. QIS-Form-I: A quarterly statement showing the estimates of current assets and current liabilities for the ensuing
quarter. It is to be submitted one week before the commencement of the quarter.
2. QIS-Form –II: A quarterly statement furnishing the actual performance during the quarter. It shall be submitted by
the borrowers within 6 weeks from the closure of the relevant quarter.
3. QIS-Form-III: A half yearly operating and funds flow statement to be submitted by the borrowers within 2 months
from the closure of the half year.
Applicability of the system: All borrowers enjoying aggregate fund based working capital limits of Rs.100 lakhs and
more from the banking system are required to submit QIS.
Penal provisions: For non-submission or delayed submission of QIS, banks shall charge penal interest of at least 1%
p.a for a period of one quarter on the outstanding's under various working capital limits.
Banking Arrangement
Banking Arrangement refers to a formal arrangement entered into by a borrower with a financial institution for
the purpose of borrowing certain credit facilities.
There are 4 types of banking arrangement prevailing in India.
They are:
Sole banking - Sole banking is a lending by single bank to a large borrower, subject to the resources available with it
and limited to the exposure limits imposed by the Reserve Bank of India. In this arrangement, the borrower solely
depends upon a single bank for all its credit needs.
Advantages For the borrower
• Borrower need not approach different banks and fulfil the lengthy paper work for his credit needs.
Advantages For the lender/bank
• Lender will be having a closer view of the borrower’s operations which helps monitoring of the cash-flow and funds
flow closely.
• Entire business of the borrower will be routed through a single bank as such bank can make a good income out of it.
• All the securities will remain with the lender.
Banking Arrangement
Multiple banking - is a banking arrangement where a borrower avails of finance independently from more than one
bank. Generally large borrowers whose credit requirements are huge and a single bank can not or not willing to expose
itself to the risk, approach different banks for their credit needs.
Advantages for the borrower:

• Borrower can enjoy competitive pricing and terms for each of the product types offered.
• Contact with more than one banker can provide the borrower with important market information regarding pricing,
terms and service.
• Borrower gets access to variety of loan products and services from different banks
Advantages for the Bank:

In this arrangement, each bank is free to do their own credit assessment and obtain security independent of other
bankers.
Banking Arrangement
Consortium banking - In Consortium financing, several banks (or financial institutions) finance a single borrower. In
this case there is a joint appraisal and assessment of credit needs of the borrower, common documentation, joint
supervision and follow-up exercises between all banks/financial institutions. The whole loan amount is divided
among those banks forming consortium, so the risk also gets divided.
The bank which takes the higher risk (by giving the highest amount of loan) will act as a leader and thus it acts as an
intermediary between the consortium and the borrower.
multiple banking arrangements adversely impacting the asset quality, commercial banks want a consortium to be made
mandatory for large corporate credit. Since, there is no contractual relationship between the bankers, exchange of
information is not binding on the banks.. But under consortium financing, several banks (or financial institutions) finance
a borrower with common appraisal, common documentation, joint supervision and follow-up exercises which lead to
better control and credit discipline.
Banking Arrangement
Loan syndication:
A syndicated credit differs from consortium advances in certain aspects. The salient features of a syndicated credit are
as follows:
• Loan syndication is an essential source of debt financing for large corporates.
• A prospective borrower intending to raise a large loan approaches a bank(commonly referred to as “Lead Manager”)
and awards a mandate to arrange a loan/credit line on his behalf.
• The mandate given to the lead manager spells out all the commercial terms of the credit and the prerogatives of the
mandated bank in resolving the contentious issues in the course of transaction.
• The mandated bank (lead manager) prepares an information memorandum about the borrower and distributes the
same amongst the prospective lenders soliciting their participation in the loan to be extended to the borrower.
• The information memorandum forms the basis for each interested bank making its own independent economic and
financial evaluation of the borrower and the project since each participating bank has to bear its own credit risk.
Banks can seek additional information if necessary from the mandated bank.
Banking Arrangement
Loan syndication:
• Thereafter, the lead manager calls for a meeting of all the banks to discuss syndication strategy relating to
coordination, communication and control within the syndication process and finalizes deal timing, charges towards
management expenses, interest rate, share of each participating bank etc.
• The loan agreement will be signed by all the participating banks.
• The participating banks disburse their portion of loan to the lead manager from whom a single loan is disbursed to
the borrower.
• The loan is maintained in the books of lead manager.
• The loan repayments and interest payments made by the borrower on due dates be shared with the participating
banks in proportion to their loan amount.
While syndication is very similar to the system of consortium lending in terms of dispersal of risk, the discipline that is
sought to be achieved through disbursement at single bank with a fixed repayment period is absent in consortium
arrangement. Thus, syndication is a convenient mode of raising long term funds by borrowers.
Summary
Summary
• Credit Management basically involves 3 phases namely a) Credit Assessment b) Credit Delivery c) Credit
Monitoring and Supervision
• Every business enterprises needs 2 types of capital. They are a) Fixed Capital-funds required for acquisition of
fixed assets b)Working Capital-funds required for meeting day today business expenditure.
• Tandon Committee recommended 3 methods for assessing Maximum Permissible Bank Finance (MPBF). These
are I method wherein borrower shall bring 25% of Working Capital Gap(WCG) as his margin contribution and II
method wherein borrower is required to bring in 25% current assets as his margin contribution. RBI has not
accepted III method.
• The assessed MPBF comprises both inventory finance and receivable finance.
• Inventory finance is delivered in the form of cash credit (cc) and receivable finance in the form of bill
discounting/purchase.
Summary
• The operations in the cash credit account are allowed to the extent of drawing power or the limit whichever is
lower. Drawing Power (DP) is fixed every month on the paid inventory after deducting margin.
• Supervision and follow-up of credit is an essential part of credit management.QIS-1, 2 and 3 forms are used for
verifying the end use of working capital funds.
• Bills finance is short term and self- liquidating finance in nature. Demand Bills are purchased and Usance bills are
discounted and the bills drawn under Letter of Credit (LC may be on sight draft or usance draft) are negotiated by
the banks.
• Commercial banks often grant bridge loans to the business enterprises to temporarily bridge the financial gap
between granting of loans by other banks and financial institutions and actual disbursement by them.
• Credit Monitoring and Supervision can be defined as a review of loan account on an going basis keeping a
continuous watch/vigil over the functioning of a borrower’s business to ensure that business operations conform to
the various assumptions made at the time of sanction of the credit facilities.
• Business units avail bank finance in 4 different methods depending upon the quantum of finance. They are Sole
banking, Multiple banking, Consortium banking and Loan syndication.
THANK
YOU
Credit Management
Unit 4
–
Working Capital Assessment
Unit Description
The business enterprises engaged in manufacturing, trading and services acquire two types of assets to run
their business activity.
Fixed Assets
Current Assets
The total of all current assets is also referred as

“GROSS WORKING CAPITAL” which is the basis to
determine the Bank finance towards the working capital
needs of a business entity.
Unit Objectives

• Identify the need for working capital
• Explain the concept of operating cycle, its components and influencing factors
• Identify the key terminologies used in working capital assessment
• Explain the holding period of various components of current assets
• Explain the Nayak committee method of working capital assessment
• List out the Tandon committee recommendations
• Explain the working capital assessment as per Tandon committee
recommendations
Operating Cycle
Operating Cycle
A business entity engaged in manufacturing has to:
• Procure the Raw materials either on cash payment basis or credit basis.
• Convert the raw Materials into Semi –Finished Goods and then to Finished Goods
• Selling the finished Goods either on Cash or on Credit Basis.
• If sold on credit, realization of Sundry Debtors into cash
This cycle of “Cash - raw material - work in process - finished goods – debtors - Cash” goes on and on for a number
of times in a running business enterprise. This cash to cash cycle is known as “Operating Cycle or “cash to cash
cycle” or “cash conversion cycle” or “Working capital cycle”.
In a trading firm, however, the Operating cycle would be “Cash – Purchase of stock – Sell finished goods – Realize
Cash”.
How to determine the length of the Operating Cycle?
The length of the operating cycle or working capital cycle (calculated in days) is the time duration between buying
goods to manufacture products and generation of cash revenue on selling the products. The shorter the working
capital cycle, the faster the company is able to free up its cash stuck in working capital.
• The working capital cycle focuses on management of 4 key elements viz. cash, receivables (debtors), payables
(creditors) and inventory (stock). A business needs to have complete control over these four items in order to
have a fairly controlled and efficient working capital cycle.
• The total amount of investment in the above components is the working capital requirement of an entity. The
working capital requirement is very much dependent on the operating cycle of the business.
The operating cycle of a manufacturing activity consists of the following sequential periods and processes:
a) Acquisition and storage period of raw material
b) Production cycle i.e. the period and process of converting raw material into finished goods
c) Average period for which the finished goods should be in store to ensure continuous supply to the customers.
d) Average collection period of receivables
The length of the operating cycle of an enterprise would be the sum of the above individual components of time i.e.
(a + b + c + d)
Key Terminologies used in WC Assessment
• Gross Working Capital (GWC) – Total of Current Assets
• Current Liabilities
• Working Capital Gap (WCG) – Total CurrentAssets – Current Liabilities (Other than bank borrowings)
• Net Working Capital
• NWC is arithmetically equal to (Total Current Assets - Total Current Liabilities)

Holding Period of Current Assets & Sundry Creditors
Holding period refers to the period for which the components of current assets held in store by the unit to
ensure continuity of production and to meet the Sales.
How to calculate holding period or holding levels?

Before understanding how to calculate holding period, we need to know how these holding periods are expressed.
(A) The following table provides details on how the holding periods are expressed:
Item How it is expressed What it indicates
Minimum level of Enterprise need not hold the total
Raw Material (RM) No.of months of consumption
year’s consumption.
Stock-In-Process (SIP) No of months of annual cost of production (CoP) Period the RM remains in the production process.
Period of stock of finished goods required for

Finished Goods (FG) No .of months of annual cost of sales (CoS)
uninterrupted sales.
Credit period extended to the buyers or time taken
Trade Receivables No.of months of annual sales
by the buyers to make payment
Trade Creditors No. of months of annual purchase of raw materials Credit period extended by the suppliers
Calculating Holding Period
Item How it is expressed
Raw Material (RM) Sock of RM x 365/Annual consumption of RM
Stock-In-Process (SIP) SIP x 365/Cost of Production Note: Holding levels can be

calculated in months also by
Finished Goods (FG) FG x 365/Cost of Goods sold
replacing 365 with 12.
Trade Receivables Receivables x 365/annual sales
Trade Creditors Trade creditors x 365/annual purchase of RM
Holding levels of Cash, Bank Balance & Other Current Assets:

Apart from inventories and Receivables, the business unit also requires other current assets like cash, bank
balance, advance given for raw materials, etc. for smooth completion of the working capital cycle.
The holding period is not calculated for these current assets. A reasonable level of these assets is allowed to be
held on the basis of the past practice.
Other Consumables: The projected level of consumable spares on the basis of past actual levels but not
exceeding 12 months consumption for imported items and 9 months consumption for indigenous items may be
treated as current assets for the purpose of assessment of working capital requirements.
Methods of Working Capital Assessment
RBI has given freedom to the individual banks to adopt their own method of working capital assessment to the
different borrowers. However, it should be heir board approved method and he same should be documented.
Accordingly, each bank spells out in their credit policy document clearly as to the method of assessing working
capital requirements of each type of borrowers.
The following are the various methods adopted by banks in the assessment of working capital needs of a business
entity:
• Projected Turnover Method (Nayak Committee Method)
• Projected Balance Sheet Method/MPBF method/Tandon Committee Recommended Methods
• Cash Budget Method of assessing Working Capital Requirement

Projected Turnover Method
Nayak Committee recommended a simplified method of working capital assessment taking into account that most of the small business entities
would not be in a position to provide formal financial statements and their inability to bring in higher margin towards working capital. The
committee recommended that:
• Projected sales turnover is the basis of working capital assessment
• 25% of the projected sales turnover to be the minimum working capital requirement
• 5% of the projected sales turnover need to be contributed by the borrower as margin
• 20% of the projected Turnover to be the minimum working capital finance by the bank
The inventory limit carved out of total MPBF is made available in the form of a running account called “Overdraft/Cash Credit” account. The
maximum withdrawals from the CC account at any point of time should not exceed the inventory limit. However, the withdrawals from the CC
account are subject to availability of Drawing Power (DP). The DP is calculated by the bank on a monthly basis over the amount of various items
of inventory available with the borrower.
• the unit has achieved its sales targets in the past
• the projected turnover is reasonable and achievable taking into account the current business environment.
• the borrower is capable of bringing in the minimum margin of 5% of the projected turnover
Projected Turnover Method
If satisfied with the clarifications and information provided by the unit, assess the bank working capital finance as under:
1 Identify the working capital required 25% of the projected Turnover

2 Confirm availability of minimum margin 05% of the projected Turnover
3 Arrive at the minimum eligibility for Bank working capital finance 20% of the projected Turnover
The following guidelines are to be taken note of:

• The minimum working capital requirement is 25 %. Here the assumed working capital cycle is 3 months (100% turnover for 12
months. Hence 25% turnover conforms to 3 months cycle) If the working capital cycle is more than 3 months, then working
capital requirement is assessed as per the projected balance sheet method or cash budget method depending upon the type
of activity. Higher amount if required need to be provided.
• The borrower needs to bring in minimum 5% of the projected sales as margin/ net working capital. If the available net working
capital is more than the minimum required (5%), then the available net working capital needs to be considered.
• The other performance and financial indicators of the unit also need to be analyzed in case financial statements are available
and to ensure that key financial indicators are per the bank loan policy benchmark guidelines.
Projected Turnover Method - Example
Illustration: M/s Bharat Saw Mills is in the business of timber processing for the last 5 years. The following are the sales figures of
the unit for the last three years. Projected sales/turnover is also given below.
(Rs. In lacks)
Particulars 2017 2018 2019 2020 (Projections)
Sales 100 120 145 180
Growth % - 20% 20.83% 24.13%
We can observe that the past growth rate in sales is around 20%.The projected growth rate is also in tune with the past trend,
though it is higher at 24.13 %. Bank needs to ask for clarifications how the unit would achieve the projected turnover and probe for
any new customers and orders on hand from the existing customers. Once the projected sales level is acceptable, the eligible
working capital is calculated as follows.
Particulars Amount
Projected turn over - {A } 180
Working capital required - (25% of A ) = {B} 45
Net Working or Margin to be brought by the party (5% of A ) = { C } 9
Eligible bank finance = (B- C ) 36
MPBF Method
This method of working capital assessment is based on the Tandon Committee Recommendations. Tandon committee
recommended 3 methods of assessment out of which first 2 methods were accepted by RBI for implementation by the
banks.
The difference between the two methods of working capital assessment is:
Method (1) Minimum NWC is 25% of the Working Capital Gap (WCG)
Method (2) Minimum NWC is 25% of the Total Current Assets (TCA)
The following examples illustrate the assessment of working capital under both the methods
(Rs. In crores)
Assessment of MPBF under the 1st method of Tandon committee recommendations: 31.03.2020
1. Total Current Assets (projected) 120.00

2. Current Liabilities(Excluding Bank borrowing towards working capital) 60.00
3. Working Capital Gap (WCG) = (1-2) 60.00
4. Minimum margin to be contributed by the owners: (25% of WCG) 15.00
5. Maximum Permissible Bank Finance = (3-4) 45.00
MPBF Method
Assessment of MPBF under the 2nd method of Tandon committee recommendations: 31.03.2020
1. Total Current Assets (projected) 120.00
2. Current Liabilities(Excluding Bank borrowing towards working capital) 60.00
3. Working Capital Gap (WCG) = (1-2) 60.00
4. Minimum margin to be contributed by the owners:(25% of total current assets) 30.00
5. Maximum Permissible Bank Finance (75% of WCG) = (3-4) 30.00
As can be seen from the above examples, the NWC under 1st method is lower than the one under 2nd method.
Consequently, the MPBF is higher under method 1 than the one under method 2.
Applicability of Tandon Committee method or MPBF method

Generally, Banks Tandon Committee Ist method and II method for working capital assessment in case of MSME and large
borrowers requiring fund based working capital of above Rs.5 Crs. Such high-value working capital facilities require a holistic
understanding of the past track record, trends, and projections. The Projected financial method provides a comprehensive
working capital assessment required for such large credits.
However, application of method I and II are left to the decision of individual banks.
MPBF Method
The working capital assessment under the above 2 methods involve the following steps:
• Accepting the reasonable level of production and sales considering the past performance is the first step towards assessment of
need based working capital fiancé. The achievability of projected production and sales shall be thoroughly examined and satisfied.
• To support the accepted level of production and sales, the level of current assets required to be maintained shall be determined.
Holding period forms the basis to arrive at the level of current assets.
• Credit available on purchases shall be discussed with the borrower and fixed. This should be in line with the past actual levels or
more. If the projected credit is less than the past levels, reasons therefor should be obtained and recorded. Likewise
reasonableness of other current liabilities also should be examined and accepted.
• Working Capital Gap (WCG) shall be arrived at by deduction current liabilities other than bank borrowings from the total current
assets.
• WCG= (Current Assets- Current Liabilities excluding bank borrowing)
• Working Capital Gap (WCG) to be met by borrower’s margin (NWC) and by bank finance.
• Maximum Permissible Bank Finance (MPBF) is arrived on deducting the NWC from the WCG.
• MPBF is bifurcated into inventory finance and sales finance in the ratio of inventory and receivables or as per the requirement of
the borrower.
Cash Budget Method
The pattern of financing the peak cash deficit(s) is followed for industries dealing in seasonal products like sugar and tea, construction
activities, film industries, order based activities etc. In the above type of industries, the requirement of finance may be peak during
some calendar months whereas the realizations of sale proceeds take place at a length of time.
Therefore, under Cash budget method, the bank finance is sanctioned based on projected monthly cash flows estimated by the
borrower and approved by the bank.
Woollen sweaters, gloves, caps and other woollen products manufacturing unit:
In this case, the unit has to procure raw material and produce the products throughout the year and hold the finished products for the
season to commence. The Maximum accumulated level of finished goods (to meet the market demand during the winter) is called
peak season for working capital. The season when the sales and cash in-flows commence is called non-peak season for working
capital.
In a scenario where operating cycle is varying, cash flows are uneven and the business has peak and non-peak activity due to
seasonality of operations resulting in variation in working capital needs, the cash budget method offers a scientific method of arriving
at the working capital required to meet both peak and non-peak level needs of the unit.
Cash Budget Method
Under the cash budget method, the working capital finance is sanctioned based on projected monthly cash flows estimated by the
borrower and bank.
The projected cash inflows and outflows have to be classified into the following groups to enable assessment of the working capital
related cash deficit and other cash requirements:
• Operating Cash Flows (OCF) – Operational cash-flows are the amount of cash generated by a company's normal and regular
business operations such as purchase of raw materials and sale of finished goods. Example - Cash receipts from cash sales and
debtors’ collection and advance received from buyers, cash purchases, trade creditor’s payment, expenses paid in cash etc.
• Non-Operating Cash Flows (NOCF) – Non-operating cash flows are inflows and outflows of cash that are not related to the day-to-
day, ongoing operations of a business. These cash flows are associated with cash flows from investing and financing activities.
Example – purchase and sale of fixed assets, capital infusion, investments in the capital market, receipt of dividends, capital gain
on investments, long term loans from banks and their repayment, payment of interest etc.
For assessing working capital finance, only cash inflows and cash outflows from operating activities will be considered. The working
capital limits sanctioned will be equal to the peak deficit, but the amount allowed to be drawn will be equal to the month to month
deficit.
Cash Budget Method
The following example will help you to understand better:

Month April May June July August
Cash inflow from operational activity 5 10 25 40 60
Cash outflow from operational activity 25 40 15 20 20
Surplus / (Deficit) (20) (30) +10 +20 +40
Cumulative (20) (50) (40) (20) +20
The peak cash deficit is Rs.50 lakhs. Working capital finance will be Rs.50 lakhs. The drawing power will be the deficit
corresponding to each month. In the above example, the drawing power for the month of August will be zero.
Monitoring of the loan account is done by using the budgeted drawing levels at the end of the respective months as benchmarks.
However, where such credit facilities are covered by the value of primary security viz. inventory holding, receivables etc., it is
necessary to compute the value of such chargeable assets at the end of each month. This would ensure that at any point of time,
the balance in the loan account is always covered by the value of primary security less margin or in other words, sufficient drawing
power would be available to support the outstanding.
Export Credit
Export Credit
Exporters require finance any time from the date of receipt of an export order till the realization of the export
proceeds. The credit facilities sanctioned to an exporter for procuring raw material, processing/manufacturing the
finished goods, packaging the goods till the day of shipment of goods are called pre shipment credit in the form of
Packing credit. The credit facilities extended to an exporter from the date of shipment of goods till the realization of
export proceeds are called post shipment finance.
Pre-shipment credit (Packing Credit)

Who can avail PC: PC can be sanctioned directly to the exporter or to supplier of goods to the exporter/supporting manufacturer
of goods for the exporter. The exporters are classified into two categories namely,
(1) Manufacturing exporter (those who manufacture the goods they export) &
(2) Merchant exporter (those who procure the finished goods from other suppliers and export the same) Eg of merchant
exporters are :- State Trading Corporation, MMTC, Star Trading House, Export Houses etc.,
These organizations, after receipt of the export order procure the goods from other suppliers or get them
manufactured/processed by others called supporting manufactures even they do not have export order in their names.
Export Credit
• Banks examine the following while entertaining proposals for export credit:
• Borrowers must be the customers of the bank and have sanctioned export working capital limits, either as part of
overall limits or as a 100% export business. Export working capital limits are fixed on the basis of:
• Export Turnover
• Raw Material Consumption
• Raw Material Stocking Requirements
• Credit Period from Suppliers
• Cycle Time to Process and Shipment The limits are split into:
• Cycle Time for Overheads • Pre-shipment
• Credit Period to Customers • Post shipment
• Profitability
• LCs
• Cash Flow
• Balance Sheet
• Guarantees
Post Shipment Export Credit (in rupees)
Post-shipment Credit' means any loan or advance granted or any other credit provided by a bank to an exporter of
goods / rendering services from India from the date of extending credit after shipment of goods to the date of
realization of export proceeds and includes any loan or advance granted to an exporter, in consideration of, or on the
security of any duty drawback allowed by the Government from time to time.
Post-shipment advance can be in the form of :
• Export bills purchased/discounted/negotiated.
• Advances against bills for collection.
• Advances against duty drawback receivable from Government.
Post-shipment credit is to be liquidated by the realization proceeds of export bills received from abroad in respect of
goods exported/services rendered. Further subject to mutual agreement between the exporter and the banker, it can
also be repaid/prepaid out of balances in Exchange Earners Foreign Currency Account (EEFC A/c) as also from
proceeds of any other un financed (collection) Bills. Such adjusted export bills should however, continue to be
followed up for realization of the export proceeds and will continue to be reported in the XOS statements.
Import Credit
Import credit involves issue of Letters of Credit on behalf the borrower in favor of a foreign supplier.
Besides observance of the exchange control regulations, every care should be taken by the bank establishing the
Letter of Credit, to ensure the ability of the importer to meet all his obligations, the integrity of the seller, the nature of
goods under import etc., since it undertakes the responsibility of honoring the drafts drawn there under.
Summary
Summary
• The Business enterprises either engaged in manufacturing, trading or other activity acquires two types of assets to
run their business activity-Fixed Assets and Current Assets.
• The total amount of money invested in the total current assets is called Gross Working Capital.
• Cycle of “Cash to Cash” towards procurement to realization continues on a repetitive basis in a going concern and
this cycle of routine business activity is called “Operating cycle” or “Working Capital Cycle”.
• The amount of working capital required by a business depends upon the length of the operating cycle. The longer
the cycle, more will be the working capital requirement.
• The length of the operating cycle or working capital cycle (calculated in days) is the time duration between buying
goods to manufacture products and generation of cash revenue on selling the products. The shorter the working
capital cycle, the faster the company is able to free up its cash stuck in working capital.
• Holding period refers to the period for which the components of current assets held in store by the unit to ensure
continuity of production and to meet the sales.
Summary
• On 9th December 1991, Reserve Bank of India constituted a committee under the Chairmanship of Shri P.R.
Nayak, Deputy Governor to examine the difficulties confronting the small-scale industries (SSI) in the country in
the matter of access to bank credit.
• Methods used for assessment of working capital needs of a business entity are:
• Projected Turnover Method
• Projected Balance Sheet Method/MPBF Method
• Cash Budget Method
• Operating Cash Flows (OCF) – Operational cash-flows are the amount of cash generated by a company's normal
and regular business operations such as purchase of raw materials and sale of finished goods.
• Working capital may be provided in the form of cash credit, bill finance, packing credit, non-fund limits etc.,
depending on the need and activity of the borrower.
• The credit facilities sanctioned to an exporter for procuring raw material, processing/ manufacturing the finished
goods, packaging the goods till the day of shipment of goods are called pre shipment credit in the form of Packing
credit. The credit facilities extended to an exporter from the date of shipment of goods till the realization of export
proceeds are called post shipment finance.
THANK
YOU
Credit Management
Unit 5
–
Non-Fund Based Facilities (NFB)
Unit Description
Business entities enter into commercial transactions day in and day out with other business concerns. The relationship
between the businesses may be a buyer-seller leading to debtor –creditor relationship, principal-agent or contractee-
contractor.
The risk of non-performance is a major challenge in the case of principal-agent or contractee-contractor relationships.
This risk is known as counter-party risk.
In such situations, one contracting party seeks to mitigate the risk of non-payment and
or non-performance on the part of the other contracting party and look for an
intermediary to protect the interest of both parties on mutually acceptable terms.
Here, the role of the banks comes. Banks offer bank guarantees and letters of credit
on behalf of their customers (contractors) to the beneficiaries (contractees) or on
behalf of debtors to the creditors or on behalf of buyers in favor of sellers as the case
may be. These guarantees and letters of credit reduce the counter party risk to nil and
the transactions between those parties will go on smoothly and continuously.
Unit Objectives

• Explain the need for Bank Guarantees and letters of credit
• Explain types of Bank Guarantees and letters of credit
• Assess the Bank Guarantee Limit and letters of credit limit
Bank Guarantees
Definition of Contract of Guarantee
Bank Guarantees are issued for various purposes depending on the

nature of transaction between parties to the contract. Some of the
Sec. 126 of Indian Contract Act defines a Guarantees are listed below:
contract of guarantee as 'a contract to
a) Guarantees for Advance payment
perform the promise or discharge the
liability of a third person in case of default'. b) Guarantees for Earnest Money Deposit
c) Guarantees for Bridge finance
A bank guarantee is an instrument issued
d) Guarantees for Performance contracts
by the bank in which it agrees to pay a
certain sum of money in the event of e) Mobilization guarantee
failure of its customer to discharge a f) Guarantees in Foreign Trade
financial obligation or a performance g) Bid-Bond guarantees
obligation to a counter party.
h) Retention Money guarantees
i) Repayment guarantees
Parties to the Guarantee
• Issuer of BG: It is generally a bank which undertakes to pay a certain sum

to a third party on behalf of its customer in the event of his/her failure to
carry out a contract or a promise etc.
• Applicant of the BG: It is one on whose behalf or at whose request, bank

issues a bank guarantee undertaking financial obligation. Banks issue
guarantees only to their customers.
• Beneficiary: Beneficiary is one in whose favor the bank guarantee is

executed. Generally, the contractees, the government departments, the
sellers of the goods on credit, buyers of the goods on credit for good
performance.
Terms used in Bank Guarantees
• Amount of BG: It is the amount of compensation to be paid to beneficiary when a claim is made on the issuer
(bank).
• Date of BG: It is the date on which the bank guarantee is issued. Bank’s obligation under the BG runs from the
date of BG.
• Due Date: Every BG will have a definite expiry date beyond which the BG can not be enforced by the
beneficiary. The said expiry date is called Due Date of the BG.
• Extension/Renewal of BG: Sometimes, the applicant of the BG may request the bank to extend the validity of
the BG for some time beyond its due date.
• Invocation of BG: In the event of failure of BG applicant to discharge his/her commitment to the beneficiary,
the latter demands BG amount from the bank (issuer) by issuing a notice in writing. The same is known as
“invocation”
• BG commission: The amount of charges payable by the applicant to the issuer of BG (Bank) for undertaking
the financial obligation on behalf of the former is called BG commission.
Types of Bank Guarantees
a) Financial Guarantee:
This is a guarantee where the banker undertakes a financial liability on behalf of its customer. Normally, all types of
guarantees executed by the banker involve financial liability when the customer fails to discharge his/her
commitment. In some cases, the contractors are required to provide security deposit/earnest money/cash deposit
with the contractee (who award contracts).In such cases, the contractee may stipulate that the customer may in
lieu of cash deposit or earnest money give his banker’s guarantee. The guarantee so executed by a banker is
usually known as financial guarantee. A financial guarantee assures payment of money in the event of claim by the
beneficiary.
Example: A contractor wants to bid for a tender of Rs.5.00 lacs for the construction of a building for a Govt.
department. The earnest money payable is Rs.25,000 (5%of contract value). The department accepts either cash
deposit from the tenderer (contractor) or in lieu of the cash deposit, it may accept a BG for Rs.25,000.
Such a guarantee is called financial guarantee. Similarly, the guarantees required in respect of payment of security
deposits, mobilization advance, for receipt of any advance money, customs/excise duties etc., are financial
guarantees.
Types of Bank Guarantees
b) Performance Guarantee:
A guarantee issued by a Bank on behalf of its customer in favor of a third party, guaranteeing the performance of
a contract or obligation by its customer is called a performance guarantee. In such a guarantee, in the event of
non- performance or short performance of the obligation, the bank will be called upon to make good the monetary
loss arising out of the non fulfilment of the guarantee obligation. Although these guarantees are performance, the
quantum of the pecuniary obligation is reduced to monetary terms
Example: If a steel manufacturer has undertaken to supply 500 tones of steel to Railways and the contracted
supply is to be completed in six months, the guarantee given by the steel manufacturer’s bank in favor of
Railways is a performance guarantee.
In the event of default by the steel manufacturer to supply the steel as undertaken, the Railways have the
authority to claim from the bank, the compensation amount mentioned in the guarantee bond. But, Railways can
not demand supply of steel by the bank as its customer failed to do so.
Types of Bank Guarantee
Types of Bank Guarantee Brief Description
Facilitates the customer (applicant) to participate in the tenders called for. However, Issue
of Bid bond Guarantee is not confirmation that the applicant would be allotted the
Bid Bond Guarantee /
contract. It is issued in lieu of Security deposit and or earnest deposit money.
Earnest Money/ Security
Example:
Deposit
• In lieu of Security deposit with BSNL to a Telephone Booth service provider
• Earnest money deposit to participate in the tender called for by NHAI
In case of high-value projects, the tender awardee (contractor) may request the
Contractee for advance money to commence the project work. In such cases, the
Advance money Guarantee contractee may call for a BG to release the advance money. If the contractor fails to
commence the work, the contractee invokes the BG and recovers advance money from
the bank in terms of the BG.
Other Details
• Nature of Bank’s Liability under BG - Bank’s liability in respect of B.G. is contingent liability, which may or may
not arise. Even if liability arises, it is a financial one and Banks cannot give guarantee for actual performance of
the promise.
• Duration of BG - Presently banks give guarantees for a maximum period of 10 years basing on the need of the
parties. Banks do not issue Perpetual Bank Guarantees.
• Capital Adequacy Norms - Banks have to maintain capital at a certain percentage of these financial and
performance guarantees differently after applying credit conversion factor (CCF) as per RBI guidelines. Presently
100 CCF is to be applied to financial guarantees and 50 CCF is to be applied to performance guarantees.
• Appraisal - Processing of B.G. application is similar to processing a funded limit with regard to various appraisals,
eligibility of B.G. limits, security stipulations etc. Margin money depends on type of customer and nature of
contract.
• Gearing Ratio: Most of the banks
consider the maximum
permissible Gearing Ratio
at 10:1
Assessment of BG Limits
To avoid over trading and resultant devolvement of non fund based facilities, assessment shall be done as under:
Mobilization Guarantees/Advance money Guarantee: Average monthly mobilization X Period of retention
Retention Money Guarantees: Average monthly Retention X Period of retention
Duty Exemption Guarantees: Average Duty Exemption per month X Period of exemption
Illustration:
M/s XYZ Electronics Bangalore engaged in manufacturing of electronic components and are supplying to Indian
Railways. They are enjoying the following limits/facilities with ABC bank.
Sl. No. Nature of credit facility Limit

1 Cash Credit Rs.2.00 Cr
2 Term Loan Rs.1.00 Cr
3 Letter of Credit Rs.0.50 Cr
Total Rs.3.50 Cr
Assessment of BG Limits
Mr. Vikram, the partner of the firm mentioned that various central government undertakings have called for tenders for
supply of electronic components to their departments and these tenders will be repetitive in nature. Mr. Vikram
requested for a regular BG limit as they are planning to participate in these tenders on a regular basis. The following
details are available to you:
• They would participate on an average of 50 tenders per annum each tender valued Rs.10 Lacs each.
• They should pay a security deposit of 15% of the tender value or provide BG for equivalent amount for all the tenders
participated.
• They anticipate that at least 10 Tenders would be allotted to them (i.e. Success rate 20%)
• They are eligible for an advance payment of 15% of the contract value if a suitable Bank Guarantee is furnished at 100% of
the advance payment
• The government authorities will hold back 5% of the bill amount on delivery for a period one year or will release the full amount
against bank guarantee for the retention amount
• Mr. Vikram further mentioned that they may request for cancellation of few BGs amounting to Rs. 40 lacs during the year
• They may request for renewal of few BGs amounting to Rs.50 Lacs.
Solution - Assessment of BG limit to XYZ Company
Particulars Calculation Amount (in lakhs)
Opening balance of BGs NIL Nil
Tenders expected to participate during the year 50 * Rs.10 lakhs each = Rs.500 lakhs
A. Security Deposit of 15% Rs.500 lakhs*15% Rs.75 lakhs @
Allotment of tenders: at 20% success rate = Rs.500 lakhs * 20% = Rs.100 lakhs.
B. Advance money BG Rs.100 lakhs*15% Rs.15 lakhs
C. Retention money BG (Rs.100 lakhs- advance money of Rs.15 lakhs already paid) *5% Rs.4.25 lakhs
Total BG requirement (A+B+C) Rs.94.25 lakhs
Add: renewal of BGs if any required Say Rs. 50 lakhs
Less: BG s returned on completion of work Say Rs.40 lakhs
BG limit proposed Rs.104.25 lakhs
@ The security deposit or EMD depends upon the period as mentioned in the tender document. Therefore the expiry period in the
tender document would impact the BG on EMD. In this example for the sake simplicity, we have taken EMD for 12 months
requirement without taking into account the average period of EMD.
Margin Requirement
• Customers/Applicants off bank guarantees shall

provide a cash margin ranging from 10% to 100%
depending upon the credit risk rating of the
customer and also the purpose of the BG. of the
customer.
• RBI has advised in January2004,that in respect of
guarantees issued for capital market operations,
banks should insist for a minimum margin of 50%
out of which half (i.e. 25%)should be by way of
cash margin.
• Banks insist upon 100% cash margin in respect of
BGs issued for the purpose of disputed tax
liabilities and legal disputes pending in the court.
Risks involved in BG Operations
Bank Guarantee is an irrevocable undertaking by the issuing bank to the beneficiary and any default by the contractor
(applicant to the BG) would result in a claim by the beneficiary and outflow of funds to the Bank. Therefore, default
risk/credit risk should be carefully analyzed before setting up any BG limit.
The risks involved in BG operations are listed hereunder:
• In case of any claim or Invocation, the bank has to make payment of the guaranteed amount to the beneficiary
without any delay or reference to the applicant.
• Delay in execution or failure to complete the contract as per the terms may result in invocation of the BG by the
beneficiary.
• In case of invocation/claim by the beneficiary, the issuing Bank should honor the claim immediately and recover the
amount from the applicant later on. If the applicant fails to reimburse the amount to the bank, the account may turn
irregular.
• Disputes between applicant and beneficiary may result in invocation of BG for no fault of the bank.
• Sometimes, the applicant may bring court injunction against the bank to prevent the bank from honoring the
commitment. This will defeat the very purpose of the BG.
Invocation of Bank Guarantees
• Failure of the contractor (applicant to the BG) to accept the contract awarded in the bid results in invocation
of Bid bond Guarantee issued.
• Failure of the contractor (applicant to the BG) to commence the contract and maintain the time schedules –
results in the invocation of the Advance money Guarantee issued.
• Even after completion of the contract in full, the beneficiary can invoke the BG if the work done by the
contractor is found defective and does not conform to the specifications. The BG will have a clause called
Grace Period clause. Banks shall levy the commission for the extended period also.
• Any work -related dispute between the contractor and the beneficiary may also result in invocation..
RBI Guidelines on Non-Fund Based Credit Facilities
RBI has prohibited banks from issuing the following types of guarantees:
• Guarantee on behalf of companies guaranteeing the repayment of bonds issued by them and guarantee of
refund of deposit/loan accepted by one NBFC from another NBFC.
• Guarantee in favor of overseas lender guaranteeing the repayment of External Commercial Borrowing
(ECB).In case of ECB by Micro and Small Enterprises, RBI may permit the same on a case-to-case basis
under the approval route.
• As per section 20 of the Banking Regulation Act 1949, banks cannot issue guarantees on behalf of their
directors without ensuring that the bank will not be required to grant any loan or advance to meet the liability
in case of invocation of guarantee.
Letter of Credit
Letter of Credit
A “Letter of Credit (LC)” is an

irrevocable, written undertaking by a
commercial bank, issued at the
request of the buyer (applicant) in
favor of seller (beneficiary), to the
effect that payment for certain
goods or services will be made
against a complying presentation of
documents.
The LC issuing Bank deals only in
documents relating to transactions
as per the Letter of Credit and it has
nothing to do with the goods or
services. These can be Inland or
foreign LCs.
How does a Simple Letter of Credit work?
Step-1
Sale Contract: A buyer and a Seller enter into a sale contract after series of correspondence regarding various
specifications pertaining to goods-such as quantity, price, quality, nature of transport, date of shipment, nature of
documents necessary to accompany the goods etc.
• Since the buyer and seller do not know each other, transfer of goods and payment thereof happens against the
guarantee of a bank in buyer’s country.
• Seller requests Buyer to provide a Letter of Credit from a commercial bank so that he is assured of payment for the
goods supplied.
Step-2
L/C Application: Buyer approaches his bank and submits an application for issue of a letter of credit in favor of the seller.
He also stipulates various documents to be provided by the seller.
Step-3
Issuing letter of credit: Buyer’s bank (issuing bank) issues LC, based on the terms and conditions stipulated by the buyer.
The LC document is advised to a bank in the seller’s country in a coded language through a communication network
called SWIFT (Society for Worldwide Interbank Financial Telecommunication).
Step-4 - Advising letter of credit:
The bank to which the LC is communicated is called Advising Bank. Advising Bank is the bank that advises the letter of
credit to the beneficiary. Advising banks act upon the request of issuing banks. Generally, advising banks are located in
the same country as beneficiaries and in most of the cases they are seller’s bankers. That is why issuing banks need
their services. Advising fee will be paid to the advising bank for this service.
Advising Bank advises the LC to the seller in a plain language. If the advising bank happens to be the bankers for seller,
the LC will be communicated to the seller directly. In case advising bank and seller’s bank are different, advising bank
communicates the LC to the seller’s bank.
Seller may not be aware of the financial standing of the issuing bank. Hence, seller sometimes insist that the LC shall be
confirmed by a bank in his country. In such a case, issuing bank requests advising bank to add its confirmation on the LC
which means that the confirming bank undertakes the responsibility of payment Issuing bank will have to pay some
charges called confirmation charges.
Step-5
Shipment: On receipt of the LC with confirmation or without confirmation as the case may be, seller ships the goods.
Step-6
Presentation of documents: Seller submits the shipping documents along with other documents as stipulated in the LC to
the LC advising bank or LC confirming bank as the case may be for onward transmission to the issuing bank.
Step-7
Presentation of documents to issuing bank: Confirming bank or Advising bank on receipt of the documents in terms of
LC, forwards the same to issuing bank.
Step-8
Document release/ Document control, payment release at maturity: LC issuing bank on receipt of the documents from
advising bank or confirming bank critically examines the same with reference to LC terms and takes the following action:
• Releases the shipping documents to the LC applicant(buyer)
• Release the payment to the seller through the advising bank on due date
• On the due date of the LC, issuing bank collects the payment from the applicant (buyer).
Types of Letter of Credit
• Transferable LC: As the name indicates, a transferable letter of credit is a letter of credit that allows the initial
beneficiary to transfer some or all of the credit to another party. It is transferable to the next supplier in chain and that
allows the beneficiary to provide its own documents. The beneficiary is only an intermediary for actual supplier.
• Non-transferable LC: The beneficiary is the recipient and can not transfer the LC to anyone.
• Revocable LC: Can be altered at any time by the issuing bank/buyer without informing the seller. It is not used
generally because of its nature.
• Irrevocable LC: Without the consent of the seller, no alterations can be made by any one. This type of LC is most
common
• Standby LC (SBLC): This type of LC guarantees the payment to the beneficiary in the event of default by the
buyer/applicant. The SBLC differs from normal LC in respect of its liability under the LC which is secondary where in
LC issuing bank’s liability in normal LC is primary.
• Confirmed LC: When the advising bank also guarantees the payment to the beneficiary, it is called confirmed LC.
• Un-confirmed LC: Payment is assured by only issuing bank and no second bank is in picture.
• Revolving LC: This LC can be used for many transactions/payments instead of issuing LC for each transaction.
• Back-to-back LC: Two LCs are issued. One by the bank of the buyer to the intermediary bank and the second by the
intermediary bank to the seller. As is often the case with LCs, back-to-back LCs are used primarily in international
transactions, with the first LC serving as collateral for the second.
• Red Clause LC: At the request of the applicant (buyer), the LC issuing bank incorporates a special clause in the LC
permitting the advising bank/seller’s bank to allow some interest free, unsecured, pre-shipment advance to enable
the seller to meet his working capital requirement. Such a special clause is known as “Red Clause”.
• Green Clause LC: Green clause LC is an extension of red clause LC. In a green clause LC, in addition to red clause,
another clause printed in green is incorporated permitting the advising bank/seller’s bank to provide additional
finance for pre-shipment warehousing at the port of origin. The warehouse receipts issued by the port authorities are
security to the advance extended by the bank. This clause is printed in green..
• Inland LC (ILC): LC issued in respect of domestic trade (buying and selling) is called ILC
• Foreign LC (FLC): LC issued in respect of foreign trade (import and export) is called FLC
• Sight LC: A sight LC is a letter of credit (LC) that is payable immediately – within five to ten days – after the seller
meets the requirements of the letter of credit. This type of LC is the quickest form of payment for sellers, who are
often selling to overseas buyers. As per sight LC conditions, LC opening bank has to remit amount of shipment to
beneficiary bank, on acceptance of documents by buyer. So, buyer’s bank (LC opening bank) delivers original bill of
lading only after receiving the export proceeds (value of goods shipped).
• Usance LC: If the seller (Exporter) agrees with the buyer (importer) for a credit period say 30 days/60 days for
making payment, this period is incorporated in LC terms. Such an LC is called Usance LC. It is also called time LC or
term LC.
General Aspects to be observed in opening of LCs
• The importer should have Exporter-Importer code number allotted by Director General of Foreign Trade (DGFT).
• The importer should be enjoying adequate sanctioned credit limits with a bank for meeting the LC commitment on due date. Value
of import should be commensurate with business requirements of the importer.
• LC issuing bank should obtain from the LC applicant/Importer, the Exchange Control copy of license in case the item of import
falls under negative list. If the import is under Open General License (OGL) obtain a declaration from the importer declaring that
the relative goods are under OGL.
• The description of goods, validity for shipment, country of shipment, origin of goods etc. are as per the provisions of Policy/
License etc., Where the value of L/C is above a certain amount as decided by the bank, bank obtains confidential report on the
overseas seller at the time of opening of L.C
• LC should be opened only in favor of overseas supplier/manufacturer or shipper of goods and not in favor of the applicant himself
or his nominee.
• LC to clearly indicate terms of shipment such as Free On Board (FOB) /Cost & Freight(C&F)/Cost, Insurance and Freight(CIF). LC
should not be opened for import of goods from the banned countries. LC should invariably contain a clause that the credit is
subject to the provisions of. UCP-600 (Uniform Customs and Practices) for documentary credit and Uniform Rules for bank to
bank Reimbursements (URR).
• Last date of shipment should be within the validity of import license. Payment to be claimed only against presentation of full set of
documents as per LC.
Assessment of Letter of Credit
M/s. XYZ pharma Ltd a pharmaceuticals company is enjoying working capital limits with ANZ bank. They have
approached for enhancement of ILC /FLC limits apart from the other fund based credit facilities.
The following information has been provided by the company.
• Company has projected a total purchase of raw material during the year 2019 –2020 as Rs.73,500 lacs.
• 50% of the total raw material requirement is met through imports.
• 50% of the inland purchases are made on cash basis and 50% on credit basis against furnishing ILCs. 90% of the
import purchases are made on credit basis against furnishing of FLCs.
• Time lag between opening of LC and shipment of goods is 15 days for inland purchases.
• Supplier extends credit for 2.50 months from the date of shipment for inland purchases.
• Company is exempt from paying customs duty on import of Raw Material.
• Time lag between opening of FLC and Shipment is 2 Months.
• Foreign suppliers extend credit of 4 Months from the date of shipment.
Please workout the ILC & FLC requirement of the company for the year 2019-2020.
Assessment for Inland Letter of Credit (ILC)
a Total purchase of raw material per annum 73,500.00
b Inland purchases (50% of total purchase) 36,750.00
c Average monthly inland purchases (b/12) 3,062.50
d Cash purchase per month (50% of c) 1,531.25
e Credit purchases per month (c-d) 1,531.25
f Lead time from the date of LC till date of shipment 0.5 months
g Usance period(credit period) 2.5 months
h Total lead time (g+h) 3.0 months
i Total ILC requirement (e*h) 4,593.75

Assessment of Foreign Letter of Credit (Import Letter of Credit)
a Imported raw material requirement per annum (50% of purchases) 36750.00
b Imported raw material requirement per month ( a/12) 3,062.50
c Material purchased on usance LC basis (90% of b) 2756.25
d Lead time from the date of LC till date of shipment 2 months
e Usance period(credit period) 4 months
f Total lead time (d+e) 6 months
g FLC requirement (c*f) 16,537.50

Advantages of Non-Fund Based Facilities from Bank point of view
• No immediate outlay of funds

• It is a contingent liability to the bank-may or may not arise.
• Risks are similar to funded exposure-procedure is same.
• Upfront earnings by way of commission, exchange and commission
• Source for mobilization of deposits by way of margin money
• Capital adequacy requirement is less compared to fund based exposure
• Low probability of default
Differences between Letter of Credit and Bank Guarantee
Letter of Credit Bank Guarantee
Generally, merchants involved in the exports and imports of

goods will choose Letters of Credit to ensure delivery and Generally, contractors bidding for infrastructure projects such as
payments. Even the domestic buyers and sellers of goods prefer roads, telecom, railways etc. prove their financial as well as
LCs to ensure delivery of goods to buyers and payment of the performance capabilities avail bank guarantees from banks.
bills to the sellers promptly
Bank’s liability arises only when the BG applicant fails to discharge

Bank’s liability to the beneficiary under LC is primary. his obligation to the beneficiary under BG. That is to say bank’s
liability is secondary.
There are several parties to an LC transaction like- Buyer, Seller, There are only 3 parties namely BG applicant, BG issuing bank
issuing bank, advising bank, confirming bank etc and the beneficiary.
LCs are mostly in lieu of fund based working capital facilities BGs are basically non-working capital in nature.
Less costlier to the applicant More costly compared to LC costs

RBI Guidelines on Bank Guarantees
• unsecured guarantees in such a manner that 20 percent of a bank’s outstanding unsecured
guarantees plus the total of its outstanding unsecured advances should not exceed 15 percent of
its total outstanding advances.
• At the time of issuing financial guarantees, banks should ensure that the customer would be in a
position to reimburse the bank in case of default.
• In the case of performance guarantee, banks should ensure that customer has sufficient
experience and means to perform the obligations under the contract, and is not likely to commit
any default.
• Bank guarantees should be issued in serially numbered security forms.
• Banks should, while forwarding guarantees, caution the beneficiaries that they should, verify the
genuineness of the guarantee with the issuing bank.
RBI Master Circular on Bank Guarantees
• Bank guarantees issued for Rs.50,000/- and above should be signed by two officials jointly.
• Bank should release vouchers for the Guarantees issued and Guarantees cancelled so that the
status of LC & BG outstanding at any point of time can be known.
• Where the customers enjoy credit facilities with other banks, the reasons for their approaching
the bank for extending the guarantees should be ascertained and a reference should be made to
their existing bankers with whom they are enjoying credit facilities.
• Where guarantees are invoked, payment should be made to the beneficiaries without delay and
demur.
• No bank guarantee should normally have a maturity of more than 10 years.
Summary
Summary
• Bank Guarantee is an irrevocable undertaking by the issuing bank to the beneficiary and any default by the
contractor (applicant to the BG) would result in a claim by the beneficiary and outflow of funds of the Bank.
• Bank guarantees can be classified as Financial and Performance guarantees.
• Financial guarantee is a guarantee where the banker undertakes a financial liability on behalf of its customer.
Normally, all types of guarantees executed by the banker involve financial liability when the customer fails to
discharge his/her commitment.
• Performance Guarantee is A guarantee issued by a Bank on behalf of its customer in favour of a third party,
guaranteeing the performance of a contract or obligation by its customer is called a performance guarantee.
• There will always be three parties for any bank guarantee. Viz: The applicant, bank and the beneficiary.
Summary
• A letter of credit is a legal document issued by a bank that acts as an irrevocable guarantee in making payment to
a beneficiary.
• Letters of credit may be Inland or foreign.
• LC issuing bank deals only in papers and not in goods or services underlying the LC.
• There are different types of LCs basing on the nature and the conditions embedded there in.
• There are several parties to an LC transaction like- Buyer, Seller, issuing bank, advising bank, confirming bank etc
THANK
YOU
Credit Management
Unit 6
–
Term Loan Appraisal and Project Finance
Unit Description
Typical business activity starts with investment in fixed assets like

plant and machinery, equipment which enables it to manufacture or
trade in products or deliver services to customers.
Such investments are called capital investments. These investments
require long-term financing as they generally involve large cash outlay
and generate cash flows over their economic life usually spread over
a few years. Since the amount of investment is generally large,
businesses use a combination of funding. Term loans from banks
enable business entities to finance such asset creation.
The capital investments are long-term in nature and carry higher risks
as the cash generation capacity of these investments is subject to
business and market fluctuations. Banks and Financial Institutions
(FIs) evaluate term loan proposals in the light of such risks associated
with long-term funding.
Unit Objectives

• Explain the process of assessment of term loan proposals
• Identify the tools used to analyze term loan proposals
• Explain the repayment methods
• Explain the steps involved in monitoring & follow up
Term Loan
Purpose of Term Loan
A term loan is basically for the following purposes:

A term loan is a long term source of
• To meet the capital expenditure (purchase of fixed assets like land,
finance provided by banks and financial
building, plant and machinery, furniture and fixtures, electrical
institutions to a business enterprise for the
installations etc.)
purpose of acquisition of fixed assets /
meeting capital expenditure to enable the • For the replacement of existing worn out or obsolete machinery
business to use them for the production of • For adding any balancing equipment to improve the efficiency of
goods and services. the unit
• For the acquisition of a new industrial unit
The loan is repayable in instalments over
a period of time out of the future earnings • For the expansion of the existing unit to add additional production
(profits) as per a pre-determined capacity. Example: Belgaum hydraulics plans to add one more
repayment schedule during the economic lathe machine costing Rs.15.00 Lacs which would help them in
life of the asset financed. increasing their production capacity.
• For the acquisition of movable assets
Characteristics of Term Loan
• Term loan commitments are to be of long term and as such they are less
liquid to the lenders.
• It will have a definite repayment schedule
• It bears interest rate
• It is supported by a tangible primary security

Term Loan Appraisal
Term loan appraisal covers the appraisal of the borrower and appraisal of the project.
• Appraisal of the borrower: Creditworthiness is assessed with parameters such as the willingness of promoters to
pay the money back and repayment capacity of the borrower. Appraisal of the borrower covers honesty and integrity
of the borrower, standing of the borrower, business capacity, managerial competence, financial resources in relation
to the size of the project.
• The following aspects shall be thoroughly checked and satisfied about the borrower:
o Market image of the borrowing company
o Clout with government and regulatory agencies
o Dynamism of top management
o Competence and commitment of employees
o Promoters’ track record in managing the company
o Are the promoters appearing in the defaulters’ list published by RBI?
Term Loan Appraisal
The sources of information for the above are:
• Personal interview of the promoters/directors/partners as the case may be
• Credit investigation
• Trade circle enquiries
• Market report
• Existing bank’s report
• CIBIL report
• Assets and liabilities statements submitted by the borrowers
• Income Tax assessment orders and wealth tax assessment orders of promoters.
• Reports from credit rating companies
• RBI defaulter list
• Newspapers and magazines
• Information from employees at the time unit inspection etc.
Appraisal of the Project
Appraisal of project covers the following details:
Technical Appraisal – An in-depth study to ensure a project is
• Soundly designed
• Appropriately engineered and
• Follows acceptable standards
Technical Appraisal is a scientific study to ascertain that the project is. sound with respect to various parameters such as
technology, plant capacity, raw material availability, location, manpower availability, etc.
Commercial Appraisal - Commercial appraisal is to establish whether a proposed activity will be viable in a commercial
sense in terms of demand for the product, market size, competition, distribution channels etc. The following factors are
critical in deciding the commercial viability of a project.
• Demand & Supply
• Distribution
• Pricing
• External Factors
Economic Appraisal – is a study that weighs the costs of an action against the benefits that it provides. The following
are the key aspects to be studied to establish the economic viability of a project.
• Earning capacity of the project.
• Market size and its growth potential
• Present and future market share of the company
• Is it cost effective?
• Employment potential
Ecological Appraisal - is the study of environmental aspects that may affect the project adversely. Important aspects to
be examined are as follows.
• Whether the project is eco-friendly or causes any damage to the ecology?
• Whether the project has provisional clearance of pollution board?
• Impact of project on quality of air, water, noise, vegetation and human life.
Social Appraisal – is an in depth study from the perspective of society as a whole. Following are some of the key
aspects to be examined.
• Is the project socially harmful?
• Does it have any moral hazards?
• Does it impact public life adversely?
Legal Appraisal - is the study of legal aspects of the project such as laws relating to land, effluents, labour, taxation
policies and any regulations that may affect the project.
Managerial Appraisal - is the study of competence and skill levels of men who are going to manage the project.
• Men behind the project-are they honest, competent and having entrepreneurial capabilities?
• Are they men of good financial standing to infuse funds into the project in case of need?
• Do they have any past experience in handling similar projects?
Financial Appraisal – Financial appraisal is an objective evaluation of the viability of a project from the perspective of
profitability of operations and financial strength. The basic purpose of financial appraisal is to assess whether the project
will generate sufficient surplus so as to meet the repayment obligations.
Financial appraisal basically examines two aspects of fiancé.
• The Cost of the Project (COP) i.e.,. the amount required to complete the project and bring it to normal operation and
• The Means of Financing (MOF) the cost i.e. the sources from which the required funds are to be raised.
Cost of the Project and Means of Finance
(Rs. In lakhs)
Cost of the Project Means of the finance
Land 100 Capital 250
Building 500 Term loans 500
Plant & Machinery 75
Other assets 10
Preliminary expenses 10
Provision for contingencies 20
Margin for Working capital 35
Total 750 750
Banks normally finance only for building, plant and machinery and other assets and the entrepreneur has to arrange funds from
other sources for other items of the cost of the project.
After computing the cost of the project and means of finance, the various factors required for assessment of financial
viability which a banker should carefully examine, are as under:
• Reasonableness of the project cost
• Debt Equity Ratio (DER) = Long Term Debt/Equity
• Promoters’ contribution
• Production and Profitability Estimates
• Estimated cash flows and projected balance sheets
• Break even analysis. BEP is where Sales = Total Cost (No profit no loss)
o Total cost is a combination of variable costs and fixed costs which the unit has to recover to reach the break-even point at
the earliest.
How the break-even point is arrived at:
• As a first step in computing the breakeven point, the costs are divided into fixed costs and variable costs. Once
costs are segregated into fixed costs and variable costs, the break-even point is calculated as follows:
• Break Even Point (BEP) = Fixed Costs / Unit selling price - Unit variable cost
• Where Unit selling price – Unit variable cost is known as “Contribution”
• BEP can be expressed in terms of:
o BEP in units = Fixed Cost ÷ Contribution per unit
o BEP in Rupees = BEP in units × sales price per unit
o BEP in capacity = No of units at BEP ÷ Total Capacity × 100
o Contribution = Sales - Variable Cost
o Margin of safety = Actual sales - BEP Sales expressed in percentage
o The margin of safety = Excess of actual sales over break-even sales, which help to find out:
• The impact of any deterioration in actual sales on the profits of the unit
• Whether the unit is able to operate above the BEP in spite of deterioration in the sales levels
Debt Service Coverage Ratio (DSCR)
In term lending, we need to find out whether the term loan repayment obligations are sufficiently covered by the
projected profits and the ability of the unit to service both interest and principal amount.
• DSCR ratio serves as a guide to determine the period of repayment of a term loan.
• This ratio indicates whether the profits projected are adequate enough to service the interest burden and
instalments of the loan
• SCR is calculated by dividing Cash accruals plus TL interest in a year by amount of repayment obligation of both
interest and principle. The cash accruals for this purpose should comprise of net profit after tax plus depreciation.
DSCR = Profit After Tax (PAT) + Depreciation + Interest on TL / T L Interest + TL Instalments
Importance of DSCR:
• DSCR indicates the debt servicing capacity of the project/unit.
• If the cash accruals are twice that of repayment obligation, then the repayment will be smooth even if the actual profitability
slips as against the projected profitability.
• The ideal DSCR is 2:1. However, banks in India accept even 1.25 :1 DSCR depending upon the nature of the project and
standing of the promoters.
Sensitivity Analysis
Sensitivity Analysis
Sensitivity analysis, sometimes called ‘what if” analysis answers questions like:
• What will happen to net profit and other dependent ratios if the sales decline from the projected level by 10% or
so?
• What will happen to net profit and other related ratios if the raw material price goes up by 10% or so from the
projected level and the price increase could not be passed on to the buyers?
The above questions drive us to a conclusion that every business activity is sensitive to certain expenditure items
apart from sales price. It may be raw Material, labor, power, or transport etc. Any adverse change in the input costs
may affect the viability of the project as the projected profitability may not materialize.
Therefore the project appraiser should critically understand the project on which type of expenditure the activity
mainly depends.
Pay Back Method
The object of this method is to find out the period of time required for recovering the entire investment in a project. The
cash flow figures (Profit after tax + depreciation + other non-cash write offs) are compared with the outlay on the project
to determine the payback period.
No.of years required to recover the investment = Total investment / Cash flow per annum.
Projects may be ranked according to their payback periods and that with the shortest payback period may be selected.
Advantages of Pay back method:
• Payback period, as a tool of analysis, is often used because it is easy to apply and easy to understand
• The payback period is an effective measure of investment risk. The project with a shortest payback period has less
risk than with the project with longer payback period.
• The payback period is often used when liquidity is an important criterion to choose a project.
Time Value of Money
• The time value of money (TVM) is the concept that money available at the present time is worth more than the
identical sum in the future due to its potential earning capacity.
o For example, a project that costs Rs.100000/- and pays back within 6 years is not as valuable as a project
that costs Rs.100000/- which pays back in 5years. Having the money sooner means more potential
investment. The shorter time scale project also would appear to have a higher profit rate in this situation,
making it better for that reason as well.
• The time value of money (TVM) is an important concept to investors because a rupee on hand today is worth
more than a rupee promised in the future. The rupee on hand today can be used to invest and earn interest or
capital gains.
• The time value of money is sometimes referred to as the net present value (NPV) of money.
Discounted Cash Flow Method (DCF Method)
Investments are essentially current capital expenditures incurred at present in anticipation of future returns. Hence, the
timing of expected future cash flows is important in the investment decision.
For example, investors place a higher value on recent returns than on future ones. Hence, the technique that discounts
[or reduces] the future values into their present values at a specified time value [discount rate] is called as DCF
technique.
There are mainly two types of DCF techniques viz;
• Net Present Value [NPV] method and
• Internal Rate of Return [IRR] method

Net Present Value [NPV]
• Net Present Value may be defined as the excess of present value of future cash inflows over that of cash
outflows [Capital expenditure].The cash inflows of a project are discounted at some desired rate of return, which
is mostly equivalent to the cost of capital.
Example: 1
M/s. X Co. Ltd. is planning to purchase a new machine costing Rs. 80,000. Earnings after taxation are
expected to be as follows:
Years Cash inflows (in rupees)
1 8,000
2 24,000
3 32,000
4 48,000
5 32,000
Total 2,24,000
The company has a target of return on capital of 10 per cent. On this basis, find the profitability of the machine and state if it is
financially preferable.
Net Present value - Solution
Year Cash Outflows (A) Cash Inflows (B) Discount factor at 10% (C) PV of cash inflows D = (B*C)
0 80,000 0 0 0
1 - 8,000 0.909 7,272
2 - 24,000 0.826 19,824
3 - 32,000 0.751 24,032
4 - 48,000 0.683 32,784
5 - 32,000 0.621 19.872
TOTAL 1,44,000 1,03,784
Net Present Value (NPV) = PV of Cash inflows (D) – PV of Cash out flows (A)
23,784 = 1,03,784 - 80,000
From the above statement, it is evident that the investment in new machine would be
profitable since the PV of cash inflows is greater than the PV of cash outflows.
Net Present Value
Example - 2:
a) Two alternative projects namely A&B are being explored.
b) For the sake of simplicity, the total amount to be invested in either of the project is taken as Rs.1,000/ -
c) The projects are required to earn at least 10% rate of return to justify the investment
Which project is investment worthy?
Project A Project B
Year Cash in-flow (A) Discount factor (B) PV C=A*B Cash inflow (A) Discount factor (B) PV C=A*B
0 Investment -1000 -1000
1 400 0.909 364 300 0.909 273
2 600 0.826 496 700 0.826 578
3 300 0.751 225 300 0.751 225
Aggregate of discounted cash flows 1085 Aggregate of discounted cash flows 1076
Net Present Value (NPV) 85 Net present Value (NPV) 76
Inference: Project A has a higher NPV compared to Project B because of timing of cash flows in the first two years. The enterprise conce rned would
rather receive an additional cash flow of Rs.100/- in the first year than in the second year. The timing of cash flow makes all the difference in favor of
project A. Generally speaking, the project with higher NPV is to be preferred. In the above case, project A is preferable to project B because of higher
Net Present Value (NPV).
Internal Rate of Return
Internal Rate of Return
The Internal Rate of Return (IRR) is that rate of discount at which the sum of present value of future cash flows
becomes equal to the amount invested in the project.. In other words, IRR is that rate of discount at which the NPV of
the cash flows becomes zero.
Importance of IRR:
• IRR takes into account the time value of money as such the entrepreneur clearly understands whether the project
is worth investing or not.
• IRR ranks the projects according to their IRR and PV of the future cash flows. A project with higher IRR is selected
from among several projects.
The IRR for a project can be calculated by discounting the future cash flows at various rates and finally by trial and
error, arriving at the rate which reduces the net present value to zero. However, this is a very tedious and time
consuming process. The easier and widely adopted method for calculation of IRR is by using the interpolation formula.
Internal Rate of Return - Example
Calculation of IRR
Discount rate :20% Discount rate :18% Discount rate :16%
Present
Year Cash flow Discount factor Present Value Discount factor Discount factor Present Value
Value
0 10000 Nil (-10000) Nil (-10000) Nil (-10000)
1 5000 0.833 +4165 0.847 +4235 0.862 +4310
2 4000 0.694 +2776 0.718 +2872 0.743 +2972
3 3000 0.579 +1,737 0.609 +1827 0.641 +1923
4 2000 0.482 +964 0.526 +1052 0.552 +1104
NPV (-358) NPV (-14) +309
• 0” year is the year of project implementation and the cash flow of Rs.10,000/- is the cash outflow by way of investment in the
project.
• From first year onwards, the cash flows shown in column No.2 represent cash inflows or the returns on the project.
• Cash outflow/investment is represented by way of negative sign(-) while the cash inflows are represented by positive sign,
• The cash inflows are discounted at 3 different rates (20%/18%/16%) to arrive at the present value (PV).
• The interest rates of 20%, 18% and 16% were converted into discount factor.
Internal Rate of Return - Example
Calculation of IRR
Discount rate :20% Discount rate :18% Discount rate :16%
Present
Year Cash flow Discount factor Present Value Discount factor Discount factor Present Value
Value
0 10000 Nil (-10000) Nil (-10000) Nil (-10000)
1 5000 0.833 +4165 0.847 +4235 0.862 +4310
2 4000 0.694 +2776 0.718 +2872 0.743 +2972
3 3000 0.579 +1,737 0.609 +1827 0.641 +1923
4 2000 0.482 +964 0.526 +1052 0.552 +1104
NPV (-358) NPV (-14) +309
From the above project becomes zero somewhere between 16% and 18% .In order to exactly find out the IRR, the following formula is used :
IRR = Lower discount rate + Diff. between two discount rates
(NPV@ the lower discount rate/Absolute difference between the NPVs at the two discount rates)
Whereas:
Lower discount rate = 16%;
Difference between two discount rates = 18 – 16 = 2
Absolute difference between the two NPVs at the two rates = 309 - (14) = 323
IRR = 16 + 2 (309 / 323) = 17.92
Repayment schedule and methods of repayment
Structuring an appropriate repayment method is one of the key decisions in term loans or else the unit may find it difficult
to service the loan instalments resulting in the deterioration of the loan asset quality.
The repayment program depends upon the frequency of income generation and adequacy of income to cover both
interest and instalment obligations.
Various repayment methods are as under:
• Equated Monthly Instalments (EMI) - Where the repayment includes principal and interest equally distributed over
the repayment period. Generally applied in case of non-business loans like housing loan, educational loan etc.
• Principal equally distributed (PED) - The principal (original amount borrowed) is divided into equal monthly
amounts, and the interest is calculated on the outstanding principal balance each month.
• Balloon repayment method - An incremental increase in the instalments at regular intervals are proposed.
Generally applied in case of business activities where the income generation is expected to go up at regular
intervals.
• Bullet repayment method - Where the repayment is in one go and one instalment as the income is expected at the
end of a particular period in bulk.
Structuring Repayment Schedule
Each repayment method as explained above depends upon the type of activity and income generation pattern. The
borrower has to be informed about the repayment period, instalment amount and due date.
• The repayment schedule would help in following up the recovery of instalments and to take necessary measures in
case of any delay and or default in repayments.
• Generally, a repayment holiday or moratorium period would be allowed to the unit to cover a period of installation of
the machinery, trial production, commencement of commercial production and stabilization to ensure that the unit
could generate profits as per their projections and commence repayment of the term loan.
Documentation
Documentation is an essential part of a loan to:
• establish the relationship between the bank and the borrower
• form the evidence for any legal action in case of any default or dispute
• form proof of bank’s charge or hold on the securities
• define the roles and responsibilities of the parties (Bank and Borrower) to the loan
Points to be noted in documentation:
• The loan to be released or disbursed only after completion of the documentation process
• The execution of the loan documents depends upon the legal constitution of the borrower like Proprietorship firms, partnership
firms, limited companies, Trust, and Societies etc.
• Documents to be obtained on the Bank’s standard loan document formats
• The documents are subject to stamp duty as per the state and or central stamp act
• The loan documents are subject to Limitation act and revival of the documents to be done before the expiry date.
• To create separate credit files for each Term Loan borrower or account and maintain copies of critical documents
Precautions to be taken in execution of the loan documents
• Ensure that all the pages of the loan documents to be signed by the borrowers as mentioned above
• The details in each of the loan documents to be filled in full without any overwriting and or corrections before they are signed by
the borrowers
• The location of the securities with full details of the address to be filled
• The description of the asset financed and details of the Bank loan, borrower ‘Margin, to be properly filled and communicated to
the borrowers
• Rate of Interest, Frequency of interest application and penalty clause for any delay or default in the repayment to be mentioned
• Bank has to clarify the borrower that Interest rates are subject to change as per the policy adopted by bank.
• In case the loan to be disbursed in stages, the drawdown schedule or disbursal schedule to be properly mentioned in the loan
documents and explained to the borrower
• The Repayment Program or schedule along with the startup or gestation period to be covered in the loan documents
• In case land and building form a party of the security to the loan, mortgage formalities to be completed as per the terms of
sanction
• Margin Money requirements are compiled to disburse the loan
• The loan documentation formalities have to be completed in one sitting. The signature of all the parties to the loan has to be
obtained on a single day and not in piecemeal on different dates
Loan Disbursal and Verification of End Use
• On completion of documentation formalities, the term loan approved along with the margin money to be contributed
by the borrower, to be directly disbursed (by way of demand draft/Pay order/RTGS/SWIFT) to the vendors of the
equipment/Machinery as described in the loan proposal.
• It should be noted that the loan amount should not be credited to the borrowers’ account unless otherwise it is
specifically approved by the competent authority. In case the loan is disbursed in stages, the details of disbursement
have to be maintained.
• It is prudent to inspect the unit after each disbursal to ensure that equipment/machinery for which the payment has
been made are delivered and are installed.
• The credit officer has to arrange for insurance coverage for the full value of the machinery/equipment installed. The
insurance costs to be recovered from the borrower and the renewal date of the policy to be diarized.
• Inspection of the unit is not a one-time activity or event, Inspection at regular intervals ensures availability of the
assets financed and to find out whether the equipment/machinery are in working condition and are properly
maintained.
Monitoring and Follow Up
Regular monitoring of the loan account and the unit visit would help:
• To ensure the availability of the assets financed with the unit
• The quality of their (machinery) performance
• To understand the reasons for the breakdown and or such occurrences if any.
• To find out the reasons for irregularity/delay/default in repayment of the loan instalments
• To discuss with the borrowers their plan of action to regularize the irregularities.
• To provide alternate solutions in case of a genuine reason for irregularity.
The credit officer has to be familiar with the desktop review of the loan account which helps:
• To find out that the installments are paid regularly
• Incidents of any default or delay in the repayment
• Monitor the fixed assets coverage ratio (FACR)
Summary
Summary
• The purpose of a term loan is for meeting capital expenditure of a business enterprise, like creation of fixed assets.
• Appraisal of term loan consists of Management appraisal, Technical appraisal, Commercial appraisal, Economic
appraisal, Social appraisal and Financial appraisal .
• Technical Appraisal is a scientific study to ascertain that the project is. sound with respect to various parameters
such as technology, plant capacity, raw material availability, location, manpower availability, etc.
• Commercial appraisal is to establish whether a proposed activity will be viable in a commercial sense in terms of
demand for the product, market size, competition, distribution channels etc.
• Economic appraisal is a study that weighs the costs of an action against the benefits that it provides. The following
are the key aspects to be studied to establish the economic viability of a project.
• Financial appraisal is an objective evaluation of the viability of a project from the perspective of profitability of
operations and financial strength. The basic purpose of financial appraisal is to assess whether the project will
generate sufficient surplus so as to meet the repayment obligations.
Summary
• Various evaluation techniques are applied while arriving at a decision on capital investment such as Payback
method, DCF method, Break even analysis, Sensitivity analysis and Internal Rate of Return etc.
• Debt service coverage ratio tells about the sufficiency of income to repay the term loan.
• A project with a higher IRR is generally preferred.
• Low BEP projects are relatively safe compared to high BEP projects.
• Generation of income from capital investment will be very slow spreading in to number of years unlike revenue
income which is accounted in the year it is earned. Hence, financing bank should carefully appraise the proposal
for its financial viability.
• As the repayment of term loans depends on the income generated by the investment for which the loan is
sanctioned, a very strict monitoring and follow up is required till the asset is created and further.
THANK
YOU
Credit Management
Unit 7
–
Documentation
Unit Description
Most of the transactions in a bank or a financial institution lead to agreements
and contracts. An agreement is usually informal, between two or more parties
that is not enforceable by law. Contract is a formal arrangement between two
or more parties that by its terms and elements is enforceable by law. Hence
an agreement enforceable by law is called a contract.
Both the agreement and the contract need not be in writing. They can be oral.
However, banks and financial institutions document all the transactions as per
law for the purpose:
• As evidence
• To identify all the parties to the transaction/contract
• To stipulate terms and conditions
• To create charge
Banks believe that proper documentation done at the time of sanction of the
credit facilities is half recovery.
Unit Objectives

• Explain the purpose and means of safe and productive deployment of bank’s funds
• Identify the importance of regulatory compliance by the bank/borrower such as prudential norms, KYC
compliance and due diligence
• Identify the different types of borrowers and securities
• List out the various credit facilities offered by banks to suit the needs of the potential borrowers
• Explain how banks and the Government support MSME under manufacturing and service sectors
Documentation
Documentation
Documentation:
The process of execution of documents by the borrowers/co-obligants/guarantors /owners

of the securities in the proper form and according to law is called documentation.
Need for Documentation:
A document is defined as a • Primary evidence of a contract or a transaction

piece of written, printed, or
• Record evidencing the terms and conditions of an advance/loan
electronic matter that
provides information or • Creating a valid and effective security in favor of the bank
evidence or that serves as
an official record. • Bind all the parties to the contract/loan
• Documents can be enforced in a court of law against the executant(s)

Execution of Documents
The Loan Documents are said to be executed when they are duly stamped and signed by all the parties to the loan
transaction and delivered by the Borrower to the bank so that such documents constitute a legal evidence of a loan
transaction.
General Guidelines:
• Should be executed at the bank and in the presence of the manager/officers of the bank
• Should not be handed over to one/some of the parties or to his/her representatives for obtaining the signature(s) of
the other party/parties.
• Concerned executant(s) should sign on all the pages on the document.
• Date of execution of the documents is the date noted in the documents at the appropriate place when they are first
signed.
• Overwriting, corrections etc., if any should be got authenticated by all the executant(s) under full signature(s).
• Documents to be filled up neatly with a standard brand of indelible ink.
• All executants should affix their full signatures in the same style throughout all the documents.
Types of Securities
Types of Securities
Assets created out of bank finance are available as security for the loan by
obtaining certain specific documents. In case of certain loans, banks also
obtain additional security/ies as a safety measure. Thus the securities
available to the bank could be broadly classified under two categories:
• Primary Security - The assets created out of bank finance are called
as Primary security. The value of the primary security must be higher
than the loan balance outstanding.
• Collateral Security - Any additional security other than the primary is

called collateral security. Banks obtain additional securities
(collateral) as a cushion to guard against default in repayment if the
primary security is inadequate to cover the loan amount. Collateral
security enhances the comfort for lending.
Types of Charges
Types of Charges
The Companies Act, 2013 defines a Charge as an interest or lien created on the assets or property of a Company or
any of its undertaking as security and includes a mortgage U/s 2(16).
Modes of charging securities or Security Charge Creation:
• The way by which a bank obtains control over the security is called mode of charging security.
• If the security is not properly charged, bank becomes an unsecured creditor.
• Bank has to select appropriate mode based on the nature of loan and nature of security.
• The following are the important modes of charging a security or creating a charge on security:
o Lien
o Pledge
o Hypothecation
o Mortgage
Types of Charges
Lien is the right of a creditor (lender) to retain in his possession, the goods and securities owned by the debtor until the
debt has been discharged, but has no right to sell the goods and securities so retained.
Lien is of two types:
1. Particular
2. General
Hypothecation is defined in SARFAESI Act 2002 as “a charge in or upon any movable property, existing or future,
created by the borrower in favor of a secured creditor without delivery of possession of the movable property to such
creditor, as security for financial assistance”.
Hypothecation is the commonly accepted practice of creating a charge on movables wherever such movables are
supposed to be held with the borrower for his routine business activity.
Types of Charges
Pledge is defined in sec172 of Indian contract act 1872 as “a Pledge is a contract where a person deposits an article or
good with a lender of money as security for the repayment of a loan or performance of a promise. The Pawnee (lender)
is under the obligation to take reasonable care of the goods of the pawner (borrower) pledged with him.
In this type of charge, the possession of the goods pledged will be with the bank, however, the ownership of the goods
will remain with the borrower. Pledge can be done only on movables.
Mortgage is defined in transfer of property act 1882 as “A mortgage is the transfer of an interest in specific immoveable
property for the purpose of securing the payment of money advanced or to be advanced by way of loan, an existing or
future debt, or the performance of an engagement which may give rise to a pecuniary liability”.
This type of security charge applies in case of Immovable properties like land and building.
Generally, immovable properties offered as security (either primary or collateral) for a loan, the security charge is created
by way equitable mortgage by deposit of title deeds with the bank.
Pari-Passu Charge
In consortium lending, two or more banks jointly lend the companies against the same securities. In such a scenario,
all the consortium banks enjoy the right over the securities of the company in the ratio of their loan amounts. This is
known as Pari-passu charge.
Example: A cash credit limit of Rs.100.00 Crs has been approved to M/s “Auto components (India) Ltd under consortium
arranged between Four member banks as under:
Share in the total consortium of

Sl. No. Name of the Bank Rs.100.00 Crs
01 Bank A 40 Crs • Bank A share – 40%
02 Bank B 30 Crs • Bank B share – 30%

03 Bank C 20 Crs
• Bank C share – 20%
04 Bank D 10 Crs
• Bank D share – 10%
Total Consortium 100 Crs.
Floating Charge/Fixed Charge
• We are aware that working capital facilities are extended against chargeable current assets like inventory/stocks and
trade receivables.
• The level of chargeable current assets and their value keep changing continuously because these are used in
production and new stocks are acquired from time to time. Thus the current assets do not remain the same and
would vary depending upon the production, fresh purchases and sales etc.
• The type of hypothecation/pledge charge created on chargeable current assets which are used in business, keep
changing whose value is dynamic is called ”Floating Charge”.
• Hypothecation charge created on stock and receivables is an example of “Floating Charge”.
• A charge which is created on a fixed asset or an asset which remains unchanged and easily identifiable is called a
“Fixed Charge”
• Fixed Charge could be by way of Hypothecation Pledge, Assignment and Mortgage.
• The hypothecation charge on machinery is a fixed charge because machine is easily identifiable and does not
undergo change.
• The mortgage on land and building is also a fixed charge as the land and building will not undergo change and are
easily identifiable.
Creation of Charge
• Creation of charge by the borrowers on various kinds of securities/assets means creation of a right in favor of the
bank or creditor.
• By creation of charge, the ownership is not transferred in favor of the ban or creditor(except in case of English
Mortgage)
• A charge is created by the borrower by executing a suitable document/agreement in favor of the bank/creditor.
• In the case of hypothecation of goods or any movables, the borrower executes an agreement called “Hypothecation
Agreement”.
• In the case of pledge of goods, the borrower executes a pledge agreement or a simple letter of pledge.
• In the case of mortgage, borrower executes either mortgage deed or simply writes a letter addressing the
banker/creditor evidencing deposit of title deeds.
Registration of Charge
• Types of charges to be registered: All types of charges(lien/pledge/hypothecation/assignment/mortgage etc.) created by
Companies in favor of the lenders need be registered with Registrar of Companies (ROC) in terms of section 77 of the companies
act 2103.
• Who need not register the charges: Proprietorship firms, Partnership firms, Societies and Trusts need not register the charges.
• Timeframe to register the charges: A company creating a charge, shall register the said charge with the ROC within 30 days of
its creation.
• The purpose of registration is to notify others that bank has lent to the company and the bank enjoys the right and priority over
the securities described in the registration report.
• Effect of non-registration of charge Section 77(3) of the Companies Act states that, in case a charge is not registered, and a
certificate of registration is not obtained from the Registrar of Companies, then the charge shall not be taken into account by the
liquidator or any other creditor.
• How to register the charge? For Creation of Charge Form CHG-1 will be filed with ROC with the prescribed. Form should be
signed by the Company and the Charge-holder (bank/lender) and should be filed together with instrument creating charge.
• This above process is referred to as Registration of charges.
Modification and Satisfaction of Charge
When a secured advance is extended to a company, bank’s charge on the security needs to be created by way of a
document. Such charge requires to be registered with the Registrar of Companies (ROC).
If there is any additional loan is sanctioned subsequently against the same security or any terms and conditions of the
original loan have been changed/modified, the charge originally registered with ROC needs to be modified by filing a
specific form with ROC within 30 days of modification.
This process is known as “Modification of Charge”.
When the loan/loans availed by the company from a bank have been fully paid off by the company, the bank is required
to discharge the company from its loan obligation by filing a specific form with the ROC within 30 days of the closure of
the loan/loans.
This process is known as “Satisfaction of Charge”.

Modification and Satisfaction of Charge
Forms to be used for Registration, Modification and satisfaction of security charges with the ROC
• For creation of charge – CHG-1 form shall be used. ROC issues Certificate of registration of charge in form CHG-2
• For any modification in the charge already registered, Form-CHG-1shall be used. ROC issues Certificate of
registration of modification of charge in form CHG-3
• For satisfaction of registered charge, Form CHG-4 shall be used. ROC issues a certificate of satisfaction of charge in
form CHG-5
• The certificates issued by registrar are the conclusive evidence that the requirements of the Act and rules made
thereunder as to registration of creation or modification of charge have been complied with.
Stamp Duty on Documentation
Stamp Duty on Documentation
• Stamp duty means a tax payable on certain legal documents specified by statute. The stamp duty may be fixed or
advalorem, meaning that:
o The duty is a fixed amount
o An amount which depends upon the value of the products, services or property on which it is levied
• Adequate stamp duty should be paid in respect of all documents before execution, which are chargeable with
stamp duty as per the provisions of the respective State Stamp Act (or) Central Act, as the case may be.
• A document will be legally enforceable only if the stamp duty is duly paid thereon.
Types of Stamps
• Revenue Stamps: Documents such as Demand Promissory Notes, Receipts, and Acknowledgements of Debt should be
stamped with Revenue Stamps of adequate value. Affixing of revenue stamp is necessary only if the amount on any of the
receipt is for more than Rs.5,000/-
• Non-judicial Special Adhesive Stamps: Printed document formats in the form of agreements etc., should be stamped with
adequate value as per the Stamp Act.
• Non-judicial Stamp Paper: Non-judicial Stamp Paper carries the stamp embossed/impressed on the paper itself. Non-judicial
stamp papers are generally used for documentation like power of attorney, sale deed, rent agreement, affidavits, transfer of
immovable property like building, land, mortgage or other important agreements etc.
• Bill of Exchange (Hundi) Stamp / Paper: “Hundi or Bill of exchange (BE)” is a financial instrument used in trade and credit
transactions. Hundis are used as a form of remittance instrument to transfer money from place to place.
• Share Transfer Stamps: With the introduction of the system of dematerialization of shares, there is no need for using share
transfer stamps/deeds for transfer of shares and Debentures.
• Foreign Bills Stamps: In the dealings of the domestic companies with the foreign companies, the Foreign Bill Stamps are
made use of.
• Insurance Stamps: These are affixed on Insurance policies.
• Franking Print: Government issues franking license to banks and Financial Institutions to use franking machines to stamp
documents or affix a denomination on them which acts as a proof that the stamp duty for the transaction has been paid.
Stamp Duty Payable as per Central Government Norms
The stamp duty payable on:
1. Demand Promissory Notes
2. Bills of Exchange payable otherwise than on demand
3. Receipts
4. Share Transfer is laid down by the Indian Stamp Act, 1899 and it is common for the entire Indian Union
Stamp duty payable as per respective State Government norms Agreements, Sale deeds, Acknowledgement of
Debts etc.
Revival of Security Documents
What is Law of Limitation?
The ''Law of Limitation'' prescribes the time-limit for seeking legal remedy in a court of law by an aggrieved person beyond which the
aggrieved ’s right of legal recourse expires. The suit, if filed after the expiry of time-limit, is struck by the law of limitation.
What is Period of limitation?

The security documents executed by the borrowers in favor of the banks or Financial Institutions are legally valid for a certain period
of time beyond which they cease to be legally valid and enforceable in a court of law. This is known as period of limitation as per
Indian Limitation Act, 1963.
The period of Limitation of time for enforcement of a document under the provisions of the Indian Limitation Act, 1963 depends on its
nature and its terms and conditions. The period of limitation commences to run from the date of cause of action. The date of cause of
action varies from document to document.
Period of limitation for different documents:
1. Demand Promissory Note (DPN) is legally valid for a period of 3 years from the date of promissory note.
2. Agreement obtained for the repayment of a term loan is valid for 3 years from the due date of each instalment.
3. Mortgage is valid for a period of 12 years from the date of default of a loan payable in instalments.
What is a Time-Barred Debt?
Once the period of limitation for enforcement of a document is crossed, the debt due under such a document becomes
time barred. Such a debt is called time-barred debt. The document becomes unenforceable and the debt cannot be
recovered through legal proceedings. However, sale of pledged goods and exercise of lien/set off are permissible.
Voluntary payments by the debtors can be received.
What is Revival of security documents? Or How to save the documents/debts from becoming time barred?
The period of limitation of a document/debt can be saved from becoming time barred by obtaining any of the following:
1. Fresh documents.
2. Acknowledgement of debt.
3. Part payment in the loan account by the borrower or his/her authorized agent or Guarantor,
4. Publication of Balance sheet by a Company which contains the details of borrowings and debts also serves as debt
acknowledgement of the Company.
Document Management System
After documentation for any advance is completed, the relative documents should be held as safe contents under joint
custody
All the documents should be entered in the Documents Register before these are held under joint custody. The
particulars such as date, nature of advance, borrower’s name, serial number of the entry, and particulars of the
documents and security lodged should be entered in the respective columns in the Register. Separate folios may be
used for noting the particulars of the documents pertaining to each head of account.
Many banks in India have moved to a centralized execution and depository of loan documents for the following
reasons:
• Individual branches may not have officers equipped with necessary skills to obtain right kind of documents for each type of loan.
Therefore, it has become necessary to centralize the documentation work where efficient and skilled staff are made available.
• It is not economically viable to post a documentation officer in each and every branch where there may not be sufficient work
load. By centralizing the process, the staff requirement can be minimized.
• In many of rural and semi-urban branches, sufficient storage space for loan documents may not be available. Hence the
depository of loan documents particularly in cities.
Precautions to be observed in handling documents
• The documents pertaining to outstanding advances should not be kept outside the joint custody overnight.
• When an advance is repaid, the promote should be cancelled and returned to the party and other documents should
be cancelled and kept in a separate folder/file meant for documents of closed advances and preserved as old
records.
• The documents should not be left on the tables/desks/contents etc., unattended. Unconcerned persons should not be
allowed to have access to the documents.
Renewal of Documents:
Working capital facilities are renewed after one/two years from the date of sanction. When such a facility is renewed with
any change in the existing terms and conditions, fresh documents should be obtained from the borrower and the co-
obligant/ guarantor, if any. If there are no changes in the existing terms and conditions, the ‘Revival Letter’ will be
obtained. Some banks may prefer to take fresh documents every time the limits are renewed.
Summary
Summary
• Contract is a formal arrangement between two or more parties that by its terms and elements is enforceable by
law. Hence an agreement enforceable by law is called a contract.
• Both the agreement and the contract need not be in writing. They can be oral. However, banks and financial
institutions document all the transactions as per law for the purpose:
• As evidence
• To identify all the parties to the transaction/contract
• To stipulate terms and conditions
• To create charge
• A document is defined as a piece of written, printed, or electronic matter that provides information or evidence or
that serves as an official record.
• The process of execution of documents by the borrowers/co-obligants /guarantors/owners of the securities in the
proper form and according to law is called documentation.
Summary
• Proper documentation is needed after sanction of credit facilities to create evidence of the liability of the borrower
with all the terms and conditions as per the sanction.
• Documents are to be stamped as per applicable law before execution.
• Standard formats of documents are prepared by banks to use depending on the mode of charge such as
hypothecation, pledge, mortgage etc.,
• The Companies Act, 2013 defines a Charge as an interest or lien created on the assets or property of a Company
or any of its undertaking as security and includes a mortgage U/s 2(16).
• The following are the important modes of charging a security or creating a charge on security:
• Lien
• Pledge
• Hypothecation
• Mortgage
• Charges are to be created with Registrar of companies as per law in case of finance to limited companies.
• Documents are to be preserved carefully till repayment of the credit facilities and even after that as decided by the
bank.
THANK
YOU
Credit Management
Unit 8
–
Credit Risk Assessment
Unit Description
A borrower may default or delay in the loan repayment either due to

internal or external factors. The default in loan repayment could
impact the top line and bottom line of the bank. The act of default on
the part of the borrower in repayment of the loan is called credit risk.
Credit risk is also called default risk and the degree of credit risk is the
probability that a loan to a borrower might not have been paid.
A borrower’s default risk is driven by the combination of managing
risk, industry risk, and business risk.
To get an overall picture of how credit risk assessment is done, we
need to understand various components of an effective credit risk
analysis and how each of these components contributes in its own
way.
Let us discuss on each of these analytical components in this unit.
Unit Objectives

• Explain credit risk
• Explain the importance of credit risk assessment in lending
• Identify the components of credit risk assessment
• Identify the credit risk assessment tools
• Identify the various tools to monitor credit risk effectively
• Explain the recovery and remedial measures
Risk
Risk
Risk has two principal characteristics:
• Uncertainty: It may or may not happen
• Loss: If it happens, losses will occur- financial and/or reputational
Risk varies along 3 dimensions:

Risk is defined as the probability of an
adverse event happening in future which • Nature of risk – What goes wrong?
impacts an individual or a business in
terms of financial and /or reputation loss. • Scope - What does it affect?
Risk can also be defined as a potential
• Timing – When does it affect
problem which may or may not happen.
Why should we accept or assume risks?
• Risk is considered to be a source of competitive advantages which need to be managed by the entrepreneur.
• Without accepting risks, there are no opportunities. Risk is invariably associated with the concept of opportunity.
Business targets are focused on seeking and exploiting opportunities that provide advantages make a difference
and add value. “Nothing ventured, nothing gained
• The fact that a company assumes risks brings with it:
o On the one hand, an opportunity, that is, the obtaining of value or the preservation of existing values.
o And on the other, a possible loss in any of the company’s key variables.
Perspectives on Risk
The concept of Risk can be analyzed from different perspectives; it has different focuses:
Risk as a Threat
Risk as Opportunity
Risk as Uncertainty
Different Types of Risk
Financial Risk Business Risk Management Risk
Operational Risk Market Risk Compliance Risk
Reputation Risk Credit Risk Facility Risk

Risk Management Techniques
• Risk avoidance: If the risk is a high probability and potentially catastrophic, the best strategy is to avoid it.
• Risk transfer: If the probability of incidence of risk is low, but the cost of managing the risk is potentially huge, we
should consider transferring the risk elsewhere. Insurance, for example, transfers the financial risk to the insurance
company.
• Risk acceptance: If the cost of mitigating the risk is too high, consider doing nothing. With some risks, this is more
cost effective than avoidance.
• Risk mitigation: This is one of the most common strategies generally banks adopt. Rather than work to avoid entire
risk, we should try to mitigate the risk to the acceptable levels.
Credit Risk Assessment
Credit Risk Management Process
A credit risk management process is the method or process of building steps to insulate a lender from the possible
risks arising out of lending credit. Banks and financial institutions offer credit in a number of ways, and hence, a credit
risk management process has to cover all these.
Credit Risk Management (CRM) focuses on two aspects namely:
• Default - Default is a situation in which bank does not receive the repayment of the loan (either principal or interest
or both) from the borrower as per the schedule of repayment.
• Credit Quality - relates to changes in the asset value. The value of credit asset(loan) may decline due to increase
in likelihood (or even perceived likelihood) of default.
CRM process involves:
1. Risk identification - All the potential risks that may trigger default in a loan asset at a future period of time are
identified during the credit appraisal process itself .and necessary checks and balances shall be put in place to
mitigate the risks.
2. Risk quantification or measurement - In order to manage and control the risk with in the risk appetite of the
bank, the risk will have to be measured and quantified. It is said that if we can not manage the risk properly, we
can not manage and control the risk. Measurement of risk is thus the critical stage in credit risk management.
Measurement of credit risk involves quantification of:
• Probability of Default (PD)
• Loss Given Default (LGD)
• Exposure at Default (EAD)
• Duration (D) or Maturity
• Expected Loss (EL)
• Unexpected Loss (UL)
Risk Weighted Assets and Capital Adequacy Ratio
Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other
financial institutions in order to reduce the risk of insolvency. The capital requirement is based on a risk assessment for
each type of bank asset.
• The capital to be maintained (capital charge) towards credit risk depends upon the risk weight (Risk weight of asset
is the portion of credit exposure on which capital is to be maintained).
• The risk weight depends upon the type of credit facility and the risk rating. RBI provides the details of risk weight to
different types of loans.
• Each bank at the corporate level would compile the Basel capital charge reports based on the data extracted from
core banking system.
Type of loan exposure Risk weight (RW)

1. Loans guaranteed by Government of India (GOI) 0%
2. Loans guaranteed by state Government (SG) 20%
3. Loans granted to public sector undertaking of GOI 100%
4. Loans granted to public sector undertakings of SG 100%
5. Bills purchased /discounted/Negotiated under Letter of Credit 20%
Risk Weighted Assets and Capital Adequacy Ratio
Type of loan exposure Risk weight (RW)
6. Loans covered by CGTMSE (for the portion covered by CGTMSE) 0%
7. Loans against Bank Fixed Deposits 0%
8. Loans to Bank staff secured by superannuation benefits 20%
9. Individual Homes Loans (linked to LTV ratio and Loan amount) LTV not to exceed R.W
90% 50%
• Up to Rs.20 Lacs 80% 50%
• Above 20 Lacs and up to 75 Lacs 75% 75%
• Above Rs.75 Lacs
Commercial real estate Loans (Residential housing – CRE RH) NA 75%
Commercial real estate Loans (other than CRE RH)
NA 150%
10.Consumer credit including personal loans, vehicle loans etc., except credit cards 100%
11.Educational Loans 75%
12.Gold Loans 50%
13. Loans above Rs.5.00 Crs are classified as corporate Loans under Basel Norms. The risk weight depends upon External rating. External
rating is mandatory for all loans of Rs.5.00 Crs and above.
Example: AAA rated firm/company Risk weight 20%
AA rated Risk weight 30%
A rated Risk weight 50%
Unrated Risk weight 100%
Calculation of CAR
Capital adequacy ratio is the ratio of capital to the risk weighted assets of a bank. As per the RBI norms, all banks in
India are expected to maintain CAR of at least 8% of the Tier-1 plus Tier-2 capital.
CAR = (Tier-1 capital + Tier-2 capital) / Risk Weighed Assets
City center branch has approved and released a loan of Rs.25.00 Lacs against a fixed deposit of Rs.40.00 Lacs to Mr.
Raghu. The loan balance in the account is Rs.25.00 Lacs as on date. The capital charge in this case is arrived as under:
Illustration No.1
Loan balance outstanding Rs.25.00 Lacs

Risk weightage 0
Calculation of Risk weighted Asset (RWA) 25 X 0% = Rs.00
Capital charge on Risk weighted Asset 00 x 9% = 0
Credit Risk Assessment Models
RBI advised banks to keep in place a Credit Rating Framework (CRF) to assess the credit risk uniformly across the
bank. Broadly, CRF can be used for the following purposes:
• Individual credit selection, wherein a borrower or a particular exposure/ facility is rated on the CRF.
• Pricing (credit spread) and specific features of the loan facility. This would largely constitute transaction-level
analysis.
• Portfolio-level analysis.
• Surveillance, monitoring and internal MIS
• Assessing the aggregate risk profile of bank/ lender.

Internal Credit Risk Rating
In case of retail loans like Housing loans, Vehicle loans, Personal Loans, Banks generally adopt the Scoring model to
analyze the risk and eligibility of the borrower to the loan in addition to other loan processing checkpoints. A typical
illustration of credit risk assessment in retails loans is as under:
Risk assessment Parameter Maximum Score Remarks
Age 09
Educational qualification 08
Employment 15
We can observe that higher weight has been
Annual Income 20 assigned to factors like Annual Income,
EMI/NMI ratio ** 13 Employment EMI/NMI Ratio and net worth which
Earning members of the family 07 are the critical factors in risk assessment supported
by others factors in this example.
Number of dependants in the family 08
Net worth 12
Mode of repayment 08
Internal Credit Risk Rating
Business Loans:
In case of business loans, the risk rating would be assessed based on several factors as explained earlier in this session
and the scorecard model may not provide an in-depth insight into the risk factors. Therefore, risk rating model is being
adopted to assess the risk factors in business loans.
Banks have developed internal credit risk rating model to analyze the management risk, financial risk, business/industry
risk of a credit proposal to assess the credit risk. We also need to know that in case of loans of Rs.5.00 Crs and above, in
addition, internal credit risk analysis, the external rating is mandatory.
It must be noted that the risk rating assessment in case of business loans has to be carried out annually and the rating
exercise based on:
• Audited annual financial statements
• Review of the loan accounts
• Review of the management
• Review of the market conditions.
External Credit Risk Rating
Banks generally use the services of the following external rating agencies in case of loans of Rs. 5.00 Crs and above.
• ICRA (Information and Credit Rating Agency)
• CARE (Credit Analysis and Research Ltd.)
• CRISIL (Credit Rating and Information Services of India Ltd.)
• BWR (Brickwork Ratings)
• SMERA (SME Rating Agency of India Ltd.)
Rating category Long Term Short Term

Highest safety AAA A1
High safety AA
A2
Adequate safety A Investment Grade
Moderate safety BBB
A3
Moderate risk BB
High risk B
A4 Non-investment grade
Substantial risk C
Default D D
Risk Based Loan Pricing
Risk-based loan pricing in banks refers to the offering of different interest rates and loan terms to different borrowers
based on their risk profile or risk rating. Risk-based pricing looks at factors such as a borrower's credit score, adverse
credit history (if any), employment status and income in case of consumer loans.
In case of business loans, the pricing depends upon Credit Risk Rating and Facility Risk Rating. These ratings basically
determine the rate of risk premium to be charged over and above a base rate. Higher the risk more will be he premium.
We now study briefly about various base rates which are basis for arriving at the risk based pricing.
• Prime Lending Rate (PLR)
• Benchmark Prime Lending Rate (BPLR)
• Base Rate System
• Marginal Cost of Funds based Lending Rate (MCLR)

Risk Based Loan Pricing
Base Rate System (effective from July1,2010) MCLR System (effective from April1,2016)
a) Cost of (borrowed) funds a) Marginal Cost of Funds

(=92% of marginal cost of deposits and other borrowings+8% of return on
net-worth)
b) Negative Carry on CRR/SLR b) Negative Carry on CRR
c) Un-allocable overhead cost c) Operating cost
d) Average return on net-worth d) Tenor premium/Discount
Base Rate = (a+b+c+d) MCLR = (a+b+c+d)
• One base rate for each bank • Tenor-linked benchmark
• Any bench mark could be used • No discretion allowed on benchmark
• Frequency : Quarterly review with Board’s approval • Frequency: Monthly on a pre-announced date
• No prescribed reset period • Reset period indicated in loan contract. Maximum one year period for floating
• Fixed rate loan- Not below base rate rate loans.
• Fixed rate loan over 3 years-exempt from MCLR
Repo Linked Lending Rate (RLLR) or External Benchmark Rate
a) All new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small
Enterprises extended by banks from October 01, 2019 shall be benchmarked to one of the following:
• Reserve Bank of India policy repo rate
• Government of India 3-Months Treasury Bill yield published by the Financial Benchmarks India Private Ltd
(FBIL)
• Government of India 6-Months Treasury Bill yield published by the FBIL
• Any other benchmark market interest rate published by the FBIL.
b) Banks are free to offer such external benchmark linked loans to other types of borrowers as well.
c) In order to ensure transparency, standardization, and ease of understanding of loan products by borrowers, a bank
must adopt a uniform external benchmark within a loan category; in other words, the adoption of multiple
benchmarks by the same bank is not allowed within a loan category.
d) RLLR = Repo rate + Margin charged by the bank.
e) RLLR is reset at least once in 3 months.
Monitoring Tools
a) Loan Review Mechanism
b) Credit Risk Rating (internal and external)
c) Industry and portfolio reviews
d) Stock Statement Analysis
e) Receivables or Book Debts Statement Analysis
f) Ledger Page Supervision (LPS) or Scrutiny of statement of CC account
g) Stock and Receivable Audit Reports
h) Periodical Inspection/Unit visit report
i) Verification of central repository of information on large credits (CRILIC) data base

Criteria for SMA Classification
Classification basis : Principal or interest payment or any other amount wholly or partly overdue
SMA sub category (for Loans)
between
SMA-0 1-30 days
SMA-1 31-60days.
SMA-2 61-90 days.
In the case of revolving credit facilities like Cash Credit , the SMA classification is as follows:
SMA sub category (for CC and other Classification basis : Outstanding balance remains continuously in excess of the sanctioned limit
revolving facilities) or drawing power, whichever is lower, for a period of:
SMA-1 31-60days.
SMA-2 61-90 days.
Note: Principal or interest payment overdue more than 90 days is treated as Non- Performing Asset (NPA)
Recovery and Remedial Measures
In respect of accounts classified under SMA-0 and 1 category, banks shall take steps to get them regularized by
contacting the borrowers or sending notices of over dues as they deem fit.
In respect of SMA-2 accounts, the financing banks shall form a forum called Joint Lender Forum (JLF) and examine the
possibility of:
1. Recovering the over dues through negotiations with the borrower
2. Restructuring the loan by way of elongation of repayment schedule etc.
If the above 2 options are no possible, the following recovery steps shall be initiated:
• Issue of notices of default to the borrower and the guarantor in a timely manner
• Compromise/settlement
• Invoking SARFEASI Act
• Legal Action
• Write-off
Summary
Summary
• Sound lending principles coupled with proper risk management frame work would be useful in maintaining the
asset quality.
• Risk is defined as the probability of an adverse event happening in future which impacts an individual or a
business in terms of financial and /or reputation loss.
• The act of default on the part of the borrower in repayment of the loan is called credit risk or default risk.
• The degree of credit risk is the probability that a loan to a borrower might not have been paid.
• Risk poses two major challenges to the managers. One is uncertainty and the other is potential adverse impact of
profitability and /or reputation.
• A credit risk management process is the method or process of building steps to insulate a lender from the possible
risks arising out of lending credit.
• CRM process involves 4 major steps. They are a) Risk identification b) Risk quantification or measurement c) Risk
mitigation and d) Risk monitoring.
Summary
• Banks check credit worthiness of the borrowers through external and internal credit rating systems.
• Banks adopt internal risk scoring models for each type of loan segment to assess and rate the loan exposures on
the risk scale of 1 to 4 (1 being the lowest risk and 4 being the highest risk).
• The internal risk rating methodology leads to risk based pricing of loans. Borrowers are offered different interest
loans based on their risk rating.
• Credit risk is dynamic in the sense that it changes its nature as well as degree from time to time. It is therefore
necessary that the credit risk should be constantly monitored through various monitoring tools.
• Loan Review Mechanism, Risk Rating Review, Industry and Portfolio reviews, Stock and Book debts statement
analysis, Stock and Book debt audits, verification of CRILIC data base etc. are some of the powerful monitoring
tools used by banks to monitor credit risk.
• Despite all the risk monitoring measures, if a borrower defaults in repayment of principal and interest, recovery
measures such as compromise/settlement, invoking SARFEASI Act, legal action etc. may be resorted to.
THANK
YOU

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MBA - Banking and Finance

A WORK INTEGRATED LEARNING PROGRAM

Unit 1 – Credit Management

At the end of this unit, you will be able to:

In Practice: To check if the Collateral is acceptable use MASTDAY

Purpose of Customer Due Diligence:

Process of Customer Due Diligence:

What analysis of bank statement/ OD statements, can tell us:

• TransUnion Credit Information Bureau (India) Limited (or CIBIL)

• Credit Rating Information Services of India Limited (CRISIL)

• CRIF High Mark

Searches in the Data

Company Search / Google Search / Defaulters /

The following are the types of Borrowers:

Further the credit facilities can be sub-categorized as under:

• All small ticket loans

• Low volume of large transactions

• Focused on few corporate customers

• Mostly products are customized

• Long-drawn decision process which is both objective and subjective

• Few number of accounts, segmentation is not so large

• Account level risk management

• MSMEs account for about 45% of India’s manufacturing output

• MSMEs account for about 40% of India’s total exports

• However, both the MSME sector and Banks have challenges.

Manufacturing units with Original Above Rs 25 Lakh to Rs 5.0 Above Rs 5 Crore to Rs 10

Investment in plant and machinery or

o The eligibility for CGTMSE cover,

o Extent of cover available

• Extra care should be taken while entertaining takeover proposals.

At the end of this unit, you will be able to:

The term financial statement refers to TWO documents namely:

It is carried out in four steps:

• Net-Worth - The sum of capital and reserves of a firm/company

• Net Sales = Gross Sales (Total Sales) minus Excise duty

• Gross Profit (GP) = Net Sales - Cost of sales

• Operating Profit (OP)`= Gross Profit (GP)-Operating Expenses

• Net Profit (NP) = Operating Profit + Non-Operating Income-Non Operating Expenses

1. Current Ratio = Current Assets / Current Liabilities.

2. Debt Equity Ratio = Long Term Debt/Tangible Net-worth

3. TOL / TNW ratio= Total Out-side Liabilities / Tangible Net Worth

11. Creditors Days or Account Payable Days = Average Creditors x 365/Purchases

Requirements to compile or prepare a funds flow statement:

• Consecutive balance sheets for two or more years

• Consecutive Profit and Loss statements for two or more years.

Cash flow Statement Analysis:

• Cash Flow from Investing Activities (Investing Cash-flow)

CMA consists of 6 forms as detailed here under:

Who should submit FFR-I & II?

In this unit, we will study

At the end of this unit, you will be able to:

a) bankers in the form of bank credit and

• Steps 1 to 3 are same as first method.

As per First Method As per Second Method

If Projected sales turn-over 200

Reserve Bank’s Direction:

Trade Creditors 100 Inventory 200

BB for WC 300 Receivables 300

TCL 400 TCA 500

• Clean Bill of Exchange