Basis For Lending - An Alternative Approach

Being a commercial banker, in the competetive environment, our Bank cannot but keep taking credit decisions. Our credit decisions cannot be entirely based on any set of guidelines or analytic technique. It is said that credit decisions should emanate out of good common sense, judgement and scrupulous providence.

However, in order to determine the size of each credit, a sound credit analysis becomes necessary. Credit analysis is the means by which we utilise the quantitative information to arrive ultimately at qualitative judgement.

Our Credit function therefore, should include

1. Evaluation of character and managerial ability of borrower.

2. Review of historical cash flow and financial policies of the borrowers.

3. Analysis of the Balance Sheet and

4. Estimate of the asset mix and leverage (gearing characteristics).

Such an assessment is to determine the impact of the loan request on sales, profits and resultant cash flow. The bank should also identify the source of repayment, the impact of the loan on the Balance Sheet, alternative means of repayment from the reserves, and additional strength in case repayment plan does not develop as projected.

Having started so, our approach to lending and the quantum thereof is hereby related to

1. Production

2. Production facilities.

3. Demand supply gap.

4. Market and marketability

5. Sales volume

6. Profits.

7. Resultant cash flow.

8. Additional strength/support

9. Future outlook, future plans of the borrowers

10. The inherent financial strength of the borrowers, investing capabilities and shock absorbing capacity and

Risk perception

In order to appraise, assess and evaluate credit requests coming from the borrower, it becomes necessary to obtain Information on the structured formal covering the above. It is therefore necessary to evolve a simple but standard application form applicable to most cases.

Borrower Evaluation Sheet

A scientific formula based on earlier methodology and the mechanics of arriving at lending decisions, really did not provide a structure format for borrower evaluation. We may consider as part of credit evaluation, introduction of borrower evaluation sheets.

The credit economics/presupposes sound lending which commence with a thorough evaluation of honesty, integrity, competence and ability to complete a loan transaction in the manner proposed. The ability to withstand pressures, his maneuverability during crisis has to be evaluated. Credit decisions are tightly bound with recurrence of recessions and recoveries, boom and bust. Therefore the behaviour of the borrower should be predictable for any given phase of business cycle.

Bank must be in a position to predict his behaviour and that will enable us to anticipate the risks that are likely to emerge when economic signals change. A proper evaluation of borrower will help us to maintain the quality of bank lending.

We may therefore evolve a structure for borrower evaluation to cover some of the qualitative characteristics.

Determination Of Quantum Of Credit

As mentioned in para the need for bank credit as well as the duration and volume is directly linked to production facility and sales. We may therefore base our starting point commencing from sales projection based on either past trend in the case of existing units or a mere forecast market, marketability and demand supply gap. Several related aspects have to be gone in detail before accepting the given level of sales.

In order to achieve the given level of sales, our experience have shown that the unit must possess certain levels of current assets. We have also witnessed that several units in the same line of business and activity do not accomplish their target with any related proportion of current asset to sales.

Though flexibility to dilute were available, variance were due to locations, historical reasons, conscious inventory policy. scarcity and strategy.

It is a well known fact that a well managed company in corporate sector is conscious about the carrying cost of current assets. Interest being a critical factor in determining a competitive price, borrowers do adopt and endeavour to be near minimum holding rather than desirable holding. Bank may therefore, leave it to the customers to decide, but over a period establish a relationship while accepting a total current asset policy.

Adequacy of Bank credit to accomplish the sales target and consequently the profits projected, is what is often a subject matter of criticism of borrowers and their representative forums. Many of them have outspokenly expressed that it is not for the Bank to dictate how much current assets they must possess. Therefore when we decide to leave it to them we should have a leverage linked to their margin paying capacity.

Throughout the world, current ratio is an important tool to determine the soundness of working capital finance. The ideal level of current ratio of 1.5:1 as a policy to be maintained by corporate borrowers is yet to take deep roots. Besides, such investment within the unit affects their diversion, diversification, expansion plans. We may therefore retain the current ratio of 1.33 now in vogue as a yardstick for measuring the quantum of working capital finance.

While this could be balancesheet based requirement for assessment purposes, it may be necessary to review our stand in regard to receivables.

In most countries receivables covered under book debts/any form of bills/cheque purchases etc, are treated as cash or very near cash. Many companies show bills etc, purchased/discounted as bank balance and show them under control. We, may for purposes of determining the credit, exclude receivables in any form as an asset qualifying for an effective limit under permissible levels. This approach will certainly give greater flexibility for effective utilisation and operation of working capital limit.

Depending upon the nature of business, the market and its requirements, customers may be sanctioned suitable bill limit by independent evaluation.

Trade Creditors/Suppliers Credit Etc

It is prudent on the part of borrowers to source attractive terms for their purchase whenever and wherever available. Inaccurate and unreliable forecast in CMA data in the past had often resulted in not only inadequate credit lines from the Bank but also raised several points for debate.

Whether such suppliers credit should be deducted from permissible finance, whether margins to be demanded on such stocks procured, whether such stock should be deducted for arriving at traditional Drawing Power continued to remain as areas of dispute/debate.

In the context of liberalised approach, we may leave it to the customer to forecast his own estimated levels under this head and give him greater flexibility to operate limits, upwards and downwards, depending upon market credit availability.

Bank should not stand in the way of desired liquidity being made continuously available so as to achieve desired levels of sales, production, profit and cash flow.

Other Sources

In the liberalised environment now prevailing, corporates have several options now in addition to bank finance for working capital.

To mention a few

1. Public issue of equity for Working Capital purposes.

2. Issue of Non Convertible Debentures for Working Capital

3. Issue of Commercial Paper

4. Recourse to foreign currency loans for Working capital.

5. Medium TL from Public Financial Institutions.

6. Short term finance from NBFCs

In addition to traditional sources such as recourse to public deposits, unsecured loans from Directors / relatives, asset credit schemes ctc.

The above sources, however are generally well planned in advance. Therefore, it should not be difficult for corporates to anticipate cash flows from these sources, before requesting for suitable limits for Working Capital from Banks.

Our formats for evaluating Working Capital finance will therefore have to be aligned to cash forecast system.

Suggested Methodology

Our present evaluation of eligible bank limit for working capital is well stabilised. We have been determining total current assets (TCA) a manufacturing unit should possess and apply 25% participative margin along with this deduct other current liabilities (OCL) other than bank borrowings to determine the eligible bank limit. When the projected net working capital of the unit is more than 25% of total current assets determined, such amount is deducted from the total current assets to determine eligible limit.

In order to do this exercise we have the support of CMA data I to V of which Form II relates to working capital assessment. There have not been any serious dispute about the methodology except

1) Rigidities in insisting on a NWC equivalent to 25% of margin on TCA.

2) Deduction of projected NWC when it is more instead of the required 25% of TCA.

3) Margin being applied on TCA instead of TCA - OCL i.e. on WCG.

4) WCG. Suppliers credit by way of sundry creditors not being favourably looked into than as a very good source of funding working capital needs.

5) Opening of LC - DA for inventory purchase is a matter of dispute and debate as to whether it should be deducted from eligible limit or should be incremental.

6) Despite application of 25% participative margin on TCA traditional drawing power system being scrupulously observed for cash credit drawings.

1) In order to assist the borrowers in deserving cases Banks have been showing lenience and flexibilities in deserving cases and have diluted current ratio so as to yield 25% on TCA.

2) Apply first method of lending wherever margin have fallen short.

3) Diluting stringent definitions of what is current liability particularly by excluding term loan instalment payable within a period of 12 months.

4) Open LC - DA has incremental limit.

With all these flexibilities the rigidities of present system stood reasonably mitigated. Yet there is enough scope for further removing areas of ambiguities and build up and formulate a system which is closer to existing methodology. These are based on our own experience in handling several large proposals. The suggested approach is given below in seriatum.

Sales

We have dealt with elsewhere in this note that acceptance of sales should be subject to capabilities, opportunities and possibilities.

1) Having said so we should leave it to the customer to determine the current assets required to execute the targeted sales. As indicated earlier borrower should have an inventory policy by which he prudently pursues, desirable level, optimum level, minimum level & comfort level as the case may be. The abolition of inventory norms by RBI bears testimony to the liberalised environment in which customers should operate. The aim is that the customer should not fall short of target mearly because adequate inventory support was not available and in time. While in respect of new clients the accepted levels are determined in project appraisal stage and get long term funds support towards margin, in respect of existing customers their past trend and the present environment depending on scarcity or plenty can be taken note of while accepting the core portion.

There is an automatic check in so far as a too ambitious projection would call for higher margin expectations and too low level of projection to suit the margins on hand may not conform to past trend or to the current environment.

The same is the case in respect of credits given or obtained on account of sales/purchases. Demand and supply terms are very relevant and it is out of place for banks to stipulate of what levels they should place their current asset position except indicating that bank may not go for financing speculative holding or for extending unviable credit period on sales indirectly benefiting the buyers.

2) Having obtained level of total current assets & core current assets portion which customer would like to hold, it is suggested that our bank would exclude receivables from Total Current Assets and include Trade Creditors as a source of funding and deduct from eligible bank limit. On the contrary, we suggest that our bank can adopt a system of reckoning excess of receivables over the Trade creditors along with total inventory or deduct excess of payable over the receivable as a liability to fund the current assets and deduct the same from the eligibile limit. This will be suitably illustrated.

3) Operation of loan form of lending to cover the total limit including those meant for receivable financing is creating lot of problems in bifurcation. Receivables having shorter duration of the operating cycle do not really get the benefit of prepayment of loan component. Therefore our bank may adopt a policy of sanctioning eligible limit meant for bifurcation only in respepct of inventory based working capital limit.

As mentioned in the para I, the demand loan can remain permanent or semi-permanent to cover core assets desired to be held. In respect of receivables wherever subjects desire to have suitable bill limit the same can be considered to the extent the borrower feel comfortable to bridge the gap between cash deficit/cash even. In as much as receivables are presumed to have been fully/partly financed by matching payables there could be a time gap between inflow and outflow. But the credit given/taken cycle should go on and therefore it is believed that any receivable financing in form of bills proceeds is used more to apply towards -

1) payment to creditors

2) payment to interest and other outgoings.

3) payment of statutory liabilities.

4) profit appropriations like TL instalment payments, interest/dividend payments, etc.

The suggested dilutions would call for close monitoring. The eligible limit viz., demand loan or CC for inventory can continue to be monitored through stock statements and through quarterly/monthly surveillence data.

1) In as much as we obtain a total charge on current assets, We may give up DP based on paid for stock concept.

2) We may quickly evolve a simple cash flow statement to be submitted to monitor inflows/outflows determine cash crunch and cash surplus, end use and diversions, if any. Temporary additional request if any, based on incremental production/sales level or due to stoppage/reduction of suppliers credit or due to sluggishness in receivables collection, etc. or arising out of bunched payment obligations - all these can be taken care of by a properly projected cash budget which can be revised depending upon change in market conditions.

Illustration

A manufacturing unit projecting a sale of Rs.60.00 crores per annum desires to have working capital limit. It is indicated they have the necessary infrastructure, market opportunities to accomplish this. It is further stated that they may need 3 months inventory at all times to ensure steady production.

We need to elicit information in regard to

1) what is inventory/material component out of unit sale

2) what is the percentage of all other costs other than depreciation and non cash payment out of a unit sale.

3) profit margin including depreciation.

4) Credits on purchases/credit extended on sales on average.

It can be reasonably expected that the above information is available from any businessmen say, from a petty trader to a big industrialist. Illustratively, in the instant case, if it is stated

1) material content out of the unit sale is say 60%

2) All costs of production including adminstration and other outgoings 30%

3) Net profit including depreciation, say 10%.

4) a) Credit available on purchases 1 month

b) Credit extended on sales 2 months

5) The working capital assessment will be as below

Core inventory

(1) 60% of the material would mean out of Rs.60.00 crores, sales Rs. 36.00 crores

(2) Monthly average purchase is Rs. 3.00 crores

(3) Monthly average sales is Rs. 5.00 crores

(4) Core inventory desired to be held is 3 months viz., Rs.9.00 crores.

In the normal course, bills limit can be made available upto Rs.3.00 Crores. This limit can be considered upto Rs.7.00 Crores under deserving circumstances provided the need is established for its end use for cash payment in line of credit from suppliers to avail discounts/bunched repayments/sluggish collections/repayment of TL instalments/NCDs/statutory outgo/dividend payments etc.

While in the normal course, the unit will enjoy a line of credit of Rs.12.00 Crores, this can be stretched up to Rs.16 Crores in times of need to achieve a total sale of Rs.60 Crores.

We have already indicated that purchase/discount of eligible bill from a bank is always treated as cash and much depends on its application. If there is surplus arising out of such bill purchase utilisation that would go to reduce creditors level or bring cash credit drawings into credit balance and /or used for repayment of DL in such frequent operating cash predictions so as to seek DL repayment once in 3 months. Therefore this unit may be sanctioned a DL with a stipulation that loan should be closed once in 3 months and avail a fresh one depending upon cash budget.

In fact it will be prudent to have recourse to bill limit as and when demand loan component is due for repayment and use surplus liquidity to ensure interest outgo and as far as possible prolong the availament of next DL till demand for cash liquidity is felt. Bank can also consider extending opening of LCs on DA terms within the creditors level projected. Upon receipt of materials covered under DA LC if the level of creditors exceed the indicated period and also the core current assets desired to be held the quarterly operating limit will undergo a change as there will be excess credit received over extended credit warranting a cut in the eligible/sanctioned limit.

On the contrary, if DA LCC are opened only to cover the projected level of trade creditors which is already reckoned for arriving at the limit, the liability under this DA LC limit will not result in any modification.

1) Problem anticipated in this methodology is with respect of borrowers who wants to avail inventory limit along with book debts. In all such cases, bank must insist on such book debts treated on par with core inventory and bring in the desired margin and also be willing to forgo set off benefits between sundry creditors and sundry debtors and will also be not entitled to any separate bill finance. From our experience, we notice that borrowers do seek bills limit but the limit do not commensurate with the entire credit given. They may therefore seek bill limit to Cover all eligible buyers.

In such cases, they have option to include unfinancned receivables/Book Debts as part of core inventory/current asset and will bave to let the entire trade creditors be deducted before applying the margin to arrive at the eligible limit meant for conversion into DL/operative CC.

It is hoped that former method will be preferred over later as in the later case, periodical book debts realisation do not help liquidation of demand loan.

2. In respect of consortium lending we may adopt the methodology followed by lead bank subject to acceptability and scrutiny.

3. In respect of A+ rated borrowers desirous of using a new flexible approach, we may permit them new suggested method subject to agreeing to submit in addition to QIS data a cash budget.

4. In respect of borrowers enjoying credit facility of Rs.2.00 crores and below, (MLI/TCD/SSI) we may adopt Nayak Committee norms.

5. In respect of SSI Borrowers enjoying credit facility of Rs. 10 lacs & below, in order to increase our exposure to such lower segments ( as per Govt of India / RBI Gudelines ) we may go in for a " Line of Credit" without any bifurcation of limits for presale / Post sale / Small value additions to fixed assets etc..

6. In respect of trade credit borrowers, the basis of lending should be linked to annual sales and size of credit limit in relation to annual turnover.

A trading unit is expected to turnaround working capital limit at least six times a year. Even manufacturing units like SSI, the sales turnover is often 4 times the working capital limit.

The evaluation process should include not only to determine the size of profit but also its adequacy to determine servicing the quarterly interest debit. If for instance, a borrower forecasting a sales turnover of Rs.60.00 crores seek working capital limit of Rs.10.00 crores, the quarterly interest debit will be to the order of Rs.40.00 lacs and annual interest debit will be approximately Rs.1.60 crores. This interest obligation is in addition to meeting all other trading and estbalishment costs. If the projected or indicated profits falls short of this, the limit sought for is not justified. We should also insist on a capital base/long term source towards margin of not less than 3 crores being 5% proportionate margin in terms of Nayak Committee recommendations. Inventory based assessment is not really workable or need be adopted by us. However, for regulating the drawings necessary inventory support will have to be insisted.