credit appraisal for term loan and working capital assessment

A SUMMER TRAINING PROJECT REPORTON “CREDIT APPRAISAL FOR TERM LOAN AND WORKING CAPITAL FINANCING” SUBMITTED UNDER THE PARTIAL FULFILLMENT FOR THE AWARD OF DEGREE OF MASTER IN BUSINESS ADMINISTRATION (2012-2014) UNDER THE GUIDANCE OF: Dr. DIVYA CHOWDHRY FACULTY, RDIAS SUBMITTED BY: TARANDEEP SINGH ENROLLMENT NO:06015903912 BATCH NO:2012-2014 RUKMINI DEVI INSTITUTE OF ADVANCED STUDIES An ISO 9001:2008 Certified institute NAAC Accredited Grade A (Approved by AICTE,HRD Ministry, Govt. of India) Affiliated to Guru Gobind Singh Indraprastha University, Delhi 2A & 2B, Madhuban Chowk, Outer Ring Road,Phase-1,Delhi-110085 CERTIFICATE (From Guide) This is to certify that the project titled “Credit Appraisal For Term Loan & Working Capital Financing ” is an academic work done by “ Tarandeep Singh” submitted in the partial fulfillment of the requirement for the award of the degree of “Master of Business Administration” in Finance from “Rukmini Devi Institute Of Advanced Studies, New Delhi” under my guidance and direction. To the best of my knowledge and belief the data and information presented by him in the project has not been submitted earlier elsewhere. Dr. Divya Chowdhry (Project Guide) RDIAS ACKNOWLEDGEMENT First and foremost I am grateful to the Head of the Organization, Mr. K. R. Kamath, CMD, Head Office, Punjab National Bank for giving me an opportunity to be a part of their esteemed organization and enhance my knowledge by granting permission to complete my SIP under their guidance. I express my sincere gratitude to my company guide Mr. Madhukar Kapoor(Chief Manager, Credit Administrative Division), for rendering me his continuous support, encouragement and guidance and also for lending a patient ear when it came to solving my problems related to the project. The project would not have been possible without his valuable time and support. I humbly thank my faculty project guide; Dr. Divya Chowdhry who provided her valued guidance that helped me to work on this project comprehensively which enabled me to hone my skills. I am deeply indebted to all the faculty members of my institute for their valuable contribution during the academic session. Also I want to acknowledge the support of the staff of the Central Library of the bank for providing with various books and study material relevant in the preparation of the project report. Last but not the least, I would like to thank everyone I was associated with, whose names have remained unmentioned here, but who have contributed by giving me a sharp and gratifying imminent approach and insight during the course of my project. Regards, Tarandeep Singh RDIAS, New Delhi managerial competence and past experience. a decision is taken. Each bank has its own set of policies that must be followed while sanctioning a loan and care must be taken that the money provided by the bank is being used up for the intended purpose only. P&L and Balance sheets. in case for a term loan. With a developing economy and many multinational companies coming up. This process of carrying out the feasibility test of the project based on the financial position of the company is called Project Appraisal. each loan proposals fall under powers of different levels depending on the size of the proposal. Primarily. The project studies the credit appraisal methodology at Punjab National Bank for a proposal received either for term loan or working capital financing or both for Rs.EXECUTIVE SUMMARY This project reflects the role of a financial analyst. appraisal of projected cash flows. Companies that intend to seek credit facilities approach the bank. This project was undertaken at the Punjab National Bank Head Office. at the Credit Administration Department. Punjab National Bank. purpose for which the facility is availed. fund flows. credit is required for following purposes: . new projects are being undertaken. As part of the appraisal process. credit history. This project explains various credit facilities and processes followed by one of the most reputed bank in the country. New Delhi. technical and financial feasibility of the project. The task ranging from acceptance of loan proposal to sanctioning of loan is carried out at Credit Division of the bank. 700 crore or more and where the borrower wants to avail the facility from a consortium of banks. These projects require huge amount of capital and thus banks come forward to finance these projects depending on the feasibility of the project. Financial requirements for Project Finance and Working Capital purposes are taken care of at the Credit Department. The study is undertaken to understand the process of project appraisal for t erm loans and assessment for working capital requirements being followed at PNB. PNB carries out an extensive study of the project and checks for it feasibility and if the project seems to be feasible. credit rating is done for the proposal and is conducted either by the bank itself or is get done by approves external agencies. etc. This includes the evaluation of current financial status. Moreover. Credit appraisal is the process of evaluating a proposal„s worthiness of being provided with the type of credit facility the borrower has asked for. but have simultaneously exposed them to various risks. Non Fund Based Limits like Letter of Guarantee. Term loan for mega projects c. In the liberalized Indian economy. allocation and management of every risk associated with the project. Efficient management of credit portfolio is of utmost importance as it has a tremendous impact on the Banks‟ assets quality & profitability. But lending by nature cannot be an aggressive selling activity. disregarding the risks involved. clientele have a wide choice. The purpose of this project is to explain. analysis. Working capital finance b. retail lending. Bank has to be . the most important is the identification. the manner in which risks are approached by financiers in a project finance transaction. In addition. The newer methods are firmer on risk management front and also the stability of economy in case of any excessive default rate. The project covers the most important aspect of a company. assess the risks. in a brief and general way. one must understand some project financing plans have succeeded while others have failed. Project finance is different from traditional forms of finance because the credit risk associated with the borrower is not as important as in an ordinary loan transaction. Such risk minimization lies at the heart of project finance.competes with corporate lending for funds and for human resources. The ongoing financial reforms have no doubt provided unparalleled opportunities to banks for growth. External Commercial Borrowings and the domestic capital markets compete with banks. Also. lending continues to be a primary function in banking. Letter of Credit etc. Different firms have different approaches to finance their working capital needs to carry out their day to day operations.both personal advances and SME advances. which need to be effectively managed. After receiving proposals for working capital loans. how to prepare the financial plan. Working Capital. design the financing mix. Project Financing discipline includes understanding the rationale for project financing. In another dimension. The RBI and its committees have introduced new methods for the calculation of credit eligibility for the working capital financing of firms.a. as a precaution banks need to assess the amount of working capital loan which can be granted and also to determine the interest rate at which the loan can be provided. and raise the funds. Report ends with the conclusion and recommendations for further refining and strengthening of the credit appraisal process. I appraised a project by a company in sugar industry for the term loan. financial evaluation. a suitable model is chosen and based on financials of the company and the track record of the management. The quality of the Bank‟s credit portfolio has a direct and deep impact on the Bank‟s profitability. To understand the process completely and clearly. Case study shows how the policies and procedures are implemented during the actual appraisal of a loan proposal. Various components of appraisal process viz. Generally. After appraisal.competitive without compromising on the basic integrity of lending. have been explained in detail. . This rating also helps in determining the rate of interest at which the loan should be given. Depending on the type of project. techno-economic evaluation. I compared my findings. analysis and recommendations with those of PNB appraising officers and found out the reasons for discrepancies. The study has been conducted with the purpose of getting in-depth knowledge about the credit appraisal and credit risk management procedure in the organization for the above said first two purposes. risk analysis etc. a company with good ratings is given loan at a lower ROI as the risk involved is lower. rating is done. housing etc and as a part of social duty. The bank takes the . The function of the bank include accepting the deposit from the public and other institutions and then to direct as loans and advance to parties for growth and development of industries. It extends loans for the purpose of education. Government uses it to control the flow of money by managing Cash Reserve Ratio (CRR) and thereby influencing the inflation level.Chapter -1 Introduction Banking industry at a glance Bank is the main confluence that maintains and controls the “flow of money”. some percentage of agricultural sectors as decided by the RBI. deposit at the lower rate of interest and gives loan at the higher rate of interest. The difference in the transaction constitutes the main source of the income for the bank. This is known as Net Interest Margin. Banking in India has undergone starling changes in terms of growth and structure. Organized banking was active in India since the establishment of the General Bank of India in 1786. The Reserve Bank of India (RBI) was established as a central bank in 1995. The imperial bank of India, the biggest Bank at that time, was taken over by the Government to form State owned STATE BANK OF INDIA (SBI). RBI under took an exercise to reduce the fragmentation in the Indian Banking Industry post independence by merging weaker banks with stronger banks. The total number of banks reduced from 566 in 1951 to 85 in 1969. With the objective of reaching out to the masses and servicing credit needs of all sections of people, the government nationalized 14 large banks in 1969. This period saw the enormous growth in the number of branches and Banks branch network become wide enough to reach the weaker section of the society in a vast country like INDIA. Major Banking Operations The main operations of a bank can be segregated into three main areas: (i) (ii) (iii) Balancing Profitability with Liquidity Management Management of Reserves Creation of Credit. Main Operations of a Bank Operations of Bank Balancing Profitability with Liquidity Management Management of Reserves Creation of Credit Balancing Profitability with Liquidity Management Banks are commercial concerns which provide various financial services to customers in return for payments in one form or another, such as interest, discount fees, commission etc. Their objective is to make profits. However, what distinguishes them from other business concerns is the degree to which they have to balance the principle of profit maximization with certain other principles. Banks in general have to pay much more attention in balancing the profitability with liquidity. Therefore, they have to devote considerable attention to liquidity management. Banks deal in other people‟s money, a substantial part of which is repayable on demand. That is why, for banks unlike other business concerns liquidity management is as important as profitability management. Management of Reserves Banks are expected to hold voluntarily a part of their deposits in the form of ready cash which is known as cash reserves and the ratio of cash reserves to deposits is known as Cash Reserve Ratio (CRR). The Central Bank in every country is empowered to prescribe the reserve ratio that all banks must maintain. The Central Bank also undertakes as the lender of last resort, to supply reserves to banks in times of genuine difficulties. Since the banks are required to maintain a fraction of their deposit liabilities as reserves, the modern banking system is also known as the fractional reserve banking. Creation of Credit Unlike other financial institutions, banks are not merely financial intermediaries but “they can create as well as transfer money”. Banks are set to create deposits or credit or money or it can be said that every loan given by bank creates a deposit. This has given rose to the concept of deposit multiplier or credit multiplier. The importance of this is that banks add to the money supply in the economy and hence, banks become responsible in a major way for changes in the economic activities. Structure of Banking Industry Scheduled banks Scheduled commercial Banks Scheduled cooperative Banks Public sector banks Regional rural Banks Foreign Banks Private sector Banks Urban Cooperative Banks State cooperative Banks SBI & its subsidiaries Nationalized Banks Old private sector Banks New private sector Banks COMPANY PROFILE Punjab National Bank (PNB) VISION use latest technology aimed at customer satisfaction and act as an effective catalyst for socio-economic development. PUNJAB NATIONAL BANK Established in 1895 at Lahore. Category – Banking Services. cost effective and customer friendly institution providing comprehensive financial and related services. Now its headquarter is at Delhi. The bank has the largest branch network In India. London. Punjab National Bank (PNB) has the distinction of being the first Indian bank to have been started solely with Indian capital. . with 5100+ branches across 764 cities and serves over 63 million customers. It was founded by Lala Lajpat Rai. Parent company – Government of India. cost effective and customer friendly institution providing comprehensive financial institution providing : To evolve and position the Bank as a world class progressive. USP – Punjab national bank if one of big four banks of India. integrating frontiers of technology and serving various segments of society especially the weaker sections. MISSION To provide excellent professional services and improve its position as a leader in the field of financial and related services. PNB was ranked as 515th biggest bank in the world by Bankers Almanac. The bank was nationalized in July 1969 along with 13 other banks. committed to excellence in serving the public and also excelling in corporate values. Today. PNB is a professionally managed bank with a successful track record over 110 years. build and maintain a team of motivated and committed workforce with high work ethos. Sector – Banking and Finance. Tag line – The name you can bank upon.To evolve and position the Bank as a world class progressive. This has positive impact on productivity indicators with business per employee increasing to Rs. Business per branch increased to Rs.154.94 lakh crore with 21. Total deposits have touched Rs. 2013 registering a YoY growth of 21.18 105 5.000 crore.5 32 bps Bank has also done well in profitability parameters viz.6.129 crore are the highest among all the Nationalized Banks. The Bank‟s CASA deposits at Rs.32 crore. Earnings per share also increased to Rs. Business Parameters (Rs.3 21.2. Net advances are around Rs.28 673363 379588 293775 134129 11.11.3 21.116 crore.2 10.414 crore during FY‟12 has been the highest among all the Nationalized Banks.3.80 lakh crore recording YoY increase of 21. Crore) .5 11. 10. Profit Parameters (Rs.3 11.3% YoY growth. culminating in improving the share of bank in the system by 32 bps to 5. Net Interest Income at over Rs.02 during the FY‟13. PNB is the first Nationalized Bank to cross Operating Profit of Rs.60% in March 2012. Net interest Margin remains the best (at 3.32 116 5.Financial Performance (2012-2013) The Bank‟s business crossed Rs.1.73 lakh crore as on March 31.3%. Operating profit and Net Income in absolute terms.3%.84% for FY 2012) once again among all the Peer Banks. 34.60 Y-o-Y (%) 21.13. Crore) PARAMETERS Total Business Total Deposits Net advances CASA deposits Business per employee Business per branch Deposit Market Share(%) Source: Annual results 2013 Mar-12 Mar-13 555005 312899 242107 120325 10. PARAMETERS Operating Profit Net Profit Net Intt Income Source: Annual results 2013 Mar-12 Mar-13 9056 4433 11807 10614 4884 13414 Y-o-Y (%) 17.6 Organization structure: PNB The bank has its corporate office at New Delhi and supervises 65 circle offices under which branches function.2 13.2 10. The delegation of powers is decentralized up to the branch level to . ..... CMD ED GM(Credit) GM(NPA & weak account) GM(Retail & lending) GM(Treasury ) GM(Deposits) GM(Audit) DGM DGM DGM DGM ......facilitate quick Board of Director decision making. FUNCTIONAL HEAD CMD – Chief Managing Director ED – Executive Director GM – General Manager AGM – Assistant General Manager DGM – Deputy General Manager Channels in PNB .. AGM AGM AGM .. Social Banking 6. Corporate Banking VARIOUS TYPES OF LOAN PROVIDED BY PNB 1. Large Industry . Current Account 3. MSME Manufacturing b. Agriculture PRODUCT AND SERVICES 1. Industry a. Savings Account 2. Credit Scheme 5. Agriculture & Allied Activity 2. Fixed Deposits Scheme 4.Corporate Office (HO) Circle Office(CO) Circle Office(CO) Circle Office(CO) Branch Office(BO) Large Corporate Branches Mid Corporate Branches Retail Hub Specialized Branches eg. Real estate 5. Retail Loans of which a. Services and Others AREAS OF CONCERN FOR PNB FOR CURRENT YEAR      Loss of Number One position in Deposits. 4. Wealth management products sales be maximized offering full range e. immediately targeting freshly slipped accounts. Lack of uniform growth in business of various Circles/Branches. Net Profit and Return on Equity. Uncontrollable growth in NPA‟s.. Dependence on high cost deposits to shore up the deposits base. Gold coins to Insurance. Comm.3. Housing b. Monitoring of Irregular Accounts be stepped up to prevent Slippages. Large Corporate Branches(LCB) and Head Office(HO). THE ACTION POINTS FOR THE CURRENT YEAR AREAS OF CONCERN DISCUSSED ABOVE      Focus on CASA: Sustainable growth in savings Deposits by offering wealth management services to the customers. Business value base current accounts be opened Retail credit especially the housing loans be marketed aggressively to record high growth. NPA reduction by one on one meetings. . CAD looks after the proposal for all type of loans which fall within the preview of GM‟s-HO/ED/CMD/MC/Board. Lead over the immediate competitor getting reduced to Rs. Mid Corporate Branches(MCB). Other Retail Loans – car loan.g. housing loan. 1115 crore. CREDIT ADMINISTRATION DIVISION (CAD) Commercial lending organization structure in PNB consists of branches. personal loan etc. Any proposal greater than Rs. ED has authority to approve loan proposals less than Rs. settlement and other financial transactions. RISK MANAGEMENT DEPARTMENT (RMD) The credit administration division is assisted by RMD and industry desk for risk analysis and technical feasibility of credit proposals. Credit Risk management structure at PNB involves  Integrated Risk Management Division (IRMD) IRMD frames policies related to credit risk and develops systems and models for identifying.  Circle Risk Management Departments (CRMDs) Risk Management Departments at circle level are known as CRMD. .“Credit risk” is the possibility of loss associated with changes in the credit quality of the borrowers or counter parties. procedure and limits are reported in a timely manner to the appropriate level of management for action. losses stem from outright default due to inability or unwillingness of a borrower or counter party to honour commitments in relation to lending. besides assisting the respective Credit Committee in addressing the issues on risk. CAD at Head Office prepares finals proposals which are then placed before ED. tracking down the health of the borrower‟s accounts through regular risk rating. 4. CMD approve proposals betwee Rs. measuring and managing credit risks. Loan proposals less than 35cr are dealt by MCB and LCB at their level and all other proposals are reffered to Circle Office which are finally handled at Head Office. MCB handle proposals between Rs. 2.Credit proposal goes through different level of sanctioning to enforce internal control and other practices to ensure that exception to policies.5 crore and Rs.100 Crore need the approval of management committee. CMD.25 crore. Their responsibilities include monitoring and initiating steps to improve the quality of the credit portfolio of the Circle. It also monitors and manages industry risks.75 crore.75 crore and Rs. In a bank‟s portfolio.100 crore. or MC as per the quantum of proposals. 3. PNB has an elaborate risk management structure in place. Authority to handle loan proposals is distributed as detailed below: 1. Credit.  Credit Risk Management Committee (CRMC) It is a top level functional committee headed by CMD and comprises of EDs. the bank has developed and placed on central server score based rating models in respect of retail banking. optimizing the return by striking a balance between the risk and the return on assets and striving towards improving market share to maximize shareholder‟s value. Financial evaluation (40%) . The bank has robust credit risk framework and has already placed credit risk rating models on central server based system “PNB TRAC”. Taking a step further during the year.  Credit Audit Review Division (CARD) It independently conducts Loan Reviews/Audits. These processes have helped the bank to achieve fast & accurate delivery of credit. emphasizing more on the promising industries. Risk Management Committee (RMC) It is a sub-committee of Board with responsibility of formulating policies/procedures and managing all the risks. processes and procedures in place. RMD provides the risk ratings for the client and project based in the patented internal models of the PNB that have been developed based on statistical analysis of data. CGMs/GMs of Risk Management. bring uniformity in the system and facilitate storage ofdata & analysis thereof. The analysis also involves analysing the projections for the future years. Treasury etc. which provides a scientific method for assessing credit risk rating of a client. This credit risk rating captures risk factors under four areas: 1. These models are placed on central server based system „PNB TRAC‟. as per the directives of RBI. The risk management philosophy & policy of the bank focuses reducing exposure to high risk areas. which provides facility to assess credit risk rating of a client. For the appraisal of the loan proposals. RISK ANALYSIS PNB has elaborate risk management structure. 2. ICRA Factors determining credit risk:       State of economy Wide swing in commodity prices Fluctuations in foreign exchange rates and interest rates Trade restrictions Economic sanctions Government policies Cumulative weighted score is calculated and rating of the project/company is ascertained as per the chart below: . Business or industry evaluation (30%) 3. FITCH 4. CIBIL 2. CARE 3. Conduct of account (10%) Various External Credit Agencies in India: 1. Management evaluation (20%) 4. CREDIT FACILITIES PNB provides different types of credit facilities according to the banking norms and convenience of the clients. government securities approved shares and/or . FUND BASED FACILITIES Fund based facilities are those that require immediate outlay of funds towards the borrowing party. Different types of facilities provided are classified below: 1. a) Overdraft Overdraft account is treated as current accounts. Normally overdrafts are allowed against the Bank‟s own deposit. life insurance policies. approved shares and/or debentures of companies. d) Bill finance Bill finance are the advances against the inland bills are sanctioned in the form of limits for purchase of bills or discount of bills or bills sent for collection. Income is in the form of fees and commissions as compared to interest income in case of fund based lending. Bills are either payable on demand of after usage period. b) Demand loans Demand loan would be a loan. government securities. cash incentive and duty drawbacks. pledge of gold/silver ornaments.debentures of companies. bullet repayment. NON FUND BASED FACILITIES While fund based credit facilities require immediate outlay of funds from the bank. . which is payable on demand in one shot i. personal security etc. The borrowing clients of banks prefer to avail of the non-fund based facilities mainly because: a) The facility does not require immediate outlay of funds and therefore the cost of such funds tend to be lower than the cost of fund based credit facilities. demand loans are allowed against the bank‟s own deposits. In cash credit accounts the borrower is allowed to draw on account within the prescribed limit as and when required. The non-fund based business is one of the main sources of bank income.e. mortgage of immovable property. government supply bills. Normally. 2. Non fund based credit plays an important role in trade and commerce. c) Cash credit advances Cash credit account is a drawing account against the credit granted by the bank and is operated in exactly the same way as a current account on which an overdraft has been sanctioned. nonfund based facilities basically include the promises made by banks in favor of third party to provide monetary compensation on behalf of their client if certain situations emerge or certain conditions are fulfilled. life insurance policies. While in BG. (i) Bank Guarantees BG may be financial of performance in nature. Canara bank . the issuing bank assumes an usual credit risk which is the domain of the banks. It is an undertaking issued by bank on behalf of the buyer to the seller. (ii) Letter of credit A document issued by a bank that guarantees the payment of a customer‟s draft. the issuing bank and the confirming bank. Andhra Bank 3. comes into play only when the principal party (the buyer) has failed to pay its supplier. and for the seller to invoke the undertaking. Competition Information 1. All letters of credit are irrevocable. In a financial guarantee.b) A bank guarantee(BG) or letter of credit(LOC) issued by a bank on behalf of its client is an off-balance sheet item in the books of clients. if any. to pay for the goods and services. the issuing bank does not wait for the buyer to default. hence do not show up as debt or liability. i. cost of providing non-fund based facilities is significantly lower than the cost of providing fund-based facilities. substitutes the bank‟s credit. For the lending banks. Indian bank 2. It is different from BG in the sense that in case of LOC. issue of a performance guarantee involved technical competency and managerial ability of a customer to ensure the performance of the contract for which guarantee has been drawn. However.e. cannot be amended or canceled without prior agreement of the beneficiary. So proper appraisal needs to be done before issuing BG as it is the responsibility of the issuing bank to honor its guarantee when invoked. Issuing bank‟s responsibility against the BG is absolute. SBI SWOT Analysis of PNB Strengths 1. . 3. Opportunities 1. T support with “best fit” approach. Schemes for small and medium scale businesses. Highly competitive environment. Diversified operations with 5100 branches.4.000+ workforce serves over 37 million customers. Small scale business banking across India. Installation of more ATM‟s and better customers‟ services. 3. Legal issues regarding employees caused a bad name of PNB. Its 56. Less penetration in the urban areas. Inadequate advertising and branding as compared to other banks. 4. 2. 2. HDFC Bank 6. 3. 2. Strong I. Expansion in other countries for international banking. 3. ICICI Bank 5. Stringent Banking Norms by the RBI and the Governments. Threats 1. It is the second largest state-owned commercial bank in India with about 5000 branches across 764 cities. 5. 2. Economic crisis and economic fluctuations. Weakness 1. 1. emphasized the need for management of working capital accounts and warned that it could vitally affect the health of the company.Chapter-2 Literature Review & Conceptual Discussion REVIEW OF LITERATURE 1. Sagan in his paper (1955). He discussed mainly the role and functions of money manager inefficient working capital management. WORKING CAPITAL 1. Sagan pointed out . perhaps the first theoretical paper on the theory of working capital management. He realized the need to build up a theory of working capital management. 3 management. Walker formulated three following propositions:  Proposition I─ If the amount of working capital is to fixed capital. the amount of risk the firm assumes is also varied and the opportunities for gain or loss are increased. They suggested that short-term debt should be used in place of long-term debt whenever their use would lower the average cost of capital to the firm. though partially. Thus. On the basis of this observation. receivables and payables because all these accounts affect cash position. They suggested that a business would hold short-term marketable securities only if there were excess funds after meeting short-term debt obligations. . They further suggested that current assets holding should be expanded to the point where marginal returns on increase in these assets would just equal the cost of capital required to finance such increases. He suggested that money manager should take his decisions on the basis of cash budget and total current assets position rather than on the basis of traditional working capital ratios. Sagan concentrated mainly on cash component of working capital. Walkerstudied the effect of the change in the level of working capital on the rate of return in nine industries for the year 1961 and found the relationship between the level of working capital and the rate of return to be negative. the greater the risk and vice-versa.2. 1.  Proposition III─ The greater the disparity between the maturities of a firm‟s debt instruments and its flow of internally generated funds. Weston and Brigham (1972) further extended the second proposition suggested by Walker by dividing debt into long-term debt and short-term debt. This is important because efficient money manager can avoid borrowing from outside even when his net working capital position is low.3.  Proposition II─ The type of capital (debt or equity) used to finance w orking capital directly affects the amount of risk that a firm assumes as well as the opportunities for gain or loss. 1. money manager must be familiar with what is being done with the control of inventories.the money manager‟s operations were primarily in the area of cash flows generated in the course of business transactions. Walker (1964) made a pioneering effort to develop a theory of working capital management by empirically testing. However. 61indicating the need for effective management of current assets. Ltd. for the years 1970 and 1971. cash working capital requirements were more in beginning years and then started reducing in the later years as compared to conventional working capital indicating the attempts to better manage the working capital. and Madura Mills.5. would be adversely affected by excessive working capital. He calculated required cash working capital by applying OC concept and compared it with cash from balance sheet data to find out the adequacy of working capital in Union Carbide Ltd. Chakraborty emphasized the usefulness of OC concept in the determination of future cash requirements on the basis of estimated sales and costs by internal staff of the firm. Abramovitz (1950) and Modigliani (1957) highlighted the impact of capacity utilization on inventory investment.. is postulated to be negatively related with the desired stock. Keen and Williams Ltd. existing stock of inventories. and Guest. Co.4. He emphasized that working capital is the fund to pay all the operating expenses of running a business. For Union Carrbide Ltd. too little working capital might reduce the earning capacity of the fixed capital employed over the succeeding periods. Thus the variable. OC . He extended the analysis to four companies over the period 1965-69 in 1974 study. The study revealed that cash working capital requirement were less than average working capital as per balance sheet for Hindustan Lever Ltd. Cash working capital requirements of Dunlop and Madura Mills were more than average balance sheet working capital for all year‟s efficient employment of resources. Similarly. Chakraborty (1973)approached working capital as a segment of capital employed rather than a mere cover for creditors. The ratio of inventory to sales may affect inventory investment positively because a high ratio of stocks to sales in the past suggests the maintenance of high levels of inventories in the past and thus also calling for high investment in inventories in the current period. an aggregate measure of overall efficiency in running a business.1. he applied Operating Cycle (OC) Concept. Existing stock of inventories is expected to take account of adjustment process to the desired levels. He pointed out that return on capital employed. For knowing the appropriateness of working capital amount. 1. The Saraiya Commission also suggested the formation of credit information bureaus on the lines of those prevalent in the US and the UK. CREDIT RISK 2. Apart from all the above steps.2. "the grant of credit is a business which involves a risk of increasing bad debts if proper care is not taken and banks therefore ascertain the creditworthiness of borrowers from time to time and maintain credit reports on them. whichever are higher. The sanctioned limits or outstanding. 3. 2. 2. scrutiny of the applications. COMPLIANCE TO EXPOSURE NORMS Exposure includes credit exposure (funded and non-funded credit limits) and investment exposure (including underwriting and similar commitments) as well as certain types of investments in companies. In India in 1962. assessment of creditworthiness and sanctions of limits by the branch manager or higher authority as well as the follow-up actions on the advances after they have been granted. banks constantly keep a check on the customers by obtaining information from all the other sources pertaining to their customers in any form. a Credit Information Division was established in RBI with the view of collection of information from banks and other financial institutions regarding data relating to the prescribed limits sanctioned by RBI even the RBI Act was amended into 1962 given powers to collect information in regard to credit facilities granted by individual banks and notified financial institutions to their constituents and to supply to these banks and institutions on application the relative information in a consolidated form. non-fund based exposure is calculated at 100% of the limits or outstanding. whichever are higher. Further. shall be reckoned for arriving at exposure limit. According to the Saraiya Commission.1. The modern rating system dates back to 1909 when John Moody started rating US railroad bonds. .concept can also be successfully employed by banks to assess the working capital needs of the borrowers. The process of grant of credit by banks comprise in the filing in of applications by the borrowers. These limits shall be reviewed on the basis of data analysis regularly. Fluctuating component is the portion above this level that is continuously changing due to changes in demand. technology employed and the level of quality control. nature of industry and its importance in economy as well as internal factors like level and trend of asset impairment.Maximum industry exposure  The bank has developed a model for fixation of industry wise credit exposure ceilings. This would be constantly tied up in the business with changes in sales and activity level. exposure level and quality of exposure in the industry. it is provided that the monitoring against such limits would be based on actual outstanding. Working capital requirements depend on various business specific internal factors like operating efficiency. WORKING CAPITAL LOANS Working capital refers to the current assets holdings of the firm. Net working capital is the difference between current assets and current liabilities. As the ceilings proposed are internal ceilings to achieve diversified growth of portfolio and reduce portfolio concentration. This model provides scientific assessment and corresponding exposure ceiling level to an industry. The model captures external factors like rating of industry by external agency. Fluctuating component is financed mainly by availing the short term loans and other credit facilities from the bank. seasonality of product etc. A manufacturing enterprise has to maintain level of inventory at any point of time below which production could get impacted. This minimum level of current asset is called Core Current Asset level. Main focus here is to avoid overfunding or . Businesses finance permanent core component through long-term sources of fund like equity or long term loans. for each customer up to which the customer can borrow money against the security of tangible assets or guarantees. The Fund based limits should not exceed MPBF in any case. Non-Fund Based Working Capital (NFBWC) – actual fund flow does not take place. at the same time under funding would seriously hamper the day-to-day operations and pose a threat to the survival of the business.Cash credit is the most popular credit system adopted in India and accounts for more than 70%of total bank credit. While overfunding will amount to locking up of assets unproductively as idling cash or inventories. Working capital loan is of two types: A. Letter of Credit (LC). Eg. Under this system. Hence it is critical to correctly determine the maximum bank finance that should be provided. Bank Guarantee (BG) etc. 1.underfunding of the operations. Types of Lending (Fund based and Non-Fund based limits) After arriving at MPBF on the basis of current assets and current liabilities and appropriate method of lending.1 Fund Based Limits The inventory limits are set up in the shape of Cash Credit. To avoid situations wherein customers seeking excessive cash credit limit. The receivable limit either by way of C/C against book debts or by way of bills limit. The borrower is charged on the actual amount and tenure of the amount utilized. These nominal charges are . Under this system. 1. The customer can withdraw money when he needs funds and deposit any amount of money that he finds surplus with him. B. In NFB earnings are in form of commission. called the cash credit limit. In FB earnings are in form of interest. banks charge a nominal fees on the unutilized amount of cash credit limit. Eg. Fund Based Working Capital (FBWC) – include those where actual funds are proposed to be given. Cash Credit (CC). banker specifies a limit. banks prescribe the cash credit limit for each of their customer on annual basis. Packing Credit (PC) etc. various Fund based and Non Fund based Limits have to be decided. Within the sanctioned limit. This company takes cash credit advances from the bank. a company ABC Ltd. Financing Fund Based Requirements An exporter may require credit facilities for completion of export contracts at two stages: A. Pre-shipment finance can be broadly classified into the following: •Packing Credit •Advance against Duty drawback entitlements •Packing Credit in foreign currency (PCFC) B. The concept of Drawing Power is explained as under: Take for an example. which does not use any Non fund based facilities. Pre Shipment (Packaging credit) Pre Shipment credit means any loan/advance granted by a bank to an exporter for financing the purchase. Post shipment credit facilities are as follows:    Export Bills purchased/discounted/negotiated Advances against bills for collection Advances against duty drawback receivables from government . This cash credit limit is calculated using the value of current assets and current liabilities of the company. processing. Post Shipment Post Shipment credit means any loan/advance granted by a lending bank to an exporter of goods from India from the date of extending credit after shipment of goods to the date of realisation of exports proceeds. manufacturing or packing of goods prior to shipment on the basis of letter of credit opened in his favour by an overseas buyer.known as “commitment charges”. Drawing Power may be allowed on the basis of value of security. Therefore.1 Guarantees Sec 126 of Indian Contract Act defines guarantee as a contract to perform the promise of discharge the liability of a third person in case of default. excise duties.  Performance Guarantee: Under this head. (ii) LG issued towards disputed liabilities. who gives the guarantee (b)Principal debtor: Person on whose behalf guarantee is given (c)Creditor: the person to whom guarantee is given (Beneficiary of LG) Types of Guarantees:  Financial Guarantee: In financial guarantee . o Securing Advance payment / in lieu of security money deposit. o Performance of plant and machinery up to agree level.2 Non fund based Limits The credit facilities given by the banks where actual bank funds are not involved are termed as 'non fund based facilities'.” Parties to a Guarantee: (a)Surety (Guarantor): Person. Term loan involves payment in cash whereas in the deferred payment guarantee. (1) LG for payment of determined liabilities towards tax. e. the Bank commits to pay the beneficiary in case of default made by its customer (purchaser). These facilities are divided in three broad categories as under: 1. custom duties octroi etc. earnest money deposit/ tender deposit/ Bid bonds  Deferred Payment Guarantee (DPG): Like term loans. the issuance of deferred payment guarantees should be treated at par with the grant . the need to pay LG amount will arise only in the event of non-performance of the contractual obligation.1.g. deferred payment guarantees are also given for acquisition of fixed assets. o Performance related to supply of goods/ materials. In these cases the LGs are issued in Lieu of Financial transactions. For example – performance with regard to construction of building installation of plant & machinery. the LGs are issued mostly to secure performance of the contracts. the guarantor is undertaking to pay damages in monetary terms on the happening of some defaults.2. The Buyer – (Applicant for L/C) – issuing bank at his request and instructions opens the L/C. The Bank executes a guarantee deed on behalf of the customer (Purchaser) in favor of the manufacturer/supplier/financial institution. a type of non-fund based facility which enables the companies to purchase raw materials or other components at credit and paying them later.of term loans and the proposals for the two should be examined in the same manner. Issuing or Opening Bank – is the bank which opens/issues the L/C at the request of applicant (buyer) and undertakes to pay/ to accept bill drawn by the beneficiary. 1. He has liability to pay the issuing bank for the drafts drawn under the L/C. LC is a letter issued by the bank on behalf of the customers. The proposal for issuances of a deferred payment guarantee can be entertained in either of the following two ways: 1. Main parties to documentary credit: a. The Seller– (Beneficiary of L/C) – is in whose favour the L/C is opened and to whom the L/C is addressed. b. . The bank charges a particular fee from the customers for opening of an LC and at a suitable rate of interest. Beneficiary is entitled to obtain payment under L/C. OR 2. c. The Bank accepts/co-accepts usance bill on behalf of its customer (purchaser) drawn by manufacturer/supplier. In simple language.2. Letter of credit is issued by the bank at the request of the customer in favour of a third party informing him that the bank undertakes to accept the bills drawn on its costumer up to the amount stated in the LC subject to the fulfilment of conditions stipulated therein.2 Letter of Credit(L/C) Bank also provides companies with the facility of letter of credit. An industry will require funds to acquire “fixed assets” like land and building. Advising Bank – is the intermediary bank. equipment. e. i. f. Negotiating Bank – is a bank to whom the seller is supposed to submit the documents for negotiation and get the payment as per the drawn bill. Confirming bank – Confirming Bank is a bank that may be requested by the issuing bank to add its confirmation. Each business unit has an operating cycle which can be illustrated below: . vehicles etc. the bank becomes a party to L/C and undertakes the responsibility to honor the bills. g. Advising Bank undertakes the responsibility of providing the authenticity of L/C. to accept or to negotiate the same. Generally the Advising Bank is asked to add confirmation to L/C. to pay. Reimbursing Bank – is a bank who is authorized by issuing bank (normally one of its correspondent banks) to reimburse the paying or negotiating bank. If agreed to. advises the Letter of Credit to the beneficiary.. as the fund required carrying the required levels of current assets to enable the unit to carry on its operations at the expected levels uninterruptedly. Working Capital Assessment The objective of running any industry is earning profits. and also to run the business i.e. its day to day operations.d.e. plant and machinery.Working capital is defined. Production and Sales). Nayak. 2. Deputy Governor to examine the difficulties confronting the small scale industries (SSI) in the country in the matter of securing finance.This cycle continues and in order to keep the operating cycle going on. Working capital loan is of two types: 1. . Bank Guarantee (BG) etc. certain level of current assets are requires. In FB earnings are in form of interest. Non-Fund Based Working Capital (NFBWC) – actual fund flow does not take place. In NFB earnings are in form of commission. various problems. Assessment of Working Capital Limits (Fund based) How much Working Capital loan should be given to the borrower is determined by evaluating the Working Capital Requirement and the Assessed Bank Finance (ABF). The representative of the SSI associations had earlier placed before the Governor. product. a Committee under the Chairmanship of Shri P. level of operations i. 2. production program. Eg. Eg. issues and the difficulties which the SSI sector had been facing. Reserve Bank of India. The volume of activity (viz.e. and the materials and marketing mix. Packing Credit (PC) etc. working capital required (WCR) is dependent on: 1. the total of which gives the amount of total working capital required. The activity carried on viz. Simplified Turnover Method/Nayak Committee: The Reserve Bank of India constituted on 9 December 1991. Cash Credit (CC). manufacturing process. This is done by 3 methods: A. Thus.R. Letter of Credit (LC). Fund Based Working Capital (FBWC) – include those where actual funds are proposed to be given. So for SSI with annual sales of less than Rs 1000 Cr the working capital requirement was set to 25% of the annual sales out of which 20% would be financed by the Banks and the rest 5% would be contributor‟s margin. The CMA is prepared by both the company as well as the bank. Bank Guarantee. MPBF is assessed by using the method recommended by Chore Committee. A profitable firm may have negative operative cash flows. recommended radical changes in the system of bank lending. Thus fund flow and cash flow analysis helps the bankers to check the sources of inflow and points of outflow. Besides shifting the basis of bank lending from the erstwhile security-oriented system to a production oriented one. Packing Credit. it also recommended certain norms . However. Preparation of CMA data forms an integral part of CAD and it is based on this data that the further steps are taken. The Study Group to frame guidelines for follow up of Bank Credit (commonly referred to as the Tandon Committee) set up in July 1974. Letter of Credit. CMA consists of six Forms and they are:  FORM – I: Break up of facility: This form give details regarding the different forms in which credit has been asked by company such as Cash Credit.B. etc. FORM – V: Maximum permissible bank finance: This forms will show how much loan bank is eligible to give to company. Traditional Method/Tandon Committee/Chore Committee: In PNB. Here we explain the preparation of CMA data using a balance sheet of SAP TELECOM Ltd. The bank uses the CMA prepared by the company to analyse the correctness of the working capital requirements and understand its validity. FORM – VI: Fund flow statement: Many companies do window dressing in their financial statements and fudge with their accounting figures.     FORM – III: Analysis of Balance sheet: This helps bankers to assess the financial health of an entity on date of documentation of the business entity FORM – IV: Comparative Statement of Current assets and current liabilities: This form explains the operating cycle of the company.  FORM – II: Operating statement or Profit and Loss statement: This help banker to know about the expenses and tells about the expenses and income generated during the year. it must be noted that the entire CMA data is prepared using the balance sheet of the company and certain other documents submitted by the company to the banks. The Committee also suggested three ways to assess the maximum permissible level of bank finance (MPBF). at the same time. CMA data is provided by the company in a prescribed format. It. The Tandon Committee suggested norms for 15 major industries (norms have since been finalized for 45 industries) on the basis of various studies conducted earlier discussions with the representatives of industry. These norms represent the maximum levels for holding inventory and receivables in each industry for the purpose of sanctioning shortterm credit limits to supplement the borrowing unit‟s own resources to carry an acceptable level of current assets. This CMA data involves the analysis of balance sheet in order to find out the working capital requirements of the company and the maximum amount of permissible bank finance.to facilitate meeting the genuine credit needs of industry while. preventing pre-emption of scarce bank resources by the large industry. Hence for Working Capital limit of greater than Rs 5 Cr the Maximum Permissible Bank Finance (MPBF) is calculated to assess the Assessed Bank Finance (ABF) and the contributor‟s margin. banks are to finance the level of current assets on the basis of such reduced levels of holding unless warranted otherwise. These are: I. a borrowing unit has managed with lower levels of inventory and receivables in the past. however. 1st Method of lending (Tondon Committee) Total Current Assets (TCA) Less: Other Current Liability (OCL) Working Capital Gap (WCG) Minimum stipulated NWC is 25% of the WCG Actual/Projected NWC WCG – (1) WCG – (2) (1) (2) (3) (4) . This method is the most widely used method and requires a great deal of understanding in order to prepare a CMA data of the company. Maximum permissible Bank Finance is Minimum of (3) or (4) Margin is (1) or (2) whichever is more 2nd Method of lending (Chore Committee) II. Total Current Assets (TCA) Less: Other Current Liability (OCL) Working Capital Gap (WCG) Minimum stipulated NWC is 25% of the TCA Actual/Projected NWC WCG – (1) WCG – (2) (1) (2) (3) (4) Maximum permissible Bank Finance is Minimum of (3) or (4) Margin is (1) or (2) whichever is more & CR will be =1. Chargeable Current Assets (CCA) Add: Other Current Assets (OCA) Total Current Assets (TCA) Less: Other Current Liability (OCL) Working Capital Gap (WCG) Minimum stipulated NWC is 25% of CCA Actual/Projected NWC WCG – (1) WCG – (2) (1) (2) (3) (4) Maximum permissible Bank Finance is Minimum of (3) or (4) Margin is (1) or (2) whichever is more (However this method is not into use) .33 or more 3rd method of lending III. Non-Transferable LC . These facilities are divided in three broad categories as under: A. Woolens etc. 2) Delivery against acceptance (DA) – USANCE: the borrower pays after certain due date of payment specified. a cash budget is estimated for the next 12 months. It contains a written undertaking given by the bank on behalf of the purchaser to the seller to make payment of a stated amount on presentation of stipulated documents and fulfillment of all the terms and conditions incorporated therein.Inland Letter of Credit (ILC) . Letters of credit Letter of credit (LC) is a method of settlement of payment of a trade transaction and is widely used to finance purchase of machinery and raw material etc.Transferable LC . The cash requirements for each month are calculated and the highest value of cash required during any month becomes the working capital of the company. Letter of credit is of two types: 1) Delivery against payment (DP) – SIGHT: The beneficiary is paid as soon as the paying bank or borrower‟s bank has determined that all necessary documents are in order. Assessment of Working Capital (Non-Fund Based) The credit facilities given by the banks where actual bank funds are not involved are termed as Non-Fund based facilities. cotton textiles and where sales is seasonal like AC.C.Foreign Letter of Credit (FLC) Letter of Credit: . which is used specially for industries where seasonality is involved like availability of raw materials is seasonal such as sugar industry. Cash Budget System: Cash Budget method. In this method. LC involves three types of pricing = Basic Cost (C) + Insurance (I) + Freight (F) Further LC is categorized in various type which are: Letter of Credit: . 2) Performance guarantees – Guarantees for due performance of a contact by customers.Revocable LC .Irrevocable LC Assessment of LC limit Annual Raw Material Consumption Annual Raw Material Procurement (through ILC/FLC) Monthly Consumption Usance Lead Time Total Time [(d) + (e)] LC limit required [(f) x (c)] (LC limit recommended) (a) (b) (c) (d) (e) (f) B. Bank provides guarantee facilities to its customers who may require these facilities for various purposes.Letter of Credit: . Guarantees A contract of guarantee can be defined as a contract to perform the promise. Assessment of BG limit Outstanding BG as per Audited Balance Sheet . or discharge the liability of a third person in case of his default. The guarantees may broadly be divided in two categories as under : 1) Financial guarantees – Guarantees to discharge financial obligations to the customers. Deferred Payment Guarantees DPG is a bank facility where the bank does not directly extend a loan. it extends a guarantee to the seller on behalf of its client that the financing extended by the seller (by himself or through its preferred financer) would be repaid as per the terms agreed upon. the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. Company has to maintain a current ratio of 1. Instead. D. . While this shows the company is not in good financial health. Key Working Capital Ratios:  Current Ratio:A liquidity ratio that measures a company's ability to pay short-term obligations. The advantage to the buyer here is that he benefits to the extent of savings in interest charges accruing on account of opting for equipment financing under installment payment system less the guarantee charges paid to the bank.The higher the current ratio. Bills Co acceptance Bills co-acceptance is same as Letter of credit the difference is in Bills co-acceptance LC is accepted by buyer as well as by co-accepting bank.33:1.Add: BGs required during the period Less: Estimated maturity/cancellation of BGs during the period Requirement of BGs(Recommended BG limit) C.  Debt Equity Ratio:Represent the ratio between capital invested by the owners and the funds provided by lenders..e. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. non-saleable or waste. Quick ratio is effective in case stocks are obsolete.. Too much debt can put your business at risk. but too little debt may mean you are not realizing the full potential of your business and may actually hurt your overall profitability. Quick Ratio:An indicator of a company's short-term liquidity.  Gross Profit Margin:A financial metric used to assess a firm's financial health by revealing the proportion of money left over from revenues after accounting for the cost of goods sold.  Operating Profit to Sales:This ratio gives the margin available after meeting cost of manufacturing. Higher the Quick ratio betters the position of the company. the pricing structure. Debt Equity Ratio should be less than 2:1. Gross profit margin serves as the source for paying additional expenses and future savings. . Higher the ratio greater the risk to a present or future creditor. It provides a yardstick to measure the efficiency of production and margin on sales price i. it indicates that the borrower is relying more on his own funds and less on outside funds and vice versa. Return on Equity:The amount of net income returned as a percentage of shareholders equity. Not written off Less: Accumulated Loss  Inventory Turnover Ratio: A ratio showing how many times a company's inventory is sold and replaced over a period. .  TOL/TNW:This ratio gives a view of borrower's capital structure. exp. Where. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Tangible Net Worth = Paid up Capital Add: Reserves & Surplus Add: Compulsory Convertible Debenture Add/Less: Deferred Tax Liability/Assets Add: Share Application Money Less: Misc. If the ratio shows a rising trend. office equipment. Non. furniture-fixture and other capital expenditure like purchase of transport vehicles and other vehicles.fund based Term loans are sanctioned for acquisition of fixed assets like land. agricultural equipment etc. This is different from the short term loans which are mainly provided for meeting working capital requirements and maintaining short term liquidity. The term loan is a loan which is not a . Term loans are provided for acquisition of fixed assets are to be repaid from the cash generated from the operations. plant/machinery. Fund based 2.TERM LOANS Term loans are those loans that are lent for extended period of time majorly for the capital expenditure by the firm. building. Credit delivery for term loans are broadly through two means: 1. TERM LOAN APPRAISAL Prior to the sanctioning of a loan it goes through a well-defined appraisal process where it is evaluated on various parameters. it becomes necessary to re-arrange the balance sheet items to achieve standardization. The process followed is reviewed regularly to account for new guidelines from the RBI and changes in bank‟s credit policies. Financial statements are rearrangement as described in detail below and rearranged financial statements are used to ascertain the capital requirements.demand loan and is repayable in terms of instalments irrespective of the period or the security cover. Various components of the appraisal process are as detailed below: Financial evaluation It involves evaluation of financial statements of the borrower to ascertain the financial health of the company. Components of the balance sheet are used in calculating ratio like Debt Equity ratio(DER). Current ratio. Since term loans are provided for long tenure ensuring the viability of the project and sufficient generation of cash over the long tenure of the loan becomes critical. Various components of financial evaluation are as follows: Reclassification and rearrangement of balance sheet items: Financial statements contain the information about the financial health of enterprise. The term loan with remaining maturity period of above 5 years shall not exceed 50% of the term deposits. Fixed asset coverage . of the business involved. Since different applicants use different formats and classification of some of the items present in the balance sheet is subjective. Term loans are normally granted for the periods varying from 3-7 years and under exceptional circumstances beyond 7 years. long term solvency. Proper due diligence is followed to mitigate the risk of default and fraud inherent in the lending process. Debt Service Coverage Ratio(DSCR). liquidity. debt-repayment capacity etc. o Advance payment for tax. for short term and fixed deposits with banks. o Stock in progress and finished goods (including goods in transit). taxes etc. should be excluded from current assets. redeemable preference shares. There are guidelines from the RBI and bank on the permissible values of these ratios. proper rearrangement of financial statements becomes critical in credit lending decision making. o Unsecured loans. o Deposits from dealers. o Miscellaneous current liabilities like proposed dividends. o Investments in government/trust securities. debentures. o Installments of deferred payments.  Current Assets o Cash and bank balances. Treatment of Export Receivables . o Sundry creditors. o Advances/progress payments from customers. advance for purchase of raw material and consumables. selling agents etc. long term deposits payable within one year.ratio(FACR).  Current Liabilities o Short term borrowings including bills purchased and discounted excluding bank finance. But slow moving and obsolete items should be excluded from current assets and should be grouped as non-current assets. o Interest and other charges accrued but not due for payment. Maximum Permissible Bank Finance(MPBF) etc. liabilities for expenses etc. investment in shares and debentures etc. o Statutory liabilities like provision for PF dues. prepaid expenses. o Raw material and consumable spares including that under transit. o Public deposits maturing within the year. Therefore. insurance. registration and development charges as also plant and machinery. Treatment of Redeemable Preference Share Preference share redeemable within one year should be considered as current liabilities. clearing. and Private Ltd. the unsecured loans raised by friends. Amount of unsecured loans over and above the net worth of the party should be treated as term liability for calculating various financial ratios. relatives. including transportation. the amount of export receivables may be excluded from the current assets as need based limits for export receivables could be sanctioned and in respect of such receivables borrowers are not required to bring in 25% by way of Net Working Capital. However. Treatment of Unsecured Loan In case of Partnership. equipment for auxiliary services. Proprietorship. preference share redeemable after one year should be considered as term liabilities. Cost of Project and means of Financing Cost of project and sources of finance are ascertained to ensure the financial viability of the project for which funding is sought. the means of financing the project cost may be one or more of the following:      Equity capital from shareholders Preference capital from preference shareholders Capital subsidies from government Debentures/ bonds issued by the company – public issue or private placements Public deposits . that remain in the business for continuous basis may be treated as quasi capital to the extent not exceeding 100% of tangible net worth of the party subject to the condition that these loans shall not be withdrawn during the currency of the loan and shall be subordinate to bank borrowings. the unsecured loans should be treated as long term debts. duty. and directors etc. Companies. loading and unloading charges etc. For Public Ltd. The major cost components of the project is given including land and building including transfer.For calculating MPBF. Companies. Generally. DER is normally higher as compared to the other industries. progressive and efficient if it is able to earn enough profits not only to service its debts timely but also for future development/growth. speaking. Revenue projection. and future projections are used for calculating key financial ratios for a period of time. after adjusting profit and loss balance. These ratios tell us about a unit‟s liquidity position. base on the Techno-Economic evaluation and past performance. free reserves. equity capital is brought in by promoter and hence lowers the DER. DER signifies how much the project is leveraged. managements stake in business. Profit. the financial ratios which are considered important are discussed as under:  Debt Equity Ratio(DER) DER = DEBT (Term Liabilities) Equity shares capital. premium on shares etc. Cash Flow and Balance Sheet Revenues during the tenor of the loan are estimated for the project. capacity to service the debts etc. in addition to the estimates of sales and other expenses are used to arrive at balance sheet projections. DER also varies from industry to industry. CALCULATING KEY FINANCIAL RATIOS Current financials of existing operations. For a project of private firm. In capital intensive industries involving large investments.  Debt Service Coverage Ratio (DSCR) . project funding information like sources of fund etc.   Unsecured loans from friend and relatives Term loans Lease finance Projections of Sales. a unit may be considered as financially viable. e the pricing structure. “interest” and “principle repayment” besides indicating the margin of safety. If the ratio shows a rising trend.DSCR = (Net Profit (after Taxes)+Annual interest on long debt+Depriciation) Annual interest on long term Debt + Amount of Principle This ratio provides a measure of the ability of an enterprise to service its debts i. this ratio shows the relationship between cash generating capacity of the unit and its repayment obligation and indicates whether the cash flow would be adequate to meet the debt obligations and whether there is sufficient margin for the lending banker. it indicates that the borrower is relying more on his own funds and less on outside funds and vice versa. It provides a yardstick to measure the efficiency of production and margin on sales price i.  Tangible Net Worth to Total Outside Liabilities (TNW/TOL) tangible net worth (paid up capital + reserve and surplus – tangible assets) TNW/TOL = total outside liabilities This ratio gives a view of borrower‟s capital structure. The ratio may vary from industry to industry but has to be viewed with circumspection when it is less than 1.  PROFIT SALES RATIO PSR = Operating profit before tax excluding other income Sales This ratio gives the margin available after meeting cost of manufacturing.5. Security .e. Collateral Security Security obtained in addition to prime security is known as collateral security. 2nd and paripassu charge: When charge is created in favor of more than one creditor. Charge on securities can be created by various methods depending on the type of security charged. Properties or assets that are offered to secure a loan or other credit. Nature of charge (Security) . Fixed charge is created on specific property like land. Collateral becomes subject to seizure on default. Collateral is a form of security to the lender in case the borrower fails to pay back the loan. 1st. A floating charge crystallizes when the company ceases to be a going concern or the charge holder (bank) initiates action to enforce security for recovery of the amount loan. creditor (bank) cab realize the security to recover its advance. building etc whereas floating charge is an equitable charge over the assets of the company. Properties or assets that are offered to secure a loan or other credit. A charge could be fixed charge or floating charge. Two types of security: A. Collateral becomes subject to seizure on default. If a charge is created on several creditors with the condition that all creditors will have equal priority in proportion to the amount of their advance it is called paripassu charge. When consortium advance is granted this type of charge is created by the borrower. Primary Security A primary security is the security against which bank finance is made or the security (asset) which is created out of bank. then the creditor in whose favor the charge was created earlier will have the first charge and any subsequent charge will be called as 2nd charge and so on. B. In case of paripassu charge sale proceeds of the property are shared among creditors in the proportion of their outstanding within sanctioned limits.Charging of a security means creating right of the creditor (bank) over the security so that in case of default by the borrower. through intervention of court and after reasonable notice without intervention of the court. A general lien confers a right to retain all goods or any property (which is in possession of holder) of another until all the claims of the holder are satisfied. stocks. . shares or any other movable property. Remarks: the person delivering the goods as security is called pledger or pawer. LIP. A lien may be general of particular. Negative lien is an undertaking in writing form the borrower not to encumber or deposit off his assets without banks permission as long as the bank‟s advance is continued. FDR  Lien: The right of a person to retain the possession of a property till dues are paid in full. vehicles Assignment. TRANSFER OF OWNERSHIP OR PROPERTY: no TRANSFER OF POSSESSION OF SECURITY: yes POWER OF SALE: yes. NSC. A pledge may be in respect of goods. Banker has a general lien on all securities deposited by a customer. hypothecation Immovable property Book Debts. The person to whom the goods are delivered is called pledge or pawnee. TRANSFER OF OWNERSHIP OR PROPERTY: no TRANSFER OF POSSESSION OF SECURITY: yes POWER OF SALE: yes Remarks: a particular lien confers right to retain the property in which a particular debt arise.Nature of Charge Pledge Hypothecation Lien Mortgage Assignment Type of Security Movable goods like stocks Movable goods like stock.  Pledge: Bailment of goods as security for payment of s debt or performance of a promise. TRANSFER OF OWNERSHIP OR PROPERTY : no TRANSFER OF POSSESSION OF SECURITY : no.  Mortgage:A mortgagees a transfer of interest in specific immovable property for the purpose of securing the payment of money advance by the way of loan. through intervention of court or after obtaining possession and giving reasonable notice without intervention of court. For. Hypothecation:When possession of the property and other movable offered as a security remains with the borrower and only constructive charge is created in favor of the lender. FUND FLOW STATEMENT A fund-flow statement is often describes as s „Statement of Movement of Funds‟ or „where got: where gone statement‟. period stock statements are obtained and the stocks are checked at regular intervals. Remarks: in hypothecation advances. but normally the creditor takes the right to obtain possession in certain circumstances.It is created by an instrument in writing viz. this purpose. A project Fund Flow Statements helps in answering the under mentioned point:    How much funds will be generated by internal operations/external sources? How the funds during the period are proposed to be deployed? Is the business likely to face liquidity problem? BALANCE SHEET PROJECTIONS . It is derived by comparing the successive balance sheet specified dates and finding out the net changes in the various items appearing in the balance sheets. effectiveness supervision over the goods and possession is absolutely necessary. an existing or future debt or the performance of an engagement which may give rise to a pecuniary liability. hypothecation agreement. POWER OF SALE: yes. the transaction is called hypothecation. A critical analysis of the statement shows the various changes in sources and applications of funds to ultimately give the position of net funds available with the business for the repayment of the loans. The financial ratios which are considered as important are disused below: A. capacity to service the debts etc. Analysis of balance sheet Balance sheet analysis is the process of identifying the financial strength and weaknesses of the firm by properly establishing relationship between the item of the balance sheet and profit and loss account. The relationship of current assets to current liabilities is known as the current ratio. An appraisal of the projected balance sheet data of the unit would be concerned with whether the projections are realistic looking to various aspects relating to the same industry. it would be advisable to analyse the important financial ratios over a period of time as it may tell us a lot about a unit‟s liquidity position. LIQUIDITY PARAMETER 1) Current ratio: This ratio is to assess the short term financial position of the enterprise. In other words. Current assets mean that the assets are in the form of cash or cash equivalents or can be converted into cash or cash equivalents in a short time (say within a year‟s time). It is concerned with the following parties:     Lender Managements Investors Trade Credits FINANCIAL RATIOS While analysing the financial aspects of project.The financial appraisal also includes study of projected balance sheet which gives the position of assets and liabilities of a unit at a particular future date. managements‟ sate in the business. the statement helps to analyse as to what an enterprise owns and what it owes at a particular point of time. Current ratio= current assets/ current liabilities . Quick ratio is effective in case stocks are obsolete. A very high ratio will indicate idleness of funds and not a good sign. Current liabilities = short term bank borrowings + commercial paper + loan from corporate bodies (including group / associate co) + bills discounted + Sundry creditors + int. Higher the Quick ratio betters the position of the company. The higher the current ratio. non-saleable or waste. the more capable the company is of paying its obligations. It thus indicates poor investment policies of the management and poor inventory control. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. . The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. While this shows the company is not in good financial health.33:1. 2) Quick Ratio:An indicator of a company's short-term liquidity. It is generally accepted that the current assets should be 2 times the current liabilities.Current assets = cash and bank balance + investments in government security + sundry debtors + bills discounted + inventories + loans and advances (other than group/associate/other companies)+ advances payment of tax + pre-paid expenses + other current assets. then only will realization from current assets be sufficient to pay the current liabilities on time and enable the firm to meet the day to day expenses. Company has to maintain a current ratio of 1. accrued + un matured financial charges + advance against work in progress + inter office adjustment + provision for tax dividend + diminution in investment + other current liabilities. It shows the number of times the current assets are in excess over the current liabilities. . ROI = (Profit before interest. Debt Equity Ratio should be less than 2:1. Equity = Tangible net worth. The sources used by the business to attain this (profit or loss) consists of both the shareholder‟s funds and loans. but too little debt may mean you are not realizing the full potential of your business and may actually hurt your overall profitability. C. Too much debt can put your business at risk. tax and dividend/ capital employed)* 100 .B..). Net Profit to Capital Employed. Rate of Return .loans from corporate bodies (including group/associate co. The resultant ratio usually expressed as a percentage is called the ROI. PROFITABILITY PARAMETER 1) Return on Investment:The net result of a business is profit or loss. LONG-TERM SOLVENCY PARAMETER 1) Debt Equity Ratio:Represent the ratio between capital invested by the owners and the funds provided by lenders. The overall performance can be judged by working out a ratio between profit earned and capital employed. Debt= Total borrowings + preference capital – short-term bank borrowing – commercial paper. ROCE. Higher the ratio greater the risk to a present or future creditor. OPBDIT (Operating profit before depreciation. Fixed assets cost less depreciation + working capital Since. profit should also exclude income from investment outside the business.Wherein . D. interest and tax. It measures how efficiently the sources entrusted to the business are being used or what is the earning power of the assets of the business. OPERATING EFFICIENCY PARAMETER 1) Operating Leverage Sales revenue Less: Variable cost = Contribution Less: Fixed cost =EBIT The relation between sales revenue and EBIT is defined as operating leverage.extra ordinary income + extra ordinary expenses – other income. Capital Employed= share capital (both equity & preference) + reserves + long term loans – fictitious assets – non-operating assets like investments. non. Or.operating assets are excluded while determining capital employed. 2) Operating profit ratio: OPBDIT Net sales Where. interest and tax)=Profit before depreciation. Return on investment judges the overall performance of concern. Operating leverage = % change in sales revenue % change in EBIT . As long as DOL is greater than 1. it indicates that the borrower is relying more on his own funds and less on outside funds and vice versa. depreciation and amortization) = Profit before depreciation. tax. interest tax and amortization + extra ordinary expenses – extra ordinary income. 2) Interest coverage ratio EBITDA Total Interest EBITDA (Earnings before interest. A positive DOL means that the firm is operating at a sales level above the break even level and EBIT will be positive. there is an operating leverage. It may be noted that this is due to the existence of fixed cost.It means that for every increase or decrease in sales level. A high DOL is considered a high risk situation and even a small decrease in sales can excessively affect the firm‟s ability to record profits. E. OTHERS 1) Total outside liability to tangible net worth TOL TNW TOL (Total outside liabilities) = Total Borrowing + Preference Capital + Current Liabilities & Provisions + Bills Discounting. . If the ratio shows a rising trend. This ratio gives a view of borrower's capital structure. Once all fixed costs are recovered by the contributions. expenses not written off – intangible assets – accumulated depreciation not provided for. TNW (Tangible net worth) = Equity capital + surplus – Revolution reserve-Accumulated losses-Misc. profits grow proportionately faster than the growth in volume. there will be more than proportionate increase or decrease in the level of EBIT. it would mean that there is only enough net operating income to cover 95% of annual debt payments. possibility of capital gains. including interest and principal repayments in term debts. Generally. this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. lenders frown on a negative cash flow. A DSCR of less than 1 would mean a negative cash flow. say 0. 3) Debt-service coverage ratio: It measures the number of times a company‟s earning cover its total long term debt. risk of pre-payment by issuer.Not a recommendation to invest since it does not evaluate reasonableness of issue price. in the context of personal finance. but some allow it if the borrower has strong outside income. over a period of one year. CREDIT RISK RATING An overview: An opinion offered by Rating Agency on the relative ability and willingness of an issuer of debt instrument to make timely payments on specific debt or related obligations over the lift of instrument. Net Profit (After Taxes) + Annual interest on long term debt +Depreciation Debt-Service Coverage Ratio = Annual interest on long term debt +Amount of installments of principalpayable during the year.Total interest = Gross interest + interest capitalized. For example. liquidity in the secondary market.95. . Relative ranking of credit quality of debt instrument. A DSCR of less than 1. Various External Credit Agencies in India:     CISIL CARE FITCH ICRA Factors determining credit risk:       State of economy Wide swing in commodity prices Fluctuations in foreign exchange rates and interest rates Trade restrictions Economic sanctions Government policies Some company specific factors are:   Management expertise Company policies The internal factors within the bank. influencing credit risk for a bank is:     Deficiencies in loan policies/administration Inadequate defined lending limits for loan officers/credit committees Deficiencies in appraisal of borrower‟s financial position Absence of loan review mechanism . Management 4. The credit risk rating tool has been developed with a view to provide the standard system for assigning a credit risk rating to the borrower of the bank according to their risk profile. Uses of credit risk rating:Whether to lend to a borrower or not: the credit risk rating of a borrower determines the appetite of the bank in determining exposure level. Financials 2. Business/Industry 3. based on the detailed analysis for their ability and willingness to repay the debt from the bank. The credit risk rating tool incorporates and includes possible factors of risk for determining the credit rating of borrower.Credit risk rating by PNB: Credit risk rating assigned to the borrower. The tool evaluated the credit risk rating of a borrower on 7 scales from AAA to D indicating AAA as minimum risk and D as maximum risk. According to these head credit score is determined based on the following weight age: . Credit risk rating helps a bank in assigning as probability of default. This risk could be internal and specific to a company. A bank would be willing to lend highly rated borrowers but would not like exposure to borrowers with very poor credit risk rating. Conduct of Account PNB also have a small weightage about the key risk factors.The credit risk rating tool has been developed to capture credit risk under four areas: 1. No. Higher the score obtained by a company. 1 2 3 4 Total Factors Financial Business/Industry Management Conduct of Account Weight assigned 40 20 20 20 100 Usage of Credit Risk Rating Tool:  The scores are assigned to each of the parameters on a scale of 0 to 4 with 0 being very poor and 4 being excellent. in percentage terms. The credit rating according to the credit scores are: . better is its credit rating. After allocating/evaluating scores to all the parameters. the aggregate score is calculated. Weights have been assigned to different parameters based on their importance. The scoring of some of these parameters is subjective while for some others it is done on the basis of predefined objective criteria.  The overall percentage score obtained is then translated into a rating on a scale from AAA to D according to the pre-defined range of credit scores.  The score given to the individual parameters multiplied by allocated weights are then aggregated and a composite score for the company is arrived at.Factor affecting Credit Rating S. B rating grade is known as “Marginally Acceptable Risk Grade” and C and D rating grade are called “High Risk Grade”.Rating with AAA. AA. A and BB grade signifies “Investment Grade”. . Overdraft. Cash Credit. 2. To understand the different types of credit facilities and credit delivery mechanisms provided to industrial customers viz. To gain insights into the Credit Administration processes of PNB. .Chapter . Non Fund Based Credit etc.3 Research Methodology Objectives of the Study 1. Fund Based Credit. Drawing Rights. that influence credit disbursal for various sectors. risk assessment.   For the people working with PNB they come to know what are parameters to be evaluated while studying an application for credit demanded by the companies. This project has usefulness for the people working with PNB and also for the people who are in corporate world and need credit facilities either for expansion orfor working capital requirements. . It is useful in today‟s time. To understand the appraisal process of Term Loan and Working Capital Financing proposals of PNB. 5. Type of Research In this project report ExploratoryResearch has been used which includes:   Search of secondary data. All possible steps need to be taken to strengthen pre sanction appraisal as “prevention is better than cure”. in the present scenario efficient project appraisal has assumed a great importance as it can check and prevent induction of weak accounts to our loan portfolio. For the people who belong to the corporate world and wants credit either for expansion or working capital requirement comes to know about the procedure of the bank for credit appraisal. So whenever the need credit they are familiar with the procedure. business considerations etc.3. bank guidelines.. To understand various norms like credit exposure limits etc. Managerial Usefulness of Study This project will help to get insight into credit appraisal procedure of PNB. companies and business groups. Scope of the Study With the opening up of the economy. exposing banks to greater risks. sectoral policies. To understand the factors affecting rate of interest levied viz. rapid changes are taking place in the technology and financial sector. 4. Thus. Survey of knowledgeable persons. The data availability is proprietary and not readily shared for dissemination. no one model or method will suffice over a long period of time and constant up gradation will be required. Case study. The study is being done keeping in mind the policies of the head office. Data Collection Method  Secondary Sources o Study of various bank guidelines and circulars. o Material provided by project guide. . o Study of proposal. anomaly or biasness in the study Due to the ongoing process of globalization and increasing competition. Limitations of the Study       All the information cannot be included as most of the information is confidential and not approachable. The staff although are very helpful but are not able to give much of their time due to their own job constraints. o CMA of company. o Annual report of company. o Study of pre-approved proposals. The data is used in the study is secondary which can lead to some kind of discrepancy.