“Credit Appraisal for Working Capital Finance to Small and Medium Enterprises at State Bank of I

CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBIPROJECT REPORT ON CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI BELGAUM. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI CONTENTS CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Particulars SECTION-A : EXECUTIVE SUMMARY Page No. 1 SECTION-B : INDUSTRY PROFILE SECTION-C : COMPANY PROFILE 2-7 8-10 11-12 13-21 22-71 SECTION-D : INTRODUCTION TO TOPIC SECTION-E : REVIEW OF LITERATURE SECTION-F : ANALYSIS AND INTERPRETATION 1. 2. 3. 4. 5. 6. SBI Loan Policy Financial Ratios used to Credit Risk Assessment Working Capital and its assessment Credit Risk Assessment Documentation Credit Process SECTION-G : FINDINGS AND OBSERVATIONS SECTION-H : SUGGESTIONS AND RECOMMENDATIONS SECTION-I : CONCLUSION SECTION-J : BIBLOGRAPHY 72-81 82-84 85-87 88-89 CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI PROJECT TITLE CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI “Credit Appraisal for working capital finance to Small and Medium Enterprises at State Bank of India” OBJECTIVE OF THE STUDY • To understand the credit appraisal system for working capital finance to SME’s To understand the rationale behind various guidelines observed by State Bank of India. • SCOPE OF THE STUDY Source of information collected is the information provided by the bank as well as the survey and the observation made there on. NEED FOR THE STUDY Lending continues to be a primary function in banking. In the liberalized Indian economy, clientele have a wide choice. External Commercial Borrowings and the domestic capital markets compete with banks. In another dimension, retail lending- both personal advances and SME advances- competes with corporate lending for funds and for human resources. But lending by nature cannot be an aggressive selling activity, disregarding the risks involved. Bank has to be competitive without compromising on the basic integrity of lending. The quality of the Bank’s credit portfolio has a direct and deep impact on the Bank’s profitability. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI INDUSTRY PROFILE CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI INDUSTRY PROFILE With the Indian economy clipping at 9 per cent, consumption levels soaring and investment riding high, the Indian banking sector is on an upswing. According to the Annual Statement on Monetary Policy for the year 2007-08 released by the Reserve Bank of India (RBI), the Indian economy has witnessed robust growth during 2006-07 for the fourth year in succession. The Central Statistical Organization (CSO) estimates that the real Gross Domestic Product (GDP) growth has accelerated from 9.0 per cent in 2005-06 to 9.2 per cent in 2006-07. The CSO’s estimates for 2005-06 places gross domestic savings (GDS) above 32 per cent of GDP and gross domestic investment (GDI) close to 34 per cent. India could become the third largest banking hub in the world by 2040, according to a PricewaterhouseCoopers (PwC) report. The potential banking market waiting to be tapped in India is fairly huge. Out of the 203 million Indian households, three-fourths, or 147 million, are in rural areas and 89 million are farmer households. In this segment, 51.4 per cent have no access to formal or informal sources of credit, while 73 per cent have no access to formal sources of credit. Similar data is not available for non-farm and urban households. Given the huge potential, corporate houses like the Tatas and Reliance - Anil Dhirubhai Ambani Group, besides several others, are said to be interested in having a slice of the banking pie. An under-penetrated market and the opportunity to service a large, young, working age population, which will create and therefore need help to manage wealth, emerging Indian multinationals with global horizons, entrepreneurs with surplus wealth and limited investment options makes India an extremely attractive market. India's per capita income is expected to rise to US$ 1,000 by the end of the 2007/08 fiscal year on the back of a 9 per cent economic growth, Finance Minister P. Chidambaram has said. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Per capita income stood at $797 in 2006/07, according to data from the central bank's web site, nearly double from US$ 460 in 2000-01 thanks to robust economic growth. Consumption, which today accounts for 60 per cent of India's gross domestic product, is set to quadruple to US$1.5 trillion by 2025, overtaking Germany as the fifth-largest consumer market, according to a forecast made by McKinsey. The credit outgo from public sector banks is expected to grow by 25 per cent for 2007-08 while deposits are set to grow by around 22 per cent. Retail banking Following the trend in other emerging economies, India is experiencing a boom in retail banking. Drawn by the promise of huge returns in this sector, a number of foreign banks are falling over each other to acquire a slice of the banking pie. A year and a half ago, Deutsche Bank launched its retail operations in India. Earlier, another German company BHW Holding AG positioned itself in this space by taking over Birla Home Finance Ltd. Now there are 29 foreign banks have a presence in India through their 268 branches. In May 2007, the 300-year old Barclays Plc followed suit. Besides credit cards, its retail foray will be in the personal loan segment. These late entrants join the ranks of Citibank India, HSBC, ICICI Bank and HDFC Bank Ltd that have aggressively begun tapping this business. In May 2007, the retail portfolio of the Indian banking sector was US$ 111.7 billion or around 11 per cent of India’s gross domestic product of US$ 1 trillion. Such loans accounted for 26 per cent of total non-food gross bank credit in the country as on May 25, 2007 and increased by 23.9 per cent on a year-on-year basis over May 26, 2006 after growing at 30 per cent for three years in a row. Mortgages or housing loans account for more than half of the retail portfolio and grew at a sizzling pace of 40 per cent plus during the last three years. Rural banking In October 2007, ABN Amro Bank announced its micro finance division has succeeded in providing basic financial support to some 500,000 underprivileged households in India. The CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Dutch bank’s micro finance portfolio is now US$ 50.8 million and the bank plans to double the coverage to a million households by 2009. It’s a profitable business that achieved break-even in the first year itself. Bank of Baroda is working on similar lines and has adopted Dungarpur district in Rajasthan. Dungarpur, consisting of 800 villages, has a population of more than 1.1 million. The bank plans to set up more than 400 farmers’ clubs for expert advice on agricultural and financial issues and form 300 new self-help groups, organise health camps and train more than 4,000 rural youth for employment generation. Last year, the Chennai-based Indian Bank adopted Puducherry for extending banking services. State Bank of India Ltd, the country’s largest commercial bank, is now drawing up plans to reach out to 100,000 villages. Mergers and acquisitions According to a PricewaterhouseCoopers (PwC) report, the banking sector in developing economies led by China and India is likely to overtake banks in the currently richest countries of the world by 2050. China and India show the greatest growth potential through organized growth and merger and acquisition (M&A) activities, PWC said. M&As volume in India's banking space increased to US$ 10.5 billion between January and September 2007 with 38 deals. In comparison, the sector had witnessed 23 deals worth US$ 707 million last year, according to a report by global data provider Dealogic. Investment banking Investment banks operating in India have earned nearly as much in the first half of 2007 as they made throughout fiscal 2006-07 from underwriting stock offerings and advising on takeovers. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Private equity and venture investments in India almost doubled to US$ 5.55 billion in the first half of this year, according to Chennai-based Venture Intelligence, which tracks such deals. It expects investments to cross US$ 10 billion by the end of the year. Indian banks in loan markets abroad With the best of India Inc. flocking to overseas loan markets for funds, Indian banks have started following their top customers. For the first time, two Indian lenders -- ICICI Bank and SBI -- figure among the top five in the league tables for loan syndication. Loan books of Indian banks with significant international operations grew sizeably in the first six months of 2007-08. In the aftermath of the US sub-prime mortgage losses, global banks had turned risk-averse causing a global credit squeeze. This forced Indian companies to turn to State Bank of India (SBI), ICICI Bank, Bank of India (BoI) and Bank of Baroda (BoB) to meet their credit requirements, particularly to fund overseas acquisitions. The loan books of the four banks grew at over 25 per cent at the end of September over the previous year, much higher than the 21.9 per cent growth for the industry despite the fact that the cost of raising funds overseas has increased by 150-200 basis points in the aftermath of the sub-prime crisis. Overseas foray As many as nine Indian banks, led by HDFC Bank and ICICI Bank, have made it to the list of top 50 Asian Banks. Bank of Baroda, the fifth largest bank in India, has opened a representative office in the heart of Sydney's central business district, adding to the 19 Indian banks that have 188 branches abroad. Managed assets to rise 6-fold by 2015 The total assets managed by all funds in the country -- mutual funds, international funds, private banking, including portfolio management services, unit-linked insurance and pension funds -- is CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI likely to grow more than six-fold to US$ 1,300 billion by 2015, from US$ 170 billion, says the Boston Consulting Group. The potential of the Indian market is attracting many new entrants and this is likely to continue over the next five years. The opportunity for various fund categories to invest in India will grow exponentially; managed assets, excluding pension, are expected to grow at least 10 times over the next 10 years. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI COMPANY PROFILE CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI PROFILE OF STATE BANK OF INDIA The origins of State Bank of India date back to 1806 when the Bank of Calcutta (later called the Bank of Bengal) was established. In 1921, the Bank of Bengal and two other Presidency banks (Bank of Madras and Bank of Bombay) were amalgamated to form the Imperial Bank of India. In 1955, the controlling interest in the Imperial Bank of India was acquired by the Reserve Bank of India and the State Bank of India (SBI) came into existence by an act of Parliament as successor to the Imperial Bank of India. Today, State Bank of India (SBI) has spread its arms around the world and has a network of branches spanning all time zones. SBI's International Banking Group delivers the full range of cross-border finance solutions through its four wings - the Domestic division, the Foreign Offices division, the Foreign Department and the International Services division. State Bank of India is the nation's largest bank. Tracing its roots back some 200 years to the British East India Company (and initially established as the Bank of Calcutta in 1806), the bank operates more than 14,000 branches within India, where it also owns majority stakes in seven associate banks. State Bank of India has more than 50 offices in nearly 35 other countries, including multiple locations in the US, Canada, and Nigeria. The bank has other units devoted to capital markets, fund management, factoring and commercial services, and brokerage services. The Reserve Bank of India owns about 60% of State Bank of India State Bank of India (SBI) is India's largest commercial bank. SBI has a vast domestic network of over 9000 branches (approximately 14% of all bank branches) and commands one-fifth of deposits and loans of all scheduled commercial banks in India. The State Bank Group includes a network of eight banking subsidiaries and several nonbanking subsidiaries offering merchant banking services, fund management, factoring services, primary dealership in government securities, credit cards and insurance. The eight banking subsidiaries are: CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 1-State Bank of Bikaner and Jaipur (SBBJ) 2-State Bank of Hyderabad (SBH) 3-State Bank of India (SBI) 4-State Bank of Indore (SBIR) 5-State Bank of Mysore (SBM) 6-State Bank of Patiala (SBP) 7-State Bank of Saurashtra (SBS) 8-State Bank of Travancore (SBT) Later under the State Bank of India Act, 1959 the former State-associated banks were taken over by the S.B.I as its subsidiaries. The Bank’s registered office is in Calcutta. The Corporate Center is in Mumbai. The Central Accounts Office is in Calcutta. In terms of SBI Act, RBI should have minimum of 55% of the capital of the bank. The Central Office is now redesigned as Corporate Center. SBI’s Present Organizational Structure: The bank has a 4 tier structure- the Central Office is the Bank’s apex policy-making body. The Central Office is now called Corporate Center. The management of the Bank vests with the Central Board consisting of a Chairman, 2 Managing Directors and other directors. The term of office of a director is 3 years. At the Local Head Office, a Local Board is constituted. The Board Members comprise CGM (ex officio), directors of the Central Board ordinarily resident in the area, one member elected by the local shareholders holding together, not less than 2.5% of the issued capital and others nominated by the Government in consultation with the RBI. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI INTRODUCTION TO THE TOPIC CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI INTRODUCTION TO THE TOPIC Working Capital Finance SBI offers working capital finance to meet the entire range of short-term fund requirements that arise within a corporate’s day-to-day operational cycle. The SBI working capital loans can help company in financing inventories, managing internal cash flows, supporting supply chains, funding production and marketing operations, providing cash support to business expansion and carrying current assets. SBI’s working finance products comprise a spectrum of funded and non-funded facilities ranging from cash credit to structured loans, to meet the different demands from all segments of industry, trade and the services sector. Funded facilities include cash credit, demand loan and bill discounting. Demand loans are considered also under the FCNR (B) scheme. Nonfunded instruments comprise letters of credit (inland and overseas) as well as bank guarantees (performance and financial) to cover advance payments, bid bonds etc. Lending continues to be a primary function in banking. In the liberalized Indian economy, clientele have a wide choice. External Commercial Borrowings and the domestic capital markets compete with banks. In another dimension, retail lending- both personal advances and SME advances- competes with corporate lending for funds and for human resources. But lending by nature cannot be an aggressive selling activity, disregarding the risks involved. Bank has to be competitive without compromising on the basic integrity of lending. The quality of the Bank’s credit portfolio has a direct and deep impact on the Bank’s profitability. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI REVIEW OF LITERATURE CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI REVIEW OF LITERATURE FICCI’S ANNUAL SURVEY ON BANKING BANKING SECTOR FOR CONSOLIDATION September 23, 2006. Faced with intensifying competition, the Indian banking sector is all for consolidation of the financial sector now and is fully endorses the need for creating six or seven banks of the size of the State Bank of India, while bulk of the public sector banks lament lack of sufficient autonomy to offer attractive incentive packages to their employees to ensure commitment and raise productivity. These and other prescriptions revealed by FICCI’s annual survey on the Indian Banking System: The Current State and the Road Ahead. The FICCI Survey, which zeroes in on the potential offered by Indian banking system and achievement of global competitiveness by Indian banks, throws up key areas that need focused attention and immediately tackled for future growth. These areas, pinpointed by the survey respondents include: Diversification of markets beyond big cities (84.2% of the respondents), HR Systems (63.15%), Size of Banks (52.63%) High Transaction Costs (47.3%), Banking Infrastructure (42%) and Labor Inflexibilities (42%). The following are the major highlights of the FICCI Survey: • Some of the major strengths of the Indian banking industry, which have helped mark its place on the global banking scene as highlighted by our survey respondents were Regulatory Systems (84.21%), Economic Growth Rate • (63.15%), Technological Advancement (52.63%), Risk Assessment Systems (47%) and Credit Quality (42.1%) Some of the areas that need to be geared up for future growth, identified by the survey respondents are Diversification of markets beyond big cities (84.2%), HR Systems CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI (63.15%), Size of banks (52.63%) High Transaction Costs (47.3%), Banking Infrastructure (42%) and Labor Inflexibilities (42%). • To a question on achieving global competitiveness, Consolidation in the financial sector has emerged to be the most significant measure required to create world class banking system followed by Strict Corporate Governance Norms, Regional Expansion, Higher FDI limits and FTA’s. • On being asked to rate India on certain essential banking parameters (Regulatory Systems, Risk Assessment Systems, Technological Systems and Credit Quality) in comparison with other countries i.e. China, Japan, Singapore, Russia, UK and USA, the following results emerged:  Regulatory systems of Indian banks were rated better than China and Russia; at Respondents rated India’s Risk management systems more advanced than China par with Japan and Singapore but less advanced than UK and USA.  and Russia; at par with Japan, and less advanced than Singapore, UK and USA. 83% of our respondents highlighted that Basel II implementation would take us a step ahead in global competitiveness.  Technological systems of Indian banks have been rated more advanced than Majority of respondents quoted credit quality of Indian banks better in China and Russia; at par with Japan, but less advanced than Singapore, UK and USA.  comparison with China, Japan and Russia; at par with Singapore but below par with UK and USA. • 75 per cent of the foreign bank’s respondents rated their working experience in India as “ extremely good”. Given India’s potential over the next decade and beyond, 100 per cent foreign banks respondents stated that they have formulated strategies for future expansion in India. • • 55 per cent of the respondents highlighted that the FTA’s signed by India till now have On possible Comprehensive Economic Co-Operation Agreement (CECA) with EU, 85 helped enhance global trade and thus been of help to banks in their global expansion strategy. per cent of domestic banks respondents also emphasized that India should not give full domestic status to EU based banks under the proposed India-EU CECA. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI • 69 per cent of respondents stated that 20 – 30 % proportion of their total Income is constituted by fee-based incomes. Banc assurance and selling of mutual funds were recognized as the most tapped business opportunities by the bankers closely followed by Forex Management. Out of these selling of mutual funds was identified as the most profitable venture by 47 per cent of respondents. • The penetration of banking services to Indian households stands at a mere 35.5%. Some of the efforts highlighted to increase this penetration level were: Tapping the Rural markets (87.5 per cent respondents) and Opening more branches in Tier II and Tier III towns (62.5 per cent respondents) • • On the question on the state of preparedness of Indian banking sector to tackle the challenges being faced by them, the following results emerged: In view of increased competition, Implementation of Basel II norms by March 2007 and opening up of sector in 2009, 95 per cent of the respondents view that this is the right time for the consolidation in the financial sector. 94 per cent respondents also fully supported government point of view of creating of 6-7 banks as big as the State Bank of India. • 92 per cent of Public sector bank’s respondents voiced that they do not have sufficient autonomy to offer attractive incentive packages to their employee to ensure their commitment levels. Out of these, 82 per cent of respondents expressed that to improve their productivity levels it is essential to offer competitive compensation packages at all levels. • 58 per cent of respondents expressed that Indian Banking Sector is prepared to achieve the Basel II milestone by 31st March 2007 whereas the remaining voiced that the deadline should get extended. 83 per cent respondents also highlighted that presently there are sufficient instruments in the market to meet the increased capital requirements of Indian Banks. SME SECTOR SHINES Mr. K.G.Mallya CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI We must congratulate the Small and Medium Enterprise Sector, popularly known as SME sector for getting due attention and recognition from all quarters. Now the SMEs are on the centre stage stealing the show basking in the limelight. So in the fitness of things, the year 2006, in India should be designated as the SME YEAR to further the cause of this particular sector. The SME Sector: This sector has a very important role to play in the economy of any country. Labour intensive, it is a small industrial enterprise to manufacture items needed in a small locality, making use of locally available resources. Basically it is a low-tech industry catering to the needs of a small market without much capital outlay, overheads or economies of scale. Even though this is the portrait of a typical enterprise, there are sizeable SMEs that have links with large industries to manufacture and supply parts and components or to undertake subcontracts or job work. Then there are SMEs that exclusively concentrate on exports also. Yet, all of them have one thing in common: That is, small size. Scope for employing people, investment in plant and machinery and the problem of access to institutional finance these are more or less the same for all the units in the entire sector as they have smaller capital base, lower production capacity, limited technical capabilities and smaller markets. In spite of these odds, the performance of the sector as a whole has stunned every one! Performance: On page 15 of the Economic Times of Tuesday the 11th Oct 2005 there is an advertisement from the ICICI Bank that gives us the following figures: 95% of Industrial Units 40% of Manufactured Output 60% of Exported Goods More than 3 Million Companies 17+ Million Employees SMEs are the backbone of the country’s economy…” ICICI Bank periodically carries a special feature of one page in the Economic Times under the caption: ICICI BANK PRESENTS SME DIALOGUE giving success stories and tips and guidance to SMEs and we must admire that the advertisement calls for entries for the awards instituted by the Bank to SMEs for the outstanding performance in certain segments. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI State Bank of India, the premier banking institution of the country ran an advertisement on Page 13 of the Times of India on Friday the 14th Oct 2005 with the caption: SBI HAS A DEDICATED UNIT THAT SERVICES SMALL & MEDIUM ENTERPRISES. At SBI we understand that to-day’s small and medium industries are tomorrow’s giants. So you’ll find an SBI Branch in almost every industrial estate…” By going through the advertisements of both these giant banking institutions we can note with satisfaction that our banks are vying with one another to woo this sector, a sector of great significance. Is the sector a new find? Is our approach to SME Sector is an innovation or something like a new invention? Going by the literature and books available on SMEs, in many countries, both the developed and developing, the SMEs have been regarded and respected for their significant contribution towards the GDP. They have beaten large industries in respect of innovations and inventions on account of hard work, personal interest and the spirit of enterprise of the owners that is normally not available with the joint stock companies. Finance, a major handicap: The mention of joint stock companies take us to the arena of finance. The main handicap of the SMES is finance and unfortunately, unless they are big enough or have earned a name and fame they cannot enter the capital market to raise the requisite finance through the issue of stocks and shares. Sometimes to raise the loans from the banks also they do not have good collateral or money to provide safety margin. They will thrive only if right quantity of finance is available at right time and at right price. Yes, in the world full of competition, the rate of interest plays a dominant role in costing and pricing. SMEs Abroad: Going back to the SMEs abroad, in some countries, they are encouraging the SMEs to grow international (transnational is the term used) and spread their wings by strategic alliance, joint ventures, having affiliates or making direct investment in capital. In some quarters loans are granted for this purpose at nominal rate of interest. Developed countries prefer developing countries in view of the latter having cheaper manpower and also natural resources. They also transfer technical know-how, impart training and hold conferences and seminars to pass on the knowledge. Indian Context: In the Indian context, financing SMEs is not something new or unknown. All CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI that we have done recently is the renewal of our pledge to serve the SME Sector with a greater vigour. The Finance Minister during his Budget Speech on 28th February 2005 set the ball rolling. The relevant portion of his speech is as follows: “SMALL & MEDIUM ENTERPRISES. In recent years our approach to small scale industry has evolved and now we are inclined to treat the sector as the small and medium enterprises sector…Small Industries Development Bank of India (SIDBI) has established this year a SME Growth Fund with a corpus of Rs.500 Crores. Small and medium units in knowledge based industries such as Pharma, Biotech and IT will be provided equity support through this Fund. There is a need for a new legislation that will provide a supportive environment for small and medium enterprises…” He concludes that the Minister of Small Scale Industries will introduce the Small and Medium Enterprises Development Bill. Three things are distinctly clear here. From the Small Scale Industries we have moved to a broader SME sector. And this integrated sector is going to get a good legal and legal support from the authorities. In fact these words have given a good fillip to move in the right direction. SME Sector: We must now acquaint ourselves with two definitions. SSI & SME. Historically our commercial banks started financing Small Scale Industrial Units way back in the year 1960 with a credit guarantee scheme by the Central Government administered by the Reserve Bank as the Agent. (Presently this scheme is not available). The SSI is defined as an industrial unit whose original investment in plant and machinery should not exceed Rs.7.50 lakhs (raised to Rs.10 lakhs on 10.9.75 and now it is Rs.1 Crore and in the case of Ancillary Unit investment in fixed assets should not exceed Rs.3 crores) And the unit should engage itself, in manufacturing, processing and preservation of goods. Mining and quarrying, servicing and repairing and custom service units are also treated as SSI units. There is a Tiny Sector where the investment in plant and machinery should be less than Rs.25 lakhs and in the case of Village and & Cottage Industries the credit requirement should not be above Rs.50,000/While determining the scale of industry in our country we have gone by the investment in plant and machinery but in some countries they base on the number of employees, say up to 200 for CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI the SSI. Beyond SSI limit the industry would fall under the category of Medium Scale or Large Scale. We have now integrated Small Scale and Medium Scale under a single category SME. Official Definition: At this juncture it is worth mentioning that Reserve Bank has come out with guidelines to the banks in respect of SME sector. They are reproduced in their monthly publication, Monetary & Credit Information Review (MCIR) issues for Aug & September 2005 which are very relevant both to the bankers and the borrowers. August issue gives guidelines for lending to the sector and September relates to the restructuring of overdue and irregular debts besides one time settlement of the dues of SME. We shall first acquaint ourselves with the definition given on page 2 of Sept 2005 issue: “At present, a small scale industrial (SSI) unit is an undertaking in which investment in plant and machinery, does not exceed Rs.1 Crore, except in respect of certain specified items under hosiery, hand tools, drugs and pharmaceuticals, stationery items and sports goods, where this investment limit has been enhanced to Rs.5 Crore. A comprehensive legislation which would enable the paradigm shift form small-scale industry to small and medium enterprises is under consideration of the Parliament. Pending enactment of the legislation, current SSI/Tiny Industries definition may continue. Units with investment in plant and machinery in excess of SSI limit and up to Rs.10 Crore may be treated as medium enterprises (ME).” Credit Flow to SME Sector: From the issue of MCIR for August 2005 we can note the anxiety and concern of the Monetary Authorities to step up the flow of credit with a substantial increase from the present levels. Among other things banks are asked to a) Formulate policies for extending credit to this sector b) Have a cluster approach to reduce the cost of finance c) Each and every Urban and Semi-urban branch of a bank should finance at least 5 new units per year. Similarly from the issue for September 05, we can note the guidelines for Debt Restructuring and Relief besides One Time Settlement (OTS) of NPAs below Rs.10 Crore classified as Doubtful or Loss Assets as on 31.3.2004 and so also for the debts classified as Sub-standard on 31.3.04 but subsequently become Doubtful or Loss Assets. The OTS is also applicable to all debts under litigation subject to obtaining a consent decree. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI The Biggest Attraction: In the whole scheme the cost of credit is not lost sight of and that is the biggest attraction. The RBI has advised the banks to take necessary steps to rationalise the cost of loans by adopting a transparent rating system with cost of credit being linked to the credit rating of the enterprise. It asks the banks to take advantage of the models developed by the SIDBI in respect of Credit Appraisal and Rating besides Risk Assessment. The National Small Industries Corporation has evolved a scheme whereby the SMEs can get themselves rated by reputed credit rating agencies. The RBI has advised the banks to take these rating also into consideration while fixing the rate of interest on the borrowings. RBI has asked banks to give wide publicity to all the above through their notice board and also through the web-site of each one of the banks so that all will get to know the facilities available. SIDBI: This write up will not complete unless we make a mention of the pivotal role played by SIDBI in developing the SME sector. It commenced operations from 1990 by financing, promoting and developing industries in the small-scale sector. Basically it is a develop bank and also a term lending institution but it provides bill discounting and working capital finance also and the units in the sector can avail of credit facilities from SIDBI at a reasonable rate of interest. The Budget has provided funds to the Corporation for equity support and more than that the Economic Survey 2004-05 under Policy Initiatives in the SSI sector during 2004-05, gives us a very heartwarming indication that, “The Small & Medium Enterprises (SME) Fund of Rs.10,000 crore was operationalised by the SIDBI since 2004. Eighty percent of the lending from this fund will be for SSI Units at interest rate of 2% below the prevailing PLR of the SIDBI.” Conclusion: The financial and banking system has placed before the SME sector a fully dressed up cake in a silver platter. It is not a birthday cake but a cake in appreciation of the efforts and also as an incentive to work hard. The sector should avail of the opportunities and scale new heights. With this the sector will be benefited and the society too. K.G.Mallya is a noted author in Banking and Finance CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI ANALYSIS AND INTERPRETATION CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI ANALYSIS AND INTERPRETATION 1. STATE BANK OF INDIA’S LOAN POLICY The basic tenets of SBI’s Loan Policy include the following: • • • • • The policy applies to all domestic lending. Foreign branches have their own policies Optimum exposure levels are set out in the Policy to different sectors in order to ensure growth of assets in an orderly manner. The policy sets out minimum scores/hurdle rates The policy lays down norms for take over of advances from other banks/ financial institutions As a matter of policy the bank does not take over any Non-performing Asset(NPA) from other banks. CREDIT APPRAISAL STANDARDS A. QUALITATIVE: At the outset, the proposition is examined from the angle of viability and also from the bank prudential levels of exposure to the borrower, group and industry. Thereafter, a view is taken about bank’s past experience with the promoters, if there is a track record to go by. Where it is a new connection for the bank but the entrepreneurs are already in business, opinion reports from existing bankers and published data if available are carefully perused. In case of a maiden venture, in addition to the drill mentioned heretofore, an element of subjectivity has to be perforce introduced as scant historical data would be available and weightage has to be placed on impressions gained out of the serious dialogues with the promoters and his business contacts. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI A. 1. QUANTITATIVE Working capital: the basic quantitative parameters underpinning the Bank’s credit appraisal are as follows: i. Liquidity: current ratio (CR) of 1.33 will generally be considered as a benchmark level of liquidity. However, the approach has to be flexible. Cr of 1.33 is only indicative and may not be deemed mandatory. In cases where the Cr is projected at a level lower than the benchmark or a slippage in the CR is proposed, it alone will not be a reason for rejection of the loan proposal or for sanction of loan. In such cases, the reasons for low CR should be carefully examined and in deserving cases the CR as projected may be accepted. In cases where projected CR is found acceptable, working capital finance as requested may be sanctioned. ii. Net working capital: although this is a corollary of current ratio, the movements in Net working capital are watched to ascertain whether there is a mismatch of long term sources via-a-vis long term uses for purposes which may not be readily acceptable to the Bank so that corrective measures can be suggested. iii. Financial Soundness: this will be dependent upon the owner’s stake or the leverage. Here again the benchmark will be different for manufacturing, trading, hire purchase and leasing concerns. For industrial ventures Total Outside Liability/Tangible Net Worth ratio of 3.0 is reasonable but deviations in selective cases for understandable reasons may be accepted by the sanctioning authority. iv. Turn –over: the trend in turn-over is carefully gone into both in terms of quantity and value as also market share wherever such data are available. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI What is more important is to establish a steady output if not a rising trend in quantitative terms because sales realization may be varying on account of price fluctuations. v. Profits: while net Profit is the ultimate yardstick, cash accruals, i.e. profit before depreciation and taxation conveys the more comparable picture in view of changes in rate of depreciation and taxation which may have taken place in the intervening years. However, for the sake of proper assessment, the non-operating incomes are excluded, as these are usually one time or extraordinary income. Companies incurring net losses consistently over 2 or more years will be given special attention, their accounts closely monitored, and if necessary, exit options explored. vi. Credit Rating: wherever a Credit Rating Agency for any instrument has rated the company, this will be taken into account while arriving at a final decision. However, as the credit rating involves additional expenditure, bank would not normally insist on this tool if such an agency had already looked into the company finances. vii. Capital Market: where the company’s shares are listed in stock exchanges, the movement of the price of its share, the market value of shares like those of competitors in the same industry, response to public/right issues are also kept in view as these are reflective of the corporate image in the eyes of the investors’ community. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 2. i. Term Loan / Deferred Payment Guarantees In case of term loans and deferred payment guarantees, the project report is obtained from the customer, which may have been compiled either inhouse or by a firm or consultants/ merchant bankers. The technical feasibility and economic viability is vetted by the Bank and wherever it is felt necessary. ii. Promoter’s contribution of at least 20% in the total equity is what bank normally expects. But the promoter contribution may vary largely in mega projects. Therefore, there cannot be a definitive benchmark. The sanctioning authority will have the necessary discretion to permit deviations. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 2. FINANCIAL RATIOS USED FOR CREDIT RISK ASSESSMENT Under the CRA system, financial risks in a proposal are sought to be captured through some relevant ratios. Different ratios are used for assessing risks for extending working capital finance and term loans under CRA system. Also, the ratios used for assessing risk for financing NBFC’s are different. Working capital finance (all segments except NBFC’s) The following are the ratios used for working capital finance: 1. Current ratio: it is calculated by dividing current assts by current liabilities. It helps to measure liquidity and financial strength. 2. Care should be taken in interpreting this ratio as: a. It is applied at a single point in time, implying a liquidation approach, rather than a judgment on the going concern, for it does not explicitly take into account the revolving nature of current assets and current liabilities. b. The seasonal character of the business resulting in fluctuating current ratio is a disturbing factor. 3. Liquidity could be severely affected if current liabilities exceed current assets. 4. The higher the ratio the better the liquidity position. 2. TOL/TNW: total outside liabilities divided by total net worth. i. ii. iii. iv. v. It indicates size of stake, stability and degree of solvency. Indicated how high is the stake of the creditors. Indicated what proportion of the company’s finance is represented by the tangible net worth The lower the ratio the greater the solvency. The ratio is usually higher in case of SME’S. Still anything over 3 or 4 should be viewed with concern. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI vi. The ratio should be studied at the peak level of operations. 3. PBDIT/interest (times): this is called ‘interest coverage’ ratio. In the current context, the servicing capability of loan is very crucial. This ratio, which indicates the number of times the gross earnings cover the interest payable is an indicator of the measure of comfort that profitability provides. i. ii. Higher ratio indicates comfortable debt servicing capability from the cash accrual of the company. A ratio of more than 3 is considered comfortable, where as a ratio of 2 and below is considered risky. 4. ROCE or ROA (%): profit before depreciation, interest and tax/ total capital employed multiplied by 100. i. ii. iii. iv. High ratio indicates that the business is run on profitable lines. It is a relationship between the profits made during the year and the finance employed to make profits i.e. it shows the earning power of the business. It is a measure of the management’s skill in profitably employing the funds in the company. It should not only compare favorably with the rate of interest on loanable funds in the market but also compensable for the risk involved in running the business. 5. Operating profits/Net sales (%): indicates operating efficiency. It should be comparable with similar industries. Trend for the company over a period should be encouraging. 6. Inventory / net sales + receivables / gross sales: expressed in days, this ratio captures the turnaround period f major items of the current asset i. ii. iii. Higher the figure, the slower is the turnaround of current asset and in general higher the risk. This ratio will vary across industries. For assessment of risk, a shorter working capital cycle can be regarded less risky. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI iv. v. Specific industry parameters should also be kept in mind while assessing the risk under this ratio. In general, it is expected that the working capital should be turned over at least twice. For NBFCs , the ratios are: 1. Current ratio 2. TOL/NOF: total outside liabilities/ net owned funds ratio represents the extent to which the company is leveraged. Net owned RBI uses funds as a reference for registration and acceptance of deposits from public. NOF represents total net worth, less investment in excess of 10% of owned funds as stipulated by RBI. i. ii. Higher ratio indicates increased dependence on borrowings and other liabilities. A ratio of 3 and below is considered very healthy, while a ratio above 7 is considered risky. 3. PBDT/ Total Assets: this ratio is a measure of gross profitability or gross return from the activity of the company. In the CPA models, for manufacturing company, the numerator is PBDIT but in NBFCs interest payment is a major component. So, it is more relevant to take PBDT for NBFCs. i. A percentage of more than 10 is considered healthy whereas below 2 is considered risky. 4. PAT/ Total Income: total income= income minus other than non-recurring income. This ratio represents the profitability of operations. Total income from operations may be considered as equal to total sales of a manufacturing company. i. a percentage of 11% and above is considered healthy and below 3 is considered risky. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 5. (Total income – other non-recurring income)/interest expenses: the interest coverage ratio in respect of NBFCs is calculated by dividing total income less nonrecurring income with interest expenses. This ratio measures the cushion available for meeting interest liability. i. A ratio of 3 or more is considered healthy while less than 1 is considered highly risky. 6. Overdue/ demand raised ratio: this ratio measures collection efficiency. The term “over dues” represents claim amounts which have not been received till due date. i. A ratio of 1 and below is considered very healthy and more than 5 is considered very risky. 7. NPA/ total working assets ratio: NPAs in this context refer to lease rentals and hire purchase installments overdue for more than 12 months. Following are some examples of Balance Sheet Analysis and calculation of ratios which are important for analyzing the financial trend of the business. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Examples 1: Rearranged statement of Assets and Liabilities (Rs. In ‘000s) LIABILTIES 2006 Current Liabilities: Creditors 40 Bills Payable 26 66 Deferred Liabilities: Debentures Capital Surplus Capital Reserves & 200 134 334 600 200 169 369 614 200 200 Fixed Assets: Block 434 440 2007 ASSESTS Current Assets: Cash Stock Debtors 2006 2007 32 13 45 31 112 23 166 52 99 23 174 600 614 Liquidity ratios: i. Current ratio : CA/ CL 2006: 166/66 = 2.5:1 2007: 174/45 = 3.9:1 ii. Quick Ratio or Acid Test Ratio: Q.A/ C.L 2006: 54/66 = 0.8:1 2007: 75/45 = 1.7:1 Capitalization Ratios: i. Term liabilities/ net worth (Funded Debt) CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 2006: 200/334 = 0.6:1 2007: 200/369 = 0.5:1 ii. Total liabilities / net worth: 2006: 266/334 = 0.8:1 2007: 245/369 = 0.6:1 Activity Ratios: i. Sales/ capital employed: 2006: 360/534 = 0.67:1 2007: 390/569 = 0.7:1 ii. Stock /sales: 2006: 112/30 = 3.7 months 2007: 99/32 = 3 months iii. Debtors/sales: 2006: 23/30 = 3/4th month 2007: 23/32 = less than 3/4th month. Comments: i. ii. iii. Liquidity: Current ratio for2006 is satisfactory; but it is rather high for 2007. Perhaps the unit is building up cash for meeting some commitments. Capitalization: the long term debt and the total outside liabilities are quite low compared to equity. Hence, the financial position of the unit if good. Activity Ratios: a. The sales/capital employed ratio is rather low. The reasons for the same have to be ascertained. b. Debtor’s management and Inventory management have marginally improved in 2007. Overall, the financial position and liquidity position of the unit are considered satisfactory. Example 2: Following is the summarized balance Sheet and Income Statement of a unit: CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Income Statement for the year ending 31-3-2007 (Rs. In 000’s) Sales Less cost of goods sold Less Selling and 1600 1310 290 Administrative 40 250 45 205 82 123 expenses Less Interest Earnings before Tax Less Tax paid Earnings After Tax Balance sheet as on 31-3-2007 (Rs. In 000’s) Liabilities Paid up Rs. capital 400 Assets Net Fixed assets Rs . 800 (40000 shares of Rs. 10 fully paid) Retained Earnings Debentures Creditors 120 700 180 Inventory Debtors Marketable securities Cash 400 175 75 50 Bills Payable 20 Other current 80 liabilities 1500 1500 The unit has approached the bank for credit limit of Rs. 5 lacs against the security of stocks and debtors. Following is the evaluation of firm’s financial position by calculating ratios useful for bank’s evaluation and problem areas suggested by ratio analysis. Ratios 1. Liquidity position: a. Current ratio b. Quick ratio 2.Capitalization ratios: Unit’s ratios Industry average 700/280 =2.5 300/280 = 1.07 2.4 1.5 Satisfactory Low Comment CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI a. Funded debt/assets 700/1500 = 46.7% b. Funded debt/equity 700/520 = 1.3:1 c. Total liabilities / 980/520 = 1.9:1 equity 40% N.A N.A Rather high Satisfactory Good 3. Profitable Ratios: a. Net profit/sales * 123/1600 * 100 = 7% 100 7.7% b. N/P / total sales * 123/1500 * 100 = 11% 100 8.2% c. N/P / capital 123/1220 * 100 = N.A 10.1% 8 36 days Satisfactory Low Satisfactory employed * 100 4. Activity ratios: a. sales to inventory 1600/400 = 4 b. average collection 175/4.4 = 40 days period: daily sales debtors/avg. Very low Marginally high Comments: Liquidity Ratios: liquidity ratios are satisfactory. They also compare favorably with industry average except that the acid test ratio is low. Activity Ratios: the sales to inventory ratio is half of the industry average. The sluggishness in turnover of stocks has to be probed into. Collection efficiency (debtors management) is marginally higher than the industry average Capitalization Ratios: the capital base ratios are satisfactory; but funded debt/assets ratio is higher than the industry average. Profitability: though the profitability on sales is better than the industry average the earnings on assets is low compared to the industry average. Thus due to lower turnover of stocks. Net profit after tax can also be used for working out the ratio. As tax rates may change from year to year a more uniform basis will be provided by NPBT. Conclusion: CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI The unit’s overall liquid, financial and profitability positions are satisfactory. The precise reasons for the low turnover of stocks have to be ascertained to find out whether the company will face any marketing problems. The unit’s NWC position is very comfortable ; hence there is no need for WC finance. FUND FLOW STATEMENT According to Roy Foulka , Funds Flow statement is a “statement of the sources and application of funds, is a technical device designed to highlight the changes in the financial condition of a business enterprise between two dates “. In India, the fund flow statement, in its present form, was not extensively used by the commercial banks for their working capital appraisal, until late sixties, when the National Credit Council Study, popularly known as Dehejia Committee came out with his report. This committee asked to determine “to what extent credit needs of the industry are likely to be inflated”, pointed out that the banks did not seek to link credit with industrial output, with the result that end-use of bank credit was not properly followed up. As a sequel to this commercial banks and RBI started looking into their appraisal procedures and thus the fund flows statement came to be registered as an important component of appraisal for working capital advances. Basically as a credit-analyst, the bank is in the following aspect of the financial position of the units financed by the bank: i. ii. Where did the profits go? Were the funds generated (cash accruals) adequate to meet the company’s responsibility to shareholders for declaring dividends? If the funds were inadequate, how the situation was handled? iii. iv. v. vi. vii. When the net income is up, did the net current assets or net working capital go up proportionately ? if, not what are the reasons? How was the capital expenditure financed? What became of the proceeds of sale of fixed assets and investments? How was the retirement of debt accomplished? How was the additional capital raised, used? CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI viii. What became of the proceeds of the debenture issue or fixed deposits raised from public? The answers to these questions are furnished by the fund flow statement analysis. As purveyors of working capital credit, these aspects are of vital interest to the bank, since commercial banks have to ensure proper end-use of bank credit towards the purpose for which it was granted and ensure against diversion of bank credit to “unapproved” purposes. The fund flow statement is divided into two portions. While one portion discloses the movement of funds known as long-term account,(comprising long term sources and long term uses), the other reflects the fund flow amongst the current assets and liabilities in the short term account. Long-term sources are indicated by changes in capital, term liabilities, fixed assets, investments, non current assets and intangible assets between two balance sheet dates. Similarly, short-term sources and uses are denoted by the changes in current assets and current liabilities. Surplus of the long-term sources over long-term uses results in increase in the net working capital equal to the surplus, whereas a deficit of long-term sources over long term uses will result in decrease in net working capital by amount of deficit. In case of deficit in long-term account, the deficit is, in turn, met by a diversion of short-term funds to long-term uses. If there is increase in activity level in a unit during a year, it is likely to result in increased holding of current assets as at end of the year compared to the position in the beginning of the year. In the face of such increases in current assets if the current ratio has to be maintained at the same level as in the beginning of the year, then the net working capital should increase in proportion to the increase in current assets. Financial propriety dictates that the unit’s management should, in the event of any inadequacy in cash generation, raise adequate long-term funds in the shape of share capital, long term loans etc. To meet fully the long term outlays like capital expenditure, retirement of loans, dividend payments, investments in other companies, acquisition of other non-current assets, etc. in as much as the net working capital is fed by the long term surplus generated in the fund flows, the banker is very particular to see that this surplus is ‘adequate’. The adequacy is, of course, determine by factors like the projected build-up of current assets (incremental), banker’s conception of the acceptable current ratio and the banker’s ability and willingness to provide additional credit to the borrower. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Thus, funds flow analysis is an integral part of the working capital appraisal, performing a very important task in the gamut of credit assessment. It is a composite an integrated statement that gives, at a glance, the salient features of funds flow and depicts the directional flow of working capital. It feeds with valuable data about the management style of functioning, its strength and weaknesses from which we enabled to form judgments on the corporate financial policy, financial prudence in planning of funds and overall financial management. On the prospective analysis, it tells us about the management intention regarding use of funds. Significant and important facets of management functioning, like dividend policy, plough back policy, growth objectives, optimum uses of fixed assets through timely capital expenditure are revealed by fund flow analysis. CASH BUDGET Contrasted with the broad level analysis of a funds flow statement, the cash budget is basically a functional statement, concerning itself with the pure cash management aspect. It is designed to throw light on: i. ii. What cash commitments are likely to arise within a short span of time and What cash resources will be available to meet them? A cash budget can be only as authentic and genuine as the underlying assumptions on which it is based are. Hence, the credit analyst will have to validate the assumptions by relating them to the unit’s past experience and data for their relevance, reasonableness and practicality. However, more than any examination of the figures, the banker has to draw upon his knowledge of borrower’s behavioral tendencies for meeting his commitments and experience of past dealings. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 3. WORKING CAPITAL AND ITS ASSESSMENT The objective of running any industry is earning profits. An industry will require funds to acquire “fixed assets” like land and building, plant and machinery, equipments, vehicles etc… and also to run the business i.e. its day to day operations. Working capital is defined, as the funds required carrying the required levels of current assets to enable the unit to carry on its operations at the expected levels uninterruptedly. Thus working capital required (WCR) is dependent on i. ii. The volume of activity (viz. level of operations i.e. Production and Sales) The activity carried on viz. manufacturing process, product, production programme, and the materials and marketing mix. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Though there are various methods used for assessing the quantum of working capital requirement for an industry, the following are commonly used. Methods and application SEGMENT SSI LIMITS UPTO Rs. 5 cr ABOVE Rs 5 cr TRADE & SERVICES ABOVE Rs 1 cr & UPTO Rs 5 cr ABOVE Rs 5 cr INDUSTRIAL UNITS Rs 25 lacs & Rs 5 cr ABOVE Rs 5 cr PROJECTED BALANCE SHEET METHOD & OVER BUT UPTO PROJECTED TURNOVER METHOD PROJECTED BALANCE SHEET METHOD UPTO Rs. 1 cr METHOD TRADITIONAL METHOD & NAYAK COMMITTEE METHOD PROJECTED BALANCE SHEET METHOD TRADITIONAL METHOD FOR TRADE & PROJECTED TURNOVER METHOD PROJECTED BALANCE SHEET METHOD & PROJECTED TURNOVER METHOD PROJECTED BALANCE SHEET METHOD BELOW Rs 25 lacs TRADITIONAL METHOD Various methods indicated are discussed in detail: Operating cycle method Any manufacturing activity is characterized by a cycle of operations consisting of purchase of raw materials for cash, converting them into finished goods and realizing cash by sale of these finished goods. The time that lapses between cash outlay and cash realization by sale of finished goods and realization of sundry debtors is known as length of operating cycle. That is , the operating cycle consists of: i. ii. iii. iv. Time taken to acquire raw materials and average period for which they are in store. Conversion process time Average period for which finished goods are in store and Average collection period of receivables (sundry debtors). Operating Cycle is also called cash-to-cash and indicates how cash is converted into raw materials, stocks in process, finished goods, bills (receivables) and finally backs to cash. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Working capital is the total cash that is circulating in this cycle. Therefore, working capital can be turned over or deployed after completing the cycle. Factors, which influence working capital requirement, are: i. ii. Level of operating expenses and Length of operating cycle. Any reduction in either of the both will mean reduction in working capital requirement or indicate an efficient working capital management. It can thus be concluded that by improving that by improving the working capital turnover ratio (i.e. by reducing the length of operating cycle) a better management (utilization) of working capital results. It is obvious that any reduction in the length of the operating cycle can be achieved only by better management only by better management of one or more of the individual phases of the operating cycle period for which raw materials are in store, conversion process time, period for which finished goods are in store and collection period of receivables. Looking at whole problem from another angle, we find that we can set up extremely clear guidelines for working capital management viz. examining the length of each of the phases of the operating cycle to assess the scope for reduction in one or more of these phases. The length of the operating cycle is different from industry to industry and from one firm to another within the same industry. For instance, the operating cycle of a pharmaceutical unit would be quite different from one engaged in the manufacture of machine tools. The operating cycle concept enables to assess working capital need of each enterprise keeping in view the peculiarities of the industry it is engaged in and its scale of operations. Operating cycle is an important management tool in decision –making. Traditional method of assessment of working capital requirement The operating cycle concept serves to identify the areas requiring improvement for the purpose of control and performance review. But, as bankers, we require a more detailed analysis to assess the various components of working capital requirement viz., finance for stocks, bills etc. Bankers provide working capital finance for holding an acceptable level of current assets viz. raw materials, stock-in-process, finished goods and sundry debtors for achieving a predetermined level of production and sales. Quantification of these funds required to be CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI blocked in each of these items of current assets at any time will, therefore provide a measure of the working capital requirement of an industry. Raw material: any industrial unit has to necessarily stock a minimum quantum of materials used in its production to ensure uninterrupted production. Factors, which affect or influence the funds requirement for holding raw material, are: i. ii. iii. iv. v. vi. vii. viii. ix. x. Average consumption of raw materials. Their availability – locally or form places outside, easy availability / scarcity, number of sources of supply Time taken to procure raw materials (procurement time or lead time) Imported or indigenous. Minimum quantity supplied by the market (Minimum Order Quantity (MOQ)). Cost of holding stocks (e.g. insurance, storage, interest) Criticality of the item. Transport and other charges (Economic Order Quantity (EOQ)). Availability on credit or against advance payment in cash. Seasonality of the materials. This raw material requirement is generally expressed as so many months requirement (consumption). Stock in process: barring a few exceptional types of industries, when the raw material get converted into finished products within few hours, there is normally a time lag or delay or period of processing only after which the raw materials get converted into finished product. During this period of processing, the raw materials get converted into finished goods and expenses are being incurred. The period of processing may vary from a few hours to a number of months and unit will be blocked working funds in the stock-inprocess during this period. Such funds blocked in SIP depend on: i. ii. iii. iv. v. The processing time Number of products handled at a time in the process Average quantities of each product, processed at each time (batch quantity) The process technology Number of shifts. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Finished goods: all products manufactured by an industry are not sold immediately. It will be necessary to stock certain amount of goods pending sale. This stock depends on: i. ii. iii. iv. v. vi. vii. viii. ix. Whether the manufacture is against firm order or against anticipated order Supply terms Minimum quantity that can be dispatched Transport availability and transport cost Pre-dispatch inspection Seasonality of goods Variation in demand Peak level/ low level of operations Marketing arrangement- e.g. direct sale to consumers or through dealers/ wholesalers. The requirement of funds against finished goods is expressed so many months’ cost of production. Sundry debtors (receivables): sales may be affected under three different methods: i. ii. iii. Against advance payment Against cash On credit A unit grants trade credit because it expects this investment to be profitable. It would be in the form of sales expansion and fresh customers or it could be in the form of retention of existing customers. The extent of credit given by the industry normally depends upon: i. ii. iii. iv. v. Trade practices Market conditions Whether it is bulky by the buyer Seasonality Price advantage Even in cases where no credit is extended to buyers, the transit time for the goods to reach the buyer may take some time and till the cash is received back, the unit will have to be cut out of funds. The period from the time of sale to receipt of funds will have to be reckoned for the purpose of quantifying the funds blocked in sundry CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI debtors. Even though the amount of sundry debtors according to the unit’s books will be on the basis of Sale Price, the actual amount blocked will be only the cost of production of the materials against which credit has been extended- the difference being the unit’s profit margin- (which the unit does not obviously have to spend) The working capital requirement against Sundry Debtors will therefore be computed on the basis of cost of production (whereas the permissible bank finance will be computed on basis of sale value since profit margin varies from product to product and buyer to buyer and cannot be uniformly segregated from the sale value). The working capital requirement is expressed as so many months’ cost of production. Expenses: it is customary in assessing the working capital requirement of industries, to provide for 1 month’s expenses also. A question might be raised as to why expenses should be taken separately, whereas at every stage the funds required to be blocked had been taken into account. This amount is provided merely as a cushion, to take care of temporary bottlenecks and to enable the unit to meet expenses when they fall due. Normally 1-month total expenses, direct and indirect, salaries etc. are taken into account. While computing the working capital requirements of a unit, it will be necessary to take into account 2 other factors, i. Is the credit received on purchases- trade credit is a normal practice in trading circles. The period of such credit received varies from place to place, material to material and person to person. The amount of credit received on purchases reduces the working capital funds required by the unit. ii. Industries often receive advance against orders placed for their products. The buyers, in certain cases, have to necessarily give advance to producers e.g. custom made machinery. Such funds are used for the working capital of an industry. It can be thus summarized as follows: 1. Raw materials Months Rs. A CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 2. 3. Stock-in-process Finished Goods requirement Months (cost of Production) Months cost of Production required to be stocked Months cost of Production (o/s credits) One month(normally) Rs. B Rs. C 4. 5. LESS Sundry Debtors Expenses Credit received on Purchases (months’ Purchase value) Advance payment Rs. D Rs. E A+B+C+D+E Rs. F Rs. G On order received WORKING CAPITAL REQUIRED (H)= (A+B+C+D+E)- (F+G) The purpose of assessing the W/C requirement of the industry is to determine how the total requirements of funds will be met. The two sources for meeting these requirements are the unit’s long-term sources (like capital and long term borrowings) and the short-term borrowings from banks. The long-term resources available to the unit are called the liquid surplus or Net Working Capital (NWC). It can be explained by visualizing the process of setting up of industry. The unit’s starts with a certain amount of capital, which will not normally be sufficient, even to meet the cost of fixed assets. The unit, therefore, arranges for a long-term loan from a financial institution or a bank towards a part of the cost of fixed assets. From these two sources after meeting the cost of fixed assets some funds remain to be used for working capital. This amount is the Net Working Capital or Liquid Surplus and will be one of the sources of meeting the working capital requirements. The remaining funds for working capital have to be raised from banks; banks normally provide working capital finance by way of advantage against stocks and sundry debtors. Banks, however, do not finance the full amount of funds required for carrying inventories and receivables: and normally insist on the stake of the enterprise at every stage, by way of CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI margins. Bank finance is normally restricted to the amount of funds locked up less a certain percentage of margins. Margins are imposed with a view to have adequate stake of the promoter in the business both to ensure his adequate interest in the business and to act as a protection against any shocks that the business may sustain. The margins stipulated will depend on various factors like salability, quality, durability, price fluctuations in the market for the commodity etc. taking into account the total working capital requirements as assessed earlier, the permissible limit, up to which the bank finance cab be granted is arrived. While granting working capital advances to a unit, it will be necessary to ensure that a reasonable proportion of the working capital is met from the long-term sources viz. liquid surplus. Normally, liquid surplus or net working capital be at least 25% of the working capital requirement (corresponding to the benchmark current ratio of 1.33), though this may vary depending on the nature of industry/ trade and business conditions. The format in which the Bank assesses the working capital requirement and the permissible limit of Bank finance under Traditional Method is shown below: Assessment Of Working Capital Requirements Name of the Unit : M/s ABC Limited * ** Anticipated monthly sales Cost of production per month Cost of raw material per month Item Stocking/ Payment Period 1 . 2 . Raw material Work in process 1 month 2 weeks (Rs. In 000’s) Rs. 100 Rs. 90 Rs. 80 Working capital Require d 80 45 25 25 20.00 11.00 60.00 34.00 Margin Amount % Permissible Limit CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 3 . 4 . 5 . 6 . Finished goods 2 weeks 45 90 10 270 (A) 25 33 100 11.00 23.00 10.00 75.00 34.00 67.00 ----195.00 Receivables (@sale value) 1 month Expenses Total Less: advance payment recd. Credit on purchase Working capital required 1 month 10.00 40.00 270-50 50.00 220 (B) (C) (A-B) Sources: Liquid surplus in Balance sheet as at the end of last year Limits from Bank Total Net deficit (C-D) 20 195 215 (D) 5 How the deficit will be met: deficit will have to be met by plough back pf profits or unsecured loans. Deficit should be reasonably small when compared to the working capital requirements / bank finance/ profitability of the unit. Note: * Sales to be computed at the maximum level anticipated production during the next 12 months ** Cost of production includes cost of raw materials plus all expenses Receivable under “working capital required” is stated at cost and under “permissible limits” value thereof is at sale value less margin. For items 3. And 4. , The basis of calculation would be the cost of production. Net working capital deficit, if any, in the balance sheet, is to be added to working capital requirement. Since the limits will be arrived on the projections given by the unit, the assumptions and presumptions made by the unit should be properly analyzed before sanction of limit. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Projected Annual Turnover Method for SME units (Nayak Committee) For SME units, which enjoy fund based working capital limits up to Rs.5 crore, the minimum working capital limit should be fixed on the basis of projected annual turnover. 25% of the output or annual turnover value should be computed as the quantum of working capital required by such unit. The unit should be required to bring in 5% of their annual turnover as margin money and the Bank shall provide 20% of the turnover as working capital finance. Nayak committee guidelines correspond to working capital limits as per the operating cycle method where the average production/ processing cycle is taken to be 3 months. Example: • • Rs. In 000’s : : 1200 (A) 300 (B) Anticipated annual output Working capital requirement @ 25% of A Less: liquid surplus or 5% of A Whichever is higher • (liquid surplus, say, is Rs. 20000) : • 60 (C) 240 Minimum permissible bank Finance (B-C) : Important clarifications: i. The assessment of WC limits should be done both as per Projected Turnover Method and Traditional Method, wherever applicable as given in the table on “Methods and Application” ; and the higher of the two is to be sanctioned as credit CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI limit. If the credit requirement based on production/ processing cycle or Projected Balance Sheet Method is higher than the one assessed under Nayak Committee Method, the same may be sanctioned, as Nayak Committee guidelines stipulate bank finance at minimum of 20% of the projected turnover. On the other hand, if the assessed credit requirement is lower than the one assessed under Nayak Committee method, while the credit limit can be sanctioned at 20% of the turnover, actual drawals may be allowed on the basis of drawing power to be determined by the banks after excluding unpaid stocks. ii. If the operating cycle is more than 3 months, there is no restriction on extending finance at more than 20% of the turnover provided that the borrower should bring n proportionally higher stake in relation to his requirements of bank finance. iii. While the approach of extending need based credit will be kept in mind, the financial strengths of the unit is also important, the later aspect assumes greater significance so as to take care of quality of bank’s assets. The margin requirement , as a general rule, should not be diluted. Appraisal i. ii. iii. iv. It should be ensured that the projected annual turnover is reasonable and achievable by the unit and further, the estimated growth if any over the previous year is realistic. The returns filed with statutory authorities may be useful guiding documents for verification of sales and assessment of reasonableness of the projections. The entire sale proceeds should be routed through the Cash Credit account of the bank. Date of actual sales pertaining to the last 5 years, estimated for the current year, and projected for the next year, together with the trend analysis of the industry to which the unit belongs, would also be useful while appraising the sales projections. v. Other information regarding modernization, expansion of the existing manufacturing capacity, government policy, taxation and other relevant internal and external factors also need to be taken into account. vi. Any projections say beyond 15% of the previous year actuals or current year estimates would need closer look. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Tandon and Chore Committee Recommendations Till year 1996-97, banks in India were following the concept of Maximum Permissible Bank Finance (MPBF) for working capital limits, as enunciated in Tandon and Chore committee reports. In the monetary and credit policy for the first half-year of 97-98, RBI announced withdrawal of their guidelines on assessment of working capital finance based on the MPBF concept. State Bank of India felt that many aspects of the Credit Monitoring Arrangement (CMA) followed till then were based on sound principles of lending. Hence, while there was a need to continue to adopt these, certain flexibility was required to be brought into the method to avoid any rigid approach to fixing the quantum of finance. In the area of supervision, there was a need to rationalize the existing financial follow up procedure. As a consequence, the bank adopted the projected Balance Sheet method in the second half of the year 1997-98 onwards. MPBF METHOD The Tandon Committee was appointed o suggest a method for assessing the working capital requirements and the quantum of bank finance. Since at that time, there was scarcity of bank’s resources, the Committee was also asked to suggest norms for carrying current assets in different industries so that bank finance was not drawn more than the minimum required level. The Committee was also asked to devise an information system that would provide, periodically, operational data, business forecasts, production plan and resultant credit needs of units. Chore Committee, which was appointed later, further refined the approach to working capital assessment. The MPBF method is the fall out of the recommendations made by Tandon and Chore Committee. Approach to lending Regarding approach to lending: the committee suggested three methods for assessment of working capital requirements. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI First method The quantum of bank’s short-term advanced will be restricted to 75% of working capital gap where “working capital gap” is equal to “current assets” minus “current liabilities other than bank borrowings”. Remaining 25% is to be met from long-term sourced. Second method Met working Capital should at least be equal to 25% of total value of acceptable level of current assets. The remaining 75% should first be financed by Other Current Liabilities and the bank may finance balance of the requirements. Third method The borrower should provide for entire core current assets and 25% balance current from the Net working Capital. To compute the level of working capital requirement of the unit, the analyst has to assess the level of current assets it has to carry, consistent with its projected level of production and sales. Inventory and receivables constitute most of the current assets. Projected Balance Sheet Method (PBS) The PBS method of assessment will be applicable to all C&I borrowers who are engaged in manufacturing, services and trading activities who require fund based working capital finance of Rs. 25 lacs and above. In case of SSI borrowers, who require working capital credit limit up to Rs. 5 cr, the limit shall be computed on the basis of Nayak Committee formula as well as that based on production and operating cycle of the unit and the higher of the two may be sanctioned.. The assessment will be based on the borrower’s projected balance sheet, the funds flow planned for current/ next year and examination of the profitability, financial parameters etc. unlike the MPBF method, it will not be necessary in this method to fix or compute the working capital finance on the basis of a stipulated minimum level of liquidity (Current Ratio). The working capital requirement worked out is based on the following: i. CMA assessment method is continued with certain modifications. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI ii. Analysis of the Profit and Loss account, Balance Sheet, Funds flow etc. for the past periods is done to examine the profitability, financial position, and financial management etc of the business. iii. Scrutiny and validation of the projected income and expenses in the business and projected changes in the financial position (sources and uses of funds). This is carried out to examine whether these parameters are acceptable from the angle of liquidity, overall gearing, efficiency of operations etc. In the PBS method, the borrower’s total business operations, financial position, management capabilities etc. are analysed in detail to assess the working capital finance required and to evaluate the overall risk. There will not be a prescription like mandatory minimum current ratio or maximum level of a current asset. Under the method, assessment of WC requirement will be carried out in respect of each borrower with proper examination of all parameters relevant to the borrower and their acceptability. The assessment procedure is as follows: i. ii. iii. iv. v. Collection of financial information from the borrower Classification of current assets / current liabilities Verification of projected levels of inventory/ receivables/ sundry creditors Evaluation of liquidity in the business operation Validation of bank finance sought CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 4. CREDIT RISK ASSESSMENT (CRA) The CRA model adopted by the bank take into account the factors, which go into appraising the risks, associated with the loan. These have been categorized broadly into : 1. Financial risks 2. Business risks 3. Industrial risks 4. Management risks They are weighted separately. To arrive at the overall risk rating, the factors duly weighted are aggregated and calibrated to arrive at “a single point indicator of risk” associated with the credit decision. 1. Financial parameters: the assessment of financial risk involves appraisal of the financial strength of the borrower based on performance and financial indicators. The overall financial risk is assessed in terms of static ratios, future prospects and risk mitigation (collateral security/ financial standing). CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 2. Business parameters: the following are the important parameters associated with business risk: • • • • 3. Technology Consistency in quality Consistency in cash flow Compliance of environmental regulations Industry parameters: the following characteristics of an industry which pose varying degrees of risk are built into the Bank’s CRA model: • • • • Competition Industry outlook Regulatory risk Contemporary issues like WTO etc. 4. Management parameters: the management of an enterprise/ group is rated on the following parameters: • • • • • • • • • • • Integrity (corporate governance) Track record Managerial competence/commitment Expertise Structure and systems Experience in the industry Credibility: ability to meet profit(PAT) projections Credibility: ability to meet sales projections Payment record Strategic initiatives Length of relationship with the bank As such, these are broad based risk categories or risk factors built into CRA models. CRA takes into account the above types of risks associated with the borrowal unit. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI The eventual CRA rating awarded to a unit is (based on a score out of 100) is a single point risk indicator of an individual credit exposure and is used to identify, to measure and to monitor the credit risk of an individual proposal. At the corporate level CRA is also used to track the quality of bank’s portfolio. The risk parameters as mentioned above are individually scored to arrive at an aggregate score of 100 subject to qualitative factors- negative parameters. Type of rating awarded to loan proposal Under CRA, the rating is graded into 8 tiers, viz., SB1 to SB8 for Working Capital Limits in an ascending order of risk levels perceived in the borrowals accounts on the basis of aggregate score out of 100. Credit rating linked to loan pricing Pricing bands over Prime Lending Rate are linked to Credit Rating , with some flexibility for deviations delegated to different Sanctioning Authorities as per prescribed structure RATING SB1 SB2 SB3 SB4 SB5 SB6 SB7 SB8 SCORING BAND >=90 >=75 >=65 >=50 >=45 >=35 >=25 <25 % OVER BPLR SSI 0.25 1.00 1.50 2.00 2.00 2.00 2.00 2.00 C&I 0.75 1.50 2.00 2.50 2.50 2.50 2.50 2.50 The CRA model also stipulates a minimum score under financial, business, industry and management risk parameters for a proposal to be considered acceptable in a given form. The details of such minimum scores are as under: Risk segments Existing units New units CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Financial Business Industry Management Total 20/47 11/20 4/8 15/25 50/100 11/25 10/25 5/10 24/40 50/100 5. DOCUMENTATION General The loan I security document are crucial importance to the bank in respect of all loans and advances as they constitute the primary evidence in any legal proceedings relationship between the bank and the barrower/guarantor. They establish the precise jural relationship between the bank and the barrower/guarantor. In absence of properly executed it may be very difficult or the bank to succeed in any of the suit filed in a court of law for enforcing its rights under the documents. The legal protection and judicial adjudication always requires and depends upon valid documents. Object (a) The object of the documentation is to serve as primary evidence of enforcing the bank’s right to recover the contracted debt through the court of law in the event of all other recourses proving to be of no avail. Documentation will succeed in fulfilling this objective only when following requirements are met i. ii. The owning of the debt to the bank by the borrower is established by documents The change created on the borrowers asset and security for the debt is preserved, protected, perfect and maintained in accordance with the law CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI iii. The bank’s right to enforce the security for recovery of the debt through court of law is not barred by expiry of limitation under the law of limitation. Purpose The purpose of the document is that it helps in identifying the parties, the nature and the extent of security, in/for providing evidence of the transaction, for settling/crystallizing the terms and conditions, for defining the rights and liabilities of parties or under the securities, for creating the charges encumbrance, for protecting /preventing the priority of charges, for computing the period of limitation and lastly for enforcing the rights under. Requirement A document to server the above purpose and objective must contain correct description of the parties, mention the actual place of execution mention correct date of execution contain accurate description of the properties/security, contain proper recitals /covenants, provide for consideration for the transaction, stipulate the term and condition of repayment, contain all other essential terms and, be duly stamped and must be registered and attested whenever the law requires the document to be so attested whenever the law requires the document to be attested and registered. Any document by borrower/guarantor of favoring the bank depends upon the type of charges (hypothecation, pledged, mortgage, etc) type of the advance (demand loan, cash credit, term loan etc), nature of the security (movable or property, actionable claims etc) and finally upon the constitution of the borrower/guarantor (individual, partnership, company, association of persons, Trust, HUF etc) While obtaining the document regard must be had to the constitution of the borrower/guarantor and its/their authority and competence to execute the documents, the nature and type of securities being the change, legal nature of the charges and applicable laws thereto. 1. Document in general parlance is understood to mean any matter written upon a paper in some language known to and understood to mean written upon a papers in some language known to and understood by the parties to such document. According to the definition given in section 3 of the evidence Act, it means any matter expressed or described or described upon any substance weather paper, letter, stone leather or leaves by means of letters, figures or mark CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI or concerning or by more than one of those means which is indented to be used for the purpose of recording that rights, obligation, responsibilities and liabilities relating to or concerning or in respect of the transaction or the parties or the ownership and/ or possession of the property and for matters incidental thereto and which is admissible in law as a piece of evidence or record of bargain/ transaction.Section 2(14) of the Indian Stamp Act 1899 defines instrument’ Instrument includes every document by which any right or liability is, or purports to be, created, transfer, limited, extended, extinguishing or recorded.Instrument is a document, which effects any right or liability. All instruments are documents but all documents need not necessarily be instruments. Other expressions of relevance to Documentation Actionable claim Means as per the definition in the Transfer of Property Act, a claim to any debt other than a debt secured by mortgage of immovable property or by hypothecation or pledge of movable property or to any beneficial interest in a movable property not in the possession, either actual or constructive, of the claimant, which the civil courts recognize as affordable for relief, whether the debt or beneficial interest be existent, accruing, conditional or contingent. Book debt Book debts are that the debts owning to a business and are taking and arise primarily out of sale of merchants to the customers on credit. This term is usually shown as the sundry debtors on the asset side of the balance sheet. Chosen in action The property which a person has not got in actual possession but which he has a right to demand an action at law. Money due upon a bill of exchange, book debts, insurance policies, the legacies, stocks and shares in the company are the example of a chosen in action. Where the money or the goods are in a actual possession, they are called chosen in possession. Documents of title to goods CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI According to section 2(4) of the sales of goods Act 1930, it includes a bill off lading, dock warranty, a warehouse-keeper certificate, wharfinger’s certificate, and railway receipt Warrant or order for the delivery of goods and other document used in the ordinary course of business as proof of the possession or control of goods or authorizing or purporting to authorize either by endorsement or by delivery, the possessor of the documents to transfer or receive goods thereby represented. Inchoate instrument Means an incomplete document signed by a person and handed over to another person to fill up and make into a complete document. Title deeds A legal instrument showing or reflecting the evidence of a person’s right to landed property. It shows in whom the legal estate is vested and how the land has been transferred from one person to another by the deed till finally it was transferred to the present owner through the longer course of years. A person’s right to a piece of land is proved by the documents called ‘title deeds’. Executed or execution Section 2(12) of the Indian stamp Act 1899 states that ‘executed’ and ‘execution’ used with reference to instrument means” signed “and signature”. Signature includes a mark by an illiterate person. Signature must be the signature of all persons necessary to complete the transaction. If a document is required to be attested under any person necessary to complete the transaction. If document is required to be attested under any law, signature of the attester/s must be written to complete the execution. The word ‘execution’ means that the person by affixing his signature or mark has signed his assets to the contents of the documents. However the proof of the signature cannot always means or regarded as tantamount to proof of the execution. It is necessary for a document to be said to have been executed by a person, that there should be not only physical contact of signing the document but a mental inclination of executing it. If a person of unsound mind CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI signs a document he cannot be said to have executed the document as mental act is silent in such case. Execution consists in signing a document written out, read and understood. It dose not merely consists of a name on a blank paper. The execution of a document means signing, sealing and delivering. To execute means to go through the formalities necessary of the validity of legal act. Execution implies conscious execution and knowledge of its contest thereof dose not amount to execution. The execution of a document is always a question of fact and it must be proved like any other fact. Execution of a document –Burden of proof The responsibility or the burden to prove a document that it has been executed by the borrower or the guarantor lies on the bank. Mere admission of the signature or the thumb impression by the borrower dose not mean that he has admitted the execution of a document. As the document do not prove themselves, it is essential for the bank, before a document is relied upon as evidence, it must be filled in the court and must be proved according to law. Bank witnesses must be examined to prove the document. The contents of the documents may be proved either by primary or secondary evidence. It must be the production of the original document itself for inspection and examination of the court unless the secondary evidence of it is permitted under section 65 of the Evidence Act. The law requires, as a first requirement, the production of the original document and as a secondary requirement proving the signature or the thumb impression or the handwritten of the borrower. In proving a document or signature, two distinct kind of evidence are produced. Firstly the evidence of witness who saw the act of writing, and secondly the testimony of a person as to the kind of writing or the signature The first is direct evidence and the second is indirect evidence. In terms of section 45 of the Evidence Act (ibid) permits the opinion of any other person acquainted with the handwriting of the person by whom it is alleged to have been written or been signed, that it was or was not so written or signed by him. Section 73 (ibid) empowers the court to compare the dispute document or the signature with the one undisputed for the purpose of deciding as to weather a CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI particular document was written or signed by a person, by whom it is supposed to be written or signed. The dispute or the signature or the writing is compared with any admitted writing or signature or with the one already proved elsewhere. It may also be compared with a writing or signature which was written or signed in the Court room itself with the old handwriting or signature of person whose handwriting or the signature is in the question or the court may make the person write or sign it and then compare the dispute writing or signature with the said specimen. Methods to prove a writing or signature A writing or signature may be proved by any of the following methods. 1. By calling a person who has signed or wrote the document, or 2. By calling a person in whose presence the document was written or signed, or 3. By calling a handwriting expert or fingerprint expert, or 4. By calling a person acquainted with the handwriting of the person by whom the document is supposed to have been signed or written, or 5. By comparing by the court of disputed signature or the handwritten with some admitted signature or handwriting, or 6. By the proof of an admission by the person who is alleged to have signed or written the document that he is signed or wrote the document, or 7. By the statement of a deceased professional scribe, made in his diary or on the course of the business, that the signature in the document is that particular person, or 8. By other circumstantial evidence. Bank document and admission of signature If the borrower contends that the bank obtained his signature or thumb impression on the blank paper and then it might have got prepared a document, it means the borrower dose not admit his signature or the impression. In such cases the burden lies on the bank to prove the execution in the manner stated above. However if the borrower admits his signature or the thumb impression on a document but contends that it was on a blank paper, then the burden lies on the borrower to prove the said contention. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Execution of documents in a language not known to borrower-burden of proof When a document has been written in a language and signed by a person not knowing that language, the burden t prove that the contents of the document was read over and explained to such borrower and that the borrower has executed the document only after understanding the implication thereof, lies on the bank who relies on document for recovery of its dues. Attestation The transfer of property Act 1882 defines the expression ‘attestation’ as Attested in relation to an instrument, means, and shall be deemed always to have meant, attested by two or more witness, each of whom has seen the executants sign or affix his mark to the instrument, or has seen some other person sign in the instrument in the presence and by the direction of the executants or has received from the executants a personal acknowledgement of his signed the instrument in the presence of the executants; but it shall not be necessary that more than one of such witness shall have been present at the same time, and no particular from of attestation shall be necessary. Attestation is not necessary for the validity of document, which are not required by law to be attested. The person must sign as a witness and for the purpose of attesting the execution of a document. An executant’s (i.e., the borrower himself) cannot be an attesting witness. General precautions to be taken at the time of execution of documents 1. The document should not be typewritten: invariably the document should be handwritten. 2. All the blanks in the document should be filled in neatly and legibly using standard indelible ink and with the same pen. 3. The document should not be filled in by the bank officials. It should be discouraged. They however may provide the entire assistance-required for the purpose to barrower/guarantor. 4. The document should be executed in the presence of bank official responsible for obtaining them. The branch officials should always be in position to identify both the borrower and the guarantor should such a need arise before any forum. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 5. The document and the schedules attached thereto should be got completed as far as possible in one sitting and in the same handwriting. 6. The immovable property should be described with the reference to their survey numbers, patta numbers etc along with their boundaries exactly as mentioned in the original title deeds. Always location or sites maps should be drawn and kept along with the loan documents. 7. All pages and schedules should be signed in full and in the same style throughout. The name should be spelt out in the block letters under the signature in the last page. Signature should be at the end of every document and also at the end of the schedules. 8. All types of additions, alterations, cutting, cancellations, deletion etc should be authenticated by the borrower/guarantors under his/her full signatures. Over writing or interlineations in a document should be avoided without any exceptions. This is because there is always a presumption in the law that the unauthenticated interlineations, alterations, additions, cuttings, cancellations and deletions were made after the execution of the document. 9. Date and place of execution should be mentioned where they must mention the two or more borrower/guarantors sign the document at different places and on the different dates and the fact of their doing is so in their handwriting. 10. When different person executes a document at different dates, the executants should be requested to sign and record the dates under their signature. Under the law the document is said to have been duly completed only when it has been executed by the last of the persons. The limitation period starts from the following day of the last date of execution by the last person mentioned in the document. 11. Never a document should be antedated. If a date on the document appears to be prior to the date of stamping or date of purchase of stamps, such document would be treated as invalid on the grounds of that it has not been duly stamped. 12. The document should not bear double dates “2/3 April2003’. All documents should bear the same date uniformly. There should not be any variation in the dates on the documents executed by the same party. Subject to what is stated in the paragraph 10 above, where the executants has recorded the date under his signature and the CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI execution of the document is complete thereto, then the date of the document should not be different from the date on which the executants had signed the document. 13. Interest clause must be mentioned correctly. The rate of interest and the mode of payment viz., monthly quarterly, half yearly should be mentioned with sufficient clarity as per the terms of sanction. 14. The document should be as per the terms and condition of sanction. 15. Signature of the person should be obtained on each page and also on pages facing each other and across the fold of the document in such a manner that the signature runs on the both pages. If a borrower /guarantor signs in the left hand, a small note should be annexed to the document recording the said fact that the borrower/guarantor have so signed in left hand. 16. On behalf of the bank only the authorized officer should sign on the last page of the document. 17. Keeping a document bank or even one or more columns in the contents of the documents should be explained in a language known to them and the fact of such explanation should be recorded. 18. If the executant is an illiterate person, his lift hand thumb impression (right hand thumb impression in case of female by convention) should be obtained on all the documents. It is always advisable to obtain a photograph bearing clear identification of such person and should be kept on record. Thumb impression is also necessary for authentication each and every blank filled in the document. 19. In case the signature is in vernacular language or the document has been affixed with the thumb impression of the person it will be necessary to obtain a separate letter of decoration in vernacular language conforming that the content of the document are properly read over and explained to the executant of the vernacular language and the executant has affixed its thumb impression or the signature in vernacular language only after understanding the nature and declaration from some person known to the executant for conforming the execution of the document s by such illiterate person on if the person is woman belonging to Muslim community, in his presence by such executant. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 20. The preamble in the bank documents dose not provide for the mentioning the name of the branch where the account is to be operated; thus where the facility is originally granted at a certain branch and it is to be availed at another branch at a later date and the relative account are transferred to that branch, it would not be necessary to obtain fresh documents. The place and date of execution of document should however need to be stated in the documents. 21. While using non-judicial stamp paper, at least some portion of the printed document should be handwritten on the stamp paper and the corresponding portion in the printed document should be deleted from the document under authentication. Under no circumstances stamp paper should be on the printed documents. 6.CREDIT PROCESS Pre-Sanction Process Indicative list of Activities in the Appraisal Function A. Preliminary appraisal • Obtain i. ii. iii. iv. v. vi. • Application for working capital Finance Audited financial for the previous three years Details of existing borrowing arrangements Reports from existing Banker on the application copy Financial statements, borrowings relationship of Associate firm/group companies Profile of promoters /senior management personnel If request includes project financing, obtain additional: CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI i. ii. iii. iv. • Project report Appraisal report form Financial institutions in case Appraisal has been one by them NOC form term lenders if already financed by them Report form Merchant bankers in case capital market is being accessed Examine the following: i. ii. iii. iv. v. vi. vii. viii. ix. x. xi. xii. xiii. xiv. xv. xvi. xvii. Bank’s lending policy/RBI guidelines, policies Prudential Exposure norms Industry Exposure restrictions Group Exposure restrictions Industry related risk factor List of defaulters Caution lists Compliances regarding transfer of borrowal accounts from one to another, it applicable Gov. regulation/legislation impacting on the industry Acceptability of the promoters Application’s status vis-à-vis other units in the industry Financial status in broad term and whether it is acceptable Examine also the following in case of request of project finance : Weather the project cost is prima facie acceptable Debt/equity gearing proposed and whether acceptable Promoter’s ability to access capital market for debt/equity support Whether critical aspect of project –demand, product cost profitability etc. are prima facie in order Arrived at a preliminary decision to support or not to support the request. bank B. Detailed appraisal Carry out a detailed appraisal alter a pre-sanction visit to applicant Company/their office/project site. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI • Working capital facilities Examine/Analyze/Assess; i. ii. iii. • • • • • iv. v. vi. vii. viii. ix. Financials (in the prescribed form) Financial ratio and other ratios relevant to the project- Dividend policy Other aspects viz. Depreciation method Revaluation method Record of defaults (tax duties etc.) Pending suits having financial implications (custom excise etc.) Qualification of balance sheets, Auditor remarks etc. Trends in sale and probability Past deviation in sale and profit projections Product capacity & use-past and projected Estimate/ projections of sales values Estimated working capital gap with reference to acceptable build up of inventory/receivable/other current asset. Project levels whether acceptable By sourcing information where necessary form: Stock Exchange Exchange Directory financial journals/ publications, professional entities like INFAC, CMIE etc. with emphasis on following aspects: • • • • • • • • • Market shore of the units under comparison Unique features Profitability factors Financial pattern of the business Inventory receivable levels Capacity utilizations Production efficiency and costs Bank borrowing patterns Financial ratio & other relevant ratio CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Credit rating Draw up trading for: • • Opinion reports Compile opinion report on partners/promoters and the proposed guarantors Working capital Term finance Review of the proposal • • • Strength and weakness of the exposure proposed Risk factor and steps proposed to mitigate them Deviations proposed from usual norms of the bank and the reasons Proposal of sanction: Prepare a draft proposal in prescribed format with required back-up details and with recommendations for sanction Sanction Indicative list of Activities Involve in the sanction Function • Peruse the proposal to see if the report prima facie present the proposal, remit it back to the Assessor for the required data/clarifications. • Examine critically the following aspect of the proposed exposure 1. Bank’s lending policy 2. Borrowers status in the industry 3. Industry aspect 4. Experience with units in similar industry CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 5. Overall strength of the borrower 6. Project level of operation 7. Risk Factors critical to the exposure and adequacy of safeguards there against proposed. 8. Value of existing connection with the borrower 9. Credit risk rating 10. Security pricing charges and concessions proposed for the exposure and covenants stipulated vis-à-vis the risk perception POST SANCTION PROCESS 1. Follow up The follow-up functions will cover the following: (a) Ensuring on an ongoing basis compliance with terms and conditions of sanction through the system of control measures/feedback viz. Inspection visits, prescribed financial/ operation statements from the borrower interaction with borrower etc. (b) Tracking performance of the borrower, ensuring safety and recoverability of the advances (c) Ensuring compliance with all the internal and external reporting covering the advances. Indicative list of the activities involved in the Follow-up function is as follows: • • • • • Conveying sanction of advances to the borrower detailing the terms and conditions and obtaining acceptance thereof Preparation-submission of control returns for sanction CMA reporting of sanction where applicable Completion of applicable documentation; maintaining custody and validity of the documents. Creation of charge over security and completion of all relevant and applicable formalities, including: 1. Creation of Registered or Equitable mortgage requirements CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 2. Creation of second charge 3. Registration of charge with ROC 4. Periodical search of charge with ROC Ongoing scrutiny of transaction in the various accounts by perusal of leaders, registers, vouchers etc. to watch for proper conduct of the accounts, healthy turnover therein and properend use of funds Ongoing verification of assets charged as security, to ensure availability and safety of the assets. Maintaining ongoing contact with the borrower and co-leaders and keeping abreast of developments in the borrower entities and business environment. Preparation of reviews of IRAC, identification of deterioration assets and initiations of corrective action where warranted. Account wise follow up of NPAs for recovery /rehabilitation, preparation of related recommendations to appropriate authority for approval. Supervision i. Supervision function should primarily ensure that the effective fallow of advances is in the place of the asset quality of good order is maintained. Supervisor should look out for early warning signals, identity ‘incipient sickness’ and initiate proactive remedial actions. ii. • Indicative list of activities involved in supervision function is as follows Ensuring proper flow-up of advances and observations at the operating level of the system laid down by the bank. Periodic and random examination of statements received, control register and files/record covering the advance will assist this process. • • Ensuring the security documents are kept current and that all related documentation formalities are observed by the officials responsible. Ensure that the function at the follow-up level are performed diligently and as per extant instructions of the bank. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Monitoring and Controlling i. Monitoring and controlling function ensures that effective supervision is maintained on advance and appropriate responses are initiated whenever early warning signals are seen. The function also tracks customer satisfaction and provides responses where necessary. ii. • Indicative list of activity involved in monitoring control function are as follows: Ensure that the effective supervision id maintained on advance by the lower level functionaries responsible for follow-up and supervision scrutiny of returns/reports received from these line functionaries, interaction with them, feedback from the customer, commentary in inspection/audit reports etc. will assess this process. • Monitoring high value advances through specific focus on these in the return/report received on advance and by keeping watch on the developments in the borrower company/industry • • • Ensuring non-recurrence at the operating level of the company noticed lapses/irregularities pointed out in various audit reports. Ongoing monitoring of asset portfolio by tracking changes from time to time; chalk out and arrange for carrying out specific action to ensure high standard asset content. Extending guidelines to down the line functionaries on the follow-up and ‘supervision’ of the exposures at risk. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI FINDINGS FINDINGS Methods of lending CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Like many other activities of the banks, method and quantum of short-term finance that can be granted to a corporate was mandated by the Reserve Bank of India till 1994. This control was exercised on the lines suggested by the recommendations of a study group headed by Shri Prakash Tandon. The study group headed by Shri Prakash Tandon, the then Chairman of Punjab National Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading banks, financial institutions and a wide cross-section of the Industry with a view to study the entire gamut of Bank's finance for working capital and suggest ways for optimum utilisation of Bank credit. This was the first elaborate attempt by the central bank to organise the Bank credit. The report of this group is widely known as Tandon Committee report. Most banks in India even today continue to look at the needs of the corporates in the light of methodology recommended by the Group. As per the recommendations of Tandon Committee, the corporates should be discouraged from accumulating too much of stocks of current assets and should move towards very lean inventories and receivable levels. The committee even suggested the maximum levels of Raw Material, Stock-in-process and Finished Goods which a corporate operating in an industry should be allowed to accumulate These levels were termed as inventory and receivable norms. Depending on the size of credit required, the funding of these current assets (working capital needs) of the corporates could be met by one of the following methods: • First Method of Lending: Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings. This approach was considered suitable only for very small borrowers i.e. where the requirements of credit were less than Rs.10 lacs CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI • Second Method of Lending: Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. RBI stipulated that the working capital needs of all borrowers enjoying fund based credit facilities of more than Rs. 10 lacs should be appraised (calculated) under this method. • Third Method of Lending: Under this method, the borrower's contribution from long term funds will be to the extent of the entire CORE CURRENT ASSETS, which has been defined by the Study Group as representing the absolute minimum level of raw materials, process stock, finished goods and stores which are in the pipeline to ensure continuity of production and a minimum of 25% of the balance current assets should be financed out of the long term funds plus term borrowings. (This method was not accepted for implementation and hence is of only academic interest). As can be seen above, the basic foundation of all banks' appraisal of the needs of creditors is the level of current assets. The classification of assets and balance sheet analysis, therefore, assumes a lot of importance. RBI has mandated a certain way of analysing the balance sheets. The requirements of this break-up of assets and liabilities differs slightly from that mandated by the Company Law Board (CLB). The analysis of balance sheet in CMA data is said to give a more detailed and accurate picture of the affairs of a corporate. The corporates are required by all banks to analyse their balance sheet in this specific format called CMA data format and submit to banks. While most qualified accountants working with the firms are aware of the method of classification in this format, professional help is also available in the form of Chartered Accountants, Financial Analysts for this analysis Committees CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI A study group headed by Shri Prakash Tandon, the then Chairman of Punjab National Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading banks, financial institutions and a wide cross-section of the industry with a view to study the entire gamut of Bank's finance for working capital and suggest ways for optimum utilisation of Bank credit. This was the first elaborate attempt by the central bank to organise the Bank credit. Most banks in India even today continue to look at the needs of the corporates in the light of methodology recommended by the Group. The report of this group is widely known as Tandon Committee report. The weaknesses in the Cash Credit system have persisted with the non-implementation of one of the crucial recommendations of the Committee. In the background of credit expansion seen in 1977-79 and its ill effects on the economy, RBI appointed a working group to study and suggest i) modifications in the Cash Credit system to make it amenable to better management of funds by the Bankers and ii) alternate type of credit facilities to ensure better credit discipline and co relation between credit and production. The Group was headed by Shri. K.B. Chore of RBI and was named Chore Committee. Another group headed by Shri. P.R. Nayak (Nayak Committee) was entrusted the job of looking into the difficulties faced by Small Scale Industries due to the sophisticated nature of Tandon & Chore Committee recommendations. His report is applicable to units with credit requirements of less than Rs.50 lacs. The recommendations made by Tandon Committee and reinforced by Chore Committee were implemented in all Banks and Bank Credit became much more organised. However, the recommendations were perceived as too strict by the industry and there has been a continuous clamour from the Industry for movement from mandatory control to a voluntary market related restraint. With recent liberalisation of economy and reforms in the financial sector, RBI has given the freedom to the Banks to work out their own norms for inventory and the earlier norms are now to be taken as guidelines and not a mandate. In fact, beginning with the slack season credit policy of 1997-98, RBI has also given full freedom to all the Banks to devise their own method of assessing the short term credit requirements of their clients and grant lines CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI of credit accordingly. Most banks, however, continue to be guided by the principles enunciated in Tandon Committee report. Recent Position State Bank of India and its associate banks have shifted to Projected Balance Sheet (PBS) Method in which the corporate is asked to project its balance sheet including the requirements for bank finance. The Bank validates these requirements through time-series and ratio analyses and sanctions the limits, if the level of finance projected by the corporate is found acceptable. Otherwise, the corporate is requested to alter its business plans and funding pattern. Some other Banks like Bank of Baroda have preferred Cash Flow method of assessment of corporate requirements and are shifting to this method. Under Cash Flow Method, the corporate is required to project its cash receipts and expenditure. Whenever, the expenditure overshoots the incomes, the Bank finance steps in to fill the gap. Many other banks, however, have continued with the method of Maximum Permissible Bank Finance (MPBF) While other bank loans have to be provided at rates of interest not less than Prime Lending Rate (PLR), discounting the bills of exchange has been permitted by the RBI at a rate less than PLR. RBI guidelines and measures taken for improving credit flow to the sector CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI It is proposed to accept the recommendation with regard to the credit facilities being offered by the banking sector and accordingly request the Reserve Bank of India to advise the banks to frame a policy for enhancing the flow of credit to both small and medium enterprises, within the overall framework of credit policy of banks to small and medium enterprises. The challenges being faced by the small and medium scale sector may be briefly set out as follows a. Small and Medium Enterprises (SME), particularly the tiny segments of the small enterprises have inadequate access to finance due to lack of financial information and non-formal business practices. SMEs also lack access to private equity and venture capital and have a very limited access to secondary market instruments. b. SMEs face fragmented markets in respect of their inputs as well as products and are vulnerable to market fluctuations. c. SMEs lack easy access to inter-state and international markets. d. The access of SMEs to technology and product innovations is also limited. There is lack of awareness of global best practices. e. SMEs face considerable delays in the settlement of dues/payment of bills by the large-scale buyers. With the deregulation of the financial sector, the ability of the banks to service the credit requirements of the SME sector depends on the underlying transaction costs, efficient recovery processes and available security. There is an immediate need for the banking sector to focus on credit and finance requirements of SMEs. Measures to increase the quantum of credit to SMEs at the right price 1. Public Sector Banks will be advised to fix their own targets for funding SMEs in order to achieve a minimum 20% year on year growth in credit to SMEs. The objective is to double the flow of credit from Rs.67,600 crore in 2004-05 to Rs.135,200 crore to the SME sector by 2009-10, i.e. within a period of 5 years. 2. Public Sector Banks will be advised to follow a transparent rating system with cost of credit being linked to the credit rating of the enterprise. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 3. 4. SIDBI in association with Credit Information Bureau(India) Ltd. (CIBIL)will expedite setting up a credit rating agency. SIDBI in association with Indian Banks’ Association (IBA) would collect and pool common data on risk in each identified cluster and develop an IT-enabled application, appraisal and monitoring system for small (including tiny) enterprises. This would help reduce transaction cost as well as improve credit flow to small (including tiny) enterprises in the clusters. 5. The National Small Industries Corporation has recently introduced a Credit Rating Scheme for encouraging SSI units to get themselves credit rated by reputed credit rating agencies. Public Sector Banks will be advised to consider these ratings appropriately and as per availability, and structure their rates suitably. 6. SIDBI has developed a Credit Appraisal & Rating Tool (CART) as well as a Risk Assessment Model (RAM) and a comprehensive rating model for risk assessment of credit proposals for SMEs. Public sector banks will be advised to take advantage of these models as appropriate and reduce their transaction costs. 7. Outreach of Formal Credit: Opening of New Accounts The commercial banks (including regional rural banks) with over 67,000 branches, will make concerted efforts to provide credit cover on an average to at least 5 new tiny, small and medium enterprises at each of their semi urban/urban branches per year. SBI’s year on year growth in credit to SMEs is 23.66%. total credit flow of SBI is 52269 crores on march31 2007. the total credit flow of all banks was146780 crores in 05-06 to Rs184589 crores 06-07 and 25.81% growth . CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI OBSERVATIONS OBSERVATIONS Credit dispensation:Till 1997, bank lending for large working capital requirements was based on the concept of Maximum Permissible Bank Finance (MPBF). This concept evolved in mid CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI 70’s when demand for credit was on the increase and the bank advances were pre-empted by a large few borrowers. Under the MPBF concept, the borrower was required to maintain a minimum current ratio (1.17:1 and 1..33:1 under Tandon Committee Norms). If a borrower could not maintain the minimum current ratio, generally he was considered ineligible for W.C. finance. Over a period, MPBF concept had become rigid and did not change with the environmental changes Kannan Committee: in the light of liberation in the financial sector and poor credit off take from the banking system,a committee headed by Mr. Kannan, the then Chairman of Bank of Baroda was constituted by IBA as per the directions of RBI to examine whether MPBF concept should be abolished and banks should have the sole discretion to determine the credit limits. RBI directive (April, 1997): however, RBI has made application of MPBF optional by banks . banks are now allowed full operational freedom for assessing the working capital requirements of borrowers and to lay down transparent policy and guidelines for credit dispensation in respect of each category of economic activities. Thus MPBF concept is now optional. Also, the financial follow up of advances is now maintained through Financial Follow up Report. Revised method of WC Assessment: arising out of the above directives, the bank has evolved a revised system for assessing Working Capital limits and for monitoring the advances Projected Balance Sheet Method: this is a fresh approach in lieu of the MPBF method of assessment. This will be applicable to C & I borrowers who are engaged in manufacturing, services and trading activities including merchant exporters who require fund based WC finance of Rs. 25 lakhs and SSI borrowers who require WC finance above Rs. 5 crores. For assessment of limits below Rs. 25 lakhs the simple method which was in use for assessing WC limits of Rs. 2 to Rs. 15 lakhs for SSI units is followed. The assessment will be based on the borrower’s projected balance sheet, the funds flow planned for current/ next year and examination of the profitability, financial parameters etc. unlike the MPBF method, it will not be necessary in this method to fix or compute the working capital finance on the basis of a stipulated minimum level of liquidity (Current Ratio). The working capital requirement worked out is based on the following: CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI i. ii. CMA assessment method is continued with certain modifications. Analysis of the Profit and Loss account, Balance Sheet, Funds flow etc. for the past periods is done to examine the profitability, financial position, and financial management etc of the business. iii. Scrutiny and validation of the projected income and expenses in the business and projected changes in the financial position (sources and uses of funds). This is carried out to examine whether these parameters are acceptable from the angle of liquidity, overall gearing, efficiency of operations etc. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI RECOMMENDATIONS AND SUGGESTIONS RECOMMENDATIONS AND SUGGESTIONS The problems faced by the bank and the suggestions given are with regards to increase credit flow the SMEs not only with respect to working capital finance but also project finance and asset finance. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI Problems faced by the Bank for SME lending and suggestions to overcome some of these problems: Banks are now better equipped to handle the varied needs of the SME sector due to better technology and risk management. As recommended by the Ganguly Committee, the Government has asked banks to adopt a full-service approach to cater to the diverse needs of the SME sector. This, it recommends, may be achieved by extending banking services to recognised SME clusters by adopting the 4-C approach: Customer focus, cost control, crossselling and containing risk. • To enable the banks take more objective decisions, the Government plans to introduce a rating mechanism for designated industrial clusters; this may be designed jointly by Crisil, IBA, Sidbi and SSI Associations. This would enable institutional funding to be channelled through homogenous recognised clusters. • There is a critical need to devote substantial resources to improving the skills and capabilities of banks' lending officers, especially with regard to the analysis of the SMEs' financial statements. Understanding the nature of the borrower's business and the cash-flow required is paramount to preventing the creation of NPAs. • Another way of extending loans to the SMEs is the relationship-lending rule, where the lending partly bases its decision on proprietary information about the firm and its owner through a variety of contacts over time. The information may be gathered from such stakeholders as suppliers and customers, who may give specific information about the owner of the firm or general information about the business environment in which it operates. • Insufficient data on the SMEs, the lack of credible published information about their financial health, the high vulnerability of small players in a liberalising market and the inadequacy of risk management systems in banks are factors leading to CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI higher NPAs and lower profitability than potential in SME lending. This can be overcome by collection of authentic data on the SME segment, educating the enterprises on the need for reliable financial data, evolving suitable risk models and close monitoring of accounts by the bank. • SMEs are increasingly using products such as derivatives to manage their forex flows. Bank needs to offer sophisticated products to the SMEs in a simplified manner. • They need to innovate their delivery platforms by using Internet banking, mobile banking and card-based platforms for delivery of transaction-banking as well as credit products, and enhance the service element. SMEs look for convenience and simplicity in their banking requirements and banks should deliver these through an effective use of technology. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI CONCLUSION CONCLUSION CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI The study at SBI gave a vast learning experience to me and has helped to enhance my knowledge. During the study I learnt how the theoretical financial analysis aspects are used in practice during the working capital finance assessment. I have realized during my project that a credit analyst must own multi-disciplinary talents like financial, technical as well as legal know-how. The credit appraisal for working capital finance system has been devised in a systematic way. There are clear guidelines on how the credit analyst or lending officer has to analyze a loan proposal. It includes phase-wise analysis which consists of 5 phases: 1. Financial statement analysis 2. Working capital and its assessment techniques 3. Credit risk assessment 4. Documentation 5. Loan administration State Bank of India’s adoptions of the Projected Balance Sheet method of assessment procedures are based on sound principles of lending. This method of assessment has certain flexibility required to avoid any rigid approach to fixing quantum of finance. It is superior and more rational compared to the Turnover Method , Cash Budget Method of assessment .It also facilitates the Bank to carry on follow up procedures. The PBS method have been rationalized and simplified to facilitate complete flexibility in decision-making. To ensure asset quality , proper risk assessment right at the beginning , is extremely important. That is why Credit Risk Assessment system is an essential ingredient of the Credit Appraisal exercise. The SBI was the first to formulate a Credit Risk Assessment model. It considers important parameters like profitability, repayment capacity, efficiency of the unit , historical / industry comparisons etc… which were not factored in other models. It is equally efficient as the SIDBI’s CART (Credit Assessment and Rating Tool) model. CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI BIBLIOGRAPHY BIBLIOGRAPHY CREDIT APPRAISAL FOR WORKING CAPITAL FINANCE TO SMEs AT SBI • • • • M.Y.Khan & P.K.Jain, Financial Management, Fourth Edition, Pp 7.1-7.73 http://www.statebankofindia.com/, 04.36 p.m, 11/12/2007 http://www.banknetindia.com/, 10.32 p.m, 23/03/2008 G.Subramanium ,SBI group Banking Guide,Twelfth edition, Pp 2-4-4- 2-4-7