INTERIM REPORT ON

CREDIT APPRAISAL OF WORKING CAPITAL LOANS FOR CORPORATE CLIENTS

BY Nikhil Sarawgi Enrollment No.: 09BSHYD0520

NAME OF THE ORGANIZATION: Canara Bank (Prime Corporate Branch)

INTERIM REPORT ON CREDIT APPRAISAL OF WORKING CAPITAL LOANS FOR CORPORATE CLIENTS

Project Guide Mr. K. D. Parameshwar (Senior Manager)

Faculty Guide Mr. S. Murali (Faculty Member, IBS Bangalore)

ICFAI BUSINESS SCHOOL, HYDERABAD 2009-2011 Nikhil Sarawgi 09BSHYD0520

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Table of Contents
Serial 1 2 Topic Abstract Introduction Objectives of the Report Purpose of the Report Scope of the Report Limitations Methodology 3 Indian Banking Industry List of Banks in India Indian Banking 2010 Banking in Karnataka 4 5 Company Profile Credit Appraisal Credit Appraisal for Term Loans Credit Appraisal for Working Capital Loans 6 Working Capital Finance Fund Based Non-fund Based 7 Methods of Assessment of Working Capital Turnover Method Cash Budget System MPBF System 8 References Page 3 5 8 8 8 8 9 10 11 13 16 17 21 24 27 34 35 40 44 44 46 47 51

Abstract
India in the post liberalization period opened itself to the world and the phenomenal growth of the commercial banks gave tremendous boost to the economy. Along with large corporate houses more and more small and medium scale industries also grew with the financial assistance of the banks. Thus credit appraisal and sanction became a major function for the commercial banks. Industrial loans are given by the banks to facilitate entrepreneurship and are an asset in the books of the bank.

Following the withdrawal of mandatory instructions relating to assessment and supervision of working capital limits to the borrowers by the RBI, greater responsibility is cast on Banks in the matter. The Banks in their own interest have to self discipline themselves and at the same time maintain and monitor the financial discipline of their borrower clients. Greater supervision and surveillance on the credit portfolio is the need of the hour. Banks have to imbibe professionalism in the approach to lending by improving their assessment techniques, inventing and adopting new monitoring tools.

Different types of loans are offered by banks to enterprises i.e. either term loan or working capital loan. Just so the banker knows that the client will be able to furnish the loan amount along with interest charges, he ensues the process of credit appraisal. The authorities have to scrutinize the minutest of details about the company and the particular proposal with great accuracy. Each type of credit has different criteria that form the basis of the analysis. A deeprooted study of the financial position, the management and the technical feasibility is required before the loan is sanctioned. The assessment of the creditworthiness of the enterprise is also essential in order to judge its ability to repay the loan and the interest amount. This project brings out how appraisal is done for term loans and working capital loans but with special interest given to later with respect to provisions followed at Canara Bank.

Working Capital can be financed in two ways by a bank. One is Fund based and the other is nonfund based. In this project, I will discuss the various methods of financing within the two broad

categories. The project will also give an insight into the various mechanisms involved in export financing.

The quantum of working capital varies from time to time and from activity to activity. Any unit would require working capital assistance from the raw materials are procured till the time the finished goods are sold and cash is realized. Due to so many activities taking place on continues basis, there is a need to assess the working capital from time to time. An attempt is made to understand the various methods of assessment of working capital.

Introduction
One of the two major activities of any Bank is to lend money. Banks accept deposit from public for safe-keeping and compensate by interest to them. They lend this money to earn interest on this money. Thus, banks act as intermediaries between the people who have the money to lend and those who have the need for money to carry out business transactions. The difference between the rate at which the interest is paid on deposits and is charged on loans, is called the "spread", and is actually what their profit is. Banks lend money in various forms and for practically every activity. One way to classify the loans is through the activity being financed. Viewed from this angle, bank loans are bifurcated into:

Priority sector lending Commercial lending

Priority Sector Lending The Government of India through Reserve Bank of India (RBI) mandates certain type of lending on the Banks operating in India irrespective of their origin. RBI sets targets in terms of percentage (of total money lent by the Banks) to be lent to certain sectors, which in RBI's perception would not have had access to organized lending market or could not afford to pay the interest at the prevailing commercial rate. This type is called Priority Sector Lending. Financing Small Scale Industries, Small businesses, Agricultural Activities and Export activities falls under this category. It is also called Directed Credit.

Financing Priority Sector in the economy is not strictly on commercial basis as not only the general approach is liberal but also the rate of interest charged is lesser. Export finance is, in fact, available at a discount of 20% or more on the normal rate of interest to Indian businesses. Fraction of the cost of this concession is borne by RBI by means of refinancing such loans at concessional rate. Indian Banks, therefore, contribute towards overall economic development of the country by subsidizing the business activities undertaken by entrepreneurs in the areas which are considered "priority sector" by RBI.

Commercial Lending This is the core of Indian Banking its bread and butter activity. Although historically, this activity had been relegated to a secondary position as banks were driven by a desire to excel themselves in what is known as "priority sector banking" yet it is this part of their loan portfolio which has kept them floating and meet the costs. The activity survived despite a number of restrictions imposed on it in the past. With financial sector reforms, the focus had shifted from "priority sector banking" and commercial lending has been reinstated to its rightful place. Today many financial institutions focus on this activity for improving their bottom lines. Fresh and innovative products are being introduced to facilitate the corporate customer who forms the core of this business. There is big rivalry among banks to secure bigger share of this business.

At present, commercial loans are available for practically all kinds of activities and also for both long and short tenures. Based on customer profile, these loans are of two types: Retail Loans Corporate Loans

Retail Loans This type of lending is meant for small entrepreneurs as well as individuals who are engaged in gainful commercial activity and have the capacity to repay the loan. Loans are given on the strength of the means of the borrower with regards to their repaying capacity. The latter is judged through the cash streams (income) available with the borrower for repayment of the loan.

Corporate Loans These loans are meant for corporate bodies (and bigger ones among other entities like proprietorships, partnerships and HUFs) engaged in any legal activity with the objective of making profit. Banks lend to such entities only after a detailed study of their management and financials such as experience of management, strength of their balance sheet, the length of cash cycle and depending upon the products available with individual banks. There are many types of loan products available for corporate clients in India. The loans are prepared depending upon the need of the client and the product available with the lending Bank.
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Every proposal made to the bank is necessarily appraised by its officers and only then a decision is taken whether to lend the money or not. Corporate credit appraisal is a fundamental business practice which assesses the potentialities of a corporation in terms of financial capabilities to honor debts and other securities. A critical role of credit rating is, in its very basic essence, to ensure that the borrowers activity has good potential to repay debts and as such determine the level of confidence a lender has with the borrower. According to Rose and Hudgins, Credit Analysis and Lending (2005), all credit officers usually never loose sight of the 6 Cs of lending. They are: Character: The specific purpose for loan and serious intent to repay it. Capacity: Whether the customer has legal authority to sign binding contract. Cash: Whether the borrower has the ability to generate enough cash to repay the loan. Collateral: Whether the borrower has adequate assets to support the loan. Conditions: Must look at the industry and changing economic conditions to assess ability to repay. Control: Does loan meet written loan policy and how changing laws would and regulations affect the loan.

Objectives of the report

Study the credit appraisal mechanism at Canara Bank Study the various forms of trade financing and advances provided Study export financing in detail Study the internal credit rating mechanism and methods of Canara Bank Study the various risk mitigation techniques Study the various methods employed for assessment of Working Capital Study the various banking arrangements for availment of credit limits

Purpose of the report

The purpose of the project is to make a comprehensive analysis on overall credit mechanism related to corporate financing with special attention to appraisal system of working capital loans. The report also aims at understanding how working capital needs are assessed and ways in which credit can be provided to borrowers.

Scope of the project

The very title of the project states that the project is the decision making process of granting credit to loan applicants in business category. It relates to determination of the credit risk which is nothing but the risk that the borrower may be unable or unwilling to owner his obligations under the terms of contract for credit. A major part of the asset of a bank consists of loan portfolio. Banks suffer maximum loss when their assets turn in to Non Performing Assets (NPAs). It is at this stage that the credit risk is quantified in terms of default probabilities and also recovery rates are determined. The credit risk is thus a major concern on management of asset portfolio of any bank.

Limitations of the study

The project is heavily dependent on primary data provided to me by the bank. Since most of it is confidential in nature, trainees are either not exposed to such data or not allowed to use it for the report. It is not always possible to verify data provided by the borrower client. Credit Appraisal is a very complex and long process; hence it is difficult to gain mastery over it. Appraisal and various other activities related to it vary from a case to case basis. Hence, the process lacks standardization.

Methodology
A combination of the following methodology will be adopted while preparing the report Literature survey Survey of Manual of Instructions provided by Canara Bank Study of RBI guidelines and its various provisions Analyze live cases of clients of Canara Bank and link it to the theories studied. Extra reading and material gathering using the internet

Indian Banking Industry

Banking in India originated in the first decade of 18th century with The General Bank of India coming to life in 1786. Next to follow was Bank of Hindustan. Neither of these banks are functional anymore. The oldest bank in existence in India is the State Bank of India being established as "The Bank of Bengal" in Calcutta in the June of 1806. Few decades later, foreign banks like Credit Lyonnais started their Calcutta operations in the 1850s. At that point of time, Calcutta was the most active trading port, mainly due to the trade of the British Empire, due to which banking activity took roots there and prospered. The first wholly Indian owned bank was the Allahabad Bank, which was established in 1865.

By the 1900s, markets expanded with the establishment of banks such as Punjab National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of which were born under private ownership. The Reserve Bank of India formally took on the responsibility of regulating Indian banking from 1935. Post India's independence in 1947, the Reserve Bank was nationalized and given broader powers.

Nationalization By the 1960s, the Indian banking industry had become an important instrument to facilitate the development of the Indian economy. At the same time, it had emerged as a large employer, and a debate had ensued about the possibility to nationalize the banking industry. Indira Gandhi, thethen Prime Minister of India expressed the intention of the Government of India in the annual conference of the All India Congress Meeting in a paper entitled "Stray thoughts on Bank Nationalisation." The paper was received with positive enthusiasm. Thereafter, the GOI issued an ordinance and nationalized the 14 largest commercial banks with effect from the midnight of July 19, 1969.

The second dose of nationalization of 6 more commercial banks followed in 1980. The stated reason was to give the government more control of credit delivery. With this, the Government controlled around 91% of the banking business of India. After this, until the 1990s, the
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nationalized banks grew at a pace of around 4%, closer to the average growth rate of the Indian economy.

Liberalization In the early 1990s the Narasimha Rao government embarked on a policy of liberalization and gave licenses to a small number of private banks, which came to be known as New Generation tech-savvy banks, which included banks such as UTI Bank (now re-named as Axis Bank) (the first of such banks to be set up), ICICI Bank and HDFC Bank. This progress, along with the rapid growth in the economy of India, kick-started the banking sector in India, which has seen rapid growth with strong contribution from all the three sectors of banks, namely, government banks, private banks and foreign banks.

In the next stage Government allowed Foreign Direct Investment (FDI) into the sector in which they were given voting rights to an extent of 10%. This has now been relaxed to 49% with certain restrictions.

The new policy completely shook the Banking sector in India. Bankers, till this time, were used to the 4-6-4 method (borrow at 4%, lend at 6%, go home at 4) of functioning. The fresh wave ushered in a modern outlook and tech-savvy methods of working for traditional banks. All this led to a retail boom in India. Now, people not just demanded more from their banks but also received more.

List of Banks in India1

Currently, the Indian Banking Industry is clustered with many small and big players. At the helm is the Central Bank of the country that controls the show. Below it are the nationalized banks, private banks, foreign banks and rural banks. Following is the list:

i. Central Bank: Reserve Bank of India

ii. Nationalized Banks: Allahabad Bank, Andhra Bank, Bank of Baroda, Bank of India, Bank of Maharashtra, Canara Bank, Central Bank of India, Corporation Bank, Dena
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Bank, IDBI Bank, Indian bank, Indian Overseas Bank, Oriental bank of Commerce, Punjab & Sind Bank, Punjab National Bank, Syndicate Bank, UCO Bank, United Bank of India, Vijaya Bank.

iii. State Bank Group: State Bank of India, State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State Bank of Indore, State Bank of Mysore, State Bank of Patiala, State Bank of Travancore.

iv. Private Banks: Axis Bank, Bank of Rajasthan, Bharat Overseas Bank, Catholic Syrian Bank, City Union Bank, Development Credit Bank, Dhanalakshmi Bank, Federal Bank, Ganesh Bank of Kurundwad, HDFC Bank, ICICI Bank, IndusInd Bank, ING Vysya Bank, Jammu & Kashmir Bank, Karnataka Bank Limited, Karur Vysya Bank, Kotak Mahindra Bank, Lakshmi Vilas Bank, Nainital Bank, Ratnakar Bank, Rupee Bank, Saraswat Bank, SBI Commercial and International Bank, South Indian Bank, Tamil Nadu Mercantile Bank, Yes Bank.

v. Foreign Banks: ABN AMRO, Abu Dhabi Commercial Bank, Antwerp Diamond Bank, Arab Bangladesh Bank, Bank International Indonesia, Bank of America, Bank of Bahrain & Kuwait, Bank of Ceylon, Bank of Nova Scotia, Bank of Tokyo Mitsubishi UFJ, Barclays Bank, Citibank India, HSBC, Standard Chartered, Deutsche Bank, Royal Bank of Scotland.

vi. Regional Rural banks: South Malabar Gramin Bank, North Malabar Gramin Bank, Pragathi Gramin Bank, Shreyas Gramin Bank.

1.

http://en.wikipedia.org/wiki/Canara_Bank

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Indian Banking 2010

India is well poised to become the fourth-largest economy in the world by 2025. Going forward, a GDP growth rate of 7-8% is seen to be sustainable, if key enabling factors have been put in place. One of the enables of a stout economic growth is a banking sector that is able to adequately and effectively meet the needs of a growing economy. I stand with a belief that the shape of the banking sector in 2010 will be the result of a strong interplay between the decisions taken by policy makers and actions of bank managements.

The last decade has seen many positive developments in the banking sector of India. The policy makers, which comprise the Reserve Bank of India (RBI), Ministry of Finance and related government and financial sector regulatory bodies have made several notable efforts to improve regulation in the sector. The sector compares favorably with the banking sectors in the region on metrics like growth, profitability and non-performing assets (NPAs). However, improved regulations, innovation, growth and value creation remain limited to a small part of the sector. Bank penetration in terms of customer segments and geographies is still far lower than in other markets. There is still a significant need for improvement and strengthening if the banking sector has to support the modern and vibrant economy which India aspires to be.

The Banking Industry Vision report 2010 urges banks to focus on cost-saving to survive in future. This report was prepared by the Indian Banks Association by a committee of experts. Pre-reforms, in the sheltered days of banking when customers could be freely charged, banks concerned themselves with only revenues which was equal to cost plus profit. Post-reforms, when the cost of services became almost equal across banks and cost control was the key to higher profits, the focus of banks shifted to profit which was equal to revenue minus cost. In the future, as domestic and international competition hots up, banks might have to shift focus to costs, i.e. revenue minus profit. In other words, cost control in tandem with efficient use of resources and increase in productivity will determine the winners and laggards in the near future.

Consolidation Due to a growing influence of globalization on the Indian banking industry, the financial sector is expected to open up for greater international competition. A number of large global banks are
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expected to take large stakes and control over banking entities in the country. They are expected to bring with them capital, technological know-how and management skills which would increase the competitive spirit in the system leading to greater efficiency. The pressure on banks to gear up to meet tough prudential capital adequacy norms under Basel II and the various Free Trade Agreements that India is entering into with other countries, such as Singapore, will also impact on globalization of Indian banking.

But the flow need not be one way, some of the Indian banks may also emerge global players. As globalization opens up opportunities for Indian corporate entities to expand their business overseas, banks in India wishing to increase their international presence could naturally be expected to follow these corporate entities and other trade flows out of India.

Alongside, a phase of consolidation in the banking industry is expected to be triggered by the growing pressure on capital structure of banks. In the past, mergers were initiated by regulative authorities to protect the interest of depositors of weak banks. In recent years, there have been a number of market-led mergers within the private banking sector. This process is likely to gain momentum in the coming years. Mergers between public sector banks or public sector banks and private banks may well be the next logical development. Consolidation could also take place through strategic alliances or partnerships jacketing specific areas of business such as credit cards, insurance etc.

Technology Technological developments would render faster flow of information and data leading to quicker appraisal and decision-making. This would enable bankers to make credit management more effective, besides leading to an appreciable reduction in transaction cost. To reduce investment costs in technology, banks may resort more and more to sharing facilities such as ATM networks. Banks and financial institutions will come together to share facilities in the areas of payment and settlement, back-office processing, date warehousing, and so on. We could also see the emergence of new players doing financial intermediation. For example, we can see utility service providers offering, say, bill payment services or supermarkets or retailers doing basic lending operations.
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Social Banking All these developments should not mean banks will ignore social banking. Rather than being seen as directed lending such lending would be more business driven. Rural market comprises 74% of the population, 41% of the middle-class, and 58% of disposable income. Small-scale industries would still remain important for banks. However, instead of the tapered definition of SSI based on the investment in fixed assets, the focus may shift to small and medium enterprises (SMEs) as a group. Changes can be expected in the delivery channel for small borrowers, agriculturists and unorganized sectors also.

Regulation The expected amalgamation of various intermediaries in the financial system would require a strong regulatory framework. It would also need a number of legislative changes to enable the banking system to remain contemporary and competitive. Underscoring that there would be an increased need for self-regulation, development of best practices could evolve better through self-regulation rather than based on regulatory prescriptions. For instance, to gain the confidence of the global investors and international market players, the banks will have to adopt the best global practices of financial accounting and reporting. It is expected that banks will migrate to global accounting standards smoothly, although it would mean greater disclosure and tighter norms.

The extent to which Indian policy makers and bank managements develop and execute such an agenda will lay the foundations for a high performing sector in 2010. The first phase of banking reforms was perhaps born out of panic. The second stage can be implemented from a position of strength and confidence in a compressed time-frame.

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Banking in Karnataka
The state of Karnataka, particularly the region comprising the costal districts of Dakshina Kannada and Udupi is known as the Cradle of Banking in India1. This is because seven of Indias leading banks, Canara Bank, Syndicate bank, Corporation Bank, Vijaya Bank, Karnataka Bank, Vysya Bank and State Bank of Mysore originated from here1. The first five were established in the district of Udupi and Dakshina Kannada. These districts have one among the best distribution of banks services in India a branch for every 500 persons2. The origin of banking in Karnatakas costal region can be traced to the year 1868 when the Presidency Bank of Madras opened a branch to cater to the needs of British companies1. In 1912, the Indian Co-operative Societies Act further energized the financial sector in the region leading to the establishment of lot of co-operative societies. The freedom movement of India also played a crucial role as can be seen in the case of Karnataka Bank which was established as an offshoot of the Swadeshi Movement of 1905. These banks were earlier created to cater the primary sector in the economy i.e. agriculture but later diversified to address other economical sectors as well. The Governments notification of nationalization of banks in the year 1969 and 1980 resulted in a lot of these banks being nationalized. The entry of private sector into the banking sector has led these banks to rethink some of their strategies. Earlier, banking was the main activity that was undertaken by these banks, but due to so much intense competition, they have been forced to diversify into other areas like insurance, equity and mutual funds etc. These have also led them into upgrading their technology and introduce services like ATMs and online banking transactions. A marked change in the overall attitude of the bank to be as customer-centric as possible can also be seen.

As of March 2002, Karnataka had 4767 branches of different banks servicing the people of the state3. The number of people served by each branch was 11,000 which is lesser than the national average of 16,000, thereby indicating better penetration of banking services in the state3.
1. 2. 3. Ravi Sharma. Building on a strong base. Online webpage of the frontline, volume 22 issue 21, Oct 08 -21, 2005. Ravi Sharma. A pioneers progress. Online edition of the frontline, volume 20 issue 15, July 19 August 01, 2003. State/Union Territory-Wise Number of Branches of Scheduled Commercial Banks and Average Population Per Bank Branch March 2002. Online webpage of the Reserve Bank of India.

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Company Profile

"A good bank is not only the financial heart of the community, but also one with an obligation of helping in every possible manner to improve the economic conditions of the common people" A. Subba Rao Pai1 Canara Bank (or CanBank) is a major and one of the most prominent commercial bank headquartered in Bangalore. It was established in 1906 (making it one of the older banks) by Ammembai Subha Rao Pai in Mangalore. The Indian Government nationalized the bank (along with 13 other major banks) on 19 July 1969. It went public in 2002-2003 raising Rs. 110 crores2. Currently, the Indian Government holds 73% stake in the Bank3.

It is said that in 1906, Late Sri Ammembai Subha Rao Pai, a philanthropist, collected handful of rice from each household, pooled the rice and sold it and used the money earned for the bank's capital2. Back then, it was called Canara Bank Hindu Permanent Fund. Mr. A. S. R. Pai had envisioned the bank to not only offer financial services but also fulfill social causes such as removing superstitions and ignorance, promote the habit of saving, provide assistance to the people in need and develop a sense of humanity among the people. The fund became a limited company and came to be known as Canara Bank ltd. in 1910 and became Canara Bank in 1969 after nationalization1. Founding Principles1 To remove Superstition and ignorance. To spread education among all to sub-serve the first principle. To inculcate the habit of thrift and savings. To transform the financial institution not only as the financial heart of the community but the social heart as well. To assist the needy. To work with sense of service and dedication.

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To develop a concern for fellow human being and sensitivity to the surroundings with a view to make changes/remove hardships and sufferings.

Growth over the years The bank has grown since then and now has 2861 (as on 2009) branches in India and other countries4. In September 2008, it had 2710 branches6. The Bank has international presence in several countries including London, Hong Kong, Moscow, Shanghai, Doha and Dubai4. Today, it is one of the largest nationalized commercial banks in India, with total business of Rs. 3,50,640 crore4 and over 22 million customers4. In the fiscal year 2005-06, Canara Bank became India's second-largest public sector bank in terms of advances and deposits3. In 2005-06, the bank had a total of 47,389 employees4. The bank boasts of having maximum number of ATM installations among all the nationalized banks other than SBI, summing up to more than 2000 covering 715 centers9. Also, as of 2009, 1591 branches of the bank provided Internet and Mobile Banking (IMB) services while 2084 branches provide Anywhere Banking services9. In 2006, Canara Bank was ranked 1299 in the Forbes Global 2000 list5.

Financials The recent history of the bank has been marked by a robust performance on the business front coupled with unprecedented gains in profitability. It posted a net profit of Rs. 2072crore in 200809, its highest since inception. For the same year, it declared dividends of 80%. It earns almost 88% of its revenues from Loans and Advances while spends about 80% as interest expenditure. Concentrating on core business operations and cost containment has been its major strength over the years.

Awards and Achievements Canara Bank has a number of achievements to its credit. Amongst others, it was the first bank in India to have launched inter-city ATM network. It was the first bank to be awarded ISO Certification for one of the branches, providing credit card for farmers for the first time in India along with offering consultancy services in the field of agriculture9. It was the first to articulate a Banks Citizen Charter Good Banking. It was also the first to commission an Exclusive Mahila Banking Branch9.
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In 2005-06, it was conferred the position of Best Public Sector Bank in India by Financial Express Ernst & Young8. In 2006-07, it won the first National Award for Excellence in Micro & Small Enterprises (MSE) Lending (instituted by the Ministry of Micro, Small & Medium Enterprises, Govt. of India)7. For the same period, Mindscape awarded it Employer Branding Award for excellence in human resource. It was the first public sector bank to receive the Golden Peacock Award for Corporate Social Responsibility for the year 2007 since the awards inception in 19917. For the same year, it was also awarded the Golden Peacock National Training Award for pioneering in quality revolution7. In 2008, it was conferred with the Business Superbrands status7.

Corporate Social Responsibility Not just in commercial banking, the Bank has also carved a distinctive mark in various social responsibilities such as serving national priorities, promoting rural development, enhancing rural development, enhancing rural self-employment through several training institutes and spearheading financial inclusion objective.

IT inititives All of Canara Bank's branches, including those located in rural areas, are computerized, in a country where that is not a given. This was after a major IT initiative to network all branches and to move them to a single software platform. All its branches are now enabled with Real Time Gross Settlement (RTGS) and National Electronic Fun Transfer (NEFT) transaction facilities, insuring smooth and swift money transfer from any one corner of the country to another. Subsidiary Companies4 Over the years, the bank has been scaling up its market position, with a view to keep up in the highly competitive scenario. In the process, Canara Bank has managed to emerge as a major Financial Conglomerate with as many as nine subsidiaries/sponsored institutions/joint ventures in India and abroad.

Canfin Homes Limited Canbank Factors Limited

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Canbank Venture Capital Fund Limited Canbank Computer Services Limited Gilt Securities Trading Limited Canara Robeco Asset Management Company Limited Canbank Financial Services Limited Canara HSBC Oriental Life Insurance Company Limited

1. 2. 3. 4. 5. 6. 7.

http://www.canarabank.com/english/Scripts/History.aspx Ravi Sharma. A pioneers progress. Online edition of the frontline, volume 20 issue 15, July 19 August 01, 2003. Canara Bank eyes Dena, appoints E&Y for deal. Online webpage of Rediff.com, 2007-05-09. http://en.wikipedia.org/wiki/Canara_Bank The Forbes 2000 Forbes.com http://www.iloveindia.com/finance/bank/nationalised-banks/canara-bank.html http://74.125.153.132/search?q=cache:Nj-vJ-_lucJ:www.canarabank.com/Upload/English/PressReleases/CanPressReleaseMar08.doc+history+canara+bank&cd=4&hl=en&ct=clnk&gl=in&clien t=firefox-a

8. 9.

http://www.economywatch.com/companies/forbes-list/india/canara-bank.html http://www.canarabank.com/English/Scripts/Profile.aspx

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Credit Appraisal

Credit Appraisal is a process to ascertain the risks associated with the extension of any credit facility. It is generally carried by the financial institutions like banks which are involved in providing financial funding to its customers. Credit risk is a risk related to non repayment of the credit, and/or interest thereon, obtained by the customer of a bank. Thus it is necessary to appraise the credibility of the customer in order to mitigate this risk. Proper evaluation of the customer is performed. This measures the financial condition and the ability of the customer to repay back the loan in future. Generally the credit facilities are extended against the security know as collateral. But even though the loans are backed by collateral, banks are normally interested in the actual loan amount to be repaid along with the interest. Thus, the customer's cash flows are ascertained to ensure the timely payment of the principal and the interest.

Credit appraisal is a skill which has to be acquired by study and supplemented by practice. Intuitive guess work has little place in appraising the credit rating or credit needs of a corporate unit. The credit managers of banks and Non Banking Finance Companies (NBFCs) are duty bound to accept or reject a proposal on the basis of its viability or non - viability.

Sources of information about borrower i. Banks and financial institutions: The source of primary information can be from the banks and financial institutions themselves which are the most original, the most detailed and by far the most trustworthy source, and as much relevant information as possible may be sought from the likely banks.

ii. Bank references: Information about the general financial health of the companies would come from the bankers with whom the company has its accounts, but also the bankers who might have lent to the company. Getting a reference through the companys bankers makes it easy to get correct information and the lending banker may remain disguised, if they wish to be so.
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iii. Trade references: They are references from the companys customers, suppliers, etc. Suppliers information would be particularly useful as, that would give an idea of the usual payment policies of the company.

iv. Credit rating agencies: Credit rating agencies like CRISIL (Credit Rating Information Services of India Limited), An RBI credit rating agency is CARE (Credit Analysis and Research Limited) and other agencies like ICRA (Investment Information and Credit Rating Agency of India), DCR INDIA (Duff and Phelps Credit Rating India Private Limited) and ONICRA Credit Rating Agency of India Limited are the main credit rating agencies in India. These agencies provide ready and thorough information required by banks and financial institutions for financing the capital requirements of the companies which are credit rated by these agencies.

v. Published books: Preliminary and basic information about a company may be taken from printed sources like the Stock Exchange Year book, Corporate Path finders data base, sources from various associations etc.

vi. Company financial reports: One of the most convenient and frequently used tools of credit evaluation by the banks is the companys annual accounts which are statutorily prepared annually and laid before the shareholders. Apart from the annual accounts, a listed company has to publish half yearly un-audited results in the newspapers twice a year.

vii. Press reports: The financial press comes out regularly with reports about companies, especially financials. Key indicators and periodic guides given in financial papers and magazines help bank to assess companies financial standing and can take a positive decision regarding financing the capital requirements of the company.

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viii. Stock market opinion: Investors perception is best judged by the market opinion about the company. This market opinion also has an indirect impact on the companys health. Hence, a bank or a financial institution may also refer to shareholders or share dealers to know the market sentiments about the prospective company.

ix. Charges registered: Any charge created on the assets of a company has to be registered with the Registrar of Companies. This information which would indicate to what extent a companys assets present and future are charged.

Viability Study At the onset, it is very important to understand that credit appraisal for term loan is very different from that of working capital. In case of a viability study of term loan, the project so proposed could be a green-field project or it could be an entirely new setup. This cannot be the case with appraising working capital loan. A working capital loan is provided only to existing businesses or to businesses who are about to begin production. However, most steps still remain the same. Just to be clearer and for a better understanding of the matter, I would like to divide the topic into two i. Credit appraisal for Term loans ii. Credit appraisal for Working capital loans

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i. Credit Appraisal for Term loans

A thorough project report is submitted by an entrepreneur, prepared by an approved agency or a consultancy organization. Such a report provides an in-depth analysis of the project requesting finance. The appraisal process of term loans deals with certain key areas that the bank has to study thoroughly before sanctioning the loan. Since this loan is for a period of 12 months and over, the bank analyses all the aspects of business in detail. It is obvious that the appraising officer should cross check the information provided in the report for determining the worthiness of the project. The following appraisals are looked into when the applicant submits its proposal in order to ask for term loans. Management Commercial Technical Financial

a. Management Appraisal: - A company has an identity distinct from its owners yet it is managed by a group of individuals collectively called the management. Thus, when the company applies for a term loan, it is important for the bank to check whether it is run by an efficient and trustworthy group of people. The performance of the company depends on its management so the bank studies the profile of all the directors and promoters with respect to the company and focuses on the following points:

Educational Qualification Experience in the field Previous Track Record Companys relation with other banks Any defaults of the past

Assessment of the management gives a deep insight about the objectives of every member and his/her contribution to the growth of the business.
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b. Commercial Appraisal: - The feasibility of the long-term finance depends on whether the company is in a position to generate sufficient returns in the future. This is where the commercial assessment comes into force. The bank checks the sales, profit or loss incurred by the enterprise in the current year, the past years and also the future projections. It is very important that the company makes realistic projections so that the future performance can be correctly estimated. Hence the bank asks the company to furnish the bases of their assumptions for the future years. Commercial appraisal caters to the following details:

Market demand for the product Substitutes for the product Future growth prospects The commercial viability of the concerned project

c. Technical Appraisal: - The bank studies the technological soundness of the company in order to satisfy itself regarding the technical viability of the project. It checks the following parameters in the project:

Status of the technology used Economic life of the present technology Technical feasibility of the project

The bank may not be aware of the technical up-gradation in that industry and so it can take the help of experts in order to judge the companys position better.

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Appraisals for term loans

Management Appraisal
Experience in the field Track Record Name of Promoters Previous Experience

Technical Appraisal
Technology Used Developed Prototype Technical Feasibility

Commercial Appraisal
Commercial Viability Demand of the product Substitute Products

Financial Appraisal

Capacity to raise funds Capital Structure Balance Sheet Analysis Ratio Analysis

Life of Technology Being Used

Scope for further growth

d. Financial Appraisal: - In this type of appraisal the bank checks whether the promoter is capable of raising finance, both equity and debt. The business should generate sufficient funds to service the debt and other stakeholders. It also deals with the identification of the various elements of the project cost. The bank looks for the answers to the following questions: Whether the capital structure is optimal What is the break-even level What is the Internal Rate of Return Is the business favorable in sensitivity and scenario analysis

Analysis of balance sheet and income statement is most important. Bank reads the financial stability, liquidity and profitability of the overall business. The major tool for the analysis of the financial position of a company is ratio analysis. The following ratios are used for the analysis before the sanction of term loan: Debt equity ratio Solvency ratio Average DSCR (Debt Service Coverage Ratio) Security coverage ratio Profitability ratio
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ii. Credit appraisal for Working capital loans

By providing working capital loans the bank supplements the resources already available to the borrower in carrying reasonable level of current assets related to his production requirement, e.g. promoters margin or other liabilities. These, the existing sources should be sufficiently utilized before applying for bank credit.

Compilation of credit reports Proposals can come from existing or new parties either for enhancements or for modification of existing limits or for fresh limits for new projects. Where the project involves finance by more than one financial institute, for a better understanding of the project, a joint appraisal is recommended. All reservations or differences of opinion between the institutions/banks should be conveyed and reconciled at the appraisal stage itself. The proposal submitted by the borrower should be studied in detail and in its entirety. The banker provides need based credit facilities, both fund based and non-fund based, after due appraisal of every proposal as per the standards laid down in this regard. Time norms for disposal of credit proposals: All loan applications upto a credit limit of Rs. 25,000/- is disposed off within a maximum period of 15 days and others within a maximum of 8 weeks. In respect of SSI proposals a. Loans upto Rs. 25,000/b. Loans upto Rs. 5 lacs In respect of export finance a. Sanction of fresh/enhanced credit limits b. Renewal of existing credit limits c. Sanction of ad-hoc credit facilities 45 days 30 days 15 days 2 weeks 4 weeks

In respect of sole banking, MBA and consortium advances

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a. Sanction of fresh/enhanced credit limits b. Renewal of existing credit limits c. Sanction of ad-hoc credit facilities

60 days (45 days) 45 days (30 days) 30 days (15 days)

Note: Days in bracket indicate the maximum time frame for sanction of export credit limits

All proposals are examined from various angels of safety, feasibility, national priority and repaying capacity of each borrower. A critical study of the financial statements, project report and other information submitted by the borrower is necessary. Every credit should be subjected to an objective appraisal as per the policy and procedural guidelines laid down from time to time to establish technical feasibility, economic viability and bankability of the project.

Appraising officers are expected to visit the factory, godowns and business places and acquaint himself with the process of production and infrastructure available to the industrial unit and business condition of the party (in the case of traders) and correctly assess the requirements and financial implications involved, before the proposal is sanctioned or forwarded. If the project happens to be an entirely new one, the evaluator is expected to understand the production process involved the various stages of production, the proposed installed capacity, number of shifts to be worked, raw materials required and its availability, availability of other external economies etc., all have to be taken into account.

The appraising officer is expected to be fully aware of all government policies governing the relevant industry. If any clearance from the local government authority like Factory Inspector, Corporation/Panchayat etc., Electricity Board, Pollution Control Board, Sanitation Department etc., is required, the same should be got.

In case, where the applicant enjoys loan assistance from other financial institutions/Banks, appropriate charge creation (second charge, pari-passu etc.) in favor of the bank should be created. This should also be registered with the Registrar of Companies in case of companies.

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Banks should not insist on deposits/mobilization of deposits as a precondition for sanction of credit facilities. All credit proposals should be processed keeping in view the applicable lending norms without giving scope for dilution of appraisal standards on account of consideration of deposit support. Also, wherever collateral securities are available or tendered as security, the proposal should be evaluated on stand alone basis without relying unduly on the availability/strength of the collateral security. It is to be noted that all such securities are only to be treated as additional comforts.

Normally, the appraising officer also interviews the borrower and the interviewing form is annexed to the application.

With regards to security, the goods/commodities which are offered to the bank should relate to the partys line of business. The bank is to make sure that wherever license/permit is required to deal in commodities, before accepting such commodities, the party should have valid license/permit. Commodities should follow the following qualities are generally acceptable for advance: a. Absence of wide fluctuations in price b. Easy marketability c. Free from risk of early deterioration d. Easy ascertainability of value When a detailed appraisal is being carried out after a pre-sanction visit to the applicant, the following factors must be critically examined and analyzed: a. Financial statements of at least of last 2 years in case of existing unit/company b. Financial and other ratios relevant to the project c. Critical analysis of profit & loss account and balanced sheet d. Level of inventory holdings past and projections e. Trends in sales and profitability f. Past deviations in sales and profit projections g. Production capacity and use past and projected h. Estimated/projections of sales values
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i. Estimated working capital gap with reference to acceptable build-up of inventory, receivables and/or other current assets j. Projected levels whether acceptable k. Compliance with lending norms and other mandatory guidelines as applicable l. Assess working capital requirement determine facilities required on the basis of turnover or cash budget or MPBF. m. Assess requirements of off-balance sheet facilities viz. LCs, BGs, co-acceptances. n. Study the off-balance sheet, non credit items like contingent liabilities, deferred payment liabilities, pending claims, guarantees offered, forward contracts, swaps etc. o. Diversion of funds p. Availability of margins in the system auditors comments q. Contingent liabilities etc.,

Proposals from new parties In addition to all the above detailed guidelines for credit appraisal, the following factors should be adhered to while entertaining proposals from new parties.

Before preparing the credit proposal, firstly, the banks should make discreet enquiries from outside parties engaged in similar line of business as regards the character and capacity of the applicant, his means and credit worthiness. This information should be recorded in the credit investigation report. If the limit is up to Rs. 50000/-, than the opinion of at least two should be obtained, else at least three outside references should be mentioned. The banker should be satisfy about the borrowers trust worthiness, prudency, capability, practical experience of the produce/goods he is pledging/hypothecating, before granting the advance. While making the credit investigation the banker should ascertain the relationship of the borrower/coobligant/guarantor/director with each other and such relationship if any should be recorded in the credit report.

The applicant should be adequately technically qualified or continued technical assistance should be ensured. This is more applicable in the case of partnership firms where it would be necessary to ensure that retirement of any one partner does not affect continuous availability
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of technical assistance. The marketing arrangements made should also be studied and found satisfactory.

Whenever parties are reported to have accounts with other banks, satisfactory OPLs have to be obtained from such other banks. The various terms used in bankers opinions issued will mean the following:

TERMS USED Very small means Small means Moderate means Moderate to fair means Fair means Fairly good means Fairly good to good means Good means Very good means Large means Very large means

MEANS (Rs.) 10,000/- or less 10,000/- to 25,000 25000/- to 50,000 50,000/- to 1 lakh 1 lakh to 2 lacs 2 lacs to 3 lacs 3 lacs to 5 lacs 5 lacs to 10 lacs 10 lacs to 25 lacs 25 lacs to 50 lacs Over 50 lacs

Proposals from existing parties fro enhancement/modification: The advantage in examining a proposal of an existing party is that the branch would have already had dealings with them and hence their financial discipline, conduct of accounts, creditworthiness, their means, etc., would be known. All other angels from which the proposal is to be examined will be the same as in the case of new parties. In the case of expansion, the following points have to be examined: a. The present and installed capacity b. The demand/supply gap for the product c. Necessity for purchase of new machinery d. Possibility of stretching the existing infrastructure to the proposed expansion project also
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e. Financial viability f. Pattern of consumption of raw material The need for enhancement/ modification should be studied, if any bulk orders have been received, the same should be called for and perused. Capacity of the party to execute the orders in terms of installed capacity of the machinery, availability of labor, finance, raw materials etc., should also be analyzed. The production and sales details of the immediately preceding months from the date of last financial statement also need to be studied. In case the request is for renewal with or without enhancement, program of production for the current year and the ensuing year besides the immediate past year should be obtained and credit requirements assessed accordingly.

Some important indicators which require attention are: a. Frequent return of cheques issued as well as lodged for collection/discount by the party b. Frequent over-drawings in the account c. Frequent return of bills lodged for discount/collection d. Higher percentage of rejections under supply bills e. Periodical review returns Financial statements submitted have to be reviewed and it has to be ensured the liquidity position of the borrower is satisfactory. It has to be ensured that the working capital finance is not diverted for other purposes.

Financial Statements The financial statements of the company are one of the most important documents that are to be submitted by the party. In respect of new units, project report and projected Balance sheet should be submitted along with the application. Financial statements mean profit and loss statement, balance sheet and their annexure. Following are the more relevant provisions regarding submission of financial statements:

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a. All corporate borrowings shall submit audited balance sheet including Directors report etc., as prescribed in the Companies Act. b. Wherever the proposals are taken for renewal/ enhancement, it should be ensured that the audited balance sheet is not older than six months. The latest balance sheet if not audited, the period within which the audited balance sheet is expected to be furnished, should be ascertained from the borrower/ banker and should be followed up. The bank must ensure that audited financial statements are submitted by the borrower clients within six months of 31st March. c. To have a critical analysis of the financial position of the borrower, a full set of the enclosures/annexure forming part of the balance sheet and profit and loss account should be obtained from both, corporate and non-corporate borrowers. All other financial statements/certificates like IT/WT/ST Assessment orders wherever applicable, should be obtained along with the balance sheet. d. The sanctioning authority must ensure that wherever latest audited balance sheet is not available, the branches have furnished the provisional figures for the current year up to a latest date as also a confirmation to the effect that the financial position of the borrower has not deteriorated. e. The reviewing authority should get the certifications in financial statements or any other certificate issued by any financial agency or Chartered Accountants verified and checked to ascertain the genuineness before taking any financial risks/ credit decisions. f. Certified copies of statements with declarations such as as extracted from books of accounts maintained by the party or found to be in agreement with the books of accounts or verified and certified and such other declarations does not amount to audit of accounts. g. For the year in which the limits are applied for, a gist of the working results from the date of balance sheet till the date of the proposal should be furnished. This need not necessarily be in the form of a balance sheet and profit and loss account. The latest balance sheet in all cases should invariably be analyzed in the prescribed format.

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Working Capital Finance

Working capital finance is extended in different forms basing on the requirements as follows:

Working Capital Finance Fund Based Non-fund Based Post Sales Bank Guarantee Letter of Credit

Pre Sales

Open Cash Credit

Simplified Open Cash Credit Key Shut Cash Credit Produce Loan Overdraft

Book Debts

Bills Financing

Supply Bills

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A. Fund Based In this type of credit immediate outlay of funds is provided to fulfill the credit requirements of the borrowing party. This type of credit is used to fulfill both short and long term requirements of the borrower. Transaction of money takes place in this credit and the money can be transferred in the form of cheques, demand drafts or it can directly be transferred to the borrowers bank account. For short term financing purpose, Fund based can be divided into Pre Sales and Post Sales.

1. Pre Sales:

i. Open Cash Credit: Open cash credit is granted against the hypothecation of stock such as raw materials, work in progress, finished goods and stock in trade, including stores and spares. It is granted by way of running account, drawings to be regulated within the drawing limit permissible which is arrived at on the basis of stock held by the borrower. The bank obtains periodical stock statement at the stipulated intervals from the borrower to have a watch over the stock position and also will check the goods at regular intervals to satisfy about the correctness of the declaration of the stock by the borrower.

Parties enjoying OCC limits should route all purchases and sale transactions through OCC accounts. In other words, these parties have to remit the sale proceeds to their OCC accounts and payment for all purchases of stock are to be made by cheques drawn on these accounts.

As possession of the security or goods remains with the borrower, the banker is advised utmost caution before granting OCC. It is important to note that OCC is made only if for some reason goods cannot be kept under the banks lock and key. The following points should also be noted: a. The party must be creditworthy b. The partys dealings with the bank should be satisfactory c. The party must be prepared to submit the stock statements as per the format prescribed by the bank at the periodicity stipulated by the bank
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d. The party must be agreeable to hypothecate the entire stock belonging to him and insure the stock for its full value for fire and other risks at his own cost. e. The party must agree to periodical inspection of stock and the books of accounts maintained by him.

ii. Simplified Open Cash Credit: Loans and advances under this scheme are granted to retail traders and SSI only, who are not in a position to maintain detailed stock books as required under OCC scheme. The maximum amount of credit facility that can be extended under this scheme is Rs. 5 lacs. This type of credit does not full under the purview of the Prime Corporate Branch.

This facility is considered only to those borrowers whose stock consists of number of items in small quantum or where stocks can not be pledged for some genuine reasons. The borrower is required to remit the daily sales proceeds to his SOCC account and issue cheques for purchases. In addition to stocks, other current assets and fixed assets may also be taken as collateral security.

iii. Key Shut Cash Credit: When the securities pledged to the bank vary from time to time by pledges and releases, facility may be granted by way of cash credit account. This is an advance by way of running account. Advance is granted as and when goods are pledged. Whenever the borrower wants to release the goods he has to credit the required amount to KCC account. Borrowers may also be permitted to operate the account by cheques. It is important to note that the goods/stocks are held under custody or lock and key of the Banks.

KCC is a running account maintained in the overdraft ledger and drawings are permitted up to the available drawing limit as per the drawing limit book. Interest is debited at periodical intervals on daily product basis.

iv. Produce Loan: Produce loan is an advance against pledge of stock. Separate loan account is maintained for advances granted each time goods are pledged. Releasing of
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goods/stocks may be done in part. Even under this kind of facility, the goods are in the custody of the Bank under its lock and key. In this case, interest is debited at periodical intervals or at the time of closure of individual PL accounts whichever is earlier.

v. Overdraft financing: This is provided when businesses make payments from their current account over and above the available cash balance. Overdraft financing facility is most commonly used by businesses as a way of making their working capital more flexible. The amount of overdraft as any point of time will depend on the cash flows of the business, the timing of receipts and payments, seasonal trends in the sales and so on. The borrower is required to pay an interest only on the overdrawn amount and for the duration overdrawn.

2. Post Sales:

i. Advances against Book debts: These are the advances granted by the bank against receivables due to parties of the bank by their debtors. Generally, the period of book debts up to 90 days should be considered while permitting the facility. Advances against book debts are normally considered in three forms: Advances against book debts as primary security. Advances with book debts as collateral security. Open cash credit advances where book debts have to necessarily be taken as collateral security. Generally, advances against book debts as prime security can be considered only to the following: Joint stock companies Small Scale Industries Trading and Commission agencies

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Advances against book debts should be considered very selectively. Before considering the proposal for advances against book debts, the borrowers debtors should be carefully analyzed to determine the following: The type of customers to whom the borrower sells, whether they are financially sound The average length of time for which debts remain outstanding Percentage of debts which are written off every year Percentage of returns, rejections, discounts etc. Whether there is a concentration of book debts on one party? As a rule, not more than 10%-15% of the book debts assigned should be concentrated on one customer.

ii. Bills Financing: A bill of exchange, when accepted by a bank becomes a source of shortterm credit for working capital. These are usually issued in tight money periods. There are two types of credit facilities under bills finance. They are:

a. Bills Purchase: When the bank negotiates bill payable on demand when clean or documentary, the facility is known as bills purchase. The face value of the bill is immediately paid to the holder of the instrument. After buying the bill, the bank becomes the holder in due course and value and acquires all rights of ownership over the instrument. b. Bills Discount: When the bank credits value of the bill (less discount) which is payable on a future date after acceptance by the drawee, it is said to be bill discount. It should be understood that demand bill is purchased and time bill is discounted.

iii. Supply Bills: A manufacturer may supply goods continuously to government department, Government undertakings or corporate of status. The goods are supplies direct to the department/undertaking. The apt authority of the buyer approves the goods received and issues an acceptance note. For a financing banker this note serves as proof

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of delivery and along with the note, the customer submits multiple copies of invoices. One copy is sent to the buyer direct on the due date payment is made to the bank by the purchasing party viz. the government body or corporate of repute.

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B. Non-fund Based
The non fund based facilities are essentially in the nature of promises made by banks in favor of a third party to provide monetary compensation on behalf of their client if certain situation emerges or certain conditions are fulfilled. No monetary transactions occur at the time of sanction of this facility. Bank gives guarantee of its client in writing and promises to pay the decided amount if its client defaults. Banks earns fee based income in lieu of providing non fund based credit. The cost of non fund based facilities charged by the bank is lower than that charged on fund based.

i.

Bank Guarantee: In this type of facility the bank acts as a guarantor of its client and promises to pay the amount in case its client is unable to pay. The liability of the bank begins only after the default is committed by the principal debtor. There are three parties involved in a contract of guarantee i.e. the applicant, the beneficiary and the guarantor. Banks issue guarantee in the following situations:

Companies participating in tenders and auctions are required to submit Bank Guarantees for a minimum stipulated amount as security deposit. Payment of mobilization advances to contractors executing civil projects is a common practice. As a security against such payments the contractors are required to submit Bank Guarantees.

In case of supply of raw materials, the supplier of the raw material may require a security from the buyer in the form of Bank Guarantee. Suppliers of goods or services often provide warranty period to the buyers. In such cases the suppliers may request the bank to issue performance guarantee in favor of the buyers.

Depending on the nature of the guarantee issued, Bank Guarantees can be of two types: Financial Guarantee Performance Guarantee

40

a. Financial Guarantee: Such a guarantee is a certificate issued by the bank ensuring the soundness of the financial ability of a client to meet certain financial obligations. For example a bank guarantee issued to a government department against security deposit guarantees the financial capability of its client to pay the indicated amount.

b. Performance Guarantee: In this type of guarantee the issuing bank guarantees to make good to the beneficiary, the monetary loss in the event of non performance or short performance of a contract by its client. Thus, the assessment of the technical competency and managerial ability is required before issuing a performance guarantee. The payment made by the issuing bank is a penalty for the nonperformance of the task by its client.

ii.

Letter of Credit: This document is issued by the bank, on behalf of the buyer, to the seller, to pay for the goods and services if the seller presents documents which comply with the terms and conditions mentioned in such letter of credit. These documents facilitate trade both at the domestic and international level. The bank acts as an intermediary between the two parties and charges a commission against its guarantee. The following are the parties in a letter of credit transaction:

The buyer prepares the terms and conditions and requests his bank to issue a letter of credit. Thus, he becomes the Applicant. The person, on whose favor the letter of credit has been issued i.e. the seller, is called the Beneficiary. The applicants bank opens the letter of credit and is hence called the Issuing/Opening Bank. If the beneficiary lives in a distant country, the issuing bank will contact another bank in that country. If that bank agrees to advise the credit to the beneficiary then it is called the Advising Bank.

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The beneficiary may want to have an additional confirmation from another bank in his country which gives its independent undertaking for making payment in addition to that of the issuing bank. This party is thus called the Confirming Bank.

The Nominated/Negotiating Bank is the bank in the beneficiarys country, which the issuing bank nominates for the beneficiary to present his documents and from which it gets the payment of the sum against the letter of credit.

The issuing bank may co-ordinate with another bank, which may reimburse the amount under the letter of credit to the bank that makes payment to the beneficiary. This bank is the Reimbursing Bank.

The following are the two types of letters of credit: Foreign Inland

a) Foreign: - Foreign letters of credit are issued in export or import transactions. The two parties to the contract of sale are required to be of different countries. In this case the terms of the letters of credit comply with the exchange regulations of the countries. For example in India, the Foreign Exchange Management Act (FEMA) and the Exchange Control Manual prescribe the conditions in this regard.

b) Inland: - Such facility is used to facilitate transactions between a buyer and a seller in the same country. The transaction takes place within the geographical periphery of the country and hence the mode of payment is the currency of that country.

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Exporter 4. LC is forwarded to the exporter

5b. Forwards documents 8. Makes Payment

Advising Bank

6. Checks docs for compliance with LC and forwards them to issuing bank 7. Makes payment

3.Issues LC to advising bank

1. Contract 5a. Ships Goods

LETTER OF CREDIT TRANSACTION

10. Releases Docs required to collect goods 9. Makes payment

2. Applies for LC in favor of exporter

Importer

Issuing Bank

A pictorial explanation of how L/C works in proper sequence.

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Methods of Assessment of Working Capital

The assessment of working capital requirement of a borrower is generally made under the following 3 methods: 1. Turnover method 2. Cash budget System 3. MPBF System

1. Turnover method
The genesis of the turnover method is traced to the P R Nayak Committee recommendations which were again reviewed by the Vaz Committee. Under this method, the working capital limit is computed at 20% of the projected gross sales turnover accepted by the Bank.

This method is applied for sanction of fund based working capital limits to non SSI borrower requiring working capital facilities up to Rs. 200 lacs from its bankers. This system is generally made applicable to traders, merchants, exporters who are not having a predetermined manufacturing/trading cycle. However, if such borrower feels that MPBF system of assessing working capital needs is more advantageous or is more suitable, then he may opt so.

The Bank is required to ensure maintenance of a minimum margin on the projected annual sales turnover. If 25% of the estimated gross sales turnover value is computed as working capital requirement, of which at least 4/5th (20%) shall be provided by bank and the balance 1/5th (5%)shall be by way of promoters contribution towards margin money. However, if the available net working capital (NWC) is more, the same shall be reckoned for assessing then extent of bank finance and lower limits is to be considered.

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Example:

Projected accepted annual gross sales turnover Working Capital requirement (25% of the above) Minimum margin to be provided by borrower

Rs. 10 lacs Rs. 2.5 lacs Rs. 0.5 lacs (Or NWC whichever is higher)

Bank finance

Rs. 2 lacs (Or lesser, in case NWC is higher)

As the working capital requirement is linked to projected turnover, the bank is required to satisfy itself regarding the reasonableness of the projections. This can be done with reference to the past performance (as reflected in the audited financial statements), orders at hand, installed capacity, availability of raw materials and other inputs and infrastructural facilities.

But there are many cases in which working capital is to be provided to new units. In such a case, the bank should ensure that the projections are realistic by analyzing the installed capacity, availability of infrastructural facilities, marketability of the product, and performance of similar units in the industry. A background check of the promoter and such other factors is recommended.

Many times it is seen that actual performance exceeds projections. In such a case working capital is found to be inadequate. The bank should reassess the working capital needs of the units and additional limits should be permitted in tune with the actual requirements of the units.

The recommendations of various committees suggest that assessment working capital credit limits should be done both as per projected turnover basis and traditional methods based on production/processing cycle (MPBF). If credit requirement based on later, the same may be sanctioned. But, if the case is otherwise, while credit limit be sanctioned at 20% of projected turnover, drawls is allowed on actual drawing power. Where turnover method is adopted, relaxations as per MPBF system can be considered.
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In addition to this, the bank also considers working capital facilities to meet any seasonal imperfections or meet borrowers emergent needs.

The benchmark current ratio for borrowers whose working capital limits are assessed based on this method is 1.25 as given in the directives to the bank.

2. Cash Budget System

This method came into practice because of the competitive banking environment which called for adopting methods of assessment appropriate to meet the needs of borrowers.

For limits of over Rs. 25 crore, credit facilities may be assessed on the basis of Cash Budget system or MPBF system, at the option of the borrower. However, in the case of specific industries or seasonal activities such as software export, construction activity, tea and sugar, normally the system of assessment based on cash budget is adopted.

Assessment of limit under this system is done by arriving at the deficit between cash inflow and cash outflow during a period of time. The various segments of cash budget are:

i) Cash Inflow: a. Receipt from debtors b. Cash Sales c. Receipt by way of trade advances d. Miscellaneous receipts e. Long term sources in the form of term loan, equity induction etc

ii) Cash Outflow: a. Payment to sundry creditors (trade creditors) b. Payment to sundry creditors (expenses) c. Cash expenses
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d. Cash purchases e. Deposits and Investments f. Advances to suppliers g. Other outflows like repayments of TL, Debentures, ICDs, CPs and other obligations

iii) Surplus/(Deficit) iv) Add opening balance v) Amount of deficit to be financed

(i-ii)

net of iii+iv or iii-iv

The cash budget has to be scrutinized by the bank. For this purpose, data is obtained from Cash flow statement, projected balance sheet and profitability statements, credit sales and purchases during the period, opening and closing stocks of finished goods, receivables and payments outstanding at the beginning and at the end.

While making forecasts, borrower is asked to make peak and non peak level of cash deficit. This is especially the case for seasonal industries, or industries having peak/ non peak level operations. The MPBF is normally fixed taking into account the peak level of cash deficit.

At many instances it has been noticed that there is no deficit in operating cycle and net deficit is only due to investing/financing cycle. Such deficit is not financed.

3. MPBF System
Tandon Committee had recommended three methods for calculating the maximum permissible bank borrowing.

Method I: Borrowers to bring 25% of the net working capital (Current Assets-Current Liabilities) Method II: Borrowers to bring 25% of the Current Assets Method III: Borrowers to bring 100% of hard core assets + 25% of other current assets.
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Under Method I, the promoter has to bring the minimum margin, and it is the maximum in the case of Method III. Chore Committee discarded Method III and recommended Method II which is also known as MPBF (Maximum Permissible Bank Finance) System. This is the most commonly used method of assessment of working capital.

This system is used as a method of assessment of working capital limits of over Rs. 2 crore for non SSI borrower but unto 25 crore. For limits of over Rs. 25 crore, credit facilities may be assessed on the basis of MPBF system or Cash budget system, at the option of the borrower.

The assessment of working capital requirement of the party is made based on a total study of the borrowers business operations vis--vis the production/processing cycle of the industry, which shall represent a reasonable build up of current assets for being supported by bank finance. The bank is at freedom, according to RBI directives (based on Kanan Committee recommendations) to decide the holding levels of various components of current assets. This is to ensure efficient functioning of the unit. However, such level of inventory and receivables is based on industry trend and closely related market developments. Projected level of inventory and receivables shall be examined in relation to the past trend and based on interfirm comparisons. These are only indicative level of inventory and borrower specific operational needs to hold projected level of inventory and reasonability thereof, ability to absorb the cost of carrying such inventory and comparison of the other similar units in the industry shall be relied upon to decide the required and acceptable level for being supported by the bank.

For the purpose of classification of current assets and current liabilities few important points are to be noted: a. All short term/ temporary investments in money market instruments like commercial paper, certificate of deposits can be considered as current assets. However, other investments such as inert-corporate deposits (ICDs), investments in shares and debentures (including those in subsidies and associates) are considered as Non-current assets.

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b. Cash margin for non-fund based limits is treated as a part of current assets for the purpose of MPBF. c. All term loan installments, fixed deposits, debentures etc repayable within the next 12 months should be considered as current liabilities. Same is the case with inter-corporate deposits. The benchmark current ratio for borrowers whose working capital limits are assessed based on this method is 1.33 as given in the directives to the bank.

Following is an example of how MPBF is calculated using the first two methods: 31.03.05 S.No. PARTICULARS Audited Audited Proj. Proj. FIRST METHOD OF LENDING 1 2 Total Current Assets Other Current Liabilities (Other than bank borrowings) 3 Working capital Gap (1-2) Min stipulated net working capital i.e. 25% of WCG (excluding Exports receivables) Actual/projected net working capital Item 3 minus item 4 Item 3 minus item 5 Maximum permissible bank finance (item 6 or 7 whichever is lower) 9 Excess borrowings representing short fall in NWC (4-5) 0.00 0.00 0.00 0.00
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31.03.06

31.03.07

31.03.08

13589.46 23297.61 52617.01 68716.90 6435.95 12433.14 24722.77 37568.98

7153.51

10864.47 27894.24 31147.92

1788.38

2716.12

6973.56

7786.98

5 6 7 8

3400.23 5365.13 3753.28 3753.28

5755.95 8148.35 5108.52 5108.52

11843.93 14989.78 20920.68 23360.94 16050.31 16158.14 16050.31 16158.14

SECOND METHOD OF LENDING 1 2 Total Current Assets Other Current Liabilities (Other than bank borrowings) 3 Working capital Gap (1-2) Min stipulated net working capital i.e. 25% of Total Assets (excluding Exports receivables) Actual/projected net working capital (45 in Form III) 6 7 8 Item 3 minus item 4 Item 3 minus item 5 Maximum permissible bank finance (item 6 or 7 whichever is lower) 9 Excess borrowings representing short fall in NWC (4 - 5) 0.00 68.45 1310.32 2168.36 3756.15 3753.28 3753.28 5040.07 5108.52 5040.07 14739.99 13968.69 16050.31 16158.14 14739.99 13968.69 7153.51 10864.47 27894.24 31147.92 13589.46 23297.61 52617.01 68716.90 6435.95 12433.14 24722.77 37568.98

3397.37

5824.40

13154.25 17179.23

3400.23

5755.95

11843.93 14989.78

50

References

Bank Manuals Manual of Instructions; Working Capital Finance; 2005 (Confidential) Manual of Instructions; Consortium Advances, Multiple Banking Arrangement and Syndication of Credit; 2004 (Confidential)

Print Material Mukharjee D. D.; 2006; Credit Appraisal, Risk Analysis and Decision Making 3rd edition; Snow Whit Publications Pvt Ltd., Mumbai Pandey I. M.; 2007; Financial Management IUP Publication; 2005; Financial management

Websites http://www.bseindia.com/BSEdata/ipo_downloads/AB.pdf www.canarabank.com www.rbi.org.in/Scripts www.investopedia.com/terms http://www.gelending.com/Clg/Resources/lendingFAQs.html www.banknet.com http://www.brickworkratings.com/criteria-large_corporate.html http://timesofindia.indiatimes.com/articleshow/710245960.cms http://en.wikipedia.org/wiki/Banking_in_India http://en.wikipedia.org/wiki/Canara_Bank http://www.blonnet.com/2004/01/23/stories/2004012300110900.htm

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Other Online citations Ravi Sharma. Building on a strong base. Online webpage of the frontline, volume 22 issue 21, Oct 08 -21, 2005. Ravi Sharma. A pioneers progress. Online edition of the frontline, volume 20 issue 15, July 19 August 01, 2003. State/Union Territory-Wise Number of Branches of Scheduled Commercial Banks and Average Population Per Bank Branch March 2002. Online webpage of the Reserve Bank of India.

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