Credit Management

ABOUT THE ORGANIZATION

Established in 1911, Central Bank of India was the first Indian commercial bank, which was wholly owned and managed by Indians. The establishment of the Bank was the ultimate realisation of the dream of Sir Sorabji Pochkhanawala, founder of the Bank. Sir Pherozesha Mehta was the first Chairman of a truly 'Swadeshi Bank'. In fact, such was the extent of pride felt by Sir Sorabji Pochkhanawala that he proclaimed Central Bank as the 'property of the nation and the country's asset'. He also added that 'Central Bank lives on people's faith and regards itself as the people's own bank'. During the past 92 years of history the Bank has weathered many storms and faced many challenges. The Bank could successfully transform every threat into business opportunity and excelled over its peers in the Banking industry. A number of innovative and unique banking activities have been launched by Central Bank of India and a brief mention of some of its pioneering services are as under: 1921: Introduction to the Home Savings Safe Deposit Scheme to build saving/thrift habits in all sections of the society. 1924: An Exclusive Ladies Department to cater to the Bank's women clientele. 1926: Safe Deposit Locker facility and Rupee Travellers' Cheques. 1929: Setting up of the Executor and Trustee Department. 1932: Deposit Insurance Benefit Scheme. 1962: Recurring Deposit Scheme. Subsequently, even after the nationalisation of the Bank in the year 1969, Central Bank continued to introduce a number of innovative banking services as under: 1976: The Merchant Banking Cell was established. 1980: Centralcard, the credit card of the Bank was introduced. 1986: 'Plantinum Jubilee Money Back Deposit Scheme' was launched. 1989: The housing subsidiary Cent Bank Home Finance Ltd. was started with its headquarters at Bhopal in Madhya Pradesh.

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Credit Management 1994: Quick Cheque Collection Service (QCC) & Express Service was set up to enable speedy collection of outstation cheques. Further in line with the guidelines from Reserve Bank of India as also the Government of India, Central Bank has been playing an increasingly active role in promoting the key thrust areas of agriculture, small scale industries as also medium and large industries. The Bank also introduced a number of Self Employment Schemes to promote employment among the educated youth. Among the Public Sector Banks, Central Bank of India can be truly described as an All India Bank, due to distribution of its large network in 27 out of 28 States as also in 4 out of 7 Union Territories in India. Central Bank of India holds a very prominent place among the Public Sector Banks on account of its network of 3126 branches and 286 extension counters at various centres throughout the length and breadth of the country In view of its large network of branches as also number of savings and other innovative services offered, the total customer base of the Bank at over 25 million account holders is one of the largest in the banking industry. Customers' confidence in Central Bank of India's wide ranging services can very well be judged from the list of major corporate clients such as ICICI, IDBI, UTI, LIC, HDFC as also almost all major corporate houses in the country. AHMEDABAD S.M.Road branch is a 27 years old branch. It presently has Deposits of 45 Crores and advances of 28 Crores. The senior manager Mr. K.B.Mehta heads this branch.

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Credit Management

THE ART OF LENDING

Credit decision-making is compared to match making. The idea is that the lender, while selecting a borrower, should take the same degree of care as is taken by the parents while finalizing alliance of their daughter. In selecting the borrower, the banker should not only satisfy himself that the project is viable but also that the borrower is one who can be entrusted with banks money. Before entertaining any credit application, the banker should ask the following questions: i. ii. iii. Who is the borrower? What is the project? How the bank funds are going to be repaid?

If answers to these questions are satisfactory, then only the banker should go ahead and take decision on the credit application.

WHO IS THE BORROWER?

The most vital part of credit analysis is identifying the right type of borrower. In case of existing entrepreneurs, banker can formulate his opinion on the person by referring to his past record. However, in case of first generation entrepreneur, this information is missing. Experience has shown that an academically qualified person does not necessarily make a successful businessman. On the contrary, a person low on qualification but high on practical experience has a fair chance of succeeding in his business activity. It is necessary to make enquiries with the existing customers to know about the antecedents of the applicant. Such enquiries should include questions about the habits of the person, his friend circle, family background etc. It is advisable to interview the applicant singly, when his consultant is not around. This will give an opportunity to the banker to find out whether he has complete idea about the project. If it is found that he requires external

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Credit Management assistance to provide such information like manufacturing process in general or sources of finance etc., it would mean that his involvement in the project is not total. Such an attitude on the part of the promoter is danger to the success of the project. A banker should be wary of any applicant who is in the habit of dropping names or citing his contacts with high officials, as he is not confident of the project getting approved on merits. Many bankers have burnt their fingers by entertaining applications on extraneous consideration like third party deposit, contact of the party with bigwigs etc. Decisions taken based on threat of the party that he will approach another bank too have, at times, proved disastrous. Does your interaction with the party give you a feeling that he wants to become rich overnight? Then it is better to avoid such a customer. A person, who wants to start in a small way and then builds upon it brick by brick, has a strong chance of succeeding as against one having grandiose plans. A promoter that allocates more space for his office and plans to decorate it very lavishly sends message that he does not know how to run the business. A person, who has not done his costing exercise but wants to launch himself because there is some other person minting money in a particular line of activity, is not the type who can be trusted by a banker. The applicant is expected to take his banker into confidence and share with him the strong points as also pitfalls about his business. has reasons to believe that the to entertain the credit request. It is likely that the applicant has promised to submit certain document or do something by a specific date, but has failed to honor the commitment. He has also not bothered to inform the bank why he could not comply with the requirement in time. If in the initial stage itself the applicant is going to behave applicant Where the banker back critical is holding likely to spell

information that has vital bearing on the success of project, it is better not

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Credit Management in this manner, you can very well imagine the type of relationship he is going to have with the bank, once the loan is disbursed. The applicant is required to contribute margin towards the project out of his own resources. Quite often a part of the capital is brought in the form of quasiequity by way of loan from friends and relatives. It is important to ascertain the source of capital, who the donors are, and their relationship with the applicant, terms of repayment etc. to make sure that there will not be sudden demand for refund of amount as this is going to cause liquidity problem for the promoter. A promoter of a small project has to perform several functions, as his finances do not permit engaging the services of various professionals. Naturally in order to succeed in his enterprise, he should be the type of person who can get along with people and having flexible approach. If the applicant maintains his savings with some other bank but has approached your bank for finance, you have right to know why he has preferred your bank to his previous banker for finance. Needless to say a confidential enquiry should be made with the other bank to ascertain whether that bank declined the loan request of the applicant.

WHAT IS THE PROJECT?

Not being a technical person, a banker does insist for project report prepared by a consultant to know about the technical feasibility and financial viability of the project. Where the project report is prepared by a consultant, who is dependant on the applicant for his regular source of income, it can be said that the report has lost its objectivity. Then again it is said that not a single project so far has failed on paper. The lesson to be drawn from the experience is that a project report, however well prepared, does not guarantee success of the project.

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Credit Management If units manufacturing a particular product are doing well in the area, that means requisite infrastructure is available and sanctioning of finance to one more unit will not entail any risk provided there is no oversupply of the particular product in the market, A project requiring raw material in bulk has a fair chance of succeeding if it is located near the source of raw material. Projects with very high break-even point take long to generate surplus and should be avoided. Instances are not lacking where the borrowers got the quotations deliberately inflated with a view to acquire machinery without contributing their share towards margin money. Likewise second hand machinery was acquired by making the bank pay the cost of brand new machinery. To put an end to such malpractices, a banker should make enquiries on telephone with the suppliers of machinery to know the exact cost. Alternately, the party should be made to produce quotations from two/three suppliers. We come across units where the commercial production is held up due to non-availability of power supply, even though the promoter had submitted noobjection certificate from Electricity Department. Against this backdrop, it will be prudent to make discreet enquiries as to whether Electricity Department is releasing new connections and whether the project to be financed stands a chance of getting power supply in the immediate future. With the integration of Indian economy with the global economy, doors have been thrown open for international competition. It has become imperative for the banker to satisfy himself that the technology to be employed is the latest and that in the market there is no over- supply of product proposed to be manufactured by the party.

HOW THE BANK FUNDS ARE GOING TO BE REPAID?

The banker should scrutinize the projections to satisfy himself that they are not over optimistic and that the project report has not been doctored to make the project viable on paper. Industry specific data published by financial

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Credit Management papers, financial institutions etc. may be used to determine the reliability of projections. Pre-sanction inspection should be carried out to crosscheck the authenticity of details mentioned in the project report. Disbursements should be made in stages depending upon the progress of work. Implementation schedule should be strictly adhered to for avoiding cost over-runs. The banker should be vigilant to see that the borrower observes financial discipline and that terms and conditions of sanction are strictly complied with. Stock statements and monthly statements of Select Operational Data (MSOD) should be scrutinized scrupulously to ensure that the sale proceeds are routed through the account. When there is delay in submission of stock statement, a surprise inspection should be carried out to ascertain whether the delay is willful. Borrowers have a tendency to delay filing of stock statement whenever the stock on hand is not adequate to cover the outstanding balance. In that event, banker should insist for refund of excess drawings in the account or for additional security to cover the excess. It must be impressed upon the borrower the necessity of proper maintenance of books of accounts and to see that they are updated from time to time. Any inspection of stock will be meaningless so long as the stock movement register is not brought up-to-date. Returns relating to quarterly projections/achievement must be compared with annual projections to ensure that the performance is not behind schedule. If there is wide gap between projections and actual, a dialogue should be held with the borrower to know the reasons for shortfall and remedial measures initiated to rectify the situation. It is noticed that international developments have started affecting the performance of Indian units. Naturally it becomes incumbent upon the banker to keep himself abreast about the developments by reading financial papers, magazines, trade journals, industry data published by C.M.I.E., I.D.B.I., I.C.I.C.I., etc. so that remedial measures could be initiated whenever there is adverse development affecting the unit financed by the bank.

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Credit Management A visit to the customers office should not be looked upon as an occasion to exchange pleasantries but as an opportunity to observe elements of business that are overlooked by financial statements and market studies. What are the orders on hand? Has any order been cancelled and on what grounds? Whether any key personnel have left the organization and what reasons have been cited in his resignation letter? Is any labor unrest brewing in the factory, which can snowball into a crisis? Is the unit maintaining proper books of accounts and whether stock movement register is posted up-to-date? Is the unit losing market share and what steps are proposed to push up sales? There is no substitute to personal inspection and the following experience of one banker should convince you that a lender could ignore the maxim `Seeing is believing only at its own peril. The bank had sanctioned large limits to a company against the security of industrial oil stored in huge containers. The bank officer deputed for inspection was received with due hospitality. He was taken around the unit and shown all records. When he expressed desire to check the stock of oil, the supervisor questioned the wisdom of going up a narrow ladder about 25 meters high. The supervisor offered to get it done through a worker of the unit. The officer persisted and when he peeped inside the container he saw a narrow cylinder in the storage tank, which alone contained oil. Same was the case with all the remaining storage tanks. The fraud was detected because the officer insisted on doing the job himself rather than getting his job done through someone else. The incident goes to establish that while examining accounts can check capital, the character and capability must be judged through wider observation. Time and again Reserve Bank of India and Finance Ministry have re-iterated that they are against further re-capitalization of nationalized banks by the government. On the contrary, they would like to see the share of government holding in these banks coming down in the near future. The investors will repose confidence in any bank only when the quality of its assets is high. This can be achieved only through proper identification of the borrower and then preserving the quality of assets through close monitoring.

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Credit Management The list is illustrative and not exhaustive and has been compiled on the basis of experiences of various bank officials working in the field. As if for no reason it is said that lending is an art and not a science. No amount of textbook reading can make you a successful lender. This art is primarily gained through experience as lender. Gaining the confidence of borrower and being able to identify the true qualities of success in a company constitute the elusive art of lending.

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Credit Management

BANK CREDIT: THE POLICY FRAMEWORK

Credit management is one of the essential functions of banking. monitoring of borrower accounts. Credit

management includes appraisal of credit proposals, loan delivery and, Although, the management of credit portfolio is as old as commercial banking, the liberalization of industrial sector coupled with the financial sector reforms reemphasizes about the importance of credit management. Building of qualitative credit portfolio and maximizing return on the portfolio with minimization of risk is continued to be an area of learning to the bankers. credit policy. This paper presents the importance of credit management in the current scenario and outlines the important aspects of

FINANCIAL SECTOR REFORMS: IMPLICATIONS ON CREDIT PORTFOLIO

The RBI has introduced several measures based on recommendations of Narasimham committee I [1991]. These measures have a direct impact on the credit portfolio of any commercial bank. Important among them are: (i) (ii) (iii) (iv) (v) Capital Adequacy Ratio [CAR] Maintenance of accounts according to Prudential Accounting Norms. Phased reduction of CRR & SLR. Deregulation of interest rates. Thrust on financing Small Scale Industries.

In 1998, RBI has moved towards the introduction of second generation reforms based on the recommendations of Narasimham Committee II, R.V.Gupta Committee on agricultural advances and Kapoor Committee on financing Small Scale Industries.

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Credit Management The implications of these reforms on credit portfolio are complex and far reaching on the banking sector. Every bank has to maintain a minimum of 9% Capital Adequacy Ratio [CAR] from March 2000 onwards. CAR is relationship between Capital of the bank and risk weighted assets. It simply indicates that, if Rs.100 advances are made Rs.9 Capital should be provided. emphasizes on quality lending. According to the prudential accounting norms, advances are to be classified as Standard, Sub-standard, Doubtful and Loss; further provisioning is to be made in the profit and loss account of bank. Higher provisioning reduces the profitability of the bank. All assets other than standard assets are indicated as Non-performing Advances (NPAs). The percentage of NPAs for any bank is an indicator of overall performance of the bank. The rating of a bank depends on the level of its NPAs. In granting the autonomy to banks, RBI considers NPAs as also one of the factors. To achieve Capital Account Convertibility, the Tarapore Committee has suggested that the banking sector Net NPAs should come down to 5%. Phased reduction of CRR and SLR by RBI over a period of time released substantial deposits, which are at the disposal of commercial banks. Commercial Banks should deploy these sources efficiently, to increase the profitability. In a phased manner RBI has deregulated the interest rates on advances and deposits. Since October 1994, banks have to price the advances on the basis of Prime Lending Rate [PLR]. Prime Lending Rate is the rate of interest charged to highly rated borrowers. Each bank has to announce the PLR on the basis of their cost of deposits and operating expenses from time to time. This has created competition among the banks. Banks are attracting the various customers by evolving suitable pricing strategies. Unless it is a quality advance, substantial return will not be generated to add a portion to the capital. This

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Credit Management

POLICY FRAME - WORK FOR CREDIT

In 1995, RBI advised the commercial banks to formulate a structured loan policy. The policy should lay emphasis on thrust areas, industry exposures, credit rating system, sanctioning powers and other procedures to be followed in the case of credit decisions. RBI has indicated prudential exposure norms. Prudential exposure norms (i) With effect from March 31, 2002, the credit limit shall not exceed 15% of the capital and free reserves of the bank to any single borrower (individual / partnership / company). (ii) (iii) Further, the credit limit shall not exceed 40% of the capital and free reserves of the bank to any group with effect from 31.03.2002. Total bank credit to any single borrower shall not normally exceed 4 times of net worth of borrower. It may be relaxable in the case of consortium accounts, where the consortium decides the norms. (iv) Till 31.03.2003, 50% of the total non-fund based facilities sanctioned to a borrower with partial margin will be taken into consideration for arriving at the total exposure limit prescribed for a borrower. (v) However, in line with best international best practices, RBI has decided that non-fund based exposures should be reckoned 100% from April 1, 2003. In addition, banks are also to include forward contracts in foreign exchange and other derivative products like currency swaps and options, at their replacement cost value in determining individual/group borrower exposure ceiling. Exposure limit for infrastructure projects: The RBI has enhanced the credit exposure limits by 10% for infrastructure projects. Banks can exceed the exposure norms of 40% of its capital funds by an additional 10% [i.e. up to 50 percent] provided the additional credit exposure is on account of infrastructure projects [i.e. power, telecom, road and ports].

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Credit Management

MPBF AND WORKING CAPITAL

With effect from April 1997 full operational freedom has been given to banks in assessing Working Capital requirements of borrowers. Banks are free to evolve their own methods of assessing the Working Capital requirements of borrowers within the prudential guidelines and exposure norms. All instructions relating to Maximum Permissible Bank Finance [MPBF] are being withdrawn. Banks may follow cash budget system for assessing the Working Capital Finance in respect of large borrowers.

TERM LOAN FOR PROJECTS

Banks have the discretion to sanction term loans to all projects within the overall ceiling of the prudential exposure norms prescribed by RBI. Banks have the freedom to decide the period of term loans keeping in view the maturity profile of their liabilities.

LOAN DELIVERY SYSTEM

A Loan Delivery System was introduced in April 1995 with a view to imparting an element of discipline in the utilization of bank credit, has been extended in phases to cover larger number of borrowers with the percentage of loan component of the working capital. Presently, Rs.10 cr. and above Less than Rs.10 cr. Minimum of 80 percent of loan component* At the discretion of the bank

* In the Credit Policy announced by RBI on 22/10/2001, banks have been given freedom to change the composition of working capital by increasing cash credit component beyond 20%.

INTEREST RATE STRUCTURE

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Credit Management

Prime Lending Rate (PLR) concept was introduced in October 1994. PLR is the rate charged to highly rated borrowers. The broad interest rate structure is as follows.

Advances up to Rs.2 lakhs Advances against term deposits Interest rates on remaining all advances

- Not more than PLR - Equal to PLR or less - Linked to PLR as specified by respective bank polices.

The interest rates on Export Credit are not linked with PLR and banks fix the rates as per RBI guidelines. The present Export Credit rates in Central Bank of India are as under: w.e.f. 1.5.2002 Interest on pre-shipment credit Rupee Export Credit up to 180 days Beyond 180 days up to 270 days Interest on Loan against incentives receivables from Govt. and Covered with ECGC up to 90 days Post-shipment Credit up to 90 days Post-shipment Credit beyond 90 days up to 6 months from the date of shipment. Over due export bills 8% 11% 8% 8% 10% ECNOS

ADVANCES AGAINST SHARES

Banks can extend loans to corporate against shares held by them to enable such corporate to meet the promoters contribution to the equity of new companies in anticipation of raising resources. Such loans shall be treated as banks investment directly in shares and would thus come under the ceiling of 5% of its outstanding domestic credit of the previous year. Regarding the margin and the period of repayment of such loans, banks determine the

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Credit Management same. Banks are allowed to grant advances against shares and debentures to individuals subject to a ceiling of Rs.10 lakh per borrower. Banks are required to maintain a minimum margin of 40% for advances against shares. If the shares are in dematerialized form the ceiling has been enhanced to Rs.20 lakh. However, the minimum margin against dematerialized shares is also 40%.

EXPORT FINANCE
Physical target for Export Credit is fixed at 12% to total credit. If the advances are for SSI Export units it forms part of Priority Sector. Any Export Credit proposal should not be kept pending for more than 45 days in the case of fresh advance, 30 days in case of renewal and for adhoc facility 15 days from the date of receipt of application. Export finance is broadly governed by FEMA (Exchange control Management Act), EXIM policy of Govt. of India, FEDAI Guidelines, International Chamber of Commerce (UCP ICC 500), and Internal guidelines of respective banks.

IMPORT FINANCE:
Multiple options are available to traditional credit products (Cash Credit, Term loans), the new products are Suppliers credit, Buyers credit and lines of credit broadly known as External Commercial Borrowings. FERA, FEDAI and RBI guidelines govern these.

HOUSING FINANCE
Banks are required to allocate 3 percent of incremental deposits of previous financial year towards housing finance. Banks may even exceed these levels if permitted by their resources. Direct housing loans up to Rs.5 lakhs in rural/Semi urban areas and up to Rs.10 lakhs in urban and metropolitan areas are treated as priority sector advances.

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Credit Management

All indirect housing loans extended by banks to housing intermediary agencies against the loans sanctioned by them will be reckoned as part of housing finance allocation. All the investment in bonds issued by NHB/HUDCO exclusively for financing of housing irrespective of the loan size per dwelling unit will be reckoned for inclusion under priority sector advances.

EDUCATIONAL LOANS
Educational Loans are treated as Priority Sector Advances. Loans are allowed both for studies in India and at abroad. The rate of interest charged under the scheme is PLR linked and depend upon the quantum of loan amount.

PRIORITY SECTOR ADVANCES:

The target set by RBI for priority sector advances is 40 percent of the net advances of the Bank. The agricultural advances should be 18 percent of the Net Advances and the other areas of Priority Sector are Small Scale industries, Advances for weaker section, DRI, Housing Finance etc. The credit to agricultural sector is thoroughly revised of R.V.Gupta Committee (1998). Similarly in the area of loans to Road and Water transporters the number of ownership vehicles increased from Six to Ten.

EMERGING TRENDS IN BANKING CREDIT

1. 2. 3. 4. Emergence of commercial paper as a substitute to working capital. Variety of debt instruments and Lease Finance as sources of Long Term Finance. International Factoring, Forfeiting and counter trade as new techniques of export finance and FCNR (B) loans. Credit cards, Hire purchase finance and various consumer finance schemes are alternatives to traditional personal & consumer Finance.

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Credit Management

CREDIT EXPOSURE LIMIT AND RESERVE BANK OF INDIA

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Credit Management

CREDIT EXPOSURE LIMIT

As a prudential measure aimed at better risk management and avoidance of concentration of risks, Reserve Bank of India has fixed limits on a banks exposure to individual borrower and group of borrowers in India w.e.f. May 1989. Ceiling The exposure ceiling is fixed in relation to banks capital funds and it shall not exceed 15 per cent of capital funds w.e.f. April 1, 2002 in the case of individual borrowers and 40 per cent in the case of group concerns. In case of Infrastructure projects the ceiling is 25% and 50% respectively for individual and group concerns. Capital Funds Capital Funds for the purpose will comprise paid up capital and free reserves as per the published accounts. Reserves, if any, created by way of revaluation of fixed assets etc. should not be included for the purpose. Exposure Exposure shall include funded and non-funded credit limits and underwriting and similar commitments. The sanctioned limits or outstanding, whichever is higher shall be reckoned for arriving at exposure limits. However, in respect of non-funded credit limits, only 50% of such limits or outstanding, whichever is higher, need be taken into account for the purpose. With effect from April 1, 2003, 100% of non-fund based limits shall be reckoned for arriving at exposure limits. Applicability

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Credit Management These stipulations shall apply to all borrowers. In so far as Public Sector Undertakings are concerned, only single exposure limit would be applicable. Borrowers, which are allotted credit limits directly by Reserve Bank of India, such as for food credits, will however, be exempted. Investments by banks in PSU bonds, shares and debentures of companies, commercial paper should also be included for arriving at single borrower/group concern exposure ceilings. Reporting of Credit Limits to Reserve Bank of India As part of its policy to secure optional deployment of the limited resources of the country and in order to channelise credit in desired directions, Reserve Bank of India had introduced Credit Authorization Scheme (CAS) in November 1965 requiring scheduled commercial banks to obtain Reserve Banks prior authorization before sanctioning any credit limit of Rs. 1 crore and above to any single party or any limit that would take the total limits enjoyed by such party from the banking system as a whole to Rs. 1 crore or more. This scheme, with stipulated limits enhanced from time to time, was dispensed with effective from October 10, 1988 and a Credit Monitoring Arrangement (CMA) was introduced requiring the banks to submit to RBI proposals for working capital limits of Rs. 10 crores and above from the entire banking system and term loans, including DPG, where the share of the banking system was Rs. 5 crores and above for post sanction scrutiny along with relevant data in the prescribed CMA format. In the wake of full operational freedom granted to banks in the assessment of working capital requirements of borrowers, CMA was considered no longer necessary. In order however, to have a database in relation to the flow of bank credit to borrowers in various industries, Reserve Bank has asked the banks to follow the under noted reporting system: a) Weekly statement in the prescribed proforma giving details of addition/enhancement in credit limits or reductions effected in respect of borrowers availing of working capital credit or term loan including

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Credit Management deferred payment guarantee limit of Rs. 10 crore or above from the banking system. b) Monthly statement in the prescribed form giving industry-wise break-up of net additional credit limits sanctioned to borrowers availing of working capital credit or term loan limit including deferred payment guarantee of Rs. 1 crore and above but less than Rs. 10 crores from the banking system. In respect of consortium/syndicated loans, banks as under will share the responsibility of reporting sanction of fund-based working capital credit limits or the term loans including DPGs: i) ii) When a bank sanctions the entire facility, the said sole bank should do the reporting. Where the facility is sanctioned by more than one bank but under a formal consortium, either voluntary or obligatory, or through syndication, the lead bank/lead manager should do the reporting, as the case may be. iii) Where the facility is sanctioned by more than one bank, but under multiple banking arrangements, each financing bank should report the facility extended by it.

BALANCE SHEET CLASSIFICATION OF ASSETS AND LIABILITIES

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Credit Management

I. 1956.

BALANCE SHEET FORMAT AS PER COMPANIES ACT

The classification of assets and liabilities as per the balance sheet drawn under the provisions of the Companies Act, 1956 differs in many respects from that according to the usually accepted approach of the bankers, based on the guidelines prescribed by the Reserve Bank of India. As per the balance sheet, the classification is done under the following main heads:

Liabilities Share capital Reserves & Surplus Secured Loans Unsecured loans Current liabilities and provisions

Assets Fixed assets Investments Current assets, loans and advances Miscellaneous expenditure and losses

The classification adopted by the bankers is done under the following broad heads:

Liabilities Current liabilities Term Liabilities Net worth

Assets Current assets Fixed assets Other non-current assets Intangible assets

The balance sheet classification is sometimes given in the column form under sources of funds and uses of funds. Items like capital and reserves and secured and unsecured loans are shown under sources of funds, while, under application of funds, fixed assets, investments and current assets are shown. At times, instead of showing current assets and current liabilities separately, net current assets figure is only shown, which is equal to the total current assets minus total current liabilities. In that case, the details of total current assets and total current liabilities are given in the schedules attached to the balance sheet.
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Credit Management

II.

NEED FOR SEPARATE CLASSIFICATION

Bankers want to study previous two years' actual, current year's estimates and following year's projections. While the balance sheet gives previous oneyear's position, it does not indicate future projections. The Companies Act, which has prescribed the balance sheet format, looks at the classification of the assets and liabilities from the point of view of shareholders and Government, whereas the banker has different perspective. The balance sheet form along with other forms as prescribed by the Reserve Bank (popularly known as CMA forms) are designed to serve the following main purposes: a. To verify whether the projections are in accordance with the past trends and current working, subject to technological and other developments;
b.

To work out the bases (i.e. cost of raw materials consumed, cost of production, cost of sales and sales) to which the inventory and receivable norms are related;

c. d. and e.

To verify whether the projected levels conform to the prescribed norms; To verify whether the various accounting ratios projected are realistic;

To fix the need - based limits.

III. HOW THE CLASSIFICATION ADOPTED BY THE BANKERS DIFFERS?

The banker's classification of assets and liabilities differs from that as per the Companies Act formats in the following major respects:

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Credit Management

a.

Share Capital

All accounts of share capital are included under one head as per the format of balance sheet under the Companies Act. However, bankers as current liabilities treat preference shares redeemable within one year while those redeemable between one year and 12 years are treated as term liabilities and beyond 12 years they form part of the net worth. Preference shares redeemable within 12 years are not treated as equity but are classified as debt as they have to be redeemed or repaid; the provisions of Capital Issues (Control) Act also follow this method. b. Secured and unsecured loans

The balance sheet classification is done on the basis of security and both term loans and working capital advances are clubbed together. debentures are included as secured loans in the balance sheet. Also, The

classification of loans adopted by the bankers is generally based on the period if the loan is repayable in one year, irrespective of the security, it is classified under current liabilities and that repayable after one year is classified under term liabilities. In fact, it would be more correct to say that the bankers classify under current liabilities all working capital advances (including working capital term loans) and installments of term loans/deferred payment credits/debentures, which are repayable within one year.

c.

Bills purchased and discounted

These are normally shown as contingent liability or indicated in the footnote to the balance sheet. As per the classification followed by the bankers, the amount involved is treated as short term borrowing from banks under current
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Credit Management liabilities and as receivables under current assets. d. Current liabilities and provisions

The classification in the Companies Act format does not meet fully the banker's requirements. For example, details of statutory liabilities like excise duty, sales tax, obligations towards workers considered as statutory (other than provident fund) may not be separately shown in the Companies Act format, while these have to be specifically indicated in the classification followed by the bankers. Similarly, sundry creditors comprise conglomerate items in the balance sheet and may also include sundry creditors for acquisition of capital assets. However, as per the classification followed by the bankers, only trade creditors, i.e., those arising out of purchase of raw materials and stores etc. are to be shown. e. Fixed Assets

Under fixed assets, goodwill, patent rights, etc. are also included, as per the Companies Act format. However, as per the banker's classification, these items are classified as intangible items. As such while working out tangible net worth, they are reduced from the figure of net worth. f. Investments

Under this item, only Government and trustee securities and fixed deposits with banks are normally included as per the banker's classification. If, however, the investments in Government and trustee securities and fixed deposits are made for long term purposes like sinking fund, gratuity fund, etc., such investments are excluded from investments under current assets. Further, as per the Companies Act format, shares held by the borrowing companies in their subsidiaries or other companies are also included under the head. But such investments are to be classified as non current assets.

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Credit Management

IV.

CURRENT LIABILITIES

The main headings under current liabilities as per the classification followed by the bankers are as under: a. Short - term borrowings from banks (including bills purchased and discounted and excess borrowings placed on repayment basis, i.e. WCTL) b. c. Short - term borrowings from others Deposits (maturing within one year)

Deposits maturing after one year are to be classified under term liabilities. Manufacturers of automobiles, two wheelers, etc. who accept deposits while booking orders for new vehicles are required under the government rules to earmark a part of such funds in certain approved securities, etc. In such cases, the benefit of netting may be allowed to the extent of such investment and only the balance amount need be classified as current liabilities. d. e. f. Sundry creditors (trade) Unsecured loans Unsecured loans taken from the Directors of the borrowing company, where no period is mentioned, are to be treated as current liabilities.

ADVANCES/PROGRESS PAYMENTS FROM CUSTOMERS

In the case of construction companies/turnkey projects, the advance payments/progress payments received against work in - progress may be

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Credit Management set off and only the net position should be shown either as a current liability or a current asset, as the case may be. Deposits from dealers and selling agents may be treated as term liabilities (and not under this head) irrespective of their tenure, if such deposits are repayable only when the dealership/agency is terminated. g. h. Interest and other charges accrued but not due for payment Provision for taxation

This relates to income - tax and not other taxes. Advance tax paid and provision therefore should be netted and the net position may be shown but netting should be made uniformly for all the years under i. consideration. Dividend payable

If dividend is only recommended and not appropriated from profits, pending approval of shareholders in the Annual General Meeting, the amount may be shown here after deducting it from general reserve and/or surplus in the profit and loss account. j. Other statutory liabilities (due within one year)

When provision for excise duty is made it should be classified as current liability. The disputed excise liability shown as contingent liability or by way of notes to the balance sheet will not be treated as current liability unless it has been collected or provided for in the accounts of the borrowers. Provision for disputed excise duty may be classified under current liability unless the amount is payable in installments, spread over a period exceeding one year, as per the orders of a competent authority like the Excise Department or in terms of the directions of a competent court, in which case the installments payable after one year are to be classified as long term liabilities. Where the
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Credit Management provision made for disputed excise duty is invested separately, say, in fixed deposits with banks, such provision may be set off against the relative investment. k. Installments of term loans/deferred payment credits/ debentures / redeemable preference shares (due within one year) Inter corporate Deposits to be treated as current Liabilities l. Other current liabilities and provisions In case specific provisions have not been made for known liabilities like dividend payable, tax payable, etc., estimates thereof should be made for eventual payment during the year and the amounts, though not provided, should be shown as current liabilities.

V.
a. b.

TERM LIABILITIES
Debentures (not maturing within one year) Redeemable preference shares (not maturing within one year but of maturity not exceeding 12 years)

c. d. year) e. f.

Term loans (exclusive of installments payable within one year) Deferred payment credits (exclusive of installments payable within one

Term deposits (repayable after one year) Other term liabilities

VI.

NET WORTH

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Credit Management a. b. c. d. e. f. Ordinary share capital Preference share capital (maturing after 12 years) General reserve Development rebate reserve Other reserves (excluding provisions) Surplus (+) or deficit (-) in profit and loss account Capital reserve, arising out of revaluation of property, may be excluded from the net worth. Consequently, the value of fixed assets to the extent they have been revalued upwards may not be increased. As stated earlier, intangible assets are deducted from the figure of net worth to arrive at tangible net worth.

VII. CURRENT ASSETS

a. b. Cash and bank balances Investments (other than long - term investments, e.g. sinking fund, gratuity funds, etc.) i. ii. Government and other trustee securities Fixed deposits with banks.

The question whether deposits representing or earmarked for margin money for issuing guarantees or opening letters of credit should be classified as current assets or non - current assets is not very clear. Some banks, inclined to be conservative, classify such deposits as non - current assets; otherwise,

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Credit Management once they are included in current assets, the borrowers' permissible level of bank finance goes up by 75% there of under the 2nd Method of lending. Dena Bank treats the investments in F.D. [encumbered] with banks including trustee securities on current Assets. Central Bank depending upon period treats as non-current asset. Investments in shares in subsidiaries and other companies should not be included under this head. Shares in which the borrowing company has made investments may be highly marketable but such investments are to be treated as non - current assets as bank finance is meant for deployment in borrower's line of activity and not in inter corporate locking of funds. shares/debentures are to be raised from the public mainly. c. i. Receivable Receivables other than deferred and export receivables (including bills Further,

purchased and discounted by banks) ii. Export receivables (including bills purchased and discounted by banks)

Bills purchased/discounted, though not shown, as liabilities/assets in the balance sheet should be classified as such, as indicated earlier. In the balance sheet drawn as per the provisions of the Companies Act, debtors are required to be classified as "Debts Outstanding for a period exceeding six months" and "other debts". Also, particulars are required to be provided relating to debts considered good and secured, debts considered good for which there is no security other than debtors' personal security and debts considered doubtful or bad. Debts, which are collectable within 12 months and after 12 months are not required to be segregated. Under CMA format, receivables realizable within 12 months (not six months) may be classified under current assets. However, some banks, taking a conservative view, do not treat receivables outstanding for more than six
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Credit Management months as current assets and the remaining as non-current assets. Receivables from subsidiaries/sister/associate concerns will be included, provided these receivables arise in the normal course of business and represent dues for sales made to them in the ordinary course of business on usual credit terms. As per the extant instructions, export receivables and Bills negotiated tender A/cs. are to be included under receivables but, for the purpose of calculating the maximum permissible level of bank finance, those are to be deducted from the total current assets for arriving at the minimum stipulated net working capital (i.e. 25% of total current assets under the 2nd method of lending). In case, the excise duty component is very large, the level of receivables may become distorted in relation to the norm/past trend. In order to make meaningful study of the position, data relating to excise duty component may be furnished separately. Similarly, if the sales tax element included is large, separate figures there of may be also furnished. d. e. i. Installments of deferred receivables (due within one year) Inventory Raw materials (including stores and other items used in the process of manufacturing) a. b. Imported Indigenous Coal, fuel, packing materials, labels, etc. may be included under this head. ii. Stock - in - process

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Credit Management Except in industries where the process cycle is long and involves various stages, the classification is fairly uncomplicated. iii. Finished goods In certain cases, where the excise duty component is very large (e.g., tobacco industry), inclusion of duty paid stock in finished goods and relating it to cost of sales which does not include excise duty creates distortion in the level of holding. In such a case, data relating excise duty may be shown separately. iv. Other consumable spares Normally loose tools or spares for machinery are not included but unused dies in a printing press or an extrusion plant poses a problem. If utilized within the maximum period of one year, such items may be classified under this head. Spares should not be linked to inventory levels but we should go by the consumption pattern in an industry. Spares should not exceed 12 months' consumption for imported items and 9 months' consumption for indigenous items. Beyond this level they should be considered as non - current assets and shown under non - current assets. 'Dead inventory' i.e. slow - moving or obsolete items should not be classified as current assets. In certain industries where the operating cycle is beyond 12 months, inventories held during such longer operating cycle will be treated as current assets.

f.

Advances to suppliers of raw materials and stores/consumable

spares. g. Advance payment of taxes

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Credit Management

As stated earlier, advance tax paid and provision therefore should be netted. h. Other current assets Security and tender deposits should not be classified under this head, irrespective of whether they mature within the normal operating cycle of one year or not but should be classified as non - current assets.

VIII. FIXED ASSETS

a. etc.) b. c. Depreciation to date Net Block Depreciation will normally include actual balances of depreciation. If, however, it is not provided and the arrears of depreciation are indicated in the notes to the balance sheet, extreme conservatism will dictate that such arrears should be included and, to that extent, accumulated profits/general reserves would be reduced. If the assets have been revalued, the increase in the value due to revaluation may be ignored. Gross block (land, buildings, machinery, construction - in - progress,

IX.
a. assets

OTHER NON - CURRENT ASSETS

Investments/book - debts/advances/deposits, which are not current

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Credit Management

i.

a. b.

Investments in subsidiary companies affiliates Others Advances to other firms/companies not connected with the business of the borrowing firm should be included under this head and not under current assets. Note 3 in the Explanatory Notes on classification of current liabilities and current assets given in the Reserve Banks' circular DBOD No. CAS/BC/119/C446-75 dated 31.12.1975 states: "Investments in shares and advances to other firms/companies not connected with the business of borrowing firms should be excluded from the current assets". That is to say, 1. 2. Investments in shares in other companies Advances to other firms/companies not

should be treated as non - current assets and connected with the business of the borrowing firm should also be treated as non current assets.

If such advances are given to the firms/companies, which are connected with the business of the borrowing firm they may, only then, be treated as current assets. However, amounts representing inter -connected company transactions should be treated as current only after examining the nature of transactions and merits of the case. For example, advance paid for supplies for a period more than the normal trade practices, in spite of any other consideration such as regular and assured supply, should not be considered as
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Credit Management current.

ii.

Advance to suppliers of capital goods/spares and contractors for capital expenditure

iii. iv. b. c.

Deferred receivables (other than those maturing within one year) Others

Non - consumable stores/spares Other miscellaneous assets including dues from directors

X.

INTANGIBLE ASSETS

(Patents, goodwill, preliminary and formation expenses, bad/doubtful debts not provided for etc.) As stated earlier, for working out the tangible not worth of a borrowing unit, intangible assets are deducted from its net worth. (A list of current assets and current liabilities as appearing in CAS format is given below with explanatory notes for the guidance. The classification is as per the directives of RBI received from time to time. The list is only illustrative and not exhaustive.) For classification of current liabilities and current assets, the Tandon study Group has suggested that the level of bank finance permissible may be determined on the basis of the working capital gap arrived at after taking into account the projected levels of current assets and current liabilities (other than bank borrowings). Although the items to be classified as current assets and current liabilities will be on the basis of the accepted approach of bankers, some of the bankers present in the Trainers seminar held in the Bankers

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Credit Management Training College in August, 1975, expressed a desire that the Reserve Bank of India should specify the nature of items to be classified as current assets and current liabilities. It was accordingly decided in the first meeting of the Committee of Direction that the committee might study the various items to be classified under the heads current assets and current liabilities so that the bankers can adopt a uniform approach in this regard. Broadly speaking, current liabilities would include items payable or expected to be turned over within one year from the date of balance sheet and the term is used principally to designate obligations whose liquidation is reasonably - expected to require the use of existing resources properly classified as current assets or the creation of other current liabilities. The term current assets is used to designate cash and other assets or resources commonly identified as those which are reasonably expected to be realized in cash or sold or consumed or turned over during the operating cycle of the business usually not exceeding one year. In the background of the common understanding as above the components of current assets and current liabilities for the purpose of determining working capital gap may broadly be taken as shown below.

I. 1.

Current Liabilities [See Note 1] Short term borrowings (Including bills purchased and discounted from: a. Banks b. Others

II. 1.

Current Assets Cash and bank balances

2.

Unsecured loans

2.

Investments (see note (3)) a. Government and other Trustee Securities (other than for long term purposes e.g. Sinking b. Fund, Gratuity Fund, etc.) Fixed deposit with banks

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Credit Management 3. Public deposits maturing within one year 3. Receivable arising out of sales other than deferred receivables, (including bills purchased and (see 4. Sundry creditors (trade) for raw material and consumable stores 5. and spares Interest and other charges accrued but not due for payment 5. 4. Note 10) Installments of deferred receivables due within one year Raw materials and components used in the process of manufacture-including those in 6. 7. 8. Advances/progress payments from customers [see Note (6)] Deposits from dealer, selling agents, etc. (see Note 97)) Installments of term loans, deferred payment credits, deferred payment credits, debentures, redeemable preference shares and long-term deposits payable within one year. 9. Statutory Liabilities a. b. c. d. e. 10. Provident fund dues Provision for taxation (see Note (2) and (8) Sales Tax, excise etc. (see Note (9) Obligation towards workers considered as statutory Others (to be specified) 10. Pre Paid expenses 9. Advance payment for tax 8. 7. 6. transit [see Note (4)] Stocks in Process including semi finished goods Finished goods including goods in transit Other consumable spares (see Note (4) and (ii)

Miscellaneous Current Liabilities: a. b. Dividends (see Note (2)) Liabilities for expenses

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Credit Management c. d. e. Gratuity payable within one year other provisions Any other payments due within 12 months 11. Advances for purchase of raw materials, components and 12. consumable stores. Monies receivable from contracted sale of fixed assets during the next 12 months Notes: 1. The concept of current liabilities would include estimated or accrued amounts which are anticipated to cover expenditure within the year for known obligations, viz, the amount of which can be determined only approximately, as for example, provisions, accrued bonus payments, taxes etc. 2. In cases where specific provisions have not been made for these liabilities and will be eventually paid out of general reserves, estimated amounts should be shown as current liabilities. 3. Investments in shares and advances to other firms/companies, not connected with the business of the borrowing firm should be excluded from current assets. 4. 'Dead inventory' i.e. slow moving or obsolete items should not be classified as current assets. 5. Amounts representing inter - connected company transactions should be treated as current only after examining the nature of transactions and merits of the case. For example, advance paid for suppliers for a period more than the normal trade practice, in spite of any other considerations such as regular and assured supply should not be
- 37 -

Credit Management considered as current. 1. Advance/Progress payments from customers (Item (4) under current liabilities) These deposits are to be classified as current liabilities. Where deposits are required, in terms of regulations framed by the Government, to be invested in a specified manner (e.g. advances for booking of vehicles), the benefit of the netting may be allowed to the extent of such investment in approved securities and only the balance amount need be classified as current liability. (c.f. paragraph 2(ii) of Circular IECD. No. PMS. 206/27c - 87/88 dated 12 May 1988). Where on account of different accounting procedure progress payment are shown on the liabilities side without deduction from work - in progress, banks may set off the progress payments against work - in progress. Advance payments received are also adjusted progressively form the value of work completed, as agreed in the contract. Outstanding advance payment is to be reckoned as current liabilities or otherwise, depending upon whether they are adjustable within a year, or later (e.f. Annexure to Circular IECD. No. CAD (PMS) 11/WGCC - 81 dated 24 October 1981). 6. Deposits from dealers, selling agents etc. (Item (7) under current liabilities) These deposits may be treated as term liabilities irrespective of their tenure if such deposits are accepted to be repayable only when the dealership/agency is terminated after due verification by banks. The deposits which do not satisfy the above condition should continue to classified as current liabilities (c.f. paragraph 2 (i) of circular IECD. No. PMS. 206/27c - 87/88 dated 12 - 5 988). Security deposits/Tender deposits may be classified as non - current assets irrespective of whether they mature within the normal operating cycle of one year or not (c.f. Para 2(iii) of Circular IECD. No. PMS. 206/27c - 87/88 dated 12 - 5 - 1988). 8. Provision for taxation
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Credit Management (Item (9) (b) under current liabilities) Netting of tax provision and advance tax paid (vide item (ix) of current assets) may be effected for all the years uniformly and, as such, for the current year also the advance tax paid can be set off against the provision, if any made for that year (Circular IECD.No.CAD. (PMS) - 89/c.446 (PMS) - 84 dated 4 June 1984). 9. Sales - tax, excise etc. (Item (9) (c) under current liabilities) Disputed excise liabilities shown as a contingent liability or by way of note to the balance sheet need not be treated as a current liability for calculating the permissible bank finance, unless it has been collected or provided for in the accounts of the borrower (c.f. pare 3 of circular IECD.PMS.170/c.446 (PL) 86/87 dated 24 June 1987). Provision for disputed excise duty should be classified as current liability, unless the amount is payable in installments spread over a period exceeding one year as per the orders of competent authority like the Excise Department or in terms of the directions of a competent court. In such cases, if the installments payable after one year are classified as long-term liability, no objection may be taken to such classification. (Para 4 of Circular IECD.No.CAD (PMS) 1/C. 446(PMS) - 85 dated 2 January 1985). Where the provision made for disputed excise duty is invested separately, say in fixed deposits with banks, such provision may be set off against the relative investment. (Para 5 of circular IECD. No. CAD (PMS) 1/c 446(PMS)/-85 dated 2 January 1985). Disputed liabilities in respect of income - tax, customs and electricity charges need not be treated as current liability for the purpose of computation of maximum permissible bank finance except to the extent provided for in the
- 39 -

Credit Management books of the borrower. (Circular IEDC.No.PMD>252/c.446 (PL) - 88/89 dated 18 May 1989). 10. Receivables arising out of sales other than deferred receivables, (including bills purchased and discounted by bankers) (Item (3) under current assets) Export receivables may be included in the total current assets for arriving at the Maximum Permissible Bank Finance but the minimum stipulated Net working Capital (i.e. 25% of total current assets under 2nd Method of Lending) may be reckoned after excluding the quantum of export receivables from the total current assets (Para 3 of circular ECD.No.PMS.206/27c.87/88 dated 12 May 1988). 11. Other consumable spares (Item (8) under current assets) Projected levels of spares on the basis of past experience but not exceeding 12 months' consumption for imported items and 9 months' consumption for indigenous items may be treated as current assets for the purpose of assessment of working capital requirements. (Circular IECD.No.PMD 231/7c.88/89 dt. 16 October 1988)

12.

The above list of current liabilities and current assets is only illustrative and not exhaustive.

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Credit Management

INCOME STATEMENT
1. profit / loss account: statement of income and expenses, statement of operation etc. are the other names of income statement. income-expenses = profit / loss is the simplest form of the income statement. however income or expenses for a given period of time consist of series of revenue or expenses transactions.
- 41 -

if these

Credit Management transactions are grouped systematically and compared, year wise, may throw useful information for a banker to understand and analyze the operations of the business concerns. 2. income statement is prepared for a given period generally one year. it is prepared on the basis accrual concept. included and prepaid expenses are excluded. there is no prescribed format for preparing p/l account. the minimum disclosures, which are statutory. 3. let us understand and discuss the p/l statement as per credit authorization scheme format. this is known as operating statement and forms part ii or the cas format. it may be noted that this statement is not named as income statement or p/l account, but operating statement. this is so because only p/l figure may not disclose actual position about the operations of the unit. there may be loss but it could be for valid reasons. likewise there may be substantial profits, which might have been possible because of income arising out of activity other than main business activity. in both these cases, the reliance on only net p/l figure may be misleading. therefore apart from p/l figure, banker is also curious to know the efficiency of unit in using installed capacity, streamlining of expenses, increase in sale volume, gross cash generating capacity and so on. therefore p/l account as per cas format is designed in such a way that all desired information would be readily available to the banker. 4. please refer the format of operating statement annexed to this chapter. the operating statement can be divided into four sections: a. sales
- 42 -

income earned but not

realized is included: so also expenditure incurred but not paid is

however

schedule vi part ii of companies act 1956 enlists requirements and

Credit Management b. c. d. 5. trading / mfg. a/c operating profit net profit/loss.

the consumption of raw material is calculated as under. opening stock + purchases - closing stock. this figure is to be calculated for imported and indigenous raw materials separately and to be entered in the respective columns. the holding level of raw material is calculated by using the formula as given here under. consumption of raw material 12

= monthly holding

let us understand these sections. A. SALES items 1 to 4 relate to sales activity. we desire to find out the net sales figure from gross sales figure. therefore items like excise duty, sales returns should be excluded from gross sales to arrive at net sales figure. the separation of sales into domestic and export would be accordingly banker can fix priority in the disposal of loan necessary. this gives an idea about the quantum of export sales in total sales. proposal of export-oriented unit. B. TRADING / MANUFACTURING ACCOUNT: (ITEM 3 TO 5) this part of operating statement includes all costs/expenses relating to manufacturing or trading activity. all these costs are direct costs and has relation with quantity of goods produced.

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Credit Management this cost when deducted from net sales, we get gross profit. in case of manufacturing unit, the total of all direct cost known as cost of sales i.e. cost of goods produced for sale (and not the sale price of goods sold.) item 5 [ i ] to [ vi ] covers all direct costs. to this figure when net stock of work in progress is added. we get cost of production [5(x)]. we can work out levels of holdings of work in progress on the basis cost of production by using formula given below: wip c of p 12 1

further, when we add net stock of finished good to cost of production we get cost of sales. the levels of stock of finished good can be worked out by using cost of sales figure. fg c of s 12 1

we get gross profit/loss when we deduct cost of sales from the net sales. i.e. gross profit/loss = net sales cost of sales C. OPERATING PROFIT we get operating profit when indirect costs relating to sale such as selling and general expenses, administrating expenses, etc. are excluded from gross profit. interest. D. NET PROFIT / LOSS so far all direct or indirect costs relating to sales have been considered. it can be worked out before or after

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Credit Management there may be other expenses such as donations, loss on sale of assets/investments, fire/theft etc. or other income such as profit on sale of assets /investments, commission, brokerage which do not arise out of normal operation of the business. therefore such non operational income and expenses required to be considered separately. similarly tax is of the head of expenses, which is not at all in the hands of the management. government stipulates tax tariff. we get net profit after adding net effect of non-operating income and expenses and deducting the tax provisions. the net profit is further transferred to p/l appropriation account. profit is appropriated as per the decision of the management. the declaration of dividend is the main feature, which interests the shareholders and also the bankers, as it will affect the profit retained in the business. i.e. plough back of profit by the concerned unit.

ANALYSIS OF OPERATING STATEMENT

1. having understood the main structure of operating statement, let us discuss as to how the information / data can be analyzed. it is to be noted that the study of operating statement for an isolated year may not lead to any meaningful conclusion. it would be necessary to study comparative figures of, say, past 3 years minimum. this would enable reader to reasonably establish some trends. in light of past average performance the rational of the projections for the ensuing year would be more clear and visible. the operating statement can be analyzed as follows: 2. SALES

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Credit Management a. sales in general should show an upward trend. percentage

increase in sales (item4) is a good indicator to judge the progress made in stepping up the sales. however it is subject to following limitations. i. growth may be due to inflation and/or increase in price level only. increased. ii. the figure should be compared with industry level (if such a data available). if it is above industry level, the performance may be considered impressive. iii. if unit has reached point of optimum capacity utilization, sale may not show noticeable growth. b. export sales may be given special consideration. if more then 25% of sales consists of export sales, unit may be given preferential treatment. the cash and sales incentives should be treated as part of sales and not as other income. in reality production level might not have

c.

projection of sale target for the following year is the key figure of all the credit appraisal exercise. the requirement of credit appraisal exercise. the requirement of credit limits would ultimately depend upon the levels of sales planned and estimated. banker has to make sure that sale target projected is realistic. it must keep pace with past trends, market potentials, installed capacity, aggressiveness of the management to push the sales etc. some times, sale target may be feasible but might not have been supported with adequate share of owners in bringing in matching contribution of own funds. thus if reliance is on more borrowings from bankers and others, bankers has to take careful decision.
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Credit Management

3.

COST OF SALES AND GROSS PROFIT gross profit is the indicator of operational efficiency of the unit on the floor. i.e. manufacturing or trading. gross profit percentage for last three years may be compared horizontally. improvement is a welcome feature. if there is decline, the reasons should be traced back. the fall may be because i. sales price may not have increased with increase in cost of inputs or ii. some of the heads of expanses may have been showing upward trend. such heads should be identified and clarification may be sought from the management.

the gross profit (or margin) may also be compared with industry level figure. the gross profit / margin generally remains the same for all units because cost of inputs would be almost same for all. for some reason if margin is less as compared to industry level, it signals some shortcomings in the working of the unit. for comparative study of various heads of expenses, the percentage method may be used. all heads of expenses can be worked out as the percentage of net sales of that year. comparative increases / the percentage figures of a particular head of fall during the year under review. the expenses, when compared horizontally gives fairly good idea about its reasonableness of projection can also be properly judged by this method. amongst various heads of expenses, the consumption of raw materials (opening stock + purchases closing stock) is an important figure because generally the cost of raw materials is the major head of expense for industries. any increase in % share of raw materials is not a good sign. the increase may
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Credit Management be due to problems in production process. the same may be ascertained. the increase in cost of repairs and maintenance may suggest that condition of plant and machinery may not be proper. increase in wage bill beyond normal, may signal aggressiveness of work force. depreciation is a non cash expense. profit or loss figure can be adjusted with changes/adjustments in depreciation. therefore it should be ensured that depreciation is charged as per accepted practices and there is no change in current year for the current year. levels of closing stock work in progress and finished goods should be watched carefully and it should be ensured that they are at normal holding levels. the gross p/l figure can be adjusted, if need be, by adjusting the figure of closing stocks, because valuation of the closing stock is done and certified by management and not by auditors or bankers. 4. OPERATING PROFIT i. selling and general expanses is a domain perfectly under control of the management. while there is limited scope to reduce cost of sales, the expenses under various heads of selling and administration could be minimized or avoided. perhaps, if the goods produced are of good quality the expenses could be on lower side. on the other hand if there is fierce competition or goods are sub-standard, selling expenses may be on higher side. ii. interest is incidental to the sums borrowed. the borrowing is the decision of the management. strictly, interest is not a therefore we work out operational cost but financial cost.

operating profit before interest and as well as after interest. increase in burden of interest may be the result of not retaining sufficient profits in business or fresh capital is not being injected in the business. some times the borrowings from friends and
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Credit Management relatives are seen to be carrying interest rates higher than bank rates. iii. operating profit is a indicator of profits generated through main business activity because income and expenses relating to business activity have been only considered. this is one of the basic financial indicators to the bankers for their credit decisions. 5. NET PROFIT/LOSS a. in operating statement heads of other non-operational income and expenses have been separated from main business operations. it may happen sometimes that unit may receive sizable, other income due to say profits on sale of investments/assets. resultantly it may be in a position to show impressive figures of profits. bankers would not like to be misleading by such a figures. therefore figures of other income and expenses should be carefully scrutinized and it should be made sure that such income or expense are incidental to normal circumstances and there is no intention to divert from main business activity. b. tax is a sensitive area. if tax tariff is on the higher side, we should understand that the firm would find ways and means to minimize tax burden. there is nothing wrong in doing so, so far the means adopted are perfectly legal and not detrimental to the interest of bankers, share holders, government etc. c. please note that due to higher taxes, firm prefers to borrow more than raising own capital (high gearing) because interest paid on borrowing can be changed to profit/loss account. d. study of p/l appropriation account is also equally important. it suggest whether management acknowledges its role of
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Credit Management conserving working capital, strengthening reserves positions or prefer to woo the share holders by declaring higher dividends despite forbidding financial position. whatever may be the management policy in appropriating p/l, banker would have a definite say, if retained profits are not sufficient to conserve working capital, maintain debt/equity ratio, honor repayment schedules. while summarizing, we may remember 1. 2. operating statement should not be looked upon as only the indicator of p/l figure. it gives an idea about the gross fund generating capacity of unit. it helps in fixing repayment schedules. 3. we can make out whether profits are generated through main business activity or through other income. 4. the comparative study of various heads of expenses helps to know whether unit is working efficiently. 5. 6. we can judge the potentials of profitability of the unit. it helps to judge the reasonableness of projected sale target and other heads of expenses. 7. the exercise of profit engineering would be based on operating statement only.

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Credit Management

ASSESSMENT OF WORKING CAPITAL REQUIREMENTS

FORM II : OPERATING STATEMENT NAME : AMOUNT RS. IN LACS ESTIMATES FOR THE YEAR ENDING /ENDED 19.. 19.. LAST 2 YEARS ACTUAL (AS PER AUDITED ACCOUNTS) 19.. CURR. YEAR ES 19.. FOLLO W-ING PROJ.

ESTIMAT YEAR

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Credit Management

1.

2. 3. 4.

GROSS SALES I. DOMESTIC SALES II. EXPORT SALES TOTAL LESS EXCISE DUTY NET SALES (1-2) % RISE (+) OR FALL (-) IN NET SALES AS COMPARED TO PREVIOUS YEAR. COST OF SALES I. RAW MATERIALS (INCLUDING STORES AND OTHER ITEMS USED IN THE PROCESS OR MANUFACTURE A IMPORTED B INDIGENOUS OTHER SPARES A IMPORTED B INDIGENOUS POWER & FUEL DIRECT LABOR (FACTORY WAGES & V VI VII VIII SALARIES OTHER MFG. EXPENSES DEPRECIATION SUB-TOTAL (I-IV) ADD: OPENING STOCK IN PROCESS SUB-TOTAL DEDUCT: CLOSING STOCK-IN-PROCESS COST OF PRODUCTION ADD: OPENING STOCK OF FINISHED GOODS SUB TOTAL DEDUCT CLOSING

5.

II III IV

IX X XI

XII

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Credit Management STOCK OF FINISHED XIII 6. 7. 8. 9. 10. 11. GOODS SUB-TOTAL (TOTAL

COST OF SALES) SELLING GENERAL & ADMINISTRATIVE EXPENSES SUB-TOTAL (5-6) OPERATING PROFIT BEFORE INTEREST (3-7) INTEREST OPERATING PROFIT AFTER INTEREST (8-9) I. ADD OTHER NONOPERATING INCOME A. B. SUB-TOTAL (INCOME) DEDUCT OTHER NONOPERATING EXPENSES A. B. SUB-TOTAL III (EXPENSES) NET OF OTHER NONOPERATING INCOME/ EXPENSES (NET OF 11 ( I )& 11 ( II ) PROFIT BEFORE TAX/LOSS (10+11 (III) PROVISION FOR TAXES NET PROFIT /LOSS (12-13) A. EQUITY DIVIDEND PAID B. DIVIDEND RATE RETAINED PROFIT (14-15) RETAINED PROFIT /NET PROFIT (1)

II

12. 13. 14. 15. 16. 17.

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Credit Management

RATIO ANALYSIS
Ratio Analysis are not ends in themselves, rather on a selective basis they may help answer significant questions Erich A. Helfert.

INTRODUCTION:
Ratio-analysis is a concept or technique, which is as old as accounting concepts. Extensive studies on the choice and use of productivity, finance and operating ratios are made. Financial analysis is a scientific tool. It has assumed important role as a tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls. Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any cross sectional and time series linkages between these ratios. Ratio-analysis means the process of computing, determining, and presenting the relationship of related items and groups of items of the financial statements. They provide in a summarized and concise form a fairly good idea about the financial position of a unit. financial analysis. The bankers use the information contained in the ratio for the purpose of control and monitoring. Bankers are concerned with the units ability to re-pay its interest, installment obligations in time and abide by the terms and conditions of sanction during the time the loan is outstanding. Bankers are also interested in determining the financial strength of the company and its performance. A ratio relates absolute figures and brings out the meaningful information. Ratios are processed data. When ratios are calculated the attention of the analyst is drawn towards the numerator and the denominator, which will indicate to him the manipulability of each variable for the purpose of They are important tools for

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Credit Management making any improvement on the ratio. The manipulability of the ratio depends upon the relationship between the two variables. variable by keeping the other constant. Absolute figures do not convey much meaning to the analysis; one is able to appreciate the significance if he relates to the other figures. For example to understand the profit generating capacity of a company, the amount of capital employed is also to be seen. Thus ratio analysis helps to describe the significant relationship between any two figures in the financial statements. Ratio analysis can provide insight into the important areas of management like (1) Return on Investments (2) Soundness of companys financial position (3) clues as to the areas which are to be focused in the subsequent analysis. In case where the two variables are mutually independent, then it is very difficult to manipulate one

CLASSIFICATION OF RATIOS
The ratios can be classified into: 1. 2. 3. Balance Sheet ratios Profit and loss account ratios Inter-statement ratios a combination of P & L and Balance sheet.

They are also classified on functional basis: 4. 5. 6. 7. Profitability ratios Turn-over ratio (Activity ratios) Liquidity ratios Leverage ratios.

USES OF RATIOS
Ratios are important indicators of the financial capacity of an organization to meet its commitments. The analysis can be done either internally by an organization, which will be a detailed one, or externally by people outside the

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Credit Management organization like creditors, investors, etc. on the basis of information available in the published financial statements. Ratio analysis is a quantitative This is a tool for technique in financial management. This is a technique for assessing the financial health of a unit from the accounting data. credit/project appraisal for bankers and financial institutions. This measures the past performance of an organization and helps projecting the future trends. Selection of proper standards is a very important element in ratio analysis. There are four types of standards against which an actual figure can be compared. 1. Historical Standards: Comparison is done of current performance with past figures of the same company. 2. External Standards: When one company is compared with another, the environmental and accounting differences affecting the two sets of figures may raise serious problems of comparability. the averages for the industry, if figures are available. 3. Experience: An analyst gradually builds up his own idea as to what constitutes good or poor performance, thus subjective standards of a competent analyst are more important than standards based on mechanical comparisons. 4. Goals: Many companies prepare budgets, which show what performance is expected to be under the circumstances prevailing. If the actual performance corresponds with budgeted performance, there is a reasonable inference that the performance is good. The ratios themselves have little meaning and to extract most meaningful comparison with previous months/years or benchmarks of other companies is The analyst should allow for these differences. Comparison can also be made with

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Credit Management needed. Before looking at the ratios there are a number of cautionary points concerning their use that need to be identified: a. The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn. b. The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciation or asset valuations for example will distort the results. c. In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required. The utility of ratio analysis will get further enhanced if following comparison is possible. 1. 2. 3. 4. 5. 6. Between the borrower and its competitor. Between the borrower and the best company in the industry. Between the borrower and the average performance in the industry. Between the borrower and the global average. Between two years. Between two months/quarters.

Ratio analysis gives overall evaluation of the companys health. Ratio analysis is not an end by itself. This is only a starting point in our endeavor to know the performance of an organization visavis its objectives. At best, this analysis can throw up the symptoms of the problems, if any, and this enables the analyst to look into their causes. In other words, the ratios are used for further investigation rather than to make final judgments. The findings based on ratio analysis has to be studied along with the findings of other quantitative techniques like funds flow analysis, cash budgeting, etc. as
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Credit Management also other relevant financial and non-financial data. Thus, ratio analysis is one of the important management tools available that aids decision-making.

LIMITATIONS OF THE ANALYSIS:

1. Ratios are not standard formula for judging the performance. They can only guide, since management problems are so complex that they cannot be reduced to a formula. 2. The makeup of ratios should be chosen with care. Otherwise the relationship may be misleading. 3. While ratios are compared on an historical basis, the time periods may be of equivalent duration, but price level changes between the periods may distort the results if no allowance is made for this factor. 4. Since the analysis is based on the financial statements, this will have all the limitations, which the financial statements themselves have (e.g. Balance sheet is as on a particular date and hence there is a possibility of window-dressing. Balance sheet is not a valuation statement. It gives value of assets inuse and not inacquired at different points of time. Fictitious assets are also given in the balance sheet. Non financial changes, although, very important from the point of view of business are not reflected). 5. Ratio based on profit, which is generally used as an indicator of effectiveness and efficiency, has certain limitations. For example, profit measures current rather than longrun performance. There is also no reliable way of measuring the profit potential of a business as to compare the reported profit with the profit that could have been earned under the circumstances.

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Credit Management 6. Generally Accepted Accounting Principles give wide latitude in measuring profit in a company. This dilutes the validity of interfirm comparisons. Nevertheless, ratio analysis is a useful aid and could be used along with other quantitative techniques in financial management to assess the financial health of an organization.

IMPORTANT FINANCIAL RATIOS FOR BANK

1. (i). Liquidity Ratios Current Ratio = Current Assets ------------------------Current Liabilities Current Assets: Raw material, Stores, Spares, Work-in-progress, Finished Goods, Debtors, Bills Receivables, Cash. Current Liabilities: Sundry Creditors, Installments of T/L, DPG, etc. payable within a year and other liabilities payable within a year. This ratio of 1.33: 1is generally preferable to ensure minimum margin of 25% of current assets as margin from long-term sources. method. Measures short term liquidity of the company and its ability to meet its short terms obligations within a time span of a year. Shows the liquidity position of the enterprise and its ability to meet current obligations in time. Under method I of Tandon Committee it will be 1.17: 1 and it will be 1.25: 1 as per turnover

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Credit Management

Higher ratio may be good from the point of view of creditors. In the long run very high current ratio may affect profitability. (E.g. High inventory carrying cost) Quality of current assets is not measured. Hence Quality composition of various types of current assets has to be seen while interpreting this ratio. The ratio indicates only the quantitative coverage. Shows the liquidity at a particular point of time. The position can change immediately after that date. So trend of the current ratio over the years is to be analyzed. Current ratio is to be studied along with the changes of Net Working Capital [NWC]. It is also necessary to look at this ratio along with the Debt-Equity ratio. Total outside liabilities Tangible Net worth

In short it indicates the extent to which short-term creditors are covered by assets that are expected to cash in a period roughly corresponding to the maturity of assets. 2. Leverage Ratios or Solvency Ratios

These ratios are also known as Gearing or financial leverage ratios. Measures the longterm financial stability of the company. It reflects on the capacity of business unit to assure the long-term creditors with regard to their repaying capacity of both interest and installment. It also reveals whether there is satisfactory balance between owned funds and borrowed funds. The ratio can be 2. Long Term Liabilities i. Debt: Equity = ----------------------------------- 60 -

Credit Management Tangible Net Worth

Total outside liabilities Total Debt: Equity = ----------------------------------Tangible Net Worth Debt should come down over a period of time in relation to equity, indicating plough back of profits.

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EVOLUTION OF WORKING CAPITAL FINANCE

From lending exclusively against the security of collaterals to financing future receivables, Indian banking has come a long way. The metamorphosis brought about by Reserve Bank through appointment of various committees was done with a view to streamline credit delivery system of commercial banks so as to fall in line with international practices.

DAHEJA COMMITTEE
Appointed in 1968 came, to the view that bank lending was unrelated to borrowers actual needs or activities as it was extended based on financial worth of borrower, collateral security and guarantee offered. The result was that there was concentration of bank finance to industrial sector. As a sequel to committees recommendations, RBI issued guidelines for systematic appraisal of working capital requirements of the industrial borrowers.

TANDON COMMITTEE (1975)

It recommended scientific approach for considering credit requirements of borrowers. The appraisal should be based on production plan, lead time for supplies, economic ordering levels and a reasonable level of receivables and other current assets. The Committee suggested three methods for fixing maximum permissible bank finance. The methods provide for a progressive increase in the contribution from the borrowers long-term sources for financing current assets. Maximum permissible bank finance was to be bifurcated in loan and fluctuating cash credit component norms for holding of inventory and receivables were also prescribed.

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CHORE COMMITTEE (1978)

Borrowers having working capital limits of Rs.10 lakhs and above should be compulsorily brought under the Second Method of lending Working Capital limit should be fixed on the basis of normal non peak level as well as peak level requirements. Borrowers with working capital limits of over Rs.10 lakhs were required to submit Monthly Select Operational Data: Banks were asked to fix operational limit on the basis of Quarterly Information System returns.

NAYAK COMMITTEE (1993)

The working capital requirements of village industries, tiny industries and other SSI units enjoying aggregate fund based working capital credit up to Rs.50 lakhs from the banking system should be computed on the basis of a minimum of 25 per cent of their projected annual turnover for new as well as existing units, of which at least four-fifth should be provided by the banking sector and the balance one-fifth should be borrowers contribution towards margin for the working capital. The norms of inventory and receivables as also first method of lending will not be applicable to such units. This method of computation of working capital finance suggested by the Nayak Committee has since been rechristened as Turnover Method.

IN HOUSE COMMITTEE (OCTOBER 1993):

The guidelines set out for arriving at working capital facilities, for village and tiny industries and other SSI units enjoying fund-based working capital limits up to Rs.50 lakhs, on the basis of minimum of 20 per cent of their projected annual turnover were extended to all borrowers enjoying aggregate fundbased working capital limits of less than Rs.1 crore from the banking system, which was raised to Rs.2 crores with effect from May 1997 as per slack season Monetary and Credit Policy 1997-98 of Reserve Bank. As per the pronouncements made by Finance Minister in his budget speeches, the limit for fund based working capital credit finance of SSI Units to be fixed under Turnover Method stands raised to

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1. 2.

Up to Rs.4 crores from June 1998 and further Up to Rs.5 crores with effect from April 1999

Freedom to Banks to determine working capital credit requirements of borrowers: In Monetary and credit Policy for the first half of 1997-98 announced on April 15, 1997, Reserve Bank informed Commercial Banks about the withdrawal of prescription in regard to assessment of working capital needs based on maximum permissible bank finance (MPBF) enunciated by Tandon Working Group, and advised them to evolve an appropriate system for assessing the working capital credit needs of borrowers, within the prudential guidelines and exposure norms already prescribed. The revised Method of Lending adopted by Central Bank of India and Dena Bank in response to the freedom granted by RBI, appears elsewhere in the booklet. Reserve Bank has also prescribed that: a. Borrowing units engaged in export activities need not bring in any contribution from their long-term source towards financing that portion of current assets as is represented by export receivables. b. Additional credit needs of exporters arising out of firm orders of confirmed letters of credit (and which were not taken into account while fixing the regular credit limits of borrowers) should be met in full even if sanction of such additional credit limits exceeds MPBF. c. Borrowing Units marketing/trading exclusively (100 per cent) the products and merchandise manufactured by village, tiny and SSI units will be subject to the First Method of Lending while assessing their MPBF provided dues of the said village, tiny and SSI Units have been settled by such borrowers within a maximum period of 30 days from the date of supply.

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Credit Management d. Credit limits of borrowing units in the sugar industry may be determined on the basis of current ratio of 1.1untill further advice. e. Sick/Weak units under rehabilitation will be exempt from the application of the Second Method of Lending.

CALCULATION OF MAXIMUM PERMISSIBLE BANK FINANCE:

First Method of Lending Total current assets (CA) Less Current liabilities Excluding bank borrowings (OCL) ----------------------------------Working Capital Gap (WCG) Less: 25% of Working Capital Gap or Net working Capital (NW i.e. (CA-CL) Whichever is higher or Net Working Capital (NW i.e. CA-CL) Whichever is higher? ----------------------------------- ------------------------------------------Maximum Permissible Bank Finance Min. Current Ratio 1.17:1 Maximum Permissible Bank Finance Min Current Ratio 1.33:1 Second Method of Lending Total current assets (CA) Less Current liabilities excluding bank borrowings (OCL) --------------------------------------Working Capital Gap (WCG) Less: 25% of total current assets

----------------------------------- ---------------------------------------------

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WORKING CAPITAL: REVISED METHODS

DENA BANKS APPROACH
As part of financial sector reforms, Reserve Bank of India granted operational freedom to commercial banks to evolve an appropriate system for assessing the working capital credit needs of borrowers within the prudential guidelines and exposure norms already prescribed. Accordingly Dena Bank at its Board meeting held on 8.1.1998, approved the revised methods of assessment of working capital limits as explained hereunder. 1) Turnover Method Fund Based Working Capital limits up to Rs. 5 crores will be assessed under Turnover Method. 2) a) b) Modified MPBF Method or Cash Budget Method

Fund Based working capital limits of Rs. 5 crores and above will be assessed under Modified MPBF Method or Cash Budget Method, at the discretion of the Bank.

TURNOVER METHOD
The methodology for computation of working capital limits has been explained in the chapter Turnover Method appearing elsewhere in the booklet. The projected annual turnover figure should be realistic and in

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Credit Management the opinion of Branch Manager, achievable. The reasonableness of projections should be satisfied by comparing with sales recorded during the past 2/3 years, industry growth etc. Achievement of projections in the past, setting up of additional capacity, change in Government policy, large/bulk recurrent orders on hand etc. may be given due weightage while accepting projections. The computation of working capital finance should be done both under Turnover Method and Traditional Method and the need based limit should be fixed. It is proposed that the current ratio of 1.33:1 will now be the Bench Mark and not the minimum requirement, with the desirable current ratio fixed at 1.15:1. For all borrowers with working capital limits up to Rs. 10 lacs, the CAS form need not be insisted upon. However the borrower will have to submit projected balance sheet and P&L account. For borrowers with limits of Rs. 10 lacs and up to Rs. 5 crores, the existing forms as prescribed by RBI would continue to be submitted/applicable except Form No. V i.e. computation of MPBF for working capital sheet.

MODIFIED MPBF METHOD

The existing MPBF method based on norms of inventory and receivables had inherent defect of rigidity. Modified MPBF Method has replaced this method. Under the Modified MPBF method the norms prescribed by Tandon Committee for the level of inventory and receivables stand withdrawn. The projected levels of inventory and receivables would now be based on actual level in the past with developments like establishment of additional capacity, diversification by way of addition to product lines etc given due weightage while determining holding levels. In case of new units, since no past data would be available, the holding level will be based on future projections only (wherever available comparative data of similar units may be taken as base).

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Credit Management

The working capital limits would continue to be assessed under second method of lending with slight modification in definition of current assets and current liabilities listed hereafter. There is no change in CAS format except that on page No. 8 compliance under Inventory & Receivables level in the columns. It is proposed that the current ratio of 1:33:1 will now be the Bench Mark and not the minimum requirement, with desirable current ratio fixed at 1:25:1.

CASH BUDGET METHOD

While the borrower would have option to be assessed either under the Cash Budget or Modified MPBF method, the discretion to accept assessment based on Cash Budget Method would be that of the Bank. This discretion will be exercised depending upon the quality of data submitted by the corporate borrower. In other words only where the data is adequate, timely and satisfactory, the borrowers request for being assessed under Cash Budget Method would be considered by the Bank. A corporate borrower put under Cash Budget System would have to submit monthly profit and loss account, the Balance Sheet and the projected cash budget for the next 12 months along with details of assumptions behind the projections. The working capital limits would be based on Monthly Cash Deficits. The peak or maximum cash deficit over the next 12 months would be the working capital limits. The borrower would have to give the Cash Budget separately for operation and all other non-operational areas such as investment in long-term assets of new projects etc. would have to be excluded from the operational Cash Budget. The bank would finance 100% of maximum monthly deficit. The drawings would be monitored on the basis of Quarterly Budget to be submitted by the company before the

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Credit Management commencement of the quarter. For the purpose of arriving at drawing power, usual margin stipulation would apply. The success of the cash budget would depend upon the proper analysis of the cash budget both past actual and projections. Current ratio of 1.33:1 will be the Bench Mark and not the minimum requirement with desirable current ratio fixed at 1.25:1. a) Loans from friends and relatives: 50% of unsecured loans from friends and relatives can be treated as quasi capital. Quasi capital should not exceed the owners fund. Owners funds mean paid up capital + free reserves excluding revaluation reserves minus intangible assets. Ship breaking industry, construction industry and other similar industries will be exempt from this stipulation. Appropriate letters/undertakings are to be obtained not to withdraw the loan without prior permission of the Bank during the currency of bank loan. The Bank has discontinued the practice of treating loans from friends and relatives as quasi capital for the purpose of credit analysis with effect from 11th March 2000 except in the case of traders and has fixed benchmark in terms of total debt equity ratio (TOL/TNW) for different types of borrowers. Category of borrower 1. Industries (Medium & Large) 2. Industries (SSI) 3. Traders 4. Ship breaking 5. Service industry Bench Mark 3:1 3.5:1 4:1 6:1 4:1

The existing borrowers whose unsecured loans were treated as quasi capital while assessing the credit limits will have to bring in adequate funds in place of unsecured loans so as to comply with the prescribed benchmarks latest by 31st March 2001.

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b)

Interest Coverage Ratio This is a risk parameter and an indicator to the extent to which the interest liability will be serviced on time. Interest for this purpose would mean gross interest payable by the borrower and profit would mean the gross profit before interest. Interest coverage should be minimum 2.25 times.

c)

Classification of Current Assets & Liabilities The following modification has been done in classification of Current Assets & Current Liabilities. Cash margin for LC/Guarantees (maximum 1 year period) will be treated as Current Asset Bills negotiated under LC and Export Receivables though Current Assets would be excluded from NWC for the purpose of assessment of MPBF. Inter Corporate Deposits (ICDs) taken will be current liability Investment in FD (unencumbered) with banks including trustee securities will continue to be current assets Installments of term loan due in one year are reckoned only for the purpose of current ratio and not for computing MPBF as per existing procedure Investment shares/debentures/advances/association/subsidiary continue to be non-current assets. in will

d)

Supervision and Follow-up.

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Credit Management MSOD and QIS statement have been withdrawn. Fixation of quarterly operative limit based on QIS statement is also similarly withdrawn. However, QIS statements are now replaced, by a new set of Financial Follow-up Report statement II and I. This will be applicable to borrowers with credit limit of Rs. 1 crore and above. Though late submission of these statements would not attract penal interest, it must be ensured that the borrowers for control purpose submit the statements. Borrowers whose working capital limits are assessed under the Cash Budget Method must submit Quarterly Cash Budget before the commencement of the quarter for monitoring the drawing. e) i. Commitment charges for unutilized portion of fund based working capital limits are withdrawn in view of credit delivery system. ii. Penal charges for non-submission/delayed submission of QIS are similarly withdrawn. iii. Any adhoc limit will continue to be part of total MPBF/assessed working capital limit. iv. Regarding selective credit control, guidelines of RBI would continue to be applicable. v. For sugar industry, the current ratio requirement would be as per RBI stipulation.

CENTRAL BANK OF INDIAS APPROACH

As part of financial sector reforms, Reserve Bank of India in its Monetary and Credit Policy, for the first half of 1997-98, bestowed operational freedom in the area of credit dispensation upon banks. The prescription in regard to assessment of working capital needs based on the concept of maximum

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Credit Management permissible bank finance (MPBF) enunciated by Tandon Committee was withdrawn and banks were advised to evolve an appropriate system for assessing the working capital credit needs of borrowers subject to observance of prudential guidelines and exposure norms already prescribed. In tune with liberalized environment, Central Bank of India has adopted the following system for assessment of working capital requirements of the borrower. Turnover Method Fund based working capital requirements i) ii) iii) Up to Rs. 1 crore for non-SSI borrowers Up to Rs. 5 crores for SSI borrowers For assessing credit requirements of Trading Concerns upto Rs 1 crore, a simplified format introduced by the Bank including the methodology prescribed therein should be followed. Traditional Method Fund based working capital requirements i) ii) Rs. 1 crore and above but less than Rs. 50 crores for non-SSI borrowers Rs. 5 crores and above but less than Rs. 50 crores for SSI borrowers should be assessed under Method II of Tandon Committee. Cash Budget Method i) ii) Cyclical industries like tea, sugar etc. Borrowers availing Fund Based Working Capital limits of Rs. 50 crores and above from the banking industry.
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METHODOLOGY
Turnover Method The methodology for computation of working capital under this method is explained in the chapter on Turnover Method appearing in the booklet. The entitlement of the borrower should be computed both under Turnover Method and Traditional Method. Where the entitlement under Turnover Method is higher than that under Traditional Method, need based limit should be fixed. Traditional Method (Modified MPBF System) Traders (Stockiest) 1) 2) 3) 4) The credit requirements will be assessed on the basis of past indicators and future projections. The current ratio should be min. 1.33 with deviation upto 1.20 permitted during peak trading periods. Subordinated debt/quasi-capital with usual declaration may be treated as part of capital employed. TOL: TNW up to 4:1 may be allowed subject to availability of collateral securities to cover the entire bank credit. Modified MPBF System The Tandon Committee Norms on holding levels of inventory and receivables have been dispensed with. Holding levels as per the past practice will continue to be the basis under the modified system. While

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Credit Management the projections should reasonably conform to the past trends, deviations can be accepted subject to satisfactory justification.

Diversion of Funds In case of borrowers with a current ratio above 1.50, the bank may permit investments that will facilitate improved profitability, tax savings, growth etc provided such investments are planned and projected in financial statements furnished to the Bank subject to the condition that the current ratio does not fall below 1.50 and under no circumstances below 1.33. Where the current ratio falls below 1.33, the existing penalties for diversion of funds should be invoked. Loan Delivery System Where the MPBF entitlement is Rs. 10 crores and above, RBI guidelines on Loan Delivery System will be applicable The Cash Budget Method The borrower is required to submit the cash budget to the bank along with actual as well as projected financial statements. The budget in the prescribed format is to be prepared for a period of one year and then split into forecasts for shorter periods say monthly or quarterly. The budget will provide the following information. 1) 2) The peak level of bank finance required during the course of the year. The current level of bank finance required as forecasted by the split budget (on monthly / quarterly) basis.

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Credit Management I. Appraisal by the bank The budget must be scrutinized vis--vis the financial statements to satisfy that the forecasts are reasonable. Once the forecasts are found acceptable, the credit limit required by the borrower is to be determined as the peak level of cash deficit as shown in the budget. The sanctioning of the limit will be subject to observance of the following benchmarks. 1. 2. 3. Maintenance of Current Ratio desired level 1.33 The Debt: Equity Ratio (TTL: TNW) normally not to exceed 2:1 Borrower/Group exposure to be within norms determined by the Bank internally, but within the Reserve Bank of India parameters. 4. 5. The appraisal will also include assessment of the Company profile and Industry profile. There has to be an evaluation of risks at the time of fixing lending limits and if felt expedient, the level of operations and cash budget projections will be pruned down by the Bank at the time of discussions before finalizing credit limits. 6. The disbursal of credit facilities will be by way of Loan and Cash Credit components as per stipulation of Loan Delivery System. Flexibility will be allowed in fixing maturity periods of the loans, which can correspond to the quarterly budgets if the borrowers so choose. Once the maturity period is fixed, prepayment of the loan component, if required, shall be subject to RBI guidelines and also payment of a penalty upto 2% of the prepaid loan amount for the un-expired period, as may be decided by sanctioning authority at his discretion. 7. Credit facilities on preferential terms like export credit should be assessed and disbursed in terms of existing procedure. However, the total of such facilities and all other fund based facilities availed should be within the limits sanctioned under the Cash Budget.

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Credit Management Note: The method of assessment as above includes only determination of working capital finance. Means of finance for long-term requirements will have to be assessed separately. Similarly, requirement of Non Fund Based facilities will be assessed as per existing practice, and it has to be ensured that the operations in L/C limits are dovetailed with the cash budget.

MONITORING OF ACCOUNT:
The credit limit sanctioned will correspond to the peak level of cash deficit, and the availment of limit should be monitored at the operating level to ensure that the drawings are as per forecasts for the short term. It would be advisable to fix monthly/quarterly-operating limit as projected by the cash budget. The borrower will also be required to furnish the actual at the end of each shortterm budget, which should be monitored to see that progress of working is as per projections. The other monitoring tools, like regular stock inspections, etc will continue to be employed. Commission Agents The credit requirements of the individual borrower should be assessed on the basis of financial projections subject to availability of collaterals and D.E (TOL/TNW) ratio of about 2:1. Subordinated debt/quasi capital in the form of loans from family members and friends may be treated as a part of capital employed subject to objection of an undertaking that such funds will be retained in business during the currency of bank finance. The quantum of bank finance should be restricted to operating expenses.

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FOLLOW-UP OF ADVANCES
INTRODUCTION:
Keeping pace with the developments in economic and industrial fronts, the Banking Industry has undergone rapid transformation during the last two decades. A banker is now required to take cognizance of concepts like (a) diversification of credit areas; (b) meeting socio-economic needs; (c) reducing inter-regional disparity in development; (d) need-based lending on the basis of viability; (e) purpose-oriented lending; (f) providing stake in the financial strength and operations of the borrower; (g) disciplined use of credit resources (h) increasing the profitability (I) keeping quality of lending portfolio etc. Hence, it has become important for a banker to involve himself in the financial operations of the borrower to ensure that the unit is running in proper direction. This can be accomplished only by a meaningful follow up of the borrowers operations. The objectives of follow-up, thus, may be stated: (1) controlling end-use of credit; (ii) ensuring good health of the account throughout (iii) safety of advances; (iv) checking diversion of funds; (v) seeing that borrowers observe financial discipline (vi) Identifying early alarm signals and initiate remedial action. The follow up of advances is a continuous process and not a one-time job. An effective follow up system can show danger signals if the account is not running in desired direction and helps the bank to take immediate corrective measures. The proposal for advances is sanctioned on several assumptions, regarding integrity of the borrower, purpose of the loan, end use of funds and financial discipline. Certain assumptions are made about production schedule, activity

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Credit Management levels and marketing efforts. Follow-up gives first hand opportunity to reexamine the assumptions on which the original proposal was sanctioned. This will include actual results, Profit & Loss Account and Balance Sheet, Cash Flow, Operating Statements and other financial data to reassess, the assumptions and renewal of facilities with necessary corrections. The security against which the loans are sanctioned is a cushion to fall back upon in case of contingency. Follow-up includes proper supervision and control over security and inspection from time to time to ensure the good condition and marketability of the securities. While demand for bank funds is ever increasing, social objectives accepted by the banks demand judicious allocation of available funds. Follow-up provides opportunities to reassess the same and arrange for redistribution of funds based on need-based approach.

AREAS OF FOLLOW-UP
The follow-up areas may be identified as under: A. Communicating borrower about sanction: Firstly, it is desirable to inform the borrower about the sanction of proposal in writing, along with the terms and conditions and guarantor, if any. It is better to accept an acknowledgement, from the borrower. The letter should contain the following points. 1. 2. 3. 4. 5. 6. 7. 8. Amount of sanction with sub-limits, if any. Margin Rate of Interest Nature of Security and Charge Names of Guarantors Repayment Schedule Insurance Date of Renewal of Facility

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Credit Management 9. Submission of necessary information systems required by banks. Any special terms or conditions such as Import Licenses, Raw Material, Debt Equity, introduction of new capital, technical know-how, plough back of profits, dividend policy, marketing arrangement, managerial competence, lien on assets, bridge finance, etc should be mentioned in sanction letter clearly. A register of advances sanctioned to be maintained with all details. In case of a running unit, it is advisable to make it known to the concern that any decision regarding operation of the unit, which are likely to affect the income generating capacity or structure of assets and liabilities should be taken with the knowledge and approval of the lending institutions. Following are some of the instances: 1. 2. 3. 4. 5. 6. 7. 8. Additional acquisition of fixed assets Expansion Plans Borrowing from outside sources Investment in subsidiaries Dividends out of years earnings Extending guarantees to sister concern Earlier repayment of loans before maturity to financial institutions Disposal of assets

DOCUMENTS
The execution of documents in proper form according to the requirement of law is known as documentation.

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Credit Management Before disbursement of an advance to the borrower, proper documents are to be obtained from the borrower and guarantor, if any. The twin objectives for obtaining documents, viz. to bind the borrower and guarantor and to create effective charge on securities are to be kept in mind. Following points should be borne in mind while obtaining documents. a) b) Complete set of documents in standard formats should be obtained. No blank document should be obtained. The documents should be filled up before execution and documents should be executed always in representative capacity of the borrower/guarantor. c) d) The documents should be duly stamped before execution. No addition/alterations should be made after execution of documents. The executants should duly authenticate any alteration. e) The documents should be executed before an Officer of the Bank. The officer should certify in a separate paper that the documents executed were duly read and understood by the executants and the same should be enclosed with the document set. In case the borrower could not understand English, then the documents are to be explained to him in his vernacular language and a certificate to this effect has to be enclosed with the documents. f) Superfluous documents need not be taken since if the basic document turns out to be defective, no superfluous document can safeguard banks interest. It is prudent to take appropriate document set only keeping in view the objectives for obtaining documents. g) In the case of consortium accounts documents should be obtained as prescribed by Indian Banks Association.

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Credit Management h) The documents so obtained should be entered into the security register and should be got verified by Chief Internal Auditor or Panel Advocate as per the policy of the Bank. i) j) The comprehensive Insurance Policy with bank clause should also be obtained along with documents. The entire set of documents is to be renewed before expiry of the existing documents. k) Acknowledgement of Debt should be obtained every six months including from the guarantors if any. In case of Limited Companies, the appropriate documents should be executed under the common seal of the company along with the copy of resolution of the Company. l) Every time the limits are increased to the borrower fresh set of documents are to be taken and in case of corporate a/c it should be registered with registrar of companies with regard to modification etc. The required fee paid should be kept along with the documents as a proof of having done so.

CONFIDENTIAL LIMIT BOOK

The Confidential Limit Book contains information relating to the limits sanctioned, authority of sanction, terms and conditions of the sanction, documents etc. This book gives a fair idea about the sanction and documents of an advance at a glance. This book is to be updated every time when there is a change.

FILING CHARGE WITH REGISTRAR

In pursuance to Sec.125 of the Indian Companies Act, when advance is made to a Limited Company, charge is to be registered with the Registrar of Companies.

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Credit Management In pursuance to Sec 135 of the Indian Companies Act, when any modification is to be registered with the Registrar of Companies Bank will lose priority to other creditors if charge is not properly registered as per the requirements of law as stated above. The charge has to be registered/modified within 30 days (as per the latest amendment) from the date of creation of charge.

INSURANCE
While disbursing any advance, comprehensive insurance policy with a bank clause should be obtained. The details of policy, such as Policy No., Date, and Risks covered, Amount, Date of Expiry, Name of the Insurance Co. with branch etc. are to be entered into the Insurance Register. Verify whether borrowers name and address of the go down is properly mentioned in the policy. If not necessary endorsements are to be obtained from the insurance company to this effect. If a claim is lodged to the Insurance Company, bank should follow-up the claim and ensures that claim is disbursed through bank only.

DISBURSEMENTS ACCORDING TO TERMS

The loan sanctioned should be disbursed according to the terms and conditions stipulated in the sanction. If the branch wants to waive some conditions, already stipulated, on the basis of representation from the borrower, permission from appropriate authority should be obtained for the same before disbursement. The terms of advances should be officially informed to the borrower and confirmation should also be obtained from him. Such a confirmation letter will be of help in case the bank resorts to legal recovery proceedings in a future date. In case of term loans, borrowers are to be advised to keep the margin amount in their account. The branch should issue a pay order to the supplier of machinery/article directly. The details of the pay order are to be noted down in the loan ledger clearly for quick reference at a future date. The details of the machinery are also to be noted and verified by the purchase bill so that

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Credit Management identification of machinery becomes easier. Installments should be intimated to the borrower and any default should be followed-up by demand notice immediately.

STOCK STATEMENTS
The submission of stock statement by borrowers on regular monthly basis is to ensure that the advance is always covered by adequate inventory and the banker should satisfy himself that this arrangement is fully complied with. Bank usually conducts regular inspection based on the stock statements to verify the availability of stocks of description, Quantity and value described as per statement submitted to them. The banker has to ensure that: (a) Adopting the same principle as for the financial statements should do valuation of stock in the stock statement. (b) Stocks Quantity and value should be reconciled from month to month. (c) During inspection, the available stocks are to be verified with the purchase invoices to ascertain the purchase value of stocks. Ascertain that the banks board is displayed prominently in the go down. (d) Calculate % of slow moving stock to the total stock. Depending upon the nature of industry, the % to be fixed. The value of slow moving stock is to be removed from the total value before arriving at the drawing power for the account. Branches have to do ABC analysis of the stock statement and pay more attention to high value items of inventory, their movement etc so that banks interest is protected. (e) Unpaid stocks to be removed from the total stock. Branches have to take all precautions to remove the value of D/A L/C stock before arriving D.P to avoid double financing. Wherever the borrowers are not

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Credit Management furnishing the particulars of unpaid stocks, branches has to get the position clarified and necessary steps are to be taken before arriving at drawing power for operating the account. The regular submission of stock statements is mandatory. Bunched submission of stock statement, i.e. submission of stock statements for 3 or 4 months together is one of the earliest symptoms of liquidity problem, which the branch has to take care. It is advisable for the branches to verify the stock statements submitted by the borrowers with the previous stock statements in the file to ensure, opening and closing balance of raw materials, price fluctuations, unpaid stocks, level of holding etc., to satisfy themselves about the quality of current assets which are the prime security against bankers finance. The value of stock vis--vis value of insurance is also to be checked and always the insurance amount should be more than the total value of the stock in the go down. Statement of debtors When bank sanctions overdraft against book-debt, a statement of debtors, indicating age-wise classification is to be obtained. Branch should not allow drawing power on the old debtors. Once in three months the book debt statements are to be certified by Chartered Accountants. Branch is also advised to have the bankers opinion of the debtors financed in their files for reference. The branch is also to verify that the book debts are well spread and there is no concentration of book debts involving large amounts against a few or allied/associated/sister concerns unless there is a specific sanction available to this effect. Even in such cases individual limit fixed for each concern should be adhered to.

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Credit Management Normally, back-debts of more than 90 days old are not to be financed. In exceptional cases if there are specific sanctions, certain book debts can figure up to six months only. During the visit to the borrowers office in order to verify the correctness of the book-debts statement submitted by the borrower, it is advisable to verify that the debts are properly entered in the books of accounts such as debtors register, party-wise register etc and tally with the borrowers invoices. Examine whether fresh book debts are appearing in the name of the customers who have already defaulted for the previous supplies and have received the goods on credit terms. Also ascertain whether there is any double counting of receivables by way of book-debts and receivables through negotiation of bills of the same party. It is also to be ensured that, whether book-debts are raised on the traders from whom the borrower purchases raw materials and all other items for his manufacturing activity. Bills Bank should pay attention to the bills returned unpaid and acceptances dishonored so that repurchase/discount of the bills of the same drawers can be done away with. While allowing limit for bills purchased, Report on the drawers whose bills are negotiated/purchased are to be obtained from their bankers and is to be kept on record. It is to be updated every year. Bill financing is a sales financing. The quick realization of bills indicates to the bankers the marketability of their customers goods. The return of the bill may indicate loosing of market share; quality of goods manufactured or the clients market share is slipping due to various reasons. The bankers have to analyze and find out the correct reason on this score. Further if there is delay in realization of bills, which normally happens before return, banker has to take corrective steps immediately. The branch has to calculate the percentage of
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Credit Management over due bills to current bills regularly to maintain a healthy bills portfolio of their borrowers and avoid slippage in the quality of their assets.

CURRENT/CASH CREDIT/OVERDRAFT ACCOUNTS

It is to be observed from the account as to whether the borrower is frequently overdrawing the account or asking for adhoc increases. Frequent overdrawing in the account is a bad sign of operation. Frequent requests for ad-hoc increase may be due to over trading non-realization of debtors etc. Branch should not encourage any such practice of the borrower. The branch has to immediately identify these symptoms to satisfy it to know whether there is any liquidity problem. This phenomenon may be preceded by return of cheques both inward and outward. Usually outward cheques are returned for want of drawing power or limit, indicating therein that there is liquidity strain. This is not a healthy sign. At the same time if outward cheques also started returning means, borrower is not in a position to realize his dues. This will lead to a situation of borrowers not paying their credits in time. All these are signs of incipient sickness. The branch has to take immediate steps to remedy the situation by taking suitable alternative actions so that the account is not slipped from performing to non-performing asset. The operations in the account are one of the very important indicators to the banker with regard to the health of the account. The branch has also to verify for any round-sum credits introduced in the account by the borrower to verify whether it is a temporary outside borrowing or actual sales realization. It is also advised that the branch may verify the cheques issued for big amounts in the cashcredit/over-draft accounts by the borrowers regularly to ensure that they are being issued only to genuine trade transactions. The branches should as far as possible avoid withdrawal of cash from the accounts. Frequent cash withdrawal is again a symptom of incipient sickness. There may be three types of inspection reports, which require follow-up. 1. 2. Inspection Report of the branch Inspection Report by SIO/Internal Auditors

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Credit Management 3. Inspection Report by Auditors/RBI Inspectors.

Branch should follow-up the irregularities indicated in the inspection reports. The irregularities indicated by the inspecting agency should never be allowed to be continued. A certificate should be sent to higher authorities certifying that the irregularities indicated in the report have been rectified. Where advances are further covered by security, proper care of security and timely visits form a part of follow-up. It is desirable to keep clear record of visits to the shop/factory/go down or to the place where security is located. Surprise element in timing of visits and sample checking of goods, wipes away the feeling of complacency that may be created at either side. There should be monthly inspection by branch officials on a rotation basis. During their visits they have to verify the latest stock statements submitted by the borrower with the purchase register, sales register, movement of goods register maintained by the party and to verify the authenticity and veracity of the statements submitted by them to the bank. They can also satisfy themselves about payment of electricity bills and staff muster roll to have an idea about the working of the factory. Physical verification of stock is also necessary on a sample basis. Further, hypothecation statement should be received regularly. Reconciliation of statement with monthly sales and purchases figures must be done. This can be further crosschecked with balance sheet figures of stocks, Sales Tax or Excise Returns, Insurance Cover and Stock Registers maintained by shopkeepers. Visits to the shop/factory can give bankers a better idea of location of shop, customer service, cash and credit sales, display of goods, morale of employees and condition of existing stocks and quality of management, internal feuds and disputes can also be disclosed during the visits.

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Credit Management Some time operational irregularities may be noticed due to outside agencies or extraneous factors. These are a) b) c) Shortage of raw material due to non-availability of quota. Power shortage Change in Government Policies etc.

Branch should enquire from the borrower as to the genuine problem and the authorities responsible for it. They may also raise certain issues in various forums to help out the borrower in overcoming such problems.

FINANCIAL STATEMENT
Financial Statements exhibit the results of operations for a particular period and position of the borrower as on a date. The important indicators of the financial statements like Sales, Stock, Debtors, Projected creditors, Net Worth, Net Working Capital and ratio analysis should be done and a report should be maintained in the file. The information generated by the verification of statements like Q.I.S. previous years achievement, of the borrower vis--vis projections as per C.M.A formats, submitted by the borrowers for renewal of accounts and the variations in cost of sales to sales if any and ratio of PBT to sales etc are also to be taken into account during the discussion with the borrower. If any negative growth or feature is noticed in the analysis, dialogue should be made with the borrower on such issues, and necessary corrective measures are to be initiated.

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Credit Management

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