Corporate Finance 2013 : Lessons learnt

Credit Rating: Do or die but maintain it

The year saw difficult time with liquidity almost drained out, financial performances dwindling, foreign money out of sight, existing lenders shying away, and all this making the job of Finance Managers worst. The existing lenders were shying away due to decline in performance or instances of occasional delay in payments due to increasing liquidity crunch. The Panacea that worked for the finance team was a good credit rating. They realized the power of a good credit rating which helped them in convincing new lenders on short notice for taking fresh exposures thereby facilitating liquidity. These managers would now swear that a good credit rating not only reflects a good health BUT ALSO HELPS IN MAINTAINING A GOOD HEALTH so do or die but maintain it otherwise ICU would be only resort !!    

Don’t repeat the mistake: Using short term for long term

Many corporates which resorted to short term funding on roll over basis for funding their long term plans discovered that this wheel may not be running for ever. And if it stops when the fuel is not there in the market then the journey may be over! Many finance managers had resorted to short term to take the advantage of low interest rates. During the year, Lenders called off these short term lines and corporate found it difficult to tie up the long term funding in the time of turmoil. The year 2013 taught to finance managers the very essence of timely tie up of long term funds and not to interchange it with short term !!

Videshi Banks: Friends of good times

Indian corporates were already finding it difficult to raise finance due to falling performances. In this difficult time, their existing foreign lenders got the message from their Head Quarters in US and Europe to reduce exposure in emerging markets including India. So, the existing funding lines to the corporates in India were put on run off basis by these lenders which acted as last nail in the coffin. In this turbulent time, when the corporates needed their lenders to provide more support, the foreign lenders showed door to these corporates. The public sector banks supported most of the suitable corporates wherever possible to make them float successfully.

Forex Hedging: It’s not so simple

Gone are the days when simple forex hedging policies of 50 per cent or some per cent of the foreign exchange exposure could help corporates in managing forex exposure. During 2013, the profits of the companies (specially the mid and small size companies) turned into losses due to huge volatility in exchange rates specially the Dollar-INR. The year 2013 taught to take forex most seriously, simple forward bookings policies does not work anymore, advisory of forex professional firms essential, and DYNAMIC FOREX MANAGEMENT POLICIES being the need of the hour.

Banking partners: few are not good

Corporate’s in relationships with few banks learnt that in difficult time everyone has a limitation on walking that extra mile but if everyone walks a bit, then its not difficult to tide over the situation. If one of your banking partners is not willing, you have other ready relationships nurtured slowly over the years to help you. The year 2013 taught that in good times its you who dictate but in bad times it’s the relationships which works and relationship cannot be created overnight. So its prudent to have a good number of banking/lenders relationships.

Business Diversification: Helps to float in rough weathers

Company’s diversified in two or three unrelated segments were in a comfortable position since downturn in one segment was balanced by better performance of other segments. So, its better to keep your business diversified as it helps to keep you floating in rough weathers.

Financing: You need soldiers and captains with War experience

Company’s enjoying good reputation, dictating terms to lenders were suddenly in a difficult position due to dwindling performance resulting in defaults on some occasions. Worst was the finance teams & promoters not having experience/in depth knowledge of managing in times of crisis. The year 2013 taught that it is prudent to have people at senior and middle management level with experience of working in such difficult times with legal and practical knowledge (RESTRUCTURING, STAY ORDERS, REVERSING TAX DEPARTMENT NOTICES ETC.) for all the required timely actions (BECAUSE ACTION MUST BE TAKEN BEFORE THE DAMAGE IS CAUSED).

Tie up > Interest Rate & other terms

When everything is good, you dictate to avail the loan, but 2013 taught that for mid and small size companies with credit rating of ‘A plus’ and below, its better to take disbursements as soon as you have tie up of funds in place, AND LATER NEGOTIATE ON TERMS, since there is nothing more important than having access to funds, and nobody knows when the changes in market conditions would change the policies of the lenders for increasing exposures !!

-Wish you all a very Happy and Prosperous New Year 2014

The World of Regulatory Rates

As a lender or borrower the regulatory rates and controls that set a direction to the liquidity and financial markets are important, and I thought to share a note on the same. Hope this is useful as a refreshing tool of those definitions:

Suppose a bank has USD 100 million of equity. Now what is the limit upto which this bank is allowed to raise funds from public in the form of deposits, and what is the limit (of its own equity and deposits raised from public) upto which it is allowed to lend to borrowers?

There is a concept of capital adequacy which controls the lending by banks. The concept explains that the more own capital the bank has the more it can lend. The concept prescribes the minimum capital as a percentage of total credit given by the bank, which is required to be maintained by the bank at all time. So say minimum capital prescribed is 10% of total credit issued, and total credit issued is USD 1000 million, then the minimum capital required to be maintained is USD 100 million. The 10% limit translates that bank is allowed to lend 10 times (i.e. 100/10=10 times) of the capital it maintains. Now suppose that this minimum capital required ratio is reduced to 9% then? This reduction translates into 11.11 times (i.e. 100/9=11.11) of the capital bank can lend. So in our example, the capital of the bank is USD 100 million and reduction in capital adequacy ratio increases its capacity of lending to USD 1111.11 million (USD 100 million X 11.11=USD 1111.11 million) which means the bank can further lend USD 111.11 million (USD 1000 million – USD 1111.11 million=USD 111.11 million). This results in release of funds in the market by bank, thereby improving the liquidity in market. The concept of minimum capital adequacy acts a lever to control lending by banks. Hope sounds simple.

For controlling the deposit raising by banks from public, there is a concept of cash and other form of securities to be kept aside by banks as percentage of total deposits/liabilities mobilized by them. These funds cannot be used by banks for lending. These controls are in the form of Cash Reserve Ratios (CRR) and Statutory Liquidity Ratio (SLR). Under Cash Reserve Ratio a bank has to keep certain percentage of deposits/liabilities raised from public/banking system with RBI in the form of cash. Therefore, the entire funds raised by bank from public are not entirely available to it for lending.

Similarly, under Statutory Liquidity Ratio, a bank is required to keep certain percentage of deposits/net demand & time liabilities raised from public, in the form of approved liquid securities (Cash, Dated Securities, Gold, Treasury Bills etc). Therefore, the bank is not allowed to lend entire funds (equity and deposits from public/liabilites) available with it.

RBI has levers in the form of interest rates at which banks can lend to or borrow huge lot of money and these bulk borrowing or lending rates set the direction of interest rates as well as liquidity in the market. So the high rates, less is liquidity, and low rates more liquidity. These interest rates levers of RBI are Repo Rate, Reverse Repo Rate, Bank Rate, Marginal Standing Facility Rate. Push & pull of these levers sets the tone of interest rates and liquidity on your corporate loans and home loans! Gotcha.

Cash Reserve Ratio (CRR): It is the amount of funds that the banks have to keep with the RBI. For example, when a bank’s deposits increase by Rs.100, and if the cash reserve ratio is 4 per cent, the banks will have to hold additional Rs. 4 with RBI and bank will be able to use only Rs. 96 for investments and lending / credit purpose. Therefore, higher the CRR, the lower is the amount that banks will be able to use for lending and investment.

RBI uses the CRR to drain out excessive cash from the system.  CRR is calculated as a percentage of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly basis. RBI can prescribe CRR for scheduled banks between 3 per cent and 20 per cent.

NDTL: is sum of demand and time liabilities (deposits) of banks with public and other banks wherein assets with other banks is subtracted to get net liabilities of the other banks.

Repo Rate:  The rate at which the RBI lends money (short term overnight lending) to commercial banks is called Repo Rate. Whenever banks have any shortage of funds they can borrow from the RBI by selling the approved securities. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. Repo rate is used by RBI to control inflation. In the event of inflation, RBI increases Repo Rate as this acts as a disincentive for banks to borrow. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

RBI takes the contrary position in the event of a fall in inflationary pressures. Repo and Reverse Repo rates form a part of the Liquidity Adjustment Facility(LAF). Repo Rate mainly targets for short term effect to control the liquidity in the market and inflation. Banks can borrow in the RBI Repo auction upto to 0.5 per cent of their NDTL.

Reverse Repo Rate:  Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend their idle cash (which they are not able to deploy) to the RBI since their money is in safe hands with a good interest.

An increase in Reverse Repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which is used by the RBI to drain excess money out of the banking system. In May 2011, RBI decided that Reverse Repo Rate will not be announced separately, but will be linked to Repo rate and it will always be 100 bps (i.e. 1 per cent) below the Repo rate.

Bank Rate: This is the rate at which RBI lends money (long term) to banks or financial institutions. If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. Thus, it can be said that in case bank rate is hiked, in all likelihood banks will hikes their own lending rates to ensure that they continue to make profit. Bank Rate mainly targets for long term effect to control the liquidity in the market and inflation. Bank Rate is also known as Discount Rate. In contrast, Repo Rate is also called Repurchase Rate.

The Bank Rate involves loans while the Repo Rate involves securities. Bank Rate doesn’t involve collateral of any kind while the Repo Rate (especially the repurchase agreement) requires the securities as the collateral in the agreement.

The Bank Rate is usually higher compared to the Repo Rate. A high Bank Rate will reflect in the high lending rate of the commercial bank to its clients. On the other hand, the Repo Rate may not be not passed to the clients of the commercial banks.

The bank rate also has importance since this impacts inter-corporate loans & investments. As per Sub Section (3) of Sec 372A “No loan to any Body Corporate shall be made at a rate of interest lower than the prevailing bank rate, being the standard rate made public under section 49 of the RBI Act, 1934 (2 of 1934)”. In case of banks failing in maintaining their required CRR and SLR ratio penal interest is charged by RBI which is linked to Bank Rate.

Liquidity Adjustment Facility (LAF): RBI’s liquidity adjustment facility helps banks to adjust their daily liquidity mismatches. LAF has two components: Repo (Repurchase Agreement) and Reverse Repo. When banks need liquidity to meet its daily requirement, they borrow from RBI through Repo. The rate at which they borrow fund is called the Repo Rate. When banks are flush with fund, they park with RBI through the Reverse Repo mechanism at Reverse Repo Rate.

Statutory Liquidity Ratio (SLR): Every bank is required to maintain at the close of business every day on fortnightly basis, a minimum proportion of their NDTL as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as SLR. Present SLR is 23%. RBI is empowered to increase this ratio up to 40%. An increase in SLR restrict the bank’s leverage position to pump more money into the economy.

Marginal Standing Facility (MSF):  Earlier there was no limit on borrowing under Repo by banks. A bank only had to maintain the SLR Ratio and any government securities it owned above that limit could be used for Repo borrowing. Later on cap of 0.50 percent of NDTL for maximum borrowing under Repo was introduced. Now, when a bank is in need to borrow more than what it can under Repo after exhausting its excess SLR securities, it can borrow under MSF by offering its SLR securities (i.e. securities already used for maintaining its SLR Ratio). Under MSF banks can borrow upto 2 percent of their respective NDTL outstanding at the end of the second preceding fortnight. Banks borrow funds through MSF during acute shortage of liquidity.  MSF Rate is kept higher than the Repo rate to make it as penal rate.

For availing MSF, the securities which can be offered to RBI include all SLR-eligible transferable Government of India (GoI) dated Securities/Treasury Bills and State Development Loans (SDL). 

MSF rate increase is done by RBI to control excess availability of the rupee and to control its depreciation with respect to the dollar. MSF represents the upper band of the interest corridor and Reverse Repo as the lower band and the Repo Rate in the middle.

Capital to Risk Weighted Assets Ratio (CRAR):  Capital Adequacy Ratio (CAR) is also known as CRAR. It is the measure of a bank's capital and is expressed as a percentage of a bank's risk weighted credit exposures.

CAR = Total Capital / Total Risk Weighted Assets

Total capital comprises of the bank's Tier I and Tier II capital. Total risk weighted assets takes into account credit risk, market risk and operational risk. This ratio is maintained to ensure that banks have enough capital to sustain operating losses while still honoring withdrawals.

Current Rates (as on December 23, 2013):

Bank Rate : 8.75 per cent

Repo Rate : 7.75 per cent

Reverse Repo Rate : 6.75 per cent

MSF Rate : 8.75 per cent

CRR : 4 per cent

SLR : 23 per cent

CRAR: 9 per cent      

Corporate Nursing : Health is Wealth

Imagine about a high-tech system : A medical clock like wrist watch on your arm, continuously analyzing your body parameters. Your doctor and his team is getting this data, and the moment there is something abnormal noted, the clock gives blip tone…, before you can think of something, you get call from your doctor on what you need to do in next one minute. In next 15-20 minutes, the medical team is in your cabin, the Helicopter is waiting for you on top of the building to take you to the Hospital ! You are out of danger. Wow ! and Why? Timely analysis and on time medical aid. Cost: Of course the service charges you pay to the doctors.

What encouraged you for this safety major? : Because you know you are important and only on-time service can avoid disasters.

I was thinking that working capital lenders are not less than the doctors team in above example since they have a hand on pulse rate of the borrower company. They have continuous watch on how the funds are being utilized by the borrower, and the moment borrower comes out with the need for temporary overdraft or shows signs in the form of delays in payments, increasing receivables, cheque dishonour, LC devolvement, etc. they get the first signs of something happening wrong with the borrower. But the million dollar question is: Whether the lenders should act like the doctors and immediately take the borrower for restructuring? And why not so? Isn’t it good to get healed? Isn’t it good to take timely action for the long term benefit of stakeholders?

First, I think restructuring would not be the right word. Because, restructuring would be something related to long term treatment, and we are talking of correcting something at the initial warning sign stage itself so that the need for restructuring can be avoided. Also in the current global economic scenario of slowdown, restructuring has not got a good reputation.

I think this area of business is still not explored in India because of the bad reputation attached with restructuring. As mentioned above, there is need to differentiate between Restructuring and Timely Corrective Action. So, it would be better to devise a suitable word for such treatment: may be ‘Corporate Nursing’.

Banks presently keep on analysing the data/accounts of the borrower, however, there is no approved plan of action in place about what to prescribe as soon borrower needs an emergency aid. As a result the borrower has to run from pillar to post for temporary overdrafts / short term loans to meet that unforeseen liquidity mismatches.

The lender and borrower need to create a plan like a reserve fund for meeting the challenges in difficult times of business like presently many of the companies are facing. It is very similar to your medical insurance where you pay a premium today in your good time for your bad time. So, why not devise an emergency plan to help the company when times are not good. No harm in paying premium today for that little but life saving service.

How this can be implemented in the real world? Here are some the possible ways which I can share:

- At the time of assessment only the lead bank, carries out the sensitivity analysis with worst case scenarios and discuss with the borrowers how the business in that situation would be managed.

- A plan of action, which could include availability of short term loans, creation of some reserve funds during good times, borrower keeping some unencumbered assets which can be offered to lenders as an additional security for the emergency support services.

- Promoters agreeing to provide their personal guarantees for emergency support from lenders.

- Borrower/Promoters agreeing to pledge shares for emergency support from lenders.

- A reserve liquid fund kept ready by promoters as their contribution before availing the emergency support.

- Borrower keeping a ready tie-up with another stronger company who will agree to lend corporate guarantee in emergency times (of course such corporate would be charging guarantee premium for this) etc.

- Insurance companies devising products of providing cover to lenders (for securing that additional exposure taken by lenders under the emergency support plan) when the agreed emergency support is facilitated on occurrence of event/parameters.

The moot point here is that the lenders find it difficult to lend an immediate help in difficult time of borrower because it is also difficult for them to pump more money into a company which is in trouble. However, if there is already an approved exigency plan and for which borrower has been paying insurance premium kind of service fee, then the lenders would have no difficulty in providing timely support.

A timely action taken by lenders and borrower would help in avoiding exigencies which could be jeopardizing the interest of all the stakeholders. Therefore, it is of utmost importance to ensure taking all the action to protect the health of the borrower in the interest of long term wealth protection.

I leave this thought here for all of you to nurture it further. Happy innovating.

Mamamiya – Bang – Bang : Outsourcing the loan pricing !!

 

Last Tuesday when I flipped my Economic Times my eyes went spiral when I read the news on SBI’s decision to link its lending rates to the external rating of the Corporates i.e. delinking it from SBI’s internal ratings. Under the existing system, the applicable rates could be advised firmly to the borrower only after approval of the proposal by SBI’s Credit Committee. This was creating hindrance for business at branch/appraisal level as the officers were not able to firmly advise the applicable interest rate to the borrower.

Under the new rule, SBI will advise the Mark-up applicable over its Base Rate for arriving at the applicable interest rate and this applicable Mark up to a borrower will be based on his external rating. So suppose two companies which are externally rated ‘BBB’ and ‘A’, and the applicable  Mark –ups for these ratings are say 3% and 2% respectively, then the applicable rate for these companies will be 12.80% p.a. and 11.80% p.a. based on the current SBI Base Rate of 9.80%.

Well, a great decision and can only be expected from great innovators. But being at the lending side and having experience of dealing with hundreds of Corporates in Indian environment, I got worried due to following nightmares if this new system is universally adopted by all the banks, take a look and enjoy:

(Note: I personally admire this bold and innovative decision in the field of finance. This will set a new paradigm in Indian lending scenario. My Hat’s-off. Writing this note just to share the fun part of our business. Hope you enjoy reading.)

1. Feeling like someone is making a great effort to produce something, and he is told that selling price of his product is outsourced to a third party!!

2. Worse: I am sitting in office, and get a call from client: Hey Kaps, sending my loan application to you. And, now we are not required to discuss the interest rate since for that banker is useless now. I will discuss that with my great external rating analyst who is meeting me on dinner tonight at Taj !!

3. All external rating agencies have suddenly increased their fee rates (and why they should not??).

4. Corporates expecting downward risk on their rating are sending bouquets to the external rating agency team.

5. The rating boys have overnight become the new blue eyed boys in the town and the poor banker who will process the entire application, weighting the entire proposal based on the risk and analysis, taking a lending call (with staff accountability on him for NPAs) and putting hard cash of the bank at a measured level of risks, is lost in dark nights.

6. In the small corner of my heart, I felt a little comfort of relief soothing myself that thank god it is decided to only outsource the loan pricing but still I am the Prince who will have a role in deciding the quantum of loan. Right then only, I got a call from the client telling me: Hey Kaps, I forgot to tell you that in the system it is felt that branches are not in position to tell the client how much loan will be sanctioned by the bank, therefore shortly the loan amount will be also linked to a Project’s/Proposal’s Report weighted by a reputed agencies OR even to the external rating. So, if I get ‘BBB’ rating for my project/proposal, you will take 50% exposure in the total loan requirement and rests by other lenders. But if I get ‘A’, you will take 80% exposure and leave the rests for other bank. At ‘AA’ or above rating, you will take entire 100% of the loan proposed.  

I asked him: What will I do then sitting in this office?

Client: Just chill, forward my project report to credit committee and take care of disbursement and monitoring. Rests I will manage with my Sweet-Heart Rating Agency!

7. Got a call from my internal rating analyst : Hey Kaps, my existence is at risk, any job for me!!

8. A recall of thoughts in my mind about the calls from rating agency guys for sharing information of the clients being rated by them, as they do not get success in extracting the critical information from the borrower, since they have no control over borrower except delaying/suspending the rating. The lender has many controls/levers which helps in extracting the information from the borrower. I was astounded thinking how rating guys will be getting that critical information before giving him the rating which will decide my loan pricing !!

9. The internal rating teams of the bank are not under any influence of the borrower since they are not exposed to the borrower. In most of the cases borrower will not even be able to know the details of the internal people who are engaged with his proposal. All information about the borrower/proposal is represented by the bank’s business/appraisal team. This system proves to be an added layer of safety. However, in case of external rating agency, its team is fully exposed to the borrower.

10. Theories supporting direct linkages between Cost of Funds of a bank and its Lending Rates become irrelevant. 

11. The fee to rating agency is directly paid by borrower. It’s a peculiar situation, in which rating agency is not participating in the loan as a lender, taking fee from my borrower, and deciding my loan pricing!! Specially of long term loans which are not traded on the exchange and which the bank cannot get rid off the moment bank decides like in case of Commercial Papers/other traded papers !

Yes, Abhimanyu can successfully exit from Chakravyuh : in the disguise of Working Capital Lender

 

Everyone knows the difficulty faced by the Vir Abhimanyu in epic Mahabharata. In his biggest war challenge what he was not knowing was how to exit from the Chakravyuh. Well, Abhimanyu was to follow that suit as the destiny had written that great end for him. What about the Working Capital (WC) lender? Lord Almighty has given a better choice to him if he is well planned and can dare to deviate from the tradition. I write this note for those who would like food for thought to innovate.

The exit strategy for a business is as important as entry, if not more.  Working capital funding is sort of short term finance. Generally the WC lines provided under the scheme are for one year period. It is experienced that with the growth of the borrower’s business, his requirement for WC assistance keeps on increasing. Depending on the performance/payment records, generally the lender supports the borrower by increasing the WC assistance. The critical point here is in contrast to that of term lending which comes  with fixed tenor, the WC facilities do not practically have fixed tenor or to say have only virtual tenor (i.e. one year valid line as per sanction terms). Lenders while assessing the Term Lending requirement clearly spell out the repayment period and thereby the drawing the exit route from the transaction i.e at the time of assessment only the lender knows when he will be able to come out/exit. But what about the WC assistance? Do the lenders draw the plan of exit from the relationship? On paper, Yes (since the line is stipulated as valid only for one year) but practically, No. This is because as long as the relationship is good, the lender keeps on being with the company (waiting for the bad time to come to deteriorate the asset quality !!).  So, do I mean to say that even if the account is good, lender should look for exit? I would suggest to consider the following points before developing views on this:

1. All industries see a cycle of performance from good times to bad and vice versa. When it would be bad time and lender would be requiring the borrower to give exit, won’t the borrower see the lender only as friend of good time? Therefore, it is the good time only when the lenders have to have a plan of exit (and it will be very easy for the borrower also to replace the lender). All private equity investment deals have this agreed plan between the parties. So, this is something which is acceptable to the financing world provided it is clearly spelled out as part of relationship terms at the beginning only.

2. By continuing with a relationship, over the years borrower leverages the relationship and succeeds in reducing lenders commissions/margins, and which is generally difficult for the lender to resist. Do you have any client who increases your commission after 4-5 years of fruitful relationship??

3. With the limited resources, lender’s activities would be concentrated only to limited no. of borrowers and lender would be missing the other new clients which may give better income.

4. By focusing his financial resources on existing borrowers lender misses the opportunity of diversifying risks.

5. Practically, if the lender try to exit at time bad time (i.e. borrower not performing well or other unfavourable reasons), it would not be possible due to stressed financial position of the borrower, and lender would most likely end up with a restructured account.

6. Borrower may not mind to know at the start only when the lender would like to exit or his exit plans. Such agreement in advance will make borrower ready to start the replacement exercise in advance.

7. If exit plans are known in advance, both the parties may not like to completely detach. Borrower may have other opportunities by way of relationship in some other group companies.

8.  In a way, the exit plan of WC lender would provide a right direction to the financing plans of the borrower as the borrower would timely take action and right approach for funding. Ascertaining the discontinuation of short term WC funds at a point of time, the borrower would be discouraged to resort to strategy of using the short term funds for long term funds.

9. Ways can be devised to recreate the relationship after a certain time, for example, the lender’s credit policy may allow to re-enter the WC relationship after a cooling period of certain years say 2-3 years.

10. What happens to your existing cross sale business penetration which you garnered over the years of relationship and which will collapse if you exit from the relationship? Suppose you have got all the cross sale business but after a certain point when the borrower requires you to increase the exposure, but your basic instinct/credit policy/assessment does not allow/suggests you to go for such enhancement, do you think that borrower will stick to the loyalty and continue to pass on that cross sale business to you?? He can’t because he will need to offer the same to other lenders in order to get them agree to increase their exposure. So, in the business of lending, advantage of cross sale cannot become the deciding factor to continue the relationship or not and therefore the loss of cross sale business should not be deterrent to exit strategy specially when it is planned at the time of entry only.

But other questions which are posed are, how or on what point one can decide to exit. What should be the parameters to decide exit point? Well, since we are looking from point of view of clarity about the exit at the time of entering into the relationship only, then the way could be a simple plan based on pre-decided period of relationship and overall profitability of account to be provided by the borrower over the planned period of relationship. The beginning of the relationship may enumerate the parameters based on which the exposure would be increased and when it would begin to recede, giving the plan a bell curve shape of lending during the relationship period. I think the best way to think would be to think like private equity investors who first thinks about the exit and overall return from the investment before making the investment !!

ECGC and Whole Turnover Policy Cover

 

 

When an Indian exporter gets orders from abroad for export of goods he faces the risk of non payment from the buyer.  In order to protect its losses due to default in payment by buyer, he can avail insurance from Export Credit Guarantee Corporation of India Ltd. (ECGC) an agency promoted by Government of India. Under this mechanism, as soon as the exporter firms up the export order, he can submit the details of the order along with the details of bank account of the buyer/importer to ECGC for obtaining the insurance. Suppose that the order is of USD 10,000 which is to be shipped in ten months with USD 1000 worth goods to be shipped per month. Say the exporter allows 90 days credit to the importer for payment.  If the first shipment is sent on April 01, second on May 01, third on June 01, by the time of fourth shipment there will be accrued credit of USD 3000 for April, May and June shipments.  When exporter decides to take insurance from ECGC, he can avail either for a shipment specific or a comprehensive buyer specific insurance. Suppose he opts for a buyer specific insurance. Based on the information submitted, ECGC through its information sources and network carries out the due diligence of the buyer and if satisfied with the credentials of the buyer, it will approve a limit for the buyer. Say for example, limit approved in the present example is USD 3000 i.e at any point of time pending payment obligation of the buyer should not be more than USD 3000. Therefore, before shipping the fourth consignment, the exporter has to ensure that the buyer has made the payment of earlier consignments in order to keep the credit within the stipulated limit of USD 3000 by ECGC.

In a Standard Shipments (Comprehensive Risks) Policy ECGC cover risks in respect of goods exported on short-term credit, i.e. credit not exceeding 180 days. This policy covers both commercial and political risks from the date of shipment. It is issued to exporters whose anticipated export turnover for the next 12 months is more than Rs.50 lacs. Under the Standard Policy, ECGC covers, from the date of shipment, the following risks: 

a. Commercial Risks viz.  Insolvency of the buyer, Failure of the buyer to make the payment due within a specified period, normally four months from the due date, Buyer's failure to accept the goods, subject to certain conditions.

 b. Political Risks viz. 1.  Imposition of restriction by the Government of the buyer's country or any Government action, which may block or delay the transfer of payment made by the buyer. 2.  War, civil war, revolution or civil disturbances in the buyer's country. New import restrictions or cancellation of a valid import license in the buyer's country. 3.  Interruption or diversion of voyage outside India resulting in payment of additional freight or insurance charges which cannot be recovered from the buyer.  4.  Any other cause of loss occurring outside India not normally insured by general insurers, and beyond the control of both the exporter and the buyer. 

There are various other insurance policies and Gurantee products by ECGC to meet the needs of the exporters and banks.

Banks in India provide pre-shipment (PC) and post-shipment (PSC) credit facilities to the exporter at the attractive terms. Banks also have the similar concerns as that of exporter regarding the non payment by the buyer. Non payment by the buyer would lead to default by the exporter in repayment of PC/PSC.  ECGC provides a comprehensive policy to the banks under which all the approved PC/PSC limits sanctioned by a bank to various clients are covered for insurance. This policy is called Whole-Turnover Policy. Under this policy all the PC/PSC limits sanctioned to the clients of the bank and status as ‘Standard’ under the RBI’s Prudential norms on Income Recognition, on a particular agreed cut-off date are covered under the policy.

Bank pays premium to ECGC on monthly basis in advance based on the average daily credit outstanding basis. Generally, the premium on PC limit is recovered from the exporter while the premium on PSC is absorbed by the bank. 

Under Whole Turnover PC policy, banks taking the cover for the first time, cover provided by ECGC is 75% up to certain Limit and 65% beyond the said Limit.  (For others it varies from 55% to 75% depending on claim premium ratio of the bank.). For Small Scale Exporters (SSE)/ Small Scale Industrial Units (SSI) with annual Export turnover not exceeding Rs. 50 Lakhs, 90% cover is provided.

Premium under Whole Turnover PC for a fresh cover is 8.5 paise (For others, varies from 6 to 9.5 paise per Rs. 100 p.m. depending on claim premium ratio) per Rs.100 per month on the average daily product basis.

Under Whole-Turnoover-PSC policy, cover provided by ECGC varies from 90% to 95% in respect of exporters who are Policyholders of ECGC and 50% to 75% for non-Policyholders, depending upon the claim premium ratio of the bank. For bills drawn on Associates of Policyholders coverage is 60% and of non-Policyholders it is 50%.

Premium charged by ECGC under Whole-Turnover – PSC Policy is 4.5 paise to 6.00 paise per Rs. 100 per month (p.m.) on the average daily product basis if advances against L/C bills are included for cover otherwise it is 5.5 paise to 7.00 paise depending upon the Claim Premium Ratio for the last 5 years.

Working Capital Lending : In the lanes of Asset Coverage

 

Under the Asset Backed Lending (ABS) environment, generally fund based and non fund working capital facilities are extended to corporates by lenders based on security of first pari passu charge on the currents assets (present & future) and second pari passu charge on the fixed assets  (present & future) of the borrower.  Although as a Working Capital (WC) lender Current Ratio is more relevant to the WC lenders, however, lenders generally monitor the building up of total assets of the borrowing company and its liabilities having charge on the assets by Asset Coverage Ratio. The ratio has more relevance when the lenders need to share charge on the assets for any new loan extended by other existing /new lender.

The existing lender generally shares the charge if the new or additional facilities (WC/capex term loan) are extended to the corporate. The reason being that the new WC facilities (subject to permitted under the MPBF) simultaneously increases current assets, and the new capex term loan facilities (permission for which from the lenders remains subject to satisfactory Debt Service Coverage Ratio and long term Debt Equity Ratio during the tenor of the new term loan) increases the fixed assets, and since the existing lender have the charge on the present and future assets, it will not decrease the asset coverage ratio (as long as the existing promoter contribution share is maintained all the time). However, if the borrower desires to share charge on the existing assets with an existing unsecured lender whose WC limits are already disbursed then generally there is a reluctance among existing charge holders in sharing the security with new lender since there would not be any improvement in assets (since the proposed lenders limits are already disbursed) and sharing of charge would result in reduction of asset coverage. However, if the existing asset coverage is substantially high then the borrower may pursue the existing charge holding lenders for sharing of charge with proposed lender. Generally for term lending, minimum fixed asset coverage of 1.50 times and for WC lending Current Ratio of 1.33 times is desired.

The WC lender generally assesses the WC requirement of a borrower on annual basis based on the audited financials for the previous year and projected financials for the next year. Let’s assume that there is only one lender with sanctioned and outstanding WC loan of USD 750 as per current audited balance sheet. Also assume that present annual WC assessment is over. Based on the assessment, MPBF worked out (based on audited financials) for previous year is USD 750, and based on the projected financials for next year the MPBF works out to USD 1000. Assume that borrower is also enjoying non fund based Letter of Credit limit of USD 100 and Bank Guarantee Limit of USD 100. Now, if the borrower proposes to bring in a new lender with WC fund based limit of USD 250 and non fund based LC limit of USD 30 and BG limit of USD 30 (assume that this proposed LC/BG requirement is within the increased assessed LC/BG limits of USD 130 each based on the projected financials), in this situation, whether the existing WC lender should share the charge on the existing securities available to him? Does he need to calculate asset coverage? What does the WC lender needs to evaluate at this point?

The existing lender should check the following points:

1. Based on current ratio principle of 1.33 times, since the projected WC fund limit requirement has been assessed to increase by USD 250, therefore accordingly there needs to be infusion of NWC/promoter contribution to the extent of 33% of the increased fund based WC which works out to USD 84. The existing WC lenders needs to ensure that these funds are infused (or there is a firm commitment as well as arrangements) by the promoters in order to maintain the current ratio at 1.33 times.

2. Of course the addition of new WC lender with required fresh infusion of NWC would maintain the Current Ratio, the sharing of residual charge on the fixed assets with the new lenders will reduce the residual FACR to the WC lender. Does it mean that no additional WC lender should be allowed unless there is increase in fixed assets? The answer to this query lies on the following two beliefs:

(A). The first school of thought believes that the primary security for WC facilities are Current Assets therefore as long as Current Ratio of 1.33 times is maintained the WC lender need not consider the residual coverage available on the fixed assets, and should share pari passu charge with the new lender.

(B). The second school of thought believes that as long as the promoter’s contribution is maintained for the proposed enhanced WC fund based limits, the WC lender should consider sharing charge with the new lender since there would be proportionate increase in Current Assets funded by new WC fund based limits and infused promoter’s contribution.

However these approaches are not favoured by the lenders who believe that such practice jeopardizes the FACR (on residual fixed assets) available to the WC lender.

 Apart from the above, some other peculiar queries are also posed while calculating the Current Asset Coverage (i.e. Total Current Assets divided by WC Capital Limits):

(i) Whether the lender should take only the sanctioned Fund Based Limit as denominator OR he should take total of sanctioned Fund Based and Non Based Limits as denominator?

(ii) Whether it is the sanctioned limit amount which is to be taken as denominator OR only the outstanding (O/s) of the fund based (OR plus outstanding of non funded limits) prevailing on the date as on which the value of Current Assets is being taken?

The first school of thought in this matter says that since during the period of stress/persistent defaults by the borrower, the borrower faces the liquidity issues and it is experienced that generally during such time, the WC FB and Non FB limits are fully utilized. In such stress time, there are high chances of default by the borrower leading to conversion of Non FB exposure into the FB exposure. Therefore, as a matter of prudent practice, the WC lender should consider the sanctioned limits (FB and NFB) as denominator while calculating the current asset coverage. This ratio should be added to the fixed asset coverage ratio (FACR) (on residual charge available to the WC lender) which is calculated based on the outstanding(O/s) term loans plus any undisbursed part, and the final Asset Coverage (i.e. total of current asset coverage ratio and FACR) should be considered by the WC lender. 

The second school of thought is this matter says that considering dynamic nature of working capital funding, the coverage should be calculated based on current data of current assets and O/s FB and Usance Letter of Credits (LCs) as long as the borrower is on the Positive List.

The current data of current assets reflects the utilized O/s FB and Usance LCs. If one takes the entire sanctioned FB limit, it may not be appropriate since the current assets available with the company are only to be extent of O/s FB and Usance LCs (plus promoter’s contribution and unsecured sundry creditors).

But what happens if the coverage is less than 1.33 times for the existing lenders? Does it mean that the short term funds have been diverted for long term purpose and therefore, the existing O/s level of current assets does not fully reflect the utilization of O/s FB and Usance LCs limits? In such cases, the lenders would need to take a separate view, away from standard logic for deciding on to share charge on the assets and based on the terms negotiated with the borrower in order to ensure suitable security for its WC limits extended to the borrower.

Non fund limits are mainly the LCs and Bank Guarantees (BGs). Outstanding (O/s) Usance LCs should be taken while calculating this coverage since the raw material under Usance LCs would have been delivered to the borrower and reflecting the current data of current assets. Under Sight LCs O/s, the related raw material would not have reached to the company therefore the current asset will be short to that extent. The Bank Guarantees (BGs) are used by the company for submission to various government departments. These BGs do not directly contribute in increasing the current assets therefore including the BG O/s in the denominator would create negative effects on the coverage ratio.

(iii) Whether one should consider the value of Current Assets and WC liabilities outstanding as per the last audited financials OR one should consider the Current Assets as given in the current available Stock Statement and outstanding/sanctioned limits prevailing on the same date?

The advantage of using the audited data is the authenticity and availability of entire current assets data. In case of using the current data of current assets generally the borrower would be able to provide only the details of raw material and receivables (details of which are also reflected in the monthly stock statement) and which is also not audited. But considering this approach being more conservative (since the lender considers only the raw material and receivables under current assets and excludes all the other heads of current assets) the lender may use the current data and also do calculation based on audited data for indicative purpose. While using the current data from the stock statement, it would be prudent to take average data of Raw Materials, Stock in Process, Finished Goods and Receivables, of 3 to 6 months depending on the conversion cycle and credit period received and provided by the borrower in its industry.

 (Disclaimer: The views expressed above are not the opinion of the author. The write up is based on the interaction of author with various related experts in the field.) 

Buyer’s Credit version : 2013

Many Indian companies which require import of materials for their production/manufacturing activities have to provide Letter of Credit to the supplier.  On expiry of LC, the importer avails Buyer’s Credit (BC) which in simplest words is a type of credit/loan made available to the importer by a bank to meet the payment of the importer to his exporter.

 

In case BC is not available, the importer will need to utilize its INR line of fund based working capital limit for the import (non capital goods) payments or a term loan for capital goods import payments. Generally, the cost of such INR funding is much higher than the cost of BC. Therefore, the importers prefer to use BC as long as such sanctioned limit is available from its bankers i.e. we can say that the BC is kind of exercise to exploit existence of interest rate arbitrage. This helps importers in reducing the finance cost. Generally, the banks in India, while assessing the fund based Working Capital (WC) needs of a borrower, also assess his needs for Letter of Credit and Buyer’s Credit based on his projected import requirements. Based on such assessment, LC/BC lines are sanctioned to the borrower. Further, sometimes when the foreign currency (FC) funds are not available with the WC banker or the rate of interest charged by WC banker on FC funds is higher than the rates offered by other banks in the market, in that situation, instead of availing BC from its WC bank (through overseas branch of the bank), the borrower avails Letter of Undertaking(LuT) (a bank guarantee) from its WC bank issued in favour of a overseas funding bank (willing to offer BC at lower rate based on the security of LuT issued by the WC bank of the borrower). Importer’s bank or importer or a BC consultant arranges BC from international branches of a domestic bank or international banks in foreign countries. For this service, importer’s bank or BC consultant charges a fee called an Arrangement Fee.

 

In regulatory terms Buyers’ Credit is defined as loans for payment of imports into India arranged by the importer from a bank or financial institution outside India for maturity of less than three years. Authorized Dealer Banks are permitted to approve trade credits for imports into India up to USD 20 million per import  (non capital goods) transaction for imports permissible under the current Foreign Trade Policy of the DGFT with a maturity period up to one year i.e. 360 days  (from the date of shipment). Recently, in July 2013 RBI has issued modification which prohibits banks to extend Buyers Credit beyond the Operating Cycle and Trade Transaction.

 

For import of capital goods as classified by DGFT, AD banks may approve trade credits up to USD 20 million per import transaction with a maturity period of more than one year and less than three years (from the date of shipment).  For Infrastructure sector, the maturity period is allowed upto 5 years for import of capital goods subject to minimum trade credit period of 15 months from the beginning and not in nature of short term roll-over.

 

No roll-over/extension will be permitted beyond the permissible period.

AD banks are permitted to issue Letters of Credit/guarantees/Letter of Undertaking (LoU) /Letter of Comfort (LoC) in favour of overseas supplier, bank and financial institution, up to USD 20 million per transaction for a period up to one year for import of all non-capital goods permissible under Foreign Trade Policy (except gold, palladium, platinum, Rodium, silver etc.) and up to three years for import of capital goods. For Infrastructure companies as mentioned above, the banks are not permitted to issue Letters of Credit/guarantees/Letter of Undertaking (LoU) /Letter of Comfort (LoC) beyond a period of three years.

 

RBI has prescribed the maximum All-in-Cost ceiling (includes arranger fee, upfront fee, management fee, handling/ processing charges, out of pocket and legal expenses, if any) for the Buyer’s Credit. The present ceiling rate is Six Months Libor plus 350 basis points and is subject to review from time to time.

Importance of Stock Audit for Working Capital Lender

The working capital finance is extended to a company/corporate borrower based on various projections about the operations/business performance. The fund based and non fund based limits are provided to the borrower for procuring raw materials required in the production process. The fund based limits are released to the borrower depending upon the Drawing Power (DP) arrived based on

Stock Statement. The non fund based limits are utilized by the borrower in the form of Letter of Credit(LC)/Buyer’s Credit (BC) for procurement of stocks. The banker understands the financial performance of the corporate borrower based on financial reports and various other statements submitted by borrower. However, since monitoring is the most critical part of working capital lending management, the bank needs to undertake assessment of the position of operations at the factories of the borrower to know about the position of stocks and receivables which are primary security to the working capital lender and appropriate safety measures and valuation of the same is of prime importance for the WC lender.

The Stock Audit report is prepared by a Chartered Account (CA) firm empanelled with the lender, and at the cost of borrower. It is preferred to conduct at least two stock audits in a financial year. The periodicity may depend upon the size of operations of the company/borrower as well their financial health/reputation deciding the criticalness of the stock audit. Sometimes, when the factories of the borrower are spread across several locations, it becomes tedious to conduct multiple stock audits. Similarly, for small companies also multiple stock audits may put burden on their budget as well as time & resources.

Stock Audit report of company is like an X-Ray Report for a Working Capital lender. It provides details of important inside information about the stocks and operations at the factories of the borrower which are generally situated at far-away locations and it is not possible for the banker to undertake regular and exhaustive inspections. The stock audit supports in fulfilling this requirement. The report covers many important details viz installed capacities, major stock items, method of inventory management/control at factory, no. of days for which stock is stored, proper preservation/handling of stocks, identification of movement of stocks, age-wise examination of receivables,  stock valuation methods adopted by borrower, adequacy of insurance coverage, job work received/outsourced, details of slow moving stocks, obsolete stocks, auditors views on marketability of stock, ownership of stock with borrower, demand/supply conditions, stock being commensurate with production or not, no. of workers, any abnormal consequence occurred at factory, data/record management, receivable collection system, quality of stock and receivables, auditors suggestion on any improvement required etc.

The fund based limits are released to the borrower based on drawing power(DP) worked out and DP depends on the stock and receivable statement. Under the stock audit, the auditor physically checks the stock position of raw materials, work in progress and sales registers at the factories. The auditor checks the production and despatch of goods through Excise Register, Purchase Invoices, Sales Bills etc. The stock auditor compares his calculations of drawing power based on his physical verification of stock & receivable position at the factory, with the calculation submitted by the borrower to the lender. Any difference in calculation is reported in the audit report, based on which the borrower is required to submit clarifications to the lender or take corrective measures.

From the above, it can be understood that stock audit is a critical tool which helps the working capital banker to understand the actual positions of the raw materials and production funded by the limits released by the lender. The audit helps to ensure that the bank funds are properly utilized without diversion. Considering, the working capital lending relationships to be long term in nature, and for the growing companies whose working capital need increase year on year, the stock audit helps in understanding the growing requirements. Stock Audit ensures proper valuation of stocks and receivables and measures for safety of stocks. In light of the above, it is of utmost importance for the banker to timely get the stock audits conducted, thoroughly analyze the stock audit report, and also take up any issue mentioned in the report with the borrower.