Corporate Finance Segment of NBFCs and Bank Finance

Non Banking Finance Companies (NBFCs) are one of the important entities in the financial sector.  The general factors of NBFCs business success lies in their cost effective delivery model, sector focused approach, faster delivery, last mile connectivity, prompt action and efficiency.

In the corporate finance sector, the prime areas of NBFC lending involves promoter funding, funding against shares, subordinated debts, senior debts, short term debt etc.

Sources of funds for on-lending business to an NBFC are promoters funding, bank finance, public deposits, commercial papers, debentures, inter corporate deposits etc. where  bank finance forms one of the major sources. There are several restrictions on use of bank funds by NBFC for on-lending like use of such funds for investment into shares, debentures, unsecured loans, inter-corporate deposits, loans & advances to subsidiaries/group companies etc.  

Recently, in two of transactions (debt funding) encountered, it was analysed that while the transactions could not pass the due diligence and guidelines of the bank, these same transactions were later on found to be present in the asset book of one of the NBFCs presented to the bank for financing.

This is one of the reasons I thought to discuss the NBFC financing. Does it mean that some NBFCs consider those transactions which are not able to pass through the banks regular due diligence/guidelines?

Under the corporate finance segment, the NBFCs get major space in lending on short term basis with prompt delivery and efficiency especially in circumstances where funds are required on very short notice. Apart from fulfilling the financing needs against shares, these NBFCs also get space in unsecured/subordinated lending. The rate of interest & transaction cost of NBFC finance under corporate segment is also generally on higher side as compared to banking channels. It appears that unless the time or non-acceptability of general banking covenants, are the key to the transaction (eligible for direct bank finance), the transaction may not be attract towards NBFC.

With the above description, the emphasis which can be derived is that bank finance to NBFCs (especially having major corporate finance segment) is a critical financing segment and it appears that reputation of NBFC/promoter group and their financial strength becomes one of the most important factors of due diligence apart from strong financials, credit rating and compliance with regulatory guidelines by the NBFCs.

Wish you all a very Happy New Year 2015.

Long Term Export Advance

I had mentioned in my earlier articles about the Pre-Shipment and Post Shipment Export Credit Advances available to Corporates (Pre-shipment Credit / Post-Shipment Credit). These are the short term facilities [maximum period of upto 360 days (preshipment) and 365 days (postshipment)] for boosting the exports from the country. The interest rate to be charged in these lines are not controlled/capped by Reserve Bank of India (RBI).

In order to ensure availability of long term finance at internationally competitive pricing to the exporters, RBI in May 2014 has allowed exporters having a minimum of three years satisfactory track record to receive long term export advance upto maximum tenor of 10 years to be utilized for execution of long term supply contract for export of goods subject to certain conditions. The exporter is allowed to provide SBLC/BG from banks in India for guaranteeing the export performance. Some of the key conditions of the guidelines are as following:

1. Firm irrevocable supply orders should be in place.

2. Company should have capacity, systems and process in place

3. Such advances should be adjusted through future exports.

4. Rate of interest payable, if any, should not exceed Libor + 200 bps.

5. Double financing for working capital for execution of export orders should be avoided.

6. SBLC/BG facility will be extended by banks only for guaranteeing export performance.

7. BG/SBLC may be issued for a term not exceeding 2 years at a time and further rollover of not more than 2 years at time may be allowed subject to satisfaction with relative export performance as per the contract.

8. BG/SBLC should cover only the advance on reducing balance basis.

9. BG/SBLC issued from India in favour of overseas buyer should not be discounted by the overseas branch/subsidiary of bank in India.

Service Tax on the value of interest received on Bill Discounting facility

Recently there was an interesting case between a Public Sector Bank (PSB) and Revenue Authorities wherein one of the issues was applicability of Service Tax on the value of interest received on Bill Discounting facility extended by the PSB to its customers.

Readers may like to read my earlier post on Bill Discounting : Issue of applicability of TDS in Bills Discounting

In the present case regarding applicability of Service Tax, the PSB argued that the interest collected on Bill Discounting was exempted from levy of Service Tax by virtue of Notification No.29/2004-ST dated September 22, 2004.

The deciding authority CESTAT accepted the argument of PSB and held that as per the first part of the said Notification, the subjects for exemption from Service Tax are OD facility, CC facility, or Bill Discounting facility and objects are value equivalent to interest or discount, as the case may be i.e. as per the circumstance. Therefore, the value of interest as well as discount in connection with providing the services of OD facility, CC facility, or Bill Discounting facility would be exempted from Service Tax under section 66 of the Finance Act 1994.

Export Credit Finance Limits

Export Credit limits is provided by the banks in India in the form of Pre-Shipment Credit and Post Shipment credit. These financing lines are provided to boost the Exports of the country. I had mentioned about these limits earlier (Pre-shipment Credit / Post-Shipment Credit). The limits are extended for a maximum period of upto 360 days (preshipment) and 365 days (postshipment).

Although the interest rate to be charged in these lines are not controlled/capped by RBI (which was the case in the past i.e. upto June 30, 2010), schemes are intended to facilitate financing to the Exporters at internationally comparable rates. 

RBI provides facility to banks for getting refinanced (upto 32 percent of the Outstanding) their Rupee Export Credit Finance portfolio for a maximum period of 180 days, thereby the loss (of margins) of deployment of funds [i.e upto 32 percent (reduced from 50 per cent to 32 per cent in June 2014)] by banks at subsidized interest rate (at Repo Rate under LAF; The World of Regulatory Rates) under these lines, is passed on to the RBI. This way the banks funds (upto 32 per cent of the Export Credit portfolio) gets unlocked, and banks can redeploy the same for generating better margins.

Although, as per RBI guidelines, the Export Credit limits should be excluded for bifurcation of the working capital limit into loan and cash credit components, generally it is observed that Export Credit limits are sanctioned by banks as part of umbrella Working Capital (WC) limits. Many times, the Export Credit limits are set as inner limit or sub limit to Cash Credit (CC)/Fund Based (FB) WC limits.

The system of Cash Credit limit requires the borrower to submit Stock & Receivable Statement based on which Drawing Power is arrived. In case, the Export Credit limits are sanctioned as inner limit to the CC limit, the Export Credit limit will also fluctuate depending on the DP arrived based on Stock & Receivable Statement. It may be observed that while the CC limit is based on MPBF (i.e under Eligible WC Limit method) arrived taking into account the Current Assets, Current Liabilities and NWC, the Export Credits limit needs to be arrived taking into account Export Orders of the borrower. It may be mentioned that while calculating the minimum required NWC, the Export Receivables are excluded from the Current Assets i.e. benefit is provided to Exporters for facilitating the 100% Export Finance. The practice of associating the Export Credit limit with the umbrella WC limit many a times leads to inappropriate assessment/management for Export Credit limit if the intention is to promote Exports from the country by providing Export Credit Finance.

RBI guidelines mention that for creditworthy Exporters, banks should calculate the need based Export Credit limit taking into account the anticipated Export turnover and track record of the Exporter. Banks should adopt any of the methods, viz. Projected Balance Sheet method, Turnover method or Cash Budget method, for assessment of working capital requirements of their Exporter-customers, whichever is most suitable and appropriate to their business operations.

In light of the above and considering RBI’s thrust on extending the Export Credit Finance for supporting the Exports of the country, there needs to be a Standard approved mechanism with clarity for arriving/calculating the limits and DPs for Export Credit Finance which may be followed by all the banks. This would standardize the system of Export Credit Finance to the Exporters.

Reschedulement of Project Loans

Corporates are passionate about expansions, growth and success. They envisage business plan, execute it, establish it and then look forward at new plans in pursuit of business growth and success. The course requires funding from banks in the form of project and non project loans. The financing plans require preparing the financial projections, project implementation and loan repayment schedules. A common situation faced by many finance teams is of delay in project implementation due to circumstances sometimes in their control and sometimes not in their control. Many a times, the business does not perform as aggressively as projected or the business faces unprecedented situation (example INR-Dollar volatility crisis) resulting in lower cash flows. This situation makes the corporates incapable of making timely repayment of the principal instalments/dues. The situation requires for relooking at financial projections, reworking the same and reschedule the loan repayment in a form acceptable to the bank, and which Corporate can also afford in the changed scenario.

It has been observed that while availing the loan, the borrower generally projects optimistic financial projections and does not factor many important aspects like hedging cost, taxes, duties, discounts, commissions etc. The Sales projections are made aggressively however the Cost of Sales is not prepared with a conservative view (i.e. keeping the cost high). This leads to financial projection picture giving acceptable financial ratios to the lenders. The appraisal teams at lenders understand this phenomena and rework on projections submitted by the borrower, realign with the industry standards and undertake sensitivity analysis.  

The reschedulement of loan generally requires to increase the remaining tenor of the loan with or without additional moratorium. The lenders have to consider this aspect from three points: (1) Capability of the borrower’s projected cash flows to repay as per the revised financial projections (2) Sacrifice of bank based on difference in present value of loan cash flows (Principal and Interest) pre and post reschedulement (3) Regulatory/RBI guidelines

Capability of the borrower’s projected cash flows to repay as per the revised financial projections

This is the most crucial aspect since understanding the capacity of the borrower’s future cash flows that can sustain the revised repayment schedule with a sufficient coverage (ie. Debt Service Coverage Ratio) is important otherwise the borrower may again face the cash flow shortfall in future in repayment of loan. Since, the process of approving a reschedulement being time consuming for large loans, it requires the finance teams to give their best possible sustainable projections so that in future such need for reschedulement does not arise. Any mistake here would cause unwanted restructuring tags in future /upset the banking relationship.    

Sacrifice of bank based on difference in present value of loan cash flows (Principal and Interest) pre and post reschedulement

The extension in remaining loan’s tenor affects the present value of the loan. Therefore, if the rate of interest on the loan is kept at the same level of pre-reschedulement, the present value of the loan will decline, and cause sacrifice to the bank. From regulatory aspects, if such reschedulement falls under restructuring, then banks have to also provide for provisioning (i.e. reducing their business profits) to the extent of sacrifice.    

Regulatory/RBI guidelines

The Reserve Bank of India (RBI) guidelines consider the term loans from Infrastructure project loans and Non infrastructure project loans. These guidelines consider the Date of Commencement of Commercial Operations (DCCO) as critical aspect for success of project loans. The guidelines provide that for infrastructure project loans, the DCCO can be extended upto two years from the original DCCO date as considered at the time of sanction of loan. Such extension in DCCO and consequential shift in repayment period by equal or shorter duration (including the start date and end date of revised repayment schedule) would also not be considered as restructuring provided all other terms and conditions of the loan remain unchanged. For non infrastructure project loans, the DCCO and consequential shift in repayment is permitted to be extended upto one year without classifying the loan as restructured.

The DCCO can be further extended by two years (i.e total four years from original DCCO) for Infra project loan and one year (i.e total two years from original DCCO) for non infra project loans from the original DCCO, classifying the loans as restructured loans. However, any change in the repayment schedule of a project loan caused due to an increase in the project outlay (increase by 25% or more of the original outlay) on account of increase in scope and size of the project, is not treated as restructuring. The classification of loan as restructured has bearing (reducing their profits) on the profitability of the bank due to sacrifice involved and also higher stipulated provisioning norms by RBI for such loans. Therefore, the banks have to really have a heart when the loan has to be acknowledged for restructuring.

It may be observed that if the shift in DCCO is within the permitted two year (for Infra Project Loans) and one year (for Non Infra Project Loans) limits from the original DCCO, the RBI guidelines allows consequential shift in repayment period by equal or shorter duration (including the start date and end date of revised repayment schedule) without classifying the loan as restructuring provided all other terms and conditions of the loan remain unchanged.

The issue faced by corporates is in situation when the DCCO is achieved within the permitted two years or one year limit (with consequential permitted change in repayment schedule) and after that during the renewed life of the loan at a later stage due to other extraneous reasons the borrower needs to again either extend the repayment schedule or to change the loan instalment amount without changing the terminal date of repayment. It is clear that since during the first instance (extension in DCCO and Repayment Schedule by two or one year) the account was not classified as restructured, therefore now at the time second instance for need of change in repayment schedule, will make the account as restructured and attract the higher provisioning norms and other bearings for the banks and borrower.

In light of the above issues, while working out the project plans and implementation schedule, deciding the DCCO has a lot of weight on financing plans. The DCCO has to be decided very cautiously since extension in DCCO is very clearly permitted to be maximum two (without Restructuring tag) to four (with Restructuring tag) years for infra project loans, and one (without Restructuring tag) to two (with Restructuring tag) years for non infra project loans.

 It would be important to note that as per the February 2014 RBI Guidelines, if banks take over/refinance the existing infra and other project loans by way of take-out financing, they can fix a longer repayment schedule provided the loan is ‘Standard’ asset in the books of existing bank, should have not been restructured in the past, substantial take over (i.e. more than 50%) and repayment schedule is fixed taking into account life cycle of the project and cash flows from the project.    

Related Article : Should RBI allow for Restructuring of Advances?

The Defence Debt / Defence WC Lines

In continuation of my thoughts on ‘Corporate Nursing : Health is Wealth’ and ‘Lender of Last Resort for the Borrowers and Critical Financial Illness Cover’, I would like to further present the concept of a Defence Debt / Defence WC Lines.

The Defence Debt is a new concept which is not explored by the financial markets. As mentioned in my above earlier notes, corporates need to devise emergency plans in their good times since only a timely financial aid can help in controlling the damage. 

When a corporate is performing well and its financial position is good, the lenders are open to extend further loans/working capital lines for supporting the business. However, when the corporate faces financial difficulties due to turmoil in the economy/industry, the new or existing lenders do not agree to sanction fresh loans or its takes a great deal of efforts in getting sanctions, NoCs from existing lenders for sharing the security, and the disbursement of fresh loans. The delay in infusion of these fresh loans in the company may jeopardize the operations and reputation of the corporate. Therefore, it is of utmost importance that fresh funds/working capital lines are immediately available to control the damage to the business/reputation/credit rating.

Since the fresh loans/WC lines are not easy to get in difficult times, therefore it would be prudent to keep ready back up arrangement for the same in the good times.

The concept of Defence Debt envisages availability of a pre-approved long term debt or a working capital line or both sanctioned to the corporate in its good times. Depending on the levels of operations and working under the various sensitivity analysis, corporates/banks can work out the worst case scenarios/peak requirement scenario (for WC lines based on MPBF/Assessment Method), and arrive at the level of a debt or working capital lines (fund based, non based based) which a corporate borrower may require in its difficult time.

In case of WC, the assessment by lead bank (in consortium arrangement or by corporate itself in case of MBA) may envisage the fund based or non based lines requirement by stretching the WC cycle under the sensitivity analysis. Lead Bank may approve a normal MPBF which can be tied up from the consortium and a top up assessment which can be also funded by the existing consortium/other lenders. The Top up WC lines/WC Term Loan (all are the forms of Defence Debt) can be permitted to be immediately rolled into the company in case of stretched cycle/liquidity issues. The advantage here is that since it is pre-approved line, all the lenders would have given NoCs and security would have been already created for the top up supporting lender. The existing lenders would be open to approve an top up debt/line even in case of marginally Fixed Asset Coverage Ratio (FACR) considering the facts that it is a contingency debt (chances of which crystalizing into an outstanding debt would be minimal). Further, since this will be an assessed finance therefore there would not be any regulatory issues.

The important issue in case of top up lines would be to ensure that the line is available from the lender on a short notice. In case of a normal line, a lender will be averse to increase its exposure to a company facing/going to face financial difficulties. Hence, there need to be a great understanding between the top up lender and the borrower that the top up line is an oxygen and delay in disbursement of the same would defeat the whole purpose. The financial cost/fee (i.e. the processing fee and the commitment fee) to be paid by the corporate to the top up lender would essentially be the cost/premium of getting the line on time.

The business of Defence Debt/Top Up lines also provides an avenue to the lenders for increasing their fee based income on secured basis and a tool to penetrate for developing relationships.

Lender of Last Resort for the Borrowers and Critical Financial Illness Cover

Over the years, I have dealt with many cases that included stressed assets also. In case of stressed assets when the stress starts reflecting in the account, it starts creating some sort of panic to the lenders. Situation becomes like this that at one end, the borrowers struggles with its liquidity issues, and on the other end, the lenders struggles with the borrower to recover their dues/loans. Many of such stressed cases undergo Debt Restructuring. Under restructuring, generally most of the borrowers seek additional funding from the existing lenders in order to cope up with the liquidity issues. However, none of the lenders, generally by Heart & Soul is ready to extend such additional finance. Such additional finance is extended only at the minimum level and after lot of follow up by the borrower. Many of the times, such additional funding comes very late by which time situation (financial troubles, liquidity) becomes grave for the borrower.

This scenario forces us to think that when there is a borrower facing genuine difficulties then why the additional finance (a kind of nursing solution) is generally not available or available after hell lot of follow ups and not on right time (a patient needs Oxygen on right time, isn’t it!). In case of bankers, if any of the bank faces any liquidity issues, the regulatory authority (i.e. Reserve Bank of India) stands as the lender of last resort for them. Why is such lender of last resort is not available to the borrower who can take the responsibility and act like a lender of last resort for the borrowers?

I would like to bring attention in this direction towards IRBI. The Industrial Reconstruction Corporation of India Ltd. was set up in 1971 for rehabilitation of sick industrial companies, and was reconstituted as Industrial Reconstruction Bank of India (IRBI) in 1985. Later on, IRBI was converted into Industrial Investment Bank of India Ltd. (IIBI) in March 1997 to offer a wide range of products and services. In 2006-2007 it was decided to close IIBI. In light of the above thoughts for specialized needs of the stressed companies, perhaps now there is much deeper experience gained over the years which justify the need of an IRBI type of institution on a long term basis for supporting the restructuring needs of corporates, and who can perform some sort of lender of last resort role for such companies.

As an alternative, it also forces us to think about a solution for the borrowers to have an arrangement of a critical financial illness event funding available as an immediate finance in the form of insurance cover for protection from the financial illness a borrower may face in future. Such types of critical illness insurance protections are available to the individuals from the Life Insurance companies. This leads us to the idea of having lenders/insurers/agencies/product available in financial markets with an obligation to extend immediate finance on triggering financial stress (or some other types of events which leads to the requirement of restructuring) event at the borrower. Such type of product would come at the cost of premium to be paid by the borrower. Such critical illness cover may be triggered on happening of events like LC Devolvements, frequent Overdrafts requirements, losses reaching to a particular pre-decided level, etc. and the other signs reflecting stress situations illustrated in the RBI guidelines on Framework for Revitalising Distressed Assets in the Economy.

I would like to mention here about the existence of Credit Default Swap product for protection of the lenders (but not for nursing of the borrowers).  A credit default swap (CDS) is a financial swap agreement under which the seller of the CDS compensates the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS fee) to the seller and, in exchange, receives a payoff if the loan defaults. There are also products like Mortgage Insurance which compensates lenders or investors for losses due to the default of a mortgage loan.

In India, specialized insurance cover products are available to the Exporters and Banks from Export Credit Guarantee Corporation of India Ltd. (ECGC).

There is also Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE). This scheme seeks to reassure the lender that, in the event of a MSE unit, which availed collateral free credit facilities, fails to discharge its liabilities to the lender, the Guarantee Trust would make good the loss incurred by the lender up to 75 / 80/ 85 per cent of the credit facility.

In light of the above, the history of existence of institutions like IRBI, the availability of insurance products from ECGC/CGTMSE, product like CDS, and larger experience gained over the last 4-5 years of the specialized needs of the stressed companies, it appears that the financial markets are open to product like critical financial illness cover, and also for the IRBI type institution to act as lender of last resort for the stressed companies.

The Essence of Margins for Non Fund Based Working Capital Limits

Corporates require different kinds of non fund based facilities from the Working Capital Lenders mainly in the form of Letter of Credit and Bank Guarantees. Depending on the business activity of the corporate, their requirement on nature (Inland LC, Foreign LC, EMD BG, Retention BG, Performance BG, Financial BG, SBLC, etc.)  of these non fund limits may vary.

The WC lenders at the time of assessment of the limits assess the requirement of these NFB limits by the corporate and accordingly sanction limits. Although these limits are secured by the security provided by the corporate (generally first pari passu charge on the current assets and second pari passu charge on the fixed assets), the lenders follow a practice of stipulating margin based on the utilization of these limits. This margin is stipulated in the form of cash margin (float in the current account) or Fixed Deposit Receipt (FDR) margin. The margin is generally stipulated as a percentage of the limit utilization and ranges generally between 0% to 25% e.i. if the requirement for LC is INR 50 million and margin is 5% then the corporate has to provide margin in the form of FDR equivalent to INR 2.5 million.

These margins stipulation more depend on how better satisfactory track record, years of banking, and Current Ratio corporate has been maintaining with the lender. Generally, with the increasing years of satisfactory track record, financial performance and maintaining better Current Ratio than stipulated, the margin is brought down.

The question arises when the fund based limits are released by the lender relying on the security offered, then what is the need for additional cash margin for the non fund based limits?

It needs to be observed here how the crystallization of non fund limits happens, specially in the context of LCs. When an LC matures, the Cash Credit (CC) account of the borrower is debited and LC is liquidated. In case the CC is fully drawn, then the borrower is required to credit the required funds in the CC account from its other bank/facilities accounts. In case borrower, is not able to bring the required funds, LC has to be devolved i.e. the lender has to make the payment from its own funds. In this situation, the non funds based exposure converts in to the fund based exposure.

This is the point where the cash margin provided by the borrower/corporate becomes helpful to the lender. The lender uses these margins for crystallization of the LCs for devolvement. Now, if we go to the mechanics of the transaction working, one can simply analyze from where this margin money would have been brought/arranged by the corporate. Of-course, these margins are created by the borrower by using the fund based limits extended by the lender. Therefore, these were not the funds of the borrower but the funds of the lender only. 
This is true when the Current Ratio goes below stipulated norm [i.e. 100 divided by (100 - margin on Current Asset which is generally 25%)] i.e 1.33 times (generally stipulated). The margin mechanism ensured reduction in fund based limit utilization (i.e. actually limiting transfer of funds outside the lender bank) by conserving the limit for crystallization of future LC payments. Therefore, the margin structure explains the views of the lender, how much fund based limit utilization it would like borrower to conserve for meeting its future non fund based limits liquidation. A borrower with small non fund based facility may not face difficulty in crystallization of its non fund based obligation, however, for a borrower with larger limits, it could be a major issue if the fund based limits are fully utilized. In case of sudden market difficulties (similar of depreciation of INR seen in the past), the cash flow of the borrower may be hugely affected and it may be short of cash.

Since, providing margin affects the borrower by increasing its transaction cost (it utilizes fund based limit say at interest rate of 13.50% for creation of FDR, gets interest on FDR say at the rate of 9%, also pays LC commission, and may be also forgoing cash discounts in case of Usance period allowed by the supplier), it forces borrower to bargain for better terms from its suppliers or try to avoid non fund based transaction by maximizing the fund based utilization. It encourages borrower to better manage its cash flows resulting in low utilization of non fund based limits.    

Unhedged Forex Exposures and Tightened Guidelines

Corporates have many activities which require expenditures in foreign currencies. A major part of these expenditures is generally on account of capital expenditure, raw material procurement and interest and principal repayment of foreign currency loans. Many corporates with rupee earnings borrow in foreign currencies to gain from lower interest rates abroad, but without adequately covering for the risk from a fall in the rupee's value that could increase their interest cost. Also, many importers do not adequately cover their dollar payables, exposing them to similar currency risks. The adverse movement in foreign exchange rates affects the financial health of the corporate which may lead to default by the corporate in servicing of loans to banks. Corporates refrain from hedging their currency risk to save cost. Therefore, the regulators in various economies have always desired to mitigate the effect of foreign exchange risk on corporates.

 

Some of the corporates who have export business in currencies matching with the expenditures in the same currencies, have natural hedge available to that extent. However there are many corporates who have significant foreign currency exposure and these corporates either are not conscious (specially the mid and SME category corporate) to risk they are exposed to the forex volatility or their call on the forex market is such that certain portion of their foreign currencies exposure is kept exposed to the volatility risk i.e. these forex exposures are not hedged.

Wikipedia defines Forex Hedging as “A foreign exchange hedge is a method used by companies to eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign currencies. A foreign exchange hedge transfers the foreign exchange risk from the trading to a business that carries the risk, such as a bank. There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.”

Reserve Bank of India (RBI) has tried to control this partial or full open exposure to the forex volatility of the corporate through banking control. Banks in India have to provide for Provisioning (An expense set aside as an allowance for bad loans) and also maintain minimum Capital in order to comply with the Capital Adequacy Ratio (CAR) (The World of Regulatory Rates). In order to contain the forex risk on the health of the corporates, RBI has stipulated increased higher Provisioning and Capital requirement by the banks for the unhedged foreign exchange risk of their borrowers i.e. if a corporate does not hedge its forex risk then its banks are penalized by reducing their profits through increased Provisioning and also by maintaining higher Capital (which comes at a cost to the bank). This has made banks to chase all their borrowers to undertake hedging at maximum level. I understand as of now Indian banks have not started penalizing the borrowers for their unhedged positions, however, going forward practice may change. Since, unhedged exposure of borrower affects bank’s financials, therefore, bank may charge a higher interest rate if borrower has unhedged positions.

As per RBI, the Foreign Currency Exposure (FCE) refers to the gross sum of all items on the balance sheet that have impact on profit and loss account due to movement in foreign exchange rates. This may be computed by following the provisions of relevant accounting standard. Items maturing or having cash flows over the period of next five years only may be considered. Unhedged FCE may exclude items which are effective hedge of each other. For this purpose, two types of hedges which may be considered are - financial hedge and natural hedge. Financial hedge is ensured normally through a derivative contract with a financial institution. Hedging through derivatives may only be considered where the borrower at inception of the derivative contract has documented the purpose and the strategy for hedging and assessed its effectiveness as a hedging instrument at periodic intervals. Natural hedge may be considered when cash flows arising out of the operations of the company offset the risk arising out of the FCE. For the purpose of computing UFCE, an exposure may be considered naturally hedged if the offsetting exposure has the maturity/cash flow within the same accounting year.

The loss to the borrower in case of movement in foreign exchange rates may be calculated using the annualised volatilities. For this purpose, largest annual volatility seen in the forex rates during the period of last ten years may be taken as the movement of the rates in the adverse direction. Once the loss figure is calculated, it may be compared with the annual EBID as per the latest quarterly results certified by the statutory auditors. This loss may be computed as a percentage of EBID. Higher this percentage, higher will be the susceptibility of the borrower to adverse exchange rate movements. Therefore, as a prudential measure, all exposures to such borrowers would attract incremental capital and provisioning requirements (i.e., over and above the present requirements) by the banks as under:

Likely Loss/EBID (%)	Incremental Provisioning Requirement on the total credit exposures over and above extant standard asset provisioning	Incremental Capital Requirement
Upto15 per cent	0	0
More than 15 per cent and upto 30 per cent	20 bps	0
More than 30 per cent and upto 50 per cent	40 bps	0
More than 50 percent and upto 75 per cent	60 bps	0
More than 75 per cent	80 bps	25 per cent increase in the risk weight

The calculation of incremental provisioning and capital requirements for projects under implementation is based on projected average EBID for the three years from the date of commencement of commercial operations and incremental capital and provisioning is accordingly computed subject to a minimum floor of 20 bps of provisioning requirement. The same framework is applicable for new entities also.

In light of these RBI controls, banks may also decide to reduce their exposure to corporates with high unhedged forex exposure and going forward the loan pricing would incorporate this aspect wherein the rates would be higher for higher unhedged exposure of the borrower.

Bite the Bullet - Ad-hoc Finance

In a recessionary environment one of the most difficult problems faced by the companies (specially the SME and Mid Corporates) is liquidity crunch. The recessionary environment leads to stretched receivables period, loss of receivables, reduced/costly credit period offered by raw material suppliers, increased financing cost, shortage of Working Capital lines, decline in sales and profits, pressure on profit  margins, good customers bargaining for increased credit period, ……. and hell of lot terrible things for a CFO to manage.

The situation becomes so worst that at one side, the sales fall, the good debtors start defaulting (which the Finance Team could never imagine), the lenders increase the interest rates, the easy clean finance available in the market disappears, and on the other side the dream orders start flowing in but Company finds itself short of cash/financing lines to execute the orders, rating agency downgrades the rating(mostly due to defaults or stretched receivables), and the lenders becomes averse to increase the finance … and so on that finding a route to escape is not easy.  

The increase in debtors period/decline in the quality of the same, results in requirement for infusion of additional capital requirement by promoters or by the lenders. Generally, in case of SME and Mid Corporates, it is observed that promoters find it difficult to bring in additional capital since the deteriorated market conditions does not support them in raising funds through equity (mostly due to lower valuation offered), and the unsecured funds are also not easily available. This situation also leads to instances of devolvement of Letters of Credit (LC) and Bank Guarantees (BG). LCs devolve due to cash shortage, and BGs get invoked due to delay in completing the orders on account of cash shortages.

Mostly, in this situation, Corporate looks at its Working Capital (WC) lenders to rescue. As I have mentioned in my earlier articles (Yes, Abhimanyu can successfully exit from Chakravyuh : in the disguise of Working Capital Lender), Working Capital financing is a Chakravyuh, exit from which is not so easy. The situation is not painless for the WC lender also since the deteriorating receivables, low order book position, low profits, defaults etc. do not support the argument of increasing the exposure on a long term basis until the situation of the Corporate improves. Typically, the solution to such situation is found by way of ad-hoc finance on temporary basis for a short term (generally 3 days to 6 months) period or for completing the specific sales contract in order to support the cash inflows/profitability. Although, the Ad-hoc finance helps the borrower, but difficulty faced by WC lenders (specially in case of restructured accounts/borrowers with track record of regular delays in payment/devolvement of LC/BGs) is in facilitating the same since in the absence of additional collateral, increasing exposure to a stressed account is big challenge. The situation requires generating confidence by past long term experience with the borrower/promoters, but more important role is performed by the clear visibility of the proposed transaction cash inflows (if ad-hoc for execution of specific order) to be channelled through the lender. In these types of difficult situations, the long term relationship between the lender and borrower shows its magic. In case of export based companies, where the international customers of the Corporate also bank with the MNC lender of the Corporate, the WC lender can greatly help in devising the ad-hoc finance transaction. Generally, the ad-hoc fund based WC limit is granted in the form of Short Term Overdraft and Working Capital Demand Loans (WCDL). However, the Sales Bills Discounting (SBD) with good credentials of the buyers is a better option for the lender in facilitating the ad-hoc finance since SBD provides the clear visibility to the transaction, its cash flows and duration.

A. I.M. : The Investor’s Guide to a Listed Company

 

 

Last month SEBI issued a discussion paper on Annual Information Memorandum (AIM) to be filed by the listed companies in India. Genesis of the paper lies in the background that under the present system, companies file a detailed memorandum for the information of the investors only at the time of launch of the Initial Public Offer (IPO). Post IPO, companies are required to submit various information through notifications to Stock Exchanges and Regulators. There is no single point reference document for the information of the investors. The happening of material events after the listing of the security is known to the investors over a period of time, and investors also find it difficult to access all relevant information for the purpose of making an informed investment decision.  This situation specially affects the secondary market investors.

In light of the above, need was felt for introduction of an annual AIM to be filed by listed companies, and accordingly, SEBI launched the discussion paper in the matter. As per the discussion paper, frequency for preparation of AIM shall be yearly. For companies which are planning IPOs, the requirement of AIM would commence with the IPO. This would require that the disclosures made by the companies at the IPO stage be updated on an annual basis so as to ensure that at any point of time, updated information about them is available in public domain. AIM shall be disseminated within 135 days from the end of financial year. AIM may be disseminated electronically by uploading the same on the company’s website and simultaneous filing with stock exchanges.AIM shall be approved by Board of Directors at their meeting prior to dissemination. SEBI has set a implementation timeline of financial year 2014-15 for the top 200 companies based on their market capitalization as on March 31, 2014, and FY 2015-16 for all others listed companies.

Considering, the spirit of making the AIM as one point source for all the important information. it would be good if the annual AIM includes some of the other critical information related to the happenings during the related Financial Year, viz:

(1) Credit Rating of the company, risk concerns raised by rating agency and response towards the same by the company.

(2) CIBIL Report scores (as on last March 31) of the Board of Directors along with comments on any negative information appearing in the reports.

(3) Brief Summary of the CIBIL Report (as on last March 31) of the company along with any negative information viz. overdues etc) appearing in the report, and comments on the same by company.

(4) No. of instances of Letter of Credit devolvements, Amount involved; Bank Guarantees invocations, Amount Involved; and clarifications from the company on these devolvement/invocations.

(5) No. of defaults incurred but the company in making payments to its lenders and current position as on the date of approval of AIM by Board.

(6) No. of instances of ad-hoc limits utilized by the company from lenders, justification from the company on the same, plans for meeting such requirements in future.

(7) Workings of Debt Equity Ratio, Total Debt to Total Liabilities Ratio, Current Ratio and Asset Coverage Ratio (Book Value Basis and Market Value Basis) [SEBI may also prescribe the method for calculation of these ratios so that there is no ambiguity].

(8) Tabular information on financial performance of the subsidiaries, associate companies, joint ventures and SPVs [SEBI may prescribe the tabular format].

(9) Details of any overdues/defaults/devolvement/invocation under the financial facilities availed by subsidiaries/associates from banking sector, present status of the same.

(10) Undertaking from the Managing Director that company does not foresee any sign/need for financial restructuring in the next financial year OR if yes, then explanatory note on the same.

(11) Note on any Financial Restructuring approved by lenders in the past five years and current status of implementation and compliance with the terms and conditions.

(12) Explanatory note on resignations of key executives viz. CFO, Head Treasury, Directors etc.

(13) Tabular information on instances of name change of the company and need for the same.

(14) Copy of RoC search report regarding the charge created on the assets of the company.

(15) Negative comments appearing in the Stock Audit Report and clarification on the same from company.

(16) Forex Risk with the company and addressing the same under the Hedging Policy and measures adopted by the company.

(17) Financial Projections for next two years (Stand-alone and Consolidated basis) along with key ratios as mentioned above and also the Debt Services Coverage Ratio,

(18) Comparison of actual financial performance for the last financial year covered in AIM with the projections for the same made during previous year. Note on achievements/non achievements of the financial projections with clarifications.

(19) Suggested names of the competitors in the local and international markets, which the management feels, can be considered by investors for comparison analysis.

(20) Note on any particular concentration risks viz. Any particular customer forming more than 25% of the sales, Any particular supplier forming more than 25% of the total procurement, Exposure of the company to risk associated with the volatility in commodity (forming more than 40% of the production cost) pricing etc.

These suggestions if implemented would be helpful for the entire financial sector including the secondary market investors and lenders, in understanding the financial strengths and hidden weaknesses of the company. The serious implications of the information under these suggestions, would bring more discipline in financial management by the listed companies.

MCA clarification on section 185 of the Companies Act 2013

Ministry of Corporate Affairs (MCA) had notified 98 sections of Companies Act 2013 in September 2013. These 98 sections included Section 185 of the Act also. The Section 372A of Companies Act 1956 is still to be repealed and Section 186 of Companies Act 2013 is pending to be notified.

Under Companies Act 1956, the section 372A deals with the Inter-Corporate Loans and Investments by Public companies. The section 186 under Companies Act 2013, regulates Inter-Corporate Loans and Investments and since this section of the new act is pending to be notified, its corresponding provision, Section 372A of the 1956 Act, continues to be in force.

Section 185 of Companies Act 2013 (replaces the old section 295 of the Companies Act, 1956) provides for loans to directors, and is applicable to private and public companies, while the old section 295 was not applicable to private companies, unless such private company was the subsidiary of a public company.

Section 372A of the Companies Act, 1956, specifically exempts any loans made, guarantee given or security provided or any investment made by a holding company to its wholly owned subsidiary.

As against section 372A, the new section 185 of Companies Act 2013, prohibits guarantee given or security provided by a holding company in respect of loans taken by its subsidiary company except in ordinary course of business.

The above situation of contradiction between provisions of Sec 185 and Sec 372A lead to the confusion. In light of this, MCA has vide its circular dated February 14, 2014 issued a clarification regarding the applicability of Sec 372A till it is repealed and notified. MCA has clarified that any guarantee given or security provided by a holding company in respect of loans made by a bank or financial institution to its wholly owned subsidiary company, exemption as provided in clause (d) of sub-section (8) of Section 372A of the Companies Act, 1956 shall be applicable. MCA has specifically added that this clarification will, however, be applicable to cases where loans so obtained are exclusively utilized by the subsidiary for its principal business activities.

The MCA circular on clarification is available at :

http://www.mca.gov.in/Ministry/pdf/General_Circular_3_2014.pdf

Issue of applicability of TDS in Bills Discounting

 

 

Recently, I read about the Income Tax Appellate Tribunal giving ruling regarding issue of applicability of deduction of tax at source (TDS) in bills discounting facility.

 

A ‘Bill’ is a written, unconditional order by one party (the drawer) to another (the drawee) to pay a certain sum, either immediately (a sight bill) or on a fixed date (a term bill), for payment of goods and/or services received. The drawee accepts the bill by signing it, thus converting it into a post-dated cheque and a binding contract.

Under bill discounting facility offered by financiers, the financier takes the bill drawn by Supplier/borrower on his (borrower's) customer and pay him immediately deducting some amount as discount/commission. The financier then presents the bill to the borrower's customer on the due date of the bill and collects the total amount.

In the given case at Income Tax Appellate Tribunal, party ‘X’ appointed ‘Y’ as its agent. Y sells the products manufactured by the X to the customers and also provides guarantee to X for payment from customers. X generates sales bills on customers with a mention that payment is guaranteed by Y. Y gets the bills discounted from financiers. The tax authorities made a case that such discounting charges are interest as per Indian Tax Laws (ITL) and attracts deduction of tax at source. Since, Y did not withheld TDS therefore the discounting charges were not allowed as expenses while calculating the business income of Y.

As per Y, when receivables are sold to financier, the ownership of the same is also passed on to the financier. Therefore there is no advance made by the financier to Y and hence there is no debtor-credit relationship between Y and financier. In case of non payment by customer, the financier will have lien over the goods sold but not on the moneys paid to Y. Y relied on Central Board of Direct Taxes (CBDT) circular which mentions that the amount paid by the banks, after deducting the bill discounting charges from the bill amount, is in the nature of price paid for the bills.

The Appellate Tribunal while taking decision in the case referred to the definition of ‘Interest’ as defined under the Interest Tax Act 1974 and also the ‘Interest’ as defined under the Indian Tax Law.

Under ITL, interest is defined to mean interest payable in any manner in respect of any moneys borrowed or debt incurred and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized.

Under the Interest Tax Act, 1974 interest is defined to mean interest on loans and advances made in India and includes commitment charges, discount on promissory notes and bills of exchange made in India.

The Appellate Tribunal noted that while the Interest Tax Act mentions discounting charges as ‘interest’ despite that ITL has consciously not included the same in its definition. Appellate Tribunal ruled in favour of Y to allow it recognizing discounting charges as expense without deduction of tax on the same.