Current Assets and Margin Money for Non Fund Based Limit

We had discussed about the Working Capital Assessment (Working Capital) and margin money for Non Fund Based limits (The Essence of Margins for Non Fund Based WC Limit) in previous articles.

I have come across many discussions on the issue of whether the margin money/cash margin/Fixed Deposit Receipt (FDR) margin provided by a company/borrower for availing non fund based limits(LC/BG), should be part of Current Assets while arriving at the Working Capital (WC) MPBF or not? In this context, let’s review the standard method of WC assessment with the following example:

A company is at the beginning stage of a business. The company needs to purchase current assets (materials) worth INR 100 million. The suppliers are ready to supply 25% of material at clean credit period of 90 days and balance with cash payment on delivery. The company also needs to provide Performance Bank guarantee (PBG) of INR 100 million to some party for getting a business contract. XYZ Bank is ready to provide PBG with 20% FDR Margin. With this information let’s assess the limit:

(A) Current Assets (CA) - Inventory Estimate : 100

(B) Margin Money for PBG Estimate  : 20

Total Assets: 120

(C) Current Liabilities (CL) – Sundry Creditors (excluding bank borrowing for WC) Estimate :25

Total liabilities: 25

NFB Limit (PBG) Estimate : 100

Under the standard MPBF assessment method, the WC gap (i.e. the difference between CA and CL (excluding the bank finance) is considered eligible for WC finance subject to 25% of CA to be funded by promoters.

Important point to remember here is that WHATEVER is INCLUDED HERE IN THE CURRENT ASSETS (AND IS HYPOTHECATED TO BANK AS PRIMARY SECURITY), IS ACCEPTED FOR FINANCING BY WC BANK. In the above example, the BG is for performance purpose. It does not result in materials/current assets on which bank will have hypothecation charge. In this example, there will be fund requirement of INR 20 million (20% of PBG required) for obtaining the PBG from bank. Since the WC banks provide finance against the hypothecation of current assets, and by establishment of PBG there will not be any creation of CA (the primary security for the bank against which lending is done), the bank will not consider this margin money as part of CA. Hence MPBF will be:

(D) WC GAP : A – C = 75

(E) Less : 25% of CA i.e. = 25

Balance eligible under MPBF (D – E) = 50

The estimated balance sheet will look like as following:

Current Assets	Current Liabilities
Inventory :100	Sundry Creditors : 25
	WC Bank Borrowing : 50
Non Current Assets
FDR Margin : 20	Non Current Liability
	Promoter’s Contribution for CA : 25
	Promoter’s Contribution for PBG FDR Margin:20
Total : 120	Total: 120
Current Ratio (Current Assets Divided by Current Liabilities)	1.33 times

With the above explanation, it can be concluded that if the NFB limit does not result in increase in equivalent CA (which are hypothecated to bank as primary security), the FDR margin cannot be treated as part of CA for arriving at the MPBF.

Now, lets consider an additional assumption in the above example. Suppose that the material supplier is willing to provide 25% of the materials on 90 days credit only if equivalent irrevocable LC is established in his favour. Bank stipulates 20% FDR margin for LC establishment. So, now the company additionally needs 20% funds of the 25% of the material value i.e.    100*25%*20%= INR 5 millions.

Again the question: whether this estimated FDR margin can be included in the CA for arriving at the MPBF? Since establishment of Usance LC will result in increase in inventory on which WC bank will have hypothecation charge, therefore, can this FDR margin be included in the CA while calculating the MPBF?

Here we need to look at the Usance LC process. It may be observed that at the time of establishing the LC, there is no current asset against this, and we have established above that WC bank finance is provided against CA (which are stored at an identified location). When LC will mature, the company can make payment by debiting its Fund Based A/c limit (generally Cash Credit A/c), and this utilization will be allowed by bank since material would have arrived and will become paid stock under the hypothecation charge of the bank. However since at the time of LC establishment there is no CA, therefore bank will not agree to fund the margin required for establishing the LC. This margin will have to be brought in by the company/promoters.

(1) If we look at the transaction from another angle, it can be also said that instead of funding the 20% margin, the bank may very well ask company/promoters for bringing 25% FDR margin instead of 20%. Why? Because under MPBF method since bank agrees to fund 75% of the CA and 25% is contributed by company/promoters, therefore future expected material delivery has to be funded in the same ratio(i.e 75:25). Hence at the time of LC establishment itself, the bank may ask for 25% margin by promoters/company. Agreeing to a lower margin (i.e. 20%) may be only on the following assumptions:

- Company/Promoter’s contribution in funding the existing CA is more than 25% resulting in Current Ratio of more than 1.33 times.

- Bank is willing to agree to a lower contribution by promoter’s/company (i.e. bank accepting Current Ratio less than 1.33 times)

(2) The bank may also ask the company/promoter to bring 100% margin. Why? Because if the company is maintaining exact 1.33 times Current Ratio  before opening of the LC, then there is no additional current asset available as a primary security to the bank. Actually, there has to be additional current assets (which are hypothecated to bank as primary security) equivalent to the difference between the LC value and FDR margin provided by company. In the absence of this validation, if the bank agrees for issuance of LC at the stipulated FDR margin, it is done on the following strength:

(1) The bank is ready to take non fund based unsecured exposure equivalent to the difference between the LC amount and FDR Margin.

(2) The company has provided sufficient collateral security which ensures that bank’s exposure is always 100% secured.   

The estimated balance sheet will look like as following:

Current Assets	Current Liabilities
Inventory : 100	Sundry Creditors:25
	Bank Borrowing  Inventory: 50
Non Current Assets	Non Current Liabilities
FDR Margin for PBG: 20	Promoter’s Contribution for CA : 25
FDR Margin for materials LC : 5	Promoter’s Contribution for FDR PBG Margin:20
	Promoter’s Contribution for FDR LC Margin:5
Total: 125	Total : 125
Current Ratio (Current Assets Divided by Current Liabilities)	1.33 times

Hope you like the article.