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.

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.