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.

What’s Exchange Earner’s Foreign Currency Account?

Over the years Exports from India have been increasing owing to an unprecedented growth in sectors like software, jewellery, textiles, biotechnology, gems, etc. This has resulted in substantial increase in the inward remittances. In order to protect the companies engaged in regular export and import from the exchange rate fluctuations, Reserve Bank of India (RBI) has allowed parking of foreign currency by exporters in an account designated as Exchange Earners Foreign Currency Account (EEFC).

Reserve Bank of India defines Exchange Earners' Foreign Currency Account (EEFC) as an account maintained in foreign currency with an Authorised Dealer i.e. a bank dealing in foreign exchange. It is a facility provided to the foreign exchange earners, including exporters, to credit 100 per cent of their foreign exchange earnings to the account, so that the account holders do not have to convert foreign exchange into Rupees and vice versa, thereby minimizing the transaction costs.

All categories of foreign exchange earners, such as individuals, companies, etc. who are resident in India, may open EEFC accounts. An EEFC account can be held only in the form of a current account. No interest is payable on EEFC accounts. 100 per cent foreign exchange earnings can be credited to the EEFC account subject to the condition that the sum total of the accruals in the account during a calendar month should be converted into Rupees on or before the last day of the succeeding calendar month after adjusting for utilization of the balances for approved purposes or forward commitments. Cheque facility is made available for operation of the EEFC account. The bank opening the EEFC A/c requires the customer to first open a parent INR Current Account for crediting the INR leg of the transaction/converting the balance held in the EEFC account into INR as well as for paying the charges.

There is no restriction on withdrawal in Rupees of funds held in an EEFC account. However, the amount withdrawn in Rupees shall not be eligible for conversion into foreign currency and for re-credit to the account. EEFC account holders are permitted to access the forex market for purchasing foreign exchange only after utilizing fully the available balances in the EEFC accounts. EEFC account balances can be also hedged however the balances in the account sold forward by the account holders has to remain earmarked for delivery. The hedge contract is allowed to be rolled over.

What’s Duty Drawback Scheme?

The Government of India supports exports of goods from the country. In order to make exports competitive, Government provides cushion to exporters by reducing their production cost through various schemes. Duty Drawback is one of the many schemes in this direction. When exporters import materials/goods which are used as input for production of Export Goods, they need to pay custom duty, excise duty and service tax on input services. These duties increase the cost of production and can make the price of export product high which may ultimately lead to making the product uncompetitive in the international market. Therefore, under the scheme Government provides reimbursement of duties paid. The Duty Drawback facility on export of duty paid on imported goods is available in terms of Section 74 of the Customs Act, 1962. Under this scheme part of the Customs duty paid at the time of import is remitted on export of the imported goods, subject to their identification and adherence to the prescribed procedure.

 

The Duty Drawback is of two types: (i) All Industry Rate and (ii) Brand Rate. The All Industry Rate (AIR) is essentially an average rate based on the average quantity and value of inputs and duties (both Excise & Customs) borne by importer and Service Tax suffered by a particular export product. The All Industry Rates are notified by the Government in the form of a Drawback Schedule every year and the present Schedule covers about 4000 entries.

 

The Brand Rate of Duty Drawback is allowed in cases where the export product does not have any AIR of Duty Drawback or the same neutralizes less than 4/5th of the duties paid on materials used in the manufacture of export goods. This work is handled by the jurisdictional Commissioners of Customs & Central Excise.

 

The AIR of Duty Drawback are notified for a large number of export products every year by the Government after an assessment of average incidence of Customs, Central Excise duties and Service Tax suffered by the export products. The AIR are fixed after extensive discussions with all stake holders viz. Trade Associations, Export Promotion Councils and individual exporters to solicit relevant data, which includes the data on procurement prices of inputs, indigenous as well as imported, applicable duty rates, consumption ratios and FOB values of export products. The AIR of Duty Drawback is generally fixed as a percentage of FOB price of export product. Caps/Upper limits have been imposed in respect of many export products in order to avoid the possibility of misuse by dishonest exporters through over invoicing of the export value.

 

In case of goods which were earlier imported on payment of duty and are later sought to be exported within a specified period, Customs duty paid at the time of import of the goods, can be later claimed as Duty Drawback at the time of export of such goods under Section 74 of the Customs Act, 1962 read with Re-export of Imported Goods (Drawback of Customs Duty) Rules, 1995. For this purpose, the identity of export goods is cross verified with the particulars furnished at the time of import of such goods. Where the goods are not put into use after import, 98% of Duty Drawback is admissible under Section 74 of the Customs Act, 1962. In cases the goods have been put into use after import, Duty Drawback is granted on a sliding scale basis depending upon the extent of use of the goods. No Duty Drawback is available if the goods are exported 18 months after import. Application for Duty Drawback is required to be made within 3 months from the date of export of goods, which can be extended up to 12 months subject to conditions and payment of requisite fee as provided in the Drawback Rules, 1995.

 

The Duty Drawback on export goods is to be claimed at the time of export and requisite particulars filled in the prescribed format of Shipping Bill/Bill of Export under Drawback. It is not mandatory to have prior repatriation of export proceeds for grant of Duty Drawback. However, as per the rule if sale proceeds are not received within the period stipulated by the RBI, the Duty Drawback will be recovered as per procedure laid down in the Drawback Rules, 1995.

Operational Aspect of Running Account Export Credit Facilities

As we know, Pre-Shipment Credit to exporters is normally provided on lodgment of L/Cs or firm export orders. In some cases it has been observed that the availability of raw materials is seasonal. While in some other cases, it is noted that the time taken for manufacture and shipment of goods is more than the delivery schedule as per export contracts. In such types of cases, the exporters have to procure raw material, manufacture the export product and keep the same ready for shipment, in anticipation of receipt of letters of credit / firm export orders from the overseas buyers. Therefore obviously availment of PC by lodgment of L/Cs or firm export orders is not possible. To overcome this situation, RBI allows banks to extend Pre-shipment Credit ‘Running Account’ facility without insisting on prior lodgement of letters of credit / firm export orders.

 

Now, operationally, the Borrower, availing PC liquidates the same by availing Post Shipment Credit (PSC), and the PSC is liquidated by the proceeds of export bills received from abroad in respect of goods exported / services rendered. This chain on PC to PSC keeps rolling on. Operationally, the banker has to ensure that under Running PC, LC/firm orders should be produced within a reasonable period of time as may be decided by the bank. The bank also has to mark off individual export bills, as and when they are received for negotiation / collection, against the earliest outstanding Pre-Shipment Credit on 'First In First Out' (FIFO) basis. While marking off the Pre-Shipment Credit in the manner indicated above, banks should ensure that export credit available in respect of individual Pre-Shipment Credit does not go beyond the period of sanction or 360 days from the date of advance, whichever is earlier and for Post-Shipment the period prescribed for realisation of export proceeds is 365 days from the date of shipment. While the PC can also be marked-off with proceeds of export documents against which no packing credit has been drawn by the exporter, the Post-Shipment can also be repaid / prepaid out of balances in EEFC A/c or also from proceeds of any other unfinanced (collection) bills.

What is Post-shipment Credit?

Post-shipment Credit means any loan or advance granted or any other credit provided by a bank to an exporter of goods / services from India from the date of extending credit after shipment of goods / rendering of services to the date of realisation of export proceeds as per the period of realization prescribed by Foreign Exchange Dept. (FED) of RBI, and includes any loan or advance granted to an exporter, in consideration of, or on the security of any duty drawback allowed by the Government from time to time. As per the current instructions of FED, the period prescribed for realisation of export proceeds is 365 days from the date of shipment. With effect from May 05, 2012, banks have been given freedom to decide rate of interest to be charged by them on Post-shipment Credit.

Post-shipment advance can mainly take the form of: (A) Export bills purchased/discounted/negotiated (B) Advances against bills for collection (C) Advances against duty drawback receivable from Government.

Post-shipment credit is to be liquidated by the proceeds of export bills received from abroad in respect of goods exported / services rendered. Further, subject to mutual agreement between the exporter and the banker it can also be repaid / prepaid out of balances in Exchange Earners Foreign Currency Account (EEFC A/C) as also from proceeds of any other unfinanced (collection) bills. Such adjusted export bills should however continue to be followed up for realization of the export proceeds. In order to reduce the cost to exporters (i.e. interest cost on overdue export bills), exporters with overdue export bills may also extinguish their overdue post shipment rupee export credit from their rupee resources.