Annexure A Credit appraisal for working capital finance A PROJECT REPORT Under the guidance of Sri Debabrata Chakraborty, Manager Indian overseas Bank, Chowringhee Branch Submitted by Mitali Bagchi Roll No 520933922 A REPORT SUBMITTED IN PARTIAL FULFILLMENT FOR THE AWARD OF THE DEGREE OF MBA PROGRAMME IN FINANCE 1
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Annexure A
Credit appraisal for working capital finance
A PROJECT REPORT
Under the guidance of
Sri Debabrata Chakraborty, Manager
Indian overseas Bank, Chowringhee Branch
Submitted by
Mitali Bagchi Roll No 520933922
A REPORT SUBMITTED IN PARTIAL FULFILLMENT FOR THE AWARD OF THE DEGREE OF MBA
PROGRAMME IN FINANCE
November 2010
1
Annexure B
I hereby declare that the project report entitled Credit appraisal for
working capital finance is submitted in partial fulfillment of the
requirement for the degree of Master of Business Administration in Finance
under Sikkim Manipal University, India, is my original work and not submitted
for the award of any other degree, diploma, fellowship, or any other similar title
or prizes.
Place: Kolkata (Mitali Bagchi)Date: Roll No 520933922
2
Annexure C
A PROJECT REPORT ON
Credit appraisal for working capital financeSUBMITTED BY MITALI BAGCHI ROLL NO 520933922
Is approved and is acceptable in quality and form.
Internal Examiner External Examiners (Name, Qualification and Designation) (Name, Qualification)
3
Chapter No.
Particulars Page No
4
AcknowledgementBonafide Certificate Executive SummaryMethodology and sources of data
6.7.8.9.
1. Introduction1.1 Banking Sector in India1.2 An Overview of Indian Overseas Bank1.3 Rationale for Study1.4 Objective
13-1415-17.18.19.
2. Bank’s Loans and Advances 20-28.3. Working Capital Management
3.1 Introduction3.2 Need of Working Capital Management3.3 Gross Working Capital and Net Working Capital3.4 Concepts3.5 Types of Working Capital3.6 Determinants of Working Capital3.7 Working Capital Cycle3.8 Working Capital financing3.9 Working Capital Products3.10 Various methods of Working Capital Assessment
29.30.31.32-38.39.40-43.44.45.46.47-49.
4. Credit Appraisal and Monitoring: Common Issues4.1 What is Credit Appraisal4.2 Data to be obtained for Credit Appraisal4.3 Credit Monitoring: Common Issues 4.3.1 Additional requirements in case of Loan is granted to Company 4.3.2 Additional requirements in case of Loan is granted to Firm4.4 Principles of Lending4.5 Principles of BASEL II Accord 4.5.1 Basel II consists of three pillars 4.5.2 PD Dynamics4.6 Financial Analysis of Lending 4.6.1 Steps involved in Financial Analysis of Lending4.7 Clarification with regard to Classification of Working Capital limits
50.51.52-53.54
55.56.57.57-59.60-61.626366-68
5. Case Study 69 -93
6. Conclusion and Recommendation6.1 Comments on financial performance of the company 94-95
Chapter No.
Particulars Page no
5
6. 6.2 Gist of Recommendations 96-98
AppendicesBibliography
99
Acknowledgement6
The project report submitted in partial fulfillment of MBA Programme in Finance is a golden
opportunity for learning and self-development. I consider myself very lucky and honored to have
many distinguished personalities to lead and guide me in completion of this project.
My grateful thanks to Mr. DEBABRATA CHAKRABARTY, CREDIT MANAGER, INDIAN
OVERSEAS BANK, CHOWRINGHEE branch who in spite of being immensely busy with his
duties, provided me the essential information and extended his best support providing me an
insight into various issues pertaining to the case mentioned in the report. His sincere support and
consistent guidance led to the completion of the project.
My humble gratitude to Mr. K PARTHASARATHY, CHIEF MANAGER, INDIAN
OVERSEAS BANK, CHOWRINGHEE branch for giving me ample scope to continue my
arranged all the facilities to make the process very easier to me. I choose this moment to
acknowledge his contribution gratefully.
I am highly indebted to Prof. SUJIT DUTTA and Prof. RANJAN DAS GUPTA for their
mentorship and valuable suggestions that gave an entirely new dimension to the project under
consideration. Their guidance gave immense confidence and encouragement that helped me to
put in my best.
In this opportunity I would like to thank my brother who has helped and encouraged me to
complete the Project work smoothly.
Last but not the least I am very grateful to my parents, husband and son for providing me all
sorts of cooperation, encouragement and inspiration.
Bonafide Certificate:
7
BONAFIDE CERTIFICATE
Certified that this project report titled Credit appraisal for Working Capital
Finance is the bonafide work of Smt Mitali Bagchi Roll No 520933922, a student
of MBA Finance of Sikkim Manipal University who carried out the project work
under my supervision during the period 21/06/2010 to 20/08/2010. I wish her all
round success in her professional career.
(P K Roy) (Debabrata Chakraborty)
Chief Manager ManagerIndian Overseas Bank Indian Overseas BankRegional Office Chowringhee BranchKolkata I
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EXECUTIVE SUMMARY
Almost all of the industrial enterprises whether they are into manufacturing trading or service
sector need bank finance in order to run the businesses. So everyone approaches the bank at the
same point of time for business loan whether it is for running day to day business or for setting
up a new project. A banker approaches the proposal and then decides whether to lend the money
or not. This report gives a clear understanding with what goes behind the credit appraisal of the
proposal.
Chennai based Indian Overseas Bank is one of the nationalized banks in India, that has a
substantive history since 1937. The bank not only deals in retail banking providing utility
services to its customers but has also expanded its area of operation in multidimensional services
like merchant banking, agribusiness consultancy and e-banking. It recently registered a core
profit of Rs.1325 crores in the financial year March‟08-March‟09.
The report deals with the lending procedures followed by Indian Overseas Bank. It explains
different types of loans and advances offered by banks. It gives an insight of the steps involved
in lending process. Working capital financing is discussed in the report. Calculation of maximum
permissible bank finance is shown with example. Common issues related to credit appraisal is
discussed in detail. This report also deals with principles of lending and principles of BASEL II
ACCORD.
The most important part of the study includes case analysis of Working Capital
Assessment/Appraisal of a partnership firm M/s XXX Co. ( Name of the firm changed )
which is a trading concern dealing in Indian manufactured foreign liquor (IMFL).
This explains the significance of study of key financial indicators, study of debt service coverage
ratio, in a precise manner. The present status of the project shown by the study of balance sheets
sand other financial details furnished by the borrower and the bank. Financial ratios, past
performance and projected future performance, study of cash flow statement and collateral
9
security are helpful to the bank while taking lending decision. Finally, conclusion and
recommendation as per the analysis during the training period winds up the report.
10
METHODOLOGY AND SOURCES OF DATA
The proposed methodology for fulfilling the objectives of the project is as follows:
The study of guidelines laid by the Reserve Bank of India and the governing authorities
of Indian Overseas Bank to be adhered to (pertaining to advances) as published in the
journals issued by these authorities from time to time.
The secondary data is deduced from the books of accounts maintained by the bank
(without disclosure of any personal details of the borrower).
The data from the official books as maintained by the bank, reference books, newsletters
published by financial institutions and websites have been utilized for the analytical study
of advances made by bank.
The methodology includes a detailed study of the data collected from the bank, pre and
post requisites of lending, calculation of interest on loans and equated monthly
installments and documentation of the same.
The observation of advances sanctioned by the bank in the past few years that resulted
successful lending constitutes the most substantial part of the project work.
It also involves active participation in banking transactions and internal functioning of the
Advances Department of the branch. An elaborate study of loans and advances granted
by the branch and analysis of the same has been the most significant component of the
project.
Information mentioned in the cases are deduced from the books of accounts as maintained by the
bank branch, the figures and facts given being realistic in nature. Finally, identification of the
problems associated with advances by bank and the solution of the same with certain
recommendations is to be provided after analyzing certain loans (stated as illustrations in the
project) to help the advances department of the bank.
11
Serial No. Abbreviation Narration1. CBS Core Banking Solution2. ISO Indian Standard Organization3. IMFL Indian Manufactured Foreign Liquor4. SCB Scheduled Commercial Banks5. ICRA International Credit Rating Agency6. FOREX Foreign Exchange7. IPO Initial Public Offer8. VISA Visa International Service Association9. NRI Non Resident Indian10. ROE Return on Equity11. WIP Work in Process12. NFS National Financial Switch13. FDR Fixed Deposit Receipt14. EPS Earnings per share15. DSCR Debt Service Coverage Ratio16. AR Accounts Receivable17. SME Small Medium Enterprise18. MPBF Maximum Permission Banks Finance19. CMA Credit Monitoring Analysis20. NWC Net Working Capital21. NSC National savings Certificate22. LIC Life Insurance Corporation23. KVP Kishan Vikas Patra24. IBA Indian Bank Association25. CIBIL Credit Information Burea India Limited26. CC Cash Credit27. ROC Registrars of Companies28. HO Head Office29. LGD Loss Given default30. EAD Exposure at Default31. MCR Minimum Capital Requirement32. RWA Risk Weighted Assets33. PD Probability of Default34. EL Expected Loss35. SWOT Strength,Weakness,Opportunity & Threat36. CLB Company Law Board37. DPG Deferred Payment Guarantee38. WCG Working Capital Gap39. TNW Tangible Net Worth40. TOL Total of Liabilities
12
Figure No Narration Page No
Fig 1 IOB 14
Fig 2 Working Capital 38
Fig 3 Working Capital Cycle 43
Fig 4 Cash Operating Cycle 44
Fig 5 Credit Appraisal 49
Fig 6 BASEL II 56
13
Table No. Narration Page No:1. Key Ratio levels 642. Nature of Facilities 693. Guarantors and their Networth 704. Collateral Securities details 705. Securities 716. FORM I 737. FORM II 74 -768. FORM III(P & L A/C) 77 -799. FORM III(B/S) 79 - 8110. FORM IV(B/S) 82 - 8311. Comparison 84 - 8512. FORM V(B/S) 86 - 8713. FORM VI(B/S) 88 - 8914. Financial Indicators 9015. Financial Position 9116. Sanction of enhancement cum renewal of limits 93
Chapter 1.
INTRODUCTION
1.1BANKING SECTOR IN INDIA
Banking in India originated in the last decades of the 18th century. The first bank in India,
though conservative, was established in 1786. From 1786 till today, the journey of Indian
Banking System can be segregated into three distinct phases. They are as mentioned below:
Early phase from 1786 to 1969 of Indian Banks
Phase from Nationalization of Indian Banks and up to 1991, prior to Indian banking
sector Reforms.
New phase of Indian Banking System with the advent of Indian Financial & Banking
Sector Reform after 1991.
Currently, India has 88 scheduled commercial banks (SCBs) - 27 public sector banks (that is
with the government of India holding a stake), 31 private banks (these do not have government
14
stake; they may be publicly listed and traded on stock exchanges) and 38 foreign banks. They
have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by
ICRA Limited, a rating agency, public sector bank holds over 75% of the total asset of the
banking industry, with the private and foreign bank holding 18.2% and 6.5% respectively.
Currently (2007) banking in India is generally fairly mature in terms of supply, product,range
and reach even though reach in rural India still remains a challenge for private sector .In terms of
capital adequacy and quality of assets, Indian banks are considered to have clean, strong and
transparent balance sheet relative to other banks in comparable economies in its region. The
Reserve Bank of India is an autonomous body, with minimal pressure from the government. The
stated policy of the bank on the Indian rupee is to manage volatility but without any fixed
exchange rate and this has mostly been true.
With the growth in the Indian economy expected to be strong for quite some time, especially in
its services sector -the demand for banking services, especially retail banking mortgages and
investment services are expected to be strong.
Without a sound and effective banking system in India it cannot have a healthy economy. The
banking system of India should not only be hassle free but it should be able to meet new
challenges posed by the technology and any other external and internal factor.
Indian Banking market is growing at an astonishing rate, with assets expected to reach US$1
trillion by 2010. An expanding economy, middle class and technological innovations are all
contributing to this growth. The country’s middle class accounts for over 330 million people. In
correlation with the growth of the economy, rising income levels, increased standard of living
and affordability of banking products are promising factors of continued expansion.
For the past three decades India's banking system has several outstanding achievements to its
credit. The most striking is its extensive reach. It is no longer confined to only metropolitans or
Borrowers enjoying working capital limits of Rs. 10 crores and above option has been given to
the borrower to be assessed as per the Cash Budget Method. For industries like the mentioned
above where in the pattern of financing the peak cash deficit(s) is followed all along, the existing
system of assessment under the Cash Budget Method is followed.
Limitations:
Will not reflect changes in various current assets and current liabilities.
It does not give any clue whether a company is earning profit or not.
Funds flow statement is required to detect any diversion of funds. But this method
does not include Funds flow statement.
Chapter 4
49
CREDIT APPRAISAL AND MONITORING: COMMON ISSUES
4.1. WHAT IS CREDIT APPRAISAL?
Credit appraisal is a process to ascertain the risks associated with the extension of the credit
facility. It is generally carried by the financial institutions which are involved in providing
financial funding to its customer. Credit risk is a risk related to non-payment of the credit
obtained by the customers of a bank. Thus, it is necessary to appraise the credibility of the
customer in order to mitigate the credit risk. Proper evaluation of the customers is performed
which measures the financial condition and the ability of the customer to repay back the loan in
future. Generally, the credit facilities are extended against the security for which the credit limit
is being sanctioned, known as PRIME SECURITY. Apart from that, financial institutions take
some other securities like fixed deposits, NSCs, LICs, KVPs, immovable properties, to be
considered as COLLATERAL SECURITY for the credit limits sanctioned by them. But even
though the loans are backed by collateral, financial institutions are normally interested in the
actual loan amount to be repaid along with the interest.
Fig 5. Credit Appraisal
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4.2. DATA TO BE OBTAINED FOR CREDIT ASSESSMENT:
Loan application of the credit facilities. A profile of the firm/ company. Financial Statements of previous years. Estimates/ projections (with quantitative details) Asset liability statement of the borrowers/ guarantors. Supporting details of the financials including income tax return, stock/ book debt
statements etc.
Apart from that bankers are to obtain the market reports of the proposed borrower as also credit opinion from other banks/ financial institutions, if any, as per INDIAN BANKS ASSOCIATION (IBA) approved format. In spite of that due to latest technological improvements bankers are viewing any default of payments towards credit obligations from other financial institutions through online CIBIL System.
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4.3. CREDIT MONITORING: Common Issues
Caution needs to be exercised when loan is to be sanctioned to a party who operates in rented
premises and leave & license agreement period is less than repayment period of the loan.
Specific enquiry should be made for approaching IOB and whether loan application has been
simultaneously submitted to other banks.
Apart from obtaining usual credit report from existing bankers, it is also necessary to find out
from other sources about the borrower’s operation with that banker as it is quite likely for any
banker to give normal report if they do not wish to retain account.
Bank should prepare S (Strength) W (Weakness) O (Opportunity) T (Threat) analysis in case of
advances of say Rs. 15 Lacs & above.
Whenever borrower submits IT Return then it should be ensured that it has been filed every year
rather all a time or in a short span of few months. It is obvious from such so-called compliance
that IT Return has been filed just to meet the stipulation for processing of loan application.
Loan should not be granted on the basis of income affidavit submitted by borrower. Reasons for
not filing IT Return should be enquired.
Net worth of secureties should be ascertained to confirm that he has the capacity to pay the loan
in case of default by borrower.
Bank should stipulate the condition that unsecured loans should not be withdrawn till currency of
Bank Loan.
Bank should stipulate the condition that expansion plans would be executed only after consulting
bank.
Bank should stipulate the condition that Key personnel appointment will be approved /
confirmed by Bank.
Collateral security should be taken to the extent possible. e.g. Residential flat, LIC, Shares, NSC,
KVP etc. More so when effective/economical life of the asset hypothecated is less than
repayment period of loan.
Bank’s nameplate should be given to borrower and his acknowledgement should be taken,
followed by his letter confirming the affixing the nameplate.
Bank should stipulate that borrower should submit Monthly Information as per the format
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stipulated by Bank.
Undertaking to deal exclusively with our bank is obtained and borrower blindly executes the
same. In fact we are aware that borrower is operating with other banks. In such case, in case he
cannot close the account with other banks as the same may be required for ST, Excise etc. then
we should specifically give permission & bank statements should be obtained monthly of such
accounts .Otherwise account closure certificate should be obtained
Disbursement should be directly made to Builder, Vendor etc. depending on type of loan. In case
the same is to be reimbursed to borrower, then stamped receipt, bills, installation report,
inspection report, insurance policy, valuation report etc. should be available on record.
Post dated cheques (payable fortnightly) should be taken from large borrowers (New) as well as
from existing borrowers not repaying the loan regularly
Insurance policy of adequate sum should be taken covering the appropriate risks such as Fire,
Burglary etc.
Security documents should be verified periodically to confirm with entries in Security Register.
Valuation report should be obtained say once in three years of security offered such as Land,
Machinery, Gala, Flat, and Vehicle etc.
Accounts, Audit report, I.T.Return etc. of Borrower, Directors, Partners and Guarantors should
be obtained in November every year.
Assets & Liabilities statement of Borrower, Directors, Partners and Guarantors should be
obtained every year.
Term Loans should be reviewed every year.
Caution is called for whenever lump sum payment is arranged by borrower to regularize the loan
account.
Bank should avoid the temptation of ever greening / window dressing the CC / Loan
account
Recovery notice should be sent whenever overdue is noticed.
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4.3.1 Additional requirements in case of Loan is granted to Company:
Search Report of ROC records should be obtained in case loan is proposed to be given / given to
Pvt. Or Public ltd. Company.
Company Secretarial Compliance Report should also be obtained in case loan has been
given to Pvt. Or Public ltd. Company.
Board resolution for making loan application to a Bank should also be obtained along with Loan
application.
Board resolution for acceptance of terms & conditions of sanctions and for execution of
documents should be kept on record. The said resolution should be typed on Company’s
letterhead and authenticated by chairman of the meeting and not by any director.
Common seal of the company should be affixed on all documents executed by the company.
Form 8 & Form 13 should be filed with ROC within 30 days of loan documentation.
Bank should stipulate the condition that dividend should not be declared without approval
of Bank.
Promoter’s contribution should be brought in the form of Capital.
If Authorized capital is not adequate to accommodate promoter’s capital
Contribution, then borrower should be requested to enhance authorized Capital clause
immediately.
List of shareholders & their relationship with the promoters /management of the company should
be ascertained.
Details of Shareholding should be obtained.
Copies of various forms filed with ROC should be obtained such Annual Audited Accounts,
Annual Return, Allotment of Shares, Agreements, Resolutions etc. should be obtained.
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4.3.2 Additional requirements in case of Loan is granted to Firm:
Certified true copy of Partnership Deed should be obtained. Original deed should also be referred
to confirm the Xerox copy.
Partnership deed should be referred to confirm as to whether firm could do banking
operations with Co-operative bank and how bank account will be operated?
Partnership should be registered with Registrar of Firms. Relevant registration certificate
and other papers filed should be kept on record.
Bank should stipulate condition that says 25 % profit & Salary due to partner should be
retained in the business
REGISTERS
HO should prescribe the format of various loan registers to be maintained by branches.
HO should arrange to print these registers or procure them on behalf of branches to ensure
uniformity.
Security register (computer) should be up dated regularly.
4.4. PRINCIPLES OF LENDING
55
According to general principles of lending, all mortgage originators should act in "good faith and
with fair dealings" in any transaction. A reliable customer forms the basis of a successful
lending. The following principles act as the foundation of a judicious lending:
Safety of funds ensures that the bank, although being a profit generating unit, continues
to build and retain the trust of the public at large.
Security accepted from the borrower as an alternative for recovery of advances in case of
default must be of significant value.
Purpose or the objective of advances should remain in favor of nation‟s security. It
should not be anti- social or illegal.
Profitability and yield on advances should be in line with the banks objective, so the
advances made must be successful.
Liquidity of advances made by the bank indicates its ability to meet its deposit liabilities,
so the advances made should be adequately liquid.
Integrity of borrower is very vital to consider the loan proposal envisaged by him for
further sanction.
Adequacy of bank finance is of prime importance for a borrower to accomplish his
project so both under and over financing should be avoided by the bank.
Timely availability of funds to the borrowers helps the bank grow in the current scenario.
These principles strengthen the bank finance eventually leading to safe advances.
4.5 PRINCIPLES OF BASEL II ACCORD
56
4.5.1 Basel II consists of three pillars
Fig 6. Basel II
PILLAR 1
It sets principles for minimum capital requirements to cover both credit and operational risks.
Capital requirement is a guarantee amount against unexpected losses. It is taken as equity in
banks accounts. To determine minimum capital requirements, a bank can either use external
sources or an internal rating base approach. There are three fundamental components to calculate
the minimum capital requirement according to Basel II.
a) Probability of Default (PD): It is the likelihood that an applicant will default in one year time
period.
b) Loss Given Default (LGD): It is the proportion of the exposure that will be lost if the applicant
defaults.
c)Exposure at Default (EAD): The nominal value of loan granted. The minimum capital
requirement (MCR) estimation is shown in with respect to Basel II:
57
MCR = 0.08*RW*EAD = 0.08 RWA
Here
RW is the risk weight calculated by using PD, LGD and remaining maturity of exposure. It has
specific formulas for each asset type. RWA is the risk weighted asset.
EL = PD*EAD*LGD
MCL=EAD*LGD*PD-b*EL
Where
EL is the expected loss and b is the proportion of expected loss of loan covered by minimum
capital requirement.
PILLAR 2
It defines principles for supervisors to review assessments to ensure adequate capital. The rating
system and risk management activities are checked by supervisors. Supervisors review process,
to be sure that banks have adequate and valid techniques for capital requirements. Accurate and
valid techniques lead to better credit risk management for the banks. Banks are expected to
manage their internal capital assessments.
According to Basel Committee, there is a relation between capital required and banks risk. Banks
should have a process for assessing overall capital adequacy in relation to their risk profile.
Supervisors are responsible for the review and evaluation of the assessment procedure. When
supervisors think the validity of the rating process is not adequate, they can take appropriate
actions. They can take early stage actions to prevent capitals from falling below the minimum
levels required to support the risk characteristic.
PILLAR 3
It sets principles about banks disclosure of information concerning their risk. Its purpose is to
maintain the market discipline by completing pillar 1 and pillar 2. The Basel Committee
encourages market discipline by developing sets of disclosure requirements.
According to the new accord, banks should have a disclosure policy and implement a process to
evaluate the appropriateness of the disclosure. For each separate risk areas banks must describe
their risk management objectives and policies.
58
4.5.2 PD Dynamics
59
Probability of default is one of the challenging factors that should be estimated while
determining the minimum capital requirement. New Accord has sets principles in estimating PD.
According to Basel II, there are two definitions of default:
a) The bank considers that the obligor is unlikely to pay its credit. There are four main indicators
that bank considers the obligor is unlikely to pat the obligation:
• The bank puts the obligation on an non-accrued stratus
• The bank sells the credit obligation at a material credit related economic Loss.
• The bank consents to a distressed restriction of credit obligation.
• The obligor sought or has been placed in bankruptcy.
b) The obligor past due more than 90 days on credit obligation to the bank.
Banks should have a rating system of its obligor with at least 7 grades having meaningful
distribution of exposure. One of the grades should be for no defaulted obligor and one for
defaulted only. For each grade there should be one PD estimate common for all individuals in
that grade. It is called as pooled PD.
There are three approaches to estimate pooled PD.
a) Historical experience approach:
In this approach, PD for the grade is estimated by using the historical observed data default
frequencies. In other words, the proportion of defaulted obligers in a specific grade is taken as
pooled PD.
b)Statistical Model Approach
In that approach, firstly predictive statistical models are used to estimate default probabilities of
obligor’s. Then, for each grade the mean or median of PDs are taken as pooled PD.
c)External Mapping Approach
In this approach, firstly a mapping procedure is established to link internal ratings to external
ratings. The pooled PD of external rating is assigned to internal rating by means the mapping
established before.
Basel II allows the banks to use simple averages of one year default rates while estimating
pooled PD.
60
While establishing the internal rating process, the historical data should be at least 5 years, and
the data used to build the model should be representative of the population. Where only limiting
data are available or there are limitations of assumptions of the techniques, banks should add the
margins of conservatism in their PD estimates to avoid over optimism. The margin of
conservatism is determined according to the error rates of estimates depending on the
satisfactory of the models. There should be only one primary technique used to estimate PD, the
other methods can be used just for comparison. Therefore, the best model should be taken as the
primary model representing the data.
After the estimation of PDs, the rating classes are needed to be built. The banks are allowed to
use the scale of external institutions.
In the PD estimation process, just building the model is not enough supervisors need to know not
only the application also the validity of the estimates. Banks should guarantee to the supervisor
that the estimates are accurate and robust and the model has good predictive power. For this
purpose, a validation process should be built.
The scoring models are built by using a subset of available information. While determining the
variables relevant for the estimation of PD, banks should use human judgment. Human judgment
is also needed when evaluating and combining the results.
4.6 FINANCIAL ANALYSIS OF LENDING
61
Financial analysis is the systematic examination and interpretation of financial data to evaluate
the past performance of a business, its present conditions and its future prospects. It refers to an
assessment of the viability, stability and profitability of a business, sub-business or a project.
Essentially, financial analysis moves from a preliminary investigation of the client to an in depth
examination of operating performance, as interpreted from historical and projected financial
statements. With financial analysis, the advances manager assesses the financial performance of
the company to arrive at a conclusion about the future prospects of the loan repayment.
4.6.1 FINANCIAL ANALYSIS ASSESSES THE FIRM’S:
62
1. Profitability - its ability to earn income and sustain growth in both short-term and long-term.
A company's degree of profitability is usually based on the income statement, which reports on
the company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations;
4. Stability- the firm's ability to remain in business in the long run, without having to sustain
significant losses in the conduct of its business. Assessing a company's stability requires the use
of income statement and balance sheet, as well as other financial and non-financial indicators.
4.6.2 STEPS INVOLVED IN FINANCIAL ANALYSIS OF LENDING
63
Step1: Company’s financial statement for at least 3 to 5 years is acquired. The financial
statement must include the following:
Balance sheets
Income statements
Shareholders equity statement
Cash flow statements
Step 2: A quick scanning of all the statements is done to look for large movements in specific
terms from one year to the next. If there is something suspicious, relevant research about the
company is done from the information available to find out the reason. Notes accompanying the
financial statements are also reviewed for additional information that may be significant to
analysis.
Step 3: This stage calls for an exhaustive scrutiny of the balance sheet. While examining, the
advances manager looks for the large changes in overall components of company‟s assets and
liabilities of equity. For example, have fixed assets grown rapidly in one or two years, due to
acquisitions or new facilities? Has the portion of debt grown rapidly, to reflect a new financial
strategy?
Step 4: This level relates to an assessment of the income statement as furnished by the client.
The advances manager looks for the trends overtime. Graphs and growth of the following entries
over the past several years are calculated.
1. Revenue (sales)
2. Net income (profit, earnings)
For each key expense components on the income statement, percentage of sales of each year is
calculated. For example, percentage of cost of goods sold over sales, general and administrative
expenses over sales and development over sales are computed. Favorable and unfavorable trends
are highlighted. Manager determines whether the spending trends support the company‟s
strategies.
Step 5: The very phase pertains to an evaluation of the cash flow statement. It gives information
about the cash inflows and outflows from operations, financing and investing. While the income
64
statement provides information about both cash and non-cash items, the cash flow statement
attempts to reconstruct that information to make it clear how cash is obtained and used by the
business, since that is what investors really care about.
Step 6: Calculation of financial ratios- Discussed in Chapter 3.
KEY RATIO LEVELS
PARTICULARS
LOW RISK MEDIUMRISK HIGH RISK
Current Ratio > 1.40 1.20-1.40 <1.20
TOL/TNW <2.00 2.00-3.50 <3.50
Interest Coverage >3.50 2.00-3.50 <2.00
PAT/SALES% >10.00 4.00-10.00 <4.00
Inventory (No. of
days
<60 60-90 >90.00
Debtors (No. of days <45 45-90 >90.00
Debt –Equity Ratio <1.25 1.25-1.75 >1.75
DSCR (For TL) >2.00 1.25-2.00 <1.25
Table 1: Key ratio levels
4.7 CLARIFICATION WITH REGARD TO ASSESSMENT OF WORKING CAPITAL LIMITS
65
Issues raised by banks Clarification
1 2
A Whether banks should sanction working capital
limits on the basis of a minimum of 20 percent of
the projected annual turn over /output value or
whether it is intended that banks should also
arrive at the requirement based on the traditional
approach of production /processing cycle and
there after decide the quantum of need based
finance.If the traditional approach is
followed ,the working capital finance arrived at
could be either more than or less than .In case it is
less than 20%,whether bank should still give 20%
?
The assessment of working capital credit limits
should be done both as per projected turnover
method and traditional method . If credit
requirement based on production/processing
cycle is higher than the one assessed on project
turn over basis ,the same may be sanctioned as
RBI guidelines stipulate bank finance at
minimum of 20% of the projected turnover.On
the other hand of it the assessed credit
requirement is lower than the one assessed on
projected turn over basis,while the credit limit
can be sanctioned at 20% of the projected turn
over ,actual drawals may be allowed on the
basis of drawing power to be determined by the
banks after excluding unpaid stocks. In case of
selective credit control commodities the
drawing power should be determined as
indicated in the RBI directives.
B Whether projected turnover/output value basis
‘gross sale’
The projected turnover/output value ,may be
interpreted as ‘gross sale’ which will include
excise duty also.
C Whether 5% promoter’s stake (Net Working
Capital) should be reckoned with reference to the
projected turnover with reference to working
capital arrived at based on production and process
cycle ?
In terms of extant guidelines the working
capital requirement is to be assessed at 25% of
projeted turnover to be shared between the
borrower and bank viz. borrower contributing
5% of the turnover as NWC and bank providing
finance at a minimum of 20% of the turn
over .The above guideline were framed
66
assuming the average production cycle of 3
months .It is possible that certain industries may
have production cycle of shorter/longer 3
months.While in the case of shorter cycle ,the
same principal could be applied as it the
intention to make available atleast 20% of
turnover by way of bank finance. In case the
cycle is longer ,it is expected that the borrower
should bring in proportionately higher stake in
relation to his requirement of bank
finance.Going by the above principal ,at least
1\5 of working capital requirement should be
brought in by way of NWC.
D Whether 5% NWC should be reckoned with
reference to turnover or with reference to
available long term source; in other words is the
prescribed NWC the minimum amount?
Since the bank finance is only intended to
support need- based requirement of a borrower
if the available NWC(net long term surplus
funds)is more than 5% of the turnover the
former should be reckoned for assessing the
extent of the bank finance.
E Whether drawing power should continue to be
regulated through stocks and whether unpaid
stocks deducted for arriving at drawing power?
It is left to the discretion of the banks.However
in arriving at drawing power,unpaid stocks are
not financed as it would result in double
financing.The drawing power should conform
to RBIdirectives in the case of selective credit
control commodities.
F Since the present instruction cover traders as
well, and most trade is done at market credit,
whether the credit limits should be assessed as
20% of the turnover per se and actual drawing
In case of traders ,while bank finance could be
assessed at 20% of the projected turnover, the
actual drawals should be allowed on the basis of
drawing power to be determined by banks after
67
regulated through stocks ? ensuring that unpaid stocks are excluded. In
case of SCC commodities the RBI directive
should be scrupulously followed.
68
Chapter 5.
A CASE STUDY
While undergoing my project work under the guidance of Indian Overseas Bank authority,
I have been assigned to do the Working Capital Assessment/Appraisal of a partnership
firm M/s XXX Co. ( Name of the firm changed ) which is a trading concern dealing in
Indian manufactured foreign liquor (IMFL).
BACKGROUND OF THE FIRM
XXX Co. is a partnership firm promoted by Mrs. A, Mr. B and Mr. C. They belong to the same
family. Mrs. A is the mother of Mr. B and Mr. C. The unit being established on 09/09/2001
started wholesale dealership trading in Indian manufactured foreign liquor and beer since 2003.
XXX Co., opened their account with INDIAN OVERSEAS BANK since 09-01-2003. At first
they availed a cash credit facility of Rs. 35 Lacs on 08-04-2003, after then it had enhanced to the
tune of Rs. 95 Lacs on 20-09-2004. So long they used to avail the same credit facility without
further enhancement. This limit expired on 31-07-2009. Earlier in this nature of business a
sizeable quantum of credit could be obtained from the manufacturers/ stockists, but as per recent
trend almost all the payments are to be made in advance to get the stocks due to shortage of
supply and huge demand of the product resulting in stiff competition amongst the wholesale
dealers. Sales are going on increasing over the years. In this year, they got an offer of
stockistship of BEER under the brand name of KINGFISHER STRONG and KINGFISHER
PREMIUM product of eminent UB GROUP which has already gain a lions share in the field of
BEER market. It is expected that with the intervention of this lucrative branded BEER market,
their sales turnover would increase by leaps and bounds. For this, they need further Working
Capital. In this year they appealed the bank to enhance the existing credit limit of Rs. 95 Lacs to
the tune of Rs. 200 Lacs. The business is sound and progressing. Partners are creditworthy, well
experienced and enjoying goodwill in the market.
In this trade, the manufacturer fix the price of the product and allow a certain percentage of
discount to the wholesaler. The wholesaler keep a portion of the discount with them and pass the
remaining discount to the retailer. The retailer sells the product at the predetermined price. The
69
discount allowed by the manufacturer to them as Stockiest/ Dealers/ Wholesalers is a lump sum
profit, but the same is shown as other income in the balance sheet.
Conduct of the account for full financial year from 01-04-2008 to 31-03-2009
47. TOTAL OUTSIDE LIABILITIES/ TANGIBLE NW WORTH [ 18/44 ]
11.40 3.78 4.07 2.91 2.72
ASSESSMENT OF WORKING CAPITALTable 10:FORM-IV(B/S)
As per balance sheet as atLAST THREE YEARS ACTUALS( AS PER AUDITED ACCOUNTS)
CURRENT YEAR ESTIMATES31-03-2009
FOLLOWING YEAR PROJECTION31-03-2010
31-03-2006 31-03-2007 31-03-2008
A. CURRENT ASSETS1. Stocks- in-trade
[ months cost of sales ]44.05 53.41 74.34 73.86 164.00
82
2. Receivables other than export and deferred receivables
( including bills purchased and discounted by bankers)
( months domestic sales)
60.46 98.99 119.48 112.32 159.84
3. Export receivables
( including bills purchased and discounted by bankers)
( months domestic sales)4. Advances to suppliers
of merchandise
5. Other current assets
( including cash and bank balances & deferred receivables due within one year) ( specially major items)
(Loan and Advances)
51.88 47.38 40.06 32.23 36.03
6. TOTAL CURRENT ASSETS
( to agree with item 34 in Form-III )
156.39 199.78 233.88 218.41 359.87
83
COMPARATIVE STATEMENT OF CURRENT ASSETS AND CURRENT LIABILITIES
As per balance sheet as at
Table 11:ComparisionLAST THREE YEARS ACTUALS( AS PER AUDITED ACCOUNTS)
CURRENT YEAR ESTIMATES31-03-2009
FOLLOWING YEAR PROJECTION31-03-2010
31-03-2006 31-03-2007 31-03-2008
B. CURRENT LIABILITIES
( other than bank borrowings for working capital)
7. Sundry Creditors ( Trade) ( Months Purchases)
49.76 61.46 89.02 66.16 60.37
8. Advance payments from 84
customer / deposits from dealers
0.43 0.12 0.02 0.00 0.00
9. Statutory Liabilities 0.07 0.07 0.13 0.00 0.00
10. Other current liabilities( specially major items such as short time borrowings, unsecured loans dividend payable , installments of TL, DPG , public deposits, debentures , etc.)
5.92 5.69 7.06 7.90 8.65
11. TOTAL( To agree with sub-total B- Form-III)
56.18 67.34 96.23 74.06 69.02
85
COMPUTATION OF MAXIMUM PERMISSIBLE BY BANK [FINANCE FOR WORKING CAPITAL]
Table 12:FORM-V(B/S)As per balance sheet as at
LAST THREE YEARS ACTUALS( AS PER AUDITED ACCOUNTS)
CURRENT YEAR ESTIMATES31-03-2009
FOLLOWING YEAR PROJECION31-03-2010
31-03-2006 31-03-2007 31-03-2008
1. Total current assets (34 Form III)
156.39 199.78 233.88 218.41 359.87
2. Current liabilities
( 2 to 9 Form III)
( other than bank borrowings)
56.18 67.34 96.23 74.06 69.02
3. Working capital gap
( WCG) ( 1-2 )100.21 132.44 137.65 144.35 290.85
4. Min. stipulated net
working capital- 25% of total current
assets other than export receivables
39.10 49.95 58.47 54.60 89.97
86
( as at 28(ii) of form III )5. Actual / projected
net Working capital
(45 in form III)
8.74 36.74 39.72 49.75 90.85
6. Item 3 minus item 4
61.11 82.49 79.18 89.75 200.88
7. Item 3 minus item 5
91.47 95.70 97.92 94.60 200.00
8. Maximum permissible
by bank finance ( item 6 or 7 whichever is lower)
61.11 82.49 79.18 89.75 200.88
9. Excess borrowings, if
any representing short fall in NWC (4-5)
87
Table 13: FORM – VI (B/S)
FUNDS FLOW STATEMENTAs per balance sheet as at
LAST TWO YEARS ACTUALS ( as per audited balance sheet)
CURRENT YEAR ESTIMATES31-03-2009
FOLLOWING YEAR PROJECTI
ON31-03-2010
31-03-2007 31-03-2008
1. SOURCESa) Net profit ( after tax)
0.01 0.04
b) Depreciation 1.64 1.40 1.19 1.04
c) Increase in capital 30.26 3.99 10.29 40.94
d) Increase in term liabilities ( including Public Deposits)
e) Decrease in I. Fixed assets
II. Other Non-Current assets
f) Others
g) TOTAL 31.91 5.43 11.48 41.98
2. USESa) Net Loss 1.06 0.48b) Decrease in term
liabilities ( including Public deposits)
1.88 1.86 0.11 0.00
c) Increase in I. Fixed assets
II. Other Non-Current assets
0.39 0.55 0.28 0.40
d) Dividend payments
88
e) Others
f) TOTAL 2.27 2.41 1.45 0.88
3. Long term Surplus (+)/ deficit (-)( 1-2)
29.64 3.02 10.03 41.10
4. Increase / Decrease in current assets
43.39 34.10 -15.47 141.46
5. Increase / Decrease in current Liabilities other than bank borrowings
11.16 28.89 -22.17 -5.04
6. Increase / decrease in working capital gap
32.23 5.21 6.70 146.50
7. Net surplus (+) / deficit (-)(Difference of 3 & 6)
-2.59 -2.19 3.33 -105.4
8. Increase / decrease in bank borrowings
2.59 2.19 -3.33 105.4
INCREASE / DEFICIT IN NET SALES -208.6 56.38 82.26 511.4
89
BRIEF FINANCIAL INDICATORS OF SUBJECT COMPANY:
(Rs. In crores)
Table 14: Financial Indicators
Year Ending 2006-2007 2007-2008 2008-2009 2009-2010
Audit Status Audited Audited Provisional Estimated
Net Sales 4.84 5.40 6.23 11.34
Operating Profit
0.23 0.29 0.26 0.49
Net Profit After Tax
0.0001 0.0004 -0.0106 -0.0048
Cash Generation
0.04 0.05 0.08 0.14
Net Working Capital
0.37 0.40 0.50 0.91
Current Ratio 1.23 1.20 1.29 1.34
TNW 0.44 0.48 0.60 0.99
TOL/TNW 3.78 4.07 2.91 2.72
Term Liability/TNW
0.05 0.00 0.00 0.00
Gross Fixed Assets
0.10 0.09 0.08 0.07
Term Loan 0.02 0.00 0.00 0.00
N.B. : Net Profit After Tax in each year have been depicted very less as per the above charge. This is so that the subjects have debited the items like Interest in Partners’ Capital, Partners’ Remuneration etc. in their Profit and Loss account.
A BRIDGED FINANCIAL POSITION:(Rs. In crores)
90
Table 15: Financial Position
Year ending 2006-2007 2007-2008 2008-2009 2009-2010
Audit Status Audited Audited Provisional Estimated
6.1 COMMENTS ON FIANCIALS/PERFORMANCE OF THE COMPANY (conclusion)
SALES: Comments on achievements of sales vis-à-vis estimates given in the past, current year sales achieved till previous month, feasibility of achieving sales estimated/ projected.
91
PROFITS: comments on trend in profitability and feasibility of achieving estimates/ projections
TANGIBLE NET WORTH (TNW): comments of trend and feasibility of achieving the estimates / projections.
TOL/TNW: comments on acceptability of key ratios and other negative features.
CR/ NWC: comments on large amounts held under “Non-Current Assets”, “other Current Assets”, “other Current Liabilities” with break up details must be furnished with justification thereof.
Sales are going on increasing over the years. In this year they got an offer of stockistship of BEER under the brand name KINGFISHER STRONG and KINGFISHER PREMIUM product of eminent UB GROUP which has already gain a lions share in the field of BEER market. It is expected that with the intervention of this lucrative branded BEER market, their sales turnover would increase by leaps and bounds. So far in this financial year, their turnover as per financial year 2009 stands at Rs. 218.69 lacs upto JULY 2009 with induction of further Working Capital and ensuing festive season and winter season, we can presume that estimated sales target of Rs. 1134.00 lacs in the financial year 2009-2010 would be achieved within rest period of 8months.
Operating Profit of the firm are going on increasing over the years. Net Profit After Tax in each year have been depicted very less as per the above charge. This is so that the subjects have debited the items like Interest in Partners’ Capital, Partners’ Remuneration etc. in their Profit and Loss account.
TNW is also going on increasing over the years due to fresh induction of capital as also retained profit which includes partners remuneration, interest on capital and capital and share of profit.
TOL/TNW IS 2.91 & 2.72 in the financial year 2008-09 & 2009-10 respective acceptable especially in this time of business where much working capital is needed to run the show.
Current Ratio is gradually improving over the years and stands well within the benchmark level ie 1.32 in the estimated in the increasing order over the years.
In a word, sales, Net profit, TNW and NWC are in the increasing order.
6.2GIST OF RECOMMENDATIONS:
Based on the aforementioned facts and figure, Partners’ Goodwill, creditworthiness and good
entrepreneurship, financials of the company, progressing trend of the business, working capital
92
need, overall security aspects and guarantee offered, we may consider favorably to enhance the
existing cash credit limit of Rs. 95 Lacs to the tune of Rs. 200 Lacs.
We recommend sanction of the same.
Table 16: SANCTION OF FOLLOWING ENHANCEMENT cum RENEWAL OF LIMITS
( IN CRORES)
Nature of
limit/
facility
purpose Existing
limit
Revised
limit
(+)/
(-)
Margin Interest%
applicable
rate
Interest %
proposed
Cash
Credit
Working
Capital
0.95 2.00 +1.05 25% on
stock
and 40%
on book-
debts
BLPR
+2.25% i.e.
at present
@14.75%
BLPR
+2.25% i.e.
at present
@14.25%
TERMS AND CONDITIONS OF SANCTION
1. A processing charge of Rs 33,600/- only is to be paid to the bank.
2. All sale transactions must be rooted through the cash credit account with the bank.
3. The firm is to deal exclusively with the bank for departmental stores with the bank.
4. Hypothecation board must be displayed in the shop/ godown.
5. Stocks and land & Buildings are to ensured in full value with the respective bank clause
6. Bank officials must have an access in the shop/ godown and all immovable properties for
the purpose of inspection as on when required.
7. Stock statements as on last date of each month must be submitted to the bank with the
10th day f the following month filing which 2% penal interest will be levied.
8. All the other norms/guidelines as applicable for finance as per bank’s book of
instructions, manual of documentation and circulars issued by RBI/Central Office from
time to time should be complied with.
** The entire working capital credit assessment of the aforementioned appraisal has been done
from one of the files of Indian Overseas Bank, Chowringhee branch and the name of the firm
93
being changed where the sanction has been based on the then current year estimates as on 2009-
2010.
After study and analysis of working capital I would like to recommend the following:
1. Company should raise funds through short term sources for short term requirement of
funds, which comparatively economical as compare to long term funds.
2. Company should take control on debtor’s collection period which is major part of
current assets.
94
3. Company has to take control on cash balance because cash is non earning assets and
increasing cost of funds.
4. Company should reduce the inventory holding period with use of zero inventory
concepts.
APPENDICES
Bibliography
Books Referred
1. I. M. Pandey - Financial Management - Vikas Publishing House Pvt. Ltd. - Ninth Edition
95
2. M.Y. Khan and P.K. Jain-Financial management – Vikas Publishing house ltd., New
Delhi.
3. K.V. Smith- management of Working Capital- Mc-Grow-Hill New York
4. Satish Imandar- Principles of Financial Management-Everest Publishing House
Websites References
1. www.jains.com
2. www.google.co.in
3. www.workingcapitalmanagement.com
4. www.wikipedia.com
All the data regarding the subject of the case study are supplied by the bank.