BANK LOANS IN THE FORM OF WORKING CAPITAL LOAN

When banks provide loan in the form of working capital, they are providing loan for funding the current assets. The working capital loan should be of short term in nature and it is given in the form of a limit. Banks specify a limit to a borrower and the borrower would be drawing the amount within the limit. This facility is called working capital facility. The working capital loan can be provided in Indian Rupees as well as in Foreign Currency. We shall first discuss different working capital loans in Indian Rupees. 

Different products for Working Capital Loan in Indian Rupees 

There are different products under which banks disburse the working capital product. These are given as below:

Cash - Credit Account 

This is the most popular mode of loan product for funding the fund based working capital requirement of a company. Once the fund based limit has been assessed by the bank and the limit is in place after fulfillment of all the steps, the fund is made available through the cash- credit product. The account operates like a typical current account. At the time of first disbursement, the drawing power is fixed on the basis of the stock statement and the company is allowed to operate within this limit till the next month when a monthly stock statement would be submitted by the company. The company can deposit and withdraw money from the fund as many times as it wants .The Company would pay interest only on the outstanding amount on a daily product basis and the interest is charged on monthly basis. This is explained with the help of the following example: 

A company has been sanctioned a fund- based working capital limit of ` 200 lacs and interest rate is Base Rate +2% p.a, payable at monthly basis. The present Base Rate of the bank is 11%. The company avails this facility through a cash credit route. The stock statement submitted on 1st of 

September 2013, stipulates that the drawing power would be ` 190 lacs. 

The transactions of the company are as follows:    

Date	Particulars	Withdrawal	Deposit	Balance
3.9.13	To Electricity	15		15
5.9.13	To Salary	45		60
6.9.13	To Raw Material Supplier	100		160
10.9.13	To Other creditor	30		190
11.9.13	By Sales Proceeds		30	160
12.9.13	To purchase	25		185
16.9.13	By Sales		50	135
30.9.13	By Sales		80	55

Since the drawing power of the company is ` 190 lacs, the balance cannot exceed ` 190 lacs. The company can withdraw and deposit as many times as possible provided the balance is within ` 190 lacs. In the above- mentioned example, the company withdraws 5 times in a month and deposits 3 

times in a month. This is one of the major advantages of the cash credit system enjoys by the corporate. The cash management responsibility is shifted to the bank. The bank has to block the entire 

` 190 lacs for this account throughout this month though the company has only drawn this amount once 

i.e. on 10.9.13. If we define that the idle fund from this account is the difference in amount between the

drawing power and the amount availed and the opportunity cost is 7.00% p.a the total opportunity cost is calculated below:

Date	Drawing Power (DP) ` lacs (A)	Balance ` lacs (B)	Idle Fund ` lacs (C) = (A) – (B)	Period (days) (D)	Cost ` lacs (E)
1.9.13	190		190	2	0.073
3.9.13	190	15	175	2	0.067
5.9.13	190	60	130	1	0.025
6.9.13	190	160	30	4	0.023
10.9.13	190	190	-	1	0.00
11.9.13	190	160	30	1	0.005
12.9.13	190	185	5	4	0.004
16.9.13	190	135	55	14	0.147
30.9.13	190	55	135	1	0.025
			Total	30	0.369

In the case of cash credit facility, the bank loses this amount due to idle fund. If the limit is substantially large, the idle fund cost is considerably higher. To help banks overcome this, RBI has stipulated a loan delivery mechanism for all the fund- based working capital limit. Under this system, 80% of the fund based working capital would be disbursed through a product called Working Capital Demand Loan (WCDL) where the repayment is to be specified by the borrower at the time of availing the disbursement. The maximum tenure of WCDL is 1 year and minimum tenure can be 7 days. The remaining 20% of limit can be availed through the normal cash credit route. In the case of WCDL, the cash management lies with the company. 

Since, in this product the cash management lies in the hands of the borrower, the borrower would have the incentive of an interest rate concession. Depending on the bank involved, the cost of borrowing would be reduced to the extent of 50 basis points to 150 basis points. 

Bill Discounting 

Bill discounting is a product where a part of the receivable can be financed. Once the assessment of the company is carried out, a portion of the assessed limit representing part of the receivable can be financed through bill discounting mode. When a company sells goods on credit, receivable is generated in the books of accounts of the company. This receivable is of two types: 

Open Account sales: Under this process only sales invoice and other sales related documents are drawn by the seller.

Bills Receivable: Under this process, not only all the documents associated with the open account sales are drawn but a Bill of Exchange is also drawn. A typical bill of exchange would look like: 

A scrutiny of the above-mentioned bills of exchange would reveal the following: 

· It is an order given by the drawer of the bill of exchange to the drawee to pay to a party after certain days. Here the drawer is generally the seller and the drawee is generally the purchaser. The payee is the bank from whom the seller gets the credit under bill discounting scheme. 

· Under normal circumstances, the seller would get the payment after 90 days from the buyer. This is the credit period extended by the seller to the buyer. This is also called the usance period of bills of exchange. 

· To improve the cash flow, the seller can get the fund from the Payee immediately on submission of bills of exchange to a bank. The bank would send it for acceptance to the drawee and drawee will accept the bills of exchange to pay on due date. 

· On receipt of acceptance from the drawee, the bank would pay to the drawer immediately. 

· On due date, the bank would collect the money from the drawee. Since the bill of exchange is a negotiable instrument, protection under Negotiable Instrument Act is available to the payee. 

Nowadays, this method of financing has become very popular for Small and Medium Enterprise (SME) financing. Many large companies outsourced their production facility to SMEs. These SMEs may not be financially strong enough to attract very competitive interest rates from the bank. The bank enters into arrangement where the large company which is the buyer of goods of SME would accept the Bills of Exchange drawn by the SME and in that case the exposure is shifted on the Large Company. 

Besides, the above working capital product, there is another product by which a company can borrow short term funds. This is called Overdraft. 

Overdraft 

Overdraft is the facility by which an entity gets loan over and above the value of the security. This can be explained with the help of the following example:

A company has a fixed deposit of ` 5 lacs maturing on 15th September 2012.The fixed deposit was made on 15th September 2011 and the interest rate was 6.5% p.a. payable quarterly. Now, on 1st September, the company requires a fund of ` 5 lacs. The company has two options: 

Option I: The Company closes the fixed deposits prematurely and in the process, it loses 1% interest. If the company exercises this option, it will earn interest to the tune of ` 27032/-. 

Option II: The Company can take a loan for 15 days against the fixed deposit and continue with the deposit itself. The interest rate on loan of fixed deposit would be 1% higher than the interest rate of fixed deposit. In this case, the company pays 7.5% interest on ` 5 lacs for 15 days. The company in 

this process would earn ` 31760/- on its investment. 

So in many cases, it is beneficial to avail an overdraft over the fixed deposit amount. This facility is called the overdraft. This is also a very popular retail banking product. 

Factoring Services 

Factoring services are the product by which the receivable is funded. In international transactions, factoring of receivable is also a very important corporate banking product. In most of the international trade transactions, besides the normal credit risks, it involves additional concepts of country and therefore sovereign risks come into play. 

Sovereign risks in international business are usually of three broad categories: 

Transaction Risk: It is linked to a specific transaction that involves a specific amount within a specific time frame, such as an export sale on six month’s draft terms; 

Translation Risk: It stems from the obligation of multinational companies to translate foreign currency assets and liabilities into the parent company’s accounting currency regularly, a process that can give rise to book- keeping gains and losses; 

Economic Risk: In the broadest sense, it encompasses all changes in a company’s international operating environment that generate real economic gains or losses. 

International Factoring and its Advantages 

The distinct advantages of a factoring transaction over other methods of finance/facilities provided to an exporter can be summarized as follows: 

1. Immediate finance up to a certain percentage (say 75-80 percent) of the eligible export receivable. This pre-payment facility is available without a letter of credit – simply on the strength of the invoice(s) representing the shipment of goods. 

2. Credit checking of all the prospective debtors in importing countries, through own databases of the export factor or by taking assistance from his counterpart(s) in importing countries known as import factor or established credit rating agencies. 

3. Maintenance of entire sales ledger of the exporter including undertaking asset management functions. Constant liaison is maintained with the debtors in importing countries and collections are

effected in a diplomatic but efficient manner, ensuring faster payment and safeguarding of financial costs. 

1. Accordingly, bad debt protection up to full extent (100 percent) on all approved sales to agreed debtors ensuring total predictability of cash flows. 

2. Efficient and fast communication system through letters, telex, and telephone or in person in the buyer’s language and in line with the national business practices. 

3. Consultancy services in areas relating to special conditions and regulations as applicable to the importing countries. 

Types of International Factoring 

The most important form of factoring is two- factor system. 

Two- Factor System 

The transaction is based on operation of two factoring companies in two different countries involving in all, four parties: Exporter, Importer, export Factor in exporter’s country and import factor in importer’s country. 

The mechanics of operation in this arrangement works out as follows: 

1. The exporter approaches the export factor with relevant information which, inter alia, may include: 

a) Type of business, 

b) Names and addresses of the debtors in various importing countries, 

c) Annual expected export turnover to each country, 

d) Number of invoices/credit notes per country, 

e) Payment terms and 

f) Line of credit required for each debtor. 

2. Based on the information furnished, the export factor would contact his counterpart (import factor) in different countries to assess the creditworthiness of the various debtors. 

3. The import factor makes a preliminary assessment as to his ability to give credit cover to the principal debtors. 

4. Based on the positive response of the import factor, the factoring agreement is signed between the exporter and export factor. 

5. Goods are sent by the exporter to the importer along with the original invoice which includes an assignment clause stipulating that the payment must be made to the import factor. Simultaneously, two copies of the invoice along with notifications of the debt are sent to the export factor. At this 

stage, prepayment up to an agreed per cent (say 75-80 percent) of the invoice(s) is made to the exporter by the export factor. 

1. A copy of the invoice is sent by the export factor to his counterpart, that is the import factor. Henceforth, the responsibilities relating to book- keeping and collection of debts remain vested with the import factor. 

2. Having collected the debts, the import factor remits the proceeds to his counterpart that is export factor. In case, payments are not received from any of the debtor(s) at the end of the previously agreed period on account of financial inability of the debtor concerned, the import factor has to pay the amount of the bill to his export counterpart from his own funds. However, this obligation will not apply in case of any dispute regarding quality, quantity, terms and conditions of supply etc. If any dispute arises, the same has to be settled between the parties concerned through the good offices of the factoring companies, otherwise legal action may have to be initiated by the import factor based on the instructions of the exporter/export factor. 

3. On receipt of the proceeds of the debts realized, the retention held (say 15-20 percent) is released to the exporter. The entire factoring fee is debited to the exporter’s account and the export factor remits the mutually agreed commission to his importing counterpart. 

Thus, the export factor undertakes the exporter risk whereas the importer risk is taken care of by the import factor. 

The main functions of the export factor relate to 

(i) Assessment of the financial strength of the exporter. 

(ii) Prepayment to the exporter after proper documentation and regular audit and post sanction control. 

(iii) Follow- up with the import factor. 

(iv) Sharing of commission with the import factor. 

The import factor is primarily engaged in the areas of 

(i) Maintaining books of exporter in respect of sales to the debtors of his country. 

(ii) Collection of debts from the importers and remitting proceeds of the same to the export factor. 

(iii) Providing credit protection in case of financial inability on the part of any of the debtors. 

The two factor systems are by all means the best mode of providing the most effective factoring facilities to a prospective exporter. However, the system is also fraught with certain basic disadvantages, i.e. delay in operations like credit decision, remittance of fund, etc., due to involvement of many parties. 

Dealer Financing 

This is a new product by which banks are providing funds to the dealers of large companies. In this case, the large corporate, say, Maruti Udyog Limited would provide a list of dealers to a bank, say,

HDFC bank Limited. Generally, the dealer selection would be carried out by the large corporate. The large corporate would identify the category A dealers and the same list would be forwarded to the bank. 

Now the bank would sanction a limit based on the intake of the dealer from the large corporate. Suppose a dealer purchases ` 250 lacs worth of car from Maruti Udyog Limited on monthly basis. Now HDFC bank would pay ` 200 lacs to Maruti Udyog Limited on behalf of the dealer. Then the dealer 

would make the payment to HDFC bank after 1 month with an interest rate. In such a case, the inventory to the tune of ` 250 lacs would be funded by HDFC bank. Now, the dealer may have already 

enjoying fund based limit from the banking system. So the dealer would inform the existing working capital banker that it has already availed ` 200 lacs from the HDFC bank and the same stock would not be shown in the inventory which the dealer would give to the existing bank for calculation of drawing 

power. In this case we have assumed a 20% margin on the inventory. The benefit to the dealer is that it would get lower rate of interest from the HDFC bank. In this type of financing there can be two types of credit enhancement: 

• Maruti Udyog Limited would give some kind of guarantee that in case the dealer does not pay, it would make the payment. The payment may be a portion of the loan outstanding. However, in many cases when the principal - in this case Maruti Udyog Limited - is an AAA rated corporate, it may not give the corporate guarantee at all. 

• In such a case, the principal may give a stop- order commitment. Under this mechanism, the principal would not dispatch any new consignment to the dealer in case HDFC bank informs it that the dealer has not paid the previous loan amount. Since the dealer is a category A dealer, the dealer may not be willing to land itself in such a situation. In such a case, it would lose its main business. The same product can be extended to many commodity dealers and large company customers. 

Term Loan for working capital purpose 

Besides the above mentioned working capital product, we can have a product which would cater to the working capital requirement; it is called term loan for augmentation of the margin money for working capital . Under this scheme, the banks would provide a term loan and the purpose of the loan is to augment the margin money for working capital. This can be explained with the help of a simple example: 

Let us assume that as on March 31, 2014, a company is estimating a current asset of ` 300 million and other current liability of ` 30 million. The total working capital gap is ` 270 million. 

Now the working capital banker would be providing a fund-based working capital limit to the tune of ` 180 million, stipulating that the borrower has to bring in ` 90 million in the form of margin money for working capital. Now as on March 31st, 2013 the company has Margin Money amounting to 75 million for Working Capital. So the company has to bring in an additional amount of 15 million in the form of augmentation of net working capital. The company decides to take ` 10 million from a bank in the form of a 3- year term loan. Such loan is called Margin Money For Working Capital Loan. This loan would be paid over a period of 3 years. The security of this loan cannot be the current asset. So the security of

this loan would be in the form of other than current asset which can be noncurrent assets of the company or any other asset outside the company’s books of account. 

Different working capital product under Foreign Currency 

One should always be aware about the competitive advantage of a particular type of borrowing source. Funds can be from the domestic sources as well as from the foreign sources, one should avail the right sources so that the overall cost goes down. Broadly, if a business borrows in foreign currency, then the total interest payment would be calculated as follows: 

Benchmark Interest Rate (say 6 months LIBOR etc.) + Spread + Foreign Exchange Premium Different working capital product under Foreign Currency has been discussed as follows: 

Buyer’s Credit 

Suppose a business entity ABC Limited wants to import `200 million worth of raw material from Germany. Now the buyer i.e. ABC Limited has arranged a foreign fund of maximum 360 days from the date of import from HSBC Frankfurt. In case no such facility was there, ABC Limited would have to make the payment from the cash credit account, and for this amount, it has to pay the interest rate at Base Rate + Spread say 13% p.a. Now Indian bank would give a Financial Guarantee or Letter of Undertaking (LOU) or Stand By Letter of Credit (SLC) in favour of HSBC, Frankfurt that in case ABC Limited does not make the payment , it would make the payment . For this LOU /SLC/FBG, the Indian Bank would charge 1% p.a. to the customer ABC Limited. Now, once the customer submits this instrument to HSBC Bank, Frankfurt, HSBC bank would lend to ABC and ABC would make the payment towards its supplier. Now the interest rate would be in foreign currency. If the 6 months’ dollar LIBOR is 0.5% p.a. and the spread is 150 bps and the forward premium is 600 bps the total cost of the borrowing is 8% p.a. When we add the FBG commission, the total cost comes to 9% p.a. So ABC could 

save a net of 4% p.a. interest rate on ` 200 million. The tenure of such buyer’s credit would be a 

maximum of 360 days from the date of import. The Indian bank, while issuing the SLC/FBG, would now ear- mark the cash credit limit of the borrower. So the buyer’s credit is disbursed under the sub- limit of Cash Credit Facility. 

Pre shipment credit in foreign currency 

If the business entity is exporting to the tune of pre shipment credit , funds can be disbursed under foreign currency . Such type of financing product is called PCFC. The benefit of this product is that the overall cost of fund is LIBOR + Spread. Since export is involved, it would lead to natural hedge and further hedging is not required. In fact, every exporter should avail this facility. Exporter should avoid availing fund under Rupee credit since the interest rate for such kind of financing would be charged as per Base Rate plus spread. 

Post Shipment Credit in Foreign Currency (PSCFC) 

Under this product, the post shipment credit to an exporter can be disbursed in foreign currency. The benefit for such type of product is that the cost of the borrowing would again be in LIBOR plus spread.

Since the actual payment would come in USD, the credit would itself be self-liquidating in nature. In case the Indian business entity is neither importing nor exporting, the entity cannot borrow in foreign currency short term except FCNR(B) loan. Under this scheme, the customer would be able to borrow only in the form of FCNR (B) loan.

Foreign Currency Non Resident Bank Loan [FCNR (B)] Loan

This has been one of the most popular methods of working capital finance. Before going into the benefits of the product, we shall first discuss the product itself. Foreign Currency Non- Resident (Bank) is the name of a deposit scheme operated by Indian bank to collect deposits from Non Resident Indians and Overseas Corporate Bodies (OCB). These deposits are collected in United States Dollars (USD), Japanese Yen (JPY),Euro ,Great Britain Pounds (GBP),Canadian Dollar and Australian Dollar. The deposit can be taken for a minimum period of 12 months and a maximum period of 36 months. The interest and principal is to be paid in foreign currency. When a bank accepts FCNR (B) deposits, it accepts deposits in these foreign currencies. The Indian bank has the following options before it:

1. It keeps the deposit in the dollar form and invests in overseas bank account. The benefit of this mechanism is that the bank has fully hedged the currency conversion risk and the counter party risk is nil. The drawback of this mechanism is that in this process, the earning is substantially lower.

2. After accepting the deposits, the bank converts this foreign currency into domestic currency. Subsequently, it lends the domestic currency to the Indian company and earns domestic interest rate. On due date of payment of interest and principal, the bank converts the Indian currency into foreign currency as it has to pay back to the depositor both interest and principal in foreign currency. The benefit of this mechanism is that the earning to the bank is more .However, the drawback is that the bank incurs a foreign exchange risk.

There can be another process by which some of the benefits from both the alternatives can be retained. Such process would lead to the development of the product called FCNR(B) loan. In the case of FCNR (B) loan, the bank can lend to Indian corporate in foreign currency held by the bank under FCNR(B) deposit .The benefit to the bank is that without incurring the conversion risk (as mentioned under drawback in option 2), the bank can earn more as the Indian corporate would pay more compared to that of the foreign bank (as mentioned in option 1 above).