Credit Monitoring Module 1 NIBM

Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune
Module I: Basics of Credit and Credit Process
Chapter 1: Introduction to Bank Lending
Dr. M. Manickaraj
The objective of this chapter is to describe the basic principles to be followed in lending,
to describe the types of borrowers and various loan products and to provide an
introduction to credit policy, credit analysis and credit administration.
Structure
1.1 Principles of Bank Lending
1.2 Types of Borrowers
1.3 Types of Credit Facilities
1.4 Credit Policy
1.5 7 C’s of Credit
1.6 Summary and Conclusion
1.1 Basic Principles of Bank Lending

Commercial banks play a pivotal role in the development of nations across the globe. They
contribute to economic development by mobilisation of savings and lending the same.
Mobilisation of savings enables formation of capital and allocating the capital to
productive sectors in the economy particularly the industrial sectors. Of course, now a
days banks do lend money to variety of customers including private business firms,
public sector enterprises, infrastructure projects, farmers, service enterprises and so on.
Banks provide credit to individuals also for purchase of house, vehicles, education and
the like.
Banks mobilise the savings of millions of people and lend the same to various types of
borrowers. As they deal with public money banks have to necessarily follow certain
principles while lending. The principles if followed will also ensure the sustainability of
banks. The main principles to be followed are discussed hereunder.
Safety: The most important principle to be followed by banks is ensuring safety of
depositors’ money. People deposit their savings with banks mainly because of the
confidence they have that the money deposited will be safe. If any one bank would lose
the confidence of the public, no bank can survive. For this reason, unlike any other
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business banks are regulated most stringently in order to ensure that they do not lose the
public confidence in them.
Lending is a risk taking business and hence banks need to have robust risk management
systems in place to ensure safety for themselves and their depositors.
Liquidity: Maintaining sufficient liquidity is another necessary condition for a bank to
survive. Banks must be able to meet the demand for withdrawal of money by depositors
at all times. Thanks to the technological advancements depositors and borrowers do not
visit bank branches to withdraw money. Rather they use alternative channels like ATMs
for withdrawal of money or internet banking and mobile banking for transfer of money.
As such banks cannot ask any customer to wait to draw money from their account. Hence,
maintaining adequate liquidity by banks is of paramount importance. To ensure liquidity
central banks have made it mandatory for banks to maintain a certain amount of money
deposited with the central bank and some amount invested in very safe and liquid
securities. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are the tools
used by the Reserve Bank of India to ensure liquidity in the banking system. CRR and SLR
demand banks to keep certain percentage of their net demand and time liabilities as cash
reserve with the RBI and as investment in government securities and other approved
securities respectively. Asset Liability Management (ALM) is another mechanism used to
ensure liquidity by managing the mismatch between the maturity profiles of assets and
liabilities.
Profitability: Sustainability of any business would depend largely on surplus (profit) it
can generate and banks are no exception. Though banks service the society and promote
economic development they are expected to generate satisfactory profits in order to
sustain themselves in the long run. They need to price loans and other services such that
they will be able to meet all costs including interest and operating expenses and also will
make profit. Banks in India have to determine rate of interest on loans using their
respective Marginal Cost based Lending Rate (MCLR) which would cover the cost of
funds, operating costs, risk costs and also profit margin.
Recovery of loans with interest as per repayment schedule given to borrowers is another
important function of banks. Basel accords and the regulations by central banks have
elaborate guidelines for determining unexpected losses due to credit default and
allocation of capital for the same.
Purpose of Loan: As discussed earlier banks need to ensure safety of deposits. Besides,
banks play the role of enabling economic development by allocating the capital mobilised
through deposits to various sectors in the economy. Banks hence shall provide credit to
productive activities only and shall not lend money for speculative and non-productive
activities. Productive activities are those that lead to economic development by boosting
demand and therefore production and sales of goods and services to consumers.
Diversification of Risk: While providing credit for productive purposes it is important
for banks to spread the credit portfolio such that the risks are fairly diversified.
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Diversification can be achieved by providing credit to many sectors and to large number
of customers in various sections of the society. Exposure norms prescribed by the RBI are
meant for ensuring diversification of risk and to see that the bank credit reaches all
deserving sectors, regions and sections of the society. Another measure taken by the RBI
in this direction is the Priority Sector Lending (PSL) norms. The PSL targets are set by the
RBI to see that all the needy sections of the society are provided with bank credit to
achieve inclusive development.
Principle of Security: It is a practice of banks to lend as far as possible against security.
The security is considered as insurance or a cushion to fall back upon in case of need. At
the same time, it provides for an unexpected change in circumstances which may affect
the borrower’s repayment capacity. However, the security and its adequacy alone
should not be the sole consideration for judging the credit worthiness.
1.2 Types of Borrowers

Banks provide loans to variety of customers who differ significantly in terms of
characteristics, loan requirements, frequency and volume of transactions, regulatory
environment, etc. Nature of relationship in each type of account or borrower calls for
differing degree of care on the part of the banker. For example, the legal requirements in
establishing a contractual relationship and in transactions for an individual borrower are
vastly different from a corporate customer. In dealing with loan accounts, the banker
should additionally be conversant with the legal provisions of various Acts as applicable
to different classes of borrowers. Major types of borrowers and a brief description of
them are as follows:
• Individual: An individual is a major who has attained 18 years of age, mentally
sound, not an insolvent and is able to enter into a contract. However, in special
circumstances guardians can borrow on behalf of minors. A married woman can
borrow provided she has independent means. Else she can be a coborrower.
Purdahnashin women are also eligible, but bank must take the required
precautions. Level of education is not a deterrent and illiterate persons can also
borrow from banks. The liability of the individual is unlimited as per law.
• Agent: An agent is a person employed by another to act on behalf of the latter.
Agent can do all such acts for the purpose of protection of the property of the
principal as a man of ordinary prudence will do under such similar circumstances.
Lending banker should take precautions such as scrutiny of the deed of agency and
verify the extent of the agent’s authority.
• Attorney: A person may appoint an attorney to deal with any specific or general
work on his/her behalf through a Power of Attorney. Power vested with the
attorney is restricted to the activities mentioned in that document only not beyond
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that. Bankers must carefully scrutinise the Power of Attorney and seek clear
instructions from principal where needed.
• Joint Borrowers: Two or more persons or a group of individuals who do not
constitute a registered body or association can be treated as joint borrowers.
Banks must obtain the signature of all the joint borrowers on loan documents or
the signature of the attorney if power of attorney had been given to any one of the
joint borrowers. As the joint borrowers are individuals joining to do an act they
are individually liable and their liability is unlimited.
• Hindu Undivided Family: HUF is composed of all the members of the family and
the male member of the family who gets the right by birth in the ancestral property
of the family is called the Kartha. Male major members of the HUF are called as
Coparceners. Kartha has the authority to borrow and coparceners’ liability for the
loan is limited to the extent of their share in the property. However, if they join the
contract with Kartha or ratify the contract entered by Kartha, they become
personally liable for the loan.
• Proprietary Firms: Business concerns owned by one individuals are called
proprietary forms. Liability of the sole proprietor (owner) business is unlimited
and hence in case of loans given to proprietary firms lenders will have recourse
not only against the assets employed in business but also against the private assets
of the proprietor. For taxation and legal purpose the owner and the business are
one and the same. The proprietor is not taxed as a separate entity.
• Partnership Firms: Partnership is a relationship that exists between persons in
a business in common with a view to profit. The conditions to be met for
entertaining a partnership firm by banks are as follows:
o Association of two or more persons
o Agreement between partners
o There must be a business
o Sharing of profit by partners
o Business must be carried out either by all or by any of the partners of the
firm
o Though partnership firm need not be registered, from bankers’ point of
view it is needed.
o The Partners of the partnership firm will be personally and severally liable
for the liability incurred by the firm.
• Limited Company: Company incorporated under and regulated by the
Companies Act. A company is a legal person and has perpetual entity. The nature
and the status of a company, its objectives, right to borrow in its name, etc. can be
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found in its Memorandum of Association and Articles of Association. Banks

providing credit to companies must necessarily collect the copies of these two
documents and scrutinise the same before getting into any loan agreement. The
liability of shareholders in a company, unlike that of a sole proprietorship or
partnership firms, is limited. The liability of the company is generally not
transferred onto the directors.
• Limited Liability Partnerships (LLP): LLPs are new set of business firms
established under the Limited Liability Partnership Act 2008. LLP is a corporate
business vehicle that enables professional expertise and entrepreneurial initiative
to combine and operate in a flexible, innovative and efficient manner. It also
provides the benefits of limited liability while allowing its members the flexibility
for organizing their internal structure as a partnership.
1.3 Types of Credit Facilities

Banks and other lending institutions offer a variety of loan products to borrowers. Credit
products can broadly be divided into three categories – credit products for business
firms, credit products for retail customers and credit products for agriculture.
Credit products for business firms: The various credit products that would meet the
requirements of business firms are as follows:
• Term loans – Loans for a specified period of time and should be repaid within the
specified period. These loans are offered generally for creating fixed assets that
would be used for producing goods and services.
• Bridge loan: Offered for a short period of time until the borrower is able raise
permanent finance. It is also referred to as interim financing, gap financing or
swing loans.
• Working capital loan: Working capital loan is meant for financing day to day
operations of a business firm. It is used for purchase of raw material, payment of
wages and salaries, electricity bill, etc. It is required because business firms in
order to fill the gap in the cash flow of a firm between purchases of raw material
till the time cash is collected from customers. Working capital loan is not meant
for investing nor for purchase of fixed assets. To many banks working capital loans
is the largest source of income. The following are the commonly offered working
capital loan products:
o Cash Credit – also referred to as line of credit or overdraft.
o Working capital demand loan (WCDL) – It is a short term loan. It can be
used by customers for meeting seasonal working capital requirements.
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o Purchase/Discounting of bills – Lending institutions provide credit by

discounting or purchasing the receivables of business firms. It can also be
referred to as receivable financing.
• Composite loan – As the name suggests composite loan is a combination of both
term loan and working capital loan. This loan is offered by banks and financial
institutions in India to MSMEs. The purpose of this loan is to ensure that the
MSMEs are provided with both term loan and working capital loan by the same
bank/financial institution.
• Demand loan – This is a unique kind loan which offered with a condition that the
loan can be called back by the lender anytime. Thus the demand loan is embedded
with a call option that can be exercised by the lender. Demand loan is offered
normally for meeting working capital requirements.
• Non-fund based credits: Letters of credit (LC) and bank guarantees (BG) are the
most commonly used non-fund credit products. Other products include buyer’s
credit, supplier’s credit, co-acceptance of bills and trade credit.
Retail loans: Retail loans are nothing but the loans offered to individuals. Variety of retail
loan products are offered by banks and financial institutions. Popular ones include
housing loan, home improvement loan, vehicle loan, consumer/personal loan, gold loan,
credit cards, etc.
Credit Products for Agriculture: Loans extended to farmers and for purposes that will
facilitate agriculture farming are called agriculture credit products. Agriculture also
includes allied activities like dairy farming, poultry farming, animal husbandry, fish
farming, etc. Broadly loans given for agriculture can be divided into investment credit
and crop loan. Investment credit would include loans for development of land, irrigation
system, purchase of equipment like tractors, tillers, harvesting machines, and so on. It
will also include loans for construction of cold storages, transport equipment and the like.
Another classification is into direct agriculture credit and indirect agriculture credit.
1.4 Credit Policy
Credit Policy is a written document which contains specific guidelines for all types of
credit decisions and determines the composition of credit portfolio. The main objective
of credit policy is to provide direction and guidance within the framework of regulatory
prescriptions, corporate goals and social responsibilities. Another objective of the credit
policy is to achieve a healthy balance between volume of credit business, earnings and
asset quality. Basic features of credit policy are:
• It is a document approved by the board of respective banks
• Credit policy must be comprehensive and provide guidance to credit function of
the bank
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• Credit policy must indicate authorities and responsibilities attached to each

functionary in credit department/branches
• Credit policy must be explicit about risk management
• Credit policy must be updated periodically. Normally it is updated every year.
Contents of Credit Policy: The following can be found in the credit policy of many banks:
• Purpose/preamble
• Exposure norms
• Goals/Targets regarding:
• Priority sector loans
• Share of fund & non-fund based assets
• Directions on focus areas such as retail
• Targets for short-term, medium term and long term
• Quality of assets
• Lending authority & responsibilities – who can sanction loans and how much?
• Credit denial and recording procedure
• Portfolio composition, concentration and diversification
• Credit rating/scoring
• Types of loans
• Appraisal policy, procedures and formats
• Pricing of loans
• Documentation (loan-file), waivers, waiver authority
• Loan review – renewal, enhancement, recall
• Loan loss provisioning
• Charged off accounts – recovery from accounts written off
1.5 7 C’s of Credit
Credit can be offered to a customer only after evaluating his/her ability to repay the loan.
A customer’s ability to repay loans can be assessed by evaluating the customer on seven
factors which can be referred to as the 7 C’s of Credit. They are briefly discussed
hereunder.
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• Character: The first and most important factor that will determine a borrower’s
repayment capacity is the integrity of the borrower. If a borrower is of decent
character and is a person of repute for his honesty and integrity then the
probability of the borrower defaulting on repayment of loans will be lower.
• Commitment: Another important factor is the commitment of the borrower. If the

borrower is committed to his profession or business then he/she will do
everything that may be necessary to run the profession/business in the best
possible manner. This will enable overcoming any challenges and hence will make
the business/profession a success.
• Capacity: Though a customer may be committed to his/her business competency

in the line of activity is equally important to be successful. Therefore, the
customer’s technical qualification, knowledge, skills, and experience should be
studied as part of credit analysis.
• Cash flow: The customer or his business should generate adequate profit and cash
flow to service the loans. If the business is incurring losses for a prolonged period
then repayment of loan would not be possible.
• Capital: While lending institutions may provide loans the borrowers should bring
in their share of capital. It is generally referred to as margin money for loan or
equity margin. Capital will indicate several things. It will ensure the commitment
of the borrower in the business and also will act as a cushion to absorb losses of
the business. If adequate capital is there then the risk of providing loans will be
less.
• Conditions: The performance of a borrower will depend on several factors which

are external to his activity/business. Such factors would include macroeconomic
conditions, industry scenario, changes in technology, competition and so on.
Therefore, external factors that could determine a borrower’s performance should
also be studied before sanctioning a loan.
• Collateral: Security for loan is also important. As a last resort the lenders can
recover loans by disposing of security provided by the borrowers for loans. The
value of security will depend on enforceability and realisable value. Therefore, due
care must be taken while accepting any asset as security for loans. Guarantees of
individual persons and business entities too are considered as security for loans.
1.6 Summary and conclusion
Banks and financial institutions play a pivotal role in development of economies through
provision of loans for various productive sectors and activities. They offer variety of loan
products to different customer segments. The customer segments can broadly be divided
into three – individuals, business firms and agriculture farmers. The loan products
offered can be classified into term loans and working capital loans. Non-fund credit
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facilities too are offered to business borrowers. Credit policy is the document that will
provide direction and guidance for providing credit. Credit can be offered to any
customer only after careful evaluation of his/her repayment capacity. 7 C’s of credit that
capture all the factors that will determine a borrower’s repayment capacity should be
studied before sanctioning loans.
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Chapter 2 Due Diligence for Lending Decisions
Dr. M. Manickaraj
The objectives of this chapter is to highlight the importance of due diligence and to
discuss the various issues to be studied diligently before lending decisions are taken.
Structure
2.1 Introduction
2.2 Due diligence for retail loans
2.3 e-KYC
2.4 Due Diligence on Corporate Borrowers
2.4.1 Basic documents
2.4.2 RBI Wilful Defaulters List and ECGC’s Special Approval List
2.4.3 Material Contracts
2.4.4 Patents, copyrights and trademarks
2.4.5 Manufacturing
2.4.6 Sales and Marketing
2.4.7 Employees
2.4.8 Management
2.4.9 Financial due diligence
2.4.10 Legal due diligence
2.4.11 Environmental due diligence
2.5 Outsourcing Due Diligence
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2.1 Introduction
According to the Cambridge Dictionary, due diligence means “the detailed examination of
a company and its financial records, done before becoming involved in a business
arrangement with it”.
(Source: https://dictionary.cambridge.org/dictionary/english/due-diligence)
One major requisite for making right credit decisions is to use reliable information. If the
data used for lending decisions are incorrect or incomplete the likelihood of loan
decisions going wrong will be high. Lending institutions collect all relevant data about
prospective borrowers from variety of sources. The main source of data is always the
customers while other sources of data include credit information bureaus, rating
agencies, government, peers, industry reports and so on. However, the onus of
verification and validation of data rests with the lender. Therefore, verification and
validation of data is very critical for successful lending business.
Due diligence is the first major step in credit analysis. It is an investigation of a borrower
in order to verify and confirm all facts. It involves collection, verification and validation
of information like identity and address of prospective borrowers, financials, legal
matters and anything that are deemed essential for making lending decisions. It can also
be defined as the care to be taken before lending money. The rigor and complexity with
which due diligence to be done depends on the nature of customers and amount of loan
involved. As such, due diligence on retail borrowers and agriculture borrowers will be
simple. On the other hand, due diligence on corporate customers will be complex.
2.2 Due Diligence for Retail Loans
Information to be collected about retail borrowers are mainly regarding identity, address,
occupation, and the like. The popular term used in this regard is the KYC (Know Your
Customer). Documents to establish KYC details include Aadhar Card, PAN card, telephone
bill, electricity bill, family ration card, salary slip, IT returns, and bank statement. Aadhar
card and PAN card are used for verification of identity whereas electricity bill, and
telephone bill are used for verification of address. Documents like salary slip, IT returns
and bank statement are used for checking the customer’s source of income, and
repayment capacity. Credit history of prospective customers can be obtained from credit
information companies like CIBIL and Experian. The credit information companies do
provide complete credit report and also a score which can readily be used for deciding
on giving or not giving loans to customers. Besides, list of wilful defaulters published by
the Reserve Bank of India too can be referred to find out if a prospective customer has
defaulted to any lending institution in the past.
Recently many banks and lending institutions have started verification of basic details
about prospective customers online. It is referred to as e-KYC. For instance, by using the
Aadhar number of a customer, details regarding identity, address and the like are verified
online and there is no need for physical documents to be obtained from customers. Of
late, Aadhar number is being used as a common thread for many other item of
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information like PAN number, bank account, mobile phone, etc. Likewise, financial profile
and social profile of customers can also be done electronically. Credit history of
customers too can be verified online by referring to the credit reports prepared by credit
information companies like CIBIL and Experian.
2.4 Due Diligence on Corporate Borrowers

Business enterprises avail large amount of loans and hence due care should be taken
before lending to them. Moreover, as they are huge organisations having presence in
many places and some of them have pan India or even global presence, information
required for credit analysis could be huge and complex. Nevertheless, all the relevant
data should be collected and carefully studied before lending to them. The various
elements of due diligence on corporate customers are discussed hereunder.
2.4.1 Basic documents:
Basic documents to be collected from business enterprises include the following:
• Memorandum of Association, and Articles of Association including all

amendments.
• Minutes of board meetings, committees of the board and shareholders.

• Permits/licenses for conduct of business, franchises, concessions and
distributorship agreements.
• List of all states where the Company has license to do business.

• List of all countries where Company is doing business and the list of countries
where the company has license to do business.
• Details of any voting trust and shareholder agreement, if any

• Copies of all agreements relating to repurchases, redemptions, exchanges,
conversions of financial securities or similar transactions.
• Copies of all agreements containing pre-emptive rights or assigning such rights.

• Last five years annual reports and quarterly earnings reports of the company and
press releases issued by the Company within the past five years.
• List of all subsidiaries and group companies.
Documents about subsidiaries and group companies: The abovementioned basic

documents may be collected for subsidiaries and group companies.
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2.4.2 RBI Wilful Defaulters List and ECGC’s Special Approval List:
Wilful defaulters list published by the RBI to find out if the company or its directors have
defaulted on payment of loans to banks or lending institutions. Export Credit Gurantee
Corporation of India (ECGC) publishes a list referred to as ECGC’s Specific Approval List.
The list gives the names of exporters whose risk is high. Both these lists shall
compulsorily be checked.
2.4.3 Material Contracts:

Any contract that will have significant impact can be called a material contract. The
following are few material contracts that will have substantial financial implication for
business firms:
• Credit agreements with banks and lending institutions and details of loans
outstanding
• Guarantees issued by the company

• All outstanding leases
• Material contracts with suppliers or customers and the suppliers who are sole
source, if any.
• Schedule of all insurance policies in force covering property of the Company and
other insurance policies such as ''key person'' policies, director indemnification
policies or product liability policies.
• Partnership or joint venture agreements.

• Bonus plans, retirement plans, pension plans, deferred compensation plans, profit
sharing and management incentive agreements.
• Any other material contracts outstanding.

2.4.4 Patents, copyrights and trademarks:
Many businesses today are knowledge intensive and their success hence depend to great
extent on intangible assets like patents. It is important for a bank giving loans to business
firms to study the nature and value of intangible assets. The following details about
intangible assets may be collected and scrutinised by banks.
• List of all foreign and domestic patents and patents held by the Company.
• List of trademarks, service marks and copyrights.
• Copies of all agreements for licensing of Company technology to third parties.
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• Copies of all agreements for licensing of technology from third parties.

• Any correspondence from third parties regarding potential infringement of
intellectual property of others.
• List of proprietary processes controlled by the Company.

2.4.5 Manufacturing:
· List of products with breakdown by manufacturing locations, number of shifts,

installed capacity and personnel employed.
· List of contract manufacturers and assemblers, if any, showing type of purchases
from each contract manufacturer or assembler.
• Agreements with suppliers, manufacturers, and customers, if any.

• Agreements relating to the sale or lease of material capital equipment.
2.4.6 Sales and Marketing:
• List of the Company's products and services.

• List of the Company's competitors.
• List of 10 to 20 largest customers of the company.
• All licensing agreements, franchises, and conditional sales contracts to which the
Company is a party.
• Agreements with distributors and dealers.

• Copies of long-term sales contracts.
• Service and support contracts, if any.
• Details of orders on hand
2.4.7 Employees:
• Number of employees broken down by major types and organization chart.

Description of any significant labour problems or union activities the Company has
experienced.
2.4.8 Management:
· Copy of promoters agreement, agreements with the management,

indemnification agreements, and ''golden parachute'' agreements, if any.
Bonus plans, retirement plans, pension plans, profit sharing and management
incentive agreements.
• Agreements for loans to officers or directors of the company.

2.4.9 Financial Due Diligence
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The ultimate objective of credit analysis is to ascertain the repayment capacity of

borrowers and to decide whether to give loan or not. It is important to find out the credit
requirements of borrowers and decide on the amount of loan. Decisions on both are
based mainly on financial statements of customers. The ability of a company to earn
profits and the value of its assets and liabilities will depend on many factors which cannot
easily be found in the balance sheet and profit and loss account of the company.
Therefore, the following need to be verified while analysing the financial statements
using tools like ratios.
• Quality of earnings & cash flows

• Quality of assets
o Fixed assets
o Working capital
• Potential liabilities & commitments

• Related party transactions
Quality of earnings & cash flows: Quality of earnings and cash flows of a company will
depend on the following:
- Seasonality in sales.
- Dependency on customers/suppliers. Higher the dependency lower the
profitability will be and vice versa.
- Assessing the impact of customers gained / lost on the bottom line. Ancillaries, for
example, will be impacted significantly if they lose just one customer.
- Trend in margins including rate of growth and sustainability
- Impact of changing costs on margins. This will depend on the company’s ability to
pass through the costs.
- Impact of exchange rate fluctuations. The impact will be substantial for those firms
involved in exports or imports. It is also relevant for those firms using substantial
amount of capital from abroad or if it has made substantial investments abroad.
- Consistency in application of accounting methods. Frequent changes in accounting
methods can be considered as an indication of trouble in the company.
- Revenue recognition. Recognition of income in advance is very common and this
will lead to inflation of profitability. There are some firms which may delay the
recognition of income for the purpose of income smoothing.
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- Nonrecurring items. Firms playing with non-recurring items too are quite
common. One common practice is to sell idle and non-core assets and investments
in order to book profit. This is normally done during periods when a firm’s
profitability might have been too low.
- Cash flows from operations – stability and certainty
Quality of fixed assets: The following details may be verified to ascertain the quality
of fixed assets:
- List of property owned by the Company.
- Documents of title, mortgages, deeds of trust and security agreements pertaining
to the properties.
- All outstanding leases for property to which the Company is either a lessor or
lessee.
- Documents showing significant acquisitions or dispositions of assets.
- Historical capex - growth and maintenance capex. Growth capex will result in
capacity addition; whereas maintenance capex will help maintain the operating
capacity and efficiency of assets.
- Capital work in progress. Capital works in progress are those capital projects
which have not been completed and will need more capital for them to be
completed. Whether the company has already tied up capital for the purpose or
not should be ascertained.
- Depreciation policy
- Capitalization of costs like R&D expenses and other costs, if any
- Capacity constraints to attain projections. Loan amount and repayment capacity
are decided based on projected financials. However, if there are capacity
constraints and hence the projected sales cannot be achieved the projections
should be revised suitably.
- Assets used but not owned; owned but not used. This is especially true for those
companies which have sister concerns sharing common facilities.
Quality of current assets: The value of current assets may depend on the following:
- Seasonality and impact on financing considerations.
- Quality of inventory. One should check if there are slow moving and non-moving
inventory, obsolete items, and perishable items in inventory.
- Quality of receivables and inventories.
o Receivables outstanding over six months
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o Valuation of work in progress

- Fixed working capital - deposits with tax authorities and retention money.
Potential liabilities & commitments: It will largely depend on the following:
- Policy on provisioning for expected and unexpected liabilities
- Contingent liabilities
- Employees related obligations like EPF, ESI, gratuity, pension, etc.
Related party transactions: Study on related party transactions will throw light on
siphoning of funds and diversion of funds.
- Appropriateness of transactions within family run businesses.
- Sharing of resources and common costs.
- Financing arrangements with related parties.
Details regarding financial securities issued:
- Copies of any stock purchase agreements.
- Copies of convertible debt agreements.
- Stock option or purchase plans
- Any other agreements relating to sale of securities by the Company including any
private placement memoranda.
- Details of all issuances of shares, options and warrants by the Company and the
shareholding pattern
2.4.10 Legal due diligence
The following documents shall be verified to find out if there are any legal issues:
• Details of active litigations/disputes, if any

• Documents showing settlement of any litigation
• Any decrees, orders or judgments of courts or government authorities issued to
the company.
• Information regarding any material litigation to which the Company is a party or

in which it may become involved.
2.4.11 Environmental due diligence
There are many instances where companies have been asked to stop operations due to
pollution and damage caused to the environment or adverse impact of the business on
society. There are also many instances where projects were not allowed to be taken up
despite the necessary clearances/licenses for setting up the factory and starting the
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business were in place. Therefore, banks must verify the impact of projects and
operations on the environment and the society. No objection certificate from the
Pollution Control Board, clearance from department of forestry, report on environment
impact analysis, and the like as may be necessary need to be obtained by companies
before commencing businesses. Specifically, the following may be verified:
• Description of all toxic/hazardous materials used in production and manner of

storage and disposition.
• List of chemicals, toxic substances or air contaminants which are regulated by law
and present in any facility of the Company.
• All instances in the past in which the Company has corrected unsafe working
conditions.
• Details of all the facilities of the Company that discharge liquid or solid waste into
any body of water, stream or any sanitation systems.
• Permits or approvals obtained from government authorities responsible for

environmental or health regulation.
• Any notices of violation served on the company for alleged failure to comply with
applicable environmental regulations.
2.5 Outsourcing Due Diligence:

Outsourcing of due-diligence activities are done by banks through various entities, such
as surveyors, advocates, KYC verifying agencies financial analysts and other verification
agencies. At times the report may be made as a routine with little scrutiny and in some
situations the report may be drafted under the influence of unscrupulous borrowers. In
such cases where due diligence was outsourced the lender should not blindly go by the
report given by such agencies, rather the banker should go through the report and
comprehend the information.
In some cases banks send their sales force instead of credit officers to carry out due
diligence such as in-person verification, background checks, and factory visits, which is
inherently conflicting with their role of loan origination. This should be avoided.
The market also has independent agencies, either government bodies or private bodies,
which hold repository of information, like Google, Probe42, Zuba Corp, e-KYC, C-KYC,
NESL, RBI defaulters’ List, RBI Caution List, ECGC Caution list, CERSAI, CRILIC,
MCA21(ROC). The future due diligence will lie with Block Chain Technology.
Due diligence is a first major step in credit analysis. If due diligence is not carried out
properly loan decisions more likely to go wrong. Therefore, all the lending institutions
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are supposed to carry out due diligence on prospective customers before deciding on
giving loan to them. Due diligence on small customers like retail b-borrowers, agriculture
farmers, micro enterprises will be simple and easy. Whereas, due diligence on corporate
customers demands many documents and information and hence is very complex.
However, corporate customers need huge loans and hence due diligence on them need to
be carried out more stringently. Due diligence on corporate customers involve collection
of documents and data from many sources, due diligence regarding material contracts,
patents, copyrights and trademarks, manufacturing facilities, sales and marketing
arrangements, employees, management, financials, legal issues, and environmental
issues. Given the importance and complexity it is advisable for the banks and other
lending institutions to have checklist for due diligence on different type of customers.
Page 10 of 10
Chapter 3: Financial Statements Analysis
Dr. M. Manickaraj
Objectives
The objective of this chapter is to analyze the financial statements using various tools.
Structure
3.1 Why financial statement analysis?
3.2 Tools for financial statement analysis
3.2.1 Common-size statements
3.2.2 Trend analysis
3.2.3 Ratio analysis
3.3 Ratios important for lending decisions
3.4 Conclusion
3.1 Why financial statement analysis?

All business transactions that can be measured in monetary terms are entered in to the
books of accounts. At the end of every year, two statements, namely, profit and loss (P&L)
account and balance sheet are prepared. These statements report the effect of all the
transactions that took place during the accounting year, in a summarised form. The P&L
account reports the profit or loss made by a business firm during the period and the
balance sheet shows the assets and liabilities of the firm as on the last day of the
accounting year.
Accounting practices are governed by globally accepted accounting standards and the
financial statements are presented in a standard format which is more or the less the
same across the entire world. One feature of financial statements is that irrespective of
size and nature of business of a firm, balance sheet and P&L account are presented in one
page each. Therefore, if one can read and analyze the financial statements of a company
one can analyse the financial statements of any firm in the world.
Performance of business firms is influenced by innumerable factors both external and
internal to a firm. External factors may include developments in global and domestic
Page 1 of 26
economies, government policy, political and social conditions, nature, etc. Internal
factors, on the other hand, may include management, human resource, financial
condition, marketing capabilities, technology and so on. The impact of all these factors
will influence business operations and will reflect in the financial statements of the firm.
Moreover, the effect of all actions and inactions of the management and their efficiency
or inefficiency too will be reflected in financial statements. Therefore, financial
statements are an indispensable source of information and hence analysing the same is a
must for managerial decisions, investment decisions and also for lending decisions.
Lenders are generally keen on ascertaining the funding requirements and repayment
capacity of a borrowing firm. Both can be ascertained from the financial statements of the
borrower.
Financial statements include:

· Profit and Loss Account
· Balance sheet
· Cash flow statement
Profit and Loss Account :

It is the Income and Expenses statement, generally, for one accounting year and reflects
the performance of the business entity giving information on the sales, production
expenses, Gross profit, Sales expenses and other costs, Net profit and how the net profit
is appropriated and what is transferred as reserves for future business.
Balance sheet : It is the statement of the Assets and Liabilities of a Business entity on a
particular date, generally the last date of an accounting year. It reflects all the funds
pooled for the Business which may be owned funds, long term loans, current liabilities
and how the same have been used by the business entity viz., Fixed Assets, Investment,
Current assets etc.
A sample balance sheet format is given below:
Liabilities (Sources of fund for the Assets (Uses of fund in the

Business) Business)
I-Owned Fund IV -Fixed Assets
v Capital/Paid up capital v Land
v Reserve & Surplus v Building & Structure
v Share Premium v Plant & Machinery
v Share Application money v Furniture & fixture
v Vehicle
II- Long Term Liabilities v Equipment
v Term Loans v Others Fixed Assets
v Unsecured loans v Capital work in progress
v Other Long term Liabilities
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V -Non-Current Assets
III- Current Liabilities v Investment
v Short Term borrowing-Working v Other non-current assets
capital
v Sundry Creditors VI - Current Assets
v Provisions v Cash & Bank Balance
v Installment of TL v Stock
v Other short term Liabilities v Trade Receivables
v Loans & Advances –short
term
VII-Intangible Assets
v Goodwill
v Patent
v Copyright
v Trade Marks
v Preliminary Expenses not
written off
Contingent Liabilities:- These are shown below the balance sheet and are
called off-balance sheet items.
Liabilities in I & II are Long term in nature and items under III, Current Liabilities are
short term in nature. Current liabilities are obligations that are due within the next
one year from the date of balance sheet.
Similarly in the Assets side, IV are long term in nature. Items in V are not immediately
convertible as cash and VII –Intangible assets are non-physical in nature. However,
preliminary expenses not written off are not assets at all. Any expenses not-written off
will appear on the asset side of the balance sheet and these are fictitious in nature.
Current assets are assets which are expected to be converted to cash within the next
one year.
3.2 Tools for financial statement analysis

There are many tools for analyzing financial statements. Commonly used tools for
financial analysis are:
• Common-size statements
• Trend statements
• Ratio analysis
• Cash flow analysis
In the following sections, financial statements of Bajaj Auto Ltd and TVS Motor Company
Ltd are used to illustrate financial statement analysis. Both companies are market leaders
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in the two wheeler industry in India. The balance sheet of both the companies for the
financial years 2014-15 and 2015-16 are presented in Annexure 1 and the P&L account
of these two companies are presented in Annexure 2.
3.2.1 Common-Size Statements

One simple approach for evaluating the performance of a firm is by comparing the
financials of the firm with that of its peers. Financial statements provide absolute value
of different items which cannot easily be compared with other firms nor with
benchmarks. Besides, absolute values cannot easily be compared across time. Therefore,
all figures shown in profit and loss account and balance sheet may be converted into
percentages.
Common-size profit and loss account presents sales of each year and each company as
100 and all the items of the income statement as percentage to sales and as all the values
in the profit and loss account have a common denominator the statement is referred to
as common-size profit and loss account.
Table 1 is the common size profit and loss account of Bajaj Auto and TVS Motor for the
financial years 2014-15 and 2015-16 (refer Annexure 1 and Annexure 2 for the absolute
values). The table shows the cost structure of a business firm and profit margins. The
figures in the table are comparable across years and also across companies.
Table 1: Common-Size Profit and Loss Accounts of Bajaj Auto Ltd and
TVS Motor Co Ltd
Bajaj Auto Ltd TVS Motor Company Ltd

2015-16 2014-15 2015-16 2014-15
Net sales 100.0% 100.0% 100.0% 100.0%
Raw material cost 66.4% 68.8% 71.4% 72.7%
Employee cost 3.9% 4.0% 5.9% 5.9%
Power and fuel 0.5% 0.5% 0.8% 0.9%
Other Manufacturing Expenses 5.1% 4.9% 5.1% 5.2%
Depreciation 1.1% 1.2% 1.7% 1.5%
Cost of Goods Sold 77.0% 79.4% 84.8% 86.2%
Gross Profit 23.0% 20.6% 15.2% 13.8%
General and Administration
Expenses 0.5% 0.5% 3.8% 3.8%
Selling and Distribution Expenses 2.8% 2.3% 6.4% 5.5%
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Total operating cost 80.3% 82.2% 95.0% 95.5%

Operating Profit (EBIT) 19.7% 17.8% 5.0% 4.5%
Interest 0.0% 0.0% 0.4% 0.3%
Other income/expenses 4.0% 2.7% 0.5% 0.3%
PBT and extraordinary items 23.7% 20.5% 5.0% 4.5%
Exceptional income/expenses 0.0% -1.6% 0.0% 0.0%
Profit Before Tax (PBT) 23.7% 18.9% 5.0% 4.5%
Tax 7.6% 5.9% 1.2% 1.1%
Profit After Tax (PAT) 16.1% 13.0% 3.8% 3.5%
Analysis of Table 1 provides the following inferences:

· The largest cost item for both the companies is raw material. However, Bajaj auto
has incurred raw material cost equivalent to 66.4% of net sales during 2015-16.
Whereas, the raw material cost for TVS Motor was 71.4% of its net sales during
the same year which was significantly higher than that of Bajaj Auto.
· The other major items of cost including employee cost, general and administration
expenses, and selling and distribution expenses too were higher for TVS Motor
resulting in very low operating profit margin (EBIT) of 5.0% compared to 19.7%
for Bajaj Auto.
Due to higher costs TVS Motor’s net profit margin was substantially lower at 3.8%
compared to 16.1% of Bajaj Auto.
Common-size profit and loss account also enables comparison of performance of

companies across time on each and every item of the P&L account. However, the
comparisons are made in reference to net sales only. That is, one can see whether a cost
item has increased or decreased as a percentage of sales. For instance, the raw material
cost of Bajaj Auto has decreased from 68.8% of net sales in 2014-15 to 66.4% in 2015-16.
Similarly, TVS Motor’s raw material cost has declined from 72.7% to 71.4% during the
same period.
Common-size balance sheet is a statement where all the assets and liabilities of a
company are expressed as percentage to total assets of the company. Total assets,
therefore, will always be shown as 100. Table 2 presents the common-size balance sheets
of TVS Motor and Bajaj Auto. It shows the share of various assets and liabilities in total
assets of the two companies. The inferences that emerge from the analysis of the table
are as follows:
· Net worth of Bajaj Auto is very high at 78.4% of its total assets against TVS Motor’s
net worth of 38.1%. It indicates the fact that Bajaj Auto uses mostly equity capital
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whereas TVS Motor relies on substantial amount of outsiders’ money including

trade credit, and borrowings.
· The asset side of the common-size statement shows that Bajaj Auto has a huge
amount of investments (60.7% of total assets) and is using a very limited amount
of fixed assets and current assets. Bajaj Auto has also substantial cash and bank
balance (5.5% of total assets) compared to TVS Motor’s cash and bank balance of
0.7%.
· Notably, TVS Motor’s inventory and receivables are very high indicating a
substantial amount of capital is locked up in those current assets. Probably
because of lower level of assets Bajaj Auto does not need loans and its profitability
is very high.
Table 2: Common Size Balance Sheets of Bajaj Auto Ltd and
TVS Motor Company Ltd

Mar-16 Mar-15 Mar-16 Mar-15
Share capital 1.8% 1.9% 1.0% 1.0%
Reserves 76.6% 66.8% 38.1% 34.7%
Net Worth 78.4% 68.7% 39.0% 35.7%
Long-term borrowings 1.0% 0.7% 12.9% 12.3%
Deferred tax liability 0.2% 0.4% 3.5% 3.3%
Other long-term liabilities 1.2% 0.9% 0.0% 0.0%
Current Liabilities and Provisions: 19.1% 29.3% 44.6% 48.7%
Short-term borrowings 0.0% 0.0% 5.3% 8.7%
Trade creditors 12.9% 11.3% 31.1% 32.1%
Other current liabilities 3.9% 5.2% 6.2% 4.7%
Provisions 2.4% 12.8% 2.0% 3.2%
Total 100.0% 100.0% 100.0% 100.0%
Net Fixed Assets 12.9% 12.3% 32.1% 28.9%

Capital work-in progress 0.3% 1.6% 0.6% 1.9%
Investments 60.7% 58.8% 23.9% 22.0%
Other non-current assets 0.6% 0.4% 0.0% 0.0%
Current assets & Loans and
advances: 25.4% 26.8% 43.4% 47.2%
Inventory 4.6% 5.2% 16.6% 17.8%
Page 6 of 26
- Raw material 2.8% 2.9% 12.7% 12.2%

- Work-in-process 0.3% 0.2% 1.3% 1.1%
- Finished goods 1.5% 2.1% 2.6% 5.1%
Receivables 4.6% 4.6% 11.7% 10.9%
Cash and bank balance 5.5% 3.8% 0.7% 0.1%
Loans and advances 4.6% 3.5% 6.4% 12.2%
Other current assets 6.2% 9.7% 8.0% 6.2%
Total assets 100.0% 100.0% 100.0% 100.0%
3.2.2 Trend Analysis

Trend statement is another tool for analysing financial statements. Trend statements
show the trend in all the items by indexing the values to the values of a base year. This is
done by treating all the items of the base year as 100 and the values of the items in the
following years as percentage to the base year value of the respective items. Normally,
the oldest period is taken as the base year. In the illustration in Table 3 (showing items
of income, expenses and profits of both Bajaj Auto and TVS Motor) only two years data
have been used and the year 2014-15 is the base year and all the items are indexed to the
values of the respective items in the year 2014-15. For example, net sales of both the
companies in 2014-15 is shown as 100% and the 2015-16 sales is expressed as
percentage of 2014-15 sales.
Table 3: Trend Profit and Loss Account of Bajaj Auto Ltd and
TVS Motor Company Ltd

2015-16 2014-15 2015-16 2014-15
Net sales 105.0% 100.0% 112.0% 100.0%
Raw material cost 101.3% 100.0% 110.0% 100.0%
Employee cost 102.3% 100.0% 112.1% 100.0%
Power and fuel 105.2% 100.0% 96.7% 100.0%
Other Manufacturing Expenses 109.3% 100.0% 108.5% 100.0%
Depreciation 98.2% 100.0% 123.8% 100.0%
Cost of Goods Sold 101.8% 100.0% 110.1% 100.0%
Gross Profit 117.0% 100.0% 123.4% 100.0%
General and Administration Expenses 109.5% 100.0% 113.7% 100.0%
Selling and Distribution Expenses 123.9% 100.0% 129.6% 100.0%
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Total operating cost 102.5% 100.0% 111.4% 100.0%

EBIT 116.3% 100.0% 123.7% 100.0%
Interest 7.4% 100.0% 164.2% 100.0%
Other income/expenses 155.6% 100.0% 165.3% 100.0%
PBT and extraordinary items 121.7% 100.0% 124.1% 100.0%
Exceptional income/expenses 0.0% 100.0% --- ---
PBT 131.8% 100.0% 124.1% 100.0%
Tax 136.3% 100.0% 123.5% 100.0%
PAT 129.8% 100.0% 124.2% 100.0%
If such a statement is prepared for many years the trend in incomes and expenses will be
clearer. The table provides the following information:
· Bajaj Auto’s sales in 2015-16 was 105.0% of 2014-15 sales indicating 5% growth
in sales (105 - 100) during the year 2015-16. TVS Motor’s sales have grown by 12
percent during the same year.
· Raw material cost of TVS Motor has increased by 10 percent only compared to 1.3
percent for Bajaj Auto during 2015-16.
· Cost of power and fuel of Bajaj Auto has declined by 3.3% and that of TVS Motor
has increased by 5.2%
· Other manufacturing expenses of Bajaj Auto has grown at a higher rate of 9.3%
compared to TVS Motor’s 8.5%
· General and administration expenses and also selling and distribution expenses of
TVS Motor have grown at a higher rate than that of Bajaj Auto.
Interest expense of TVS has grown at a very high rate of 64.2%. Whereas, Bajaj Auto’s
interest expense declined sharply by 92.6%.
Balance sheet shows many non-recurring items like capital, long term borrowings, fixed
assets, investments and the like. Therefore, analysing the trend in balance sheet items
would not provide any meaningful information.
Common-size statements and trend statements enable comparison of financial
performance of business firms and they are also highly useful for preparing projected
financial statements.
3.2.3 Ratio Analysis
Ratio is a fraction and the result of one number or quantity divided by another number
or quantity respectively. Financial ratios are the simplest mathematical tools that reveal
relationships hidden in mass of data, and allow making meaningful comparisons.
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Financial ratios are the most widely used tool for financial statements analysis. Various
ratios under the following headings are discussed in this chapter:
· Profitability ratios
· Turnover/Efficiency ratios
· Leverage/Solvency ratios
· Liquidity ratios
· Holding periods
· Operating cycle
· Equity ratios
Ratios are expressed in several ways. Some ratios are expressed as numbers, some in
number of days and some as percentages. Profitability ratios are expressed in percentage,
turnover ratios, liquidity ratios and few equity ratios are expressed in numbers. Leverage
ratios are expressed in proportion, and holding periods like inventory period, receivables
period, operating cycle and the like are expressed in number of days or in months.
Profitability Ratios
Profitability of a firm can be analysed from two points of view – (1) profit per every rupee
of income; and (2) return on investment. The former set of ratios including gross profit
margin, cash profit margin, operating profit margin and net profit margin are referred to
as profit margin ratios. The latter including return on total assets, return on capital
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employed and return on equity are ratios which show the profit earned on investment.
The later three ratios show the profitability from three different points of view. Return
on total assets is the profit on total investment made in the firm (including owners’ funds
and outsiders’ funds), return on capital employed is the profitability on total long-term
capital employed and return on equity is the profit made on equity investment.
The profitability ratios are classified under the three heads, namely, profit margins,
return on investment and coverage ratios.
Profit margin ratios:
Gross Profit
Gross Profit Margin = ´ 100 ........................ (1)
Net Sales
EBITDA
Cash Profit Margin = ´ 100 ........................ (2)
Net Sales
EBIT
Operating Profit Margin = ´ 100 ...................... (3)
Net Sales
Profit After Tax
Net Profit Margin = ´ 100........................ (4)
Net Sales
Return on Investment Ratios:
EBIT
Return on Assets = ´ 100 .......... .......... ... (5)
Average Total Assets
EBIT
Return on Capital Employed = ´ 100 .......... ...... (6)
Average Long Term Capital Employed
Profit After Tax
Return on Equity = ´ 100 .......... .......... ... (7)
Average Tangible Net Worth
Profitability ratios are expressed in percentage and the results for the two companies,
TVS Motor and Bajaj Auto, for the year 2015-16 are shown in Table 4. The results show
that Bajaj Auto’s performance is much better than TVS Motor on all the parameters.
Return on equity (ROE) of Bajaj Auto, for instance is 31.80 percent compared to TVS
Motor’s24.10 percent.
Page 10 of 26
Table 4: Profitability Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Margin Ratios:
Gross Profit Margin 23.0% 15.2%
Cash Profit Margin 20.9% 6.7%
Operating Profit Margin 19.7% 5.0%
Net Profit Margin 16.1% 1.1%
Return on Investment Ratios:
ROA 28.6% 11.7%
ROE 31.8% 24.1%
ROE(NNOI)# 23.8% 21.2%
#: ROE (NNOI) = ROE, net of non-operating items
It may be noted that ROE is calculated based on the profit after tax which includes non-
operating incomes and gains as well as non-operating expenses and losses. Such non-
operating items like gain or loss on sale of assets and investments cannot be expected to
happen every year. Other income/expenses and exceptional income/expenses are the
two non-operating items in the profit and loss account of the two companies (Annexure
2). Therefore, such items shall be ignored while calculating ROE. The ROE excluding non-
operating items also has been calculated for both the companies and the same too have
been presented in Table 4. The table shows that the ROE adjusted for non-operating
items is lower than unadjusted ROE for both TVS Motor and Bajaj Auto.
Turnover Ratios
Turnover ratios measure how efficiently the assets have been turned over into sales.
Some of the turnover ratios used for analysis are total assets turnover ratio, fixed assets
turnover ratio and current assets turnover ratio. In all the three ratios net revenue from
operations (net sales) is the numerator. Every business firm uses various types of assets
to produce goods or services and then to sell them to customers. However, business firms
can differ in their efficiency in utilising their assets to generate income (i.e. sales). Higher
the turnover ratio, higher is the efficiency of the firm. Formulae for the three different
turnover ratios are:
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Net Sales
Total Assets Turnover = .......................... (9)
Average Total Assets
Net Sales
Fixed Assets Turnover = .........................(10)
Average Fixed Assets
Net Sales
Current Assets Turnover = ..............(11)
Average Total Current Assets
Turnover ratios of TVS Motor and Bajaj Auto for the year 2015-16 are shown in Table 5.
Total assets turnover ratio of TVS Motor is 2.4 which is greater than Bajaj Auto’s ratio of
1.5. One has to note here that total assets of a firm include all assets used in its operations
and also investments made outside the business. Bajaj Auto has substantial investment
(Rs. 9512.66 crore) as can be seen in Annexure 1.Investments made in subsidiaries and
marketable securities do not contribute to sales and therefore, total assets turnover ratio
may not be comparable. Fixed assets turnover ratio, hence, is a better indicator of
efficiency and is comparable across firms. However, two other factors which would make
the turnover ratios (both total assets turnover and fixed assets turnover) not comparable
is the level of outsourcing and vertical integration. If one firm produces most of its
requirements in-house and another procures mostly from outside, the ratios of the two
firms cannot be compared.
Table 5 shows that Bajaj Auto is more efficient than TVS Motor in terms of both fixed
assets turnover and current assets turnover.
Table 5: Turnover Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Total Assets Turnover 1.5 2.4
Fixed Assets Turnover 11.5 7.7
Current Assets Turnover 5.6 5.2
Profit Margins Vs Return on Investment: Business managers and investors would be

particularly interested in return on investment. They would be eager to know how much
return has been made out of the investment made in the business. Moreover, return on
investment ratios are inclusive of profit margins. For instance, return on assets ratio
(equation 5) can be rewritten as follows:
EBIT Net Sales
Return on Assets = ´ ´ 100 ........................... (8)
Net Sales Average Total Assets
The above equation captures operating profit margin as well as the efficiency with which
the assets have been utilised. Therefore, return on investment ratios are more
informative and important than profit margins.
Page 12 of 26
Leverage Ratios
Two most widely used leverage ratios are Debt-to-Equity ratio and Total Outside
Liabilities to-Equity ratio (TOL/TNW)1. Both the ratios take tangible net worth (TNW) in
the denominator. The difference between the two ratios is the numerator. While the
former takes long-term debt in the numerator the later uses total outside liabilities in the
numerator. Both the ratios show the relationship between owners’ funds and outsider’s
funds. Higher the ratio higher the leverage indicating greater dependence on outsiders’
funds. Therefore, in times of distress the creditors will not be able to recover their dues
fully from the sale of the firm’s assets. Besides, the interest on borrowings is a fixed cost
and is payable irrespective of the amount of profit earned. Therefore, during years when
a business firm has made very low profit or loss it will not be able to service debt. Use of
borrowings thus increases the risk of business firms. The risk arising due to use of debt
funds is called the financial risk. If owner’s funds are large the risk will be less. Between
the two ratios TOL/TNW is more important because it takes all the liabilities of a firm
into account.
................................ (12)
Long Term Borrowings
Debt to Equity Ratio =
TNW
(Long Term Debt + Short Term Debt)
Total Debt to Equity Ratio = ..................................(13)
TNW
TOL
Total Outside Liabilitie s to Equity Ratio = ................................ (14)
TNW
The results of the three ratios of our sample companies are given in Table 6. The ratios
show clearly that TVS Motor is using more long-term debt/outsiders’ funds than Bajaj
Auto. Nevertheless, the leverage in both the companies is very less and hence their
solvency position is good.
Table 6: Leverage Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Debt to Equity 0.0 0.3
Total Debt to Equity 0.01 0.47
TOL/TNW 0.3 1.6
Coverage Ratios: Lending institutions are particularly interested in knowing whether a

borrower will be able to service the loan given to them or not and hence Interest Cover
Ratio and Debt Service Cover Ratio (DSCR) are the two ratios they are especially
interested in. The former ratio measures the ability of the borrower in paying interest
1
TOL is nothing but total assets minus net worth.
Page 13 of 26
from out of his operating profit. The later ratio indicates the borrower’s ability to pay
interest and loan instalments from out of his operating profit.
Three different methods are given hereunder for finding out interest cover and three
methods are given for DSCR. According to the author, equations 15 and 18 are the
prudent ones for determining interest coverage and DSCR respectively. Accordingly the
ratios given in Table 7 have been calculated.
EBIT - Tax
Interest Cover = .......... .......... .......... ......... (15 )
Interest
( or )
EBITDA - Tax
Interest Cover = .......... .......... .......... .........( 16 )
Interest
(or )
PAT + Depreciati on + Interest

Interest Cover = .......... .......... .(17 )
Interest
EBITDA- Tax
DSCR= ..................(18)
Interest+ CurrentPortionof LongTermDebt
(Or)
EBITDA- Tax- Intereston WorkingCapitalCredit

DSCR= ................(19)
Intereston TermLoans+ CurrentPortionof LongTermDebt
(Or)
PAT+ Depreciati
on + Intereston TermLoans
DSCR= ................(20)
Intereston TermLoans+ CurrentPortionof LongTermDebt
The interest cover ratio of TVS Motor and Bajaj Auto are given in Table 7. The
interpretations of the results in the table are as follows:
· The ratio of Bajaj Auto is very high at 5707.5 because of very small amount of
borrowings used by the company and hence the interest burden. Besides, the
company’s profitability is very high compared to TVS Motor.
· Interest cover ratio of TVS Motor, on the other hand, is 8.90.
· Though the ratio for TVS Motor is very low compared to Bajaj Auto the ability of
the company to service its loans is more than adequate.
· Similarly, DSCR of Bajaj Auto is very high at 6247.8 compared to TVS Motor’s 3.20.
Page 14 of 26
· It may be noted that though the coverage ratios of TVS Motor is substantially lower
than that of Bajaj Auto it can comfortably service its loans. For instance, the DSCR
of TVS Motor reveals the fact that the company’s profit is 3.2 times the amount of
interest and principal of loan repayable during the year.
Table 7: Coverage Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Interest Coverage 5707.5 8.9
DSCR 6247.8 3.2
Liquidity Ratios
Another aspect different stakeholders in a business would be interested in is liquidity.
Three commonly used liquidity ratios are current ratio, quick ratio, and cash ratio2. The
ratios measure the ability of a firm to meet its current obligations (current liabilities)
from its current assets. While current ratio relates current assets to current liabilities the
quick ratio relates quick assets (current assets excluding inventory) to current liabilities.
Current assets are those which can be converted into cash within a period of one year and
current liabilities are obligations to be settled within one year. Amongst the various
current assets inventory cannot easily be converted into cash during times of distress and
hence it is not considered as a quick asset. To elaborate, if a business firm faces severe
crisis and could not run its business its ability to sell its inventory will be difficult. If at all
it can sell, it can do so at a substantially low price. On the other hand, sundry debtors,
another major current asset for any business firm, can be realised into cash quite easily
because the customers who have bought goods have to necessarily pay for it.
Current Assets
Current Ratio = .......... .......... ....... (21)
Current Liabilitie s
Current Assets - Inventory
Quick Ratio = .......... ........(2 2)
Cash and Bank Balance
Cash Ratio = .......... .......... ......(23)
Current ratio of TVS Motor is 0.97 (Table 8) compared to Bajaj Auto’s ratio of 1.33. The
ratio indicates clearly that Bajaj Auto has higher liquidity Than TVS Motor. The cash ratio
of Bajaj Auto (0.29) too is significantly greater than TVS Motor’s (0.01). All the three ratios
thus show that the liquidity position of Bajaj Auto is significantly higher than TVS Motor.
2
Current assets and current liabilities used for these ratios are current assets and loans and advances and
current liabilities and provisions respectively.
Page 15 of 26
Liquidity ratios should be interpreted from two different points of views. One is liquidity
and another important aspect is efficiency. Universally, business firms are working hard
to improve their working capital management such that they can run the business with
minimum amount of current assets. Just-in-time (JIT) is one approach to achieve this.
These two companies could probably be using all possible techniques including JIT to
minimise the level of their current assets.
Current ratio is also believed to show the proportion of current assets being funded by
equity capital. It is referred to as margin for working capital by banks and other lending
institutions. This is a wrong notion. Current ratio shows how much of the current assets
is funded by long term sources of finance and not by equity capital alone.
Note: It may be noted that the original balance sheets of both the companies have
reported the figures as per the revised format given in Schedule VI of Companies Act.
Under the revised format current investments will be shown under current assets.
Whereas, under the old format investments were being reported separately and as a
single item. Similarly, current maturities of long-term loans are shown under current
liabilities under the new format which was not the case earlier. Current ratio and quick
ratio of TVS Motor and Bajaj Auto have been calculated excluding investments from
current assets and current maturities of long-term loans from current liabilities.
Moreover, total provisions including noncurrent and current, total trade creditors
including noncurrent and current have been treated as current liabilities and total loans
and advances including noncurrent and current have been treated as current assets.
Table 8: Liquidity Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

Current Ratio 1.33 0.97
Quick Ratio 1.09 0.60
Cash Ratio 0.29 0.01
Holding Periods
Another set of financial ratios one would be interested in is the holding period of current
assets and current liabilities. The holding periods which are important especially for the
lending institutions are inventory period, receivables period and payables period
(creditors period).
Inventory period is the time taken by a company to sell the finished goods from the date
of purchase of raw material. It can be broken down into (1) raw material holding period;
(2) work-in-process holding period and (3) finished goods holding period. Raw material
Page 16 of 26
holding period shows the material in stock is equivalent to how many days consumption.
Work-in-process inventory period is the time taken by a company to convert raw material
into finished goods and the finished goods inventory period is the time taken to sell the
finished goods from the date of completion of production.
Receivable period is the credit period offered by the company to its customers. It may
also be referred to as the collection period or the time taken for collecting money from
customers. Creditors period, on the other hand, is the time taken by the company to pay
the suppliers. Creditor period is also referred to as payable period.
The length of these holding periods will vary due to nature of business and efficiency of
working capital management. For instance, a firm manufacturing heavy machinery will
have a longer manufacturing cycle and hence the work-in-process inventory period. For
a food processing unit, on the other hand, the manufacturing cycle will be very short and
hence the work-in-process inventory holding period too will be short. Receivables
holding period would depend on the bargaining power of a company with its customers
and creditors period on the other hand would depend on the company’s bargaining
power with its suppliers. Therefore, while financing working capital the acceptable level
of inventory and receivables should be determined based on nature of business amongst
others.
The equations for calculating various holding periods are as follows:
Average Inventory
Inventory Period = ......................................... (24)
Cost of Goods Sold/365
Average Inventory of Raw Material

RawMaterial Inventory Period = .......................(25)
Raw Material Cost/365
Average Inventory of W.I.P
Work - in - Process Inventory Period =
(Raw Material Cost + 50% of other Manufactur ing Expenses)/365
.......................... (26)
Average Inventory of Finished Goods
Finished Goods Inventory Period = .....................(27)
Cost of Goods Sold/365
Average Receivables
Receivables Period = ..................................................................(28)
Sales/365
Average Trade Creditors

Creditors Period = ............................................................(29)
Raw Materials Cost/365
The holding periods for TVS Motor and Bajaj Auto for the year 2015-16 are presented in
Table 9. The table provides the following facts:
· The holding periods of Bajaj Auto is significantly shorter than TVS Motor’s.
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· Inventory period of Bajaj Auto is just 16 days compared to TVS Motor’s inventory
period of 31 days.
· Similarly, the receivable period of TVS Motor too is longer than that of Bajaj Auto.
· TVS Motor’s creditor period is 69 days compared to Bajaj Auto’s 46 days revealing
the fact that TVS Motor takes substantially longer time to pay its suppliers.
It may be noted that longer current assets holding periods will lead to higher capital
requirement. If only TVS Motor can reduce its inventory holding period and receivables
period it will result in substantial release of capital locked up in these two items. This
will definitely help in minimising the interest cost, insurance cost, storage cost, and the
like and will help improve its profits.
Table 9: Holding Periods of Bajaj Auto Ltd and TVS Motor Company Ltd

Inventory Period (A) 16 31
- Raw material holding 11 27
- WIP holding 1 2
- Finished goods holding 6 7
Receivables Period (B) 12 18
Creditors Period ( C) 46 69
Operating Cycle
Holding periods that make up the operating cycle and cash cycle are mainly the ones
indicating the holding periods of different current assets and current liabilities. Holding
periods for the purpose of finding out the length of operating cycle can be calculated by
using sales as the common denominator as in equations 30, 31, and 32. Operating cycle
of a typical business firm will start with the purchase of raw material and end with
collection of cash from its customers. To elaborate, the operating cycle will start with
purchase of raw material, conversion of raw material into finished goods, sale of finished
goods and finally collecting cash from customers. The time period between purchase of
raw material and sale of finished goods is nothing but the inventory period and the time
period between sale of finished goods and collection of cash is the receivable period.
Operating cycle, therefore, is the sum of inventory period and receivable period.
Page 18 of 26
Average Inventory
Inventory Period = ............................................ (30)
Net Sales/365
............................................ (31)
Average Receivable
Receivable Period =
Net Sales/365
............................................ (32)
Average Trade Creditors
Creditors Period =
Net Sales/365
Operating Cycle = Inventory Period + Receivable Period ............................................ (33)
Net Operating Cycle = Operating Cycle - Creditors Period ............................................ (34)
Longer operating cycle may be due to inefficiency in operations and hence every firm
would strive for reducing the length of operating cycle. A part of the operating cycle is
financed by suppliers of raw material and other services and the remaining part of the
operating cycle can be called as the net operating cycle or as cash cycle. It may also be
referred to as cash-to-cash cycle.
The results shown in Table 10 show that Bajaj Auto’s operating cycle is of 24 days and
TVS Motor’s operating cycle is 44 days. However, both the companies are availing credit
from their suppliers for a period longer than their operating cycle and hence they do not
need working capital. The net operating cycle of the two companies hence are negative.
Table 10: Operating Cycle of Bajaj Auto Ltd and TVS Motor Company Ltd

Inventory Period (A) 12 27
- Raw material holding 7 19
- WIP holding 1 2
- Finished goods holding 5 6
Receivables Period (B) 12 18
Creditors Period ( C) 30 49
Operating Cycle (D = A+B) 24 44
Net Operating Cycle (D - C) -7 -5
Equity Ratios
In addition to the ratios discussed in the previous sections various stake holders are also
interested in calculating and analysing equity ratios. The key equity ratios which are
commonly used are as follows:
Earnings per share (EPS) = Profit after tax / Number of shares outstanding…………..
(32)
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Dividend per share (DPS) = Total dividends paid in a year / Number of shares
outstanding…(33)
Pay-out ratio = DPS / EPS
……………………………………………………………………………. (34)
Retention ratio = 1 – Pay-out ratio
………………………………………………………………. (35)
Book value per share = Tangible net worth / Number of shares outstanding
.………….. (36)
PE Ratio = Current Market Price of Equity Shares/ EPS
…………………………………….. (37)
PB Ratio = Current Market Price of Equity Shares / Book value per share
……………. (38)
Caution is required while interpreting ratios which are expressed as value per share. EPS,
DPS and book value per share should not be compared with other companies. In fact,
these three are not ratios. Rather, they are absolute values per share. Moreover, they are
not only influenced by the performance of the companies but also by face value of shares,
bonus issues, and stock splits. Supposing, if a company goes for splitting its shares from
say Rs. 10 per share to Rs.5 per share it will result in a sudden fall in the values of these
ratios by 50 percent because the number of shares will become double but the amount of
capital will remain the same. Bonus issue will also have the same effect. Moreover, the
book value of shares will also be influenced by the age of a firm. Longer the existence of
a company larger could be the amount of reserves and surpluses and hence the book
value. Contrarily, for a new company the book value will be less though the performance
of the company in terms of profitability and other parameters might be comparable.
The equity ratios of TVS Motor and Bajaj Auto have been calculated and the results are
presented in Table 11. EPS, DPS and book value of Bajaj Auto is much larger than TVS
Motor. This is due to better performance of Bajaj Auto and also might be due to the above
mentioned factors.
Pay out and retention of profit are determined by factors like growth potential and
requirement of capital for tapping the potential. If a firm has great potential to grow then
the need for ploughing back the profits will be very high. Such companies and those
companies in emerging sectors will pay out very less of their profits as dividends to their
shareholders. Therefore, the pay-out ratio of such companies will be very less and
retention rate will be very high. These two ratios will also be decided by the dividend
policies of the companies. Table 11 shows that TVS Motor has paid out 27 percent of its
profits earned during 2015-16 as dividends and balance is retained. Bajaj Auto, on the
other hand, has paid out 44 percent of profits as dividends and only 56 percent is
retained.
Page 20 of 26
PE and PB ratios are comparable and are very widely used by the investors for valuation
and other purposes. Normally, companies whose earnings grow at very high rates will
have very high PE ratio and high PB ratio. The results shown in Table 11reveal that equity
shares of Bajaj Auto are trading at 21.1 times its earnings and 6.3 times its book value.
Whereas, TVS Motor’s shares are trading at 31.6 times its earnings and 7.1 times its book
value. The shares of TVS Motor thus are trading at a higher level. This could be because
the investors expect the performance of the company to be better in the future.
Table 11: Equity Ratios of Bajaj Auto Ltd and TVS Motor Company Ltd

EPS 126.22 9.10
DPS 55.00 2.50
Book value per share 424.77 40.77
Pay-out ratio 44% 27%
Retention ratio 56% 73%
P/B 6.3 7.1
P/E 21.1 31.6
3.3 Ratios Important for Lending Decisions

Though many ratios have been discussed in this chapter and many more ratios can be
calculated for analysis of financial statements the following ratios are highly relevant for
making lending decisions.
For Working Capital Loan Decisions For Term Loan Decisions

· Interest coverage ratio · DSCR
· Holding periods and operating cycle · Debt/Equity Ratio
· TOL/TNW · TOL/TNW
3.4 Conclusion
Financial statement analysis is critically important for various managerial, investment
and lending decisions. While different tools help in making various decisions common-
size statements and trend statements will be more relevant while preparing projected
financial statements. Ratios are useful for variety of purposes including for projecting
Business firms though may be in the same line of business they may differ in their level
of forward and backward integration, etc. Besides, business firms are able to reduce the
level of assets while maintaining their level of activities and hence the standards for
various financial parameters are becoming irrelevant. For instance, adopting techniques
like JIT level of inventory can be reduced to bare minimum. Similarly, by arranging
Page 21 of 26
finance for customers receivables period can be reduced. Therefore, one should be very
cautious in interpreting the ratios especially when comparing ratios of one firm with
another.
Annexure 1
Balance Sheet of Bajaj Auto Ltd and TVS Motor Company Limited
Mar-16 Mar-15 Mar-16 Mar-15
Share capital (A) 289.37 289.37 47.51 47.51
Reserves (B) 12002.29 10402.78 1889.29 1597.85
Net Worth (C = A+B) 12291.66 10692.15 1936.80 1645.36
Long-term borrowings (D)@ 162.48 112.35 638.10 564.38
Other long-term liabilities (E ) 29.78 57.59 175.67 152.75
Deferred tax liability (F) 188.25 141.58 0.00 0.00
Current Liabilities and Provisions:
(G = H+I+J+K) 3000.59 4558.65 2212.00 2242.16
Short-term borrowings (H) 0.00 0.25 264.23 399.76
Trade creditors (I) 2027.04 1760.53 1543.71 1478.50
Other current liabilities (J) 604.53 805.86 305.60 215.14
Provisions (K) 369.02 1992.01 98.46 148.76
Total Capital and Liabilities
(C+D+E+F+G) 15672.76 15562.32 4962.57 4604.65
Net Fixed Assets (L) 2025.67 1917.24 1592.85 1329.63
Capital work-in progress (M) 52.24 254.94 30.96 89.36
Investments (N) 9512.66 9153.32 1184.57 1012.46
Other non-current assets (O) 94.28 67.23 0.00 0.00
Current Assets & Loans and
Advances: (P) 3987.91 4169.59 2154.19 2173.20
Inventory (Q = R+S+T) 719.07 814.15 825.97 819.68
- Raw material (R ) 433.90 456.28 631.62 563.95
- Work-in-process (S) 42.61 28.65 63.55 48.71
- Finished goods (T) 242.56 329.22 130.80 234.02
Receivables (U) 717.93 716.96 578.69 503.86
Cash and bank balance (V) 859.52 586.15 32.84 5.39
Loans and advances (W) 722.56 543.67 318.75 561.07
Other current assets (X) 968.83 1508.66 397.94 283.20
Total Assets (L+M+N+O+P) 15672.76 15562.32 4962.57 4604.65
Page 22 of 26
@: includes Current Portion of Long

Term Debt 0.00 0.58 143.87 45.40
Stock Price on July 27, 2016 2668.75 287.8
Face Value 10 1
Number of shares 28.937 47.51
Annexure 2
Profit and Loss Account of Bajaj Auto Ltd and TVS Motor Company Limited

2015-16 2014-15 2015-16 2014-15
Net sales (A) 22687.59 21612.01 11243.87 10042.33
Raw material cost (B) 15060.08 14861.31 8025.48 7297.13
Employee cost (C ) 884.74 865.24 664.23 592.42
Power and fuel (D) 120.66 114.70 88.29 91.29
Other Manufacturing Expenses (E ) 1150.84 1053.10 570.56 525.73
Depreciation (F) 259.30 264.17 189.84 153.33
Cost of Goods Sold
(G = B+C+D+E+F) 17475.62 17158.52 9538.40 8659.90
Gross Profit (H = A - G) 5211.97 4453.49 1705.47 1382.43
Expenses (I) 112.70 102.91 428.89 377.08
Selling and Distribution Expenses
(J) 626.88 505.93 715.68 552.06
Total operating cost (K = G+H+I) 18215.20 17767.36 10682.97 9589.04
Operating Profit (EBIT) (L = A-K) 4472.39 3844.65 560.90 453.29
Interest (M) 0.48 6.49 47.94 29.20
Other income/expenses (N) 913.27 586.92 53.01 32.07
PBT and extraordinary items
(O = L-M+N) 5385.18 4425.08 565.97 456.16
Exceptional income/expenses (P) 0.00 -340.29 0.00 0.00
Profit Before Tax (PBT) (Q = O +P) 5385.18 4084.79 565.97 456.16
Tax (R ) 1732.77 1271.05 133.83 108.33
Profit After Tax (PAT) (S = Q-R) 3652.41 2813.74 432.14 347.83
Dividend 1591.54 1446.85 118.78 90.27
EBITDA (L + F) 4731.69 4108.82 750.74 606.62
Page 23 of 26
Case Exercise
Given below are the balance sheet and profit and loss account of Venus Ltd and do the
following based on the same. Calculate the ratios of the company and fill-in the blank cells
in Table 1
Balance Sheet of Venus Ltd (All figures are in INR Crore)
2015-16 2014-15
Share capital 296.5 296.5
Reserves 43612.06 33761.37
Net Worth 43908.6 34057.9
Long-term borrowings 26172.91 24530.07
Other long-term liabilities 1197.53 202.59
Current Liabilities and Provisions: 24700.2 19743.9
Short-term borrowings 16275.44 13128.72
Trade creditors 3421.19 2878.81
Other current liabilities 4915.08 2754.75
Provisions 88.52 981.59
Total Capital and Liabilities 95979.2 78534.4
Net Fixed Assets 30679.05 22125.86
Capital work-in progress 13567.15 17422.16
Investments 32461.19 26464.57
Other non-current assets 182.24 5.37
Current assets & Loans and advances: 19089.6 12516.4
Inventory 5026.14 5442.07
Receivables 1429.12 1157.69
Cash and bank balance 642.56 464.14
Loans and advances 11119.98 4500.52
Other current assets 871.8 952.02
Total assets 95979.2 78534.4
Current Portion of Long Term Debt 2856.49 2759.44

Stock Price on Nov 11, 2016 229.6
Face Value 1
Page 24 of 26
Profit and Loss Statement of Venus Ltd (All figures are in INR Crore)
2015-16 2014-15
Net sales 29810.62 32502.41
Raw material cost 18339.8 20105.77
Employee cost 603.53 650.13
Power and fuel 4541.65 4534.41
Other Manufacturing Expenses 1235.56 1099.99
Depreciation 1217.97 1011.67
911.23 925
Expenses
Selling and Distribution Expenses 268.02 236.04
Miscellaneous Expenses 5.01 322.43
Total operating cost 27122.77 28885.44
EBIT 2687.85 3616.97
Interest 3541.36 3655.93
PBT and extraordinary items -853.51 -38.96
Other income/expenses 8823.82 2008.86
Exceptional income/expenses -2490.41 -2.43
PBT 5479.9 1967.47
Tax 8.02 40.27
PAT 5471.88 1927.2
Dividend 1037.75 1215.65
Page 25 of 26
Table 1: Ratios of Venus Limited

Cash Profit Margin
Operating Profit Margin
Net Profit Margin
ROA
ROE
Total assets turnover
Fixed Assets Turnover
Current Assets Turnover
Current Ratio
Debt-Equity
TOL/TNW
Interest Cover
Inventory Period
Receivables Period
Creditors Period
Operating Cycle
Net Operating Cycle
Book value per share
P/B
P/E
Page 26 of 26
Chapter 4: Cash Flow Statement Analysis
Dr.Dipali Krishnakumar
Objectives
 Understand the significance of cash flow statements

 Differentiate between cash from operating, investing and financing activities;
 Prepare cash flow statements
 Analyse cash flow statements and related ratios
Structure
1.0 Introduction
1.1 Cash from operating activities
1.2 Cash from investing activities
1.3 Cash from financing activities
2.0 Preparing cash flow statements
2.1 Cash flow statement
2.1.1 Cash flow from operating activities
2.1.1.1 Direct method
2.1.1.2 Indirect method
2.1.2 Cash flow from investing activities
2.1.3 Cash flow from financing activities
2.1.4 Regulatory Requirements
2.1.5 Practice Solved Problems
3.0 Analysis of Cash Flow Statements
1.0 Introduction
If an analyst would like answers to questions such as:
 How much cash did the business generate?
 Does the business have the ability to repay loans?
 How much cash has been paid out as dividend to shareholders?
 How did the business finance its investments, is it from internal operations or did
it need to borrow external funds?
Page 1 of 26
 How is the company managing its accounts receivable and payables?

 How much loans did the business take?
 What amount of additional financing did the business obtain from shareholders?
The answers would be available /presented in a statement called the cash flow statement.
The cash flow statement provides reconciliation of how cash balance at the beginning of
the year changed due to different activities – operating activities, investment activities
and financing activities to arrive at the cash balance at the end of the year. The term cash
for the purpose of this statement includes cash, bank balances and short term highly
liquid instruments that are typically classified under cash and cash equivalents.
Profit and loss account and balance sheet are prepared under accrual method. Therefore,
actual cash available can be different from profit shown in P&L account. It should be
noted that a poor or declining profitability need not result in weak cash flow. Similarly,
increasing sales and profitability need not result in strong cash flow and liquidity.
Therefore, there is a need to know the sources and uses of cash as also the liquidity
position and health of a firm.
Let us use an example of a small grocery store business that we assume has been
incorporated as a company to understand the three categories of cash flows.
1.1 Cash from operating activities

The routine business of the grocery store involves the following activities:
Paying wholesalers/suppliers for grocery stock; paying for utilities such as electricity,
telephone bills; paying salary to staff; paying bank charges; paying taxes; receiving money
from customers etc.
All these are the routine operating activities of the business. Cash inflows and outflows
associated with these day to day operations would be classified as cash from operating
activities.
1.2 Cash from investing activities

At the time of setting up or expanding the grocery store the company incurs expenses for
buying new equipment such as check-out counters, racks, refrigerators, vehicles etc.
It may also decide to buy out an existing business. It may sell old equipment if outdated
or surplus. In case excess funds are available it may invest in equity or debt of other firms
which may or may not be related to its core operations. All these inflows and outflows
which are in the nature or investments are categorized as cash flow from investing
activities.
Page 2 of 26
1.3 Cash from financing activities

The company needs to raise funds for its business through multiple sources such as bank
loans, issue of equity shares or debt. It would also return money to shareholders through
dividends or buy back of shares; and to lenders through repayment of loan and interest.
All these activities which are in the nature of financing the business are categorized as
cash flows from financing activities.
2.0 Preparing Cash Flow Statements

Let us prepare a cash flow statement for the grocery business. The cash flow statements
have been computed for two scenarios. The first scenario is for a business which has all
cash transactions. The second is for one that has both credit and cash transactions.
Scenario 1 – All cash business and no stock remaining at the year end.
Refer to the following list of transactions for the first year of business operations:
 A grocery business was started by the owners investing ₹ 200,000 which was
deposited in the Bank.
 Stock of grocery worth ₹ 100,000 was purchased and full amount paid by cheque
 The sales for the year were ₹ 180,000. No credit was provided to customers.
 The entire stock of groceries of ₹ 100,000 was sold out.
 Salaries and other expenses such as telephone, electricity etc. were paid by cheque
₹ 30,000
 The business did not own any fixed assets and operated out of a furnished rental
place for which a rent of ₹ 10,000 was paid.
 Tax rate is 20% and paid out
Compute Net Profit of the business and prepare a statement of Cash Flows.
Profit & Loss Statement:
₹ ₹
Sales 180,000
Expenses
Cost of Goods sold 100,000
Salaries and utilities 30,000
Rent 10,000
Total Expenses 150,000
Profit Before Tax 30,000
Tax Expense 6000
Net Profit 24,000
Page 3 of 26
2.1 Cash Flow Statement

2.1.1 Cash Flows from Operating Activities
In this simplified case we have assumed that all transactions are in cash; the business sold
out all stock purchased and the business does not own any fixed assets. What would be
the cash generated by operations?
There could be two answers.
1) Same as Net Profit
2) Different from Net Profit
If you chose option 1 you are right. Since there are no credit transactions, no stock
remaining at the year end and no depreciation provisions, Net Profit and Cash from
Operations would be equal. Let us prepare a simple cash flow statement for this business.
There are two ways of reporting cash flows from operating activities: The direct method
or the indirect method.
2.1.1.1 Direct method
In the direct method the major items of cash receipts and payments are shown to arrive
at the cash flow from operations. Let us first prepare the cash flow from operations for
the business using the direct method. Here all items of income and expenditure are in
cash.
Cash flows from Operating Activities ₹ ₹

Cash received from customers 180,000
Cash paid to suppliers (100,000)
Cash paid for expenses (40,000)
Income tax paid (6,000)
Net Cash from Operating Activities 24,000
2.1.1.2 Indirect Method
Indirect method. The statement starts with the “Profit Before Tax” which is then adjusted
for items of expense and income included in the Profit or Loss figure which were non cash
in nature. For example if the sales figure included credit sales, then an adjustment to the
extent of credit sales would be required. We will work out such examples later. However,
in our simplified scenario 1, there are no credit transactions so the Profit and Loss figure
would be the same as cash generated from operations. The format of the statement using
the indirect method would be as follows
Page 4 of 26

Adjustments
- Nil-
Income Tax paid 6,000
The indirect method is more commonly found in published reports, though both methods
are permitted by accounting standards. The Indian Accounting standards converged with
IFRS recommends the use of the direct method, but does not make the direct method
compulsory. We will discuss the accounting standards for cash flow statements in a
subsequent section.
2.1.2 Cash Flows from Investing Activities
In our example, the business has not purchased any fixed assets nor has it invested its
surplus funds. What would be the cash flow from investing activities? There would be nil
cash flows from investing activities
Cash flows from Investing Activities ₹ ₹

Purchase of Fixed Assets 0
Purchase of investments 0
Sale of Fixed Assets 0
Sale of investments 0
Net Cash from investing activities 0
2.1.3 Cash Flows from Financing Activities

The owners have put in an equity Capital of ₹ 200,000. There are no additional loans taken
and no pay outs made to the owners or lenders. The cash flows from financing activities
would be as follows
Cash flows from Financing Activities ₹ ₹

Equity Capital issued 200,000
Dividend Paid 0
Loans Taken 0
Repayment of Loans 0
Net Cash from financing activities 200,000
Page 5 of 26
Putting all the statements together we would get the following

Cash received from customers 180,000
Cash paid to suppliers (100,000)
Cash paid for expenses (40,000)
Income tax paid (6,000)
Cash flows from Investing Activities
Purchase of Fixed Assets 0
Net Cash from investing activities 0
Cash flows from Financing Activities
Equity Capital issued 200,000
Dividend Paid 0
Loans Taken 0
Net Cash from financing activities 200,000
Net increase/decrease in cash and cash 224,000
equivalents
Cash and cash equivalents at the beginning of the Nil
period
Cash and cash equivalents at the end of the period 224,000
We have prepared the Cash Flow Statement for the first year of the business.
As the business expands operations, there is a requirement to give and take credit,
increase the stock held, buy additional equipment etc. Following transactions take place
in year 2.
 Stock of grocery worth ₹ 500,000 was purchased and some credit was provided
by the supplier, as a result ₹ 50,000 was outstanding to the creditor at year end.
 The sales for the year were ₹ 700,000. Credit was provided to select customers.
Total outstanding from customers at the end of the year was ₹ 80,000.
 At the end of the year stock of grocery items worth ₹ 30,000 remain with the
business.
Page 6 of 26
 Salaries and other expenses such as telephone, electricity etc. were₹ 70,000.
However, some bills which have been accounted in the expenses are yet to be paid
out at the end of the year. Hence the business has made a provision of ₹ 10,000
for outstanding expenses at the end of the year.
 The business continued to operate out of a furnished rental place for which a rent
of ₹ 5000 per month is payable. However, the landlord has requested for rent to
be paid in advance for each month. Hence, as of the end of the year, an amount of
₹ 5000 which pertains to rent for the next year has been paid as advance.
 A refrigerator is purchased for ₹ 50,000 and payment made by cheque.
 Depreciation at the rate of 10% is to be provided for the full year on the
refrigerator.
 Tax rate is 20% and paid out.
 A dividend of ₹ 7,600 was paid to owners.
Let us prepare a profit and loss statement for the firm.
Profit & Loss Statement:
Note ₹ ₹.
Sales 1 7,00,000
Expenses
Cost of Goods sold
Opening Stock - 0
2 4,70,000
Purchases - 500,000
Less closing stock - 30,000
Salaries and utilities 3 70,000
Rent 4 60,000
Total Expenses 6,00,000
Earnings Before Tax Amortization and

1,00,000
Depreciation (EBITDA)
Depreciation 5 5000
Tax 19000
Net Profit 6 76,000
Dividend to shareholders 7,600
Retained earnings 68,400
Notes:
1. All expenses and income are on accrual basis and not cash basis. So entire sales is
shown as income, irrespective of actual receipts.
Page 7 of 26
2. We need to determine the actual stock of goods used to generate the sales figure
for the year, hence the adjustment of stock is required. The stock remaining at the
end of the year would be utilized for future sales.
3. The amount of expense that pertains to the current year is charged irrespective of
the actual pay out.
4. The rent for the year is ₹ 5000 * 12. The additional ₹ 5000 paid in advance is for
next year’s rent and cannot he charged in this year’s profit & loss statement.
5. Depreciation is computed at 10% on ₹ 50,000 for the refrigerator. This is a
notional expense, no money is actually paid out.
6. Refrigerator purchased is not a revenue item, hence will not feature in the Profit
and loss statement.
What would be the cash generated by operations?
It could be
1. Same as Net Profit
2. Different from Net Profit
Here, the right answer would be option 2. This is because there were credit
transactions in both receipts and payments resulting in a difference in the amount
shown as income and expenditure and the actual cash that was exchanged.
Direct method
For preparing the cash flows from operations using the direct method. Every item of
income and expense is examined and only the actual cash received or paid is listed.
Cash flows from Operating

₹ ₹
Activities Note
Cash received from customers 1 6,20,000
Cash paid to suppliers 2 -4,50,000
Cash for Salaries and utilities 3 -60,000
Cash paid for rent 4 -65,000
Income tax paid 5 -19,000
Thus, while the business generated a profit or Rs 76,000. The cash generated from
operations is only ₹ 26,000.
Page 8 of 26
Indirect Method
The value of cash from operations using the indirect method should give the same
answer. In this case we start with the Profit before Tax and make adjustments for
items that are not paid out or received in cash.
Cash flows from Operating Activities Notes ₹ ₹

Adjustments
Add: Depreciation provided 1 5000
Add : payable to creditors 2 50000
Add: payable for expenses 3 10000
Less : outstanding from customers 4 -80000
Less Rent advance paid to landlord 5 -5000
Less : stock on hand at the end of the year 6 -30000
Income Tax paid 7 -19,000
Notes :
1. Depreciation is a notional expense and no cash is paid out hence we need
to adjust it.
2. The full purchase amount of ₹ 500,000 is recorded in profit and loss
statement, however cash of ₹ 50,000 is not yet paid out to suppliers.
3. Salary and utilities charged but not yet paid out in cash are ₹ 10,000
4. The sales figures of ₹ 700,000 includes a value of ₹ 80,000 that is
receivable from customers.
5. Rent charged to profit and loss is ₹ 60,000. However and additional ₹ 5000
has been paid to the landlord.
6. Stock lying in the grocery at year end.
7. Income tax is the actual pay out.
The cash flows from operations using either the direct or indirect method should be
equal.
Page 9 of 26
Cash Flows from Investing Activities

This statement will include the refrigerator purchase. No other investments were made
during the year.
Cash flows from Investing Activities ₹ ₹

Purchase of refrigerator -50,000
Net Cash from investing activities -50,000
Cash flow from financing activities

The shareholders have not invested any additional funds in the business, nor have any
loans been taken. However, an amount of Rs 7,600 has been paid out as dividend. The
dividend amount would appear in the cash flow from investing activities.
Cash flows from Financing Activities ₹ ₹.

Equity Capital issued 0
Dividend Paid -7600
Loans Taken 0
Net Cash from financing activities -7600
Page 10 of 26
Putting all the three statements together and adding the opening balance we should
get the following statement
Cash Flow Statement
Profit Before Tax 95000
Adjustments:
Add: Depreciation provided 5000
Add : payable to creditors 50000
Add: payable for expenses 10000
Less : outstanding from customers 80000
Less Rent advance paid to landlord 5000
Less : stock on hand at the end of the year 30000
Income Tax paid 19000
Net Cash from Operating Activities 26000
Cash flow from investing activities

Purchase of refrigerator -50,000
Net Cash from investing activities -50,000
Equity Capital issued 0
Dividend Paid -7600
Loans Taken 0
Net cash from financing activities -7600
Net increase/decrease in cash and cash equivalents
Cash and cash equivalents at the beginning of the period -31,600
Cash and cash equivalents at the end of the period 224000
Net increase/decrease in cash and cash equivalents 1,92,400
Note: The cash flow from operations, has been to be substituted by table as per indirect
method in page 10.
Page 11 of 26
We can tie up these figures with the Balance Sheet1. The Cash and cash equivalents as per
the Balance Sheet matches with the figure in the Cash Flow Statement.
Balance Sheet as on March 31 XXXX ₹

Equity and Liabilities
Equity Capital 200,000
Reserves and Surplus 92,400
Current Liabilities
Trade Creditors 50,000
Provision for Expenses 10,000
Total 3,52,400
₹
Assets
Fixed Assets 45,000
Current Assets
Stock 30,000
Trade Receivables 80,000
Rent Advance 5,000
Cash and Cash equivalents 1,92,400
Total 3,52,400
The cash flows have been generated using a summary of all the transactions that took
place during the year. In most circumstances the analyst would not have all the detailed
transactions, but would be presented with a Balance sheet and Profit & Loss statement.
She would be required to prepare a cash flow statement using these two statements. The
next examples covers such a scenario where only the final Balance Sheet and Profit &Loss
statements are provided to the analyst.
2.14 Regulatory Requirements
Prior to Companies Act 2013, a cash flow statement was mandatory only for listed
entities. But, as per Companies Act 2013 all companies including unlisted and private
1
Note: Detailed instructions for preparing the Balance Sheet are not included in this chapter,
as this is not the intent of this chapter.
Page 12 of 26
companies are required to prepare a cash flow statement. An exemption has been
provided to one person companies, small companies and dormant companies2.
Accounting standard IND AS 7 specifies the requirements for preparation and disclosure
of cash flow statements. Cash comprises cash on hand, demand deposits. Cash
equivalents are short-term, (typically 3 months or lesser) highly liquid investments that
are readily convertible to known amounts of cash and which are subject to insignificant
risk of changes in value.
IND AS 7 encourages entities to prepare cash flows using the direct method as this
provides useful information which could be used to estimate future cash flows.
An issue that may come up in the preparation of cash flows is the treatment of bank
overdrafts. A clarification is provided in IND AS7 - Bank borrowings are generally
considered to be financing activities. However, where bank overdrafts which are
repayable on demand form an integral part of an entity's cash management, bank
overdrafts are included as a component of cash and cash equivalents. A characteristic of
such banking arrangements is that the bank balance often fluctuates from being positive
to overdrawn.
2
One Person Company means a company which has only one person as a member;
Small company means a company, other than a public company,—
(i) paid-up share capital of which does not exceed fifty lakh rupees or such higher amount as may be prescribed
which shall not be more than five crore rupees; or
(ii) turnover of which as per its last profit and loss account does not exceed two crore rupees or such higher amount
as may be prescribed which shall not be more than twenty crore rupees:
Provided that nothing in this clause shall apply to—
(A) a holding company or a subsidiary company;
(B) a company registered under section 8; or
(C) a company or body corporate governed by any special Act
Dormant Company - Where a company is formed and registered under this Act for a future project or to hold an asset or
intellectual property and has no significant accounting transaction, such a company or an inactive company may make an
application to the Registrar in such manner as may be prescribed for obtaining the status of a dormant company.
Page 13 of 26
2.15 Practice Solved Problems on Preparing Cash Flow Statements

Problem 1
The Chief Manager of Omex Chemicals Ltd is surprised to find that though his company
has incurred a loss during the year ended March 31, 2011, the cash has increased during
the period. He wants to find what has happened?
Profit and Loss Account (for the year ended March 31, 2011)
₹ ₹
Sales 5,60,000
Cost of goods sold (including depreciation on 3,85,000
equipment Rs60,000)
Gross Profit 175,000
Operating Expenses 170,000
Office and administrative expenses 55,000
Amortization of goodwill 25,000 250,000
Net Profit/ Loss (75,000)
Balance Sheet as on March 31, 2011

Assets 2011 2010
₹ ₹
Cash 1,40,000 95,000
Debtors 80,000 55,000
Stock 100,000 80,000
Prepaid rent 10,000 12,000
Land 1,50,000 1,50,000
Equipment, net of depreciation 4,40,000 600,000
Goodwill 75,000 100,000
Total Assets 9,95,000 10,92,000
Capital and Liabilities
Creditors 60,000 90,000
Bills Payable 20,000 14000
Accrued Wages 20,000 18,000
Long-term loans 2,45,000 2,45,000
Share Capital 600,000 600,000
Reserves and Surplus 50,000 1,25,000
Total Liabilities 9,95,000 10,92,000
Page 14 of 26
Solution:
We prepare the cash flows from operations using the indirect method. As discussed in the
previous section we start with the profit before tax and make adjustments for non-cash
items or items that were charged to Profit & loss but are not routine operating activities
of the business.
Cash Flow Statement

Cash flows from Operating Activities note ₹ ₹ ₹
Profit Before Tax 1 -75,000
Add Depreciation 2 60000
Add Goodwill amortized 2 25000
Changes in Working Capital 3
Increase in debtors 4 -25,000
Increase in stock 5 -20,000
Reduction in rent advances 6 2,000
Decrease in creditors 7 -30,000
Increase in bills payable 8 6,000
Increase in wages payable 9 2,000
Net changes in working capital -65,000
Income tax paid 0
Net Cash from Operating Activities3 -55,000
Cash flows from Investing Activities
Sale of Equipment 10 100000
Net Cash from investing activities 1,00,000

Dividend paid 11 0
Loans Taken 12 0
Equity capital raised 13 0
Net Cash from financing activities 0
Net increase/decrease in cash and cash equivalents 45000
Cash and cash equivalents at the beginning of the
95,000
period
Cash and cash equivalents at the end of the period 14 1,40,000
3
Cash flows from operations have been generated using the indirect method. The same final value of operating
cash flows would be obtained using the indirect method.
Page 15 of 26
Notes
1 Profit before tax is the same as net profit. No tax has been charged as the business
is making losses.
2 Depreciation and amortization are not cash expenses
3 Changes in current assets and current liabilities are grouped under working
capital to give a sense of how the business is managing its working capital
4 An increase in amount due from debtors is a cash outflow
5 Cash has been used to purchase stock as the stock has increased
6 Rent advance paid by the business has gone down, thus cash has been released
7 The amount due to creditors has reduced, so the business had paid out₹ 30,000
additional cash to creditors during the year
8 There is an increase in bills payable, the business has spent this amount less on
paying bills, thus an inflow for the business
9 Increase in payables for wages, thus that much cash has not been paid out yet
10 Every item in the Balance Sheet is to be checked for changes to see if there could
be any items that could impact cash. For example, Net value of equipment has
decreased from 600,000 to 440,000. The case mentions that depreciation is ₹
60,000. No other changes had taken place in equipment. The value of equipment
in 2011 should be ₹ 600000 less ₹ 60,000 =₹ 5,40,000. However the actual value
of equipment is ₹ 4,40,000. In the absence of any other information, we assume
that₹100,000 worth equipment is sold at cost. In case additional data had been
provided we would adjust accordingly.
11 Reconciling the Reserves and Surplus figure
Opening Balance 125000
Profit and Loss for the year - 75,000
Closing balance 50,000
This tallies with the closing balance in 2011. Hence, there is no other adjustment
for cash.
12 Loan balance is unchanged at ₹ 2,45,000, thus no additional loans have been
taken
13 Equity capital is unchanged at ₹ 600,000, thus no additional funding from
shareholders.
Page 16 of 26
14 This ties up with the cash balance as of yearend 2011 which was the purpose of
the exercise.
Let’s try to answer the following questions
a) How has the business sustained itself without loans?
b) Do you see any concern areas that it could improve?
Discussion: - Cash flows from operations are negative₹ 55,000. The primary funding has
come through sale of equipment. This is not a sustainable strategy. The business needs to
relook at its operations to make the business more profitable and generate adequate cash.
Even if an immediate turnaround in profitability is not possible, it would be able to make
positive operating cash flows if it is able to manage its working capital better. The
business has increased the funds tied up with debtors (₹ 25000) and stock (₹ 20,000).
At the same time creditors have offered reduced amount of credit (₹ 30,000) to the
business. All these are not very positive signs for the business.
Learning Nugget
We have seen that profits do not necessarily represent cash generated by the business. This is
because financial statements are prepared using an accrual method of accounting. Sales typically
include both cash and credit sales. However, only cash sales generate cash while credit sales
may take some time to convert into cash. Similarly, expenses include both cash and credit
expenses. There are some items of expense that do not involve a cash outflow, e.g. depreciation
and amortization. Some expenses charged to Profit or loss may pertain to financing and not
operations for e.g. interest expenses are typically classified under cash flows from financing.
Cash may be generated by or be spent on investment activities or financing activities. These

activities are not reflected in the profit and loss statements but can be found by reviewing the
Balance Sheet.
Page 17 of 26
Problem 2
Classify the following transactions into operating, investing and financing activities.
Commenced business with Cash deposited in Bank
Purchased goods on Credit from Niharika for ₹ 200,000
Borrowed ₹ 10,00,000 from Bank
Paid office rent ₹ 10,000
Sold goods for ₹ 100,000 in cash and ₹ . 2,50,000 on credit to Avanti
Received commission from Abhishek ₹ 20,000
Paid dividends ₹ 25,000
Paid Salary to Staff ₹ . 6000 in Cash
Paid an instalment of ₹ 20,000 to the bank towards loan instalment, ₹ 8000 of the
repayment was towards interest component.
Paid Telephone and electricity bill
Purchased Computers for ₹ . 100,000 by cheque
Received an advance of ₹ 20,000 for goods to be dispatched in Feb
Paid an MSEB deposit of ₹ 10,000
Invested surplus cash in equity
Solution
Transaction Classification
Commenced business with Cash deposited in Bank Financing
Purchased goods on Credit from Niharika for ₹ 200,000 Operating
Borrowed ₹ 10,00,000 from Bank Financing
Paid office rent ₹ 10,000 Operating
Sold goods for ₹ 100,000 in cash and ₹ . 2,50,000 on credit to Avanti Operating
Received commission from Abhishek ₹ 20,000 Operating
Paid dividends ₹ 25,000 Financing
Paid Salary to Staff ₹ . 6000 in Cash Operating
Paid an instalment of ₹ 20,000 to the bank towards loan instalment, ₹ Financing
8000 of the repayment was towards interest component.
Paid Telephone and electricity bill Operating
Page 18 of 26
Purchased Computers for ₹ . 100,000 by cheque Investment

Received an advance of ₹ 20,000 for goods to be dispatched in Feb Operating
Paid an MSEB deposit of ₹ 10,000 Operating
Invested surplus cash in equity Investing
Problem 3
ABC & Co. Ltd disclosed that during the year 2010 it had sold equipment for ₹ 15000. The
equipment had been purchased for₹ 65,000 and had a book value of ₹ 12,000.
Following details are available in the closing balance sheets
Balance Sheet for the Year Ending: 2010 2009

Plant and Equipment at cost 12,00,000 800,000
Accumulated Depreciation 90,000 1,45000
Compute the cash flow from investing in Plant & equipment.

Solution
We will reconcile the plant and equipment account to understand the reason for the
movement
1. Plant and Equipment at cost opening Balance 800,000
Less cost of equipment sold 65,000
Expected balance if no other transaction 7,35,000
Actual Closing balance 12,00,000
The difference of ₹ 465,000 (12,00,000 – 7,35,000) represents the cost of
additional plant and equipment acquired.
Cash flow from investing would have the following entries
Sale of Equipment 15,000
Purchase of Equipment (4,65,000)
(4,50,000)
Net cash flow from investing in Plant &Equipment is an outflow of ₹ 450,000/-
Page 19 of 26
3.0 Analysis of Cash Flow Statements

The cash flow statement is a powerful tool for ascertaining the credit worthiness and
repaying capacity of borrowers. We will understand the tools for analysis through a few
case studies.
Case Study 1: Apex Foods Ltd
The cash flow statement of Apex Foods Ltd is provided here:
2016
(in 000’₹ )
Operating profit 131.93
Plus: Depreciation 37.50
Less: Tax paid -0.34
Changes in Current Assets and Current Liabilities:
Inventory 64.45
Receivable 13.94
Advance, deposits and prepayments -49.56
Trade creditors -23.52
Other liabilities 0.58
Cash flow from operating activities (A) 174.98
Purchase of fixed assets -23.01
Other income 39.06
Cash flow from investing activities (B) 16.05
Change in capital 0.34
Change in term loans -58.32
Change in short-term borrowings -78.06
Interest paid -104.13
Dividend paid -10.26
Cash flow from financing activities (C) -250.43
Net Cash Flow (A+B+C) -59.40
Opening balance of cash 301.45
Closing balance of cash 242.05
Page 20 of 26
Following additional data is available for the firm for the year 2014
Sales =₹ 3,845,000
Total Assets = ₹ 1,55,000
Long Term Debt Outstanding at the end of the year ₹ 120,000
We can note from the above that the firm has positive cash flows from operations. There
has been a reduction in inventory to the tune of ₹ 64,000.This could be caused by better
management of inventory, but on the other hand could indicate a slowing down of
operations which could be a matter of concern. The firm has invested ₹ 23,000 for
expanding operations and has recorded an inflow of ₹ 39,000 from investing activities.
The firm has repaid borrowings and interest to the tune of ₹ 240,000. These repayments
have been funded from a small surplus from investment activities but primarily from
operating cash flows which is a positive sign.
We now review some ratios that are used for the analysis of cash flow statement
Cash Flow from Operations/Sales
Indicates ability to generate CFs from sales. Higher ratio is better. Change in ratio
indicates changes in credit policy and business conditions.
Cash Flow from Operations/Total assets
Ability to generate cash from assets or the asset utilization.
Cash Flow from Operations / Interest
Cash flow interest cover ratio. Indicates the firm’s ability to repay interest from
operating cash flows
Cash Flow from Operations / (Interest + current portion of long term debt)
Cash Flow Debt service coverage ratio. The firm’s ability to repay interest and long
term debt.
Total long term debt / Cash Flow from Operations
Indicates the number of years it would take to repay the principal portion of the
long term debt if the operating cash flows were to remain constant.
Cash Flow from Operations – Essential Capex
Free Cash Flow. Signals firm’s ability to repay debt, pay dividends, and facilitate
growth of business.Free CF of more than 10% of sales may be considered good
Page 21 of 26
These ratios have been computed for Apex Foods as follows
Cash Flow from Operations / Sales 4.6%

Cash Flow from Operations / Total Assets 112.89 %
Cash Flow Interest Cover 1.68
Cash Flow DSCR(total debt including short term 0.73
Long-term debt pay-out ratio 0.69
Cash Flow from Operations - Essential Capex (Free Cash Flow) 151.97
All the above ratios indicate a robust cash position for the firm. . The firm has the ability
to repay interest from operating cash flows. The firm has had to dip into other sources of
funds from investing activities to repay the debt as the DSCR has fallen below 1at 0.73.
However, the firm is likely to be debt free within the next year as the long term debt pay-
out ratio is below 1, provided it does not take on additional debt during the next year.
Page 22 of 26
Case Study 2: SMT Ltd

Cash flow data are available for SMT Ltd as under:
2016-17
(in 000’₹ )
Profit after tax 13.30
Plus: Depreciation 1.90
Plus: Interest 8.60
Plus: Bank charges 2.70
Less: Other income -2.60
Less: Deferred tax paid -0.10
Change in Current Assets:
Inventory 12.30
Sundry Debtors -62.20
Loans and Advances -11.60
Change in Current Liabilities
Creditors for purchases 27.00
Other creditors 9.50
Provisions 0.80
Cash flow from Operating Activities (A) -0.40
Fixed assets -1.40
Investments 3.10
Other income 2.60
Cash Flow from Investing Activities (B) 4.30
Capital -19.30
Term loans 1.70
Cash credit 32.60
Interest -8.60
Bank charges -2.70
Cash Flow from Financing Activities (C) 3.70
Net Cash Flow (A+B+C) 7.60
Opening balance of cash 8.40
Closing balance of cash 16.00
Page 23 of 26
Comment on the cash ratios computed for the firm
Cash Flow from Operations / Sales -0.2%

Cash Flow from Operations / Total Assets -0.2%
Cash Flow Interest Cover 0.0
Long-term debt pay-out ratio -20%
Cash Flow from Operations - Essential Capex (Free Cash Flow) -1.80
While, the profits for the year are positive, the picture is completely reversed when we
review the cash flow statement. We find that the firm has negative cash flows from
operations. Additional credit has been extended to Debtors to the tune of ₹ 62,200
indicating a deteriorating collections. The shortfall in operating cash flows and interest
pay outs have been financed by way of cash credit facilities. Despite the poor financial
condition of the firm, the equity investors have withdrawn ₹ 19,300 funds from the
business. All the computed ratios show a bleak picture and raise a question on the
continuity of the business.
Page 24 of 26
Self-Study Problem
Examine the cash flow statement of Larsen & Toubro provided in the Table 1and answer
the following questions.
1. What are the factors that have led to the company generating negative cash flow
from operations in the year 2015-16?
2. How has the business funded the shortfall in cash from operation?
3. Comment on the cash flow statement for Larsen & Toubro.
Table 1: Cash Flow Statement of Larsen & Toubro Limited
Page 25 of 26
Source: Larsen & Toubro Annual Report 2015-16
References:
Indian Accounting Standard (Ind AS) 7 Statement of Cash Flows
Page 26 of 26
Chapter 5: Credit Appraisal for Term Loans
Dr. M. Manickaraj
Objectives
The objective of this chapter is to provide a foundation for appraisal of business
projects and to explain how to decide on term loans for projects.
Structure
5.1 Introduction
5.2 Types of Projects
5.3 Appraisal of Projects
5.3.1 Technical
5.3.2 Commercial
5.3.3 Management
5.3.4 Legal
5.3.5 Environmental
5.3.6 Financial
5.4 Viability and repayment capacity
5.5 Determining repayment Schedule
5.6 Sensitivity analysis
5.7 Scenario analysis
5.1 Introduction
Business firms normally need two different types of credit facilities – term loan and
working capital loan. While working capital is used for financing day to day operations of
the business, term loans are used for financing projects. Term loans are used to purchase
fixed assets such as machinery used in production of goods. Fixed assets will have a
certain useful life and hence the term loan provided for purchasing and setting up assets
Page 1 of 15
should be recovered fully before the end of their life. As such, the main character of term
loan is that it will have a specified repayment schedule.
5.2 Types of Projects
Business projects can broadly be classified into industrial and infrastructure projects.
Though both types of projects have common characteristics, infrastructure projects are
large in size and more complex in nature and require specially trained professionals to
deal with them. Projects can also be classified into the following types:
 New Business Projects– This involves starting a new firm along with setting up
new manufacturing and other facilities. Assessing risk of such firms could be
very difficult because of lack of track record, lack of credit history and probably
the promoters are new to the business and the like.
 Green Field Projects: These are new projects entered into by existing firms such
as setting up a new factory, plant for a new line of business, or a new location.
 Brown Field Projects: These are additional investments made on existing
operations such as for expansion/modernisation of existing facilities or
replacement of existing assets with new ones.
Among the abovementioned three types of projects new business projects are the most
risky followed by green field projects and brown field projects are the least risky.
5.3 Appraisal of Projects
Project appraisal is the process of assessing projects before term loans are sanctioned.
Appraisal of projects is intended to fulfil the following three objectives:
 Choosing projects objectively and consistently. Banks and financial
institutions are huge organisations where thousands of employees handle the
business of lending. Moreover, there are layers in the organisational structure
of banks. There will be officers at different layers of the organisation involved
in making loan decisions. In order to communicate among all the officers
involved in the decision making process there is a need for doing the credit
appraisal in a structured manner so that everyone involved in the process will
be on the same page.
 Creating documentation to meet financial and regulatory requirements.
Another important objective of project appraisal is to create a record of all the
facts and findings so that it can be referred to by anyone and anytime in the
future.
 Laying foundation for lending decisions. The most important reason for doing
credit appraisal of projects is to enable decision making on loan proposals.
Project appraisal usually covers the following six areas:
 Technical
 Commercial
Page 2 of 15
 Management
 Legal
 Environmental
 Financial
5.3.1 Technical Appraisal

Among the various aspects of a project the following need to be studied carefully to
evaluate technical feasibility:
- Project area: The area where a project is planned to be set up should be based on
considerations such as +climatic condition, natural resources, presence of support
industries and services, availability of human resource, etc. which are necessary
for running a project are important. If an auto component manufacturing unit is
set up in a place where there are no automobile manufacturing units then the
project will not likely to be feasible. Similarly, if a cement manufacturing unit is set
up in a place where there no limestone reserves the project cannot succeed.
- Project site: The exact place where the project is being put up will also determine
the success of a business. For instance, if a manufacturing project is set up near a
school or a hospital the public may oppose the project. There were instances
where everything with the site was fine but the project site had no access to the
nearby road. Project site may also be seen from the point of view of connectivity
to inputs like electricity, water, raw material and also outlets for effluents. If
projects are established in industrial estates most of the resources like utilities,
roads, etc will be available and there would not be any objection to the project
from any quarters.
- Approvals and clearances: Business projects may need approvals from different
government authorities like the central government, state government, local
government like Municipal Corporation, pollution control board, department of
forest, registration with relevant government departments, GST number, and so
on.
- Technology: Many alternative technologies may be available for the proposed
project. Appropriate technology should be chosen based on proposed scale of the
project, quality of output, availability of maintenance service, spare parts, and the
like. The technology chosen should not be obsolete. Energy efficiency of the
machineries installed matters. When very advanced technology is used
indigenous service or support should be available.
- Installed capacity and operating capacity: The installed capacity of the project is
production capacity of plant and machinery installed and is supposed to be
decided based on the quantity of output that can be sold in the target market.
Operating capacity is the actual production to be decided on seasonality in
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operations, number of shifts of operation and so on. While assessing a term loan
it has to be kept in mind that the capacity of the project is selected keeping in mind
the total outlay from the promoter and the desired level of output envisaged
depending on the market. Installation of over capacity would increase the cost of
capital. Similarly there should be optimal utilisation of the installed capacity.
Underutilisation may reduce profitability.
- Implementation schedule: The length of time needed for completion of the
proposed project including milestones and timeline must be studied. The schedule
should be feasible such that it shall not be too ambitious that it cannot be
completed within the scheduled time nor it will take too long a time. While the
implementation schedule is important for the promoters it is also important for
the banks providing loan for the project for determining the loan release schedule.
When a Project Loan is given, Banks monitor the progress of the project with
reference to the implementation schedule. The Date of Commencement of
Commercial operations (DCCO) is of importance to the Banker since delay in DCCO
beyond the RBI permitted period can render the Loan as an NPA.
- Availability of inputs: Availability and accessibility to inputs including raw
material, energy, water, and human resource are critical for running projects.
They may also affect profitability.
- Quality of input/output: Quality of inputs will determine the quality of output.
Therefore, if a certain quality product is planned to be produced the choice of
input should be chosen accordingly. Tie ups for procurement of inputs of desired
quality may have to be made beforehand.
5.3.2 Commercial Appraisal
Commercial feasibility is highly critical for success of any business. The factors that would
determine the commercial feasibility include the following:
- The Industry outlook, whether the industry is a sun rise industry / sun set
industry and the prospects of the product proposed to be manufactured. The
degree of health or sickness prevalent in the industry to be scrutinised.
- Market size: Number of potential consumers, expected quantity of consumption
and frequency of consumption will determine the size of the market. Larger the
size of the market better would be the prospects for a company.
- Demand-Supply Gap: This is a critical factor that will determine the profitability
of business firms. Positive demand-supply gap (demand is greater than supply) is
an indicator of growth potential and also will enable the companies to enjoy higher
bargaining power. Players in a sector with positive demand-supply gap will
generally enjoy higher profitability.
- Competition: Nature and intensity of competition are the two other factors that
will determine the success of firms. If competition is cut throat all players are
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likely to suffer losses or very low profitability. The price assumed by the Borrower
should be realistic and in tune with the market.
- Substitution: If the product can be easily substituted the risk of failure will be high.
Apart from the above three factors arrangements for marketing the product and
necessary logistics are also necessary for making a project commercially successful.
5.3.3 Management Appraisal
Appraisal of management should consider three major elements including the promoters,
the management and the executive team.
Promoters are the owners of the project who invest money in the project. The promoters’
credentials, experience, competence, and resources should be studied.
Top management (board of directors) of a firm is another element to be analysed as part
of management appraisal. Competency of members on the board of directors should
therefore be assessed.
Executive team is the key persons who will head the various functions like production,
technology, marketing, human resource, and finance. In today’s world business projects
are highly technology and knowledge intensive and hence persons of relevant
competency are supposed to be chosen for the various functions.
For small businesses all the three elements of management may be handled by the same
person or team. In case of large businesses all the three may be made up of different set
of people.
5.3.4 Appraisal of Legal Matters
Legal aspects to be verified before committing funds in a project include regulations
governing the business, approvals from government authorities, viz., Factory licences,
Building approvals from competent authority, PCB approvals, EPR registration, title
deeds etc. Besides, contractual arrangements between the project/company and other
stakeholders like suppliers, customers, contractors, service providers and so on should
also be studied.
5.3.5 Environmental Analysis
Impact of the proposed project on the environment and the society need to be assessed
and one should verify if the project is violating any law governing environment and
society. In case of big projects Environmental Impact Analysis (EIA) is supposed to be
done and clearances from the ministry of environment and forests or state pollution
control board or the national green tribunal as the case may be should be obtained.
5.3.6 Financial Appraisal
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The last and most critical step in project appraisal is the appraisal of the project’s
financials. The various aspects about a project’s financials that need to be carefully
studied are discussed hereunder.
- Project cost: Estimation of project cost will determine the amount of capital
required for the project. Accordingly, project promoters should make necessary
arrangements for raising the required capital. Under estimation as well as
overestimation of project cost are possible. Under estimation of project cost will
lead to not being able to complete the project. It will also result in choosing non-
viable projects for investment. On the other hand, overestimation may lead to
rejection of viable projects. Banks therefore shall check every item in the project
cost estimation thoroughly. Wrong estimation of project cost could also be due to
omission of certain items. Project cost may generally have the following heads:
S No Items
1 Land and Site Development
2 Buildings
3 Plant & Machinery
4 Engineering & Consultancy fees
5 Miscellaneous Fixed Assets viz., Furniture, equipments,
vehicles etc.,
6 Preliminary & pre-operative expenses including interest
during construction (IDC)
7 Provision for contingencies
8 Margin money for working capital
Working capital margin: One item that is commonly underestimated or even

ignored is the margin for working capital. It is the amount of equity capital for
financing current assets. The need for working capital will arise once the
construction of the project is completed and commercial operations start.
However, as the margin for working capital is supposed to be equity capital
adequate provision for the same should be made in the project cost. Otherwise it
may so happen that the project promoters approach the bank for working capital
but may not bring the equity capital for working capital. This will put the bankers
in a tight spot that they cannot say no to working capital support because the term
loan provided can be recovered only if the operations of the project start and
continue. Simply put each and every item of project cost and also working capital
margin should be checked.
- Once the project cost is accepted the next question will be the means of financing
the project. Banks do not fund expenses and margin money, generally. The
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promoters will have to bring margin as stipulated by the Banks for funding other
assets as well.
- Means of finance and source of equity capital: After checking the project cost
the sources from where capital for the project are planned to be raised should be
examined. While banks may decide on the amount of loan to be provided for the
project they should also check the source of equity capital and the feasibility of
raising equity capital. Net worth of promoters may give an indication about their
ability to bring in the necessary amount of equity capital. If raising capital from
the market is proposed, market conditions should also be studied.
- Break Even Analysis :
- The repayment of the Term Loan is proposed to be made from the profits to be
generated from the project. Hence studying and accepting profitability estimates
and cash flows projected is a crucial role of the Banker.
- For this, it is necessary to estimate the cost of production and projected sales so
as to arrive at the profitability estimates. Therefore, analysing what level of sales
will cover the cost and from where the unit will start making profit becomes
important.
- So it is necessary to ascertain the minimum level of production and sale at which
the unit will run on "no profit no loss" basis. This is known as Break Even Point
(BEP).Bankers are keen that the unit achieves this level at the earliest and
operates well above this level to sustain profitability and ensure repayment.
To calculate the BEP, as a first step, the total cost has to be bifurcated into fixed
and variable items.
Fixed costs refer to those costs which are incurred regardless of the operation
and/or level of activity of the unit e.g., rent, taxes, insurance, depreciation,
maintenance of building, machinery, etc.
The variable costs or marginal costs on the other hand are expenses which vary
directly in proportion to level of activity or sales or production e.g., raw materials,
power & fuel, consumables etc.
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝐸𝑃 (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦) = (𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
(Or)
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝐸𝑃 (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦) = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
- Sale Price per unit – Unit variable cost per unit is also known as contribution
Breakeven point (in value) = BEP in quantity (units) X Selling price per unit
Page 7 of 15
In Breakeven analysis, the measure of profitability is Margin of Safety

Margin of Safety = Actual sales - Break even sales (in units)
Margin of safety can also be measured as a % of actual sales.

Profit = Margin of safety (units) X Contribution
- The size of the margin of safety is an indicator of company’s financial health,

i.e. low margin of safety is indication of higher risk and vice versa.
Illustration for Break Even Point :
Ramu is an entrepreneur who has put a small tailoring shop in Ranganathan street, for
stitching readymade shirts and selling in bulk to number of established textile shops in
the market. 5 textile shops have agreed to buy 1000 pieces per month at a selling price of
Rs 70. The shop proposes to work for 25 days and on an average each can stitches 40. The
costs per month are as follows :
Fixed Costs (Rs) Variable costs per unit (Rs)
Salary for tailors on 21000 Raw material cost 50

fixed pay basis
Rent 10000 Threads and other 4

consumables
Machinery maintenance 3000 Power required for 1

running the machinery per
shirt
Other fixed expenses of 1000

the shop
Total Fixed Expenses 35000 Total variable expenses 55
Page 8 of 15
- Selling Price per unit = Rs 70
- Variable costs per unit = Rs 55
- Therefore Contribution = Rs 70 – Rs 55 = Rs. 15
- Breakeven point (Quantity) = 35000 / 15 = 2334units
- Margin of safety = 5000 – 2344 = 2667
- Margin of safety in % =2667 /5000 = 53.34 %
- Profit per month = 2667 X 15 = Rs 40005/-
Projection of cash flows: Cash flows for a project are drawn based on several
assumptions. Assessment of project viability and repayment capacity therefore will
largely depend on how realistic the projection of cash flows. Lenders must question each
and every assumption behind the projections, check if all the relevant items of income
and costs have been taken into account and also verify whether all the items have been
correctly estimated. The following items may be paid closer attention:
Revenue from projects would depend on:
 Installed capacity and operating capacity
 Capacity utilisation
 Seasonality and working days
 Operational efficiency
 Quantity and quality of output
 Selling Price
Omission of cost items: It is possible that some items of costs are taken into account.
Management compensation, selling and distribution expenses, and transportation cost
are the few items which are commonly ignored.
5.4 Viability and Repayment Capacity
The next step after studying the project cost and projected cash flows is to check the
viability and repayment capacity of projects. Viability of projects is tested with the
following:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Repayment capacity will be measured by using the Debt Service Coverage Ratio (DSCR)
Page 9 of 15
5.4.1 NPV: NPV or Net Present Value is present value of future cash flows minus the
project cost. Value of cash flows depends on time and hence time value of money needs
to be taken into consideration. Normally, all the future cash flows will be converted into
present value by discounting the cash flows with a discount rate. Mathematically, NPV
may be expressed as follows:
n
Cash Flowt
NPV    Pr oject Cost
t 1 (1  Discount Rate )
t
Where, ‘t’ refers to the relevant year and ‘n’ is the life of the project in years.
Project cash flows are the cash flows available for disbursement to the capital
providers including the lenders and the equity capital providers.
Discount rate is nothing but the cost of capital of the project in question. Cost of
capital is the minimum rate of return expected from the project.
If the NPV is greater than zero one can say that the project is offering higher return than
the discount rate and hence the project is viable. If the NPV is negative then the project is
not viable. In other words, the cash outflows and cash inflows over the entire project
period is discounted at a predetermined rate (which can be cost of capital/weighted
average cost of funds/minimum acceptable rate of return) and the net present value is
derived as a surplus of discounted inflows over discounted outflows. If the NPV is zero
the benefits derived from the project are just sufficient to cover cost of the capital.
5.4.2 IRR: Though NPV can be used to assess the viability of projects its limitation is that
it does not measure the rate of return offered by projects. Moreover, if discount rate is
changed NPV should be calculated using the new discount rate. Internal Rate of Return
or IRR is the rate of return offered by projects. It is the discount rate that will make the
discounted value of project cash flows equal to the project cost. If IRR is used as the
discount rate NPV will be zero. Viability of projects can be determined by comparing the
IRR with the discount rate. If the IRR is greater than the discount rate the project can be
said to be viable.
For the purpose of estimating NPV and IRR cash outflow will generally be the project cost
plus initial working capital requirement. Cash inflow will be calculated as net operating
profit + depreciation + interest on borrowings. Net cash flow is derived as cash inflow
minus cash outflow plus residual value of investments at the terminal year.
5.4.3 NPV and IRR: Illustration

The cost of Project X is Rs.40 million and it is expected to generate cash flow over its life
of 5 years as in the table below. The cost of capital of the project is 10%.
Page 10 of 15
Year Cash Flow (Rs. Million)

Project Cost -40
1 10
2 11.5
3 12.5
4 10
5 12
Total cash flow 56.0
NPV of Project X: In order to find out NPV of the project its cash flows should be
discounted by its cost of capital as in table below. The present value of cash flow in year
1 is calculated as 10/(1+10%). It works out to 9.09.The present value of cash flow in year
2 works out to 9.50 (i.e., 11.5/(1+10%)2 and so on.
Calculation of NPV of Project X
Year Cash Flow (Rs. Million) Present Value (at 10%)

1 10 9.09
2 11.5 9.50
3 12.5 9.39
4 10 6.83
5 12 7.45
Total cash flow 56.0 42.3
NPV (PV of all cash flows – Project Cost) 2.3
NPV of the project = Sum of present value of all cash flows – Project Cost
= 42.3 – 40
= 2.3 million
As the NPV is positive at 2.3 million the project can be termed as viable.
IRR: As the NPV of the Project X is positive one can say that the IRR is greater than its
discount rate. Therefore, one shall discount the cash flows of the project with a higher
discount rate. The present values of the cash flows discounted by 12% are as follows:
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Year Cash Flow (Rs. Million) Present Value (at 12%)

Project Cost -40
1 10 8.93
2 11.5 9.17
3 12.5 8.90
4 10 6.36
5 12 6.81
Total cash flow 56.0 40.16
NPV (PV of all cash flows – Project Cost) 0.16
At 12% discount rate the NPV of the project is 0.16. Therefore, one may say that the IRR
of project X is roughly 12%. The exact IRR of the project is 12.16%. It shall be noted that
if IRR should be calculated manually ‘trial and error’ method should be used.
Both NPV and IRR will give the same result. In the above illustration the NPV is positive
and the IRR is greater than the discount rate. The project hence is viable according to both
NPV as well as IRR.
Data required for calculating NPV and IRR are project cost, projected cash flows and
discount rate. The discount rate is also referred to as hurdle rate, minimum required rate
of return, cost of capital, and weighted average cost of capital (WACC). One thumb rule to
be used is higher the risk of a project higher should be discount rate and lower the risk
lower should be the discount rate.
5.4.4 Debt Service Cover Ratio (DSCR)
DSCR indicates the adequacy or otherwise of project cash flows to service term loans. It
can be calculated as follows:
(𝐸𝐵𝐼𝑇𝐷𝐴 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑇𝑎𝑥)
𝐷𝑆𝐶𝑅 =
(𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛 𝐼𝑛𝑠𝑡𝑎𝑙𝑚𝑒𝑛𝑡 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛)
Or
(𝑃𝐴𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛)

𝐷𝑆𝐶𝑅 =
(𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛 𝐼𝑛𝑠𝑡𝑎𝑙𝑚𝑒𝑛𝑡 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛)
Where, EBITDA is the operating profit before interest, tax, depreciation and amortization.
The above equation will be used to find out the DSCR of a project every year. In addition,
Average DSCR should be calculated. It can be calculated using the following equation:
Page 12 of 15
Sum of all cash flows during the repayment period

Average DSCR =
Sum of all term loan instalments and interest
DSCR of greater than 1 would indicate that the cash flow is sufficient to service the loan
and if it is less than 1 the cash flow is not sufficient to service the loan. Therefore, every
year the DSCR should be greater than 1 and the average DSCR should also be greater than
1.
Generally, yearly DSCR of 1.25 and Average DSCR of 1.75 are considered to be
comfortable.
Illustration of DSCR calculation:
Let us assume that a Term Loan of Rs 50 L is proposed for Project X. The repayment is
proposed to be made in 60 instalments with a moratorium of 6 m in year I. The data on
PAT, Depreciation and interest on Term Loans are as follows:
(Rs in Lacs)
Years I II III IV V VI Total
PAT 3 8 10 15 16 18 70
Depreciation 6 8 8 8 8 8 46
Interest on TL 5.42 2.86 5.85 4.43 3.01 1.78

27.79
Instalment on Term Loan 5 10 10 10 10 5
50
DSCR will be as follows:

Years I II III IV V VI
DSCR 1.38 1.47 1.50 1.90 2.08 4.10
70 + 46 + 27.79
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑆𝐶𝑅 =
27.79 + 50
In all the years the DSCR is above 1 and the average DSCR is also 1.85 which is very
comfortable. If the DSCR or average DSCR is low, then the ability to service the loan is low.
If DSCR is less than the acceptable norms (stipulated by Banks), the loan repayment
period may be increased, provided the project is otherwise viable.
If the DSCR is high, then the repayment period should be reduced.
Page 13 of 15
5.5Determining Repayment Schedule

One necessary condition for determining the repayment schedule is that it must match
with the cash flow of the project. For instance, neither interest nor instalments shall be
recovered during project construction. Generally, in big projects, interest during the
construction period (IDC) is estimated and added to the project cost as well as the
principal of the loan for the project. Moratorium is the repayment holiday given i.e.,
Repayment will start after the moratorium period (which will be few months after
commercial production, generally). Moratorium may be for both interest and principal.
If the moratorium is for both principal and interest, interest will be capitalised and added
to the principal.
However, where moratorium is extended only for principal, interest should be paid
during the moratorium period. Margin for IDC should be 100%. In case of small projects
banks prefer the same after confirming that the funds are available with the promoter.
Repayment schedule shall be determined keeping in mind the following:
 Start of commercial production
 Moratorium period
 Cash flows e.g., if in the initial years the cash flow is less, ballooning repayment
schedule may be fixed.
Supposing a project is viable, then debt servicing should not be an issue. However, if the
repayment schedule doesn’t match the project cash flows or if the repayment period is
significantly shorter than the life of the project then the loan cannot be serviced.
5.6Sensitivity Analysis
Sensitivity analysis is the study of how the uncertainty in the cash flows of a project can
be apportioned to different sources. Sensitivity analysis answers the question, "if the
input variables like cost of raw material, cost of labour, tax rates, selling price, etc. deviate
from expectations, what will the effect be on cash flows or NPV or IRR or DSCR?“
Therefore, to see the impact of a particular variable the same alone will be changed
keeping other variables at the base case level. This way one can check sensitivity of a
project’s cash flows to different variables. NPV, IRR and DSCR after each change should
be noted and finally average NPV, average IRR and average DSCR should be calculated. If
the average NPV/IRR/DSCR is above the minimum required level the project will be
accepted and funding support can be provided.
Different variables that can be changed for sensitivity analysis could be the Project cost,
Capacity utilization, Quantity of sales, Selling price, Raw material cost, Labour cost,
Discount rates, etc.
5.7Scenario Analysis
Scenario analysis is a process of analyzing possible future events by considering
alternative possible scenarios. The scenarios can be base case scenario, optimistic
scenario and pessimistic scenario but not necessarily restricted to these three scenarios.
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Unlike sensitivity analysis scenario analysis allows variation in multiple variables at a

time. Rather, the entire scenario is changed and the effect of the same is studied. Under
each scenario NPV, IRR and DSCR should be estimated and the average of them should be
calculated.
Term loans are needed for business projects to finance fixed assets necessary for
establishing projects. The types of projects include new businesses, green field projects
and brown field projects. New business projects are the most risky and brown field
projects are the least risky. Appraisal of projects is necessary for making loan decisions.
It will help in choosing projects objectively and consistently, will provide documentation
for meeting financial and regulatory requirements and also will enable loan decisions.
Project appraisal will normally include appraisal of technical, commercial, managerial,
legal, environmental and financial aspects of projects. Financial appraisal of projects will
include checking project cost, means of finance, and working capital margin, projection
of cash flows, and ascertaining viability and repayment capacity of the project. While
viability of projects can be measured by NPV or IRR repayment capacity it measured by
DSCR. Lenders should determine the repayment schedule such that it will match with the
cash flows of the project.
As the estimates and projects are based on assumptions there is a need to carryout
sensitivity analysis and scenario analysis. Sensitivity analysis allows changing only one
assumption at a time whereas scenario analysis allows changing many variables at a time.
Page 15 of 15
Chapter 6: Working Capital Finance
Dr. M. Manickaraj
Objective
After reading the chapter one will be able to appreciate the importance of working capital
finance, alternative methods for estimating working capital requirement of business
firms and various products for financing working capital.
Structure
6.1 Introduction
6.2 Operating cycle and working capital requirement
6.3 Working capital requirement
6.4 Methods for assessing working capital requirement
6.5 Products for financing working capital
6.1 Introduction
Historically, providing working capital finance was the main business of commercial
banks. Term loans and project finance were provided by the development finance
institutions (DFIs) also referred to as term lending institutions. Agriculture credit was
provided mainly by cooperative banks and literally no lending institution was providing
retail loans. However, after liberalisation of banking industry commercial banks have
started providing a variety of loans to all types of customers. Nonetheless, working capital
finance remains the major business for many commercial banks.
Term lending institutions and non-banking finance companies (NBFCs) too provide
working capital. However, they do not provide cash credit which is referred to as line of
credit, because in order to operate cash credit there is a need for a current account which
can be offered by commercial banks only. As such working capital loan offered by
institutions other than commercial banks is nothing but term loans for a short period.
Cash credit offered by a bank is always offered as a limit within which the customer can
draw money from the loan account whenever needed and deposit money in the account
whenever money is available. To put it differently, cash credit allows both debit and credit
Page 1 of 18
into the loan account. On the one hand, this flexibility provides comfort to the customers
and on the other hand, it enables banks to monitor borrower’s operating performance
from the transactions made in the loan accounts.
Working capital loan is offered to finance day to day operations of borrowing companies.
Exit from working capital relationship by banks is very difficult. Exit from working capital
relationship may lead to shutting down operations of the company. It may be possible if
the company is able to raise equity capital or working capital is raised from some other
lender. Thus, cash credit offered by commercial banks in India is not self-liquidating in
nature. Therefore, close monitoring of cash credit becomes extremely important.
Working capital support will be needed as long as business operations continue and
hence if a customer is doing well and pays interest on cash credit regularly the lending
bank can get perpetual business from the customer. Rather, if the business of the
customer grows the customer’s working capital requirement will normally grow and
hence the bank’s loan book will also grow.
6.2 Operating cycle and working capital requirement
As discussed in the previous section, working capital is meant for financing the operating
cycle of borrowers. For a typical manufacturing firm operating cycle is the time lag
between procurement of raw material and collection of cash from its customers. It covers
the time taken for converting raw material into finished goods, sale of finished goods and
collection of cash from customers (Figure 6.1).
From the time raw material is procured and till the time finished products are sold the
company concerned will be holding the material in the form of raw material, work in
process and finished goods. This period may be referred to as inventory period. Time
taken for collecting cash from the customers may be referred as receivable period. The
operating cycle of a manufacturing firm thus is the sum of inventory period and
receivable period. (Chapter on Financial Statements Analysis may be referred to for the
equations for finding out inventory period, receivable period and creditor period).
A part of the operating cycle will be financed by suppliers of raw material and the balance
(operating cycle minus creditor period) is referred to as net operating cycle (Figure 6.2).
Net operating cycle is also referred to as cash cycle or cash to cash cycle. Net operating
cycle is the period for which working capital is needed.
Figure 6.1 : Operating Cycle
Page 2 of 18
Figure 6.2: Net Operating Cycle
Operating cycle and net operating cycle can be written as in Equations 6.1 and 6.2
respectively.
Operating Cycle  Inventory Period  Receivable Period . . . . . . . . . . . . . . . . . . . . . . (6.1)
Net Operating Cycle  Operating Cycle  Creditors Period . . . . . . . . . . . . . . . . . . . . . . (6.2)
The length of operating cycle determines the working capital requirement. Longer the
operating cycle higher will be the working capital requirement and shorter the operating
cycle lower will be the working capital requirement. As such, it is highly important for
working capital provider to know the operating cycle of his customer. Longer operating
cycle will result in higher levels of inventory and receivables and hence higher working
capital requirement. Therefore, it is prudent for the working capital provider to question
whether the length of the operating cycle of the customer is optimal or not. In fact, shorter
operating cycle means the customer is able to convert the raw material into finished
goods, sell the finished goods and then could collect cash from his customers within a
short period of time. Thus shorter the operating cycle more efficient the operations are
and longer the operating cycle less efficient the operations are. Therefore, the lenders
should be wary of financing a customer whose operating cycle is very long. However, the
following points need to be kept in mind while providing working capital:
• Length of operating cycle varies from sector to sector: Each industry differs from
other industries in terms of the raw material availability, manufacturing process,
customer expectations, nature of product, and so on. Accordingly, the length of
raw material holding, manufacturing cycle and inventory policy will vary.
Similarly, different industries may follow different terms for collecting cash from
customers and similarly different terms for payment to suppliers of raw material.
• Benchmarks need to be set for different sectors specifically: For the reason
explained in the previous point, benchmarks for the holding periods and operating
cycle may be set for each sector specifically.
• The length of operating cycle varies from time to time: Various factors particularly,
demand supply conditions change from time to time and hence the operating cycle
Page 3 of 18
length changes over time. In general, during boom periods the length of operating
cycle will decrease substantially and vice versa.
• Bargaining power of players determine operating cycle: Bargaining power of
suppliers will determine the length of raw material inventory period and creditor
period. Similarly, bargaining power of customers will determine the receivable
period. For examples in the automobile industry the suppliers of auto components
do not have the bargaining power. Therefore, the auto component vendors have
to carry the inventory so that they can deliver them as when the vehicle
manufacturers need. The vendors also have to accept delayed payment for their
components. On the other side of the value chain the dealers who buy the vehicles
from the vehicle manufacturers and sell them to end customers too lack
bargaining power. Therefore, they have to make payment for the vehicles to the
vehicle manufacturers quickly. Vehicle manufacturers therefore enjoy long
creditor period and short receivable period.
• Banks can target the sectors which need working capital: As explained in the
previous point vehicle manufacturers may not need any working capital support.
Whereas, auto component manufacturers and dealers would need working
capital.
• Banks may also design suitable working capital products: One popular working
capital product is channel finance. This is offered to auto component vendors.
Similarly, dealer finance is offered to dealers of automobiles. For more details on
working capital products the section on Products for Financing Working Capital
may be referred.
• Macroeconomic conditions impact the operating cycle: One major factor that
influences operating cycle of various sectors is the macroeconomic conditions.
Cyclical sectors like consumer durables, capital goods, real estate and the like are
particularly affected significantly by changes in macroeconomic conditions. In
general, the length of operating cycle of various sectors will increase during
economic slowdown/recession and will decrease when the economy recovers.
• Length of operating cycle may also indicate the level of efficiency and/or risk:
Other things remaining the same, a company with longer operating cycle can be
said to be inefficient and hence is risky.
6.3 Working Capital Requirement
Working capital can also be viewed as the capital required for financing current assets of
business firms. It can be understood by reading Table 6.1 which is the shape of balance
sheet of typical manufacturing firms. The table shows that current assets can be financed
by current liabilities including short term borrowings and the balance by long term
sources of finance including equity capital and long-term borrowings. Ideally, a part of
current assets should be financed by equity capital. Equity capital used for financing
current assets is often referred to as margin for working capital.
Page 4 of 18
Banks in India generally consider only inventory and receivables for determination of
working capital financing. Other items like cash and bank balance, other current assets
and loans and advances are not considered. Similarly, short term borrowings and trade
credit are the two primary sources of finance for working capital. While borrowings are
loans offered by banks trade credit is offered by suppliers of raw material.
Table 6.1: Shape of Balance Sheet
Capital and Liabilities Amount Assets Amount

Equity Capital Fixed Assets
Long-term borrowings
Current Assets:
- Inventory
- Trade receivables
Current Liabilities: - Cash & bank balance
- Short-term borrowings - Other current assets
- Trade credit - Loans and advances
- Other current liabilities
- Provisions
6.4 Methods for Assessing of Working Capital Requirement

Estimating working capital requirements of firms is one of major challenges before
commercial banks. The requirements should be assessed such that it will not result in
excess financing nor under financing. There are various methods in vogue for estimating
working capital requirements. These methods can be broadly classified under the
following headings:
 Balance sheet based methods
 Turnover based methods
 Cash flow based methods
6.4.1 Balance Sheet Based Methods
A Study Group under the chairmanship of Mr PrakashTandon, the then Chairman and
Managing Director of Punjab National Bank was constituted by the Reserve Bank of India
in July 1974. The study group has recommended three alternative methods for estimating
working capital requirement of business firms which is referred to as the maximum
permissible bank finance (MPBF). The methods recommended by the study group are
commonly referred to as MPBF1, MPBF2, and MPBF3 respectively. These methods are
also referred to as the first method, second method and third method respectively. The
Page 5 of 18
first and second methods are used by many banks in India till today. Whereas the third
method is not in use. The three methods are as follows:
• First Method
MPBF = 0.75 * (Current Assets – Other Current Liabilities) …………………………. (6.3)
• Second Method:
MPBF = 0.75 * Current Assets – Other Current Liabilities ………………………….. (6.4)
• Third Method:
MPBF = 0.75 * (Current Assets - Core Current Assets) – Other Current Liabilities… (6.5)
Where,
• Other current liabilities are current liabilities other than bank credit (i.e., total
current liabilities minus short term borrowings)
• Core current assets are the current assets that will have to be maintained at the
lowest level of operations
• Current assets minus other current liabilities is called Working Capital Gap
(WCG)
Comparison of MPBF 1 and MPBF2
It is necessary for every banker to understand the implications of using the first method
(MPBF1) and second method (MPBF 2) recommended by the Tandon Committee. Let us
assume that the total current assets of X Ltd is Rs. 100 crore and other current liabilities
will be in the range of 50 to 100. At different levels of other current liabilities, bank credit
that can be sanctioned under both the methods, current ratio and equity margin have
been worked out and the same are presented in Table 6.2.
Table 6.2 provides the following information:
 Working capital credit that can be sanctioned under the second method will
always be lower than under the first method.
 Working capital margin under the second method will be not less than 25%
 If second method is followed current ratio will be not less than 1.33.
 If the first method is used the current ratio will be different at different levels of
other current liabilities. Higher the amount of other current liabilities lower will
be current ratio and equity margin. Lower the amount of other current liabilities
higher will be the current ratio and equity margin.
Page 6 of 18
Table 6.2: Comparison of First and Second Method recommended by

Tandon Committee
Current assets = Rs. 100 crore
Total Current
Other Working Bank Credit Liabilities Current Ratio Margin (%)
current Capital MPBF MPBF MPBF MPBF MPBF MPBF
liabilities Gap MPBF 1 MPBF 2 1 2 1 2 1 2
100 0 0 0 100 100 1 1.00 NA NA
90 10 7.5 0 97.50 90 1.026 1.11 2.50 NA
80 20 15 0 95.00 80 1.053 1.25 5.00 NA
75 25 18.75 0 93.75 75 1.067 1.33 6.25 NA

70 30 22.5 5 92.50 75 1.081 1.33 7.50 25
60 40 30 15 90.00 75 1.111 1.33 10.00 25
50 50 37.5 25 87.50 75 1.143 1.33 12.50 25
Table 6.2 shows clearly that the first method will result in inconsistent level of current
ratio and equity margin. One cannot be sure how much margin will be available if working
capital is estimated using the first method. Therefore, it is suggested that the first method
shall not be used.
Banks use the first method in order to provide more credit and hence the equity margin
to be provided by owners of firms will be less. If this is the reason behind the use of the
first method it is suggested that the second method may be modified as in Table 6.3.
Table 6.3: Modified Versions of the Second Method (MPBF2)
Current
Method Ratio Margin
MPBF = 0.60 x CA - CL 1.67 40%
MPBF = 0.70 x CA - CL 1.43 30%
MPBF = 0.75 x CA - CL 1.33 25%
MPBF = 0.80 x CA - CL 1.25 20%
MPBF = 0.83 x CA - CL 1.20 17%
MPBF = 0.85 x CA - CL 1.18 15%
MPBF = 0.90 * CA - CL 1.11 10%
Page 7 of 18
6.4.2 Turnover Based Method

In December 1991, the RBI constituted a committee under the chairmanship of Mr P R
Nayak the then Deputy Governor RBI and the committee has recommended a method for
estimating working capital requirements of small enterprises. The method was meant to
be used in case of small enterprises which are not equipped to prepare the projected
The Nayak Committee has suggested that the minimum working capital requirement
shall be estimated as 25% of projected turnover. Out of the 25%, bank credit should be
20% and margin should be 5%.
The method has assumed that the minimum length of operating cycle of small enterprises
is three months. Hence, if the operating cycle of a borrower is longer than three months
bank finance will be inadequate and if the cycle is shorter than three months bank credit
will exceed the need.
As per a recent Government Advisory the Banks are have make following modifications
in working capital assessment process with respect to Micro and Small Enterprises whose
Fund Based W.C. requirements are up to Rs.5.00 Crores.
 To increase the working capital credit limit from Minimum 20% of accepted
projected turnover to 25%.
 To consider providing Working Capital up to 30% of projected turnover if the
borrower will sell goods online.
Revised Guidelines MSMEs:
Particulars Existing Revised
1 For MSMEs whose FB WC 20% of the projected 25% of the projected
limits requirement is upto turnover or computed turnover or computed
Rs.5 crores. on the basis of Tandon on the basis of Tandon
first method of lending first method of lending
whichever is higher whichever is higher
Margin 5% of the projected 6.25% of the projected
turnover turnover.
2 For MSMEs who maintain No guidelines 30% of the projected
digital records and whose turnover which is
Fund based working expected to be digitally
capital limits requirement transacted.
is upto Rs.5.00 crores
Margin NA 7.5% of the portion of
turnover which is
projected to be digitally
transacted.
Page 8 of 18
Illustration I :
Projected Turnover by Company X : Rs.10.00 crores

Of which - Non Digital Mode : Rs. 6.00 crores
- Digital Mode : Rs. 4.00 crores
Hence company X has 40% of turnover under Digital mode. Hence it is eligible for
additional working capital.
Calculation:
1. Sales through Non Digital Mode:
Turnover method Amount in
Crore
Projected Sales 10.00
Non Digital Mode 6.00
Accepted level by Bank (Assumption) 6.00
31.25% of Turnover (i.e.,) 25% of Turnover plus margin of a 1.88
6.25%
Min. Margin 6.25% of Turnover b 0.38
Actual /Projected NWC * c 0.38
Owners Margin (Higher of (b) & (c)) d 0.38
MPBF = (a) – (d) a-d 1.50
2. Digital Mode
Turnover method Amount in
Crore
7.50%
Page 9 of 18

MPBF = (a) – (d) a-d 1.50
For illustration purpose we have assumed actual/projected NWC is the same as

required margin.
The Limit will be as under:

Limit assessed for Non Digital Mode : Rs.1.50 crores
Limits assessed for Digital Mode : Rs.1.20 Crores
Total limit to be sanctioned : Rs.2.70 crores
However, if FB limit assessed as per the Tandon first method of lending is more, then
limit assessed as per first method of lending is to be sanctioned.
Illustration II:
Turnover of Company Y : Rs.10.00 crores
Of which - Non Digital Mode : Rs. 8.00 crores
- Digital Mode : Rs. 2.00 crores
Company Y has only 20% of turnover under Digital mode. Hence it is not eligible for
additional working capital as the turnover projected under digital mode is less than
25% of the total turnover. In such cases the whole turnover will be considered as
Non Digital mode and assessment will be carried out accordingly.
Calculation:
1. Sales through Non Digital Mode:
Turnover method Amt. In
Crore.
Page 10 of 18

6.25%
MPBF = (a) – (d) a-d 2.40
However, if FB limit assessed as per the Tandon first method of lending is more, then
limit assessed as per first method of lending is to be sanctioned.
6.4.3 Cash Flow based Methods

Following are the two methods which enable estimation of working capital based on cash
flow of borrowing companies.
 Operating cycle method
 Cash budget method
a. Operating Cycle Method
As discussed earlier in the chapter working capital is meant for financing operating
cycle of business firms. According to the method working capital requirements of firms
may be estimated as follows:
Bank Credit = Inventory + Receivables – Trade Credit – Margin …………………… (6.6)
Where,
Inventory = Projected Sales x Inventory Period / 365 …………………… (6.7)
Receivables = Projected Sales x Receivable Period / 365 ……………………. (6.8)
Trade Credit = Projected Sales x Creditors Period / 365 ……………………. (6.9)
Inventory 365
Inventory Period 
Sales ………………………………………… (6.10)
Receivable s  365
Receivable Period 
Sales ………………………………………… (6.11)
Trade Creditors  365
Creditors Period 
Sales …………………………………………. (6.12)
Margin can be preferably determined as % of (Inventory + Receivables)
Page 11 of 18
It may be noted that holding periods of inventory, receivables and creditors need to be
decided beforehand. One alternative for determining the holding periods is to consider
the average of holding periods over few years in the past.
Estimation of working capital under Operating Cycle Method - Illustration
Given below is the data of Mars Ltd.
• Projected Sales of X Ltd : Rs. 730crore
• Inventory period : 30 days
• Receivable period : 45 days
• Creditors period : 25 days
• Margin required for working capital is : 25%
Working capital requirement of Mars Ltd can be estimated as in Table 6.4.
Table 6.4: Estimation of Working Capital under Operating Cycle Method
Item Amount
Inventory (730 x 30/365) 60
Receivables (730 x 45/365) 90
Total (Inventory + Receivables) 150
Margin (25% of Total) 37.50
Trade Credit(730 x 25/365) 50
Bank credit (Total – Margin – Trade Credit) 62.50
b. Cash Budget Method

Cash budget is a statement showing budgeted receipts, payments, and surplus/deficit
during each period, say, every month. It is an ideal tool for ascertaining working capital
requirement of not only seasonal enterprises but also of all types of firms. Cash budget
will show the cash gap (i.e., working capital requirement) which will be different during
different months. Firms will require higher working capital during peak seasons. During
off seasons it may need very less or no working capital. Accordingly, the bank can release
the loan. The highest gap is called the peak level deficit and this may be fixed as the peak
level working capital limit.
The unique advantages of cash budget for working capital estimation are as follows:
• Cash budgets will enable effective monitoring of loans
• It will enable effective credit planning by lending institutions
• Need for sanctioning adhoc limits and/or enhancement of credit limits during
the currency of a loan may not normally arise
Page 12 of 18
Cash budget is used by many banks for estimating working capital requirement of
seasonal businesses like sugar, tea and the like. However, the method can be used for
estimating working capital requirement of any business firm.
Cash Budget – An Illustration
Royal Manufacturing Company has asked to create a cash budget in order to determine
its borrowing needs for the period June to October. The following information are
gathered.
Month Sales (INR) Other Payments (INR)
June 172,000 80,000
July 142,000 75,000
August 121,000 70,000
September 93,000 50,000
October 76,000 45,000
November 81,000
April and May sales were INR115,000 and INR135,000, respectively. The firm collects
35% of its sales during the month, 55% the following month, and 10% two months after
the sale. Each month it purchases raw material equal to 60% of the next month’s expected
sales. The company pays for 40% of its raw material purchases in the same month and
60% in the following month. However, the firm’s suppliers give it a 2% discount if it pays
during the same month as the purchase. A minimum cash balance of INR25,000 must be
maintained each month, and the firm pays 6% annually for short-term borrowings from
its bank.
Create a cash budget for June to October. The cash budget should account for short-term
borrowing and payback of outstanding loans. The firm ended May with INR30,000 cash
balance.
Royal Manufacturing Company’s cash budget may be prepared by using the following
steps:
1. Estimation of collection from customers during each month
2. Estimation of purchases of raw material during each month
3. Finally, preparation of cash budget
Page 13 of 18
Collection from Customers

% of sales to be
June July August September October
collected
Same month 35% 60200 49700 42350 32550 26600
Previous month 55% 74250 94600 78100 66550 51150
2 months before 10% 11500 13500 17200 14200 12100
Total collection 100% 145950 157800 137650 113300 89850
Payment for Purchases

Payment
(% of May June July August September October
purchases)
Purchases --- 103200 85200 72600 55800 45600 48600
Same
month 40% 33398.4@ 28459.2 21873.6 17875.2 19051.2
Previous
month 60% 61920 51120 43560 33480 27360
Total 100% 95318 79579 65434 51355 46411
@: 85200 x 40% less 2% discount. Payment made in subsequent months have been
estimated similarly.
Cash Budget of Royal Manufacturing Company
June July August September October
Opening balance of cash 30000 25000 25000 25000 25000
Collection from customers 145950 157800 137650 113300 89850
Total 175950 182800 162650 138300 114850
Payments:
To suppliers 95318 79579 65434 51355 46411
Other payments 80,000 75,000 70,000 50,000 45,000
Total 175318 154579 135434 101355 91411
Surplus (Deficit) 632 28221 27216 36945 23439
Closing balance 25000 25000 25000 25000 25000
Borrowing (Repayment) 24368 -3221 -2216 -11945 1561
Page 14 of 18
6.5 Products for financing working capital

Following is the list of some products that can be offered by lending institutions to firms
for financing working capital:
• Cash credit
• Secured line of credit with specified drawing limit offered to
businesses for a period of one year for their working capital
requirement. Banks open a cash credit account with cheque facility
for the customer to operate the same.
• Working capital term loan
• This is a funded facility provided to bank customers wherein the
irregular portion of cash credit other than unrealised interest (on
both cash credit and institutional loans) may be converted into term
loan with certain specified repayment period.
• Seasonal loan
• Such loans meet the short term financing needs of seasonal
companies. It is usually offered as a line of credit lasting for a certain
number of months.
• Collateral/asset based finance
• Such loans are specialized methods of providing working capital
based on certain assets such as inventory or receivables as
collateral.
• Order based
• Such loans provide working capital finance for executing specific
purchase or work orders from specific clients. Upfront payment can
be made to suppliers under purchase orders followed by an invoice
discounting structure where the final payment is collected from the
OEMs at the end of the credit period.
• Channel finance
• Such loans are based on supply chain finance relationships between
companies where working capital financing to a vendor may be
based upon the credit standing of a large OEM client.
• Discounting/purchase of bills.
• Such loans finance receivables by discounting the bills before they
are due. The loans are for a certain period and are usually followed
by a bullet repayment of loan amount.
Page 15 of 18
• Factoring
• Such loans also finance a supplier’s invoices and receivables at a
discount for certain period of time. The factor is usually then
responsible for collecting the amount from the customer.
Provision of working capital is a major business for lending institutions and commercial
banks are having an edge over other lending institutions in providing working capital that
will match the actual requirement of borrowers. Working capital is meant for financing
operating cycle of business firms and hence banks need to understand the length of
operating cycle and the efficiency of operations of borrowing companies to determine the
working capital requirement and to understand the risk involved. There are various
methods for estimating working capital requirement. However, balance sheet based
methods and turnover based methods may mislead and hence operating cycle method or
cash budget method may be used. Similarly, there are many alternative products for
meeting working capital requirements of business firms. Depending on the customers’
requirements and risk involved appropriate product may be offered.
Page 16 of 18
Annexure 1
Case Study on Estimation of Working Capital Requirement
Projected financials of Solar Steel Ltd for the year 2017 are given in Table 4.5. The
historical average holding periods of current assets and current liabilities of the
company were as follows:
 Inventory period : 45 days
 Receivable period : 40 days
 Creditor period : 60 days
The company has sought working capital loan of Rs. 200 crore from Jupiter Bank.
However, the credit department of the bank wishes to find out the amount that can be
sanctioned. The equity margin for the loans as stipulated by the bank’s credit policy is
25%.
Table 4.5: Projected Financials of Solar Steel Ltd for the year 2017
2017 2017
Tangible Net Worth 417.31 Net Sales 3735.81
Medium & Long Term Loans 181.29 Other Income 3.35
Current Liabilities# 811.23 EBIDTA 204.35
Net Block 222.44 Depreciation 26.85
Investments in group
2.79 Interest 105.13
companies
Taxes 24.68
Current Assets 1184.60
Net Profit / (Loss) 54.68
#: Includes working capital loan of Rs. 200 crore. All figures are in INR Crore.
Assessment of Working Capital Requirement of Solar Steel Ltd:
Turnover Method:
25% of projected sales (25% of 3735.81) = Rs. 933.95
Less Margin of 5% of projected sales (5% of 3735.81) = 186.79
Bank Loan = 747.16
Page 17 of 18
First Method of Tandon Committee:

Bank Loan = 0.75 x (Current Assets – Other Current Liabilities)
Other Current Liabilities = Current Liabilities – Bank Loan
= 811.23 – 200
= 611.23 crore
Bank Loan = 0.75 x (1184.60 – 611.23)
= 430.03 crore
Second Method of Tandon Committee:
Bank Loan = 0.75 x Current Assets – Other Current Liabilities
= 0.75 x 1184.60 – 611.23
= 277.22crore
Operating Cycle Method:
Item Amount
A. Inventory 470.81
B. Receivables 409.40
C. Total (A + B) 880.21
D. Margin (25% of C) 220.05

E. Trade Credit 624.34
F. Bank loan (C – D – E) 35.82
Page 18 of 18
Chapter 7: Non Fund Based Facilities
Prof. Jayant Keskar
Objective
The objective of this chapter is to give an overview of non-fund working capital facilities
offered by banks, the process involved, and the regulatory guidelines for the same.
Structure
7.1 Introduction
7.2 Letter of Credit
7.2.1 Introduction to LC
7.2.2 Parties to Letter of Credit apart from Applicant and beneficiary
7.2.3 Type of Letter of Credits
7.2.4 RBI Guidelines
7.2.5 Document generally asked under LC
7.2.6 Incoterms 2010
7.2.7 Checklist for issuing LC
7.2.8 Charges
7.2.9 LC Mechanism
7.3 Standby Letter of Credit
7.3.1 Usage of Standby LC by Authorised Dealers
7.4 Bank Guarantee
7.4.1 Introduction to BG
7.4.2 Governing Rules/Guidelines
7.4.3 Types of Bank Guarantee
7.4.4 Check List for processing request
7.4.5 Guidelines for the Issuance of Guarantee
7.4.6 Invocation of Bank Guarantee
Page 1 of 21
7.4.7 Payment of Invoked Guarantees

7.4.8 Extension of BGs
7.4.9 Onerous clauses in BG
7.4.10 Auto Closure of BG
7.5 Trade Credit
7.5.1 Buyer’s Credit
7.5.2 Seller’s Credit
7.5.3 Coacceptance
7.1 Introduction
In assessment of the working capital of a borrower, banks shall consider the following
two types of facilities:
· Fund based facilities – These refer to the facilities for drawing cash and funds as
per requirement of the concerned borrower. Chapter 6 may be referred to for the
details on fund based working capital financing.
· Non-fund based facilities – The credit facilities given by the bank where actual
funds are not involved are termed as Non-fund based facilities. The banks are
facilitators in a trade transactions whereby there offer their
commitment/promise/undertaking to pay in case the buyer fails to pay the seller
and seller remains unpaid. So the financial guarantee/ assurance is offered by
banks to facilitate the trade transaction by offering suitable instrument to cater to
the needs of buyer and seller. Non-funded instruments are designed in such a way
whereby the seller of the goods or services gets financial commitment by a solvent
person like bank subject to the compliance of terms and conditions as mentioned
in the related trade instrument.
The non-funded facilities are divided in to three broad categories as under:
· Letter of Credit
· Guarantees
· Co-acceptance of Bills
· Depending upon the nature of the transactions some variant of the above products
are offered to suit the domestic and international trade. These are
· Trade Credit for import of goods
· Deferred payment guarantee for import of capital equipment and technical know-
how.
Page 2 of 21
Now we shall discuss each product of non-funded facilities with reference to the
regulations, procedures, significance and usage.
7.2 Letters of Credit
7.2.1 Introduction
Letter of Credit (LC) is a payment mechanism wherein the credit issuing bank acts as
an intermediary between buyer and seller to address risk of both the parties and there
by facilitates the transaction.
The credit issuing bank undertakes irrevocably on behalf of its client
(Buyer/applicant) and in favour of the beneficiary (seller) to honour the payment
obligation against documents presented by the beneficiary in accordance with:
-The terms and conditions of the documentary credit
-Applicable provisions of UCPDC rules
-International Standard Banking Practice (ISBP)
7.2.2 Parties to LC:
The following are the parties involved in a LC:
a. Applicant : The buyer.

b. Beneficiary : The Seller
c. LC issuing Bank : The bank of the buyer which issues the LC favouring the
beneficiary (seller).
d. Advising Bank: Advising Bank advises the credit (LC) to the beneficiary, thereby
assuring the genuineness of the credit.
e. Confirming Bank: Generally a Bank in the country of seller. Confirming Bank on
adding its confirmation thereby undertakes the obligation of Issuing Bank.
f. Nominated Bank: The Bank with which credit is available or any Bank in the case
of a freely negotiable credit.
g. Reimbursing Bank: It is the Bank, authorised to honour the reimbursement
claim in settlement of negotiation acceptance / payment lodged with it by the
paying, negotiating or accepting Bank.
7.2.3 Type of Letter of Credits:
Ø Irrevocable - Can be cancelled or amended with consent of both the parties
(applicant & beneficiary) only.
Ø Revocable - Can be amended or cancelled by the applicant without notice to
beneficiary. Such LCs do not exists in practice now.
Ø Restricted Credit - Documents are restricted for negotiation under such credit to
a particular nominated Bank.
Page 3 of 21
Ø Freely Negotiable Credit (Unrestricted Credit) - Free from any restriction can
be negotiated with any Bank.
Ø Sight Credit- Payment on demand or on presentation/sight of documents.
Ø Usance Credit- Payment to be made after certain credit period as extended by the
seller.
Ø Deferred Payment Credit- It is a usance credit where payment will be made by
designated Bank, on respective due dates, determined in accordance with
stipulations of the credit, without the drawing of drafts.
Ø Revolving Letter of Credit – In Such LCs, the amount of credit is revived or
reinstated without requiring specific amendment to the credit. Revolving LCs with
automatic renewal clause is associated with risk and branches need to be careful
about the clauses. The reinstatement clause in the revolving LC assumes great
significance, hence the branches should put maximum liability clause in such LCs
and also maximum instances of reinstatement may be stated. Also branches
should not allow “waive – all – discrepancy” clause in such LCs.
Ø Transferable Letter of Credit- Such a credit states it is “transferable”. It can be
transferred in whole or in part to another beneficiary (“second beneficiary”) at the
request of the beneficiary (“first beneficiary”). However, it cannot be transferred
further.
Ø Back-to-back Credit or Countervailing Credit- When a second LC is issued on
the Backing of Principal LC, it is known back-to-back Credit or Countervailing
Credit.
Ø Anticipatory Credit: Anticipatory Credit Provides for payment to Beneficiary at
Pre-shipment stage also. Two types of Anticipatory Credit:
· Red clause Letter of Credit: A letter of credit which provides for an amount
in advance to Beneficiary for Purchasing raw material/Processing/Packing of
goods etc.
· Green Clause Letter of Credit: It is an Extended version of Red Clause Credit
and provides advance to Beneficiary for Warehousing, Insurance charges etc.
also.
7.2.4 RBI Guidelines
The following are the guidelines issued by the RBI relating to LCs:
· Bank should normally open letters of credit for their own customers who enjoy
credit facilities with them. Customers maintaining current account only and
not enjoying any credit limits should not be granted LC facilities except in cases
where customer is keeping 100 per cent cash collateral.
· The request of such customer for sanctioning and opening of letter of credit
should be properly scrutinised to establish the genuine need of the customer.
Page 4 of 21
The customer may be, required to submit a complete loan proposal including
financial statements to satisfy the bank about his, needs and also his financial
resources, to mire the bills drawn under.
· Where a customer enjoys credit facilities with some other bank, the reasons
for his approaching the bank for sanctioning LC limits have to be clearly stated.
The bank opening LC on behalf of such customer should invariably make a
reference to the existing banker of the customer
· In all cases of opening of letters of credit, the bank has to ensure that the
customer is able to retire the bills drawn under LC as per the financial
arrangement already finalised.
7.2.5 Document generally asked under LC
· Invoice
· Packing List/Weight list
· BL (Bill of Lading)/AWB (Air way Bill)/ Lorry receipt (These are Title to
goods)
· Insurance (only if Incoterm applied requires)
· Test /inspection certificate
· Certificate of origin (for import LCs)
· Bill of exchange.
7.2.6 Incoterms 2010:
International Commercial Terms, popularly known as INCOTERMS, were devised by
ICC which defines rights and obligation of the buyer and seller as regards delivery of
the goods and cost connected there to. We state below various INCOTERMS and their
significance.
Page 5 of 21
EXW FCA FAS FOB CFR CIF CPT CIP DAF DES DEQ DDU DDP
Free Free Cost Carriage Delivered Deliver Delivered Ex Delivered

Ex Free Cost & Carriage Delivered
SERVICES Alongside Onboard Insurance Insurance At ed Ex Quay Duty Duty
Works Carrier Freight Paid To Duty Paid
Ship Vessel & Freight Paid To Frontier Ship Unpaid Unpaid
Warehouse
Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Storage
Warehouse
Labor
Export
Packing
Loading
Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Charges
Inland Buyer/
Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Freight Seller*
Terminal
Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Charges
Forwarder's
Buyer Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller
Fees
Loading On
Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Vessel
Ocean/Air
Buyer Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller
Freight
Charges On
Arrival At Buyer Buyer Buyer Buyer Buyer Buyer Seller Seller Buyer Buyer Seller Seller Seller
Destination
Duty, Taxes
& Customs Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Seller
Clearance
Delivery To
Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Seller Seller
Destination
Page 6 of 21
Letter of Credit is popularly known as Documentary Credit in international parlance. It is

an undertaking of the issuing bank to pay on complying presentation as per UCPDC
(Uniform Customs and Practices for Documentary Credits ICC version 600). The Letter
of Credit is of two types:-
· Inland LC – These relate to the transactions done within India under LC.
· Foreign LC – These relate to import and export of goods and services done through
the LC route.
7.2.7 Checklist for issuing LC:
· Import LC shall be opened as per UCP-600 by a Forex B category branch only. Any
other originating branch will forward their application along with the documents
as listed above (section 7.2.5) to nearest Forex B category branch. Inland LC may
be issued by designated retail and corporate branches as per the policy of the
bank.
· Franked/Stamped LC Application to be attached
· Duly certified I E Code copy ( for Import LC)- For international trade transaction
the client needs to be issued importer-exporter code number by DGFT
(Directorate General of Foreign Trade) on an online application by the importer
or exporter.
· FEMA Declaration (For Import LC) to be attached
· Sanction Note/LOI to be checked for Customers having regular LC Limits
· Margin to be taken/confirmed as per Sanction in Consultation with original
branch.
· Board Resolution(for Limited Companies) or Consent Letter (for Partnership
Firms) to be attached
· Underlying Sales Contract / Performa Invoice/Indent/Purchase order etc. to be
attached.
· Insurance Policy if insurance is to be arranged by the importer as per Incoterms
(Except for CIF/CIP)
· In case of import LC, confidential opinion report (D&B, Experian etc.) for LC Value
USD 3 lakh to confirm the credentials of the overseas exporter and the exporter
are dealing in same line of business.
· Commission has to be charged as per Sanction/SOC (Schedule of Charges)
· Importability of goods/ services to be checked before LC opening as per extant
foreign trade policy.
Page 7 of 21
7.2.8 Charges :
Commission and other charges at sanctioned rate are to be applied upfront, while
issuing the LC. In case of LC against 100% cash collateral, charges as per card rate are
to be applied unless concessional rates are given by the sanctioning authority.
7.2.9 Letter of Credit (LC) Mechanism
Any business/industrial venture will involve purchase transactions relating to
machine/other capital goods and raw material etc., and also sale transactions relating
to its products. The customer may, therefore, find himself on either side of a LC
transaction at different times depending upon his position at that particular moment.
He may be an applicant for a letter of credit for his purchases while be the beneficiary
under other letter of credit for his sale transaction. It is, therefore, necessary that
complete LC mechanism covering the liabilities and rights and both the applicant and
the beneficiary are understood for maximum advantage.
The complete mechanism of a letter of credit may be divided in three parts as under:
1. Issuing of Credit – Letter of credit is always issued by the buyer’s bank (issuing
bank) at the request and on behalf and in accordance with the instructions of the
applicant. The LC may either be advised directly or through some other bank
(advising bank). The advising bank is responsible for transmission of credit and
verifying the authenticity of signature of issuing bank and is under no
commitment to pay the seller. The advising bank may also be required to add
confirmation and in that case will assume all the liabilities of issuing bank in
relation to the beneficiary as stated already. It will then be called as Confirming
Bank.
2. Negotiation of Documents by beneficiary – On receipt of letter of credit, the
beneficiary shall arrange to supply the goods as per the terms of LC and draw
necessary documents as required under LC. The documents will then be
presented to the negotiating bank for payment/acceptance as the case may be.
The negotiating bank will make the payment to the beneficiary and obtain
reimbursement from the opening bank in terms of credit.
3. Settlement of Bills Drawn under LC by the opener – The last step involved in letter
of credit mechanism is retirement of documents received under LC by the opener.
On receipt of documents drawn under LC, the opening bank is required to closely
examine the documents to ensure compliance of the terms and conditions of credit
and present the same to the opener for his scrutiny. The opener should then make
payment to the opening bank and take delivery of documents so that delivery of
goods can be obtained by him (where the credit is drawn under DP terms) and
should provide funds on due date in case of usance LC)
Page 8 of 21
8 Operational Guidelines for Issuance of LC:

1. LCs are transmitted through SWIFT/SFMS but hard copy of LCs are issued in
security form only affixed with security holograms.
2. LCs are issued under two authorised signatures wherever they are not
transmitted by SFMS/SWIFT.
3. LC should be opened for the purchase of Goods / Services, which have relevance
to the line of activity of the applicant company.
4. Capital goods LC should be opened after ensuring tie- up of the funds on due date.
LC sanctioned for the purchase of raw material, should not be used for purchase
of capital goods.
5. For Import LC exceeding value USD 3,00,000/- opinion report on overseas
supplier from International Credit Agency be obtained.
6. Confirming to the sanction terms, LC may be amended at the request of applicant.
9 Examination of Documents:
Under Article 14, UCP 600, the documents under LC shall be closely scrutinised by the
Issuing Bank, to confirm that all the terms and conditions as mentioned in the Letter of
Credit are totally complied with. In case of noncompliance, such LCs will be refused for
payment, pointing out the discrepancy in the presentation and refusal notice be issued
to the negotiating Bank, stating not honouring of the LC claim and asking for further
disposal instruction.
10 Payment under Letter of Credit:
Once the documents are examined and found to be in order as per LC term, Bank
has a payment obligation towards the same. The document will be presented to the
customer and payment will be made to the negotiating Bank, either on sight basis or
on due date. If the customer does not have adequate funds, the payments will be done
by the Bank by opening a devolved account, as per Circular (IDBI Bank/ 2010-
11/261/CBG/TF/27 dated November 10, 2010 & IDBI BANK/2013-
14/383/CBG/TF/25 dated September 25, 2013).
11 Export LC Advising :
Any LC received on behalf of the constituent exporter shall be advised by the
branch to the said exporter promptly only after checking the apparent authenticity of
the credit established by the issuing Bank. Also, branch should go through the contents
of LC and shall advise the beneficiary in the matter. However, if the Branch is unable
to verify the authenticity and chose to advise the LC to the beneficiary, it may do so
clearly indicating in the advising memo that “LC Advised Unauthenticated”. Branch
also should charge one time advising commission for LC / Amendment as per SOC.
Page 9 of 21
12 Adding Confirmation to Export LC

Adding confirmation on Export LC constitutes an additional undertaking on part
of the confirming bank to negotiate the LC on complying presentation. Therefore, the
branches need to pass on contingent exposure entries for non -funded exposure taken
by the bank after verifying the availability of bank line exposure sanctioned and also
recover the confirmation charges from beneficiary/LC opener as per terms of the LC.
13 Reversal /closure of expired LCs:
The bank needs to close all expired/un-availed LCs as it has an implication of risk
weighted assets and customers rotation of the limit for business purpose.
14. Assessment Of Letter Of Credit Limits
For assessing LC requirements of a borrower the followings points are to be considered:
(i) Purpose for opening L/C could be
· For import of raw material or a fixed asset or consumable stores and the
overseas seller is willing to sell only against L/C.
· In case of domestic purchase also the seller may be willing to sell the goods
against L/C only.
The document showing the terms of the seller will help establish the purpose of opening
a LC.
(ii) The quantity of goods to be purchased under L/C annually
(iii) Terms of L/C (Whether DP or DA)
(iv) Time taken by the seller to despatch the goods.
(v) Lead Time : The time taken to receive goods after opening an L/C.
(vi) Minimum level of stocks to be kept at all times/ Economic order quantity i.e.,
Minimum size of each consignment which will make economic sense.
(vii) Freight cost and insurance charges.
Assessment of DP LC limit
Assume a borrower purchases raw material worth Rs. 24 lacs in a year. Out of the above
50% of raw material are purchased through L/C. 50% of the purchase through LC is
imported. The indigenous raw material purchased through L/C takes 1 month to be
delivered after opening of L/C and in the case of imported ones it takes 4 months.
Page 10 of 21
In the above case the monthly consumption of indigenous raw material is Rs. 100,000 and
the monthly consumption of imported raw material is Rs. 12/12 = 100,000 lac. The
amount of the limit for indigenous raw material will be computed as under :
Assessment of DP LC Limits:
Annual purchase = Rs 24 lacs

Purchase through LC = Rs 12 lacs
Lead time = 1month
LC Limit required for Indigenous purchase =
Monthly consumption X (Lead Time + Usance period)
= 100,000 x 1 = Rs 100,000
The amount of LC limit for imported raw material will be
= Monthly consumption x (Lead time + Usance period)

= 50000 x 4 = Rs. 200,000
= The total L/C limit would then be Rs. 100,000 + 200,000 = Rs.300,000
Assessment of DA LC limits
Assume that a borrower purchases raw material worth Rs. 48 lacs in a year. Out of the
above 50% of raw material are purchased through L/C. 50% of the purchase through LC
is for imports. The indigenous raw material purchased through L/C takes about 2 months
to be delivered after opening of L/C and in the case of imported ones it takes about 4
months. Both the L/C's are to be on 2 months DA basis. Lead time for indigenous LC is 15
days and lead time for import LC is 2 months.
The assessment is as follows :
Then 2 months should be added to the Lead Time subject to adjustment of transit period
already covered under the Lead Time. Assuming such transit period is 15 days (0.5
month) then the requirement will be
Annual purchase = Rs 48 lacs

Purchase through LC = Rs 12 lacs
Purchase through inland LC = Rs 6 lacs
Purchase through import LC = Rs 6 lacs
LC indigenous Limit = Monthly consumption x (Lead Time + Usance period)

= 0.5 x (0.5 + 2) = Rs 1.25 lacs
LC for import = 0.5 x (2+2)

= Rs 2 lacs
Page 11 of 21
7.3 Standby Letter of Credit

Standby Letter of Credit (SBLC) is a financial support instrument and have similarities
with Commercial Letter of Credit (LC) and Bank Guarantee (BG). This is in substitution of
Demand Guarantees and supports payment when due or after default. Documents
generally called for under SBLC are a simple statement of claim and / or proof of delivery
of goods and / or certificate of non-performance. This type of Letter of Credit is opened
mostly by banks in countries where, by law they are precluded from issuing guarantees
and in such cases this type of Credit is issued as substitutes for performance or other
financial guarantees. Even though Standby Credit is a mere substitute for Guarantee it
has developed as an all-purpose financial support instrument embracing wider range of
uses than the normal Demand Guarantee and is issued to cover situations of non-
performance. No Transport Document is called for under this Credit.
In a SBLC:
· The Issuer, usually a Bank
· At the request of its customer, Applicant
· Agrees that the Beneficiary will be paid
· Before the credit’s expiry
· Upon the beneficiary’s presentment of:
i. Its demand for payment and
ii. Any documents evidencing the Applicant’s Non-performance.
There are following type of SBLCs:
1) Commercial SBLC
2) Financial SBLC
3) Performance SBLC
4) Advance payment SBLC
5) Bid Bond SBLC
7.3.1 Usage of SBLC by Authorised Dealers:
SBLC may be undertaken for the following transactions:
i. As a document of promise in respect of “non-performance’ situation especially
as a substitution to the guarantees which ADs are permitted to issue under
FEMA, such as issuing a guarantee in respect of any debt, obligation or other
liability incurred by:
a) An exporter on account of exports from India.
Page 12 of 21
b) Owed to a person resident in India by a person resident outside India for a

bonafide trade transaction, duly covered by a counter guarantee of a bank
of international repute resident abroad.
ii. Exporters may opt to receive SBLC in respect of exports from India.
Appropriate safeguards and precautions some of which are illustrated below shall be
observed by Authorised Dealers where such SBLCs are issued.
a) The facility of issuing Commercial SBLCs shall be extended on a selective basis
and to the following categories of Importers only:
i. Where such Standbys are required by Applicants who are independent
power producers/importers of crude oil and petroleum products.
ii. Special category of importers viz. Export Houses/Trading Houses/Star
Trading Houses/Superstar Trading Houses/ 100% EOUs.
iii. Public Sector Units/Public Limited Companies with good track record.
b) Satisfactory credit report on the overseas supplier should be obtained by the
Issuing Bank before issuing Standbys.
c) Invocation of the Commercial SBLC by the Beneficiary is to be supported by
proper evidence. The beneficiary of the credit should furnish a declaration to the
effect that the claim is made on account of failure of the importer to abide by his
contractual obligations, along with the following documents:
i. A Copy of Invoice
ii. Non-negotiable set of documents including a copy of Non-negotiable Bill
of Lading/Transport Document.
iii. A Copy of Lloyds /SGS Inspection Certificate wherever provided for as per
the underlying contract
d) Incorporation of suitable clause to the effect that in the event of such
Invoice/Shipping Document has been paid by the Authorised Dealer earlier,
provisions to dishonour the claims quoting the date/manner of earlier payment
of such documents may be considered.
e) The Applicant of a Commercial SBLC (Indian importer) shall undertake to
provide evidence of imports in respect of all payments made under SBLC (Bill of
Entry).
Authorised Dealers shall follow up evidence of imports as provided for under FEMA in
all cases of payments made.
SBLC are governed by UCP 600, URDG 758 and ISP 98 depending upon the choice and
agreement between applicant and beneficiaries.
Page 13 of 21
7.4 Bank Guarantee

7.4.1 Introduction
Bank Guarantee (BG) is an instrument issued by the Bank in which the Bank agrees to
stand guarantee against the non-performance of some action of a party. The
quantum of guarantee is called the guarantee amount. The guarantee is issued upon
receipt of a request from applicant for some purpose/transaction in favour of a
Beneficiary. The issuing bank will pay the guarantee amount to the beneficiary of the
guarantee upon receipt of the claim from the beneficiary. This results in invocation
of the Guarantee.
Bank guarantees can be Inland (which are issued in favour of Beneficiary within the
country) as well as Foreign (which are issued in favour of Beneficiary outside the
country)
7.4.2 Governing Rules/Guidelines :
A. Indian Contract Act;
B. Reserve Bank of India;
C. FEMA (Foreign Exchange Management Act)*;
D. URDG758 (Uniform Rules for Demand Guarantees)*;
(*Applicable for Foreign Bank Guarantee)
7.4.3 Types of Bank Guarantee :
7.4.3.1 Financial BG:
Financial guarantees are direct credit substitutes wherein a bank irrevocably
undertakes to guarantee the repayment of a contractual financial obligation.
Examples:-
Ø Guarantees for credit facilities;
Ø Guarantees in lieu of repayment of financial securities;
Ø Guarantees in lieu of margin requirements of exchanges;
Ø Guarantees for mobilisation advance, advance money before the
commencement of a project and for money to be received in various stages of
project implementation; such guarantees are also known as Advance Payment
Guarantee.
Ø Guarantees towards revenue dues, taxes, duties, levies etc. in favour of Tax/
Customs / Port / Excise Authorities and for disputed liabilities for litigation
pending at courts;
Ø Deferred payment guarantees.
Page 14 of 21
(As per RBI circular RBI/2012-13/467 dated April 02, 2013 on New Capital Adequacy
Framework, Financial guarantees attract credit conversion factor (CCF) of 100%).
7.4.3.2 Performance BG :
Performance guarantees are essentially transaction-related contingencies that
involve an irrevocable undertaking to pay a third party in the event the
counterparty fails to fulfil or perform a contractual non-financial obligation. In
such transactions, the risk of loss depends on the event which need not
necessarily be related to the creditworthiness of the counterparty involved.
Examples:-
Ø Guarantees in lieu of security deposits / earnest money deposits (EMD) for
participating in tenders, such guarantees are also known as Bid Bond
Guarantee.
Ø Performance bonds and export performance guarantees;
Ø Retention money guarantees;
Ø Warranties, indemnities and standby letters of credit related to particular
transaction.
7.4.4 Check List for Processing request
Ø Request Letter by the client – BG applicant
Ø Board Resolution(for Company) | Consent Letter (for Partnership Firm) ; For non-
limit clients
Ø Duly attested Copy of Underlying such as Contract/Agreement etc.
Ø Counter Guarantee duly franked or on stamp paper; (For non-limit clients);
Ø F.D.R (valid till BG expiry) duly discharge- 100% Margin for Inland Bank
guarantee/110% Margin for Foreign Bank guarantee if BG is against .cash margin
Non Limit Clients. Margin in form of FD as per sanction for Regular Limit Clients.
Ø Duly vetted hard copy of BG format accepted by customer (soft copy to be
obtained for issuance )
Ø Scrutiny of the BG text and approval by competent authority for onerous
clause/Deletion of Notwithstanding, Clause/BG Cashable at other location/BG
issuance against counter guarantee (approved format) of other bank. (Availability
of credit line and tenor as well as acceptability of counter guarantee format to be
checked for issuance of Foreign BG;
Ø BG should be printed on the stamp paper as per the stamp duty applicable in the
state.
Page 15 of 21
7.4.5 Guidelines for the Issuance of BG:

Ø The text of the BG should be carefully scrutinized so as to confirm that the BG will
not have any onerous clause or any other clause affecting the interest of the Bank.
Vetting of the BG should be done prior to the stage of issuance.
Ø All BG shall be signed by two officials jointly.
Ø Bank should issue Guarantees in terms of sanction for maturity period upto 10
years. For maturity period above 10 years, appropriate assessment and approval.
Ø BG should not be issued with onerous clauses, such as Auto Renewal, Open ended,
etc.,
Ø No BG should be issued without notwithstanding clause.
Normally a BG is payable on invocation at the counter of the Issuing Branch, however
sometimes branches may get a request for the issuance of guarantees which are en-
cashable at a branch other than the issuing branch,
7.4.6 Invocation of Bank Guarantee:
Ø Any claim for invocation of the guarantee should be thoroughly checked, as
regards in terms of the guarantee and the same should be processed.
7.4.7 Payment of Invoked Guarantees :
Ø Where BG are invoked payment should be made to the beneficiaries, without delay
and demur.
Ø It is to be noted that a BG is a contract between the beneficiary and bank. When
the beneficiary invokes the BG and a letter invoking the same is in conformity with
the terms of the BG, it is obligatory on the part of the Bank to make payment to the
beneficiary.
7.4.8 Extension of BGs:
Ø Request letter from customer for extension should be obtained.
Ø Availability of credit line and tenor as per sanctioned terms (in sanctioned cases)
or approval for extension.
Ø Availability of Margin (FDR) for extended period.
Ø Notwithstanding clause should be incorporated in BG extension invariably.
7.4.9 Onerous clauses in BG:
Ø Normally no BG should be issued without the notwithstanding clause at the end of
the guarantee, as mentioned below :
· Notwithstanding anything contained herein–above our liability shall not
exceed Rs._ _ _ _ /- (Rupees in words), and the guarantee will be valid till
(Date:_ _ / _ _ /_ _ _ _). Unless a demand is made in writing on the bank at
(Address of the Branch:_ _ _ _) on or before (Date:_ _ / _ _ /_ _ _ _), all your
Page 16 of 21
rights under this guarantee will be forfeited and we shall be relived and
discharged from all liabilities thereunder.
Ø The BGs in which there is inbuilt and auto renewal clause, such BGs are called open
ended and the liability of the bank for such BGs is perpetual in nature. A guarantee
should be definite in terms of liability for the amount and period.
7.4.10 Auto closure of the BG:
Ø In case of BGs issued favoring government authorities/ departments, Courts an
additional precautionary measure
All the proofs of dispatch of the notice/reminders to the beneficiary are to be kept on
record and preserved as per extant “Preservation of documents” policy.
7.4.11 Closure / reversal of expired Bank Guarantee :
Ø As Bank’s precious capital is engaged in outstanding BG balance.
Ø The BG liability should be reversed after Bank receives either the original BG duly
discharged by the beneficiary or a Letter of Discharge in lieu of the original BG.
7.5 Trade Credit
Reserve Bank of India (RBI) has allowed a special facility to finance the imported goods
by raising foreign currency loan from the overseas lender. Depending upon the source of
finance such credits are known as byer’s credit or supplier’s credit.
7.5.1 Buyer’s Credit – If the credit is arranged by the buyer (importer) for a payment of
imports into India such credits are known as buyer’s credit. Subject to the rules stated
here under, the trade credit will facilitate the payment of imported goods by raising
foreign currency loan under the guarantee of the importer’s bank.
7.5.2 Supplier’s Credit – Supplier’s credit relates to credit for imports into India
extended by the overseas supplier or overseas bank or any other financial intermediary
in the world.
The rules governing trade credit are mentioned below:
a) Amount – USD 20 million or equivalent in any other foreign currency per instance
of shipment. For amount exceeding USD 20 million prior approval from RBI may
be sought.
b) Period - For raw materials upto 1 year from the date of shipment.
i. For capital goods – 5 years from the date of shipment (capital goods
as defined by DGFT)
ii. However, the period shall be subject to the operating cycle of the
customer and the above will be the outer limits only.
c) Pricing - All in cost ceiling – six months LIBOR plus 350 basis point per cent per
annum.
Page 17 of 21
d) Guarantee – AD banks are allowed to issue Letters of Credit / Guarantee / Letter

of Undertaking / Letter of Comfort in favour of overseas supplier, bank and
financial Institutions as under:
i. Raw material - guarantee upto one year
ii. Capital goods – guarantee upto first three years of trade credit.
iii. Gold, Platinum, Silver, polished diamonds shall have total credit period
including LC and DA documents should not exceed 90 days.
e) Trade credit cannot be offered for import of services and units located in SEZ.
However, trade credit can be offered for Merchant Trade imports to the extent
advance remittance against exports are not received.
f) Interest payment of trade credit to the overseas lender shall be subject to
provisions withholding tax.
g) AD banks needs to correctly report to RBI through their nodal office monthly
statement punishing details of fresh disbursement under trade credit, repayment,
roll over etc. and cumulative position.
So the trade credit is an extension of the product bank guarantee whereby foreign
currency loans are raised at internationally competitive rate of interest to facilitate
import payments.
7.5.3 Co-acceptance
Facilities of co-acceptance bill deferred payment guarantees are generally required for
acquiring plant and machinery technically be taken as a substitute of term loan which
requires detailed appraisal of the borrower’s needs and financial position as required in
a sanction of term loan proposal. RBI terms this facilities as BAF (Banker’s Acceptance
Facility). The effect of such facility is that once the bank co-accepts the bill it becomes
commitment of the bank guaranteeing payment to beneficiaries. So the banker needs to
be very careful in granting such facilities as banks undertake to pay on co-accepted bills
despite funds position of the clients. RBI guidelines being as under:
1) Detailed appraisal of the customer’s requirement be completed and the bank
needs to fully satisfy about genuine ness of the need of the customer.
2) Genuine trade bill of bonafide transaction only should be co-accepted. House
bill/accommodation bill drawn on good concerns needs to be abided.
3) Co-acceptance facilities will normally not be sanctioned to the customers enjoying
credit limit with other banks.
4) Once the bill is co-accepted a non-fund liability entry needs to be recorded in the
books of the bank engaging the customers’ liability for the transaction
Page 18 of 21
7.6 Illustrations and Case lets
Illustration 1
Assume a borrower purchases raw material worth Rs. 48/- lacs in a year. Out of the above
Rs. 24/- lacs worth of raw material are purchased through L/c. Further out of this Rs.
24/- lacs worth of raw material purchased through L/C, Rs. 12/- lacs worth of raw
materials are imported. The indigenous raw material purchased through L/C takes about
2 months to be delivered after opening of L/C and in the case of imported ones it takes
about 4 months and the minimum import consignment is Rs. 3/- lacs.
In the above case the monthly consumption of indigenous raw material is Rs. 12/12 - Rs.
1/- lac and the monthly consumption of imported raw material is Rs. 12/12 = 1/- lac. The
amount of the limit for indigenous raw material will be computed as under :
Monthly consumption X (Lead Time + A weeks cushion)

= 1 X (2 + 0.25 months)
= Rs. 2.25 lacs
The amount of LC limit for imported raw material will be

Monthly consumption X (Lead time + A month's cushion)
= 1 X (4 + 1) = Rs. 5/- lacs.
The total L/C limit would then be Rs. 2.25 + 5.00 = Rs. 7.25 lacs say Rs. 8/- lacs.
Assessment of DA-LC limits:
If in the above example both the L/C's are to be on 2 months DA basisthen 2 months
should be added to the Lead Time subject to adjustmentof transit period already covered
under the Lead Time. Assuming suchtransit period is 15 days or 1/2 month then the
requirement will be
Indigenous = 1 x (2 + 0.25 + 1.5) = 3.75 lacs

Imported = 1 X (4 + 1 + 1.5) = 6.50 lacs
---------
9.25 lacs
Example 2:
ABC Co. P Ltd., has approached us for credit limit which includes Term Loan, Cash Credit,
BG and LC.
The LC limit is for purchase of raw material both from the domestic market and also from
abroad. The details of the procurement of raw material under LC and various terms
under which the purchase is made is as under:
Total Sales is projected at Rs.1200 crores.
RM Purchase is projected at 80% of the total sales.
Page 19 of 21
Under the RM purchases, 30% is by way of CC and 70% is by way of LC. Of the 70%
purchased of RM under LC, 30% of such purchases is from the domestic market and 70%
is from international market.
Other details of terms of LC is as under:
Domestic puchases Purhases from abroad
Customs duty 0 2%
Lead Period 40% in 20 days 30% in 30 days
Including transit period 60% in 15 days 70% in 20 days
Usance period 80% - 0 days 10% - 90 days
20% - 90 days 80% - 80 days
10% - 60 days
Cushion period 2 days 7 days
Total Sales : Rs.1200 crores

Of which Raw material Rs.960.00 crores
Total Purchase under LC Rs.672.00 crores
Domestic Foreign
Purchase under LC Rs.202.00 crores Rs.470.00 crores
Less : Customs duty Rs.0.00 crores Rs. 10.00 crores
Net purchase under LC Rs.202.00 crores Rs.460.00 crores
Lead Period 40% - 20 days=8 days 30% - 30 days=9
60% - 15 days=9 days days
70% - 20 days=14
days
Usance 80% - 0 days = 0 days 10% - 90 days=9
20% -90 days=18 days days
80%-80 days=64
days
10%- 60 days=6 days
No of days 37 days 109 days
Limit 37/360*202=21 crores 109/360*460=139
Limit Rs.21 crores Rs.139 crores
Page 20 of 21
Caselets
• Total expected value of tenders in a year -Rs.60.00 Crores

• Success/Strike rate- 20%
• Average earnest money required-3%(get released/adjusted
with a quarter)
• Performance deposit ranges between-10%( Contract period
maximum 12 Months)
• Mobilization of advance-10% of advance there are 4 stages
• Retention Money -10% for 2 years(50% get released after
ayear)
• Existing outstanding Guarantee-0.80 Crores
• Guarantee expired in current year-060 Crores
• What would be eligible limit for BG?
Caselets
parameters calculation
Successful bid monthly 60cr=60Cr/12=5 crores
Earnest money BG 50000000X3%=1500000X3=45 Lacs
Performance BG 60crX20%=12Cr/12=1crX10%=10 lacsX12=120
lacs
Mobilisation of advance 10 lacsX3=30 lacs
Retention money 10lacsX24=240 lacs less 50%=120 lacs
Total 45+120+30+120=315 lacs
Add Opening balance of BG 80 lacs
less BG retired 50 lacs

Bg Required 315+80-50=345 lacs
Page 21 of 21
Chapter 8: Priority Sector Lending
Dr. M. Manickaraj
The objective of this chapter is to discuss the priority sector lending scheme (PSLS)
implemented by the Reserve Bank of India (RBI).
Structure
The chapter has been organised into the following five sections:
1. Introduction
2. RBI Guidelines on PSL
3. Priority Sector Lending Certificate (PSLC)
4. Monitoring of PSL Targets
5. Summary and Conclusion
1.0 Introduction
Historically banks have been providing loans liberally to big companies and neglecting
other sectors like agriculture and small enterprises. Two major reasons for lack of
interest among banks could be risk aversion and high operating cost of managing small
loans. Therefore, the government had to promulgate regulations for banks to necessarily
lend a certain portion of their loan portfolio to the neglected sectors. One extreme action
by the Government of India in this regard was nationalisation of banks. The government
of India had constituted several committees for channelling bank credit to the needy
sectors and had announced several schemes for the purpose. One such scheme is the Lead
Bank Scheme and another major scheme is the PSL scheme. Yet another scheme
announced in the recent past is the Priority Sector Lending Certificate (PSLC) scheme.
Priority Sector refers to those sectors of the economy which may not get timely and
adequate credit unless the lending institutions are directed to lend to these sectors.
Reserve (RBI) has made it mandatory for the banks to provide a specified portion of their
total loans and advances portfolio to certain sectors. This is meant for achieving all round
and inclusive development of the economy. Targets for PSL was set in 1974 for the first
time in India and the overall target was 33.3%. Later it was revised to 40% in 1980. The
scope and extent of the scheme have been changed several times and the latest guidelines
on PSL are discussed in the next section.
Page 1 of 10
Directing banks to provide credit to specific sectors is not unique to India only. In other
countries it is called directed lending and is in vogue in many countries including
developed and developing countries. The various forms of directed lending are as follows:
· Sectoral lending programmes designed to channel bank finance to a specific sector

or a section of the society
· Administered interest rate programmes directing banks to lend money to certain
sectors or sections of the society at a lower rate of interest. In some cases, the
government may subsidise the interest. For example, interest on agriculture loans
is subsidised by the Government of India.
· Refinance programmes. Loans given to certain sectors will be refinanced by the
government or by the institutions created for the purpose. In India, NABARD,
SIDBI, NHB and MUDRA provide refinance.
· Development financial institutions (DFI)/Public sector banks. Financial
institutions created for the purpose of providing loans to the target sectors.
NABARD, SIDBI, NHB and MUDRA are examples. Regional Rural Banks (RRBs) is
another example. RRBs have been established for the purpose of providing bank
credit in the rural areas.
· Credit guarantee programmes. One primary concern of banks in providing loans
to certain sectors is the risk and lack of collateral for covering the risk. Credit
guarantee will help overcome this problem. CGTMSE is a case in point. Similar
credit guarantee schemes have been designed for MUDRA loans and education
loans, and loans to start-ups.
2.0 RBI Guidelines on PSL
Reserve Bank of India is authorised by the Government of India to issue directions to

banks regarding priority sector lending. The most recent direction is the Master Direction
–Priority Sector Lending-Targets and Classification, dated July 7, 2016. The master
direction provides all the necessary details to be followed by the banks. Few details given
in the master circular are discussed briefly hereunder. According to the master direction
the broad sectors to which commercial banks in the country are supposed to provide
credit under the PSL scheme are as under.
(i) Agriculture and allied activities

(ii) Micro, Small and Medium Enterprise
(iii) Export Credit
(iv) Education
(v) Housing
(vi) Social Infrastructure
(vii) Renewable Energy
(vi) Others
Page 2 of 10
Apart from lending directly to the above categories classified as priority sectors, RBI
allows banks to the following activities for achieving PSL targets subject to certain conditions.
a. Investment in securitised assets, representing loans to the abovementioned

priority sectors except ‘others’
b. Transfer of assets through direct assignment / outright purchase of pool of
assets, representing loans to priority sectors except ‘others’
c. Inter Bank Participation Certificate (IBPC) purchased by banks
d. Priority Sector Lending Certificates bought by banks
e. Loans to MFIs for on lending
RBI also monitors the flow of credit to PS on a quarterly basis through reporting
mechanism by Banks.
In case of Non – achievement of PS Targets, the shortfall to be contributed to Rural

Infrastructure Development Fund (RIDF)
Common guidelines for compliance in the PSL accounts is stipulated by RBI.
Targets and Sub-Targets for Priority Sector Lending in India
Page 3 of 10
Table 1: Targets and Sub-Targets for Priority Sector Lending

Domestic
commercial
Foreign
banks and
banks with Regional Rural Small Finance
Categories Foreign banks
less than 20 Banks (RRBs) Banks (SFBs)
with 20
branches
branches and
above
75% of ANBC or
CEOBE,
40% of ANBC
whichever is
or CEOBE,
higher.
whichever is
However,
higher; out of
lending to
which 32%
medium
40% of ANBC can be in the 75% of ANBC or
Total enterprises,
or CEOBE, form of CEOBE,
Priority social
whichever is lending to whichever is
Sector infrastructure
higher. exports and higher.
and renewable
not less than
energy shall be
8% can be to
reckoned for
any other
priority sector
priority
achievement
sector.
only upto 15%
of ANBC.
18% of ANBC 18% of ANBC or 18% of ANBC or

or CEOBE CEOBE CEOBE
whichever is whichever is whichever is
higher; out of higher; out of higher; out of
Not
Agriculture which 10%# is which 10%# is which 10%# is
applicable
prescribed for prescribed for prescribed for
Small and Small and Small and
Marginal Marginal Marginal
farmers. farmers. farmers.
7.5% of ANBC 7.5% of ANBC 7.5% of ANBC or

Micro or CEOBE Not or CEOBE CEOBE
Enterprises whichever is Applicable whichever is whichever is
higher. higher. higher.
12%# of ANBC 15% of ANBC or 12%# of ANBC or

Advances
or CEOBE, Not CEOBE, CEOBE,
to Weaker
whichever is Applicable whichever is whichever is
Sections
higher. higher. higher.
Page 4 of 10
# Revised targets for agriculture and Small and Marginal Farmers will be implemented in
a phased manner.
Table 1 above shows that there are specific targets for agriculture (18% of ANBC) and
micro enterprises (7.5% of ANBC) only. Weaker sections of the society will cut across all
the sectors and hence it may be achieved by providing loans to the weaker sections under
each category including agriculture, MSMEs, exports and so on. Therefore, the balance
14.5% of the overall target can be achieved by lending to other sectors like exports,
education, housing, etc.
2.1 Description of Eligible Categories under Priority Sector
The various categories of PSL are briefly described in the following paragraphs.
2.1.1 Agriculture: According to the RBI agriculture sector includes (i) farm credit (ii)
Agriculture Infrastructure and (iii) Ancillary Activities.1
· Farm credit incudes loans extended to individual farmers including Self Help
Groups (SHGs) or Joint Liability Groups (JLGs) and proprietorship firms directly
engaged in Agriculture and Allied Activities, viz., dairy, fishery, animal husbandry,
poultry, bee-keeping and sericulture. This includes (i) Crop loans (ii) Medium and
long-term loans for agriculture and allied activities (iii) Loans for pre and post-
harvest activities, (iv) Produce pledge loans up to ₹ 50 lakh (v) Loans to distressed
farmers indebted to non-institutional lenders, (vi) KCC loans, (vii) Loans to small
and marginal farmers for purchase of land for agricultural purposes.
· Loans, given to co-operatives of farmers (not applicable to UCBs), corporate
farmers, producer organizations/companies/partnership firms which are directly
engaged in activities mentioned up to an aggregate limit of Rs 2 Crores per
borrower entity.
· Agriculture infrastructure: Loans up to Rs 100 Crores per borrower for

construction of storage facilities to store agriculture produce/products, Soil
conservation and watershed development, plant tissue culture and agri-
biotechnology, seed production, production of bio-pesticides, bio-fertilizer, and
vermi-composting.
· Ancillary activities: This includes loans up to ₹ 5 crore to co-operative societies
of farmers for disposing of the produce of members, loans for setting up of Agri
clinics and Agribusiness Centres, Loans for Food and Agro-processing up to an
aggregate sanctioned limit of ₹ 100 crore per borrower from the banking system,
1
For details refer to RBI Master Direction – Priority Sector Lending – Targets and Classification, dated Sep 4, 2020.
https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MDPSL803EE903174E4C85AFA14C335A5B0909.PDF
Page 5 of 10
Loans to Custom Service Units managed by individuals, institutions or

organizations who maintain a fleet of tractors, bulldozers, well-boring equipment,
threshers, combines, etc., and undertake farm work for farmers on contract basis,
loans extended by banks to Primary Agricultural Credit Societies (PACS), Farmers’
Service Societies (FSS) and Large-sized Adivasi Multi-Purpose Societies (LAMPS)
for on-lending to agriculture, Loans sanctioned by banks to MFIs for on-lending to
agriculture sector as per the conditions specified and outstanding deposits under
RIDF and other eligible funds with NABARD on account of priority sector shortfall.
2.1.2 Micro, Small and Medium Enterprises (MSMEs): Micro, Small and Medium
Enterprises have been defined by GOI on the basis of a composite criteria of investment
in plant and machinery/equipment and annual turnover. The definition is applicable to
both manufacturing and service enterprises.
Table 2: Definition of MSMEs w.e.f July 1, 2020
Composite Plant Criteria: Investment in & Machinery/equipment and Annual

Turnover
For both Manufacturing and Service Enterprises
Micro Small Medium
Investment of Investment of not more Investment not more than

not more than Rs.1 crore than Rs.10 crore and Rs.50 crore and Annual
and Annual Turnover not Annual Turnover not Turnover not more than
more than Rs. 5 crore more than Rs. 50 crore Rs. 250 crore
Loans to MSMEs in manufacturing & service sectors can be classified under the priority
sector as follows:
· Manufacturing Enterprises: The MSME should be engaged in the manufacture

or production of goods to any industry specified in the first schedule to the
Industries (Development and Regulation) Act, 1951 and as notified by GOI.
· Service Enterprises: All bank loans to MSMEs engaged in providing or rendering
of services as defied in terms of investment in equipment under MSMED Act 2006
shall qualify under Priority Sector.
· Factoring Transactions: Factoring transactions “with recourse” by banks,
wherever assignor is MSME and Factoring transactions taking place through the
Trade Receivables Discounting System (TReDS) are eligible for classification as
priority sector loans.
Page 6 of 10
· Khadi and Village Industries Sector (KVI): All loans to units in the KVI sector
will be eligible for classification under the sub-target of 7.5 percent prescribed for
Micro Enterprises.
· Other Finance to MSMEs
(i) Loans to entities involved in assisting the decentralized sector in the supply
of inputs to and marketing of outputs of artisans, village and cottage
industries,
(ii) Loans to co-operatives of producers in the decentralized sector viz.
artisans, village and cottage industries,
(iii) Loans sanctioned by banks to MFIs for on-lending to MSME sector.
(iv) Credit outstanding under General Credit Cards, Artisan Credit Card, Laghu
Udyami Card, Swarojgar Credit Card, and Weaver’s Card
(v) Overdrafts extended by banks upto Rs 10,000 (age limit 18-65 years and
there will not be any condition for overdraft upto Rs 2000) under Pradhan
Mantri Jan Dhan Yojana (PMJDY) accounts. These overdrafts will qualify as
achievement of the target for lending to Micro Enterprises,
(vi) Outstanding deposits with SIDBI and MUDRA Ltd. on account of priority
sector shortfall.
2.1.3 Export Credit: Pre-shipment and post shipment export credit extended by
domestic banks not exceeding 2% of ANBC or Credit equivalent amount of Off-Balance
Sheet Exposure, whichever higher, and subject to a limit of Rs 25 Crore per borrower to
units having turnover upto Rs. 100 crore. The per Borrower limit and turnover cap are
not applicable for Foreign Banks with 20 branches and above.
2.1.4 Education: Loans to individuals for educational purposes including vocational

courses upto₹ 10 lakh irrespective of the sanctioned amount will be considered as eligible
for priority sector.
2.1.5 Housing: The following are the items eligible to be treated as PSL:
(i) Loans to individuals up to ₹ 35 lakhs (and cost of dwelling unit upto Rs 45

lakhs) in metropolitan centres and loans up to ₹25 lakhs (and cost of the
dwelling unit is upto Rs 25 lakhs) in other centres for purchase/construction
of a dwelling unit per family.
(ii) Loans for repairs to damaged dwelling units of families up to ₹ 5 lakh in
metropolitan centres and up to ₹ 2 lakh in other centres.
(iii) Loans to any governmental agency for construction of dwelling units or for
slum clearance and rehabilitation of slum dwellers subject to a ceiling of ₹ 10
lakh per dwelling unit.
(iv) Loans for housing projects exclusively for the purpose of construction of
houses for economically weaker sections(EWS having income upto Rs 3 lakhs),
Page 7 of 10
and low income groups (LIG having income upto Rs 5 lakhs per annum) and
total cost per unit not above Rs 10 lakhs.
(v) Bank loans to Housing Finance Companies (HFCs), for on-lending for housing
purposes, subject to a maximum of 5% of the Bank’s PSL.
(vi) Outstanding deposits with NHB on account of priority sector shortfall.
2.1.6 Social infrastructure: Loans up to a limit of ₹ 5 crores per borrower for building
social infrastructure for activities viz., schools, health care facilities, drinking water,
sanitation facilities etc. Credit extended to Micro Finance Institutions (MFIs) for on-
lending for the purpose of water and sanitation facilities is also eligible under this
category.
2.1.7 Renewable Energy: Bank loans up to a limit of ₹ 15 crores to borrowers for

purposes like solar based power generators, biomass based power generators, wind
mills, micro-hydel plants and for non-conventional energy based public utilities viz. street
lighting systems, and remote village electrification. For individual households loan upto
Rs.10 lakh per borrower is eligible.
2.1.8 Others
(i) Loans not exceeding ₹ 50,000/- per borrower provided directly by banks to
individuals and their SHG/JLG.
(ii) Loans to distressed persons not exceeding Rs. 100,000 per borrower to prepay
debt to non-institutional lenders.
(iii) Loans sanctioned to State Sponsored Organisations for SC/ST for purchase and
supply of inputs and/or marketing of outputs of beneficiaries of these
organisations.
(iv) Weaker Sections: In the above loans banks should ensure that 10 percent of
ANBC or Credit Equivalent of off Balance sheet exposure, whichever is higher,
is given to weaker section as defined in the RBI circular
(v) Investments in approved funds etc.
For more details please refer to the RBI Master Direction on priority sector lending
https://rbidocs.rbi.org.in/ rdocs/notification/PDFs/ 33MD08B3F0C
C0F8C4CE6B844B87F7F 990FB6.PDF
3.0 Priority Sector Lending Certificate (PSLC)
The genesis for the PSLC scheme can be found in The Raghuram Rajan Committee Report
on Financial Sector Reforms (2008). The committee had recommended the introduction
of PSLC in order to make use of the comparative strength of banks and financial
institutions in lending to the priority sector. The committee was of the view that those
institutions good at lending to the priority sector shall focus on the same. Banks and
Page 8 of 10
institutions which were able to exceed the PSL target will be issued with the PSLC. Those
banks which are not able to achieve the PSL targets may buy the PSLC to offset their
shortfall. This arrangement will enable each bank to do their business well utilising their
core strengths and at the same time desired amount of bank loans are directed to the
priority sectors in the country. The RBI has launched an online platform called e-Kuber
for trading in PSLCs on April 7, 2016. During 2017-18, the PSLCs trading volume increased by 270
per cent to ₹1,84,200 crores. In H1:2018-19, trading volume more than doubled from the level a year
ago.
Types of PSLCs: The following four types of PSLCs are available for trading:
(i) PSLC Agriculture

(ii) PSLC for small and marginal Farmers (PSLC SF/MF)
(iii) PSLC Micro Enterprises
(iv) PSLC General
The above mentioned PSLCs will enable banks to fulfil the overall target as well the sub-
targets. In course of time PSLC on other specific sectors may also be issued.
4.0 Monitoring of PSL Targets
The PSL target and sub targets will be monitored by the RBI on quarterly basis. If a bank
has any shortfall in achieving the PSL target the bank will be directed to deposit an
amount equivalent to the shortfall in the Rural Infrastructure Development Fund (RIDF)
established with the NABARD or SIDBI or NHB or MUDRA Bank as may be appropriate. It
may be noted that the interest offered by RIDF is set by the RBI. The rate is linked to the
bank rate and it may be in the range of bank rate minus 2% to bank rate minus 5%. The
rate of interest will be determined depending on the shortfall and it can also be negative.
The rate of interest on deposits into RIDF, tenure of deposits, etc will be fixed by the RBI
from time to time.
Historically, commercial banks have been lending to corporates and were not interested
in lending to small borrowers like farmers and micro enterprises. Governments, on other
hand, are interested in achieving balanced and inclusive growth and hence wanted to
provide bank credit to all the needy sectors and sections of the society. Various methods
are adopted by different nations to ensure the flow of credit to the needy sectors. Among
other schemes Government of India is implementing the PSL scheme through the RBI.
The sectors to which commercial banks in the country are supposed to provide credit
under the PSL scheme are Agriculture, MSMEs, Export, Education, Housing, Social
Infrastructure, Renewable Energy, and others. To facilitate the banks to achieve the PSL
targets efficiently the RBI has introduced a trading scheme called PSLC and an online
trading platform for the same called e-Kuber. The achievement of PSL targets by the
banks is monitored by the RBI on quarterly basis and any shortfall in the target will have
Page 9 of 10
to be offset by depositing money into RIDF. The objective of RIDF is to penalise the banks
which are not able to achieve the PSL targets and hence the rate of interest offered by the
RIDF is very low.
Page 10 of 10

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Module I: Basics of Credit and Credit Process

Chapter 1: Introduction to Bank Lending

1.1 Basic Principles of Bank Lending

1.2 Types of Borrowers

found in its Memorandum of Association and Articles of Association. Banks

1.3 Types of Credit Facilities

o Purchase/Discounting of bills – Lending institutions provide credit by

• Credit policy must indicate authorities and responsibilities attached to each

• Commitment: Another important factor is the commitment of the borrower. If the

• Capacity: Though a customer may be committed to his/her business competency

• Conditions: The performance of a borrower will depend on several factors which

Module I: Basics of Credit and Credit Process

Chapter 2 Due Diligence for Lending Decisions

2.6 Summary and conclusion

2.4 Due Diligence on Corporate Borrowers

• Memorandum of Association, and Articles of Association including all

• Minutes of board meetings, committees of the board and shareholders.

• List of all states where the Company has license to do business.

• Details of any voting trust and shareholder agreement, if any

• Copies of all agreements containing pre-emptive rights or assigning such rights.

Documents about subsidiaries and group companies: The abovementioned basic

2.4.3 Material Contracts:

• Guarantees issued by the company

• Partnership or joint venture agreements.

• Any other material contracts outstanding.

• Copies of all agreements for licensing of technology from third parties.

• List of proprietary processes controlled by the Company.

· List of products with breakdown by manufacturing locations, number of shifts,

• Agreements with suppliers, manufacturers, and customers, if any.

• List of the Company's products and services.

• Agreements with distributors and dealers.

• Number of employees broken down by major types and organization chart.

· Copy of promoters agreement, agreements with the management,

• Agreements for loans to officers or directors of the company.

The ultimate objective of credit analysis is to ascertain the repayment capacity of

• Quality of earnings & cash flows

• Potential liabilities & commitments

o Valuation of work in progress

• Details of active litigations/disputes, if any

• Information regarding any material litigation to which the Company is a party or

• Description of all toxic/hazardous materials used in production and manner of

• Permits or approvals obtained from government authorities responsible for

2.5 Outsourcing Due Diligence:

Module I: Basics of Credit and Credit Process

Chapter 3: Financial Statements Analysis

3.1 Why financial statement analysis?

Financial statements include:

Profit and Loss Account :

Liabilities (Sources of fund for the Assets (Uses of fund in the

3.2 Tools for financial statement analysis

3.2.1 Common-Size Statements

Bajaj Auto Ltd TVS Motor Company Ltd

Total operating cost 80.3% 82.2% 95.0% 95.5%

Analysis of Table 1 provides the following inferences:

Common-size profit and loss account also enables comparison of performance of

whereas TVS Motor relies on substantial amount of outsiders’ money including

Bajaj Auto Ltd TVS Motor Company Ltd

Net Fixed Assets 12.9% 12.3% 32.1% 28.9%

- Raw material 2.8% 2.9% 12.7% 12.2%

3.2.2 Trend Analysis

Bajaj Auto Ltd TVS Motor Company Ltd

Total operating cost 102.5% 100.0% 111.4% 100.0%

Profit margin ratios: