Management of

Inventory

BLOCK 3
FINANCING OF WORKING CAPITAL

185
Management of
Current Assets BLOCK 3 FINANCING OF WORKING
CAPITAL
The previous block has focused on the management of the components of
working capital. Prudent management implies management of every
constituent in the most efficient manner. Units 4-7 of Block-II provide the
reader with such understanding and also guide him through the relevant
techniques that need to be employed for better management of working
capital. The present block focuses on the theoretical issues governing the
determination and also the practices followed by banks and other financial
institutions.

After estimating the funds needed for working capital purposes of a firm, the
next task is to decide the sources from which such funds are to be raised. As
already noted, Gross Working Capital denotes the total amount of funds
which are required for investment in current assets. A part of such assets is
financed through trade credit which is an autonomous source of finance. Rest
of the current assets are financed through other sources both short term and
long term. The permanent portion of the working capital always remains
blocked up in business and hence must be financed from long term sources
like share capital, debentures and term loans. This is the reason why a part of
the permanent Working Capital is included in the cost of the project as
margin money for working capital and is raised from long term sources.

Unit -8 attempt to highlight the theories and approaches to working capital

management. It also discusses the impact of different choices of investment
and financing on working capital policy. Unit-9 deals with the payables
management. It explains the significance of payables as a source of finance.
The unit also makes an incisive analysis of the nature of trade credit, its
determinants and costs. Normally, trade credit is considered spontaneous
financing. But it carries with it several other costs, if not tackled properly.
Finally, it also deals with the methods of effective management of payables.
Unit-10 discusses the basic concepts and practices relating to borrowings
from banks, as they prevail in India. It also deals with the methods of
assessment of working capital needs which are adopted by banks and other
related methods. The concluding unit of this block (unit-11) highlights other
sources of short term finance used to finance the working capital needs of a
firm.

186
 Theories and
UNIT 8 THEORIES AND APPROACHES Approaches

Objectives
The objectives of this unit are:
• To provide you an understanding as to the policy making in the area
of working capital management.
• To examine the different approaches to working capital management.
• To highlight the impact of different choices of investment and financing on
working capital policy.

Structure
8.1 Introduction
8.2 Creation of Value through Working Capital Management
8.3 Approaches to Working Capital Investment
8.4 Approach to Financing Working Capital
8.5 Effect of Choice of Financing on ROI
8.6 Summary
8.7 Key Words
8.8 Self-Assessment Questions
8.9 Further Readings

8.1 INTRODUCTION
In the previous two Blocks, we have discussed about the concept of
Working Capital and various methods for determining working capital
requirements and the management of various components. The present block
focuses on the theoretical issues governing the determination and also the
practices followed by banks and other financial institutions. This is
expected to help the student come closer to the reality. There has been little
difficulty in segregating the issues under this block into individual units due
to their overlapping content. Therefore, an attempt has been made in this
unit to cover all those issues that could not be covered under the earlier
Blocks, yet focusing on the theme of the present Block. As you could
observe from the structure of the lesson presented above, enough care has
been taken to include only pertinent matters in the discussion that follows.
Major concentration has been on the following:
a) What is the objective function in taking working capital decisions?
b) How to create value through working capital?
c) Is there any scope to lay down time-tested principles of working
capital policy?
d) How do risk-return relationships operate in the area of working capital
decision making?
187
Financing of
Working Capital
8.2 CREATION OF VALUE THROUGH
WORKING CAPITAL MANAGEMENT
Creation of value has been said to be the objective of a company. In the
realm of finance it turns out to be the function of firm’s investment,
financing and dividend decisions. In addition to long term investment
decisions, companies face many decisions involving investment in current
assets. Quite often, maximisation of profits is regarded as the proper
objective of the firm. but it is not as inclusive as that of maximising
shareholders’ value. A right kind of approach to decisions of investment
and financing of working capital can contribute to the achievement of the
objective function.

Value maximisation is considered consistent with the interests of various

groups that interact with the business. Take for instance shareholders;
businesses can often do what individuals cannot do on their own. Business
houses pool up resources and engage in mass production, which is beyond
the capacity of an individual as shareholder. Perpetual succession ensures
enough confidence to a creditor. The point of view of society is well taken
care of, since there is a realisation on the company that it cannot pursue
profit maximisation as a goal. A framework is thus created for analysing the
financial decisions from the standpoint of maximising value.

Be that as it may, how should one proceed to create value through working
capital management. The answer is: invest in an asset, if its net present
value is positive. The fact is that the basic principles of long term asset
investment decisions should apply equally well to short term asset
investment decisions. Therefore, it is useful to examine this criterion more
closely in terms of current asset investment decisions.
The general formula for finding net present value of a project is:
A1 A2 A3 An
NPV = 1 2 3 ...... n C
1 K 1 K 1 K 1 K

Where A1 to An represent annual cash inflows on an after tax basis. ‘K’ is the
discount factor, which is generally taken as the cost of capital. ‘C’
represents the initial outflow.

This equation can be used to decide the choice of investment in current

assets taking into account their shorter life span. Accepting one year life
as standard to categorise assets into fixed and current, NPV has to be
calculated for each year. For this purpose, the above equation can be
modified as follows to elicit NPV.
A1 A2 A3 An
NPV = ......... C
K K K K

Like the decisions in capital budgeting, the problem remains as that of

determination of risk and thus the appropriate discount rate to apply.

188
Sometimes, practitioners tend to use net profit criterion to decide the Theories and
Approaches
investment in current assets; which they consider is a simple modification of
the concept of NPV as shown below:

r
Net profit per period = Annuity = NPV n
1 1 r

Example 8.1
There is an investment proposal involving Rs.5000 initial investment and
generating Rs.500 per year, so long as we keep the investment intact. The
NPV in this case depends on the discount rate and time period assumed.
We may also calculate an annuity that has a present value equal to the NPV
of above investment using the above equation. Assuming that the discount
rate is 8%. Net profit per period will be Rs.100. See the following
derivation:

r
Net profit per period = Annuity = NPV n
1 1 r

500 500 5000 r

5000 n n n
1 r 1 r 1 r 1 1 r

n
1 1 r r
500 n
r 1 1 r

n r
= – 5000 5000 1 r n
1 1 r

1 1 r
n 1
But r
n
r 1 1 r

r
So Net Profit = 500 – 5000 [1– (1+ r )–n ] n
1 1 r

= 500 – 5000 (r)

= 500 – 5000 (8%)
= 500 – 400 = 100

The Rs. 400 is the annual capital cost of Rs.5,000 investment at an 8 per
cent rate of interest, and the annual net profit of Rs. 100 does not depend
on when the investment is reversed. The result is that we can use net
profit per period as a criterion for choosing among alternative reversible
investments. The investment with the highest value of net profit per period
is also the investment with the highest net present value, regardless of
when the investment is reversed. Investments with positive NPVs will have
positive net profits, investments with zero NPVs will have zero net profits,
and investments with negative NPVs will have negative net profit. Thus, 189
Financing of net profit per period instead of NPV, can be used as a decision criterion
Working Capital
for working capital management.

While the above sounds logical theoretically, in practice, firms are choosing
innovative approaches to create value through current assets management.
For instance, firms are very active in commodity markets to buy raw
materials while they are in full supply. They are not minding the size and cost
of investment in this asset. More so, firms are also adopting risk management
techniques like options, hedging, etc. Like any usual trader in the stock
market, they are watchful of the trends in both stock and commodity markets.
Similarly, idle cash is now intelligently invested in various markets such as
Money Market, Mutual Funds and finally equities. Gone are the days when
companies used to focus on their core activities of operations; they are now
exploring ways to maximize value through every means. Mergers, takeovers
and acquisitions are the best examples of utilizing surplus cash and every
cash-rich firm got benefitted by these choices.

Many current asset decisions, particularly inventory decisions, can be

made on the basis of minimising cost. There also, instead of minimising
the net present value of costs. One may minimise total annual cost where
the annual capital cost of the investment is the discount rate times the
amount invested. In sum the current assets may be treated as reversible
and investment policies may be selected that maximise net profit or
minimise total cost per period. The choice between the profit or cost
criterion will of course depend on the particular problem being analysed.

8.3 APPROACHES TO WORKING CAPITAL

INVESTMENT
Every business enterprise needs to pay particular attention towards the
planning and control of working capital. Different approaches have been
suggested for this purpose. Of them, let us focus our attention on the
following two approaches:
i) Walker’s approach
ii) Trade off approach

8.3.1 Walker’s Approach

Early in 1964 Ernest W. Walker has developed a four-part theory of
working capital. He has laid down that a firm’s profitability is determined
in part by the way its working capital is managed. When the working
capital is varied relative to sales without a corresponding change in
production, the profit position is affected.
If the flow of funds created by the movement of working capital is
interrupted, the turnover of working capital is decreased, as is the rate of
return on investment. In this regard, Walker has laid down the following
four principles with respect to working capital investment.

190
First principle: This is concerned with the relation between the levels of Theories and
Approaches
working capital and sales. His principle is that: if working capital is varied
relative to sales, the amount of risk that a firm assumes is also varied and
the opportunity for gain or loss is increased. This implies that a definite
relation exists between the degree of risk that management assumes and
the rate of return. The more the risk that a firm assumes, the greater is
the opportunity for gain or loss. Consider the following data:

Table 8 .1: XYZ Manufacturing Company

1 2 3
Level of working capital (Rs.) 50,000.00 90,000.00 1,20,000.00
Fixed capital (Rs.) 10,000.00 10,000.00 10,000.00
Liabilities 30,000.00 30,000.00 30,000.00
Net Worth 30,000.00 70,000.00 1,00,000.00
Sales 1,00,000.00 1,00,000.00 1,00,000.00
Fixed Capital Turnover 10.00 10.00 10.00
Working Capital Turnover 2.00 1.1 0.8333
Total Capital Turnover 1.66 1.00 0.761
Earnings (as Percent of Sales) 10.00 10.00 10.00
Rate of Return (Percent) 16.60 10.00 7.60

It can be seen from the data that the return on investment has increased
from 7.6 percent to 16.6 per cent when working capital fell from Rs.
1,20,000 to Rs.50,000. Moreover, it is believed that while the potential gain
resulting from each decrease in working capital is greater in the beginning
than potential loss, exactly opposite occurs, if the management continues to
decrease working capital (see-Figure 8 .1).

Fig. 8.1: Working Capital Relative to Sales

Gain
Rate of Raturn
0
Loss

Decreasing Level of Working Capital per Unit of Sales

191
Financing of It is also presumed that by analysing correctly the factors determining the
Working Capital
amount of the various components of working capital as well as
predictions of the state of the economy, management can determine the
ideal level of working capital that will equilibrate its rate of return with its
ability to assume risk. However, since most managers do not know what
the future holds, they tend to maintain an investment in working capital
that exceeds the ideal level. It is this excess that concerns us, since the
size of the investment determines a firm’s rate of return on investment.

Second principle: Capital should be invested in each component of

working capital as long as the equity position of the firm increases. This
principle is based on the concept that each rupee invested in fixed or
working capital should contribute to the net worth of the firm.

Third principle: The type of capital used to finance working capital

directly affects the amount of risk that a firm assumes as well as the
opportunity for gain or loss and cost of capital. It is indisputable that
different types of capital possess varying degrees of risk. Investors relate the
price for which they are willing to sell their capital to this risk. They may
charge less for debt than equity, since debt capital possesses less risk. Thus
risk is related to the return. Higher risk may imply a higher return too.
Unlike rate of return, cost of capital moves inversely with risk. As
additional risk capital is employed by management, cost of capital declines.
This relationship prevails until the firm’s optimum capital structure is
achieved.
Fourth principle: The greater the disparity between the maturities of a
firm’s short-term debt instruments and its flow of internally generated
funds, the greater the risk and vice-versa. This principle is based on the
analogy that the use of debt is recommended and the amount to be used
is determined by the level of risk, management wishes to assume. It should
be noted that risk is not only associated with the amount of debt used
relative to equity, it is also related to the nature of the contracts negotiated
by the borrower. Some of the more important characteristics of debt
contracts directly affecting a firm’s operation are restrictive clauses of
the contracts and dates of maturity.
Lenders of short-term funds are particularly conscious of this problem, and
in an effort to protect themselves by reducing the risk associated with
improper maturity dates, they are requiring firms to produce documents
depicting cash flows. These documents when properly prepared, not only
show the level of loans necessary to support sales but also indicate when
the loans can be repaid. In other words, lenders realize that a firm’s ability
to repay short-term loans is directly related to cash flow and not to
earnings, and therefore, a firm should make every effort to the maturities
to its flow of internally generated funds.

8.3.2 Trade off Approach

It is evident from the study of Walker’s principles that working capital
decisions involve a trade-off between risk and return. The same is sought
192 to be further examined in this section.
All decisions of the financial manager are assumed to be geared to Theories and
Approaches
maximisation of shareholders wealth, and working capital decisions are no
exception. Accordingly, risk-return trade-off characterises each of the
working capital decision. There are two types of risks inherent in working
capital management, namely, liquidity risk and opportunity loss risk.
Liquidity risk is the non-availability of cash to pay a liability that falls due.
Even though it may happen only on certain days, it can cause, not only a
loss of reputation but also make the work condition unfavourable for
getting the best terms on transaction with the trade creditors. The other risk
involved in working capital management is the risk of opportunity loss i.e.
risk of having too little inventory to maintain production and sales, or the
risk of not granting adequate credit for realising the achievable level of
sales. In other words, it is the risk of not being able to produce more or
sell more or both, and therefore, not being able to earn the potential profit,
because there are not enough funds to support higher inventory and book
debts. Thus, it would not be out of place to mention that it is only theoretical
that the current assets could all take zero values. Indeed, it is neither
practicable nor advisable. In practice, all current assets take positive values,
because firms seek to reduce working capital risks.

As a matter of fact, there are many studies carried out to establish the link
between the profitability (return) and the investment in various components
of working capital (risk factors). In an interesting study conducted by Majid
Imdad Akash and others (2011) examined the risk-return relationships with
the empirical evidence drawn from Textile Sector of Pakistan. The authors
started with a hypothesis that working capital management has effect on
profitability and there exist a tradeoff between risk and return. Through this
study, they found that there existed significant relationship between
profitability and average college period in a negative manner. However, the
study proved that there was positive relationship between profitability and
other variables like: (a) average collection period, (b) inventory turnover in
days, (c) sales, (d) debt to total assets. The regression results of the study had
clearly indicated the strong relationship between profitability and the
important variables of working capital.

In another study, Daniel Kaman and Amos Ayuo (2014) investigated the
relationship between working capital management and organizational
performance among a sample of 13 manufacturing firms in Kenya through
both quantitative and qualitative dimensions found that the working capital
management is negatively correlated with Return on Assets (ROA) and
Return on Equity (ROE), indicating the “R’ values of -0.148 and -0.231
respectively. Likewise, many studies conducted in this area, have clearly
established the fact that there existed a clear tradeoff between the risk and
return.

The risk-return trade-off involved in managing the firm’s liquidity via

investing in marketable securities is illustrated in the following example.
Firms A and B are identical in every respect but one. Firm B has invested
Rs. 5,000 in marketable securities which has been financed with equity. That
is, the firm sold equity shares and raised Rs.5,000.00. The balance sheets
and net incomes of the two firms are shown in Table 8.2. Note that Firm A 193
Financing of has a current ratio of 2.5 (reflecting net working capital of Rs. 15,000)
Working Capital
and earns a 10 percent return on its total assets. Firm B, with its larger
investment in marketable securities has a current ratio of 3 and has net
working capital of Rs. 20,000. Since the marketable securities earn a return
of only 9 percent before taxes (4.5 percent after taxes with a 50 percent
tax rate). Firm B earns only 9.7 percent on its total investment. Thus,
investing in current assets and in particular in marketable securities, does
have a favourable effect on firms liquidity but it also has an unfavourable
effect on the firm's rate of return earned on invested funds. The risk-return
trade-off involved in holding more cash and marketable securities, therefore,
is one of added liquidity versus reduced profitability.

Table 8.2 : The Effects of Investing in Current Assets on Liquidity and

Profitability

Balance Sheets A (Rs.) B (Rs.)

Cash 500 500
Marketable securities 5,000
Accounts receivable 9,500 9,500
Inventories 15,000 15,000
Current assets 25,000 30,000
Net fixed assets 50,000 50,000
Total 75,000 80,000
Current liabilities 10,000 10,000
Long-term debt 15,000 15,000
Capital Equity 50,000 55,000
Total 75,000 80,000
Net Income 7,500 7,725*

Current ratio (Current assets/Current liabilities)

25, 000 30,000
2.5 times 3.0 times
10, 000 10, 000

Net working capital 15,000 20,000

(Current assets – Current liabilities)

Return on total assets (net income/total assets)

7,500 7, 725
10% 9.7%
75, 000 80,000
*During the year Firm B held Rs.5,000 in marketable securities, which earned a 9
percent return or Rs.450 for the year. After paying taxes at a rate of 50 percent, the
firm netted a Rs.225 return on this investment.

Activity 8.1
i) Give points of distinction between the Walker's Approach and Trade
off Approach.
…………………………………………………………………………….
…………………………………………………………………………….
194
 ……………………………………………………………………………. Theories and
Approaches
…………………………………………………………………………….
…………………………………………………………………………….

ii) What do you think are the possible ways by which Value Maximisation
would be possible through Current Assets Management
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

8.4 APPROACH TO FINANCING WORKING

CAPITAL
Financing the firm’s working capital requirements has been shown to involve
simultaneous and inter-related decisions regarding the firm’s investment in
current assets. Fortunately, there exists a principle, which can be used as a
guide to firm’s working capital financing decisions. This is the hedging
principle or matching principle.
Simply speaking, the hedging principle involves matching the cash flow
generating characteristics of an asset with the maturity of the source of
financing used to finance its acquisition. For example, a seasonal expansion
in inventories, according to the hedging principle, should be financed with a
short-term loan or current liability. The rationale underlying the rule is
straight forward. Funds are needed for a limited period of time, and when
that time has passed, the cash needed to repay the loan will be generated
by the sale of the extra inventory items. Obtaining the needed funds from a
long-term source (longer than one year) would mean that the firm would
still have the funds after the inventories (they helped finance) have been
sold. In this case the firm would have “excess” liquidity, which they either
hold in cash or invest in low yielding marketable securities until the
seasonal increase in inventories occurs again and the funds are needed.
This would result in an over-all lowering of firms profits, as we saw
earlier in the example presented in Table 8 .2.

Let us take another example in which a firm purchases a new packing

machine, which is expected to produce cash saving to the firm by
eliminating the need for two labourers and, consequently their salaries.
This amounts to an annual savings of Rs.20,000. While the new machine
costs Rs. 1,00,000 to install and will last 10 years. If the firm chooses to
finance this asset with a one-year loan, then it will not be able to repay
the loan from the cash flow generated by the asset. Hence, in accordance
with the hedging principle, the firm should finance the asset with a source
of financing that more nearly matches the expected life and cash flow
generating characteristics of the asset. In this case a 7 to 10-year loan
would be more appropriate than a one-year loan. 195
Financing of To put it very succinctly the hedging principle states that the firm’s assets
Working Capital
not financed by spontaneous sources should be financed in accordance
with the rule: permanent assets (including permanent working capital
needs) financed with long- term sources and temporary assets (viz.
fluctuating working capital need) with short-term sources of finance towards
the liquidity risk.
We may graphically illustrate the hedging principle as depicted in Figure 8.2A

Figure: 8.2A: Hedging Financing strategy

Note that permanent asset needs are matched exactly with spontaneous plus long-term
sources of financing while temporary current assets are financed with short-term sources
of financing.

This may be termed as hedging financing strategy. In practice we may

come across certain modifications of this strict hedging strategy. Figure
8 .2B and 8.2Cdepict two modifications.

Figure 8.2B: Conservative financing strategy: Long term financing exceeds permanent assets

Shaded area represents the firm’s use of long-term plus spontaneous financing in excess
of the firm’s permanent asset financing needs.

196
 Theories and
Approaches

Figure 8.2 C: Aggressive Financing strategy: Permanent Reliance on Short Term

Financing

Shaded area reflects the firm’s continuous use of short-term financing to support its
permanent asset needs.

In Figure 8.2 B the firm follows a more cautious plan, whereby long-term
sources of financing exceed permanent assets in trough period such that
excess cash is available (which must be invested in marketable securities).
Note that the firm actually has excess liquidity during the low ebb of its
asset cycle and thus faces a lower risk of being caught short of cash than a
firm that follows the pure hedging approach. However, the firm also
increases its investment in relatively low-yielding assets such that its return
on investment is diminished.

In contrast, Figure 8.2 C depicts a firm that continually finances a part of its
permanent asset needs with short term funds and thus follows a more
aggressive strategy in managing its working capital. It can be seen that even
when its investment in asset needs is lowest the firm must still rely on
short-term financing. Such a firm would be subjected to increased risks of
cash shortfall, in that it must depend on a continual rollover or
replacement of its short-term debt with more short-term debt. The benefit
derived from following such a policy relates to the possible savings
resulting from the use of lower-cost short-term debt as opposed to long-
term debt.

Most firms will not exclusively follow any one of the three strategies outlined
above in determining their reliance on short-term credit. Instead, a firm will
at times find itself overly reliant on long term financing and thus holding
excess cash and at other times it may have to rely on short-term financing
throughout an entire operating cycle. The hedging principle does, however;
provide an important guide regarding the appropriate use of short-term credit
for working capital financing.

Going by the trends in the interest rate structure prevailing in the money and
capital markets, the distinction between short-term and long-term finance
seems rarely relevant. Take for instance, the State Bank of India offers 5.20
per cent on a Fixed Deposits of 1-2 years (as on 30-04-2022); whereas it
offers just 5.40 per cent on a deposit made for the duration between 5 and 10
years. See how thin the margin between short-term and long-term finance.
197
Financing of Same is true in case of many other banks; excepting the fact that private
Working Capital
banks offering little higher rates over PSBs. Whereas the yield on
Government Securities per year stood at 6.779 per cent over the period
between May 1996 and January 2019; as per the data compiled by Census
and Economic Information Center. And whereas, Money Market instruments
like Treasury Bills are yielding 4.41 per cent on an average (2021-22 data),
Long-term Government Bonds (of 5 – 10 years) also are yielding about 4.81
per cent. These examples clearly indicate that the divergence between short
and long has become very thin and fading.

8.5 EFFECT OF CHOICE OF FINANCING ON

ROI
It would be now pertinent to examine the impact of the choice of financing on,
return on investment. Consider the following Data in Table-8.3

Table 8 .3: Effect of choice of financing on ROI

Balance Sheet Firm X Firm Y

Rs. Rs.
Current Assets 40,000 40,000
Fixed Assets 80,000 80,000
Total Assets 1,20,000 1,20,000
Accounts payable 10,000 10,000
Bank credit (10%) 0 30,000
Current liabilities 10,000 40,000
Long Term Debt (16%) 30,000 0
Equity 80,000 80,000
Total Liabilities 1,20,000 1,20,000

Income Statement Firm X Firm Y

Net operating Income (EBIT) 64,800 64,800
Less Interest 4,800 3,000
Taxable Income 60,000 61,800
Taxes @ 50% 30,000 30,900
PAT (Net Income) 30,000 30,900
Measures of Liquidity
(a) Current Ratio 4:1 1:1
(b) Net working capital 30,000 0
Measures of profitability
(a) ROl 37.5% 38.6%
(b) EPS Rs 3.00 Rs 3.09

198
It is evident from the data contained in Table 8.3 that the Firm (X) using Theories and
Approaches
long term debt has a current ratio of 4 times and Rs.30,000 in net working
capital, whereas Firm Y’s current ratio is only 1 time, which represents
zero net working capital. Because of lower interest rates on short-term debt
(bank credit in this case) Firm ‘Y’ was able to earn a ROI of 38.6
percent compared to that of ‘X’, which could earn only 37.5 percent. Thus
a firm can reduce its risk of illiquidity through the use of long term debt
at the expense of a reduction of its return on investment funds. Once again
we see that the risk-return trade-off involves an increased risk of illiquidity
versus increased profitability.

8.6 SUMMARY
It has been noted in this unit that value is created by virtue of investment
in both fixed and current assets. It is also found that the same criterion of
selection of projects used for fixed investment holds good for investments
in working capital; though the inter-related nature of current assets and
current liabilities makes the job of managing working capital difficult. To
attain this objective function, different approaches have been suggested. The
early contribution of Walker is found to be of immense use in this regard.
The principles laid down by him need to be tested in practice and
deviations to be examined. It is further highlighted that working capital
decisions involve trade-off between risk and return. This operates within the
investment and financing areas. Different approaches have been examined
in this unit with suitable examples to highlight the impact of the variables
on the working capital decision-making. Against these theoretical
foundations, the students are expected to compare the practices followed in
their organisations and enrich the existing knowledge base.

8.7 KEY WORDS

Aggressive financing Strategy: A portion of permanent assets financed
with short-term sources.
Conservative financing strategy: A portion of the temporary assets
financed with long term sources.
Hedging principle: The firm’s assets not financed by spontaneous sources
should be financed in accordance with the rule: permanent assets financed
with long-term sources and temporary assets with short-term sources.
Reversible investment: An investment, the cash flow related to which
could be readily reversed.
Spontaneous finance: Credit, which arises in direct conjunction with the
day-to-day operations of the firm.
Creation of value: The process of maximising the market price of the
company’s common stock. This occurs when the finance manager does
something that shareholder cannot do for themselves.
Net present value: The difference between the present value of inflows
generated by a project minus the initial investment made in that project.
199
Financing of
Working Capital
8.8 SELF-ASSESSMENT QUESTIONS
1) Distinguish between Fixed asset management and current asset
management.
2) How is value created through working capital management?
3) ‘Merely increasing the level of investment in current assets does not
reduce the working capital risks of a firm’ - comment.
4) ‘Working capital, like other financial management decisions involves
risk-return trade-off: yet the same is unique’. Elaborate with suitable
examples.
5) Examine with suitable examples the principles of Walker.
6) Illustrate, using hypothetical data, the risks-return trade-off involved in
current asset investment and financing decisions.
7) Distinguish matching, conservative and aggressive working capital
financing strategies. Under the present capital and money market
conditions, which of these would you recommend to a consumer durable
manufacturing firm? Why? List out your assumptions, if any.
8) The balance sheet of the Cooptex Manufacturing Company is presented
below for the year ended December 31, 2021.
Cooptex Manufacturing Co.
Balance sheet as on Dec. 31, 2021
Current Liabilities Rs 30,000 Net Fixed Assets Rs 50,000
Long-Term Liabilities Rs 20,000 Current Assets:
Equity Capital Rs 50,000 Cash 5,000
Inventories 25,000
Accounts Receivable 20,000 Rs 50,000
1,00,000 1,00,000

During 2003 the firm earned net income after taxes of Rs. 10,000 based
on net sales of Rs.2,00,000.
a) Calculate Cooptex current ratio, net working capital and return on total
assets ratio (net income/total assets) using the above information.
b) The General Manager (Finance) of Cooptex is considering a Plan for
enhancing the firm’s liquidity. The plan involves raising Rs.l0,000 by
issuing equity shares and investing in marketable securities that will
earn 10 percent before taxes and 5 per cent after taxes. Calculate
Cooptex’s current ratio, net working capital and return on total assets
after the plan has been implemented.
(Hint: Net Income will now become Rs 10,000 plus .05 times Rs. 10,000
or Rs 1,05,000)
c) In what manner will the plan proposed in part (b) affect the firm’s
liquidity and profitability? Explain.
9) The manager of farm supply store is evaluating two alternative levels of
investment in sand inventory. A & B. The relevant data for the two
alternatives are shown below:
200
 A B Theories and
Approaches
Average Monthly Investment Rs. 2000 Rs. 4000
Monthly Cash Revenues Rs. 1200 Rs. 1600
Monthly Cash Costs Rs. 400 Rs. 780

The discount rate for the investment is 1 per cent per month. The Income Tax
rate is 40 per cent. In six month’s time, inventories of this item will be
reduced to zero. The Manager expects to realize the amount invested at that
time.
a) Calculate the monthly net profit for the two alternatives.
b) Calculate the net present value for the two alternatives.
c) Which alternative is better? Does it matter whether net profit per month
or net present value is used to decide on the alternative?
Answers:
9 (a): A= Rs. 444 B= Rs. 438
9 (b): A=Rs.2661 B= Rs. 2627

8.9 FURTHER READINGS

1) Hrishikes Bhattacharya, Working Capital Management, Strategies and
Techniques, Prentice Hall.

2) Gup Benton E., Principles of Financial Management, John Wiley &

Sons, New York.
3) Walker, Ernest W., Essentials of Financial Management, Prentice Hall.

4) Weston, Fred J. & Brigham, E.F., Managerial Finance, The Dryden

Oress, Illinois.

201
Financing of
Working Capital UNIT 9 PAYABLES MANAGEMENT

Objectives
The objectives of this unit are to:
• Explain the significance of payables as a source of finance
• Identify the factors that influence the payables quantum and duration
• Highlight the advantages of payable and provide hints for effective
management of payables.

Structure
9.1 Introduction
9.2 Payables: Their Significance
9.3 Types of Trade Credit
9.4 Determinants of Trade Credit
9.5 Cost of Credit
9.6 Advantages of Payables
9.7 Effective Management of Payables
9.8 Summary
9.9 Key Words
9.10 Self-Assessment Questions
9.11 Further Readings

9.1 INTRODUCTION
A substantial part of purchases of goods and services in business are on
credit terms rather than against cash payment. While the supplier of goods
and services tend to perceive credit as a lever for enhancing sales or as a
form of non-price instrument of competition, the buyer tends to look upon it
as a loaning of goods or inventory. The supplier’s credit is referred to as
Accounts Payable, Trade Credit, Trade Bill, Trade Acceptance, Commercial
Draft or Bills Payable depending on the nature of credit provided. The extent
to which this ‘buy-now, pay-later’ facility is provided will depend upon a
variety of factors such as the nature, quality and volume of items to be
purchased, the prevalent practices in the trade, the degree of competition and
the financial status of the parties concerned. Trade credits or Payables
constitute a major segment of current liabilities in many business enterprises.
And they primarily finance inventories which form a major component of
current assets in many cases.

9.2 PAYABLES: THEIR SIGNIFICANCE

Payables constitute a current or short term liability representing the buyer’s
obligation to pay a certain amount on a date in the near future for value of
202
goods or services received. They are short term deferments of cash payments Theories and
Approaches
that the buyer of goods and services is allowed by the seller. Trade credit is
extended in connection with goods purchased for resale or for processing and
resale, and hence excludes consumer credit provided to individuals for
purchasing goods for ultimate use and instalment credit provided for
purchase of equipment for production purposes. Trade credits or payables
serve as non-interest bearing source of funds in most cases. They provide a
spontaneous source of capital that flows in naturally in the course of business
in keeping with established commercial practices or formal understandings.

9.3 TYPES OF TRADE CREDIT

Trade Credits or Payables could be of three types: Open Accounts,
Promissory Notes and Bills Payable.

Open Account or open credit operates as an informal arrangement wherein

the supplier, after satisfying himself about the credit-worthiness of the buyer,
despatches the goods as required by the buyer and sends the invoice with
particulars of quantity despatched, the rate and total price payable and the
payment terms. The buyer records his liability to the supplier in his books of
accounts and this is shown as payables on open account. The buyer is then
expected to meet his obligation on the due date.
The Promissory note is a formal document signed by the buyer promising to
pay the amount to the seller at a fixed or determinable future time. Where the
client fails to meet his obligation as per open credit on the due date, the
supplier may require a formal acknowledgement of debt and a commitment of
payment by a fixed date. The promissory note is thus an instrument of
acknowledgement of debt and a promise to pay. The supplier may even
stipulate an interest payment for the delay involved in payment.

Bills Payable or Commercial Drafts are instruments drawn by the seller and
accepted by the buyer for payment on the expiry of the specified duration. The
bill or draft will indicate the banker to whom the amount is to be paid on the
due date, and the goods will be delivered to the buyer against acceptance of
the bill. The seller may either retain the bill and present it for payment on the
due date or may raise funds immediately thereon by discounting it with the
banker. The buyer will then pay the amount of the bill to the banker on the
due date.

Activity 9 .1.
Try to ascertain from a Finance Manager:

i) What forms of credit is the firm obtaining?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
……………………………………………………………………………. 203
Financing of ii) Which of these forms is most economical from the purchasing firm’s
Working Capital
point of view and why?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

iii) How does the company organize itself to negotiate effectively with the
suppliers for obtaining the best possible credit terms?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

9.4 DETERMINANTS OF TRADE CREDIT

Size of the Firm
Smaller firms have increasing dependence on trade credit as they find it
difficult to obtain alternative sources of finance as easily as medium or large
sized firms. At the same time, larger firms that are less vulnerable to adverse
turns in business can command prompt credit facility from the supplier, while
smaller firms may find it difficult to sustain credit worthiness during periods
of financial strain and may have reduced access to credit due to weak
financial position.

Industrial Categories
Different categories of industries or Commercial enterprises show varying
degrees of dependence on trade credit. In certain lines of business the
prevailing commercial practices may stipulate purchases against payment in
most cases. Monopoly firms may insist upon Cash on delivery. There could
be instances where the firm’s inventory, turns over every fortnight but the
firm enjoys thirty days credit from suppliers, whereby the trade credit not
only finances the firm’s inventory but also provides part of the operating
funds or additional working capital.

Nature of Product
Products that sell faster or which have higher turnover may need shorter term
credit. Products with slower turnover take longer to generate cash flows and
will need extended credit terms.

Financial Position of Seller

The financial position of the seller will influence the quantities and period of
204 credit he wishes to extend. Financially weak suppliers will have to be strict
and operate on higher credit terms to buyers. Financially stronger suppliers, Theories and
Approaches
on the other hand, can dictate stringent credit terms but may prefer to extend
liberal credit so long as the transactions provide benefits in excess of the
costs of extending credit. They can afford to extend credits to smaller firms
and assume higher risks. Suppliers with working capital crunch will be
willing to offer higher cash discounts to encourage early payments.

Financial Position of the Buyer

Buyer’s creditworthiness is an important factor in determining the credit
quantum and period. It may be logical to expect large buyers not to insist on
extended credit terms from small suppliers with weak bargaining power.
Where goods are supplied on a consignment basis, the supplier provides extra
finance for the merchandise and pays commission to the consignee for the
goods sold. Small retailers are thus enabled to carry much larger levels of
stocks than they will be able to finance by themselves. Slow paying or
delinquent accounts may be compelled to accept stricter credit terms or higher
prices for products, to cover risk.

Terms of Sale
The magnitude of trade credit is influenced by the terms of sale. When a
product is sold, the seller sends the buyer an invoice that specifies the goods
or services, the price, the total amount due and the terms of the sale. These
terms fall into several broad categories according to the net period within
which payment is expected. When the terms of sale are only on cash basis,
there can be two situations, viz., Cash On Delivery (COD) and Cash Before
Delivery (CBD). Under these two situations, the seller does not extend any
credit.

Cash Discount
Cash discount influences the effective length of credit. Failure to take
advantage of the cash discount could result in the buyer using the funds at an
effective rate of interest higher than that of alternative sources of finance
available. By providing cash discounts and inducing good credit risks to pay
within the discount period, the supplier will also save on the costs of
administration connected with keeping records of dues and collecting overdue
accounts.

Degree of Risk
Estimate of credit risk associated with the buyer will indicate what credit
policy is to be adopted. The risk may be with reference to buyer’s financial
standing or with reference to the nature of the business the buyer is in.

Nature and Extent of Competition

Monopoly status facilitates imposition of tight credit term whereas intense
competition will promote the tendency to liberalise credit. Newly established
companies in competitive fields may more readily resort to liberal trade credit
for promoting sales than established firms which are more formal in deciding
on credit policies.
205
Financing of Datings
Working Capital
In seasonal industries, sellers frequently use datings to encourage customers
to place their orders before a heavy selling period. For many consumer
durables, the demand will be of this type. The need for an air-conditioner is
felt in the summer, leading to heavy ordering at a particular point of time.
This has double advantages. For manufacturer, he can schedule production
more conveniently and reduce the inventory levels. Whereas, the buyer has
the advantage of not having to pay for the goods until the peak, of the selling
period. Under this arrangement, credit is extended for a longer period than
normal.

9.5 COST OF CREDIT

Billing methods can vary. The payment of invoices may be stipulated as a
number of days after the date of the invoice or after the receipt of the goods.
In instances of seasonal business, when the supplier wishes to induce
customers to acquire and hold inventories in advance of the peak sales period,
he may resort to dating. The supplier, under this arrangement, extends longer
duration credit to the buyer and allows him to pay for the goods when the
peak period sales pick up. In some cases, a series of despatches effected
during a period, say, a month, are bunched together for invoicing and the
credit term is reckoned from the invoice date.

When the credit does not cover cash discount for early payment, the trade
credit is considered to be a cost free source of financing for the buyer. It is
not uncommon for some of the buyers to delay payments beyond the due
date, thus extending the period of use of costless trade credit.

Trade credit is a built-in source of financing that is normally linked to the

production cycle of the purchasing firm. If payments are made strictly in
accordance with credit terms, trade credit can be regarded as a cost free, non-
discretionary source of financing. But where the buyer takes the privilege of
delaying payment beyond the due date, it assumes the form of discretionary
financing and if this becomes a regular feature resulting in delinquency, trade
credit will cease to be cost free. The supplier may stop credit or may charge a
higher price for the product, to cover the risk.

The supplier may offer cash discount for payment within a specified number
of days after the invoice or after the receipt of goods. Generally such
concessions for expedited settlement are given to select customers on
informal basis. Where the aim is to induce earlier payment wherever possible,
cash discounts are provided for in the credit terms. The quantum of discount
offered will vary for different categories of business and clients.

Cash discount is to be distinguished from the other categories of discount that

may be offered by the seller, namely, the trade discount and the quantity
discount. The trade discount is a reduction from the invoice or list price
offered to the dealer or trader in the channel of distribution. Quantity
discounts are given when purchases are made insizeable lots.

206
When the cash discount is allowed for payment within a specified period, we Theories and
Approaches
can compute the cost of credit. For instance, if 30 days’ credit is offered with
the stipulation of a 2 per cent cash discount for payment within 10 days, it
means that the cost of deferring payment by 20 days is 2 per cent. If payment
is made 20 days earlier than the due date, 2 per cent of the amount due can be
saved, which amounts to an attractive annual saving rate of 36 per cent.
If cash discount is not availed, the effective rate of interest of the funds held
will work out to 36.7 per cent. The interest is Rs. 2 on Rs. 98 for a period of
20 days, and the rate of interest will be:
2/98 × 360/20 = 36.7 per cent.

If 60 days’ credit is extended, with a cash discount of 2 per cent for payment
within 10 days, there is a saving of Rs. 2 for paying 50 days ahead. The
effective rate of interest is 2/98 × 360/50 = 14.7 per cent. For 90 days’ credit,
with 2 per cent cash discount for payment within 10 days, the effective
interest works out to 9.2 per cent. Thus the more liberal the credit terms, the
saving from cash discount declines and so does the effective rate of interest
for using the funds till the due date. If, however, the discounts are not taken
and the settlement is made earlier than the due date, the effective rate of
interest will vary. For a firm that resists from taking the cash discount, its
cost of trade credit declines the longer it is able to delay payment.

The rationale for availing trade credit should be its savings in cost over the
forms of short term financing, its flexibility and convenience. Stretching
trade credit or accounts payable results in two types of costs to the buyer.
One is the cost of cash discount foregone and the other is the consequence of
a poor credit rating.
The contention that there is no explicit cost to trade credit if the payment is
made during the discount period or if the payment is made on the due date
when no cash discount is offered, is not totally tenable. The supplier who is
denied the use of funds during the credit period may bear the cost fully or
pass on part of it to the buyer through higher prices. This will depend on the
nature of demand for the product. If the demand is elastic, the supplier may
opt to bear the cost himself and refrain from charging higher prices to recover
part of it. The buyer should satisfy himself that the burden of trade credit is
not unduly loaded on him through disguised price revisions.

Repeated delinquency and deterioration in credit reputation do involve an

opportunity cost though it is difficult to measure. Some suppliers may be more
tolerant to delayed payments at some times than on other occasions. A policy
of delayed payments is bad business practice and in the long run can prove
very expensive or may even lead to freezing of credit source. Credit
reputation is a precious asset that needs to be preserved with utmost care. The
long run policy should be to avail discounts, if offered, utilize credit periods
to the full and discharge obligations on schedule.

The following formula can be used for determining the effective rate of
return: R = C (360)/D (100-C), where

R = Annual interest rate for the use of funds C = Cash discount 207
Financing of D = Number of extra days the customer has the use of supplier’s funds.
Working Capital
Let us take an illustration.

A firm wants to hold additional inventory but does not have the cash to
finance it. If the credit term is 2 per cent discount for payment within 10 days
with 60 days credit period, and the bank rate is 9 per cent, should the firm
take the discount?

If the discount is not taken by the 10th day, the effective rate of interest on
the funds held and utilized for the remaining 50 days will be:

2/98 × 360/50 = 14.7 per cent.

The bank rate is 9 per cent only. Therefore it is advisable to take the discount
offered, even if it involves utilizing bank borrowing for effecting early
payment for availing the cash discount.

Stretching Accounts Payable

It is normally assumed that the payment to the supplier is made at the end of
due date. However, a firm may postpone payment beyond this period. This
type of postponement is called stretching or Leaning on the trade. The cost of
stretching accounts payable is two fold : the cost of cash discount foregone
and the possible deterioration in the credit rating. If a firm stretches its
payables excessively, so that its payables are significantly delinquent, its credit
rating will suffer. Suppliers will view the firm with apprehension and may
insist on rather strict terms of sale. Although it is difficult to measure, there is
certainly an opportunity cost to a deterioration in the firms quality of
payment.

Activity 9 .2
i) Do the suppliers change their trade credit policy from time to time or are
they consistent irrespective of customer’s shifting fortunes?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) Compare Manufacturing companies against Service Firms in terms of

Credit Policies.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

208
 Theories and
9.6 ADVANTAGES OF PAYABLES Approaches

Easy to obtain
Payable or Trade Credit is readily obtainable, in most cases, without extended
procedural formalities. During periods of credit crunch or paucity of working
capital, trade credit from large suppliers can be a boon to small buyers.

Suppliers assume the risk

Where the suppliers have the advantage of high gross margins on their
products, they would be able to assume greater risks and extend more liberal
credit.

Informality
In trade credit, there is no rigidity in the matter of repayment on scheduled
dates, occasional delays are not frowned upon. It serves as an extendable,
convenient source of unsecured credit.

Continuous Financing
Even as the current dues are paid, fresh credit flows in, as further purchases
are made. It is a continuous source of finance. With a steady credit term and
the expectation of continuous circulation of trade credit-backing up repeat
purchases, trade credit does in effect, operate as long term source.

9.7 EFFECTIVE MANAGEMENT OF PAYABLES

The salient points to be noted on effective management of payables are:

• Negotiate and obtain the most favourable credit terms consistent with the
prevailing commercial practice pertaining to the concerned product line.
• Where cash discount is offered for prompt payment, take advantage of
the offer and derive the savings there from.
• Where cash discount is not provided, settle the payable on its date of
maturity and not earlier. It pays to avail the full credit term.
• Do not stretch payables beyond due date, except in inescapable
situations, as such delays in meeting obligations have adverse effects on
buyer’s credibility and may result in more stringent credit terms, denial of
credit or higher prices on goods and services procured.
• Sustain healthy financial status and a good track record of past dealings
with the supplier so that it would maintain his confidence. The quantum
and the terms of credit are mainly influenced by suppliers’ assessment of
buyer’s financial health and ability to meet maturing obligations promptly.
• In highly competitive situations, suppliers may be willing to stretch credit
limits and period. Assess your bargaining strength and get the best
possible deal.
• Avoid the tendency to divert payables. Maintain the self-liquidating
character of payables and do not use the funds obtained there from for
209
Financing of acquiring fixed assets. Payables are meant to flow through current assets
Working Capital
and speedily get converted into cash through sales for meeting maturing
short term obligations.
• Provide full information to suppliers and concerned credit agencies to
facilitate a frank and fair assessment of financial status and associated
problems. With fuller appreciation of client’s initiatives to honor his
obligations and the occasional financial strains which he might be
subjected to for a variety of reasons, the supplier will be more
considerate and flexible in the matter of credit extension.
• Keep a constant check on incidence of delinquency. Delays in settlement
of payables with reference to due dates can be classified into age groups
to identify delays exceeding one month, two months, three months, etc.
Once overdue payables are given priority of attention for payment, the
delinquencyrate can be minimized or eliminated altogether.
• Managers shall not think that payables management is a back-office
function. In view of the competing uses for materials, advancements in
the technology and the growing significance of Supply Chain
Management (SCM), this function also needs to be viewed as priority.
• Coordination between the Purchase department and Accounts department
is very much necessary.
• In the light of the EFTS and RTGS practices becoming widespread and
moving towards paperless processing, the issue shall be not about
delaying the payments, but it is about effective ‘scheduling of purchase
orders and payments’. Continuous monitoring of suppliers portals may
help schedule them properly and efficiently.
• Finally, it is the command of the company on the Data Flow about
suppliers, shortages, market trends that would greatly contribute in
designing newer and innovative ways in the management of payables.

In an interesting study done on ‘Accounts Payable Optimisation’, the

Institute of Finance and Management (IOFM), Geneva, Switzerland has
identified 17 ways to optimize investment in payables. They are:
• Self-Service Web Portal for vendors.
• Travel & Expense (T&E) Automation.
• Spend Analysis for Vendor Consolidation.
• Electronic Data Interchange (EDI).
• Automated Clearing House (ACH).
• Migrating Suppliers to e-invoicing.
• Document imaging as and when invoices are received (Front-end
processing).
• Automated Workflows for invoice approval.
• Automated workflows for Exceptions handling.
• Automated Data Capture (ADC).
210 • Cash forecasting with payables data.
• Recovery Audits. Theories and
Approaches
• Outsourcing/Off-shoring.
• P-cards (purchasing/procurement cards).
• Evaluated Receipt Settlement (ERS).
• Web Invoicing.
• Dynamic Discounting.

After having surveyed the practices of firms, the study found that the
following three methods are very popular among the companies:
a) Automated Clearing House.
b) P-cards.
c) Document Imaging and e-invoicing.

Advancements in the technology have really changed the way the corporate
affairs are handled across the globe. Many multinational companies like
ABB, Canon, Oracle, etc., are increasingly adopting many of the above
methods.

9.8 SUMMARY
Payables or trade credit is a self liquidating, easy-to-obtain, flexible source of
short term finance. Buyer’s credit reputation, as reflected in evidences of his
willingness and ability to meet maturing obligations will determine the
quantum and period of credit he can command. Factors like competition,
nature of the product and size of the supplier’s firm also influence terms of
credit, besides relevant commercial practices or conventions. It will be
prudent to take advantage of cash discount facilities when available and avoid
over-stretching payables by frequent delays in payments. If good credit
relations are maintained with suppliers, payables can be a ready and
expanding source of short term finance that will correspond to the needs of a
growing firm.

Payables are not altogether cost-free but if managed well, the costs can be
substantially lower than the alternative sources of short term finance.

9.9 KEY WORDS

Accounts Payable: is a liability arising from the purchase of goods or
services on credit.
Trade Acceptance: is a bill or instrument drawn by the seller on the buyer,
the amount which the buyer accepts to pay at an agreed future date.
Promissory Note: is a formal document signed by the buyer promising to
pay the amount thereof to the seller on demand or at a certain future date.
Delinquency: is the failure to meet the obligation on the due date.
Datings: A practice of encouraging buyers to place orders before a heavy
selling period.
211
Financing of Stretching : Postponement of payment beyond due date.
Working Capital

9.9 SELF ASSESSMENT QUESTIONS

1) Why is trade credit used extensively by firms?
2) What are the different forms of trade credit? Explain.
3) Trade credit is regarded as a spontaneous source of short term finance.
Comment.
4) Distinguish between trade discount, quantity discount and cash discount.
5) What are the factors that influence the availability of trade credit?
6) What are the principal advantages of trade credit or payables?
7) Over extension of trade credit is a major factor in the financial difficulties
of most companies that fail. Explain.
8) A company has regularly been obtaining 90 days’ credit, with a cash
discount of 2 per cent for payment within 10 days and has found that it
can let the account slide for an extra 30 days without injuring its credit
rating or losing its source of supply. Will it pay the firm to borrow from a
finance agency at a rate of 7 per cent to take advantage of cash discount?
9) Compute the cost of not availing the following discounts on a purchase of
Rs. 10lakh a year.
a) 2/10, net 30
b) 3/10, net 40
c) 2/5, net 25
d) 1/10, net 46

10) You receive a bill from a supplier with the term 2/15, net 45.

a) If you can borrow funds from your bank at 12% per annum, should
you avail discount?
b) Suppose the terms are 1/5, net 15, and you can borrow at 12%, should
you avail discount?

9.10 FURTHER READINGS

Satish B. Mathur, 2002, Working Capital Management and Control, New
Age International (P) Ltd., New Delhi.

R.M. Srivastava, 1986, Essentials of Business Finance, Himalaya Publishing

House, Bombay (Chapter 20),
Van Horne, James C, 1985, Fundamentals of Financial Management,
Prentice Hall of India, New Delhi.

212
 Bank Credit -
UNIT 10 BANK CREDIT - PRINCIPLES Principles a nd
Practices
AND PRACTICES
Objectives
The objectives of this unit are to explain:
• The basic principles of sound lending
• The style of Credit — their merits and demerits
• The types of security required and the modes of creating charge, and
• The methods of credit investigation

Structure
10.1 Introduction
10.2 Principles of Bank Lending
10.3 Style of Credit
10.4 Classification of Advances According to Security
10.5 Modes of Creating Charge Over Assets
10.6 Secured Advances
10.7 Purchase & Discounting of Bills
10.8 Non Fund Based Facilities
10.9 Credit Worthiness of Borrowers
10.10 Summary
10.11 Key Words
10.12 Self Assessment Questions
10.13 Further Readings

10.1 INTRODUCTION
Bank credit constitutes one of the major sources of Working Capital for trade
and industry. With the growth of banking institutions and the phenomenal
rise in their deposit resources, their importance as the suppliers of Working
Capital has significantly increased. Of the total gross bank credit outstanding
as at the end of February 2022 of Rs.116,27,008 crore, an amount of
Rs.31,35,271 crore is advanced to industry; which included all types of Micro,
Small, Medium and large industries. This works out to around 27.0 per cent. If we
also take into consideration the service industry, wholesale and retail trade
this percentage goes up very significantly to 52.5 per cent. Individually,
service industry alone accounted for about 25.5 per cent of the total gross
bank credit outstanding at Rs.29,66,593 crore. More particularly, there has
been significant rise in the credit towards industry in the recent past. In this
unit, first we shall examine the basic principles of bank credit, followed by a
detailed account of the various types of credit facilities offered by banks and
the securities required by them.
213
Financing of
Working Capital
10.2 PRINCIPLES OF BANK LENDING
While granting loans and advances commercial banks follow the three
cardinal principles of lending. These are the principles of safety, liquidity and
profitability, which have been explained below:
1) Principle of Safety: The most important principle of lending is to ensure
the safety of the funds lent. It means that the borrower repays the
amount of the loan with interest as per the loan contract. The ability to
repay the loan depends upon the borrower’s capacity to pay as well as his
willingness to repay. To ensure the former, the banker depends upon his
tangible assets and the viabilityof his business to earn profits. Borrower’s
willingness depends upon his honesty and character. Banker, therefore,
takes into account both the above mentioned aspects to determine the
credit - worthiness of the borrower and to ensure safety of the funds lent.
2) Principle of Liquidity: Banks mobilize funds through deposits which
are repayable on demand or over short to medium periods. The banker
therefore lends his funds for short period and for Working Capital
purposes. These loans are largely repayable on demand and are granted
on the basis of securities which are easily marketable so that they may
realise their dues by selling the securities.
3) Principle of Profitability: Banks are profit earning institutions. They
lend their funds to earn income out of which they pay interest to
depositors, incur operational expenses and earn profit for distribution to
owners. They charge different rates of interest according to the risk
involved in lending funds to various borrowers. However, they do not
have to sacrifice safety or liquidity forthe sake of higher profitability.
Following the above principles, banks pursue the practice of diversifying
risk by spreading advances over a reasonably wide area, distributed
amongst a good number of customers belonging to different trades and
industries. Loans are not granted for speculative and unproductive
purposes

10.3 STYLE OF CREDIT

Commercial banks provide finance for working capital purposes through a
variety of methods. The main systems or style of credit, prevalent in India are
depicted in the following diagram.
Bank Credit

Loans and advances Discounting of bills

Overdrafts Cash Credit Loans

Short-term Personal Medium & Bridge Composite Others/ including credit cards/
Loans Loans Long-term Loans Loans Education Loans/Housing
Loans, etc.
214
The terms and conditions, the rights and privileges of the borrower and the Bank Credit -
Principles a nd
banker differ in each case. We shall discuss below some of these methods of Practices
granting bank credit.

10.3.1 Overdrafts
This facility is allowed to the current account holders for a short period.
Under this facility, the current account holder is permitted by the banker to
draw from his account more than what stands to his credit. The excess
amount drawn by him is deemed as an advance taken from the bank. Interest
on the exact amount overdrawn by the account-holder is charged for the
period of actual utilisation. The banker may grant such an advance either on
the basis of collateral security or on the personal security of the borrower.
Overdraft facility is granted by a bank on an application made by the
borrower. He is also required to sign a promissory note. Therefore, the
customer is allowed the amount, upto the sanctioned limit of overdraft as and
when he needs it. He is permitted to repay the loan as per his convenience
and ability to do so.

10.3.2 Cash Credit System

Cash Credit System accounts for the major portion of bank credit in India.
Thesalient features of this system are as follows:
1) Under this system, the banker prescribes a limit, called the Cash Credit
limit, upto which the customer- borrower is permitted to borrow against
the securityof tangible assets or guarantees.
2) The banker fixes the Cash Credit limit after considering various aspects
of the working of the borrowing concern i.e production, sales, inventory
levels, past utilisation of such limit, etc.
3) The borrower is permitted to withdraw from his Cash Credit account,
amount as and when he needs them. Surplus funds with him are allowed
to be deposited with the banker any time. The Cash Credit account is
thus a running account, wherein withdrawals and deposits may be made
frequently any number of times.
4) As the borrower withdraws from Cash Credit account he is required to
provide security of tangible assets. A charge is created on the movable
assets of the borrower in favour of the banker.
5) When the borrower repays the borrowed amount in full or in part,
security is released to him in the same proportion in which the amount is
refunded.
6) The banker charges interest on the actual amount utilised by him and for
the actual period of utilisation.
7) Though the advance made under Cash Credit System is repayable on
demand and there is no specific date of repayment, in practice the
advance is rolled over a period of time i.e. the debit balance is hardly
fully wiped out and the loan continues from one period to another.
215
Financing of 8) Under this system, the banker keeps adequate cash balance to meet the
Working Capital
demand of his customers as and when it arises, but interest is charged on
the actual amount of loan availed of. Thus, to neutralize the loss caused
to the banker, the latter imposes a commitment charge at a normal rate of
1% or so, on the unutilised portion of the cash credit limit.

Merits of Cash Credit System

The Cash Credit System has the following merits:
1) The borrower need not keep surplus funds idle with himself. He can
deposit the surplus funds with the banker, reduce his debit balance, and
thus minimise the interest burden. On the other hand he can withdraw
funds at any time to meet his needs.
2) Banks maintain one account for all transactions of a customer. As
documents are required only once in a year the costs of repetitive
documentation is avoided.

Demerits of Cash Credit System

The Cash Credit System, on the other hand, suffers from the following
demerits:
1) Cash Credit limits are prescribed only once in a year and hence they are
fixed keeping in view the maximum amount that can be required within a
year. Consequently, a portion remains unutilised for part of the year
during which bank funds remain unemployed.
2) The banker remains unable to verify the end use of funds borrowed by
the customer. Such funds may be diverted to unapproved purposes.
3) The banker remains unable to plan the utilisation of his funds as the level
of advances depends upon the borrower’s decision to borrow at any time.
4) As the volume of cash transactions increases significantly under the
cash credit system as against the loan system, the cost of handling cash,
honouring cheques, taking and giving delivery of securities increases the
transactions cost of banks.
5) As there is only commitment charge of 1% or less, there will be a
tendency on the part of companies to negotiate for a higher limit.

10.3 LOAN SYSTEM

Under the loan system, a definite amount is lent at a time for a specific period
and a definite purpose. It is withdrawn by the borrower once and interest is
payable for the entire period for which it is granted. It may be repayable in
installments or in lump sum. If the borrower needs funds again, or wants to
renew an existing loan, a fresh proposal is placed before the banker. The
banker will make a fresh decision depending upon the availability of cash
resources. Even if the full loan amount is not utilised the borrower has to pay
the full interest.
216
 Bank Credit -
Advantages of the Loan System Principles a nd
Practices
The loan system has the following advantages over the Cash Credit System:
1) This system imposes greater financial discipline on the borrowers, as
they are bound to repay the entire loan or its installments on the due
date/ dates fixed in advance.
2) At the time of granting a new loan or renewing an existing loan, the
banker reviews the loan account. Thus unsatisfactory loan accounts may
be discontinued at his discretion.
3) As the banker is entitled to charge interest on the entire amount of loan,
his income from interest is higher and his profitability also increases
because of lower transaction cost.

Short Term Loans

Short term loans are granted by banks to meet the Working Capital
requirements of the borrowers. Such loans are usually granted for a period
upto one year and are secured by the tangible movable assets of the borrowers
like goods and commodities, shares, debentures, etc. Such goods and
securities are pledged or hypothecated with the banker.

As we shall study in the next unit. Reserve Bank of India has exercised
compulsion on banks since 1995 to grant 80% of the bank credit permissible
to borrowers with credit of Rs 10 crore or more in the form of short term
loans which may be for various maturities. Reserve Bank has also permitted
the banks to roll over such loans i.e. to renew the loan for another period at
the expiry of the period of the first loan.

As per the Master Circular issued by the Reserve Bank of India on the
‘Management of Advances’ dated April 8, 2022, Banks are free to assess the
working capital requirements of the borrowers either on the basis of turnover
or the old method based on the Tandon Committee methodology. Whatever
be the method followed, borrowers are required to bring in their own
resources to the extent of 5 per cent and the banks share the remaining 20 per
cent. Similarly, the total working capital finance is required to be divided
between Term-loan and cash credit. Of the total amount agreed upon, 80 per
cent should be in the form of Term Loan (WCTM) and the remaining could
be the cash credit portion.

In order to meet the special requirements, Banks may also grant Ad-
hoc/additional credit limits, subject to proper scrutiny and in complete
satisfaction of the requirement. Further banks are permitted to fix separate
lending rates for loan component and cash credit component.

Medium and Long Term Loans

Such loans are generally called ‘Term Loans’ and are granted by banks with
All India Financial Institutions like Industrial Development Bank of India,
Industrial Finance Corporation of India, Industrial Credit and Investment
Corporation of India Ltd. Term loans are granted for medium and long
terms, generally above 3 years and are meant for purchase of capital assets 217
Financing of for the establishment of new units and for expansion or diversification of an
Working Capital
existing unit. At the time of setting up of a new industrial unit, term loans
constitute a part of the project finance which the entrepreneurs are required to
raise from different sources. These loans are usually secured by the tangible
assets like land, building, plant and machinery etc. Banks now have the
discretion to sanction term loans to all projects within the overall ceiling of
the prudential exposure norms prescribed by Reserve bank. The period of
term loans will also be decided by banks themselves.

Though term loans are meant for meeting the project cost but as project cost
includes margin for Working Capital , a part of term loans essentially goes to
meet the needs of Working Capital.

Bridge Loans
Bridge loans also called swing loans, interim funding, gap financing, are in fact
short term loans which are granted to industrial undertakings to enable them
to meet their urgent and essential needs. Such loans are granted under the
following circumstances:
1) When a term loan has been sanctioned by banks and/ or financial
institutions, but its actual disbursement will take time as necessary
formalities are yet to be completed.
2) When the company is taking necessary steps to raise the funds from the
Capital market by issue of equities/debt instruments.

Bridge loans are provided by banks or by the financial institutions which

have granted term loans. Such loans are automatically repaid out of the
amount of term loan when it is disbursed or out of the funds raised from the
Capital Market.
Reserve Bank of India has allowed the banks to grant such loans within the
ceiling of 5% of incremental deposits of the previous year prescribed for
individual banks’ investment in Shares/ Convertible debentures. Bridge loans
may be granted for a maximum period of one year. Normally, the interest
rates on these loans are high.

Composite Loans
Composite loans are those loans which are granted for both, investment in
capital assets as well as for working capital purposes. Such loans are usually
granted to small borrowers, such as artisans, farmers, small industries etc.
Under the composite loan scheme, both term loans and Working Capital are
provided through a single window. The limit for composite loans has been
increased from Rs.10 lakh to Rs.1.00 crore now for MSME units. These
loans are sanctioned to encourage small borrowers to meet all kinds of
requirements and make the loans sanction process hassle-free.

Cluster Financing:
Cluster based financing is devised by the banks to provide a full service
approach to cater to the diverse needs of small borrowers. This approach is
218 said to help in: (a) dealing with well defined and recognized groups,
(b) information risk management; (c) feedback mechanism, and (d) cost Bank Credit -
Principles a nd
reduction. The Government of India has been advising Banks to adopt at least Practices
one cluster on each district.

Personal Loans
These loans are granted by banks to individuals specially the salary-earners
and others with regular income, to purchase consumer durable goods like
refrigerators, T.V.s, cars etc. Personal loans are also granted for
purchase/construction of houses. Generally the amount of loans is fixed as a
multiple of the borrower’s income and a repayment schedule is prepared as
per his capacity to save.

Activity 1 0 .1
i) What are the Basic Principles that guide banks in lending?
…………………………………………………………………………….
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ii) What is meant by Bridge Loan? What is the necessity for granting such
loans?
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…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

iii) Have an informal chat with a Bank Manager and try to understand the
merits and demerits of various types of loans sanctioned by him/her.
…………………………………………………………………………….
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10.4 CLASSIFICATION OF ADVANCES

ACCORDING TO SECURITY
Banks attach great importance to the safety of the funds, lent as loans and
advances. For this purpose, they ask the borrowers to create a charge on their
tangible assets in their favour. In some cases, the banks secure their interest
by asking for a guarantee given by a third party. Besides the tangible assets
or a guarantee, banks rely upon the personal security of the borrower and
grant loans which are called unsecured advances’ or ‘clean loans’. In the
219
Financing of balance sheet, banks classify advances as follows:
Working Capital
Advances

Secured by Covered by Unsecured

Tangible Bank /Govt.
Assets Guarantees

Secured Advances
According to Banking Regulation Act 1949, a secured loan or advance means
“a loan or advance made on the security of assets, the market value of which
is not at any time less than the amount of such loan or advances”. An
unsecured loan or advance means a loan or advance not so secured.
The main features of a secured loan are:

• The advance is made on the basis of security of tangible assets like goods
and commodities, life insurance policies, corporate and government
securities etc.

• A charge is created on such security in favour of the banker.

• The market value of such security is not less than the amount of loan. If
the former is less than the latter, it becomes a partly secured loan.

Unsecured Advances
Unsecured advances are granted without asking the borrower to create a
charge on his assets in favour of the banker. In such cases the security
happens to be the personal obligation of the borrower regarding repayment of
the loan. Such loans are granted to parties enjoying high reputation and sound
financial position.

The legal status of the banker in case of a secured advance is that of a

secured creditor. He possesses absolute right to recover his dues from the
borrower out of the sale proceeds of the assets over which a charge is created
in his favour. In case of an unsecured advance, a banker remains an
unsecured creditor and stand at par with other unsecured creditors of the
borrower, if the latter defaults.

Guaranteed Advances
The banker often safeguards his interest by asking the borrower to provide a
guarantee by a third party may be an individual, a bank or Government.
According to the Indian Contract Act, 1872, a contract of guarantee is
defined as “a contract to perform the promise or discharge the liability of
third person is case of his default”. The person who undertakes this
obligation to discharge the liability of another person is called the guarantor
or the surety. Thus a guaranted advance is, in fact, also an unsecured
advance i.e. without any specific charge being created on any asset, in
220
favour of the banker. A guarantee carries a personal security of two persons Bank Credit -
Principles a nd
i.e. the principal debtor and the surety to perform the promise of the Practices
principal debtor. If the latter fails to fulfill his promise, liability of the surety
arises immediately and automatically. The surety therefore, must be a reliable
person considered good for the amount for which he has stood as surety. The
guarantee given by banks, financial institutions and the government are
therefore considered valuable.

10.5 MODES OF CREATING CHARGE

OVER ASSETS
As we have noted above, in case of secured advance, a charge is created
over an asset of the borrower in favour of the lender. By creation of charge it
is meant that the banker gets certain rights in the tangible assets of the
borrower. The borrower still remains the owner of the asset, but the banker
gets the right of realizing his dues out of the sale proceeds of the asset. Thus
banker’s interest is safeguarded.
There are several methods of creating charge over the borrower’s assets as
shown below:

Modes of creating charge

Pledge Hypothecation Mortgage Lien Assignment

10.5.1 Pledge
Pledge is the most popular method of creating charge over the movable
assets. Indian Contract Act, 1872, defines pledge as ‘bailment of goods as
security of payment of a debt or performance of a promise”. The person
who offers the security is called the pledger and the person to whom the
goods are entrusted is called the ‘pledgee’. Thus bailment of goods is the
essence of a pledge. Indian Contract Act defines bailment as “delivery of
goods from one person to another for some purpose upon the contract that the
goods be returned back when the purpose is accomplished or otherwise
disposed of according to the instructions of the bailor”.
Thus when the borrower pledges his goods with the banker, he delivers the
goods to the banker to be retained by him as security for the amount of the
loan. Delivery of goods may be either (i) physical delivery or (ii) constructive
or symbolic delivery. The latter does not involve physical delivery of the
goods. The handing over of the keys of the godown storing the goods, or even
handing over the documents of the title to goods like warehouse receipts, duly
endorsed in favour of the banker amounts to constructive delivery.

It is also essential that the banker must return the same goods to the borrower
after he repays the amount of loan along with interest and other charges. The
pledgee (banker) is entitled to certain rights, which are conferred upon him
221
Financing of by the Indian Contract Act. The foremost right is that he can retain the goods
Working Capital
pledged for the payment of debt and interest and other charges payable by
the borrower. In case the pledger defaults, the pledgee has the right to sell the
goods after giving pledger reasonable notice of sale or to file a suit for the
amount due from him.

10.5.2 Hypothecation
Hypothecation is another method of creating charge over the movable assets
of the borrower. It is preferred in circumstances in which transfer of
possession over such assets is either inconvenient or is impracticable. For
example, if the borrower wants to borrow on the security of raw materials or
goods in process, which are to be converted into finished products, transfer of
possession is not possible/practicable because his business will be impeded in
case of such transfer. Similarly a transporter needs the vehicle for plying on
the road and hence cannot give its possession to the banker for taking a loan.
In such circumstances a charge is created by way of hypothecation.

Under hypothecation, neither ownership nor possession over the asset is

transferred to the creditor. Only an equitable charge is created in favour of
the banker. The asset remains in the possession of the borrower who
promises to give possession thereof to the banker, whenever the latter
requires him to do so. The charge of hypothecation is thus converted into that
of a pledge. The banker enjoys the rights and powers of a pledgee. The
borrower uses the asset in any manner he likes, viz he may take out the stock,
sell it and replenish it by a new one. Thus a charge is created on the movable
asset of the borrower. The borrower is deemed to hold possession over the
goods as an agent of the creditor. To enforce the security, the banker should
take possession of the hypothecated asset on his own or through the court.

10.5.3 Mortgage
A charge on immovable property like land & building is created by means of
a mortgage. Transfer of Property Act 1882 defines mortgage as” the
transfer of an interest in specific immovable property for the purpose of
securing the payment of money, advanced or to be advanced by way of
loan, an existing or future debt or the performance of an engagement
which give rise to a pecuniary liability”. The transferor is called the
‘mortgagor’ and the transferee ‘mortgagee’.

The owner transfers some of the rights of ownership to the mortgagee and
retains the remaining with himself. The object of transfer of interest in the
property must be to secure a loan or to ensure the performance of an
engagement which results in monetary obligation. It is not necessary that
actual possession of the property be passed on to the mortgagee. The
mortgagee, however, gets the right to recover the amount of the loan out of
the sale proceeds of the mortgaged property. The mortgagor gets back the
interest in the mortgaged property on repayment of the amount of the loan
along with interest and other charges.

222
 Bank Credit -
Kinds of Mortgages Principles a nd
Practices
Though Transfer of Property Act specifies seven kinds of mortgages, but
from the point of view of transfer of title to the mortgaged property,
mortgages are divided into-
a) Legal mortgages and
b) Equitable mortgages
In case of Legal Mortgage, the mortgagor transfers legal title to the property
in favour of the mortgagee by executing the Mortgage deed. When the
mortgage money is repaid, the legal title to the mortgaged property is re-
transferred to the mortgagor. Thus in this type of mortgage, expenses are
incurred in the form of stamp duty and registration charges.
In case of an equitable mortgage the mortgagor hands over the documents of
title to the property to the mortgagee and thus creates an equitable interest of
the mortgagee in the mortgaged property. The legal title to the property is not
passed on to the mortgagee but the mortgagor undertakes through a
Memorandum of Deposit to execute a legal mortgage in case he fails to pay
the mortgaged money. In such situation the mortgagee is empowered to apply
to the court to convert the equitable mortgage into legal mortgage.
Equitable Mortgage has several advantages over Legal Mortgage. It is not
necessary to register the Memorandum of Deposit or the covering letter sent
along with the Documents of title. Actual handing over by a borrower to the
lender of documents of title to immovable property with the intention to
constitute them as security is sufficient. As registration is not mandatory,
information regarding mortgage remains confidential and the mortgagor’s
reputation is not affected. When the debt is repaid documents are returned
back to the borrower, who may re-deposit the same for taking another loan
against the same documents. But the banker should be very careful in
retaining the documents in his possession, because if the equitable mortgagee
is negligent or mis-represents to another person, who advances money on the
security of the mortgaged property, the right of the latter will have first
priority.

10.5.4 Assignment
The borrower may provide security to the banker by assigning any of his
rights, properties or debts to the banker. The transferor is called the
‘assignor’ and the transferee the ‘assignee’. The borrowers generally assign
the actionable claims to the banker under section 130 of the Transfer of
Property Act 1882. Actionable claim is defined as a claim to any debt, other
than a debt secured by mortgage of immovable property or by hypothecation
or pledge of movable property or to any beneficial interest in movable
property not in the possession of the claimant.

A borrower may assign to the banker (i) the book debts, (ii) money due from
a government department or semi-government organisation and (iii) life
insurance policies.

Assignment may be either a legal assignment or an equitable assignment. In

case of legal assignment, there is absolute transfer of actionable claim which
must be in writing. The debtor of the assignor is informed about the 223
Financing of assignment. In the absence of the above the assignment is called equitable
Working Capital
assignment.

10.5.5 Lien
The Indian Contract Act confers upon the banker the right of general lien.
The banker is empowered to retain all securities of the customer, in respect of
the general balance due from him. The banker gets the right to retain the
securities handed over to him in his capacity as a banker till his dues are paid
by the borrower. It is deemed as implied pledge.

Activity 10.2
i) Distinguish between a secured advance and a guaranteed advance.
…………………………………………………………………………….
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ii) Distinguish between pledge and hypothecation. Which provides better
securityto the banker and why?
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iii) What do you understand by Equitable Mortgage? What are its

advantages vis-a-vis legal mortgage?
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10.6 SECURED ADVANCES

Secured advances account for significant portion of total advances granted by
banks. As we have seen, in case of secured advances, a charge is created on
the assets of the borrowers in favour of the banker, which enables him to
realise his dues out of the sale proceeds of the assets. Banks grant advances
against a variety of assets as shown below:
224
 Bank Credit -
Securities for Advances Principles a nd
Practices

Goods & Documents Real Estates Book Supply

Commodities Debts Bills

Documents of Stock Exchange Life Insurance Fixed Deposit

Title to goods Securities Policies Receipts

Let us first study the general principle of secured advances:

1) Marketability of Securities: The banker grants advances on the basis of
those securities which are easily marketable without loss of time and
money, because in case of non-payment by the borrower, the banker
shall have to dispose off the security to realise his dues.
2) Adequacy of Margin : Banker also maintains a difference between the
value of the security and the amount lent. This is called ‘margin’.
Suppose a banker grants a loan of Rs. 100 /- on the security valued at Rs.
200/- the difference between the two (i.e. Rs. 200 - Rs. 100 = Rs. 100) is
called margin. Margin is necessary to safeguard the interest of the
banker as the market value of the security may fall in future and /or
interest and other charges become payable by the borrower, thus
increasing the liability of the borrower towards the banker. Different
margins are prescribed in case of different securities.
3) Documentation: Banker also requires the borrower to execute the
necessary documents e.g. Agreement of pledge, Mortgage Deed,
Promissory notes etc. to safeguard his interest.
Goods and Commodities
Bulk of the advances granted by banks are secured by goods and
commodities, raw material and finished goods etc., which constitute the
stock-in-trade of business houses. However, agricultural commodities are
likely to deteriorate in quality over a period of time. Hence banks grant short
term loans only against such commodities. The problem of valuation of stock
pledged with the bank is not a difficult one, as daily quotations are easily
available. Banker usually prefers those commodities which have steady
demand and a wider market. Such goods are required to be insured against
fire and other risks. Such goods either pledged or hypothecated to the banker
are released to the borrower in proportion to the amount of loan repaid.

Agro-based commodities such as food grains, sugar, pulses, oilseeds, cotton

are sensitive to the market forces of demand and supply, and prices. As our
country has faced seasonal shortages in several of these commodities, the
Reserve Bank of India under the authority vested in it by the Banking
Regulation Act, issues directives known as Selective Credit Control (SCC) to
scheduled commercial banks during the commencement of each busy season
which is, in practical terms, the commencement of the Kharif or the Rabi
season each year. In order to ensure that speculation in these sensitive
commodities does not take place, the Reserve Bank of India in its busy 225
Financing of season policy issues direction to control the credit for commodities by:
Working Capital
Fixing an overall ceiling for credit to sensitive commodities for each bank as
whole. For example, total credit against these commodities in a particular year
may be restricted to 80% of the previous year’s level;

i) Fixing margins and rates of interest that can be levied by banks in their
credit against the selected commodities; and
ii) Banning the flow of bank credit towards financing one or more of these
selected commodities.

Each bank takes into consideration the RBI’s policy on selective credit control
while determining its own credit policy. The Head Offices of banks advise
their branches on the terms and conditions applicable to SCC commodities.

Documents of Title to Goods

These documents represent actual goods in the possession of some other
person. Hence, they are proof of possession or control over the goods. For
example, warehouse receipts, railway receipts, Bill of lading etc. are
documents of title to goods. When the owner of goods represented by these
documents wants to take a loan from the banker, he endorses such documents
in favour of the banker and delivers them to him. The banker is thus entitled
to receive the delivery of such goods, if the advance is not repaid. However,
there remains the risk of forgery in such documents and dishonesty on the
part of the borrower.

Stock Exchange Securities

Stock Exchange Securities comprise of the securities issued by the Central
and State governments, semi-govt. organisations, like Port Trust &
Improvement Trust, Shares and Debentures of companies and Units of the
Mutual Funds listed on the Stock Exchanges. The Govt. securities are
accepted by banks because of their easy liquidity, stability in prices, regular
accrual of income and easy transferability.

In case of corporate securities banks prefer debentures of companies vis-à-

vis shares because the debenture holder generally happens to be secured
creditor and there is a contractual obligation on the company to pay interest
thereon regularly. Amongst the shares, banks prefer preference shares,
because of the preferential rights enjoyed by the preference shareholders
over equity shareholders. Banks accept equity shares of those companies
which they approve after thorough screening and examination of all aspects
of their working. A charge over such securities is created in favour of the
banker.

Reserve Bank of India has permitted the banks to grant advances against
shares to individuals upto Rs. 20 lakhs w.e.f. April 29, 1998 if the advances
are secured by dematerialized Securities. The minimum margin against such
dematerialized shares was also reduced to 25%. Advances can also be
granted to investment companies, shares & stock brokers, after making a
careful assessment of their requirements.
226
 Bank Credit -
Life Insurance Policies Principles a nd
Practices
A life insurance policy is considered a suitable security by a banker as
repayment of loan is ensured to the banker either at the time policy matures
or at the time of death of the insured. Moreover, the policy has a surrender
value which is paid by the insurance company, if the policy is discontinued
after a minimum period has lapsed. The policy can be legally assigned to the
banker and the assignment may be registered in the books of the insurance
company. Banks prefer endowment policies as compared to the whole life
policies and insist that the premium is paid regularly by the insured.
Fixed Deposit Receipts
A Fixed Deposit Receipt issued by the same bank is the safest security for
granting an advance because the receipt represents a debt due from the
banker to the customer. At the time of taking a loan against fixed deposit
receipt the depositor hands over the receipt to the banker duly discharged,
along with a memorandum of pledge. The banker is thus authorised by the
depositor to appropriate the amount of the FDR towards the repayment of
loan taken from the banker.
Real Estate
Real Estate i.e immovable property like land and building are generally not
regarded suitable security for granting loans for working capital. It is difficult
to ascertain that the legal title of the owner is free from any encumbrance.
Moreover, their valuation is a difficult task and they are not readily realizable
assets. Preparation of mortgage deed and its registration takes time and is
expensive also. Real Estates are, therefore, taken as security for term loans
only.
Book Debts
Sometimes the debts which the borrower has to realise from his debtors are
assigned to the banker in order to secure a loan taken from the banker. Such
debts have either become due or will accrue due in the near future. The
assignor must execute an instrument in writing for this purpose, clearly
expressing his intention to pass on his interest in the debt to the assigner
(banker). He may also pass an order to his debtor to pay the assigned debt to
the banker.

Supply Bills
Banks also grant advance on the security of supply bills. These bills are
offered as security by persons who supply goods, articles or materials to
various Govt. departments, semi-govt bodies and companies, and by the
contractors who undertake government contract work. After the goods are
supplied by the suppliers to the govt. department and s/he obtains an
inspection note or Receipted Challan from the Department, s/he prepares a
bill for the goods supplied and gives it to the bank for collection and seeks an
advance against such supply bills. Such bills are paid by the purchaser at the
expiry of the stipulated period.

Security for bank credit could be in the form of a direct security or an indirect
security. Direct security includes the stocks and receivables of the customers 227
Financing of on which a charge is created by the bank through various security documents.
Working Capital
If in the view of the bank, the primary or direct security is not considered
adequate or is risk- prone, that is, subject to heavy fluctuations in prices,
quality etc. the bank may require additional security either from the customer
or from a third party on behalf of the customer. The additional security so
obtained is known as Indirect or “Collateral Security”. The term collateral
means running parallel or together and collateral security is an additional and
separate security for repayment of money borrowed.

In case the customer is unable to provide additional security when required

by the bank, he may be required to provide collateral security from a third
party. The common form of the third party collateral security is a guarantee
given by a person on behalf of the customer to the bank. The third party
collateral security in turn may be unsecured or secured. For example, where
the guarantor has executed a guarantee agreement only. The collateral
security is unsecured. However, if he lodges along with the guarantee
agreement, security such as title deeds to his property creating mortgage by
deposit of title deeds with the bank, a secured collateral security is created.

10.7 PURCHASE AND DISCOUNTING OF BILLS

Purchase and discounting of bills of exchange is another way banks provide
credit to business entities. Bills of exchange and promissory notes are
negotiable instruments which arise out of commercial transactions both in
inland trade and foreign trade and enable the debtors to discharge their
obligations towards their creditors.
On the basis of maturity period, bills are classified into (i) demand bills and
(ii) usance bills. When a bill is payable ‘at sight’ ‘on demand’ or on
presentment, it is called a demand bill. If it matures for payment after a
certain period of time say 30, 60, 90 days, after date or sight, it is called a
usance bill. No stamp duty is required in case of demand bills and on usance
bills, if they (i) arise out of the bonafide commercial transactions , (ii) are
payable not more than 3 months after date or sight and (iii) are drawn on or
made by or in favour of a commercial or cooperative bank.

When the drawer of a bill encloses with the bill, documents of title to goods
such as the railway receipt or motor transport receipt, to be delivered to the
drawee, such bills are called documentary bills. When no such documents are
attached the bill is called a clean bill. In case of documentary bills, the
documents may be delivered on accepting the bill or on making its payment.
In the former case it is called Documents against Acceptance (D/A) basis,
and in the latter case Documents against Payment (D/P) basis. In case of a
clean bill, the relevant documents of title to goods are sent directly to the
drawee.

Procedure for Discounting of Bills

When the seller of the goods draws a bill of exchange on the buyer (debtor),
he has two options to deal with the bill.

228 a) to send the bill to a bank for collection, or

b) to sell it to, or discount it with, a bank Bank Credit -
Principles a nd
Practices
When the bill is sent to the bank for collection the banker acts as the agent of
the drawer and makes its payment to him only on the realisation of the bill
from the drawee. The banker sends it to its branch at the drawee’s place,
which presents it before the drawee, collects the amount and remits it to the
collecting banker, who credits the same to the drawer’s account. In case of
collection of bills, the bank acts as an agent of the drawer of the bill and does
not lend his funds by giving credit before actual realisation of the bill.
The business of purchasing and discounting of bills differs from that of
collection of bills. In case of purchase/discounting of bills, the bank credits
the amount of the bill to the drawer’s account before its actual realisation
from the drawee. The banker thus lends his own funds to the drawer of the
bill. Bills purchased or discounted are therefore, shown under the head
‘Loans and Advances’ in the Balance Sheet of a bank.
The practice adopted in case of demand bills is known as purchase of bills.
As demand bills are payable on demand, and there is no maturity, the banker is
entitled to demand its payment immediately on its presentation before the
drawee. Thus the money credited to the drawer’s account, after deducting
charges/discount, is realised by the banker within a few days.
In case of a usance bill maturing after a period of time generally 30, 60, or 90
days, therefore banker discounts the bill i.e credits the amount of the bill, less
the amount of discount, to the drawer’s account. Thereafter, the bill is sent to
the bank’s branch at the drawee’s place which presents it to the drawee for
acceptance. Documents of title to goods, if enclosed with the bills, are
released to him on accepting the bill. The bill is thereafter retained by the
banker till maturity, when it is presented to the acceptor of the bill for
payment.

Advantages of Discounting of Bills

A banker derives the following advantages by discounting the bills of
exchange:

1) Safety of funds lent

Though the banker does not get charge over any tangible asset of the
borrower in case of discounting of bills, his interest is safeguarded by the fact
that the bills of exchange contain’s signatures of two parties - the drawer and
the drawee (acceptor), who are responsible to make payment of the bill. If the
acceptor fails to make payment of the bill the banker can claim the whole
amount from his customer, the drawer of the bill. The banker can debit the
customer’s account and recover the money on the due date. The banker is
able to recover the amount as he discounts the bills drawn by parties of
standing and good reputation.

2) Certainty of payment
Every usance bill matures on a certain date. Three days of grace are allowed
to the acceptor to make payment. Thus, the amount lent to the customer by
229
Financing of discounting the bills is definitely recovered by the banker on its due date.
Working Capital
The banker knows the date of payment of the bills and hence can plan the
utilisation of his funds well in advance and with profit.

3) Facility of re-discounting of bills

The banker can augment his funds, if need arises, by re-discounting the bills,
already discounted by him, with the Reserve Bank of India, other banks and
financial institutions and the Discount and Finance House of India Ltd.
Reserve Bank of India can also grant loans to the banks on the basis of the
bills held by them.

4) Stability in the value of bills

The value of the bills remain fixed and unchanged while the value of all other
goods, commodities and securities fluctuate over a period of time.

5) Profitability
In case of discounting of bills, the amount of interest (called discount) is
deducted in advance from the amount of the bill. Hence the effective yield is
higher than loans and advances where interest is payable quarterly/half
yearly.

Derivative Usance Promissory Notes

As noted above, banks may re-discount the discounted bills of exchange with
other banks and financial institutions. For this purpose, under the normal
procedure, the bills are endorsed in favour of the re-discounting bank
/institution and delivered to it. At the time of maturity reverse process is
required.

To simplify the procedure of re-discounting, Reserve Bank of India has

dispensed with the necessity of physical lodgment of the discounted bills.
Instead, banks are permitted, on the basis of such discounted bills, to prepare
derivative usance promissory notes for suitable amounts like Rs. 5 lakhs or
Rs. 10 lakhs and for suitable maturities like 60 days or 90 days. These
derivative usance promissory notes are re- discounted with the re-discounting
bank or institution. The essential condition is that the derivative promissory
note should be backed by unencumbered bills of exchange of atleast equal
value till the date of maturity. In the meanwhile, any maturing bill may be
replaced by another bill for equal amount. No stamp duty is required on such
derivative usance promissory notes.

Compulsion on the Use of Bills

To encourage the use of bills of exchange by corporate borrowers, the
Reserve Bank of India had directed the commercial banks to advice their
corporate borrowers to finance their domestic credit purchases from small
scale industrial units as well as from others at least to the extent of 25 percent
by way of acceptance of bills drawn upon them by their suppliers. This was
to be stipulated as a condition for sanctioning working capital credit limits.
Banks were also authorized to charge an additional interest from those
230 borrowers who did not comply with this requirement in any quarter. In
October 1999 Reserve bank of India permitted the banks to charge interest Bank Credit -
Principles a nd
rate on discounting of bills without reference to Prime Lending Rate. They Practices
are now free to offer competitive rate of interest on the bill discounting
facility. The above-mentioned compulsion was also withdrawn.
Revised Guidelines of RBI on Discounting of Bills
• Banks may sanction working capital limits as also bills limits to borrowers
after proper appraisal of their credit needs and in accordance with the
loan policy as approved by their Board of Directors.
• Banks are required to open Letters of Credit (LCs) and purchase
/discount/ negotiate bills under LCs only in respect of genuine
commercial and trade transactions of their borrower constituents who
have been sanctioned regular credit facilities by them.
• For the purpose of credit exposure, bills purchased discounted/negotiated
under LCs or otherwise would be reckoned as exposure on the bank’s
borrower constituent. Accordingly, the exposure should attract a risk-
weight appropriate to the borrower constituent (viz.100 per cent for firms,
individuals, corporates) for capital adequacy purposes.
• Banks have been permitted to exercise their commercial judgment in
discounting of bills of services sector. Banks would need to ensure that
actual services are rendered and accommodation bills are not discounted.
Services sector bills should not be eligible for rediscounting.

10.8 BANK CREDIT ON CAPITAL MARKETS

INSTRUMENTS
There has been a representation from the industry and borrowers that banks
shall also extend loans on the security of capital market instruments, which
may include Equity, Debt Instruments, Mutual Fund Investments, Venture
Capital Investments, etc. based on this, the RBI has formulated certain
guidelines permitting banks to expose themselves to the capital market by
way of advancing loans on these instruments. The guidelines included the
following:

• The aggregate exposure of a bank shall not exceed to 40 per cent of its
net worth on a solo and consolidated basis.
• Subject to the above ceiling, Banks are permitted to directly invest in
capital market securities upto 20 per cent of their net worth.

• Individual ceilings are also suggested to be followed by Banks while

exposing them to diverse instruments. For instance, the ceiling against
loans sanctioned on shares to an individual shall be below Rs.10 lakh.
Likewise, separate limits are fixed for lending on employees, stock
brokers, joint holders, venture capitalists, etc.
While the above guidelines are indicative and suggestive, Banks following
robust risk management practices can approach RBI requesting for relaxation
in the ceiling limit.
231
Financing of
Working Capital
10.9 CONSORTIUM ADVANCES
Credit needs of large borrowers may be met by banks in any of the following
ways:
a) By sole bank
b) By multiple banks
c) On consortium basis
d) On syndication basis

Sole banking: lending by a single bank to a large borrower, subject to the

resources available with it and limited to the exposure limits imposed by the
Reserve Bank of India. When the credit requirements of a borrower are
beyond the capacity of a single bank, the borrower may resort to multiple
banking i.e borrowing from a number of banks simultaneously and
independent of each other, under separate loan agreements with each of
them. Securities are charged to them separately.
Consortium lending: also called joint financing or participation financing, is
also undertaken by a number of banks but against a common security which
remains charged to all the banks for the total advance. Usually, in case of
consortium lending one of the banks acts as a consortium leader and takes a
leading part in the processing of the loan proposal, its documentation,
recovery etc. The participating banks enter into an agreement setting out the
terms and conditions of such participation arrangement.

Reserve Bank Directives

Consortium lending by banks in India commenced in 1974 when Reserve
Bank of India issued guidelines to the banks in this regard. In 1978 formation
of consortium was made obligatory where the aggregate credit limits
sanctioned to a single borrower amounted to Rs. 5 crore or more. In later
years, this limit was revised upwards to Rs.50 crore. But now, there is no
mandatory requirement for formation of consortium.

Following the policy of liberalisation and deregulation in the financial sector,

the Reserve Bank of India decided, that whenever a consortium is formed
either on a voluntary basis or on obligatory basis, the ground rules of the
consortium arrangement would be framed by the participating banks in the
consortium. These rules may relate to the following:
i) Number of participating banks
ii) Minimum share of each bank
iii) Entry to exit from a consortium
iv) Sanction of additional/ad hoc limit in emergency situation/contingencies
by lead bank/other banks
v) The fee to be charged by the lead bank for the services rendered by it
vi) Grant of any facility to the borrower by a non-member bank
vii) Deciding time frame for sanctions/ renewals.
232
Basing on the above, Reserve bank has advised the banks to evolve an Bank Credit -
Principles a nd
appropriate mechanism for adoption of a sole bank/multiple bank/consortium Practices
or syndication approach by framing necessary ground rules on operational
basis. While the aforesaid flexibility has been granted to the banks, they are
required not to exceed the single borrower/group exposure limits laid down
by the Reserve Bank. Banks have been advised to ensure to have an effective
system for appraisal, flow of information on the borrower among the
participating banks, commonality in approach and sharing of lending
resources, under the single window concept. Banks have also been permitted
to adopt the syndication route, if the arrangement suits the borrower and the
financing banks.

10.10 SYNDICATION OF CREDIT

As you have noted in the previous section, Reserve Bank of India has
permitted the banks to adopt syndication route to provide credit in lieu of
consortium advance. A syndicated credit differs from consortium advance in
certain aspects. The salient features of a syndicated credit are as follows:
1) It is an agreement between two or more banks to provide a borrower a
credit facility using common loan documentation.
2) The prospective borrower gives a mandate to a bank, commonly referred
to a ‘Lead Manager, to arrange credit on his behalf. The mandate gives
the commercial terms of the credit and the prerogatives of the mandated
bank in resolving contentious issues in the course of the transaction.
3) The mandated bank prepares an Information Memorandum about the
borrower in consultation with the latter and distributes the same amongst
the prospective lenders, inviting them to participate in the credit.
4) On the basis of the Information Memorandum each bank makes its own
independent economic and financial evaluation of the borrower. It may
collect additional information from other sources also.
5) Thereafter, a meeting of the participating banks is convened by the
mandated bank to discuss the syndication strategy relating to coordination,
communication and control within the syndication process and to finalise
the deal timings, charges for management, cost of credit, share of each
participating bank in the credit etc.
6) A loan agreement is signed by all the participating banks
7) The borrower is required to give prior notice to the Lead Manager or his
agent for drawing the loan amount so that the latter may tie up
disbursement with the other lending banks.
8) Under the system, the borrower has the freedom in terms of competitive
pricing.

As per the existing guidelines of RBI, Banks are free to adopt syndication
route, irrespective of the quantum of credit involved, upon mutual agreement
between the borrowing company and the Bank.
233
Financing of
Working Capital
10.11 NON-FUND BASED FACILITIES
The credit facilities explained above are fund based facilities wherein funds
are provided to the borrower for meeting their working capital needs. Banks
also provide non-fund based facilities to the customers. Such facilities
include (i) letters of credit and (ii) bank guarantees. Under these facilities,
banks do not immediately provide credit to the customers, but take upon
themselves the liability to make payment in case the borrower defaults in
making payment or performing the promise undertaken by him.

Letter of Credit
A letter of Credit (L/C) is a written undertaking given by a bank on behalf of
its customer, who is a buyer, to the seller of goods, promising to pay a certain
sum of money provided the seller complies with the terms and conditions
given in the L/C. A Letter of Credit is generally required when the seller of
goods and services deals with unknown parties or otherwise feels the
necessity to safeguard his interest. Under such circumstances, he asks the
buyer to arrange a letter of credit from his banker. The banker issuing the
L/C commits to make payment of the amount mentioned therein to the seller
of the goods, provided the latter supplies the specified goods within the
specified period and comply with other terms and conditions.
Thus by issuing Letter of Credit on behalf of their customers, banks help
them in buying goods on credit from sellers who are quite unknown to them.
The banker issuing L/C undertakes an unconditional obligation upon himself,
and charge a fee for the same. L/Cs may be revocable or irrevocable. In the
latter case, the undertaking given by the banker cannot be revoked or
withdrawn.

Bank Guarantee
Banks issue guarantees to third parties on behalf of their customers. These
guarantees are classified into (i) Financial guarantee, and (ii) Performance
guarantee. In case of the financial guarantee, the banker guarantees the
repayment of money on default by the customer or the payment of money
when the customer purchases the capital goods on deferred payment basis.

A bank guarantee which guarantees the satisfactory performance of an act,

say completion of a construction work undertaken by the customer, failing
which the bank will make good the loss suffered by the beneficiary is known
as a performance guarantee.

10.12 CREDIT WORTHINESS OF BORROWERS

The business of granting advances is a risky one. It is more risky specially in
case of unsecured advances. The safety of the advance depends upon the
honesty and integrity of the borrower, apart from the worth of his tangible
assets. The banker has, therefore, to investigate into the borrower’s ability to
pay as well as his willingness to pay the debt taken. Such an exercise is
called credit investigation. Its aim is to determine the amount for which a
234
person is considered creditworthy. Credit worthiness is judged by a banker on Bank Credit -
Principles a nd
the basis of borrower’s ( i ) character, (ii) capacity and (iii) capital. Practices

1) Character includes a number of personal characteristics of a person, e.g.

his honesty, integrity, promptness in fulfilling his promises and repaying
the dues, sense of responsibility, reputation and goodwill enjoyed by him.
A person having all these qualities, without any doubt in the minds of
others, possesses, an excellent character and hence his creditworthiness is
considered high.
2) Capacity If the borrower possesses necessary technical skill, managerial
ability and experience to run a particular business or industry, success of
such an enterprise is taken for granted except in some unforeseen
circumstances. Such a person is considered creditworthy by the banker.
3) Capital The borrower is also expected to have financial stake in the
business, because in case the business fails, the banker will be able to
realise his money out of the capital put in by the borrower. It is a sound
principle of finance that debt must be supported by sufficient equity.

The relative importance of the above factors differs from banker to banker
and from borrower to borrower. Banks are granting advances to technically
qualified and experienced entrepreneurs but they are required to put in a
small amount as their own capital. Reserve Bank of India has recently
directed the banks to dispense with the collateral requirement for loans upto
Rs. 1 lakh. This limit has recently been further increased to Rs. 5 lakh for the
tiny sector.
Determination of credit worthiness of a borrower has become now a more
scientific exercise. Special institutions like rating companies such as CRISIL,
ICRA, CARE, have come on to the field and each of them has developed a
methodology of its own.

Students are advised to take special interest in these rating processes.

Activity 10.3
i) Why do banks prefer Govt. and semi-govt. securities vis-à-vis Corporate
Securities for granting credit? Amongst the Corporate Securities why do
they prefer debt instruments?
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

ii) How do Banks judge credit worthiness of a borrower?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
235
Financing of
Working Capital
10.13 SUMMARY
In this unit we have discussed the basic concepts, principles and practices of
bank credit as a source of working capital. Various forms in which bank
credit is granted viz. Overdrafts, loans, cash credit and discounting of bills
etc. are discussed with their merits and demerits. Different types of loans, and
their classification on the basis of security and guarantee have been
explained. After explaining the various modes of creating charge over the
borrower’s assets, we have discussed merits and demerits of different types
of securities taken by banks. Purchase and discounting of bills as a method of
granting credit has been duly explained. Concept of credit worthiness of the
borrower has been clarified. In the end, the two important non- fund based
facilities such as letter of credit and guarantee given by banks have also been
dealt with. Attention of the students is also drawn towards the
regulations/guidelines of RBI in the management of their Advances.

10.14 KEY WORDS

Overdrafts: This is a facility allowed to a current account holder for a short
period. Under this facility, the account holder is allowed to draw from his
account more than what stands to his credit, either on the personal security of
the borrower or on the basis of collateral security.
Cash Credit System: This is a method of granting credit by banks. Under
this method the bank prescribes a limit, called the Cash Credit limit, upto
which the customer is permitted to borrow against the security of tangible
assets or guarantee. The borrower may withdraw from the account as and
when he needs money. Surplus funds with him may be deposited with the
banker any time. Thus, it is running a/c with the banker, wherein withdrawals
and deposits may be made frequently in any number of times.
Loan: Under the Loan System of granting credit, a definite amount is lent
for a specified period.
Bridge Loan: Bridge Loan is a short term loan which is usually granted to
industrial undertakings to enable them to meet their urgent needs. It is
granted when a term loan has already been sanctioned by a bank/financial
institution, but its disbursement takes some time or when the company is
taking steps to raise funds for the capital market. It is a type of interim
finance.
Composite Loan: Those loans that are granted for both investment in
capital assets and for working capital purposes, are called composite loans.
Secured Loans: A secured loan is a loan made on the security of any
tangible asset of the borrower. It means that a charge or right is created on
the assets of the borrower in favour of the lender. The value of the security
must be equal to the amount of the loan. If the former is less than the latter, it
is called partly secured loan. An advance without such security is called
unsecured advance. In case of secured loan the lender gets the right to realise
his dues from the sale proceeds of the security, if the borrower defaults.
236
Pledge: Pledge is a method of creating a charge over the movable assets of Bank Credit -
Principles a nd
the borrower in favour of the lender. Under the pledge, the movable assets of Practices
the borrower are delivered to the banker as a security, which he will return
back to the borrower, after he repays the amount due from him in respect of
principal and interest.
Hypothecation: It is another method of creating charge over the movable
assets. Under hypothecation the possession over such assets is not
transferred to the banker. Only an equitable charge is created in favour of
banker. The assets remain in the possession of the borrower, who promises to
give possession of the same to the banker, whenever he is requested to do so.
Mortgage: It is a method of creating charge over the immovable property
like land and building. Under Mortgage the borrower transfers some of the
rights of ownership to the banker (or mortgagee) and retains the remaining
rights with himself. The objective is to secure a loan taken from the banker.
Actual possession over the property is not passed on to the mortgage in all
cases.

Equitable Mortgage: In this type of mortgage the mortgagor hands over the
documents of title to the property to the mortgagee and thus an equitable
interest of the mortgagee is created in the property. If the mortgagor fails to
repay the amount of the loan, he may be asked to execute a legal mortgage in
favour of the lender.
Assignment: It is a method whereby the borrower provides security to the
banker by assigning (transferring or parting with) any of his rights, properties
or debts to the banker.
Lien: Lien is the right of the banker to retain all securities of the customer,
until the general balance due from him is not repaid.
Documents of title to goods: These are the documents which represent the
goods in the possession of some other person. For example a warehouse
receipt or a railway receipt. By endorsing such documents in favour of the
banker, the borrower entitles the banker to take delivery of the goods from
the warehouse or railway, if he does not repay the advance.

Credit worthiness: Creditworthiness indicates the quality of the borrower. It

denotes the amount for which a borrower is considered worthy for borrowing
from a bank. It depends upon his ability and willingness and is judged on the
basis of character, capacity and capital of the borrower.

10.15 SELF ASSESMENT QUESTIONS

1) Explain briefly the nature of Bank lending.
2) What are the common securities against which a bank may lend for
working capital purposes? Can a bank extend an unsecured loan or
advance?
3) Explain the merits and demerits of the Cash Credit System.

237
Financing of 4) What do you understand by Term Loans? For what purposes are they
Working Capital
granted by banks? What is Reserve Bank’s directive to banks in this
regard?
5) What are the different types of ventures that a bank can finance? Does it
include a handcart operator selling vegetables?
6) What are the advantages of discounting of bills to the banks? Is it
compulsory for corporate borrowers to use bills of Exchange?
7) What do you understand by credit-worthiness of a borrower? What
factors are taken into account by the banker to determine credit-
worthiness? Can you suggest anything beyond?
8) Discuss the different ways by which banks provide credit to business
entities?
9) Do you think that banks should lend on Equities? Argue for and against.

10.16 FURTHER READINGS

1) Taxman’s Banking Law and Practice.
2) P. N. Varshney- Banking Law & Practice
3) P. N. Varshney- Indian Financial System and Commercial Banking.
4) S. Srinivasan 1999; Cash and Working Capital Management, Vikas
Publishing house, New Delhi.
5) Master Circulars of RBI on ‘Advances by Commercial Banks’.

238
 Other Sources of
UNIT 11 OTHER SOURCES OF SHORT ShortTerm
Finance
TERM FINANCE

Objectives
The objectives of this Unit are:
• To discuss the sources of short term finance, other than bank credit and
trade credit, to meet the working capital needs, and
• To highlight the framework of rules and regulations prescribed by the
authorities regarding these non-bank sources of finance.

Structure
11.1 Introduction
11.2 Public Deposits
11.3 Commercial Paper
11.4 Inter-Corporate Loans
11.5 Bonds and Debentures
11.6 Factoring of Receivables
11.7 Summary
11.8 Key Words
11.9 Self-Assessment Questions
11.10 Further Readings

11.1 INTRODUCTION
Trade credit and commercial bank credit have been two important sources of
funds for financing working capital needs of companies in India, apart from
the long term source like equity shares. However, more stringent credit
policies followed by banks, tightening financial discipline imposed by them,
and their higher cost, led the companies to go in for new and innovative
sources of finance. As the new equities market has remained in a subdued
condition and investor interest in the equities has almost vanished during
recent years, corporates have raised larger resources through debt
instruments, some of them being for as short a period as 18 months. The
situation has turned buoyant for corporates during the 21st Century for any
type of finance.

Raising short term and medium term debt by inviting and accepting deposits
from the investing public has become an established practice with a large
number of companies both in the private and public sectors. This is the
outcome of the process of dis-intermediation that is taking place in Indian
economy. Similarly, issuance of Commercial Paper by high net-worth
Corporates enables them to raise short-term funds directly from the investors
at cheaper rates as compared to bank credit. In practice, however,
commercial banks have been the major investors in Commercial Paper in 239
Financing of India, implying thereby that bank credit flows to the corporate sector through
Working Capital
the route of CPs. Inter-Corporate loans and investments enable the cash rich
corporations to lend their surplus resources to those who need them for their
working capital purpose. Factoring of receivables is a relatively new
innovation which enables the corporates to convert their receivables into
liquidity within a short period of time. In this unit, we shall discuss the salient
features of various sources of non-bank finance and the regulatory framework
evolved in respect of them.

11.2 PUBLIC DEPOSITS

Public deposits are unsecured deposits accepted by companies for specific
periods and at specific rates of interest. These deposits have acquired
prominence as a source of finance for the companies, as it is more convenient
and cheaper to mobilise short term finance through such deposits. Public
deposits provide a fine example of dis-intermediation, as the borrower
directly accepts the deposits from the lenders, of course with the help of
brokers.
In India, acceptance of deposits from the public is regulated by sections 58A
and 58B of the Companies Act 1956, and the Companies (Acceptance of
Deposits) Rules, 1975. The above sections were inserted in the Companies
Act in 1974 with the objective to safeguard the interests of the depositors.
The regulatory framework in this regard is contained in the Companies Act
and the Rules.

This legal position has changed with the passage of New Companies Act,
2013. The position was revamped to a great extent. The New Sections in the
Companies Act that pertain to ‘deposits’ are 73 to 76 (corresponding to
Sections 58A and 58B). Many of the deposits which were considered as such
in the previous situation, are not accepted as deposits now. There have been
stringent restrictions in accepting deposits from the public now. The
following are the pertinent aspects relating to this issue:

• No company shall invite or accept deposits from public unless the

company meets a specified criteria. As at present, a public company
having net worth of Rs.100 crore or turnover of not less than Rs.500
crore will only be eligible to accept deposits from public.

• The public company shall obtain credit rating every year from a rating
agency and publish it properly.

• It shall create a charge on the assets equal to the amount of issue.

• All other companies can accept deposits only from their Members.

The Ministry of Corporate Affairs, through the Notification dated 31-03-

2014, issued ‘Companies (Acceptance of Deposits) Rules, 2014,
incorporating rules on the following:
• Terms and conditions of acceptance of deposits by companies.
• Form and particulars of Advertisements or circulars.
240
• Manner and extent of deposit insurance. Other Sources of
ShortTerm
• Creation of security. Finance

• Appointment of Trustee for depositors and their duties.

• Meeting of depositors.
• Form of Application for deposits.
• Maintenance of liquid assets and creation of deposits repayment reserve
account.
• Register of deposits.

Maintenance of Liquid Assets

Every company accepting public deposit is required to deposit or invest
before 30th April of each year, an amount which shall not be less than 15% of
the amount of its deposits which will mature during the next financial year
ending 31st March in any one or more of the following:
a) in a current or other deposit account with any scheduled bank, free from
charge or lien,

b) in unencumbered securities of the central or state governments,

c) in unencumbered securities in which Trust funds may be invested under

the Indian Trust Act, 1882; or

d) in unencumbered bonds issued by Housing Development Finance

Corporation Ltd.

The securities referred to in clauses (b) or (c) shall be reckoned at their

market value. The amount deposited or invested as aforesaid shall not be
utilised for any other purpose than the repayment of deposits maturing during
the year.

Rates of Interest and Brokerage

The Rules prescribe the maximum rate of interest payable on such deposits.
At present companies are allowed to pay interest not exceeding 15% per
annum at rates which shall not be shorter than monthly rests.
Companies are permitted to pay brokerage to any broker at the rate of 1% of
the deposits for a period of upto 1 year, 1½ % for a period more than 1 year
but upto 2 years and 2% for a period exceeding 2 years. Such payment shall
be on one time basis.

Advertisement
Every company intending to invite or accept deposits from the public must
issue an advertisement for that purpose in a leading English Newspaper and in
one vernacular newspaper circulating in the state in which the registered
office of the company is situated.

The advertisement must be issued on the authority and in the name of the
Board of Directors of the company. The advertisement must contain the
conditions subject to which deposits shall be accepted by the company and 241
Financing of the date on which the Board of Directors has approved the text of the
Working Capital
advertisement. In addition, the advertisement must contain the following
information, namely:
a) Name of the company,

b) The date of incorporation of the company,

c) The business carried on by the company and its subsidiaries with the
details of branches of units, if any,
d) Brief particulars of the management of the company

e) Names, addresses and occupations of the directors,

f) Profits of the company, before and after making provision for tax, for the
three financial years immediately preceding the date of advertisement,

g) Dividends declared by the company in respect of the said years.

h) A summarised financial position of the company as in the two audited

balance sheets immediately preceding the date of advertisement in the
prescribed form.
i) The amount which the company can raise by way of deposits under these
rules and the aggregate of deposits actually held on the last day of the
immediately preceding financial year.

j) A statement to the effect that on the day of the advertisement, the

company has no overdue deposits, other than the unclaimed deposits, or
a statement showing the amount of such overdue deposits, as the case
may be, and

k) A declaration as prescribed under the Rules.

The advertisement shall be valid until the expiry of six months from the date
of closure of the financial year in which it is issued or until the date on which
the balance sheet is laid before the company at its general meeting, or where
Annual General Meeting for any year has not been held, the latest day on
which that meeting should have been held as per the Companies Act,
whichever is earlier. A fresh advertisement is required to be made in each
succeeding financial year.

Before issuing an advertisement, a copy of such advertisement shall have to

be delivered to the Registrar for registration. Such advertisement should be
signed bythe majority of the Directors of the company or their duly authorised
agents.

The above provision regarding mandatory publication of an advertisement is

necessary in case the company invites public deposits. But if the company
intends to accept deposits without inviting the same, it is not required to issue
an advertisement but a statement in lieu of such advertisement shall have to
be delivered to the Registrar for registration, before accepting deposits. The
contents of the statement and its validity period shall be the same as in the
case of an advertisement.
242
 Other Sources of
Procedure for Accepting Deposits ShortTerm
Finance
Every company intending to accept public deposits is required to supply to
the investors, forms which shall be accompanied by a statement by the
company containing all the particulars specified for advertisements. The
application must also contain a declaration by the depositor stating that the
amount is not being deposited out of the funds acquired by him by borrowing
or accepting deposits from any other person.

On accepting a deposit or renewing an existing deposit, every company shall

furnish to the depositor or his agent a receipt for the amount received by the
company within a period of eight weeks from the date of receipt of money or
realisation of cheques. The receipt must be signed by an officer of the
company duly authorised by it. The company shall not have the right to alter
to the disadvantage of the depositor, the terms and conditions of the deposit
after it is accepted.

Register of Deposits
Every company accepting deposits is required to keep as its registered office
one or more registers in which the following particulars about each depositor
are to be entered:
a) Name and address of the depositors,
b) Date and amount of each deposit
c) Duration of the deposit and the date on which each deposit is repayable
d) Rate of interest
e) Date or dates on which payment of interest will be made.
f) Any other particulars relating to the deposit.

These registers shall be preserved by the company in good order for a period
of not less than eight years from the end of the financial year in which the
latest entry is made in the Register.

Repayment of Deposits
Deposits are accepted by companies for specified period say 12 months, 18
months, 24 months, etc. Companies prescribe different rates of interest for
deposits for different periods. Other terms and conditions are also prescribed
by the companies and interest is paid at the stipulated rate at the time of
maturity of the deposit.

But, if a depositor desires repayment of the deposit, before the period

stipulated in the Receipt, companies are permitted to do so, but interest is to
be paid at a lower rate. Rules prescribe that if a company makes repayment
of a deposit after the expiry of a period of six months from the date of such
deposit, but before the expiry of the period for which such deposit was
accepted by the company, the rate of interest payable by the company shall
be determined by reducing one percent from the rate which the company
would have paid had the deposit been accepted for the period for which the
deposit had run.
243
Financing of The rules also provide that if a company permits a depositor to renew the
Working Capital
deposit, before the expiry of the period for which such deposit was accepted
by the company, for availing of benefit of higher rate of interest, the company
shall pay interest to such depositor at higher rate, if
a) such deposit is renewed for a period longer than the unexpired period of
the deposit, and

b) the rate of interest as stipulated at the time of acceptance or renewal of

a deposit is reduced by one percent for the expired period of the deposit
and is paid or adjusted or recovered.

The Rules also stipulate that if the period for which the deposit had run
contains any part of a year, then if such part is less than six months, it shall be
excluded and if part is six months or more, it shall be reckoned as one year.

Return of Deposits
Every company accepting deposits is required to file with the Registrar every
year before 30th June, a return in the prescribed form and giving information
as on 31st. March of the year. It should be duly certified by the auditor of the
company. A copy of the same shall also be filed with the Reserve Bank of
India.

Penalties
The Rules, 2014 also provided machinery for repayment of deposits on
maturity and also prescribes penalties for defaulting companies. If a company
fails to repay any deposit or part thereof in accordance with the terms and
conditions of such deposit, the Company Law Board may, if it is satisfied,
direct the company to make repayment of such deposit forthwith or within
such time or subject to such conditions as may be specified in its order. The
Company Law Board may issue such order on its own or on the application
of the depositor and shall give a reasonable opportunity of being heard to the
company and to other concerned persons. Further, the company shall pay
penal interest at the rate of 18 per cent, if the deposits remain unpaid after
due date.

If any company contravenes these rules, the company and every officer of the
company, who is in default, shall be punishable with fine which may extend
to five thousand rupees and the contravention is continuing, the company and
every officer shall be liable with a further fine which may extend to Rs.500
per day.

Deduction of Tax at Source

According to section 194 A of the Income Tax Act, 1961, the companies
accepting public deposits are required to deduct income tax at source at 10%,
if the aggregate interest paid or credited during a financial year exceeds Rs.
40,000.

244
 Other Sources of
Activity 11.1 ShortTerm
Finance
i) Can a company repay a deposit before the period stipulated in the
Receipt? Will the depositor suffer in such a case?

…………………………………………………………………………….

…………………………………………………………………………….
…………………………………………………………………………….

…………………………………………………………………………….

ii) What penalty is imposed on the company if it accepts deposit in excess of

the prescribed limits?

…………………………………………………………………………….

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

11.3 COMMERCIAL PAPER

Commercial paper (C.P) is another source of raising short term funds by
highly rated corporate borrowers for working capital purposes. A
commercial paper at the same time provides an opportunity to cash rich
investors to park their short term funds. The Reserve Bank of India permitted
companies to issue Commercial paper in 1989 and issued guidelines entitled
“Non banking Companies (Acceptance of Deposits through Commercial
Paper) Directions 1989,” to regulate the issuance of C.Ps. The guidelines have
been significantly relaxed and modified from time to time. The salient features
of these guidelines (as amended to date) are as follows:

Eligibility to Issue CPs

Companies (except the banking companies) which fulfil the following
requirements are permitted to issue CPs in the money market:
i) The minimum tangible net worth of the company is Rs. 4 crore as per the
latest audited balance sheet.

ii) The company has fund-based working capital limits of not less than Rs. 4
crore.
iii) The shares of the company are listed at one or more stock exchanges.
Closely held companies whose shares are not listed on any stock
exchange are also permitted to issue CPs provided all other conditions
are fulfilled.

iv) The company has obtained minimum credit rating from a Credit rating
agency i.e. CP2 from Credit Rating Information Services of India Ltd.,
A2 from Investment Information & Credit Rating Agency or PR2 from
Credit Analysis and Research. 245
Financing of Terms of Commercial Paper
Working Capital
The Commercial paper may be issued by the companies on the following
terms and conditions:
a) The minimum period of maturity should be 15 days (It was reduced from
30 days effective May 25, 1998) and the maximum period less than one
year.
b) The minimum amount for which a CP is to be issued to a single investor
in the primary market should be Rs. 25 lakhs and thereafter in multiple of
Rs. 5 lakhs.
c) CPs are to be issued in the form of usance promissory notes which are
freely transferable by endorsement and delivery.
d) CPs are to be issued at a discount to face value. The rate of discount is
freely determined by the issuing company and the investors.
e) The issuing company shall bear the dealers fee, rating agencies fee, and
other charges. Stamp duty shall also be applicable on CPs.

f) CPs may be issued to any person, corporate body incorporated in India,

or even unincorporated bodies. CPs may be issued to Non-resident
Indians only on non- repatriation basis and such CPs shall not be
transferable.
g) The issue of CP will not be underwritten or co-accepted by any individual
or institution.

h) There will be no grace period for payment. The holder of the CP shall
present the instrument for payment to the issuing company.

Ceiling on the amount of issue of Commercial Paper

The amount for which the companies issue Commercial Paper is to be carved
out of the fund based working capital limit enjoyed by the company with its
banker. The maximum amount that can be raised through issue of
commercial paper is equal to 100 percent of the fund based working capital
limit. The latter is reduced pro-tanto on the issuance of CP by the company.
Effective October 19, 1996 the amount of CP is permitted to be adjusted out
of the loans or cash credit or both as per the arrangement between the issuer
of the CP and the concerned bank.

Standby facility withdrawn

As stated above, the amount of CP is carved out of the borrower’s working
capital limit. Till October 1994 commercial banks were permitted to provide
standby facility to the issuers of CPs. It ensured the borrowers to draw on
their cash credit limit in case there was no roll-over of CP. Thus the
repayment of the CP was ensured automatically.

In October 1994 Reserve bank of India prohibited the banks to grant such
stand-by- facility. Accordingly, banks reduce the cash credit limit when CP is
issued. If subsequently, the issuer requires a higher cash credit limit, he shall
246
have to approach the bank for a fresh assessment of his requirement for the Other Sources of
ShortTerm
enhancement of credit limit. Banks do not automatically restore the limit and Finance
consider the sanction of higher limit afresh. In November 1997, Reserve Bank
of India permitted the banks to decide the manner in which restoration of
working capital limit is to be done on repayment of the CP if the corporate
requests for restoration of such limit.

Procedure for Issuing Commercial Paper

1) The company which intends to issue CP should submit an application in
the prescribed form to its bankers or leader of the consortium of banks,
together with a certificate from an approved credit rating agency. The
rating should not be more than 2 months old.
2) The banker will scrutinize the proposal and if it finds the proposal
satisfying all eligibility criteria and conditions, shall take the proposal on
record.
3) Thereafter, the company will make arrangement for privately placing the
issue within a period of 2 weeks.
4) Within 3 days of the completion of the issue, the company shall advice
the Reserve Bank through its bankers the amount actually raised through
CP.
5) The investors shall pay the discounted value of the CP through a cheque
to the account of the issuing company with the banker.
6) Thereafter, the fund-based working capital limit of the company will be
reduced correspondingly.

Commercial Paper in India

The Vagul Committee suggested the introduction of commercial paper in
India to enable the high worth corporates to raise short term funds cheaper as
compared to bank credit. On the other hand, the investors in CPs were
expected to earn a better return because of the absence of intermediaries
between them and the borrowers. As the issuer bears the cost of issuing the
CPs, his total cost is higher by 1% point or so over the discount rate on the
CPs issued by him.

Commercial paper is being issued by corporates in India for about three

decades now. During this period the quantum of outstanding CPs has
gradually increased. In the recent past, the issue of CPs is picking up very
fast. As per the latest (June 2021) data of RBI monthly fresh issues of CP is
growing by about 37 per cent every year and touched a record of 1.71 lakh
crore by June 2021. Whereas the size of outstanding CP amount stood at
Rs.3.89 lakh crore by May 2021. The highest touched in this regard stood at
Rs.5.04 lakh crore in the First Quarter of the Financial Year 2020-21. It is
also to be noted that the number of corporate tapping the CP market are
growing year after year. And about 70 corporates and about 50 NBFCs or
HCFs have raised resources through this mechanism.

247
Financing of The Reserve Bank of India has issued revised draft guidelines on August 10,
Working Capital
2017 for the issuance of commercial paper. The important changes proposed
were:
i) Companies willing to issue CP and having fund based credit facility,
should have been classified as ‘Standard Asset’.
ii) Entities like Co-operatives, Government entities, Trusts, LLPs, etc.,
should have a net worth of Rs.100 crore or more.
iii) The exact purpose for which CP are proposed to be issued should be
declared.
iv) Shall obtain credit rating from at least two agencies, if their issue size
crosses Rs.1000 crore.
v) CP shall be issued as a ‘Stand-alone’ product.
vi) The settlement cycle for trading in CPs shall be T+0 or T+1.
vii) The Buyback of the CP must be at the prevailing market price only.
viii) Every company intending to issue CP shall appoint a Issuing and Paying
Agent (IPA) and comply with all the requirements specified by the IPA.
ix) The company shall inform Credit Rating Agency (CRA) and IPA about
the delay/default in the CP related payments. If the issuer has defaulted,
the entity shall not be allowed to access the CP market for six months,
after the due are cleared.

11.4 INTER-CORPORATE LOANS

Short term finance for working capital requirements of a company may be
raised through accepting inter-corporate loans or deposits. Some companies,
which may have surplus idle cash due to seasonal nature of their operations
or otherwise would like to lend such resources for such period when they are
not needed by them. On the other hand, some other companies face financial
stringency and need cash resources to meet their immediate liquidity needs.
The former lend their surplus resources to the latter through brokers, who
charge for their services. Inter- corporate loans facilitate such lending and
borrowings for short periods of time. The rate of interest and other terms and
conditions of such loans are determined by negotiations between the lending
and borrowing companies. The prevailing market conditions do exert their
influence on the determination of interest rates.

Statutory Provisions Prior to January 1999

The Inter-corporate loans were, till 1999 were governed by the provisions of
section 370 of the Companies Act, 1956 and the Rules framed thereunder.
This section provided that no company shall (a) make any loan to or (b) give
any guarantee or provide any security in connection with a loan given to any
body corporate unless such loan or guarantee has been previously authorised
by a special resolution of the lending company. But such special resolution
was not required in case of loans made to other bodies corporate not under
the same management as the lending company where the aggregate of such
248
loans did not exceed thirty percent of the aggregate of the subscribed capital Other Sources of
ShortTerm
of the lending company and its free reserves.’ Finance

Further the aggregate of the loans made by the lending company to all other
bodies corporate shall not, except with the prior approval of the Central
Government, exceed.
a) Thirty percent of the aggregate of the subscribed capital of the lending
company and its free reserves, where all such other bodies are not under
the same management as the lending company.

b) Thirty percent of the aggregate of the subscribed capital of the lending

company and its free reserves, where all such corporates are under the
same management as the lending company.

Section 372 of the Companies Act laid down the limits for investment by a
company in the shares of another body corporate. Rules framed there under
laid down that the Board of Directors of a company shall be entitled to
invest in the shares of any other body corporate upto thirty percent of the
subscribed equity share capital or the aggregate of the paid up equity and
preference share capital of such other body corporate whichever is less.
Permission of the Central Government was also required in case the
investment made by the Board of Directors in all other bodies corporate
exceed thirty percent of the aggregate of the subscribed capital and reserves
of the investing company.

Later, the Government brought out Companies (Amendment) Ordinance

1999, the provisions of sections 370 and 372 were made ineffective and
instead a new section 372A was inserted to govern both inter-corporate loans
and investments. According to the new section 372 A, a company shall,
directly or indirectly.
a) make any loan to any other body corporate,
b) give any guarantee, or provide security in connection with a loan made by
anyother person to anybody corporate, and
c) acquire, by way of subscription, purchase or otherwise, the securities of
any other body corporate upto 60% of its paid up capital and free
reserves or 100% of the free reserves, whichever is more.

The loan, investment, guarantee or security can be given to any company

irrespective of whether it is subsidiary company or otherwise. If the
aggregate of all such loans and investments exceed the above limit the
company would have to secure the permission of shareholders through a
special resolution which should specify the particulars of the company in
which investment is to be made or loan, security or guarantee is proposed to
be given. It should also specify the purpose of the investment, loan, security
or guarantee and the specific sources of funding. The resolution should be
passed at the meeting of the Board with the consent of all directors present at
the meeting and the prior approval of the public financial institutions where
any term loan is subsisting, is obtained. But no prior approval of the public
financial institution is necessary, if there is no default in payment of loan
249
Financing of installment or repayment of interest thereon as per the terms and conditions
Working Capital
of the loan.

The above provisions of Section 372 A will not apply to any loan made by a
holding company to its wholly owned subsidiary or any guarantee given by
the former in respect of loan made to the latter or acquisition of securities of
the subsidiary by the holding company. Section 372 A Shall not apply to any
loan, guarantee or investment made by a banking company, an insurance
company or a housing finance company or a company whose principal
business is the acquisition of shares, stocks, debentures etc or which has the
object of financing industrial enterprises or of providing infrastructural
facilities.

The loan to anybody corporate shall be made at a rate of interest not lower
than the Bank rate. A company which has defaulted in complying with the
provisions of the section 58A of the Companies Act, 1956 shall not be
permitted to make inter- corporate loans and investment till such default
continues.

Companies making inter- corporate loans/ investment are required to keep a

Register showing the prescribed details of such loans/investments/guarantees.
Such Register shall be open for inspection and extracts may be taken
therefrom. The provisions of the new section are not applicable to loans made
by banking, insurance/housing finance/investment company and a private
company, unless it is subsidiary of a public company.
If a default is made in complying with the provisions of section 372A, the
company and every officer of the company who is in default shall be
punishable with improvement upto 2 years or with fine upto Rs. 50,000/-.

Present Statutory Provisions as per Companies Act, 2013:

Under the New Companies Act, 2013, Inter-corporate loans are governed by
the provisions incorporated in section 186. According to this, a company can
extend loans or guarantees, acquire securities or make investments in any
other company upto 60% of the paid-up capital, or upto 100% of the share
premium or free reserves, whichever is higher. The other salient aspects in
this regard are:

• If the company wants to grant loans/guarantees above the prescribed

limit, there must be a special resolution passed by the company.
• Inter-corporate investments can be made above the threshold limit, if the
same are proposed to be extended to wholly-owned subsidiary, or Joint
Venture.
• The ceilings also do not apply to the companies registered under section
12 of the SEBI Act, 1992.
• No company can extend these loans at a rate lower than the prevailing
yield of the similar term.
• The company shall follow all disclosure norms and follow the procedure
as specified in the section 186 (2) of the Act.
250
• There are also penalties specified for contravention of the above rules. A Other Sources of
ShortTerm
penalty of not less than Rs.25,000 and upto Rs.5.00 lakhs may be Finance
imposed. The Directors of the company are also liable for imprisonment
for a term not exceeding 2 years and penalty of not less than Rs.25,000
and upto Rs.1.00 lakh.

Activity 11.2
i) Fill in the blanks:
a) The minimum period of maturity of CP. should be……….. days
b) The CP must have………………………………… Rating from
Credit Rating Information Services Ltd.
c) The loans by a company to another company shall carry a rate of
interest which is not less than .....................................

ii) Explain what do you understand by Standby facility?

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
iii) State the latest provisions regarding Inter-corporate Loans.

…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

11.5 BONDS AND DEBENTURES

Bonds and debentures are another form of raising debt for augmenting funds
for long term purposes as well as for working capital. It has gained popularity
during recent years because of the depressed conditions in the new equities
market and the permission given to the banks to invest their funds in such
bonds and debentures. These debentures may be fully convertible, partly
convertible, or non-convertible into equity shares.
The salient points of the Guidelines issued by Securities and Exchange Board
of India (SEBI) in this regard are as follows:
1) Issue of fully convertible debentures having a conversion period more
than 36 months will not be permissible unless conversion is made optional
with “put” and “call” options.
2) Compulsory credit rating is required, if conversion of fully convertible
debentures is made after 18 months. If the issue size is above Rs.1000
crore, two ratings are necessary. 251
Financing of 3) Premium amount on conversion, and time of conversion in stages, if any,
Working Capital
shall be predetermined and stated in the prospectus. The rate of interest
shall be freely determined by the issuer.
4) Companies issuing debentures with maturity upto 18 months are not
required to appoint debentures trustees or to create Debentures
Redemption Reserves. In other cases the names of debentures trustee
must be stated in the prospectus. The trust deed must be executed within
6 months of the closure of the issue.
5) Any conversion in part or whole of the debentures will be optional at the
hands of the debenture holders, if the conversion takes places at or after
18 months from the date of allotment but before 36 months.
6) In case of Non-Convertible Debentures and Partly convertible
debentures, credit rating is compulsory.
7) Premium amount at the time of conversion of Partly convertible
debentures shall be pre-determined and stated in the Prospectus. It must
also state the redemption amount, period of maturity, yield on redemption
for Non-convertible/ Partly Convertible Debentures.
8) The discount on the non-convertible portion of the Partly convertible
debentures, in case they are traded and procedure for their purchase on
spot trading basis, must be disclosed in the prospectus.
9) In case, the non-convertible portions of partly Convertible Debentures or
Non- Convertible Debentures are to be rolled over without change in the
interest rate, a compulsory option should be given to those debenture
holders who want to withdraw and encash their debentures. Positive
consent of the debenture holders must be obtained for all-over.
10) Before the rollover, fresh credit rating shall be obtained within a period
of six months prior to the due date of redemption and must be
communicated to the debenture holders before the rollover. Fresh Trust
Deed must be made in case of rollover.
11) The letter of information regarding rollover shall be vetted by SEBI.
12) The disclosure relating to raising of debenture will contain amongst other
things
a) The existing and future equity and long term debt ratio,
b) Servicing behaviour of existing debentures,
c) Payment of interest due on due dates on term loans and debentures
d) Certificate from a financial institution or bankers about their no
objection for a second or pari passu charge being created in favour
of the trustees to the proposed debenture issue.
13) Companies which issue debt instruments through an offer document can
issue the same without submitting the prospectus or letter of offer for
vetting to SEBI or obtaining an acknowledgement card from SEBI in
respect of the said issue, provided the:
252
 a) Company’s securities are already listed on any stock exchange Other Sources of
ShortTerm
Finance
b) Company has obtained atleast an ‘adequately safe’ credit rating for
its issue of debt instrument from a credit rating agency.
c) The debt instrument is not convertible, is not issued along with any
other security or, without any warrant with an option to convert into
equity shares.
14) In such cases a category I Merchant bank shall be appointed to manage
the issue and to submit the offer document to SEBI. The Merchant
banker acting as Lead Manager should ensure that the document for the
issue of debt instrument contains the required disclosure and gives a true,
correct and fair view of the state of affairs of the company. The merchant
banker will also submit a due diligence certificate to SEBI.
15) The debentures of a company can be listed at a Stock Exchange, even if
its equity shares are not listed.
16) The trustees to the Debenture issue shall have the power to protect the
interest of debenture holders. They can appoint a nominee director on the
Board of the company in consultation with institutional debenture holders.
17) The lead bank will monitor the utilisation of funds raised through
debentures for working capital purposes. In case the debentures are
issued for capital investment purpose, this task of monitoring will be
performed by lead Institution/ Investment Institution.
18) In case of debentures for working capital, institutional debenture holders
and trustees should obtain a certificate from the company’s auditors
regarding utilisation of funds at the end of each accounting year.
19) Company should not issue debentures for acquisition of shares or for
providing loans to any company belonging to the same group. This
restriction does not apply to the issue of fully convertible debentures
provided conversion is allowed within a period of 18 months.
20) Companies are required to file with SEBI certificate from their bankers
that the assets on which security is to be created are free from any
encumbrances and necessary permission to mortgage the assets have
been obtained or a No objection from the financial institutions/ banks for
a second or pari passu charge has been obtained, where the assets are
encumbered.
21) SEBI permits the issue of Debt instruments only when the instrument
carries minimum “A’ Grade rating.
22) The face value of the debenture/debt instrument shall be Rs.100 and shall
be listed in one or more Stock Exchanges.
23) A premium of 5% is only allowed in case of Non-convertible debentures.
24) The Redemption of the instrument shall not start before 7 years.
25) The issue of debentures should not exceed more than 20% of the gross
current assets, including loans and advances.
253
Financing of 26) The debt-equity ratio of the company shall not be above 2:1. However,
Working Capital
this shall not apply to capital intensive projects.

11.6 FACTORING OF RECEIVABLES

Factoring of receivables is another source of raising working capital by a
business entity. Factoring is an agreement under which the receivables
arising out of the sale of goods/services are sold by a firm (called the client)
to the factor (a financial intermediary). The factor thereafter becomes
responsible for the collection of the receivables. In case of credit sale, the
purchaser promises to pay the sale proceeds after a period of time. The seller
has to wait for that period for realising his claims from the buyer. His cash
cycle is thus prolonged and he needs larger working capital. Factoring of
receivables is a device to sell the receivables to a factor, who pays the whole
or a major part of dues from the buyer immediately to the seller, thereby
reducing his cash cycle and the requirements of working capital. The factor
realizes the amount from the buyers on the due date.
Factoring is of recent origin in India. Government of India notified factoring
as a permissible activity for the banks in July 1990. They have been
permitted to set up separate subsidiaries for this purpose or invest in the
factoring companies jointly with other banks. Two factoring companies have
been set up by banks jointly with Small Industries Development Bank of
India. SBI Factors and Commercial Services Ltd. has been promoted by State
Bank of India, Union Bank of India and the Small Industries Development
Bank of India. Canbank Factors Ltd. is another factoring company promoted
jointly by Canara Bank, Andhra Bank and SIDBI. The Foremost Factors
Ltd. is the first private sector company which has commenced its operations
in 1997. One other private sector company is Bibby Financial Services
(India) Pvt. Ltd., SBI also floated SBI Global Factors Ltd.

With Recourse and Without Recourse Factoring

Factoring business may be undertaken on ‘with recourse’ or ‘without
recourse’ basis. Under with recourse factoring, the factor has recourse to the
client if the receivable purchased turn out to be irrecoverable. In other words,
the credit risk is borne by the client and not the factor. The factor is entitled
to recover the amount from the client the amount paid in advance, interest for
the period and any other expenses incurred by him.
In case of, without recourse factoring, the factor does not possess the above
right of recourse. He has to bear the loss arising out of non-payment of dues
by the buyer. The factor, therefore, charges higher commission for bearing
this credit risk.
Mechanism of Factoring
1) An agreement is entered into between the seller and the factor for
rendering factoring services.
2) After selling the goods to the buyer, the seller sends copy of invoice,
delivery challan, instructions to make payment to the factor, to the buyer
and also to the factor.
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3) The factor makes payment of 80% or more of the amount of receivable Other Sources of
ShortTerm
to the seller. Finance

4) The seller should also execute a deed of assignment in favour of the

factor to enable him to recover amount from the buyer.
5) The seller should also obtain a letter of waiver from the banker in favour
of the factor, if the bank has charge over the asset sold to the buyer.
6) The seller should give a letter of confirmation that all conditions of the
sale transactions have been completed.
7) The seller should also confirm in writing that all payments receivable
from the debtor are free from any encumbrances, charge, right of set off
or counter claim from another person, etc.
8) The facility of factoring in India is available to all forms of business
organisations in manufacturing, service and trading. Sole proprietary
concerns, partnership firms and companies can avail of the services of
factors, but a ceiling on the credit which they can avail of in terms of the
value of the invoice to be purchased is generally fixed for each client in
medium and small scale sectors. Generally the period for which
receivables are factored ranges between 30 and 90 days.
9) The factor evaluates the client on the basis of various criteria e.g. level of
receivables turnover, the quality of receivables, growth in sales, etc. The
factor charges a service fee and a discount. The service fee is charged in
advance and depends upon the invoice value for different categories of
clients. It ranges between 0.5–2% of the invoice value.
Moreover, the factor also charges a discount on the pre-payment made to the
client. It is payable in arrears and is generally linked to the bank lending rate.
In case of high worth clients, the discount rate is presently one percentage
point lower than the rate charged under the cash credit system.

The cost of funds under, without recourse, factoring is much higher than,
with recourse, factoring due to the credit risk borne by the factor. However,
the service fee and discount charge depends upon the cost of funds and the
operational cost.

RBI Regulations on Factoring Services:

The Government of India has originally issued Factoring Regulations in
2011. The same were amended in 2022. As per these regulations, all the
existing NBFC Investment and Credit Companies with asset size of Rs.1000
crore and above are permitted to undertake factoring services. Based on this
norm, there are about 182 firms that would be eligible to do this business.
While all other conditions of Regulations, 2011 are in force. As per these,
every firm intending to start this business shall register with the Reserve
Bank of India. Similarly, the procedure to conduct this business shall be as
specified in these regulations. RBI in this regard has the power to give
directions and collect information from factors registered.
Though the service was started with huge expectation, it did not meet with
any success. The total factoring business stood at 1625 million Euros; of this 255
Financing of domestic turnover remained at 1450 million Euros. As a matter of fact, till
Working Capital
recently (2015), the number of factoring companies stagnated at 8 only. After
the 2022 amendment, it is now expected that the number would grow to 182.
It remains to be seen to what extent the factoring business would also grow at
the same pace.

Activity 11.3
i) Fill in the blanks:
a) The Credit Rating required for debentures ………………………..
b) The names of Debenture Trustees must be disclosed in
..........................
c) In case of ‘with recourse factoring’, the loss arising out of non-
payment ofthe dues by the buyer is borne by........................
ii) Explain the mechanism of factoring of receivables.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….

11.7 SUMMARY
In this unit, we have discussed various sources of short term funds, other than
bank credit and trade credit which are used by business and industrial houses
in India to finance their working capital needs. The unit covers public
deposits, commercial paper, inter-corporate loans, bonds and debentures and
factoring of receivables. The statutory framework, along with rules and
regulations concerning these sources have been explained in detail. Relative
significance of these sources has also been explained by citing relevant facts
and figures. Though these sources are deemed as non-bank sources of
finance, involvement of commercial banks in providing such finance is
evident, specially, in case of commercial paper, bonds and debentures and
factoring of receivables.

11.8 KEY WORDS

Public Deposits: Public deposits are deposits of money accepted by
companies in India from the public for specified period ranging between 12
months and 36 months. These deposit are accepted within the limit and
subject to terms prescribed under Companies (Acceptance of Deposits) Rule,
2014.
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Commercial Paper: Commercial paper is an unsecured instrument through Other Sources of
ShortTerm
which high net worth corporates borrow funds from any person, corporate or Finance
unincorporated body. It is issued in the form of usance promissory note;
which is freely transferable by endorsement and delivery. Its minimum
period of maturity should be 15 days and maximum period less than a year,
It is issued at a discount to face value.
Inter-Corporate Loans: These are loans made by a company to another
company, whether its own subsidiary or otherwise. These loans and
investments in the securities of another company should be upto the limits
specified in section 186 of the Companies Act, 2013.

Convertible Bonds: These are bonds issued by the companies to the

investors, which are convertible either fully or partly into the equity shares of
the company within a specified period of time at the option of the investor.

Put and Call Options: The debt instruments like bonds and debentures are
issued for a fixed period of time-i.e. they are redeemable at the expiry of a
fixed period say 5 or 7 years. But sometimes the issuer includes the ‘put’
or/and ‘call’ options in the terms of issue. ‘Put’ option means that the investor
may, if he so desires ask for the redemption of the bond after a specified
period is over but before the period of maturity. If the issuer reserves this
right to himself to redeem the bond after a specific minimum period but
before the date of maturity, such right is called ‘call’ option.
Credit Rating: Credit Rating is an opinion expressed by a Credit Rating
Agency about the ability of the issuer of a debt instrument to make timely
payment of principal and interest thereon. It is expressed in alphabetical
symbols. All types of debt instruments may be rated. Rating is given for
each instrument and not for the issuer as such.

Factoring of Receivables: Factoring is an agreement under which the

receivables arising out of the sale of goods/services are sold by a firm (called
the client) to the factor (a financial intermediary), who becomes responsible
for the collection of the receivable on the due date.
With Recourse and without Recourse Factoring: When the factor bears
the loss arising out of non-payment of the dues by the buyer, it is called
without recourse factoring. In case of ‘With Recourse Factoring’ he can
recover the loss from the client (seller).

11.9 SELF ASSESSMENT QUESTIONS

1) State the broad categories of deposits which non-banking companies can
accept to meet their working capital needs.
2) State the existing guidelines regarding maintenance of liquid assets
prescribed for a company accepting deposits from the public.
3) What remedy is available to the depositor, if the company fails to repay
the deposit as per the terms and conditions of the deposit?
4) Describe the eligibility conditions prescribed for issuing the Commercial
Paper. 257
Financing of 5) Describe five important terms and conditions for issuing Commercial
Working Capital
Paper.
6) Why are banks major investors in Commercial Paper?
7) Explain the provisions of section 186 regarding inter-corporate loans and
investments.
8) Describe the guidelines issued by SEBI for the conversion of debentures
into equity.
9) What do you understand by factoring? Discuss With Recourse and
Without Recourse factoring?
10) Write a short note on ‘company deposits’ as a source of working capital
finance for industry in India.

11.10 FURTHER READINGS

1) Reserve Bank of India: Report of the Study Group on Examining the
Introduction of Factoring Services in India (Chairman: E.S. Kalyana
Sundaram).
2) Reserve Bank of India: Report of the Working Group on Money Market
(Chairman: N. Vaghul).
3) Jain, A.P., Company Deposit: Law and Procedure, Chapters 1, 2 & 3.
4) Taxman’s Companies Act with SEBI Rules/Regulations and Guidelines.
5) Aswath Damodaran, Corporate Finance: Theory and Practice, Wiley
Estern, 2020.
6) Jaswant Saini, Corporate Finance, University Book House Pvt. Ltd.,
2021.

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