FUNDAMENTALS OF CREDIT

PGDM RURAL TRIM – IV (2021 -23)

WELINGKAR INSTITUTE OF MANAGEMENT
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FUNDAMENTALS OF CREDIT
 Introduction to Credit  Credit Functions of Commercial Banks
a) What is Credit a) Principles of lending
b) Characteristics of Credit b) Various categories of borrowers &
c) Importance of Credit facilities
d) Forms of Credit c) Charging of Securities
e) Purveyors of Credit in India  Basics of Lending
 Credit Infrastructure of Commercial Banks a) Due Diligence
a) Credit Organization b) Appraisal and Documentation
b) Credit Policy c) Pricing, Rating
c) Relevant Acts / Regulations  Related Issues
a) Schematic Lending - Various Schemes
b) Financing start ups and risks involved
c) Annexure : Select Terminologies
FUNDAMENTALS OF CREDIT

INTRODUCTION
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FUNDAMENTALS OF CREDIT - INTRODUCTION

 Credit – a process for completing a transaction
 Transaction - a completed agreement between a buyer and a seller to exchange goods, services, or financial
assets in return for money
 Two parties to a transaction :
 Receiver / Buyer
 (Provider / Seller)
 When Buyer / Receiver receives the object of the transaction (goods / services) from the Seller / Provider
without having to pay the consideration immediately, the transaction is identified as a credit transaction
 Characteristics :
 Benefits are availed today
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FUNDAMENTALS OF CREDIT - INTRODUCTION

 Characteristics :
 Promise to redeem (repayment of money / payment of cost of goods services) the availed benefits in
future
 Money has time value. Hence something extra is required to be paid with redemption
 Such extra is interest. When future interest is included in cost, the benefits are made available at
present at discounted value
 Embedded in the transaction is the risk of not being able to realize / recover contracted dues on due
date (Credit Risk)
 Importance :
 An important input for supplementing capital funds
 At macro level, it helps propagate monetary transmission

FUNDAMENTALS OF CREDIT - INTRODUCTION
 Forms of Credit
: Instalment
• Lumpsum amount of money lent or
• Sale (FA) on Deferred Payment terms
• Loan / Asset made available upfront with
repayment terms fixed over a period with pre
determined amount (known as repayment
schedule) during which the loan amortizes
• Repayment schedule consists of no of
instalments, pro rata principal and periodical
interest. Ex: Term Loan / Demand Loan
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Revolving Open
• LoC for a fixed period of time (-1- year usually) • Kind of revolving credit but for a shorter tenure
• During this period, facility (credit limit) may be • Monthly payments vary
• Balances fall due in full at the end of each billing
drawn down multiple times subject to
cycle
outstanding being within the lower of advance
• Instances : Electricity Bill (amount due depends on
value / credit limit sanctioned
how much electricity is consumed in a particular
• Generally granted for working capital finance
month), Telephone Bills, Gas Bill, Trade Payables
• Instances : Overdraft, Cash Credit, Bills
etc..
Purchased / Discounted • Beneficiary expected to pay the entire bill within a
certain number of days after receiving bill
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FUNDAMENTALS OF CREDIT - INTRODUCTION

Purveyors of Credit

Organized Unorganized

Money Indigenous Sellers for

Banks NBFI
Lenders Bankers Trade Credit

Co-op
SCBs DFI NBFC HFC
Banks

PSB Private RRB

FUNDAMENTALS OF CREDIT

CREDIT INFRASTRUCTURE OF COMMERCIAL BANKS

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CREDIT INFRASTRUCTURE IN COMMERCIAL BANKS

 Credit Organization
:
Compliance & Monitoring Credit Operations* Stressed Asset Management

• Credit Rating • Financial Institutions Group • SMA Account Management

• Credit Audit • Large Corporate • Resolution of Stressed Assets
• Credit Compliance • Mid Corporate • NPA Recovery
• Stock and Book Debt Audit • MSME including MLP • Litigation Management
* Break Up in Next

• Pre Disbursement Monitoring • Agriculture • Legal Services

• Collection Strategy & Action • Retail
Slide

• Techno Economic Viability Studies

Supported by Risk Management Department

and
Inspection & Audit Department
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CREDIT INFRASTRUCTURE IN COMMERCIAL BANKS

 Credit Organization (Break up of Credit Operations) :

Large & Mid Corporate Financial Institutions Group MSME, Agri & Retail

• Structured Finance & LC / LG • Relationship Management  MSME (including MLP) Product

• Transaction Banking • Business Development  MSME Credit
• • 
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CREDIT INFRASTRUCTURE IN COMMERCIAL BANKS

Credit Policy :
 A written Document, duly approved by Board
 A dynamic document and is reviewed at defined periodicity, normally a year
 Considered to be the Bible of Credit Department and employees are expected to remain within the
confines delineated in the approved Policy Document
 Policy for overseas branches is independent of the one drafted for domestic operations considering
different operating conditions and regulations
 However, they remain aligned at the level of risk adjusted return on capital employed
 Policy provides for exceptions subject to approval / reporting to various authorities within the Bank
 At the time of Annual Financial Inspection, the document is critically examined by RBI
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CREDIT INFRASTRUCTURE IN COMMERCIAL BANKS – POLICY

 Aspects of Board Approved Credit Policy :

Aspects Aspects
 Graded Loan Authorities  Financial information and analysis requirements
 Limits on aggregate loans and commitments – Exposure Norms  Collateral and structure requirements.
 Portfolio distribution by loan category and product  Margin Requirements
 Geographic limits  Pricing guidelines
 Desirable types of loans  Documentation standards
 Underwriting criteria  Collections and charge-offs
 Reporting requirements  Off-balance-sheet exposure
 Guidelines for loan participations  Analysis of portfolio risk/reward tradeoffs
 Stress testing of Portfolios  Independent and effective control functions

CREDIT INFRASTRUCTURE IN COMMERCIAL BANKS –KEY REGULATIONS
For details please refer to RBI Site
Only a few of the Acts, Rules and Directions
(Notification Section) and Standard Text
for Commercial Banks in India are mentioned
While On Boarding Customers
• Reserve Bank of India Act, 1934
• Banking Regulation Act, 1949
• Prevention of Money Laundering
Act, 2002 (“PMLA”)
• Foreign Exchange Management Act,
1999
Books on mercantile law.
• Indian Contract Act, 1872
• Banking Ombudsman
• The Consumer Protection Act, 1986
• Banking Codes and Standards Board
of India (“BCSBI”)
• Information Technology Act 2000
• Partnership Act
here.
• Companies Act


At Credit Operations Phase
• Indian Contract Act, 1872
• Usurious Loans Act 1918
• Payment & Settlement Systems Act
2007
• Sale of Goods Act, 1930
• Transfer of Property Act,1882
• Limitation Act, 1963
• Fair Practice Code for Lenders
• Reserve Bank of India (Interest Rate
on Advances) Directions, 2016
• Prudential IRAC Norms
• Loans and Advances – Statutory and
Other Restrictions
• Prudential CRAR Norms
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At Loan Sale / Recovery Stage
• Limitation Act, 1963
• Bankers Books Evidence Act 1891;
• Recovery of Debts Due to Banks
and Financial Institutions Act 1993;
(DRT)
• The Securitization and
Reconstruction of Financial Assets
and Enforcement of Security
Interest Act (SARFAESI) 2002
• The Insolvency and Bankruptcy
Code, 2016 (IBC)
• Reserve Bank of India
(Securitization of Standard Assets)
Directions, 2021
• Reserve Bank of India (Transfer of
Loan Exposures) Directions, 2021
FUNDAMENTALS OF CREDIT

CREDIT FUNCTIONS OF COMMERCIAL BANKS

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COMMERCIAL BANKS – PRINCIPLES OF LENDING

Basic Principles General Principles

Safety Credit worthiness of Borrower

Liquidity Purpose of Credit

Profitability Diversification of Risk

 Banks make money by (a) maturity transformation (b) sector diversification and (c) product diversification with an eye on spread which is nothing but
the difference between interest earned on credit and interest paid on deposits
 Hence Safety of funds lent and liquidity of funds deployed are crucial determinants
 Under Safety norms banker should check that the borrower is in a position to repay the loan, along with interest in a specified time without default,
according to the terms and conditions imposed by the bank at the time of the loan agreement.. Repayment in turn depends on the nature of security, the
character of borrower and his capacity and willingness to repay
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CREDITWORTHINESS OF BORROWER –5C / 3R

Character Capacity Capital Collateral Conditions Reliability Responsibility Resources

 Liquidity of portfolio is ensured partly by retaining a portion of deposits raised in liquid assets and rest by ensuring possibility of getting back cash from funds lent in
accordance with terms of loan agreement without delay / default. Liquidity is important as banks should at all times be able to meet depositors’ claim without delay
 Profitability is an inalienable principle of business and banking is no exception. The paradox of banking business is banks have to remain liquid which adversely affects
profitability and yet has to earn profits by taking little risk in asset allocation. This is achieved by maturity transformation (borrowing short and lending long)
 General Principles are followed to honour basic principles
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CREDIT FUNCTIONS IN COMMERCIAL BANKS – CLASSES OF BORROWERS & FACILITIES

Constitution Based Tenor Based Purpose Based Category Based Commitment Based Security Based

Individual Retail
(competent to Revolving MSME Priority Sector Fund Secured
contract) Agri

Non Corporate
[HUF, Sole Prop, LLP, Instalment Mid Corporate Commercial Non Fund Unsecured
Partnership,, Co-operative
Society etc..]

Large Corporate
Corporate Open Credit
Fin Institutions
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CREDIT FUNCTIONS IN COMMERCIAL BANKS – FEW FACILITIES EXPLAINED

Commitment Based Security Based Category Based

• Fund Based : Term Loan, Demand
Loan, Cash Credit, Overdraft, Bills
Purchased , Bills Discounted etc..
• Non Fund Based : Letter of Credit,
Letter of Guarantee etc.
• Secured : Loans against the security
of tangible assets like goods and
commodities. (Immovable Property,
Plant & Machinery, Vehicles, Stock
in Trade, Life Policies, FDRs etc..)
• Unsecured : Loans and advances
where no tangible security is
available
• Priority Sector : Loans and
advances to socially desirable
segment of the population based on
directives of the Govt ( Agriculture,
SSI, SB, Exports etc..)
• Non Priority Sector : Also known as
Commercial Lending, These loans
are meant for business entities
(company, proprietorships,
partnerships and HUFs etc..)
engaged in any legal activity with
an objective of making profit. Retail
Lending to very small entrepreneurs
/ individuals is also included

Constitution Based and Purpose Based classifications are more of legal / administrative in nature
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CREDIT FUNCTION IN COMMERCIAL BANKS –FUND BASED FACILITIES

Bills Purchased /
Term Loan Demand Loan Cash Credit Overdraft
Discounted

Mortgage Mortgage Hypothecation Pledge Pledge (Doc

of Title to
(IM FA) (IM FA) (Current Assets) ( Fin A) Goods)

Hypothecation/ Hypothecation/
Pledge Lien
Pledge Pledge
(Inventory) (FD)
(M FA / Fin A) (M FA / Fin A)
 Term Loan is repayable in  These are all instances
Lien / instalments (F/A only) of secured advance
Lien /  Normally granted for 3+ years  These facilities if and
Assignment Assignment
Assignment  Demand Loan is repayable on when extended without
(FD/ LIP / demand (Both F/A and C/A) (LIP) security, become clean /
(FD / LIP unsecured advance
NSC)  Normally these are granted for
short term (up to 1 year), mid term
(> 1 year <3 years)
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CREDIT FUNCTION IN COMMERCIAL BANKS –NON FUND BASED FACILITIES

 These facilities are normally extended to clients who

Letters of
Letters of Credit
enjoy fund based credit facilities Guarantee
 Besides cash margin, Security is taken in the form of
extension of charge on current assets / fixed assets
 Amount of exposure exceeding the value of margin Documents Performance
against Payment Guarantee
and primary charge on other tangible securities is
reckoned as unsecured exposure
 In International transactions, often Stand Bye LCs are Documents
Financial
against
Guarantee
issued in lieu of Financial Guarantee Acceptance
 Deferred Payment Guarantee is a type of Financial
Guarantee that enables buyers to source capital asset
on deferred payment terms
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FUND BASED FACILITIES : METHODS OF WORKING CAPITAL FINANCE

 Cash Credit (CC) :

 A running (revolving) account in which deposit / withdrawal is made frequently subject to Limit and DP
 Banker specifies a limit for the borrower for a given period (normally one year) with stipulated margin on Current Assets
 Borrower permitted to borrow against the security of tangible assets (normally by way of floating charge on stock of raw
materials, stock in process, finished goods and book debt / receivables)
 Variants :
 Cash-Credit (Pledge) : Limit against security of pledge of goods
 Cash-Credit Combo : Limit against hypothecation of stocks and book debts
 Cash-Credit (Hypothecation) : Limit against hypothecation of stocks
 Cash-Credit (Book Debts) : Limit against hypothecation of receivables
 Cash-Credit (Government Supply Bills) : Limit against hypothecation of government supply bills
 Cash-Credit (Imports) : Limit against hypothecation of imported goods
 Cash-Credit (Clean) : Limit against Trust Receipts
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BASICS OF LENDING : WORKING CAPITAL FINANCE

 Margin :
 Borrower’s stake in business
 Difference between the 100% value of requirement less the maximum amount sanctioned by banks
 Needs to be brought in up front by borrower from own sources / pro rata if draw down is in phases
 The more liquid the asset, the less is normally the margin
 Level of Margin also depends upon the sensitive nature of commodity ( Selective Credit Control), stability of market
value of the asset to be financed etc..
 Drawing Power (DP)
 Value of Asset – Margin . Also known as Advance Value
 DP so arrived is subject to the credit limit sanctioned. Hence limit sanctioned or the DP assessed, whichever is lower
is the funds available for drawdown
 In working capital finance (Hypothecation of current assets) DP is calculated based on certified / audited monthly
statement of stock and book debts furnished by the borrowers and periodically inspected by the banker.
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FUND BASED WORKING CAPITAL FACILITIES

 Overdraft (OD) :
 Facility that allows a current account holder to withdraw in excess of his credit balance up to a sanctioned limit
 Operated similar to CC , OD is either temporary in nature, provided for short term and repayable on demand, or in the
form of regular limit sanctioned for other purposes.
 OD is normally sanctioned against bank deposits and other liquid securities
 Demand Loan (DL) :
 Borrower is allowed to avail full borrowed money in single installment.
 Normally DL is sanctioned for short term, repayable on demand. At times, core component of CC limit is also made
available by way of DL. Packing Credit is also a variant
 Bills Purchased / Discounted (BP/BD) :
 Demand Bills arising from trade transactions are purchased while Usance Bills arising from trade transactions are
discounted by lending bank.
 A revolving self liquidating short term loan that gets repaid at the time of maturity of the bill when paid by the
drawee.
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NON FUND BASED CREDIT FACILITIES - LG

 Letters of Guarantee (LG) : A contract of guarantee is a contract to perform the promise or discharge the liability of a third

person in case of his default. There are three persons in a contract of guarantee. The person giving the guarantee is called the

Guarantor or Surety; the person on whose behalf the guarantee is given is called the Principal Debtor (PD) and the person in

favor of whom the guarantee is given is called the Creditor or Beneficiary

 In LG, Bank’s liability arises only when the customer fails to perform the act for which the guarantee had been issued and the

bank is required to pay up the beneficiary of the guarantee upon demand (Invocation) without demur. This act of paying up the

beneficiary merely on demand is what is undertaken in the LG and to keep bank harmless in such contingency, the PD keeps

bank indemnified through written undertaking, margin and collateral.

 Upon making payment on demand, Bank is entitled to exercise ‘Right of Subrogation’ and recover due from PD. Upon such

payment, the NFB gets converted to FB facility (Crystallization) and is straight deemed irregular advance (Special Mention

Account)
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NON FUND BASED CREDIT FACILITIES - LC

 Letter of Credit :
 A written instrument issued by a banker at the request of a buyer (applicant) in favor of the seller (beneficiary)
undertaking to honor the documents or drafts drawn by the seller in accordance with the terms and conditions specified
in the credit, within a specified time
 Parties to LC:
 Buyer / Importer : One who applies for a LC
 Opening Bank / Issuing Bank / Buyer’s Bank / Importer’s Bank : Bank which opens the LC, thereby substituting its superior credit standing
to that of the buyer .
 Beneficiary / Seller / Exporter: One who sells / exports / ships and is the beneficiary under the credit.
 Advising Bank / Notifying Bank: The Bank that advised the LC to the beneficiary
 Negotiating Bank / Paying Bank / Nominated Bank: Is a Bank at which the Beneficiary may ‘negotiate’ the Drafts drawn under LC.
 Confirming Bank: The Bank which, while advising the LC, also confirms the credit.
 Reimbursing Bank: The Bank which reimburses, the Negotiating / Paying / Confirming Bank
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BASICS OF LENDING – CHARGING OF SECURITIES

 Charge : Right created by “the borrower” on its assets and properties, present and future, in favor of a financial
institution or a bank (“the lender”), which has agreed to extend financial assistance
 Type of Charge :
Charge
 Mortgage : Transfer by borrower to lender
interest in specific immovable property as
security for payment of debt
On Movables On Immovables On Intangibles

Set off Lien Assignment Hypothecation Pledge Mortgage Assignment

 Set off : Right of lender to adjust deposits of borrower against borrower’s dues
 Lien : Right of lender to retain securities of borrower till debt is redeemed  Fixed Charge: on FA
 Assignment : Transfer of debt , right or property by borrower in favour of lender  Floating Charge : on CA
 Hypothecation : Equitable charge created in lender’s favour over goods without passing on ownership / possession
 Pledge : Bailment of goods / document of title to goods by borrower favouring lender with intent to create charge as security
FUNDAMENTALS OF CREDIT

BASICS OF LENDING
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BASICS OF LENDING – CUSTOMER DUE DILIGENCE

 Purpose :
 To ensure adherence to principles of bank credit
 To assess credit worthiness (ability and willingness to repay) of a borrower
 Process :
 Investigation, analysis, and / or review of stated facts or details as stated in the application, accompanying documents or
during initial interaction with bank officials
 KYC (Identity / Address) Due Diligence, Financial Due Diligence, End use Due Diligence, Collateral Due Diligence,
Guarantor Due Diligence, Legal Due Diligence, Compliance Due Diligence
 When :
 Before Bank enters in to the transaction
 Source :
 CERSAI CKYC Registry
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BASICS OF LENDING – APPRAISAL

 Appraisal : Detailed assessment of the requirements of the borrower vis a vis performance, ability and
willingness to perform repayment obligations within contracted period and on contracted terms.
 Proposal : collected Information : (a) On Industry (b) On Company (c) On promoters (d) On Management (e)
On Financials (f) On Competitors (g) On Collaterals (h) On Guarantors etc.. are encapsulated in a structured
Aspects Aspects
format:
 Financial information including:

– Projected, current and historical balance sheet and income data  Loan terms, including tenor and repayment structure
– Balance sheet, income, and cash flow projections, when appropriate
– Comparative industry data when appropriate

 Financial analysis including Ratio Analysis
 Assessment of Repayment Capacity
 Collateral identification and valuation
 Guarantor support and related financial information
 Summary of borrower and affiliated credit relationships
 Pricing information, including relationship profitability data
 Covenants and requirements for future submission of financial data
 Exceptions to policy and underwriting guidelines if any and mitigants
 Pre approval and post approval concentration reporting
 Risk rating / Risk scoring
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BASICS OF LENDING – DOCUMENTATION

 Meaning :
 Implies obtaining of security documents (relevant to a sanctioned credit facility vis a vis terms and conditions of
sanction, of the security and of the legal status of the borrower) properly executed by the constituents to whom credit
facilities have been sanctioned by the Bank and /or by whom the said facilities are guaranteed
 While nature of documents obtained varies with the nature of advance, terms and conditions of the advance, nature of
security and nature of the legal status of the borrower, mode of execution thereof varies with the legal status of the
executant alone
 Importance :
 Records the rights and obligations inter se the bank, the borrower and the guarantor
 Needs correct drafting and stamping, proper execution and compliance with necessary legal formalities
 To protect the rights of the lender, these documents need to be kept valid and enforceable on a continuous basis
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BASICS OF LENDING – LOAN PRICING & CREDIT RATING

 Fixed Rate : In this type of loan pricing contract, the rate of interest remains constant
throughout the loan period irrespective of the changes in market conditions. Here
borrower is hedged against interest rate risk
 Floating Rate : In this type of loan pricing contract, the rate of interest can decrease or
increase depending on market fluctuations. Here lender is hedged against interest rate risk.
Credit
It is normally quoted at certain basis points over the Base Rate Rating
 Base Rate : Extrapolated from an external benchmark rate which includes:

 Reserve Bank of India policy Repo Rate ECRA ICR

 Government of India 3-Months and 6-Months Treasury Bill yields published by
Financial Benchmarks India Private Ltd (FBIL)
 Any other benchmark market interest rate published by FBIL.
Though Point in Through Point in
 Pricing is normally done based on the credit rating of the client and the client specific the Cycle Time the Cycle Time
spread is added to Base Rate to arrive at the client specific rate
 Credit Rating : Opinion / assessment of the credit worthiness of a rated entity and the
facilities the entity enjoy. Ratings represent summary indicators of risks of default
inherent in individual credit
FUNDAMENTALS OF CREDIT

RELATED ISSUES
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FUNDAMENTALS OF CREDIT – RELATED ISSUES

 Schematic Lending :
 Implies lending based on a template with defined scale of finance for a particular activity or group of activities
 The template with scale of finance is known as Scheme and Banks follow the template for extending credit facilities so
that activities are neither under financed or over financed
 Advances granted to Priority Sector (PS) in India mostly fall within the ambit of schematic lending
 Objective of PS lending guidelines is to channelize credit to some of the vulnerable sectors of the economy
 Priority Sector in India & credit targets and sub targets : (% of ANBC / CEOBE)
 Agriculture
Sectors SCBs Foreign Banks RRBs SFBs
 Micro, Small and Medium Enterprises excluding
 Export Credit
 Total Priority Sector 40 40 75 75
 Education
 Housing  Agriculture (SMF) 18 (10) NA 18 (10) 18 (10)
 Social Infrastructure  Micro Enterprises 7.5 NA 7.5 7.5
 Renewable Energy  Weaker Section 12 NA 15 12
 Others
[ For detailed description of eligible categories under Priority Sector, please refer to RBI Notification updated till Aug 2, 2022]
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FUNDAMENTALS OF CREDIT – SAMPLE SCHEME (AGRICULTURE)

 Scheme for Development of Horticulture including Raising Fruit (Orchard) Garden, Plantation & Nursery Crops
Item Description

For establishing new or for maintenance of existing orchards, gardens, plantations and nurseries. All capital
costs for development of orchards, gardens, plantations (including purchase and installation of machinery,
Purpose
construction of processing houses etc..) and maintenance costs (such as cost of plants, seedlings, grafts,
fertilizers, insecticides, pesticides etc.., wages and salaries of permanent employees such as supervisors,
Mali's etc.. can be financed under the scheme
All persons engaged in raising fruit gardens, plantations and nursery crops as owners of land or as
Eligibility
permanent tenants or as lease-holders (for a reasonably long period)
a. Term Loan (for capital expenditure)
Facility
b. Cash credit (for working capital)
Margin & Security As detailed in next slide

ROI As per RBI / Bank Guidelines

Repayment a. Term Loan – 5 ~ 7 years * b. Cash credit – 12 months

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FUNDAMENTALS OF CREDIT – SAMPLE SCHEME (AGRICULTURE)

Item Description

 Borrowers should seek technical guidance of the research station for development and maintenance of
plantations.
 Loans should be sanctioned for raising plants in the first year and for maintenance in subsequent years
till the plants come to a bearing stage.
Other Conditions  Plants and other materials of good quality and in required quantities should be purchased by the
borrowers from reliable sources.
 Borrowers should have sufficient resources of their own to meet the deficit during the initial years.
 Satisfactory arrangements for processing of the produce should exist/be made.
 Since the replanting will be done by the interlining method, old plants should be removed at the
appropriate time.

Facility Margin Facility Limit Security

Up to ₹ 10K NIL Up to ₹10K -
Crop Loan / Short Term Loan
Above ₹10K 15% Up to ₹50K Hypothecation of Standing Crop
Crop Loan
Up to ₹10K NIL Above Do + Mortgage / 3rd Party Guarantee
₹50K
Term Loans Tractor / HAM 10% Term Loan Project Cost up to Up to ₹1 lac Hypothecation of Assets
Others 15% Above Do + Mortgage / 3rd Party Guarantee
Term Loan Project Cost above
₹1lac
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FUNDAMENTALS OF CREDIT – FINANCING START UPS & RISKS

 Start Ups:
 Entrepreneurs with innovative ideas that can reap commercial values but lack required finance and experience to start a
business are start ups
 No matter how great the business idea is, one essential element of startup success is the ability to obtain sufficient
funding to start and grow the business
 Definition as per Startup India Scheme of GOI :
 An entity shall be considered as a Startup:
• Up to a period of -5- years from the date of incorporation/ registration,
• Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded Rs. 25 crore.
• Entity is working towards innovation, development, deployment or commercialization of new products, processes or
services driven by technology or intellectual property
• Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a
'Startup'
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FUNDAMENTALS OF CREDIT – FINANCING START UPS

 Life Cycle based Sources of Funds :

 Angel Financing : Angel investors are typically individuals who
invest in startup or early-stage companies in exchange for an equity
ownership interest. They usually gain significant control over
company decisions, in addition to a significant portion of the
company’s ownership (and subsequently value).
 Crowdfunding : “Crowdfunding” is the practice of raising funding
through multiple funders, often via popular crowdfunding websites
 Small Business Credit Cards :
 Venture Capital : typically want to invest in startups that are
pursuing big opportunities with high growth potential, and that have
already shown some traction
 Small Business Loans :
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FUNDAMENTALS OF CREDIT – SAMPLE SCHEME OF FINANCING START UPS

 Scheme of a Public Sector Bank

Parameter Scheme details
 Eligibility Eligible and certified as “Start-up” by the concerned Government Authority as per Start-up India scheme launched by Government of India (GoI)
 Period of An entity shall cease to be a Startup on completion of ten years from the date of its incorporation/registration or if its turnover for any previous year exceeds
Existence Rs. 25 crore.
 Constitution Private Limited Company, Registered Partnership and Limited Liability Partnership or as acceptable for classification as “Start-up” under Start-up India
Scheme of GoI
 Approvals All the statutory approvals / NOCs from the respective Department etc.. should be in place as per the progress of the project / operational stage of the Unit
 Rating Credit Rating of the New Borrowers should not be below the grade acceptable as per Loan Policy

 Banking Sole Banking

 Facility Term Loan and / or Working capital (Fund Based and Non-Fund Based) for the purpose of financing for innovation, development or improvement of products
or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation as per Start-up India Scheme
 Limit Rs.10 lakh – Rs. 5 crore
 Margin 20%
 ROI / Charges 1% below applicable ROI subject to minimum appropriate MCLR / EBLR ; All Charges waived
 Repayment Working Capital: 12 months subject to annual review . Facility would be available on completion of project
Term Loan : Max 10 years with 3 years moratorium
 Security Primary : Charge on all tangible assets created with Bank Finance / Collateral : May not be insisted upon if CGTF cover is available
 05-09-2022

FUNDAMENTALS OF CREDIT – START UP RISKS

 Startup risks, because of very nature of business, are high on an average across the life cycle
 Still people take risks in expectation of high rewards
 Hence to investment in startups for a non promoter, it requires above average risk appetite
 According to statistics on start ups , 90% of startups fail in general, 75% of VC-funded startups fail, and only
50% of startups make it past their fifth year of business
 This is why the financing model of start ups is a combination of debt, conditional loan, equity, quasi equity etc.
 Risks in the start up business may be summarized as under :
Inexperience Market Competition Strategy Politico Econ Technology Attrition Financial Operational Environment

• Promoters • Growing • Not having • Inappropriat • tax rates, • Disruptive • High Failure • Investment • Infrastructure • Disaster
not having enough e pricing, tariffs, Technology Rate in • Credit • Process • Pollution
vs • long and • People
experience knowledge marketing, expropriatio certain • Interest • Anti Habitat
in running Declinin about or n of assets, costly sectors • Systems
• Exchange
business g Market competition distribution and acceptance • Price
/ substitutes strategy repatriation cycle
of profits
THANK YOU
ANNEXURES

IMPORTANT TERMINOLOGIES
 12-07-2022

SELECT TERMINOLOGIES
 Charge as per Companies Act : Section 2(16) of the Companies Act, 2014 defines charges so as to mean an interest or lien created on the property or assets of a
company or any of its undertakings or both as security and includes a mortgage
 Charge as per Transfer of Property Act : According to Section 100 of the Transfer of Property Act, 1882, where an immovable property of one person is by act of
parties or operation of law made security for the payment of money to another and the transaction does not amount to a mortgage, the latter person is said to have
a charge on the property, and all the provisions which apply to a simple mortgage shall, so far as may be, apply to such charge
 Essential Features of Charge :
 Parties : Minimum -2- . (a) the creator (b) the charge holder.
 Subject Matter : existing or future current assets and other properties of the borrower.
 Intention : To offer one or more of borrower’s specific assets or properties as security for repayment of the borrowed money together with payment of
interest at the agreed rate
 Manifestation : Should be manifested by an agreement between charge creator and lender, written or otherwise.
 Types of Charges :
 Fixed Charge : a charge on the real asset of the company that is identifiable and ascertained when the charge is created (e.g. Plant & Machinery)
 Floating Charge : a charge which is created over the assets circulatory in nature (e.g. Current Assets)
 24-08-2022

SELECT TERMINOLOGIES
 Lien as per Indian Contract Act : A banker’s general lien refers to his right to retain any property of his customer for the
general balance (i.e., any debt) due from the customer
 Features of Lien :
 No agreement is necessary for the creation of a lien in favor of the banker,
 Though the right of general lien is conferred on a banker by law, to be on the safer side, generally, the banker gets a
letter of lien signed by the borrower which empowers the banker to retain any property of the borrower.
 Lien does not involve transfer of ownership of the property from the customer to the banker
 Generally, lien confers on the creditor only the right to retain the property of his debtor until the debts are repaid. It does
not confer on the creditor the right of sale.
 But a banker’s general lien is an exception to this general principle. It confers on the banker the right of sale also. The
banker can sell the customer’s property in his hands after giving a reasonable notice to the customer, in case the
customer fails to repay the debts on the due date.
 24-08-2022

SELECT TERMINOLOGIES
 Pledge as per Indian Contract Act : Section 172 of the Indian Contract Act of 1872 defines pledge as "a bailment of goods as security for payment of
a debt or performance of a promise"
 Thus a pledge is contract whereby a borrower offers his movable property to his lender as a security for the amount of borrowed on the
understanding that the property pledged will be returned to the borrower when the debt is repaid
 Features :
 Charge created on a movable property.
 Agreement between the borrower and the lender is necessary.
 Agreement may be oral or written though t is advisable to have the agreement in writing
 Generally, a pledge is supported by a memorandum of deposit which contains the particulars of the property pledged, the purpose of deposit,
the amount of advances, etc.
 Delivery, actual or constructive, of the property by the pledger to the pledgee is essential
 Ownership of the property remains with the pledger.
 Pledgee can sell the property pledged after giving a reasonable notice to the pledger, in case the pledgee commits default in repayment of the
debt.
 However, if the pledger repays the debt, the property pledged must be returned by the pledgee to the pledger.
 24-08-2022

SELECT TERMINOLOGIES
 Hypothecation : A contract of Hypothecation is a contract whereby a movable property is made available by the borrower to the lender as a security for an advance without
transferring either the possession of the property or the ownership of the property
 Generally, hypothecation is done by the borrower by executing a document called a letter of hypothecation in favor of the lender
 The letter of hypothecation binds the borrower to give the possession of the hypothecated property to the lender whenever he is called upon to do so by the lender. It may also
empower the lender to sell the hypothecated property in the event of default of repayment by the borrower
 Features :
 A method of creating an equitable charge on a movable property
 Neither the possession of the property nor the ownership of the property is transferred from the borrower to the lender.
 Rights of the lender depend upon the terms of the letter of hypothecation executed by the borrower.
 Letter of hypothecation may or may not confer the right of sale of the hypothecated property to the lender
 Mortgage as per Transfer of Property Act : According to Section 58 of the Transfer of Property Act,, 1882, a mortgage is the transfer of the interest in a specific immovable
property by one person to another for the purpose of securing an advance of money.
 Features :
 A method of creating charge on a specific immovable property.
 Possession of the mortgaged property need not be transferred to the mortgagee.
 In a mortgage, the interest in the mortgaged property is transferred from the mortgagor to the mortgagee.
 Upon repayment of the advance, the interest in the property is re-transferred to the mortgagor. However, if the mortgagor fails to repay the advance, the mortgagee gets
the right to sell the mortgaged property and recover his advance out of the sale proceeds of the property
 24-08-2022

SELECT TERMINOLOGIES
 Assignment : is an agreement by which the right, interest or title in a property or a debt is transferred by one person to another ( e.g., a life insurance policy)
 Assignment is effected by an endorsement on the body of the instrument, followed by a notice of assignment
 Types :
 Legal Assignment: In a legal assignment, the transfer of the actionable claim is absolute, and not by way of charge only. A legal assignment must be in
writing, and must be signed by the assignor. Again, in a legal assignment, a written notice of the assignment, containing the name and address of the
assignee, should be given by the assignor to his debtor. In the case of a legal assignment, the assignee can sue in his own name.
 Equitable Assignment: An assignment which does not satisfy the requirements of a legal assignment is an equitable assignment. In the case of an
equitable assignment, the assignment cannot sue in his own name

Lien : Right of lender to secure possession and Hypothecation : equitable charge created on
retain asset of borrower till repayment movable assets by borrower favoring lender

Mortgage : Transfer of interest in specific

Set off : Adjusting credits available in any
immovable property for securing repayment of
account of borrower against unpaid dues
loan

Assignment : Transfer of actionable claims (claim

Pledge : Ceding possession (bailment) of goods
to a debt other than a debt secured by mortgage /
of borrower to lender as security
hypothecation / pledge)
 12-07-2022

SELECT TERMINOLOGIES
 Performance Guarantees : These are Guarantees issued in respect of performance of a contract or obligation (e.g. Construction Contract). In the event of non-performance or deficient performance of

the obligations, the Bank will be called upon to make good the monetary loss arising out of the non-fulfillment of the guarantee obligation, within the amount guaranteed. This is a guarantee

confirming the performance competency of the person on whose behalf the guarantee is issued

 Financial Guarantees : In certain contracts (e.g., large construction contracts), there is a provision for extension of advance (mobilization advance) to enable PD to commence execution of awarded

contract and the advance is recovered by the contractor from running bills raised by the PD on the contractor. Such advance is provided against LG from Bank and the LG terms, inter-alia, include

that the amount will be paid by the Bank in case of customer does not fulfill the terms of the contract within the period stated in the contract. In this case, the entire amount of money is received by the

PD and as such, such guarantees are known as Financial (Money) Guarantees

 Deferred Payment Guarantees (DPG) : DPGs are substitutes of Term Loans which involve upfront outlay of funds by both lenders and borrowers. DPGs are normally issued in the case of purchase of

high value machinery or such other capital equipment by customers (from suppliers in India or outside). The attraction of DPG lies normally in a longer repayment at softer terms extended by the

manufacturer seller. The manufacturer of the machinery supplies the machinery against a cash payment of say, 10% or 15% and recovers the remaining amount by getting bills or promissory notes

towards instalments accepted by the buyer and co accepted by the buyer’s banker. Alternatively, the manufacturer simply asks for DPG supporting the accepted bills / promissory notes from buyer’s

banker

 Prohibited Guarantees : (a) Guarantees in respect of contracts which are likely to lead to disputes about their actual performance or which cast on the bank the responsibility to determine fulfillment of

the terms of the guarantee. (b) Guarantees which are anomalous in nature and content and create unknown and unascertainable responsibilities and liabilities on the Bank. © Transferable / Assignable

Guarantees (transferable and assignable by the beneficiaries) (d) Guarantees for example to Shipping Companies or Railways for converting a ‘Claused’ Bill of Lading or Railway Receipt into a

‘Clean’ one
 12-07-2022

SELECT TERMINOLOGIES
 Inland LC : An LC where all the parties to an LC are located within the country

 Foreign LC : An L/C where either the opener or the beneficiary is located outside the country of issue and arising out of export or import of

goods/services out of/into the country of issue

 Irrevocable LC : LCs that cannot be cancelled by the buyer on whose behalf it is opened or be revoked by the bank which has opened it without the

consent of the beneficiary/seller. Once a credit of the above type is opened and the beneficiary is advised, the drafts drawn under the credit together with

documents there under if found to be in conformity with the terms of the credit, will have to be paid by the opening bank

 Revocable LC : Such credits may be modified or cancelled at any moment without notice to the beneficiary. However, when a credit of this nature has

been transmitted to a branch or to another bank, its modification or cancellation can take effect only upon receipt of notice thereof by such branch or other

bank, prior to payment or negotiation, or the acceptance of drawings there under by such branch, or other bank. Bill/Bills paid, negotiated or accepted by

the negotiating branch/bank prior to the receipt of cancellation or modification of such credit will have to be honored by the opening branch/bank

 Confirmed LC : Where credits carry the confirmation of the advising bank. It constitutes a definite undertaking of such confirming bank in addition to

that of the opening bank

 12-07-2022

SELECT TERMINOLOGIES
 Back to Back LC : The terms of the back to back letters of credits will be almost identical to the letters of credit received from the buyer except to the

extent of amount, price and delivery dates. The beneficiary will substitute his own invoices for negotiation under the original letters of credit

 Acceptance LC : LC where the payment is to be made on the maturity date calculated on/after in terms of the credit

 Revolving LC : LC that provides that the amount of drawing stipulated in it will be available to the beneficiary again and again as may be agreed

between the buyer and the seller within a stipulated period. Provision can also be made in this to control the frequency of the drawing and limit the

total extent that could be thus drawn within the due date

 Stand-By LC : Such LC is usually issued by banks where the local laws do not permit issue of guarantees. Thus, Stand-By LCs are substitute for the

guarantees. Generally, such LCs are resorted to guarantee the payment in the event of failure of the opener to perform the contracted obligation/pay

the indebtedness undertaken. Accordingly, under the ‘Stand-By LC' there may be or may not be a transaction in sale of goods. So we may term the

words “opener” and “beneficiary” of credit, instead of “buyer” and “seller”

 12-07-2022

SELECT TERMINOLOGIES
Net
Fixed Current Current
A long term Expected to be Expected to be Working Also known as
Assets Assets Liability
tangible Asset realised within settled within Capital Net Current
owned and used to normal operating normal operating Assets it is the
produce income cycle or 12 cycle or 12 difference
months months between CA and
CL
Not expected to be Operating Cycle is Ex: Trade A positive NWC
sold within 12 the period taken Payables in is a strength while
months of for converting respect of amount a negative NWC
acquisition (L & cash to cash due against goods is a weakness
B, P&M, OFA etc) purchased

 For the purpose of assessment of Bank Finance for Working Capital, Net Working Capital is crucial. Bank first takes out Current Liabilities other
than Bank Borrowing from Current Assets to assess Working Capital Gap. Bank expects borrowers to fund a percentage of current assets from their
own sources (usually 25% in India). Hence the residual portion of Working Capital Gap is funded by Banks unless available Net Working Capital is
more than the residual portion
 05-09-2022

TEST YOURSELF
1. Net working capital is (a) Gross Current Assets (b) Net Current Assets (c) Net Worth (d) none of
these
2. Revolving Credit, Instalment Credit and Open Credit are __________ classification (a)
commitment based (b) category based (c) tenor based (d) purpose based
3. FBIL is (a) Department of RBI (b) Department of Ministry of Finance (c) SEBI (d) none of these
4. Negotiation in LC means (a) communicating LC to beneficiary (b) submitting documents to
opener © Making payment against documents as per LC terms (d) none of these
 05-09-2022

QUESTIONS
1. What is a Secured Loan ?
2. What is Revolving Credit?
3. What are Current Assets ?
4. What is the difference between loans and advances ?
5. What is a Charge ?
6. What is Hypothecation
7. What is CERSAI
8. What is Assignment
9. What is Working Capital
10. What is Floating Charge
11. What is a Letter of Credit
12. What is a Performance Guarantee