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Financing Retail, SME & Corporates Sources And Risk Factors CAs Role

-By S.V.Ramana MBA (Fin), AICWA, M.Com

Need for Finance

Finance is life blood of any business organization. Organizations require finance to meet basic objectives: To set up, modernize, expand business activity i.e to acquire fixed assets for facilitating productive endeavour To meet the day-to-day working capital requirements i.e operating cycle To meet the former, long term finance is required and the latter, short term finance due to their inherent difference in life of assets. A portion of current assets is to be met through long term sources for having long term stability, liquidity etc in the event of exigencies.


Long term sources of funds could be primarily own

i.e capital, retained earnings, subsidies / grants etc External sources i.e Banks, Financial Institutions in the form of term loans, capital market, Debentures, Preference shares, Deferred Payment Guarantees etc Short Term or Working Capital: requirements of SME / Corporate are predominantly funded by Commercial Banks. Working capital will be in the form of credit facilities involving both funds and without providing funds also.

Fund Based Facilities

Various fund based facilities extended by Commercial Banks are in the form of the following: Cash Credit / Overdraft Short Term Loan / Demand Loan Key Loan / Mortgage Loan Bill Discounting / Cheque purchase Export Credit (pre shipment and post shipment) Factoring / Forfeiting etc

Major Non Fund Facilities are as under:

Letters of Credit Bank Guarantees Uniform Customs and Practices for Documentary Credits (UCPDC) all LCs are governed by UCPDC Types of LCs: Sight or Acceptance LCs Revolving Credits (repeated purchases) Red clause LC: Advising / confirming bank to advance part of LC amount for meeting expenses etc in the form of packing credit (export orders) Green clause LC: In addition to red clause, the goods are to be warehoused in the name of issuing bank and payment made against warehouse receipts.

Transferable Credits: The beneficiary may ask for transferring the credit in full or part to one or more other beneficiaries (textile exports) Back to Back Credits: The beneficiary gets LC from a bank and requests his bank to open another LC/LCs in favour of his suppliers. One LC is backed by another LC Standby Credits: are security cover for beneficiaries and the issuing bank undertakes to pay only on default by the applicant (buyer). If any one transaction is not paid by the buyer, the standby LC will authorise the beneficiary to draw on the issuing bank, giving a certificate that the default has occurred.

Bank Guarantees:

Financial Guarantees (Bid bond/EMD, Mobilisation advance, retention money )-risk weightage 100% Performance Guarantee-Risk weightage 50%

Primary & Collateral Security

Banks in India invariably adopt security oriented approach while granting both long term and short term facilities, whether Fund or Non-Fund Even big corporate houses are not an exception to this Securitization Act shot in the arm to the Bankers Security is for fall back in the event of default, reduction in Capital requirements of Banks in compliance to Basel II norms

Long Term Sources / Project Finance:

Before approaching any Bank / FI/ Capital Market, detailed appraisal of the proposed business plans in the form of Red Herring Prospectus, project report shall be made A project report / appraisal is not complete without discussing the following in greater sense: Group / Promoters background, track record, Management capacity etc Types of assets to be acquired, suppliers, arrangement etc Technical & Financial Feasibility of the project

Environmental, PCB clearances Demand Forecasting, demand supply gap Production capacity, product features etc Cost of the project, means of finance Time schedule Commercial viability of the project Security primary, collateral, margin etc Financial projections, sensitivity analysis, DSCR, BEP analysis Funds Flow Statement Rate of return etc Pay Back period, IRR, NPV etc.

The main sources of finance would be: Owned Funds - Share Capital ( public, promoters etc) Preference Shares Internal cash accruals (existing entities) Debt Funds Term Loans Debentures Leasing (Air Craft, Oil rigs) Deposits Unsecured Loans Central or State Govt Subsidies Interest Free Loans (ST def.) Deferred Payment Guarantees etc


Appraisal / interpretation of financial statements:

Banks and FIs seek audited financial statements, projections covering the period of credit facilities requested. The single most widely followed testing tool by Indian Bankers being Ratio Analysis, The analyst / appraiser reads and interprets the Balance Sheet and P&L account of the enterprise. Ratios are not end in themselves; rather on a selective basis, they help answer significant questions. As a part of credit appraisal, the following tools are used: Percentage analysis Ratio Analysis Funds Flow Statements Cash Flow Statements

Percentage Analysis

Various figures appearing in the financial statements are reduced to percentage of total. This tool may be applied for big corporates and with history for studying the changes in components

Ratio analysis

The analyst / appraiser to determine relationships that are to be interpreted thru ratio analysis. Ratios should be computed in respect of figures which have significant relationships. For ex. Sundry Debtors to Sales etc. Comparison is to examine the ratio of one year to previous year and reasons for variances, and with similar business units in the industry for the same period.


The ratios can be broadly classified into the following: Capitalization / Leverage Ratios ( Debt/Equity, TOL/TNW etc) Liquidity Ratios (Current Ratio, Quick Ratio, NWC etc) Profitability Ratios (OPBDIT/sales, PAT/Sales, RONW, ROI etc) Coverage ratios (Interest coverage, fixed assets coverage, DSCR) Turnover Ratios (raw material to consumption; stores/spares to consumption; SIP/Cost of Prod; Finished goods to Cost of Sales etc)


Funds Flow Analysis

Gives us picture of movement of funds between one balance sheet date and the next one Banks are interested in movement of funds separately under short term and long term categories and also long term surplus. The short term movement of funds would indicate the variations in current assets and current liabilities. The long term movement of funds would depict the differences in term liabilities and net worth on one hand and fixed, non-current and intangible assets on the other. This would directly reflect the movement in net working capital. However, MNC and New Generation Banks rely more on cash flow rather than funds flow

Cash flow analysis

Cash flow or cash budget statements are used to ascertain the actual cash requirements of the company. Cash conversion efficiency free cash flow from operations Cash flow really shows the profitability of core business Enrons cash conversion efficiency was negative during late boom years. Majority money is either investing or from financing Cash flow tracks the actual movement of cash whereas funds flow details the movement in value of assets Sales and purchases are recorded only when cash is received or paid; whereas in funds flow they are recorded irrespective whether cash is received/paid. Method of valuation of stocks do not have any impact on cash flow whereas in funds flow it has impact on the profit Prepared usually on monthly basis where as funds flow is prepared for longer periods at least for an year or quarter.

Contingent Liabilities
A contingent liability is a liability which may or may not occur in the future, arising out of the existing situation. A contingent becomes an actual liability based on the occurrence or non-occurrence of one or more uncertain events in future Examples: Claims against the company not acknowledged as debts Arrears of fixed cumulative dividends Bills discounted with Banks Guarantees issued on behalf of the company and also on behalf of subsidiaries, group companies Letters of credit outstanding Estimated amount of contracts remaining to be executed on capital account not provided for


Other financial products :

Credit Guarantee Scheme for Micro and Small Enterprises: CGTMSE provides guarantee cover for collateral free loans given by Banks to Micro and Small Enterprises from INR 50 Lakhs to INR 100 lakhs. CGTMSE charges guarantee fee and service fee for sharing the risk of providing collateral free credit facilities. This is catching up now as it has given a shy of relief to many entrepreneurs who are unable to provide collaterals to Bank. Export Credit Guarantee Corporation of IndiaWTPCG, WTPSG Bridge Loans-may be sanctioned by Banks for <1yr against expected equity flows/issues; NCD, ECB, FDI


Business Risk Management Risk Financial Risk Credit Risk Market Risk Industry Risk Operational Risk Environmental Risk Concentration Risk Reputation Risk Socio, economic and Political Risks Structure Risk RISK vis a vis REWARD; RAROC


Role of Chartered Accountants

CAs enjoy lot of reputation with Banks and Statutory Authorities Should play advisor role to the client on continuous basis CAs should evaluate various risks associated and suggest mitigants CAs shall ensure that the client meets the statutory & regulatory requirements at all times CAs should ensure that a sound project / credit appraisal is done before implementation /starting of project. CAs should evaluate the managerial & financial strengths of borrowers before recommending any loan proposal CAs should ensure that the entrepreneur has multiple funding options and not confined to single source


Role of Chartered Accountants

CAs should advise clients to go for Credit Rating wherever applicable thereby pricing will be competitive. Clients Business model, business plans, revenues / profits forecast should be realistic and achievable Entrepreneurs should have financial strength to withstand the downturn in the industry / business CAs should vet proposals only for clients with high integrity and sound business principles CAs should ensure that the promoters bring in their share of contribution before starting new business, expansions. CAs should ensure that their clients are not financing long-term assets with short-term liabilities liquidity risk CAs should not issue certificates to clients of other CA firms

Impact of Basel II on Banking and borrowers

Basel II is recommendatory framework for Banking Supervision. RBI in Apr 2007 issued guidelines on New Capital Adequacy Framework to Banks operating in India. The revised framework is effective from March 31, 2009 for all commercial banks (except LAB and Regional Rural Banks) The Revised Framework consists of three-mutually reinforcing Pillars, viz. Minimum capital requirements, supervisory review of capital adequacy, and market discipline.


Impact of Basel II on Banking and borrowers

Pillar 1, the Framework offers three distinct options for computing capital requirement for credit risk and three other options for computing capital requirement for operational risk. The options available for computing capital for credit risk are Standardised Approach, Foundation Internal Rating Based Approach and Advanced Internal Rating Based Approach. Under the Standardised Approach, the rating assigned by the eligible external credit rating agencies will largely support the measure of credit risk. Under the new framework, banks need to provide capital for credit risk based on the risk associated with their loan portfolios. High quality credit exposure attracts lower capital on credit risk; Capital required = Loan amount X Risk Weight X 9%

Credit Risk
Credit risk =Risk that a party to a contractual agreement or transaction will be unable to meet their obligations or will default on commitments. Credit risk can be associated with almost any transaction or instrument such as swaps, repos, CDs, foreign exchange transactions, etc apart from FB, NFB facilities Specific types of credit risk include sovereign risk, country risk, legal or force majeure risk, marginal risk and settlement risk.


Credit Ratings
In the Standard & Poor rating system, AAA is the best rating. After that comes AA, A, BBB, BB, B, CCC, CC, and C The corresponding Moodys ratings are Aaa, Aa, A, Baa, Ba, B,Caa, Ca, and C Bonds with ratings of BBB (or Baa) and above are considered to be investment grade Historical Data Historical data provided by rating agencies are also used to estimate the probability of default


Impact of Basel II on Capital requirement of Banks -Loan of INR 1000 mio Basel-I Basel II
Rating Risk Wt Cap req Rs.mio 90.00 90.00 90.00 90.00 90.00 90.00 Risk Wt Cap req Rs.mio 18.00 27.00 45.00 90.00 135.00 135.00 Cap saved Rs. mio 72.00 63.00 45.00 nil (45.00) (45.00)

AAA AA A BBB BB and below unrated

100% 100% 100% 100% 100% 100%

20% 30% 50% 100% 150% 150%

Do Default Probabilities Increase with Time?

For a company that starts with a good credit rating default probabilities tend to increase with time For a company that starts with a poor credit rating default probabilities tend to decrease with time


Cumulative Ave Default Rates (%) (1970-2006, Moodys

Aaa Aa A Baa Ba B Caa-C
0.000 0.008 0.021 0.181 1.205

0.000 0.019 0.095 0.506 3.219

0.000 0.042 0.220 0.930 5.568

0.026 0.106 0.344 1.434 7.958 22.054 46.904

0.099 0.177 0.472 1.938

0.251 0.343 0.759 2.959

0.521 0.522 1.287 4.637

10.215 14.005 19.118 26.794 34.771 43.343 52.622 59.938 69.178

5.236 11.296 17.043 19.476 30.494 39.717


Interpretation The table shows the probability of default for companies starting with a particular credit rating A company with an initial credit rating of Baa has a probability of 0.181% of defaulting by the end of the first year, 0.506% by the end of the second year, and so on


Risk weights for other exposures

Claims included in this portfolio shall be assigned a risk-weight of 75 per cent Lending to individuals meant for acquiring residential property fully secured by mortgages on the residential property having loan to value (LTV) of 75%. Risk Weight for loans upto Rs. 30 lakhs - 50% Risk weight for loans Rs. 30 Lakhs and above - 75% Lending for acquiring residential property of LTV >75 % attract a risk weight of 100 per cent. Loans secured by commercial real estate as defined above will attract a risk weight of 150 per cent. (reduced to 100%)


Risk weights for other exposures

FB and NFB claims on Venture capital funds, commercial real estate are considered high risk exposures and attract risk weight of 150 % Consumer Credit including personal loans and credit card receivables attract a higher risk weight of 125%. Capital market exposures attract 125% risk weight NBFCs: The claims on Non-deposit taking systemically important NBFCs: BBB and above 125% Below BBB 150% Off-balance sheet items: Sanctioned credit facilities which are undrawn attracts Risk weightage of 20% Recently risk weight to non-rated companies reduced to 100%


Operational Risk
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk. There are 3 methods of calculating Operational Risk; (i) the Basic Indicator Approach (BIA) (ii) the Standardised Approach (TSA)- Divided into 8 business lines; 12% for retail brokerage to 18% for corporate finance (iii) Advanced Measurement Approaches (AMA) Internal risk measurement both qualitative and quantitative subject to approval by RBI


Operational Risk

Minimum capital required under the Basic Indicator Approach is 15% of average of previous three years annual gross income for operational risk some of the risks that the banks are generally exposed to but which are not captured or not fully captured would include: (a) Interest rate risk in the banking book; (b) Credit concentration risk; (c) Liquidity risk; (d) Settlement risk; (e) Reputation risk; (f) Strategic risk; The methodologies and techniques are still evolving w.r.t measurement of non-quantifiable risks, such as reputation and strategic risks.


Market Risk
Market risk is defined as the risk of losses in onbalance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are: The risks pertaining to interest rate related instruments and equities in the trading book; and (ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books). Trading book for the purpose of capital adequacy will include: (i) Securities included under Held for Trading


Market Risk
(ii) Securities included under the Available for Sale (iii) Open gold position limits (iv) Open foreign exchange position limits (v) Trading positions in derivatives, and (vi) Derivatives entered into for hedging trading book exposures. The minimum capital requirement is expressed in: specific risk charge for each security, designed to protect against any adverse movement in the price of an individual security owing to factors related to the individual issuer general market risk charge towards interest rate risk


In the last 25 years derivatives have become more popular in the world of finance. A derivative can be defined as a financial instrument whose value depends or derives from the values of other, more basic, underlying variables. Futures and Options are now traded actively on many exchanges throughout the world. Different types of forward contracts, swaps, options and other derivatives were regularly traded by Financial Institutions, Fund Managers, Corporate Treasurers either to hedge or speculate or to take advantage of arbitrage. Derivatives o/s US$ 680 trillion Forex derivatives are denominated in one leg US$-83%, Euro 41%, Yen 22%

Derivatives are Used mainly:

To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another


Forward Contracts
Forward contract is a simple derivative product. It is an agreement to buy or sell an asset at a certain future time for a certain price. This is in contrast to the Spot Contract. A forward contract is traded usually between two financial institutions or between a financial institution and one of its clients. Forward Contracts on foreign exchange are very popular and are being used predominantly by Exporters and importers or enterprises having FOREX commitments Futures Contract: is a standardised contract traded on an exchange. A range of delivery dates is usually specified. It is settled daily and usually closed prior to maturity.

Forward Contracts vs Futures Contracts

FORWARDS Private contract between 2 parties Non-standard contract

FUTURES Exchange traded Standard contract

Usually 1 specified delivery date

Settled at end of contract Delivery or final cash settlement usually occurs
Some credit risk

Range of delivery dates

Settled daily

Contract usually closed out prior to maturity

Virtually no credit risk


Options are traded on exchanges and OTC. There are two basic types. A call option, put option A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A Put Option gives the holder the right to sell the underlying asset by a certain date for a certain price. Advantage-holder of options does not have to exercise the right. In case of forwards and futures, the holder is obliged to buy or sell the underlying asset. Forward contracts-designed to neutralize the risk by fixing the price that the hedger will pay/receive Options, by contrast, provide insurance. Costs nothing to enter into a forward or future contract whereas up-front fee is to paid for options


Interest Rate Swap:

Swap is an agreement between two companies to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid, the way in which they are to be calculated (interest rate, exchange rate and/or other market variable)

The most common type of swap is Plain Vanilla interest rate swap. A company agrees to pay cash flows equal to the interest at a predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time. Floating rate in most interest rate swaps agreements is LIBOR, as LIBOR is quoted in all major currencies for 1 month, 3 m, 6 m and 12 month period.

Example of a Plain Vanilla Interest Rate Swap

An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million The slide illustrates cash flows that could occur


Cash Flows to Microsoft

---------Millions of Dollars--------LIBOR FLOATING Date Rate FIXED Net Cash Flow Cash Flow Cash Flow +2.10 2.50 0.40

Mar.5, 2004
Sept. 5, 2004


Mar.5, 2005
Sept. 5, 2005 Mar.5, 2006

5.5% 5.6%

+2.65 +2.75

2.50 2.50

+0.15 +0.25

Sept. 5, 2006
Mar.5, 2007






Typical Uses of an Interest Rate Swap

Converting a liability from fixed rate to floating rate floating rate to fixed rate
Converting an investment from fixed rate to floating rate floating rate to fixed rate


An Example of a Currency Swap An agreement to pay 5% on a sterling principal of 10,000,000 & receive 6% on a US$ principal of $18,000,000 every year for 5 years


The Cash Flows Dollars Pounds $ ------millions-----18.00 +10.00 +1.08 0.50 +1.08 0.50 +1.08 0.50 +1.08 0.50 +19.08 10.50

Year 2004 2005 2006 2007 2008 2009


Exchange of Principal
In an interest rate swap the principal is not exchanged In a currency swap the principal is usually exchanged at the beginning and the end of the swaps life Typical Uses of a currency Swap Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency


Credit Default Swaps

A huge market with over $60 trillion of notional principal Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity) Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X Premium is known as the credit default spread. It is paid for life of contract or until default If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds are typically deliverable)


CDS Structure

90 bps per year Default Protection Buyer, A Default Protection Seller, B

Payoff if there is a default by reference entity=100(1-R)

Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after default to the face value of the bond


Attractions of the CDS Market

Allows credit risks to be traded in the same way as market risks Can be used to transfer credit risks to a third party Can be used to diversify credit risks


Asset Backed Securities

Security created from a portfolio of loans, bonds, credit card receivables, mortgages, auto loans, aircraft leases, music royalties, etc Usually the income from the assets is tranched A waterfall defines how income is first used to pay the promised return to the senior tranche, then to the next most senior tranche, and so on.


Possible Structure
Asset 1 Asset 2 Asset 3
Tranche 1 (equity) Principal=$5 million Yield = 30% Tranche 2 (mezzanine) Principal=$20 million Yield = 10% Tranche 3 (super senior) Principal=$75 million Yield = 6%


Asset n Principal=$100 million

International Swaps and Derivatives Association (ISDA)

has produced Agreements which consist of clauses defining in default by either side. Signing of ISDA Master Agreement tantamount to conformation which is a legal agreement underlying a swap and is signed by the representatives of the two parties. Another popular swap is a Currency Swap. This involves exchanging principal and interest payments in one currency for principal and interest payments in another. Derivatives are very versatile instruments and can be used for hedging, for speculation and for arbitrage.

Currency Swaps


Types of Traders Hedgers Speculators Arbitrageurs

Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (for example Barings Bank)


Big Losses by Financial Institutions

Subprime Mortgages (> $5 trillion) Fannie Mac & Freddie Mac Credit Default Swaps (CDS) - >$ 60 trillion Societe Generale ($7 billion/ INR 28000 crores) due to indiscriminate trading by Rogue Trader Mr.Jerome Kerviel Lehman Brothers subsequently takenover by Barclays Merill Lynch taken over by Bank of America American International Group takenover by US Govt Bear Sterns Barings ($1 billion) Daiwa ($1 billion)


Risks and Mitigants

Credit Risk Liquidity Risk Market Risk Reputation Risk Concentration Risk Operational Risk


Role of Chartered Accountants

Derivatives were created and proliferated, at last count surpassing US$ 600 trillion in notional value CAs must make the clients aware of the risks associated with derivatives and they are able to define the limits, quantify CAs first responsibility is to ensure good accounting infrastructure with sound controls, financial reporting CAs should play active role in identification, recruitment, development of finance team of the client CAs should advise clients that the risk be diversified CAs should insist clients to go for scenario analysis and stress testing which is important


Role of Chartered Accountants

Clients should not give independence to traders Clients should separate the front, middle and back office Clients need not always follow Models. Very often they are wrong Clients should be conservative in recognizing inception profits Advise clients to buy only appropriate products relevant to their business model CAs should ensure Liquidity of the enterprise as prime, since liquidity risk is of paramount importance There are dangers when many are following the same strategy. CAs should advise the clients not to fall into this trap


Role of Chartered Accountants

CAs should advise clients that they should not opt for products where market transparency is in question CAs shall make the clients fully understand the products, risks involved in which they trade Clients should ensure that hedging should not become speculation CAs should advise that they should not make Treasurers department a profit center




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