Fund based Working Capital Limits 

• Banks will assess the genuine working capital  requirements of the borrower keeping in mind the business cycle and short term credit requirements
• In case of limits up to 5 Cr banks will assess based on Nayak committee report which is 20% of the estimated turnover
• Funding can be for both domestic and export /import components
• Working capital can be in the form of 
  • Cash credit loan
  • Bills discounting
  • Short term unsecured loan 
  • Loans under CGTMSE
  • Bank guarantees
  • Letters of credit

 Methods of Lending

• U K Sinha expert committee recommendation ;
• Banks presently assess the working capital requirement of MSME units based on various methods viz cash Budget method, Nayak committee of 20%of Turnover method, Traditional or operating cycle method.
• Nayak committee method is followed when the limits under consideration are less than  Rs 5  crores.
• In case of limits above 5 crores the 2nd method of lending ( MPBF) will be the base
• Minimum projected margin will be 25% of the total buildup Current assets
• Current Ratio expected to be 1.33:1

 Methods of Lending – Cash Budget Method

• Cash method in case of specific industries like Sugar, tea, Information Technology, etc.
• In this method the peak level cash deficit will be the total working capital finance to be extended to the borrower.
• The peak level would be ascertained from the projected cash budget statement submitted by the borrower.
• The cash budget statement would comprise projected receipts and payments for the next 12 months on account of business operations including advance payment, mobilization advance cash flow from sundry accounts, etc.

Cash Credit

• Cash credit facility is sanctioned as mentioned to meet the working capital requirements of the borrower.
• A cash credit loan can be used to meet the working capital gap in situations such as the following
  • Purchase of Raw materials
  • Inventory maintenance
  • Payment of salaries, wages, rent, utility payments
  • Warehousing /storage charges etc.
  • Financing sales ( Sundry debtors etc.)
• As mentioned earlier the limit is based either on the turnover method or on the MPBF method
• The limit available to the borrower/customer will be based on Drawing Power.
• Drawing Power is calculated based on margin prescribed by the bank/ financial institutions for Raw materials etc and a separate margin for book debts.
• Higher margin maintained for book debts as the  book debts include a profit margin
• The primary security will be stocks and book debts, collateral can be taken based on the limits/ borrowers holding of collateral, etc.
• Rate of interest will be based on the rating of the borrower.
• The borrower’s account to be rated by an external agency above a particular limit as stipulated by respective banks.
• CMA data for the last two years and projections to be considered for an existing unit

Overdraft

Overdraft limits can be classified under 2 major headings

• Overdraft for business activity 
• Overdraft to meet the personal requirements of customers
  • Fixed deposit .
  • Overdraft against property.
  • Overdraft against tangible assets

Features of Overdraft facilities

• Banks offer overdraft facilities over a predetermined limit, which may differ for every borrower.
• Overdraft limit account is a running account in which you can deposit/ withdraw an amount anytime up to the specified limit.
• The bank levies the interest on the overdraft amount used by the borrower at a predefined rate. The interest is calculated daily and billed/debited to you on a monthly basis. The interest amount increases if you default on paying the due overdraft amount.
• Unlike most loans wherein you have to pay a prepayment penalty for repaying the loan before tenure; banks do not levy any prepayment charges on overdraft limits. You can pay off the overdraft amount cumulatively without incurring any prepayment penalties.
• You can repay the overdraft, in different amounts, whenever you have the money. The system of EMIs, which is prominent with most loans, does not exist in the case of overdraft limits.
• While there is no minimum monthly repayment schedule in the case of overdraft loans, the amount owed by you should be within the overdraft limit.
• Joint borrowers may avail of overdraft limits. However, both the applicants are equally responsible for repaying the sanctioned Overdraft limit

Collaterals for Overdraft facilities

• Overdrafts against your house or property
• Overdrafts against your fixed deposits
• Overdrafts against your life insurance policy
• Overdrafts against your equity holdings
• Overdrafts against your salary

Final word: As is evident, the overdraft facility is one that can truly help you when you need money. Banks also fix decent repayment tenures, so that you can repay the overdraft loan flexibly. However, before availing of this facility from your bank, you must ensure that you find out the overdraft facilities advantages and disadvantages and then proceed with the limit.

Demand loans

• Demand loans can be sanctioned basically as short-term loans
• As the name suggests it is be repaid on demand
• These loans are preferred by borrowers in case of need of funds for a short term
• They are sanctioned against security /tangible assets 
• Minimum tenor is 7 days for business activity
• In fact Demand loans are generally taken against Fixed deposits/LIC policy shares etc.

Bills Discounting

Bills that are to be discounted/purchased are classified under a few heads 

• BDLC: Bills discounted under Letter of credit
• BD: Bills discounted which are not backed by LC (though all documents pertaining to sale to be present like LR/RR etc.)
• Drawee bill discounting
• Invoice bill discounting (this will be Clean)

Process of Bill Discounting

• The seller who is the customer approaches the bank 
• He has sold his goods on credit and raises invoices on the borrower
• The buyer has accepted the invoice/ bill of exchange
• The seller/bank customer wants the bank /financial institution to purchase/discount the bill
• The bank/ financial organization after verifying the genuineness of documents purchases or discounts the documents

Export credit

• This scheme is intended to make short term working capital finance available to exporters at concessional rates of interest
•  Largely 2 types of Credit – Pre Shipment Credit & Post Shipment Credit

Export credit : Pre Shipment Credit

• Packing credit is sanctioned to an exporter for financing the purchase, processing, manufacturing, or even packing of goods prior to shipment.
• Packing credit can also be extended to as working capital assistance to meet expenses such as wages, salary utility payments required for manufacture or processing goods/services for exports
• Packing credit is sanctioned /granted on the basis of confirmed orders/ Irrevocable Letter of credit etc.
• Different kinds of letters of credit are there based on which quantum of finance is considered.
• Normal period of packing credit is based on the tenor of the confirmed order /letter of credit.
• It should not in the normal circumstances exceed 6 months

Types of Pre Shipment Credit

• Confirmed orders
• Advances against back to back letters of credit
• Red or green clause letter of credit
• Advances against export incentive
• Running packing credit for good exporters

Export credit : Post Shipment Credit

• Post shipment credit means any loan, credit, or advance granted to an exporter by banks / financial institutions. 
• This is generally given after the shipment of goods/services by the exporter takes place.
• This loan can also be sanctioned against duty drawback allowed by the govt of India.
• As per extant guidelines of RBI the period prescribed for realization of export proceeds is 12 Months

 Types of Post Shipment Credit

• Export bills purchased and discounted
• Export bills negotiated advance against export bills sent on collection advance against exports on a consignment basis
• Advance against the undrawn balance on exports
• Advance against claims of Duty Drawback

Term loans for new projects/ expansion

Method

• In case of a new project or expansion of an existing unit banks consider funding by way of Term loans
• Term loans are generally given for new projects or for expansion of projects.
• Depending on the project size, a TEV study by an industry expert is done to assess the Technical feasibility and economic viability of the project.
• Important Ratios to be calculated are the Debt Equity Ratio DE) and Debt Service coverage ratio (DSCR)
• The cash flow and fund flow statement to be properly analyzed
• Tenor of loan to be fixed based on the project

Types of Term loans

• Term loans come in several varieties, usually reflecting the lifespan of the loan. These include:
• Short-term loans: These types of term loans are usually offered to firms that don't qualify for a line of credit. They generally run less than a year, though they can also refer to a loan of up to 18 months.
• Intermediate-term loans: These loans generally run between one to three years and are paid in monthly installments from a company’s cash flow.
• Long-term loans: These loans last anywhere between three to 25 years. They use company assets as collateral and require monthly or quarterly payments from profits or cash flow. They limit other financial commitments the company may take on, including other debts, dividends, or principals' salaries, and can require an amount of profit set aside specifically for loan repayment.
• Both short- and intermediate-term loans may also be balloon loans and come with balloon payments. This means the final installment swells or balloons into a much larger amount than any of the previous ones.
  

ZED Certification Scheme

• The ministry of MSME, GOI, launched the ZED certification scheme. 
• ZED maturity assessment model consists of 50 parameters for projecting a holistic picture of MSMEs ( covering various aspects like production, quality, design, safety, environmental energy, Natural resources human resources, intellectual property, and Performance)
• Each parameter has 5 levels and the rating is on a weighted average of marks obtained in each parameter.

Non-Fund based Working Capital Limits 

Credit facilities

• Various types of guarantees are issued by the banks on behalf of their customers. Bank Guarantees (BG) is also known as Letter of Guarantees which can be broadly classified as (i) Financial Guarantees and (ii) Performance guarantees. Earnest money Deposit guarantee or Bid Bond Guarantee, Guarantee for Payment of Customs duty (specific or continuing), Advance Payment Guarantee (APG), Deferred Payment Guarantee (DPG), Shipping Guarantee, Performance guarantee, Retention Money guarantees, etc. are some of the prominent types of guarantees issued by the banks.
• Bank Guarantee or letter of guarantee is a fee-based credit facility extended by the banks to their customers. The non-fund-based facilities are the letter of guarantee or letters of credit by the banks wherein banks get fee income. Since there is no immediate outflow of funds from the banks they are also known as the non-fund-based facility. However in the case of a non-fund based credit facility, the bank has to discharge the financial liability of the contract agreed to the guarantee or documentary credit, if the contract is partly or fully not performed by the custom
  

Financial Guarantees

Financial guarantees are issued by the banks whenever a contract is awarded to their customer, who is generally a contractor of civil work or a supplier of goods, machinery, equipment by a Government Department or large industrial undertakings, the customer is under obligation to offset cash security or earnest money as a token of due compliance of the terms and conditions of the contract. This cash security provided by the contractor or supplier is forfeited by the Government Department or the company which awarded the contract, in the event the contractor or supplier fails to comply with the terms stipulated in the sanction. The customer normally will have an option to furnish a bank guarantee in lieu of cash security, so that his working funds are not unnecessarily blocked. The guarantees issued by banks for the above purpose is called financial guarantee wherein the banks undertake to pay the guaranteed amount during a specified period on demand from the beneficiary. 

Financial Guarantees - Examples

• Guarantee for Earnest money Deposit (Local Tender)/Bid Bond Guarantee (international tender): A bid bond guarantee is a guarantee issued by the bank to the effect that the bidder would not withdraw the bid before the expiry of the bid/tender period or in case the contract is awarded to the bidder that he would comply with the terms of the tender and enter into the contract.
• Guarantee for Payment of Customs duty (specific or continuing): A customer may require a guarantee favoring the customs department for payment of customs duty covering import of raw materials. It means that the guarantee covers custom duty in arrears to the Customs Department by the customer up to a limit (stating maximum of amount) of guarantee undertaken by the bank.
• Advance Payment Guarantee (APG): Although Advance Payment guarantee is associated with the financial guarantee it has the inherent risk of performance guarantee Advance payment guarantees are issued on behalf of the (i) Supplier of raw materials/finished goods or (ii) on behalf of a contractor for execution of contract when he receives the advance payment. Since the supplier receives an advance from the purchaser for the supply of raw material or finished goods on a future date, it is a substitution of working capital funds. In the case of execution of the contract, if any one of the terms of the contract is not fulfilled, the guarantee is likely to be invoked. While accepting the request from the customer for APG limit the banker should thoroughly analyze all risk factors.
•  Deferred Payment Guarantee (DPG): In the cases of purchase of capital goods/machinery where the seller offers credit to the buyer and the buyer’s bank guarantees the due payments to the seller. Here the seller draws drafts of different maturities on the buyer which are accepted by the buyer and co-accepted by the Buyer’s bank. Thereby the buyer’s bank guarantees due payment of those drafts drawn by the seller which represents the total consideration of the contract of sale/supply. The seller avails the refinance from his bank against co-accepted bills. DPG involves the substitution of the term loan. Hence procedure applicable for assess

Letters of Credit

• To put it in simple terms, a letter of credit is a piece of document that serves as instruction of guaranteed payment from the buyer to the seller. Also known as documentary credit, a letter of credit is issued by the bank and acts as a promise of timely payment to the seller.
• If the buyer supposedly fails to perform his due obligation, then the bank pays the seller on behalf of the buyer who in turn repays the bank. This is a brief summation of the letter of the credit process.
• Types of Letters of Credit

1. 1. A revocable letter of credit
   2. Revolving letter of credit
   3. A standby letter of credit
   4. Irrevocable letter of credit

• A number of banks adopt the practice of parking the dues of the borrower in respect of devolved LCs and invoke guarantees in a separate account which is not a regular sanctioned facility. As a result, these are not reflected in the principal operating account of the borrower. This renders application of the prudential norms for the identification of NPAs difficult. It is, therefore, advised that if the debts arising out of devolvement of LCs or invoked guarantees are parked in a separate account, the balance outstanding in that account also should be treated as a part of the borrower’s principal operating account for the purpose of application of prudential norms on income recognition, asset classification, and provisioning.

Trade Finance

• Trade Finance is by way of a letter of credit: this can be sight/demand LC or Usance LC
• Advantage of Usance LC is the availability of time period to make the payment
• In case of Import or export Letters of credit, it is better to take forward cover to hedge the risk of currency fluctuation
• Banks/ financial institutions normally advise the customer for a minimum percentage of hedging unless the customer has a natural hedge in their business activity
• SBLC; Standby letter of credit; standby letters of credit are irrevocable agreements for the payment of money. They function like guarantees or obligations and are provided by the bank for the benefit of the beneficiary

Difference between a Buyers Credit and Letter of Credit

Acceptances

• Co-acceptance of Bills (2.1 Irregularities in Co-acceptance of Bills)
• Banks have been co-accepting bills of their customers. On many occasions, these bills turn out to be accommodation bills drawn by groups of sister concerns on each other where no genuine trade transaction takes place. Such bills on maturity are not honoured by the drawers and the banks which have co-accepted the bills have to make payment of these bills and thereafter, they find it difficult to recover the amount from the drawers/drawers of bills. This happens because the financial position and capacity of the parties to honour the bills, in the event of need, is not gone into by the banks co-accepting the bills. (ii) There have also been cases where the particulars regarding co-acceptance of bills are not recorded in the bank’s books with the result that the extent of co-acceptance cannot be verified during inspections and the Head Office becomes aware of the co-acceptance only when a claim is received from the discounting bank.
  
  

Conclusion

• MSMEs are the growth engine propelling job creation, urbanization, higher education. and increasing the quality of life of people.
• The MSMEs should make use of its benefits and contribute their best to enable the country to realize its ambitious goals of Make in India and Self Reliant India through the development of goods and services to substitute the imported goods and services and to improve its export performances.
• Maintaining efficiency in cost, upgradation of products with the changing needs of the customer are some of the parameters for the success of MSMEs.
• Their healthy growth is a key aspect for building India’s economic progress in post COVID ERA.
• Bank and financial institutions should give maximum support to this industry