working capital need

7/30/2019 working capital need

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Financing Working

Capital Needsaspects to determine the credit - worthiness of the borrower and to ensure

safety of the funds lent.

2) Principle of Liquidity : Banks mobilize funds through deposits which are

repayable on demand or over short to medium periods. The banker therefore

lends his funds for short period and for Working Capital purposes. These loans

are largely repayable on demand and are granted on the basis of securities

which are easily marketable so that he may realise his dues by selling the

securities.

3) Principle of Profitability: Banks are profit earning institutions. They lend their

funds to earn income out of which they pay interest to depositors, incur

operational expenses and earn profit for distribution to owners. They charge

different rates of interest according to the risk involved in lending funds tovarious borrowers. However, they do not have to sacrifice safety or liquidity for

the sake of higher profitability.

Following the above principles banks pursue the practice of diversifying risk by

spreading advances over a reasonably wide area, distributed amongst a good number

of customers belonging to different trades and industries. Loans are not granted for

speculative and unproductive purposes

9.3 STYLE OF CREDIT

Commercial banks provide finance for working capital purposes through a variety of

methods. The main systems or style of credit, prevalent in India are depicted in the

following diagram.

Bank Credit

Loans and advances Discounting of bills

Overdrafts Cash Credit Loans

Short term Medium & Bridge Composite

Personal

Loans Long term loans loans

loans

loans

The terms and conditions, the rights and privileges of the borrower and the banker

differ in each case. We shall discuss below these methods of granting bank credit.

9.3.1 Overdrafts

This facility is allowed to the current account holders for a short period. Under this

facility, the current account holder is permitted by the banker to draw from his


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account more than what stands to his credit. The excess amount drawn by him is

deemed as an advance taken from the bank. Interest on the exact amount

overdrawn by the account-holder is charged for the period of actual utilisation. The

banker may grant such an advance either on the basis of collateral security or on the

personal security of the borrower. Overdraft facility is granted by a bank on an

application made by the borrower. He is also required to sign a promissory note.

Therefore, the customer is allowed the amount, upto the sanctioned limit of overdraft

as and when he needs it. He is permitted to repay the loan as per his convenience

and ability to do so.

9.3.2 Cash Credit System

Cash Credit System accounts for the major portion of bank credit in India. The

salient features of this system are as follows:

1) Under this system, the banker prescribes a limit, called the Cash Credit limit,

upto which the customer- borrower is permitted to borrow against the security

of tangible assets or guarantees.

2) The banker fixes the Cash Credit limit after considering various aspects of the

working of the borrowing concern i.e production, sales ,inventory levels, past

utilisation of such limit, etc.

3) The borrower is permitted to withdraw from his Cash Credit account, amount as

and when he needs them. Surplus funds with him are allowed to be deposited

with the banker any time. The Cash Credit account is thus a running account,

wherein withdrawals and deposits may be made frequently any number of times.

4) As the borrower withdraws from Cash Credit account he is required to provide

security of tangible assets. A charge is created on the movable assets of the

borrower in favour of the banker.

5) When the borrower repays the borrowed amount in full or in part, security is

released to him in the same proportion in which the amount is refunded.

6) The banker charges interest on the actual amount utilised by him and for the

actual period of utilisation.

7) Though the advance made under Cash Credit System is repayable on demand

and there is no specific date of repayment, in practice the advance is rolled overa period of time i.e. the debit balance is hardly fully wiped out and the loan

continues from one period to another.

8) Under this system, the banker keeps adequate cash balance to meet the

demand of his customers as and when it arises, but interest is charged on the

actual amount of loan availed of. Thus, to neutralize the loss caused to the

banker, the latter imposes a commitment charge at a normal rate of 1% or so, on

the unutilised portion of the cash credit limit.

Merits of Cash Credit System

The Cash Credit System has the following merits:

1) The borrower need not keep surplus funds idle with himself. He can deposit the

surplus funds with the banker, reduce his debit balance, and thus minimise the

interest burden. On the other hand he can withdraw funds at any time to meet

his needs.

2) Banks maintain one account for all transactions of a customer. As documents

are required only once in a year the costs of repetitive documentation is avoided.


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Financing Working

Capital NeedsDemerits of Cash Credit System

The Cash Credit System, on the other hand, suffers from the following demerits:

1) Cash Credit limits are prescribed only once in a year and hence they are fixed

keeping in view the maximum amount that can be required within a year.

Consequently, a portion remains unutilised for part of the year during which bank

funds remain unemployed.

2) The banker remains unable to verify the end use of funds borrowed by the

customer. Such funds may be diverted to unapproved purposes.

3) The banker remains unable to plan the utilisation of his funds as the level of

advances depends upon the borrowers decision to borrow at any time.

4) As the volume of cash transactions increases significantly under the cash

credit system as against the loan system, the cost of handling cash, honouring

cheques, taking and giving delivery of securities increases the transactions cost

of banks.

5) As there is only commitment charge of 1% or less, there will be a tendency on

the part of companies to negotiate for a higher limit.

9.3.3 Loan System

Under the loan system, a definite amount is lent at a time for a specific period and a

definite purpose. It is withdrawn by the borrower once and interest is payable for the

entire period for which it is granted. It may be repayable in instalments or in lump

sum. If the borrower needs funds again , or wants to renew an existing loan, a fresh

proposal is placed before the banker. The banker will make a fresh decision

depending upon the availability of cash resources. Even if the full loan amount is not

utilised the borrower has to pay the full interest.

Advantages of the Loan System

The loan system has the following advantages over the Cash Credit System:

1) This system imposes greater financial discipline on the borrowers, as they are

bound to repay the entire loan or its instalments on the due date/ dates fixed in

advance.

2) At the time of granting a new loan or renewing an existing loan, the banker

reviews the loan account. Thus unsatisfactory loan accounts may be

discontinued at his discretion.

3) As the banker is entitled to charge interest on the entire amount of loan, his

income from interest is higher and his profitability also increases because of

lower transaction cost.

Short Term Loans

Short term loans are granted by banks to meet the Working Capital requirements ofthe borrowers. Such loans are usually granted for a period upto one year and are

secured by the tangible movable assets of the borrowers like goods and commodities,

shares, debentures etc. Such goods and securities are pledged or hypothecated with

the banker.

As we shall study in the next unit. Reserve Bank of India has exercised compulsion

on banks since 1995 to grant 80% of the bank credit permissible to borrowers with

credit of Rs 10 crore or more in the form of short term loans which may be for


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various maturities. Reserve Bank has also permitted the banks to roll over such

loans i.e. to renew the loan for another period at the expiry of the period of the first

loan.

Medium and Long Term Loans

Such loans are generally called Term Loans and are granted by banks with All

India Financial institutions like Industrial Development Bank of India, Industrial

Finance Corporation of India, Industrial Credit and Investment Corporation of India

Ltd. Term loans are granted for medium and long terms, generally above 3 years

and are meant for purchase of capital assets for the establishment of new units and

for expansion or diversification of an existing unit . At the time of setting up of a new

industrial unit, term loans constitute a part of the project finance which the

entrepreneurs are required to raise from different sources. These loans are usuallysecured by the tangible assets like land, building, plant and machinery etc. In October

1997 Reserve Bank of India permitted the banks to announce separate prime

lending rate for term loans of 3 years and above. In April 1999 Reserve bank of

India also permitted the banks to offer fixed rate loans for project financing. Reserve

Bank of India has encouraged the banks to lend for project finance as well. In

September, 1997 ceiling on the quantum of the term loans granted by banks

individually or in consortia/syndicate for a single project was abolished. Banks now

have the discretion to sanction term loans to all projects within the overall ceiling of

the prudential exposure norms prescribed by Reserve bank. ( Fully discussed in the

next unit). The period of term loans will also be decided by banks themselves.

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

the needs of Working Capital.

Bridge Loans

Bridge loans are in fact short term loans which are granted to industrial undertakings

to enable them to meet their urgent and essential needs. Such loans are granted

under the following circumstances:

1) When a term loan has been sanctioned by banks and/ or financial institutions, but

its actual disbursement will take time as necessary formalities are yet to be

completed.

2) When the company is taking necessary steps to raise the funds from the Capital

market by issue of equities/debt instruments.

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

granted term loans. Such loans are automatically repaid out of the amount of term

loan when it is disbursed or out of the funds raised from the Capital Market.

Reserve Bank of India has allowed the banks to grant such loans within the ceiling

of 5% of incremental deposits of the previous year prescribed for individual banks

investment in Shares/ Convertible debentures. Bridge loans may be granted for a

maximum period of one year.

Composite Loans

Composite loans are those loans which are granted for both, investment in capital

assets as well as for working capital purposes. Such loans are usually granted to

small borrowers, such as artisans, farmers, small industries etc. Under the

composite loan scheme, both term loans and Working Capital are provided through

a single window. The limit for composite loans has recently (in Feb., 2000) been

increased from Rs. 5 lakhs to Rs.10 lakhs for small borrowers.


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tangible assets in their favour. In some cases, the banks secure their interest by

asking for a guarantee given by a third party. Besides the tangible assets or a

guarantee, banks rely upon the personal security of the borrower and grant loans

which are called unsecured advances or clean loans. In the balance sheet, banks

classify advances as follows:

Advances

Secured by Covered by Unsecured

Tangible Assets Bank /Govt. Guarantees

Secured Advances

According to Banking Regulation Act 1949, a secured loan or advance means a

loan or advance made on the security of assets, the market value of which is not at

any time less than the amount of such loan or advances. An unsecured loan or

advance means a loan or advance not so secured.

The main features of a secured loan are:

1) The advance is made on the basis of security of tangible assets like goods and

commodities, life insurance policies, corporate and government securities etc.

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

3) The market value of such security is not less than the amount of loan. If the

former is less than the latter, it becomes a partly secured loan.

Unsecured Advances

Unsecured advances are granted without asking the borrower to create a charge on

his assets in favour of the banker. In such cases the security happens to be the

personal obligation of the borrower regarding repayment of the loan. Such loans are

granted to parties enjoying high reputation and sound financial position.

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

creditor. He possesses absolute right to recover his dues from the borrower out of

the sale proceeds of the assets over which a charge is created in his favour. In case

of an unsecured advance, a banker remains an unsecured creditor and stand at par

with other unsecured creditors of the borrower, if the latter defaults.

Guaranteed Advances

The banker often safeguards his interest by asking the borrower to provide a

guarantee by a third party may be an individual, a bank or Government. According

to the Indian Contract Act, 1872, a contract of guarantee is defined as a contract to

perform the promise or discharge the liability of third person is caseof

his

default. The person who undertakes this obligation to discharge the liability of

another person is called the guarantor or the surety. Thus a guaranted advance is, in

fact, also an unsecured advance i.e. without any specific charge being created on

any asset, in favour of the banker. A guarantee carries a personal security of two

persons i.e. the principal debtor and the surety to perform the promise of the

principal debtor. If the latter fails to fulfill his promise, liability of the surety arises

immediately and automatically. The surety therefore, must be a reliable person

considered good for the amount for which he has stood as surety. The guarantee

given by banks, financial institutions and the government are therefore considered


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because his business will be impeded in case of such transfer. Similarly a transporter

needs the vehicle for plying on the road and hence cannot give its possession to the

banker for taking a loan. In such circumstances a charge is created by way of

hypothecation.

Under hypothecation, neither ownership nor possession over the asset is transferred

to the creditor. Only an equitable charge is created in favour of the banker. The

asset remains in the possession of the borrower who promises to give possession

thereof to the banker, whenever the latter requires him to do so. The charge of

hypothecation is thus converted into that of a pledge. The banker enjoys the rights

and powers of a pledgee. The borrower uses the asset in any manner he likes, viz he

may take out the stock, sell it and replenish it by a new one. Thus a charge is

created on the movable asset of the borrower. The borrower is deemed to hold

possession over the goods as an agent of the creditor. To enforce the security, thebanker should take possession of the hypothecated asset on his own or through the

court.

9.5.3 Mortgage

A charge on immovable property like land & building is created by means of a

mortgage. Transfer of Property Act 1882 defines mortgage as the transfer of an

interest in specific immovable property for the purpose of securing the payment

of money, advanced or to be advanced by way of loan, an existing or future

debt or the performance of an engagement which give rise to a pecuniary

liability. The transferor is called the mortgagor and the transferee mortgagee.

The owner transfers some of the rights of ownership to the mortgagee and retains

the remaining with himself. The object of transfer of interest in the property must

be to secure a loan or to ensure the performance of an engagement which results in

monetary obligation. It is not necessary that actual possession of the property be

passed on to the mortgagee. The mortgagee, however, gets the right to recover the

amount of the loan out of the sale proceeds of the mortgaged property. The

mortgagor gets back the interest in the mortgaged property on repayment of the

amount of the loan along with interest and other charges.

Kinds of Mortgages

Though Transfer of Property Act specifies seven kinds of mortgages, but from thepoint of view of transfer of title to the mortgaged property, mortgages are divided

into-

a) Legal mortgages and

b) Equitable mortgages

In case of Legal Mortgage, the mortgagor transfers legal title to the property in

favour of the mortgagee by executing the Mortgage deed. When the mortgage

money is repaid, the legal title to the mortgaged property is re-transferred to the

mortgagor. Thus in this type of mortgage expenses are incurred in the form of stamp

duty and registration charges.

In case of an equitable mortgage the mortgagor hands over the documents of title to

the property to the mortgagee and thus creates an equitable interest of the mortgagee

in the mortgaged property. The legal title to the property is not passed on to the

mortgagee but the mortgagor undertakes through a Memorandum of Deposit to

execute a legal mortgage in case he fails to pay the mortgaged money. In such

situation the mortgagee is empowered to apply to the court to convert the equitable

mortgage into legal mortgage.

Equitable Mortgage has several advantages over Legal Mortgage. It is not


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Financing Working

Capital Needsnecessary to register the Memorandum of Deposit or the covering letter sent along

with the Documents of title. Actual handing over by a borrower to the lender of

documents of title to immovable property with the intention to constitute them as

security is sufficient. As registration is not mandatory, information regarding

mortgage remains confidential and the mortgagors reputation is not affected. When

the debt is repaid documents are returned back to the borrower, who may re-deposit

the same for taking another loan against the same documents. But the banker should

be very careful in retaining the documents in his possession, because if the equitable

mortgagee is negligent or mis-represents to another person, who advances money on

the security of the mortgaged property, the right of the latter will have first priority.

9.5.4 Assignment

The borrower may provide security to the banker by assigning any of his rights,

properties or debts to the banker. The transferor is called the assignor and the

transferee the assignee. The borrowers generally assign the actionable claims to

the banker under section 130 of the Transfer of Property Act 1882. Actionable claim

is defined as a claim to any debt, other than a debt secured by mortgage of

immovable property or by hypothecation or pledge of movable property or to any

beneficial interest in movable property not in the possession of the claimant.

A borrower may assign to the banker(i)the book debts, (ii) money due from a

government department or semi-government organisation and (iii)life insurance

policies.

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

legal assignment, there is absolute transfer of actionable claim which must be inwriting. The debtor of the assignor is informed about the assignment. In the

absence of the above the assignment is called equitable assignment.

9.5.5 Lien

The Indian Contract Act confers upon the banker the right of general lien. The

banker is empowered to retain all securities of the customer, in respect of the general

balance due from him. The banker gets the right to retain the securities handed over

to him in his capacity as a banker till his dues are paid by the borrower. It is deemed

as implied pledge.

Activity 9.2

1) Distinguish between a secured advance and a guaranteed advance.

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

2) Distinguish between pledge and hypothecation. Which provides better security

to the banker and why?

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

3) What do you understand by Equitable Mortgage? What are its advantages

vis-a-vis legal mortgage?

.......................................................................................................................


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.......................................................................................................................

.......................................................................................................................

.......................................................................................................................

9.6 SECURED ADVANCES

Secured advances account for significant portion of total advances granted by banks.

As we have seen, in case of secured advances, a charge is created on the assets of

the borrowers in favour of the banker, which enables him to realise his dues out of

the sale proceeds of the assets. Banks grant advances against a variety of assets as

shown below:

Securities for Advances

Goods & Documents Real Estates Book Supply

Commodities Debts Bills

Documents of Stock Exchange Life Insurance Fixed Deposit

Title to goods Securities Policies Receipts

Let us first study the general principle of secured advances:

1) Marketability of Securities: The banker grants advances on the basis of those

securities which are easily marketable without loss of time and money, because

in case of non-payment by the borrower, the banker shall have to dispose off the

security to realise his dues.

2) Adequacy of Margin : Banker also maintains a difference between the value

of the security and the amount lent. This is called margin. Suppose a banker

grants a loan of Rs. 100 /- on the security valued at Rs. 200/- the difference

between the two (i.e. Rs. 200 - Rs. 100 = Rs. 100) is called margin. Margin is

necessary to safeguard the interest of the banker as the market value of the

security may fall in future and /or interest and other charges become payable by

the borrower , thus increasing the liability of the borrower towards the banker.

Different margins are prescribed in case of different securities.

3) Documentation: Banker also requires the borrower to execute the necessary

documents e.g. Agreement of pledge, Mortgage Deed, Promissory notes etc. to

safeguard his interest.

Goods and Commodities

Bulk of the advances granted by banks are secured by goods and commodities, raw

material and finished goods etc., which constitute the stock-in-trade of business

houses. However, agricultural commodities are likely to deteriorate in quality over a

period of time. Hence banks grant short term loans only against such commodities .

The problem of valuation of stock pledged with the bank is not a difficult one, as

daily quotations are easily available. Banker usually prefers those commodities which

have steady demand and a wider market. Such goods are required to be insured

against fire and other risks. Such goods either pledged or hypothecated to the banker

are released to the borrower in proportion to the amount of loan repaid.

Agro-based commodities such as foodgrains, sugar, pulses, oilseeds, cotton are


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Financing Working

Capital Needssensitive to the market forces of demand and supply and prices. As our country has

faced seasonal shortages in several of these commodities, the reserve bank of India

under the authority vested in it by the Banking Regulation Act, issues directives

known as Selective Credit Control (SCC) to scheduled commercial banks during the

commencement of each busy season which is, in practical terms, the commencement

of the Kharif or the Rabi season each year. In order to ensure that speculation in

these sensitive commodities does not take place, the Reserve Bank of India in its

busy season policy issues direction to control the credit for commodities by:

i) Fixing an overall ceiling for credit to sensitive commodities for each bank as

whole. For example, total credit against these commodities in a particular year

may be restricted to 80% of the previous years level;

ii) Fixing margins and rates of interest that can be levied by banks in their credit

against the selected commodities; and

iii) Banning the flow of bank credit towards financing one or more of these selected

commodities.

Each bank takes into consideration the RBIs policy on selective credit control while

determining its own credit policy. The Head Offices of banks advise their branches

on the terms and conditions applicable to SCC commodities.

Documents of Title to Goods

These documents represent actual goods in the possession of some other person.

Hence they are proof of possession or control over the goods. For example,

warehouse receipts, railway receipts, Bill of lading etc. are documents of title togoods. When the owner of goods represented by these documents wants to take a

loan from the banker, he endorses such documents in favour of the banker and

delivers them to him. The banker is thus entitled to receive the delivery of such

goods, if the advance is not repaid. However, there remains the risk of forgery in

such documents and dishonesty on the part of the borrower.

Stock Exchange Securities

Stock Exchange Securities comprise of the securities issued by the Central and State

governments, semi-govt. orgaisations, like Port Trust & Improvement Trust, Shares

and Debentures of companies and Units of the Mutual Funds listed on the Stock

Exchanges. The Govt. securities are accepted by banks because of their easyliquidity, stability in prices, regular accrual of income and easy transferability.

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

because the debenture holder generally happens to be secured creditor and there is a

contractual obligation on the company to pay interest thereon regularly. Amongst the

shares, banks prefer preference shares, because of the preferential rights enjoyed

by the preference shareholders over equity shareholders. Banks accept equity

shares of those companies which they approve after thorough screening and

examination of all aspects of their working. A charge over such securities is created

in favour of the banker.

Reserve Bank of India has permitted the banks to grant advances against shares toindividuals upto Rs. 20 lakhs w.e.f. April 29, 1998 if the advances are secured by

dematerialized Securities. The minimum margin against such dematerialized shares

was also reduced to 25%. Advances can also be granted to investment companies,

shares & stock brokers, after making a careful assessment of their requirements.

Life Insurance Policies

A life insurance policy is considered a suitable security by a banker as repayment of

loan is ensured to the banker either at the time policy matures or at the time of death


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of the insured. Moreover, the policy has a surrender value which is paid by the

insurance company, if the policy is discontinued after a minimum period has lapsed.

The policy can be legally assigned to the banker and the assignment may be

registered in the books of the insurance company. Banks prefer endowment policies

as compared to the whole life policies and insist that the premium is paid regularly

by the insured.

Fixed Deposit Receipts

A Fixed Deposit Receipt issued by the same bank is the safest security for granting

an advance because the receipt represent a debt due from the banker to the

customer. At the time of taking a loan against fixed deposit receipt the depositor

hands over the receipt to the banker duly discharged, along with a memorandum of

pledge. The banker is thus authorised by the depositor to appropriate the amount of

the FDR towards the repayment of loan taken from the banker.

Real Estate

Real Estate i.e. immovable property like land and building are generally not regarded

suitable security for granting loans for working capital. It is difficult to ascertain that

the legal title of the owner is free from any encumbrance. Moreover, their valuation

is a difficult task and they are not readily realizable assets. Preparation of mortgage

deed and its registration takes time and is expensive also. Real Estates are,

therefore, taken as security for term loans only.

Book Debts

Sometimes the debts which the borrower has to realise from his debtors are assignedto the banker in order to secure a loan taken from the banker. Such debts have either

become due or will accure due in the near future. The assignor must execute an

instrument in writing for this purpose, clearly expressing his intention to pass on his

interest in the debt to the assigner (banker). He may also pass an order to his debtor

to pay the assigned debt to the banker.

Supply Bills

Banks also grant advance on the security of supply bills. These bills are offered as

security by persons who supply goods, articles or materials to various Govt.

departments, semi-govt. bodies and companies, and by the contractors who undertake

govt. contract work. After the goods are supplied by the suppliers to the govt.department and he obtains an inspection note or Receipted Challan from the Deptt.,

he prepares a bill for the goods supplied and gives it to the bank for collection and

seeks an advance against such supply bills. Such bills are paid by the purchaser at

the expiry of the stipulated period.

Security for bank credit could be in the form of a direct security or an indirect

security. Direct security includes the stocks and receivables of the customers on

which a charge is created by the bank through various security documents. If in the

view of the bank, the primary or direct security is not considered adequate or is risk-

prone, that is, subject to heavy fluctuations in prices, quality etc., the bank may

require additional security either from the customer or from a third party on

behalf of the customer. The additional security so obtained is known as Indirect orCollateral Security. The term collateral means running parallel or together and

collateral security is an additional and separate security for repayment of money

borrowed.

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

bank, he may be required to provide collateral security from a third party. The

common form of the third party collateral security is a guarantee given by a person

on behalf of the customer to the bank. The third party collateral security in turn may


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Financing Working

Capital Needsbe unsecured or secured. For example, where the guarantor has executed a guaran-

tee agreement only, The collateral security is unsecured. However, if he lodges along

with the guarantee agreement, security such as title deeds to his property creating

mortgage by deposit of title deeds with the bank, a secured collateral security is

created.

9.7 PURCHASE AND DISCOUNTING OF BILLS

Purchase and discounting of bills of exchange is another way banks provide credit to

business entities. Bills of exchange and promissory notes are negotiable instruments

which arise out of commercial transactions both in inland trade and foreign trade and

enable the debtors to discharge their obligations towards their creditors.

On the basis of maturity period , bills are classified into (i) demand bills and (ii)usance bills. When a bill is payable at sight on demand or on presentment, it is

called a demand bill. If it matures for payment after a certain period of time say

30,60,90 days , after date or sight, it is called a usance bill. No stamp duty is required

in case of demand bills and on usance bills, if they (i) arise out of the bona fide

commercial transactions , (ii) are payable not more than 3 months after date or sight

and (iii) are drawn on or made by or in favour of a commercial or cooperative bank.

When the drawer of a bill encloses with the bill documents of title to goods, such as

the railway receipt or motor transport receipt, to be delivered to the drawee , such

bills are called documentary bills. When no such documents are attached the bill is

called a clean bill. In case of documentary bills, the documents may be delivered on

accepting the bill or on making its payment. In the former case it is called

Documents against Acceptance (D/A) basis, and in the latter case Documents

against Payment (D/P) basis. In case of a clean bill, the relevant documents of title

to goods are sent directly to the drawee.

Procedure for Discounting of Bills

When the seller of the goods draws a bill of exchange on the buyer (debtor), he has

two options to deal with the bill.

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

b) to sell it to, or discount it with, a bank

When the bill is sent to the bank for collection the banker acts as the agent of the

drawer and makes its payment to him only on the realisation of the bill from the

drawee. The banker sends it to its branch at the drawees place, which presents it

before the drawee, collects the amount and remits it to the collecting banker, who

credits the same to the drawers account. In case of collection of bills, the bank acts

as an agent of the drawer of the bill and does not lend his funds by giving credit

before actual realisation of the bill.

The business of purchasing and discounting of bills differs from that of collection of

bills. In case of purchase/discounting of bills, the bank credits the amount of the bill

to the drawers account before its actual realisation from the drawee. The banker

thus lends his own funds to the drawer of the bill. Bills purchased or discounted aretherefore, shown under the head Loans and Advances in the Balance Sheet of a

bank.

The practice adopted in case of demand bills is known as purchase of bills. As

demand bills are payable on demand, and there is no maturity, the banker is entitled to

demand its payment immediately on its presentation before the drawee. Thus the

money credited to the drawers account, after deducting charges/discount, is realised

by the banker within a few days.


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In case of a usance bill maturing after a period of time generally 30,60,or 90 days,

therefore, banker discounts the bill i.e. credits the amount of the bill, less the amount

of discount, to the drawers account. Thereafter, the bill is sent to the banks branch

at the drawees place which presents it to the drawee for acceptance. Documents

of title to goods, if enclosed with the bills, are released to him on accepting the bill.

The bill is thereafter retained by the banker till maturity, when it is presented to the

acceptor of the bill for payment.

Advantages of Discounting of Bills

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

1) Safety of funds lent

Though the banker does not get charge over any tangible asset of the borrower in

case of discounting of bills, his interest is safeguarded by the fact that the bills of

exchange contains signatures of two partiesthe drawer and the drawee

(acceptor) who are responsible to make payment of the bill. If the acceptor fails

to make payment of the bill the banker can claim the whole amount from his

customer, the drawer of the bill. The banker can debit the customers account and

recover the money on the due date. The banker is able to recover the amount as he

discounts the bills drawn by parties of standing and good reputation.

2) Certainty of payment

Every usance bill matures on a certain date. Three days of grace are allowed to the

acceptor to make payment. Thus, the amount lent to the customer by discounting the

bills is definitely recovered by the banker on its due date. The banker knows the date

of payment of the bills and hence can plan the utilisation of his funds well in

advance and with profit.

3) Facility of re-discounting of bills

The banker can augment his funds, if need arises, by re-discounting the bills, already

discounted by him, with the Reserve Bank of India, other banks and financial

institutions and the Discount and Finance House of India Ltd. Reserve Bank of

India can also grant loans to the banks on the basis of the bills held by them.

4) Stability in the value of bills

The value of the bills remains fixed and unchanged while the value of all other goods,

commodities and securities fluctuate over period of time.

5) Profitability

In case of discounting of bills, the amount of interest (called discount) is deducted in

advance from the amount of the bill. Hence the effective yield is higher than loans

and advances where interest is payable quarterly/half yearly.

Derivative Usance Promissory Notes

As noted above, banks may re-discount the discounted bills of exchange with other

banks and financial institutions. For this purpose, under the normal procedure, the

bills are endorsed in favour of the re-discounting bank /institution and delivered to it.

At the time of maturity reverse process is required.

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

with the necessity of physical lodgment of the discounted bills. Instead, banks are

permitted, on the basis of such discounted bills, to prepare derivative usance


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does not entail banks obligation to grant advances to priority sectors based thereon.

Further, the relaxation granted by Reserve Bank of India in April 1997 to the banks to

invest in the bonds and debentures of private corporate sector without any limit, has

also contributed to the greater flow of bank credit through debt instruments.

9.8 NON FUND BASED FACILITIES

The credit facilities explained above are fund based facilities wherein funds are

provided to the borrower for meeting their working capital needs. Banks also provide

non-fund based facilities to the customers. Such facilities include ( i ) letters of credit

and (ii) bank guarantees. Under these facilities, banks do not immediately provide

credit to the customers, but take upon themselves the liability to make payment in

case the borrower defaults in making payment or performing the promise undertaken

by him.

Letter of Credit

A letter of Credit(L/C) is a written undertaking given by a bank on behalf of its

customer, who is a buyer , to the seller of goods, promising to pay a certain sum of

money provided the seller complies with the terms and conditions given in the L/C. A

Letter of Credit is generally required when the seller of goods and services deals

with unknown parties or otherwise feels the necessity to safeguard his interest.

Under such circumstances, he asks the buyer to arrange a letter of credit from his

banker. The banker issuing the L/C commits to make payment of the amount

mentioned therein to the seller of the goods, provided the latter supplies the specified

goods within the specified period and comply with other terms and conditions.

Thus by issuing Letter of Credit on behalf of their customers, banks help them in

buying goods on credit from sellers who are quite unknown to them. The banker

issuing L/C undertakes an unconditional obligation upon himself, and charge a fee

for the same. L/Cs may be revocable or irrevocable. In the latter case, the

undertaking given by the banker cannot be revoked or withdrawn.

Bank Guarantee

Banks issue guarantees to third parties on behalf of their customers. These

guarantees are classified into (i) Financial guarantee, and (ii) Performance

guarantee. In case of the financial guarantees, the banker guarantees the repayment

of money on default by the customer or the payment of money when the customer

purchases the capital goods on deferred payment basis.

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

completion of a construction work undertaken by the customer, failing which the bank

will make good the loss suffered by the beneficiary is known as a performance

guarantee.

9.9 CREDIT WORTHINESS OF BORROWERS

The business of granting advances is a risky one. It is more risky specially in case ofunsecured advances. The safety of the advance depends upon the honesty and

integrity of the borrower, apart from the worth of his tangible assets. The banker

has, therefore, to investigate into the borrowers ability to pay as well as his

willingness to pay the debt taken. Such an exercise is called credit investigation.

Its aim is to determine the amount for which a person is considered creditworthy.

Credit worthiness is judged by a banker on the basis of borrowers ( i ) character, (ii)

capacity and (iii) capital.


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Financing Working

Capital Needs1) Character includes a number of personal characteristics of a person e.g his

honesty, integrity, promptness in fulfilling his promises and repaying the dues,

sense of responsibility, reputation and goodwill enjoyed by him. A person having

all these qualities, without any doubt in the minds of others , possesses, an

excellent character and hence his creditworthiness is considered high.

2) CapacityIf the borrower possesses necessary technical skill, managerial ability

and experience to run a particular business or industry, success of such an

enterprise is taken for granted except in some unforeseen circumstances, Such a

person is considered creditworthy by the banker.

3) CapitalThe borrower is also expected to have financial stake in the business,

because in case the business fails, the banker will be able to realise his money

out of the capital put in by the borrower. It is a sound principle of finance thatdebt must be supported by sufficient equity.

The relative importance of the above factors differs from banker to banker and from

borrower to borrower. Banks are granting advances to technically qualified and

experienced entrepreneurs but they are required to put in a small amount as their own

capital. Reserve Bank of India has recently directed the banks to dispense with the

collateral requirement for loans upto Rs. 1 lakh. This limit has recently been further

increased to Rs. 5 lakh for the tiny sector.

Determination of credit worthiness of a borrower has become now a more scientific

exercise. Special institutions like rating companies such as CRISIL, ICRA, CARE,

have come on to the field and each of them has developed a methodology of its own.

This was discussed in earlier Block under Receivables Management in more detail.

Activity 9.3

1) Why do banks prefer Govt. and semi-govt. securities vis--vis Corporate

Securities for granting credit? Amongst the Corporate Securities why do they

prefer debt instruments?

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2) What are the advantages of discounting of bills to the banks? Is it compulsory

for corporate borrowers to use bills of Exchange?

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3) What do you understand by credit-worthiness of a borrower? What factors are

taken into account by the banker to determine credit-worthiness?

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9.10 SUMMARY


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