“A study on credit appraisal for

working capital finance to

SMEs at ING Vysya bank”

SUBMITTED BY

HERM
AS CHRISTO.P

09BA021
Objectives:

 To study the credit policy of the bank and the credit appraisal process as a
whole.
 To study the credit appraisal system for working capital finance to SME’s
 To suggest the bank to improve the credit appraisal policy

Methodology:
Secondary data are those, which have already been collected by some one
else. Secondary Data

Sources those helpful in research were:-

1. Balance sheet of the company

2. Credit policy book of the bank
3. Bank website
4. Various articles on banking

Tools :

1. Ratios to be used
 Liquidity ratio
 Capitalization ratio
 Activity ratio
 Profitability ratio
2. Working capital assessment of the company
Under MPBF method(MAXIMUM PERMISSIBLE BANK FINANCE)
Introduction of the topic

Working Capital Finance

ING Vysya offers working capital finance to meet the entire range of short-term
fund requirements that arise within a corporate’s day-to-day operational cycle.

The ING Vysya working capital loans can help company in financing inventories,
managing internal cash flows, supporting supply chains, funding production and
marketing operations, providing cash support to business expansion and carrying
current assets.

ING Vysya working finance products comprise a spectrum of funded and non-
funded facilities ranging from cash credit to structured loans, to meet the different
demands from all segments of industry, trade and the services sector. Funded
facilities include cash credit, demand loan and bill discounting. Demand loans are
considered also under the FCNR (B) scheme. Non-funded instruments comprise
letters of credit (inland and overseas) as well as bank guarantees (performance and
financial) to cover advance payments, bid bonds etc.

Lending continues to be a primary function in banking. In the liberalized Indian

economy, clientele have a wide choice. External Commercial Borrowings and the
domestic capital markets compete with banks. In another dimension, retail lending-
both personal advances and SME advances- competes with corporate lending for
funds and for human resources. But lending by nature cannot be an aggressive
selling activity, disregarding the risks involved. Bank has to be competitive
without compromising on the basic integrity of lending. The quality of the Bank’s
credit portfolio has a direct and deep impact on the Bank’s profitability.
ING VYSYA’S LOAN POLICY

The basic tenets of ING Vysya Loan Policy include the following:

 Optimum exposure levels are set out in the Policy to different sectors in
order to ensure growth of assets in an orderly manner.
 The policy sets out minimum scores/hurdle rates
 The policy lays down norms for take over of advances from other banks/
financial institutions
 As a matter of policy the bank does not take over any Non-performing
Asset(NPA) from other banks.

CREDIT APPRAISAL STANDARDS

QUALITATIVE:

At the outset, the proposition is examined from the angle of viability and also
from the bank prudential levels of exposure to the borrower, group and
industry. Thereafter, a view is taken about bank’s past experience with the
promoters, if there is a track record to go by. Where it is a new connection for
the bank but the entrepreneurs are already in business, opinion reports from
existing bankers and published data if available are carefully perused. In case
of a maiden venture, in addition to the drill mentioned heretofore, an element
of subjectivity has to be perforce introduced as scant historical data would be
available and weightage has to be placed on impressions gained out of the
serious dialogues with the promoters and his business contacts.
 QUANTITATIVE

1. Working capital: the basic quantitative parameters underpinning the

Bank’s credit appraisal are as follows:

I. Liquidity: current ratio (CR) of 1.33 will generally be considered as a

benchmark level of liquidity. However, the approach has to be flexible. Cr of
1.33 is only indicative and may not be deemed mandatory. In cases where the
Cr is projected at a level lower than the benchmark or a slippage in the CR is
proposed, it alone will not be a reason for rejection of the loan proposal or for
sanction of loan. In such cases, the reasons for low CR should be carefully
examined and in deserving cases the CR as projected may be accepted. In cases
where projected CR is found acceptable, working capital finance as requested
may be sanctioned.
II. Net working capital: although this is a corollary of current ratio, the
movements in Net working capital are watched to ascertain whether there is a
mismatch of long term sources via-a-vis long term uses for purposes which
may not be readily acceptable to the Bank so that corrective measures can be
suggested.
III. Financial Soundness: this will be dependent upon the owner’s stake or the
leverage. Here again the benchmark will be different for manufacturing,
trading, hire purchase and leasing concerns. For industrial ventures Total
Outside Liability/Tangible Net Worth ratio of 3.0 is reasonable but deviations
in selective cases for understandable reasons may be accepted by the
sanctioning authority.
IV. Turn –over: the trend in turn-over is carefully gone into both in terms of
quantity and value as also market share wherever such data are available. What
is more important is to establish a steady output if not a rising trend in
 quantitative terms because sales realization may be varying on account of price
fluctuations.
V. Profits: while net Profit is the ultimate yardstick, cash accruals, i.e. profit
before depreciation and taxation conveys the more comparable picture in view
of changes in rate of depreciation and taxation which may have taken place in
the intervening years. However, for the sake of proper assessment, the non-
operating incomes are excluded, as these are usually one time or extraordinary
income. Companies incurring net losses consistently over 2 or more years will
be given special attention, their accounts closely monitored, and if necessary,
exit options explored.
VI. Credit Rating: wherever a Credit Rating Agency for any instrument has rated
the company, this will be taken into account while arriving at a final decision.
However, as the credit rating involves additional expenditure, bank would not
normally insist on this tool if such an agency had already looked into the
company finances.
VII. Capital Market: where the company’s shares are listed in stock exchanges,
the movement of the price of its share, the market value of shares like those of
competitors in the same industry, response to public/right issues are also kept
in view as these are reflective of the corporate image in the eyes of the
investors’ community.
1. Term Loan / Deferred Payment Guarantees
I. In case of term loans and deferred payment guarantees, the project report is
obtained from the customer, which may have been compiled either in-house or
by a firm or consultants/ merchant bankers. The technical feasibility and
economic viability is vetted by the Bank and wherever it is felt necessary.
II. Promoter’s contribution of at least 20% in the total equity is what bank
normally expects. But the promoter contribution may vary largely in mega
 projects. Therefore, there cannot be a definitive benchmark. The sanctioning
authority will have the necessary discretion to permit deviations.

2. FINANCIAL RATIOS USED FOR CREDIT RISK ASSESSMENT

Under the CRA system, financial risks in a proposal are sought to be captured
through some relevant ratios. Different ratios are used for assessing risks for
extending working capital finance and term loans under CRA system. Also, the
ratios used for assessing risk for financing NBFC’s are different.

Working capital finance (all segments except NBFC’s)

The following are the ratios used for working capital finance:

1. Current ratio: it is calculated by dividing current assts by current liabilities. It

helps to measure liquidity and financial strength.

2. Care should be taken in interpreting this ratio as:

a. It is applied at a single point in time, implying a liquidation approach, rather

than a judgment on the going concern, for it does not explicitly take into account
the revolving nature of current assets and current liabilities.

b. The seasonal character of the business resulting in fluctuating current ratio is

a disturbing factor.

3. Liquidity could be severely affected if current liabilities exceed current assets.

4. The higher the ratio the better the liquidity position.

2. TOL/TNW: total outside liabilities divided by total net worth.

i. It indicates size of stake, stability and degree of solvency.

ii. Indicated how high is the stake of the creditors.
iii. Indicated what proportion of the company’s finance is represented by the
tangible net worth
iv. The lower the ratio the greater the solvency.
v. The ratio is usually higher in case of SME’S. Still anything over 3 or 4
should be viewed with concern.
vi. The ratio should be studied at the peak level of operations.

3. PBDIT/interest (times): this is called ‘interest coverage’ ratio. In the current

context, the servicing capability of loan is very crucial. This ratio, which indicates
the number of times the gross earnings cover the interest payable is an indicator of
the measure of comfort that profitability provides.

i. Higher ratio indicates comfortable debt servicing capability from the cash
accrual of the company.
ii. A ratio of more than 3 is considered comfortable, where as a ratio of 2
and below is considered risky.

4. ROCE or ROA (%): profit before depreciation, interest and tax/ total capital
employed multiplied by 100.

i. High ratio indicates that the business is run on profitable lines.

 ii. It is a relationship between the profits made during the year and the
finance employed to make profits i.e. it shows the earning power of the
business.
iii. It is a measure of the management’s skill in profitably employing the
funds in the company.
iv. It should not only compare favorably with the rate of interest on
loanable funds in the market but also compensable for the risk involved
in running the business.

5. Operating profits/Net sales (%): indicates operating efficiency. It should be

comparable with similar industries. Trend for the company over a period should be
encouraging.

6. Inventory / net sales + receivables / gross sales: expressed in days, this ratio
captures the turnaround period f major items of the current asset

i. Higher the figure, the slower is the turnaround of current asset and in
general higher the risk.
ii. This ratio will vary across industries.
iii. For assessment of risk, a shorter working capital cycle can be regarded
less risky.
iv. Specific industry parameters should also be kept in mind while
assessing the risk under this ratio.
v. In general, it is expected that the working capital should be turned over
at least twice.
For NBFCs , the ratios are:

1. Current ratio

2. TOL/NOF: total outside liabilities/ net owned funds ratio represents the
extent to which the company is leveraged. Net owned RBI uses funds as a
reference for registration and acceptance of deposits from public. NOF
represents total net worth, less investment in excess of 10% of owned funds
as stipulated by RBI.
i. Higher ratio indicates increased dependence on borrowings and other
liabilities.
ii. A ratio of 3 and below is considered very healthy, while a ratio above
7 is considered risky.

3. PBDT/ Total Assets: this ratio is a measure of gross profitability or gross

return from the activity of the company. In the CPA models, for
manufacturing company, the numerator is PBDIT but in NBFCs interest
payment is a major component. So, it is more relevant to take PBDT for
NBFCs.
i. A percentage of more than 10 is considered healthy whereas below
2 is considered risky.

4. PAT/ Total Income: total income= income minus other than non-recurring
income. This ratio represents the profitability of operations. Total income
from operations may be considered as equal to total sales of a manufacturing
company.
 i. a percentage of 11% and above is considered healthy and below 3 is
considered risky.

5. (Total income – other non-recurring income)/interest expenses: the

interest coverage ratio in respect of NBFCs is calculated by dividing total
income less non-recurring income with interest expenses. This ratio
measures the cushion available for meeting interest liability.
i. A ratio of 3 or more is considered healthy while less than 1 is
considered highly risky.

6. Overdue/ demand raised ratio: this ratio measures collection efficiency.

The term “over dues” represents claim amounts which have not been
received till due date.
i. A ratio of 1 and below is considered very healthy and more than 5
is considered very risky.

7. NPA/ total working assets ratio: NPAs in this context refer to lease rentals
and hire purchase installments overdue for more than 12 months.
3.WORKING CAPITAL AND ITS ASSESSMENT

The objective of running any industry is earning profits. An industry will require
funds to acquire “fixed assets” like land and building, plant and machinery,
equipments, vehicles etc… and also to run the business i.e. its day to day
operations.

Working capital is defined, as the funds required carrying the required levels of
current assets to enable the unit to carry on its operations at the expected levels
uninterruptedly.

Thus working capital required (WCR) is dependent on

i. The volume of activity (viz. level of operations i.e. Production and Sales)
The activity carried on viz. manufacturing process, product, production
programme, and the materials and marketing mix

Though there are various methods used for assessing the quantum of working
capital requirement for an industry, the following are commonly used.

Operating cycle method

Any manufacturing activity is characterized by a cycle of operations consisting of

purchase of raw materials for cash, converting them into finished goods and
realizing cash by sale of these finished goods. The time that lapses between cash
outlay and cash realization by sale of finished goods and realization of sundry
debtors is known as length of operating cycle. That is , the operating cycle consists
of:

i. Time taken to acquire raw materials and average period for which they are
in store.
 ii. Conversion process time
iii. Average period for which finished goods are in store and
iv. Average collection period of receivables (sundry debtors).
Operating Cycle is also called cash-to-cash and indicates how cash is converted
into raw materials, stocks in process, finished goods, bills (receivables) and
finally backs to cash. Working capital is the total cash that is circulating in this
cycle. Therefore, working capital can be turned over or deployed after
completing the cycle.

Factors, which influence working capital requirement, are:

i. Level of operating expenses and

ii. Length of operating cycle.
Any reduction in either of the both will mean reduction in working capital
requirement or indicate an efficient working capital management.

It can thus be concluded that by improving that by improving the working capital
turnover ratio (i.e. by reducing the length of operating cycle) a better management
(utilization) of working capital results. It is obvious that any reduction in the length
of the operating cycle can be achieved only by better management only by better
management of one or more of the individual phases of the operating cycle period
for which raw materials are in store, conversion process time, period for which
finished goods are in store and collection period of receivables. Looking at whole
problem from another angle, we find that we can set up extremely clear guidelines
for working capital management viz. examining the length of each of the phases of
the operating cycle to assess the scope for reduction in one or more of these
phases.
The length of the operating cycle is different from industry to industry and from
one firm to another within the same industry. For instance, the operating cycle of a
pharmaceutical unit would be quite different from one engaged in the manufacture
of machine tools. The operating cycle concept enables to assess working capital
need of each enterprise keeping in view the peculiarities of the industry it is
engaged in and its scale of operations. Operating cycle is an important
management tool in decision –making.

Traditional method of assessment of working capital requirement

The operating cycle concept serves to identify the areas requiring improvement for
the purpose of control and performance review. But, as bankers, we require a more
detailed analysis to assess the various components of working capital requirement
viz., finance for stocks, bills etc.

Bankers provide working capital finance for holding an acceptable level of current
assets viz. raw materials, stock-in-process, finished goods and sundry debtors for
achieving a predetermined level of production and sales. Quantification of these
funds required to be blocked in each of these items of current assets at any time
will, therefore provide a measure of the working capital requirement of an
industry.

Raw material: any industrial unit has to necessarily stock a minimum quantum of
materials used in its production to ensure uninterrupted production. Factors, which
affect or influence the funds requirement for holding raw material, are:

i. Average consumption of raw materials.

 ii. Their availability – locally or form places outside, easy availability /
scarcity, number of sources of supply
iii. Time taken to procure raw materials (procurement time or lead time)
iv. Imported or indigenous.
v. Minimum quantity supplied by the market (Minimum Order Quantity
(MOQ)).
vi. Cost of holding stocks (e.g. insurance, storage, interest)
vii. Criticality of the item.
viii. Transport and other charges (Economic Order Quantity (EOQ)).
ix. Availability on credit or against advance payment in cash.
x. Seasonality of the materials.
This raw material requirement is generally expressed as so many months
requirement (consumption).

Stock in process: barring a few exceptional types of industries, when the raw
material get converted into finished products within few hours, there is
normally a time lag or delay or period of processing only after which the raw
materials get converted into finished product. During this period of processing,
the raw materials get converted into finished goods and expenses are being
incurred. The period of processing may vary from a few hours to a number of
months and unit will be blocked working funds in the stock-in-process during
this period. Such funds blocked in SIP depend on:

i. The processing time

ii. Number of products handled at a time in the process
iii. Average quantities of each product, processed at each time (batch
quantity)
iv. The process technology
 v. Number of shifts.

Finished goods: all products manufactured by an industry are not sold

immediately. It will be necessary to stock certain amount of goods pending sale.
This stock depends on:

i. Whether the manufacture is against firm order or against anticipated order

ii. Supply terms
iii. Minimum quantity that can be dispatched
iv. Transport availability and transport cost
v. Pre-dispatch inspection
vi. Seasonality of goods
vii. Variation in demand
viii. Peak level/ low level of operations
ix. Marketing arrangement- e.g. direct sale to consumers or through dealers/
wholesalers.
The requirement of funds against finished goods is expressed so many months’
cost of production.

Sundry debtors (receivables): sales may be affected under three different

methods:

i. Against advance payment

ii. Against cash
iii. On credit
A unit grants trade credit because it expects this investment to be profitable.
It would be in the form of sales expansion and fresh customers or it could be
 in the form of retention of existing customers. The extent of credit given by
the industry normally depends upon:

i. Trade practices
ii. Market conditions
iii. Whether it is bulky by the buyer
iv. Seasonality
v. Price advantage
Even in cases where no credit is extended to buyers, the transit time for the goods
to reach the buyer may take some time and till the cash is received back, the unit
will have to be cut out of funds. The period from the time of sale to receipt of
funds will have to be reckoned for the purpose of quantifying the funds blocked in
sundry debtors. Even though the amount of sundry debtors according to the unit’s
books will be on the basis of Sale Price, the actual amount blocked will be only the
cost of production of the materials against which credit has been extended- the
difference being the unit’s profit margin- (which the unit does not obviously have
to spend)
The working capital requirement against Sundry Debtors will therefore be
computed on the basis of cost of production (whereas the permissible bank finance
will be computed on basis of sale value since profit margin varies from product to
product and buyer to buyer and cannot be uniformly segregated from the sale
value).

The working capital requirement is expressed as so many months’ cost of

production.
Expenses: it is customary in assessing the working capital requirement of
industries, to provide for 1 month’s expenses also. A question might be raised as to
why expenses should be taken separately, whereas at every stage the funds
required to be blocked had been taken into account. This amount is provided
merely as a cushion, to take care of temporary bottlenecks and to enable the unit to
meet expenses when they fall due. Normally 1-month total expenses, direct and
indirect, salaries etc. are taken into account.

While computing the working capital requirements of a unit, it will be necessary to

take into account 2 other factors,

i.Is the credit received on purchases- trade credit is a normal practice in trading
circles. The period of such credit received varies from place to place, material to
material and person to person. The amount of credit received on purchases reduces
the working capital funds required by the unit.
Industries often receive advance against orders placed for their products. The
buyers, in certain cases, have to necessarily give advance to producers e.g. custom
made machinery. Such funds are used for the working capital of an industry.

Projected Annual Turnover Method for SME units (Nayak Committee)

For SME units, which enjoy fund based working capital limits up to Rs.5 crore, the
minimum working capital limit should be fixed on the basis of projected annual
turnover. 25% of the output or annual turnover value should be computed as the
quantum of working capital required by such unit. The unit should be required to
bring in 5% of their annual turnover as margin money and the Bank shall provide
20% of the turnover as working capital finance. Nayak committee guidelines
correspond to working capital limits as per the operating cycle method where the
average production/ processing cycle is taken to be 3 months.

Tandon and Chore Committee Recommendations

Till year 1996-97, banks in India were following the concept of Maximum
Permissible Bank Finance (MPBF) for working capital limits, as enunciated in
Tandon and Chore committee reports. In the monetary and credit policy for the
first half-year of 97-98, RBI announced withdrawal of their guidelines on
assessment of working capital finance based on the MPBF concept. State Bank of
India felt that many aspects of the Credit Monitoring Arrangement (CMA)
followed till then were based on sound principles of lending. Hence, while there
was a need to continue to adopt these, certain flexibility was required to be brought
into the method to avoid any rigid approach to fixing the quantum of finance. In
the area of supervision, there was a need to rationalize the existing financial follow
up procedure. As a consequence, the bank adopted the projected Balance Sheet
method in the second half of the year 1997-98 onwards.

MPBF METHOD

The Tandon Committee was appointed o suggest a method for assessing the
working capital requirements and the quantum of bank finance. Since at that time,
there was scarcity of bank’s resources, the Committee was also asked to suggest
norms for carrying current assets in different industries so that bank finance was
not drawn more than the minimum required level. The Committee was also asked
to devise an information system that would provide, periodically, operational data,
business forecasts, production plan and resultant credit needs of units. Chore
Committee, which was appointed later, further refined the approach to working
capital assessment. The MPBF method is the fall out of the recommendations made
by Tandon and Chore Committee.

Approach to lending
Regarding approach to lending: the committee suggested three methods for
assessment of working capital requirements.

First method
The quantum of bank’s short-term advanced will be restricted to 75% of working
capital gap where “working capital gap” is equal to “current assets” minus “current
liabilities other than bank borrowings”. Remaining 25% is to be met from long-
term sourced.Second method

Net working Capital should at least be equal to 25% of total value of acceptable
level of current assets. The remaining 75% should first be financed by Other
Current Liabilities and the bank may finance balance of the requirements.

Third method
The borrower should provide for entire core current assets and 25% balance
current from the Net working Capital.

To compute the level of working capital requirement of the unit, the analyst has to
assess the level of current assets it has to carry, consistent with its projected level
of production and sales. Inventory and receivables constitute most of the current
assets.

Projected Balance Sheet Method (PBS)

The PBS method of assessment will be applicable to all C&I borrowers who are
engaged in manufacturing, services and trading activities who require fund based
working capital finance of Rs. 25 lacs and above. In case of SSI borrowers, who
require working capital credit limit up to Rs. 5 cr, the limit shall be computed on
the basis of Nayak Committee formula as well as that based on production and
operating cycle of the unit and the higher of the two may be sanctioned.. The
assessment will be based on the borrower’s projected balance sheet, the funds flow
planned for current/ next year and examination of the profitability, financial
parameters etc. unlike the MPBF method, it will not be necessary in this method to
fix or compute the working capital finance on the basis of a stipulated minimum
level of liquidity (Current Ratio). The working capital requirement worked out is
based on the following:

i. CMA assessment method is continued with certain modifications.

ii. Analysis of the Profit and Loss account, Balance Sheet, Funds flow
etc. for the past periods is done to examine the profitability, financial
position, and financial management etc of the business.

iii. Scrutiny and validation of the projected income and expenses in the
business and projected changes in the financial position (sources and
uses of funds). This is carried out to examine whether these
parameters are acceptable from the angle of liquidity, overall gearing,
efficiency of operations etc.

In the PBS method, the borrower’s total business operations, financial position,
management capabilities etc. are analysed in detail to assess the working capital
finance required and to evaluate the overall risk.

There will not be a prescription like mandatory minimum current ratio or

maximum level of a current asset. Under the method, assessment of WC
requirement will be carried out in respect of each borrower with proper
examination of all parameters relevant to the borrower and their acceptability. The
assessment procedure is as follows:

i. Collection of financial information from the borrower

ii. Classification of current assets / current liabilities

iii. Verification of projected levels of inventory/ receivables/ sundry

creditors

iv. Evaluation of liquidity in the business operation

v. Validation of bank finance sought