Project Appraisal to Working Capital

DECLARATION This is to certify that the project titled “Project Appraisal for working capital and term loan financing” is a bonafide work done by Mr. Nishit Chhabra, enrollment no : 09BSHYD0531, in partial fulfillment of the requirements of MBA program and submitted to IBS, Hyderabad. I also declare that the project is a result of my own efforts and that has not been copied from anyone. This work was not submitted earlier to any other university or institute for the award of the degree. Nishit Chhabra Place of SIP: New Delhi

ACKNOWLEDGEMENT It’s a great honor for me to undergo training at PUNJAB NATIONAL BANK, NEW DELHI as it gave me an opportunity to get practical exposure in the field of banking and understand the functioning of credit department. I am deeply indebted to my company guide, MR. SATISH PURI, SENIOR MANAGER, CAD, PNB for his valuable and enlightened guidance and encouragement during the training and who assisted me to a great extent in compilation of this report on PROJECT APPRAISAL FOR WORKING CAPITAL AND TERM LOAN FINANCING.

I am extremely grateful to him for giving me an opportunity to work with him and providing me with maximum resources and his valuable time. I am also thankful to my faculty guide, MR. V. NARENDER, LECTURER, IBS, HYDERABAD who has regularly guided me with his thoughts and given me regular feedbacks about my report and without his help, I would not have been able to shape my report. Last but not the least, I am also grateful to the MR. MONISH MISHRA who has been of immense help in clearing my queries and preparation of the report. NISHIT CHHABRA (09BSHYD0531) MBA- 2009-2011 BATCH

ICFAI BUSINESS SCHOOL, HYDERABAD EXECUTIVE SUMMARY Today, banks play a very important role in the economic life of the nation. The health of economy is closely related to the soundness of the banking system. The activities of the banks lead to stronger economic growth of country. Seeking opportunity for a wide exposure in banking sector, I, NISHIT CHHABRA (09BSHYD0531) undertook training at the CREDIT DIVISION of one of the most reputed bank in the country, PUNJAB NATIONAL BANK, NEW DELHI. Working here, I seek an opportunity to get the practical exposure of the banking industry and its functioning.

The objective of the study was to analyze in depth, the loan policies and its sanctioning for corporate bodies. Different corporate bodies require capital for two main purposes: •To finance their new projects •To meet their working capital requirements Based on the above needs, I have prepared a report titled CREDIT APPRAISAL FOR WORKING CAPITAL AND TERM LOAN FINANCING focusing on various credit facilities provided by the bank. This project explains in detail both these kind of financing through different case studies on different companies.

The study is undertaken to understand the process of project appraisal, credit risk rating and working capital assessment at PNB. Appraisal of project involves study of technical, economic and financial feasibility of the project. It is based on this analysis that a term loan for the project is sanctioned by the bank. However, in case of working capital financing, the basic task for the bank and the company is to calculate the Net working capital, which is done through working capital assessment. There are different ways based on which working capital can be calculated such as CMA Data, Nayak committee or Tandon Committee.

Lastly, this project explains how PNB carries out its risk rating to rate a company, in order to determine the credit risk involved with the company. This credit risk rating can be helpful in fixing the correct pricing for financing. All the above mentioned topic put together, form the core functions of credit department at PNB. In order to understand this core functions, I went through various books provided by the bank’s library to understand the basic theory behind working capital and appraisal system. Apart from books, I also studied live cases of ifferent companies which helped me a lot in understanding the basic procedure involved and preparing this report. Bank has to be very cautious while providing credit to companies and must ensure the end use of such funds is according to the proposed use by the company. Thus in order to minimize the risk and at the same time to earn suitable income in the form of interest, a thorough understanding of the project and the company is required. This project explains the basic procedure necessary to achieve the above mentioned objectives.

INTRODUCTION Banking Industry at a glance: Today, banks play a very important role in the economic growth of the country. The health of the economy is closely related to the soundness of the banking system. The activities of the banks lead to a stronger economic growth. Bank is the main confluence that maintains and controls the “flow of money” to make commerce of lending possible. Government uses it to control the flow of money by managing Cash Reserve Ratio (CRR) and thereby influencing the inflation level.

The functions of the banks include accepting deposits from the public and private institutions and then to direct them as loans and advances to various companies for growth and development of industries. The banks take the deposits at a lower rate of interest and give loans at higher rate, thus constituting the only source of income for banks. Banking in India has undergone startling changes in terms of growth and structure. Organized banking was active in India since the establishment of The General Bank of India in 1786. The Reserve Bank of India (RBI) was established as the central bank in 1955.

The Imperial Bank of India, the largest bank at that time, was taken over by the government to form state owned State Bank of India (SBI). RBI undertook an exercise to reduce the fragmentation in the Indian banking industry by merging weaker banks with stronger ones. The total number of banks reduced from 566 in 1951 to 85 in 1969. With the objective of reaching out to masses and servicing credit needs of all the industries, the government nationalized 14 large banks in 1969 followed by another 6 banks in 1980. This period saw an enormous growth in the banking sector. However, the economic reforms nleashed by the government in 1990s played a significant role in the growth of Indian economy. Entry of new private banks was permitted under RBI guidelines. A number of liberalization and deregulation measures like efficiency, asset quality and profitability were introduced to bring Indian banks in line with best international practices. With a view of giving the operational flexibility and functional autonomy, partial privatization was authorized, thus reducing the stake of government to 51%. Today, Indian banking system is among the best in the world and is growing at a very high pace. According to FICCI survey: Newly granted autonomy would certainly make public sector banks more competitive and profitable ? Up gradation of technology being used would certainly make Indian banks more competitive. About Punjab National Bank, 1895 Punjab National Bank was setup in 1895 in Lahore by patriots like Lala Lajpat Rai, Dayal Singh and Mahatma Hans Raj. PNB has the distinction of being the first Indian Bank to have been started solely with Indian Capital. The bank was nationalized in 1969 along with 13 other banks. Today, PNB is a professionally managed bank with a successful track record of over 115 years.

The bank has the largest branch network in India with over 4500 branches. PNB was ranked as 248th biggest bank in the world by Bankers Almanac, London. PNB is not only the first bank to specialize in credit rating models in India but also the first one to launch image based cheque transaction system in India for collection of cheques. PNB has proved itself offshore with more than 50 renowned international banks maintaining their rupee account with it. From its modest beginning, the bank has grown in size and stature to become a front line banking institution in India.

Based on its sound and prudent banking experience and consistent profit performance, PNB looks confidently to the future……. the name you can bank upon…… Profile and Achievements With over 38 million satisfied customers and 4500 offices, PNB has continued to retain its leadership position among the nationalized banks. The bank enjoys strong fundamentals and a good brand value. Besides being ranked as one of India’s top service brands, PNB has remained fully committed to its guiding principles of prudent banking. Apart from offering banking products, the bank has also entered the credit and debit card, life and non-life insurances business.

Over the years, PNB has achieved significant growth in business which amounted to Rs 3,64,463 crore at the end of March 2009. Today, PNB is among the top banks in the country achieving a net profit of Rs 3091 crores during FY 2008-09. PNB has always looked at technology as a key facilitator to provide better customer services and it has ensured that its IT strategy follows the business strategy so as to arrive at best fit. Along with 100% branch computerization, PNB covers all its branches under core business solutions (CBS) and thus providing anytime anywhere banking facility to all its customers.

The bank has also been offering internet banking services and thus has used technology as a key for growth. Financial Performance PNB continues to maintain its frontline position in the Indian banking Industry. The impressive operational and financial performance has been brought about by the bank’s focus on customer based businesses with thrust on SME, agriculture, asset liability management and efficiency in core operations. The financial performance of the bank can be seen in the table below (Rs Cr): ParametersMarch 2007March 2008March 2009

Operating profit361740065744 Net Profit154020493091 Deposits139860166457209760 Advances96597119502154703 Organizational Structure The bank has its corporate office at New Delhi and supervises 65 circle offices under which branches function. The delegation of powers is decentralized up to the branch level to facilitate quick decision making. Head About Credit Administration Division (CAD) Credit administration division looks after all the proposals of all types of loans which fall within the powers of GMs-HO/ED/CMD/board.

A credit proposal goes through different levels of verifications to enforce internal controls and other practices to ensure that exceptions to policies and procedures are reported in timely manner to an appropriate level of management for action. The bank has introduced “committee” system in credit sanction process where in every loan proposal falling within vested powers is discussed in credit committee. Such committees have been formed both at head office and zonal levels. The CAD is assisted by Risk Management Department (RMD) and the industry desk for risk analysis and technical feasibility of credit proposals.

CREDIT RISK MANAGEMENT STRUCTURE at PNB involves ?Risk Management division ?Zonal risk management department ?Regional risk Management department ?Risk management committee ?Credit risk management committee ?Credit audit review division PROJECT AT A GLANCE Project proposed The project focuses on various credit facilities provided by one of the most reputed bank in the country, Punjab National Bank. This study covers various aspects of working capital assessment and project appraisal from banker’s perspective. Various companies undertake new project or require capital for daily operations.

In order to finance these needs, a company approaches a bank for credit facility. CAD at PNB takes care of these facilities and based on the project proposed by the company and its credit worthiness, the bank sanctions it at a particular rate of interest. This project is explains the detailed analysis on working capital requirements, project appraisal and the credit risk rating done at PNB. In order to understand the above mentioned topics, one must be clear with basic concepts such as working capital management, balance sheet analysis, forecasting and cash budget.

Objective The objective of this project is to understand the basic concepts involved in providing credit facilities to various companies. The project uses the concepts studied in financial management and involves its practical implementation. The in depth analysis on these topics has been done in this project through different case studies which provide a better understanding and show its practical implementation. Methodology In order to learn and observe the practical implementation of the concepts, the following sources of information have been used Primary sources Meeting with the project guide ?Meeting with other staff members of various departments Secondary sources ?Book on instructions and policies on loan ?Study of proposals and manuals ?Various books by different authors ?Annual reports of companies WORKING CAPITAL ASSESSMENT Pre sanction Appraisal Working Capital is defined as the total amount of funds required for daily operations of the company. It is often classified as Gross Working Capital or net working capital (NWC). Gross working capital refers to the fund required for financing total current assets of a business unit.

NWC, on other hand is the difference between current assets and current liabilities (including bank borrowing) which is same as surplus of long term sources of funds over its uses. This NWC can be positive or negative, however, it is always desirable to have a positive NWC. Every business unit has an operating cycle which indicates that a unit procures raw materials from its funds, converts it into stock in process, which is again transformed into finished goods. Finally, these finished goods are transformed back into cash.

Alternatively, these finished goods are converted into receivables if sales are made on credit, which are later realized. FUND RAW MATERIAL SIP FG RECEIVABLES FUND This cycle continues and in order to keep the operating cycle going on, certain level of current assets has to be maintained. Thus the total working capital can be obtained by assessing the levels of various current assets in terms of time and their value as shown StageTimeValue IRaw MaterialHolding periodvalue of RM consumed during the period IISIPTime taken in converting the RM into FGRM + mfg. xp. during the period (Cost of production) IIIFGHolding period of FG before being soldR. M + mfg. exp. +adm. overheads for the period (Cost of sales) IVReceivablesCredit allowed to buyerRM+ Mfg. Exp. + Adm. Exp. + Profit for the period (sales) A series of committees were established to assess the working capital requirements of a business unit to suggest appropriate modalities of financing working capital. These are: Tandon Committee A committee headed by Shri. P. L. Tandon, the ex chairman of PNB, was constituted with view to suggest improvement in the existing cash credit system.

It suggested three methods of lending Ist method of lending According to this method, banks would finance up to a maximum of 75% of Working capital gap (WCG), which is the difference between the current assets and current liabilities excluding bank borrowings and the balance 25% was considered as a margin which would be bought through long term funds. IInd method of lending As per this method, banks would finance maximum of 75% of total current assets (TCA) and borrowers have to provide a minimum of 25% of TCA as margin out of long term uses. This will give a minimum current ratio of 1. 33.

IIIrd method of lending It is same as IInd method, with a difference that TCA excludes core current assets which is financed through long term funds. Examples: Current LiabilitiesCurrent assets Creditors for purchase100Raw material200 Other current liability50Stock in process20 Bank borrowings200Finished goods90 Receivables50 Other current assets10 350370 1st method2nd method3rd method Total C/A370Total C/A370Total C/A370 Less CL-Bank150Less 25% of CA92Less core95 BorrowingCA from LT 278275 W C Gap220Less CL-Bank150Less 25% from LTS69 25% of WCG from long term sources55BorrowingLess CL150

MPBF165MPBF128MPBF56 Current ratio1. 17: 1Current ratio1. 33: 1Current ratio1. 79: 1 Nayak Committee This method is also known as simplified turnover method and it focuses on small scale industries and other tiny industries having an aggregate fund based working capital limits up to Rs 5 crores. For such companies, the working capital requirement is calculated solely on the basis of their sales turnover. The sanctioning authority may satisfy themselves about the reasonableness of the projected turnover of the company based on their annual statements and assumptions.

These units would require bringing in 5% of turnover as the margin. In other words, according to nayak committee recommendations 25% of the projected turnover would be the working capital requirements of the company, of which 4/5th would be financed by the bank and the remaining 1/5th has to be brought by the owner as margin. For example, ABC is a company with a projected sales turnover of 100 crores. Then, working capital requirement is 25% of 100 i. e. 25 crores Of the above amount, bank would give 4/5th or 20 crores and the rest 5 crores is to be arranged by the owner as margin. Chore Committee

The RBI constituted, in 1979, a working group under the chairmanship of Mr. K. B Chore, to review the cash credit system with particular reference to the gap between sanctioned limit and the extent of their utilization. It was also asked to suggest alternative types of credit facilities which would ensure greater flexibility. Recommendations given were I) Continuance of the existing system:- It was not considered feasible to replace the cash credit system altogether by any other system. It was, however, considered that the existing system be streamlined and a periodical review of limits fixed under the system be made compulsory.

With this end in view, banks were advised to enforce review of all borrowal accounts with working capital limits of Rs. 10 lacs and over from the banking system at least once a year. ii) No bifurcation of cash credit accounts: – RBI’s earlier instruction to bifurcate the cash credit (as recommended by the Tandon Committee) into demand loan component and cash credit portion and to maintain a differential in interest rate between these two components be withdrawn. In cases, where the cash credit account have already been bifurcated, the banks be asked to take steps to abolish the differential interest rates with immediate effect. ii) Separate limit for peak level and non peak level periods:- While assessing the credit requirement of borrowers, bank should fix separate limits, where feasible, for the normal non peak level as also for the peak level credit requirements indicating the period during which the separate limits would be utilized by borrowers. However, in cases where there is no pro¬nounced seasonal trend, peak level and normal requirements would be treated as identical and limit fixed on that basis. CMA Data (Credit Monitoring arrangement) Companies approaching bank for working capital financing need to assess their working capital requirements.

This assessment forms the most basic part of working capital and companies must present a clear picture of this assessment to the banks for sanction of loan. CMA data is one of the methods used to assess working capital for a company and is involves preparation of a number of forms. These forms have a prescribed format in which they are presented and these forms clearly define financial position of the company. CMA data distinguishes current assets and current liabilities and determines the net working capital for the company for a particular period.

This net working capital is then used to determine one of the most important variables according to banker. This is called maximum permissible bank finance. The bank adopts a suitable method for the determination of MPBF using any of one method, Tandon or Chore committee. Preparation of CMA data forms an integral part of CAD and it is based on this data that the further steps are taken. Some of the forms included in CMA are ? Analysis of balance sheet ?Current assets and current liabilities ?Operating statement ?Maximum permissible bank finance The CMA is prepared by both the company as well as the bank.

The bank uses the CMA prepared by the company to analyze the correctness of the working capital requirements and understand its validity. However, it must be noted that the entire CMA data is prepared using the balance sheet of the company and certain other documents submitted by the company to the banks. The next section explains the preparation of CMA data using a balance sheet of a company NC Iron Pvt. Ltd. The CMA is prepared using its balance sheet for the year 2006-2007. The terms used in the CMA have been explained after the forms. Case 1: NC Iron Pvt. Ltd. Balance Sheet (2006-2007) I Sources of fundsas on Mar’2007as on Mar’2006

Shareholder’s funds: 1. Share capital27872987 2. Reserves and surplus96048355 Loan funds: 1. Secured loans1079614216 2. Unsecured loans158109 Deferred tax liability 87- 2343225667 II Application of funds Fixed Assets: 1. Gross block2082519729 2. Less: depreciation110588880 3. Net block976710849 4. Capital work in progress10411163 Investments118177 Deferred tax assets-56 Current assets, loans and advances 1. Inventories 92949899 2. Debtors74827177 3. Cash and bank balances311797 4. Loans and advances33892371 2328119544 Less: Current liabilities and provisions 1. Current liabilities107426102 2. Provisions3320 07756122 Net Current Assets1250613422 Total2343225667 Profit and Loss Account Incomeas on Mar’2007as on Mar’2006 Sales and operational income6645957953 Less: Excise duty51865345 Other income10692052 Variation in stocks10072232 6335155045 Expenditure Raw materials consumed5040246182 Mfg and operating costs34484719 Employment costs424409 Administrative, selling And general expenses32722129 Interest and finance charges1372996 Depreciation21952442 6111356877 Profit before tax2238(1833) Provision for taxation: Current year (including wealth tax Rs 68000) (236)(0. 71) Fringe Benefit tax(10)(8) Earlier years (net)-0. 9 Deferred tax(143)345 Profit after tax1849(1496) Balance from previous year(1421)75 Balance carried to balance sheet428 (1421) Basic earning per share (Rs)116. 82(112. 45) The above balance sheet is used to prepare CMA data as illustrated Form II: Operating statement S No. Particulars20062007 1. Gross sales i. Domestic ii. Exports57953 39983 1797066300 35838 30462 2. Less excise duty53455186 3. Net sales (1-2)5260861114 4. % change over previous-16% 5. Cost of sales: iRaw materials i. Imported ii. indigenous 22097 24085 14579 35823 iiOther spares14141133 iiiPower fuel and electricity26921886 vDirect labor332343 vOther mfg expenses613428 viDepreciation24422195 viiSub total (i to vi)5367556387 viiiAdd: opening Stock in process20684195 ixLess: closing Stock in process41954288 xCost of production5154856294 xiAdd: opening FG362467 xiiLess: closing FG4671381 xiiiTotal cost of sales5144355380 6. Selling, general and administrative expenses22063353 7. Sub total5364958733 8. Operating profit before interest(3-7)(1041)2381 9. Interest and finance charges9961372 10. Operating profit after interest (8-9)(2037)1009 11. Add: other income2051229 12. Less: other expenses– 13. Provision for taxation336389 14.

Net profit (10+11-12-13)(1496)1849 15. Retained profit(1496)1849 The above form is similar to the profit and loss account and tells about the expenses and income generated during the year. With the help of this table, the amount of profit generated during the year is calculated which is distributed in the form of dividend or transferred to reserves and surplus. The cost of production and cost of sales are determined which is used to calculate net profit. Items such as raw materials, depreciation, and spares consumption are directly involved with manufacturing activity and thus used to calculate the cost of production.

Income from other sources is considered under item other income which is not directly related to the main activity of the company. Form III: Analysis of balance sheet S No. Particulars20062007 Current liabilities 1. Short term borrowings from banks (including bills discounted)106918021 2. Short term borrowings from others– 3. Sundry creditors583410263 4. Advance payment from customers/dealers225436 5. Provision for taxation315 6. Dividend payable– 7. Other statutory liabilities– 8. Deposits/installments of term loans/debentures(due within one year)10001000 9. Other current liabilities1718 10.

Total current liabilities (1 to 9)1777019753 Term liabilities 11. Debentures– 12. Preference shares– 13. Term loans( excl. installment with in one year)25251775 14. Deferred payment credits– 15. Term deposits4343 16. Other term liabilities109158 17. Total term liabilities (11 to 16)26771976 18. Total outside liabilities (10 + 17)2044721729 Net worth 19. Share capital29872787 20. General reserves11662587 21. Share premium71546554 22. Other reserves3535 23. Deferred tax-87 24. Surplus/deficit in P/L account-428 25. Net worth1134212478 26. Total liabilities (18 +25)3178934207 Current assets 27.

Cash and bank balance1031 28. Investments (other than long terms) i. government and other trustee securities) ii. others – 3000 – – 29. Receivables other than deferred71777482 30. Inventory: a. raw materials b. stock in process c. finished goods d. other spares e. goods in transit 4563 4195 467 466 210 2860 4288 1381 613 151 31. Advance to suppliers of raw materials and spares22533285 32. Advance payment of taxes15- 33. Other current assets i. prepaid expenses 30 28 34. Total current assets (27 to 33)2238620120 Fixed assets 35. Gross block2089321866 36. Less: depreciation888011058 37. Net block1201310808

Other non current assets 38. Investments/book debts i. subsidiary companies ii. others iii. deferred tax iv. margin money 105 72 55 86 70 48 – 86 39. Other consumable spares– 40. Other non current assets (deposits and interest accrued)7375 41. Total other non current assets390279 42. Intangible assets (patents, goodwill, prelim expenses)– 43. Total assets (total of 34,37,41,42)3478931207 44. Tangible net worth (25-42)1134212478 45. Net working capital (34-10)4616367 46. Current ratio (34/10)1. 261. 02 47. TOL/TNW (18/44)1. 801. 50 This form gives a detailed analysis of the balance sheet of the company.

The balance sheet contains two important parts assets and liabilities. However, while talking about working capital assessment, we are basically interested in Current assets and current liabilities. Current Assets are those assets for the company that are reasonably expected to be converted into cash within one year during the normal course of business. Current assets include cash, account receivables, inventories, short term investments, prepaid expenses and many others as explained in the form. These assets are used for the main activity of the business and must be kept at certain reasonable level for the efficient working of the business.

For example, cash can be used to purchase raw materials from which finished goods can be manufactured. These current assets are very necessary for day to day operations of the company. Current Liabilities are the company’s debts or obligations that are due within one year. They appear on the balance sheet and include many important items such as short term debt, sundry creditors, provisions for taxation, dividend payable, advances from customers and installments of term loans. These liabilities are obligations that must be fulfilled within one year and form an important part of working capital since these are the short term sources of funds.

The form gives a detailed analysis of current assets and current liabilities which can be used to calculate the working capital requirements as shown in form V of CMA data. The above table shows the calculation of net working capital for NC Iron Pvt. Ltd. the working capital requirements for 2006 is Rs 4616 lacs and for the next year, it is Rs 367 lacs. Of the above calculated NWC, some part would be financed by the bank and the rest has to be brought by the owner. Form IV: Comparative statement S No. Particulars20062007 ACurrent assets 1. Raw materials month’s consumption)4563 (1. 17)2860 (0. 68) 2. Other consumable spares (month’s consumption)466 (3. 95)613 (6. 49) 3. Stock in process (month’s cost of production)4195 (0. 98)4288 (0. 91) 4. Finished goods (month’s cost of sales)467 (0. 11)1381 (0. 30) 5. Receivables (month’s sale)7177 (1. 49)7482 (1. 35) Total current Assets2238620120 Total current liabilities1777019753 This form explains the operating cycle of the company. Operating cycle of the firm forms an integral part of the company and tells about the ability of the company to generate cash in business.

It helps in understanding the health of the business and is calculated using various parameters such as (Raw materials holding period + Work in process holding period + finished goods holding period + receivables collection period) – Accounts payable period The figures in brackets in above table indicate these parameters which are of prime importance for the bank. The bank analyzes these parameters comparing it with previous year’s values to understand the trend, to check whether values are reasonable and to finally know the health of the company. These values can be in days or months.

Form V: Calculation of MPBF S No. Particulars20062007 1. Total current assets2238620120 2. Other current liabilities (excl. bank borrowings)707911732 3. Working capital gap (1-2)153078388 4. Min. stipulated working capital (25% of WCG)38272097 5. Actual/projected NWC4616367 6Item 3-4114806291 7Item 3-5106918021 8. MPBF (6 or 7 whichever is lower)106916291 9. Excess borrowing (4-5)(789)1730 The above table shows that the bank is eligible to give maximum finance of Rs 6291 lacs as working capital for year 2007. Actual NWC is the money that must be arranged by the owner to meet his requirements.

However, in 2007 he could only arrange 367 lacs as against 2097 lacs requires, so he ends up having an excess borrowing of 1730 lacs. This borrowing excludes the working capital financing. In the above table, we have used the Ist method of lending suggested by tendon committee, however we can also use the IInd method of lending in which we decide MPBF based on Total current assets. CASH CREDIT AND LETTERS OF CREDIT The working capital financing facilities provided by the bank to the companies is provided in two main forms. These are ? Fund based working capital ?Non fund based working capital

Fund based working capital is the one for which immediate funding is required such as the cash credit given by the bank on some rate of interest. While non fund based is the one in which immediate funding is not required such as letters of credit which allow companies to buy raw materials and other products by opening LCs in a particular bank. The NWC calculated defines the limit of the working capital financing. However, the limits for fund based and non fund based is also calculated as per the policy of the bank. The next section explains how these limits are calculated taking a hypothetical example of a company.

Cash Credit (CC) Cash credit is a facility granted against the hypothecation and pledge of goods or produce, book debts, bills and trust receipts. In cash credit accounts, borrower is allowed to draw on account within a prescribed limit or drawing power. Also when the advance is secured by pledge or hypothecation of goods, the security may be deposited or withdrawn by the borrower from time to time to suit his requirements. This drawing power is generally based on monthly stock statements depending upon the regularity and reliability and to ensure there is no double financing.

The security provided for CC must be maintained at a suitable margin to provide for any possible shortage in storage, shrinkage fall in prices or borrowers stake in the project. Moreover, these CC advance provided by the bank are charged at a particular rate of interest as applicable according the policies of the bank. Take for an example, a company XYZ Ltd. which does not has any non fund based working capital requirements. This company takes cash credit advances form the bank. This cash credit limit is calculated using the value of current assets and current liabilities of the company. Items Value (Rs Crores) . Chargeable current assets 2. Other current assets 3. Total current assets 4. Other current liabilities 5. Net current assets 6. Actual working capital 7. Permissible bank finance 8. Cash credit limit 3000 600 3600 (1+2) 600 3000 (3-4) 1000 (arranged by the owner) 2000 (5-6) 2000 The above table shows that the cash credit limit for the company is 2000 since it does not use the facility of Letters of credit. So the entire working capital requirement is financed through the cash credit advances of Rs 2000 Crores. However the company is not allowed to avail the above limit at once.

The drawing power is calculated using its monthly stock statement which includes only the chargeable current assets such as stocks and receivables. The table below shows the value of current assets of the company for a particular month which is used to calculate the drawing power. The bank maintains a margin of 25% on stocks and 30% on receivables which has to be arranged by the owner. As a result the total cash credit advance of 2000 crores has drawing power of 1050 + 700 i. e. 1750 crores. StocksReceivables Value of stocks 2000

Less: creditors 600 Chargeable stocks 1400 Less: 25% margin 350 CC for stocks 1050Receivables 1000 Less: 30% margin 300 CC for receivables 700 Drawing power 1750 Letters of credit (LC) Bank also provides companies with the facility of letters of credit, a type of non fund based facility which enables the companies to purchase raw materials or other components at credit and paying them later.

Letter of credit is issued by the bank at the request of the customer in favor of a third party informing him that the bank undertakes to accept the bills drawn on its customer up to the amount stated in the LC subject to the fulfillment of conditions stipulated therein. In simple language, LC is a letter issued by the bank on behalf of the customer to the third party guaranteeing him that the bank would be paying on behalf of the customers. The bank charges a particular fee from the customers for opening of an LC and a suitable rate of interest.

These LCs involve role of many bans such as buyer’s bank, seller’s bank, negotiating bank, and reimbursing bank. Letters of credit are of various types and are broadly classified as Revocable or irrevocable LCs An irrevocable LC cannot be revoked, cancelled or altered without the consent of the parties concerned. But in case of revocable LC, the bank reserves the right to cancel or alter the credit unilaterally by giving notice to all the parties concerned. Inland or foreign LCs

An inland LC is issued basically for domestic purchases where both the parties are in the same country while a foreign LC is issued when one of the parties is in different country. Drawn against payment (DP) or drawn against acceptance (DA) LCs When a buyer pays the bank for opening an LC as soon as it receives the goods is called DP while if a buyer pays the bank after a certain period upon receiving of goods, it is DA. This period can be 90 or 180 days and is called usance period. These terms and conditions are already defined in an LC. A variety of documents are required while using LC.

These include bills, Railway receipts, motor transport receipts and others. These are called documents of title to goods which is sent to the buyer by the seller to claim for goods. Calculation for LC limits Bank has its own procedure to calculate the limit for issuing LCs. This limit is calculated using the purchases made during the year by the company. Suppose the company XYZ Ltd. needs 1200 crores of Raw material for the current year. Then its LC require is calculated as shown below Total purchases under LC1200 LC required per month (divide by 12)100 Usance period90 days or 3 months

Lead time15 days or 0. 5 month Time for one cycle (opening and closing of LC)105 days or 3. 5 months LC required for one cycle 100 * 3. 5 = 350 Lead time is the time required to receive the goods which includes time taken during transit of goods from seller to buyer. Thus for the company the LC requirement is Rs 350 crores at any point in time for a particular year. Thus for XYZ Ltd. the working capital requirements can be divided into fund based and non fund based limits as shown below Fund Based: Cash credit: 2000 crores (if no LC) Non fund based: Letter of credit: 350 crores

PROJECT APPRAISAL SYSTEM What does it mean? Effectiveness of credit management in the bank is highlighted by the quality of its loan portfolio. Every bank is striving hard to ensure that its credit portfolio is healthy and its non performing assets are kept at the lowest level as both these factors have direct impact in its profitability. In the present scenario, efficient project appraisal has assumed a great importance as it can check and prevent induction of weak accounts. All possible steps need to be taken to strengthen the pre sanction appraisal.

Project appraisal has become very important in today’s world, as rapid changes are taking place in the technology and financial sector exposing banks to greater risks. These risks can be broadly classified as under Industry risks It includes risks like Government regulations and policies, availability of infrastructure facilities, industry ratings, industry scenario, technology up gradation, availability of inputs and product obsolescence Business risks It includes risks like operating efficiency, competition faced from the units, demand and supply position, cost of labor, cost of raw materials and other inputs and pricing of products.

Management risks It includes integrity, background, reputation of promoters, organizational setup, expertise of management officials, track record in execution of projects, track record in debt repayment and industrial relations. Financial risks It includes financial strength of the promoters, reliability and reasonableness of projections, past financial performance, financial ratios, adequacy of provisioning for bad debts and lastly qualifying marks of auditors. Considering the above risks, the project appraisal methodology should keep pace with ever changing economic environment.

The appraisal system aims to determine the credit needs of the borrower taking into account the financial resources of the client. The end objective of the appraisal system is to ensure that there is no under or over financing. The following aspects need to be taken care of while appraising a project MARKET (DEMAND AND POTENTIAL) The market demand and potential is to be examined for each product item and its variants by taking into account the selling price of the products to be marketed vis-a-vis prices of the competing products, discount structure, rrangement made for after sale service, competitor’s status and their level of operation with regard to production. Critical analysis is required regarding size of the market for the products, based on the present and expected future demand in relation to supply position and availability of substitutes. Competition from imported goods, government import policy and import duty structure also need to be evaluated. TECHNOLOGY ASPECTS In a dynamic market, the product, its variants and the product mix proposed to be manufactured in terms of quality, quantity, value, application and current taste requires thorough investigations. )Location and site Based on the assessment of factors of production, markets, government policies and other factors, location and site selected for unit with advantages and disadvantages should be such that the overall cost is minimized. It is to be seen that site selected has adequate availability of infrastructure facilities like power, water, transport, communication, state of information technology and is in agreement with govt. policies. The adequacy of size of land and building for carrying out its present or proposed activity with enough scope for accommodating future expansions need to be judged. ii)Raw materials

The cost of essential raw materials and consumables required, their past and future prices, quality, availability on regular basis, transportation charges and govt. policies need to be examined. iii)Plant and machinery, capacity and manufacturing process The selection of plant and machinery proposed to be acquired whether indigenous or imported has to be in agreement with required plant capacity, inputs, investment outlay and production cost while for the new unit, it is to be examined whether these are of proven technology as to its performance. The technology used should be latest and cost effective enabling the unit to compete in market.

Also plant and machinery and other equipments needed for various utility services, their supply position, specifications, price and performance as also suppliers credentials. Plant capacity and the concept of economic size has a major bearing on the present and the future plans of entrepreneurs and should be related to the availability of raw materials, product demand, product price and technology. The selected process of manufacturing indicating adequacy, availability and suitability of technology to be used along with plant capacity, needs to be studied in detail with capacities at various stages of production.

It is also to be ensured that arrangements are made for inspection at intermediate and final stages of production for ensuring quality of goods on successful commencement of production and completion wherever required. FINANCIAL ASPECTS The aspects which need to be analyzed under this head should include cost of project, means of financing, cost of production, breakeven analysis, financial statements as also profitability, financial ratios, sensitivity analysis which are discussed as under i)Cost of project and means of financing

The major cost components of any project are land and building including transfer, registration and development charges as also plant and machinery. It also involves consultancy and know how expenses which are payable to foreign consultants who are imparting the technical know how. Further preliminary expenses such as cost of incorporation of the company, its registration, and creation of feasibility report, salaries and travelling expenses also form a part of cost of project. It is to be ensured while appraising the project that the cost and various estimates given are realistic.

Besides bank’s loan, the project cost is normally financed by bringing capital in the form of equity, debentures, unsecured long term loans and deposits raised from friends and relatives which are not repayable till repayment of bank’s loan. Resources are raised for financing project by raising term loans from institutions and banks which are repayable over a period of time. The financing structure accepted must be in consonance with generally accepted levels along with adequate promoter’s stake. In case of project finance, the promoter may bring in upfront margin first before disbursement of loan starts. i)Profitability statement The profitability statement also known as income and expenditure statement is prepared after considering the net sales figure and details of direct costs relating to raw material, wages, power, fuel, and other manufacturing expenses to arrive at the figure of gross profit. The projections of profit or loss are prepared for a period covering repayment of loans. The economic appraisal includes scrutinizing all costs and examining the assumptions to ensure that these are realistic and achievable.

Generally speaking, a unit may be considered as financially viable, progressive and efficient if it is able to earn enough profits not only to service its debts timely but also for future growth. iii)Break even analysis Analysis of break even point of a business enterprise would help in knowing the level of output and sales at which the business enterprise just breaks even i. e. there is no profit no loss. A business earns profit if it operates at a level higher than the breakeven level and vice-a versa. The breakeven point can be calculated as

Breakeven point (units) = total fixed cost / (sales price per unit- variable cost per unit) Breakeven point (sales) = (total fixed cost* sales)/ (sales – variable costs) The fixed costs include all those costs which tend to remain the same up to a certain level of production while variable costs are those which tend to change in proportion with the volume of production. The breakeven analysis can help in making vital decisions relating to fixation of selling price, make or buy decision, maximizing production of the item. iv)Fund flow statement

A fund flow statement is often described as a statement of movement of funds. It is derived by comparing the successive balance sheets and finding put the net changes in various items. A critical analysis of the statement shows various changes in sources and uses of funds to ultimately give the position of net funds available for repayment of loans. v)Financial ratios While analyzing the financial aspects of project, it would be advisable to analyze the important financial ratios over a period of time as it may tell about the unit’s liquidity position, management’s stake in business and ability to service debts.

Important financial ratios are Debt equity ratio = debt (term liabilities) / equity (share capital, reserves and surplus) This ratio tells about the capital structure of the company and according to the policies of the banks, the infusion of equity or funds by promoters should be such that the stipulated level of DER is maintained at all times. However, the level of DER varies from case to case depending on the nature of project, promoter’s strength, availability of collateral securities apart from the type of industry.

Debt service coverage ratio = (net profit + annual interest + depreciation) Annual interest + amount of installments of principal The ratio of 1. 5 to 2 is considered reasonable. A very high ratio may indicate the need for lower repayment period. This ratio measures the ability of a company to service it debts besides indicating the margin of safety. Tangible net worth = tangible net worth (net worth – intangible assets) Total outside liabilities total outside liabilities (total liabilities- net worth) This ratio gives a view of borrower’s capital structure.

If the ratio shows a rising trend, it indicates that the borrower is relying more on his own funds and less on outside funds. Profit sales ratio = operating profit / sales This ratio gives the margin available after meeting cost of manufacturing. It provides a yardstick to measure the efficiency of production and margin on sales price. Current ratio = current assets / current liabilities Higher the ratio, greater the short term liquidity. This ratio is indicative of short term financial position of the business enterprise. It provides margin as well as it is a measure of business enterprise to pay off the current liabilities as they mature.

Internal rate of return It is the rate at which the Net present value of the project is 0 and the cost benefit ratio is equal to one. It is the rate of return of the project for the company and is a very important rate as according to the company. vi)Sensitivity analysis The sensitivity analysis is carried out by the banks in order to evaluate the capacity of the project to absorb shocks due to adverse movement in prices or some other adverse developments and sustain financial viability. The analysis is carried out to capture the decline in revenue of the project assuming adverse changes in certain parameters.

While preparing and appraising projects, certain assumptions are made in respect of certain critical and sensitive variables like selling price or cost price, product mix, plant capacity utilization and sales. The sensitivity analysis helps in arriving at profitability of the project wherein critical or sensitive elements are identified which assigned different values and the values are assigned are optimistic and pessimistic such as increasing and decreasing sales price. The critical variables can then be thoroughly examined so as to make possible improvements in the project and make it operational on viable lines.

The viability of a project is dependent on various factors which include selling price, cost of raw materials, cost of finance, availability of critical inputs and dependence on market like buyer/seller market. While preparing the projected statements, the value of these parameters are arrived at on the basis of certain reasonable assumptions. While analyzing the projects, the values of the key parameters are critically examined for financial viability of the project and are also subjected to sensitivity analysis which captures the effect of change in these values on the profitability of the project. MANAGEMENT AND ORGANIZATION

Appraisal of project would not be complete till it throws enough light on the persons behind the project i. e. management and organization of the unit. It is seen that some project may fail not because these are not viable but because of the ineffectiveness of the management and the organization in controlling various functions like production, marketing, finance and personnel. The appraisal report should highlight the strengths and weaknesses of the management by commenting on the background, qualifications, experience, capability of promoters, relations with labor, working condition and wage structure.

Further, management should be conducive to the type and size of business. APPRAISAL OF PROJECT- A check list An indicative list of issues which need to be looked into while appraising a project is given below Marketing ?Reasonable demand projections keeping in view the size of market, consumption level and the supply position ? Competitor’s status and their level of operation ?Technology advancement ?Marketing policies and distribution channels used ?Influence of govt. policies ?Marketing professionals employed, their competence, knowledge and experience Technical ?product and its life cycle, product mix and their application ?

Location, its advantages and disadvantages, availability of infrastructural facilities and govt. concessions ? Plant and machinery with supplier’s credentials and capacity attainable under normal working condition ? Manufacturing process indicating technology used. ?Plant and machinery- its availability, specifications, price and performance ? Govt. clearance like pollution control certificate ?Labor or manpower, type of skills required and its presence in the specified area Financial ?Total project cost and means of financing ?Profitability projections based on realistic capacity utilization and sales forecast with proper justification ?

Breakeven analysis and funds flow projections ?Financial ratios Managerial ?Resourcefulness of the management ?Qualifications and experience of the promoters and key management personnel ? Track record of management for execution of project and timely service of debts ? Internal control systems, delegation of adequate powers and entrusting responsibility at various levels Economic ?project contribution towards creation and rate of increase of employment opportunity, achieving self sufficiency ? project contribution towards the development of the region, its impact on environment and pollution control.

Case 2: Project Appraisal for NC Textiles This section explains briefly how the appraisal of a project is carried out. The project taken up by the company NC textile is setting up of a cotton spinning unit in Gujarat with a capacity of 52224 spindles. Project proposed NC textiles has proposed a project to set up an cotton spinning unit in Gujarat with an installed capacity of 52224 spindles and total outlay of Rs 211 crores. This unit is being set up as a part of backward integration strategy. The lower cost of production as a result of this integration will reflect in better profit margins and provide competitive edge to the company.

Industry and market assessment Cotton is the most important segment of the Indian textiles industry. With around 9. 37 million hectares under cotton cultivation during the year, India has the largest area employed for this purpose in the world. Currently, India is the second largest producer of raw cotton in the world after China and a significant portion of cotton is being exported in the form of yarn, fabrics and apparels. Demand and supply After a period of strong consumption, India’s cotton consumption growth slowed down significantly because of weak export demand for cotton yarns and textiles.

India’s cotton consumption is expected to stagnate in current year 2009 primarily because of worsening demand prospects in the domestic and international markets. This trend is likely to continue in 2009-2010 with an expected stagnation in cotton consumption. Cotton Price movement World cotton prices have increased sharply during 2003-2008. During 2007, prices remained stable but later on increased. This increase was due to tightening supplies and increased domestic supplies. Domestic raw cotton prices had increased significantly during last few years.

Despite heavy market arrivals, domestic prices had been relatively firm on strong export demand. However, during 2009, in spite of GOI raising minimum support price of cotton seeds by 40%, cotton prices have declined because of weaker international prices and less favorable demand prospects. Prices are expected to slide further on strong late season arrivals and government price measures to liquidate stocks. Despite the sharp rupee depreciation in 2009, Indian cotton is uncompetitive in international market due to higher domestic price and weaker international price. Growth potential

Since 1990s, India’s demand for domestic fibres has increased at a very high rate driven by strong economic growth and increase in per capita income. According to the data from Textile committee, GOI, India’s domestic textile purchases increased 8. 8% in 2007 as against 8. 6% in previous year. Extent of competition These are large number of textile players in Indian textile industry. Further there are some companies that have been established by equity contribution from technology licensors. Thus it can be concluded that there is a stiff competition in this segment of the industry.

Barriers to entry for new players It is a highly capital intensive industry with the net sales as percent of average assets being around 98%. However, players can enter into the industry in low value added stages with highly volatile returns. Marketing channels of the company Today, NC textiles is one of the largest institutional supplier in India amongst the organized sector players. It further plans to expand its presence in multi branded outlets, establish high impact presence in large format chain stores and set up exclusive stores for all its brands.

It must be noted that NC textiles has got well established marketing setup and strong distribution channels. Government policies The structure of the industry has been shaped by govt. policies, favoring small scale decentralized sectors. In 2000 , GOI came out with a new textile policy that outlines the direction of policy reforms to be followed in near term. The steps outlined in the policy are geared mainly towards removing the bias in policy towards the small scale sectors and promoting modernization. Technical Feasibility Location and site

The site chosen for the cotton spinning unit is in Gujarat which has many advantages such as ? Project located in well developed industrial area where land availability and conversion of land and getting necessary approval is easy. ?Low labor cost ?Easy availability of skilled and semi skilled labor ?Favorable industrial environment ?One of the new textile hub in India ?Peaceful labor environment ?All infrastructural facilities such as roads, natural gas for power plant and effluent discharge facility with water. Technology and Manufacturing process

The company has initiated the process of setting up world class integrated textile plant in order to make it one of the leading textile companies in the country. The adoption of new and latest technology will transform their manufacturing process into an efficient mode. NC textiles proposes to set up a spinning unit with a capacity of 52224 spindles, fully automated with almost non touch manufacturing process, automation would also reduce the number of workmen resulting in non dependence on workmen. The report explains the entire manufacturing process in detail and how the production would be carried out.

Availability of raw materials Cotton: The main raw material for the plant is cotton which is easily available in Indian markets at reasonable prices. Fuel: Company has made provisions to establish captive power plants of matching requirements. The supply line of gas is already available. Power: The power demand for the spinning unit has been estimated to be about 4 MW. The power requirements will be met by installing a 4 MW gas based captive power plant by the company itself. Firefighting: Appropriate equipment and gadgets such as carbon dioxide and dry powder extinguishers are considered.

Plant lighting: The entire plant area, work shed will be provisioned with adequate luminous lighting as per laid down industry standards. Further, all internal transport routes and general working areas are provided with adequate lighting. Pollution control measures The provision of water treatment plant and effluent treatment plant of matching capacities has been made to recover and recycle the water and minimize the water requirement. Financials Project cost and Means of Finance The total cost of the project is estimated to be 211 crores which will be financed through DER of 2. 2. The company proposes to bring in additional capital from its existing operations amounting to 60 crores which becomes the part of promoter’s contribution. The table below gives the project cost and means of finance: ParticularsCotton spinning unit at Gujarat (Rs lacs) Location XYZ Capacity 52224 spindles Cost of project Land 500 Building 2050 Plant and machinery13978 Misc. fixed assets2207 Total 18735 Preliminary expenses375 Interest during construction1281 Contingency expenses335 Margin money for working capital380 Total 2410 Grand total21100 Means of finance

Internal sources6000 Term loan15100 Grand total21100 From the above table, it can be concluded that the cost of the project has been estimated to be around 21100 lacs which the company is planning to finance through debt of Rs 15100 lacs and equity of Rs 6000 lacs. The DER for the project comes to around 2. 52. Overall comments on plant and machinery The cost of entire plant and machinery is estimated at 13978 lacs inclusive of freight, insurance, and taxes including custom duty. The suppliers for most of the equipments have already been finalized after suitable negotiations.

The comparative analysis related to the cost of plant and equipment has found to be comparable with other projects of similar capacity. Finally, the proposed plant, machinery and equipments are suitable for the envisaged production capacity and incorporate the well established and proven technology. Breakeven analysis As per the estimates, the company is to achieve breakeven point at the sales of Rs 7137 lacs at the capacity utilization of 90% in the year 2014. This is illustrated in the following table (Rs in lacs) Capacity 90 % (2014)Variable (%)Fixed (%)Variable costsFixed costs Sales (A)10499

Expenses Raw materials3929100%3929 Power and fuel713100%713 Wages 35080%20%28070 Factory overheads24280%20%19349 Adm. Expenses20880%20%16642 Interest 1794100%1794 Depreciation 1592100%1592 Total 88275281 (B)3547 Contribution (A- B)5218 Breakeven (sales)7137 Break even (capacity)67. 98% DSCR calculation DSCR helps to understand the debt servicing capability of the company. Generally, higher the ratio, greater is the ability of the company to pay its debt. The project of cotton spinning unit will start its commercial operations in 2013 and start generating revenue.

The profit that will be generated will first be used to pay off its debts in the form of installments and interest. This ratio forms a crucial part from banker’s point of view as it helps the bank to know the financial status of the company in near future. The profits generated in future are calculated based on certain assumptions which are the used to calculate DSCR (Rs in Lacs). Year ending 31 march20132014 EBITDA46955058 PAT549947 Depreciation18291829 Deferred tax liability189182 Interest19071657 Total44744616 Interest19071657 Installment18881888 Total37943544 DSCR1. 181. 30 ISCR2. 52. 79 The above table shows two ratios DSCR (debt service coverage ratio) which seems to be reasonable and it can be said that the company will be able to service its debt without any difficulty. ISCR (interest service coverage ratio) tells the ability of the company to pay the interest on debt on time. The above values of this ratio seem to be satisfactory without causing any problem to the company. Normally, the above ratios are calculated for the entire period of debt (period for which the debt service is availed) and the average of these ratios is considered for bank’s purpose.

Management The project is being promoted by one of the largest companies in the country, NC textiles. The promoters have long experience of setting up of new textile projects, running and operating plants with complete range of textile fabrics, backed by well qualified team of professional and management personnel. The management has a good track record of execution of projects of similar costs and has serviced its debts timely. The vast experience of the management personnel is the major strength of the company which makes it eligible for sanctioning of loan.

The company has planned expansion with the best technology and machinery from suppliers of good reputation to become competitive in international market. The company is also known for maintaining good industrial relations and has a very good reputation in the domestic market. Economic The project has also been considered useful for the society as a whole. The project would be creating a large number of employment opportunities for the locals thus providing self sufficiency and financial support to the workers. This distribution of income would ultimately lead to increase in saving and the standard of living for the people.

Finally, the project aims to develop textiles of world class quality that will be able to give stiff competition to international brands and thus leading to the growth of Indian economy. The above section explains the appraisal system followed at PNB. This appraisal is carried out by the technical cell of the bank and it is based on this report that the viability of the project is determined. The techno-economic viability of the project is of major concern for the bank and forms an important step in decision making.

The appraisal system at PNB is very crucial for sanctioning of financing facility and with the help of it, the bank gets to know in depth detail of the company and the project being undertaken. CREDIT RISK RATING What is Credit Risk? The risk that the borrower might fail to meet the obligations towards the bank in accordance with the agreed terms and conditions is called credit risk. It measures the inability or unwillingness of the borrower to pay its debt. Identification of credit risk forms the crucial part of risk management and is very important for the bank.

It helps the bank in determining the potential defaulters and abstain the bank from providing financing facility to such borrowers or in case they provide, than provide them at a higher r

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