Debt Funding-Indian Fund Based (Government Debt & Banking Finance) – CS Professional Study Material

Chapter 7 Debt Funding-Indian Fund Based – Corporate Funding and Listing in Stock Exchange ICSI Study Material is designed strictly as per the latest syllabus and exam pattern.

Debt Funding-Indian Fund Based – Corporate Funding & Listing in Stock Exchange Study Material

Question 1.
Write a short note on the following:
Bills re-discounting (Dec 2012, 3 marks)
Answer:
Bills Re-discounting: Bills Re-discounting means the re-discounting of trade bills, which have already been purchased by/discounted with the bank by the customer. These trade bills arise out of supply of goods/ services. Bill re-discounting is a money market instrument where the bank buys the bill (i.e. Bill of Exchange of Promissory Note) before it is due and credits the value of the bill after a discount- charge to the customer’s account. Now, the bank which has discounted the bill may require getting it ‘re-discounted’ with some other bank to get the fund.

Question 2.
Write a note on Rupee Deemed Export Credit. (Dec 2020, 3 marks)
Answer:
Rupee Deemed Export Credit:

1. A deemed export transaction is one in which goods are supplied to a project in India itself which are funded by International/Multilateral agencies or where goods are supplied to units in SEZs or foreign shipping companies calling on Indian ports, supply of goods to foreign tourists etc.

2. Such that the proceeds of such goods supplied will be paid in foreign currencies. Such transactions are treated as prima facie export transactions and enjoy incentives and other concessions given to normal export transactions.

3. Pre-shipment and Post-shipment credit facilities granted to Rupee Deemed Export Credit transactions are similar to finance/credit extended under Rupee Export credit Pro-shipment as well as Post-shipment as described herein.

4. Although in deemed export transactions the date of supply to the projects /SEZ units/foreign tourists is taken as date of export.

5. Also the value of the transaction will be based on Free on Rails (FOR) basis instead of usual Free on Board (FOB) basis, usually associated with export transactions.

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material

Question 3.
Distinguish between the following
Bill Discounting and Factoring (June 2019, 5 marks)
Answer:
Bill Discounting: Commercial bills are basically negotiable instruments accepted by buyers for goods or services obtained by them on credit. Such bills being bills of exchange can be kept upto the maturity date and encashed by the seller or may be endorsed to a third party in payment of dues owing to the latter. The most common practice is that the seller who gets the accepted bills of exchange discounts it with the Bank or financial institution or a bill discounting house and collects the money (less the interest charged for the discounting).

Factoring: Factoring is a financial transaction wherein an entity sells its receivables to a third party called a factor’, at discounted prices. Factoring is a financial option for the management of receivables. In simple definition it is the conversion of credit sales into cash. In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80% (rarely up to 90%) of the amount immediately on formation of agreement.

Question 4.
Distinguish between the following:
Bills Finance and Project Finance (Dec 2019, 5 marks)
Answer:
Bills Finance and Project Finance are two different methods of financing:

Bills Finance:
Bills finance is short term and self liquidating finance in nature. The bills can be classified as Demand Bills and Usance Bills. Demand Bill is purchased and Usance bill is discounted by the banks. The credits available to the seller against the bills drawn under Letter of Credit either on sight draft or usance draft are called bills negotiated by the banks.

The advantage of bills finance is that the seller of goods (borrower) gets immediate money from the bank for the goods sold by him irrespective of whether it is a purchase, discount or negotiation by the bank. The Demand Bills’ can be documentary or clean. Usually banks accept only documentary bills for purchase. However, clean bills from good parties also purchased by the banks.

The ‘Documentary Bills’ may be drawn by a Seller of Goods (‘Drawer’) on D/P (Delivery against payment) or D/A (Delivery against Acceptance) terms. In case of D/P terms the documents of title to goods are delivered to the buyer of the goods (drawee) against payment of bill amount in case of D/A bills, the documents to the title of goods are to be delivered to the drawee (Buyer) against acceptance of bills.

Those types of bills are called Usance
Bills’ which means bills are maturing on a future date and payment will be made on due date. In case of ‘Usance Bdls’ bills become clean after it is delivered to drawee on acceptance. Therefore banks take into consideration the credit worthiness not only of the borrower but also of the drawee.

Project Finance:
It is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project. Usually, a project financing structure involves a number of equity investors, known as ‘sponsors’, a ‘syndicate’ of banks or other lending institutions that provide loans to the operation.

They are most commonly loans which are secured by the project assets and paki entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets and are able to assume control of a project if the project company has difficulties complying with the loan terms.

Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound or to assure the lenders of the sponsors’ commitment. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the infrastructure industry.

Question 5.
Differentiate between Hire Purchase and Hypothecation. (Dec 2020, 5 marks)
Answer:
Hire Purchase:

  • HP transactions are very similar to leasing transactions. Like Leasing Finance, in Hire Purchase, the ownership of the vehicle continues to remain with the Leasing Company till the agreement period ends.
  • Although, at the end of the stipulated period, the hirer (lessee) has options either to return the asset to leasing company while terminating the agreement or purchase the asset upon terms set out in the hire-purchase agreement.
  • Under Hire Purchase the financing entity may get the benefit of depreciation as well as ownership of the asset financed.
  • Also, banks cannot take benefit of Hire Purchase Arrangement, as ownership aspect of the asset will result in violating permitted line of activity under the banking license granted by RBI.

Hypothecation:

  • Prior SARFARSI Act, 2002, it was not define legally in India. It is a charge on any movable asset of a borrower for which bank has extended its finance.
  • It is an equitable charge on the assets in favour of the financing bank where the asset is owned by the borrower as well as possession is with him on behalf of the bank.
  • If a borrower fails to repay the finance extended for the movable asset the bank can repossess the asset with the consent of the borrower.
  • If the borrower surrenders the asset to the bank, bank has a legal right to sell the asset without the intervention of the court and adjust the proceeds towards the loan dues.
  • Under SARFAESI Act bank also has got the right to sell the movable asset of a defaulted borrower without the Intervention of a court subject to following rules laid down in this regard.

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material

Question 6.
Distinguish between the following:
(i) Overdraft and Cash Credit Account
(ii) Buyers’ Credit and Suppliers’ Credit (Aug 2021, 5 marks each)
Answer:
(i) Overdraft: Overdraft means allowing the customer to draw cheques over and above credit balance in his account Bank overdraft is line of credit that overs the transaction if the bank account balance drops
below zero.

Overdraft is normally allowed to Current Account customers and in exceptional cases Savings bank account holders are also allowed to overdraw their account.

High rate of Interest is charged on daily debit balance of overdraft account as these are clean advances i.e. banks do not have any securities to fall back if these facilities are not repaid.

There are two types of overdraft accounts as prevalent in Banks i.e.

  1. Temporary overdraft or dean overdraft and
  2. Secured overdraft.

Temporary overdrafts are allowed purely on personal credit worthiness of the customer concerned and it is meant for the customer to meet some urgent commitments on rare occasions. Allowing a customer to draw against his cheques sent in clearing known as ‘against clearing’ also falls under this category.

Secured overdraft is allowed up to a certain limit against some tangible security like bank deposits, LIC policies, National Saving Certificates, shares and other similar assets.

Secured overdraft is most popular with traders as lesser operating cost, simple application and document formalities are involved in this facility.

Cash Credit Account: A cash credit facility is a short-term finance to a borrower company, having a tenure of up to one year which can be renewed for further period by the bank on the basis of Projected sales and satisfactory operation in the account during the period of finance. Cash credit facility is extended in two forms viz. Open Cash Credit and Key Cash Credit.

Open Cash credit account is a running account just like a current account where the borrower is allowed to maintain debit balance in the account up to a sanctioned limit or drawing power whichever is lower. The Cash Credit facility is offered to borrowers normally either against pledge (Key Cash Credit) or hypothecation of stocks of raw materials, semi-finished goods and finished goods and Book Debts (Receivables). This type of limit is offered mainly to traders who find it difficult to maintain stock register and submitting periodic stock statements.

In the case of Key Cash Credit, the borrower lodges the stocks in his godown and the key of the godown will be handed over to the bank. By this process, the goods lodged in the godown are pledged to the bank and the bank will allow the customer to draw funds against the value of the goods less margin. This is known as Drawing Power.

The pledged goods are allowed to be removed by the borrower on remitting into his CC account the amount equivalent to value of the goods.

The bank would release further funds to the borrower within the Drawing Power (DP)Isanctioned limit on borrower depositing (pledge) more stock in the godown. Hence, such facility is called Key Cash Credit. Cash Credit limits are also sanctioned to a borrower against security of term deposits, LIC policies, National Saving Certificates or Gold Jewels.

(ii) 1. Buyers’ Credit: It refers to loans for payment of imports into India arranged by the importer from overseas bank or financial institution. Imports should be as permissible under the extent of Foreign Trade Policy of the Director General of Foreign Trade. For the overseas exporter the transaction becomes a cash sale.

2. Suppliers’ Credit: Suppliers’ credit relates to the credit for imports into India extended by the overseas supplier. In this case too, imports should be as permissible under the extent of Foreign Trade Policy of the DG FT. Usually this type of facility is availed for import of Capital goods. The importer pays an agreed amount of down payment and the balance amounts are paid in instalments over a deferred period. Interest rates for the transactions are decided at the initial contracting stage and are included in the instalments payable by the importer.

Question 7.
Discuss the steps involved in the process of factoring. (Dec 2013, 5 marks)
Answer:
Following steps are involved in “Factoring Process”:

(i) The seller interacts with the funding specialist or broker and explains the funding needs.

(ii) The broker prepares a preliminary client profile form and submits to the appropriate funder for consideration.

(iii) Once both parties agree that factoring is possible, the broker puts the seller in direct contact with the tunder to ask answer any additional questions and to negotiate a customized factoring agreement, which will meet the needs of all concerned.

(iv) At this point, the seller may be asked to remit a fee with formal application to cover legal research costs, which will be incurred during the course of “due diligence”. Here “Due Diligence” means a process by which the buyer’s credit worthiness is evaluated through background checks, using national database services.

(v) During the next several days, the funder completes the “Due Diligence” process on the seller, further verifies invoices and acknowledges any liens, UCC filings, judgments or other recorded encumbrances on the seller’s accounts receivables.

(vi) The seller is advised with the facility and is asked to advise the buyers of the ‘Factor’ by letter and submit an acknowledged copy of the same to the ‘Factor’ for records.

(vii) A detailed sanction letter is given to the seller and acceptance on the same taken, with the required stationaries. The sanction letter mušt contain following terms:

(a) All facilities covered under the sanction.
(b) The period for which the sanction is valid.
(c) When the facility comes into effect.
(d) Who the authorized signatories are for signing invoices for factoring.
(e) The limits.
(f) The seller has to advise the buyer of the factoring agreement.
(g) Copy of such advice acknowledged by the buyer should be submitted to the factor.

(viii) The discounting rates, charges fixed.

(ix) In case of discounts given by the seller to the buyer, which value will be financed by the factor (Since the factored amount shall not ever exceed the amount actually payable by buyer).

(x) Usually within 7 to 1o days of the initial contact with the factor, agreements are signed, customers are notified, UCC forms filled and the first advance is forwarded to the company. This advance can vary between 70-80% of the face value of the invoices being factored.

(xi) The seller performs services or delivers products, thus creating an invoice.

(xii) The seller sends or faxes a copy of the invoice directly to the factor.

(xiii) The funder verifies the invoice and the advance is sent to the seller as per the agreement :

(xiv) The buyer pays the factor. The factor then returns any remaining reserve, minus the fee, which has been predetermined in the negotiated agreement.

Question 8.
Treasury bills are effective cash management product.” Comment. (June 2014, 5 marks)
Answer:
Treasury Bills” are very useful instruments to deploy short term surpluses depending upon the availability and requirement. Banks generally do not pay any interest on fixed deposits of less than 15 days, or balances maintained in current accounts, whereas treasury bills can be purchased for any number of days depending on the requirements. This helps in deployment of fund for very short periods as well. Further, since every week there is a 91 days treasury bill maturing and every fortnight a 364 days treasury bills maturing.

One can purchase treasury bills of different maturities as per requirements so as to match with the respective outflow of funds. At times when the liquidity in economy is tight, the returns on treasury bills are much higher as compared to bank deposits even for longer term. In addition to better yields and availability for very short tenures, another advantage of treasury bills over bank deposits is that surplus cash can be invested depending upon the staggered requirements.

Question 9.
“Factoring is a financial option for the management of receivables.” In the light of this statement, explain the meaning and advantages of factoring. (June 2015, 5 marks)
Answer:
(I) Meaning: Factoring is a financial transaction where an entity sells its receivables to a third party called a ‘factor’, at discounted prices. Factoring is a financial option for the management of receivables. In simple definition it is the conversion of credit sales into cash. In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80%(rarely up to 90%) of the amount immediately on formation of agreement. Factoring company pays the remaining amount (Balance 20%-finance cost-operating cost) to the client when the customer pays the debt. Collection of debt from the customer is done either by the factor or the dent depending upon the type of factoring. The account receivable in factoring can either be for a product or service.

(II) Advantages of Factoring:

(a) Seller gets funds immediately after the sale is effected and on presentation of accepted sales invoices and Promissory notes.
(b) Major part of paper work and correspondence is taken care of by the factor.
(c) Follow-up, for recovery of funds, is done mainly by the factor.
(d) Interest rates are not as high as normal discounting.
(e) Increased cash flow to meet payroll.
(f) Immediate funding arrangements.
(g) No additional debt Is incurred on balance sheet.
(h) Other assets are not encumbered.
(i) Approval is not based on seller’s credit rating.

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material

Question 10.
In the recent past, a listed housing finance company issued MASALA BONDS for a sum of ₹ 3,000 crore. Explain the term MASALA BONDS. Is there any advantage of MASALA BONDS over NORMAL BONDS? (June 2019, 5 marks)
Answer:
Masala Bonds are rupee denominated borrowings by Indian companies in the overseas markets. This is different from the other overseas borrowings in the sense that the in the other borrowings, the currency is normally dollar, euro, yen etc.

The masala bonds were reckoned under both corporate debt and external commercial borrowings for Foreign Portfolio investment.

The Reserve Bank of India recently amended the Regulations and currently treats Masala Bonds under the ECB category only, where a borrower just needs to seek the RBI’s approval to sell those securities. The main advantage of issuing masala bonds is that the company does not have to worry about the depreciation in the rupee in comparison to the other currencies. This is normally a big worry for corporates while raising money in the overseas markets. If the rupee weakens at the time of the redemption of the bonds, the company will have to pay more rupees to repay the dollars.

This is a big advantage, as many companies which had raised via the Foreign Currency Convertible Bonds in 2007 found themselves in a great difficulty as the rupee had depreciated very sharply during the global financial crisis. In order to compensate the risk of currency depreciation, the buyer of the Masala Bond will get a higher coupon rate and therefore earns a higher-yield. Many public and private companies are in the fray to issue masala bonds as the companies can have access to more funds at a marginally higher cost of financing.

Question 11.
Write a detailed note on Islamic Banking. (June 2019, 5 marks)
Answer:
Islamic Banking or Sharia: Compliant Finance is banking or financing activity that complies with shana (Islamic law) and its practical application through the development of Islamic economics. Some of the modes of Islamic banking/finance include Mudara bah (Profit sharing and loss bearing), Wadiah (safekeeping), Musharaka (joint venture), Murabahab (cost plus), and ljara (leasing).

Shana prohibits riba, or usury, defined as interest paid on all loans (although some Muslims dispute whether there is a consensus that interest is equivalent to riba). Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also haraam (sinful).

Islamic Banks work on the principles of an interest free banking. Riba or interest under Islamic Law basically means anything in “excess” — the investor should not make an “undue” profit from the hard work of the other. Islamic banks make available accounts which provide profit or loss instead of interest rates. The banks use this money collected by them and invest in something that is shah at compliant, that is not haraam and does not involve high risks.

Question 12.
State the guidelines issued by RBI (Reserve Bank of India) for large borrowers under the cash credit facility. (Dec 2020, 5 marks)
Answer:
In respect of borrowers having aggregate fund based working capital limit of ₹ 1500 million and above from the banking system, a minimum level of ‘loan component’ of 40 percent shall be effective from April 1, 2019. Accordingly, for such borrowers, the outstanding ‘loan component’ (Working Capital Loan) must be equal to at least 40 percent of the sanctioned fund based working capital limit, including ad hoc limits and TODs.

Therefore, for such borrowers, drawings up to 40 percent of the total fund based working capital limits shall only be allowed from the ‘loan component’. Drawings in excess of the minimum ‘loan component’ threshold may be allowed in the form of cash credit facility.

The bifurcation of the working capital limit into loan and cash credit components shall be effected after excluding the import credit limits and bills limit for inland sales from the working capital limit.

Question 13.
You are required to compute Maximum Permissible Bank Borrowings (MPBB) under three methods of Tandon Committee Norms pertaining to M L Ltd. from the following data and how you will present it to the Board:
Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material 1
Answer:
Answer:
Maximum Bank Borrowings: (Tandon Committee norms)

Method – I Method – II Method – III
= 0.75 (CA-CL)
= 0.75 (14,80,000­-6,00,000)
= 0.75(8,80,000)
= 6,60,000
= 0.75 (CA)-CL =
= 0.75(14,80,000) -6,00,000 = 5,10,000
= 0.75 (CA-CAA)-CL
= 0.75 (14,80,000- 3,80,000)-6,00,000 = 0.75 (11,00,000)-6,00,000 = 2,25,000

Review:

Method-I Method – II Method – III
Maximum Bank Borrowings
Actual Bank Borrowings
Excess Bank Borrowings
6,60,000
8,00,000
1,40,000
5,10,000
8,00,000
2,90,000
2,25,000
8,00,000
5,75,000

Under all the 3 methods, the excess bank borrowings can be converted in to long term debt.

Question 14.
Following data relates to M/s ABC Pvt. Ltd.:
Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material 3
Calculate the Maximum Permissible Bank Finance (MPBF) as per the Tandon Committee Recommendations using the norm of a current ratio of 1.33. (Dec 2019, 5 marks)
Answer:
Working Note:

Particulars Amount (₹ in lakhs)
Raw Material 380
Work in Process 40
Finished Goods 10
Receivable 110
Other Current Assets 30
Total Current Assets 740

Calculation of Maximum Permissible Bank Finance (MPBF) as per 2nd Method of Lending (Tandon Committee Recommendations) are as under:

Particulars Amount (₹ in lakhs)
1. Total Current Assets (TCA) 740
2. Less: Current Liabilities other than banking borrowing 300
3. Working Capital Gap (WCG) (I -2) 440
4. Less: 25% of Total Current Assets (25% of I) 185
5. Maximum Permissible Bank Finance (MP BF) (3-4) 255

With this additional borrowing the Current Liabilities shall become ₹ 555 lakhs (300 + 255) and the new Current Ratio shall become 1.33 (740/555).

Question 15.
Balance Sheet of X company as at 31st March, 2018 and its statement of changes in financial position for the year ending on 31st March, 2019 are presented below:

Liability Assets
Common Stock 6,000 Land 9,800
Reserves 6,560 Equipment 12,200
Preferential Stock 2,500 Accumulated Depreciation (2,000)
Long term Bonds 7,000 Inventory 2,370
Amount Payable 2,140 Amount Receivable 1,300
Cash 530
24,200 24,200

Statement of changes in Financial Position for the year ended on 31st March, 2019:

Sources Uses
Net Income 1,200 Paid Cash Dividend 360
Depreciation 600 Repaid Preferential Stock 2,500
Loss on sale of land (80) Retired Bond Payable 1,400
Issued Stock 4,000 Purchased Equipment 3,000
Sold land 1,880 Increase in Working Capital 340
7,600 7,600

Calculate the working capital as on 31st March, 2019. (Dec 2020, 5 marks)
Answer:
Working capital as on 31st March, 2018
Opening w. c. (₹) = Cash + AR + Inv. – AP
= 530 + 1,300 + 2,370 – 2,140
= ₹ 2,060
Therefore W.G. as on 31st March 2019
= Opening w.c. + change in w.c. for the year ended on 31st March, 2019
= ₹ 2,060 + ₹ 340
= ₹ 2,400

Question 16.
The following data pertains to XYZ Ltd :
Projected Sales : ₹ 20,00,000
Creditors : ₹ 3,00,000
Bank Borrowings : ₹ 3,30,000
Current Assets : ₹ 7,40,000
Assess the Working Capital requirement of XYZ Ltd. using the method given by Nayak Committee. (Aug 2021, 3 marks)
Answer:
Net Working Capital = Current Assets – Current Liabilities Net Working Capital = ₹ 7,40,000 – ₹ 6,30,000 = ₹ 1,10,000
(i) Minimum Working Capital required i.e 25% of Sales = 25% of 20,00,000 = ₹ 5,00,000
(ii) Margin or Minimum Borrower’s contribution i.e. 5% of projected sales = 5% of 20,00,000 = ₹ 1,00,000
(iii) Margin or Net Working Capital whichever is higher to be deducted from 25% of Sales i.e. ₹ 5,00,000 – ₹ 1,10,000 = ₹ 3,90,000
Consequently, maximum permissible finance as per Nayak Committee’s recommendation in the case under consideration shall be ₹ 3,90,000.

Question 17.
On the basis of the following infonmation, calculate the operating cycle of Raksha Goods Limited:

Particulars As at April 1, 2019 As at March 31,2020
Inventory ₹ 4,00,000 ₹ 3,80,000
Accounts receivable ₹ 18,00,000 ₹ 22,50,000

The sales and cost of goods sold for the year ended March 31, 2020 are ₹ 2,65,00,000 and ₹ 1,55,00,000 respectively. (Dec 2021, 5 marks)
Answer:
Computation of Operating Cycle of Raksha Goods Limited
Operating cycle = Inventory period + Accounts receivable period
Inventory period = Average inventory/Cost of goods sold × 365
Average Inventory = (₹ 4,00,000 + ₹ 3,80,000)/2 = ₹ 3,90,000
Inventory period = ₹ 3,90,000 / ₹ 1,55,00,000 × 365 = 9.18 days
Average Accounts receivable = (₹ 18,00,000 + ₹ 22,50,000)/2 = ₹ 20,25,000
Accounts receivable period = ₹ 20,25,000 / ₹ 2,65,00,000 × 365 = 27.89 days
Operating cycle = 9.18 + 27.89 days = 37.07 days

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material

Question 18.
Somaskanda Printers Limited approached Support Bank, for working capital facilities. The projected annual turnover of the Company is ₹ 1,85,00,000. Explain the assessment of working capital requirement as per Nayak Committee and compute the working capital finance which can be extended by the Bank. (Dec 2021, 5 marks)
Answer:
As per Nayak Committee, bank credit for working capital purposes for borrowers requiring fund-based limits up to ₹ 5 crores for Small Scale Industries(SSI) borrowers and ₹ 2 crores in case of other borrowers, may be assessed at minimum of 25% of the projected annual turnover of which should be provided by the borrower (i.e. minimum margin of 5% of the annual turnover to be provided by the borrower) and balance 4/5th (i.e. 20% of the annual turnover) can be extended by way of working capital finance.

The projected turnover or output value may be interpreted as projected gross sales which will include excise duty also.

Because the bank finance is only intended to support the need-based requirement of a borrower, if the available Net Working Capital is higher than 5% of the turnover the former should be reckoned for assessing the extent of bank finance.

Calculation of Working Capital
Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material 4

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) Notes

1. Bonds
Bonds are the debt security where an issuer is bound to pay a specific rate of interest agreed as per the terms of payment and repay principal amount at a later time. The bond holders are generally like a creditor where a company is obliged to pay the amount. The amount is paid on the maturity of the bond period. Generally, these bonds duration would be for 5 to 10 years.

There are various types of bonds in India:

(i) Government Bonds: These are the bonds issued either directly by Government of India or by the Public Sector Units (PSU’s) in India. These bonds are secured as they are backed up with security from Government. These are generally offered with low rate of interest compared to other types of bonds.

(ii) Corporate Bonds: These are the bonds issued by the private corporate companies. Indian corporates issue secured or non secured bonds. E.g. IIFL bonds issue which came up during Sep-2012 was unsecured bond and Shriram city union bond issue in Sep-2012 was a secured bond issue.

(iii) Banks and other financial institutions bonds: These bonds are issued by banks or any financial institution. The financial market is well regulated and the majority of the bond markets are from this segment. However care to be taken to consider the credit rating given by Credit Rating Agencies before investing in these bonds. In case of poor credit rating, better to stay away from such bonds.

(iv) Tax saving bonds: In India, the tax saving bonds are issued by the Government of India for providing benefit to investors in the form of tax savings. Along with getting normal interest, the bond holder would also get tax benefit.

2. Masala Bonds
Masala Bonds are rupee denominated borrowings by Indian companies in the overseas markets. This is different from the other overseas borrowings in the sense that the in the other borrowings, the currency is normally dollar, euro, yen etc.

The advantage of issuing masala bonds is that the company does not have to worry about the depreciation in the rupee in comparison to the other currencies. This is normally a big worry for corporates while raising money in the overseas markets. If the rupee weakens at the time of the redemption of the bonds, the company will have to pay more rupees to repay the dollars.

In order to compensate the risk of currency depreciation, the buyer of the Masala Bond will get a higher coupon rate and therefore earns a higher yield.

HDFC was the first company to issue Masala Bonds for an aggregate amount of ₹ 3,000 crores and has raised an aggregate of ₹ 5,000 crores through issuance of Masala Bonds in four tranches. The First issue of Masala bond by HDFC bears a fixed semi-annual coupon of 7.875 percent per annum and has a tenor of 3 years and 1 month. The bonds have been issued at a price of 99.24% of the par value and will be redeemed at par. The bonds are traded on the London Stock Exchange and not in India. Further, the provisions in respect of maturity period, all-in-cost ceiling and recognized lenders (investors) of Masala Bonds as under:

(i) Maturity period: Minimum original maturity period for Masala Bonds raised upto USD 50 million equivalent in INR per financial year should be 3 years and for bonds raised above USD 50 million equivalent in INR per financial year should be 5 years.

(ii) All-in-cost ceiling: The all-in-cost ceiling for such bonds will be 300 basis points over the prevailing yield of the Government of India securities of corresponding maturity.

(iii) Recognised investors: Entities permitted as investors, under the provisions of paragraph 3.3.3 of the Master Direction No.5 dated January 1, 2016 but should not be related party within the meaning as given in Ind-AS 24.

3. Bank Finance
Indian Banking Act, classifies bank finance into secured loans and unsecured loans. Secured loan means loans granted on the backing of some tangible security, while Unsecured loan is one for which the banker has to rely upon the personal security of the borrower. Unsecured advances are not popular in India. Most of the bank advances are secured ones. Only a small portion of about 11% to 15% of the total bank advance is unsecured.

4. Overdrafts
Overdraft means allowing the customer to draw cheques over and above credit balance in his account. Overdraft is normally allowed to Current Account Customers and in exceptional cases Savings bank account holders are also allowed to overdraw their account. High rate of interest is charged on daily debit balance of overdraft account.

There are two types of overdraft accounts are prevalent in Banks i.e.

(i) Temporary overdraft or clean overdraft
(ii) Secured overdraft. Temporary overdrafts are allowed purely on personal credit of the party and it is for party to meet some urgent commitments on rare occasions. Allowing a customer to draw against his cheques sent in clearing also falls under this category. Secured overdraft is allowed up to a certain limit against some tangible security like bank deposits, LIC policies, National Saving Certificates, shares and other similar assets.

5. Cash Credit Account (CC A/C)
A cash credit facility is a short-term finance to a borrower company, having a tenure of up to one year which can be renewed for further period by the bank on the basis of projected sales and satisfactory operation in the account during the period of finance. Cash credit facility is extended in two forms viz. Open Cash Credit and Key Cash Credit. Open Cash credit account is a running account just like a current account where the borrower is allowed to maintain debit balance in the account upto a sanctioned limit or drawing power whichever is lower.

6. Bills Finance
Bills finance is short term and self liquidating finance in nature. The bills can be classified as Demand Bills and Usance Bills. Demand Bill is purchased and Usance bill is discounted by the banks. The credits available to the seller against the bills drawn under Letter of Credit either on sight draft or usance draft are called bills negotiated by the banks.

The advantage of bills finance is that the seller of goods (borrower) gets immediate money from the bank for the goods sold by him irrespective of whether it is a purchase, discount or negotiation by the bank. The ‘Demand Bills’ can be documentary or clean. Usually, banks accept only documentary bills for purchase. However, clean bills from good parties also purchased by the banks.

7. Hire-purchase Finance
Hire-Purchase transactions are very similar to leasing transactions. In the Hire-purchase finance takes place predominantly in automobile sector. Like Leasing Finance, the ownership of the vehicle continues to remain with the Leasing Company till the agreement period ends.

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material

8. Project Finance
Project Finance is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project. Usually, a project financing structure involves a number of equity investors, known as ‘sponsors’, a ‘syndicate’ of banks or other lending institutions that provide loans to the operation. They are most commonly loans which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors.

The features of project finance transactions are:

  1. Capital Intensive – They tend to be large scale projects requiring debt and equity in a large amount.
  2. Highly leveraged – These transactions have high debt proportion as compared to equity.
  3. Long Term – The tenure for project financings can easily reach 15 to 20 years.
  4. Independent Entity With A Finite Life – They form a new legal entity with the sole purpose of executing the project.
  5. Non-Recourse Or Limited Recourse Financing – It means a the creditor has no or limited claims on the loan in case of default.
  6. Many Participants – There are many national and international participants involved in a project laying different risk.
  7. Allocated Risk – There are many risk involved in a project for example Environmental, Country risk, Market risk, Project risk, Product risk, Supply risk, Funding risk, Currency risk, Interest risk.
  8. Costly – Raising capital through project finance is generally more costly than through typical corporate finance avenues.

9. Project Report
For getting financial assistance from any Bank or Financial Institution for implementation of any business idea, a company is required to prepare a Project Report. A Project Report is a detailed report containing all the details of company. A good project report must present diverse range analytical challenges to its clients and shareholders.
Report covering certain important aspects of the project as detailed below:

  • Introductory Page.
  • Summary of the project.
  • Details about the Promoters, their educational qualifications, work experience, etc.
  • Current Status of the Bank, its products and services, target market, and activities.
  • Infrastructure facilities, tools deployed, operational premises, machinery. etc.
  • Customers, details about them as well as prospective customers.
  • Fiscal acquisitions and tie-ups.
  • Means of Financing.
  • Profitability projections and Cash flows for the entire repayment period of financial assistance.
  • Balance Sheet.
  • Profit and Loss Statements.
  • Fund Flow Statement.
  • Chief Ratios.
  • Break Even Point Evaluations.
  • Product with capacity to be built up and processes involved.
  • Project location.

10. Loan Against Securities
Banks and financial institutions come up with Innovative ways to fulfill the monetary requirements of every individual as per their credit worthiness and paying capacity. One step ¡n this direction has been Loan against Securities, popularly referred to as LAS. Under “Loan against Securities”, loan is advanced to a customer against pledge of securities or simply put loan against insurance policy, mutual funds, NSC and other securities. The list of approved securities against which LAS can be advanced varies from bank to bank, but primarily the following are considered to be approved securities against which LAS could be given.

  1. Non-Convertible Debentures.
  2. Mutual Fund Units.
  3. NABAR D Bonds.
  4. Dematerialised Shares.
  5. National Saving Certificates/Kissan Vikas Patra (Accepted only in Demat form).
  6. Insurance Policies.

Features of Loan Against Securities

  1. Secured Loan – Loan against securities is a secured loan as the bonds, shares, debentures or mutual funds owned by the borrower are kept as collateral security when this loan is advanced.
  2. Tenure – The tenure of loan against securities is generally one year.
  3. Rate of Interest – Generally interest rates at which loan against securities is advanced varies from 12% -15% p.a.
  4. Processing Fees – Banks and financial institutions usually charge approximately 2 % as processing fees.
  5. Loan Amount – The loan amount for which the borrower may be eligible depends upon the type of security that is being offered. For example, in case equity shares are offered then the amount that is eligible would be 50% of the value of such shares.
  6. Prepayment Charges — There are generally no prepayment charges.

11. Bill Discounting
Commercial bills are basically negotiable instruments accepted by buyers for goods or services obtained by them on credit. Such bills being bills of exchange can be kept upto the due maturity date and encashed by the seller or may be endorsed to a third party in payment of dues owing to the latter. The most common practice is that the seller who gets the accepted bills of exchange discounts it with the Bank or financial institution or a bill discounting house and collects the money (less the interest charged for the discounting).

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material

12. Factoring
Factoring is a financial transaction where an entity sells its receivables to a third party called a ‘factor’, at discounted prices. Factoring is a financial option for the management of receivables. In simple definition it is the conversion of credit sales Into cash. In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80% (rarely up to 90%) of the amount immediately on formation of agreement.

Parties in Factoring
The factoring transaction involves three parties:

  • The Seller, who has produced the goods/services and raised the invoice.
  • The Buyer, the consumer of goods/services and the party to pay.
  • The Factor, the financial institution that advances the portion of funds to the seller.

13. Factoring Process
The steps involved in factoring are listed below:

  • The seller interacts with the funding specialist/broker and explains the funding needs.
  • The broker prepares a preliminary client profile form and submits to the appropriate funder for consideration.
  • Once both parties agree that factoring is possible. the broker puts the seller in direct contact with the hinder to ask/answer any additional questions and to negotiate a customized factoring agreement, which will meet the needs of all concerned.
  • At this point, the seller may be asked to remit a fee with formal application to cover the legal research costs, which will be Incurred during “due diligence”. This is the process by which the buyer’s credit worthiness is evaluated through background checks, using national database services.
  • During the next several days. the funder completes the “due diligence” process on the seller, further verifies invoices and acknowledges any liens, UCC filings, judgments or other recorded encumbrances on the seller’s accounts receivables.
  • The seller is advised of the facility and is asked to advise the buyers of the Factor by letter and submit an acknowledged copy of the same to the Factor tor records.
  • A detailed sanction letter is given to the seller and their acceptance on the same taken, with the Required signatories. (Authorized signatories would be mentioned in the “Signing Authorities” section of the Proposal presented by seller).
  • The discounting rates, charges fixed.
  • In case of discounts given by the seller to the buyer, which value would be financed by the factor (since the factored amount should never exceed the amount actually payable by buyer).

Usually within 7 to 10 days of the initial contact with the factor, agreements are signed, customers are notified, UCC forms filed and the first advance is forwarded to the company. This advance can vary between 70 – 80% of the face value of the invoices being factored. In the construction industry, the advances may be In the range of 60- 70%. The remaining amount is called the reserve which is held by the factor until the invoices are paid. The factor then deducts his fee and returns the remaining funds to the seller.

  • The seller performs services or delivers products, thus creating an invoice.
  • The seller sends or faxes a copy of the invoice directly to the factor.
  • The funder verifies the invoice and the advance is sent to the seller as per the agreement with the factor. In certain cases, the funder wires the funds to the seller’s account for an additional fee.
  • The buyer pays the factor. The factor then returns any remaining reserve, minus the fee, which has been predetermined in the negotiated agreement.

14. Types of Factoring
Non-Recourse or Full Factoring
Under this type of factoring the bank lakes all the risk and bear all the loss in case of debts becoming bad debts.

Recourse Factoring
Under this type of factoring the bank purchases the receivables on the condition that any loss arising out or bad debts will be borne by the company which has taken factoring.

Maturity Factoring
Under this type of factoring bank does not give any advance to the company rather bank collects it from customers and pays to the company either on the date of collection from the customers or on a guaranteed payment date.

Advance Factoring
Under advance factoring arrangement the factor provides an advance against the uncollected and non-due receivables to the firm.

Undisclosed Factoring
Under this type of factoring, the customer is not informed of the factoring arrangement. The firm may collect dues from the customer on its own or instruct to make remit once at some other address.

Invoice Discounting
Under this type of factoring the bank provide an advance to the company against the account receivables and in turn charges interest rate from the company for the payment which bank has given to the company.

Debt Funding-Indian Fund Based (Government Debt & Banking Finance) - CS Professional Study Material

15. Islamic Banking
Islamic Banking or Sharia-Compliant Finance is banking or financing activity that complies with sharia (Islamic law) and its practical application through the development of Islamic economics. Some of the modes of Islamic banking/finance include Mudarabah (Profit sharing and loss bearing), Wadiah (safekeeping), Musharaka Goint venture), Murabahah (cost plus), and Ijara (leasing).

Islamic Banks work on the principles of an interest free banking. Riba or interest under Islamic Law basically means anything in “excess” – the investor should not make an “undue” profit from the hard work of the other. But it is permitted to follow a system of reasonable profit and return from investment where the investor takes a risk that is well calculated.

Thus, Islamic banks make available accounts which provide profit or loss instead of interest rates. The banks use this money collected by them and invest in something that is shariat compliant, that is not haraam and does not involve high risks. Thus, businesses involving alcohol, drugs, war weapons etc. as well as all other high risk and speculative activities are prohibited. Islamic Banking, therefore, acts as an agent by collecting the money on behalf of its customers, investing them in shariat compliant projects and sharing the profits or losses with them.

Appraisal Methodology for Different type of Loans and Credit Products
Credit Appraisal is the process by which a lender appraises the technical feasibility, economic viability and bankability including credit worthiness of the prospective borrower. Appraisal of credit is generally carried by the Banks/financial institutions which are involved in providing financial funding to its customers.

Credit appraisal process of a customer lies in assessing if that customer is capable of repaying the loan amount in the stipulated time, or not. The banks have has their own methodology to determine if a borrower is creditworthy or not. It is determined in terms of the norms and standards set by the banks. All banks employ their own unique objective, subjective, financial and non-financial techniques to evaluate the creditworthiness of their customers.

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