At this juncture when we are trying to make inroads in understanding the corporate banking, it is important to understand the key products, their application & key risk assessment metrics. This article might sound a bit boring, but if you want to put on the hat of participating in deals where there are crores of funds involved, then a bit of lecture is bearable, isn’t it? 😛
Key Products:
As we discussed briefly in our article https://www.minervagc.com/corporatebanking1/ ,corporate banking loan products are bifurcated into two main categories: (a) Fund based (b) Non Fund Based. Let’s deep dive into these:
- Fund Based :
- Short Term (Time frame : < 1 year)
- Cash Credit (CC)
- Working Capital Demand Loan (WCDL)
- Short term loan (STL)
- Packing Credit (Pre shipment/post shipment ; domestic currency/foreign currency)
- Bill Discounting
- Overdraft
- Long Term (Time frame : > 1 year)
- Rupee Term Loan (RTL)
- Foreign Currency Term Loan (FCTL)
- Short Term (Time frame : < 1 year)
- Non
Fund Based:
- Letter of Credit (LC)
- Bank Guarantees (BG)
- Advance BG
- Performance BG
- Others
Why?
The basic question that arises in mind when looking at such list of corporate banking products (and these are key ones, there are others as well) is why do a company need so many facilities or how did someone thought of these products? Well the answer is rather simple, every company has a finance department that does budgeting for all the projects that are being run or proposed to be run. Budgeting can be understood as where you map out how much it’s going to cost at different stages (a) for manufacturing a product (R&D, raw material cost domestic as well as imports, labor, electricity etc.) (b) taking it to the market (logistics etc.) and (c) selling it (advertising etc.) and (d) after sales services. Further there is also fixed cost like capital expenditure where you have to setup a plant for manufacturing as well. Now in the long run, for company to survive, at some point the money that customers are paying must surpass the budgeted cost (fixed and variable) which is basically the break-even point and only after that company starts to make actual profits. But as we realise, initially the cash outlay is higher than cash inflows so to bridge this gap till breakeven, ‘someone’ has to fund it. This ‘someone’ constitutes both promoters of the company as well as banks. Why promoters though? For the reason that banks want promoters skin in the game as well so that interests of promoters towards other stakeholders can be managed. Coming back to the finance department of a company, one of its key performances metric which are closely watched by the management is to keep the finance costs low so that profits can be higher. Now to keep finance costs low, ideally that will happen when you take a loan from the bank for exactly the time till you need it because for any loan amount you got to pay interest to banks and that is computed from the number of days for which the loan is being utilized. On the other hand, banks have to be sure that their loan is being utilized for the purpose for which it has been sanctioned and not for any other purposes. At this stage it is important to understand the concept which is commonly heard in banking space “Cash is fungible”. What this means is once money is credited to a company’s account be it from loan or from collection of customers, it can be used for any purpose right because cash is cash, it cannot be differentiated. But it can be monitored. That is how considering interests of both company as well as banks, these products started to come out and evolved further with regulatory guidelines, thanks to lot of loopholes that companies exploited and siphoned money out of banks.
What?
Let us try and understand what these products are. The basic difference between fund based and non-fund based products is w.r.t. outlay of funds by bank. For fund based products there is an upfront outlay of funds to the company while non-fund based products there is no upfront outlay and hence this term ‘fund’ and ‘non-fund’.
- Fund Based Products (Short Term): Primarily these are for meeting the
working capital requirements of the company or with a time frame of less than
an year. Working capital to put simply is management of (a) inventories (b)
receivables and (c) creditors.
- Inventories pertain to time required to manufacture a product from acquiring the raw material to producing the finished goods. Once these finished goods are sold to customers, their needs to be collection or receivables from the customers and this time for inflow of funds from customers is called receivable cycle. Now as the customers might not pay upfront, similarly for procuring the raw material and other resources required for manufacturing the finished goods, the company can ask for credit period from its suppliers and this is called as Creditor cycle.
- Inventory cycle and receivable cycle together determine by when company will start receiving funds from customers while credit cycle is basically when company has to pay. Generally (inventory cycle and receivable cycle > creditor cycle) and this leads to a cash flow mismatch. For eg. It takes 15 days to manufacture a product and 10 days to receive money from customers so total in 25 days there is cash inflow. However you need to pay suppliers in 20 days and hence there is 5 days gap when there will be fund insufficiency. Churn this cycle repeatedly for an year and here arises the need of short term fund based products.
- Cash
Credit (CC):
- Details: Is a revolving facility. A sanction limit is set based on assessment done by bank (MPBF: maximum permissible bank finance or ABF: Assessed Bank Finance method)and every month utilization is determined based on previous months stock statement which is nothing but representation of working capital cycle of company. You can withdraw and replenish multiple times in a month capped to the utilization which has been ascertained by the assessing bank. Interest rate is charged on the actual utilization amount.
- Pricing: It is generally charged to 1M-MCLR/3M-MCLR/6M-MCLR + Spread along with additional charges in case of default.
- Working
Capital Demand Loan (WCDL):
- Details: To reduce the burden on bank by offering a CC facility where bank has to ensure that at all times, for the assessed utilization limit, the funds are available in the bank, another product working capital demand loan was brought into existence where the client can intimate for withdrawal on prior basis and usually there is a minimum period stipulated before which the company cannot repay.
- Pricing: It is generally charged to 1M-MCLR/3M-MCLR/6M-MCLR + Spread along with additional charges in case of default. However, as this is beneficial for bank as well, the pricing is lower than CC facility.
- Short
Term Loan (STL):
- Details: Similar to WCDL, but the assessment is differently done by the bank than what is done for CC/WCDL. The company borrows a lump-sump amount for a duration which is less than an year.
- Pricing: It is generally charged to 1M-MCLR/3M-MCLR/6M-MCLR + Spread along with additional charges in case of default.
- Packing
Credit (Pre shipment/post shipment ; domestic currency/foreign currency):
- Details: This facility pertains to company which exports its products. As the nature of exports can be domestic or foreign currency, so are the products. As the name suggests, pre shipment packing credit pertains to loan availed by companies before exporting their products and post shipment is after exporting.
- Bill
Discounting:
- Details: Let us consider that the supplier which is supplying products to a company wants loan because after all supplier also has to deal with costs and its working capital cycle. Now the supplier has raised a bill to the company for the products it has supplied and as per the track record of company, it has always paid on time. So the supplier approaches bank with this bill and ask for upfront cash from bank against this bill. The bank charges commission on this and pays the amount to the supplier upfront while the proceeds from company for this bill will come at later date.
- Overdraft
(OD):
- Details: This is a limit linked to a company’s current account where in the company is allowed to overdraw from their current account i.e. more than the balance in their current account. Usually this facility is provided to borrowers that have good internal credit rating.
- Fund Based Products (Long Term): These
products are for meeting long term requirements (typically greater than 1 year)
of company say a company is planning to set up a new manufacturing plant or an
infrastructure company is developing a road project and so on.
- Rupee Term Loan (RTL): Denominated in INR with pricing of 1Y-MCLR + Spread or as decided
- Foreign Currency Term Loan (FCTL): Denominated in foreign currency with pricing of LIBOR + Spread. The exchange rate risk is borne by the client and usually they take derivative products to hedge this risk.
- Non-Fund Based Products:
- Letter of
Credit:
- Details: The Company has to provide letter of credit while buying material from supplier on credit basis, i.e. company buys material from its supplier who provides them with a credit period of say 1 month. So actual payment to supplier will happen after 1 month but what if company does not pay. To guarantee that, suppliers ask for letter of credit where in bank on behalf of company/client has the obligation to clear supplier’s dues in case the company fails to do so.
- Pricing: Charged in terms of commission say 1% on LC amount based on actual number of days for which the LC is opened.
- Bank
Guarantees (BG):
- Details: Suppose the supplier wants to start supplying material to the company but supplier is just setting up his business so he might ask the company for some advance. For company to ensure that its advance is protected, it will ask the supplier to get bank guarantee from bank where in if the supplier meets his milestone of supplying the raw material then his advance bank guarantee is released but in case supplier defaults then this BG can be devolved and company can claim its money from the bank on behalf of the supplier. Similarly the performance bank guarantee is on account of fact that supplier needs to meet the performance obligations of the products that it is supplying and after expiry/claim period this BG is released or else company devolve this BG and can claim its money from the bank on behalf of the supplier.
- Pricing: Charged in terms of commission say 1% on BG amount based on actual number of days for which the BG is opened or may be lump-sum charges per BG.
- Letter of
Credit:
Good Resource: For detailed study of each of these products along with their assessments and in case you want to make a career in corporate banking, pls. purchase a copy of “Credit Appraisal, Risk Analysis & Decision Analysis by D D Mukherjee”. This is a must have book in your shelf and it’s more like a bible.
Key Risk Assessment Metrics:
There are primarily 3 types of risks which are analyzed for any company and give a view of overall risk that a bank is undertaking in sanctioning a loan to a company/client:
- External Risk
- Internal Risk
- Structure Risk
External Risk: Pertains to industry risk on account of demand supply, impact of government policies, global factors, competitors, key input risks, overall financial performance of the industry (ROCE, operating margins etc.).
Internal Risk: Pertains to company specific risk and is evaluated for following
- Business Risk
- Financial Risk
- Management Risk
- Project Risk
Structure Risk: Pertains to risk of the structure of loans and security which is collateralized, its enforceability etc.
The above risks are further detailed and analyzed for every company whose loan is being appraised so as to assess the risk of the company.
We will be happy to know your thoughts on our posts. Feel free to reach out in case of any further discussion 🙂
By:
Nishant Gupta
(Email id: nishant@minervagc.com)
Disclaimer: The views and opinions expressed in the article are those of the author and do not necessarily reflect the official policy or position of any other agency, organization, employer or company. Since we are critically-thinking human beings, these views are always subject to change, revision, and re-thinking at any time. Please do not hold us to them in perpetuity.