Principles of Lending, Working Capital Assessment, and Credit Monitoring – JAIIB Notes

Principles of Lending

Lending is not without its risks, especially when lending banks rely heavily on borrowed capital. The fundamental principles include 

1. Liquidity 
2. Diversity
3. Safety
4. Stability 
5. Profitability
6. Purpose

The detail regarding the same has been given below-

Liquidity – Bank lending is based on the idea of liquidity. Banks only lend for short durations because they are lending public money that depositors can withdraw at any time. As a result, they make loans secured by easily marketable assets that they can convert into cash at a moment’s notice.

Diversity – A commercial bank should use the principle of diversification when deciding on its investment portfolio. It should invest its surplus cash in various assets rather than a single type of investment. It should select shares and debentures from various industries located in various parts of the country. Diversification tries to reduce the risk in a bank’s investment portfolio.

Safety – Safety means that the borrower should be able to repay the loan and interest in time at regular intervals without default. The repayment of the loan depends upon the nature of security, the character of the borrower, his capacity to repay, and his financial standing. 

Stability – Another essential component of a bank’s investment strategy should be to invest in stocks and assets with a high degree of price stability. The bank cannot afford to lose any of its securities’ value, and as a result, it should place its money into shares of well-known companies with a low likelihood of price declines.

Profitability – This is the foundational principle behind a bank’s investment decisions. It must be profitable enough, and as a result, it should invest in securities that guarantee a fair and consistent return on investment. The ability of stocks and shares to earn money is determined by the interest rate, dividend rate, and tax benefits they provide. 

Purpose – Loans for unfavourable or speculative purposes are not available. Even though the profits from such economic activities are higher, a bank cannot use these loans at that time.

Working Capital and Term Loan

Working Capital Loan – A working capital loan is a short-term loan used to finance a company’s day-to-day business activities. Working capital loans aren’t utilized to put money into a business or buy long-term assets or investments. Instead, it’s utilized for things like paying monthly interest, settling accounts payables, and anything else that has to do with current assets and liabilities.

The formula for Working Capital Requirement = Account Receivables Inventory – Accounts Payables

Term Loan – A term loan is a loan that is repaid over a certain length of time at regular intervals. A term loan can run anywhere from one to ten years, with some term loans lasting up to 30 years. They are further divided into two types – one having a fixed rate of interest and the other having a floating rate of interest.

Working Capital Needs 

Commercial banks have stringent requirements for lending on a short-term basis. A consumer must prove his creditworthiness to his bank by demonstrating his character, capacity, capital, and collateral. If the total assessment is favourable, the bank will finance only the remaining gap in the customer’s resources after considering the predicted availability of funds from all other sources. The working capital can be estimated based on four methods-

1. Projected Net Working Capital Method
2. Projected Turnover Method
3. Operating Cycle Method
4. Cash Budget

In these methods, projected fund flow statements, projected financial statements, and projected cash flow statements are prepared.

Operating Cycle Method

The duration of the operating cycle is used to estimate working capital using the operating cycle approach. The greater the cycle’s duration, the greater the working capital requirements. The raw material to work in progress to finished items to accounts payable to cash cycle is referred to as the operating cycle. The time it takes to go from purchasing raw materials to converting them into cash is referred to as the operating cycle time. 

To assist borrowers in such a circumstance, banks have made the following decisions as part of their loan policies:

1. Creditors will not be offset against equity for determining working capital requirements.
2. The borrowers will provide a detailed list of creditors and debtors by age, as well as a stock statement.
3. Only debtors who have been past due for less than the required period (up to 180 days maximum) will be assessed on a case-by-case basis.
4. The bank will have to hypothecate the borrower’s whole book debts.
5. If creditors outnumber debtors, the bank will not finance the borrower’s book debts.

Projected Turnover Method

Banks analyze the working capital requirements of village industries, tiny industries (SSI units and traders) with a fund-based working capital limit of up to Rs 5 crore using the turnover technique as a matter of policy and based on RBI recommendations.

The Turnover Method is used to determine a borrower’s working capital needs based on the company’s turnover.

The RBI has issued the following directives:

1. Banks may regard 20 per cent of their estimated yearly gross sales turnover as minimum working capital finance.
2. A 5% contribution is made to promoters in order to ensure that a minimal margin supports a borrower’s working capital needs.
3. The turnover technique is framed using a three-month average operational cycle as a guideline. If the cycle is longer than three months, the borrower should put up a correspondingly bigger amount of money in relation to the amount of money he needs from the bank.
4. The stock statement is used to compute drawing power. Unpaid stacks should not be sponsored because this would result in double funding.

Projected Net Working Capital Method

The borrower must meet the margin requirements from accruals throughout the year and other long-term funds in the form of net working capital. The expected net working capital, which would be larger than the borrower’s existing level, would be built up gradually as production, sales, and profits increased.

Cash Budget System

Most banks’ existing loan policies stipulate that an assessment of the working capital needs of a borrower who enjoys or requires fund-based limits in excess of Rs 10crs must be conducted. It is recommended that the cash budget system be implemented.

When preparing a cash budget for a quarter, the following stages must be followed in order-

1. Actual payments and receipts during the first, second, and third months.
2. The cash surplus/deficit position is calculated on a monthly basis. When receipts exceed payments, a surplus is created, and when payments exceed receipts during the month, a cash deficit is created. 
3. The first month’s opening cash balance is adjusted against the cash surplus/deficit generated during the month. The adjusted figure is the first month’s closing balance, which becomes the opening balance for the next month, i.e. the second month. 
4. A cash surplus generated during a month reduces the level of borrowed funds at the end of the month if the company has a net position on borrowed funds (the company maintains a cash credit/ overdraft account).

Credit Management

Credit management entails the process of granting credit, determining the terms on which it is granted, recovering the credit when it is due, and ensuring compliance with the company’s credit policy, among other things. The purpose of credit control at a bank or firm is to increase revenue and profit by facilitating sales and lowering financial risks. 

Credit Monitoring

Credit monitoring involves keeping an eye on a person’s credit history for any changes or unusual activity. A credit monitoring service will reveal an individual’s credit report and update them on new credit inquiries, accounts, and so on. The individual might also check to see if the information is accurate. Individuals can utilize credit monitoring to keep an eye on their credit score and maintain track of it, allowing them to be aware of their credit history before applying for loans and mortgages. The monitoring procedure entails a number of measures to guarantee that careless loans are made within the limitations of the credit policy in place when it comes to delinquency. The credit management component will ensure that the loans are collected. 

Step by Step Process of Credit Monitoring

1. When a loan has been in default for two months, look for potential NPAs.
2. Examine the reasons for default, including if it is due to intrinsic flaws or temporary liquidity or cash flow problem.
3. If cash flow imbalances are real, offer quick contingency aid in the form of ad-hoc limitations.
4. If the loan limit is found to be insufficient due to loan default during the year, ask the borrower to submit a renewal proposal and improve it appropriately.
5. If the stock statement has not been submitted, go to the plant right away to verify the securities.
6. Keep the documents alive and examine them regularly.
7. Implement the concurrent auditor’s report, statutory auditor’s report, branch inspector’s report, credit audit, regional manager’s report, and so on.

Conclusion

We hope the article gives you detailed information about the Principles of Lending, Working Capital Assessment, and Credit Monitoring Unit of the JAIIB. For any queries, contact us at Oliveboard.

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