FINANCIAL PRODUCTS & PARAMETERS....

FINANCIAL PRODUCTS & PARAMETERS

One of the most important considerations for an Entrepreneur- Company in implementing a new project or undertaking expansion, diversification, and modernization and rehabilitation scheme is ascertaining the cost of project and the means of finance. There are several sources of finance/funds available to any Company. The three major factors that determine the capital structure of a particular business are a proper balance of risk, cost of capital and control considerations. An effective analytical mechanism of various sources of funds available must be instituted by the Company to achieve its main objectives. Such a mechanism is required to evaluate risk, tenure and cost of each and every source of fund. The selection of the fund source is dependent on the financial strategy pursued by the Company, the leverage planned by the Company, the financial conditions prevalent in the economy and the risk profile of both the Company as well as the industry in which the Company operates. Each and every source of fund has some advantages as well as disadvantages.

With the Indian economy moving on to a high growth trajectory, consumption levels soaring and investment riding high, the Indian banking sector is at a watershed. Further, as Indian companies globalize and people of Indian origin increase their investment in India, several Indian banks are pursuing global strategies, the industry has been growing faster than the real economy, resulting in the ratio of assets of commercial banks to GDP increasing.

With the growth of development banking in India, the country has witnessed a phenomenal growth in industrialization. Necessity had been felt to properly organize the flow of financial assistance to the industry through a well-knit network of various Banks and Financial Institutions spread all over the country. Before the Company can approach the financial institutions and Banks for financial assistance it has to prepare a ‘Feasibility Study Report’ which enables in placing the Promoters in a better position to respond to all the queries, requirements in the project. The entrepreneurs approach these institutions with a request for the sanction of necessary financial assistance either by way of Rupee Loans or by way of foreign currency loans or special kind of loans under different schemes of the banks/institutions. The equity support similarly may be by way of Seed Capital Assistance, Risk Capital Assistance or Equity participation by the Institutions or by way of private placement by the Institutions.

Today, in India there are many categories of banks viz. Nationalized Banks, Foreign Banks, Private Banks, Co-operative Banks etc. and Financial Institutions providing financial assistance to smoothen the business activities. Currently financial assistance is easily available at very competitive rates due to competition amongst banks. The trend has changed from sellers market to buyers market resulting in borrower having choice to select banks based on the terms offered by different types of banks.

Sources of Finance

A basic principle is that short-term financial needs should be met from short-term sources, medium term financial needs from medium term sources and long-term financial needs from long-term sources. Moreover a proper balance between loan funds and own funds has to be maintained

Sources of Finance can be classified on the basis of time:

Long-Term

• Share Capital – Equity/Preference (including cumulative convertible preference shares) from promoters, their friends and relatives, public institutions RCTC, Mutual Funds UTI, SIDCS, etc.

• Reserves and Surplus

• Retained earnings/internal cash accruals

• Long-Term loans from FIs and Banks (Rupee and Forex)

• Deferred payments

• Unsecured loans from promoters and sister concerns

• Public deposits

• Deposits from dealers

• Asset Securitisation

• Lease financing

Apart from the above traditional source of finance there are various avenues available to raise long-term finance like Venture Capital Finance and International Financing.

• Venture Capital Financing

Venture Capital Financing refers to financing of new high-risk venture promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas. In broad sense, under venture capital financing venture capitalist make investment to purchase equity or debt securities from inexperienced entrepreneurs who undertake highly risky ventures with a potential of success. Some common method of venture capital finance is as follows:

• Equity financing

• Conditional loan

• Income Note

• Participating Debenture

Presently there are 129 Foreign Venture Capital Investors (FVCI) and 132 Venture Capital Funds (VCF) registered with SEBI (Securities Exchange Board of India). For details please visit

https://www.sebi.gov.in/investor/venturecap.H T M L

• International Financing

There are various avenues available to raise funds from the international market. Euro Issues, Global Depository Receipts (GDR), American Depository Receipts (ADR) and Foreign Currency Convertible Bonds (FCCB) are more popular in India.

• Euro Issues

Euro Issues are listed on a European Stock Exchange.

• Euro Convertible Bonds

A Convertible bond is a debt instrument, which gives the holders of the bond an option to convert the bond into predetermined number of equity shares of the company. The bonds carry a fixed rate of interest. Such bonds may carry 2 options viz.

(i) Call Option (Issuer’s Option)

(ii) Put Option (Holder’s Option)

• Global Depository Receipts (GDR)

GDR is negotiable certificate, denominated in US dollar that represents a non-US company’s publicly traded local currency equity shares.

• American Depository Receipts (ADR)

Depository receipt issued by a company in the USA is known as ADRs. Such receipts have to be issued in accordance with the provision of Security and Exchange Commission of USA.

• Foreign Currency Convertible Bonds (FCCB)

FCCB means bonds issued in accordance with a scheme and subscribed by a non-resident in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in whole, or in part, on the basis of any equity related warrants attached to debt instruments.

• Private Equity Funding

Private Equity is also known as equity finance, equity loans, venture capital or private venture capital. PE can be defined as investment in unlisted companies not quoted on a stock exchange and is usually seen as an alternative (or an addition) to the more traditional forms of finance such as bank debt. It includes forms of venture capital and Management Buyout (MBO) financing. PE can be derived from a number of areas such as superannuation funds, overseas investors, other companies, high net worth investors, a venture capitalist or venture capital firms.

PE enables entrepreneurs to achieve success that may otherwise have been beyond reach by providing resources over and above money. Success of PE Fund is dependent on success of the venture. PE funds make sure that their star entrepreneurs are helped with all the resources and learning which can be mustered by the fund to help them realise their dream.

Typically if a private equity investor agrees to invest in a company, they will require some kind of representation on the board and hold a shareholding in that company. Normally these investments lack security and as a consequence a venture capitalist will be looking for high returns on their investment which means they will be aiming to identify companies with high growth potential.

The private equity investor or venture capitalist aims to exit the business usually 3 to 7 years after the investment through the company listing on the stock exchange, selling the business or through a management buyout. Accordingly, the primary return on investment from equity funding is usually through capital gain at the exit stage. Private equity finance is suitable for less mature companies with developing or under developed concepts or revenue as well as for more mature established companies to finance expansion or turnaround strategies.

Private equity investors will examine the following key areas when considering a loan investment:

• Strength of Management

• Business Strategy

• Target Market

• Competition

• Innovation

Whether the business is a start up or an existing company, any period of forecasted growth will bring additional risks which may also stretch the financial requirement beyond the current capabilities of the company. Bank debt may prove to be too restrictive on cash flow or even impossible to obtain. In these circumstances equity funding may provide the much needed capital base as well as the support to achieve goals.

• Short-Term

• Bank Overdrafts

• Trade Credit

• Short-Term Loans

• Bridge loans

• Factoring

• Bills of Exchange

• Hire purchase

• Invoice Discounting

• Lease

• FD’s for less than a year

• Forfaiting

Today, in addition to traditional products viz. Term Loans, Cash Credit & Overdraft Facilities etc. various different types of products are available in market, financing each stage of business activity. A prudent financial manager is one who can take advantage of the products to minimize the cost of borrowing for a corporate.

Sources other than the Traditional Lending

Sr.No.	Type of the Product	Purpose/Meaning	Eligibility	Cost	Security	Tenure
(A)	Bridge Loans/      Short-term Loans	To meet temporary cash flow mismatches	Corporate with good credit rating	Available at MIBOR / LIBOR	Current Assets	Matching with Cash Flows
(B)	Commercial Paper	Short-term borrowing Denomination of CP Note - Rs. 5 Lakhs or multiples thereof	Highly rated corporate having minimum net worth of Rs. 4.00 crores & Credit rating of P2 or equivalent of credit rating agencies approved by RBI, Primary Dealers, Satellite Dealers & FIs	Sub-PLR depending on rating	Unsecured	7 days to one year
(C)	Factoring	Outright sales of the receivables of a firm to another agency specializing in the management of trade credit called the factor	Corporate having large numbers of debtors	Nominal service charges compensated by saving in managing receivables in-house	Receivables	Continuous process
(D)	Forfeiting	Discounting export receivables	Exporters	Fixed rate basis discount	Bills of Exchange	Medium to long -term maturities
(E)	Securitisation of Future Receivables	Discounting certain or near certain cash flows	Continuity of specific business and borrowers’ ability to perform consistently	Sub-PLR depending on rating	Quality of receivables	Continuous process
(F)	Sales Bill Discounting	To finance sales receivables	Any	Lower than CC/ WC Limit	Bills of Exchange	90 days to 180 days
(G)	Supplier Bill Discounting	Financing of receivables due from govt.	Suppliers to Government corporations and govt. depts.	Lower than CC/ WC Limit depending on comfort	Bills of Exchange, Power of Attorney registered with the govt. dept.	Normally 90 to 180 days
(H)	Invoice Financing	To facilitate direct collection of receivables	Regular suppliers of reputed Corporate	Lower than CC/ WC Limit	Assignment of receivables in favour of financing banks	Normally 90 to 180 days
(I)	Export Finance	Pre Shipment Finance	Exporters who holds Export order or letter of credit in his own name.	Concessional  rates depends on credit rating subject to maximum rate of PLR minus 2.5 %	Export orders	Normally 90 to 180 days
		Post Shipment Finance	-Do-	-Do-	Export bills	Normally 90 to 180 days
(J)	Channel Financing	Purchase bill   discounting wherein Bills of exchange (BoE) rose by a Corporate on its distributors is discounted by the Bank & proceeds are directly paid to the seller (Corporate).	Distributors who purchases goods from reputed corporate	Sub-PLR depending on rating	Bill of Exchange, Post dated cheque (PDC),Invoice & Transport  proof	Continuous process
(K)	Cash Management Products	Cheque collections deposited in banks are credited on the date of deposit or prior to the date of clearing as per the arrangement with the bank. This is done at a nominal fee for the service provided but it improves the cash flows considerably when collections against sales are spread over remote locations.
(L)	External Commercial Borrowings	For investment in real/ industrial sector and infrastructure	Corporate registered under the Companies Act except financial intermediaries (such as banks, financial institutions (FIs),housing finance companies and NBFCs)	Maximum LIBOR plus 150 basis points for 3 to 5 years	Choice of security to be provided to the lender/supplier is left to the borrower	More than 3 years
				Maximum LIBOR plus 250 basis points More than 5 years
(M)	FCNR-B Loans	Loans against FCNR Deposits (Foreign Currency)	Generally to Corporate who  have natural hedge due to exports	LIBOR +	Fixed/Current Assets

The above-mentioned products are mainly to meet the shortfall in working capital and working capital requirements of the business and are offered by Nationalised Banks, Private Banks and Foreign Banks (depending upon the credit rating of the borrower).

It is also found that some of the SIDCs (State Industrial Development Corporations) and large Co-operative banks have also joined the bandwagon of providing structured products to the Corporate.

Banks are offering interest rates on financial assistance based on the credit rating of the individual borrowers. Credit rating is assessed based on the scoring system, which differ from bank to bank. All banks are having their own credit rating system and considering the various parameters pertaining to risks attached like financial risks, business risks, management risk etc, assesses the same.

Generally, following parameters are considered while assessing the credit rating:

Sr. No.	Parameter	Acceptable Level
A.	FINANCIAL RISK
(i)	Current Ratio	1.33:1
(ii)	TOL/TNW (Total Outside Liabilities / Tangible Net Worth)	Not more than 3:1
(iii)	Debt/ Equity Ratio	1.50:1 to 2:1 sometime 3:1 depends on the nature of the project.
(iv)	PAT/Net Sales (%)	In excess of 5%
(v)	PBDIT/Interest	There is no such level, more than 2.5 times will be satisfactory
(vi)	Trends in Performance	Upward Trend
(vii)	Gross Average DSCR	Minimum 1.75 to 2.00
(viii)	Achievement in Projected Profitability	Achievement of 80% - 90% is considered satisfactory
(ix)	Collateral Security / Financial Standing	Tangible Security – 0% to 25% of the banking facility
B.	BUSINESS RISK
(i)	Technology	Technology should be competent to beat the competition.
(ii)	Capacity Utilization vs. Break Even Point	Capacity Utilization should be 25% - 30% above the BEP
(iii)	User / Product Profile	Products should be well accepted by the users & should beat competition.
(iv)	Consistency in Quality	Quality should be consistent
(v)	Distribution Network	Wide & Adequate Distribution channel
(vi)	Consistency of Cash Flows	Cash Flows should be consistent
C.	INDUSTRY RISK
	Under this broad parameter, various parameters are considered like facing of competition, Industry Outlook, Regulatory Risk and other important factors which need to be considered to evaluate the Risk.
D.	MANAGEMENT RISK
	Many factors are considered while evaluating management risk. Some of the factors are Integrity/Corporate Governance, track record, payment record, Managerial competence/commitment, expertise, structure & system, Experience in Industry, credibility, Strategic initiatives, length of relationship etc. considered while evaluating management risk.
E.	QUALITATIVE FACTORS: NEGATIVE PARAMETER
	Factors like Contingent Liabilities, Auditors Qualifications, Accounting Policies as regards to Depreciation, inventory etc. are considered.
F.	QUANTITATIVE – INDUSTRY COMPARISON
	Borrower’s financial ratios should be compared with the standard industry norms to evaluate the risk.

There are several instances wherein a corporate may not be able to achieve the desired rating as per the bank/institution due to weight age given by it to certain parameters, which may reduce the scoring of the corporate. Despite this a fundamentally strong corporate can avail a pricing on the products much below the rating which however will depend on the negotiating skills of the corporate. The important considerations in effective negotiations are a proper cultivation and maintenance of a good banking relationship, good understanding of the theory and practice of term lending, repayment, planning and agreeing to the covenants. Due to competition though each bank/institution rates the corporate as per their rating parameter it still succumbs to the demands of the corporate for finer pricing. Though each bank/institution have set their PLR as a benchmark, in today’s scenario the same is irrelevant since most of the banks/institutions find it a deterrent for lending. Most of the banks have already started lending much below the PLR, which is more out of compulsion.

 

Source: ICAI(WIRC)