Financing Retail, SME & Corporates – Sources
And Risk Factors – CAs Role
-By S.V.Ramana – MBA (Fin), AICWA, M.Com
1
Need for Finance
Finance is life blood of any business organization.
Organizations require finance to meet basic objectives:
To set up, modernize, expand business activity i.e to
acquire fixed assets for facilitating productive endeavour
To meet the day-to-day working capital requirements
i.e operating cycle
To meet the former, long term finance is required and
the latter, short term finance due to their inherent
difference in life of assets.
A portion of current assets is to be met through long
term sources for having long term stability, liquidity etc in
the
event
of
exigencies.
2
funds
Long term sources of funds could be primarily own
i.e capital, retained earnings, subsidies / grants etc
External sources i.e Banks, Financial Institutions in the
form of term loans, capital market, Debentures, Preference
shares, Deferred Payment Guarantees etc
Short Term or Working Capital: requirements of SME /
Corporate are predominantly funded by Commercial Banks.
Working capital will be in the form of credit facilities
involving both funds and without providing funds also.
3
Fund Based Facilities
Various fund based facilities extended by
Commercial Banks are in the form of the
following:
Cash Credit / Overdraft
Short Term Loan / Demand Loan
Key Loan / Mortgage Loan
Bill Discounting / Cheque purchase
Export Credit (pre shipment and post
shipment)
Factoring / Forfeiting etc
4
Major Non Fund Facilities are as under:
Letters of Credit
Bank Guarantees
Uniform Customs and Practices for Documentary Credits’
(UCPDC) – all LCs are governed by UCPDC
Types of LCs:
Sight or Acceptance LCs
Revolving Credits (repeated purchases)
Red clause LC: Advising / confirming bank to
advance part of LC amount for meeting expenses etc
in the form of packing credit (export orders)
Green clause LC: In addition to red clause, the goods
are to be warehoused in the name of issuing bank
and payment made against warehouse receipts.
5
Transferable Credits: The beneficiary may ask for
transferring the credit in full or part to one or more
other beneficiaries (textile exports)
Back to Back Credits: The beneficiary gets LC from a
bank and requests his bank to open another LC/LCs
in favour of his suppliers. One LC is backed by
another LC
Standby Credits: are security cover for beneficiaries
and the issuing bank undertakes to pay only on
default by the applicant (buyer). If any one
transaction is not paid by the buyer, the standby LC
will authorise the beneficiary to draw on the issuing
bank, giving a certificate that the default has
occurred.
6
Bank Guarantees:
Financial Guarantees (Bid bond/EMD, Mobilisation
advance, retention money )-risk weightage 100%
Performance Guarantee-Risk weightage 50%
Primary & Collateral Security
Banks in India invariably adopt security oriented
approach while granting both long term and short
term facilities, whether Fund or Non-Fund
Even big corporate houses are not an exception to
this
Securitization Act – shot in the arm to the Bankers
Security is for fall back in the event of default,
reduction in Capital requirements of Banks in
compliance to Basel II norms
7
Long Term Sources / Project Finance:
Before approaching any Bank / FI/ Capital Market,
detailed appraisal of the proposed business plans in
the form of Red Herring Prospectus, project report
shall be made
A project report / appraisal is not complete without
discussing the following in greater sense:
Group / Promoters background, track record,
Management capacity etc
Types of assets to be acquired, suppliers,
arrangement etc
Technical & Financial Feasibility of the project
8
Environmental, PCB clearances
Demand Forecasting, demand – supply gap
Production capacity, product features etc
Cost of the project, means of finance
Time schedule
Commercial viability of the project
Security – primary, collateral, margin etc
Financial projections, sensitivity analysis, DSCR, BEP
analysis
Funds Flow Statement
Rate of return etc Pay Back period, IRR, NPV etc.
9
The main sources of finance would be:
Owned Funds - Share Capital ( public, promoters etc)
Preference Shares
Internal cash accruals (existing entities)
Debt Funds Term Loans
Debentures
Leasing (Air Craft, Oil rigs)
Deposits
Unsecured Loans
Central or State Govt
Subsidies
Interest Free Loans (ST def.)
Deferred Payment Guarantees etc
10
Appraisal / interpretation of financial statements:
Banks and FIs seek audited financial statements,
projections covering the period of credit facilities
requested.
The single most widely followed testing tool by
Indian Bankers being Ratio Analysis,
The analyst / appraiser reads and interprets the
Balance Sheet and P&L account of the enterprise.
Ratios are not end in themselves; rather on a
selective basis, they help answer significant
questions.
As a part of credit appraisal, the following tools are used:
Percentage analysis
Ratio Analysis
Funds Flow Statements
Cash Flow Statements
11
Percentage Analysis
Various figures appearing in the financial statements
are reduced to percentage of total.
This tool may be applied for big corporates and with
history for studying the changes in components
Ratio analysis
The analyst / appraiser to determine relationships
that are to be interpreted thru ratio analysis.
Ratios should be computed in respect of figures
which have significant relationships.
For ex. Sundry Debtors to Sales etc.
Comparison is to examine the ratio of one year to
previous year and reasons for variances,
and with similar business units in the industry for the
same period.
12
The ratios can be broadly classified into the following:
Capitalization / Leverage Ratios ( Debt/Equity,
TOL/TNW etc)
Liquidity Ratios (Current Ratio, Quick Ratio, NWC
etc)
Profitability Ratios (OPBDIT/sales, PAT/Sales, RONW,
ROI etc)
Coverage ratios (Interest coverage, fixed assets
coverage, DSCR)
Turnover Ratios (raw material to consumption;
stores/spares to consumption; SIP/Cost of Prod;
Finished goods to Cost of Sales etc)
13
Funds Flow Analysis
Gives us picture of movement of funds between one
balance sheet date and the next one
Banks are interested in movement of funds
separately under short term and long term categories
and also long term surplus.
The short term movement of funds would indicate
the variations in current assets and current liabilities.
The long term movement of funds would depict the
differences in term liabilities and net worth on one
hand and fixed, non-current and intangible assets on
the other.
This would directly reflect the movement in net
working capital.
However, MNC and New Generation Banks rely more
on cash flow rather than funds flow
14
Cash flow analysis
Cash flow or cash budget statements are used to ascertain
the actual cash requirements of the company.
Cash conversion efficiency – free cash flow from operations
Cash flow really shows the profitability of core business
Enron’s cash conversion efficiency was negative during late
boom years. Majority money is either investing or from
financing
Cash flow tracks the actual movement of cash whereas
funds flow details the movement in value of assets
Sales and purchases are recorded only when cash is
received or paid; whereas in funds flow they are recorded
irrespective whether cash is received/paid.
Method of valuation of stocks do not have any impact on
cash flow whereas in funds flow it has impact on the profit
Prepared usually on monthly basis where as funds flow is
prepared for longer periods at least for an year or quarter.
15
Contingent Liabilities
A contingent liability is a liability which may or may not
occur in the future, arising out of the existing situation.
A contingent becomes an actual liability based on the
occurrence or non-occurrence of one or more uncertain
events in future
Examples: Claims against the company not acknowledged
as debts
Arrears of fixed cumulative dividends
Bills discounted with Banks
Guarantees issued on behalf of the company and also on
behalf of subsidiaries, group companies
Letters of credit outstanding
Estimated amount of contracts remaining to be executed
on capital account not provided for
16
Other financial products :
Credit Guarantee Scheme for Micro and Small
Enterprises:
CGTMSE provides guarantee cover for collateral free
loans given by Banks to Micro and Small Enterprises
from INR 50 Lakhs to INR 100 lakhs.
CGTMSE charges guarantee fee and service fee for
sharing the risk of providing collateral free credit
facilities.
This is catching up now as it has given a shy of relief
to many entrepreneurs who are unable to provide
collaterals to Bank.
Export Credit Guarantee Corporation of IndiaWTPCG, WTPSG
Bridge Loans-may be sanctioned by Banks for <1yr
against expected equity flows/issues; NCD, ECB, FDI
17
RISKS AND MITIGANTS
Business Risk
Management Risk
Financial Risk
Credit Risk
Market Risk
Industry Risk
Operational Risk
Environmental Risk
Concentration Risk
Reputation Risk
Socio, economic and Political Risks
Structure Risk
RISK vis a vis REWARD; RAROC
18
Role of Chartered Accountants
CAs enjoy lot of reputation with Banks and Statutory
Authorities
Should play advisor role to the client on continuous basis
CAs should evaluate various risks associated and suggest
mitigants
CAs shall ensure that the client meets the statutory &
regulatory requirements at all times
CAs should ensure that a sound project / credit appraisal
is done before implementation /starting of project.
CAs should evaluate the managerial & financial strengths
of borrowers before recommending any loan proposal
CAs should ensure that the entrepreneur has multiple
funding options and not confined to single source
19
Role of Chartered Accountants
CAs should advise clients to go for Credit Rating wherever
applicable thereby pricing will be competitive.
Client’s Business model, business plans, revenues / profits
forecast should be realistic and achievable
Entrepreneurs should have financial strength to withstand
the downturn in the industry / business
CAs should vet proposals only for clients with high
integrity and sound business principles
CAs should ensure that the promoters bring in their share
of contribution before starting new business, expansions.
CAs should ensure that their clients are not financing
long-term assets with short-term liabilities – liquidity risk
CAs should not issue certificates to clients of other CA
firms
20
Impact of Basel II on Banking and borrowers
Basel II is recommendatory framework for Banking Supervision.
RBI in Apr 2007 issued guidelines on New Capital Adequacy
Framework to Banks operating in India. The revised framework
is effective from March 31, 2009 for all commercial banks
(except LAB and Regional Rural Banks)
The Revised Framework consists of three-mutually reinforcing
Pillars, viz.
Minimum capital requirements,
supervisory review of capital adequacy,
and market discipline.
21
Impact of Basel II on Banking and borrowers
Pillar 1, the Framework offers three distinct options for
computing capital requirement for credit risk and three other
options for computing capital requirement for operational risk.
The options available for computing capital for credit risk are
Standardised Approach, Foundation Internal Rating Based
Approach and Advanced Internal Rating Based Approach.
Under the Standardised Approach, the rating assigned by the
eligible external credit rating agencies will largely support the
measure of credit risk. Under the new framework, banks need
to provide capital for credit risk based on the risk associated
with their loan portfolios.
High quality credit exposure attracts lower capital on credit risk;
Capital required = Loan amount X Risk Weight X 9%
22
Credit Risk
Credit risk =Risk that a party to a contractual agreement or
transaction will be unable to meet their obligations or will
default on commitments.
Credit risk can be associated with almost any transaction or
instrument such as swaps, repos, CDs, foreign exchange
transactions, etc apart from FB, NFB facilities
Specific types of credit risk include sovereign risk, country risk,
legal or force majeure risk, marginal risk and settlement risk.
23
Credit Ratings
In the Standard & Poor rating system, AAA is the best rating.
After that comes AA, A, BBB, BB, B, CCC, CC, and C
The corresponding Moody’s ratings are Aaa, Aa, A, Baa, Ba,
B,Caa, Ca, and C
Bonds with ratings of BBB (or Baa) and above are considered to
be “investment grade”
Historical Data
Historical data provided by rating agencies are also used to
estimate the probability of default
24
Impact of Basel II on Capital requirement of Banks
-Loan
of
INR
1000
mio
Basel-I
Basel
–
II
Rating
Risk Wt
Cap req
Rs.mio
Risk Wt
Cap req
Rs.mio
Cap
saved
Rs. mio
AAA
100%
90.00
20%
18.00
72.00
AA
100%
90.00
30%
27.00
63.00
A
100%
90.00
50%
45.00
45.00
BBB
100%
90.00
100%
90.00
nil
BB and
below
100%
90.00
150%
135.00
(45.00)
unrated
100%
90.00
150%
135.00
(45.00)
25
Do Default Probabilities Increase with Time?
For a company that starts with a good credit rating
default probabilities tend to increase with time
For a company that starts with a poor credit rating
default probabilities tend to decrease with time
26
Cumulative Ave Default Rates (%) (1970-2006,
Moody’s
1
2
3
4
5
7
10
Aaa
0.000
0.000
0.000
0.026
0.099
0.251
0.521
Aa
0.008
0.019
0.042
0.106
0.177
0.343
0.522
A
0.021
0.095
0.220
0.344
0.472
0.759
1.287
Baa
0.181
0.506
0.930
1.434
1.938
2.959
4.637
Ba
1.205
3.219
5.568
7.958
10.215 14.005 19.118
B
5.236 11.296 17.043
22.054
26.794 34.771 43.343
19.476 30.494 39.717
46.904
52.622 59.938
Caa-C
69.178
27
Interpretation
The table shows the probability of default for
companies starting with a particular credit rating
A company with an initial credit rating of Baa has a
probability of 0.181% of defaulting by the end of
the first year, 0.506% by the end of the second
year, and so on
28
Risk weights for other exposures
Claims included in this portfolio shall be assigned a risk-weight
of 75 per cent
Lending to individuals meant for acquiring residential property
fully secured by mortgages on the residential property having
loan to value (LTV) of 75%.
Risk Weight for loans upto Rs. 30 lakhs - 50%
Risk weight for loans Rs. 30 Lakhs and above - 75%
Lending for acquiring residential property of LTV >75 % attract
a risk weight of 100 per cent.
Loans secured by commercial real estate as defined above will
attract a risk weight of 150 per cent. (reduced to 100%)
29
Risk weights for other exposures
FB and NFB claims on Venture capital funds, commercial real
estate are considered high risk exposures and attract risk
weight of 150 %
Consumer Credit including personal loans and credit card
receivables attract a higher risk weight of 125%.
Capital market exposures attract 125% risk weight
NBFCs: The claims on ‘Non-deposit taking systemically
important NBFCs: BBB and above 125%
Below BBB 150%
Off-balance sheet items: Sanctioned credit facilities which are
undrawn attracts Risk weightage of 20%
Recently risk weight to non-rated companies reduced to 100%
30
Operational Risk
Operational risk is defined as the risk of loss resulting
from inadequate or failed internal processes, people
and systems or from external events. This definition
includes legal risk, but excludes strategic and
reputation risk.
There are 3 methods of calculating Operational Risk;
(i) the Basic Indicator Approach (BIA)
(ii) the Standardised Approach (TSA)- Divided into 8
business lines; 12% for retail brokerage to 18% for
corporate finance
(iii) Advanced Measurement Approaches (AMA) –
Internal risk measurement both qualitative and
quantitative subject to approval by RBI
31
Operational Risk
Minimum capital required under the Basic Indicator
Approach is 15% of average of previous three years
annual gross income for operational risk
some of the risks that the banks are generally
exposed to but which are not captured or not fully
captured would include:
(a) Interest rate risk in the banking book;
(b) Credit concentration risk;
(c) Liquidity risk;
(d) Settlement risk;
(e) Reputation risk;
(f) Strategic risk;
The methodologies and techniques are still evolving
w.r.t measurement of non-quantifiable risks, such as
reputation and strategic risks.
32
Market Risk
.
Market risk is defined as the risk of losses in onbalance sheet and off-balance sheet positions arising
from movements in market prices.
The market risk positions subject to capital charge
requirement are:
The risks pertaining to interest rate related
instruments and equities in the trading book; and
(ii) Foreign exchange risk (including open position in
precious metals) throughout the bank (both banking
and trading books).
Trading book for the purpose of capital adequacy will
include: (i) Securities included under Held for Trading
33
Market Risk
.
(ii) Securities included under the Available for Sale
(iii) Open gold position limits
(iv) Open foreign exchange position limits
(v) Trading positions in derivatives, and
(vi) Derivatives entered into for hedging trading book
exposures.
The minimum capital requirement is expressed in:
specific risk charge for each security, designed to
protect against any adverse movement in the price of
an individual security owing to factors related to the
individual issuer
general market risk charge towards interest rate risk
34
Derivatives
In the last 25 years derivatives have become more
popular in the world of finance.
A derivative can be defined as a financial instrument
whose value depends or derives from the values of
other, more basic, underlying variables.
Futures and Options are now traded actively on
many exchanges throughout the world.
Different types of forward contracts, swaps, options
and other derivatives were regularly traded by
Financial Institutions, Fund Managers, Corporate
Treasurers either to hedge or speculate or to take
advantage of arbitrage.
Derivatives o/s US$ 680 trillion
Forex derivatives are denominated in one leg
US$-83%, Euro 41%, Yen 22%
35
Derivatives are Used mainly:
To hedge risks
To speculate (take a view on the future direction of
the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without
incurring the costs of selling one portfolio and buying
another
36
Forward Contracts
Forward contract is a simple derivative product.
It is an agreement to buy or sell an asset at a certain
future time for a certain price.
This is in contrast to the Spot Contract.
A forward contract is traded usually between two
financial institutions or between a financial institution
and one of its clients.
Forward Contracts on foreign exchange are very
popular and are being used predominantly by
Exporters and importers or enterprises having FOREX
commitments
Futures Contract: is a standardised contract traded on an
exchange. A range of delivery dates is usually
specified. It is settled daily and usually closed prior
to maturity.
37
Forward Contracts vs Futures Contracts
FORWARDS
FUTURES
Private contract between 2 parties
Exchange traded
Non-standard contract
Standard contract
Usually 1 specified delivery date
Settled at end of contract
Delivery or final cash
settlement usually occurs
Some credit risk
Range of delivery dates
Settled daily
Contract usually closed out
prior to maturity
Virtually no credit risk
38
Options
Options are traded on exchanges and OTC.
There are two basic types. A call option, put option
A call option gives the holder the right to buy the
underlying asset by a certain date for a certain price.
A Put Option gives the holder the right to sell the
underlying asset by a certain date for a certain price.
Advantage-holder of options does not have to
exercise the right.
In case of forwards and futures, the holder is obliged
to buy or sell the underlying asset.
Forward contracts-designed to neutralize the risk by
fixing the price that the hedger will pay/receive
Options, by contrast, provide insurance.
Costs nothing to enter into a forward or future
contract whereas up-front fee is to paid for options
39
Swaps
Swap is an agreement between two companies to
exchange cash flows in the future.
The agreement defines the dates when the cash
flows are to be paid, the way in which they are to be
calculated (interest rate, exchange rate and/or other
market variable)
Interest Rate Swap:
The most common type of swap is “Plain Vanilla”
interest rate swap.
A company agrees to pay cash flows equal to the
interest at a predetermined fixed rate on a notional
principal for a number of years.
In return, it receives interest at a floating rate on the
same notional principal for the same period of time.
Floating rate in most interest rate swaps agreements
is LIBOR, as LIBOR is quoted in all major currencies
for 1 month, 3 m, 6 m and 12 month period.
40
Example of a “Plain Vanilla” Interest Rate Swap
An agreement by Microsoft to receive 6-month LIBOR
& pay a fixed rate of 5% per annum every 6 months
for 3 years on a notional principal of $100 million
The slide illustrates cash flows that could occur
41
Cash Flows to Microsoft
---------Millions of Dollars--------LIBOR FLOATING
FIXED
Net
Date
Rate
Cash Flow Cash Flow Cash Flow
Mar.5, 2004
4.2%
Sept. 5, 2004
4.8%
+2.10
–2.50
–0.40
Mar.5, 2005
5.3%
+2.40
–2.50
–0.10
Sept. 5, 2005
5.5%
+2.65
–2.50
+0.15
Mar.5, 2006
5.6%
+2.75
–2.50
+0.25
Sept. 5, 2006
5.9%
+2.80
–2.50
+0.30
Mar.5, 2007
6.4%
+2.95
–2.50
+0.45
42
Typical Uses of an Interest Rate Swap
Converting a liability from
fixed rate to floating rate
floating rate to fixed rate
Converting an investment from
fixed rate to floating rate
floating rate to fixed rate
43
An Example of a Currency Swap
An agreement to pay 5% on a sterling principal
of £10,000,000 & receive 6% on a US$ principal
of $18,000,000 every year for 5 years
44
The Cash Flows
Year
2004
2005
2006
2007
2008
2009
Dollars Pounds
$
£
------millions-----–18.00 +10.00
+1.08 –0.50
+1.08 –0.50
+1.08 –0.50
+1.08 –0.50
+19.08 −10.50
45
Exchange of Principal
In an interest rate swap the principal is not exchanged
In a currency swap the principal is usually exchanged at
the beginning and the end of the swap’s life
Typical Uses of a currency Swap
Conversion from a liability in one currency to a liability in
another currency
Conversion from an investment in one currency to an
investment in another currency
46
Credit Default Swaps
A huge market with over $60 trillion of notional principal
Buyer of the instrument acquires protection from the seller against
a default by a particular company or country (the reference entity)
Example: Buyer pays a premium of 90 bps per year for $100 million
of 5-year protection against company X
Premium is known as the credit default spread. It is paid for life of
contract or until default
If there is a default, the buyer has the right to sell bonds with a
face value of $100 million issued by company X for $100 million
(Several bonds are typically deliverable)
47
CDS Structure
90 bps per year
Default
Protection
Buyer, A
Payoff if there is a default by
reference entity=100(1-R)
Default
Protection
Seller, B
Recovery rate, R, is the ratio of the value of the bond issued
by reference entity immediately after default to the face value
of the bond
48
Attractions of the CDS Market
Allows credit risks to be traded in the same way as market
risks
Can be used to transfer credit risks to a third party
Can be used to diversify credit risks
49
Asset Backed Securities
Security created from a portfolio of loans, bonds, credit card
receivables, mortgages, auto loans, aircraft leases, music
royalties, etc
Usually the income from the assets is tranched
A “waterfall” defines how income is first used to pay the
promised return to the senior tranche, then to the next most
senior tranche, and so on.
50
Possible Structure
Tranche 1
(equity)
Principal=$5 million
Yield = 30%
Asset 1
Asset 2
Asset 3

Asset n
Principal=$100
million
SPV
Tranche 2
(mezzanine)
Principal=$20 million
Yield = 10%
Tranche 3
(super senior)
Principal=$75 million
Yield = 6%
51
International Swaps and Derivatives Association
(ISDA)
has produced Agreements which consist of clauses
defining in default by either side.
Signing of ISDA Master Agreement tantamount to
conformation which is a legal agreement underlying
a swap and is signed by the representatives of the
two parties.
Currency Swaps
Another popular swap is a Currency Swap. This
involves exchanging principal and interest payments
in one currency for principal and interest payments in
another.
Derivatives are very versatile instruments and can be
used for hedging, for speculation and for arbitrage.
52
Types of Traders
Hedgers
Speculators
Arbitrageurs
Some of the largest trading losses in derivatives have
occurred because individuals who had a mandate to be hedgers
or arbitrageurs switched to being speculators (for example
Barings Bank)
53
Big Losses by Financial Institutions
Subprime Mortgages (> $5 trillion) Fannie Mac & Freddie Mac
Credit Default Swaps (CDS) - >$ 60 trillion
Societe Generale ($7 billion/ INR 28000 crores) due to
indiscriminate trading by Rogue Trader Mr.Jerome Kerviel
Lehman Brothers – subsequently takenover by Barclays
Merill Lynch – taken over by Bank of America
American International Group – takenover by US Govt
Bear Sterns
Barings ($1 billion)
Daiwa ($1 billion)
54
Risks and Mitigants
Credit Risk
Liquidity Risk
Market Risk
Reputation Risk
Concentration Risk
Operational Risk
55
Role of Chartered Accountants
Derivatives were created and proliferated, at last count
surpassing US$ 600 trillion in notional value
CAs must make the clients aware of the risks associated with
derivatives and they are able to define the limits, quantify
CAs first responsibility is to ensure good accounting
infrastructure with sound controls, financial reporting
CAs should play active role in identification, recruitment,
development of finance team of the client
CAs should advise clients that the risk be diversified
CAs should insist clients to go for scenario analysis and stress
testing which is important
56
Role of Chartered Accountants
Clients should not give independence to traders
Clients should separate the front, middle and back office
Clients need not always follow Models. Very often they are
wrong
Clients should be conservative in recognizing inception profits
Advise clients to buy only appropriate products relevant to their
business model
CAs should ensure Liquidity of the enterprise as prime, since
liquidity risk is of paramount importance
There are dangers when many are following the same strategy.
CAs should advise the clients not to fall into this trap
57
Role of Chartered Accountants
CAs should advise clients that they should not opt for
products where market transparency is in question
CAs shall make the clients fully understand the products, risks
involved in which they trade
Clients should ensure that hedging should not become
speculation
CAs should advise that they should not make Treasurer’s
department a profit center
58
Questions..
59
Thank you
60