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					     SMALL AND MEDIUM ENTERPRISES FINANCE

               Project Report On


   “SMALL AND MEDIUM ENTERPRISES
                     FINANCE”


SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF
DEGREE OF POST GRADUATE DIPLOMA IN BUSINESS
MANAGEMENT (PGDBM)




                  SUBMITTED BY




             UNDER THE GUIDANCE OF



                  Faculty Finance
        SMALL AND MEDIUM ENTERPRISES FINANCE

                        Certificate




Project Guide                          DIRECTOR




Date:
SMALL AND MEDIUM ENTERPRISES FINANCE

         Acknowledgement
       SMALL AND MEDIUM ENTERPRISES FINANCE

                  EXECUTIVE SUMMARY:


       One of the significant characteristics of a flourishing and growing economy
is a booming and blooming small and medium enterprises (SMEs) sector. Small
and medium enterprises play an important role in the development of a country.
SMEs contribute to economic development in various ways: by creating
employment for rural and urban growing labor force, providing desirable
sustainability and innovation in the economy as a whole .In addition to that, a
large number of people rely on the small and medium enterprises directly or
indirectly. Most of the current larger enterprises have their origin in small and
medium enterprises. SMEs are different from large scale enterprises in three main
aspects; uncertainty, innovation and evolution.. SMEs are the starting point of
development in the economies towards industrialization. However, SMEs have
their significant effect on the income distribution, tax revenue, and employment,
efficient utilization of resources and stability of family income.In the Indian
context, the report of Ganguly Committee has provided impetus to the authorities
to increasingly cater to the emerging financial needs of the SME sector. Bank/
Institutional finance is expected to be made available on easy terms and conditions
and on priority basis. This is more so, as Basel Accord II on Risk Management
provides for 25% lower risk weightages on SME loan/advances.


       Large scale generation of wage employment is possible with the growth of
SMEs in an economy. SME projects / ventures do not generally involve large
financial resources but at the same time, the sector is growth driver in an economy.
Entrepreneurial interest would be encouraged and the growth in the the number of
SME may be possible. When compared to similar products / services of large sized
units, SME products / services are competitive and customer friendly in terms of
cost. Hence it is possible to set up SMEs in large number in a country in order to
       SMALL AND MEDIUM ENTERPRISES FINANCE

usher rapid progress and prosperity. On the other hand, the banks must not go
overboard, instead, be careful to see whether the borrower fulfils the set criteria
before making advance




                                 CONTENTS


Sr.                                Particulars                               Page
No                                                                           no.
1.    FINANCING SME                                                          8
2     SME Architecture                                                       10
          SME Defined
          characteristics
          Activities of SMEs
          Features of SMEs
          Importance of SMEs
          Benefits of financing SMEs
          Banks reluctant to lend
3     Financial Requirements of SMEs                                         18
           Model Application Form
           Utility
           Fund Based Requirements
           Fund for Capital Assets
           Fund for Working Capital
           Ideal Financing Mix
           Non-Funded Working Capital
           Means of sme financing
4     Processing of SME Credit Application                                   37
          Calculation of working capital requirement
          Calculation of non fund based requirement
          Credentials
          Site Visit
          Analysis of Financial Statements
          Analysis of Viability Report.
5     Credit Rating for SME Lending                                          45
          Utility of Credit Rating
          Method of Credit Rating
          Parameters of Credit Rating
          How Credit Rating should be undertaken for an SME
      SMALL AND MEDIUM ENTERPRISES FINANCE

         Risk weightage for CAR
         Case Study
6    Terms& Conditions of Sanction                        54
          Main Terms & Conditions
          Additional Terms & Conditions
          Reasons For Spelling Out Terms & Conditions
7    Post Disbursement Supervision                        56
         Why Post-Disbursement Supervision.
         Points to be Examined during Site Visit
8    Nursing of SMEs                                      59
         When is an SME considered Sick?
         Warning signals of Insipient Sickness
         How is Financial nursing generally Undertaken
9    Capital Adequacy Requirement                         63
         Capital Adequacy for SME Exposure
         Benefits to SME Borrowers.
         Benefits to Lending Banks.
10   Conclusion & current scenario                        64
11   Bibliography                                         65
       SMALL AND MEDIUM ENTERPRISES FINANCE



                      SMEs have been playing a pivotal role in country‟s overall
economic growth, and have achieved steady progress over the last couple of years.
From the perspective of industrial development in India, and hence the growth of
the overall economy, SMEs have to play a prominent role, given that their labour
intensiveness generates employment. The SME segment also plays a major role in
developing countries such as India in an effort to alleviate poverty and propel
sustainable growth. They also lead to an equitable distribution of income due to
the nature of business.


The enactment of the Micro, Small and Medium Enterprises Development
(MSMED) Act, 2006 was a landmark initiative taken by the Government of India
to enable the SMEs‟ competitive strength, address the issues and challenges and
reap the benefits of the global market. SME policy initiatives at the national and
state level are aimed at strengthening the role of SMEs at the base as well as at the
higher level.


                     The combined effect of market liberalization and deregulation
has forced the SME segment to change their business strategies for survival and
growth. Some of the changes that SMEs are focusing on include acquiring quality
certifications, increasing use of ICT, creating e-business models and
diversification to meet the increasing competition. Globalization, economic
liberalization and the WTO regime would undoubtedly open up a unique
opportunity for the largest business community, i.e. SMEs through effective
involvement in international trade by streamlining certain factors, such as, access
to markets, access to technology, access to skills, finance, development of
necessary infrastructure, SME-tax friendly environment, exchanges of best
practices to name a few.
        SMALL AND MEDIUM ENTERPRISES FINANCE

                   1. Financing the SMEs

                 In Feb 2008, the Ministry of Micro, Small and Medium Enterprises
(MSME), continued with its dereservation policy by removing 79 items from the
list of 114 items reserved specifically for SSI (small scale industries)
manufacturing. Only 35 items remain in the reserved category from the total 836
selected in 1994 denoting the declining monopoly of the SSI segment on the
reserved products. However, the government has set up various schemes in place
such as the Credit Linked Capital Subsidy Scheme, MSME Cluster Development
Scheme and ISO 9000 Reimbursement Scheme to help SMEs for procuring timely
funds. Also the government has put in place the Credit Guarantee Scheme to
encourage banks to lend up to Rs 0.50 million without collateral. There has also
been a recent budget announcement of setting up of a Risk Capital Fund.

            Though SMEs are being touted as the priority sector within the
economy, they continue to face problems pertaining to finance. When it comes to
banks, they have a very traditional way of lending to this segment against
collateral and SMEs end up being under financed. Evidently, the biggest challenge
before the SMEs today is to have access to non debt based and non-traditional
financial products such as external commercial borrowings, private equity,
factoring etc.

Lately this segment has been witnessing winds of change in the new sources of capital- in
the form of private equity (PE) and foreign direct investments (FDI). In Jan 2008, The
Soros Economic Development Fund (SEDF), Omidyar Network and Google.org
announced a Small to Medium Enterprise Investment Company with an initial corpus of
$17 million for providing capital to SMEs in underserved markets.Mauritius-based
Frontline Strategy launched a $200 million India Industrial Growth Fund (IIGF) for
investment in SMEs targeting companies, primarily in the industrial space with revenues
between Rs 200 – 1,000 million. In 2007, Mauritius-based Horizon advisors launched
        SMALL AND MEDIUM ENTERPRISES FINANCE

Ambit Pragma Fund I, an India dedicated PE fund, with a corpus of $100 million
for providing equity capital and professional management advice to SMEs.


Investments in the SME sector are not only by PE funds but this sector is also
attracting FDI. In this respect the government has removed the 24 per cent cap on
FDI in the SME sector. Foreign entities are also keen on promoting traded and
cooperation between SMEs of different countries. Genesis Initiative, an UK-based
organisation consisting of entrepreneurs, policy makers and SMEs, is trying to
forge mutual cooperation between SMEs in India and UK for in terms of JVs and
partnerships in sectors such as textiles, IT, infrastructure etc.


A stock exchange purely dedicated for SMEs seems to be the next big thing. A
SME-focused stock exchange is likely to boost the confidence of SMEs planning
to tap the capital market to raise low cost capital. Currently only companies with a
minimum paid up capital of Rs 100 million and a market capital of Rs 250 million
are eligible to list on NSE while those with a post issue capital of Rs 30 million
and a minimum market cap of Rs 50 million are eligible to list on the BSE. Thus
SMEs which in spite of having a good track record of growth but do not meet this
criteria are kept away from the listed category. Some examples of SME dedicated
stock exchanges include AltX, Africa‟s first alternative exchange for SMEs, a
partnership between the Johannesburg Stock Exchange Ltd and the Department of
Trade and Industry and AIM, a sub market of the London Stock Exchange that
allows smaller companies to float shares with a more flexible regulatory system as
compared to the main market. Although BSE Indolent, an alternate national
platform, a joint initiative by The Stock Exchange, Mumbai (BSE) and the
Federation of Indian Stock Exchanges (FISE) exists, a separate exchange
exclusively for SMEs might prove helpful for the SMEs to raise equity and debt as
well as facilitate trading in such companies.
         SMALL AND MEDIUM ENTERPRISES FINANCE

                           SME ARCHITECTURE

SME DEFINED:


   There is no standard, universal definition of Small and Medium Enterprises. In
June 2004, the Basel Committee stated in the Basel accord that SME borrowers
are defined as those with annual sales turnover of less than Rs.250 Crores.


   The working group constituted by RBI called Ganguly Committee has
recommended “turnover” as a measure of defining SMEs. According to them the
outer limit of annual sales for the recognition of SME status should be fixed at
Rs.50 Crores.




EU definition of SMEs


Criteria             Micro Enterprises     Small Enterprises     Medium
                                                                 Enterprises
No of Employees      <10                   <50                   <250
Turnover (Million    2                     10                    50
Euros)
Balance sheet total 2                      10                    43
(million Euros)
        SMALL AND MEDIUM ENTERPRISES FINANCE



TYPES OF SMEs


   The Gangly Committee has recommended that in India three types of SMEs be
recognized:
   1. TINY TYPE- Annual turnover of Rs.2 Crores
   2. SMALL TYPE- Annual turnover of more than Rs.2 Crores and up to Rs.10
        Crores.
   3. MEDIUM TYPE- Annual turnover of more than Rs.10 Crores and upto
        Rs.50 crores.


   Of all the three types, the major focus is on tiny type.




 Characteristics of SMEs


       Born out of individual initiatives &skills
       Greater operational flexibility
       Low cost of production
       High propensity to adapt technology
       High capacity to innovate & export
       High employment orientation
       Utilization of locally available human & material resources
       Reduction of regional imbalances
         SMALL AND MEDIUM ENTERPRISES FINANCE

ACTIVITIES OF UNDERTAKEN BY SME


   The SME sector may concern itself with any commercial activity permissible
under Law. Hence, any type of manufacturing, processing or industrial activity, or
trading or allied operations, may be domain of the SME sector. However the
following activities may be encouraged by the financial institutions for the SME
sector


    Village and Cottage industries
    Call centre
    Computer software development and computer services
    Data conversion / data processing service
    Website design and development
    Servicing and repairing machinery and equipments
    Content development and animation
    Medical / Legal transcription activities
    Video film making
    Advertising agency
    Marketing consultancy
    Industrial consultancy
    Equipment rental and leasing
    PCO / photocopying centre / typing
    Industrial R & D laboratory
    Laundry and Dry cleaning
    Tailoring
    Studios
    Cable TV network
    SMALL AND MEDIUM ENTERPRISES FINANCE

FEATURES OF SMEs


   SME „s are mostly promoted and run by individuals as sole proprietary
     firms or by group of individuals as partnership concerns, some times as
     Private Limited companies or any other form of organizations. SME s as a
     Public Limited Companies are rarely seen.
   An SME is a business that is predominantly dependent on technical /
     managerial enterprise of promoter skilled personnel are also employed
     wherever necessary.
   SMEs mostly operate on a regional basis, more in rural and semi urban
     centres and depending upon size and nature of their goods / services they
     have national / international presence.
   Capital funds of SMEs are generally small, compared to external funds in
     the form of Loans / Advances, hence the debt equity ratio is larger than
     the conventional 2 : 1 ratio
   At present many Indian SMEs do not have a compatible technological
     base
   Activities of SMEs are primarily in the area of durable consumer goods /
     personalized services
   Products / services of SMEs are generally are cheaper compared to the
     large sized ones, primarily due to lower business overheads
   SMEs are better equipped to render personalized attention and care to
     their customers.
   SMEs have backward / forward linkages with large corporates in matters
     of purchases/ sales are in a position to better business performance
     SMALL AND MEDIUM ENTERPRISES FINANCE

IMPORTANCE OF SMEs


  1. Large scale generation of wage employment is possible with the growth of
     SMEs in an economy. It is quite likely that employees of SMEs may not
     have advantages equal to those of their counterparts in established business
     units, but they would never the less be gainfully employed.
  2. The pattern of contribution of GDP in an economy will show that the SME
     sector is a dominant contributor to the well being of the country.
  3. SME projects / ventures do not generally involve large financial resources
     but at the same time, the sector is growth driver in an economy.
  4. The time lag between the conception of an SME project / venture and
     commencement of business is not substantial. Hence it is possible to set up
     SMEs in large number in a country in order to usher rapid progress and
     prosperity
  5. SME cluster take care of 4 Cs as per the Ganguly Committee report;
     customer focus, cost control, cross sale and containing risk.
  6. When compared to similar products / services of large sized units, SME
     products / services are competitive and customer friendly in terms of cost.


   The degree of importance of SMEs in India is reflected in the following
   position.


        In India it accounts for
        95% of all industrial units
        40% of industrial output
        45% of industrial employment
        35 % of exports
        Prime driver of new employment
         SMALL AND MEDIUM ENTERPRISES FINANCE


    The contribution of SME „s in economies of USA, France, Japan and Korea
         is as follows


Country         Share of total Share of   Share of   Share of        Criteria for
                Establishment Output      Employment exports         Recognition
India           95%            40%        45%           35%          Fixed assets
U.S.A.          98%            n.a.       53%           n.a.         Employment
Japan           99%            52%        72%           13%          Employment
Taiwan          97%            81%        79%           48%          Paid up capital,
                                                                     assets & sales
Singapore       97%            32%        58%           16%          Fixed assets &
                                                                     Employment
Korea           90%            33%        51%           40%          Employment
Malasia         92%            13%        17%           15%          Shareholders
                                                                     funds
                                                                     & employment
Indonesia       99%            36%        45%           11%          Employment




It can be observed that by and large, SMEs in India met the expectations of the
Government in this respect. SMEs developed in a manner, which made it possible
for them to achieve the following objectives:

· High contribution to domestic production

· Significant export earnings

· Low investment requirements

· Operational flexibility

· Location wise mobility

· Low intensive imports
       SMALL AND MEDIUM ENTERPRISES FINANCE

· Capacities to develop appropriate indigenous technology

· Import substitution

· Contribution towards defense production

· Technology – oriented industries

· Competitiveness in domestic and export markets




BENEFITS IN FINACING SME


From the point of view of economy, the benefits arising from higher order focus
on SME financing may be broadly stated as follows.


   1. Looking at importance of SME in India , SME financing will increase its
      contribution in GDP of country
   2. SME financing will encourage entrepreneurial
   3. New products / services would be increasingly available for consumers
   4. Business will become more competitive
      SMALL AND MEDIUM ENTERPRISES FINANCE

Why banks are reluctant to lend to SME in India



    SME‟s are regarded by creditors and investors as high-risk borrowers due
      to insufficient Assets and low capitalization, vulnerability to market
      fluctuations and high mortality rates
    Information asymmetry arising from SME‟s lack of accounting records,
      inadequate financial statements or business plans make it difficult for
      creditors and investors to assess the credit – worthiness of potential SME
      proposals.
    Commercial banks generally need collateral from borrower as a guarantee
      towards repayment of loans. SME‟s generally need collateral from
      borrower as a guarantee towards repayment of loans. SME‟s generally find
      it difficult to fulfill this requirement.
    High administrative costs of lending or investing small amounts do not
      make SME financing a profitable business.
       SMALL AND MEDIUM ENTERPRISES FINANCE

         3. FINANCIAL REQUIREMENTS OF SMEs

MODEL/ STANDARDISED APPLICATION FORM:
Standardized application form will contain following fundamental things


    Origin of the borrowing firm/owners/promoters with brief bio-data of
      owners/promoters.
    Whether operating/to be operated in a cluster.
    Past performance in case of existing unit.
    Expected/future performance of both the existing and new units, stating the
      basis of computation of the next one year‟s projections.
    Financial make-up as appearing in the last concluded financial year in case
      of an existing unit, providing financial statements as maybe available.
    For new units, the initial contribution of capital from the owners/promoters.
    The number of skilled/semi-skilled/unskilled employees in case of an
      existing unit.
    For a new unit, the number of skilled/semi-skilled/unskilled employees to
      be recruited to achieve the first year‟s expected business performance.
    For a new unit in manufacturing/allied operations, whether any independent
      viability study was undertaken, if so, a copy thereof.
    Basis of computation of financial requirements.
    Tangible marketable securities offered for the facilities, and their present
      value as per the assessment of the borrowers.
    Period for which, the loan for capital assets is required and the exact source
      of repayment within the period.
    Names/addresses      of   existing   bankers     if   any   of   the   borrowing
      concern/promoters/owners, and the nature of the account relationships.
       SMALL AND MEDIUM ENTERPRISES FINANCE

    Names, addresses, occupation, business of guarantors, if offered, and their
       relationship with the promoters/owners, if any




UTILITY
       A standardized application form is advantageous to both the lender and the
borrower in more than one way. Since the information required for arriving at the
lending decision are structured, uniform and pointed ones, it becomes convenient
to process the same at a faster speed. For the borrowers also, it is easier to fill out
the form, seeking clarification where necessary, without placing an overload of
information to support the application.
       At the banks/financial institutions, the staff entrusted with SME
applications get familiarized with the management‟s requirements for making
decision about loan applications on the basis of the borrower‟s applications. They
are thus better placed to dispose off the applications. In this way, credit delivery
process at the level of lenders is accelerated.




FUND BASED REQUIEMENTS:
Fund based requirement are those requirement where there is actual outflow
of cash.
As for any other business segment, SMEs may require cash/cash equivalent for
acquisition of, holding and dealing with various categories of tangible assets for
commencing and sustaining business operations. Thus, they may require funds for:
   1) Acquisition of capital assets or
   2) Purchase of stocks of raw materials/finished goods, extending credit to
       trade debtors and for other day to day business operations or
   3) Both 1) & 2) ABOVE.
        SMALL AND MEDIUM ENTERPRISES FINANCE

FUND FOR CAPITAL ASSETS:
   1. In the case of land/building:
        Break-up of costs for land & building-location.
        Specific benefits that are likely to accrue on purchase of land/building
         with loan, in place of having a rental arrangement.


   2. In case of machinery/equipments/computers/other items of fixed assets:
        Details of each item with cost, names/addresses of suppliers etc.
        How technical viability of the items is ensured. In case a viability report
         is available, it should be furnished.
        Details of periodic servicing arrangements and their likely costs.
        Whether use of machinery/equipment would be in conformity with
         pollution control guidelines if any.
        Details of technical staff/Skilled staff to be deployed, if necessary, for
         operating machinery and equipments.


   3. Margin Money:
       Since banks/financial institutions generally extend financing upto 75% of
the total cost of capital assets, the applicant is required to indicate the source for
the balance amount of 25%.


FUND FOR WORKING CAPITAL
The quantum of finance required for each of the above three stages is linked
with the following factors:
    A manufacturing / industrial unit‟s requirement for inventory holding will
       be generally higher than that of a trading unit
    Trade debtor‟s holding in a trading unit will generally be higher than that of
       a manufacturing / industrial unit
       SMALL AND MEDIUM ENTERPRISES FINANCE

    Market standing / track record / items of manufacture/ trade may determine
       the varying degrees of working capital requirements of SMEs.
    The availability of the owner‟s funds towards working capital management
       may be different in different SMEs. Those who have a larger financial base
       may require less funding.
    Service- based SMEs like professionals / consultants may require a lower
       working capital fund when compared with other sectors.


Depending upon the past/ project scale of business operations, SMEs may need
institutional working capital support to take care of
   1. Optimum holding level of stocks
   2. Safe level of trade debtors outstanding
   3. Minimum cash holdings


Under the theory of finance, institutional working capital support is greatly
necessary for one working capital cycle in a period of twelve months and such a
cycle comprises of
    Period of holding of inventory /book debt
    Minimum cash holding period
    Recovery cycle from the trade debtors
    Payment cycle to trade creditors
       SMALL AND MEDIUM ENTERPRISES FINANCE

IDEAL FINANCE MIX
    An industrial / manufacturing SME may operate smoothly with its working
       capital finance of 50 % of loan component for capital assets
    A trading / consultancy unit may often be found with a 10 % loan for
       capital asset and 90 % loan for working capital
    As a very rough guide, if other aspects are acceptable by a lender,
       preference may be given to an SME borrower whose loan for capital assets
       does not exceed 25 % of total debt fund the underlying reasons is that a
       loan for capital assets is usually for a medium term /long term nature while
       a loan for working capital is short term facilitating more rapid recycling of
       funds.




NON FUNDED WORKING CAPITAL REQUIREMENTS


There are three categories of non funded working capital facilities available for
SME client:
   1. Full risk
     Financial Guarantees / standby letters of credit issued in favour of a
     beneficiary on behalf of SME clients etc enable them to obtain funds from
     the beneficiary as per contractual terms.


   2. Medium risk
      Issuance of Bid bonds, Performance guarantee, trade letter of credit and
     Indemnity bonds in favour of a beneficiary for SME clients etc. facilitate
     business transactions between them, without any movement of funds from
     the beneficiary to the client on whose behalf banks / financial institutions
     may undertake such commitments. These therefore, being the credit
     substitute only, may come under Medium Risk category
   SMALL AND MEDIUM ENTERPRISES FINANCE


3. Low Risk
 In normal course of business, derivative instruments such as swaps, options,
 futures etc do not carry any noticeable element of risk, however experience
 indicates that there are hardly any occasions when SMEs seek recourse to
 such financial products.
 The Basel II accord provides that any exposure would carry risk weightage of
 75 % from the capital adequacy point of view.
 Non funded facilities provide a fee based income and hence banks / financial
 institutions look to such applications with greater interest. But at the same
 time, they endeavor to ensure that
a. The facilities sought is not disproportionate to the particular SME„s past
   /projected volume of business.
b. Financial guarantees may be accorded lower priority than bid bonds /
   performance guarantees in view of their nature and risk propensity.
c. Some cash margin may be required as a cover ( for financial guarantee it
   may be 25 % or lower in case of bid bonds and performance guarantees)
   along with tangible security cover.
d. For sight trade letter of credit with a document of title to goods, the cash
   margin may in some cases be waived and no additional cover may be
   required.
e. Usually banks / financial institutions prefer SME borrowers should also
   have appropriated funded working capital facility. In majority of cases non
   funded facility to an SME constitute about 25 % of funded working capital
   facility.
       SMALL AND MEDIUM ENTERPRISES FINANCE

 Capital Requirements of SME’s


 Promotional Expenses: project planning, feasibility studies, company
   formation, preliminary expenses.
 Fixed Capital/ Long Term Capital: land, factory building, plant and machinery,
   installation, electrification, furniture and fixtures, office equipment etc.
 Working Capital / Short term capital: Purchase of raw materials, spare parts &
   consumables, salary and wages, office expenses, staff welfare, insurance,
   electricity and telephone expenses, credit to customers, payment of statutory
   dues.
 Development Capital: purchasing new machinery, replacing old assets,
   expansion and diversification expenses.


Sources of Finance for SME’s
 Own Capital
 Long term Loans from family and friends
 Term loans from institutions and banks
 Working capital loans from banks
 Credit on raw material purchases
 Dealer deposit/ customer advance
       SMALL AND MEDIUM ENTERPRISES FINANCE

MEANS OF SME FINANCING BY BANKS

FOR FUND BASED FINANCING

1. Overdraft

      When a customer maintaining a current account is allowed by the bank to
draw more than the credit balance in the account, such facility is called an
Overdraft facility. At the request and requirement of customers temporary
overdrafts are also allowed. However, against certain securities, regular
overdraft limits are sanctioned.

   Salient features of this type of account areas under

    Overdraft is a running account and hence debits and credits are freely
      allowed.
    Interest is applied on a daily product basis and debited to the account on
      monthly basis.
    Overdrafts are generally granted against the security of government
      securities, shares and debentures, LIC policies and bank‟s own deposits etc.
      and also on unsecured basis.
    Temporary overdrafts should be allowed only on written request of the
      customer. A letter of recording should be obtained from a customer when a
      temporary overdraft is granted to him.
    However, temporary overdrafts should be granted sparingly to meet the
      short term requirements of customers.
    In case it is decided to withdraw/ reduce overdraft facility to the customer,
      sufficient notice of the same should be given to the customer.
       SMALL AND MEDIUM ENTERPRISES FINANCE

2. Cash Credit

   A cash – credit is an arrangement to extend short term working capital facility
under which the bank establishes a credit limit and allows the customer to borrow
money upto a certain limit. The bank sanctions a limit called the cash- credit limit
to each borrower upto which he is allowed to borrow against the security of
stipulated tangible assets i.e. stocks, books debts etc. The customer need not draw
at once the whole of the credit limit sanctioned but can withdraw from his cash –
credit account as and when he needs the funds and deposit the surplus cash / funds
proceeds of sale etc., into the account. Besides this, facility of frequent and
unrestricted transactions is available.

Salient features of cash – credit system are as under

    Sanction of Limit:        Cash- Credit limit is sanctioned after taking into
       account several factors detailed later in the product note. The drawings are
       restricted upto the sanctioned limits or available Drawing Power (which is
       lower) and should be only for the purpose for which the limit has been
       sanctioned.
    Running account: A cash- credit account is an active running account.
       It is expected that all sales/ purchase/ other transactions of the
       borrower should be routed through this account. In fact a healthy
       churn rate in the account to be encouraged, the account may move
       freely between debit and credit balances as well.
    Repayment: Cash- Credit facility is technically repayable on demand
       and there is no specific date of repayment. Quarterly behaviour
       scoring shall indicate the health of the account and an annual review to
       be conducted to decide on account renewal.
         SMALL AND MEDIUM ENTERPRISES FINANCE

Application of interest and service charges:

    Interest is calculated on a daily product basis, applied on a calendar
         monthly basis
    For credit balance lying in cash –credit account, no interest is payable as
         cash- credit account is in nature of current account.
    Service charges as per current account rules are to be levied.

Calculation of Drawing Power:

   It is based on the value of security charged to the bank and other applicable
factors, the stipulated margin is reduced and the advance value is calculated
subject to overall limits. No drawings in the cash- credit accounts beyond the
drawing power should be allowed. However, interest and other charges may be
force debited exceeding drawing power. Changes in drawing power are done on a
monthly basis based on the stock/ debtors statements submitted by the borrower.

3. Term loans :

    A term Loan is an advance allowed for a fixed period either in lump sum or in
installments and which is repayable according to a schedule of repayment as
against on demand and at a time.

Period     : A term loan is granted for a period exceeding 3 years but not exceeding
5 years.

Purpose :       Term loans are generally granted to meet the need of capital
expenditure i.e. acquiring fixed assets like land, building, plant & machinery etc.
for the purpose of setting up of new units or expansion, modernisation, renovation,
replacement of existing units, adding more bays in the service station, more floors
in a department store etc.
       SMALL AND MEDIUM ENTERPRISES FINANCE

Repayment: A monthly repayment schedule is fixed and accordingly loan is repaid
in installments.

Interest : interest is as per the EMI schedule calculations

Security : Term loans are granted against the security of immovable properties,
plant & machinery , vehicles , acceptable liquid securities, etc




4. Bill Purchase/Discounting

       These represent advances against bills of exchange drawn by the customers
on their clients. Bills are either purchased or discounted. Demand bills are
purchased and usance bills are discounted. Bills may be either clean or
documentary. Bills accompanied by title to goods i.e. R/R, MTR, etc are called
documentary bills. Bills without such documents are known as clean bills.
Documents under bills are ether deliverable against acceptance or against
payment.

       A seller of goods draws a bill of exchange (draft) on buyer (drawee), as per
payment terms for the goods supplied. Such bills can be routed through the banker
of the seller to the banker of the buyer for effective control.

Clean & Documentary bill :

       When documents to title to goods are not enclosed with the bill is called
Clean Bill. When documents to title to goods along with other documents are
attached to the bill, such a bill is called „Documentary Bill‟.
        SMALL AND MEDIUM ENTERPRISES FINANCE

        Documents, the due possession of which give title to the goods covered by
them such as     RR/MTR, bill of lading, delivery orders etc. are called documents
to title to goods.

Cheques and drafts are also examples of clean bills.

Demand & Usance bill:

       When the bill of exchange whether clean or documentary is made payable
on demand or sight, such a bill is called Demand Bill. The buyer is expected to
pay the amount of such bill immediately at sight. If such a demand bill is a
documentary bill, then the documents including document to title to goods are
delivered to the buyer only against payment of the bill. (Documents against
payment- DP Bills).

       When a bill, either clean or documentary is drawn payable after certain
period or on a specified date, the bill is called Usance Bill. Such bill id presented
to the buyer once for Acceptance, when he accepts to pay the bill on due date the
bill is presented again for payment. In case of documentary usance bill, the
documents are delivered to the buyer (drawee/acceptor) against his acceptance of
bill (Documents against acceptance-DA Bills).




Finance against bills of exchange

       Working capital finance to meet the post sale requirements of borrowers
can be also met through bill finance either by „Purchasing‟ bills or „Discounting‟.

       Bill Purchase facility is extended against clean demand bills like Cheques/
drafts/ bills of exchange/ hundies and demand documentary bills, whereby the
bank lends money to the payee of the cheque/ draft and to the drawer of the bills
by purchasing the same against tendering of such bills by the payee/drawer. The
       SMALL AND MEDIUM ENTERPRISES FINANCE

bank in turn sends the bills for collection, preferably to it‟s own branch at the
place of drawee or to its correspondent bank or to the buyers (drawee‟s) bank.

       Bills discounting facility is extended against usance bills. In such cases, the
sellers tenders the usance bill drawn by him usually alongwith documents to title
to goods, to his banker who discounts the bill i.e. levies discount charges for the
unexpired portion of the duration of the bill and credits the balance amount to the
seller‟s account. Thereafter the drawer‟s bank sends the bill to collecting bank at
the centre of drawee either to its own branch or drawee‟s bank, with instructions to
release the documents to title against acceptance and thereafter, to recover the bill
amount on due date. Sometimes the accepted usance bills are also tendered and
discounted by the bank.




5. Export Finance

Export Finance is broadly classified into:

1) Pre- shipment finance and

2) Post – shipment finance

       Financial assistance extended prior to the shipment of goods shall fall under
Pre-shipment finance whereas; financial assistance extended subsequent to the
shipment of goods shall fall under the purview of Post-shipment Finance.

Export finance is governed, by and large, by RBI directives, FEDAI rules, Exim-
Policy etc. and, therefore, knowledge of the Exchange Control, Trade Policy,
procedures and directives of trade control authorities, international trade practices,
particularly those of International Chamber of Commerce (ICC), Paris, etc. is
very much essential. It is an additional responsibility on the part of lending banker
        SMALL AND MEDIUM ENTERPRISES FINANCE

to keep in mind all such rules and regulations, over and above the usual practices,
procedures and principles of lending




B. Non Fund Based
       There are certain types of advances which do not involve deployment of
funds at least in the initial stage. These are called Non- Fund Based Credit.
Performances Guarantee issued by the bank on behalf of a customer to third party
for fulfillment of terms of contract, Letter of Credit issued by the bank on behalf
of its customer favouring the third party in India or abroad are some of the
examples of this type of finance. Even though funds are not involved at the initial
stage, bank is taking risk, and on failure of its client to fulfill terms of guarantee or
letter of credit, we will have to pay out funds to the beneficiary on behalf of the
customer and recover it later from him.




Bank Guarantees

       A “Contract of Guarantee” under the Indian Contract Act is a contract to
perform the promise or discharge the liability of a third person in case of his
default.
        SMALL AND MEDIUM ENTERPRISES FINANCE

       A “Contract of Guarantee” should be distinguished from “ Contract of
Indemnity” , in the later case, party promises to save another person from loss
caused to him by the conduct of the promisor himself or by any other person.

       We come across a „Guarantee‟ in two capacities. One as a beneficiary when
somebody guarantees the payment of debt of bank‟s borrower in case of default.
The other as a guarantor, when the bank itself promises to pay the dues or
discharge the liabilities of its customers in favour of a third party. While in the
former case, Bank‟s liability is co- extensive with that of the debtor.

       The need for such guarantees to be issued by banks arises due to the
business and financial requirement of Bank‟s constituents. There are many
situations wherein, the constituent is required to provide a guarantee from his
banker in lieu of some money owed by the constituent to others or likely
loss/damage that may be caused by constituents performing/ non- performing of
specified task. Thus, the bank by issuing such guarantees steps into the non-
performing of specified task. Thus, the bank by issuing such guarantees steps into
€the shoes of the constituent and assumes the financial risk and responsibility
attached to it.




Beneficiaries of guarantees:

       Guarantees are generally executed favouring: Statutory / Government
authorities, Public Sector Undertakings, Overseas suppliers of goods / machinery
on deferred payment terms, Reputed institutions/ limited companies / firms.

Types of Guarantees:

Guarantees issued can be broadly classified into three categories viz. Financial,
Performance and Deferred Payment Guarantees.
       SMALL AND MEDIUM ENTERPRISES FINANCE

 Financial Guarantees:

   In case of financial guarantees, the bank guarantees the customer‟s financial
worth, credit worthiness and his capacity to take up financial risks. Therefore,
guarantees issued in respect of constituents liability, such as guarantees favouring
tax/ customs/excise/court authorities in respect of disputed claims, payment of
taxes, customs and excise etc. will come under the classification of financial
guarantees. While issuing such guarantees one needs to be sure about the financial
strength/liquidity of the party.

   Guarantees covering security deposit/ earnest money/ advance payment/
mobilization advance etc. would come under this category. Similarly, guarantees
covering payment for supplies to be lifted by parties will also be treated as
financial guarantees




 Performance Guarantees:

       Performance guarantees are issued on behalf of constituents guaranteeing
their performance as per the contracts entered into, performance of machineries
supplied, due to discharge of other contractual obligations undertaken by the
customer under the contract, in the event of his failure/default as they may be of a
highly technical nature. The purpose of the performance guarantee is only to fix
the financial responsibility in the event of default or failure on the part of the
customer to perform the obligations undertaken by him. Hence, in the event of
default of the customer and being notified to that effect, the bank will make
payment under the guarantee.
       SMALL AND MEDIUM ENTERPRISES FINANCE

 Letters of Credit

       Any businessman who supplies goods/services would like to receive
payment before the delivery of goods /services to a buyer. Similarly the buyer
would also like to ensure that the goods/services bought are as per his
specifications and deliveries are effected in time, before partying with money. If
the buyer and seller are at two different, far away stations, both the factors can not
be satisfied simultaneously.

       As a compromise, services of third party as an n intermediary are utilized.
This intermediary is usually a bank who issues a letter of assurance to a seller at
the request of a buyer for payment of cost of goods/services sold on certain terms
and conditions. Such an assurance letter is named as a “letter of credit”.

       A letter of credit is a written instrument issued by a banker at the request at
the request of a buyer (applicant) in favour of the seller (beneficiary) undertaking
to honour the documents or drafts drawn by the seller in accordance with the terms
and conditions specified in the credit, within a specified time.




       Thus the credit is made available to the seller against delivery of certain
specified documents. When the credit stipulates payment of money when the
documents are presented to the paying bank, the L/C is called a Documents against
Payment L/C ( D/P/L/C ). If the credit stipulates the delivery of documents by the
seller against acceptance and that the payment will be made on the due date, the
L/C or D/A L/C.
       SMALL AND MEDIUM ENTERPRISES FINANCE

Parties to a Letter of Credit:



Following are the parties to a credit:



Applicant          The buyer of the goods/ services (borrower)
Opening Bank       The Bank / Branch which lends its name /credit
Advising Bank      Opening Bank’s branch or another bank at beneficiary’s
                   place to whom the Letter of Credit is sent for onward
                   transmission to the beneficiary
Seller             The party to whom the credit is addressed (seller or
/Beneficiary       supplied f the goods/ services)
Negotiating        Opening Bank’s branch or another bank who negotiates the
Bank               documents
Confirming         The bank adding confirmation to the letter of credit
Bank




Kinds of Credits

The different types of credits which banks generally issue are:

Inland L/C: An L/C where all parties to an L/C are located within the country.

Foreign L/C : An L/C where either the opener or the beneficiary is located
outside the country of issue and arising out of export or import of goods /services
out of/into the country of issue.
       SMALL AND MEDIUM ENTERPRISES FINANCE

Revocable Credit: A credit that can be cancelled or amended at any time without
the prior knowledge of the beneficiary.

Irrevocable Bank : It is a definite undertaking of the issuing bank to honour
documents strictly drawn as per the terms and conditions of credit which cannot be
amended or cancelled without the agreement of all the parties to the credit, in
particular the beneficiary. In practice, LC are almost always irrevocable.

Revolving Credits: It is an L/C where the amount of drawings made there under
would be reinstated and made available to the beneficiary again and again for
further drawings during the currency of credit, upto a certain sum subject to
certain conditions specified therein.
       SMALL AND MEDIUM ENTERPRISES FINANCE

    4. PROCESSING OF SME CREDIT APPLICATION


CALCULATION OF SME WORKING CAPITAL REQUIRMENT

Method 1: Based on projected sales turnover

    The sales turnover of the establishment is A
    The establishment expect 25% increase in the above turnover in the current
      financial year.
    Expected sales turnover is B = A*1.25
    Maximum working capital limit that can given to the establishment is 20%
      of the expected sales turnover C = B*0.20
    Minimum margin that would be brought in by the promoters D = B*0.05
    Maximum working capital limit that can be given by the bank E = C-D
    Credit facility availed from other bank is F
    Limits that can therefore be extended to the establishment G = E-F
    Limit granted to the establishment H (=<G)
    ( The difference of G-H to be brought in by the promoter)
    The sales turnover will mean gross sales including excise duty




Method 2: Bases on production / processing cycle

     Current assets (including inventories, sundry debtors, cash & bank
       balance.) M
     Current liabilities (excluding bank borrowings) N
     Working capital gap O = M-N
     Funding available from long term sources P = 0.25*O
       SMALL AND MEDIUM ENTERPRISES FINANCE

     Max. Working capital limits that will be given to the establishment Q = O-
       P
     Credit facilities availed from other banks R
     Limits that can be extended S = Q-R
     Limit granted to the establishment T (=<S)
     ( The difference of S-T to be brought in by the promoter)

    If the credit requirement based on the production/ processing cycle is higher
than the one assessed in projected turnover basis, the same may be sanctioned. If
the assessed credit requirement is lower than the one assessed on the projected
turnover basis, the credit limit to be sanctioned will be at 20% of the projected
turnover.

The drawing power will be determined by applying appropriate margin on the
levels of the stocks and book debts indicated in the monthly stock and book debt
statement after excluding unpaid stocks


CALCULATION OF NON FUND BASED REQUIREMENT


CALCULATION OF LC FINANCING:


(A)Total Raw material Required            Xxx
(B) assuming 30% of raw materials         =.3*A
purchased using LC
(C) Monthly requirement for Raw           XXX
Materials
(D) Average Usance period                 X MONTHS
(E) Lead Time                             X MONTHS
(F) L/C Limit                             =C*(D+E)
         SMALL AND MEDIUM ENTERPRISES FINANCE




CALCULATION OF GURANTEEE REQUIREMENT


(A) Gross sales                              XXX
(B)assuming average project life of          =X YEARS*(A)
X years the amount of contract
needed to achieve the required
sales
(C) assuming a strike rate of X% the         =(B)/X%
value of the orders for which the
company will participate in the
tender process
(D)Earnest Money Deposists                   =X%*(C)
assumed to be X%
(E) assuming a security deposit of           =X%*(C)
X% of contract value
Sub Total                                    =D+E




The following guideposts of credit application processing are very important:


1.                            CREDENTIALS/TRACK RECORD:
     Usually, SMes are set up as sole proprietary, partnership or Private Ltd.
     Companies. For a new SME business, performance data and other avenues for
     the study of the credentials/track record of an SME would not be available. In
     such cases, the study of the credential/track records are to be carried on with
     respect to:
       SMALL AND MEDIUM ENTERPRISES FINANCE

   a) Sole proprietor/Partners/Directors etc. in their individual capacities.
   b)Any existing associated concern having market dealings where Sole
     proprietor/Partners/Directors are directly or indirectly interested.


The credentials/track records study shall reflect:
    How the SME has been meeting its financial commitments to its
       vendors/creditors.
    How business transactions are settled with its debtors.
    How financial transactions are passed through accounts with its existing
       banks/financial institution.
    In-house trained officials may make spot enquiries, by calling for necessary
       documentary evidence such as invoices/challans/passbook, statement of
       accounts etc.
    Indirect enquiries may be made from valued customers of the
       banks/financial institution.
    When necessary, and subject to prior consent of the applicant SME,
       services of private enquiry agencies may be availed.
    For obtaining a Banker‟s Report(with whom, the SME has an account),
       reference may be made. The concerned bank is expected to send the report
       in a structured manner. While a banker‟s report is general and may not
       show any details, it is a fact that if an SME‟s dealings with any bank has
       been unsatisfactory, they would indicate it by way of a suitable negative
       remark.
       SMALL AND MEDIUM ENTERPRISES FINANCE

B. SITE VISIT:
   As valuable input in the process of scrutiny of an SME borrower‟s application,
   it is required that a site visit by officials of the banks/financial institution be
   organized. Such a visit may take any of the following forms.
    For     an   existing unit,     the   business     assets   and   records    to     be
       inspected/verified.
    For a new unit, the suitability of the place, and of the arrangements in place
       for starting the business, to be examined.
       The implications of a site-visit of a manufacturing-industrial SME are
different in view of following reasons:
    A manufacturing/industrial unit in particular would have to work with plant
       & machinery, equipment etc. In case of an existing unit, the condition of
       this, and their efficiency levels should be satisfactory. However, for a new
       unit, the locational advantage/constraints, if any, for operating the
       machinery/equipment will need to be examined.
    On the other hand, for an existing/new trading unit, a site visit is fairly
       simple. The official will be requested to assess the storage capacity and
       trading advantages/constraints, if any.
    In case of manufacturing/industrial unit, a very important aspect presently
       surfacing in many countries is with regard to affluent control systems in the
       unit, from the angle of pollution control. During the site visit, therefore, the
       pollution control angle is to be fully satisfied.
       SMALL AND MEDIUM ENTERPRISES FINANCE

C. ANALYSIS       OF     THE     PAST      AND      PROJECTED         FINANCIAL
   STATEMENTS:
As for other business units, financial statements of SME applicants would cover:
   1. The Balance Sheet on a particular date reflecting the position of assets and
      liabilities, including contingent assets & liabilities on the date when the
      balance sheet is drawn.
   2. The Profit & Loss Account reflecting the end result of the operation in
      terms of profit or loss during a particular period.
   3. Profit & Loss Appropriation Account
   4. Statement of Cash Flows.


Following purposes are served by Analysis of the financial statements:
   a. How assets/ liabilities are balanced from the safety angle- also taking into
      account, contingent liabilities and assets.
   b. To assess the operating efficiency of the applicant, with regard to past
      business performance in terms of sales/main imcome vis-à-vis net profit for
      an existing unit, and the future date analysis for new units, keeping
      prevailing market dynamics in view.
   c. To assess the quality of liquidity management if the owner/management
      and how the firm is equipped to face a sudden financial stress due to
      adverse market movement.
   d. How the firm undertakes operating, investing and financial activities, as
      evidenced by its statement of cash flows.
   e. Whether or not, any conservative policy of disposition of annual profit is
      followed.
         SMALL AND MEDIUM ENTERPRISES FINANCE

Some specific ratios for evaluation of SME applicants:
1. Short Term Solvency Angle:
      Current Ratio- minimum expected level may be 1.10:1
      Acid test Ratio minimum expected level may be 0.8:1
      Cash Ratio- minimum expected level may be 0.4:1
2. Long Term Solvency Angle
      Debt-Equity Ratio-maximum may be 4:1
      Debt-Service Coverage ratio- minimum level may be 1.33:1
3. Profitability Angle:Operating Profit Ratio- Depends upon the industry.
      ROCE- Expected levels are 15%-20%
      Interest Coverage Ratio- minimum level may be 2:1
      Profit Asset Ratio-depends upon the industry.
      Indirect Overhead Ratio- Maximum level may be 10%-15%
4. Asset Movement Angle:
      Inventory Turnover Ratio.
      Debtors Turnover Ratio.


5. Trade Credit Payment Angle:
      Creditors Turnover Ratio.


D.    ANALYSIS OF VIABILITY STUDY REPORT:
               A business, whether it is manufacturing/processing, or simply a
trading sector has to satisfy the following broad objectives:
      It is in a position to sustain operations on a continuous basis for a fairly
        long period, going by technological requirements (where applicable) and/or
        business fundamentals.
      It is in a position to market its products/services/goods with a fair return on
        capital to be deployed after taking into account all overheads, going by
   SMALL AND MEDIUM ENTERPRISES FINANCE

   prevailing market environment and/or future scenario on a continuous basis
   for a fairly long period.
 Management, i.e. those entrusted/ to be entrusted with running the business
   are competent, taking into account, their technical and/or managerial
   background.
 Social consideration- in particular whether the operation of the unit is
   socially acceptable, e.g. where a unit emits harmful smoke/waste material
   creating damage to the environment, the unit shall not be allowed to
   function.
       SMALL AND MEDIUM ENTERPRISES FINANCE

5. CREDIT RATING FOR SME LENDING

       Rating implies an assessment/ evaluation of particular credit proposition-
Funded as well as Non-funded on the basis of Credit parameters such as
Performance Analysis, management quality and market scenario, etc., with scores
for each parameters. The aggregate score in an account in relation to the overall
score, reflects the strengths/weaknesses of the respective account.
       The BASEL COMMITTEE of the Bank International Settlements has
defined Credit Rating as a summary indicator of the risk inherent in an individual
credit and embodies an assessment of the risk of loss due to the default of counter
party on consideration of relevant quantitative & qualitative information.


UTILITY OF CREDIT RATING FOR SMEs
       In the context of an SMEs, the utility of a credit rating may be viewed from
the following aspects:
    Evaluation of the Borrower in totality
    Transaction level analysis, Credit pricing & Tenure.
    Activity-wise/sector-wise portfolio study, keeping in view a macro level
       position.
    Fixation of an outer limit for taking up / maintaining an exposure that arises
       out of risk rating
    Monitoring of Existing exposures, and deciding exit strategies in
       appropriate cases.
    Allocation of risk capital in case of poor graded accounts.
    Avoidance of an over concentration of exposures in specific risk grades.
       SMALL AND MEDIUM ENTERPRISES FINANCE

METHOD OF CREDIT RATING
A credit rating must satisfy the following aspects:
    It must generate an accurate information base
    In must facilitates a consistent evaluation
    It must provide flexibility to allow professional judgment influence a rating
The following Two methods are prescribed in the credit rating system:
   1. Through – The –Cycle Methods
          Under this method the financial position of the borrower and /or
       position of exposure is assessed, assuming the worst possible business
       cycle. An element of subjectivity of the evaluator may influence the
       grading of an account.


   2. Point-in-time method
          A rating system based on the current condition of the borrower/exposure
       is done with this method. For assessing such current condition, financial
       statements, current market position of trade/business, and overall
       management expertise are taken into account.
    This method is simple to adopt even for small accounts
    It can be applied consistently & objectively to generate a fair estimate of
       the risk grade of an account
    It has the flexibility of periodic review
       SMALL AND MEDIUM ENTERPRISES FINANCE

PARAMETERS FOR CREDIT RATING
Quantitative parameters are:
   1. How the units conforms to the regulatory norms
   2. Experience of the Top management of the unit in various activities in the
      business
   3. Initiative of the top management in staying ahead of competition
   4. Honoring financial commitments
   5. End-use of Borrowed funds
   6. Firm‟s ability to cope with major technological, regulatory and legal
      changes if any.
   7. Product characteristics- scope of diversification.
   8. Approach to face the threat of the substitutes.


Quantitative parameters:
   1. Sales/main income year- on-year.
   2. Growth in operating profit, net profit, year-on-year.
   3. ROCE,
   4. Debt-Equity ratio.
   5. DSER
   6. Current ratio
   7. Speed of debt collection.
   8. level of contingent liabilities.
   9. Holding level of inventory/finished goods.
   10. Speed of payment to trade creditors.
   11. Speed of creditors‟ collection from trade creditors.
   12. Security offered/available


   In short, business performance, financial performance, conduct of account and
security aspects are considered major aspects.
       SMALL AND MEDIUM ENTERPRISES FINANCE

   In practice, each bank, depending upon its corporate policy on financing
SME‟s decides on the nature of the parameters, and the weightage for each
parameter, with the ultimate objective of use of the Credit Rating tool as the
facilitator for risk grading of each account.




HOW CREDIT RATING SHOULD BE UNDERTAKEN FOR AN SME
STEP ONE
To decide various risk grades
As per RBI guidelines issued on 12 October 2002, a Credit Rating System should
be broadly as below:
    Rating scale may consist of 9 levels.
    Of the above, the first 5 levels may represent an acceptable credit risk, and
       the remaining 4 levels represent an unacceptable credit risk.
    Rating scales may be by number or alphabet etc. Basel Accord-II, has,
       however indicated rating scales using letters, as under:
       1. AAA
       2. AA
       3. AA-
       4. A+
       5. A
       6. A-
       7. BBB+
       8. BBB
       9. BB
       10. BB-
       11. Below BB (say B)
       12. Unrated
       SMALL AND MEDIUM ENTERPRISES FINANCE

STEP TWO
To devise parameters, and a score for each parameters.




STEP THREE
To devise a score for each grade.


STEP FOUR
To decide the periodicity of the Credit Rating for each account. It may be
annually/half-yearly/quarterly.
For some SME‟s, half yearly Credit Rating may serve the purpose.


STEP FIVE
To device a structured format to give effect to the above.




RISK WEIGHT FOR SME CREDIT FOR CAPITAL ADEQUACY
REQUIREMENT
       For the purpose of computing the Capital Adequacy Ratio for each bank
(minimum 9% of risk weighted assets as per RBI guidelines, minimum 8% as per
Basel Accord) with regard to SME credit, a straight 75% has been recommended
for each SME account fulfilling certain criteria.
       SMALL AND MEDIUM ENTERPRISES FINANCE

CASE STUDY ON SME RATING
       M/s. ABC Auto Pvt Ltd commenced its business of manufacturing auto
parts in the year 2003 as an SSI unit. The company supplies its products to the
replacement market. The products covers the two wheeler segment ( Scooter and
Motor cycle). The companies factory is located in Ludhiana, which is a major
centre for manufacturing and supplying of auto parts. The company has a Cash
Credit Limit of Rs.35 Lakhs and a Term Loan of Rs.50 Lakhs from ABC Bank.
The Company projected its sales turnover of Rs.2.50 Crores for the financial year
2003-04, against its actual sales of Rs.2.20 Crores from the year 2002-03. It
projected a net profit of Rs.12 Lakhs, against its actual profit of Rs. 10.25 Lakhs
during the year 2002-03. The company had a debt equity ratio (total outside
liability / tangible networth) of 2.35 as on 31.3.2003, which has been projected at
1.95 as on 31.3.2004. The company has projected a current ratio of 1.30 as on
31.3.2004, against its actual of 1.25 as on 31.3.2003. The company has been
dealing with ABC Bank since its inception. The conduct of their account has been
satisfactory, but there have been occasion where their cheques have been returned
unpaid due to the financial reasons; this has been particularly true during the last
four months, when two or three cheques were returned unpaid. The company has
been prompt in making payment of all dues to the Bank. It has to open an ad-hoc
BG of Rs.2.50 Lakhs during the last one year, which has been returned duly
discharged by the beneficiary.


The Company achieved sales of Rs.2.45 Crores with a net profit of Rs.11.80
Lakhs for the year 2003-04. Its debt equity ratio and current ratio as of 31.3.2004
come to 1.90 and 1.27 respectively.


The account came to review on 30th August 2004. As a finalization of the results
for the year 2003-04 took time, the company was able to submit its audited
        SMALL AND MEDIUM ENTERPRISES FINANCE

financial papers by 16th August 2004. The Company has requested for
enhancement of their Cash Credit Limit to Rs.50 Lakhs.


The facilities are secured by an equitable mortgage of personal property of the
Director‟s of the Company, which are worth Rs.30 Lakhs against Cash Credit and
Term Loan facilities, in addition to the primary security of Current assets and
Machinery against the respective facility.


Before considering the request of the Company, the bank is required to compute
the latest credit rating of the borrower.




Sr. no.                                                                       Marks
  Section A- Business Potential
1       Market potential                       Favourable Neutral     Unfavorable   2
                                               (4)         (2)        (0)
2     Diversification                          Favourable Neutral     Unfavorable   0
                                               (4)         (2)        (0)
3     Cyclicality                              Low         Moderate   High          2
                                               (4)         (2)        (0)
4     Business Activity                        Low         Moderate   High          2
                                               (4)         (2)        (0)
5     Competition                              Favourable Neutral     Unfavorable   2
                                               (4)         (2)        (0)
6     Location                                 Favourable Neutral     Unfavorable   4
                                               (4)         (2)        (0)
7     Experience                               Favourable Neutral     Unfavorable   4
                                               (4)         (2)        (0)
Max. marks       28                                Marks Obtained      16

  Section B- Financial Performance
1     Achievement of              Achieved      Upto75%,Less   Below 75%      2
      projected turnover        (4)             less than          (0)
                                                100%
                                                     (2)
2    Achievement of                Achieved     Upto75%,Less   Below 75%      2
     projected Net Profit         (4)           less than          (0)
     Before Tax                                 100%
                                                     (2)
3    Growth in Sales over          Above 10%    0 to 10%       No growth      4
     previous year                increase      positive            (0)
         SMALL AND MEDIUM ENTERPRISES FINANCE

                                (4)             growth
                                                     (2)
4    Increase in net profit      Above 10%      0 to 10%       No increase        4
     before tax over previous   increase        increase          (0)
     year                       (4)                   (2)
5    Current ratio              1.33 & above    Below 1.33 to Below 1.17          2
                                (4)             1.17                (0)
                                                      (2)
6    Total outside liability    Below 2         2 to 3         Over 3             4
     /Equity                    (4)                  (2)            (0)
Total marks 24                                  Marks Obtained   18

 Section C - Conduct of Account
1     Honouring commitments Timely within       Delayed          Delayed          4
                                seven days      within one       beyond one
                                (4)             month (2)        month (0)
2     Irregularities in account No return (4)   Not more         More than        0
                                                than 2 returns   two returns(0)
                                                (2)
3    Excess drawing             No excess       Not more         More than        4
                                drawing (4)     than 2 excess    two returns(0)
                                                drawing (2)
4    No retirement of bills     Timely within   Delayed          Delayed          2
     under LC                   10 days (4)     within one       beyond one
                                                month (2)        month(0)
5    Invocation of guarantee    No invocation   ----------       Invocation(0)    4
                                (4)
6    Routing of sales           Above 75%       50% - 75%      Below              4
                                (4)             (2)            50%(0)
7    Compliance of terms &      Fully           -----------    Non-               4
     Conditions                 complied (4)                   compliance(0)
8    Submission of comtrol      Timely (4)     Delayed but     Submitted          2
     statements                                within 15       beyond 15
                                               days (2)        days(0)
9    Submission of financial    Submitted      Submitted       Submitted          2
     statements                 before due (4) before (2)      after due (0)
10   Relation with bank         Over three     1-3 years (2)   Less than 1        4
                                years (4)                      year(0)
11   Display of banks board.    Displayed (4) ---------        Not                4
                                                               displayed(0)
Maximum marks 44                                      Obtained      34

Section D- Primary Security
1    Marketability              Good (2)        Average(1)       Very poor(0)     1
2    Durability                 Good (2)        average(1)       Very poor(0)     2
3    Price stability            Good (2)        average(1)       Very poor(0)     2
4    Storability                Good (2)        average(1)       Very poor(0)     2
5    Type of collateral         Property        machinery(2)     Current          4
     security                   security                         asset(0)
6    Coverage of above          100% or         100%-50%(2)      Below            0
          SMALL AND MEDIUM ENTERPRISES FINANCE

                                     above                        50%(0)
7      Marketability of              Good (2)     Average(1)      Very poor(0)      2
       collateral
8      Price stability of            Good (2)     Average(1)      Very poor(0)      1
       collateral
9      Convenience of                High(2)      Moderate(1)     low(0)            2
       ascertainment of title
10     Convenience of                High(2)      Moderate(1)     low(0)            1
       transferability
11     Owner of collateral           Borrower‟s   Jointly with    Third party‟s     0
       security                      name         borrower‟(2)s   name(0)
                                                  name
Max marks      28                                                       17


Sec.                Definition       Max Total    Score           Weightage         Final Score
                                                  Obtained
A                   Business         28           16              25                14.29
                    Potential
B                   Financial        24           18              40                30
                    Performance
C                   Conduct of       44           34              20                15.45
                    Accounts
D                   Security         28           17              15                9.10
                                                                  100               68.84


Grade                       Nature                Scores                     Definition
1                           AAA                   85-100                     Highest safety
2                           AA                    80-84                      Very high safety
3                           AA-                   75-79                      High safety
4                           A+                    70-74                      Adequate safety
5                           A-                    65-69                      Moderate safety
6                           BBB                   60-64                      Marginal safety
7                           BB+                   50-59                      Low safety
8                           BB-                   40-49                      Substandard
9                           BB                    30-39                      Doubtful
10                          B                     0-29                       Loss


Final rating allotted to the borrower- A- = moderate safety.
     SMALL AND MEDIUM ENTERPRISES FINANCE

       6. TERMS AND CONDITIONS OF SANCTIONS

MAIN TERMS & CONDITIONS:
   Nature of charging of security e.g. Hypothecation, mortgage.
   Specific    documentation     formalities   to   be   carried   out   by     the
     borrower/guarantor, so as to avail sanctioned facilities. This may cover
     submission of Board Resolution in case of a limited company
     borrower/guarantor, formalities relating to creation of charge on securities
     by examination of the mortgage deed and other documents, producing an
     NOC from concerned authorities.
   Depositing cash margin where stipulated. E.g. guarantee/L.C. facilities,
     inter-alia with some cash margin.


ADDITIONAL TERMS & CONDITIONS:
   Examination of various undertakings such as agreeing not to repay
     unsecured loans, if any, to associates without prior consent of the bank.
   Routing all business transactions through a bank account.
       SMALL AND MEDIUM ENTERPRISES FINANCE

REASONS FOR SPELLING OUT TERMS AND CONDITIONS.


       Borrowing and Lending transaction is a commercial contract and as such,
must be based on clear terms and conditions. In case of an eventual breach of any
of the terms, it will remain open for the affected party to claim damages arising
out of the breach.
       In case of lending & borrowing transactions, the terms and conditions play
a special role as outlined below:
    The borrower acknowledges that the lender may extend credit upto an
       agreed amount (technically known as LIMIT in Banking), provided the
       securities remain intact as per agreed terms, and all the covenants are
       complied with.
    In case of secured facilities, the borrower is aware that in case of default, if
       any, or in case of breach of any terms & conditions, the lender may deal
       with the securities towards repayment of the advance.
    The borrower agrees to pay interest as per terms & conditions as also the
       fees/charges of the lender from time to time.
    The borrower agrees to keep the securities insured against usual risks, in
       case this is not done, the lender is empowered to do the needful at the cost,
       risk and responsibility of the borrower.
    When an advance is covered by a third party guarantee, the terms &
       conditions of the guarantee need to be adhered to by the guarantor, and in
       executing the guarantee, the guarantor acknowledges the fact that in case of
       default by the borrower, the lender may initiate action for recovering
       against him either singly, or jointly with the borrower.
       SMALL AND MEDIUM ENTERPRISES FINANCE

7. POST DISBURSEMENT SUPERVISION

WHY POST DISBURSEMENT SUPERVISION
    It enables the lending banker to exercise on-site and off-site „control‟ over
      the account.
    Inspection of securities (charged to the bank) periodically by a bank official
      facilitates evaluation of the condition and value of securities vis-à-vis the
      amount lent, and wherever necessary to initiate necessary protective
      measures.
    Periodic verification of books of accounts, vouchers, invoices and other
      records maintained by the borrower provides an indication as to how the
      business affairs are being managed.
    Scrutiny of operations reflected in the account of the borrower provides
      clues as the well-being ( or otherwise) of the borrower.
    Interaction with the borrower/guarantor from time to time may throw up
      very useful signals having a bearing on the account and the bank may
      accordingly exercise greater control.
    Obtaining the statement of stock/current assets, and the analysis thereof,
      may indicate as to excessive inventory/book debts built up etc., which
      immediately may be taken up appropriately.
    Verification of securities, documents from time to time at post-
      disbursement stages, in order to ensure their validity and legal
      enforceability, is possible when effective post disbursement supervision
      measures are initiated by the financing bank.


   In short, periodic inspection of securities, both movable & immovable as the
case may be, verification of business records, discussion with the owners of the
borrowing firm, and on the top of all, examination of the operation of bank
       SMALL AND MEDIUM ENTERPRISES FINANCE

accounts are all the subject matter of post-disbursement supervision, with the sole
objective of ensuring safety of the advance of the bank.


POINTS TO BE EXAMINED DURING SITE VISIT/INSPECTION


Inspection of Security in the case of Manufacturing Companies
Type of           Documents required for              Remarks
Inventory         verification
Raw Material         1. Purchase bills                Bills raised by raw material
                     2. Copy of LR/RR of the          suppliers to be selected
                         material suppliers.          randomly for verification but
                     3. Excise register               atleast one of the latest dates.
                                                      Rates to be compared with
                                                      published rates in technical
                                                      journals
WIP                   1. Job cards pertaining to a    PPD in consultation with
                         particular job released by   accounts dept. at the
                         Production Planning &        company allots value addition
                         Control Dept. (PPD) of       at each stage of process at
                         the borrower.                various cost centres. Value
                      2. Progress Sheet attached      addition at different stages of
                         with each job under          the production as WIP to be
                         process.                     checked.
Finished Goods        1. Sales tax registered.        Sales turnover in the account
                      2. Copies of sales invoices     may be checked from the
                         raised by company.           books of accounts of the
                      3. Challans of advance CST      company as also at the bank‟s
                                                      branch where the facilities
                                                      are availed. The difference
                                                      may be tallied for routing of
                                                      sales through some other
                                                      bank accounts maintained at
                                                      any other bank.
Plant &               1. Copy of original bill of      1. Visual inspection is
machinery and            purchase.                         required to ascertain the
Factory/Office        2. Copy of valuation report          contents of plant &
building                 by approved valuer (if            machinery and its wear &
                         purchased second hand)            tear.
                      3. Audited balance Sheet         2. Fast wearing parts like
                         showing fixed Assets              bearing sockets, chains
       SMALL AND MEDIUM ENTERPRISES FINANCE

                         schedules.                       etc. may be inspected for
                                                          wear & tear.
                                                       3. Title Deeds duely
                                                          registered with Registrar
                                                          of Assurances

Inspection of Security in the case of Trading Accounts.
Type of Inventory           Documents required for Remarks
                            verification
Purchased material for         1. Purchase bills      Bills raised by raw
Trade                          2. Copy of LR/RR        material suppliers may
                                   of       the        be selected randomly.
                                   material           Methods of valuation
                                   suppliers.          be ascertained from the
                                                       concern.

Goods traded                   1.Sales tax              Sales turnover in the
                               registered.              account may be checked
                               2.Copies of sales        from the books of accounts
                               invoices raised by       of the company as also at
                               company.                 the bank‟s branch where the
                               3.Challans of            facilities are availed. The
                                advance CST             difference may be tallied
                                                        for routing of sales through
                                                        some other bank accounts
                                                        maintained at any other
                                                        bank.
Fixed Assets                Inventory of fixed          Value of the fixed asset and
                            assets such as office       their condition/maintenance
                            building, furniture etc.    position to be verified
                                                        visually.
       SMALL AND MEDIUM ENTERPRISES FINANCE

7. NURSING OF SMEs

WHEN AN SME IS CONSIDERED SICK
An SME is considered sick, if
   a) The account remains SUB-STANDARD for more than 6 months
                                    OR
   b) 50% of the networth (i.e. Capital+Reserves) is eroded due to accumulated
       losses.
                                    AND
   c) The borrower has been in the business (commercial production in the case
       of manufacturing unit) for atleast 2 years.


WARNING SIGNALS OF INCIPIENT SICKNESS


       While the Regulatory Authorities have not laid down any specific warning
signals, the following features generally indicatd the incipient sickness of SME
accounts.
    Default/delayed payment of installments and/or interest in borrowal
       accounts like term loan, cash credit, overdraft etc.
    Cash credit/overdraft facilities are supposed to be drawn upto a maximum
       of the sanction limit, barring exceptional situations. In case there is a
       continuous excess drawing in such accounts and/or the value of securities
       does not cover the outstanding balances, as per the terms & conditions for
       facilities.
    Non- submission/delayed submission of the statement of the hypothecated
       stock, book debts, other securities as required periodically.
    Frequent return of cheques due to financial reasons and return of bills
       drawn on various parties.
    SMALL AND MEDIUM ENTERPRISES FINANCE

 Large number of bills purchased/discounted, (under BP/BD facilities)
   remaining overdue for long periods.
 Invocation of guarantees by the beneficiaries issued on behalf of the SME.
 Non- retirement/delayed retirement of bills drawn under L.C, issued on
   behalf of SMEs.
 Receipt of notices from taxation authorities for non-payment of statutory
   liabilities.
 Frequent complaints from the supplier of materials of SME about non-
   payment of bills.
 Purchase of fixed assets that divert working capital funds from the business,
   without prior intimation/approval from the financing banks.
 Routing sale proceeds through the current account, with the non-financing
   bank/s.
 Downward trend in production/sales and operating profit.
 Large inventory built up, as compared to the volume of business.
 Existence of large amount of very old stock of raw material/goods.
 Allowing trade credit to its buyers for a very long period.
 Providing disproportionate discounts/concession to the customers in respect
   of sale prices.
 Non-submission/delayed submission of Balance Sheet and Profit & Loss
   Account.
 Not extending due co-operation in placing records/registers/data during
   periodical visits of business site by bank officials.
       SMALL AND MEDIUM ENTERPRISES FINANCE

GENERAL FACTORS RESPONSIBLE FOR SME ACCOUNTS
BECOMING SICK
       Reason for sickness of each SME account needs to studied separately and
appropriate remedial steps taken. However, the following general factors are
responsible for sickness in SME accounts:
Internal Factors:
    Diversion of Funds, especially for associated, sister concerns with/without
       any interest.
    Time/cost overruns of the project leading to the project being unviable.
    Business failures.
    Strained labour relations, leading to frequent disruption of work.
    Recurring technical problems without any permanent solution.
    Product obsolescence.


   External Factors:
    Recession/ severe deceleration.
    Non-payment of customers of the concerned SME.
    Inputs/power shortage.
    Price escalation without any scope of passing costs onto the customers.
    Accidents and natural calamities
    Changes in government policies.




HOW FINANCIAL NURSING IG GENERALLY UNDERTAKEN
       Once an SME is identified as potentially viable, financial nursing is to be
drawn up in such a way that the unit turns out and starts normal functioning as
soon as possible, with regard to meeting its financial commitments. Financial
       SMALL AND MEDIUM ENTERPRISES FINANCE

nursing takes the form of providing various reliefs and concessions which are
generally as follows:
    Penal Interest, if any, charged in borrowal account is to be waived from the
       date of the unit incurring cash losses.
    Unpaid normal interest that is not serviced may be converted into a term
       loan to be repaid over a period of time, as may be assessed and agreed to.
    Rate of interest for existing term loan and Working Capital accounts may
       be reduced where justified subject a maximum reduction of 3% PER
       ANNUM.
    Excess in Working Capital Accounts, over the sanctioned limit, is to be
       converted into a Working Capital Term Loan to be repaid over a period of
       time as may be assessed and agreed to.
    Interest rate on fresh working capital amount may be charged @ 1.5% p.a.
       less than the normal rate for such account.
    Funds for start-up expenses, including payments to pressing creditors, may
       be provided after due assessment, with an interest rate charged @ 1.5% p.a.
       less than the normal rate for such account.
    Promoters should contribute fresh funds towards rehabilitation package,
       which should generally be a minimum of 20% of additional term loan
       requirements under the rehabilitation package.
    For meeting escalations in capital expenditure ( after working out an initial
       estimate) a contingency term loan may be provided upto a maximum of
       15% of the rehabilitation package, at a concessional interest rate.
       Repayment is to be made over a period of time as may be assessed and
       agreed to.
       SMALL AND MEDIUM ENTERPRISES FINANCE

         8. CAPITAL ADEQUACY REQUIREMENTS

CAPITAL ADEQUACY FOR SME EXPOSURE
       In order to provide the needed boost for the growth in the SME sector,
Basel Accord II provides for capital adequacy at a reduced level of 75%, provided
that the following conditions are satisfied:
    Annual Sales of the concerned SME are less than 250 crores.
    Exposure confirms to the criteria of retail credit (e.g. exposure to one SME
       should not exceed 0.2 % of the overall retail credit portfolio of the lending
       bank.) that have been laid down.
   As regards to the basic criteria for the annual sales, it appears that the amount
may be limited upto 50 crores (as against euro 50mn under the Accord) in respect
of SMEs in India.


IMPLICATIONS


The new guidelines have overall implications as under:
    Once a borrower is treated as a SME, no discrimination in terms of
       concessions/benefits is possible by a lender.
    Quantum of SME finance is usually limited, as compared to the overall
       credit portfolio of the bank. The risk element, owing to reduction of risk
       weight by 25% (from 100% to 75%), may not significantly increase.
    The SME sector is generally involved in diversified activities with a lower
       operating cycle. The availability of easy finance may foster rapid economic
       growth in a country.
    Quicker recycling of funds is possible in SME exposures un view of lower
       operating cycle, as compared to the exposures to large units.
     SMALL AND MEDIUM ENTERPRISES FINANCE

BENEFITS TO SME BORROWERS
    Since the lending institution‟s locking of owned fund will be lower by
      25% risk weight, a more liberal approach is expected in the matter of
      obtaining finance.
    As the cost of funds towards providing finance to an SME borrower will
      be lower, it is expected that such borrowers may have a cheaper source of
      funds.
    A current trend the world over is to focus on the growth of “retail credit”
      by banks, since large borrowers are increasingly resorting to alternative
      sources of finance. Finance to SMEs is treated as “retail credit” under
      Basel Accord II. Hence banks will encourage such a secor in their bid to
      grow retail credit


BENEFITS TO LENDING BANKS
   Lower capital adequacy requirement presupposes release of source for
     financing the remunerative sector.
   Financial requirement for a general SME borrower is not large- hence credit
     risk content is more measurable.
   Usually, the rate of interest for retail credit is higher than that for large
     AAA rated borrowers the world over. Therefore, banks may have an
     opportunity to earn more.
   Pre-sanction as well as Post-sanction disbursement formalities in respect of
     SME exposures a fairly simple, as compared to those for large exposures.
     Hence, the cost of supervision of SME exposures may be lower for banks.
   Lending skills and expertise for financing an SME by bank staff are of a
     minimum nature. Even a junior staff member, with initials briefs, maybe in
     a position to process SME credit applications quickly, and in accordance
     with laid-down norms and guidelines.
          SMALL AND MEDIUM ENTERPRISES FINANCE

      CONCLUSION AND CURRENT SCENARIO


SMEs play very important role in india. It contributes significantly to GDP,
employment generation, export, development of entrepreneurial. Looking at the
importance of SMEs , more finance should be available from banks at reasonable
terms. One of the biggest problems for SMEs is that they are supplier to big
companies , due to which they don‟t have bargaining power and payment is not
made to them on time. In current scenario where there is recession in US and other
countries , SME are badly impacted because they are export oriented and they
have huge exposure to these countries .
In present context banks are not ready to lend to SME because of following
reasons
    Since SME are export oriented , due to recession and slowdown SME are
       not getting enough business
    Banks are concern about repayment capacity of SME. Banks have a view
       that financing SME could increase their NPA
    SME have very small capital base and they are mainly dependent on bank
       finance. In absence of bank finance, they are having any other source od
       finacing
     SMALL AND MEDIUM ENTERPRISES FINANCE

                         BIBLIOGRAPHY
 Small and Medium Enterprises – S.K. Bagchi
 Practical Microfinance – Malcolm Harper
 Periodical Journal- Professional Banker
   Management of Bank Credit – H R Suneja
   Cash Flow Based Lending Approach for SMEs – Dr. Satish Shinde
   www.rbi.org.in
   www.pnb.com
   www.wikipedia.com
   www.icicibank.com
   www.indusind.com
   www.indiainfoline.com
   www.ingvysyabank.com
   www.financialexpress.

				
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