Bank Finance For SMEs1 EXECUTIVE SUMMARY: Small&MediumEnterprises(SMEs)haveacquiredenormousimportancein contemporary worldfinances. Thisis primarilydue to the nationalfocusand priority of variouscountries-developed,developingaswellasunderdevelopedones.Small& MediumEnterprisessectorconstitutethegrowthengineoftheeconomywith contributiontoGDPestimatedat40%,contributiontoexportsestimatedat50%and employmentopportunitiestonearly4crorepersons.TheSMEsleadtoentrepreneurial developmentanddiversificationoftheindustrialsector,andalsoprovidedepthto industrialbaseoftheeconomy.Moreemploymentopportunitiesaregeneratedandthe capitalcostperemployeeislow.WiththeServicessectordominatingtheSME,and MNCsoutsourcingtheirvariousrequirementstoIndianserviceproviders,thescopefor SMEfinancehasincreased evenfurther. SMEshave a unique contributionin providing employmenttoskilled/unskilledpeople.Furthermore,qualitygoods/servicesaremade available at cheaper rates generally by SMEs. IntheIndiancontext, thereport ofGangulyCommitteehasprovidedimpetusto theauthoritiestoincreasinglycatertotheemergingfinancialneedsoftheSMEsector. 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 inaneconomy.SMEprojects/venturesdonotgenerallyinvolvelargefinancial 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. Whencomparedtosimilarproducts/servicesoflargesizedunits,SMEproducts/ 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 usher rapid progress and prosperity.Ontheotherhand,thebanksmustnotgooverboard,instead,becarefultosee whether the borrower fulfils the set criteria before making advance. Bank Finance For SMEs2 SME ARCHITECTURE SME DEFINED: Thereisno 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 ameasure 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. TYPES OF SMEs The Ganguly Committee (Constituted by RBI) in MAY 2004, has recommended three types of SMEs: 1.TINY TYPE- Annual turnover of Rs.2 Crores 2.SMALLTYPE-AnnualturnoverofmorethanRs.2CroresanduptoRs.10 Crores. 3.MEDIUMTYPE-AnnualturnoverofmorethanRs.10CroresanduptoRs.50 crores. Of all the three types, the major focus is on tiny type. Bank Finance For SMEs3 MICRO, SMALL, AND MEDIUM ENTERPRISES DEVELOPMENT ACT, 2006: The following chart indicates the threshold investment levels for both Manufacturing sector(INVESTMENTINPLANT&MACHINERY)*andServicessector (INVESTMENT IN EQUIPMENT)* for the above three categories of Manufacturing and Services Enterprises: EnterpriseEngaged in Manufacturing / Preservation of Goods(incl. Processing Units) Engaged In Providing/ Rendering of Services Remarks Micro EnterpriseNot to Exceed Rs. 25 Lakhs. Not to Exceed Rs. 10 Lakhs. 1.Separate threshold investment limits proposed by the Act for Manufacturing and Services Sectors. 2. Micro Enterprises newly introduced under both the sectors. Small EnterpriseMore than Rs.25 lakhs but does not exceed Rs. 5 Crores. More than Rs.10 lakhs but does not exceed Rs. 2 Crores. Medium EnterpriseMore than Rs.5 Crore Rupees but does not exceed Rs. 10 Crore. More than Rs. 2 Crore Rupees but does not exceed Rs. 5 Crore. Bank Finance For SMEs4 ACTIVITIES OF SME TheSMEsectormayconcernitselfwithanycommercialactivitypermissibleunder Law.Hence,anytypeofmanufacturing,processingorindustrialactivity,ortradingor alliedoperations,maybedomainoftheSMEsector.Howeverthefollowingactivities 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 / typingIndustrial R & D laboratory Laundry and Dry cleaning Tailoring Studios Cable TV network Pathology clinics Bank Finance For SMEs5 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 companiesoranyotherformoforganizations.SMEsasaPublicLimited 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. CapitalfundsofSMEsaregenerallysmall,comparedtoexternalfundsinthe formofLoans/Advances,hencethedebtequityratioislargerthanthe conventional 2 : 1 ratio At present many Indian SMEs do not have a compatible technological base ActivitiesofSMEsareprimarilyintheareaofdurableconsumergoods/ personalized services Products/servicesofSMEsaregenerallyarecheapercomparedtothelarge sized ones, primarily due to lower business overheads SMEsarebetterequippedtorenderpersonalizedattentionandcaretotheir customers. SMEshavebackward/forwardlinkageswithlargecorporatesinmattersof purchases/ sales are in a position to better business performance Bank Finance For SMEs6 IMPORTANCE OF SMEs 1.Large scale generation of wage employment is possible with the growth of SMEs inaneconomy.ItisquitelikelythatemployeesofSMEsmaynothave advantagesequalto thoseoftheircounterpartsinestablishedbusinessunits,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 generallyinvolvelargefinancial resourcesbut at the same time, the sector is growth driver in an economy. 4.ThetimelagbetweentheconceptionofanSMEproject/ventureand 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.SMEclustertakecareof4CsaspertheGangulyCommitteereport;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, the SME sector is the second largest employer of manpower 40 to 50 % of output / services originatefrom this sector. Also, over 30 % of Indian exports are on account of SMEs. Bank Finance For SMEs7 BENEFITS IN FINANCING SME From the view point of national economy, the benefits arising from higher order focus on SME financing may be broadly stated as follows. 1.Increasing the contribution of the SME sector in the GDP ofthe country 2.Entrepreneurial interest would be encouraged and the growth in the the number of SME may be possible 3.New products / services would be increasingly available for consumers 4.Competitiveness in business will increase. Bank Finance For SMEs8 FINANCIAL REQUIREMENTS OF SMEs MODEL/ STANDARDISED APPLICATION FORM: It will appear that the application covers the following fundamentals: Originoftheborrowingfirm/owners/promoterswithbriefbio-dataof 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 years 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. Thenumberofskilled/semi-skilled/unskilledemployeesincaseofanexisting unit. Foranewunit,thenumberofskilled/semi-skilled/unskilledemployeestobe recruited to achieve the first years expected business performance. Foranewunitinmanufacturing/alliedoperations,whetheranyindependent 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. Periodforwhich,theloanforcapitalassetsisrequiredandtheexactsourceof repayment within the period. Names/addressesofexistingbankersifanyoftheborrowing concern/promoters/owners, and the nature of the account relationships. Names,addresses,occupation,businessofguarantors,ifoffered,andtheir relationship with the promoters/owners, if any. Bank Finance For SMEs9 UTILITY Astandardizedapplicationformisadvantageoustoboththelenderandthe borrower in more than one way. Since the information required for arriving at the lending decisionarestructured,uniformandpointed ones,itbecomesconvenient toprocess the sameatafasterspeed.Fortheborrowersalso,itiseasiertofillout theform,seeking clarification wherenecessary,without placing anoverload ofinformation to support the application. Atthebanks/financialinstitutions,thestaffentrustedwithSMEapplicationsget familiarizedwiththemanagementsrequirementsformakingdecisionaboutloan applicationsonthebasisoftheborrowersapplications.Theyarethusbetterplacedto dispose off the applications. In this way, credit delivery process at the level of lenders is accelerated. FUND BASED REQUIEMENTS: Asforanyotherbusinesssegment,SMEsmayrequirecash/cashequivalentfor acquisitionof,holdinganddealingwithvariouscategoriesoftangibleassetsfor commencing and sustaining business operations. Thus, they may require funds for: 1)Acquisition of capital assets or2)Purchaseofstocksofrawmaterials/finishedgoods,extendingcredittotrade debtors and for other day to day business operations or3)Both 1) & 2) ABOVE. FUND FOR CAPITAL ASSETS: 1.In the case of land/building: Break-up of costs for land & building-location. Specificbenefitsthatarelikelytoaccrueonpurchaseofland/buildingwith loan, in place of having a rental arrangement. Bank Finance For SMEs10 2.In case of machinery/equipments/computers/other items of fixed assets: Details of each item with cost, names/addresses of suppliers etc. Howtechnicalviabilityoftheitemsisensured.Incaseaviabilityreportis available, it should be furnished. Details of periodic servicing arrangements and their likely costs. Whetheruseofmachinery/equipmentwouldbeinconformitywithpollution 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 costofcapitalassets,theapplicantisrequiredtoindicatethesourceforthebalance amount of 25%.

FUND FORWORKINGCAPITAL The quantumoffinancerequiredforeachoftheabovethree stagesislinkedwiththefollowing factors: Amanufacturing/industrialunitsrequirementforinventoryholdingwillbe generally higher than that of a trading unit Tradedebtorsholdinginatradingunitwillgenerallybehigherthanthatofa manufacturing / industrial unit Marketstanding/trackrecord/itemsofmanufacture/trademaydeterminethe varying degrees of working capital requirements of SMEs. Theavailabilityoftheownersfundstowardsworkingcapitalmanagementmay bedifferentindifferentSMEs.Thosewhohavealargerfinancialbasemay require less funding. Service- based SMEs like professionals / consultants may require a lower working capital fund when compared with other sectors. Bank Finance For SMEs11 Dependinguponthepast/projectscaleofbusinessoperations,SMEsmayneed institutional working capital support to take care of1.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 IDEAL FINANCE MIX Anindustrial/manufacturingSMEmayoperatesmoothlywithitsworking 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. Bank Finance For SMEs12 NON FUNDED WORKING CAPITAL REQUIREMENTS TherearethreecategoriesofnonfundedworkingcapitalfacilitiesavailableforSME client:1. Full risk Financial Guarantees / standby letters of credit issued in favour of a beneficiary on behalfofSMEclientsetcenablethemto obtainfundsfromthebeneficiaryasper contractual terms. 2. Medium risk IssuanceofBidbonds,Performanceguarantee,tradeletterofcreditand Indemnitybondsinfavour of abeneficiaryfor SME clientsetc. facilitatebusiness transactions between them, without any movement of funds from the beneficiary to theclientonwhosebehalfbanks/financialinstitutionsmayundertakesuch commitments.Thesetherefore,beingthecreditsubstituteonly,maycomeunder Medium Risk category 3. Low Risk In normal course of business, derivative instruments such as swaps, options, futures etcdonotcarryanynoticeableelementofrisk,howeverexperienceindicatesthat 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. Nonfundedfacilitiesprovideafewbasedincomeandhencebanks/financial institutionslooktosuchapplicationswithgreaterinterest.Butatthesametime, they endeavour to ensure that a.ThefacilitiessoughtisnotdisproportionatetotheparticularSMEspast /projected volume of business. b.Financialguaranteesmaybeaccordedlowerprioritythanbidbonds/ performance guarantees in view of their nature and risk propensity. Bank Finance For SMEs13 c.Some cash margin may be required as a cover ( for financial guarantee it may be 25%orlowerincaseofbidbondsandperformanceguarantees)alongwith tangible security cover. d.For sight trade letter of credit with a document of title to goods, the cashmargin may in some cases be waived and no additional cover may be required. e.Usuallybanks/financialinstitutionspreferSMEborrowersshouldalsohave appropriatedfundedworkingcapitalfacility.Inmajorityofcasesnonfunded facility to an SME constitute about 25 % of funded working capital facility. Bank Finance For SMEs14 PROCESSING OF SME CREDIT APPLICATION The following guideposts of credit application processing are very important: CREDENTIALS/TRACK RECORD: Usually, SMes are set up as sole proprietary, partnership or Private Ltd. Companies. ForanewSMEbusiness,performancedataandotheravenuesforthestudyofthe 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: a) Sole proprietor/Partners/Directors etc. in their individual capacities. b)AnyexistingassociatedconcernhavingmarketdealingswhereSoleproprietor/Partners/Directors are directly or indirectly interested. The credentials/track records study shall reflect: HowtheSMEhasbeenmeetingitsfinancialcommitmentstoits vendors/creditors. How business transactions are settled with its debtors. Howfinancialtransactionsarepassedthroughaccountswithitsexisting banks/financial institution. In-housetrainedofficialsmaymakespotenquiries,bycallingfornecessary documentary evidence such asinvoices/challans/passbook, statement of accounts etc. Indirectenquiriesmaybemadefromvaluedcustomersofthebanks/financial institution.Whennecessary,andsubjecttopriorconsentoftheapplicantSME,servicesof private enquiry agencies may be availed. For obtaining a Bankers Report(with whom, the SME has an account), reference maybemade.Theconcernedbankisexpectedtosendthereportinastructured manner.While abankers report is general andmaynot show any details,itisa fact that if an SMEs dealings with any bank has been unsatisfactory, they would indicate it by way of a suitable negative remark. Bank Finance For SMEs15 SITE VISIT: AsvaluableinputintheprocessofscrutinyofanSMEborrowersapplication,itis requiredthatasitevisitbyofficialsofthebanks/financialinstitutionbeorganized. Such a visit may take any of the following forms. For an existing unit, the business assets and records to be inspected/verified. Foranewunit,thesuitabilityoftheplace,andofthearrangementsinplacefor starting the business, to be examined. The implications of a site-visit of a manufacturing-industrial SME are different in view of following reasons: Amanufacturing/industrialunitinparticularwouldhavetoworkwithplant& machinery,equipmentetc.Incaseofanexistingunit,theconditionofthis,and theirefficiencylevelsshouldbesatisfactory.However,foranewunit,the locationaladvantage/constraints,ifany,foroperatingthemachinery/equipment will need to be examined. Ontheotherhand,foranexisting/newtradingunit,asitevisitisfairlysimple. Theofficialwillberequestedtoassessthestoragecapacityandtrading advantages/constraints, if any. Incaseofmanufacturing/industrialunit,averyimportantaspectpresently surfacing in many countries is with regard to affluent control systems in the unit, fromtheangleofpollutioncontrol.Duringthesitevisit,therefore, thepollution control angle is to be fully satisfied. ANALYSIS OF THE PAST AND PROJECTED FINANCIAL STATEMENTS: As for other business units, financial statements of SME applicants would cover: 1.TheBalanceSheetonaparticulardatereflectingthepositionofassetsand liabilities,includingcontingentassets&liabilitiesonthedatewhenthebalance sheet is drawn. 2.TheProfit&LossAccountreflectingtheendresultoftheoperationintermsof profit or loss during a particular period. 3.Profit & Loss Appropriation Account 4.Statement of Cash Flows. Bank Finance For SMEs16 Following purposes are served by Analysis of the financial statements: a.Howassets/liabilitiesarebalancedfromthesafetyangle-alsotakinginto account, contingent liabilities and assets.b.Toassesstheoperatingefficiencyoftheapplicant,withregardtopastbusiness performanceintermsofsales/mainimcomevis--visnetprofitforanexisting unit,andthefuturedateanalysisfornewunits,keepingprevailingmarket dynamics in view. c.To assess the quality of liquidity management if the owner/management and how thefirmisequippedtofaceasuddenfinancialstressduetoadversemarket movement. d.Howthefirmundertakesoperating,investingandfinancialactivities,as evidenced by its statement of cash flows. e.Whetherornot,anyconservativepolicyofdispositionofannualprofitis followed. 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% Bank Finance For SMEs17 4. Asset Movement Angle: Inventory Turnover Ratio. Debtors Turnover Ratio. 5. Trade Credit Payment Angle: Creditors Turnover Ratio.

ANALYSIS OF VIABILITY STUDY REPORT: Abusiness,whetheritismanufacturing/processing,orsimplyatrading sector has to satisfy the following broad objectives: Itisinapositiontosustainoperationsonacontinuousbasisforafairlylong period,goingbytechnologicalrequirements(whereapplicable)and/orbusiness 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 prevailing market environment and/or future scenario on a continuous basis for a fairly long period. Management,i.e.thoseentrusted/tobeentrustedwithrunningthebusinessare competent, taking into account, their technical and/or managerial background. Socialconsideration-inparticularwhethertheoperationoftheunitissocially acceptable, e.g. where a unit emits harmful smoke/waste material creating damage to the environment, the unit shall not be allowed to function. Bank Finance For SMEs18 CREDIT RATING FOR SME LENDING Rating implies an assessment/ evaluation of particular credit proposition- Funded aswellasNon-fundedonthebasisofCreditparameterssuchasPerformanceAnalysis, managementqualityandmarketscenario,etc.,withscoresforeachparameters.The aggregatescoreinanaccountinrelationtotheoverallscore,reflectsthe strengths/weaknesses of the respective account. TheBASELCOMMITTEEoftheBankInternationalSettlementshasdefined CreditRatingasasummaryindicatoroftheriskinherentinanindividualcreditand embodiesanassessmentoftheriskoflossduetothedefaultofcounterpartyon consideration of relevant quantitative & qualitative information. UTILITY OF CREDIT RATING FOR SMEs Inthecontext ofanSMEs,theutilityofacreditratingmaybeviewedfromthe 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 ratingMonitoringofExistingexposures,anddecidingexitstrategiesinappropriate cases. Allocation of risk capital in case of poor graded accounts. Avoidance of an over concentration of exposures in specific risk grades. METHOD OF CREDIT RATING A credit rating must satisfy the following aspects: It must generate an accurate information base In must facilitates a consistent evaluationIt must provide flexibility to allow professional judgment influence a rating Bank Finance For SMEs19 The following Two methods are prescribed in the credit rating system: 1.Through The Cycle Methods Underthismethodthefinancialpositionoftheborrowerand/orpositionof exposureis 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 Aratingsystembasedonthecurrentconditionoftheborrower/exposureis done with this method. For assessing such current condition, financial statements, currentmarketpositionoftrade/business,andoverallmanagementexpertiseare taken into account. This method is simple to adopt even for small accountsIt can be applied consistently & objectively to generate a fair estimate of the risk grade of an account It has the flexibility of periodic review 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.Firmsabilitytocopewithmajortechnological,regulatoryandlegalchangesif any. 7.Product characteristics- scope of diversification. 8.Approach to face the threat of the substitutes. Bank Finance For SMEs20 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.Current ratio 6.Speed of debt collection. 7.Level of contingent liabilities. 8.Holding level of inventory/finished goods. 9.Speed of payment to trade creditors. 10. Speed of creditors collection from trade creditors. 11. Security offered/available Inshort,businessperformance,financialperformance,conductofaccountand security aspects are considered major aspects. Inpractice,eachbank,dependinguponitscorporatepolicyonfinancingSMEs decides on thenature of the parameters, and theweightagefor each parameter, with the ultimateobjectiveofuseoftheCreditRatingtoolasthefacilitatorforriskgradingof each account. HOW CREDIT RATING SHOULD BE UNDERTAKEN FOR AN SME STEP ONE To decide various risk grades AsperRBIguidelinesissuedon12October2002,aCreditRatingSystemshouldbe broadly as below: Rating scale may consist of 9 levels. Oftheabove,thefirst5levelsmayrepresentanacceptablecreditrisk,andthe remaining 4 levels represent an unacceptable credit risk. Ratingscalesmaybebynumberoralphabetetc.BaselAccord-II,has,however indicated rating scales using letters, as under: Bank Finance For SMEs21 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 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 SMEs, half yearly Credit Rating may serve the purpose. STEP FIVE: To device a structured format to give effect to the above. RISKWEIGHTFORSMECREDITFORCAPITALADEQUACY REQUIREMENT ForthepurposeofcomputingtheCapitalAdequacyRatioforeachbank (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 foreach SME account fulfilling certain criteria. Bank Finance For SMEs22 CASE STUDY ON SME RATING M/s. Shyam Auto Pvt Ltd commenced its business of manufacturing auto parts in theyear2001asanSSIunit.Thecompanysuppliesitsproductstothereplacement market.The productscovers the two wheelersegment ( Scooter and Motor cycle). The companies factory is located in Ludhiana, which is a major centre for manufacturing and supplyingofautoparts.ThecompanyhasaCashCreditLimitofRs.35Lakhsanda Term Loan of Rs.50 Lakhs from ABC Bank. The Company projected its sales turnover of Rs.2.50Croresfor thefinancialyear2003-04,againstitsactualsalesofRs.2.20Crores from the year 2002-03. It projected a net profit of Rs.12 Lakhs, against its actual profit of Rs.10.25Lakhsduringtheyear2002-03.Thecompanyhadadebtequityratio(total outside liability / tangible networth) of2.35 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 sinceitsinception.Theconductoftheiraccounthasbeensatisfactory,buttherehave beenoccasionwheretheirchequeshavebeenreturnedunpaidduetothefinancial reasons;thishasbeenparticularlytrueduringthelastfourmonths,whentwoorthree cheques were returned unpaid. The companyhasbeen promptinmaking payment of all dues to the Bank. It has to open an ad-hocBG of Rs.2.50 Lakhs during the last one year, which has been returned duly discharged by the beneficiary. TheCompanyachievedsalesofRs.2.45CroreswithanetprofitofRs.11.80Lakhsfor 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 companywasable to submitits auditedfinancial papersby 16thAugust2004.TheCompanyhasrequestedforenhancementoftheirCashCredit Limit to Rs.50 Lakhs. Bank Finance For SMEs23 The facilities are secured by an equitable mortgage of personal property of the Directors oftheCompany,whichareworthRs.30LakhsagainstCashCreditandTermLoan 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. Section A- Business Potential

Sr. no.Marks 1Market potentialFavourable (4) Neutral (2) Unfavorable (0) 2 2DiversificationFavourable (4) Neutral (2) Unfavorable (0) 0 3CyclicalityLow(4) Moderate (2) High (0) 2 4Business ActivityLow(4) Moderate (2) High (0) 2 5CompetitionFavourable (4) Neutral (2) Unfavorable (0) 2 6LocationFavourable (4) Neutral (2) Unfavorable (0) 4 7ExperienceFavourable (4) Neutral (2) Unfavorable (0) 4 Max. marks 28Marks Obtained 16 Bank Finance For SMEs24 Section B- Financial Performance 1Achievementof projectedturnover Achieved (4) Upto75%,Lesslessthan 100% (2)Below75% (0) 2 2Achievementof projectedNetProfit Before Tax Achieved (4) Upto75%,Lesslessthan 100% (2)Below75% (0) 2 3GrowthinSalesover previous year Above10% increase (4) 0to10% positive growth (2) Nogrowth (0) 4 4Increaseinnetprofit beforetaxover previous year Above10% increase (4) 0to10% increase (2) Noincrease (0) 4 5Current ratio1.33& above (4) Below1.33to 1.17 (2) Below1.17 (0) 2 6Totaloutsideliability /Equity Below2 (4) 2to3 (2) Over3 (0) 4 Total marks24Marks Obtained18

Bank Finance For SMEs25 Section C - Conduct of Account 1Honouring commitments Timely withinseven days (4) Delayed withinone month (2) Delayed beyondone month (0) 4 2Irregularities in accountNo return (4)Notmore than 2 returns (2)Morethantwo returns(0) 0 3Excess drawingNoexcess drawing (4) Notmore than2excess drawing (2) Morethantwo returns(0) 4 4Noretirementofbills under LC Timely within10 days (4) Delayed withinone month (2) Delayed beyondone month(0) 2 5Invocation of guaranteeNo invocation (4) ----------Invocation(0)4 6Routing of sales Above75% (4) 50%-75% (2) Below 50%(0)4 7Complianceofterms& Conditions Fully complied (4) -----------Non- compliance(0) 4 8Submissionofcomtrol statements Timely (4)Delayedbut within15 days (2) Submitted beyond15 days(0) 2 9Submissionoffinancialstatements Submitted beforedue (4) Submitted before (2) Submittedafter due (0) 2 10Relation with bankOverthree years (4) 1-3 years (2)Lessthan1 year(0) 4 11Display of banks board.Displayed(4) ---------Not displayed(0) 4 Maximum marks 44Obtained 34 Bank Finance For SMEs26 Section D-Primary Security 1MarketabilityGood (2)Average(1)Very poor(0) 1 2Durability Good (2)average(1)Very poor(0) 2 3Price stability Good (2)average(1)Very poor(0) 2 4StorabilityGood (2)average(1)Very poor(0) 2 5Typeofcollateral security Property security machinery(2)Current asset(0) 4 6Coverage of above100%or above 100%-50%(2) Below 50%(0) 0 7Marketabilityof collateral Good (2)Average(1)Very poor(0) 2 8Pricestabilityof collateral Good (2)Average(1)Very poor(0) 1 9Convenienceof ascertainment of title High(2)Moderate(1)low(0)2 10Convenienceof transferability High(2)Moderate(1)low(0)1 11Ownerofcollateral security Borrowers name Jointlywith borrower(2)s name Third partys name(0) 0 Max marks2817 Bank Finance For SMEs27 Sec.DefinitionMax TotalScore Obtained WeightageFinal Score ABusiness Potential 28162514.29 BFinancial Performance 24184030 CConductof Accounts 44342015.45 DSecurity2817159.10 10068.84 GradeNatureScoresDefinition 1AAA85-100Highest safety 2AA80-84Very high safety 3AA-75-79High safety 4A+70-74Adequate safety 5A-65-69Moderate safety 6BBB60-64Marginal safety 7BB+50-59Low safety 8BB-40-49Substandard 9BB30-39Doubtful 10B0-29Loss Final rating allotted to the borrower- A- = moderate safety. Bank Finance For SMEs28 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 astoavailsanctionedfacilities.ThismaycoversubmissionofBoardResolution incaseofalimitedcompanyborrower/guarantor,formalitiesrelatingtocreation ofchargeonsecuritiesbyexaminationofthemortgagedeedandother documents, producing an NOC from concerned authorities. Depositingcashmargin wherestipulated. E.g. guarantee/L.C.facilities,inter-alia with some cash margin. ADDITIONAL TERMS & CONDITIONS: Examinationofvariousundertakingssuchasagreeingnottorepayunsecured loans, if any, to associates without prior consent of the bank. Routing all business transactions through a bank account. 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. Incaseoflending&borrowingtransactions,thetermsandconditionsplaya special role as outlined below: Theborroweracknowledgesthatthelendermayextendcredituptoanagreed 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 securedfacilities, the borrower is aware that in case of default,if any, orincaseofbreachofanyterms&conditions,thelendermaydealwiththe securities towards repayment of the advance. Bank Finance For SMEs29 Theborroweragreestopayinterestasperterms&conditionsasalsothe fees/charges of the lender from time to time. The borrower agrees to keep the securities insured against usual risks, in case this isnotdone,thelenderisempoweredtodotheneedfulatthecost,riskand responsibility of the borrower. When an advance is covered by a third party guarantee, the terms & conditions of theguaranteeneedtobeadheredtobytheguarantor,andinexecutingthe guarantee,theguarantoracknowledgesthefactthatincaseofdefaultbythe borrower, thelendermayinitiate actionfor recovering against himeither singly, or jointly with the borrower.

Bank Finance For SMEs30 POST DISBURSEMENT SUPERVISION WHY POST DISBURSEMENT SUPERVISION Itenablesthelendingbankertoexerciseon-siteandoff-sitecontroloverthe account. Inspectionofsecurities(chargedtothebank)periodicallybyabankofficial facilitates evaluation of the condition and value of securities vis--vis the amount lent, and wherever necessary to initiate necessary protective measures. Periodicverificationofbooksofaccounts,vouchers,invoicesandotherrecords maintainedby the borrower provides anindication as to how the business affairs are being managed. Scrutiny of operations reflectedin the account oftheborrower provides clues as the well-being (or otherwise) of the borrower. Interactionwiththeborrower/guarantorfromtimetotimemaythrowupvery usefulsignalshavingabearingontheaccountandthebankmayaccordingly exercise greater control. Obtainingthestatementofstock/currentassets,andtheanalysisthereof,may indicateastoexcessiveinventory/bookdebtsbuiltupetc.,whichimmediately may be taken up appropriately. Verificationofsecurities,documentsfromtimetotimeatpost-disbursement stages,in order to ensure theirvalidity andlegalenforceability,is possible when effectivepostdisbursementsupervisionmeasuresareinitiatedbythefinancing bank. Inshort,periodicinspectionofsecurities,bothmovable&immovableasthecase maybe,verificationofbusinessrecords,discussionwiththeownersoftheborrowing firm,andonthetopofall,examinationoftheoperationofbankaccountsareallthe subjectmatterofpost-disbursementsupervision,withthesoleobjectiveofensuring safety of the advance of the bank. Bank Finance For SMEs31 POINTS TO BE EXAMINED DURING SITE VISIT/INSPECTION Inspection of Security in the case of Manufacturing Companies Type of InventoryDocuments required for verificationRemarks Raw Material1.Purchase bills 2.CopyofLR/RRofthematerial suppliers. 3.Excise registerBillsraisedbyrawmaterialsuppliers tobeselectedrandomlyfor verification but atleast one of the latest dates.Ratestobecomparedwith published rates in technical journals WIP1.Jobcardspertainingtoa particularjobreleasedby ProductionPlanning&Control Dept. (PPD) of the borrower. 2.ProgressSheetattachedwith each job under process. PPDinconsultationwithaccounts dept.atthecompanyallotsvalue additionateachstageofprocessat variouscostcentres.Valueadditionat differentstagesoftheproductionas WIP to be checked. Finished Goods1.Sales tax registered. 2.Copiesofsalesinvoicesraised by company. 3.Challans of advance CST Salesturnoverintheaccountmaybe checked from the books of accounts of thecompanyasalsoatthebanks branch where the facilities are availed. Thedifferencemaybetalliedfor routingofsalesthroughsomeother bank accounts maintained at anyother bank. Plant&machinery andFactory/Office building 1.Copyoforiginalbillof purchase. 2.Copyofvaluationreportby approvedvaluer(ifpurchased second hand) 3.AuditedbalanceSheetshowing fixed Assets schedules. 1.Visualinspectionisrequiredto ascertainthecontentsofplant& machinery and its wear & tear. 2. Fastwearingpartslikebearing sockets,chainsetc.maybe inspected for wear & tear. 3.Title Deeds duely registered with Registrar of Assurances Bank Finance For SMEs32 Inspection of Security in the case of Trading Accounts. Type of InventoryDocumentsrequiredfor verification Remarks Purchased material for Trade1. Purchase bills 2.CopyofLR/RRof the material suppliers. Billsraisedbyrawmaterial suppliersmaybeselected randomly. Methodsofvaluationbe ascertained from the concern. Goods traded1.Sales tax registered. 2.Copiesofsalesinvoicesraisedby company. 3.Challansof advance CST Salesturnoverintheaccountmay becheckedfromthebooksof accountsofthecompanyasalsoat thebanksbranchwherethe facilitiesareavailed.Thedifference maybetalliedforroutingofsales throughsomeotherbankaccounts maintained at any other bank. Fixed Assets Inventoryoffixedassetssuch asofficebuilding,furniture etc. Valueofthefixedassetandtheir condition/maintenancepositionto be verified visually. Bank Finance For SMEs33 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 monthsOR b)50%ofthenetworth(i.e.Capital+Reserves)iserodedduetoaccumulatedlosses.AND c)Theborrowerhasbeeninthebusiness(commercialproductioninthecaseof manufacturing unit) for atleast 2 years. WARNING SIGNALS OF INCIPIENT SICKNESS WhiletheRegulatoryAuthoritieshavenotlaiddownanyspecificwarning 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/overdraftfacilities aresupposed to be drawn upto a maximum of the sanction limit, barring exceptional situations. In case there is a continuous excess drawinginsuchaccountsand/orthevalueofsecuritiesdoesnotcoverthe outstanding balances, as per the terms & conditions for facilities.Non- submission/delayed submission of the statement of thehypothecated stock, book debts, other securities as required periodically. Frequentreturnofchequesduetofinancialreasonsandreturnofbillsdrawnon various parties. Largenumberofbillspurchased/discounted,(underBP/BDfacilities)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. Receiptofnoticesfromtaxationauthoritiesfornon-paymentofstatutory liabilities. Bank Finance For SMEs34 Frequent complaints from the supplier of materials of SME about non-payment of bills. Purchaseoffixedassetsthatdivertworkingcapitalfundsfromthebusiness, 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. Providingdisproportionatediscounts/concessiontothecustomersinrespectof 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. GENERALFACTORSRESPONSIBLEFORSMEACCOUNTSBECOMING SICK ReasonforsicknessofeachSMEaccountneedstostudiedseparatelyand appropriate remedial steps taken. However, the following general factors are responsible for sickness in SME accounts: Internal Factors: DiversionofFunds,especiallyforassociated,sisterconcernswith/withoutany interest. Time/cost overruns of the project leading to the projectbeing unviable. Business failures. Strained labour relations, leading to frequent disruption of work. Recurring technical problems without any permanent solution. Product obsolescence. Bank Finance For SMEs35 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 calamitiesChanges in government policies. Bank Finance For SMEs36 HOW FINANCIAL NURSING IG GENERALLY UNDERTAKEN Once an SMEisidentified as potentiallyviable,financialnursingis to be drawn up in such a way that the unit turns out and starts normal functioning as soon as possible, withregardtomeetingitsfinancialcommitments.Financialnursingtakestheformof providing various reliefs and concessions which are generally as follows: Penal Interest, if any,chargedinborrowal account is to be waivedfrom the date of the unit incurring cash losses. Unpaidnormalinterest that isnot servicedmaybe convertedinto a termloan to be repaid over a period of time, as may be assessed and agreed to. RateofinterestforexistingtermloanandWorkingCapitalaccountsmaybe 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 aWorking Capital TermLoan to be repaid over a period of time asmaybe assessed and agreed to. Interestrateonfreshworkingcapitalamountmaybecharged@1.5%p.a.less than the normal rate for such account. Fundsforstart-upexpenses,includingpaymentstopressingcreditors,maybe provided after due assessment, with an interest rate charged @ 1.5% p.a. less than the normal rate for such account. Promotersshouldcontributefreshfundstowardsrehabilitationpackage,which shouldgenerallybeaminimumof20%ofadditionaltermloanrequirements under the rehabilitation package. Formeetingescalationsincapitalexpenditure(afterworkingoutaninitial estimate)acontingencytermloanmaybeprovideduptoamaximumof15%of therehabilitationpackage,ataconcessionalinterestrate.Repaymentistobe made over a period of time as may be assessed and agreed to. Bank Finance For SMEs37 CAPITAL ADEQUACY REQUIREMENTS CAPITAL ADEQUACY FOR SME EXPOSURE InordertoprovidetheneededboostforthegrowthintheSMEsector,Basel AccordIIprovidesforcapitaladequacyatareducedlevelof75%,providedthatthe 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 notexceed0.2%oftheoverallretailcreditportfolioofthelendingbank.)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 in respect of SMEs in India. IMPLICATIONS The new guidelines have overall implications as under: OnceaborroweristreatedasaSME,nodiscriminationintermsof concessions/benefits is possible by a lender. QuantumofSMEfinanceisusuallylimited,ascomparedtotheoverallcredit portfolio of the bank. The risk element, owing to reduction of risk weight by 25% (from 100% to 75%), may not significantly increase. TheSMEsectorisgenerallyinvolvedindiversifiedactivitieswithalower operatingcycle.Theavailabilityofeasyfinancemayfosterrapideconomic growth in a country. . BENEFITS TO SME BORROWERS Since the lending institutions locking of owned fund will be lower by 25% risk weight, a more liberal approach is expected in the matter of obtaining finance. AsthecostoffundstowardsprovidingfinancetoanSMEborrowerwillbe lower, it is expected that such borrowers may have a cheaper source of funds. Bank Finance For SMEs38 Acurrenttrendtheworldoveristofocusonthegrowthofretailcreditby banks,sincelargeborrowersareincreasinglyresortingtoalternativesourcesof finance.FinancetoSMEsistreatedasretailcreditunderBaselAccordII. Hence banks will encourage such a secor in their bid to grow retail credit BENEFITS TO LENDING BANKS Lowercapitaladequacyrequirementpresupposesreleaseofsourceforfinancing the remunerative sector. Financial requirementfor a general SMEborrower isnot large-hence credit risk content is more measurable. Usually, the rate of interest for retail credit is higher than that for large AAA rated borrowerstheworldover.Therefore,banksmayhaveanopportunitytoearn more. Pre-sanction as well as Post-sanction disbursement formalities in respect of SME exposuresafairlysimple,ascomparedtothoseforlargeexposures.Hence,the cost of supervision of SME exposures may be lower for banks. LendingskillsandexpertiseforfinancinganSMEbybankstaffareofa minimumnature.Evenajuniorstaffmember,withinitialsbriefs,maybeina position to process SME credit applications quickly, and in accordance with laid-down norms and guidelines. Bank Finance For SMEs39 RECOVERY OF NON-PERFORMING AVANCES (NPA) Banksarerequiredtohaveaconsistentapproachtowardsearlyproblem recognition, the classification of problem exposures, and remedial action. NPA DEFINED: TheSecuritisation&ReconstructionofFinancialAssetsandEnforcementof Security Interest Act 2002 defines NPA as under: Non- Performing Asset means an asset or account of a borrower which has been classifiedbyabankorfinancialinstitutionassub-standard,doubtfulorloss-assetin accordancewiththedirectionsorguidelinesrelatingtoassetclassificationissuedby Reserve bank of India. TheReserve Bank of Indiahas directed that,if anexposure payment ofinterest, repayment of installation of principal, or both remain unpaid for a period of 90 days, such exposure is to be treated as non-performing. ACTION FLOW IN NPA RECOVERY IN CASES OF SME ADVANCES ToidentifyNPAwiththetoolofCreditRating(aconsiderabledowngradeina shortperiodisadirectindication)and/orothertools(e.g.depletionofsecurity cover/operationinaccounts)accountswhichcanbeturnedviableoveratime horizon with a planned rehabilitation/nursing program. Unviable accounts where EXIT strategies are by way of : 1.Crystallisation/Sales of assets. 2.For the deficit, if any, to decide compromised settlement with/without any sacrifice, or to initiate legal action by filling up suit. Forbothviableandnon-viable,appropriateprovisioningasperregulatory guidelines should be made/held during the subsistence of the account.(Insomecountries,atthecommencementofdisbursementofanycredit,some provisions are made and are progressively increased as a buffer. In India, as per RBI,guidelines,evenforaccountsclassifiedasStandardAssets,aminimum provision of 0.25% is to be made). Bank Finance For SMEs40 CorporateDebtRestructuring(foraccountswithexposureofRs.20Croreand above,underConsortium/Syndicate/MultipleBankingarrangement)istobe initiated as per regulatory guidelines, considering eligible are viable. DEBT RECOVERY TRIBUNAL (DRT) The DRT decides on applications from banks/financial institutions for recovery of theiradvancestoborrowersmadeatplacesthatfallwithinthelocallimitsofthe concerned DRT. The Supreme Court of India has clarified that the objective of the act in establishingaDRTistofacilitateexpeditiousrecoveryofadvancesofbanks/financial institutionsDRT is deemed to be a civil court. Important practical aspects: Theclaimantbank/financialinstitutionmustensurethateachclaimperpartyis not less than Rs.10 lacs. The application must be made in the prescribed format. Theclaimmustbemadewithintheprescribedlimitationperiod,underthe Limitation Act. The DRT must issue an order (certificate) for recovery. TheorderoftheDRTmustbeenforcedbytherecoveryofficer,whois empowered to : a)Attach and sell the properties of the defendant. b)Arrest and detain the defendant in prison. c)Appoint a Receiver for the management of defendants properties. Bank Finance For SMEs41 LATEST LEGISLATION ON RECOVERY OF ADVANCES Banks/FinancialInstitutions(holdingsecuritycoveragainstanadvance-except securitycoverbywayofpledge/lien/shippingvessel/agricultureland)withan outstanding advance of over Rs. 1 lac, and with a further stipulation that the same be over 20% principal + interest, may enforce their security interest by taking over the assets and salethereofinconformitywiththeprovisionsunderTHESECURITISATIONAND RECONSTRUCTIONOFFINANCIALASSETSANDENFORCEMENTOF SECURITY INTEREST ACT, 2002 with recent amendments. Important Practical Aspects: Claimantbank/financialinstitutionmayinitiatetheapprovedrecoveryprocess underthisstatutefortherecoveryofadvances,whichareclassifiedasNon-Performing Assets in accordance with the RBI guidelines. Lendingbank/financialinstitutionmustfirstissueaDemandnotice,giving60 days time. Uponnon-paymentoffulldebts,evenafterstipulatednoticeperiodisover,the following recovery measures (one or more) may be initiated: a)Taking possession of securities and subsequent sale thereof. b)Taking over management off the business. c)Appointingamanagertomanagethesecuritieschargedtothe bank/financial institution. d)Askinganyothercreditorwhohasacquiredanyoftheassetsofthe borrower to pay the amount due. For any shortfall, even after takinginto account, the abovemeasures, (no. a) &d))thebank/financialinstitutionmayfiletherequiredapplicationtothe DRT/court of law for further steps. Bank Finance For SMEs42 EXAMPLE M/S Good Business stores is a small super market. It has asked for: 1.A loan for renovation of shop premises: Rs. 10 lacs 2.Working Capital by way of cash credit/overdraft: Rs. 5 lacs 3.Bank Guarantee favouring its suppliers of materials: Rs. 5 lacs Total Exposure sought for Rs. 20 lacs. Under Basel Accord I, the entire exposure of Rs. 20 lacs would attract 100% risk weight, i.e. Rs. 20 lacs against which banks in India are required to set aside 9%(i.e. Rs. 1.80 lacs) as regulatory capital. UnderBaselAccordII,riskweightwillbe75%,i.e.Rs.15lacs.Hence,the capital requirement will be 9% of Rs.15lacs (i.e. Rs. 1.35 lacs). ThusanamountofRs.0.45lacswouldbefreelyavailableforfindingother borrowers, while maintaining the same exposure level of Rs. 20 lacs.

Bank Finance For SMEs43 CASE STUDY M/s.ABC and Company is a proprietorship firm that is engaged in manufacturing partsfor officefurniture.Theproprietor ofthefirmhashadtenyearsexperienceinthe trade,workingasaproductionmanagerwithanotherunit.Hehasstartedhisown manufacturing unit in the name of ABC and Company with a capital of Rs.40 lakhs. The firm has rented some factory premises. The first year operations for the firm was2003-04anditsBalanceSheetisshownasbelowon31.3.2004.Thefirmachievedsalesof Rs.60.00 Lakhs during this period. LiabilitiesAmountAssets Amount Capital37.5Machinery35 Ceditors15Inventory3 Shortterm borrowings 10Debtors20 OtherCurrent Liabilities 2Advances2.5 Other Current assets4 Total64.5Total64.5 ThefirmhasprojectedsalesofRs.1.50CroresforthesecondyearandRs.3.00 Crores for the third year. To achieve this projections the firm needs additional machinery worth Rs.30 Lakhs and Working CapitalFinance of Rs.25 Lakhsfor 2004-05 and Rs.50 Lakhsfor 2005-06. The proprietor has proposed to bring Rs.10Lakhsfor the expansion plans.Hedoesnothaveanyadditionalsecuritytooffertothebankotherthanthe business assets. He is ready to arrange for a personal guarantee from his family members, that his spouse and father who is retired Government employee. Bank Finance For SMEs44 SOLUTION A.Term Loan Total cost of new machinery Rs.30 Lakhs Normally the Bank insists on 25 % margin and for SME the bank may accept 20 % also.So Bank loan after taking into consideration 20 % margin isRs.24 Lakhs B.WorkingCapital-Foranormalworkingcyclewithaunitof3months,thebank mayassessthetotalworkingcapitalat25%ofprojectedsalesandfinancemaybe granted upto 20 % of the sales leaving 5 % to be financed by the borrower. Total sales projected Rs.150 Lakhs 25 % of projected turnover Rs.37.50 Lakhs Margin 5 % projected turnover Rs.7.50 Lakhs Limit at 20 % of projected turnover Rs.30 Lakhs Limit requested Rs.25 Lakhs Margin required for the limit requested Rs.6.25 Lakhs NowthetotalcontributionrequiredfromtheborrowerwillbeRs.12.25Lakhs,The proprietor has proposed to bring Rs.10 Lakhs and there is already a net working capital gap of Rs.2.50 Lakhs. Bank Finance For SMEs45 Bank Finance to the SME Sector Issues And Perspectives There are anumber ofissuesinlending to the SME sector, whichbanks generallyface. The key issues among them are outlined below: Information Asymmetry: Accurate information about the borrower is a critical input for decision-making by banks in the lending process. Where information asymmetry (a situation where business owners or managers know more about the prospects for, and risks facing their business than their lenders) exists, lenders may respond by increasing lending margins to levels in excess of thatwhichtheinherentriskswouldrequire.However,thesheerticketsizeofSME lendingmakesitunviableforbankstoinvestindevelopmentofinformationsystems aboutSMEborrowers.Insuchsituations,banksmayalsocurtailtheextentoflending even when SMEs are willing to pay a fair risk adjusted cost of capital. The implication of raising interest rates and/or curtailing lending is that banks will not be able to finance as many projects as otherwise would have been the case. Granularity: Thisreferstoasituationwheretheriskgradingsystematbanksdoesnothavethe requisitecapabilitytodiscriminatebetweengoodandbadrisks.Theconsequenceis tighteningofcreditterms,oranincreaseinprices,orboth.Fromtheborrowers perspective,thisleadstoanoutcomewherethebankisover-pricinggoodrisksand under-pricing bad risks. The fact that most banks in India have not developed adequate expertiseinSMElendingriskassessmentexercisesleadstotheproblemofgranularity when it comes to SME lending. Pecking Order Theory: Pecking order theory flows from the above two issues, which makes SME lending highly difficultforbanks.Underthishypothesis,SMEs,whichfaceacostoflendingthatis abovethetruerisk-adjustedcost,willhaveincentivestoseekoutalternativesourcesof funding.EvidencesuggeststhatinsuchsituationsSMEsprefertoutiliseretained earnings instead of raising loans from banks. Bank Finance For SMEs46 Moral Hazard: EvenwhenloansaremadetoSMEs,itmaysohappenthattheownersoftheseSMEs take higher risks than they otherwise would without lending support from the banks. One reasonforthissituationisthattheownerofthefirmbenefitsfullyfromanyadditional returns but does not suffer disproportionatelyif the firm is liquidated. This is referred to asthemoralhazardproblem,whichcanbeviewedascreatingsituationofover-investment. The moral hazard problem may, thus, result in SME lending turning bad in a short period of time, a situation that all banks would like to avoid. Switching Costs: SMEs may find it harder to switch banks, when countered with any issue. It is a known fact that the smaller the business, the more significant the switching costs are likely to be and, therefore, it is less likely that the benef ts of switching outweigh the costs involved. This situation results in SME lending becoming a sellers market, which may not be attractive to SME borrowers. Steps for Smooth SME Lending Inorder toensurethat theaboveissuesdonotstandbetweenSMEsandBankFinance, the following steps could be taken as remedial measures: Collateral:Existence of collateral that can be offered tobanks by SMEs could be one effective way ofmitigatingrisk.Bankscould,therefore,lookatcollateralwhenpursuingthequestion ofSMElending.Itcanalsobestatedthataborrowerswillingnesstoaccepta collateralisedloancontractofferinglowerinterest(relativetounsecuredloans)willbe inverselyrelatedtoitsdefaultrisk.However,notallSMEswouldbeabletooffer collateral to banks. Hence, Reserve Bank of India (RBI) allows banks, with a good track record andfinancialpositiononSSIunits,todispensewithcollateralrequirementsforloansupto Rs. 25 lakhs. Bank Finance For SMEs47 Relationships: ThelengthoftherelationshipbetweenabankanditsSMEcustomersisalsoan important factor in reducing information asymmetry, as an established relationship helps tocreateeconomiesofscaleininformationproduction.ArelationshipbetweenaSME andabankofconsiderabledurationallowsthebanktobuildupagoodpictureofthe SME,theindustrywithinwhichitoperatesandthecalibreofthepeoplerunningthe business.Theclosertherelationship,thebetterarethesignalsreceivedbythebank regarding managerial attributes and business prospects. Quality of Information: SMEs are required to provide accurate and qualitative information to the banks for them toundertakeareliableriskassessment.Accurateriskassessmentsobviouslyrelyupon good information regarding the SME and its prospects. Hence, it is suggested that banks should make efforts to encourage SMEs to improve the quality of information provided. Customer Consideration: TheSMEmarketissomewhatdifferenttothecorporatemarketinthatcorporate customers generally have a wide range of financing options to choose from and are not as dependentonbankfinancingasisthecasewithSMEs.TheextenttowhichSMEscan take necessary steps, with the aid of public initiatives, to easily switch to another bank is another factor that can influence the level of competitive pressure on banks in the case of SME lending. Bank Finance For SMEs48 ROLE OF GOVERNMENT AND BANKING REGULATOR IN SME LENDING: As is apparent, the above factors are only idealistic solutions and may not be practical for SMEstofollowbecausetheyarefacedwithseveralproblemssuchasweakfinancial strength,inabilitytoprovideadequatecollateralandotherfactors.Hence,the GovernmentandbankingsupervisorsshouldtakeaholisticviewoftheSMESector whileconsideringSMEfinancing,takingintoaccounttherisksfacedbybanksandthe problems facedbySMEs.Inthisregard, theinitiativestakenupbytheGovernmentandBanking Regulators in India are as follows: Government initiatives:EveninIndia,thefinancingoftheSMEsectorhasreceivedsomeattentionsince independence.SomeoftheinitiativestakenbytheGovernmentinthisregardareas follows: SettingupoftheSmallIndustriesDevelopmentBankofIndia(SIDBI),asthe apexrefinanceinstitutioninIndiaforthepurposeofchannellingoffinanceto Small Scale Industries (SSIs) and SMEs in an organized manner. InlinewiththeannouncementmadeintheInterimBudgetfor2004-2005,SIDBIhas proposedtwofundbasedinitiativesforimprovingcreditflowtotheSMEsectoras follows: AcontributionofRs.100crore to theRs.500crorecorpus oftheSMEGrowth Fund (SGF), which shall make primarily equity/equity related capital investments in accordance with SEBI guidelines, in SMEs operating in various growth sectors such as the life sciences, biotechnology, etc. The SME Fund of Rs. 10,000 crore to give an impetus to the flow of funds to the SME sector. Thisfundhasbegun operations with effectfromApril 2004. Under the Fund, assistance is provided to SMEs at affordable rates of interest, and direct finance is extended to SMEs through SIDBIs network of branches. Bank Finance For SMEs49 Further,refinancetoStateFinancialCorporations(SFCs)hasalsobeenmade attractive in terms of low rates of interest. The Government of India has launched the Credit Linked Capital Subsidy Scheme (CLCSS), which aims at facilitating technology upgradation of SMEs in specified products/sub-sectors. SIDBI has recently negotiated a line of credit with the World Bank for financing and development of SMEsin India, with aview to upscale the creditflow to the sector and raising resources for the SME Fund. RBI INITIATIVES: The RBI, from time to time, has formed several committees and working groups to study the flow of credit to the SME sector in a comprehensive manner, and has issued detailed guidelines in this regard. Recently it has constituted an Internal Group under the Chairmanship of Shri C. S. Murthy to,interalia, consider the relaxation and liberalisation of credit lending norms that are applicable to the SME sector. The Group has submitted its report on June 6, 2005. The Internal Group, with reference to financing of SMEs, has recommended: ConstitutionofempoweredcommitteesattheregionalofficesoftheReserve Bank to periodically review the progress in SME financing and also to coordinate withotherbanks/financialinstitutionsandthestategovernmentsinremoving bottlenecks, if any, to ensure smooth flow of credit to the sector. OpeningofspecializedSMEbranchesinidentifiedclusters/centreswith preponderance of SME units to enable entrepreneurs to have easyaccess to bank credit and to equip bank personnel to develop the requisite expertise. Empowermentoftheboardsofbankstoformulatepoliciesrelatingto restructuring of accounts of SME units subject to certain guidelines. RestructuringofaccountsofcorporateSMEborrowershavingcreditlimits aggregatingRs.10croreormoreundermultiplebankingarrangementstobe covered under the revised CDR mechanism. Appropriate authorities are currently examining the above recommendations of the Internal Group. Bank Finance For SMEs50 CONCLUSION SmallandMediumEnterprises(SMEs)playaverysignificantroleintheeconomyin termsofbalancedandsustainablegrowth,employmentgeneration,developmentof entrepreneurialskillsandcontributiontoexportearnings.However,despitetheir importancetotheeconomy,mostSMEsarenotabletostanduptothechallengesof globalisation, mainly because of difficulties in the area of financing. With the opening up oftheIndianeconomy,ithasbecomenecessarytoconsidermeasuresforsmoothening the flow of credit to this sector. Without adequate bank finance, SMEs cannot acquire or absorb new technologies nor can theyexpandtocompeteinglobalmarketsorevenstrikebusinesslinkageswithlarger firms. Similarly,banks cannot consider thefinancing of SMEs asaviable option unless their priorities are addressed by SMEs. In this regard, SMEs should be assisted largely by publicinitiativesinvolvingparticipationofthebankingindustry.InIndia,however,the various publicinitiativesfor promotingfinance to SMEshavenot been assuccessfulas envisagedbecausetherehasbeensomeoverlappingofregionalandnationalinitiatives. Effortstoharmonisethestandardsandpractices,therefore,needtobeproperly coordinated to facilitate SME finance further. Despite its commendable contribution to the Nation's economy, SME Sector does not get therequiredsupportfromtheconcernedGovernmentDepartments,BankingSector, FinancialInstitutionsandCorporateSector,whichisahandicapinbecomingmore competitive in the National and International Markets and which needs to be taken up for immediate and proper redressal. ToempowertheSMESectortotakeitsrightfulplaceasthegrowthengineofIndian economy,itisnecessarytosupporttheSMEs,educateandempowerthemtomake optimum utilization of the resources, both human and economic, to achieve success. The SMEs need to be educated and informed of the latest developments taking place globally andhelpedtoacquireskillsnecessarytokeeppacewiththeglobaldevelopments. Bank Finance For SMEs51 BIBLIOGRAPHY Books Small and Medium Enterprises S.K. Bagchi Periodical Journal- Professional Banker Websites www.bifr.com www.rbi.com www.bankofindia.com www.iibf.org.in