structuring financial requirements [ib 2001]

STRUCTURING FINANCIAL REQUIREMENTS FOR MANUFACTURING COMPANY

CASE STUDY

RAZAKMOEISPartnership

Advocates & Solicitors Peguambela & Peguamcara

Syarie Counsel Peguam Syarie

Trademark Agent Agen Cap Dagangan

RAZAKMOEISPartnership A d v o c a t e s & S o l i c i t o r s

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TABLE OF CONTENTS BACKGROUND OF THE BUSINESSES .......................................................................................... 3 FINANCIAL ASSESSMENT ........................................................................................................... 3 Type of Financing Facilities required by PFM ........................................................................... 3 Financing Assessment of PFM’s Business ....................................................................................... 4 Islamic Banking Facilities applicable for PFM ........................................................................... 4

(i) Musharakah Mutanaqisah Fixed Asset Financing ....................................................... 4 (ii) Bai Inah Cashline Financing-i ........................................................................................... 7 (iii) Murabahah Working Capital Financing-i ...................................................................... 8 (iv) Kafalah Bank Guarantee-i ................................................................................................ 9 (v) Trade Financing ............................................................................................................... 10

(a) Letter of Credit (Wakalah) .................................................................................... 10 (b) Islamic Trust Receipt ............................................................................................... 10 (c) Islamic Accepted Bills .............................................................................................. 10 (d) Islamic Shipping Guarantee ................................................................................... 11

THE ADVANTAGES OF USING THE RECOMMENDED FACILITIES ............................................ 11 Fixed Asset Financing – Murabahah Fixed Asset Financing ................................................... 12 Working Capital – Bay’ Al-Dayn Working Capital Financing ........................................................ 12 Trade Financing Products – Letter of Credit with Murabahah Financing and Letter of Credit with Musharakah Financing .............................................................................................................. 12


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CASE STUDY : STRUCTURING FINANCIAL REQUIREMENTS FOR MANUFACTURING

COMPANY

By Abdul Razak Bin Jamaludin1

BACKGROUND OF THE BUSINESSES Premier Foods Manufacturing Limited [PFM] is an established halal canned foods manufacturer listed in the Malaysian Stock Exchange. As part of its expansion plan, currently, PFM has already expanding their market to the other Middle Eastern and Central Asia countries through strategic partnership or venture with trading companies in those countries. In order to minimize their manufacturing cost, PFM intends to set up their factory in Vietnam due to the low cost of production for sourcing the raw materials. Due to the demand from the Middle Eastern and Central Asia Countries for PFM to be shariah-compliant manufacturer whereby these countries are their biggest market, PFM plans to convert their stocks or shares under shariah counter of Bursa Malaysia. It is a requirement for PFM to convert their existing conventional facilities into Islamic banking facilities. FINANCIAL ASSESSMENT (a) Type of Financing Facilities required by PFM

Basically, PFM is a manufacturer and normally the manufacturer requires three types of financing which includes ; firstly, the fixed asset financing for the purpose of purchasing land, factory and machineries, secondly, the working capital financing for the purpose of purchase of goods for sale, raw materials and semi-finished products and thirdly, for the manufacturer that export their product to other countries, they require trade financing for import – export business purposes. PFM has the intention to set up their factory in Vietnam and currently has already expanding their business to the Middle Eastern and Central Asia countries, considering the current business position and dealing by PFM, they required all the three fixed asset, working capital and trade financing facilities. For the purpose of setting up their factory in Vietnam, PFM require a fixed asset financing facility in order to purchase land and factory in order to locate their manufacturing business to Vietnam. PFM also require working capital financing facility to purchase raw materials and semi finished products for manufacturing purposes and the trade lines financing facilities for exporting of the finished products.

1 Advocate and Solicitor and Trademark Agent at M/s RazakPartnership and a founding member of ZRC International Trust Inc – an offshore

trust company ; Chartered Islamic Finance Professional (INCEIF) ; Member of Chartered Institute of Islamic Finance Professional


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(b) Financing Assessment of PFM’s Business

PFM has an excellent track record or history in the market for being an establish manufacturer for about twenty four (24) years and more over PFM also is a public listed company in Bursa Malaysia. In term of financing capabilities, it is proven that PFM has not defaulted from servicing their current conventional loan facilities amounting to $100 million which consist of Term Loan facility of $20 million, Overdraft facility of $20 million, Revolving Credit facility of $20 million, Bank Guarantee of $10 million and Trade Financing facilities of $30 million.

PFM also is expected to generate income derive from the annual sales amounting to $1.5 billion by the 4th year. The projection of income made by PFM demonstrate their capacity to generate productions and capabilities of ploughing back profits into their manufacturing business, thus it can be treated as an assurance by them to serve and repay the financing facilities granted to them.

Even though the operating cycle for manufacturing business may take longer, the financing facilities granted to PFM could be secured by having a collateral on the fixed asset of the company such as building or factory belong to the company. The financing facilities also could be secured by creating a Debenture on a fixed and floating assets of the company as well as providing Directors’ Personal Guarantee and a Corporate Guarantee.

(c) Islamic Banking Facilities applicable for PFM

Currently, PFM has the following conventional banking facilities –

No. Type of Facilities Tenor/Duration Current Outstanding Balance ($ mil)

1 Term Loan 5 years (remaining tenor)

18.00

2 Overdraft Yearly review 16.00

3 Revolving Credit 3 years 15.00

4 Bank Guarantee 3 years 6.00

5 Trade Financing (LC/TR/BA/SG)

3 years 20.00

Total 75.00

(i) Musharakah Mutanaqisah Fixed Asset Financing

PFM has a conventional term loan financing with the current outstanding of $18 million with a remaining tenor of five years. A suitable Islamic banking product to replace this type of conventional term loan financing is Musharakah Mutanaqisah Fixed Asset Financing . The Musharakah Mutanaqisah financing


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could be utilized by PFM to finance the purchase of land or factory or machineries for the setting up of their factory in Vietnam. Musharakah means sharing and basically is a kind of partnership in which the partners join together with their contributions for the common objective of undertaking business and trade in accordance with the principles of shariah. Musharakah Mutanaqisah or Diminishing Musharakah (DM) is a special form of Musharakah. It culminates in the ownership of asset or project to the PFM. Under DM, bank participate as a financial partner in a project or business venture. From time to time PFM will buys over the Bank’s share until PFM gets complete ownership of the property. The bank will the release the property to PFM.

Below are the three (3) stages whereby PFM will ultimately own asset under the DM;

Stage 1

INITIAL EQUITY RATIO 80 : 20

CAPITAL CAPITAL CONTRIBUTION CONTRIBUTION

ASSET

BANK PFM

BANK’S

PORTION

PFM’S

PORTION


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Stage 2

PFM Promise buy the Bank’s

Portion


ASSET

Stage 3

PFM keeps buying Bank portion until

Completion


ASSET

BANK’S

PORTION

PFM’S

PORTION

BANK PFM

PFM’S Share

100%

BANK PFM


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Under the DM asset financing , normally the financing margin provided by the bank is up the maximum of 90% of the value of the purchase of the purported land or factory by PFM and the bank would be able to grant up to 15 years term of financing. The bank is also offer a fixed profit rate for example 7.0 % per annum or floating profit rate with a ceiling rate of 7.0%. With regard to the method of payment, it is a fixed installment methodology and PFM has the liberty to choose and agree with the bank for the repayment either monthly, or quarterly or half yearly depending on the income pattern of PFM. The asset which jointly belong by PFM and the bank and in this case the factory will be treated as the security or collateral under the DM financing facility. In the DM financing facility both parties the bank and PFM shall be required to execute Diminishing Musharakah Agreement, Ijarah Agreement and Payment Agreement.

(ii) Bai Inah Cashline Financing-i

Apart from term loan conventional financing facility, PFM also has the Overdraft facility as a working capital facility on yearly review with the current outstanding sum of $16 million. Bai Inah contract which is subjected to yearly review is designed to provide Cash Line facility to meet PFM’s requirements in business , both the bank and PFM will enter into two contracts as follows- (1) The first contract - the bank first sell the asset to PFM at a price

comprising of the financing amount plus the bank’s profit margin, whereby the payment by PFM is on deferred payment term. The selling price of the asset belongs to the bank and it become the financing amount plus profit that PFM has to repay to the bank on deferred payment term ; and

(2) The second contract – after the ownership was transferred from the bank to PFM, subsequently the bank will purchase back the asset from PFM on cash basis which equivalent to the financing amount. It become the principal amount or total limit of cashline (OD) given by the bank to PFM.

Under Bai Inah, the profit rate will be capping rate selling price at 10% per annum and the effective profit rate is BFR + 1.5% spread subject to changes on floating rate within the selling price. The profit is calculated on daily average balance. The cash line will be disbursed into wadi’ah current account which is to be opened by PFM. The repayment of cash line Bai Inah facility shall be made on monthly basis of the profit on the utilized sum. PFM also is required to pay in lump sum at the end of facility period or the bank has the option to reduce the yearly limit.


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The bank also required the cash line Bai Inah facility to be secured by Assignment of Contract, Directors’ Guarantee or charge on property belong to PFM or any third party charge. Both the PFM and the bank are required to execute Property Sale Agreement and Property Purchase Agreement.

Diagram – Bai Inah Cash Line

1st Contract

2nd Contract

(iii) Murabahah Working Capital Financing-i

PFM also enjoy working capital loan facilities under conventional loan facilities in the form of revolving credit facility with the current outstanding balance of amounting to $15 million for the term of 3 years. The conventional working capital financing facilities could be converted into Islamic financing facilities under the principles of Murabahah Working Capital Financing. This facility provided by the bank under revolving basis. Murabahah concept refers to the sale of goods at a price which includes profit margin as agreed by both seller and buyer. In this case, the bank must make known the cost and profit of the goods to PFM. MWCF is a transaction whereby the bank appoints PFM as their agent to purchase goods, stocks or raw material for PFM business. Upon receipts of invoices on the purchase of the goods from the supplier, the bank will pay the cost of the goods to the supplier. The bank shall then sells the goods to PFM on selling price inclusive of the cost of the goods plus margin i.e cost plus.

PFM BANK

Asset (owned) By the Bank


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The bank will be able to provide financing margin as previously enjoy by PFM which is $15 million and the bank also would be able to finance up to 80% of the cost of the purchase for each bill. The MWCF facility is available for utilization by PFM up to 3 years on revolving basis subject to yearly review. The duration of invoices or bills will be for the maximum period of 180 days with a profit rate of BFR + 1.5% spread. The disbursement of fund will be paid directly to the supplier or vendor. PFM is required to repay in lump sum payment at the maturity of each murabahah note as follows –

Date/Contract Note Tenor (Days)

Amount ($) Pricing BFR + 1.5% p.a

xx/xx/xx – MCN 001 30 $xxx,xxx.xx 7.5%




In the event if PFM manage to settle the purchase price prior to the maturity date of the Murabahah Contract Note, ibra’ or rebate will be given to PFM. In this kind of financing the bank may require Assignment of Contract and/or Directors’ Personal Guarantee and/or charge on property belong to PFM as forms of security. For MWCF, both of the bank and PFM are required to execute Murabahah Security Agreement and Murabahah Contract Notes.

(iv) Kafalah Bank Guarantee-i

Currently, under the conventional facility, PFM enjoy a Bank Guarantee facility with a current outstanding balance of $6 million. The current conventional Bank Guarantee could be converted and change into Islamic banking facility of Kafalah Bank Guarantee-i. The bank provides the Kafalah Bank Guarantee-i to PFM for the purpose of providing payment guarantee to PFM’s supplier when there are events of default or any breach occur on part of PFM. In the event if any claim submitted to bank by any of PFM’s supplier, the bank will make good or payment of the claim. Later, the bank shall request PFM to pay back to the bank. Under the shariah principle of kafalah, it is a form surety given by one party who agree to discharge a liability of a third party defaults in fulfilling obligations. The fee chargeable by the bank under kafalah principle is 0.12% per month. The bank also require 10% security deposit, Assignment of Contract, Directors’ Personal Guarantee and Charge on property. Both PFM and the bank are required to execute a Facility Agreement, Guarantee and Charge document.


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(v) Trade Financing The conventional bank provide trade financing facilities to PFM which include Letter of Credit, Trust Receipt, Banker’s Acceptance and Shipping Guarantee for the period of 3 years. Currently, the outstanding balance for all the trade financing facilities are $20 million. PFM has the option to change the current conventional trade financing facilities into Islamic banking trade financing facilities as follows – (a) Letter of Credit (Wakalah) –

In Letter of Credit (Wakalah) or agency (LC-i), PFM must pay in advance

the full value of the goods to be purchased or imported prior to the issuance of the LC-i. The bank then issue LC-i to exporter through their bank and upon negotiation of the LC-i, the bank will remit payment for the goods purchased on behalf of PFM. After the goods has been shipped to PFM, the bank will negotiate and make payment to the exporter. The bank will receive a commission or service fee upon the service rendered to PFM.

(b) Islamic Trust Receipt –

The conventional trust receipt could be converted into the Islamic Trust Receipt (ITR). The ITR is financing facility drawn against LC-i or wakalah inward bills for collection. The bank will issue the ITR facility to PFM based on murabahah principle for financing the purchase of goods.PFM will sign a trust document whereby the bank will allow PFM to obtain release of goods but makes a lump sum payment at later date. In the ITR, the bank will pay the exporter for the cost of the goods based on the invoice value. The bank will resell the goods to PFM on deferred payment term at a price inclusive of the bank’s profit margin. The deferred payment terms of sale of goods granted to PFM constitutes creation of debt. This is securitized in the form of bill of exchange drawn by the bank and accepted by PFM ang payable on maturity date. The profit rate will be 10% per annum for a period of 90 days.

(c) Islamic Accepted Bills – The conventional Banker’s Acceptance which currently enjoy by PFM could be replace by Islamic Accepted Bills (IAB). The IAB shall be divided into two categories which are IAB-Imports and IAB-Exports. The IAB-Imports would fall under the murabahah working capital financing mechanism. Under this financing mechanism, the bank


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appoints PFM as the purchasing agent for the bank. PFM then purchases the required goods from the seller on behalf of the bank, which would then pay the seller and resell the goods to PFM at a price, which takes into consideration the profit margin. PFM is allowed to deferred payment term of up to 200 days. Upon maturity of the murabahah financing, PFM pays the bank the cost of goods plus a profit margin. The sale of goods by the bank to PFM on deferred payment terms constitutes the creation of debt, this is then securitized in the form of bill of exchange drawn by the bank and accepted by PFM for the full amount of the bank’s selling price payable upon maturity. On the other hand, the IAB-Exports is the bills that have been created will then be traded under the concept of bay’ al-dayn. PFM as an exporter who has been approved for the IAB facility will require to prepare the export documentation under the sale of contract of LC-Ii. The export documents shall be sent to the importer’s Islamic bank. PFM shall then draw upon the commercial the bank a new bill of exchange as a substitution bill and this bill be known as the IAB. The bank shall purchase the IAB at a mutually agreed price using the concept of bay’ al-dayn and the proceeds will be credited to PFM’s account. In the IAB-Export the rate of discount offered to PFM is 3.5% per annum and a commission at the rate of 1% per annum for a period of 90 days.

(d) Islamic Shipping Guarantee The conventional Shipping Guarantee shall be replaced with the Islamic Shipping Guarantee (ISG) which is use by the bank under the principle of kafalah for the issuance of this instrument. It is primarily a letter of indemnity to the owners and/or agents or master of the vessel for the delivery of goods without presentation of the document of title of goods or the original bill of lading. It is contract where the bank agrees to discharge the liability of a third party in case of default by the third party. In ISG, PFM as the importer or the buyer is required to inform the bank of the ISG requirements and requests the bank to provide the facility. The bank may require PFM to place a deposit to the full amount of the price of the goods to be purchased or imported which the bank accepts under the principle al-wadiah yad dhamanah. The bank establishes the ISG and pays proceeds to the negotiating bank utilizing PFM’s deposit ; and subsequently releases the documents to PFM. The bank charges the customer fees and commission for its services under the principle of al-ujr.


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THE ADVANTAGES OF USING THE RECOMMENDED FACILITIES There are few other Islamic banking facilities which are available in the market which were not being recommended to PFM. The products which are currently available in the market are as follows – (a) Fixed Asset Financing – Murabahah Fixed Asset Financing -

The Murabahah Fixed Asset Financing is not a flexible mode of financing. It is based on sale and purchase arrangement whereby PFM will identify a property which they interested to purchase and the bank will purchase it and pay to the vendor with cost price. The bank then sell to PFM at a cost plus price with deferred payment arrangement with the bank. In Murabahah Fixed Asset Financing, PFM is required to pay a monthly installment regardless of the performance of the business. Compare with Musharakah Mutanaqisah Fixed Asset Financing of Diminishing Musharakah (DM) , it is more suitable for business venture arrangement on a profit and loss sharing basis whereby both the bank and PFM has the common objective of undertaking business and trade in accordance with shariah. It has the wide purpose and application for financing of fixed asset such as land, building, machineries and factory. Apart from that, the repayment method also can be arranged either on monthly basis, quarterly basis or half yearly basis depending on the income pattern of PFM

(b) Working Capital – Bay’ Al-Dayn Working Capital Financing –

PFM as a manufacturer require a facility that could be utilized to finance the purchase of raw materials or semi finished products for the production and manufacturing of canned products. PFM require the bank to finance the purchase of the raw material and semi finished product before they could start their manufacturing process. The appropriate mode of working capital financing that could provide the intended facilities is Murabahah Working Capital Financing whereby the bank will purchase the goods identify by PFM with a cost price then sell the goods to PFM with a cost plus price with a deferred payment arrangement. In contradiction with Bay’ Al-Dayn Working capital Financing, PFM is required to manufactured the products first which means they have to incur their manufacturing cost and sell the products on credit to the buyer. Later , the bank will purchase the debt arising from the sale on discount.

(c) Trade Financing Products – Letter of Credit with Murabahah Financing and Letter of

Credit with Musharakah Financing –

Both Letter of Credit with Murabahah Financing and Letter of Credit with Musharakah Fiancing are not suitable for utilization by PFM due to the nature of PFM business as the manufacturer. PFM require Letter of Credit in order to facilitate the importation of any raw materials or semi finished products or any goods or item which they required to manufacture products and operate their factory. The Letter of Credit with


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Murabahah Financing is more suitable for a trading company which import finished products to resell either in the local or foreign market. With regard to Letter of Credit with Musharakah Financing, it is more profitable and cost saving for PFM to utilize Letter of Credit (Wakalah) due to the reason that PFM shall only require to pay fee or ujra which is relatively small amount compare with Letter of Credit with Musharakah Financing whereby PFM is required to share the profit on the agreed ratio with the bank. Furthermore, the Letter of Credit with Musharakah Financing is more suitable for the importation of finished products for reselling purposes whereby the profit could realize faster.

Disclaimer: This document is intended as a general guide only. M/s RazakPartnership (RPLaw)

disclaim all liability from any damages caused by reliance on this document. RPLaw strongly

recommends seeking professional legal advice prior to any transaction

structuring financial requirements [ib 2001]

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