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Corporate Economy Expressions Markets Leisure   02 March 1998 Do not cheat on the purpose of the loan  Raghu Palat   The pivotal question upon which the decision to lend rests is the purpose for which the loan is sought and this is usually the first issue that a banker ascertains when approached for any credit facility. In regard to this, there are a few critical factors that must be remembered. 1. The nature of the credit facility sought must be consistent with the borrower's activities. Raman Menon is a garment exporter. It would be inconsistent and illogical to advance him a loan to purchase a chemical agitator. 2. It must be a matching need. That is, a short term funding should be sought for a short term need. Raman Menon, exporter of garments, should not seek a term loan to finance preshipment expenses. Alternatively, a manufacturer should not seek to finance a factory expansion with an overdraft. In short: A company that needs working capital to purchase inventories (stocks) and pay expenses should seek an overdraft. An exporter who needs finance to purchase goods to export shouldseek a preshipment packing loan An exporter who needs finance on goods exported under a usance letter of credit (payment is made after 90 to 180 days after the acceptance of the documents by the buyer) should seek an export bill discount facility nBut an industrialist who needs a large loan to finance an expansion, build a factory or buy some very expensive machinery should seek a term loan (a loan payable over a period of time). Often due to the gestation period, banks would give a moratorium regarding payment of interest and principal for a year or so. At times a loan may be required for a short period to bridge two events. This is known as a bridge loan. A company may have had a public issue to finance its expansion. In order not to hold up work until the final allotment is made and the monies are available to the company, it may seek a bridge loan. Certain companies and industries require facilities seasonally. A classic example is the sea food industry. It requires finance soon afterthe monsoons to purchase and process seafood for export. During the monsoons no finance is usually required. Similarly the tea industry requires finance when there is no picking of tea - to replant tea and to maintain the tea gardens. It is imperative that the nature of the facility sought is compatible with the reason it is sought. Otherwise, there could be horrendous repercussions as did happen soon after the liberalisation initiatives announced after 1992.At that time the capital markets were booming and most industrialists believed that they could access the markets at will. Many accessed the markets, began projects and utilised the monies for other purposes too. They did not foresee the virtual death of the capital market. When they found issues being undersubscribed and devolving, short term funds such as overdrafts were utilised to complete projects begun. I can understand and sympathise with this though I think it is dangerous. If a company has spent Rs 10 crores and needs another Rs 2 croresto complete an installation, it is better to complete it so that it can begin producing and earning profits as opposed to allowing it to be a non- productive white elephant. However, in practise (although at that time it may appear to be a stroke of genius and a way out of a dangerous situation), it is foolhardy to finance a long term asset with a short term loan. The two are incompatible and there is a maturity mismatch. Consequently, when short term funds begin to become tight, as has happened in the last eighteen months, several companies began to resort to accommodating financing (discounting of bills that were not backed by genuine trade transactions). Once begun one usually gets sucked into the situation and it has a snowballing effect. Once in it it becomes difficult to get out. A bill maturing is paid by another bill that is discounted. At each stage charges have to be paid. The result is one pays so much, much more than one would have had one taken a term loan. Additionally, one would wouldhave saved oneself from a tremendous amount of tension. Additionally, the accommodation financing route can lead to lack of liability (if the next bill is not discounted), the loss of credibility and can, as has happened in several cases recently, lead to the closure of the concern. It is important that a prospective client is honest and open with his banker. He should tell the banker exactly what the purpose of the loan is and advise him his concerns and his problems. Bankers are there to help and not hinder. If the banker has a full appreciation of his clients' concerns, his strengths and weaknesses and he is convinced of the person's integrity, the banker will go out of his way if required to sanction the loan. It is always better to apprise the banker of all the issures at the outset - especialy the more crucial ones. It would be very difficult to explain at a later stage why something crucial was not mentioned. An omission of an important issue may also make the banker wonder whether there are anyothers that have not been mentioned which may be critical. Honesty and transparency are without doubt the best policy. (Next: Collateral and repayment of facilities taken) Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.