FINANCIAL INSTRUMENTS

CHAPTER 4 FINANCIAL INSTRUMENTS USED AT AARTI INDUSTRIES LIMITED

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FINANCIAL INSTRUMENTS USED AT AARTI INDUSTRIES LIMITED

4.1 Fund Based Credit from Banks and FIs 4.2 Non-Fund Based Credit from Banks and FIs 4.1 FUND BASED CREDIT FROM BANKS AND FIs 1.1 Overdrafts / Cash Credits 1.2 Packing Credit 1.3 Packing Credit in Foreign Currency (PCFC) 1.4 Bills Purchased/Discounted 1.5 Foreign Currency Non-Resident (Bank) - FCNR (B) 1.6 Advances against Undrawn Balances 1.7 Commercial Paper 1.8 Working Capital Demand Loan
Once the Bank arrives at the Limit Assessed Bank Finance earlier known as MPBF, which is lower of the Drawing Power and the Bank Financing Limit, the company can utilize multiple numbers of instruments to get finance for supporting their working capital needs. The Company cannot exceed its borrowing from the limit of ABF / MPBF.

How fund based working capital loans are divided among different sub- heads:Company gets Fund based loans against Stock and Debtors. For e.g. if the company is having stock of 100 crore, debtors of 300 crore and Creditors of 150 crore then company will get Fund based loan of 150 crore.

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For e.g.

Stock Debtors Total Less: - 25% Margin Money Less: - Creditors Fund Based Loans

Amt in crores 100 300 400 (100) 300 (150) 150

These 150 crore amount is also known as Drawing Power of the company. The company receives these amounts from bank under two heads. They are Fund Based Loan Packing Credit First of all the amount of packing credit is deducted from the amount sanctioned by the bank for Fund based loans. Company gets packing credit against export material. Company receives Packing Credit for the purchase of the raw materials. Whenever the bank receives the payment from the party then the amount of packing credit is reversed by the bank. After the amount of Packing Credit is deducted from the amount sanctioned, the Remaining amount is divided among various components. These components are Cash Credit Working Capital Demand Loan Foreign Discounting Bill Purchase Foreign Currency Non-Resident loan

The amount is divided among various components as per the decision of Bank. Generally the bank gives Cash Credit equal to 20% of the remaining amount. The company can ask the bank to transfer funds from Working Capital Direct Loan to Cash Credit loan. For e.g. If the company is having 20 crore in Cash Credit a/c and it has to make payment of 30 crore then the company can ask bank to release 10 crore from Working Capital Direct Loan to Cash Credit a/c. The company can ask bank to release funds from the Working Capital Direct Loan as and when need arises. The bank charges interest on WORKING CAPITAL MANAGEMENT Page 42

FINANCIAL INSTRUMENTS the amount utilized by the company. It is not necessary for the company to raise Foreign Currency Non-resident Loan. Company raises this type of loan when it is required to make payment in currency other than Rupee.

1.1 Cash Credit/Overdrafts

Under cash credit/overdrafts form/ arrangement of bank finance, the bank specifies a predetermined borrowings/credit limits. The borrower can draw/ borrow up to the stipulated credit/overdraft limit. Within the specified limit/line of credit, any number or drawings are possible to the extent of his requirement periodically. Similarly, repayments can be made whenever desired during the period. The interest is determined on the basis of the running balance/amount actually utilized by the borrower and not on the sanctioned limit. A minimum charge may be payable irrespective of the level of borrowing, for availing o this facility. This form of advance is highly attractive from the borrowers point of view because while the borrower has the freedom of drawing the amount in installments as and when required, interest is payable only on the amount actually outstanding. Also, it is flexible in that borrowed funds are repayable on demand, banks usually do not recall cash advances. Aarti Industries Ltd. has to keep margin of 25% for cash credit/overdraft. Rate of interest on OCC is not exceeding 9% for company irrespective of BPLR (Banking Prime Lending Rate).

1.2 Packing credit

Packing credit is also known as Pre-shipment Credit. Financial assistance provided by the commercial banks to exporters before the shipment of goods is called pre-shipment finance. Pre-shipment finance is given for working capital for purchase of raw material, processing, packaging, transportation, ware-housing etc. of goods meant for export. Pre-shipment finance is presently given to Indian exporters at a concessional rate of 10% for a period of 180 days. Pre-shipment credit for a further period of 180 days to 270 days is given at 12%.

Packing Credit Finance Categories: Packing credit falls in following categories. Rupee Pre-shipment credit or Packing Credit
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Packing credit on deemed exports Rupee export packing credit to manufacturer-supplier for export routed through export houses. Rupee packing credit to sub-suppliers Rupee pre-shipment credit to specific sectors/segments. Eligibility:
The packing credit is given on the strength of letter of credit opened in favor of exporters or in favor of some other person by foreign buyer or against a confirmed and revocable export order received by company. The applicant should, however, hold an importer exporter code number from the licensing authority concerned.

Company can avail any loan or advance on the basis of:

Letter of Credit opened in your favor or in favor of some other person, by an overseas buyer; (a) A confirmed and irrevocable order for the export of goods from India; (b) Any other evidence of an order or export from India having been placed on the exporter or some other person, unless lodgments of export order or Letter of Credit with the bank has been waived.

Packing Credit is granted for a period depending upon the circumstances of the individual case, such as the time required for procuring, manufacturing or processing (where necessary) and shipping the relative goods. Packing credit is released in one lump sum or in stages, as per the requirement for executing the orders/LC.

The pre-shipment / packing credit granted has to be liquidated out of the proceeds of the bill dawn for the exported commodities, once the bill is purchased/ discounted etc., Thereby converting pre-shipment credit into post-shipment credit. AIL has to keep margin of 10% for packing credit. Rate of interest on Packing credit is not exceeding 5%irrespective of BPLR.

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FINANCIAL INSTRUMENTS It is granted to the clients for making advance payment to the suppliers for acquiring goods to be exported. Thus, it is clean in nature and usually extended to the parties, who are rated as first class, for a very short duration. However, bank should assess the procurement period and once the goods are acquired and are in the custody of the companys client.

There are three broad types of packing credit: A. CLEAN PACKING CREDIT
This represents an advance made to the exporter on the basis of a firm export order or a letter of credit, without any control over raw materials or goods. Each proposal is decided on the basis of particular requirement of the trade and the credit worthiness of the exporter.

B. PACKING CREDIT AGAINST HYPOTHECATION OF GOODS

Under this arrangement, the goods meant for export are hypothecated to the bank as security. When the bank advance is to be utilized, the exporter is required to furnish stock statements and continue to do so whenever there is stock movement.

C. PACKING CREDIT AGAINST PLEDGE OF GOODS

Under this arrangement, the goods meant for export are pledged to the bank with an approved clearing agent who ships the same on the advice of the exporter.

1.3 Packing Credit in Foreign Currency (PCFC)

The packing credit or pre-shipment credit that was spoken earlier was disbursement of rupee funds, that is, advancing money in rupee to the exporter for the purpose of procuring, processing or manufacturing the goods for exports. Under this scheme the pre-shipment credit is disbursed in foreign convertible currency at interest rates linked with LIBOR (London Inter Bank Offered Rate). This credit is again self-

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FINANCIAL INSTRUMENTS liquidating in nature and is adjusted by the discounting or purchase or negotiation of the export bills. The banks change Earners Foreign Currency (EEFC), resident foreign currency accounts, foreign currency non-resident account bank scheme accounts and foreign currency available in escrow account. For all practical purposes this resembles the packing credit advance disbursed in rupees, except that the interest charged is based on LIBOR and the disbursement is made in foreign convertible currency. The advantage of this scheme is lower rate of interest and covering of foreign exchange risk where goods are imported for the purposes of export. For instance, if export order is for US$ 20,000 and the import component is say 60percent, assuming that the exporter avails PCFC of US$ 12,000, the liability would be adjusted against the submission of the export documents. Under the PCFC of US$ 12,000 no exchange conversion is involved. The exporter saves the difference between buying and selling exchange rates. If PCFC is availed by the exporter against an export order, the bills drawn under the said export order will be discontinued at LIBPR plus the loading factor of the bank. Indian exporters can avail both pre and post shipment finance in foreign currency. Interest rates under the scheme are linked to LIBOR and the rates charged by Indian Banks over LIBOR for such credits would not exceed 1.5%. Export credit in foreign currency is available in US Dollar, Euro, Pound Sterling and Japanese Yen. Export credit is available without exchange risk and at internationally competitive rates. Banks extend credit on "need basis" of exporters and collateral security is not insisted. Banks also provide lines of credit for longer periods say three years, to exporters with satisfactory track records without insisting on the submission of export order/Letter of Credit.

Packing Credit Foreign Currency (PCFC)

Interest charged at LIBOR + 1.5% (Max.) A 90 days Dollar Packing Credit can be availed at 3m LIBOR + 1.5%. 6.10% + 1.50% = 7.60%. PCFC drawls in cross currencies are allowed, subject to the exporter bearing the risk in currency fluctuations. However, cross currency drawls are restricted to the US Dollar. For instance, for an export order in a non-designated currency like the Swiss Franc, PCFC will be given only in USD.

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1.4 Bills Purchased/Discounted

Bank credit is being made available through discounting of usance bills by banks. The RBI envisaged the progressive use of bills as an instrument of credit as against the prevailing practice of using the widely-prevalent cash credit arrangement for financing working capital. The amount made available under this arrangement is covered by the cash credit and overdraft limit. Before discounting the bill, the bank satisfies itself about the credit-worthiness of the drawer and the genuineness of the bill. To popularize the scheme, the discount rates are fixed at lower rates than those of cash credit, the difference being about 1-1.5 percent. The modus oprendi of bill finance as a source of working capital financing is that bill arises out of a trade sale-purchase transaction on credit. The seller of goods draws the bill on the purchaser of goods, payable on demand or after ausance period not exceeding 90 days. On acceptance of the bill the bank releases the funds to the seller. The bill is presented by the bank to the purchaser/acceptor of the bill on due date for payment. The bills can also be rediscounted with the other banks. PCFC will be liquidated with the discounting of bills under export bill rediscounting (EBR). All export bills, demand and usance, are eligible for EBR scheme. All exporters are eligible to cover their bills drawn under letters of credit, non-credit bills under sanctioned limits in the bill rediscounting scheme. The bank offers export bill rediscounting for a maximum period of 180 days, inclusive of grace and transit periods.

1.5 Foreign Currency Non-Resident (Bank) - FCNR (B)

FCNR (B) loans are a source of short term funding available to corporate. Out of the resources mobilized by the banks under the FCNR (B) scheme, banks have been permitted to provide foreign currency denominated loans to their customers. Banks decide the purpose, tenor and interest rates on such loans. While the introduction of the scheme has placed cheap credit at the disposal of Indian corporate (as interest rates are linked to LIBOR), the foreign exchange risk is borne by the party who has availed the loan.

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FINANCIAL INSTRUMENTS The interest rate for the tenor of the loan is fixed on the date of draw down and the corporate can hedge his exchange rate risk by booking a forward cover. The illustration given below will provide you with more clarity. Corporate A has got a rupee credit at 16% p.a. Corporate A can switch this rupee loan to a dollar FCNR (B) loan/take a fresh.

FCNR (B) loan. The cost of a 6-month FCNR (B) LOAN is as follows Date of Draw down 14/2/2007
6 Month $ Libor (%)-6.32 Banks Margin (Spread over LIBOR assumed)-2.00 Cost of forward cover (annualized %)-3.10 Other transaction costs-0.58 Net rate (%)-12.00 The comparative cost advantage is evident as it results in a net saving of 4% over his rupee cost of funding. The spread over LIBOR would depend on the credit worthiness of the party involved. Thus, corporate can utilize this opportunity to reduce their interest burden and thereby minimize costs. Term deposit can be placed with authorized dealers in India in four specific foreign currencies (US Dollar, Pound Sterling, Euro or Japanese Yen). These accounts earn fixed or floating rate of interest within the ceiling rate of LIBOR/SWAP rates for the respective currency/ corresponding term minus 25 basis points (except on Yen). AIL has to pay rate of interest on FCNR loans is LIBOR + 2%.

1.6 Advances against Undrawn Balances

Usually, in case of certain products exporters are required to draw bills on overseas buyers upto 90 to 98% of FOB value of the contract, the residuary balances i.e. unknown balances is payable by the overseas buyer after satisfying himself about the quality/quantity of goods. Hence, undrawn balances exist where the overseas buyer makes payment, after making adjustment for difference in weight quality/quantity of goods. Payment of undrawn balances is contingent in nature. Banks may consider granting advances against undrawn balances at concessional rate of interest based on their commercial judgments and the track record of the buyer. Advance against undrawn balances can WORKING CAPITAL MANAGEMENT Page 48

FINANCIAL INSTRUMENTS be made at a concessive rate of interest for a maximum period of 90 days. Such advances are, however, eligible for concessional rate of interest for a maximum period of 90 days only to the extent these are repaid by actual remittances are from abroad and provided such remittances are received in 180 days.

1.7 COMMERCIAL PAPER

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. It is a short-term loan issued by a corporation, typically for financing accounts receivable and inventories It was introduced in India in 1990.It was introduced with a view to enabling highly rated corporate borrowers/ to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations. The people eligible to issue commercial paper are corporate, primary dealers (PDs) and the All-India Financial Institutions (FIs).

But there is also a limitation to the corporate that are eligible. Only those corporate who has: the tangible net worth of the company, as per the latest audited balance sheet, not less than Rs. 4 crore; been sanctioned working capital limit by bank/s or all-India financial institutions and the borrower account classified as a Standard Asset by the financing bank/s/ Institutions are eligible to issue commercial paper. Commercial paper is available in a variety of denominations and usually ranges in maturity from 2 to 270 days. A minimum of 15 days and a maximum of 1 year time period have been prescribed for the commercial paper. The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating, whichever is lower. As regards FIs, they can issue CP within the overall umbrella limit fixed by the RBI i.e., issue of CP together with other instruments viz., term money borrowings, term deposits, certificates of deposit and inter-corporate deposits should not exceed 100 per WORKING CAPITAL MANAGEMENT Page 49

FINANCIAL INSTRUMENTS cent of its net owned funds, as per the latest audited balance sheet. Usually the CP is issued in the denominations of Rs.5 Lacs or multiples thereof. Individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs) etc. can invest in CPs. However, amount invested by single investor should not be less than Rs.5 Lacs (face value). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI). There is an Issuance and Paying Agent (IPA) which is usually a scheduled bank. The role of IPA is an important one when the redemption procedure is to be carried out. Initially the investor in CP is required to pay only the discounted value of the CP by means of across account payee cheque to the account of the issuer through IPA. On maturity of CP, (a) When the CP is held in physical form, the holder of the CP shall present the instrument for payment to the issuer through the IPA. (b) When the CP is held in demat form, the holder of the CP will have to get it redeemed through the depository and receive payment from the IPA.

The roles and responsibilities as prescribed by the RBI can be briefly stated as: Issuer:
Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the investor and the issuer, Issuing company shall issue physical certificates to the investor or arrange for crediting the CP to the investor's account with a depository. Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid agreement with the IPA and documents are in order (Schedule II).

Issuing and Paying Agent:

IPA would ensure that issuer has the minimum credit rating as stipulated by the RBI and amount mobilized through issuance of CP is within the quantum indicated by CRA for the specified rating. IPA has to verify all the documents submitted by the issuer viz., copy of board resolution, signatures of authorized executants (when CP in WORKING CAPITAL MANAGEMENT Page 50

FINANCIAL INSTRUMENTS physical form) and issue a certificate that documents are in order. It should also certify that it has a valid agreement with the issuer (Schedule III). Certified copies of original documents verified by the IPA should be held in the custody of IPA.

1.8 Working Capital Demand Loan

A borrower may sometimes require ad hoc or temporary accommodation in excess of sanctioned credit limit to meet unforeseen contingencies. Banks provide such accommodation through a demand loan account or a separate non-operable cash credit account. The borrower is required to pay a higher rate of interest above the normal rate of interest on such additional credit. AIL has to pay rate of interest on WCDL not exceeding 7% irrespective of bankers BPLR.

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4.2 NON-FUND BASED CREDIT FROM BANKS AND FIS

Credit facilities, which do not involve actual deployment of funds by banks but help the obligations to obtain certain facilities from third parties, are termed as non-fund based facilities. These facilities include issuance of letter of credit, issuance of guarantees, which can be performance guarantee/financial guarantee. For its export financing purposes as well as for supplying and erection of transmission it mainly uses non fund based working capital i.e.

2.1 Letter of Credit 2.2 Bank Guarantee

2.1 Letter of Credit

A letter of credit, often abbreviated as an LOC or LC, and also referred to as a Documentary credit is a document issued by a financial institution or any bank which essentially acts as an irrevocable guarantee of payment to a beneficiary. This means, that once the beneficiary has presented to the issuing or negotiating bank documents complying with the LC terms, the bank is obliged to pay irrespective of any instructions of the applicant to the contrary. In other words, the obligation to pay is shifted from the applicant to the LC issuing bank. The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. Letters of credit are used nowadays almost exclusively in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. The parties to a letter of credit are usually a beneficiary who is to receive the money (seller), the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e. cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any), the applicant is not a party to the letter of credit.

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A. Flow in Letter of Credit Transactions

The procedure as to how the letter of credit is processed can be explained elaborately as below:

1. A commercial negotiation or purchase order is binding the importer and the exporter. 2. Upon such a request from the exporter, the importer may request the opening of documentary credit to its issuing bank in favor of the exporter, hence becoming the beneficiary of the credit. 3. The issuing bank advises the documentary credit to the bank of the exporter. 4. The bank of the exporter subsequently notifies (and it is called advising bank) or confirms (and it becomes the confirming bank) the letter of credit. 5. The next step is up to exporter who will have to ship the goods ordered. The documents of transport required for the completion of the transaction will be remitted to the exporter typically by the shipping company.

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FINANCIAL INSTRUMENTS 6. The exporter presents the whole set of documents required in the terms of the Letter of Credit to its bank. This bank will perform some document checking to ensure their compliance with the terms of the documentary credit. In case the bank had originally confirmed the credit or if a discount is granted to the exporter, the payment will be done to the exporter. 7. The bank of the exporter is sending the documents to the issuing bank that performs the payment or acceptance after a thorough checking of the documents. 8. The issuing bank transfers the documents to the importer and proceeds with the debit of its account for the principal amount. 9. The importer receives the goods, especially thanks to the document of title (bill of lading).

B. Price of LC
The issuer pays the LC fee to the bank, and may in turn charge this on to the beneficiary. From the bank's point of view, the LC they have issued can be called upon at any time (subject to the relevant terms and conditions), and the bank then looks to reclaim this from the issuer. There is the chance that the issuer goes insolvent, for example, and thus the bank is unable to claim back the money it has already paid out. This credit risk to the issuer thus makes up a large portion of the cost of issuing LCs.

C. Forms of LC
The various types of letters of credit which are commonly used in the commercial market are:

Revocable Credit
This can be amended or cancelled at any time by the importer without the consent of the exporter. This option is not often used, as there is little protection for the exporter. By default all credits are irrevocable, unless otherwise stated.

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Irrevocable Credit
Once issued this can only be changed or cancelled with the consent of all the parties. The seller must merely comply with the terms and conditions of the credit in order to receive payment.

Confirmed Credit
In some instances, exporters may request a credit to be confirmed by another bank, (usually a bank in their own country). If a bank adds its confirmation to a credit, it means that it is obliged to pay if the terms and conditions of the credit are complied with. This obligation to pay exists even if the issuing bank or country defaults.

Payment Credit
This is available for payment at the tellers of the paying bank, as nominated in the credit. The seller can, therefore, present documents to the paying bank and does not have to wait for the documents to be forwarded to the issuing bank for checking and subsequent payment.

Negotiation Credit
This is always payable at the counters of the issuing bank. Buyers can use negotiation credits to delay payment until the documents have been received and checked by the issuing bank.

Deferred Payment Credit

Similar to payment credits, except that they are payable at a future date.

Acceptance Credit
The accepting bank guarantees payment to the holder of the bill of exchange on maturity date - regardless of whether the credit is confirmed or not. This option comes with an acceptance fee which can be substantial.

Back-to-Back Credit
The original letter of credit is used as security to open another credit in favor of the exporter's own supplier. The bank confirming the original credit may not necessarily be the issuing bank of the second credit.

Transferable Credit
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Red Clause Credit

This enables the exporter to obtain advance payment before shipment. This is provided against the exporter's certificate confirming its undertaking to ship the goods and to present the documents in compliance with the terms and conditions of the documentary credit.

Green Clause Credit

Similar to a Red Clause Credit, but in addition to pre-shipment finance the exporter also receives storage facilities at the port of shipment at the expense of the buyer.

Packing Credit
This offers pre-shipment finance to the seller against warehouse receipts, forwarding agent's receipts or similar documents that prove the goods are no longer in the seller's possession.

Standby Credit
Similar to a normal letter of credit, this method differs in that it is a default instrument, whereas a normal credit is a payment instrument. A standby credit is only called upon in the event of failure to perform. Its function is, therefore, that of a guarantee.

Revolving Credit
This allows for the credit to be automatically reinstated under certain circumstances. It is normally used where shipments of the same goods are made to the same importer.

D. Parties to Letter of Credit:There may be three to four parties to a Letter of Credit. Applicant / Importer :
Importer is the opener on whose behalf or account Letter of Credit issued the bank. by

Applicant Bank :
The bank that issues or opens the Letter of Credit on behalf of the customer / importer is Applicant Bank.

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Exporter:
Exporter is the Beneficiary of the Letter of Credit who is entitled to receive the payment of his bills according to the terms of Letter of Credit.

Intermediary bank / Confirming bank :

Intermediary bank is the bank usually a branch or the corresponding of the opening bank in the exporting country through which the credit without any obligation on its parts, it is called the Advising or Notifying bank. If the beneficiary bank adds its own undertaking to the credit while advising it to the beneficiary, it becomes the confirming bank.

Paying / Negotiating bank:

The bank which negotiates the beneficiarys bills under the credit and pays for it is known as Paying Negotiating bank. In the international market, the company is executing more & more projects. Projects worth USD 150 Million are under execution apart from the bids submitted and jobs under view in the international market. The turnkey international jobs are having three components which are supply of towers, supply of bought-outs and local construction work. The bought-outs are supplied internationally qualified supplier only and these suppliers dont agree to supply without L/C, which has resulted into higher requirements of L/Cs. In the current year company is expected to buy bought out of approx. Rs.150 crores for which the L/Cs will be opened on DA 90/180 days basis. The availability of raw materials like chemicals Benzene, Sulphur, Chlorine, Nitric Acid in time has become very difficult and since there is gap between supply and demand so even certain domestic suppliers insists for letter of credit or cash payment terms against delivery of goods. Of course, in oversea market, the suppliers are ready to extend credit upto 360 days under L/C or company can arrange cheaper finance upto 360 days on its financial strength from overseas branches of Indian banks.

Advantages of the L/C:

Provides a sort of an assurance to the exporter. The exporter does not have to bother about the exchange control regulations of

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FINANCIAL INSTRUMENTS the importers country, since the banks of the importers country, since the banks of the importers country open them and these institutions are in the know of the exchange control regulations of that country. Eases the financial position of the exporter since he can get pre-shipment as well as post-shipment credit. If importer takes care of certain safeguards, the quantity and the quality of the goods are assured.

Discrepancies:
Discrepancies are the mistakes committed either by negotiation or from common errors. But due to this negotiation importer has to suffer a lot, and also at a same time exporter has to pay fine for that so one should take precautions for that.

Some common Discrepancies are as under:

Credit expired. Classed Bill of Lading. Presented after permitted time from the date of issue of shipping documents. Credit amount exceeds. Short shipment. Description of goods on invoice differs from that of credit. Goods shipped on decks. Bill of Lading, Insurance documents, bill of exchange not endorsed correctly. Absence of signature, where required on the paper. Bill of exchange drawn on wrong party.

2.2 Bank Guarantee

A bank guarantee means the guarantee from a lending institution ensuring that the liabilities of a debtor will be met. A letter of guarantee is a written promise issued by the Bank to compensate (pay a sum of money) to the beneficiary (third party, local or foreign) in the event that the obligor (customer) fails to honor its obligations in accordance with the terms and conditions of the guarantee/agreement/contract. In other words, if the debtor fails to settle a debt, the bank will cover it.

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The purpose for which the bank guarantee is usually provided is for two reasons: Foreign Bank Guarantee
This guarantee is issued at the request of a correspondent bank in favor of local companies that organize international bids or foreign suppliers.

Local Bank Guarantee

This is issued by the Bank at the request of contractors, wholesalers, companies involved in transaction, etc. for the purpose of handling the guarantee request they receive in their operation. The Guarantee is a unilateral agreement between the Bank and the beneficiary, which is conducted on behalf of a third, party usually the beneficiarys business partner.

A. Legal Requirements:Guarantees are not governed by any particular legal regulations. Issuing Guarantees for foreign beneficiaries is not subject to approval nor need these Guarantees be reported. Guarantees can be issued by authorized dealers under their delegated authorities notified vide FEMA 8/2000 date 3rd May 2000. Only in case of revocation of Guarantees involving US $ 5000/- or more to be reported to Reserve Bank of India along with the details of claim received or details of claim not honored by the mandatory on revocation.

B. Elements of Guarantees:There are no standard International regulations for Guarantees, so Guarantees may be worded freely, depending on individual requirements. However Guarantees should at least contain the following clauses: i) An introduction referring to the key elements of the underlying transactions. ii) An abstract undertaking according to which Guaranteeing Bank promises to pay the Guarantee amount upon receipt of the first written demand from the beneficiary together with his statement of default. iii) A clause specifying the expiry date by which any claim amount must have been received by the Bank indicating specific calendar date or a statement that the validity of the Guarantee is unlimited.

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C. Direct or Indirect Guarantee: Direct Guarantee:

A Direct Guarantee is one given directly to the beneficiary abroad by the Bank, resulting in a direct legal relationship between the issuing Bank and the beneficiary. The advantage of a direct Guarantee is not only that it is less expensive but also that it is subject to the law of the country in which the Guarantee is issued unless otherwise specified in the Guarantee. If the Guarantee indicates a specific calendar date on which the Guarantee will expire, the Bank and consequently the mandatory will be released from their liability even if the letter of Guarantee is not returned.

Indirect Guarantee:
When a beneficiary insists that the Guarantee be issued by a local bank then the Guarantee will be issued through a correspondent of issuing Bank at the country of the beneficiary. In such cases the Guarantee is known as Indirect Guarantee. Such Guarantees will be issued by the correspondent against the counter Guarantee of the mandatory. Issuing Indirect Guarantee is more time consuming and always more expensive, because of the cost in addition to the Guarantee commission charged by the foreign Bank. Commission is charged till final validity of the Guarantee and usually it will be collected in advance.

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Flow of Bank Guarantee:The flow for acquiring bank guarantee is as follows: 1 Contract 2 - Application to issue of a bank guarantee 3a - Letter of guarantee sent to the beneficiary directly 3b - Letter of guarantee sent through the advising bank

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Mode of security:
For working capital Loans, commercial banks seek security either in the form of Hypothecation or in the form of pledge.

Hypothecation:
Under this arrangement, the owner of the goods borrows money against the security of movable property, usually inventories. The owner does not part with the possession of property. The rights of the lender (hypothecate) depend upon the arrangement between the ender and the borrower. Should the borrower default n paying his dues, the lender (hypothecate) can file a suit to realize his dues by selling the goods hypothecated. In Aarti Industries Ltd. Working capital loans availed from scheduled banks, are secured/to be secured by hypothecation of Raw materials, Stock-in-progress, Semifinished goods, Finished goods, Packing materials and Stores and Spares, Bills receivables and Book debt and all other moveable, Both present and future. Also by way of joint equitable mortage of the companys immovable properties situated at Sarigam, Vapi and Jhagadia, in the state of Gujarat being second to the charge held by ECB/Term lenders and further by way of hypothecation of all moveable Plant & Machinery, Machinery Spares, Tools and Accessories and other movables, both present and future (except Book Debt & Inventories) wherever situated.

Pledge:
In a pledge arrangement, the owner of the goods (pledge) deposits the goods with the lender (pledge) a security for the borrowing. Transfer of possession of goods is a precondition for pledge. The lender (pledge) is expected to take reasonable care of goods pledged with him. The pledge contract gives the lender (pledge) the right to sell goods and recover dues, should the borrower (pledge) default in paying debt.

WORKING CAPITAL MANAGEMENT

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