Lending Against Current Assets: Issues, Associated Risks, and Way Outs

- Saurab Kumar Sanjel

Banks and financial institutions' core functions entail accepting the public deposits from the market and lending the collected deposit in the form of individual and business loans. Borrowers pay the applicable interest and principal at regular intervals on the availed loans. Banks make a profit by leveraging the margin which ascends out of the difference between the rate of deposit and the rate of loans.

Thus, banks' profitability highly depends on the interest income earned from the loans which subsequently determines its sustainability. As per the monthly banking and financial data published by NRB as of Mid- July 2020, the total income of A, B & C class financial institution was NPR 379.84 billion, under which NPR 305.72 billion, i.e. almost 80% was contributed by interest income on loans and advances. The staggering contribution of interest income to the total income size depicts the requisite to remain more heedful while lending.

Current assets of the company include inventory, debtors/account receivables, advances & deposits, cash & bank balance, etc. Current assets financing takes the form of working capital business loans which are short-term in nature in which hypothecation of business inventory and assignment of current assets in favor of lenders serve as the primary collateral for the loan. Usually, lending is done against the business inventory and accounts receivables, collectively termed as trading assets. Business uses the working capital loan to uphold their short term funding gap which gets tied up in the current assets in its normal business course.

The prevailing trend of Current assets financing

The prevailing trend of current assets financing in Nepal is credit facility against the net trading assets, serving as the primary collateral with partial or token collateral, i.e. real estate mortgage as secondary collateral. In many cases, lending is solely done against the net trading assets with no provisions of real estate as secondary collateral. The quarterly position of the core trading assets such as inventory and receivables is summed up and netted off with trade-related creditors of the company to derive the net trading assets of the firm. Drawing power of credit limit, maximum up to 80% is assigned against the net trading assets.

 Banks conduct quarterly on site current assets/business inspection to validate the actual current assets and current liabilities positions, which remains crucial to authenticate the actual report and ensure prudent lending. Under the outlined financing arrangement, charge on other current assets is obtained vide execution of legal documents. Such forms of financing is preferred for large business houses with high level of credibility. Lending to the SMEs on sole basis of stock financing is generally dissuaded in the Nepalese banking industry.

Existing composition of working capital loan in Nepal:

Source: NRB 2020, Current Macroeconomic and Financial situation, provisional- as of Mid July 2020.

The total credit exposure of the BFIs is NPR 3,266.01 billion as of Mid July 2020, which comprises private sector credit exposure of A, B, C class financial institutions and another concessional loan. The total credit exposure figure is 87% of the country’s GDP. The total exposure of A-class financial institutions stands at NPR 2,851.03 billion which is 87% of total credit exposure and 76% of GDP. The combined total exposure of B, C class FIs stands at NPR 359.66 billion which is 11% of total loan size and 10% of GDP. The remaining concessional loan figure is NPR 55.32 billion which is  2% of the total loan size and 1.5% of GDP.

Of the total credit exposure, total working capital business loan accounts to NPR 1,131.99 billion which is 35% of total credit exposure and 30% of GDP. Under total working capital business loan, lending against current assets as primary collateral is NPR 424 billion which is 38% of total working capital business loan, 13% of total credit exposure, and 11% of GDP.

The credit exposure of A class financial institution has dominated the total credit exposure of BFIs. The interesting fact is that the existing business loan figures against current assets of class A financial institution, i.e. NPR 424 billion is actually higher than the combined credit size of B & C Class financial Institution, i.e. NPR 359 billion. With considerable figures of current assets based working capital business loan under the total business loan ,total figure  vis-a-vis GDP, and heavy dependence of banks in the overall financial system of economy, banks must remain extra vigilant to defuse the credit losses which might invoke substantial economic impact and macroeconomic difficulties owing to the risky lending.

Prevailing Current Assets financing issues

 Current Assets financing is not free from risks and there exists multiple issues that require serious deliberation. Some of the issues include marketability risk of the hypothecated stocks, requirement of frequent stock inspection, assessing the quality of inventory, ascertaining the quality of the debtors/receivables and risk of over financing. Of the various outlined risk, the article aims to discuss issues regarding risk of over financed inventory, ascertaining the quality of debtors/account receivables and assessing the quality of inventory in detail.

A) Risk of Over-financed Inventory

The over-financing of the inventory was highly prevalent in the banking industry up to 2014, amid the difficulties in identifying and creating a charge over the inventory which are movable current assets. Like real assets collateral, which can be mortgaged at the Land Registry office, institutional arrangement for registration of the movable assets was not available. Hence, many borrowers succeed in obtaining loan facilities from different financial institutions against the hypothecation of the same value of inventory. The banking industry was engulfed by such a trend which made inventory financing much risky.

Secured Transaction Act 2006 -A sigh of relief

To address the challenge of over- financing and ensure access to finance to borrowers having no real estate collateral, GON enacted Secured Transaction Act 2006, providing the organized platform to register the movable assets as collateral. Provision was made to register the current assets collateral at the Secured Transaction Registry Office which is managed by Credit Information Bureau Nepal. However, there was a huge delay in implementing the act which was actually done in 2014, almost eight years after its promulgation, until then banks were floundering to identify the risk mitigates.

Security Transaction Act of Nepal provides legal framework for filing the notice of secured transaction in which movable assets serve as collateral and the enforcement of a security interest by a security holder should the security provider default. The transactions which can be registered under the act comprises all transactions including pledge, hypothecation and hire-purchase transactions to be made for securing obligations with a collateral, sale of accounts & sales contracts and lease of goods. The act has incorporated broad definition of “collateral” as intangible property of any nature, fixtures, movable property such as timber to be cut, minerals to be extracted, which is subject to a security interest, and the term includes collateral that arises in the future, collateral located in or outside of the country, accounts or secured sales contracts that have been sold, leased goods and proceeds of collateral. Lenders create the charge over the current assets by entering the details of the exposure availed by the borrower in the secured registry office. In case of multi-banking lending arrangement such as paripasu or consortium, multiple charge over the collateral is created. Since it is now mandatory to check the STRO record of the borrowers prior to lending against the movable assets, lenders can ascertain the duplicate financings of the current assets which has curbed the risks of over financing.

Shortcomings of Secured Transaction Act 2006

Although the provisions of the act has allowed the platform to register the current assets in the bank’s favour, banks still grapple to recover their exposure in case of loss. The act has mere served as a registry platform to avoid duplication financing of the current assets. There is no provision of automatic seizure of the inventory for recovery of credit in case of default. With no physical access to the movable pledged assets, the assets can change hand/ownership under the nose of the bank. Since, the normal bank recovery process still have to be followed for collateral confiscation, the defaulter may sell the inventory to others which makes the lending vulnerability from recovery perspective. Hence, the domain of the act requires further augmentation to address the recovery issues of the bank which remains imperative to build confidence for current assets financing from lenders perspective.

The underlying problem- Lending above the Cash Conversion Cycle ( CCC) of the borrower

Despite the existence of a legal framework of current assets collateral registration in Nepal and its implementation from 2014, the risks of over-financing still persist. Whilst Secured Transaction registry somewhat curtailed the chances of over financing, other issues on course of lending are giving the way to it. The over financing in the economy is plying, owing to the difficulty in actually ascertaining the actual credit requirement of the applicant given the nature and stage of industry the business is involved in. In many cases, the issue might get condoned by the lender due to which the borrowers might reap unwanted benefits and such practice actually steers the financial institution to greater credit risk.

For instance, a manufacturing company with a large network of dealers is allowing trade credit facilities to its buyers/dealers. The same buyer approaches a financial institution and succeeds in obtaining the bank credit against the inventory for which the dealer is already enjoying the trade credit from the supplier. Here the dealer enjoys the credit period both from the supplier and the bank.

• Let's say, the dealer is allowed a credit period up to an average of 60 days by the manufacturing firm.
• Here the dealer is a trading unit, which means the stock is expected to remain in the godown of the dealer for a shorter period, let's say average up to 28 days.
• The dealer’s average collection period of the account receivables after it sells the stock is assumed to be around 35 days.
• Cash Conversion Cycle (CCC): Average inventory days+ Average account receivables days– Average payable period
• 28+35-60= 3 days.

Post assessment of the working capital needs of a borrower might depict an interesting scenario. The dealer’s cash conversion cycle may be lower or equal to the actual credit period it has been enjoying from the supplier. This is largely owing to the practice of stretching the initial agreed trade credit period. In other words, the dealer might have been generating the cash by selling the products and recouping the receivables more quickly or within the actual trade credit period, it has been enjoying. In the above illustration, the funding gap is observed for three days which the dealer is expected to manage from its own source. The bank credit requirement actually doesn’t exist for such dealers as the shorter credit period can be stretched by re-negotiating with the supplier to manage its cycle. Such dealers with a lower working capital cycle, if succeeds in obtaining working capital limit from a bank, tenure of which is generally up to one year, then there is a higher risk of imprudent use of bank credit. In many cases, a combination of trade credit and bank credit is actually used for managing the working capital. It is usually required for buyers with limited cash resources. For the cash-rich buyers, trade credit alone might substantiate its working capital needs.

Moreover, there are higher chances of over financing if any such dealer succeeds in availing credit facility from a financial institution, citing the reason to manage the working capital requirement, of which the business module is such that it boasts a shorter cash conversion cycle compared to credit period already offered by the supplier. In this scenario, the unit might be able to maintain healthy books of accounts and satisfactory financial indicators, however, a major problem that remains highly impending is fund diversion.  The borrowed fund from the banks might not be invested in the business itself because the requirement actually does not exist. Whilst lending to the borrowers with a highly volatile industry might warrant the financing needs even in case of a shorter cash conversion cycle, lending to the borrowers plying in a less volatile industry might not be justified. Financial institutions need to be extra vigilant to quell such practice which actually makes the lender vulnerable to over-financing and also to ensure that the bank credit gets channeled for the business growth.

Way outs

Identifying the actual Cash Conversion Cycle (CCC) remains a challenging task for the lenders owing to their variability in various economic periods. To address the risk of over financing, the lender should strive to understand the overall business module of the client, i.e. its revenue-generating cycle from the early step of raw material procurement to selling the products in the market and collection of the receivables. The CCC varies from industries to industries and is influenced by cyclical variation in the economy. The lender should compare the CCC of the borrower and the standard cycle of its associated industry to gauge its actual credit requirement and tenure.

In developed countries where there is an institutional arrangement of almost every industrial data, lending becomes much standardized and prudent. In addition to this, the availability of various research agencies makes easy access to data.  Nepalese bank is clearly deprived of such privileges, hence lending is done on the basis of limited information of the borrower and the associated industry. For instance, while lending to an iron manufacturing industry, analysis and information are highly dependent on the methodologies solely used by the credit department. Research and development departments with the core functions of the market and industry research might not be available in every financial institution. In such a case, the lender is deprived of credible and detailed information on the steel industry for better credit assessment.

It becomes imminent that the lending agency itself should aim to establish its own research and development department with the core job of industry analysis, prioritize its growth and develop in-house experts or specialized manpower in order to validate the assumption made while facilitating the credit request in different sectors. In addition, the role of regulatory agencies also remains crucial to address this challenge. Regulatory agencies should aim to make the institutional arrangement of information access much robust and endeavor to act as a data bank. They should act as a facilitator of the macro -economic information most relevant to lending in order to make lending highly consistent and prudent within the banking sector.

B) Ascertaining the quality of debtors

Almost in every business’s balance sheet, debtors or account receivables occupy some portion of the current assets. The value of the debtor in the current assets depends upon the activity of the business. For instance, in supermarket and online trade business, debtors occupy a negligible portion, in fact, the value can be found to be nil. However, in most businesses, negotiation is done between the supplier and buyers on a certain credit payment period which determines the level and aging of the debtor. The credit period can be 60 days, 90 days, or any other depending upon the standard industry practice. Usually, the shorter the credit period, the better is the quality of the debtor. The aging of the debtor signifies the health of the company, hence it becomes imperative to understand the debtor’s position and its quality before making lending decisions.

Verifying the aging report on debtors, submitted by the borrower is much cumbersome if a supplier has large networks with multiple buyers. Lenders are bound to rely on the records submitted by the company with the spirit of good faith while considering the value of the receivables. The risk to this practice is the inclusion of bad debts with no realization chances for allowing the loan drawdown. To curtail such risks and encourage the lenders to consider the quality debtors while lending, NRB has introduced the provision of submitting independent auditor certified Current Assets and Liabilities report during new credit request and renewal.

Provision of Current Assets and Liabilities certification by Independent auditor- An Encouraging sign

The provision disseminated by NRB from the fiscal year 2018/19 is applicable for all the companies that are availing of working capital loans of NPR 250 million and above. The certification has to be done by the independent auditor only, i.e. auditor not involved in regular year-end financial audit. These provisions of NRB endeavor to curtail various associated risks with regard to the quality of debtors of the company. The provision has been implemented in full swing and borrowers have been submitting the report at least one-quarter end during new credit facility and renewal.

Other Way Outs to be adopted

 Assessing the quality of the debtors of the company requires careful analysis of the industry trend and more importantly the relationship between the buyer and supplier. Lenders perceive higher credit risk if a single party/buyer occupies a major portion in overall debtors composition. It is because the default by such a buyer might inflict a significant impact on the company’s financial health which can be disastrous for the supplier. Measuring the contribution of a single or group of buyers to the overall debtors' position remains a key area to be reviewed while lending.

The long-standing relationship between the buyer and supplier with a good track record between them can be considered as a comfort factor even while financing to the borrowers against the receivable with a slightly higher collection period. However, on a best effort basis, the collection period aligned with the industry trend, and most preferably debtors with lower aging needs to be considered while assigning the drawdown value. If the lenders' assessment satisfies the fact that collections with higher aging are highly likely to get recouped, the value of such debtor can also be considered, however with the assignment of the lower drawing power.

From the regulatory perspective, the refinement of existing provisions needs to be assessed by NRB. The practice has recently been introduced, gradual refinement is mandatory to cater to the lending risk on receivable financing. NRB should explore to augment the domain and the frequency of submission of such certification in the days ahead.

C) Assessing the quality of inventory

The performance of a company in a fiscal year is largely dependent on its inventory management. Although it might look very lucrative to finance a unit with sufficient inventory levels, assessing the actual shelf life or the quality of the inventory remains imperative. In the Nepalese context, assessing the quality of the inventory as part of conducting the financial capacity of the borrower remains in the very primitive stage. The reason for it can be highly attributed to the dearth of expert manpower in the industry. Banks and financial institutions also lack expert manpower for measuring the health of the inventory. In pure inventory-based lending, the hypothecated inventory serves as primary collateral that secures the bank. Hence, it becomes paramount to make inventory-based lending much stricter. Condoning the quality of the inventory during financing is steering the bank financing to higher credit risks.

Way outs

The inventory appraising practice is much stricter in banks of advanced and developing economies. Nepal can adopt some of their measure to minimize the risk in inventory financing. The whole system of inventory audit should be well institutionalized within the banking system. Appraising the value of the inventory must be done by expert appraisals and the drawdown or LTV shall be restricted to the actual liquidation value rather than the market value. The finished goods type of inventory shall be allowed comparatively higher drawdowns than the raw material types from the standpoint of its marketability.

Special attention must be given during inventory financing of fashion-based and technological-based companies, given the shorter product life cycle of their products. Although the product obsolescence risk is prevalent in almost any industry, the risk is much higher in such industries. For instance, if a company involved in trading of mobile phones apply for the credit facility against its inventory, one of the major assessment part that entails focus of discussion is the brand of smart phones it has obtained the agency for trading. If the company apparently trades less preferred and outdated brands, financing against such inventory can be risky business. In case of distress, the bank may not be able to recoup enough value from the liquidation of the inventory which compensates for the loss. Similarly, inventory financing of food and medicine industries requires additional vigilance because of the limited shelf life of such items. The market value can be absolutely zero in no time if such inventory remains in the go down over a certain period of time. In other cases, the company usually has multiple storage locations of its inventory. Monitoring and controlling the inventory stored in multiple locations is usually costly and daunting. In such cases, assigning a lower drawdown against such inventory reduces the credit risk to some extent.

The Bottom Line

The commercial banks of Nepal have already witnessed the full-fledged implementation of Basel III procedures which is the globally adopted standard framework for capital measurements formulated by the Basel Committee for Banking Supervision. The compatibility of Basel III measures in Nepalese banks illustrates the capacity of Nepalese banks to adopt internationally practiced norms. From the client’s perspective, NFRS based audit has now become mandatory from 2018/19. The requirement is mandatory even for small-scale industries with an annual turnover of less than NPR 100 million from the fiscal year 2019/20. Adoption of NFRS based accounting system shall align the financial accounting with the globally accepted module. Contemplating the outlined facts, it now becomes pivotal to move towards adopting some of the globally practiced credit assessment procedures and other recommendations outlined above to remain on the same page and also to reduce the overall risk on part of the lenders.

Article by Saurab Kumar Sanjel
Relationship Manager, Corporate Banking
Global IME Bank Limited