The assessment LC/LG limits are fixed by banks based on annual consumption of raw material to be purchased against LC or LG. The raw material holding in terms of consumption is worked out as under.
Assessment of LC/LG limits for import of materials.
Ascertain from customer the Consumption of Material (CM) per annum,( to be purchased under LC or LG.)
Find out Procurement Time or lead time (PT) for importing the materials.
If the material is purchased under credit, add Credit Period (CP) to procurement time.
We get Total Time (TT) when we add credit period to procurement period. TT=PT+CP
If CM is Annual Consumption of Material to be purchased against LC or LG
We can compute the LG or LC limit required to the company by dividing the annual consumption of raw material to be purchased against LC or LG and same is divided by 12 and multiplied by total time.
Formula for LC/LG Limit=CM×TT ÷ 12
However, if minimum quantity to be procured is more than the limit arrived, such request should be considered. This equation is to be adapted for LC under DA terms as well for inland LG.
Assessment of DPG/APG: Assessment of DPG is done in the same method term loan is assessed, as it is a substitution of the term loan. The assessment of Advance Payment Guarantee (APG) is done in the same way for fund based limits. Since the borrower receives advance payment for the material to be supplied by him at future date, advance received should be reduced from working capital gap.
Whenever LC/LG limits are sanctioned for import of raw material or goods imported for the trading purpose such limit shall normally help in reducing the working capital limit. Therefore, following points to be noticed while sanctioning/opening LCs
- In the case of DA LCs, the customer gets sufficient time to process or sell the goods imported. Hence the cash flow of the transaction must be studied for DA LCs.
- The LC limit for working capital purpose shall be considered based on annual consumption of raw material to be purchased. The limit sought after must be consistent with the known trade practice of the borrower.
- The LC limit sanctioned for working capital purpose cannot be used for import of capital goods. Bank has to check up from the customer how he would arrange funds for retirement of LC opened for import of capital goods (either by term loan or from other sources for margin etc.).