How to calculate LC and LG limits?

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.

Ascertain from customer the requirement of Consumption of Material (CM) per annum, which is  to be purchased under LC or LG.

Find out Procurement Time or lead time (PT) for importing the materials.

(Procurement Time or Lead time means the time taken in recving the goods including transit period after the LC is opened)

If the material is purchased under credit, add usance period or  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.(i.e.Monthly purchases ×total time) . Note: Purchase value of goods for assessment of LC is done on the basis of CIF (cost, insurance and frieght) of goodsWht is EOQ-economic order quantity which is calculated by source of supply,means of transport and any discount.

Thus the formula for LC/LG Limit=CM×TT ÷ 12

However, if minimum quantity  (EOQ-economic order 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 as for inland LG.( The EOQ-economic order quantity is calculated taking into account of source of supply,means of transport and any discount for order of larger quantity etc.).

Illustration 1: calculation of DP- LC limit:

(i)Total annual purchase: 12000000

(ii) of which purchase under LC (50%) :6000000

(iii) Of import of RM under LC (50%): 3000000

Assessment of Inland LC:

Lead time: 2 months

Monthly purchase for indigenous RM (6000000-3000000)/12 =2, 50,000

Therefore, Inland LC requirement (Monthly purchase x lead time i.e 250000×2 = 5, 00,000…… (A)

Assessment of import LC:

Monthly purchase of import RM (3000000/12) = 250000

Lead time: 4 months

Import LC requirement: 250000×4= 1000000 (B)

Total LC requirement (A+B) = 500000+1000000= 1500000 i.e. LC limit of Rs.15 lakh with the sublimit of Rs.10 lakh for import LC and Rs.5 lakh for domestic LC.

Illustration 2 : Calculation of LC-DA limit

In the above example assume that there is usance of 2 months available in both for domestic and import cases. While assessing the LC under Usance, the usance period is to be added to the lead time.

• Inland LC requirement= (monthly purchase x (lead time+ usance period

= (250000 x (2.00+2.00) = 10, 00000

• Import LC requirement =(monthly purchase x (lead time+ usance period)

= (250000 x (4.00+2.00) = 15, 00000

Total LC requirement (i) +(ii)= 25 lakhs with the sublimits of Rs.10 lakh for domestic   LC and Rs.15 lakh for import LC.

Illustration 3: Calculation of (import) DA- LC limit with EOQ (Economic order quantity)

Total annual purchase of import RM = 30 00000…………. (A)

Monthly requirement of import RM=250000………………   (B)

Minimum order level (EOQ) = 1000000……………………….. (C)

No. of LC required to be opened (A/B) 3000000/1000000=3………  (D)

Frequency of LCs: (12/ No. of LC required to be opened) =12/3 =4 months…………………… (E)

Therefore Import order will be placed under LC once in 4 months.

However,Credit (usance)available for 6 months and lead time is 2 months

Total lead time is (2+6) = 8 months…………………………………  (F)

Since the second order of RM under LC shall be placed by the customer before the retirement of first LC is for Rs.10lakh, therefore LC outstanding at any point of time shall be less than Rs.20 lakhs.

In the instant case Import LC requirement without EOQ:

LC limit without EOQ = (monthly purchase x (lead time+ Usance period)

= (250000x (2.00+6.00) = 2000000/- (Twenty Lakhs]

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.

Effect on Working Capital limit: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 are 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.).
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• Cash Budget pattern of financing seasonal productions
• Things to know before starting appraisal of working capital limits 
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