The assessment Letter of Credit, Bank Guarantee (BG), or Letter of Guarantee (LG) limits are fixed by banks based on the annual consumption of raw materials to be purchased against the Letter of Credit or Letter of Guarantee (Bank Guarantee).
Ascertain from the 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 receiving the goods including the transit period after the LC is opened)
If the material is purchased under credit, add the usance period or Credit Period (CP) to procurement time.
We get Total Time (TT) when we add the credit period to the procurement period. TT=PT+CP
If CM is the Annual Consumption of Material to be purchased against LC or LG
We can compute the LG or LC limit required by the company by dividing the annual consumption of raw material to be purchased against LC or LG and the 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 freight) of goodsWht is EOQ-economic order quantity which is calculated by the source of supply, means of transport, and any discount.
Thus the formula for LC/LG Limit=CM×TT ÷ 12
However, if the minimum quantity (EOQ-economic order quantity) to be procured is more than the limit arrived, such a 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 the source of supply, means of transport, and any discount for orders of a larger quantity, etc.).
Illustration 1: calculation of DP- LC limit:
(i)Total annual purchase: 120,00000
(ii) of which purchase under LC (50%):60,00000
(iii) Of import of RM under LC (50%): 30,00000
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 (30,00000/12) = 2,50,000
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 sub-limit 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 a usance of 2 months available in both 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 sub-limits 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=2,50,000……………… (B)
Minimum order level (EOQ) = 10,00000……………………….. (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 orders will be placed under LC once in 4 months.
However, Credit (usance) is available for 6 months, and the 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 the first LC is for Rs.10lakh, therefore LC outstanding at any point in 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 the 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, the advance received should be reduced from the working capital gap.
Effect on Working Capital limit:
Whenever LC/LG limits are sanctioned for the import of raw materials or goods imported for trading purposes such limits shall normally help in reducing the working capital limit. Therefore, the 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 purposes shall be considered based on the annual consumption of raw materials 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 purposes cannot be used for the import of capital goods. Bank has to check with the customer on how he would arrange funds for the retirement of LC opened for the import of capital goods (either by term loan or from other sources for margin etc.).
RBI guidelines (Master circular dated April 1, 2022):
Guarantees executed on behalf of any individual constituent, or a group of constituents, should be subject to the prescribed exposure norms.
As regards the purpose of the guarantee, as a general rule, the banks should confine themselves to the provision of financial guarantees and exercise due caution with regard to performance guarantee business.
As regards maturity, as a rule, banks should guarantee shorter maturities and leave longer maturities to be guaranteed by other institutions.
The guarantees should not normally be allowed to customers who do not enjoy credit facilities with the banks but only maintain current accounts. If any requests are received from such customers, the banks should subject the proposals to thorough scrutiny and satisfy themselves about the genuine need of the customers. The banks should be satisfied that the customers would be in a position to meet the claims under the guarantees, when received, and not approach the bank for a credit facility in this regard. For this purpose, the banks should enquire into the financial position of the customers, the source of funds from which they would be in a position to meet the liability and prescribe a suitable margin and obtain other security, as necessary. The banks may also call for the detailed financial statements and Wealth-tax / Income-tax returns of the customer to satisfy themselves with their financial status. The observations of the banks in respect of all these points should be recorded in the banks’ books.
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I am a Chief Manager SBI and want to connected with you
Sir, your article is really helpful. May I get an example or cash study in the reference of LC BG assessment. Regards Sanchit Kumar
Click the following link: https://bankingschool.co.in/financial-analysis/how-to-calculate-lc-and-lg-limits/
I want to understand whether Bills payable under usance LC forming a part of current liabilities will be included under other than bank borrowing and be reduced from current liabilities for the purpose of computation of working capital gap?
If the bill under usance LC is already negotiated by the bank it will not be treated as current liabilities of the firm. At the same time, it cannot be treated as bills receivable (asset) as the customer has received the bills proceed from the bank.
Whether Non Fund Based Capital Limit ( LC and LG) amount is included in the calculation of MPBF ?
If non-fund based limits are sanctioned for purchase of capital goods such limit does not affect working capital limit to be sanctioned to the borrower. 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. In case of performance guarantees also advance received by the borrower is to be taken into account for considering working capital limits.
Thanks a lot for your early revert