Advantages and Disadvantages of Drawing Power

What is Drawing Power?

Drawing power is a concept used in conjunction with cash credit and overdraft. Banks allow a sanctioned limit while extending cash credit and overdraft facilities. The sanction limit is the total exposure a bank is willing to take on a borrower. In contrast, drawing power is the limit up to which actual withdrawal can be made maximum up to the sanctioned limit. Unlike sanction limits, banks update drawing power periodically, say monthly or quarterly.

Here are some of the advantages and disadvantages of Drawing Power. For a basic understanding of the definition, calculation, etc., refer to “Drawing Power.”

Advantages of Drawing Power

Minimizes Financial Risk

The best feature of drawing power is that the bank regularly updates it. It helps them to minimize the financial risks associated with the advance. Drawing power is basically a credit monitoring tool adopted by the banks. It helps them monitor the company’s performance and analyze whether the company would be able to repay its loans on the basis of its performance. A decline in the company’s performance would alert the bank in advance, and they can then curtail themselves by capping the maximum utilization of the loan.

Keeping a Check on Borrower

Financial institutions keep a tab on the borrower’s business through monitoring of drawing power. Banks have a separate credit monitoring department that sees into the financial performances of the borrowers. As banks run the financial risk, they have to be very sure of the borrower and his products. Banks demand various reports from the borrower to analyze the product’s profitability, marketability, cost, and various other parameters.

Banks grant the loan on the basis of CMA data (Credit Monitoring and Analysis data) which shows past performances of the borrower and future projections. It might be possible that the borrower has misrepresented the projections and obtained the loan. Hence, banks need a check to regularly assess the borrower and his business based on actual figures. They need to ensure that the loan is properly backed up by sufficient assets.

Logical Concept

The concept of drawing power is very rational and logical in the practical world. It limits actual withdrawal by the borrower without affecting the actual sanction limit of the loan. Lenders calculate drawing power by adding inventory and accounts receivables and subtracting accounts payables for the past month. Then banks reduce a certain margin from the above-mentioned amount. The margin is generally 25% on inventory and 40% on netbook debts (trade receivables minus trade payables). The margin is lesser on the stock because it’s a more liquid form of current asset.

Advantages and Disadvantages of Drawing Power

Disadvantages of Drawing Power

Selective Criteria

Banks follow selective criteria for the calculation of drawing power. The criteria and formula are very stringent. Banks run the financial risk, so they take only the insured inventory into account, while the calculation of drawing power as the uninsured stock would be of no value to them in case of default by the borrower. Similarly, accounts receivables not exceeding 90 months are only taken in its calculation as older book debts would suggest that it’s difficult to realize funds from the debtors on short notice. However, these criteria are subject to changes depending on the individual bank policies.

Compliance

The borrower has to submit a monthly/quarterly report to the bank according to the bank’s policies. Such reports contain information about inventory, trade receivables, and trade creditors and are furnished for the previous month. This frequent preparation and submission of reports cause hindrances in the primary operation of the business and are time-consuming too. Because of increased compliances like these, the business adds up an administrative burden on the staff. It might be a post-sanction credit monitoring tool employed by the bank, but it does not go well with the borrowers.

Volatility

Due to the stringent compliances of the lending institution, there is a need for the monthly furnishing of statements and new reports by the borrower. On the basis of these monthly reports and new statements, banks calculate new drawing power each month. The drawing power of the business increases when the reports show a good amount of inventory and receivables. But when the reports are of an unfavorable nature (showing less stock and receivables), the bank subsequently lowers the drawing power. This might limit the availability of funds to the borrower who needs a higher amount of funds.

Conclusion

The concept of drawing power offers numerous merits to the lender as it acts like a post-sanction credit monitoring tool. However, borrowers face certain demerits too. But the demerits do not outweigh the bank’s right to protect itself from financial risks associated with lending.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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