Drawing Power generally addressed as “DP,” is an important concept for Cash Credit (CC) facility availed by banks and financial institutions. It is the limit to which a firm or company can withdraw from the sanctioned working capital limit. Updating drawing power for working capital by the bank is an important credit monitoring exercise.
Understanding Drawing Power
Drawing Power is calculated after deducting the margin from “Stock Less Creditors + Book Debts” for the month. Banks practice updating drawing power based on monthly/quarterly closing stock-book debt and trade creditors’ statements submitted by the firm/company. To understand this better, we need to have a better understanding of what is “margin” and how to calculate the DP.
An important point to note is that “Stock” considered for calculating DP should be insured stock. Stock not covered under insurance, if considered for drawing power, does not reflect the true drawing power since the bank runs a huge risk in the case of any mishappening. It is generally a post-sanction credit monitoring tool. After sanction of limits, it helps the bank keep a tab on the performance of the firm or company to whom the limits are sanctioned. If the debtors become sticky at any point in time, or if the paid stock shows decreasing trend constantly month on month, it is an alarm bell for the bank.
Calculation of Drawing Power
While opening a CC account, DP has arrived basis of the stock, book debts, and creditors statement based on the closing position of the earlier month. The customer (Firm or the company availing working capital limits from the bank) can utilize these limits for a month i.e., till the time the new statement is prepared for the consequent month-end position.
It is calculated by considering the total value of paid stock (Paid stock=Stock fewer Creditors) plus book debts (not more than 90 days old) and deducting margin from the same. In most cases, debtors for up to 90 days are considered for calculating DP. But, if the business has a longer credit cycle, more than 90 days of debtors might be considered for DP calculation. This is to be done if it is clearly mentioned as part of sanction terms.
The margin is the fund brought into the business by the firm/company itself from long-term sources of finance. In most cases, a margin on stock and book debts is 25%, while some banks consider a 25% margin for stock and 40% for net debtors (Debtors with fewer creditors) since the stock is a more liquid current asset. How much margin is considered is already mentioned as terms of sanction in the “sanction letter” and may vary from bank to bank. Depending upon the aggression of the bank in lending, the margin is kept. Banks who are more aggressive keep less margin and vice versa. In addition, from industry to industry, the margin will vary depending upon the operating/working capital cycle.
Also, refer to Advantages and Disadvantages of Drawing Power.
Example of Calculating Drawing Power
If the details are as below:
|As on 31.10.2018||$ Mio|
|Debtors > 90 Days||10|
|Stock Covered Under Insurance||44|
|Margin on Stock||0.25|
|Margin on Debtors||0.4|
|Sanctioned Working Capital Limit||70|
Drawing Power Calculation
|Particulars||INR Mio||Allowed for DP Calculation|
|Stock (Insured Stock)||44|
|Less: 25% Margin||8||24|
|Less: Debtors > 90 Days||10|
|Debtors allowed for DP||60|
|Less: 40% Margin||24||36|
Working Capital limit works out before sanction. Working capital limits are primarily secured against the stock and book debts of the firm or company. It is to be noted that even if the drawing power for some months works out to be more than the sanctioned limit, the maximum withdrawal limit is “Sanctioned Amount.” That means a customer can utilize the maximum amount as the limit sanctioned, even if the drawing power arrived is more for a particular month’s closing. If the sanctioned limit were “$ 50 Mio” in the above limit, then DP would be restricted to “$ 50 Mio” only.
Read Drawing Power v/s Sanctioned Limit for more details.