What is Drawing Power?
Drawing Power, generally addressed as “DP”, is an important concept used in conjunction with cash credit (CC) and overdraft facilities offered by banks and financial institutions. It is the limit to which the withdrawal can be made from the sanctioned working capital limit. Unlike sanction limit, banks update drawing power periodically, say monthly or quarterly.
How to Calculate Drawing Power?
Drawing Power is calculated after deducting the margin from “Stock – Creditors + Debtors” for the month. To understand this better, we need to have a better understanding of what “margin” is and how to calculate the DP.
- What is Drawing Power?
- How to Calculate Drawing Power?
- Example of Drawing Power Calculation
- Advantages of Drawing Power
- Disadvantages of Drawing Power
- Frequently Asked Questions (FAQs)
The margin is the owner’s contribution brought into the business. In most cases, a margin on stock and debtors is 25%, while some banks consider a 25% margin for stock and 40% for net debtors. And, this margin may vary from bank to bank. Depending upon the aggression of the bank in lending, the margin is kept. Banks that are more aggressive keep less margin and vice versa. In addition, from industry to industry, the margin will vary depending on the operating/working capital cycle.
Now, that you are clear about what margin is, let us move forward to understand the calculation of stock and debtors. Drawing power considers the total value of the paid stock (paid stock = stock “less” creditors) plus debtors (not more than 90 days old).
Stock considered for calculating DP should be insured stock. Uninsured stock, 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.
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 the sanction terms.
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.
The table below explains the calculation of drawing power:
|Particulars||Amt. ($)||Amt. ($)|
|Less: Margin @ X% of Paid Stock||(XX)||XXX (A)|
|Less: Debtors > 90 Days||(XX)|
|Less: Margin @ X% of Net Debtors||(XX)||XXX (B)|
|Drawing Power (A + B)||XXX|
Example of Drawing Power Calculation
Consider the following details given as below:
|Debtors > 90 Days||10|
|Stock covered under Insurance||44|
|Margin on Stock||0.25|
|Margin on Debtors||0.4|
|Sanctioned Working Capital Limit||70|
|Stock (Insured Stock)||44|
|Less: 25% Margin||8|
|Stock allowed for DP calculation (A)||24|
|Less: Debtors > 90 Days||10|
|Less: 40% Margin||24|
|Debtors allowed for DP Calculation (B)||36|
|Drawing Power (A + B)||60|
Working Capital limit works out before sanction. Working capital limits are primarily secured against the stock and debtors 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 the “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 in the above example, then DP would be restricted to $50 only.
Yes, the sanction limit and drawing power are not the same. 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. Read Drawing Power v/s Sanctioned Limit to learn about the differences between the two.
Advantages of Drawing Power
The following are the 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 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.
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 account 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 inventory is a less liquid form of current assets.
Disadvantages of Drawing Power
The following are the disadvantages of drawing power:
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.
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.
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.
Frequently Asked Questions (FAQs)
To calculate drawing power, we need to take “paid stock”. For the amount of creditors outstanding, the stock is unpaid to that extent. So, deduction of creditors is done as the bank shall not be funding for something that is not being spent.
When creditors are more than the stock, it means that the stock have been fully funded by creditors and therefore bank finance is not needed. Therefore, stock will not qualify for bank finance.
Under normal circumstances, creditors will not exceed stock. If it happens, it should be examined in more detail, before even considering working capital finance.