LETTER OF CREDIT CALCULATIONS
In this article, we will provide you some easy notes on the Calculations related to Letter of Credit from CAIIB ABM Study material 2022.
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Now, coming to main topic, our focus in today’s article is to clear your understanding of all the calculations related to Letter of Credit. So, let us begin with them.
But, first let us refresh the meaning of LC:
LETTER OF CREDIT:
A letter of credit, in short LC, is a written document which is issued by the importer’s bank (opening bank) on behalf of importer. Its purpose is to assure the exporter that the issuing bank will make a payment to the exporter for the international trade/deal conducted between the involved parties.
Process of Issue:
The importer is basically the applicant of the LC, while the exporter is the beneficiary & as per the T&Cs’ agreed timeline of LC, the issuing bank promises to pay the mentioned amount against specified documents.
As a general principle, an LC is issued based on the documents presented to the issuing bank, and the issuing bank is not responsible for ensuring shipment of the goods. And unless the documents presented are contrary to the terms and conditions of the LC, the bank cannot deny the payment.
CALCULATIONS RELATED TO LCs | CAIIB ABM DEC 2022 STUDY MATERIAL
Limits of Letter of Credit
LC limits are fixed by the banks based on annual consumption of raw material which will be purchased against the LC. The Raw material in terms of consumption is calculated in the following way:
- Banks are to ascertain what will be the requirement of ‘Consumption of Material (CM)’ per annum, which will be purchased under LC by the bank customer.
- Then you need to calculate the Procurement Time or lead time (PT) for importing the raw materials. Procurement Time or Lead time is the time period in which goods are to be received including transit period after the LC is opened.
- If the raw material is purchased under credit, you can also add usance period or Credit Period (CP) to procurement time.
- This way, we will have the Total Time (TT) on adding credit period to procurement period. TT = PT + CP
In case Consumption of Material = Annual Consumption to be purchased against LC
We can compute LC limit which will be required by the customer by dividing the annual consumption of raw material to be purchased against LC by 12 and then multiplied by total time.
i.e. Monthly Raw Material Purchases × Total Time.
Note: For assessment of LC, Purchase value of goods is calculated on the basis of CIF i.e. is the total of cost, insurance and freight of goods.
Thus, the formula for calculation of LC Limit = CM × TT ÷ 12
EOQ: Economic Order Quantity is a calculation done to find out the ideal order / purchase size, which allows to meet demand without overspending. Inventory managers also calculate EOQ to minimize the holding costs and excess raw materials.
However, if minimum quantity (i.e. EOQ) to be procured > the limit calculated, then such request should be considered. This equation is to be adapted for LC under DA terms.
Calculation of DP- LC Limit:
- Total annual purchase = Rs. 120,00,000
- of which purchase under LC (50%) = Rs. 60,00,000
- Of import of Raw Materialunder LC (50%) = Rs. 30,00,000
Assessment of Inland LC:
Lead time = 2 months
Monthly purchase for indigenous Raw Material
= Rs. 60,00,000 – Rs. 30,00,000 / 12
= Rs. 2,50,000
Therefore, Inland Letter of Credit requirement
= Monthly purchase * lead time
= Rs. 250000 × 2 = Rs. 5,00,000 ———–(A)
Assessment of import LC:
Monthly purchase of import Raw Material
= Rs. 30,00,000 / 12
= Rs. 250000
Lead time = 4 months
Import LC requirement
= Rs. 250000 × 4
= Rs. 1000000 ———-(B)
Total LC requirement (A+B)
= Rs. 500,000 + Rs. 10,00,000
= Rs. 15,00,000
i.e LC limit of Rs.15 lacs having the sub-limit of Rs.10 lacs for import LC and Rs.5 lakh for domestic LC.
Calculation of LC-DA limit
In the same example above, assume that there is usance of 2 months available in both for domestic and import cases.
So, for assessment of LC under Usance, the usance period is to be added to the lead time.
Inland LC requirement =
= monthly purchase x (lead time + usance period)
= Rs. 2,50,000 x (2 + 2)
= Rs. 10,00,000 ———–(i)
Import LC requirement =
= Monthly purchase x (lead time + usance period)
= Rs. 2,50,000 x (4 + 2)
= Rs. 15,00,000 ———–(ii)
Total LC requirement (i) + (ii) = 25 lacs having the sub-limits of Rs.10 lacs for domestic LC and Rs.15 lacs for import LC.
Calculation of (import) DA – LC limit with the help of EOQ
- Total annual purchase of import Raw Material= Rs. 30,00,000
- Monthly requirement of import Raw Material= Rs. 2,50,000
- Minimum order level (EOQ) = Rs. 10,00,000
- No. of LCs required to be opened (A / B) = Rs. 30,00,000/10,00,000 = 3
- Frequency of LCs: (12/ No. of LC required to be opened) =12/3 = 4 months. (Therefore, the import order will be placed under LC once in every 4 months.
- But the Credit (usance) is available for 6 months and lead time of 2 months, making the Total lead time = (2 + 6) = 8 months
Because the 2nd order of Raw Material under LC shall be placed by the customer before the retirement of the 1st LC = Rs.10 lacs, therefore, LC outstanding at any point of time shall be < Rs.20 lacs.
In the instant case Import LC requirement without EOQ:
LC limit without EOQ =
= monthly purchase x (lead time + Usance period)
= Rs. 2,50,000 x (2 + 6) = Rs. 20,00,000.00
Assessment of DPG/APG:
Since DPG is a substitution for term loans, it is assessed in the same manner as term loans. In the same way that fund-based limits are assessed, Advance Payment Guarantee (APG) is assessed. As the borrower receives advance payment for the material he will supply at a later date, the advance payment should be deducted from working capital gap.
Effect on Working Capital limit:
Whenever LC limits are sanctioned for the import of raw material or goods imported for the trading purposes, then such limits shall normally help in decreasing 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 adequate time to process or sell the goods imported, therefore, the cash flow of the transactions is to be studied for DA LCs.
The LC limit for the working capital purpose shall be considered based on the annual consumption of raw material to be purchased as mentioned earlier. The limit sought after has to be uniform with the borrowers’ known trade practice.
The LC limit approved for working capital purposes cannot be utilized for the importing goods of capital nature. Therefore, banks have to check up from the customers on how they would arrange funds for retirement of LC which has been opened for the import of capital goods.
So, this was all about the Calculations that are important from the Letter of Credit Chapter of ABM Latest Syllabus 2022 from Certified Associate of the Indian Institute of Bankers.
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