Drawing power refers to the monetary credit limit that a banker permits a borrower to cater for the working capital needs. Working capital is the financial resources necessary to cover everyday business requirements such as paying creditors, covering operational expenses, fulfilling tax obligations, etc.
Examples of working capital include revolving loans, bank overdrafts, letters of credit, and cash credits. Despite the product name appearing to be different, the way these borrowings operate is the same.
Drawing power Calculation doesn’t have any formal formula. Lets understand some basic concepts before deep diving into the drawing power calculation.
Basis of drawing power
The Concept of drawing power is linked with the security on which borrowings are sanctioned. So, we will understand about the assets on which these finances are made.
Working capital debts are secured on either book debts or stocks.
Stocks or inventory include raw materials, work in progress, and finished goods. Book Debts refer to the receivable balances against the sale of goods or services.
Considering the funds requirement, business often hypothecates either of them or both. Here, security is in the form of hypothecation.
What does Hypothecation mean?
Hypothecation bears a resemblance to a mortgage. However, it does not lead to the transfer of the ownership of assets.
That’s nothing but pledging of goods while borrower retains the possession. There are no limitations on carrying out the business operations.
Understanding drawing power calculation
The borrowings amount depends on the value of the collateral.
The closing balance of the stocks and book debts is the starting point for deriving the borrowing limit.
It does not mean that the approval of loan happens for the entire value of the security. Bankers retain a certain percentage of security as a margin and allow borrowings on the remaining percentage.
If the bank margin percentage is 25% of the security value, then the maximum allowable borrowings are up to the remaining 75%.
This percentage of security after reducing the margin is called the drawing power of the borrower. So, the power calculation for drawing is simple and depends on the value of security.
What’s the significance of drawing power?
The use of drawing power calculation does not confine only during the sanction of borrowings. It’s a prerequisite to maintain throughout the tenure of working capital loans.
Let’s break this down through an example.
Example on how to calculate drawing power
Super Power is a business enterprise with an inventory and book debts amounting to $120,000 and $150,000 as of year-end. Considering the operational need, Super Power wants to opt for working capital financing from a well-known banker, Mighty Power.
Margin percentages for the banking terms are 25% and 40% for the inventory and book debts, respectively. It also requires the submission of quarterly financial statements.
Therefore, the working capital loan equals $120,000*75% + 150,000 *60% = $180,000.
The first three months’ quarterly financial statements comprise the inventory and receivables as $100,000 and $120,000. This results in a drawing power of $147,000. However, the outstanding balance of the borrowings is $160,000.
Now, the Banker mentions that the outstanding balance exceeds the current drawing power. However, Super Power claims that the balance doesn’t exceed the sanction limit of $180,000. Mighty Power and Super Power have different views. So, they are seeking an opinion from an expert.
In this scenario, the bankers’ claims are appropriate. That’s due to the fact that underlying loan drives the borrowing limits of working capital loans.
In other words, Super Power will not be able to honor an outstanding balance of $160,000 with security of $147,000. So, Super Power needs to take appropriate remediation steps.
Q&A Corner
What are the remediation steps if the running balance of borrowing exceeds drawing power?
It needs immediate attention, and the borrower shall make sure the outstanding balance falls below the stipulated drawing power. Otherwise, it will attract penal interest.
What’s the basis for the calculation of margin percentages?
It’s an internal process for bankers or borrowing institutes. However, borrowers often consider factors such as borrower credibility, nature of security, past repayment history, if any, etc.
How’s the accounting part of the change in drawing power done?
The short answer is that there will be no impact on accounting.
Working capital limits will have a maximum cap within which the borrower can utilize the credit limit for business operations. These funds are not disbursed to the borrower bank account.
Borrowers utilize it by issuing checks or wire/bank transfers to their stakeholders. For example, the payments to creditors happen through checks issued against the working capital borrowings.
Similarly, receivables are credited to the bank loan account. So, the transactions are recorded as and when the funds are spent or received.
These are similar to Credit cards for individuals. It allows for spending the amount on a credit basis. So, there is no need to record the change in drawing power.
Let’s understand the logical part of it.
This kind of restriction by bankers ensures the end use of funds only towards the business operations.
It also benefits the borrower as the interest calculation is only to the extent of usage.
Key Takeaways
Drawing power calculation is a simple math. The key inputs are the margin percentage and security value. Calculation of drawing power is an iterative process. Lender performs this check throughout the loan tenure on a periodic basis
Borrower need to submit periodical statement of security balance to the lender. Lender adds these asset balance against the borrowings and checks if the drawing power is as per the lending terms. If the drawing power is less than the outstanding loan, it might result in penal interest. So, that’s a crucial covenant of the working capital and the borrower has to keep an eye on meeting those limits throughout the borrowing period.