What to look for in a Bank's Sanction Letter?
Most of the SME entrepreneurs / business owners in India would vouch for the fact that it is not easy to avail loans from the Banking system. So, when they finally get a Sanction Letter - they rejoice with happiness. They decide to sign & accept the Sanction Letter by merely looking at 2 important points:
a. How much loan has been sanctioned?
b. What is the applicable interest rate?
They are least bothered & do not even read properly the entire Sanction Letter simply because either they do not understand the implications of jargons used or are in hurry to avail loans from the banking system.
Consequently, after certain months - they start facing the music of their own ill-made decisions and their business starts to suffer.
Hence, it is very crucial from a long term perspective to read and understand each aspect of the sanction letter before signing & accepting it. Following are some important parameters which one should take note of (apart from loan amount & interest rate):
1. Credit Limit Structure - Is there any sub-limit of the main limit? Are there any restrictions of how much a particular facility can be used within the limit, etc.
2. Pricing - is the interest rate fixed or floating? What is the benchmark / reference rate used for pricing? What is the interest rate reset mechanism - These questions directly impact your applicable interest rate.
3. Commitment Fee - Normally, a businessman thinks that irrespective of his sanctioned amount, he shall pay interest only on the portion of funds used. However, this is not always true. In case, his utilization is below a certain % threshold, then Banks may charge a penalty by the name of commitment fee towards lower utilization.
4. Security - These are predominantly of two types - primary security (main assets which are funded directly by banks) and secondary security (other collaterals offered). One also needs to see whether the lending bank has first charge / second charge / subservient charge on the above securities.
5. Guarantee - Banks will always insist on securing as many guarantees as possible - be it the Personal Guarantee of Promoter, family members, Corporate Guarantee, etc. However, as a borrower, one needs to offer limited guarantee only (depending upon case to case). In fact, at times, even the Personal Guarantee of Promoter gets waived off.
6. Covenants - These are important ratios which should not be breached during the entire loan period and more particularly as at respective year end. Hardly any borrower keeps track of these - however, bankers always keep note of it. In case of breach, bankers may charge extra interest / penalty which you may not even be aware of.
7. Prepayment Penalty - In case you have surplus funds and decide to repay loans earlier - bankers will ask you to pay an exorbitant extra amount as penalty. This becomes very painful and at times you are even forced not to close the loan (despite your wish). However, there are ways and mechanisms to reduce / waive off this prepayment penalty and it is apt that this be cleared and documented on Day 1 itself.
8. DP Parameters - For working capital loans, banks release funds to the tune of eligible Drawing Power (DP) irrespective of the sanctioned limit. Hence, at times, even though you have a sanctioned limit, you are not allowed to avail loans simply because your DP is low. This is strictly monitored on a monthly basis. A proper review and negotiation of margin, cover period, etc. can enable a borrower to ensure that their DP is always at a higher level.
9. Various fees - We feel that banks just charge interest for the loans provided. However, this is a myth and there are many forms of charges, fees, etc. (including hidden ones) which gets debited to your account and maybe you are not even aware of. Hence, it is crucial to understand, negotiate and regularly review all types of charges / fees.
10. Other Misc restrictions - There are many operational / financial / strategic and other business restrictions imposed by banks as mentioned in the sanction letter - which very few pay heed to. However, when times are bad - these hurdles act as a big bottleneck and also legally makes the case weak (from a borrower perspective). Hence, one needs to understand the implications of these parameters.
Hence, to conclude - one must read between the lines before signing / accepting a Bank’s Sanction Letter.