The monthly stock statement arrives. The borrower reports inventory of Rs 14 crore and receivables of Rs 8 crore. After applying the prescribed margins (25% on stock, 40% on receivables), the drawing power is Rs 15.3 crore. The outstanding working capital facility is Rs 13.8 crore. The borrower is within limits.
The credit monitoring officer records: “Drawing power adequate. Account within limits. No adverse observations.”
The observation is accurate. The observation is also incomplete. The drawing power calculation tells the lender that the reported numbers, after applying prescribed margins, produce a limit that exceeds the outstanding. It does not tell the lender whether the reported numbers are reliable.
This is the gap that has produced some of the most significant credit losses in Indian banking: borrowers who were technically within drawing-power limits at every reporting date, whose stock statements were filed on time, whose interest was paid regularly and whose accounts showed no external symptoms of stress, until the day the lender discovered that the collateral behind the drawing power did not exist, was not eligible or was worth materially less than the statement
Drawing power is a mechanical calculation. It takes the reported value of eligible current assets (inventory and receivables that meet the lender’s eligibility criteria), applies prescribed margins and produces a number that represents the maximum the borrower can draw against the facility.
The calculation assumes three things: the reported inventory exists, the reported receivables are collectible and both meet the eligibility criteria specified in the sanction terms. If any of these assumptions is wrong, the drawing power overstates the available collateral, which means the lender’s exposure exceeds the collateral coverage.
Three different numbers
In every stock and receivable verification Northrop has conducted for lending institutions, the investigation produces three numbers that are rarely the same:
Number 1: The borrower’s reported position. This is the number on the stock statement, submitted monthly by the borrower. It shows inventory and receivables at the values the borrower’s accounting records reflect.
Number 2: The eligible position. This is the reported position adjusted for the lender’s eligibility criteria: stock older than the prescribed age limit is excluded, receivables older than 90 or 120 days are excluded, receivables from related parties may be excluded, stock in transit (not in the borrower’s physical possession) may be excluded, disputed receivables are excluded, stock pledged to another lender is excluded. The eligible position is almost always lower than the reported position because the eligibility criteria filter out the assets that carry higher risk.
Number 3: The verified position. This is the eligible position adjusted for what the independent verification actually finds: stock that is on the statement but not in the warehouse (it was sold, consumed, damaged, stolen or never existed), stock that is in the warehouse but at quantities or values materially different from the statement, receivables that the debtor does not acknowledge or disputes, receivables where the debtor has already paid the borrower but the borrower has not reported the collection (diversion of collections), and receivables where the debtor cannot be contacted because the debtor does not exist (fictitious receivables created to inflate the drawing power).
The gap between Number 1 and Number 3 is the lender’s true exposure. In Northrop’s experience, the gap in a healthy, well-managed borrower account is small (5% to 10%, attributable to timing differences, classification issues and normal estimation variance). In a stressed or fraudulent account, the gap can be 30% to 70% of the reported position.
Where stock statements mislead
Slow-moving and obsolete inventory. The borrower’s stock statement shows Rs 14 crore of inventory. The physical verification finds Rs 2.5 crore of raw material that has not moved in 8 months (the product it was purchased for has been redesigned and the material is no longer required), Rs 80 lakh of finished goods that have been in the warehouse for more than a year (the customer cancelled the order after the goods were produced) and Rs 40 lakh of packing material for a product variant that has been discontinued. The Rs 3.7 crore of slow-moving and obsolete stock is on the statement, is included in the drawing power and is not eligible under the sanction terms (which exclude stock older than 6 months). The reported drawing power includes it. The eligible drawing power does not.
Stock in transit and with third parties. The statement includes Rs 1.2 crore of “stock in transit” (goods shipped but not yet received by the borrower) and Rs 80 lakh of “stock with job workers” (material sent to third parties for processing). Neither is in the borrower’s physical possession. Neither can be physically verified without visiting the transporter or the job worker. The sanction terms may or may not include these categories. If excluded, the drawing power drops by Rs 2 crore.
Valuation inconsistencies. The borrower values finished goods at selling price (Rs 1,200 per unit) rather than at cost (Rs 850 per unit). The stock statement shows Rs 4.8 crore of finished goods. At cost, the value is Rs 3.4 crore. The Rs 1.4 crore difference is a valuation inflation that directly inflates the drawing power.
Where receivable statements mislead
Ageing manipulation. The borrower submits a receivable ageing that shows 85% of receivables within 90 days (eligible). The verification reveals that the borrower reclassified Rs 1.5 crore of receivables from the 120-day bucket to the 60-day bucket by issuing credit notes and re-invoicing the same amounts. The goods were not returned. The original sale was not reversed. The re-invoicing was performed solely to reset the ageing clock and keep the receivables within the eligible window.
Related-party receivables. The receivable book includes Rs 2.2 crore owed by three entities that share common directors, common addresses or common shareholders with the borrower. Related-party receivables may be excluded from drawing power under the sanction terms (because the lender cannot rely on a related party to pay independently of the borrower). If excluded, the drawing power drops accordingly.
Fictitious receivables. In the most serious cases, the receivable book includes amounts owed by entities that do not exist or by entities that deny any transaction with the borrower. The invoices are fabricated. The delivery notes are fabricated. The receivable is a fiction designed to inflate the drawing power and enable the borrower to draw more than the genuine collateral supports.
The verification process
Independent verification follows a defined sequence:
- Reconcile the stock statement to the books. Does the stock statement match the inventory ledger? Discrepancies between the statement submitted to the bank and the company’s own books are the first red flag.
- Physical verification. Visit the warehouse, the factory, the godowns. Count the stock. Compare the count to the statement. Identify items that are on the statement but not in the warehouse (shortage) and items in the warehouse but not on the statement (unrecorded stock). Assess the condition of the stock: is it saleable, damaged, obsolete, expired?
- Receivable confirmation. Contact the top debtors directly (not through the borrower). Confirm the balance, the age and the existence of any disputes. Compare the debtor’s confirmed balance to the borrower’s reported balance.
- Eligibility testing. Apply the sanction terms’ eligibility criteria to the verified position: exclude overage stock, exclude overage receivables, exclude related-party balances, exclude stock in transit if not permitted, exclude disputed amounts. Calculate the eligible drawing power from the verified, eligible position.
- Gap quantification. Compare the borrower’s reported drawing power to the verified eligible drawing power. Quantify the gap. Classify the gap: valuation difference, ageing difference, eligibility exclusion, physical shortage, fictitious asset.
What the lender should do
A drawing-power calculation based on the borrower’s self-reported stock statement is a starting point. It is not a verification. The credit monitoring framework should include:
Periodic independent verification (quarterly for standard accounts, monthly for accounts showing adverse signals) performed by a professional appointed by the lender, not by the borrower’s own auditor.
Surprise inspections (unannounced visits to verify physical stock against the latest statement) at intervals determined by the account’s risk profile.
Debtor confirmation (direct contact with the borrower’s customers to verify receivable balances) at least annually for the top 20 debtors and immediately when the receivable book grows faster than revenue.
Eligibility monitoring (systematic tracking of overage stock, overage receivables, related-party balances and other ineligible categories) at every reporting period, not just during the annual review.
The lender who relies solely on the borrower’s stock statement is trusting the borrower to report accurately. The lender who independently verifies is testing whether the trust is justified.
Northrop Management conducts independent stock and receivable verification, drawing-power assessment, fund monitoring and credit surveillance for banks, NBFCs and lending institutions.
Business@NorthropIndia.com | +91 92899 25657 | northropindia.com