Letter of Credit & Bank Gurantee impact on working capital and Cycle

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Hukam Chand (Querist)
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21 January 2025 Dear CA Club Team,
I took multiple Letter of Credit (LC), Bank Guarntee (BG) from multiple Bank as well as i took an Cash credit limit (CC) approx 2Cr for full fill our company working capital limit and also i have to submit the Stock Statement with the Bank but i have an issue in front of me How LC and BG impact on my Monthly Drawing power(DP) Because Stock + Debtors-Creditors but Creditors and debtors will be depending on the LC & BG based. How can i resolve for it Kindly Give me some Resolution and practical aspect and example while i could be used in my business secnerio Please share with me the suitable example whose covered Drawing power (DP), CC Limit, LC, BG etc.
Please

Asha Kanta Sharma

Asha Kanta Sharma (Expert)
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12 August 2025 Certainly! Let’s break this down step by step in a **practical and business-friendly manner**, using an example to explain the **impact of LC (Letter of Credit), BG (Bank Guarantee), and CC (Cash Credit)** on your **Working Capital Cycle**, **Drawing Power (DP)**, and **bank limits**.

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## 💡 1. **Key Concepts First**

### 🔹 Working Capital Cycle (WCC):

* Time taken to convert inventory into cash.
* Formula:
**WCC = Inventory Days + Receivables Days – Payables Days**

### 🔹 Drawing Power (DP):

* The **amount you are eligible to draw** under your **Cash Credit (CC)** based on stock and debtors.
* Formula (general):
**DP = (Eligible Stock + Eligible Debtors) – Creditors (Trade Payables)**
\[As per bank norms, certain margins apply]

### 🔹 LC & BG Usage:

* **LC**: Bank promise to pay supplier on your behalf – usually results in **Credit Purchases**, which adds to **Trade Payables (Creditors)**.
* **BG**: A contingent liability, not cash outflow upfront – does not impact stock/debtors directly but can affect **bank exposure**.

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## 🧾 2. **How LC & BG Affect Drawing Power (DP)**

### 🔸 LC (Letter of Credit)

* When you **open an LC**, it is **not shown in stock immediately**.
* Once the **goods are received**, stock increases → this helps your **DP**.
* However, since the LC creates a **creditor payable**, it increases **Trade Payables** → reducing DP (as per formula).
* So, **LC increases creditors**, which **reduces DP**, unless stock also increases proportionately.

### 🔸 BG (Bank Guarantee)

* Treated as a **non-fund-based limit**.
* It **does not affect your DP directly**, unless invoked.
* But BGs are considered while calculating **overall bank exposure** (i.e., total limit utilization).

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## 🧮 3. **Practical Example**

Assume the following:

| Particulars | Amount (₹ in Lakhs) |
| ------------------------------- | ------------------- |
| Stock (as per stock statement) | 100 |
| Debtors (Receivables) | 80 |
| Creditors (Payables – LC based) | 50 |
| Bank Margin on Stock | 25% |
| Bank Margin on Debtors | 40% |
| Cash Credit Limit (Sanctioned) | 200 |
| LC Outstanding | 40 |
| BG Outstanding | 20 |

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### 🔹 Step 1: Calculate **Eligible Stock & Debtors**

* **Stock** after margin:
₹100 – 25% = ₹75
* **Debtors** after margin:
₹80 – 40% = ₹48

✅ Total primary security = ₹75 + ₹48 = ₹123 lakh

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### 🔹 Step 2: Subtract Creditors (LC related)

* ₹123 – ₹50 = **₹73 lakh (Drawing Power)**

So, even though your CC limit is ₹200 lakh, you can **only draw ₹73 lakh** because of margining and trade creditors.

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### 🔸 Step 3: Understand Fund-Based vs Non-Fund-Based Exposure

| Limit Type | Exposure (₹ in Lakh) |
| ----------------------- | -------------------- |
| CC Utilization | ₹73 (as per DP) |
| LC Outstanding | ₹40 |
| BG Outstanding | ₹20 |
| **Total Bank Exposure** | **₹133 lakh** |

→ Still within ₹200 lakh limit

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## 📌 4. Business Advice & Resolution

### ✅ **Tips to Manage LC/BG Impact on DP:**

1. **Match LC purchases with stock reporting**: Once you receive goods under LC, update your stock statement quickly.
2. **Negotiate longer payment terms**: This increases creditors and can reduce immediate DP impact.
3. **Discuss LC-BG sharing under total limit** with the bank: You can have flexibility between fund-based (CC) and non-fund-based (LC/BG) limits.
4. **Avoid overuse of LC if stock doesn't reflect quickly**: It will reduce DP even though the goods are in transit or not reported.

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## 📘 5. Summary

| Component | Impact on DP |
| ---------------------- | ------------------------------------------------ |
| Stock (↑) | Increases DP |
| Debtors (↑) | Increases DP |
| Creditors (↑ – via LC) | Decreases DP |
| LC Outstanding | Indirect – as it increases creditors |
| BG Outstanding | No direct effect on DP; only on overall exposure |

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## ✉️ Letter Format (CA Club / Banker Communication)

> **Subject: Clarification Request Regarding Impact of LC/BG on Drawing Power Calculation**
>
> Dear \[Bank Manager / CA Club Team],
>
> I seek your support in understanding the practical treatment of Letter of Credit (LC) and Bank Guarantee (BG) in the calculation of Drawing Power (DP) for my Cash Credit limit. As my company regularly uses LC for purchases and issues BGs for contracts, it significantly impacts my reported creditors and overall bank exposure.
>
> Specifically, I would like to understand how the trade payables created through LC are factored into DP, and how I should report stock once goods are received. Additionally, your guidance on managing the DP effectively while using both fund and non-fund based facilities would be highly appreciated.
>
> Kindly advise with any bank-specific policies or formats that may help streamline our monthly stock and debtor statements.
>
> Regards,
> \[Your Name]
> \[Company Name]
> \[Account Number / Branch Name]

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If you’d like, I can also help you build an **Excel template** to calculate Drawing Power with margins and LC/BG utilization. Just let me know.

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