Hire Purchase Evolution Of Credit Finance Essay - Free Essay Example

Business has evolved since the ancient times from barter, business, commercial venture, general manufacturing to specialized manufacturing today. Initially, only the seller and buyer were parties to a business transaction. The title to the asset is given by bill or invoice. Bill is used for consumables or low value assets that are usually purchased in cash. Invoice is used to specify durables or high value assets that are purchased on credit. Sales can be in either cash or credit. The two tasks for the seller are to sell and to monitor credit. Credit/ loan were evolved to bridge the gap between the purchasing power and demand. Over time credit organizations differentiated into sales and finance organizations. Today, three parties are involved in business transactions: seller, buyer and financier. Advantages of credit Higher purchasing power Working capital is retained, increasing liquidity levels in the business Tax shield on interest expense Credit sales can be differentiated into Loan/Hypothecation Hire Purchase Leasing HISTORY OF HIRE PURCHASE Hire purchase originated in England and is now unique to former British colonies. The financier purchases the asset and lets it on hire to the user. The user exercises an option to purchase the asset at the end of the contract after paying all the dues. HP is a transaction in which the purchaser of goods pays an initial deposit and takes possession. Subsequent installments are made over a specified time after which ownership passes to the purchaser. The parties to the contract are Owner (financier) and Hirer (purchaser / user). The installments are called Hire Money. If there is a default in the payment of any installment, the financier retains the right to repossess the asset from the purchaser without any refund. Sundaram Finance is one of the first hire purchase companies in India. In fact, they were instrumental in the creation of the Hire Purchase Act of 1972. ELEMENTS OF HIRE PURCHASE AGREEMENT To be a valid hire purchase agreement, the following elements must be clearly specified in writing and signed by the hirer as well as the financier: Identifying attributes of the asset, such as chassis number, engine number etc. Cash price of the goods i.e. price at which the goods may be purchased Hire purchase price, which is the amount payable by the hirer under the agreement Down payment or initial hire payable by the hirer Number, amount and date of each installment payable by the hirer Date of commencement of hire purchase agreement Rate of interest charged by financier COMPARISON OF LOAN, HIRE PURCHASE AND LEASE Table 2.1 Comparison of Loan, Hire Purchase and Lease Criteria Hypothecation Hire Purchase Lease Sale of asset Sold to borrower, hypothecated to financier Sold to financier, financier hires to buyer (hirer) Sold to financier (lessor), financier leases to lessee Initial payment Margin money Initial hire Lease deposit Ownership Title is with borrower from the beginning At the end of the contract, title transfer to buyer is done Title remains with lessor throughout the life of the asset Cash flow to seller Loan value of the asset is paid by financier, balance amount by borrower 100% of asset cost is paid by financier 100% of asset cost is paid by lessor In case of default Money is the consideration Court intervention is necessary POA* is obtained to bypass court intervention Asset can be taken away by financier Court intervention is not necessary since the financier is the owner of the asset Asset can be taken away by lessee Court intervention is not necessary since the lessee is the owner of the asset *- POA is Power of Attorney. The lender/financier reserves the right to repossess the asset without court intervention, to save time and resources. PROCESS OF A HIRE PURCHASE TRANSACTION Eligibility to avail hire purchase The field officers approach a prospective client and explain the terms of the hire purchase deal. Generally, assets with a high rate of depreciation are financed through hire purchase. The following entities can avail finance: Persons of contractual capacity i.e. of age greater than 18 years (as verified by birth certificate), sound mind Partnership firms Proprietary organizations Companies Public limited companies Quasi- Governments Governments POA holders Natural Guardians Under Hindu Law, the partys father is preferred as natural guardian. Only by way of practice/ convenience the mother is accepted as guardian. Under Christian Law, either father or mother can be accepted as guardian. Under Muslim Law, there is no guardianship. Further, ladies behind purdah cannot be signatories to a hire-purchase agreement. Proposal Analysis Before entering into a contract with an applicant for a hire-purchase financing, field investigation is a must. The following aspects of a client are verified through field analysis: Place of residence (applicant should have resided in the place for a minimum of 2 years) Standard of life Character of applicant (determining willingness to pay) Income details Source of income Property owned by applicant Expenses Credit rating of the individual This is a strictly subjective judgment performed by the branch office and sent to the head office for verification. At Sundaram Finance, the applicants income and monthly commitment alone are considered. In case of salaried professionals, latest salary slip and annual tax returns or Form 16 have to be submitted. This is used to determine the gross salary, from which statutory deductions and total borrowings are reduced, arriving at net salary. This is the basis for capacity determination. In case of businesspeople, the companys balance sheet and PL account are scrutinized to determine the cash profit i.e. net profit after tax plus depreciation from PL account. Net annual income should be equal to or greater than twice the annual commitment of the contract. This is called cash flow cover. Amount Commitment is the sum of all the Equal Monthly Installments paid in a year i.e. [EMI] x 12. Calculation of EMI The total amount repayable is the sum of the principal (cost price of the asset) and interest (cost of funds). EMI = Amount repayable / Number of installments The interest component is given by Interest = Principal * Flat rate of interest * Number of years Flat Rate of Interest Simple Rate of Interest This is generally used for computing the EMI manually, easily and easy understanding of a monthly commitment. This rate of interest is used for the purpose of accounting and banking. The EMI is initially fixed and the hirer has to pay this fixed amount for all the installments. The EMI charges payable by the consumers vary for every installment when calculated using simple rate of interest and hence it is confusing. The amount contributed towards the interest and principle varies with installments. Interest amount is calculated for every month with respect to the principal remaining. At Sundaram Finance, hire purchase contracts normally exist for a period of between 12 months and 60 months, in multiples of 6 months. Operations The asset is purchased according to the hirers specifications. The engine number and chassis number specified in the invoice are noted in the contract. These details should be identical in the RC book, contract and invoice for the agreement to be legal. The date of the agreement and the invoice should be identical in a hire purchase contract, since the asset comes into existence on that date. However, this is not mandatory in hypothecation. The following documents are collected to process a hire purchase application: 1. Income proof Salary slip Form 16 Latest IT return PL A/C, balance sheet (audited) 2. Identity proof Passport Photo credit card Pan card Driving license Voter id Ration card Partnership deed Trust deed Certificate of incorporation 3. Location proof Ration card Telephone bill House tax challan Driving license Electricity bill 4. Asset proof House tax challan Copy of sale deed Wealth tax assessment Housing cooperation society bill 5. Signature verification Passport Photo credit card Pan card Driving license Voter ID card Signature verification from bank 6. Bank statement 7. Photograph Serving debt In hire purchase, debt need not be served in full. The buyer or renter is free to return the asset at any period in the agreement, and no further installments need to be paid. This is why 100% financing is never performed in a hire purchase transaction. At Sundaram Finance, the dates of payment are fixed as 3rd, 10th, 17th and 22nd of every month. Post dated cheques are collected. In event of default Default or non-payment of installments is defined as For car 2 months lapse in payment. For commercial vehicle 90 days lapse in payment. The following procedure is followed by the financier for repossession of asset in the event of payment default: Figure 2.1 Procedure to deal with payment default Contract termination At the end of the hire purchase contract Re. 1 is collected as option money to terminate the contract. Form 35 is issued. Financier endorses the RC book with no dues enabling title transfer to the hirer / purchaser. In a hypothecation, Form 35 is issued to terminate the contract. OTHER ASPECTS PERTAINING TO HIRE PURCHASE Motor Vehicles Act Any vehicle plying on a public road must be registered. Form 20 application to register a new vehicle Form 34 to register a new vehicle Form 29 30 transfer of ownership (If there is an endorsement in the RC book by a financier, title cannot be transferred unless a NOC No Objection Certificate is gained.) Form 35 termination or extension of contract Insurance Insurance can be defined as a lot of people sharing the burden of one deprived man. Motor Vehicle insurance does not specify a limit on the value of claims that can be made. It can be differentiated into comprehensive and third-party insurance. Third-party insurance merely compensates damages caused to third party by the actions of the vehicle user provided valid drivers license is present. Any vehicle plying on the road must have third party insurance. Comprehensive insurance also compensates for damage to the vehicle and owner, in addition to third party damage. Any vehicle under finance must compulsorily have comprehensive insurance. Insurance does not cover war war-like activities, nuclear reactions and acts of terrorism. CREDIT POLICY Credit policy aids the financier in preparing the terms of a hire purchase contract. It is merely a guideline for conducting the business. At Sundaram Finance the first written credit policy was established in 2000 when the volume of business crossed Rs. 2 crore. It is now reviewed every year, and is subject to change based on economic and other market conditions. Credit policy has an effect on three main variables: Percentage of funding Repayment period Interest rate Percentage of funding In hire purchase, 100% of asset value is never financed. The loan to value ratio varies according to the type of asset and the credit risk. The ratio is always calculated on the ex-invoice price less discount. Loan to Value ratio, or LTV, can increase if market expands or delinquencies decrease. Higher LTV means that a higher portion of the asset price is funded by the financier, with lesser initial hire amount. This is fixed according to the company policy and reviewed periodically. Interest rate The interest rate is inclusive of the internal return rate or profit margin for the financier. This is variable based on Return on Investment RBI regulations Economic reforms Market conditions Presently, the IRR cannot vary during the term of a contract. It has to be fixed at the time of drawing up the contract. Repayment Period This is almost always constant for a given type of asset and class of customer, owing to the depreciation of asset with time. ASSETS FINANCED THROUGH HIRE PURCHASE Sundaram Finance extends finance through hire purchase for Cars Commercial vehicles Cars are an expense, while commercial vehicles are an income generating asset. For financing a car, past income is considered, while for commercial vehicle, predicted future income flows are considered. Presently the market share of Sundaram Finance in hire purchase finance of cars is about 7 16%, with up to 24% in some pockets such as Vellore district. Credit Classification of Cars Table 2.2 Classification of Cars CLASSIFICATION NAME VALUE OF ASSET (in Rs. lakhs) A Small Car 3-4 B Medium Car 4-7.5 C Large Car 7.5-15 D Luxury Car 15 Table 2.3 LTV Funded for Cars and Jeeps SALARIED BUSINESS Small 90% 85% Medium 85% 85% luxury 80% 75% Repayment period for A B class cars, for salaried class, is 60 months. For others, it is 48 months. In the event of gifting a car acquired through hire purchase, third party guarantee with evidence must be present. Credit Classification of Commercial Vehicle Any vehicle that runs on the road for remuneration is a Commercial Vehicle. They can be classified as load carrying or passenger carrying vehicles stage carriage or contract carriage vehicles LCV, MCV, HCV or multi-axle vehicles Stage carriage is on a fixed route, with fixed timings and fixed fare. Ex. Public buses. Contract carriage is where every aspect route, timings and fare is customized according to individual customer needs. Ex. Autorickshaw. Table 2.4 Classification of Commercial Vehicles ABBREVIATION CLASSIFICATION GROSS LOAD WEIGHT (in tons) LCV Light Commercial Vehicle 5 MCV Medium Commercial Vehicle 5-10 HCV Heavy Commercial Vehicle 10-15 Multi Axle Vehicle 15 Table 2.5 LTV Funded for Commercial Vehicles TRUCK BUS LCV Experience (in years) 3 3 3 Tenure (in months) 48 48 36 LTV of total chassis cost 95% 90% 85% LTV of total body cost 90% 90% 85% Repayment period for LCVs alone is 36 months as they depreciate faster and earn less revenue. For other classes the period is 60 months. For used commercial vehicles, the following are the credit norms applicable at Sundaram Finance: Table 2.6 Credit Policy for Hire Purchase Finance of Used Commercial Vehicles CREDIT POLICY NEW CUSTOMER EXISTING CUSTOMER Age of vehicle at closure of contract = 8 years = 8 years Maximum tenure (in months) 36 36 LTV (on basis of market value) 60% 60% Paper cash cover (times net income) 1.5 1.5 Assessed cash cover (times net income) 2.0 2.0 Exposure limit (in Rs. Lakhs) 10 10(if not fixed by HO/RO) Age (in years) at the closure of contract 65 65 Years in business 2 2 Years in location 3 3 Eligibility criteria Should own one free and road-worthy vehicle Previous closed contract to be not greater than 12 months ago