white paper credit appraisal (2)

A White Paper on CREDIT APPRAISAL

By Krishna Teja C, Senior Associate, Kharagpur Finance and Marketing Group.

This White Paper on “Credit Appraisal” emphasizes on understanding the procedure and process used by various Banks/Financial Institutions in India to assess the credit worthiness of the borrower. The paper is aimed at explaining Credit appraisal, its dimensions and process. The paper analyzes the credit appraisal procedure, which includes knowing about the different credit facilities provided by the banks to its customers, how a loan proposal is being made, what are the formalities that are to be satisfied and most importantly knowing about the various credit appraisal techniques which are different for each type of credit facility.

CREDIT APPRAISAL

INTRODUCTION TO CREDIT

APPRAISAL

Credit Appraisal is the process by which

the lender assesses the credit worthiness

of the borrower. It revolves around

character, collateral capability and

capacity. It takes into account various

factors like income of the applicants,

number of dependents, monthly

expenditure, repayment capacity,

employment history, number of years of

service and other factors which affect

credit rating of the borrower. It is

generally carried by the financial

institutions which are involved in

providing financial funding to its

customer.

It is a holistic exercise which starts

from the time a prospective borrower

walks into the funding institution for a

loan and comes to an end with credit

delivery and monitoring with the objective

of ensuring and maintaining the quality of

lending and managing credit risk within

acceptable limits. It refers to the

consideration of a fresh proposal for loan

or an enhancement proposal for an

additional loan. Previously, all credit

decisions were taken purely on the basis

of security criterion. Banks/Financial

Institutions are now considering need

based credit and the viability of the

proposal, which should justify the credit

request. Hence, credit appraisal has

become an indispensable tool for the

bankers and therefore they have to be

careful in appraising the proposals of their

clients.

Credit analysis requires the Funding

Institution to assess the risks and rewards

of extending a loan. Credit risk is a risk

related to non repayment of the credit

obtained by the customer of a bank. Thus

it is necessary to appraise the credibility of

the borrower in order to mitigate the

credit risk. Given the risks inherent in

lending, all lenders conduct their credit

analysis with the following principles in

mind:

The purpose of the loan should be

credible.

The Funding Institution must

acquire in-depth knowledge of a

borrower’s capabilities, including

the business and market

environment in which the borrower

operates.

CREDIT APPRAISAL

The lender must have a reasonable

expectation of when a loan can be

repaid.

The lenders have a back-up

position or secondary source of

repayment, other than collateral

liquidation, to keep it as a shield in

case the borrower encounter

encounters cash flow problems.

The borrower must exhibit

character and integrity above

reproach.

Therefore, a borrower should apply due

diligence and look for the purpose of the

loan, identify the primary and

secondary sources of repayment, assess

the business’s and industry risks that

could inhibit repayment, and analyze

the applicants financial statements

before granting a loan.

However, there are certain common

weaknesses in loan portfolios that

seriously hinder effective credit analysis.

The most common of these deficiencies

are: poor industry analysis, cursory rather

than a detailed analysis of borrower’s

financial position, excessive reliance on

collateral, etc. Also there are certain note

parts of the credit analysis function like

absence of written loan policies, excessive

centralization or decentralization of loan

authorities, infrequent contacts with

borrowers, incomplete and badly

organized credit files, etc that contribute to

difficulties lenders face in repayment,

underscoring the importance of analyzing

the entire credit administration process to

avoid loan losses.

DIMENSIONS OF CREDIT

APPRAISAL

1. MANAGEMENT APPRAISAL

A lot of attention has to be paid to this

area, for this is one of the long term factors

affecting the business of the concern. Does

the management have enough experience

in the line? What is its track record? What

are the antecedents? Introduced to us by

whom? These are some of the questions

that need to be answered before we can

take up any kind of exposure.

2. COMMERCIAL APPRAISAL

The business has to be commercially

viable for us to proceed further. Is there

enough demand in the market? Is the

product accepted in the market? How

many substitute products are there? What

about entry and exit barriers? Is there

scope for further growth?

The nature of the product, demand for the

same, the existing and perceived

CREDIT APPRAISAL

competition in the segment, ability of the

proponents to withstand the same,

government policies governing the

industry, etc. need to be taken into

consideration.

3. FINANCIAL APPRAISAL

Does the promoter has the capacity to raise

finance- both own equity and debt? What

are the sources of margin? Will the

business generate sufficient funds to

service the debt and other stakeholders? Is

the capital structure optimal?

Thorough scrutiny of the financial aspects

of the request needs to be carried out.

Apart from ascertaining the need based

character of the limits requested for, the

financial health of the proponents, ability

to absorb unanticipated financial costs

need to be looked into. Where higher

limits are considered, detailed analysis of

the financial health would be made and the

following ratios computed:

Current ratio

Total outside liabilities/equity ratio

Profit before interest and

taxes/interest ratio

Profit before tax/Net sales ratio

Inventory + receivables/Sales ratio

DSCR if the borrower enjoys any

term loan with any bank/FI even if no TL

is being considered by our bank.

Assessment of working capital credit

requirements hinges normally on the

projected sales and other financial figures.

All the above ratios would be compiled for

the past two/three years including the latest

audited balance sheet. As the ratios would

vary from industry to industry, services,

trade, etc.

4. ECONOMIC APPRAISAL

What is the breakeven level? Will the

business post positive net present value

through its economic life? What is the

level of cost /benefit? What is the Internal

Rate of Return (IRR)? Will the cost of

funding and operations be well below the

IRR?

The 6 C’S

As a cautious lender the following areas

need to be particularly looked into:

CHARACTER

Antecedents-introduced by whom- Is

it a takeover account? In which case,

what does the status report say? -

Background Educational Professional

Socio –economic, Political- Initiative

and Drive.

CREDIT APPRAISAL

CAPACITY

Experience in the activity – track

record – planning, budgeting and

review handling –production capacity -

capacity utilization- professional

capacity to handle men, material,

money and minutes – capacities to

handle contingencies and crises.

CAPITAL

Extent of stake in business-Ability to

raise finance – both owned equity and

debt-ability to inspire and sustain

investor confidence-Ability to absorb

losses – expected and unexpected-

Structuring and budgeting capital.

CONDITION

Condition of economy – growing,

stagnant or depressed-Numbers of

competitors-Substitutes in the market-

Demand vs. Supply-Government

policies and regulations-Status of

technology-Availability of manpower,

material other resources- Pollution

control and effluent treatment

COLLATERAL

Risk perception and evaluation-

Financial parameters-Debt/equity

ratio-Asset Cover-Interest Cover-

DSCR-Availability, suitability and

chargeability of security –MAST

principle

CASH FLOW

Pattern of cash generation- Liquidity

risk- Break-even analysis- DCF

Technique- NPV- IRR- PV Index

PROCESS OF CREDIT

APPRAISAL

The process of credit appraisal would

begin with the selection of the

proponent. It would involve appraising

the background of the

proponent/management, commercial,

technical and financial appraisal. The

appraisal would be different in respect

of:

personal loans for consumer durables,

houses etc;

loans to tiny business enterprises;

loans to agriculturists ; and,

Credit facilities to firms, corporate and

others for business/trade/ industry.

CREDIT APPRAISAL

THE STAGES OF CREDIT APPRAISAL

1. Interview with the proponent and gathering of application on Lenders’ prescribed format.

2. Adherence of norms stipulated by Reserve Bank of India.

3. Obtaining and verification of documents/financial statements

1. Inspection: Pre sanction inspection 2. Preparation of credit proposal : Credit Approval

Memo containing the complete information about the proponent’s background, appraisal of financial & managerial status, technical and economic viability of the activity and future prospects

3. Sanction of Credit Proposal

1. A sanction letter is given to the proponent. It contains the type and size of facility & margin stipulated with all terms and conditions including rate of interest & charges, Insurance of the proposed security and periodicity of inspections.

2. After agreement of the terms and conditions by the proponent, Account is opened for Disbursement and post disbursement inspections follow.

Stage 3

Stage 2

Stage 1

The General Process

In Banks the process of credit appraisal

would begin with the selection of the

proponent. It would involve appraising the

background of the proponent/management,

commercial, technical and financial

appraisal. In Banks/Financial Institutions

Appraisal of credit facilities would

comprise two distinct segments:

Appraising the acceptability of the

customer

Assessment of the customer's

credit needs.

Both the aspects need to be examined

simultaneously at the time of the initial

CREDIT APPRAISAL

entry of a customer to the Bank as also

subsequent periodic renewals.

1. Background of the

proponent/management:

The identification of the borrower needs to

be done properly through scrutiny of his

antecedents, experience, competence,

integrity, initiative etc. This may be done

by obtaining status reports from previous

bankers or meaningful assessment of his

dealings with bank. In case of corporate,

the management structure, the background

of the top management, needs to be

scrutinised. Bank should be careful if the

names of prospective borrowers/promoters

appear in the list of defaulters published by

RBI/ ECGC etc or in any other list of

undesirable customers.

2. Commercial appraisal

The nature of the product, demand for the

same, the existing and perceived

competition in the segment, ability of the

proponents to withstand the same,

government policies governing the

industry, etc. need to be taken into

consideration

3. Technical appraisal

Technical appraisal of the project needs to

be carried out for industrial activity

proposals beyond the cut-off limits

prescribed from time to time. Such

appraisal may be carried out in-house by

officers having the technical expertise for

the same or by an outside agency as

determined by the appropriate authority,

where technical appraisal is carried out by

All India Financial Institutions. PSU

Banks/other leading banks having

expertise in the area and the same may be

accepted for an appraisal purpose.

4. Financial appraisal:

Thorough scrutiny of the financial aspects

of the request needs to be carried out.

Apart from ascertaining the need based

character of the limits requested for, the

financial health of the proponents, ability

to absorb unanticipated financial costs

need to be looked into. Ascertaining the

need based character of the limits would

include scrutiny of the cost of the project,

means of financing, financial projections

etc

.

CREDIT APPRAISAL

Financial Ratios

Liquidity ratios

Ratios Objective Formulae Significance

Current ratio Ability of the firm to

meet its short term

obligations

Current assets

Current liabilities

2:1

Quick ratio or

liquid ratio

Ability to meet short

term obligations as and

when its due

Quick assets

Current liabilities

1:1

Absolute ratio To measure the

expenses& balances

Absolute liquid

assets

Current liabilities

1:2

Leverage ratios


Debt –equity ratio To measure the

proportion of debt

&equity in financing

a firm

Long term debt

Shareholder’s fund

2:1

Debt-asset ratio To measure

proportion of debt

and assets

Long term debts

Total assets

1:2

Interest coverage

ratio

To measure how

many times a firm

can pay its interest

EBIT

Interest

2 or more

CREDIT APPRAISAL

Turnover ratios


Fixed asset

turnover ratio

To determine the efficiency with

which the fixed assets are used

Net sales

Net fixed assets

Higher the more effective

utilization of assets

Working capital

turnover ratio

To determine the efficiency of

working capital used

Net sales

Net working

capital

Higher the more efficient

usage

Total assets

turnover ratio

To determine the total efficiency

of assets

Net sales

Total assets

Higher indicates over

trading and lower shows

idle capacity

Inventory

turnover ratio

Firm’s ability to manage its

inventory

COGS

Average

inventory

Higher inventory shows

good inventory

management

Debtor’s

turnover ratio

To convert debtor’s into cash in

the shortest time

Net credit sales

Average debtors

Higher ratio shows better

management of current

assets

Profitability ratios


Net profit ratio To determine overall

profitability

Net profit

Net sales

Higher ratios shows good

economic condition

Return on

equity

Earnings of company as

compared to shareholder’s

equity

Net profit after tax

Net worth

Higher ratio shows better

cash generation

CREDIT APPRAISAL

Return on

capital

employed

How efficiently are the

long term funds used by

the share holders

NP before tax x 100

Capital employed

Higher ratio shows better use

of capital

Return on total

assets

How assets have been used

by the management

NP before tax x 100

Total assets

Higher ratio shows more

effective use of total assets

Conclusion

Credit appraisal is not simply a

quantitative exercise of “numbers

crunching”. Borrowers operate in a

dynamic environment, and their ability to

repay is rarely the result of static

conditions reflected in periodic financial

statements. The recent era of volatile

social, political, and economic change

across the globe is only one example of the

unpredictable forces at work. Therefore, a

sound credit rating system requires an

analysis of broader credit risk management

issues as well.

A very important suggestion we would

like to make through this whitepaper is

that known customers are the best potential

working capital customers because of

many reasons like The Knowledge about

the reputation of the customer in the

market, Information about the banking

conducts of the customer, The comfort

level that has been developed, which is any

time move than a new customer, The

amount churned by the current account.

Therefore it is always easier and safer to

fund a known customer.Also it should be

kept in mind that to allot the credit to an

enterprise, not only the firm’s financials

are to be analyzed but there should also be

a bird’s view on the firm’s industry, the

credit ratings given to the firm and also

thorough verification regarding the firm’s

implementation of the project. Thus credit

analysis helps us give an overall picture

about the industry as a whole and the

firm’s position and to assess whether it

would be able to repay the credit or run

into crisis.

white paper credit appraisal (2)

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