A White Paper on

CREDIT APPRAISAL
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.

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

CREDIT APPRAISAL

INTRODUCTION TO CREDIT APPRAISAL

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 Credit Appraisal is the process by which the lender assesses the credit worthiness of the borrower. It revolves around character, collateral capability and 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 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 analysis with the following principles in mind: The purpose of the loan should be credible. The Funding Institution must

capacity. It takes into account various factors like income of the applicants, number of dependents, repayment monthly capacity,

expenditure,

employment history, number of years of service and other factors which affect credit rating of the borrower. It is generally institutions providing customer. carried which financial by are the financial in its

involved to

funding

acquire in-depth knowledge of a borrowers capabilities, including the business and market

consideration of a fresh proposal for loan or an enhancement proposal for an

environment in which the borrower operates.

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CREDIT APPRAISAL The lender must have a reasonable expectation of when a loan can be The lenders have a back-up 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. repaid.

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 and must integrity exhibit above

character reproach.

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

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 businesss and industry risks that could inhibit repayment, and analyze the applicants financial statements

before granting a loan. However, there are weaknesses in loan certain common that

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?

portfolios

seriously hinder effective credit analysis. The most common of these deficiencies are: poor industry analysis, cursory rather than a detailed analysis of borrowers 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, borrowers, infrequent incomplete contacts and with badly

The nature of the product, demand for the same, the existing and perceived

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CREDIT APPRAISAL competition in the segment, ability of the proponents government to withstand the same, the 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 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 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. 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? vary from industry to industry, services, trade, etc.

policies

governing

industry, etc. need to be taken into consideration.

The 6 CS

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. Page 4

CREDIT APPRAISAL CAPACITY Experience in the activity track record planning, budgeting and review handling production capacity capacity utilizationprofessional ratio-Asset Cover-Interest suitability security Coverand MAST

DSCR-Availability, chargeability principle CASH FLOW of

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 unexpectedStructuring and budgeting capital. CONDITION Condition of economy growing, stagnant or depressed-Numbers of competitors-Substitutes in the marketDemand policies vs. and Supply-Government regulations-Status of

Pattern of cash generation- Liquidity riskBreak-even analysisDCF

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.

technology-Availability of manpower, material other resources- Pollution control and effluent treatment COLLATERAL Risk perception and evaluation-

Financial

parameters-Debt/equity

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CREDIT APPRAISAL

THE STAGES OF CREDIT APPRAISAL

Stage 1

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

Stage 2

1. Inspection: Pre sanction inspection 2. Preparation of credit proposal : Credit Approval Memo containing the complete information about the proponents background, appraisal of financial & managerial status, technical and economic viability of the activity and future prospects 3. Sanction of Credit Proposal

1.

Stage 3
2.

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

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 Page 6

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 . 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 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:

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CREDIT APPRAISAL

Financial Ratios
Liquidity ratios

Ratios Current ratio

Objective Ability of the firm to meet its short term obligations

Formulae Current assets Current liabilities Quick assets Current liabilities Absolute liquid assets Current liabilities

Significance 2:1

Quick ratio or liquid ratio

Ability to meet short term obligations as and when its due

1:1

Absolute ratio

To measure the expenses& balances

1:2

Leverage ratios

Ratios Debt equity ratio

Objective To measure the proportion of debt &equity in financing a firm

Formulae Long term debt Shareholders fund

Significance 2:1

Debt-asset ratio

To measure proportion of debt and assets

Long term debts Total assets EBIT Interest

1:2

Interest coverage ratio

To measure how many times a firm can pay its interest

2 or more

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CREDIT APPRAISAL

Turnover ratios

Ratios Fixed asset turnover ratio Working capital turnover ratio

Objective To determine the efficiency with which the fixed assets are used To determine the efficiency of working capital used

Formulae Net sales Net fixed assets Net sales Net working capital

Significance Higher the more effective utilization of assets Higher the more efficient usage

Total assets turnover ratio

To determine the total efficiency of assets Firms ability to manage its inventory To convert debtors into cash in the shortest time

Net sales Total assets

Higher indicates over trading and lower shows idle capacity

Inventory turnover ratio Debtors turnover ratio

COGS Average inventory Net credit sales

Higher inventory shows good inventory management Higher ratio shows better

Average debtors management of current assets

Profitability ratios

Ratios Net profit ratio

Objective To determine overall profitability

Formulae Net profit Net sales

Significance Higher ratios shows good economic condition

Return on equity

Earnings of company as compared to shareholders equity

Net profit after tax Net worth

Higher ratio shows better cash generation

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CREDIT APPRAISAL Return on capital employed How efficiently are the long term funds used by the share holders Capital employed NP before tax x 100 Higher ratio shows more effective use of total assets Total assets NP before tax x 100 Higher ratio shows better use of capital

Return on total How assets have been used assets by the management

Conclusion
level that has been developed, which is any 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 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 firms financials are to be analyzed but there should also be a birds view on the firms industry, the credit ratings given to the firm and also thorough verification regarding the firms implementation of the project. Thus credit analysis helps us give an overall picture about the industry as a whole and the firms position and to assess whether it would be able to repay the credit or run into crisis.

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