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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.
Previously. all credit decisions were taken purely on the basis of security criterion. collateral capability and proposal. Thus it is necessary to appraise the credibility of the borrower in order to mitigate the credit risk. The Funding Institution must capacity. repayment monthly capacity. It revolves around character. number of dependents. including the business and market consideration of a fresh proposal for loan or an enhancement proposal for an environment in which the borrower operates.CREDIT APPRAISAL INTRODUCTION TO CREDIT APPRAISAL additional loan. number of years of service and other factors which affect credit rating of the borrower. expenditure. It takes into account various factors like income of the applicants. 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. Credit analysis requires the Funding Institution to assess the risks and rewards of extending a loan. It is generally institutions providing customer. It refers to the analysis with the following principles in mind: The purpose of the loan should be credible. 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. credit appraisal has become an indispensable tool for the bankers and therefore they have to be careful in appraising the proposals of their clients. Given the risks inherent in lending. Hence. Credit risk is a risk related to non repayment of the credit obtained by the customer of a bank. employment history. which should justify the credit request. carried which financial by are the financial in its involved to funding acquire in-depth knowledge of a borrower’s capabilities. Page 2 .
The most common of these deficiencies are: poor industry analysis. the existing and perceived Page 3 . repaid. cursory rather than a detailed analysis of borrower’s financial position. However. infrequent incomplete contacts and with badly The nature of the product. borrowers. for this is one of the long term factors affecting the business of the concern. MANAGEMENT APPRAISAL A lot of attention has to be paid to this area. a borrower should apply due diligence and look for the purpose of the loan. DIMENSIONS OF CREDIT APPRAISAL 1. 2.CREDIT APPRAISAL The lender must have a reasonable expectation of when a loan can be The lenders have a back-up organized credit files. COMMERCIAL APPRAISAL The business has to be commercially viable for us to proceed further. position or secondary source of repayment. Also there are certain note parts of the credit analysis function like absence of written loan policies. there are weaknesses in loan certain common that that need to be answered before we can take up any kind of exposure. other than collateral liquidation. etc. and analyze the applicants financial statements before granting a loan. demand for the same. identify the primary and secondary sources of repayment. excessive centralization or decentralization of loan authorities. assess the business’s and industry risks that could inhibit repayment. etc that contribute to difficulties lenders face in repayment. to keep it as a shield in case the borrower encounter encounters cash flow problems. underscoring the importance of analyzing the entire credit administration process to avoid loan losses. The borrower and must integrity exhibit above character reproach. 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. excessive reliance on collateral. 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.
Where higher limits are considered. etc. etc. All the above ratios would be compiled for the past two/three years including the latest audited balance sheet. what does the status report say? Background Educational Professional Socio –economic. 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. Apart from ascertaining the need based character of the limits requested for. need to be taken into consideration. ability to absorb unanticipated financial costs need to be looked into. ability of the proponents government to withstand the same.Is it a takeover account? In which case. The 6 C’S 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.CREDIT APPRAISAL competition in the segment. 4. trade. Page 4 . Political.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. policies governing industry.Initiative and Drive. FINANCIAL APPRAISAL Does the promoter has the capacity to raise finance. As the ratios would 3. services. the financial health of the proponents. 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. the Assessment of working capital credit requirements hinges normally on the projected sales and other financial figures.
budgeting and review handling –production capacity capacity utilizationprofessional ratio-Asset Cover-Interest suitability security Coverand –MAST DSCR-Availability.PV Index PROCESS OF CREDIT APPRAISAL The process of credit appraisal would begin with the selection of the proponent.NPV. Credit facilities to firms. technical and financial appraisal. material other resources. and. houses etc. material. money and minutes – capacities to handle contingencies and crises. stagnant or depressed-Numbers of competitors-Substitutes in the marketDemand policies vs. commercial. technology-Availability of manpower. and Supply-Government regulations-Status of Pattern of cash generation. CONDITION Condition of economy – growing. It would involve appraising the background of the proponent/management. chargeability principle CASH FLOW of capacity to handle men. loans to tiny business enterprises. 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.CREDIT APPRAISAL CAPACITY Experience in the activity – track record – planning.IRR. loans to agriculturists . The appraisal would be different in respect of: personal loans for consumer durables.Liquidity riskBreak-even analysisDCF Technique.Pollution control and effluent treatment COLLATERAL Risk perception and evaluation- Financial parameters-Debt/equity Page 5 . corporate and others for business/trade/ industry.
appraisal of financial & managerial status. Insurance of the proposed security and periodicity of inspections. A sanction letter is given to the proponent. Account is opened for Disbursement and post disbursement inspections follow. Stage 3 2. Preparation of credit proposal : Credit Approval Memo containing the complete information about the proponent’s background. It would involve appraising the background of the proponent/management. Inspection: Pre sanction inspection 2.CREDIT APPRAISAL THE STAGES OF CREDIT APPRAISAL Stage 1 1. Obtaining and verification of documents/financial statements Stage 2 1. 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 . Adherence of norms stipulated by Reserve Bank of India. Sanction of Credit Proposal 1. technical and economic viability of the activity and future prospects 3. After agreement of the terms and conditions by the proponent. 3. 2. Interview with the proponent and gathering of application on Lenders’ prescribed format. technical and financial appraisal. It contains the type and size of facility & margin stipulated with all terms and conditions including rate of interest & charges. commercial. The General Process In Banks the process of credit appraisal would begin with the selection of the proponent.
demand for the same.CREDIT APPRAISAL entry of a customer to the Bank as also subsequent periodic renewals. 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. integrity. 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. 4. government policies governing the industry. need to be taken into consideration . 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. In case of corporate. where technical appraisal is carried out by All India Financial Institutions. Commercial appraisal The nature of the product. PSU Banks/other leading banks having expertise in the area and the same may be accepted for an appraisal purpose. the background of the top management. ability of the proponents to withstand the same. initiative etc. the management structure. Financial appraisal: Page 7 . 2. This may be done by obtaining status reports from previous bankers or meaningful assessment of his dealings with bank. Background of the proponent/management: The identification of the borrower needs to be done properly through scrutiny of his antecedents. ability to absorb unanticipated financial costs need to be looked into. experience. etc. means of financing. needs to be scrutinised. the existing and perceived competition in the segment. Thorough scrutiny of the financial aspects of the request needs to be carried out. competence. Apart from ascertaining the need based character of the limits requested for. 1. financial projections etc 3. the financial health of the proponents. Ascertaining the need based character of the limits would include scrutiny of the cost of the project.
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 Shareholder’s 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 Page 8 .
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 Firm’s ability to manage its inventory To convert debtor’s into cash in the shortest time Net sales Total assets Higher indicates over trading and lower shows idle capacity Inventory turnover ratio Debtor’s 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 shareholder’s equity Net profit after tax Net worth Higher ratio shows better cash generation Page 9 .
Borrowers operate in a dynamic environment. The recent era of volatile social. 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. and economic change across the globe is only one example of the unpredictable forces at work. Therefore it is always easier and safer to fund a known customer. the credit ratings given to the firm and also thorough verification regarding the firm’s implementation of the project. Information about the banking conducts of the customer. not only the firm’s financials are to be analyzed but there should also be a bird’s view on the firm’s industry.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. 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. which is any Credit appraisal is not simply a quantitative exercise of “numbers crunching”. Therefore. political.Also it should be kept in mind that to allot the credit to an enterprise. a sound credit rating system requires an analysis of broader credit risk management issues as well. and their ability to repay is rarely the result of static conditions reflected in periodic financial statements. The amount churned by the current account. The comfort time move than a new customer. Page 10 .