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BACK TO BASICS

TERM LOAN
WRITTEN BY:

SANTOSH KUMAR PANDEY


CHIEF MANAGER & FACULTY (CR)
State Bank Academy, Gurgaon

BACK TO BASICS : TERM LOAN


FOREWORD
It gives me great pleasure to release this booklet titled Back to Basics on
Term Loan.
The Indian Economy is going through a metamorphosis. In order to
sustain 9-10% growth consistently over the next 20-25 years, it is
imperative that production capacity has to be enhanced for increasing
manufacturing value of GDP. It is in this context that term loan is important
as they constitute long term debt which results in creation of capital goods
and thereby adds to the manufacturing capacity of the economy.
Thus it is important that our Officials understand the fundamentals of
appraising a term loan proposal in order to book good business and
maintain asset quality. This back to basics is an endeavor towards this
purpose to improve the knowledge, understanding and skills while
handling term loan proposals.
It has been our experience during various training programmes that there
exist skill deficits for term loan appraisal. Term loan, being in the nature of
long term debt needs proper handling because the pro-rata risks involved
are greater compared to short term working capital finance. The appraisal
methods adopted in our Bank are lucid and time tested and following the
same shall help the credit officers in accurately appraising the viability of
any term loan project. This is precisely the objective of this back to basics
booklet which has been presented in simple language without any jargons
for better understanding of the issues concerned. For elucidating the
concepts, simple numerical examples have also been worked out at the
relevant place.
This booklet has been written by Shri Santosh Kumar Pandey, CM &
Faculty and edited by Shri D.K.Verma, DGM & Senior Faculty (Credit

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&IB). I appreciate their efforts in delivering a good and simple product on
an important issue. We would also welcome any suggestions and
feedback from the readers which shall enable us to further enrich the
quality of our publications in future.
N.K.Gupta

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INDEX
CHAPTER I

INTRODUCTION

Page 2

CHAPTER II

APPRAISAL OF TERM LOANS:

Page 5

TECHNICAL VIABILITY
ECONOMIC VIABILITY
FINANCIAL VIABLITY

CHAPTER III

APPRAISAL OF TERM LOANS


COMMERCIAL VIABILITY

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CHAPTER I
INTRODUCTION
Definition: Term loan is defined as an advance which is granted for the
acquisition of fixed assets for a predetermined term of not less than 3 years.
Working Capital Advances vs. Term Loans: Along with Working Capital
Facility, Term Loan is one of the most important forms of credit facility
required by Borrowing Companies. Whereas working capital is a short term
facility utilized for carrying of short term current assets, term loan on the other
hand is a long term facility utilized basically for creation of long term assets
particularly fixed assets.
The differences between a working capital and a term loan facility are as
follows:
WORKING CAPITAL

TERM LOAN

Funds are utilized ( i.e end use of

Funds are utilized (i.e end use of

funds) for investments in current

funds) for investments in fixed

assets and operating cycle.

assets.

Is a short term credit facility.

Is a long term credit facility.

Is repayable on demand.

It has repayment tenure.

Is sanctioned generally for a period of

It has a repayment tenure generally

1 year subject to renewal / review

of more than 3 year to 8 years

thereafter.
Working capital advances are

Is supposed to be liquidated out of

supposed to be liquidated out of the

cash accruals.

sale proceeds generated from


amortization of Current Assets.
Primary Security consists of stocks,

Primary Security consists of fixed

bills, advance payments and other

assets / capital goods.

chargeable current assets which are


readily salable.
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Purpose of a Term Loan: A term loan is utilized basically for the following
purposes:
1) Acquisition of fixed assets like land & buildings, plant & machinery etc.
2) Modernization / Renovation / expansion / diversification of an existing unit.
3) Strengthening the Net Working Capital.
4) Purchase of Balancing Equipments.
5) Purchase of second hand machinery.
6) Replacement of high cost debts. (for the residual period only)
7) Funding various long term expenses like VRS, R&D etc.
VARIOUS TYPES OF TERM LOAN FACILITIES

: The term loan facility

can be a fund based or non fund based facility. In a fund based facility the
funds are parted with immediately and the term loan is directly utilized for
purchase / investments in fixed assets. The non fund based term loans are in
the form of Deferred Payment Guarantees (DPG) used for acquisition of fixed
assets. In DPGs, the payment liability crystallizes only after the presentation
of the bills under such guarantees.
LOAN POLICY GUIDELINES APPLICABLE TO TERMS LOANS: are as
follows:
1. Maturity of Banks Advances: The maturity of any term loan
including moratorium should not normally exceed 8 years, except
cases under CDR mechanism / Rehabilitation packages approved
by the Bank, Infrastructure Loans, Housing Term Loans to
individuals, Education loans and Agricultural Term Loans under
approved schemes.
2. In case the maturity exceeds 8 years, the loan should be
administratively cleared by the appropriate authority.
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3. Term loans which are irregular shall have to be reviewed once in 6
months.
4. Term loans with residual maturity of over 3 years should not in
aggregate exceed 35% of the total advances in SBI.
5. The Bank shall endeavor to restrict the term loan exposure to
infrastructure projects to 15% of the Banks total advances.
6. Credit Appraisal Standards are as follows:

FINANCIAL PARAMETER

BENCHMARK

NET DSCR

Not to be normally below 2:1

GROSS DSCR

Not to be normally below 1.75 : 1

MARGIN

This would depend on the Debt / Equity


gearing for the project. To be maximum
2:1

PROMOTERS CONTRIBUTION

To be at least 30% for manufacturing

TO EQUITY

and
20% for trading Companies (However
this is not a definitive benchmark.

Technical Feasibility & Economic

To be vetted by the Bank, if required

Viability.

second opinion of TCC / Consultants of


the Bank / SBI Caps may be sought.

While the benchmarks should generally be followed, any deviation from


these appraisal standards is considered to be a Minor Deviation and this
deviation needs to be approved by the sanctioning authority on the basis
of specific justifications and recommendations given by the appraising &
assessing Officers. Needless to add, deviations are permitted very
selectively only upon appropriate justification where the creditworthiness
of the promoter(s) is beyond doubt and the project is considered to be
sound and feasible.

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CHAPTER II

APPRAISAL OF TERM LOANS


The purpose of term loan appraisal is to ascertain whether the project is
sound technically, economically, financially and managerially and is
ultimately viable as a commercial proposition.
Term loans are long term credit facilities and therefore the risk associated
with term loan exposures is more. Thus the approach towards appraisal of
term loans has to be more rigorous and comprehensive in order to establish
and satisfy that the project is sound and is commercially viable. The various
parameters upon which the viability of term loan project is judged are as
follows:
1. Pre-Sanction due diligence (Prima-facie acceptability):

Who is the man behind the project i.e the main promoter? What is his
track record both financial as well as business track record? Does he
have adequate proficiency, experience and managerial ability in the
proposed business activity?

Establish the KYC of the proprietor, partner (s), director (s), Company
etc. as per the KYC guidelines of the Bank.

Judge the credit worthiness of the promoters and guarantors.

Prepare the Opinion reports on the promoter (s). While preparing the
opinion reports, the details of properties should be specific: in case of
immovable property: - Khata No, Plot No, Area, Location, Value should
be mentioned. In case of marketable securities: FD No, LIC No, Mutual
Fund No, Face Value, Maturity Value, Interest Rate etc. must be
furnished.

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The extant guidelines on preparation of opinion reports state that: As


far as possible, written statements of properties should be taken from
the borrowers/guarantors duly backed by documentary evidence (eg
Xerox copies of title deeds / investment duly verified from the
originals). In order to impart reliability to the details of personal assets,
branches should obtain statement of assets and liabilities as a
notarized affidavit from the borrowers/guarantors, whose personal
guarantees form part of terms of sanction, in case of the following
types of loans.

New loans

For all loans rated SB4(old) /


SB9 (new) and below

Existing loans - renewal/ enhancement

For all loans rated SB4 (old) /


SB9 (new) and below

Existing loans - rehabilitation/

In all cases

restructuring

Adherence to Exposure norms ( prudential, substantial, industry & group)

Refer to caution lists, RBI suit filed accounts, RBI Defaulters list, CIBIL,
ECGC caution list to ensure that the promoter / Company is not a
defaulter borrower.

See the memorandum & articles of association examine the object


clause and the borrowing powers of the Company. Conduct due diligence
by carrying out a search of the books maintained at ROC: (a) charges
register - to know about the status of any earlier / existing charge. (b)
Register of resolutions to know about the various activities indulged into
by the Company & (c) register of Corporate Guarantees to ascertain the
status of any corporate guarantees provided by the Company and the
financial effect of such corporate guarantees on the TNW of the said
Company.

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Ensure adherence to various guideline of RBI and the regulatory norms of


the Government.
Detailed Appraisal:
The detailed appraisal has to be carried out under the following sub-heads
to judge the overall viability of the proposal:

Technical Feasibility

To ensure that adequate technology


has been adopted for the project

Does the project involve proven technology or is the technology new


and untested?

If the technology is new, a detailed feasibility report to be obtained


from technical experts / technical cells at district industries centers
(DIC) / outside agencies like SBI Caps / PECC situated at LHOs /
Project Uptech reports / TEV studies by professionals / National
Physical Laboratory / CSIR etc.

Is the plant size optimal for generating economies of scale?

Does the project have advantage in terms of its location: (a) availability
of infrastructure like power, water, roads, ports, rail-heads etc. (b)
distance of the plant from the sources of raw materials.

Adherence

to

environmental

and

regulatory

guidelines:

Environmental issues have currently gained much importance. The


CRA2007 model of the Bank (as per its latest amendments) takes the
environment issue extremely seriously stating that non adherence to
environment guidelines i.e a score of 0 under this parameter shall
constitute an entry barrier for the credit exposure. Thus the project
should conform to the pollution control norms, have proper effluent
disposal systems etc.

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Assessment of the requirements of various factors of production i.e


availability of manpower, both skilled and un-skilled labour should not
be a bottleneck.

Thus technical feasibility is an omnibus study of the availability, cost,


quality, quantity and accessibility of all the factors required for production.

Economic Viability

To examine that the economic environment,


the regulatory norms and the market
dynamics are suitable for the project.

The viability of any term loan proposal depends upon ability of the
enterprise to generate stable cash flows. Cash flows in turn depend
upon the capability of the Company to sell its products in the market.

Economic viability consists of :


1. What is the demand of products manufactured by the Company
in the market i.e forecasting of demand 7 overall market
potential?
2. What is the supply position of these products?
3. How

many

Companies

producing

identical

product

are

functional in the market domain i.e what the degree of


competition is?
4. What are the various substitutes available?
5. Validation of the demand supply gap i.e whether the market has
unsaturated demand so that the Companys products can be
absorbed?
6. What can be the potential market share of the Company?
7. What are new projects in pipeline in the area of product profile
being manufactured?
8. What are the selling arrangements?

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9. What is the pricing policy and is it optimal can the price be
sustained in the market.
Thus economic viability establishes and validates the relationship
between the earning capacity of the project and the volume of sales
that can be achieved. All the sale projections must be critically
validated in light of the economic viability parameters to ensure that
over-ambitious projects / optimistic sale projections are not
accepted by the credit officer. The sale projections must be
subjected to inter firm and intra firm comparisons to establish
their credibility.

Financial Feasibility

To validate the acceptability of the cost


estimates, validate the Cost of Project &
Means of Finance and examine the
soundness of the capital structure.

The cost estimates have to be scrutinized to determine their


acceptability and accuracy. This can be done through (a) obtaining
competitive quotations (b) inter firm comparison (c) intra-firm
comparison. The costing has to realistic as per the current pricing
trends and there should no padding of expenditure.
Items of Project Cost
SL
NO.
1.

ITEM.
Land & Buildings.

a) Cost of Land.
b) Cost of Land Development & leveling.
c) Cost of erection and civil construction.
The evaluator should convince himself that

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the cost of land is equivalent to the current
prices prevailing in that area. Further specific
issues to be examined are:
a) Suitability of land for the project.
b) Availability of infrastructure facilities
like power, roads, railways etc. in
proximity.
c) Whether sufficient elbow room exists
for future expansion / diversification.
d) Title of land to be clear and there
should be no clauses which may be
detrimental to Banks interests.
e) In case of leasehold land, the lease
period should be sufficiently long i.e at
least longer than the repayment period
of Banks loan.
2.

Plant
Machinery

and The reasonableness of the cost estimates


should be cross checked by competitive
quotations and independent verifications from
reputed manufacturers.
The credibility, experience and standing of
machinery suppliers have to be examined.
The prices quoted in the respective supply
contracts have to be firm. In case price is
subject

to

escalation

clause,

adequate

contingency provision must be made in cost of


project.
3.

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Technical
Know- The costs estimates have to be crosshow, engineering &
checked from the relative contracts.
consultancy fees.
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4.

Miscellaneous
Fixed Assets

These may include furniture & fixtures,


electrical

fittings,

laboratory

equipments,

effluent disposal systems, office equipments


etc.
5.

Preliminary & Pre- Preliminary expenses are expenses incurred


operative Expenses
from the date of conception to the date of
incorporation of the Company.
a) Expenses incurred in registration with
ROC, preparing project reports, M&A of
association, consultancy fees etc.
b) Capital

raising

costs,

underwriting,

brokerage & commissions.


Pre-operative expenses are expenses made
from the date of incorporation to the date of
Commercial production:
c) Interest on Term Loan.
d) Insurance & Freight.
e) Day to day administrative costs.
f) Expenses towards trial run.
The preliminary & pre-operative expenses are
capitalized and thereafter when the company
comes into commercial production, they are
written off / amortized over a period of time.
6.

Provision
contingencies.

for This has to be made to take care of cost


escalations, fluctuations of foreign exchange,
unforeseen expenses and to meet any cost
over-runs

due

to

delays

in

project

implementation.
Although no standard norm can be set for
contingencies, the accepted practice is to
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keep

10-15%

of

the

project

cost

as

contingency requirements.

7.

Margin for Working Company has to finance a part of its Current


Capital.
Assets through long term sources. Moreover it
has to keep cash margins on any LC/ BG /
DPG issued in its favor. Generally margin
requirements for W/C for the first full year of
commercial production are taken in total
project cost.

Items of Means of Finance


The project can be funded by a combination of debt and equity. The
optimal ratio between debt and equity depends upon many variable
factors and differs from project to project:
1) Cost: Debt is considered to be cheaper than Equity. Equity is
considered to be the costliest form of funds, reason being that
whereas interest cost of debt is tax deductible, payment of
dividends is not tax deductible. Moreover, equity being in the nature
of risk capital demands a higher pricing / opportunity cost.
Moreover raising equity involves substantial capital raising costs,
underwriting & brokerage commissions.
2) Risk: Debt is considered to be more risky than equity. The reason
being that irrespective of whether the Company posts profit or loss,
the interest cost of debt has to be serviced. However, in case of
equity, dividends may not be paid if the Company incurs a loss.

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While determining debt-equity gearing, the Banks loan policy guideline of
2:1 should be kept as the benchmark, although in projects of high capital
intensity / infrastructure projects this gearing may be on the higher side.
The various means of finance are as follows:
Sl NO.
1

ITEMS
EQUITY

a) Share Capital: It represents equity


shares and preference shares brought
into

the

capital

Company.

While

structure

of

examining

the
this

source, care should be taken of the


loan

policy

guidelines

regarding

promoters contribution to equity: 30%


in manufacturing & 20% in trading
concerns.
b) Internal Cash Accruals: Can be utilized
for

funding

projects

for

existing

Companies. However, while utilizing


this source, it should be ensured that
the NWC, Current Ratio & liquidity
position of the Company is not allowed
to deteriorate.
c) Miscellaneous:

Sometimes

the

Government or other statutory bodies


provide long term seed money /
subsidies which are in the nature of
equity.
2.

DEBT.

a) Debentures: Are interest bearing debt


instruments.

The

matters

to

be

examined are: inertest rate at which


debentures have been raised, what
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has been the security offered to secure
the debentures and the redemption
period.
b) Term Loans from financial institutions.
c) Deferred Payment Facilities.
d) Unsecured Loans
e) Public Deposits
f) Lease Finance.
The above means are not exhaustive. Companies are also raising funds
with many innovative hybrid instruments which have the characteristics of
debt and equity e.g mezzanine capital, venture capital, private equity etc.
Thus financial feasibility aims to:

To determine the accuracy of cost estimates, suitability of the


envisaged pattern of financing and soundness of the capital
structure.

Estimated project cost is reasonable and complete and has a fair


chance of materializing.

Financial arrangements are complete (financial closure) without any


gaps and cash is available as and when needed for incurring
expenses.

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CHAPTER III
COMMERCIAL

To determine the Cost of production,

VIABILITY

profitability, cash flows and the repayment


capacity of the Company.

Appraising Commercial Viability is the heart of any term loan appraisal. In


a snapshot, commercial viability refers to the process of examining
whether the cost and profitability estimates are reasonable and whether
the cash accruals to be generated by project shall be sufficient to ensure
comfortable servicing of the loan along with interest.
The various tools used in appraising commercial viability are as follows:
Debt Service Coverage Ratio (DSCR):
DSCR analysis is termed as the core test of term loan appraisal and it
examines the ability of the project to repay back the debt. This ratio
answers the most important question asked by the Banker while
appraising a term loan proposal: Whether the servicing capability of the
borrower in making repayment of the term loan principal obligations along
with the interest component is comfortable or not? The DSCR analysis
measures the following crucial aspects of a term loan proposal:
1) What is the extent of cash accruals available to the Company to
cover the maturing term loan obligations during the year? Thus
DCSR establishes the relationship between the cash accruals
and the maturing term loan repayments during that year.
2) DSCR answers the question what should be the repayment
schedule of the term loan? This is done by linking the annual
repayments to the size of annual cash flows.

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3) DSCR analysis provides a tool to the credit officer to establish /
judge about what should be the comfortable relationship among
(a) profitability (b) repayment period and (c) quantum of the
loan.
We employ the following two DSCR ratios for arriving at the Commercial
viability:
1) NET DSCR =

CASH ACCRUALS

--------------------------------------------------------------ANNUAL REPAYMENT OBLIGATIONS

CASH ACCRUALS = PAT + DEPRECIATION + AMORTIZATION

Cash Accruals consist of profit after tax plus all non cash
expenses like depreciation and amortizations eg write off of
preliminary & preoperative expenses.

Maturing term loan obligations may include: Instalments of


Term Loan, DPG, Unsecured Loans, and Public Deposits etc.

The loan policy guidelines set the benchmark of Net DSCR at


2:1. This means that for reasons of safety, the cash accruals
must at least twice of the maturing term loan repayment
obligations.

The Banker would preferably wish that the Company maintains a


uniform Net DSCR of 2:1 or above throughout the repayment period.
However the same may not be possible as Cash Flows are subject to
fluctuations and accordingly Net DSCR would also fluctuate during the
repayment period. In this case it is better to judge the proposal by

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calculating the Average Net DSCR of the Project for the entire
repayment period.

A
B

Year
Cash
Accruals
Annual
Repayment
Net DSCR
(A/B)

1
100

2
125

3
150

4
180

5
200

TOTAL
755

75

75

75

75

75

375

1.33:1 1.66:1

2:1

2.40:1 2.66:1

2.01:1

In the initial 2 years of operation, the Net DSCR is less than 2:1.
However, when you compare the trend, it is improving over the years.
Moreover, the Average Net DSCR of the Project is 2.01, which is
acceptable as per the benchmarks set up in the loan policy guidelines.
In this case please note that the Average Net DSCR of the project is
not the arithmetical average for the 5 years Net DSCR, but it has been
calculated by taking the summation of cash accruals to the
summations of annual repayment obligations spread over the 5 years
in consideration.
These are the following risk categorizations adopted for judging the
efficacy of Net DSCR:

MORE THAN 2:1

SURPLUS SERVICING CUSHION AVAILABLE **

2:1

IDEAL

1.75 2:1

MODERATE RISK RANGE

LES THAN 1.75

HIGH RISK

** In this case the credit officer has the option of accelerating the term
loan repayment schedule since surplus servicing cushion is available.

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2) GROSS DSCR = CASH ACCURALS +INTEREST ON TERM LOAN


-----------------------------------------------------------------------ANNUAL REAPYMENT OBLIGATIONS+INTEREST ON TERM LOAN
Thus while calculating Gross DSCR, we are adding the interest
component of term loan to both the numerator and denominator in the
formula of Net DSCR. Gross DSCR in comparison to Net DSCR, takes
the term loan interest component both as an accrual (by adding the
same in the numerator) and as a repayment obligation (by adding in
the denominator).
The loan policy guidelines set the benchmark of Gross DSCR at
1.75:1.
Once again, the Banker would preferably wish that the Company
maintains a uniform Gross DSCR of 1.75:1 or above throughout the
repayment period. However the same may not be possible as Cash
Flows are subject to fluctuations and accordingly Gross DSCR would
also fluctuate during the repayment period. In this case it is better to
judge the proposal by calculating the Average Gross DSCR of the
Project for the entire repayment period.

A
B
C
D
E
F

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Year
Cash Accruals
Interest On T/L
A+B
Annual
Repayment
Interest On T/L
C+D
Gross DSCR
(C/F)

1
100
41
141
75

2
125
32
157
75

3
150
23
173
75

4
180
14
194
75

5
200
9
209
75

TOTAL
755
119
874
375

41
116
1.22

32
107
1.47

23
98
1.77

14
89
2.18

9
84
2.49

119
494
1.77

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If we observe here also, in the initial 2 years of operation, the Gross
DSCR is less than 1.75:1. However, when you compare the trend, it is
improving over the years. Moreover, the Average Gross DSCR for the
Project is 1.77:1, which is acceptable as per the loan policy guidelines.
In this case please note that the Average Gross DSCR is not the
arithmetical average for the 5 years Gross DSCR, but it has been
calculated by taking the summation of cash accruals + interest on term
loan to the summations of annual repayment obligations + interest on
term loan spread over the 5 years in consideration.
SECURITY MARGIN COVERAGE RATIO
SECURITY MARGIN COVERAGE RATIO = WDV OF FIXED ASSETS-TL DUES
WDV OF FIXED ASSETS

This important ratio reflects the relationship between the outstanding


balances in the term loan account to the written down value of fixed
assets which have been financed by the Bank. The importance of this
ratio is that the depreciated value of fixed assets (which constitutes the
primary security charged to the Bank) should never fall down the below
the term loan outstanding in the account. The underlying rational is that
Banks term loan outstanding should remain fully secured by the value
of primary security (depreciated book value of fixed assets) at any
point of time so that in the event of default the full amount may be
recovered by disposal of the fixed assets.
Assumption: Amt of term loan sanctioned = Rs 1000=00
Margin = 30%
Repayment = Rs 140/= per year in 5 years.
Depreciation = 20% WDV
YEAR
0
1
2
3
4
WDV of fixed
1000
800
640
512
410
assets
Term Loan
700
560
420
280
140
Outstanding
SMCR
30%
30%
34%
45%
66%
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BACK TO BASICS : TERM LOAN

The observations are:

As the Term loan is repaid, the SMCR keeps on improving i.e


the

pro-rata

margin

contribution

of

the

Company

is

strengthening.

The SMCR is 30% or more throughout the repayment schedule


i.e the sanctioned margin has been protected through-out / has
not been diluted.

If the SMCR deteriorates below 30% in any of the years, it


would reflect that repayment schedule has not been adhered to
and a default has been committed by the borrower. In this case
the credit officer has to take pro-active action in order to
maintain asset quality:
1. If the cash accruals have fallen below projections than
the term loan has to be re-phased / re-scheduled
provided the project is still viable i.e the credit officer has
to attempt re-structuring of the account.
2. Examine the reasons of default, recognize the early
warning signals and take mitigating measures to
maintain health of the account.

BREAK-EVEN ANALYSIS (BEP)


The next important tool of judging commercial viability is breakeven
analysis. Break even point is defined to be that level of production &
sales where the Company encounters a no profit / no loss situation.
BEP thus represents that particular level of production where the total
manufacturing costs is equal to sales revenue. Mathematically:
BEP = FC / C (FC = fixed costs, C=contribution)

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STATE BANK ACADEMY, GURGAON

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The graphical representation of BEP is produced below. The point at
which neither profit nor loss is made is known as the "break-even point"
and is represented on the chart below by the intersection of the two lines
A and C.

OB = Fixed Costs
BC = Variable Costs
OA = Sales Volume
P = BEP. Here Sales Volume = Fixed Costs + Variable Costs
Before P, THE Company is incurring losses.
At P, The Company operates on no profit no loss basis.
After P, The Company starts having profits.

Thus when we talk of break-even, the first task is to classify all the
costs / expenses as fixed costs and variable costs.

24 | P a g e

STATE BANK ACADEMY, GURGAON

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Fixed Costs: Are those expenses which are independent of the level
of production /sales. These expenses have to be incurred by the
Company irrespective of the fact whether production takes place or
not.
Semi Fixed Costs: Are those costs which remain fixed upto a certain
level of production and thereupon when the production crosses the
benchmark these costs become variable in nature.
Variable Costs : Are those expenses which vary according to the level
of production and sales. As the production and sales increase, the
variable costs also go up.
Variable Costs

Fixed Costs & Semi


Fixed Costs

Contribution =

Raw Material Cost, Packing Materials, Power &


Fuel, Factory Labor, Manufacturing Expenses,
Costs towards consumable stores & spares,
Repairs & Maintenance
A small percentage of : (power & fuel, wages &
salaries, factory overheads), Depreciation, Interest
on Term Loan, Administrative Expenses
Sales Variable costs

Break Even Point = Fixed & Semi Fixed Costs


----------------------------------- x 100
Contribution

Break Even Sales =

Fixed & Semi Fixed Costs


-----------------------------------xSalesX100
Contribution

Break Even at =

Fixed & Semi Fixed Costs

Installed Capacity----------------------------------xCapacity Utilization x100


Contribution
25 | P a g e

STATE BANK ACADEMY, GURGAON

BACK TO BASICS : TERM LOAN

Cash Break Even at =

Fixed & Semi Fixed Costs - Depreciation

Installed Capacity ----------------------------------- x Capacity Utilization %


Contribution

The break even point should be calculated for 2 years: (a) First full
year of commercial production (b) Year of maximum capacity
utilization. There cannot be a uniform prescription for an ideal
breakeven point and every project shall have its own unique
breakeven depending upon multiple variables like plant efficiency
and stabilizations of various inputs. However the general dictum is
lower the breakeven point, higher the profitability of the
project leading to better viability. The risk categorizations in
terms of break even at installed capacity are as follows:

Break even at installed capacity


51-65 %
65 70%
71 85%
More than 85%

Risk Range
Low Risk
Medium Risk
High Risk
Very high risk range

Thus as a corollary lower the BEP, higher the Margin of Safety.


Margin of Safety is the cushion available to the project before it
starts defaulting on its repayment commitments.
Suppose BEP = 40%
Then Margin of Safety = 60%.
Thus a good project should have a low BEP and a high Margin of
Safety.

26 | P a g e

STATE BANK ACADEMY, GURGAON

BACK TO BASICS : TERM LOAN

BREAK-EVEN ANALYSIS - An illustration

Installed capacity (per annum) (IC)


Production per annum
Capacity utilization

10000 Nos.
7000 Nos.

(CU)

70%

We assume a sale price of Re 1/= per unit of production.


A

Sales Volume

Variable Expenses
Raw Materials
Packing Materials
Consumable Stores
Power & Fuel
Repairs & Maintenance
Distribution Expenses
Interest on Working
Capital
Contribution
Fixed and semi-fixed
expenses
Wages & Salaries
Factory overheads
Depreciation
Sale Expenses
Interest on term loans
and deferred payment
credits
Administrative Expenses
Royalty and know how
Operating Profit

C
D

7000=00

4000
200
300
150
120
100
150

5020=00

A-B

1980 (C )

200
100
200
250
300

250
50
C-D

Break Even Sales = (FC /C) X Sales = (1350/1980)X7000=4772


Therefore margin of safety for sales = 7000-4772=2228

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1350 (FC)
630

STATE BANK ACADEMY, GURGAON

BACK TO BASICS : TERM LOAN

Break Even at Installed Capacity = (FC/C)XCU =


(1350/1980)X70 =

47.72%

Therefore margin of safety for breakeven at installed capacity =


100 47.72 = 52.28%
In case of this project as the break even at installed capacity is
47.72% (i.e below 50%), it is in low risk zone.

Cash Break Even at Installed Capacity=(FC- Depreciation)/C)XCU

(1350-200/1980)X70 =

28 | P a g e

40.65%

STATE BANK ACADEMY, GURGAON

BACK TO BASICS : TERM LOAN


SENSTIVITY ANALYSIS

While appraising a term loan proposal and taking a credit decision,


judgment of commercial viability and satisfactory repayment
capacity is based upon a set of projections & assumptions.
Profit

Sales Volume - Expenses / Costs

This relation between CPV (sensitivity analysis is also called CPVcost, volume, price analysis) is subject to many uncertainties which
can adversely affect cash flows. For e.g suppose Sales falls by
10% (say) with the Cost remaining the same, the profitability and
consequently the cash accruals also fall having the debilitating
effect on the DSCR. Similarly if the Costs increase by 10% (say)
with sales volume remaining constant, the situation becomes
critical i.e profits, cash accruals & DSCR are affected adversely.
Thus, sensitivity analysis allows the Banker to judge the resilience
of the project to adverse variations in costs and sales. It tells the
analysts: what is the cushion of profits available to the Company to
service its debts if the projected / assumed financial results fall
short of expectations owing to any uncertainties arising in future.
In a nutshell sensitivity analysis is done to discern whether the
project can survive the effect of any unfavorable changes in
profitability, and if so, how much.
Sensitivity analysis is done by decreasing price or by increasing
costs in the range of 5% - 15%. Inevitably this leads to stress on
profitability. DSCR and Breakeven is than calculated under these
stressful conditions to judge the tolerance & sustainability of the
project.

29 | P a g e

STATE BANK ACADEMY, GURGAON

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10% increase
in Variable
Costs
A
B
A-B
C
A-B-C

10%
decrease
in Volume
of sales

10%
decrease
in selling
price

Sales
Variable Exp
Contribution
Fixed Exp
Operating Profit
Break Even Sales
BEP
PAT
Cash Accrual
Repayment
Obligation
DSCR

The risk range i.e the span of resilience in sensitivity is categorized


as follows:

Project can sustain an adverse change


of 15% in the three variables
Project can sustain an adverse change
of 10% in the three variables
Project cannot sustain an adverse
change of 5% in the three variables

Span of resilience
High
Medium
Low

A high span of resilience provides more comfort to the Banker in


sanctioning the loan as it reflects that the project has the capacity to
overcome adverse impact on its financial results.

FUNDS FLOW STATEMENT (FFS)


Funds flow statement details the sources and the uses of funds
between two balance sheet dates. The funds flow statement should
be examined carefully for optimal deployment of both long term &
short term funds.
30 | P a g e

STATE BANK ACADEMY, GURGAON

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On the long term side of the FFS it has to be ensured that the
deployment of funds is consistent with the funding pattern of the
project and the capital assets required as envisaged in the cost of
the project have been created. Moreover, it has to be ensured that
all the fund outflows required for expenditure on fixed assets, taxes,
dividends, interest payments & repayment obligations have been
fully provided for. The cash generation must be sufficient to meet all
these essential funding commitments during currency of the
repayment period of the term loan.
On the short term side of the FFS, the projected increase in
sources (bank borrowings, other current liabilities etc) should be
matched by commensurate increase in current assets (inventories,
debtors, advance payments etc). This build up of current assets
should be adequate to sustain the operating cycle in order to
achieve the projected sales turnover. Moreover the CA build up
should also be commensurate with the projected inventory holding
patterns.
The credit officer must critically examine the FFS to establish the
following:

Internal Cash Accruals are sufficient to meet the requirements for


addition to fixed assets during the period of Banks loan.

Adequate long term surpluses are available during the currency of


the loan to meet the margin requirements (NWC) for the working
capital facilities.

To ensure that liquidity is satisfactory and there has been no


diversion of funds from short term sources for long term uses.

31 | P a g e

STATE BANK ACADEMY, GURGAON

BACK TO BASICS : TERM LOAN


Evaluation of Return on Capital Invested.
Any investor will invest capital only when he is assured of a return
which is greater than the cost of funds so that after servicing the
cost of capital he is left with a return from the project which is
comparable / or more than the returns he would obtain from
alternative investments. There are three methods in vogue for
evaluating the returns from a project:
1. Pay Back Period Method
2. Net Present Value Method
3. Internal Rate of Return Method.
Pay Back Period Method
This method tells us the period in which the original investment
made by the promoter shall be recovered.

Year

Cash

Cash

Cumulative

Cumulative Cash

Outflow

Inflow

cash inflow

Outflow

-500

-500

150

-500

150

200

-500

350

200

-500

550

The promoter invests Rs 500/= in setting up the project. This initial


investment is fully recovered from the cash inflows in the 4th year of
operations.
Net Present Value Method
The Net Present Value method is based upon the concept of
discounting of future cash flow to present value. In the above
32 | P a g e

STATE BANK ACADEMY, GURGAON

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example of pay back period method, Rs 200/= was the cash
generation in the 4

th

year of operations. As a promoter, I am

interested in the value of this Rs 200/= as of today (time value of


money) so that I can compare it with the investment that has been
made in the project.
Assumptions: Initial Investment = Rs 500/=
Minimum Rate of return desired by the promoter = 15%

Year

Cash

Cash

Discount

Outflow

Inflow

Factor @

Present Value

NPV

15% **
1

-500

1.000

-500

-500

150

0.870

(0.870x150)= 131

-369

200

0.756

(0.756 x 200)= 151

-218

200

0.658

(0.658x200)= 132

-86

250

0.572

(0.572x250)=143

+57

** The discount tables at various interest rates are given in text books.
Thus we observe in the NPV method, that the original investment is
recovered only in the 5

th

year of operation rather than the 4

th

year

in the Pay back period method. Moreover, when we have to


evaluate two projects, NPV of both the projects is calculated and
the project giving the higher return is preferred.
Internal Rate of Return Method
Internal Rate of Return (IRR) : It is the rate at which the sum of the
discounted cash flows is equal to the investment outlay. It gives an
idea about the rate of return that a project is likely to earn over its
useful life.
33 | P a g e

STATE BANK ACADEMY, GURGAON

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IRR

Lower Discount Rate


Difference between the two discount rates

(+)
(x)

NPV @ lower discount rate


Absolute difference between the NPV of the two
discount rates

Thus IRR is the rate at which the sum of discounted cash flows
(both inflows as well outflows) becomes zero. Two different rates of
returns (one high & one low) are used and the IRR is calculated by
extrapolating the same.
The IRR is compared to the cost of capital. If the IRR is sufficiently
high i.e it is able to meet the cost of capital and thereafter provides
a return to the promoter which is comparable to the returns from
investment in alternative avenues, the project is considered to be a
paying one and can be accepted.
XXXXX

34 | P a g e

STATE BANK ACADEMY, GURGAON