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CREDIT APPRAISAL

Effectiveness of Credit Management in the bank is highlighted by the quality of its loan
portfolio. Every Bank is striving hard to ensure that its credit portfolio is healthy and that NonPerforming Assets are kept at lowest possible level, as both of these factors have direct impact on
its profitability. In the present scenario efficient project appraisal has assumed a great importance
as it can check and prevent induction of weak accounts to our loan portfolio. All possible steps
need to be taken to strengthen pre sanction appraisal as always Prevention is better than Cure.
With the opening up of the economy rapid changes are taking place in the technology and
financial sector exposing banks to greater risks, which can be broadly classified as under:

Industry Risks

Government regulations and policies, availability of infrastructure


facilities, Industry Rating, Industry Scenario & Outlook, Technology Up
gradation, availability of inputs, product obsolescence, etc.

Business Risks

Operating efficiency, competition faced from the units engaged in


similar products, demand and supply position, cost of labor, cost of raw
material and other inputs, pricing of product, surplus available,
marketing, etc.

Management Risks

Background, integrity and market standing/ reputation of promoters,


organizational set up and management hierarchy, expertise/competence
of persons holding key position in the organization, delegation and
decentralization of authority, achievement of targets, track record in
execution of project, debt repayment, industry relations etc.

Financial Risks

Financial strength/standing of the promoters, reliability and


reasonableness of projections, past financial performance, reliability of
operational data and financial ratios, adequacy of provisioning for bad
debts, qualifying remarks of auditors/inspectors etc.

In light of the foregoing risks, the banks appraisal methodology should keep pace with ever
changing economic environment. The appraisal system aims to determine the credit
needs/requirements of the borrower taking into account the financial resources of the client. The
end objective of the appraisal system is to ensure that there is no under - financing or over -

financing. Following are the aspects, which need to be scrutinized and analyzed while
appraising.
1. MARKET ANALYSIS
The market demand and potential is to be examined for each product item and its
variants/substitutes by taking into account the selling price of the products to be marketed vis-avis prices of the competing products/substitutes, discount structure, arrangement made for after
sale service, competitors' status and their level of operation with regard to production and
products and distribution channels being used etc. Critical analysis is required regarding size of
the market for the product(s) both local and export, based on the present and expected future
demand in relation to supply position of similar products and availability of the other substitutes
as also consumer preferences, practices, attitudes, requirements etc.

Further, the buy-back

arrangements under the foreign collaboration, if any, and influence of Government policies also
needs to be considered for projecting the demand. Competition from imported goods,
Government Import Policy and Import duty structure also need to be evaluated.
2. TECHNICAL ANALYSIS
In a dynamic market, the product, its variants and the product-mix proposed to be manufactured
in terms of its quality, quantity, value, application and current taste/trend requires thorough
investigation.
a. Location and Site
Based on the assessment of factors of production, markets, Govt. policies and other factors,
Location (which means the broad area) and Site (which signifies specific plot of land) selected
for the Unit with its advantages and disadvantages, if any, should be such that overall cost is
minimized. It is to be seen that site selected has adequate availability of infrastructure facilities
viz. Power, Water, Transport, Communication, state of information technology etc. and is in
agreement with the Govt. policies. The adequacy of size of land and building for carrying out its
present/proposed activity with enough scope for accommodating future expansion needs to be
judged.

b. Raw Material
The cost of essential/major raw materials and consumables required their past and future price
trends, quality/properties, their availability on a regular basis, transportation charges, Govt.
policies regarding regulation of supplies and prices require to be examined in detail. Further, cost
of indigenous and imported raw material, firm arrangements for procurement of the same etc.
need to be assessed.
c. Plant & Machinery, Plant Capacity and Manufacturing Process
The selection of Plant and Machinery proposed to be acquired whether indigenous or imported
has to be in agreement with required plant capacity, principal inputs, investment outlay and
production cost as also with the machinery and equipment already installed in an existing unit,
while for the new unit it is to be examined whether these are of proven technology as to its
performance. The technology used should be latest and cost effective enabling the unit to
compete in the market. Purchase of reconditioned/old machinery is to be dealt in terms of laid
down guidelines. Compatibility of plant and machinery, particularly, in respect of imported
technology with quality of raw material is to be kept in view. Also plant and machinery and
other equipments needed for various utility services, their supply position, specification, price
and performance as also suppliers' credentials, and in case of collaboration, collaborators' present
and future support requires critical analysis. Plant capacity and the concept of economic size has
a major bearing on the present and future plans of the entrepreneur(s) and should be related to
the availability of raw material, product demand, product price and technology.
The selected process of manufacturing indicating the adequacy, availability and suitability of
technology to be used along with plant capacity, manufacturing process needs to studied in detail
with capacities at various stages of production being such that it facilitates optimum utilization
and ensures future expansion/ debottlenecking, as and when required.

It is also to be ensured

that arrangements are made for inspection at intermediate/final stages of production for ensuring
quality of goods on successful commencement of production and completion, wherever required.

3. FINANCIAL ANALYSIS
The aspects which need to be analyzed under this head should include cost of project, means of
financing, cost of production, break-even analysis, financial statements as also profitability/funds
flow projections, financial ratios, sensitivity analysis which are discussed as under:
a. Cost of Project & Means of Financing
The major cost components of any project are land and building including transfer, registration
and development charges as also plant and machinery, equipment for auxiliary services,
including transportation, insurance, duty, clearing, loading and unloading charges etc. It also
involves consultancy and know-how expenses which are payable to foreign collaborators or
consultants who are imparting the technical know-how. Recurring annual royalty payment is not
reflected under this head but is accounted for under the profitability statements.

Further,

preliminary expenses, such as, cost of incorporation of the Company, its registration, preparation
of feasibility report, market surveys, pre-operative expenses like salary, travelling, startup
expenses, mortgage expenses incurred before commencement of commercial production also
form part of cost of project. Also included in it are capital issue expenses which can be in the
form of brokerage, commission, advertisement, printing, stationery etc. Finally, provisions for
contingencies to meet any unforeseen expenses, such as, price escalation or any other expense
which have been inadvertently omitted like margin for working capital requirements required to
complete the production cycle, interest during construction period, etc. are also part of capital
cost of project. It is to be ensured while appraising the project that cost and various estimates
given are realistic and there is no under/over estimation. Further, these cost components should
be supported by proper quotations, specifications and justifications of land, machinery and
know-how expenses etc.
Besides Banks loan, the project cost is normally financed by bringing capital by the promoters
and shareholders in the form of equity, debentures, unsecured long term loans and deposits raised
from friends and relatives which are not repayable till repayment of Bank's loan. Resources are
raised for financing project by raising term loans from Institutions/Banks which are repayable
over a period of time, deferred term credits secured from suppliers of machinery which are

repayable in installments over a period of time. The above is an illustrative list, as the promoters
have now started raising funds through Euro-issues, Foreign Currency loans, premium on capital
issues, etc. which are sometimes comparatively cheap means of finance.

Subsidies and

development loans provided by the Central/State Government in notified backward districts to


attract entrepreneurs are also means of financing a project. It is to be ascertained that requirement
of finance has been properly tied-up for unhindered implementation of a project. The financing
structure accepted must be in consonance with generally accepted levels along with adequate
Promoters' stake. The resourcefulness, willingness and capacity of promoter to contribute the
same have also to be investigated.
In case of project finance, the promoter/borrower may bring in upfront his contribution (other
than funds to be provided through internal generation) and the branches should commence its
disbursement after the stipulated funds are brought in by the promoter/borrower. A condition to
this effect should be stipulated by the sanctioning authority in case of project finance, on case to
case basis depending upon the resourcefulness and capacity of the promoter to contribute the
same. It should be ensured that at any point of time, the promoters contribution should not be
less than the proportionate share.
b. Profitability Statement
The profitability statement which is also known as `Income and Expenditure Statement' is
prepared after considering the net sales figure and details of direct costs/expenses relating to raw
material, wages, power, fuel, consumable stores/spares and other manufacturing expenses to
arrive at a figure of gross profit. Thereafter, all other expenses like salaries, office expenses,
packing, selling/distribution, interest, depreciation and any other overhead expenses and taxes
are taken into account to arrive at the figure of net profit. The projections of profit/loss are
prepared for a period covering the repayment of term loans. The economic appraisal includes
scrutinizing all the items of cost, and examining the assumptions, if any, to ensure that these are
realistic and achievable. There should not be any optimism or pessimism in working out
profitability projections since even a little change in the product-mix from non-remunerative to
remunerative or vice-versa can distort the picture. While preparing profitability projections, the

past trends of performance in an industry and other environmental factors influencing the cost
and revenue items should also be considered objectively.
Generally speaking, a unit may be considered as financially viable, progressive and efficient if it
is able to earn enough profits not only to service its debts timely but also for future
development/growth.
c. Break-Even Analysis
Analysis of break-even point of a business enterprise would help in knowing the level of output
and sales at which the business enterprise just breaks even i.e. there is neither profit nor loss. A
business earns profit if it operates at a level higher than the break-even level or break-even point.
If, on the other hand, production is below this level, the business would incur loss. The breakeven point in an algebraic equation can be put as under:
d. Break-even point

Break-even point

Total Fixed Cost / (Sales price per unit - Variable Cost per unit)

(Volume or Units)

Break-even point

(Total Fixed Cost x Sales) / (Sales - Variable Costs)

(Sales in rupees)

The fixed costs include all those costs which tend to remain the same up to a certain level of
production while variable costs are those costs which tend to change in proportion with the
volume of production. As regards unit sales price, it is generally the same for all levels of
output.
The break-even analysis can help in making vital decisions relating to fixation of selling price
make or buy decision, maximizing production of the item giving higher contribution etc. Further,
the break-even analysis can help in understanding the impact of important cost factors, such as,
power, raw material, labor, etc. and optimizing product-mix to improve project profitability.

e. Fund-Flow Statement
A fund-flow statement is often described as a Statement of Movement of Funds or where got:
where gone statement. It is derived by comparing the successive balance sheets on two specified
dates and finding out the net changes in the various items appearing in the balance sheets.
A critical analysis of the statement shows the various changes in sources and applications (uses)
of funds to ultimately give the position of net funds available with the business for repayment of
the loans. A projected Fund Flow Statement helps in answering the under mentioned points.

How much funds will be generated by internal operations/external sources?

How the funds during the period are proposed to be deployed?

Is the business likely to face liquidity problems?

f. Balance Sheet Projections


The financial appraisal also includes study of projected balance sheet which gives the position of
assets and liabilities of a unit at a particular future date. In other words, the statement helps to
analyze as to what an enterprise owns and what it owes at a particular point of time.
An appraisal of the projected balance sheet data of the unit would be concerned with whether the
projections are realistic looking to various aspects relating to the same industry.
g. Financial Ratios
While analyzing the financial aspects of project, it would be advisable to analyze the important
financial ratios over a period of time as it may tell us a lot about a unit's liquidity position,
managements' stake in the business, capacity to service the debts etc. The financial ratios which
are considered important are discussed as follows:

Ratio

Formula

Remarks
There cannot be a rigid rule to a satisfactory debtequity ratio, lower the ratio higher is the degree of
protection enjoyed by the creditors. These days the
debt equity ratio of 1.5:1 is considered reasonable.
It, however, is higher in respect of capital intensive

Debt-Equity
Ratio

projects. But it is always desirable that owners


Debt (Term Liabilities)

have a substantial stake in the project.

Other

features like quality of management should be kept

Equity

in view while agreeing to a less favorable ratio.


(Where, Equity = Share capital,
free reserves, premium on shares,
, etc. after adjusting loss balance)

In financing highly capital intensive projects like


infrastructure, cement, etc. the ratio could be
considered at a higher level.
This ratio of 1.5 to 2 is considered reasonable. A

Debt + Depreciation +
Net Profit (After Taxes)
Debt2

Service

+ Annual interest on long


term debt

moratorium period/repayment of loan in a shorter


schedule. This ratio provides a measure of the
ability of an enterprise to service its debts i.e.

Coverage
Ratio

very high ratio may indicate the need for lower

Annual interest on long


term debt + Repayment

`interest'

and

`principal

repayment'

besides

indicating the margin of safety. The ratio may vary


from industry to industry but has to be viewed with

of debt

circumspection when it is less than 1.5.


3

TOL / TNW Tangible Net Worth (Paid This ratio gives a view of borrower's capital
Ratio

up Capital + Reserves
and Surplus

Intangible Assets)

structure. If the ratio shows a decreasing trend, it


indicates that the borrower is relying more on his
own funds and less on outside funds and vice versa

Total outside Liabilities


(Total Liability - Net
Worth)
Operating Profit (Before
4

Profit-Sales
Ratio

Taxes excluding Income


from other Sources)
Sales

This ratio gives the margin available after meeting


cost of manufacturing. It provides a yardstick to
measure the efficiency of production and margin
on sales price i.e. the pricing structure
This ratio is of a primary importance to see how
best the assets are used. A rising trend of the ratio

Sales5

Tangible

reveals that borrower has been making efficient


Sales

Assets
Ratio

utilization of his assets. However, caution needs to


be exercised when fixed assets are old and

Total Assets - Intangible


Assets

depreciated, as in such cases the ratio tends to be


high because the value of the denominator of the
ratio is very low.
Higher the ratio greater the short term liquidity.
This ratio is indicative of short term financial
position of a business enterprise. It provides
margin as well as it is measure of the business

Current
Ratio

enterprise to pay-off the current liabilities as they


Current Assets

mature and its capacity to withstand sudden


reverses by the strength of its liquid position. Ratio

Current Liabilities

analysis gives indications; to be made with


reference to overall tendencies and parameters in
relation to the project.

Output

Sales

Investment
Ratio

This ratio is indicative of the efficiency with which


the total capital is turned over as compared to other

Total capital employed


(in fixed & current

units in similar lines.

assets)

h. Internal Rate of Return


The discount rate often used in capital budgeting that makes the net present value of all cash
flows from a particular project equal to zero. Higher a project's IRR the more desirable it is to
undertake the project. IRR should be higher than the Cost of the project. (Interest rate in case of
project financing)
4. SENSITIVITY ANALYSIS
While preparing and appraising projects certain assumptions are made in respect of certain
critical/sensitive variables like selling price/cost price per unit of production, product-mix, plant
capacity utilization, sales etc. which are assigned a `VALUE' after estimating the range of
variation of such variables. The `VALUE' so assumed and taken into consideration for arriving
at the profitability projections is the `MOST LIKELY VALUE'.

Sensitivity Analysis is a

systematic approach to reduce the uncertainties caused by such assumptions made. The
Sensitivity Analysis helps in arriving at profitability of the project wherein critical or sensitive
elements are identified which are assigned different values and the values assigned are both
optimistic and pessimistic such as increasing or reducing the sale price/sale volume, increasing
or reducing the cost of inputs etc. and then the project viability is ascertained. The critical
variables can then be thoroughly examined by generally selecting the pessimistic options so as to
make possible improvements in the project and make it operational on viable lines even in the
adverse circumstances.
5. MANAGEMENT & ORGANIZATION ANALYSIS

Appraisal of project would not be complete till it throws enough light on the person(s) behind the
project i.e. management and organization of the unit. It is seen that some projects may fail not
because these are not viable but because of the ineffectiveness of the management and the
organization in controlling various functions like production, marketing, finance, personnel, etc.
The appraisal report should highlight the strengths and weaknesses of the management by
commenting on the background, qualifications, experience, and capability of the promoter, key
management personnel, and effectiveness of the internal control systems, relation with labor,
working conditions, wage structure, and the other assigned essential functions. In case the
promoters have interest, in other concerns as Proprietor or Partner or Director, the appraisal
report should also comment on their performance in such concerns.
A business is more vulnerable if decision making in all the functional areas rests with a particular
person, in other words, `one man show'. Further, the management and the organization should be
conducive to the size and type of business. In case it is not so, it should be ensured that
professional managers are inducted to strengthen the organization.

CREDIT RISK
Credit risk means the possibility of loss associated with diminution in the credit quality of
borrowers. In a banks portfolio, losses stem from outright default due to inability or
unwillingness of a customer or counter party to meet, commitments in relation to lending,
trading, settlement and other financial transactions.
A comprehensive credit risk management system, which is in place in the bank, encompasses the
following processes:

Identification of Credit Risk

Measurement of Credit Risk

Grading of Credit Risk

Reporting and analysis of rating related data

Control of Credit Risk

CREDIT RISK IDENTIFICATION


In order to take informed credit decisions, it is necessary to identify the areas of credit risk in
each borrower as well as each industry. Risk Management Division HO, in coordination with
other HO divisions involved in disbursal of credit and also the risk management departments of
various zonal offices identifies these risks areas and develops necessary tools and processes to
measure and monitor the risk.

CREDIT RISK MEASUREMENT


In order to measure the credit risk in banks portfolio, the bank has developed the following
models:
Credit Risk Rating Model

Total limits Applicable from the Bank

Small 2 Loans

Above Rs. 20 lacs and up to Rs. 50lacs

Small Loans

Above Rs. 50 lacs and up to Rs. 5crores

Mid Corporate

Above Rs.5 crores and up to Rs. 15crores

Large Corporate

Above Rs. 15 crores

Non-Banking Financial Corporation Model

(irrespective of any limit)

New Business Model

Below Rs. 5 crores

New Project Model

Above Rs. 5 crores

The credit risk rating models have been developed with a view to provide a standard system for
assigning a credit risk rating to all the borrowers on the basis of the overall credit risk involved
in them. Inputs to the models are the financial, management, business and conduct of account,
industry information. The evaluation of a borrower is done by assessment on various
objective/subjective parameters. The model evaluates the credit risk rating of a borrower on a
scale of AAA to D with AAA indicating minimum risk and D indicating maximum risk.
The credit risk-rating models incorporate therein all possible risk factors, which are important
for determining the credit quality/ rating of a borrower. These risks could be:

Internal and specific to the company,

Associated with the industry in which the company is operating or

Associated with the entire economy and can influence the repayment capacity
and/ or willingness of the company.

Evaluation methodology under rating models


The scores are assigned to each of the parameters on a scale of 0 to 4 with 0 being very
poor and 4 being excellent. The scoring of some of these parameters is subjective while
for some others it is done on the basis of pre-defined objective criteria.
The scores given to the individual parameters multiplied by allocated weights are then
aggregated and a composite score for the company is arrived at, in percentage terms.
Higher the score obtained by a company, the better is its credit rating. Weights have been
assigned to different parameters based on their importance. Weights assigned to different
parameters have been loaded in the software. After allocating/evaluating scores to all the
parameters, the aggregate score is calculated and displayed by the software.
The overall percentage score obtained is then translated into a rating on a scale from
AAA to D according to a pre-defined range of scores.
Wherever a particular parameter is not applicable, no score should be given and the
parameter should be made Not Applicable.
For multi-divisional companies, which are involved in more than one industrial activity,
evaluation should be done separately for each business. However, the management
evaluation, conduct of account and financial evaluation will be done on a common basis.
In such cases, for the business section, each business should be evaluated and scored
separately, taking into account the different industrial activity involved.

GRADING OF BORROWERS UNDER THE RATING SYSTEM


In order to provide a standard definition and benchmarks under the credit risk rating system,
following matrix has been adopted in all the risk rating models.
For the rating purpose in Credit Appraisal, Indian Overseas Bank depends on CRISIL ratings.
A CRISIL rating reflects CRISIL's current opinion on the relative likelihood of timely payment
of interest and principal on the rated obligation. It is an unbiased, objective, and independent
opinion as to the issuer's capacity to meet its financial obligations.
So far, CRISIL has rated 30,000 debt instruments, covering the entire debt market.
The debt obligations rated by CRISIL include:

Non-convertible debentures/bonds/preference shares

Commercial papers/certificates of deposits/short-term debt

Fixed deposits

Loans

Structured debt

CRISIL Ratings' clientele includes all the industry majors - 23 of the BSE Sensex constituent
companies and 39 of the NSE Nifty constituent companies, accounting for 80 per cent of the
equity market capitalization.
CRISIL's credit ratings are;

An opinion on probability of default on the rated obligation

Forward looking

Specific to the obligation being rated

But they are not;

A comment on the issuer's general performance

An indication of the potential price of the issuers' bonds or equity shares

Indicative of the suitability of the issue to the investor

A recommendation to buy/sell/hold a particular security

A statutory or non-statutory audit of the issuer

An opinion on the associates, affiliates, or group companies, or the promoters, directors,


or officers of the issuer

CRISIL ratings are based on a robust and clearly articulated analytical framework, which ensures
comprehensiveness, standardization, comparability, and effective communication of the ratings
assigned and of every timely rating action. The assessment is based on the highest standards of
independence and analytical rigor.
CRISIL rates a wide range of entities, including:

Industrial companies

Banks

Non-banking financial companies (NBFCs)

Infrastructure entities

Microfinance institutions

Insurance companies

Mutual funds

State governments

Urban local bodies

CRISIL RATING
CRISIL AAA
(Highest Safety)

Instruments with this rating are considered to have the highest degree
of safety regarding timely servicing of financial obligations. Such
instruments carry lowest credit risk.

CRISIL AA
(High Safety)

Instruments with this rating are considered to have high degree of


safety regarding timely servicing of financial obligations. Such
instruments carry very low credit risk.

CRISIL A
(Adequate Safety)

Instruments with this rating are considered to have adequate degree of


safety regarding timely servicing of financial obligations. Such
instruments carry low credit risk.

CRISIL BBB
(Moderate Safety)

Instruments with this rating are considered to have moderate degree of


safety regarding timely servicing of financial obligations. Such
instruments carry moderate credit risk.

CRISIL BB
(Moderate Risk)

Instruments with this rating are considered to have moderate risk of


default regarding timely servicing of financial obligations.

CRISIL B
(High Risk)

Instruments with this rating are considered to have high risk of default
regarding timely servicing of financial obligations.

CRISIL C
(Very High Risk)

Instruments with this rating are considered to have very high risk of
default regarding timely servicing of financial obligations.

CRISIL D
Default

Instruments with this rating are in default or are expected to be in


default soon.