Course: Credit Management (Module III: Credit Management) NIBM, Pune

Module III: Credit Management

Chapter 2: Credit Monitoring and Early Warning Signs

Dr. M. Manickaraj

Objective:
The objective of this chapter is to make the readers understand and appreciate the
meaning and importance of credit monitoring, various tools for monitoring and to equip
them with various early warning signs and signs of fraud and what can they do to
safeguard the interests of the banks. The lesson will also make the readers to be aware
of the relevance and importance of automating credit monitoring.

Structure
1. Introduction
2. Objectives of credit monitoring
3. Instruments for credit monitoring
3.1. Stock audit
3.2. Quarterly reports
3.3. Annual reports
3.4. Annual review
3.5. Stock price movements
4. Early warning signs
4.1. Liquidity indicators
4.2. Financial indicators
4.3. Behavioural indicators
5. Signs of fraud
6. What should lenders do?
7. Automation of credit monitoring
8. Summary

1. Introduction

Credit Monitoring is an integral and an important part of credit management of banks

and lending institutions. Though loans might have been given after thorough due
diligence and credit analysis borrowers’ ability to repay loans may be influenced by
variety of factors. The factors could be both external as well as internal. It is possible
that even a best rated customer may end up with difficulty in generating sufficient cash
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Course: Credit Management (Module III: Credit Management) NIBM, Pune

flow to repay loans. Lending institutions therefore have to track the performance as
well the behaviour of borrowers in order to make sure that the loan given to them will
be repaid on time. In order to ensure this, loans should be monitored regularly using
appropriate tools and techniques. Moreover, lenders will have to look out for signs of
distress of borrowers so that timely action can be taken to avoid loans becoming non-
performing assets (NPA). Besides, borrowers may face temporary problems and lenders
may have to provide additional support.

2. Objectives of Credit Monitoring

Monitoring of the borrower accounts on an ongoing basis will facilitate foreseeing the
problems and taking corrective measures to meet the adverse impact. Effective credit
monitoring will also ensure proper usage of loan funds and reduce the loan losses which
will in turn maximize the returns to the banks.

Among others the following are the main objectives of credit monitoring:

 To check if the loans are used for the purpose for which they have been provided
 The borrowing firm’s performance is as expected and will be able to service the
loans
 The security offered for the loans are intact

If the above aspects are satisfactory the account will be regular and there will be no
concern about the asset quality. As such banks need to put in place a very sound and
effective credit monitoring system.

3. Instruments for credit monitoring

Most commonly used instruments for monitoring loans banks are as follows:

• Stock audit

• Inspection (onsite monitoring)

• Stock statement

• Quarterly reports

• Annual reports

• Annual review of loan account

• Stock price movements

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Course: Credit Management (Module III: Credit Management) NIBM, Pune

3.1 Stock Audit

Provision of working capital loan to business enterprises is a major business for

commercial banks. Inventory is one major item for which working capital is used.
Therefore, verification of stock is necessary to find out if the value of stock reflects the
loan utilised. Moreover, it will throw light on the level of activity of the borrowing firm.
It will also help find out if the firm is not able to sell the goods. Onsite as well as offsite
verification of stock can be done. Onsite verification (inspection) is nothing but visiting
the premises of the borrower firm and checking the stock and comparing it with the
stock statement submitted by the firm and also corroborating with the level of activity
in the business. Stock audit will also help verify if the borrower is maintaining a reliable
management information system and proper records are maintained.

Offsite stock verification is done by using a third party to verify and submit a statement
showing the details stock. In India, stock statements submitted periodically by
borrower firms are used for verification of stock and also to determine how much loan
should be released to the borrower. Normally, stock statements certified by an external
auditor should be submitted to banks every month or every quarter. The stock
statement will also show the details of receivables, payables and the amount of loan the
borrower is eligible. The eligible amount is called the Drawing Power. A typical stock
statement of manufacturing firms would like the table below.

Table: Stock Statement

Items Amount
Stock (A)
- Raw material
- Work in process
- Finished goods
Receivables (B)
Total current assets (A + B)
Trade credit (C )
Margin for working capital (D)
Drawing Power (A + B – C – D)

All these will ensure that the account is not misused. As the bank staff handle a larger
number of accounts there could be a tendency to ignore some of the above steps. At
times if the account is regular there could be laxity in the stock verification, both off site
and on site. This could encourage even the regular borrower to use the laxity to their
advantage. This must be avoided. Another issue is how fast the bank acts if something is
amiss or if the borrower is not regular in submitting statement or if the statement is
factually incorrect. Bank should immediately ask the borrower to set it right and ensure
the same. If the stock statement is delayed the bank should immediately get across to
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Course: Credit Management (Module III: Credit Management) NIBM, Pune

the borrower and if necessary freeze the limit. Immediate and prompt action will deter
the borrower from taking wrong steps. If the delay or defect in stock statement is
deliberate bank should treat it as an early warning. This also shows the borrowers
character in an adverse way.

3.2 Quarterly Reports

Another off site monitoring tool quarterly reports to be submitted by the borrowers.
The quarterly reports are submitted in the format prescribed by banks and are
popularly known as QIS (Quarterly Information System) reports. The quarterly reports
provide a summary of financial performance and the details of current assets of the
borrower. Certain guidelines for preparation and submission of QIS reports are as
follows:

(i) Information should be furnished for each line of activity / unit separately as
also for the company as a whole. In cases where the different activities / units
are financed by different banks, the concerned activity / unit wise data and
data relating to the company as a whole should be furnished to each financing
bank.
(ii) The valuation of current assets or current liabilities in these forms should be
on the same basis as adopted for the annual balance sheet and it should be
applied on a consistent basis.
(iii) The period should be shown in relation to the annual projection for the
relative item. If the levels of inventory / receivables are higher than the
stipulated norms, reasons therefor should be given.
(iv) If the canalized items form a significant part of raw materials inventory, these
may be shown separately.
(v) Amount of bills discounted with bankers should be indicated separately.
(vi) The classification of current assets or current liabilities should be made as
per the usually accepted approach of bankers and not as per definitions in the
Companies Act.

3.3 Annual Reports

Every business enterprise prepares its annual accounts and present the annual balance
sheet and profit and loss account to various stakeholders including the
owners/shareholders, government, lenders and the like. Public limited companies do
prepare a comprehensive annual report containing various reports including directors’
report, management discussion and analysis, report on corporate governance, auditors
report, and financial statements. These reports, if made available to lenders on time, will
provide data necessary for ascertaining the performance of the firm and to know the
repayment capacity of the firm.

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Course: Credit Management (Module III: Credit Management) NIBM, Pune

3.4 Annual Review

Every loan account will be subjected to a through and comprehensive review once every
year. The annual review is supposed to be done in a manner similar to credit analysis
and it will help the bank to evaluate the performance of the customer during the last
one year and to decide on continuing the loan relationship, credit risk rating of the firm,
revising the rate of interest, and to decide on the loan amount to be sanctioned.

3.5 Stock price movements

Companies listed in the stock exchanges are major borrowers of commercial banks. The
equity shares of listed companies are traded in the stock exchanges. The movement in
the stock prices of the companies in comparison with that of any share price index or
with that of competitor companies will provide indications regarding the performance
of the borrower company and it will also provide signals regarding the distress, if any,
in the company. Share price movements and the factors causing the movement are
monitored by a host of players including analysts, institutional investors, retail
investors, regulators, government, and so on. Therefore, stock prices can be considered
by lenders as reliable indicators of financial health of companies and also as an indicator
of early warning signal.

4. Early Warning Signs

One of the most important outcomes expected of monitoring is indications of

deterioration in the risk of loans. It would be or great use to lenders if the indicators
provide early warning signs. There are a number of early warning signals. These are
classified into

a. Liquidity indicators

b. Financial indicators

c. Behavioural indicators

4.1 Liquidity indicators

Liquidity indicators are the strongest and first apparent signs of trouble. Symptoms of
liquidity problems include:

• Increased credit enquiries about the customer from suppliers. This indicates
shortage of liquidity and that the borrower is seeking funds/goods from
many to overcome shortages.

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Course: Credit Management (Module III: Credit Management) NIBM, Pune

• Increase in the need for guarantees and LCs. This would indicate fall in the
credit worthiness of the borrower and hence the suppliers demand guarantee
from the banks.

• Return of cheques issued by the customer. This is a strong indication of

liquidity problem.

• Working capital loan limits fully utilised for extended periods without any
transactions and overdrawal from working capital loan account too
indicators of liquidity crisis of borrowers and significant rise in the credit risk
of the borrower.

• Increase in litigation against the client

• Third party claims like local bodies and tax authorities

• Delayed payment of salaries to employees

• Accelerated collection of bills by the customer or by the suppliers from the
customer

• Frequent and sudden request for enhancement of loan limits

• Breach of covenants related to working capital

• Full utilisation of loan limits inconsistent with sales

4.2 Financial Indicators

The following financial indicators too provide early warning signs of distress and can be
used by lenders for taking corrective steps:

• Working capital ratios: If current assets are more it could point excess
stock or poor collection efficiency. Similarly, a higher level of current
liabilities could show a higher credit period enjoyed or delays in settling
payables.

• Holding periods (inventory period, receivable period and payable period).

A longer holding period shows a poor turnover and hence a matter of
concern. Higher level of current assets, current liabilities and longer
operating cycle are indicators of inefficiency in operations and poor
performance. These will automatically lead to higher working capital
requirement.

• Profitability ratios and solvency ratios are good indicators of financial health and
the borrowers’ ability to service loans. However, if they can be calculated at
frequent intervals, say quarterly, they may provide early warning signs.
• Cash flow statement is a powerful tool to find out the liquidity position of
business firms.
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Course: Credit Management (Module III: Credit Management) NIBM, Pune

4.3 Behavioural Indicators

Behavioral indicators provide clues about customers’ integrity and competency.

Competence is implicit in the financial performance. Integrity is very difficult to
measure. However, there are indicators which point out to poor or doubtful integrity.
The following are indicators of borrowers’ integrity.

• Any deception, misrepresentation of facts or lie

• Delay in releasing financial statements and submission of reports/data to the

banks

• Reluctance or unwillingness to communicate

• Failure to respond to a specific question directly or entirely

• Providing evasive or unspecific information to a request

• Any indication that records have been misplaced or destroyed by the borrower

• Absence of key personnel from crucial meetings

5. Signs of Fraud

The points discussed above are indications of distress in the business and the
consequent difficulty in servicing loans by the borrower. However, there could be
borrowers who may like to defraud the lenders. The following are signs of fraud which
can be used by banks to protect their interests from such frauds.

• Sudden or rapid and significant decline in liquidity inconsistent with business

conditions or events

• Significant changes in accounting policies and methods

• Major change in accounting personnel

• Changing statutory auditors too often

• Engaging an auditing firm which doesn’t have the required skill and depth of
knowledge required for the business

• Excessive number of cheques issued to individuals other than employees

• Payroll inconsistent with the list of employees and/or volume of business

• Sale of assets without a sound business reason or at lower than fair value

• Lapping (misdirection of payments). Lapping is a fraudulent practice of

concealing theft of cash. Lapping occurs when a cashier or clerk steals cash from
one customer's payment and covers it up by stealing cash from the next

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Course: Credit Management (Module III: Credit Management) NIBM, Pune

customer's payment ... and so on. It is easier where cash handling and cash
recording duties are handled by the same person. Also called teeming and lading.
(Source: http://www.businessdictionary.com/definition/lapping.html)

• Use of shell entities to manipulate transactions

6. What Should Lenders Do?

Credit monitoring is a tool in the hands of banks. It is not an end itself. Unless the banks
take appropriate action credit monitoring will not achieve its objectives. Following is
the list of activities that bank can do enhance the effectiveness of credit monitoring.
• Know the customer – understanding customer is the first principle. Proper due
diligence before sanctioning loans will facilitate this.

• Sanctioning adequate amount and at reasonable terms is essential as failure to

do so will almost immediately result in credit quality issues ever before credit
monitoring begins.

• Bank should communicate with customers frequently. This helps bank to get
information from the customer some of which could indicate the shape of things
to come.

• Bank should meet key members of the accounting department and external
auditors of the borrowers.

• Obtain monthly statements on time and use the monthly information for
comparative analysis. Seek clarification if there is any deterioration in the
performance from the customer or from their accountants.

• Use plant/site/shop visits and monthly reports to identify behavioural signals.

• Stipulate a minimum number of but relevant covenants. Breach of such

covenants will provide action points for the banks.
• Heed to any warning signals particularly liquidity problems and frauds and
initiate appropriate action.

• Multiple warning signs are an indication of serious distress.

• Timely action is critical for good credit management. However, before any action
is taken, viability of the business should be studied.

7. Automation of credit monitoring

Advancement in information technology has enabled the banks and financial

institutions to automate various functions and operations. Automation in turn
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Course: Credit Management (Module III: Credit Management) NIBM, Pune

empowers the management of organisations to take right decisions and timely action.
Thanks to liberalisation and competition banks have become financial super markets
and offer variety of loan products to large number of customers. The variety and
number make it very difficult to monitor loans manually and hence there is a need for
monitoring of loans as well as loan portfolios. Automation of credit monitoring will
enable monitoring not only individual loan accounts but also loan portfolios. Loan
portfolios like overall portfolio, product portfolios, regional portfolios, portfolio of
various customer segments, and the like can be monitored effectively if automated.
Automation will also enable the banks to send reminders to customers regarding
payment of dues and also submission of reports. It will also provide triggers/signals to
the management of the bank at different levels which will enable timely action.

Ideally, an automated system should be put in place which takes care of the following:

• Identification of symptoms of sickness, weakness and deterioration of asset

quality well in time

• There should not be excessive reliance on securities in preference to viability

and cash flow. Collaterals do not ensure smooth running of loan accounts.
Collateral becomes critical once the account fails or defaulted. Whereas
monitoring happens before default and used to predict and prevent default. As
such there should not be excessive reliance on collateral.
• There should not be excessive lending to certain borrowers, industrial sectors,
and business groups.

• At the time of sanction of loans, there should not be over valuation of securities.

• The charges on securities should be properly created and on time.

• Stock statements, quarterly statements and annual reports should be submitted

in time by borrowers.

• All the covenants stipulated while sanctioning loan are adhered to.

• The interest and instalments are paid as per the agreed schedule.

8. Summary

One of the critical factors that will determine the quality and profitability of a bank’s
credit portfolio is the bank’s ability to detect problems early combined with prompt
action. Effective credit monitoring will also ensure proper usage of loan funds and
reduce the loan losses which will in turn maximize the returns to the banks. Banks use
variety of instruments for monitoring loans and major ones are: stock audit, inspection
(onsite monitoring), stock statement, quarterly reports, annual reports, annual review
of loan account, and stock price movements.

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Course: Credit Management (Module III: Credit Management) NIBM, Pune

Early warning signs will enable banks to initiate appropriate action. The early warning
signs are classified into three different types, namely, liquidity indicators, financial
indicators and behavioural indicators. In addition to the early warning signs banks shall
also look out for signs of frauds by the borrowers. The signs will enable banks to initiate
appropriate action at the right time.

Advancement in information technology enables automation of various functions of

banks and financial institutions. One big area where automation will provide substantial
results is credit monitoring. Automation of credit monitoring will help manage
individual loan accounts as well as loan portfolios efficiently.

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