Capital

Capital represents the funds available to

operate a business, of which there are two
portion viz. equity capital that is invested
in the business by the owners and the
borrowed capital that is borrowed from
other sources. Credit officer should
concern about the equity capital because
more the equity capital more sincere
would be the owner about their stake hence
more safeguard will be the borrowed funds.
 What should look by credit
officer
• 1)The value of assets, 2) The value of
liabilities 3) Whether equities he has in his
assets give adequate backup for his loan
request, 4) Whether capital increased
from profits or form appreciation in stating
assets 5) What assets and liabilities does
he have outside the business?
 Capacity
• Management ability to generate enough
cash to satisfy all obligations is defined as
capacity. Capacity also means borrowers’
business acumen and management ability
to deal with men and matters so that he
would be able to make effective and
profitable use of funds, thereby able to
repay the dues.
 Indicators to judge repayment
capacity of borrowers
• The followings are the indicator by which
one can judge the repayment capacity of
borrowers: (1) Collection of notes and
accounts receivable, (2) Income, earnings,
or new equity contributions, (3) Borrowing
from other source, (4) The education and
experience of each member of
management (5) Involvement in other
enterprises etc.
 Collateral
• If the cash for repayment of a loan is not
available from the earning of the business
then collateral is used for repayment of the
loan. Collateral offsets the weakness of
other cash. Dealing with collateral, a credit
officer should keep in mind the followings:
(1) Possession of the assets, (2)
Valuation, (3) Age, condition, technology,
(4) Marketability etc.
 Consequences- Purpose
In making granting decision, a credit
officer should confirm the purpose of the
credit. To gain an insight into the purpose
of the credit, a credit officer should inquire
about the questions: (1) Is the loan a
productive one? (2) Does the loan replace
other creditors? and Why? (3) Will the
borrower and the bank benefit on both
short term and long-term basis? How is it
in each case?
 Cash flow
There are three sources of generating cash
to repay the loan: (1) Cash flow from sales
or income; (2) Sale or liquidation of assets or;
(3) Funds raised by issuing debt or equity
securities.
By analyzing cash flow the lender can get two answers:
(1) Will the expected cash receipts of a business during
the term of a loan be adequate to meet all required cash
payments? (2) Has the firm the financial flexibility to
survive a period of adversity where the firm failed to
generate enough cash flow?
 Conditions
Conditions suggest a forecast of the most
likely sale figure and profitability for the
coming year. By analyzing economic,
industry, or business conditions, a credit
officer can get an answer to the question:
Can the borrowers repay?
There is an alternative interpretation of
conditions. How vulnerable is the borrower
to change in the economy?
 Current Information
• To make good commercial lending decisions, credit
officers need useful information about certain critical
variables. Information is of two types: financial and non-
financial. A credit analyst can get financial information
from the published financial statements and other
published records. For getting non financial information
credit analysts should look at the management ability
and uses his/her experience for analyzing it. Financial
statements contain lot of information. There is a debate
that which information is more important to lender in their
lending decisions, and to what weight should be given to
particular information. A lot of models have been
developed for credit analysis where financial (Altman “Z”
score) and financial and non financial information (LRA,
VaR etc) were given proportionate weight.
 Customer Relationships
• It is a conception that a customer of another
institution approached for credit will be treated
as “red flag”. In this case a credit officer should
look for the answer why didn’t the customer
borrow from his or her existing institutions? In
today’s highly competitive banking environment,
however, banks are actively trying to take away
good customers from other. Customer
relationships also relate to the question “can the
customer repay”. A credit officer can procure the
answer from information about past credit
experience with his/her institution.
 Corporate Life Cycle
Stages of corporate life cycle: “Growth” “Mature” and Decline stage.
Characters: Growth stage: Younger, smaller, less well capitalized,
limited line of credit. Suppliers are reluctant to extend liberal terms of
credit to these firms and these firms have limited access in the
capital market.
Declining stage: Limited access in the line of credit, high cost of
financing.
Mature stage: Cost efficiency.

Credit analyst task: For growth and declining firm’s credit officer should
look through the liquidity ratio.

For mature firm whether firms are in maintaining sufficient competitive

advantage and related efficiency such as “economics of scale”
premium pricing from effective product and service differentiation,
and / or low cost advantage from inputs such as labors, suppliers,
and so forth.
 Economic Condition
• For credit analysis, analysts should
consider some economic indicators like
unemployment rate, inflation rate,
bankruptcy filings, and stock markets
return have strong power for forecasting
credit risk.
 Credit Analysis Reports
/Preparation of Proposal
• Scope, Depth, and Completion date
• Scope refers to the number of entities to be analyzed.
Scope increases as the number of borrowers, endorsers,
and guarantors and size of the collateral base increase
• Depth refers to the degree of historic and forecasted
information to be evaluated. Depth increases with the
increases of terms of the accommodation, amount of the
credit and the risk.
The report should always describe the proposed loan
structure, repayment ability, summarize strengths and
weaknesses, and recommended alternatives that reduce
credit risk.
 Types of Credit Reports
Basic reports and Update reports
Basic reports are the reports that have not been analyzed
before.
Update report describes and examines significant changes,
events, and data subsequent to the time period covered
in the basic report.
Basic reports usually update in first and second year and
revises in the third year.
Full Reports: Detailed and most complete credit analysis.
Partial reports: Little information, unsubstantiated data, or
volatile performance. Limit to industry comparisons,
trend analysis, background data, and financial analysis.
 Credit Approval
• Systems of credit approval
• Committee System: Under credit
committee system, the credit officer of the
branch makes necessary appraisal and
sent it to the committee for the sanction,
• Sequential process: Sequential process
involves an approval chain of individual
credit officers with ascending levels of
authority.
 Credit Structuring
• Credit structuring means determination of
loan tenure, it pricing, repayment mode,
covenants, security and others.
 Credit Negotiation
• After approval and structuring credit, a credit
officer prepares an offer letter which contains
terms and condition laid down in the credit
structuring and sends it to the borrower for
acceptance. If borrower accepts the proposal,
he/she sign the letter and return it to the credit
officer. Borrower may appeal to the bank to
change the terms and conditions of the letter
and the bank may accept it or not.
 Credit Documentation
• The legal relationship between the
borrowers and the lender establish
through documentation.
• Behrens explore ten problem areas in loan
documentation: proper entity, names and
signatures, evidences of authority and capacity,
collateral descriptions, filling or recording, title
and record searches, guarantee agreements,
collateral valuations, security position, and
casualty insurance coverage.
 Suggestion to improve loan
documentation
• Hire experts from outside the bank
• Sign all notes by borrowers and at least by two
credit officers,
• Typed by one secretary and sign by him
• Double-check
• Document appraisals
• File borrowing authorization form
• Record real estate and commercial collateral
from UCC
• Maintain records on insurance
• Maintain financial statements of borrowers
and guarantors
• Arrange loan files in logical order
• Attach to each file what should be a
dwindling list of document exceptions in
need of correction.
•
 Credit Disbursement
• After completion of documentation, bank
makes disbursement. How loan will be
disbursed is generally mentioned in the
credit negotiation. It is customary that term
loans are disbursed on installment basis
and short term loans are transferred to
borrowers’ account. Borrowers can
withdraw from his/her account when deem
it necessary.
Internal Audit/ management audit
• It is necessary to audit the credit to verify
whether credit has been made by following
all the guidelines of credit set in the credit
policy. Responsibility of internal audit is to
identify criticized credit and to make
recommendation to take necessary action
against person involved in the criticized
credit.