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OVERVIEW OF CREDIT APPRAISAL

Credit appraisal means an investigation/assessment done by the bank prior before providing any loans & advances/project finance & also checks the commercial, financial & technical viability of the project proposed its funding pattern & further checks the primary & collateral security cover available for recovery of such funds.

Brief overview of credit:


Credit Appraisal is a process to ascertain the risks associated with the extension of the credit facility. It is generally carried by the financial institutions which are involved in providing financial funding to its customers. Credit risk is a risk related to non repayment of the credit obtained by the customer of a bank. Thus it is necessary to appraise the credibility of the customer in order to mitigate the credit risk. Proper evaluation of the customer is performed which measures the financial condition and the ability of the customer to repay back the loan in future. Generally the credit facilities are extended against the security know as collateral. But even though the loans are backed by the collateral, banks are normally interested in the actual loan amount to be repaid along with the interest. Thus, the customer's cash flows are ascertained to ensure the timely payment of principal and the interest. It is the process of appraising the credit worthiness of a loan applicant. Factors like age, income, number of dependents, nature of employment, continuity of employment, repayment capacity, previous loans, credit cards, etc. are taken into account while appraising the credit worthiness of a person. Every bank or lending institution has its own panel of officials for this purpose. However the 3 C of credit are crucial & relevant to all borrowers/ lending which must be kept in mind at all times. Character Capacity Collateral

If any one of these are missing in the equation then the lending officer must question the viability of credit.

There is no guarantee to ensure a loan does not run into problems; however if proper credit evaluation techniques and monitoring are implemented then naturally the loan loss probability / problems will be minimized, which should be the objective of every lending officer. Credit is the provision of resources (such as granting a loan) by one party to another party where that second party does not reimburse the first party immediately, thereby generating a debt, and instead arranges either to repay or return those resources (or material(s) of equal value) at a later date. The first party is called a creditor, also known as a lender, while the second party is called a debtor, also known as a borrower. Credit allows you to buy goods or commodities now, and pay for them later. We use credit to buy things with an agreement to repay the loans over a period of time. The most common way to avail credit is by the use of credit cards. Other credit plans include personal loans, home loans, vehicle loans, student loans, small business loans, trade. A credit is a legal contract where one party receives resource or wealth from another party and promises to repay him on a future date along with interest. In simple terms, a credit is an agreement of postponed payments of goods bought or loan. With the issuance of a credit, a debt is formed.

Basic types of credit


There are four basic types of credit. By understanding how each works, you will be able to get the most for your money and avoid paying unnecessary charges. Service credit is monthly payments for utilities such as telephone, gas, electricity, and water. You often have to pay a deposit, and you may pay a late charge if your payment is not on time. Loans let you borrow cash. Loans can be for small or large amounts and for a few days or several years. Money can be repaid in one lump sum or in several regular payments until the amount you borrowed and the finance charges are paid in full. Loans can be secured or unsecured. Installment credit may be described as buying on time, financing through the store or the easy payment plan. The borrower takes the goods home in exchange for a promise to pay later. Cars, major appliances, and furniture are often purchased this way. You usually sign a contract, make a down payment, and agree

to pay the balance with a specified number of equal payments called installments. The finance charges are included in the payments. The item you purchase may be used as security for the loan. Credit cards are issued by individual retail stores, banks, or businesses. Using a credit card can be the equivalent of an interest-free loan--if you pay for the use of it in full at the end of each month.

Brief overview of loans:


Loans can be of two types fund base & non-fund base: FUND BASE includes: Working Capital Term Loan

NON-FUND BASE includes: Letter of Credit Bank Guarantee Bill Discounting

FUND BASE: WORKING CAPITAL: 1. General The objective of running any industry is earning profits. An industry will require funds to acquire fixed assets like land, building, plant, machinery, equipments, vehicles, tools etc., & also to run the business i.e. its day to day operations. Funds required for day to-day working will be to finance production & sales. For production, funds are needed for purchase of raw materials/ stores/ fuel, for employment of labour, for power charges etc., for storing finishing goods till they are sold out & for financing the sales by way of sundry debtors/ receivables. Capital or funds required for an industry can therefore be bifurcated as fixed capital & working capital. Working capital in this context is the excess of current assets over current liabilities. The excess of current assets over current liabilities is treated as net working capital or liquid surplus & represents that portion of the working capital, which has been provided from the long-term source. 2. DEFINITION Working capital is defined as the funds required to carry the required levels of current assets to enable the unit to carry on its operations at the expected levels uninterruptedly. Thus Working Capital Required is dependent on (a) The volume of activity (viz. level of operations i.e. Production & sales) (b) The activity carried on viz. mfg process, product, production programme, the materials & marketing mix.

3. Methods & Application SEGMENT SSI SBF C&I Trade LIMITS Upto Rs 5 cr Above Rs 5 cr All loans & Upto Rs 1 cr Above Rs 1 cr & upto Rs 5 cr Above Rs 5 cr Industrial Below Rs 25 lacs Rs 25 lacs & Over but upto Rs 5 cr Above Rs 5 cr METHOD Traditional Method & Nayak Committee method Projected Balance Sheet Method Traditional / Turnover Method Traditional Method for Trade & Projected Turnover Method Projected Balance Sheet Method & Projected Turnover Method Projected Balance Sheet Method Traditional Method Projected Balance Sheet Method & Projected Turnover Method Projected Balance Sheet Method

Services

C&I Units

4. Operating cycle method 4.1 Any manufacturing activity is characterized by a cycle of operations consisting of purchase of purchase of raw materials for cash, converting these into finished goods & realizing cash by sale of these finished goods. 4.2 Diagrammatically, the OPERATING CYCLE is represented as under 4.3 The time that lapses between cash outlay & cash realization by sale of finished goods & realization of sundry debtors is known as the length of the operating cycle.

4.4 That is, the operating cycle consists of:

Time taken to acquire raw materials & average period for which they are in store. Conversion process time Average period for which finished goods are in store & Average collection period of receivables (Sundry Debtors)

4.5 Operating cycle is also called the cash-to-cash cycle & indicates how cash is converted into raw materials, stocks in process, finished goods, bills (receivables) & finally back to cash. Working capital is the total cash that is circulating in this cycle. Therefore, working capital can be turned over or redeployed after completing the cycle.

4.6 The length of the operating cycle = a+b+c+d (as in 4.4)

If a = 60 days b = 10 days c = 20 days d = 30 days The operating cycle is 120 days (nearly 4 months). This means there are 365/120 = 3 cycles of operations in a year. Sales Operating expenses = Rs. 1,00,000 per annum = Rs. 72,000 per annum

But the working capital requirement, as you know, is not Rs. 72,000. In these cases, there are 3 operating cycles in a year. That means each rupee of working deployed in the unit is turned over 3 times in a year. (This is also known as working capital turnover ratio). Therefore WCR = Operating Expenses No. of cycles per annum = Rs. 72,000/- = Rs. 24,000/3

WCR is therefore not Rs. 72,000/- but only Rs. 24,000/-

4.7 Assessment of Working Capital Requirement & Permissible Bank Finance using Operating Cycle Concept

Let us consider a case of a unit where: Sales Raw Materials Wages = Rs. 20,000 p.m. (A) = Rs. 14,000 p.m. = Rs. 2,000 p.m.

Other manufacturing Expenses Total expenses Profit = Rs. 3,000 p.m. = Rs. 19,000 p.m. (B) = Rs. 1,000 P.m. (C)

The operating cycle is Raw Materials Stock in Process FG Sundry Debtors The total length of Operating cycle = 35 days (D) = 15 days = 2 days = 3 days = 15 days

WCR = B * D = 19,000 * 35 = Rs. 22,167/- (approx.) 30 30

Where B = Operating Expenses; & D = Length of Operating cycle

The length of the operating cycle is different from industry to industry and from one firm to another within the same industry. For instance, the operating cycle of a pharmaceutical unit would be quite different from one engaged in the manufacture of machine tools. The operating cycle concept enables us to assess the working capital need of each enterprise keeping in view the peculiarities of the industry it is engaged in and its scale of operations. Operating cycle is an important management tool in decisionmaking.

Traditional Method of Assessment of Working Capital Requirement The operating cycle concept serves to identify the areas requiring improvement for the purpose of control and performance review. But, as bankers, we require a more detailed analysis to assess the various components of working capital requirement viz., finance for stocks, bills etc. Bankers provide working capital finance for holding an acceptable level of current assets, viz. raw materials, stocks-in-process, finished goods and sundry debtors for achieving a predetermined level of production and sales. Quantification of these funds required to be blocked in each of these items of current assets at any time will, therefore provide a measure of the working capital requirement (WCR) of an industry.

It can thus be summarized as follows:

Projected Annual Turnover Method for SSI units (Nayak Committee) For SSI units which enjoy fund based working capital limits up to Rs.5 cr, the minimum working capital limit should be fixed on the basis of projected annual turnover. 25% of the output or annual turnover value should be computed as the quantum of working capital required by such unit .The unit should be required to bring in 5% of their annual turnover as margin money and the Bank shall provide 20% of the turnover as working capital finance. Nayak committee Guidelines correspond to working capital limits as per the Operating Cycle method where the average production / processing cycle is taken to be 3 months (i.e. working capital would be turned over 4 times in a year).

Projected Annual Turnover Method for C & I industrial units (limits upto Rs 5 cr) Bank has decided to extend Nayak Committee approach for assessment of limits to C&I industrial units requiring credit limits upto Rs.5 cr. That is, credit requirement up to Rs.5 crores of C&I borrowers (industrial units) may be assessed at a minimum of 20% of projected annual turnover. In other words, the working capital requirement will be assessed at 25% of projected annual turnover, of which 5% should be borne by entrepreneur as margin and 20% would be allowed as Bank Drawings. While accepting projected annual sales turnover, a cap of 25% over actual annual sales turnover in the immediately preceding year should be set, except where production capacity has been substantially increased.

Projected Annual Turnover Method for Business Enterprises in Trade & Services Sector:

i) For working Capital limits up to Rs. 5 cr to C&I(Trade) sector, the assessment of credit limit is to be based upon annual turnover. Thus, an across the board credit limit equal to 15% of projected annual turnover be offered to business enterprises in the T&S sector. It would be available for utilization generally as a cash credit limit. However, where needed an LC limit (as a sub-limit of total), may also be allowed. ii) The credit limit would be secured by hypothecation charge on the current assets of the enterprise. Periodical stock statements are to be obtained and margin of 25% be retained. iii) Credit limits under this assessment method may be offered to established (at least 3 years old) profit making business enterprises, eligible for credit rating of SB-4 and above. Mortgage of property valued at least at 33% of the limit is to be prescribed. Further, an interest rebate of 0.50% p.a. may be given to borrowers who offer mortgage of property valued at over 75% of the credit limit. iv) While accepting projected annual sales turnover, a cap of 25% over actual annual sales turnover in the immediately preceding year should be set. When circumstances warrant its breach, reasons therefor should be recorded. v) Where borrowers indicate need for credit limits which are higher than the amount indicated above, assessment under the traditional PBS method may be resorted to. Projected Balance Sheet Method (PBS) The PBS method of assessment will be applicable to all C&I borrowers who are engaged in manufacturing, services, and trading activities, including merchant exports and who require fund based working capital finance of Rs. 25 lacs and above. In the case of SSI borrowers, who require working capital credit limit up to Rs.5 cr, the limit shall be computed on the basis of Nayak Committee formula as well as that based on production and operating cycle of the unit and the higher of the two may be sanctioned. Fund based working capital credit limits beyond Rs 5 cr for SSI units shall be computed in the same way as for C&I units. For business enterprises in Trade and Services Sector, where the projected turnover method is not applicable, PBS method shall be followed. 8.1 In the Projected Balance Sheet (PBS) method, the borrowers total business operations, financial position, management capabilities etc. are analyzed in detail to assess the working capital finance required and to evaluate the overall risk of the exposure. The following financial analysis is also to be carried out:

Analysis of the borrowers Profit and Loss account, Balance Sheet, Funds Flow etc. for the past periods is done to examine the profitability, financial position, financial management, etc. in the business. Detailed scrutiny and validation of the projected income and expense in the business, and projected changes in the financial position (sources and uses of funds) are carried out to examine if these are acceptable from the angle of liquidity, overall gearing, efficiency of operations etc.

8.2 There will not be a prescription like mandatory minimum current ratio or maximum level of a current asset (inventory and receivables holding level norms) under PBS method. Under the PBS method, assessment of WC requirement will be carried out in respect of each borrower with proper examination of all parameters relevant to the borrower and their acceptability.

TERM LOAN: 1. A term loan is granted for a fixed term of not less than 3 years intended normally for financing fixed assets acquired with a repayment schedule normally not exceeding 8 years. 2. A term loan is a loan granted for the purpose of capital assets, such as purchase of land, construction of, buildings, purchase of machinery, modernization, renovation or rationalization of plant, & repayable from out of the future earning of the enterprise, in installments, as per a prearranged schedule. From the above definition, the following differences between a term loan & the working capital credit afforded by the Bank are apparent: The purpose of the term loan is for acquisition of capital assets. The term loan is an advance not repayable on demand but only in installments ranging over a period of years. The repayment of term loan is not out of sale proceeds of the goods & commodities per se, whether given as security or not. The repayment should come out of the future cash accruals from the activity of the unit.

The security is not the readily saleable goods & commodities but the fixed assets of the units.

3. It may thus be observed that the scope & operation of the term loans are entirely different from those of the conventional working capital advances. The Banks commitment is for a long period & the risk involved is greater. An element of risk is inherent in any type of loan because of the uncertainty of the repayment. Longer the duration of the credit, greater is the attendant uncertainty of repayment & consequently the risk involved also becomes greater. 4. However, it may be observed that term loans are not so lacking in liquidity as they appear to be. These loans are subject to a definite repayment programme unlike short term loans for working capital (especially the cash credits) which are being renewed year after year. Term loans would be repaid in a regular way from the anticipated income of the industry/ trade. 5. These distinctive characteristics of term loans distinguish them from the short term credit granted by the banks & it becomes necessary therefore, to adopt a different approach in examining the applications of borrowers for such credit & for appraising such proposals. 6. The repayment of a term loan depends on the future income of the borrowing unit. Hence, the primary task of the bank before granting term loans is to assure itself that the anticipated income from the unit would provide the necessary amount for the repayment of the loan. This will involve a detailed scrutiny of the scheme, its financial aspects, economic aspects, technical aspects, a projection of future trends of outputs & sales & estimates of cost, returns, flow of funds & profits.

7. Appraisal of Term Loans Appraisal of term loan for, say, an industrial unit is a process comprising several are four broad aspects of appraisal, namely Technical Feasibility - To determine the suitability of the technology selected & the adequacy of the technical investigation & design; Economic Feasibility - To ascertain the extent of profitability of the project & its sufficiency in relation to the repayment obligations pertaining to term assistance; steps. There

Financial Feasibility - To determine the accuracy of cost estimates, suitability of the envisaged pattern of financing & general soundness of the capital structure; &

Managerial Competency To ascertain that competent men are behind the project to ensure its successful implementation & efficient management after commencement of commercial production