INTRODUCTION TO CREDIT RISK APPRAISAL

Credit appraisal means an investigation/assessment done by the bank prior before providing any

loans/advances and also before financing a project. In this Process, The bank checks the

financial, technical and commercial viability of the Project. Further to this, It also checks the

proposed funding pattern, primary and collateral security cover available for the recovery of such

funds. The credit proposal is prepared to indicate the need based requirement and the rationale

for its recommendation. Bank has a well defined framework for approving credit limits of

different segments. Request for credit facilities from the prospective borrowers shall be on the

prescribed format and the full fledged proposal should be prepared for submission to the

appropriate sanctioning authority for approval. These proposals analyze various risks associated

with bank lending i.e business risk, financial risk, management risk etc.., and clarify the process

by which such risk will be managed on an ongoing basis.

Credit appraisal is done to evaluate the credit worthiness of the borrower. 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 that a loan does not run into problems; however if proper credit

evaluation techniques and monitoring are implemented then naturally the probability of a loan

loss can be minimized, which is the primary objective of a 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 BASED LOANS include:

Working Capital

Term Loan

NON-FUND BASED LOANS include:

Letter of Credit

Bank Guarantee

Bill Discounting

FUND BASED :

WORKING CAPITAL :

Working capital is the money needed to fund the normal, day to day operations of a business. It

ensures that the business or the company has enough cash to pay all the debts and expenses as

they fall due, particularly during the start-up period. Very few new businesses are profitable as

soon as they open their doors. It takes time to reach your breakeven point and start making a

profit.

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 labor, for power

charges etc., for storing finishing goods till they are sold out & for financing the sales by the way

of sundry debtors/ receivables.

DEFINITION :

A measure of both a company's efficiency and its short-term financial health.

The working capital ratio is calculated as:

Working capital = Current Assets - Current Liabilities

THE RIGHT LEVEL OF WORKING CAPITAL :

The right level of working capital depends on the industry and the particular circumstances of the business. The above ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.

It is also known as "net working capital", or the "working capital ratio".

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, the materials & marketing mix.

THE WORKING CAPITAL CYCLE :

The working capital cycle is made up of the following four core components:

1. Cash (funds available)

2. Creditors (accounts payable)

3. Inventory (stock on hand)

4. Debtors (accounts payable)

The key to successful cash management is to be in control of each step in the cycle. If you can

quickly convert your trading operations into available cash, you will be increasing the liquidity

in your business and will be less reliant on cash from customers, extended terms from suppliers,

overdrafts, and loans.

VARIOUS METHODS FOR ASSESSMENT OF WORKING CAPITAL :

Following methods have been prescribed for working capital assessment :

1. Projected Balance Sheet Method (PBS Method).

2. Cash Budget Method.

3. Nayak Committee or Turnover Method.

4. Other Assessment Methods.

5. Assessment in Sole/Multiple/Consortium Banking Arrangements.

PROJECTED BALANCE SHEET METHOD (PBS METHOD) :

Under this method, the assessment of working capital is computed on the basis of the borrower's

projected Balance sheet, the fund flow panned for the current / following year and examination

of the profitability, financial paramaeters etc..,The Quantum of the Working Capital Credit Limit

is not linked to that computed on the basis of a stipulated minimum level of liquidity(Current

Ratio). The Key Determinants for the limit can be the extent of financing support required by a

borrower and the acceptability of the borrower's overall financial position including the

projected level of liquidity(Current Ratio).The key Determinants of the limit can be the extent of

financing support required by the borrower and the acceptability of the borrower's overall

financial position including the projected level of liquidity.

CASH BUDGET METHOD :

Cash Budget method is used for assessing Working Capital Finance for seasonal industries like

sugar, tea etc.., and for construction activity. The cash budget analysis is also used for sanction

of ad hoc WC limits. In these cases, the required finance is quantified from the projected cash

flows and not from the projected values of current assets and current liabilities. Under this

method of assessment, besides the cash budget other aspects of assessment like examination of

funds flow, profitability, financial parameters, etc.., will be carried out as per the PBS method.

NAYAK COMMITTEE OR TURNOVER METHOD :

Under this method, working capital requirement is computed at a minimum 25 % of output value

of which at least four-fifths should be provided by the bank and the balance one-fifth

representing the borrower's contribution towards margin for the working capital. In other words,

WC credit limit should be computed at a minimum of 20 % of the projected annual turnover. The

turnover method shall be used for sanction of fund based WC finance of SSI units only up to a

stipulated limit advised by the corporate centre from time to time.

OTHER ASSESSMENT METHODS :

WC finance required by NBFCs will be assessed on the basis of a minimum current ratio of 1.33.

ASSESSMENT IN SOLE/MULTIPLE/CONSORTIUM BANKING ARRANGEMENTS :

The PBS or Cash Budget method is applicable to WC finance given by the Bank in

sole/multiple/consortium banking arrangements. However, in respect of advances under

consortium arrangements, branches may sanction the Bank's share of limits on the basis of

assessment in the PBS or cash budget method provided by the overall limits assessed by them

are not different from the limits assessed by the leader of the consortium. Under consortium

arrangements, the Lead Bank is required to circulate to where we are only participants in a

consortium, branches should duly validate and subject the lead bank/FI estimates to critical

examination. This would help the bank in noticing errors, if any, in the judgement of the Lead

Bank and taking corrective action in time.

APPLICATION :

SEGMENT LIMITS METHOD

SSI Upto Rs 5 cr Traditional Method & Nayak Committee method

Above Rs 5 cr Projected Balance Sheet Method

SBF All loans Traditional / Turnover Method

C&I Trade &

Services

Upto Rs 1 cr Traditional Method for Trade &

Projected Turnover Method

Above Rs 1 cr

& upto Rs 5 cr

Projected Balance Sheet Method &

Projected Turnover Method

Above Rs 5 cr Projected Balance Sheet Method

C&I Industrial

Units

Below

Rs 25 lacs

Traditional Method

Rs 25 lacs &

Over but upto

Rs 5 cr

Projected Balance Sheet Method &

Projected Turnover Method

Above Rs 5 cr Projected Balance Sheet Method