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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
Business Risks
Management Risks
Financial Risks
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.
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
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
(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.
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
Other
Equity
Debt + Depreciation +
Net Profit (After Taxes)
Debt2
Service
Coverage
Ratio
`interest'
and
`principal
repayment'
besides
of debt
TOL / TNW Tangible Net Worth (Paid This ratio gives a view of borrower's capital
Ratio
up Capital + Reserves
and Surplus
Intangible Assets)
Profit-Sales
Ratio
Sales5
Tangible
Assets
Ratio
Current
Ratio
Current Liabilities
Output
Sales
Investment
Ratio
assets)
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:
Small 2 Loans
Small Loans
Mid Corporate
Large Corporate
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:
Associated with the entire economy and can influence the repayment capacity
and/ or willingness of the company.
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;
Forward looking
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
Infrastructure entities
Microfinance institutions
Insurance companies
Mutual funds
State governments
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)
CRISIL A
(Adequate Safety)
CRISIL BBB
(Moderate Safety)
CRISIL BB
(Moderate Risk)
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