Financial and Credit Analysis

MAHENDRA K PATIDAR
PGDMBIF
Institute of Public Enterprise,
Hyderabad
 Agenda

• Loan Appraisal
• Appraisal of working capital, term loans
• Security – General
• Security – Specific Forms, advantages
and disadvantages
• Monitoring and Control of loans
 Loan Appraisal
• Loan appraisal does not mean only
analyzing P&L and Balance Sheet for
sanction of loan by banks

• There is… definitely…. Something

beyond!!
 Loan appraisal
• It is a structured analytical tool to take a
credit decision

Viability of the Business

The promoter Macro and Micro environment
Of the business

Various risks and

Business financials their mitigation
 Viability of the business

SWOT
analysis

Opportunities and Threats Strengths and Weaknesses

External Internal
 Threats
• Growing competitive pressures
• Growing bargaining power of
customers/suppliers
• Changing buyers needs / tastes
• Rising sale of substitute products
• Adverse Govt. policies
• Vulnerability to recession/business cycles
 Opportunities
• Industrial scenario
• Faster market growth
• Enter new market / customer segments
• Expand product line
• Backward and Forward integration
• A form of vertical integration that involves the purchase
of suppliers in order to reduce dependency.
• business strategy that involves a form of vertical
integration whereby activities are expanded to
include control of the direct distribution of its products.
 Weaknesses
• Lack of Management depth / talent
• Deteriorating competitive position
• Newcomer with unproven track record
• Short on financial resources
• Technological obsolescence
 Strengths
• Competent Management
• Distinctive competitive edge in terms of
cost, product differentiation, R&D, skills
etc.
• Good Brand image, strong and growing
customer base
• Industrial relations – low attrition rate
• Sufficient financial resources
 Credit appraisal for loans
(Term loans, working capital,
personal loans, SMEs)
• Before a credit facility is sanctioned to any
borrower firm, the proposal should be rigorously
appraised.
• In-depth study of the financial, commercial,
technical and managerial aspects of the
borrower.
• An assessment of the financial requirement.
• Greater reliance is to be placed on data
obtained from independent sources.
 Term loan appraisal
• The essence of the term loan appraisal is to
assess the ability of the unit to repay the loan
and interest, from the surplus generated by
utilizing the fixed assets acquired.
• Project appraisal involves detail study of the
arrangements made for production, marketing
and financing. It examines a systematic way
whether the resources are properly utilised to
produce the best results, i.e. whether the project
is viable
 Aspects of viability study

• Technical Feasibility
•   Commercial and Economic Viability
• Marketing appraisal
•   Financial Feasibility
•   Managerial Competence
• Ecological analysis
 Technical feasibility
• Focuses mainly on the following aspects:
i. Product mix
ii. Capacity
iii. Process of manufacture
iv. Engineering know-how and technical collaboration
v. Raw materials and consumables
vi. Site and location
vii. Building
viii. Plant and equipments
ix. Manpower requirements
x. Break-even point
 Financial Appraisal
• It seeks to assess the following:
i) Reasonableness of the estimate of capital
cost: to ensure that –
• a) Under-estimation (Padding) of costs is
avoided.
• b) Specification of machinery is proper.
• c) Proper quotations are obtained from potential
suppliers.
• d) Contingencies are provided.
• e) Inflation factors are considered
 Financial Appraisal
ii) Reasonableness of the estimate of working
results based on:
• a) A realistic market demand forecast.
• b) Price computations for inputs and outputs that
are based on current quotations and inflationary
factors.
• c) An appropriate time schedule for capacity
utilisation.
• d) Cost projections that distinguish between
fixed and variable costs
 Financial Appraisal
iii) Adequacy of Rate of Return – General
Norms for financial desirability (However a
certain degree of flexibility is allowed).
• Debt-Equity Ratio: 1.5:1
• Internal Rate of Return (IRR): 15% to 20%
• Return on Investment (ROI): 20% to 25%
after tax
• Debt-Service Coverage Ratio (DSCR): 1.5
to 2.0
 Financial Appraisal
iv) Appropriateness of the Financing pattern
• a) Debt-Equity Ratio norm of 1.5:1
• b) Promoters should contribute 20% to 25% of
the project cost.
• c) Stock exchange listing requirements in case
part of the equity is proposed to be raised by the
public.
• d) Promoters capacity and means to contribute a
reasonable share of the project finance
 Economic Appraisal
• Also referred to as “Social Cost Benefit
Analysis” and is labelled as “Partial Little
Mirrless” approach. It involves evaluation
of the project from the social angle.
• Economic appraisal involves analysis of
the critical factors, socio-economic benefit,
availability of labour, import substitution,
technology absorption, impact on ecology,
value addition, FOREX earnings, etc
 Economic Appraisal
i. Economic rate of return
Interest rate at which the cost and benefits of a project, discounted over its
life, are equal..

ii. Effective rate of production.

Output rate at which an end product can be manufactured at the least total
cost

iii. Domestic resource cost.

The DRC Compares the social opportunity costs of domestic production to the
value added it generates in international prices
 Market/Marketing Appraisal
1) Examine the reasonableness of the demand projections
by utilizing the findings of available market survey
findings/reports. Industry association projections,
planning commission projections and independent
market surveys
2) Assess the adequacy of the marketing infrastructure in
terms of:
• i) Promotional effort,
• ii)  Distribution network,
• iii) Transport facilities,
• iv) Stock levels, etc.
3) Judge the knowledge, experience and competence of
the key marketing personnel.
 Managerial Appraisal

i. Howresourceful are the

promoters?
• Judged in terms of the –
a) Prior experience of the promoters.
b) Progress achieved in organizing various
aspects of the project.
c) Skill with which the project is presented.
 Managerial Appraisal
• How sound is the understanding of the project
by the promoters? Assessed in terms of the –
• Credibility of the project plan including
• the organization structure
• the estimated costs
• the financing pattern
• the assessment of various inputs and the
marketing programme
• the details furnished to the financial institution
 Managerial Appraisal
• How committed are the promoters?
• Gauged by the –
• a) Resources (financial, managerial and other applied to
the project).
• b) Zeal with which the objectives of the project, both
short term as well as long term, are pursued.
• c) Assessment of the caliber of the key technical and
managerial personnel working on the project, the
schedule for training them, and the remuneration
structure for rewarding and motivating them.
 Managerial Competence
• The essence of managerial appraisal is to ensure that
the project is in the hands of people competent to
implement it and carry on the business efficiency. The
ability of the people behind the project is the most
important factor determining its future.
• In applying the above norms, however, a certain degree
of flexibility is shown on the basis of the nature of the
project, the risks inherent in the project, and the status of
the promoter.
• The review is done by qualifies and experienced
personnel available in the institutions and/or outside
experts – particularly where large and technologically
sophisticated projects are involved.
 Ecological Analysis
In recent years, environmental concerns have assumed a
great deal of significance. Ecological analysis should be
done particularly for major projects which have
significant ecological implications like power plants and
irrigation schemes, and environmental polluting
industries (like pharmaceuticals, chemicals, leather
processing to name a few). The key questions raised in
ecological analysis are:
• a. What is the likely damage caused by the project to the
environment?
• b. What is the cost of restoration measures required to
ensure the damage to the environment and whether it is
contained within acceptable limits?
Working capital appraisal
 Definition of working capital
• Working capital represents those funds which are
required to manage day-to-day business operaions
• These funds get locked in current assets such as cash,
debtors, inventories, less: short term liabilities like
payables
• Funds thus invested keep revolving from one to other CA
• Working capital is also known as
revolving/circulating/short term/ asset conversion cycle
 Various Current Assets
• Cash and bank balances
• Short term investments in Govt. securities
• Short term deposits with banks
• Receivables
• Short term loans and advances
• Inventory
• Advance to suppliers
Exclusions from Current Assets
• Receivables outstanding for more than six
months
• Non moving or bad and doubtful
receivables
• Deferred receivables maturing beyond one
year
• Dead inventory i.e. slow moving or
obsolete items
 Various Current Liabilities
• Short term borrowings from banks
• Bills purchased and discounted
• Sy. Creditors
• Interest / expenses accrued but not due
for payment
• Dividends payable
• Instalments of loans etc. due within one
year
Operating cycle is described as the time gap
between investment and realisation
SECURITY IN LENDING
 Security
• Security is what secures or guards a loan
against default
• Securing a loan protects against default
and ensures that the loan is repaid in due
course
• Security obtained by a lender is a claim on
the borrower and provides a recourse that
is available to a bank should the terms of
the loan be breached by the borrower
• Primary security for a loan is the borrower

• Creditworthiness is a lender’s measure of

likelihood that a borrower will meet debt
obligations – it involves both the
willingness and ability of the borrower to
repay the loan
 Attributes of a good security
• VMCR

• Adequate and stable Value that is

expected to rise over time
• Easy to measure and Monitor,
Charge/take and Realise
 Charge
• A Charge is the process whereby an asset is
converted by the lender to a security for the
repayment of debt

• A Charge is a contractual agreement , which will

specify:
- which assets are being taken as security;
- the circumstances in which the lender can
dispose the assets
- the circumstances in which the borrower can
regain full control over the assets
 Security – specific forms
Security can take the following forms:
• Proprietary security, such as commercial or residential
land and property – in this case, the lender does not take
possession of the asset and the borrower is able to
continue to make use of it
• Possessory security – in relation to which the lender is
able to take possession of the assets – a/c receivable
• Intangible security over assets such as intellectual
property and licenses
• Financial instruments – shares and bonds
• Insurance policies
• Third party security – such as guarantees
• Refer to the handouts for a detailed
description on the securities, and the
related advantages and disadvantages
 Realisation of the security
• Realisation is the process whereby the
assets taken as security for advances are
sold in order to repay a debt that is in
default
• Action to be taken will depend on:
- the nature of charge
- the nature of security
- the circumstances of the case
 Realisation risk

• Accessibility risk
• Integrity risk
• Valuation risk
• Forced sale risk
• Legal risk
 LENDING CYCLE
– MONITORING AND CONTROL
PROCESS
 Aspects to monitor
• Be fully aware of the up-to-date situation to
ensure that borrowing remains within the
capacity to repay
• Detect any adverse trends
• Ensure documentation and charges over
collateral security remain up to date
• Ensure legal and regulatory requirements are
met
• Assess overall condition and continued
profitability of the loan portfolio
Information sources for review

Sources of information

Internal External

hard soft hard soft

Internal sources of hard information

• Accounts information
• Turnover data
• Debit and credit vouchers
• Customer databases
Internal sources of soft information
• Staff who interact with the borrower as
part of head office, branch offices, the
marketing department, customer services
department

• Personal interviews with the borrower

 External sources of hard
information
• Audited financial statements and accounts
• List of pending advance orders
• Copies of quarterly tax returns
• Info. About companies with similar businesses
• Governmental – regulatory reforms
• Commercial and semi-official sources – E&Y
reports
• Newspaper and journals
External sources of soft information
• Telephonic conversations and meetings at
borrowers premises

• Trade associations, related interviews

 Early warning signals
Detection of problems
• Delay in auditing / submission of financial statements
• Deterioration in financial ratios
• Cash flow problems and declining cash balances and large increase in
receivables, short term debt
• Deteriorating relations with trade suppliers
• A decrease in inventory turnover
• Loss of key customers
• Lock-outs, strikes, general deterioration of labour relations
• Production and delivery problems
• Negative press reports
• Delayed payment of principal and interest
• Decline in margin and increase in LTV
• Loan proceeds being used for unintended purposes
• Expiry or cancellation of insurance policies