8-10-22-CER-Lesson 02

Lesson 02
Basic principles of credit evaluations
By Nadun Sooriyaarachchi
(ACMA,CGMA,FICM(SL),AIB(SL),BA(Hons) IBF(2nd class)-
UWS(UK),Cert in counselling psychology(University of
Peradeniya)
This session will cover
• Basic principles of credit management

• Principles to follow in credit evaluation process
• Other important factors to be considered in the credit
evaluation process
By Nadun Sooriyaarachchi(ACMA,CGMA,FICM(SL),AIB(SL),BA(Hons) IBF(2nd

2
class)-UWS(UK),Cert in counselling psychology(University of Peradeniya)
Credit management plays a vital role in the banking and financial sector. As we all know bank and financial
institutions are the major source of lending capital. Following principles are following by a formal financial institution
in the process of credit granting.
1. Liquidity
2. Safety
3. Diversity
4. Stability
5. Profitability
6. Eligibility
7. Risk Management
By Nadun
Sooriyaarachchi(ACMA,CGMA,FICM(SL),AIB(SL),BA(Hons) IBF(2nd
class)-UWS(UK),Cert in counselling psychology(University of 3
Peradeniya)
• Financial institutions are in to financial intermediation business and maintaining a healthy liquidity position is vital important in the
credit granting process. Even though the financial institutions are mostly investing their depositors funds in loan asset ,they
should maintain a sufficient liquidity position(cash flows/cash ) in the business to cater the withdrawal requirements of their
depositors. If a financial institution is falling to honour the deposit withdrawal requirements of their depositors on due date, they
may face an issue of surviving in the business due to various issues such as reputational damages, loss of confidence of the
public of the business, pressure from the regulator and finally the bankruptcy in the long run.
• So, to avoid this chaos, Financial institutions lend loans after the borrower produces enough security of assets which can be
easily marketable and transformable to cash in a short period of time. A Financial institution is in possession to take over
these produced assets if the borrower fails to repay the loan amount after some interval of time as decided.
• A Financial institution has its own selection criteria for selecting a collaterals. Only those securities which acquires enough
liquidity are added in the financial institution’s lending portfolio. This is important as the financial institutions require funds to meet
the urgent needs of its customers or depositors. The financial institutions should be in a condition to sell some of the securities at
a very short notice without creating an impact on their market rates much.
• Shares and debentures of large industries are also addressed under this category. But the shares and debentures of ordinary
industries are not easily marketable without having a fall in their market rates. Therefore, financial institutions should always
make investments in government securities and shares and debentures of reputed industrial businesses.
By Nadun
Peradeniya)
Safety means that the borrower should be in a position to repay the loan and interest at regular durations of time
without any fail. The repayment of the loan relies on the nature of security and the potential of the borrower to
repay the loan.
Therefore, from the financial institution’s way of perceiving, the nature of security is very essential while granting a
loan facility. Even after considering the securities, the financial institutions should check the creditworthiness of the
borrower which is monitored by his character(financial/social), capacity to repay, and his financial standing. The
safety of financial institutions funds relies on the technical feasibility and economic viability of the project for which
the loan is to be given.
Mitigating the credit risk
By Nadun
Peradeniya)
When choosing an asset/investment portfolio, a financial institution should abide by the principle of diversity. It
should never invest its total funds in a specific type of securities, it should prefer investing in different types of
securities and industries of business.
The principle of diversity is applicable to the advancing of loan facilities to different types of firms, industries,
factories, businesses and markets. A financial institution should abide by the maxim that is “Do not keep all eggs
in one basket.” It should distribute its risks by granting loans to different trades and companies in different parts of
the country.
By Nadun
Peradeniya)
A financial institution should prefer investing in stocks and securities which hold a high degree of stability in their
costs. Any financial institution not willing to incur any loss on the rate of its securities. So it should always invest
funds in the shares of branded companies and stable securities where the probability of decline in their rate and
market value is less.
Financial institutions are prefer for
1.Market interest rates stability
2.Security/asset price stability
By Nadun
Peradeniya)
A financial institution should only invest if it earns sufficient profits from it. Thus, it should, invest in securities that
have a fair and stable return on the funds invested.
Lending money to someone is accompanied by some risks mainly. As we know that bank lends the money of its
depositors as loans. To put it simply the main business of a financial institution is to rent money from depositors
and give money to the borrowers as loans and advances. As the primary source of funds for a financial institution
is the money deposited by its customers on their savings and term deposits which are repayable on demand by the
depositors, therefore financial institutions need to be very careful when lending money to customers.
Financial institutions make money by lending money to borrowers and charging an interest. Therefore it is very
essential from the financial institution’s duty to follow the cardinal principles of lending. When these principles are
abided, they assure the safety of the financial institution’s funds and in response to that they assure its depositors
and shareholders.
In this whole process, financial institutions earn good profit and growth while sound lending principles by financial
institutions help the economy of a nation to prosper.
By Nadun
Peradeniya)
Credit evaluation is the process of see the pros and cons of a borrower in order to grant a credit facility. Following
questions to be asked and evaluate the credit proposal based on the answers are providing by the prospecting
borrower.
• 1. Is the proposal is acceptable according to the credit policy of the financial institution?
• This is the first step, credit officer should be able to see whether the new credit applications are forwarding for
the recommendations in line with the existing credit policy.
• 2. Viability of the project of generating healthy future cash flows to repay the instalments of the loan
• This is one of major concern which every credit officer should have on the process of evaluating a credit
proposal. It should go through whole the credit proposal and need to see the possible cash flow generation in
order to serve the monthly installments. If there is a proposal which would not able to generate future cash
flows, may causes to restrict the borrower’s future capacity to repay. Therefore every credit proposal must have
a financial benefit to the borrower. Also it should support to increase future cash flows of the borrower where
supporting to improve living standard of the borrower. If there’s any project which may lead to deteriorate the
status of the borrower should be rejected/declined at the very first point of the evaluation. But causes need to
justify.
By Nadun
Peradeniya)
• 3. Has the borrower provided sufficient, accurate information to carry out proper credit evaluation?
• This is utmost important for the credit officer to undertake to proceed a better credit evaluation of the credit
proposal. Credit officer should be satisfied with the information provided by the borrower and random cross
checking should verify the accuracy of the details provided by the borrower.
• Also it is necessary to provide requested details by the lender. The lender needs to make sure, only relevant
information for granting a facility has requested from the borrower. If any information is very confidential and
sensitive, the lender must have proper information management system to handle those information.
• 4. Does the borrower has convincing plan and in-depth understanding of the business to success the
project in the future?
• Lender must make sure that they are providing loans with an intention of developing borrower and supporting
him to increase his living standards. However borrower should be able to explain his plans to the lender to
convince the loan granting, Therefore he needs to have better understanding of the purpose of the credit
proposal. Further, in depth understanding about his business.
• In brief, borrower should have competency and skill of his industry.
By Nadun
Peradeniya)
• 5. Does any proposition for amendments or modification of the proposed project
• Credit officer should see the capacity of the borrower and possible cash flow generation through the new project
after the loan granted. If there’s anything to modify or amend in the first proposition that has to be highlighted
and communicated among both parties.
By Nadun
Peradeniya)
Financial sector is exposing to many risks and those can be broadly categorized into two such financial and non-
financial risk.
Financial risk Non-Financial risk

There are two main categories under this as Operational risk is the risk seen in this category
1. Credit risk
2. Market risk
By Nadun
Peradeniya)
• Credit risks involve borrower risk, industry risk and portfolio risk.
• It is also known as default risk which checks the inability of an industry, borrowers who are unable to meet the
commitments of making timely settlement of financial obligations.
• Internal and external factors are influencing credit risk of a financial institution.
• Internal factors consist of lack of proper evaluation of borrower’s financial status, inadequate risk pricing,
lending limits are not defined properly, absence of post sanctions surveillance/credit review, proper loan
agreements or credit policies are not defined etc.
• Whereas external factor comprises of trade restrictions, fluctuation in exchange rates and interest rates,
fluctuations in commodities or equity prices, tax structure, government policies, political system instability etc.
By Nadun
Peradeniya)
• credit risk was the primary task or challenge for financial institution in early days.
• Due to the modernization and progress in banking and non-banking financial sector, market risk started arising
such as fluctuation in interest rates, changes in market variables, fluctuation in commodity prices or equity prices
and even fluctuation in foreign exchange rates etc.
• it became essential to manage the market risk too as minor change in market variables results into substantial
change of economic value of financial institutions.
• Market risk comprises of liquidity risk, interest rate risk, foreign exchange rate risk and hedging risk.
By Nadun
Peradeniya)
• For a better risk management practice, it is essential to manage the operational risk.
• Operational risk arises due to the modernization of banking and non-banking industry and financial markets
which gave rise to structural changes, increase in volume of transactions and complex support systems.
• Operational risk can be described as risk related to settlement of payments, interruption in business activities,
legal and administrative risk.
• As operational risk involves risk related to business interruption or problem so this could trigger the market or
credit risks. Therefore, operational risk has indirect link with credit or market risks.
By Nadun
Peradeniya)
• However the credit officer should be able to convey the credit decision to the borrower without undue delays. As
bankers and financiers, we need to understand that as one important fact of lending. No any borrower is liking to
be in long suspense period or to honor unnecessary information requirements. He/she may like to have the loan
in shorter time with minimal information requirements. If a bank or finance institution is requesting clients to
submit more information and documents in addition to he/she was previously communicated, there has to be
justifiable reasons. Other than that, the lender should follow the initially communicated process to grant the
facility without additional documentation.
• This may show how competent you are in your job role, and understanding of the entire credit grating process of
the bank.
• Delays of the process may lead to borrower’s dissatisfaction and subject to incur loses to the borrower.
• However even if the SLA (Service level agreement) it says, to give speediest service to the customers,
• The prudent credit officer should evaluate the capacity of the borrower, possible cash flow generations, viability
of the project and profitability to the bank in detailed manner. If the credit officer is satisfied, need to go with the
proposal or decline if the factors are not satisfactory.
• Nadun
By If any loan is going to NPA /NPL (Non performing advances/non-performing loans) category, there’s huge
responsibility of the credit officer forIBF(2nd
Sooriyaarachchi(ACMA,CGMA,FICM(SL),AIB(SL),BA(Hons) such scenarios. 16
class)-UWS(UK),Cert in counselling psychology(University of
Peradeniya)
• Further to above principles, the following factors are very much important of the credit granting process. It may
support to have quality loan portfolio of the company.
• 1. The borrower’s reputation
• 2. The Capacity to borrow and repay.
• 3. Profitability to the lender
• 4. Purpose of Advance
• 5. Amount Requested
• 6. Duration of the advance / Terms
• 7. Collaterals and security available
By Nadun
Peradeniya)
• The banks and financial institutions are facing many difficulties on finding new borrower with credit worthiness
and trustworthiness. Both these aspects should go in pararall. However the creditworthiness can be ascertained
to a certain level but ascertaining trustworthiness is quite challenging.
• We cannot expect all borrowers to be very honest and reliable. There are many instances where we have
experienced that many borrowers who had creditworthiness but willfully defaulted the loans. Therefore to strike
a balance between those two key factors is difficult in practical application.
• The borrower’s reputation describes in financial terms, the financial discipline of the prospecting borrower and
willingness to repay the loans without any delay. The borrower should have a better financial character. Lender
can refer the CRIB report of the borrower to verify those. However CRIB report may not show all the borrowings
but only the facilities granted through member institutions of the CRIB.
By Nadun
Peradeniya)
• Further to the financial character of the borrower, banker may see the memberships and social activities and
positions holds by the borrower. Those factors may reflect the social involvement of the client and his social
reputation to a greater extend.
• Ex:-Pensioner those who holds positions of civil society, sports clubs.
• Anyway the banker should have well-planned discussion with the client to reveal those information, well –
organized questionnaire can support to this objective.
• The borrower’s educational qualification, his business achievements, social activities and the positions held by
the borrower, memberships with professional institutions are some other key factors to measure the borrower’s
character.
• Finally the banker should see whether the borrower is honest, reliable and having proper satisfactory track
records on the previous loans.
• If any borrower with financial discipline may have satisfactory relationship with other financial institutions as well.
• Being a person with good character is not sufficient to grant a loan but it may be a key factors coming forth other
than the rest of the considerations.
By Nadun
Peradeniya)
• Financial institutions are considering only the borrowers those who have regular monthly or annual income to
grant loans.
• However other than above conditions, bankers may see few other eligible factors of the borrowers before they
go with loan contract.
• Eligibility for a loan facility will be determined with following factors as well.
• i). Legal age to enter into contractual legal relationship (This age may be considered as 18 years or
above in Sri Lanka)
• However minors can be considered as borrower when granting educational loans with joint party such as their
parents or guardians.
By Nadun
Peradeniya)
• ii). Good mental health to understand the terms and conditions of the contract
• If anyone suffering from any mental illness or being mentally incapable for entering into legal contractual
relationship will not be considered as prospecting borrower to a loan facility. Therefore banker or the financial
institution needs to check whether the borrower has good mental health and free from any mental incapability to
be eligible for entering into legal contract.
• iii). Physical health of the borrower
• Banker should ensure the borrower is not suffering from any severe illness and physical weakness. If any
person suffering from any severe illness or physical weakness may disqualify for being prospective borrower for
a loan contract.
• iv). People who are in defaulted list of any credit bureau.
• If anyone in the defaulted list of any credit bureau and if that information has been captured by the lender, lender
may not grant any further loan facilities to such borrowers. Therefore no any black listed person according to
credit bureau may consider as eligible borrower for further loans.
By Nadun
Peradeniya)
• v). Banckypt people
• If anyone has been declared as bankrupt person by a legal framework, he or she may not be an eligible
prospecting borrower for loan facility.
• vi). Clients those who are reluctant to give required information

• If any client is not willing to disclose required information according to the banking framework required, may not
be eligible client for borrowing from that particular company. Therefore such borrower’s loan applications will be
rejected without taking into consideration for further proceeds.
By Nadun
Peradeniya)
• Those are few factors to be eligible for credit and there are other factors to be considered to measure the
repayment capacity of the prospecting borrower.
• If anyone who has fixed monthly income may be considered for borrowing with the base of his monthly regular
income as security.
• However the lender needs to ensure that present obligations of the borrower should not exceed 60% of his
gross income and at least 40% of the gross salary needs to be available for him as take home salary.
• Incentives, annual bonuses or any other one off payments will not be taken into calculation of regular income,
but incentives and commissions as average of last 06 months or 12 months may be considered and regular
income when calculating the income of a sales /marketing person.
• If anyone has signed as guarantor to any other person and the rental of that loan should be provisioned and
considered as present obligation of the borrower, however this may be set with accordance of the credit policy of
specific company. As lender you may have right to treat guarantor facility’s rental as present obligation or ignore
it, However it has to be clearly mentioned in the credit policy document of the lending institution.
• Corporate borrowers and other business people’s repayment capacity can be accessed based on their
revenues. Income and expenses can be referred through their financial statements.Calcuating financial ratios is
one technical method to check the eligibility of the borrower in terms of repayment capacity.
By Nadun
• Also the clients those who have notIBF(2nd
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loan.
Peradeniya)
• Profitability to the lender is the margin of interest income and interest expense basically. However when
calculating the margin to the lender there are another factors to be taken in to the consideration such as
overhead expenses (Other expenses) and risk premium.
• The loan pricing is concerning on the lending rate can be charged to borrowers. This can be seen in different
forms such as
• i)Fixed Rate
• ii) Floating Rate
• iii) Prime Lending Rate
By Nadun
Peradeniya)
• Fixed rate is basically charge equal interest rate over the period of loan and it will never change based on any
other concerns in timely manner. Bank will be benefitted when the situations of lending rate goes lower and
borrower may be benefitted when the lending rate goes high. However fixed rate is more suitable for the
borrower where they borrowing money in weaker economies with no proper predictions can be taken place.
By Nadun
Peradeniya)
• Floating rate is the rate which subject to change over the period of loan with the market conditions. If the market
rate is high the borrower may be charged higher rate and lower the market rate will effect lower rate to the
borrower. This agreement has speculation where lender can win or lose at any given time period.
By Nadun
Peradeniya)
• Prime lending rate is the rate which a premier client of the bank can entertain. This rate will be offered to the
high net worth clients of the bank. This rate usually lower than the regular rate of the bank. Offering prime
lending rate is solely depending on the total business volume and the nature of the business each premier client
has. Sometimes this may call as average weighted prime lending rate (AWPLR).
• Average Weighted Prime Lending Rate

• Average Weighted Prime Lending Rate (AWPLR) is compiled weekly by the CBSL based on information
provided by Commercial Banks regarding lending rate offered to their prime customers during the week. These
loans are granted by Commercial Banks usually on a short term basis.
By Nadun
Peradeniya)
i) Cost of funds
ii) Profit targets/Profit expectation/Target profit margin
iii) Risk premium
iv) Guidelines of the regulator
v) Cost of the company (operational and overhead expenses)
vi) Loan type (secured loans /unsecured loans)
vii) Interest rate type (fixed or floating)
viii) Period of loan
By Nadun
Peradeniya)
• As we know that no any financial institution is capable of providing all the funds itself. They all have to have
different funding sources such as public deposit taking (Fixed deposits and savings), corporate borrowings,
issue of shares, debentures or any other options available for them.
• Each source of borrowing may have different cost to the company, Always the finance company needs to set the
lending rate above its borrowing rate/or the total cost incurred to borrow the funds which made available for
lending.
By Nadun
Peradeniya)
• a profit margin on each loan that provides the bank with an adequate return on its capital.
By Nadun
Peradeniya)
• No each and every loan contains a same level of risk, however measuring each loan contract’s risk is not be
very practical. Therefore finance institutes are categorizing loans based on the risk weighting of each segment
and price the loan. The loan with higher risk premium may be charged higher rate and lower risk premium loans
may be charged lower rate.
Note: The risk premium is the rate of return on an investment over and above the risk-free or guaranteed rate of
return.
Risk premium=Expected rate of return-Risk free return
The risk-free rate is the rate of return on an investment when there is no chance of financial loss. For example, the
government backs Treasury bills, which makes them low risk. However, because the risk is low, the rate of return is
also lower than other types of investments.
By Nadun
Peradeniya)
• CBSL being the governor to all finance institutions, it temped to offer guidelines of lending rates according to the
sector and requirement of the government. It may be imposed a ceiling of rates and issue several guidelines on
maximum loan rates.
• Ex:-Government needs to develop agriculture in next 10 years and CBSL will ask financial institutions to grant
agriculture loans at ceiling /controlled rate of 4%.
By Nadun
Peradeniya)
• Some financial Institutions may have higher operational costs such as salaries and wages, infrastructure,
building rent etc. Therefore loan pricing is a depended factor of other costs related to the bank or the financial
Institution.
• What are Overhead Costs?
• Overhead costs, often referred to as overhead or operating expenses, refer to those expenses associated with
running a business that can’t be linked to creating or producing a product or service. They are the expenses the
business incurs to stay in business, regardless of its success level.
• Overhead Cost Examples
• A company’s overhead costs depend on the nature of the business
• Overhead costs can be broken down into three types:
• Fixed
• Variable
• Semi-variable
By Nadun
• Fixed expenses are the same every month – such as rent. Variable costs increase or decrease, depending on 33
how busy the business is. This could include wages for certain employees. Semi-variable costs are those that
Peradeniya)
are incurred regardless of the activity level, but which might increase as business gets busier.
• There are two types of loans available in the loan portfolio of any financial Institution. Some loans may have a
security such and property mortgaged, personal guarantors, vehicle or stock in trade. Those loans will be called
as secured loans and they are subjected to security realization in event of loan default. Bank has assurance of
realizing the secured asset if the borrower no longer available to repay the loan. These loans are subject to
realization of security as per the bank which any some loans such as credit cards, other professional loans
without guarantors.
• Unsecured loans are meant to be the loan which not security to minimize the risk for the lender’s perspective.
Usually those loans charged higher rate than other secured loans.
• Further each loan product has pre-determined interest based on its features.
Ex:-personal loans/mortgage loans/leasing(Auto loans)/
By Nadun
Peradeniya)
• Interest rates come in two basic types: fixed and floating/adjustable. Fixed interest rates don’t change over time.
Floating/Adjustable rates may have an initial fixed period, after which they go up or down each period based on
the market.
• Usually initial interest rate may be lower with floating/adjustable-rate loan than with a fixed rate loan, but that
rate might increase significantly later on(depends on market conditions).
By Nadun
Peradeniya)
• Usually loan term and interest rate are having positive relationship.
• The loan period given by the lender to the borrower in paying instalments. Generally, the longer the tenor/period,
the higher the interest rate offered. On the other hand, shorter period will offer lower interest rate.
By Nadun
Peradeniya)
• The purpose of the loan must be very much specific. Borrower needs to prove the funds received through a
lending is used for the specific purpose as mentioned in the loan application. No any deviations are accepted by
the lender. Also lender should be able to conduct relevant inspections to assure the loan is granted for the
purpose which declared in the application by the borrower.
• Banks and financial institutions are not accepted to grant loans for the purposes which are not acceptable
according to society and law of the country.
• Those are such,
• i) Illegal activities
• These activities are involved such as dealing of dangerous drugs, dealing of lethal weapons and smuggling.
However there are so many we can name here and need to avoid from financing for such businesses as they
are prohibited by the law.
• ii) Terrorist financing
• Nadun
By If anyone involved in terrorist activities directly or indirectly, they are not eligible for credit facilities from a bank or
Sooriyaarachchi(ACMA,CGMA,FICM(SL),AIB(SL),BA(Hons)
financial institution. Such purposes IBF(2nd are not be considered for any credit facility in the form of personal loan, 37
project loan or credit cards.
Peradeniya)
• There are many purposes of a loan, However we can divide all loan purposes to broader few categories such as
i. Long term finances/project finances /term loans
ii. Working capital loans/short term loans
iii. Consumption purpose loans
iv. Speculative purposes
By Nadun
Peradeniya)
• These loans are granted for long term investments such as undertaking projects, buying fixed assets such as
land, buildings or machineries (usually called as PPE-Property, plants and equipment)
• Before granting these loans, the lender needs to evaluate the project for its financial viability, entepreneual skills
of borrower and industry knowledge of borrower. Those factors may let feel the lender comfortable to a certain
extend. However it is not enough to satisfy with the proposal there are many to deep analyze and understand.
• Term loans are given an opportunity to lender to have a grace period for loan repayments, May this period will
start from 6 moths to 1 to 2 years based on the cash flow generation (projected cash flows of project).Grace
period means client is paying only the interest component of the rental and capital repayments will start after the
grace period.
By Nadun
Peradeniya)
• Working capital loans are granted for businesses to meet their day to day expenses. Many businesses are
needing working capital loans to finance their day to day business activities such as paying for creditors, paying
utility bills, salary payments or buy new stock for trading or raw materials for productions.
• Lender needs to proceed few calculations and confirm the exact requirement of working capital for a certain
period. That amount will grant to client. However it is advisable to proceed better checking and evaluation before
you proceed a working capital loan.
By Nadun
Peradeniya)
• Amount required is linked with the purpose directly. Borrower may require specific amount of money for a
purpose such as building house, undertaking a new project or buying new vehicle to business. However
measuring the exact money which the borrower required quite challenging. A prudent credit officer may access
the fund requirement at the first time of interviewing client. Further this will be the fact that measure the real
ownership of borrower to the new project. Meaning which the real portion of money he/she puts out of total value
of project.
• For an example think of a situation of buying a vehicle for Rs.1mn.
• 1st situation
• Lender may grant 1mn loan to borrower to finance the requirement. The borrower may feel that asset (vehicle) is
fully owned by the lender as he contributes nothing, also in case of ceasing the asset borrower may lose only
the paid rental value.
• 2nd situation
• Lender may grant only Rs.0.7mn for finance the same requirement and borrower should bring Rs.0.3mn from
By Nadun
his own fund. In case of ceasing the asset borrower may lose paid rentals plus capital he /she
brought in to
finance thisinrequirement.
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• Most lenders do wrong on determining the amount of a loan. Usually they may cut a portion requested and lend lesser
than the amount requested by borrower. Some may overly lent without proper analyzing of the requirement. Both
situations are bad and both are having their own disadvantages.
• If overly lent
• Borrower may misuse the excess money as no pre plan
• Add unwanted features to project which can lead high maintain costs in the future
• Gearing position of borrower may go up (Interest cost will increase)
• If lent with shortage

• Abandon/give up the project/or delay
• Default on amount granted
• Borrowing from another party to bridge the gap
• Increased interest cost
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requirement.
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• Duration of a loan causes to determine the monthly installment, Duration of a loan may decide the interest rate
applicable for the loan.
• If it explains further ,if you want to borrow some money for 3 years(36 months) the rate applicable for the loan
may be 12% ,however if you are asking lending institution to extend the period for 5 years (up to 60 months ) the
lender may apply 14% for the same loan.
• Why this happen so, if you extending the period /duration of a loan borrower may tie up for longer period with an
obligation to repay monthly installment. The risk factor may increase for the lender’s side as borrower may stop
payments at any given point of time of loan period causing lender to lose the rest of rentals.
By Nadun
Peradeniya)
• Borrower with high integrity would meet financial obligations in absence of collaterals or securities offered.
• However situations are worst in current business context where some loans are not getting proper repayments
even if strong collaterals are given.
• Bankers and financiers are tempted to obtain strong collaterals/securities when offering loans to clients in form
of mortgages.
• Lender has two options of get loan repayments (cover the interest receivable plus capital) ,one is getting all due
rental payments on time and 2nd is realizing collaterals to recover the financial obligations of borrower when he
stops repaying the loan.
• First option is called “first way out” and 2nd option is “second way out” which lender needs to resort for realizing
assets given as securities/collaterals.
By Nadun
Peradeniya)
• Securities are starting from cash to immovable properties such as land, buildings and machineries fixed to land.
Base of having this order is liquidity of assets, cash is known as highly liquid and properties such as lands,
buildings are lesser liquid by its nature.
• Important factors are to be considered when taking collaterals,
i. Clarity/clearance of the ownership of the asset
ii. The lender should have right to control the security (Need to have legal ownership of the asset)
iii. Marketability of the asset
iv. Maintenance of the asset by the borrower/consistence market value
v. Emotional /social factors beyond legality
• For an example-Assuming a given housing loan facility been defaulted by a client and will not be able to find
sufficient income to pay off them in future as well. However borrower has a child with serious illness under
By Nadun
medical treatments,
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in counselling psychology(University 45
Peradeniya)
• Loan documentation can be considered as the main function of financial institutions in its credit granting
process.
Importance of loan documentation

• To verify the customer's identity
• To verify the customer's financial status and ability to repay
• To successfully complete the respective loan process by adhering to the policy document
• To reduce the risk of credit using acceptable securities
• To meet legal requirements
• In order to maintain the smoothness of the risk-managed lending process
By Nadun
Peradeniya)
• Documents related to the customer
1. Loan application
2. Documents confirming identity
i) National Identity Card
ii) Passport
iii) Driving License
3. Documents confirming residence
i) Electricity Bill
ii) Water Bill
iii) Gramsevaka Certificate
iv)Tenancy Agreements
By Nadun
Peradeniya)
4. Income verification documents
Recent salary statements(Preferably last 03 months or 06 months)
Recent account statements
Financial Statements(Balance sheet, income statement and cash flow statement document)
5. Documents confirming the profession or the relevant business engaged in

Business Registration Certificate
Company Registration Certificate
Partnership Agreements
By Nadun
Peradeniya)
6. Credit Information Bureau Report
7. Documents related to the security offered
i) Property securities
Valuation report
mortgage deed
Street line certificate
Approved survey plan
ii) Vehicle securities
Valuation report
Revenue Licence
CR copy/ original, Transfer papers(MTA 06/08),vehicle photos
By Nadun
Peradeniya)
8. Documents related to the financial institution
Offer letter, Agreement,guarantees,Inspection reports
Based on the purpose

* Sales agreement-Land purchases related
* Bill of quantity –Housing loan purposes
* Balance confirmation letters –(For loan takeovers )
By Nadun
Peradeniya)
Offer letter
The offer letter consists of the following components prepared by the financial institution presenting the proposal related to
the granting of the credit facility and forwarding to the customer's acceptance for the same.
Date ,Borrower's Full Name & Address ,Credit Facility Value ,Purpose ,terms and conditions of interest repayments and
Securities are included in the offer letter.
Loan application
After receiving the application submitted by a borrower for obtaining a loan, it is an essential factor that the financial
institution granting the loan to properly identified applicant. It is hereby established that the accuracy of the important
information disclosed by the applicant in his application should be taken into account, especially in the event that the
applicant has not maintained strong relationships with the lending institutions for a period that can be considered
reasonable.
It is very important to follow KYC(Know your customer) and CDD(customer due diligence) principles and requirements
imposed by the regulator(CBSL) as well.
By Nadun
Peradeniya)
Loan agreement
Loan agreement is a formal contract between a lender and a borrower.
Lending agreements spell out all the details of the loan, such as the principal amount, interest rate, terms and
conditions , fees, payment terms and any covenants. It also outline the rights of a lender to collect payment in the
event of borrower defaults.
promissory note
Promissory note is a written agreement under which one party agrees to pay another party a certain amount of
cash on a future date. The date may be a fixed date sometime in the future, or on demand. The note typically
contains the name of the payee, the name of the maker (payer), and the sum to be paid. It also includes the
interest rate that applies to the debt, the maturity date, the signature of the maker, and the date signed.
The payee is the holder of a promissory note. Once the underlying funds have been paid to the payee, the payee
cancels the note and returns it to the maker.
By Nadun
Peradeniya)
Letter of set off
Financial Institutions obtain borrower’s written consent to seize an account for non-payment of a loan or other
obligations. In order to offset credit balance of one account with the debit balance of another ,this letter would be
essential. Other than such consent to set off credit balances with debit balance of another account would be
challenged to financial institution in a situation where client defaults.
By Nadun
Peradeniya)
Credit Officer responsibilities include preparing loan applications, evaluating client’s creditworthiness through
analysing financial ,non-financial information and calculating risk ratios as applicable.
Credit officer plays a vital role in credit granting process of a financial institution in the way of
* Acquiring profitable clients to the business
* Maintaining healthy relationship with internal and external clients
* Identifying risk areas and work with relevant teams to overcome them
* Support to define and draft credit products
* Support business development through acquiring good credit clients
* Better awareness of internal and external environment
* Comply with internal procedures and regulator guidelines
By* Nadun
Follow up and maintain healthy credit portfolio for the betterment of the company
Peradeniya)
Nadun Sooriyaarachchi
(ACMA,CGMA,FICM(SL),AIB(SL),BA(Hons) IBF(2nd class)-
UWS(UK),Cert in counselling psychology(University of
Peradeniya
0773822174
Email:
nandun.sooriyaarachchi.ns@gmail.com

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Lesson 02

Basic principles of credit evaluations

• Basic principles of credit management

By Nadun Sooriyaarachchi(ACMA,CGMA,FICM(SL),AIB(SL),BA(Hons) IBF(2nd

Financial risk Non-Financial risk

• vi). Clients those who are reluctant to give required information

• Average Weighted Prime Lending Rate

• If lent with shortage

Importance of loan documentation

5. Documents confirming the profession or the relevant business engaged in

Based on the purpose

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