CREDIT APPRAISAL PROCESS

&
FINANCIAL PARAMETERS
Presented by-
Arpan Jyoti Sarma- PM-211-836-0005
Ashish Boruah- PM-211-836-0007
Debabrat Das- PM-211-836-0013
Gayatri Nath- PM-211-836-0022
Pulakesh Tahbildar- PM-211-836-0048
Rashmi Rose Doley-PM-211-836-0050
WHAT IS 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.
 Proper evaluation of the customer is preferred which measures the
financial condition & ability to repay back the loan in future.
 Role Of Banks as Financial Intermediaries
• Prime objective of Financial system is to channel surpluses arising in
the economy into deficit units.
• Financial Intermediaries create assets out of the surpluses .
• Financial Intermediaries Serve three important purposes
 Mitigate the default risk of deficit units when surplus units lend them
 Ensure Liquidity of Savings
 Lowers Information Cost
Who needs Credit?
 Banks give credit to different borrowers for different purposes
and this is the primary and cheapest source of debt financing.
 Both demand and supply side of the economy requires bank
Credit.
 Consumers of goods and services constitute demand side and
they take credit to acquire assets
 On the supply side is the corporate and government sectors that
require credit for manufacturing.
 Financing demand side of the banking is called retail banking and
supply side is called wholesale banking
Features of Bank Credit

 For banks, good loans are the most profitable assets.

 Banks always looks for higher returns. Returns come directly loan
interest or from indirect fee based ancillary service.
 Risk like interest rate risk & default risk are always associated with
loans.
 Loan maturities, pricing and methods of principal repayment affects the
timing and magnitude of banks cash inflow
 THE CREDIT PROCESS

 The credit officer has to deal with conflicting

objectives of increasing the loan portfolio (his
targets) while maintaining loan quality.

 The
strategic role of credit officers assumes
utmost importance.
CONSTITUENTS OF CREDIT
PROCESS

THE LOAN POLICY

 These are written documents, authorized by individual bank’s Board of Directors, that formalize
and set guidelines for lending to be followed by decision-makers in the bank.

 BUSINESS DEVELOPMENT AND INITIAL RECOMMENDATIONS

 Business development efforts for credit expansion should preferably begin with market research and detailed credit
investigation.
 Once prospective credit customers are identified, credit officers try to obtain formal loan requests from these
customers.
A typical credit appraisal would deal with the following issues

 What are the risks inherent in the borrower’s business? These risks are classified into market-related risks,
technology-related risks, environment-related risks and so on.
 What are the antecedents of the borrower? What is his reputation and integrity?
 How is his track record?
 What are the financial risks inherent in the borrower’s business?
 Is the project economically viable?
 Is the project financially feasible?
 What risks are inherent in the operations of the business?
 What have the managers of the borrower firm done to mitigate these risks?
 Does the bank want to lend to this borrower in spite of the risks? If so, what steps should the bank take to ensure that
debt repayments are not hampered?
 What risks will the bank have to take if it decides to fund the borrower? How does the bank propose to mitigate these
risks?
 Broad Steps to Credit Analysis
Step 1—Building the ‘credit file’.
The preliminary information so obtained would throw light on the borrower’s antecedents, his credit history and
track record.
Step 2—Project and financial appraisal.
Here the internal and external factors, such as management integrity and capability, the company’s performance
and market value and the industry characteristics are evaluated. One of the important activities at this stage is
financial analysis.
Step 3—Qualitative analysis.
Integrity is the most important quality that the banker looks for in a borrower, and the most difficult to measure.
Step 4—Due diligence.
Due diligence can include checking on the borrower’s address (if a new borrower), pre-approval inspections of the
borrower’s workplace, and interviews with the borrower’s competitors, suppliers, customers and employees
Step 5—Risk assessment.
A key function of the credit officer is to identify and analyze the key risks associated with the proposed credit.
Step 6—Making the recommendation.
 CREDIT DELIVERY & ADMINISTRATION

 Depending on the size of the bank, the loan size and type of exposures planned ,the final decision to lend may
be taken by an authorized layer of the bank.
 The sanction letter is generally in the form of a ‘loan agreement’, to be signed by the borrower(s)
and guarantors, if any. The loan agreement contains the following essential features:
 Nature/type of credit facility.
 Interest/discount/charges as applicable.
 Repayment terms.
 Stipulations regarding end use of each facility.
 Additional fees applicable such as processing fees, closing fees or commitment fees.
 Prime security for each credit facility.
 Full description of the collateral securities.
 Details of personal/third party guarantees.
 Covenants—terms and conditions under which the loan facilities are being granted.
 Events of default and penal provisions
 Loan Documentation

Different types of borrowers and different types of security

interests necessitate loan documentation procedures that would be
valid in a court of law. Accordingly, once the loan agreement is
signed, the borrowers and guarantors execute the loan documents.
 The security interest is said to be perfected when the bank has the
claim on the borrower’s asset .
Proper Loan documentation secures the right to take possesion of
the asset and liuidate it in case of default.
 Terms and Conditions of Lending

 These are very important ingredients of any loan agreement. The terms and conditions comprise
of three distinct portions:
 Conditions precedent: These are requirements that a borrower should satisfy before the bank
acquires the legal obligation to disburse the loan amount. relies on Material adverse change.
 Representations and warranties: The assumptions based on which credit appraisal is done and
the bank has agreed to lend money, emanate from the information the borrower himself provides
to the bank.
 The third and most negotiated part of the loan agreement is the ‘covenants’ of the borrower.
They normally take two distinct forms—‘affirmative’ and ‘negative’.
 Affirmative covenants are those actions the borrower should take to legally and ethically carry
on the business.
 Negative covenants place clear and significant restrictions on the borrower’s activities.
 Events of Default
 Such events, when they happen, may trigger the end of the banker–borrower relationship. An illustrative list of
situations that may lead to an event of default include the following:
 Failure to repay principal when due.
 Failure to service interest payments on due dates.
 Failure to honour a covenant.
 Misrepresentation of facts.
 Reneging on declarations made under representations and warranties.
 Diversion of funds without bank’s knowledge to other creditors or other accounts of the borrower.
 Change in management or ownership structure.
 Bankruptcy or liquidation proceedings.
 Falsification or tampering with records.
 Impairment of collateral, or entering into invalid agreements.
 Material adverse changes that drastically change the assumptions under which the loan agreement was entered into.
 All other force majeure events that imperil debt service
 Updating the Credit File and Periodic Follow-Up
 The credit file has to be continuously updated throughout the above process.
 Process loan payments and send reminders in case loan payments are received late.
 The borrower will have to submit updates of financial performance periodically or as per the accounting practices
in force.
 The bank can call on the borrower at any time, even without prior intimation, where the prime objective will be to
ensure borrower’s activities with bank’s expectations.

Credit Review and Monitoring

 The credit review and monitoring process is typically bifurcated into the distinct functions of monitoring the
performance of existing loans and problem accounts.
 Monitoring performance of existing loans is done in two ways.
 One is a continuous monitoring of the trans-actions in the accounts of the borrower.
 The second type of monitoring will be done through external or internal audit teams, and will be periodic or
continuous, depending on the size of credit exposures or the importance of the credit disbursing office in the bank.
 Modification of repayment of loans of watch list accounts.
FINANCIAL APPRAISAL FOR CREDIT DECISIONS
FINANCIAL RATIO ANALYSIS

• Assessment of borrower’s financial health.

• Identification of potential risk to borrower’s financial stability.
• Rearrangement of balance sheet & income statement data over a period of time to facilitate comparison.
Types of financial ratios :
• Liquidity ratio : Reflects the sufficiency of cash(liquid funds) to meet firm’s liabilities.
1. Current ratio: (2:1).
2. Quick ratio/ Acid test ratio: (1:1)
• Leverage ratios : Reflects the inherent risk in the borrower’s firm.
1. Debt-equity ratio:
It determines the long term solvency of the firm. The ratio should decrease over time & the greater
the ratio, the greater the financial risk of the firm.
2. Long term liabilities ratio:
3. Interest coverage ratio:
4. Dividend payout ratio:
• Profitability ratios: The bank expects its borrowing firm to conduct its business prudently, mitigate risks and
to yield enough profits for the long term repayments of loans, taxes and other obligations
1. ROE:
2. ROA: .
3. Gross profit ratio:
( Determines manufacturing efficiency of manufacturing firms & contribution of sales in case of other
firms)
4. Operating profit ratio:
( Measures operational efficiency)
• Valuation ratios: The real value of the borrower. The future potential is the major determinant of market
value of the firm.
1. Book value per share:
2. Price/ Earnings ratio:
3. Price/ Sales ratio:
4. Liquidation value:
• Operating ratio/Activity ratio:
1. Day’s cash inventory turnover:
2. Debtor’s turnover ratio :
3. Creditor’s turnover ratio:
4. Sales to fixed assets:
COMMON-SIZE RATIO COMPARISONS:
• Banks additionally use these comparisons along with financial ratio analysis.
• Independent of firm size and thus facilitate inter-firm comparisons
• Used along financial ratio analysis to be more specific.

CASH-FLOW ANALYSIS:
• The income statement is converted into cash flow statement just to analyze the ability of borrower to repay.
• Divided into four parts namely cash flow from operating activities, investing activities, financing activities.
• It is done to make clear distinction accounting profits measured by net income in income statement and firm’s
various activities that affects the cash flow, but not recorded.
 FORMS OF LENDING
FUND BASED LENDING

NON FUND BASED LENDING

ASSET BASED LENDING

 FUND BASED LENDING
• Direct form of lending in which a loan with an actual cash outflow is
given to the borrower by the bank

• Can be for financing capital goods, working capital requirement

• Loan syndication

• Retail lendings , education , housing, medical care

NON FUND BASED LENDING
• a promise of financial support compared to actual funds

• Letters of Credit-LC , a letter from a bank guaranteeing that a

buyer’s payment to a seller will be received on time and for the
correct amount

• and Bank Guarantee-BG , in which the bank will promise the

original creditor that if the borrower fails to satisfy his or her
obligations, the bank will take care of them
 ASSET BASED LENDING
• An asset based lending may be secured by equipment, inventory, accounts
receivable, or properties in the name of the borrower

• it is considered to be less risky as compared to unsecured lending and,

hence, it attracts a lower interest rate

• used by companies only after they have exhausted all other options of
raising capital for project financing, such as mergers & acquisitions, debt
purchasing, etc
Loan Pricing and Customer Profitability Analysis:

The Pricing of a tangible product is determined by-

• The selling price should be covered.

• It should cover the portion of the Fixed cost.
• Thereafter, it should yield a net positive return at a rate according to the firm’s policy and Market expectation.

The difference between Loan Pricing and Product Pricing:

• Every loan has a unique risk profile, which will have to be quantified and built into the price.
• The Price also depends on the profitability of the customer to the bank(Relationship pricing)

Therefore, The proper pricing of a loan is more complex and non-standardized than the pricing of a product or
service.

It also follows that, for every loan, at the minimum,

Loan Price= Cost of fund+ servicing costs+ Risk premium+ desired profit margin
Loan pricing Model:
Step 1: Arrive at Cost of funds
• Objective: To ensure that the loan price covers the variable cost.

• It is also known as the basic model for pricing the loan.

• Loan Price= Cost of funds + Desired Profit Margin

• Cost of Fund is a function of investment policy that the bank follows and is crucial in ensuring
that the bank does not make a gross loss on the loan transaction.
Step 2: Determine Servicing Costs for customer
The followings are typically assessed for each customer-

• Identify the full list of services used by the customer.

• Assess the cost of providing each service.

• Multiply the unit cost with the extent to which such non-credit services
are availed.

• The cost of credit services depends on the loan size and forms a major
portion of the servicing cost.
Step 3: assess Default Risk and Enforceability of securities
• One of the basic methods of assessing default risk is a credit scoring system. A typical credit scoring
system includes many of the risk classification criteria.

• Based on the risk value assigned to the borrower, banks build models to assess the probability of
default(PD), arising out of the bank’s prior experience with borrowers having similar risk profiles.

• The bank then puts a value on the enforceability and strength of the securities the bank holds or
propose to hold for the loan. Thus, the probable loss given default is also assessed.

• Assigning these probabilities to the loan amount and interest recoverable, the bank computes the risk
premium that will fit the borrower.

• When there is no probability of default, the bank would receive the return it desires or the rate
contracted with the borrower.
• When there is a probability of default, the expected rate would be an aggregate of the following:

a) (The probability of repayment) x ( The contracted rate Plus)

b) (The probability of Default) x ( The irrecoverable portion of the advance)

E(r) = P(R) + P(D) x ({R(P+ Pr)P}-1)

Where,
 E(r) = Expected rate
 P(R) = Probability of recovery
 R = contracted rate of interest
 P(D) = the probability of default
 P = Principal amount
 R = the recovery rate in the event of default
Step 4: Fixing the profit Margin

• One approach that can be used to set the profit margin for loan transactions is to use the ROE
as a determinant.

• ROE= ROA x EM

Where,
ROA = Net return on asset
EM = Equity Multiplier/ ‘Equity/ assets, a measure of capital adequacy of the bank.
THANK YOU