INTRODUCTION
Credit Assessment involves and thereby, determining the amount of loan to be granted to them.
A proper analysis of discharge of funds should be made as excess finance may result into investment in non-productive areas and lesser finance can result in underutilization of capacity. Proponents have to submit their proposals for loans in Loan Application Forms.
PROCESSING LOAN PROPOSALS
General Factors:
Before analyzing the information provided by the proponent in the Loan Application Form, it is important for the banker to take into consideration certain factors. These factors constitute an important determinant of the company’s ability to become profitable in its later years.
The factors can be categorized into two groups:
Intangible Factors
·Integrity
·Experience
·Technical and Managerial Competence
·Motivation and Initiative
·Financial Acumen
·Temperament
Integrity
This factor plays a vital role in assessing the borrower. He should be sincere and trustworthy, to become eligible to get the approval for open loans. These loans are granted against current assets under a floating charge.
Experience
For a businessperson, experience counts largely. Experienced people run the business more successfully than inexperienced or fresh graduates.
Technical and Managerial Competence
Every business requires talented and capable managers to achieve utmost success in the performance. The banker must closely examine at the achievements of the company. He can make a surmise about the ability of the managers working therein.
Motivation and Initiative
An internal desire to excel at work is a necessity for a businessperson to become successful. Thus, a motivated businessperson is likely to take more initiative to capture half-opportunities and later turn them into profitable accomplishments, than an unenthusiastic person.
Financial Acumen
Apart from technical knowledge, drive, and initiative, the banker should make sure that the borrowers possess sound knowledge of accounts and financial management, in order to bring efficiency in their work performance.
Temperament
The borrower should have a sound temperament, which means his intention should be to make investment in the upgradation or improvement in the firm’s capacity, and not for speculative purposes. This way he would also qualify as a good credit risk.
Objective Factors
·Quantum of Finance
·Purpose
·Business Prospects
·Source of Repayment
·Proportionate Stake
·Security
Quantum of Finance
The amount of lending should necessarily match the borrower’s needs. Surplus funds may result into diversion of funds, whereas, shortage of funds may lead to the unfeasible operations becoming, or otherwise forcing the borrower to borrow from other sources at excessive rates.
Purpose
The banker should ascertain that the proponent determines the purpose for which borrowed funds would be utilized. This would form the basis for processing and monitoring the credit proposal of the proponent.
Prospects of Business
The business prospects should be carefully examined to assess their viability and growth. The prospects of business depends upon the following factors:
·Market scenario in the industry
·Suitability of the location
·Quality of management
·Availability of raw material, labour and other inputs
Source of Repayment
The banker should try to anticipate the source for repayment of the loan. They could be the following:
·Capital inflows. For e.g. loan proceeds, sale of investments, etc.
·Non-operational profits. For e.g. sale of license, sale of a brand name, etc
·Conversion of assets into cash
·Profit after tax
Proportionate Stake
The banker should make sure that the owner has a considerable stake in the business. The amount of funds invested by the proprietor or shareholders should match with the risks involved in the project.
This can be measured with the help of two ratios:
·The ratio of Long-term Debt to Net Worth should not be more than 2:1. This means Debt should not be more than twice the Net Worth.
·The ratio of Total Outside Liabilities to Tangible Net Worth should not be more than 3:1. This means the Total Outside Liabilities should not be more than thrice the Tangible Net Worth.
However, these standard ratios keep changing on the basis of the industry norms and the policy of the lending bank.
Security
The analysis of Credit proposals is based on assumptions and future predictions, which are not reliable. Thus, the risk or uncertainty can be minimized if the credit is supported with a security that can be liquidated in case of non-payment of loan. A margin should be kept on the value of security on the basis of the variability risk in the value of security.
‘Margin’ is the difference between the value of security offered against a loan and the outstanding value of the loan.
A security must possess the following features:
·Marketability
·Easily ascertainable value
·Stability of value
·Storability
·Transportability
·Durability
·Ascertainment of title
·Easy transfer of title
·Absence of contingent liability
Information Sources
The Banker can obtain all relevant information about the proponent with the help of the following sources:
Loan Application Form
The loan application form gives details on the type and amount of facility required; the names, addresses and background of the proponent, and details about the business, such as line of activity, plant location, market share, competitors, etc.
Financial Statements
Financial statements of the proponent are quite useful. These include Balance Sheet, Profit and Loss Account and Fund Flow Statement of a firm. A thorough analysis of these statements provides relevant information about the proponent. The balance sheet provides a snapshot of the proponent’s assets, liabilities, and net worth. The profit and loss account summarizes the financial transactions of the proponent’s business over a period in time.
Credit Report
The financial statements of borrowers are rated by various credit rating agencies such as CRISIL, ICRA, CARE, etc. on the basis of detailed assessment of credit risks. This rating can prove to be a valuable source for providing information on the degree of risk involved in lending credit.
Income Tax / Sales Tax / Wealth Tax Returns
The banker can utilize the information provided in various tax returns of the proponent to check for any mismatch in the information provided by the proponent in person.
For example,
·The amount of sales declared in the sales-tax returns should be corresponding to the turnover in the Profit and Loss Account.
·The Profit and Loss Account may show overstated profits, if the income declared in the income-tax return is considerably lower than the profit as per Profit and Loss Account.
Operations in the account
In case of an existing account, before lending further, the operations in the account should be properly examined keeping in mind the following aspects:
·Turnover in the account - The total credit in the account over a period should match the turnover of the proponent.
·Regularity in servicing of dues / frequency of over-drawings - There should be regularity in servicing of dues, as recurrent overdrawing or delay may indicate lack of financial control.
·Return of cheques - Frequent return of cheques drawn by the borrower may indicate lack of liquidity. Return of cheques deposited by the borrower may indicate complexity in realizing receivables.
·Cheques - The cheques drawn by the borrower should be in favor of suppliers, and not in favor of sister concerns to avoid the possibility of diversion of funds.
·Income generated - Income via interest, commission and fees should be enough to cope with the risk and exposure involved.
Stock Statement and Debtors Statement
The stock statement and debtors statement should be carefully examined to check for any obsolete or outstanding debts. The stocks statement provides information about the price and quantity of inventory held, while the debtors’ statement provides age-wise breakup of outstanding receivables.
Stock Inspection Report
The banker can get information about the proponent from the stock inspection report made during an inspection of the financed unit by the bank's officials.
Market Report
Market report can be a very useful source for providing information about the earnings, the position, and the reliability of the applicant.
Bank Report
The banker should obtain the opinion of previous lenders. This will help in ascertaining the track record of dealings with them.
Cash Flow / Funds Flow Statements
These statements provide information about the sources from which funds have been raised and the uses for which these have been applied. A close analysis of these statements would indicate any diversion of funds or investment in non-productive areas. These statements also help in analyzing the sources where the short-term funds have been put to use.
Personal Interview
A personal interview can be used effectively in making an assessment about the proponent’s own understanding about the business, his disposition and his personal integrity.
Project Report
A project report provides information about the expected outflows and inflows from a project over the years to come. The outflows can take the form of capital expenditure, day-to-day running expenses and repayment of loans and other liabilities. The inflows can take the form of capital, loans and trade credit.
The assumptions drawn on the viability of the project should be properly examined and the banker must ensure that various calculations have been made correctly.
The banker should also consider for any changes / alterations in the assumptions.
RECLASSIFICATION - THE CMA FORMAT
Before analyzing the financial statements, the banker must organize the items in a standard format as per the RBI under the Credit Monitoring Arrangement (CMA) Scheme.
The reclassification of the financial statements is quite essential from the shareholder and the government’s point of view, whereas, the banker acts as a lender of ‘Working Capital’ and, so he has a different perspective altogether.
The main area of focus for a banker is the liquidity of the borrower’s business and his capability to repay loans on time.
Thus, the CMA format has been specially designed to reiterate the information presented in the financial statements, and provide the banks with useful information about the borrower.
WORKING CAPITAL
This refers to the amount of money that a company has tied up in funding its day-to-day operations, such as payroll, benefits, rent, and other operating costs.
The amount of working capital can be positive or negative. Companies with enough working capital is successful as they can invest the capital in expansion and improving their operations, whereas, companies with negative working capital may lack the funds necessary for growth.
The Banks reclassify the items of financial statements of the proponent to get a clearer picture of the working capital employed in the business.
The aim of every business owner is that his production process should run smoothly.
·Getting converted into finished goods at a fast pace
·Getting sold off immediately for cash after rolling off the assembly line
·Available in the market at any quantity, at any time, and at a fixed cost
However, in practice, the situation is completely different.
An industrialist often faces the problem of shortage of raw materials in the market as per the desired quantity. The prices too do not remain fixed always. This situation is more prominent in case of raw materials seasonally available.
Sometimes, even production process gets delayed. For e.g. in case of shipbuilding, the production process may stretch a little longer.
In actual situation, finished goods cannot be sold off immediately. Most of the time, stocks keep lying in the warehouse, and only a certain portion of them gets sold off in a particular accounting year.
In fact, sales are not always made in cash. Due to intense competition and industry norms, sales are made in credit basis.
All these factors give rise to a delay in time between outflow and inflow of funds. Due to time delay, assets are created for this intermediate period known as ‘Current Assets’. The total amount of funds required to create these assets is known as the ‘Working Capital’.
Working Capital – Sources of Finance
The sources of financing current assets include the raw materials’ suppliers, advances against orders and security deposits from their distributors, etc. These comprise the current liabilities, and these liabilities are used to finance a portion of the current assets.
Working Capital Gap is the difference between a firm's current assets and current liabilities.
The working capital gap is financed partly by the owners of the business through the excess of long-term liabilities over long term uses. This is known as the ‘Net Working Capital’.
MAXIMUM PERMISSIBLE BANK FINANCE (MPBF)
We have to understand the mechanism of calculating the required working capital as well as bank finance. To calculate the ‘permissible level of bank finance’, the Tandon Committee has set up the following guidelines:
·The credit needs of the borrowers / proponents should be assessed on the basis of their business strategies.
·Bank credit should be in addition to the borrower's own resources, i.e., banks should not finance the entire working capital gap.
·Borrowers must hold inventory according to the norms set by the RBI.
·Credit should be made available in different components only, depending upon the nature of holding of various current assets.
·The borrowers have to submit data with respect to their nature of business and financial operations for the past and future periods at regular intervals, in order to facilitate the lender to have a close watch on them.
The Tandon Committee suggests that banks should invest only a portion of the working capital, and the borrowers should become less dependent on banks to finance their working capital requirements.
In the background of credit expansion seen in 1977-79 and its ill effects on the economy, RBI appointed a working group to study and suggest:
1) Modifications in the Cash Credit system for the better management of funds by the Bankers.
2) Alternate types of credit facilities to ensure better credit discipline and co-relation between credit and production.
The Group was headed by Shri K. B. Chore of RBI and was named Chore Committee. The recommendations given by the Tandon Committee were implemented in all Banks. Thereafter, Bank Credit became much more organized.
However, it was observed that there is a mismatch of demand and availability of Bank Credit during peak and non-peak periods of activity.
The Committee later suggested that the limits should be sanctioned separately to take care of the situations where the operations were thought to be cyclic in nature.
Since 1997, the MPBF has been into existence and the banks have been given full freedom to devise their own method of assessing the short-term credit requirements of the borrowers and grant lines of credit accordingly. Most banks, however, continue to be guided by the principles enunciated in Tandon Committee report.
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