Credit appraisal is the process by which the lender asses the credit worthiness of the borrower
Validation of proposal
In credit appraisal first step is to verify the factual information with the documents provided of loan applicant. For example, in case of applicant company verify registration of company by check certification of incorporation and certificate of commencement of business. Next step is take visit of all units (factory and office) of applicant and verified all statutory required approvals and licence both on record and on display at the premises. Invariably a note on the visit and observations should be recorded and should be a part of the file of the borrower.
Six “C” s of Credit Appraisal
1. Character – This is a highly subjective evaluation of the business owner’s personal history. Lenders have to believe that a business owner is a reliable individual who can be depended on to repay the loan. Background characteristics such as personal credit history, education, and work experience are all factors inn this business credit analysis. Character is the single most important factor considered by a reputable bank. Banks want to do business with people who are honest, ethical and fair.
2. Capacity – This is an evaluation of the company’s ability to repay the loan. The bank needs to know how you will repay the funds before it will approve your loan. Capacity is evaluated by several components, including the following:
Cash Flow refers to the income a business generates versus the expenses it takes to run the business analyzed over a specific time period-usually two or three years. If the business is a start up, prepare a monthly cash flow statement for Year 1.
Payment history refers to the timeliness of the payments that have been made on previous loans. Today there are companies that evaluate commercial credit ratings that are able to provide this kind of history to lenders.
Contingent sources for repayment are additional sources of income that can be used to repay a loan. These could include personal assets, savings or checking accounts, and other resources that might be used. For small businesses, the income of a spouse employed outside the business is commonly considered.
3. Capital – A company’s owner must have his own funds invested in the company before a financial institution will be willing to risk their investment. Capital is the owner’s personal investment in his/her business which could be lost if the business fails. The single most common reason that new businesses fail is undercapitalization. There is no fixed amount or percentage that the owner must be vested in his/her own company before he is eligible for a business loan. However, most lenders want to see at least 25% of a company’s funding coming from the owner.
4. Collateral – Machinery, accounts receivable, inventory, and other business assets that can be sold if a borrower fails to repay the loan are considered collateral. Since small items such as computers and office equipment are not typically considered collateral, in the case of most small business loans, the owner’s personal assets (such as his/her home) are required in order for the loan to be approved. When an owner of a small business uses his/her personal assets as a guarantee on a business loan, that means the lender can sell those personal items to satisfy any outstanding amount that is not repaid. Collateral is considered a “secondary” source of repayments-banks want cash to repay the loan, not sale of business assets.
5. Conditions – This is an overall evaluation of the general economic climate and the purpose of the loan. Economic conditions specific to the industry of the business applying for the loan as well as the overall state of the country’s economy factor heavily into a decision to approve a loan. Clearly, if a company is a thriving industry during a time of economic growth, there is more of a chance that the loan will be granted than if the industry is declining and the economy is uncertain. The purpose of the loan is an important factor. If a company plans to invest the loan into business by acquiring assets or expanding its market, there is more of a chance of approval than if it plans to use the fund for more expenses. Typical factors included in this evaluation step include: the strength and number of competitors, size and attractiveness of the market, dependence on changes in consumer tastes and preferences, customer or supplier concentration, length of time in business, and any relevant social, economic, or political forces that could impact the business.
6. Confidence – A successful borrower instills confidence in the lender by addressing all of the lender’s concerns on the other Five C’s. Their loan application sends the message that the company is professional, with an honest reputation, a good credit history, reasonable financial statements, good capitalization and adequate collateral.
Credit Risk
Credit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk. Although it’s impossible to know exactly who will default on obligations, properly assessing and managing credit risk can lessen the severity of a loss. Interest payments from the borrower or issuer of a debt obligation are a lender’s or investor’s reward for assuming credit risk.
Credit risk is the possibility of losing a lender takes on due to the possibility of a borrower not paying back a loan.
Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the loan’s conditions, and associated collateral.
Consumers posing higher credit risks usually end up paying higher interest rates on loans.
Credit Risk Ratings
Risk rating involves the categorization of individual loans, based on credit analysis and local market conditions, into a series of graduated categories of increasing risk. Risk ratings are most commonly applied to all loans.
Risk ratings should be conducted:
• At the time of application for all new or increased loan facilities
• As part of the annual review process
• In situations where new information is considered that may materially affect the credit risk of the loan
A primary function of a risk rating model is to assist in the underwriting of new loans. As well, risk rating assists management in predicting changes to portfolio quality and the subsequent financial impact of such changes. Risk rating can also lead to earlier responses to potential portfolio problems, providing management with a wider choice of corrective options and decreased exposure to unexpected credit losses. Finally, risk ratings are useful for pricing loans and regulating the commercial portfolio exposure to maximum levels of risk. Board policy should optimally set the maximum credit risk allowable by credit classes and aggregate maximum portfolio credit risk.
Credit Worthiness of Borrower
The first thing is that a lender should check applicant’s creditworthiness. If the applicant is an individual If the applicant is an individual applying for a personal loan or home loan, his/her credit history is checked from credit bureaus like CIBIL. This along with his/her personal financial statement will give enough information about the individual based on which a lending decision can be taken. Most banks use score card templates for filling in the applicant’s financial data and loan request details. The template is used for scoring the loan request. Loan amount, EMI, repayment period etc. are all formula driven based on the data input in the template. The lender of course will perform the due diligence exercise and examine the individual’s character capacity etc. through market enquiring, or enquire with the applicant’s employer. It should be noted that unlike the past when the banks relied solely on market reports the lender can now call for a credit report from a credit bureau which is arrived on a factual basis. (More information on the appraisal of loans to individuals for non- productive purposes is provided in the unit on Retail lending). In case of partnership concerns, Private Limited and Limited companies, the creditworthiness from their financial statements, would be determined among other things, by undertaking discrete enquiring/search in CERSAI records, ROC, RBI defaulters’ list and other sites such as Insolvency and Bankruptcy Board of India (IBBI) etc. Searches to be conducted in respect of encumbrances on the properties proposed to be given as mortgage It is necessary that a complete analysis of financial statement is performed and the banker obtains full information on all financial data. A lender will go through all the ratios. Yet an understanding of the solvency, liquidity and profitability of the borrower company is adequate to draw prima facie conclusions on the financial soundness of a company.
Purpose of Loan
The banker must be convinced that the customer has a well-defined purpose for requesting credit and a serious intention to be in business. As to why the customer is requesting a loan must be clarified to the lender’s satisfaction. Once the purpose is known, it must be determined if it is consistent with the lending institution’s current loan policy. Further the banker must determine if the borrower has a responsible attitude toward using borrowed funds, is truthful in answering questions, and will make every effort to repay what is owed. Responsibility, truthfulness, purpose, and serious intention to repay monies and not to indulge in speculation make up what a banker would call ‘Character’. If the banker feels the customer is insincere in promising to use the borrowed funds as planned and in repaying as agreed, the loan should not be made, for it will almost certainly become a problem credit.
In the case of project financing some questions that will arise are: What is the project idea ? What effort has gone into designing the manufacturing processes and selection of technology, installing equipment, specifying material, and prototype testing, material input and utilities, product mix, plant capacity, location and site, machinery and equipment, structure and civil works ?
Source of Repayment
An important aspect of appraisal is the source of repayment. Repayment of dues of the lender should normally come from the cash flows of the company; or more specifically from the profits of the company. The borrower company’s/firm’s profits must be adequate to service the interest, to repay the debt or agreed installment, pay dividends and finally leave something plough back which will strengthen the company’s financial position. And the company has to be continuously run on profitable lines to ensure continued financial strength. These issues are measured by understanding the profitability ratios. What is a good rate of return on the company’s investment (total assets, own funds, etc.) is usually decided by a benchmark rate of return set by the promoters. There are various measures like payback period, Net Present Value, and Internal Rate of Return (IRR) which help decide on the acceptability of a proposal or project. If IRR or is more than the pre set threshold return or industry return a proposal may be accepted.
Cash Flow
When preparing credit appraisal basic question is “ Does the proposed business have the ability to generate enough cash to repay the loan?” In general, business firms have only four sources to draw upon to repay their loans:
Cash flows generated from sales or other income,
The sale or liquidation of assets, or
Funds raised by issuing debt or equity securities ( borrowing)
Additional capital infusion
Any of these sources may provide sufficient cash to repay a loan. However lenders would prefer that repayment comes from the cash flow from business activity or in other words profits generated. This is because asset sales can weaken the business capacity. Banks would not like the repayment out of borrowing as it impacts the firm/company’s leverage and moves the firm into a higher debt whereas it is not able to manage a lower debt. Normally fresh capital is insisted at the time of reworking the terms of credit as the infusion is a clear indication of difficulties in the venture. Sale of assets and fresh equity are definite indicators of constraints in business and troubled loan relationships.
Cash flow is defined as follows:
Cash Flow = Net Profit + Non-cash expenses
Cash Flow = Sales Revenue (-) Cost of Goods Sold (-) Selling, General and Administrative Expenses (-) Taxes Paid in Cash
Cash Flow = Profit after tax (+) Non-Cash Expenses (such as depreciation, provisions etc.)
A more focused approach to measuring cash flow is the direct cash flow method. This helps to understand as to why cash flow is volatile ? Why is cash flow changing over time?
In this method cash flow is studied in terms of three principal sources :
Net Cash Flow from operations on cash basis and not on accrual basis. This does not take into account cash from sources other than main activity.
Net Cash Flow from financing activity: This is the study of net cash flow on account of the borrowings of the company or firm. These are not revenue items. Wherever the borrowings are more in the current year there will be net inflow and vice versa
Net Cash Flow from investing activities. The net cash flow here is a function of purchase and sale of borrower’s assets.
Analyses of Cash Flow Statements can be doneby Direct Method or Indirect Method. The cash flow analysis is useful in understanding clearly the sources of a borrower’s cash flow. As far as bankers/lenders are concerned it would be ideal if most of cash comes from operations (sales oriented). Evidently if a substantial proportion of cash inflow happens due to sale of assets (investing activities) or borrowing or issuing debt (financing activities), the borrower may find it difficult to generate cash in the future which will make the bank loan exposed to more risk.