ROLL NO.

17PBA061

Q. What do you mean by credit evaluation? Explain term loan and

working capital finance?

In general, the granting of credit depends on the confidence the lender has in the
borrower's credit worthiness. Credit worthiness-; which encompasses the borrower's
ability and willingness to pay-; is one of many factors defining a lender's credit policies.
Creditors and lenders utilize a number of financial tools to evaluate the credit worthiness
of a potential borrower. When both lender and borrower are businesses, much of the
evaluation relies on analyzing the borrower's balance sheet, cash flow statements,
inventory turnover rates, debt structure, management performance, and market
conditions. Creditors favor borrowers who generate net earnings in excess of debt
obligations and any contingencies that may arise. Following are some of the factors
lenders consider when evaluating an individual or business that is seeking credit:

Credit worthiness. A history of trustworthiness, a moral character, and expectations

of continued performance demonstrate a debtor's ability to pay. Creditors give more
favorable terms to those with high credit ratings via lower point structures and interest
costs.

Size of debt burden. Creditors seek borrowers whose earning power exceeds the
demands of the payment schedule. The size of the debt is necessarily limited by the
available resources. Creditors prefer to maintain a safe ratio of debt to capital.

Loan size. Creditors prefer large loans because the administrative costs decrease
proportionately to the size of the loan. However, legal and practical limitations recognize
the need to spread the risk either by making a larger number of loans, or by having
other lenders participate. Participating lenders must have adequate resources to
entertain large loan applications. In addition, the borrower must have the capacity to
ingest a large sum of money.

Frequency of borrowing. Customers who are frequent borrowers establish a

reputation which directly impacts on their ability to secure debt at advantageous terms.
Length of commitment. Lenders accept additional risk as the time horizon
increases. To cover some of the risk, lenders charge higher interest rates for longer
term loans.

Social and community considerations. Lenders may accept an unusual level

of risk because of the social good resulting from the use of the loan. Examples might
include banks participating in low-income housing projects or business incubator
programs.

What Is a Term Loan?

A term loan is a loan from a bank for a specific amount that has a specified repayment
schedule and either a fixed or floating interest rate. A term loan is often appropriate for
an established small business with sound financial statements and the ability to make a
substantial down payment to minimize payment amounts and the total cost of the loan.

How a Term Loan Works

In corporate borrowing, a term loan is usually for equipment, real estate or working
capital paid off between one and 25 years. Often, a small business uses the cash from
a term loan to purchase fixed assets, such as equipment or a new building for its
production process. Some businesses borrow the cash they need to operate from
month to month. Many banks have established term-loan programs specifically to help
companies in this way.
The term loan carries a fixed or variable interest rate– based on a benchmark rate like
the U.S. prime rate or the London Interbank Offered Rate (LIBOR) – a monthly or
quarterly repayment schedule and a set maturity date. If the money is being used to
finance the purchase of an asset, the useful life of that asset has a hand in the
repayment schedule. The loan requires collateral and a rigorous approval process to
reduce the risk of default. However, term loans generally carry no penalties if they are
paid off ahead of schedule.

Types of Term Loans

Term loans come in several varieties, usually reflecting the lifespan of the loan.

 A short-term loan, usually offered to firms that don't qualify for a line of credit,
generally runs less than a year, though it can also refer to a loan of up to 18
months or so.
 An intermediate-term loan generally runs more than one – but less than
three – years and is paid in monthly installments from a company’s cash flow.
 A long-term loan runs for three to 25 years, uses company assets as
collateral, and requires monthly or quarterly payments from profits or cash flow.
The loan limits other financial commitments the company may take on, including
other debts, dividends or principals’ salaries and can require an amount of
profit set aside for loan repayment.

Working Capital Finance

• Working Capital is a financial metric which represents operating liquidity available to a

business. The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing short-
term debt and upcoming operational expenses.

Sources of Working Capital Finance

• There are two most significant short-term sources of finance for working capital are

1. Trade credit

2. Bank borrowing

Trade Credit

• Trade Credit: It refers to the credit that a customer gets from suppliers in normal
course of trade. This deferral of payments is a short term financing which is called trade
credit.

• It is a major source of finance for firms. In India, it contributes to about 1/3rd of the
total short term financing.
 • Particularly, small firms are heavily dependent on trade credit as a source of finance
since they find it difficult to raise funds from banks or other sources.

• Trade Credit is also called Spontaneous Source of Financing.

5. Credit Terms

• Credit Terms: This refers to the conditions under which the supplier sells on credit to
the buyer, and the buyer is required to repay the credit.

• A typical way of expressing credit terms is for example: 3/15 net 45. This means 3%
discount is available if payment is made within 15 days and if this discount is not availed
payment is to be made on or before 45 days.

Benefits of Trade Credit

• Benefits

1. Easy Availability.

2. Flexibility.

3. Informality.

Suppliers sometimes offer cash discount to buyers for making prompt payment. Buyer
should calculate the cost of foregoing cash discount to decide whether or not cash
discount should be availed

Bank Finance for Working Capital

• Overdraft

• Cash Credit
• Purchase or Discounting of Bills
• Letter of Credit
• Working Capital Loan