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Appraisal of Term Loan - Concepts, Process and Guidelines

V.S.Kaveri

Summary The overall performance of Indian economy is quite impressive which is marching ahead to achieve even a double digit figure of GDP in the near future. All sectors of the economy namely, agriculture, industry, service and infrastructure are performing exceedingly well. Enterprises in these sectors are planning to go in for expansion, modernization and diversification for which demand for term loan would be substantially large. Hence, banks perceive lot of potential to provide term loan in which credit risk is relatively high. Similarly, deficiencies are being observed in credit decisions which have led to mega loan scandals. Hence, it is necessary to improve the quality of appraisal of term loan on one hand and to strengthen due diligence in credit, on the other. Towards this end, the present article guides on appraisal of term loan by discussing both conceptual and operational aspects, besides providing a list of items of due diligence in credit in terms of bank guidelines

Appraisal of Term Loan - Concepts, Process and Guidelines


V.S.Kaveri Introduction: Firms engaged in industrial and service related activities require funds for various purposes. To commence business, they are expected to invest in fixed assets comprising land and building, plant and machinery, furniture & fixtures etc. Initially, each firm requires minimum fixed assets. Subsequently, additional plant capacity may be created for expansion or for purchase of new plant and machinery for the purposes of modernization and diversification. Besides, the firms require funds to finance other fixed assets also, which include goodwill, trade mark and other non-current assets. To finance all these fixed assets, each firm raises funds in the form of capital, subsidies and grants from the Government, retained earnings in the case of existing firms, term loan from banks and financial institutions and loans received from noninstitutional sources such as friends and relatives etc. Grants and subsidy received from the government are expected to supplement the capital of an entrepreneur and the same are considered as part of long-term funds. Capital and reserves & surplus constitute owned funds (equity or net worth). In general, term loan from banks and financial institutions is the main source of funds for financing of fixed assets. Relatively speaking, for banks, risk in term loan is high since repayment is expected to take place during the next 5-7 years during which there could be many uncertainties in respect of performance of the firm, value of money, erosion in the value of securities, integrity of the borrower etc. Hence, it calls for a detailed appraisal of term loan not only to keep the entrepreneur happy but also to ensure a professional approach in financial analysis and decision making and also to observe due diligence of lending norms, policy guidelines and global best practices. This paper deals with various aspects of term loan to fill up knowledge and skill gaps on the part of credit officers and branch managers in banks and financial institutions. Term lending Conceptual Aspects The essence of term loan appraisal is in assessing the ability of a firm to repay the principal amount and the interest thereon from the cash surplus generated from operations by utilizing fixed assets which are generally financed by banks. For sanctioning of the term loan by banks, it is necessary to carry out financial appraisal carefully by using analytical tools, observing due diligence, paying special attention to risk related aspects & working out strategies to cover risk, adopting the global best practices and using common sense. A request for term loan is made

both by newly set up firms as well as existing firms. Relatively speaking, a detailed credit appraisal is needed in case of new firms in the absence of past experience. For appraisal of term loan, it is necessary for the credit officer in a bank to have a good understanding of Project Finance since project / credit appraisal of the term loan is a core component of the same. Project Finance refers to the proposed plan of business activities of a firm and arrangements to raise funds for meeting the project cost. This has four components: Project formulation, Project appraisal, Project implementation and monitoring and Management of problem projects. To elaborate, in Project Formulation, it is the primary responsibility of the applicantborrower to formulate a project proposal. The applicant-borrower first conceives an idea to set up an industrial firm/business establishment and thereafter formulates a project proposal which highlights technical, commercial, financial and managerial aspects of the project. The preparation of a project proposal is a must which enables the credit officer to assess feasibility of the project. The project proposal should be submitted to the bank along with projected (A) Production and Profitability Statement, (B) Cash Flow Statement and (C) Balance Sheet. The nature and contents of the project proposal depend upon the types of the project which may include setting up a new firm, business expansion, modernization, diversification, debt restructuring and rehabilitation of a sick firm etc. There is no standard format for preparing the project proposal. However, a broad check list of items to be covered in the project proposal may be provided to a potential borrower by the bank. Generally, consultants are engaged in preparing the project proposal. The next important component of project finance is Project / Credit Appraisal, which is done by the bank. Project Appraisal covers term loan, working capital and non fund based credit facilities. Project appraisal is expected to be done by using analytical tools, observing lending norms, respecting due diligence of legal and other regulatory compliances and learning from experiences of the bank in the related areas. The other component of Project Finance is Project Implementation and Monitoring which is the job of both borrower and bank. The process of implementation starts from the date of disbursement of term loan till the date of commencement of commercial production. On the other hand, monitoring takes place during the post commercial production period and is carried out till the term loan is paid back with interest. Lastly, Management of Problem Project is yet another task assigned to both borrower and bank. Due to certain internal or external factors, a project may experience problems in timely implementation which leads to cost overrun. In this regard, banks provide debt restructuring support to make the project financially viable under Debt Restructuring Scheme for Small and Medium Enterprises (SMEs) or through Corporate Debt Restructuring (CDR) 3

mechanism. As part of debt restructuring, certain concessions are given to the firm in the form of waiver of penal interest, reduction in the rate of interest, reschedulement of unpaid loan installments, sanctioning additional loan despite loan default, conversion of debt into equity (if applicable) etc. Besides debt restructuring, rehabilitation support to sick units is also carried out. The present article focuses on the second component of Project Finance. i.e. Project /Credit Appraisal with special reference to term loan. Appraisal of Term Loan: Purpose: The main purpose of appraisal of term loan is to confirm whether funds are safe in the hands of a potential borrower and whether the project would generate sufficient cash surplus from operations to service the debt and repay the principal amount. For this purpose, a scrutiny of the projected statements by using analytical tools is a must. Further, judgment has to be exercised by the credit officer by taking a view on assumptions made in preparing the projected statements and overall integrity and reputation of the borrower based on available information. Thus, appraisal of term loan involves two major criterions to decide on the borrowers request: (A) Borrowers Appraisal and (B) Project Appraisal (A) Borrowers Appraisal: Borrowers appraisal refers to assessment of a Person behind the project, who may be a proprietor, a key partner, a key promoter / director, etc. For appraisal of the borrower, several aspects need to be looked into which may include his educational and professional background, constitution - how often changed, management team consisting of professional in key management areas, leadership qualities, credit history of the persons concerned; compliance of KYC norms observed for a new borrower while opening an account, age and physical health of the borrower etc. For appraisal of the borrower, attention should be paid to 5 Cs viz., character (intention to repay, reputation), capacity (ability to manage the enterprise), capital (financial stake), collateral, and conditions (possibility to comply with the laid down terms and conditions). To gather the required information for appraisal of the borrower, it is necessary to refer to several sources of information such as loan application form; past dealings with the bank by the borrower; credit report from other banks; report from the supplier/customer of the borrower if it is an existing firm, report from the guarantor, news paper - cuttings or personal enquiry in the market, study of annual report of a company.

(B) Project / Credit Appraisal: 4

To decide on the request from the borrower for term loan, a detailed credit appraisal is called for. In this regard, it is necessary to study various aspects of term lending which include: Cost of the Project and Sources of Funds, Scrutiny of Projected Production and Profitability Statement and Cash Flow Statement, Compliance of Lending Norms, Repayment Schedule, Deferred Payment Guarantee, Securities, Pre-sanction Inspection, Documentation and Disbursement, Schedule of Implementation, Post-implementation and Follow up, Cost overrun, Terms and Conditions, Due Diligence in Credit Appraisal and Preparation of Appraisal Note . These aspects are discussed in the following paragraphs. Cost of the Project and Sources of Funds: A broad list of items of cost of project and sources of finance is as under: Cost of Project: Land and site development Building Sources of Finance: Capital : equity, preference shares Reserves & surplus/ internal cash accrual Seed Capital, subsidies from the Government Plant & machineries Misc. fixed assets Technical know how Preliminary expenses Pre-operative expenses Provision for contingencies Margin for working capital Debentures Quasi equity/unsecured loans, Public Deposits Term loan Deferred payment credit from suppliers Leasing finance Others

The capacity of the firm to mobilize resources to meet project cost depends upon the current position of stock market / debt market, regulatory framework, promoters contribution in the form of net worth (in case of existing firms) being sufficient to meet margin money for working capital, project related expenses such as preliminary and pre-operative, R& D etc for which bank finance is not available for future expansion. In other words, term loan from banks is just meant for meeting the cost of fixed assets net of security margin or promoters contribution. Hence, banks should ensure that the lending norm of Debt: equity ratio is complied with, which is indicated in the bank scheme/loan policy. This ratio varies from time to time and also from one scheme to another. But debt: equity norm needs to be fulfilled as specified. There shall be some relaxation in compliance of the ratio in certain cases such as a firm being set up in a backward area; proposed activities of a firm are being in the priority list 5

of banks, hi-tech projects, etc. This ratio is decided by considering several factors including the position of market, project cost, tax laws, etc. Regarding subsidies from the Government, the borrower is expected to furnish an undertaking to the bank to bring in the equivalent of funds and retain the same until the receipt of subsidies. Scrutiny of Projected Production and Profitability Statement and Cash Flow Statement: The projected Production and Profitability Statement and Cash Flow Statement are very important documents for term loan appraisal. The projected Production and Profitability Statement helps in assessing (a) earning capacity of the firm (b) capacity of the firm to amortise and service the borrowed cost (c) ability to service the share capital and (d) surplus available for future expansion. This statement is useful to calculate break-even analysis, Internal Rate of Return , inter-firm comparison, etc. For estimating cost of production, several factors are examined which include: installed capacity, capacity utilization (generally low in the first year), product mix, selling price, cost of sales (consisting of raw material consumed including wastage, labor, repairs and maintenance, plant overheads, administrative expenses, packing cost, sales expenses, financial expenses, depreciation etc). Banks have to ensure that (a) all costs are covered (b) there is no over/under estimation (c)it is possible to meet cost from the timely release of funds (d) margin is adequately available to raise working capital finance and (e) arrangements are made to raise funds to implement the project as per the schedule. The projected Cash Flow Statement is prepared based on the projected Production and Profitability Statement and Projected Balance Sheet. The Cash Flow Statement starts with cash surplus from operations (net profit after tax plus depreciation) to which changes in liabilities and assets (except cash) are adjusted to obtain the figure of net surplus or deficit. When opening balance of cash is adjusted to net surplus or deficit, closing cash balance is arrived at. This statement should be prepared for each year of the loan period. The projected Cash Flow Statement helps in ascertaining the timing and adequacy of cash surplus, available for servicing of loan and payment of term loan installments. This also helps in deciding the moratorium period or repayment holiday, maturity of loan and repayment schedule. Banks should ensure that projected production profitability statement and cash flow statement are prepared on realistic basis. The credit officer should verify projected sales in terms of past achievements, nature of competition, developments in market, etc. Raw material cost should be compared with sales value, raw material holding, prevailing prices of raw materials etc. Regarding cost of sales, it should be ensured that factory overheads, repairs and maintenance, 6

offices expenses are around 5-10%, 2% and 5 to 10% sales respectively. The method of depreciation on fixed assets should be as per the normal practice and interest on borrowing and lease rent should be at agreed rates. Similarly, value of fixed assets should be as per the invoices/quotations. Compliance of Lending Norms: The decision to sanction term loan depends upon compliance of lending norms which include Debt: Equity (D:E)ratio, Debt Service Coverage Ratio (DSCR), Internal Rate of Return (IRR), Sensitivity Analysis and Break Even (BE) Analysis. D:E ratio is already explained earlier. DSCR should be calculated for each year of the loan period. Average DSCR for the entire loan period is a guiding factor, which should be more than 1.0. But in practice, the acceptable level is in the range of 1.5 to 2.0. If DSCR is reasonably high, the bank can reduce the repayment period and vice-versa. Regarding IRR, it should be higher than the weighted average cost of total funds for the firm. Normally, each bank sets a desired IRR for the purpose of credit appraisal which is normally 2 to 3 per cent higher than cost of funds. The IRR is widely in use for appraisal of high value advances. Both DSCR and IRR vary with changes in certain variables such as capacity utilization, selling price per unit, sales volume, cost of raw materials etc. In a dynamic world, these can not remain constant. Hence, it is necessary to carry out sensitivity analysis by recalculating DSCR and IRR on conservative basis by considering 5-10 per cent decline in the selling price or 5-10 per cent increase in variable cost or when both to happen. Thus, sensitivity analysis is useful to assess the financial soundness even under the adverse situations. Lastly, each firm is expected to break even early (preferably within 6-12 months from the date of commencement of commercial operations by SMEs and a little longer in respect of non SMEs) and also at lower plant capacity (preferably at 50-60 percent of installed plant capacity).This would ensure the margin of safety in terms of contribution per unit (selling price per unit less variable cost per unit). Repayment Schedule: Usually, the maturity of term loan is ranging from 3-7 years. But in respect of capital intensive project, it is still longer. The repayment period is fixed taking into the Projected Cash Flow Statement, DSCR and IRR. If cash surplus is substantially larger, the repayment period may be reduced. Moratorium period or initial repayment holiday (from the date of disbursement till the due date of commencement of commercial production) may be granted based on cash losses (cash payments less receipts) that the firm may incur in the beginning. However, the repayment holiday should not be too long (reasonable repayment holiday ranges from 6 -12 months). But interest on term should be fixed on quarterly basis from the date of disbursement of term loan. 7

The payment of interest and loan installment starts after the repayment holiday. The rate of interest on term loan should be as per the loan policy of the bank. Deferred Payment Guarantee: This is essentially a non fund based facility granted to a borrower for availing a deferred credit from suppliers for purchase of machinery, capital goods etc. As agreed upon, the bank is liable to make the payment of installments to the suppliers or retire bills upon the borrowers default. To grant Deferred Payment Guarantee (DPG) by a bank, appraisal should be done on the same lines of term loan. Securities: Term loan should be secured against hypothecation / mortgage of fixed assets. All charges should be registered with the Registrar of Assurances and Registrar of Companies. Additional collateral in the form of mortgage of land in the personal name of the promoters/ guarantors may be obtained. Other forms of collateral securities shall include assets such as shares, government securities, etc, which may be considered in this regard. Plant and Machinery Register should be maintained by the bank. Pre- Sanction Inspection: To ensure the end use of funds, pre-sanction inspection is a must. In the case of existing unit, inspection should be done at the site. The Inspection report should cover the position of licenses/ registration formalities, arrangements for importing of machines, details of foreign collaboration, particulars of land, position of power, time schedule for implementation of project, likely date for carrying out trial run, progress made in the promoters contribution, list of existing fixed assets etc. In this regard, banks have developed pre-sanction inspection report format. Documentation and Disbursement: Prior to documentation, it should be ensured that all terms and conditions of term loan are fulfilled. In respect of high value advances, documents prepared at the branch need to be approved by the lawyer/law officer in the bank. No disbursement should be done unless all documents are executed. Wherever mortgage of land and building is stipulated, the bank should ensure the clear titles/lease rights of the property, marketability/ transferability of the title, feasibility to comply legal requirements, absence of restrictions in the lease deed to create mortgage etc. Advocates opinion in these regards should be obtained. After the documentation, the borrower has to deposit his contribution and thereafter, the bank should make direct payments to the parties concerned such as builders, suppliers of plant and machineries etc. Prior to this, the borrower has to approve the relevant bills or invoices. 8

Further, a letter from the borrower authorizing the bank to make payment should be also be obtained. Photocopies of all such bills/ invoices should be kept on record. Schedule of Implementation: The project report should contain the time schedule for implementation of the project which shall be supported by the PERT chart, wherever feasible. The borrower should submit a letter of Date of Commencement of Commercial Operations (DCCO) to the bank. This indicates various stages involved in construction work and time required. The progress in implementation should be closely monitored by obtaining a periodical progress report and conducting inspection at the site / factory. Banks have developed a prescribed format for progress report and site/ factory inspection report which should be filled in periodically and kept on record. Reasons for delay in implantation, if any, should be ascertained and implications of the same on project cost should be ascertained. Post Implementation Follow up: After the project has been implemented and commercial operations begin, follow up of actual performance of the firm is called for. Actual performance in production, sales, profits etc should be compared with the budgeted performance on periodical basis. Banks have developed Formats for follow up - such as Monthly Select Operations Data (MSOD), Quarterly Information System (QIS), etc. The borrower has to fill in the formats and submit to the bank monthly/ quarterly. These formats facilitate to monitor the progress in respect of key performance areas such as efficiency of the plant, quality and quantity of production, sales, position of inputs, level of current assets, orders in hand, pending bills, etc. In addition, Factory Inspection should be carried out at least once a year and a copy of the visit report should be kept on record. If a bridge loan is granted in lieu of the government subsidy, it should be ensured that the same gets liquidated on receipt of the subsidy. It should also be ensured that the firm is adhering to pollution/effluent control norms of the government. Cost Over-run: Cost over-run may occur due to delay in implementing the project, leading to increase in the cost of assets purchased, adverse exchange fluctuation, hike in custom duties etc. Normally, provision made for contingencies would meet the marginal cost over-run. The borrower is expected to meet such cost over-run from his own resources. This should be stipulated in the terms and conditions. Any major cost over-run calls for a detailed analysis and, both the bank and the borrower should work out suitable strategies to meet such cost over-run by raising further funds. Terms and Conditions: 9

Besides, standard terms and conditions as applicable to all borrowers, additional terms and conditions may be considered for a specific borrower. For instance, wherever risk is perceived to be high, personal guarantee of the borrower may be sought for. Bank should have the right to inspect the applicants books of accounts in respect of new borrowers. The property should be adequately insured. The borrower should furnish an undertaking to the bank stating that no dividend would be declared if there are arrears in payment of installments and/or interest. No withdrawal of deposits/ repayment of loans from the associates/ friends & relatives are permitted during the currency of loan. Further, interest on such deposits/ loans is not to exceed the rate of interest charged by the bank on term loan. Legal and inspection charges should be borne by the borrower. In case of default of installment/interest on due date, the bank may charge a penal interest. In case of consortium financing, every bank shall share information of the borrower with other banks. The borrower should also inform the bank about any change in the constitution. Additional terms and conditions shall be considered, if necessary. Credit Appraisal Due Diligence In terms of bank guidelines, it is necessary to observe due diligence for offering term loan. It is difficult to prepare a long list of items of due diligence. But major items of due diligence in credit my include: - Fulfill the KYC norms for opening a savings / current account by a potential borrower obtain photograph, IT PAN, sales tax/excise registration number, shop and establishment registration number, etc. of the person authorized to operate the account. - Give a loan application form only if found eligible under the bank scheme. - Receive the loan application form if filled in properly and submitted along with: Project proposal, financial statements both audited (for the last three years) and Projected balance sheet, profit & loss account and cash flow statement, copies of the relevant certificates; Bio-data of the promoter, etc. The project proposal should contain the required details which should be verified carefully. - Issue a receipt of the loan application form and record in the Loan Application Received Register in case of proposals from small borrowers. - As part of credit appraisal, verify the documents such as partnership deed, certificate of incorporation cum articles of association, resolution of the board to raise borrowings, trust deed, certificate of registration, and verify the registered office address. office/business

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- Obtain market report of the borrower, credit report from the existing bankers, and reference letters. - Ascertain the details of existing borrowing arrangements with the present bank and other banks, if any. - Assess the financial status of associated companies, if any, and call for their latest audited financial statements. - Scrutinise the details of the guarantors which include their relationship with the borrower, net worth, business activities, if any, securities to be offered, etc. Conduct pre-sanction inspection to verify information as furnished in the loan application form and assess the antecedents of the promoters/guarantors. Verify the details of the securities to be offered; proof of the residence, lease deed, sales deed, rent agreement, etc. and obtain a search report - Interview the applicant and record the conversation in brief. - Prepare a credit appraisal/ process note - Sanction credit facilities keeping in mind the lending powers and send a draft letter of sanction to the borrower stating the required details including the terms and conditions and obtain his/her a written consent. If decided not to sanction, state reasons thereof. Observe the time limit set for loan sanction. - Execute documents as per guidelines of the bank. Obtain documents properly stamped and vetted. Create legal charge over the assets financed including collaterals. - Disburse the loan amount as per bank guidelines. Promoters contribution should be deposited first before disbursement of the amount. The amount should be disbursed as per the progress made in construction work, procurement of capital assets etc. - Conduct post disbursement inspection of the factory/business within a month from the date of disbursement to ensure the end use of borrowed funds. Preparation of Appraisal Note: After going through the project proposal submitted by the borrower for term loan, carrying out a detail of the borrower and his project, observing lending norms and bank guidelines and carrying out pre sanction, it should be attempted to prepare appraisal note / process note. The broad contents of the appraisal note/ credit process note include: the borrower request, background of the entrepreneur and project, present business activities, industry prospects; feasibility of the project.; past performance and future projections; cost of project and sources of funds, compliance of lending norms, etc. The note should conclude with the bank decision. which could be yes (with terms and conditions) or no (with convincing reasons). If decided 11

to sanction the term loan, terms and conditions have to be indicated. There is no standard format for preparing the appraisal / process note. But it should be ensured that the note is carefully prepared covering all vital aspects of the borrower and his project. Conclusion: India is marching ahead to maintain as high as 10 percent GDP in the coming years since all sectors of the economy are witnessing a good pick up in their performance. In particular, firms in agriculture, industry, service and infrastructure sectors are planning to go in for expansion, modernization and diversification. In this regard, banks have lot of potential to provide term loan. But this should be done carefully because, non performing loan assets are on the rise. Similarly, many loan scandals are being observed, calling for improving the quality of due diligence in credit. In this backdrop, banks have to adopt a professional approach in credit decisions since risk associated with term lending is perceived to be high. Credit officers in banks have to sharpen their analytical tools. Besides collecting information from the borrower, extra efforts have to be put in by the banks to strengthen their database by collecting data from the market and other sources about borrower, performance of industry, likely policy guidelines having impact on the performance of firms, etc. Above all, they have to become more customer friendly by providing need based and timely finance despite having shortage of staff and increasing work load in the banks. Thus, it is a challenge for the credit officers in banks to ensure a good quality term lending. Towards this end, the present article loan by discussing both conceptual and operational aspects. attempts to fill up knowledge and skill gaps on the part of credit officers in banks relating to appraisal of term

References: 1. 2. Bank Lending Principles: Theory Practice, Hrishikesh Bhattacharya, Noya Prokash Publication, Kolkata Management Techniques of Bank Lending, A K Chatterjee, Himalaya Publishing House 12

3. 4. 5.

Bank Lending Law and Practice Part I and Part II, Arun Chatterjee, Skylark Publications RBI Circular of August 7, 2004 on Deficiencies found in sanctioning of Loans and Monitoring of Borrowal Accounts by Banks and Financial Institutions Master Circular of RBI of July 1, 2010 on Loans and Advances- Statutory and Legal Restrictions

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