Credit Appraisal Process
by Waman Gokhale, Former Deputy General Manager, Central Bank of India
Credit Appraisal Process
The three fundamental pillars on which the credit appraisal is based are :-
- Integrity of the borrower now commonly referred to as the due diligence
- Financials of the borrower
- Market Trends & guarantor
Bankers study these aspects by undertaking the following steps:-
Pillar - 1: Integrity of the Borrower / Due diligence
- It includes the virtues like Honesty to carry out the proposed activity.
- Studying the Social, Financial, Business status of the borrower.
- Past performance of the borrower.
- KYC compliances.
- Credit worthiness.
- Business experience.
Due Diligence process for borrowers
The process by which this initial study or assessment of the borrowing entity and its owner/ promoter is carried out has come to be known as “due diligence” or “pre-sanction due diligence” in banks. Generally speaking, due diligence is the detailed investigation of a person or a business entity, which is necessary to be carried out prior to signing of a contract. The investigation is to be carried out with a level of care that a reasonable person is expected to take considering the nature of the contract. In banks, it refers to a set of procedures which is carried out before opening the account of a customer or before granting loan facilities to a borrower, since in both cases the bank enters into a contractual relationship with the customer/borrower. It will be obvious that the scope of due diligence will be much wider and deeper when considering sanction of a loan facility as compared to when opening a deposit account.
The basic objective of carrying out due diligence in the case of a prospective borrower (whether in the form of an individual, non-corporate or corporate entity) is to establish the borrower’s identity, good standing, means and credit-worthiness as well as to verify the borrower’s track record of past dealings and honouring financial commitments on time.
1. Pre-Sanction Credit Investigation of Borrowers
Traditionally, bankers have been carrying out pre-sanction credit investigation of borrowers and their promoters by doing the following:-
- Collecting market reports from independent sources in the same or related line of business and other parties with whom the borrower may have financial dealings such as suppliers and buyers.
- Suitable references from other prominent businessmen in the locality, industry or trade associations.
- Scrutiny of account statements in respect of existing accounts with other banks.
- Obtain confidential credit opinion reports from the existing bankers, as per a procedure laid down by the Indian Banks Association (IBA).
- Obtaining & verifying the financial statement of the business enterprise and net worth statements of the promoters.
The same principles are applicable even today in borrower due diligence exercises. However, the process of carrying out pre-sanction due diligence has become more elaborate in view of the growing complexities of today’s marketplace. The specific procedures laid down by RBI under the KYC/AML/CFT norms have also become a part of borrower due diligence. In fact, the Customer Due Diligence (CDD) procedure prescribed for opening of bank accounts under the KYC norms will constitute the first and an important step in carrying out the due diligence for borrowers.
The KYC policy has four key elements, viz. (i) Customer Acceptance Policy, (ii) Risk Management, (iii) Customer Identification Procedure and (iv) Monitoring of Transactions. While the CDD/Customer Identification Procedure applicable for general customers as per the Bank’s KYC Policy will be applicable in the cases of borrowers also.
Bankers draw Financial Credit Report / Due-Diligence Report based on all these aspects.
2. Interview of the borrower
An important step in Credit appraisal involves Interview of the Borrower. It may be only of the "Key Person" of the Unit or of 2/3 persons associated with the firm. The meetings and interview techniques are to be leveraged for getting an insight into the various aspects such as Borrowers interest in the venture, his vision, his plans, the study undertaken by him about the backward linkages (supply side) and forward linkages (marketing). By raising tactful questions, the banker has to obtain the vital information beyond the documents or data submitted by the borrower.
Pillar 2 : Financials of the borrower
A banker further undertakes:
1. Managerial Evaluation
The persons behind a project are of vital importance. They should be forming the core of the business. Management of the company needs to be appraised for their intentions, knowledge, and dedication towards the project. By intention, it is meant to evaluate the willingness of the promoters of the company to pay the money back. It needs to evaluate the real objective of borrowing. Only good intentions would not generate cash flows to honour the instalments of the loan. The management needs to be strong in terms of their knowledge about business, commitment towards achieving the set goals etc.
2. Economic viability /Economic Evaluation
It is to study in the context of the current situation, the existing demand, price level, controls, idle/installed capacity, and bottlenecks in production, labour situation and changes in the pattern of supply and demand. To study the details of similar other units in the industry, the future trend of prices and income and how far the project contributes to the growth of other business units/ancillary units.
It is the study of availability or creation of the market to achieve the projected sales. It undertakes the demand forecasting based on local and global scenario that is overall demand and supply position into account and the prices at which the product will be sold in the market.
3. Technical Feasibility/ Technical Evaluation
To satisfy that the project or the venture to be undertaken has given consideration in respect of availability, suitability and sufficiency of land, its location, building, essential inputs such as raw material, power, water, labour (both skilled and unskilled), technology, know how, transportation and other infrastructure. The pollution control and effluent control mechanism, safety and fire control measures are provided for. The factors of production to carry out the proposed activity conform to the quality necessary for manufacture of the concerned goods or services and to achieve the projected level of output and timely delivery is the technical feasibility of the project.
4. Financial Viability
It is the examination of estimates of :-
- Cost of the project i.e. it covers all items of expenditure and that the costs are fairly realistic.
- Means of finance: The projected amount of finance can be raised from the given sources, it is adequate and can be raised at requisite time and costs. It also includes the study of the likely impact of the project on level of production, sales, net earnings, borrowings, costs etc. So that the break-even can be worked out and the stage when the project will start yielding profits and service the Interest and principle on borrowed money.
Pillar - 3 : Market Trends
Study is carried out to learn:-
- Demand and absorbing capacity for the proposed product
- How the market was in the past, what are the present trends and what will be the future trends in view of the economic changes
- What is the Economic, Technical and Operational viability of the proposed activity?
Thus we have to study all Business Proposals in the light of TOTAL OPERATIONAL APPROACH.
How a Financial Report / Status Report/ Due Diligence is undertaken.
THE REPORT CONSISTS of TWO Parts – Qualitative & Quantitative aspects.
The following aspects are embodied while drawing reports. It should not be a casually drawn report but an in-depth study of:-
- Status of the borrower
- Business report
- Credit in the market.
- Dealings with Buyers and Suppliers.
- Financial worth of the borrower.
We obtain Assets and Liabilities of the borrower/guarantors. They should be properly supported by documents such as Documents of Immovable properties, Municipal Corp Property Card, IT Returns, Wealth Tax Returns, Bank account Statements, Details of Insurance Policies, Holding statement of Shares, Debentures, MF, Govt securities, NSC/KVP, Balance sheet of the concerns etc. Bankers obtain the details of movable properties such as vehicles etc. The details of loans outstanding and due from banks/ financial institutions/ others.
Financials of the borrower
By critical analysis of financial statements such as Balance Sheet, Profit and Loss Accounts, Cash Flow and Funds Flow Statements etc:-
FINANCIAL WORTH (Quantity part) For an Individual Net Worth will be = Market value of the Assets ( Immovable and movable) + Financial assets (cash+ bank balances +NSC/KVP etc + PV of Life policies +Bank/company deposits or Shares debentures etc),+ Capital invested in firms.
All types outstanding liabilities such as Housing/ Personal loans/ Borrowing from market etc.
Remember it is an approximate/ estimated financial worth and may be rounded off in Lakh Rupees or Thousand Rupees say worth of a firm M/s Banking Quest is Rs.25.50 lakh.
Worth of a Firm will be = Net worth as per BS + Individual Worth of partners (of course individual capital should not be counted again.)
Appropriate mention about guarantees given by the borrower if any is included in the report [this is the non crystallized amount].
In respect of the Limited Companies Net Worth means:- Total Net Worth plus The Free Reserves of the Company.