Credit appraisal of a term loan denotes evaluating the proposal of the loan to find out repayment capacity of the borrower. The primary objective is to ensure the safety of the money of the bank and its customers. The process involves an appraisal of market, management, technical, and financial.
Getting term loans from a financial institution is not so easy. The corporate asking for the term loan has to go through several tests. The bank follows an extensive process of credit appraisal before sanctioning any loan. It analyses the loan proposal from all angles. The primary objective of credit appraisal is to ensure that the money is given in the right hands and the capital and interest income of the bank is relatively secured.
While appraising term loans, a financial institution would focus on evaluating the credit-worthiness of the company and future expected stream of cash flow with the amount of risk attached to them. Creditworthiness is assessed with parameters such as the willingness of promoters to pay the money back and repayment capacity of the borrower.
Four broad areas of appraisal by banks are a market, management, technical and management.
As part of the market appraisal, the very first thing a financial institution would look at is the gap between demand and supply. Bigger the demand-supply gap, higher is the chances of the flourishing of that business. The demand versus the proposed supply by the borrower should have a wide difference in demand of 50000 units against the proposed supply of 10000 units.
Another most important parameter is marketing efforts and infrastructure. This is the factor which converts a demand into sales for a business. The marketing side of the company needs to be very strong as it is very critical to the success of the venture.
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 honor the installments of the loan. The management needs to be strong in terms of their knowledge about business, commitment towards achieving the set goals, etc.
A technical appraisal is subject to the kind of business and industry of the borrower. If it’s a manufacturing concern, all those parameters like project site, availability of raw material and labor, capacity utilization, vicinity to selling market, transportation, etc would be examined. A project needs to be technically very sound to be able to sustain all business cycles.
After all the other kinds of appraisal, everything boils down to financial appraisal. This probably is the most important part of credit appraisal of business loans. The reason is that it expresses everything in terms of money.
Financial appraisal tries to assess the correctness or reasonability of the estimates of costs and expenses and also the projected revenues. These may include the estimation of the selling price, cost of machinery, the overall cost of the project and the means of financing.
Financial appraisal involves extensive financial modeling in excel. It takes the financial statements of previous periods and forecasts the future financial position for at least till the loan matures. From that, the cash flows of each year are compared with the installment of loan because ultimately the cash flows are going to honor the payments of the bank.
Feasibility of the project is evaluated in terms of the debt servicing capacity of the firm. Debt service coverage ratio is a key ratio which is calculated for each future financial period and if that ratio is satisfying the norms accepted by the bank, the loan would get another green signal.
It is difficult to explain the process of appraisal in an article or even a set of articles. It is a very extensive work being done at financial institutions. They have a separate team of professionals for conducting such project appraisals.Last updated on : August 26th, 2019