3. Credit Worthiness
Characterstics of
the borrower
Repayment
capacity of the
borrower
Willingness to
repay
Management
talents
Ability i.e.
Results of
economic
activities
4. 3 stages of any new business
Project
Implementation
Gestation Period Earning Profits
5. 3 stages of any new business
Stage 1: Project Implementation
Project
Implementation
This is the period when no
cash is generated from the
operations. During this
period the movement of
money is only from bank to
the borrower. The Borrower
is busy in setting the
project
6. 3 stages of any new business
Stage 2: Gestation Period
Gestation Period
The unit comes into
operation and starts
generating cash but
takes time to reach the
break-even point.
Interest is accrued
during this period to
include it into the
cost of product.
No money movement takes place between the
borrower and the bank (Moratorium Period)
7. 3 stages of any new business
Stage 3: Earning Profits
Earning Profits
This is the stage when enough
cash flows are expected to be
generated from the business to
meet the instalments (including
interest and principle).
The cash-flows should be at least
1.5 times the instalments amount.
At this stage the movement of
money is from borrower to bank.
9. Economic Evaluation
The demand of the product is evaluated.
There should be a demand-supply
gap, price advantage, timing and other
such benefits.
The prime attention is that the project
should survive the three stages of the
business (implementation, gestation
and operations).
10. Economic Evaluation
The bank prefers lending into sector where there is a Major gap
between the supply and current demand.
E.g.:
Where a manufacturer of tables needs a loan:
1) Demand = 10,000 Units
Supply = 12,000 Units
New Project = 2,000 Units
2) Demand = 10,000 Units
Current Supply = 8,000 Units
New Project = 2,000 Units
3) Demand = 10,000 Units
Current Supply = 2,000 Units
New Project = 2,000 Units
The market already
has enough supply
(prices might also fall).
Enough demand
and supply gap.
Large gap, thus the
product has a wide
market.
11. Economic Evaluation
Case Study #1:
A company specialising in plastic engineered goods
wants to setup a plant for manufacturing large
computer keyboards (back in 90’s) seeing the large
market demand.
12. Economic Evaluation
Case Study #1:
A company specialising in plastic engineered goods
wants to setup a plant for manufacturing large
computer keyboards (back in 90’s) seeing the large
market demand.
Banks rejects it as it was found that the new types of
keyboard were soon to be introduced with new
additional features.
The survival of the project throughout the loan period
was doubtful.
13. Economic Evaluation
Case Study #2:
A person wants to set up a mini cement plant in the
local area. However UltraTech, Ambuja etc rule the
current market.
14. Economic Evaluation
Case Study #2:
A person wants to set up a mini cement plant in the
local area. However large cement plant like
UltraTech, Ambuja etc rule the current market.
Cement plants are basically of three sizes, Ultra,
Mega and Mini Cement Plant. The Ultra Projects
have lower fixed costs per tonne but higher
transportation costs.
The mini plants though higher on fixed costs have
the benefit of low transport costs, thus if there is
potential of cement market within 100 kilometres,
then the project is economically viable.
15. Management Evaluation
Case Study #1:
A “Lalaji” from Varansi (with enough land there),
seeing the rise in IT Industry, too wants to start a
new IT Company.
16. Management Evaluation
Case Study #1:
A “Lalaji” from Varansi, UP (with enough land there),
seeing the rise in IT Industry wants to start a new
IT Company.
Bank might rate him good with the entrepreneur
skills but rate him very low for the lack of
experience in the business.
17. Management Evaluation
Case Study #1:
A “Lalaji” from Varansi, UP (with enough land there),
seeing the rise in IT Industry, too wants to start a
new IT Company.
He still enthusiastic about
the IT business and hires 2
IT professional (both from big
Large IT companies)
18. Management Evaluation
Case Study #1:
A “Lalaji” from Varansi, UP (with enough land there),
seeing the rise in IT Industry, too wants to start a new
IT Company.
“He is still enthusiastic about the IT business and hires 2
IT professional (both from big Large IT companies)
Bank still are skeptical since the main promoter is not
aware of the business, however he is dependent totally
on the these IT professionals. There is always a risk of
these professionals leaving Lalaji’s company.
Bank needs to have safety and surety of survival
throughout the three periods i.e. survival of the
business
19. Management Evaluation
• Thus the “promoters” MUST be in the core of the
business.
• Good Collaterals are often taken as enough
security to skip any other evaluation.
• However a term loan is a loan where the
instalments are to be paid by earning from the
assets (not from selling the assets – though bank
can always do so) so earning potential of business
is always given prime importance.
20. Technical Evaluation
Technical Evaluation is closely linked to the
Economic and Managerial Evaluation. The
technical competencies of the Management and
technicalities are evaluated in economic
specifications.
These ensure the technical feasibility of a project as
to whether a particular capacity machine is
available in market or not and all other such
technical evaluations.
21. Financial Evaluation
This is the ultimate part of the evaluation process
where all the things are summed up in terms of
money.
The cash flows are estimated, the instalments periods
are fixed, the interest rate is computed and the
project is made bankable.
22. Cash Flow Structure
Cash from Operations:
Profit generated by the production & sales of goods and services
+/- Adjustments for the expansion and tightening of working
assets
+/- Adjustments for non-cash income and expense items
Cash from Investments:
Cash generated by changing the asset base
Cash from Financing:
Cash associated with borrowings, dividends paid and
private withdrawals
+ Consideration of opening cash balance
23. Analysis of Cash Flows
The most commonly used indicators for
doing this are:
• Debt Service Coverage Ratio
(DSCR); and
• net cash flow after loan repayment
or “free net cash flow.”
24. Debt Service Coverage Ratio (DSCR);
Cumulative Net Cash Flow over Loan Period
Total Loan Repayment plus Interest
> 1.5
This indicator is calculated by adding up all the
monthly/quarterly balances during the envisaged
loan term and comparing this figure to the total
amount to be repaid (including both principal and
interest). Since the cumulative net cash flow needs
to be higher than the total repayment obligation
which the applicant would have towards the lender,
this indicator must be above 1 (recommended at
1.5).
25. Case Study
A new manufacturing unit which wants a four year term loan
has following projected cash flows:
Loan Application Net Cash Flow before Loan repayment
200.00
69.93
Loan amount
Equal annual
instalments @
15% per annum
All amounts in Rs. crores
First Year
Second Year
Third Year
Fourth Year
50
100
175
300
TOTAL 279.72 TOTAL 625
26. Case Study
A new manufacturing unit which wants a four year term loan has
following projected cash flows:
Loan Application Net Cash Flow before Loan repayment
200.00
69.93
Loan amount
Equal annual
instalments @
15% per annum
All amounts in Rs. crores
First Year
Second Year
Third Year
Fourth Year
50
100
175
300
TOTAL for 4 years 279.72 TOTAL 625
Accumulated Repayment Capacity = 625 / 279.72 = 2.23
However, it does not show whether the applicant will be able to
cover every individual repayment instalment (as in first year).
Thus comes the “free net cash flow” method.
27. Free net cash flow method
Net Cash Flow after Repayment
Loan Repayment Instalments
> 0.5
This indicator is ratio of the net cash flow after
repayment and the loan repayment instalments. A
“free net cash flow” indicator must be positive
(recommended at 0.5).
28. Case Study
A new manufacturing unit which wants a four year term loan has
following projected cash flows:
Loan Application Net Cash Flow before Loan repayment
200
69.93
Loan amount
Equal annual
instalments @
15% per annum
All amounts in Rs. crores
First Year
Second Year
Third Year
Fourth Year
50
100
175
300
TOTAL 279.72 TOTAL 625
Accumulated Repayment Capacity = 625 / 279.72 = 2.23
The free Net Cash Flow is negative in the first year and too low
in the second year. Thus, it is recommended to reschedule the
loan and provide necessary moratorium period.
-0.28
0.43
1.50
3.29
Free Net Cash Flow
29. Financial Evaluation
The interest rates are fixed based on the degree of
risk. This risk is computed based on the concepts
of probability and margin of safety.
Margin of Safety- is how much output or sales level
can fall before a business reaches its breakeven
point.
Thus where the margin of safety is riskier, the
interest premium applied is also higher (above the
Base Rate – Benchmark Lending Rate)
30. RISK
“The only man who sticks closer to
you in adversity than a friend is a
creditor.”
31. RISK
Webster’s Dictionary- “exposing to danger or hazard.”
Chinese Symbol- “The first symbol is the symbol for ‘danger’, while
the second is the symbol for ‘opportunity’, making risk a mix of
danger and opportunity.”
Financial Terms- Risk, as we see it, refers to the likelihood that we
will receive a return on an investment that is different from the
return we expected to make. Thus, risk includes not only the bad
outcomes, i.e. returns that are lower than expected, but also good
outcomes, i.e., returns that are higher than expected. In fact, we
can refer to the former as downside risk and the latter is upside
risk; but we consider both when measuring risk.
- From “Damodaran on Valuation” by Aswath Damodaran
32. RISK
There are 3 types of business decisions:
1)Certainty: These are those decisions relating to
events which are bound to happen. Thus these are
risk free.
The good companies (often with a very high credit
rating) even bargain for loans at rates very close to
the Base Rate. The reason being, they take their
borrowings as almost risk free.
33. RISK
The second is not “Uncertainty” but “Risk”
2)Risk: These are those decisions relating to events
which are risky and might not happen as expected.
These are the decisions where the profits are made. The
banks give the loans on evaluation of risk and thus
charge a higher interest.
This is based on the same principle as the principle of
insurance business.
34. RISK
In insurance business the loss of few people is
distributed among a large group (via premiums).
Similarly the bank operates, based on the probability.
Say that out off every 100 borrowers – 4 make a
default. Thus the bank charges around 4% higher
interest (i.e. above PLR) from each of the borrower.
Thus these “risky” lending are more generous.
Also, if the bank is able to recover from those 4% who
default, then the are the even higher super profits
resulting from risks.
35. RISK
The third is “Uncertainty”
3)Uncertainty: The decisions relating to
events which can not be predicted.
These are baseless.
A gambling is an example of “Uncertainty” as the
results cannot be predicted but only hoped for. The
result of such is mostly LOSS.
36. A Good Bank ?
Overall, a good bank is not the one that
rejects “not-so-good” loans, but the
one that makes every loan appraisal
bankable.
