1. MAHARANA PRATAP GROUP OF INSTITUTIONS
KOTHI MANDHANA, KANPUR
(Approved by AICTE, New Delhi and Affiliated to Dr.AKTU, Lucknow)
Digital Notes
[Department of Business Administration]
Subject Name : Financial Credit & Risk
Analytics
Subject Code : KMBN FM05
Course : M.B.A.
Semester : IV
Prepared by : Ms. Arpita Shukla

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UNIT-1
What is Credit?
Credit is created when one party (a creditor) provides resources to another party (a debtor) where no
immediate payment is made; rather, the resources are provided with a promise of future payment.
 Credit is created when one party provides resources to another party, but no immediate payment
is made.
 Broadly speaking, there are two types of credit – loans and trade credit.
 Creditors go to great lengths to measure and mitigate credit risk before extending resources to
their borrower(s).
 When a specific term or condition of a credit agreement is breached, an “event of default” is said
to have occurred.
How Does Credit Work?
Credit is extended based on a promise of future payment (or repayment); this promise is best documented
using a legal contract.
In the event of a loan or other type of financial resource, a formal agreement is typically drafted between
the counterparties. This agreement may be called a variety of things, including a loan contract,
a promissory note, or a credit agreement.
It should outline the terms of the credit, including the interest rate, repayment schedule, covenants what
constitutes an event of default if collateral is being pledged, and any other characteristics that are relevant
to the two counterparties. In all instances, the agreement is legally binding.
When it comes to trade credit, the transaction is typically consummated with a Purchase Order (PO), where
the buyer legally agrees to purchase the good(s) or service(s) from the seller. Once the product is delivered
or the service is rendered, the purchase order is considered fulfilled and the seller then issues a payment
invoice to the buyer. Like a loan agreement, the invoice includes payment terms (like due date, payment
instructions, late payment penalties, etc.)

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Types of Credit
#1 – Trade Credit
Trade Credit refers to credit in business dealings like selling goods on credit where the customer promises
to pay money later, buying goods on credit where we, the customer of the supplier, promise to pay to the
supplier on a later date. It is given based on the borrower’s financial capability, i.e., credit taker. In some
cases, it is given based on a relationship with the person asking for credit, or it depends upon business
rules. In a large organization, the credit rules are the same for all the customers.
#2 – Trade Credit
Consumer Credit refers to money, goods, or services provided on the agreement with the consumer to pay
later with the charges for using the credit. Consumer credit is specifically designed for consumers to give
them various benefits. Consumer credit involves the hire purchase goods, personal loans, credit insurance,
vehicle finance, etc. consumer credit is given on the basis creditworthiness of the consumer, and rules of
credit are the same for all the parties. Purchasing goods on EMI is also an example of consumer credit. The
banks gives the overdraft facility also falls under consumer credit..

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#3 – Bank Credit
Bank Credit is an extension of consumer credit. In bank credit, the bank gives loans and credit facilitates to
clients. Consumer credits are given based on creditworthiness, analysis of financial statements, and value
of the asset given by consumers as security. Examples of consumer credit are mortgage loans, cash credit
facility, housing loans, etc., letter of credits, bank guarantee, discounting of bills of exchange also falls
under the bank credit facility.
#4- Revolving Credit
Revolving credit involves the continuous credit in which the lender gives the extension of credit to the
borrower so long as the account is regular and open by regular payments like in case of credit card the
credit is given regularly and limit of credit is given and payment to be made on monthly or quarterly basis.
And the account will continue till it is closed, i.e., credit is extended every month.
#5 – Open Credit
Open Credit has a feature of both installment credit and revolving credit. If an open credit limit is not set,
the credit card is given, and then one will use it throughout the month, and at the end of the month, the
bill will be given to the cardholder to re-pay and continue the service. Electricity bills, gas bills, telephone
bills, etc., are examples of available credit, i.e., use first and then pay later and available for all.
#6 – Installment Credit
Installment credit is the extension of bank credit. When we obtain credit from banks by way of loan, the
bank sets the fixed monthly installment as repayment type of loan along with interest up to a certain
period till the loan gets re-paid along with interest. The bank or finance company charges a penalty if the
borrower cannot pay the installment.
#7 – Mutual Credit
In mutual credit, money is not used as in this case. If one person owes another person for something that
another person also owes to the first one, the credit becomes mutual credit. So credit gets canceled with
each other, and in case a balance remains after that, then the same is settled by the mode of cash or
equivalent. Like in business, one person is a creditor and a debtor. Hence, they mutually settle the
payments.
#8 – Service Credit
In-service credit, the credit is given for services availed earlier. Like lawyers ask for final fees once the case
is over, the accountants charge after filing the returns. Electricity bills, telephone bills, gas bills, and post-
paid bills are examples of service credit. Service credit borrowers can pay after availing of the service at
fixed intervals. But if the service receiver fails to pay at fixed intervals, it may cancel services or charge a
penalty for late payments.

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What is Credit Risk?
Credit Risk is the probability of a borrower defaulting on debt obligations. Lenders risk not receiving the
principal and interest component of the debt. This can result in an interrupted cash flow and increased cost
of collection.
What is Credit Risk?
Credit risk is the uncertainty faced by a lender. Borrowers might not abide by the contractual terms and
conditions.
Financial institutions face different types of credit risks—default risk, concentration risk, country risk,
downgrade risk, and institutional risk.
Lenders gauge creditworthiness using the “5 Cs” of credit risk—credit history, capacity to repay, capital,
conditions of the loan, and collateral.
The following formula is used to find the expected loss on debts:
Expected loss = Probability of default × Exposure at default × Loss given default
How is Creditworthiness Measured?
Credit professionals use a variety of risk rating and loan pricing models to understand a prospective
borrower’s likelihood of triggering an event of default (and to price the risk accordingly).
For personal borrowings like car loans and home mortgages, it’s a fairly formulaic process; a lender may
use a few financial ratios, but their models are heavily reliant on the borrower’s credit history (like their
FICO score).
For corporate borrowers, risk models tend to be much more advanced since there is a lot more information
to unpack in order to understand the financial health of a business and its operations.
A common framework used to assess the creditworthiness of a borrower (and to understand the strength
of a borrowing request more broadly) is the 5 Cs of Credit. These are:
Character
Capacity
Capital
Collateral, and
Conditions

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What is the “Credit Market”?
Many public companies want to borrow money, too. These large firms may not be able to borrow directly
from a financial institution as it might not make sense for the lender to take on the balance sheet risk
associated with such a large borrowing amount.
These public companies may instead issue bonds, which are fixed income securities. Individual investors
and asset managers can then purchase these bonds in the credit market, in turn becoming creditors to the
public issuer.
The creditworthiness of these public issuers must also be monitored and updated based on improvement
(or deterioration) in their credit quality. Credit analysts at the various third-party credit rating agencies
(Standard & Poor’s, Fitch, Moody’s, etc.) are responsible for objectively assessing the issuers and assigning
a credit rating to their fixed income securities accordingly.
Financial institutions may also “package” and sell individual loans that were previously held on their
balance sheets (student loans, mortgages, credit card debt, etc.) – a process known as securitization.
These securitized products also trade in the credit market and are also rated by credit analysts at various
rating agencies.
A robust credit risk management predicts negative circumstances and measures the potential risks
involved in a transaction. To manage risk, most banks rely on technological innovations. But these, risk
management systems are very expensive. The system measures, identifies, and controls credit risk as part
of Basel III implementation.
To determine the right amount that can be lent to a borrower, financial institutions use credit risk
modeling. It is an alternative to traditional pricing techniques and hedging. Lenders use various models to
assess risks—financial statement analysis, machine learning, and default probability. But, at the end of the
day, none of the methods provide absolute results—lenders have to make judgment calls.

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Types of Credit Risk
Credit risks are classified into three types:
#1 – Default Risk
It is a scenario where the borrower is either unable to repay the amount in full or is already 90 days past
the due date of the debt repayment. Default risk influences almost all credit transactions—securities,
bonds, loans, and derivatives. Due to uncertainty, prospective borrowers undergo thorough background
checks.
#2 – Concentration Risk
When a financial institution relies heavily on a particular industry, it is exposed to the risk associated with
that industry. If the particular industry suffers an economic setback, the financial institution incurs massive
losses.
#3 – Country Risk
Country risk denotes the probability of a foreign government (country) defaulting on its financial
obligations as a result of economic slowdown or political unrest. Even a small rumor or revelation can make
a country less attractive to investors. The sovereign risk mainly depends on a country’s macroeconomic
performance.
#4 – Downgrade Risk
It is the loss caused by falling credit ratings. Looking at the credit ratings, market analysts assume
operational inefficiency and a lower scope for growth. It is a vicious cycle; the speculation makes it even
harder for the borrower to repay.

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#5 – Institutional Risk
Borrowers may fail to comply with regulations. In addition to the borrower, contractual negligence can be
caused by intermediaries between the lenders and borrowers.
Calculation and Formula
To gauge creditworthiness, lenders use a system called “The 5Cs of Credit Risk.”
Credit history: Lenders look into borrowers’ credit scores and check their backgrounds.
Capacity to repay: To ascertain borrowers’ repayment ability, lenders rely on the debt-to-income ratio. It
indicates efficiency in paying off debts from earnings.
Capital: Lenders determine every borrower’s net worth. It is computed by subtracting overall liabilities
from total assets.
Conditions of loan: It is important to determine if the terms and conditions suit a particular borrower.
Collateral: Lenders assess the value of collateral submitted by borrowers. Collateralization mitigates
lenders’ risk.
One of the simplest methods for calculating the expected loss due to credit risk is given below:

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Expected Loss=PD×EAD×LGD
Here, PD refers to ‘the probability of default.’ And EAD refers to ‘the exposure at default’; the amount that
the borrower already repays is excluded in EAD. LGD here, refers to loss given default. If LGD is not given, it
is calculated as ‘1 – recovery percentage.’
Credit Risk Example
Let us assume that a bank lends $1000,000 to XYZ Ltd. But soon, the company experiences operational
difficulties—resulting in a liquidity crunch.
Now, determine the expected loss that could be caused by a credit default. The loss given default is 38%;
the rest can be recovered from the sale of collateral (building).
Solution:
Given,
Exposure at default (EAD) = $1000,000
Probability of default (PD) = 100% (as the company is assumed to default the full amount)
Loss given default (LGD) = 38%
The expected loss can be calculated using the following formula:
Expected Loss = PD × EAD × LGD
Expected Loss = 100% × 1000000 × 38%
Expected Loss = $380000
Thus, the bank expects a loss of $380,000.

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What is Credit Analysis?
Credit analysis is a process undertaken by lenders to understand the creditworthiness of a prospective
borrower, meaning how capable (and how likely) they are of repaying principal and interest obligations.
The borrower, also known as the debtor, could be an individual or a business entity; the former is referred
to as retail (or personal) lending, and the latter is what’s known as commercial lending.
Lenders, also known as creditors, employ a variety of qualitative and quantitative techniques (including risk
models) when conducting credit analysis in order to quantify and effectively price risk.
Key Highlights
*Credit analysis is how lenders understand a borrower’s creditworthiness, whether they’re a business or an
individual.
*Analysts use a variety of qualitative and quantitative techniques and frameworks to conduct credit
analysis.
*A common framework to support credit analysis is the 5 Cs of Credit.
*Technology platforms called “Fintechs” are looking to disrupt traditional credit analysis techniques by
developing AI and machine-learning programs to evaluate credit risk.

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How is Credit Analysis Conducted?
Credit professionals analyzing a prospective borrower will employ a variety of qualitative and quantitative
techniques.
Qualitative techniques include trying to understand risks in the external environment, like where interest
rates are heading and the state of the broader economy, among others. A framework like PESTEL is often
employed.
For commercial lenders, specifically, they’ll also want to understand business characteristics – like the
borrower’s competitive advantage(s) and industry trends (using frameworks like SWOT and Porter’s 5
Forces, respectively). Management experience is another very important consideration.
Quantitative elements of the analysis include assessing financial ratios using risk models, understanding
financial projections, employing sensitivity analysis, and evaluating the strength of any physical collateral
that could serve as security against the credit exposure.
* Credit analysis is how lenders understand a borrower’s creditworthiness, whether they’re a business or
an individual.
* Analysts use a variety of qualitative and quantitative techniques and frameworks to conduct credit
analysis.
*A common framework to support credit analysis is the 5 Cs of Credit.
*Technology platforms called “Fintechs” are looking to disrupt traditional credit analysis techniques by
developing AI and machine-learning programs to evaluate credit risk.
Credit Analysis Conducted

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Credit professionals analyzing a prospective borrower will employ a variety of qualitative and quantitative
techniques.
* Qualitative techniques include trying to understand risks in the external environment, like where interest
rates are heading and the state of the broader economy, among others. A framework like PESTEL is often
employed.
* For commercial lenders, specifically, they’ll also want to understand business characteristics – like the
borrower’s competitive advantage(s) and industry trends (using frameworks like SWOT and Porter’s 5
Forces, respectively). Management experience is another very important consideration.
* Quantitative elements of the analysis include assessing financial ratios using risk models, understanding
financial projections, employing sensitivity analysis, and evaluating the strength of any physical collateral
that could serve as security against the credit exposure.
Credit Analysis Framework – The 7 Cs
A popular credit analysis framework is the 5 Cs of Credit; the 5 Cs underpin the component parts of most
risk rating and loan pricing models. The 5 Cs are:
1. Character
2. Capacity
3. Cash
4. Capital
5. Collateral
6. Condition
7. Control

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1. Character
Character as tool for analysis of creditworthiness is most vital factors consider by the lenders because
character of the promoter of company or Individual is the most powerful motivation of borrower to repay
the money. Responsibility, truthfulness serious purpose and serious intention of replaying the money is the
character. The banks try to prevent the willful defaulters from accessing the loan.
Credit history, Education, Knowledge and skills are also part of character which evaluated by the lenders.
For example suppose a bank X received loan application from Vijaya Mallya ,will he get credit or loan? No,
because his character will sufficient for rejection of the application.
Better the character better the creditworthiness.
2. Capacity
The basic of finance or loan is to give to those people or company who can refund the same and have
capacity to replay the principal with interest. The capacity is determined by the Asset, liability, Cash flow,
Network, existing debit obligations, industry risk and credit and credit utilization ratio. The cash flow
statement of organization and the person is helpful in determining it's capacity. Next is alternative sources
of repayment of the loan amount which is vital because sometimes the serious person also fails to repay
the loan because of genuine reason that time this alternative sources helps. Suppose the company have
also alternative business he may repay from that source also. In case of Individual having earning spouse is
added advantage in repayment of loan.
Higher the capacity higher the creditworthiness.
3. Capital
Normally loans are sanctioned for a project or a reason, so applicant must have invested sizable amount in
the enterprise or project. The loan applicants percentage of ownership is used to build confidence in the
project. A companies owner must have invested his own money before The Financial Institutions sanction
loan. The single biggest reason for failure of any company is under capitalization. In individual case the
same also applicable. Ideally the banks sanction up-to 75% of the total project cost this is because they
want to share the risk sharing technique. A well capitalised project is better places in obtaining the loan.
Higher the initial capita higher the creditworthiness.
4. Cash
Cash particularly the free cash generated in business or the monthly surplus cash in case of individual case
is key to repayment of advance. If someone is earning high but the expense to earn that amount is also
more than that then he becomes cash deficiency. Some one have expenses more than income is cash
negative so they are not creditworthy. We can use cash flow statement for evaluation of the net cash

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available for repayment. If Mr X is sanctioned housing loan but his salary is not enough for his existing
expenses then they may find difficult to repay. One Company is unable to pay salary to employees, how it
will repay the loan to bank.
More is the surplus cash higher is there creditworthiness.
5. Collateral
This the asset which are pledged against the loan. Mean in case the company or the person fails to repay
the amount then those asset are auctioned and amount is recovered . Land, factory, shares, bonds,
buildings , Bank deposit, Bank guarantee, LIC Policies etc are treated as the collateral for sanction of
loan. Lenders actually sanction the loan against the collateral. In case of gold loan company like
Manapuram Finance, Mutooth Finance they take gold as collateral. For sanction of working capital the
machine and factory is taken as collateral.
Higher the collateral higher the creditworthiness.
6. Condition
The condition is the overall economic and political environment and it's impact on the the business and it's
revenue. The purpose of the loan and it's value addition to the growth of business in current environment
is the measure factor for sanction of debit. The company investing the loan amount in accusation or
expansion or purchase of asset then there is more chances for sanction of advance in comparison to the
amount used in date today expenses. During the condition evaluation the strength and number of
competitors, size of market, correlation with existing rules and regulations, change in consumption taste
and relevant social, economic and political influence on business.
More favorable the condition better is the creditworthiness.
7. Control
Last but not the least factor of creditworthiness is control. This factor check the consistency of the business
with the rules and regulations. This also check control on business in achieving it's corporate goals.
More the control higher the creditworthiness.
Credit Analysis Definition
Credit analysis is a process of concluding available data (both quantitative and qualitative) regarding the
creditworthiness of an entity and making recommendations regarding the perceived needs and risks. Credit
Analysis is also concerned with identifying, evaluating, and mitigating risks associated with an entity failing
to meet financial commitments.

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Credit Analysis Process
Credit Analyst – Obtaining Quantitative Data from the Clients
Other than the above questions, the analyst also needs to obtain quantitative data specific to the client:
Borrower’s history – A brief background of the company, its capital structure, its founders, stages of
development, plans for growth, list of customers, suppliers, service providers, management structure,
products, and all such information are exhaustively collected to form a fair and just opinion about the
company.
Market Data – The specific industry trends, size of the market, market share, assessment of
competition, competitive advantages marketing, public relations, and relevant future trends are studied
to create a holistic expectation of future movements and needs.
Financial Information – Financial statements(Best case/ expected case/ worst case), Tax returns, company
valuations and appraisal of assets, current balance sheet, credit references and all similar documents which
can provide an insight into the financial health of the company are scrutinized in great detail.
Schedules and exhibits – Certain key documents, such as agreements with vendors and customers,
insurance policies, lease agreements, and pictures of the products or sites, should be appended to the loan
proposal as proof of the specifics as judged by the indicators mentioned above.
Credit Analysis – Judgement
Loan – After understanding the client’s need, one of the many types of loans, can be tailored to suit the
client’s needs. The amount of money, the maturity of the loan, and the expected use of proceeds can be
fixed, depending upon the industry’s nature and the creditworthiness of the company.
Company – The market share of the company, products and services offered, major suppliers, clients, and
competitors, should be analyzed to ascertain its dependence on such factors.
Credit History – The past is an important parameter to predict the future. Therefore, keeping in line with

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this conventional wisdom, the client’s past credit accounts should be analyzed to check for any
irregularities or defaults. This also allows the analyst to judge the client we are dealing with by checking the
number of times late payments were made or what penalties were imposed due to non-compliance with
stipulated norms.
Analysis of market – Analysis of the concerned market is of utmost importance as this helps us identify and
evaluate the company’s dependency on external factors. Market structure, size, and demand of the
concerned client’s product are important factors that analysts are concerned with.
Credit Analysis Ratios
A company’s financials contain the exact picture of what the business is going through, and this
quantitative assessment bears the utmost significance. Analysts consider various ratios and financial
instruments to arrive at the true picture of the company.
Liquidity ratios – These ratios deal with the ability of the company to repay its creditors, expenses, etc.
These ratios are used to determine the company’s cash generation capacity. A profitable company does not
imply that it will meet all its financial commitments.
Solvability ratios – These ratios deal with the balance sheet items and are used to judge the future path
that the company may follow.
Solvency ratios – Solvency ratios are used to judge the risk involved in the business. These ratios take into
the picture the increasing amount of debts, which may adversely affect the company’s long-term solvency
of the company.
Profitability ratios – Profitability ratios show the ability of a company to earn a satisfactory profit over
time.
Efficiency ratios– These ratios provide insight into the management’s ability to earn a return on the capital
involved and the control they have on the expenses.
Cash flow and projected cash flow analysis – A cash flow statement is one of the most important
instruments available to a Credit Analyst, as this helps him to gauge the exact nature of revenue and profit
flow. This helps him get a true picture of the movement of money in and out of business.
Collateral analysis – Any security provided should be marketable, stable, and transferable. These factors
are highly important as a failure on any of these fronts will lead to the complete failure of this obligation.
SWOT analysis – SWOT Analysis is again a subjective analysis done to align expectations and current
reality with market conditions.
Credit Rating
A credit rating is a quantitative method using statistical models to assess creditworthiness based on the
borrower’s information. Most banking institutions have their rating mechanism. This is done to judge under
which risk category the borrower falls. This also helps determine the term and conditions, and various

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models use multiple quantitative and qualitative fields to judge the borrower. Many banks also use external
rating agencies such as Moody’s, Fitch, S&P, etc. to rate borrowers, which then forms an important basis
for consideration of the loan.
Lesson Learned
So, let’s illustrate the whole exercise with the help of the example of Mr. Sanjay Sallaya, a liquor Barron and
a hugely respected industrialist who also owns a few sports franchises and has bungalows in the most
expensive locals. He now wants to start his airline and has therefore approached you for a loan to finance
the same.
The loan is for a meager $1 million. So, as credit analysts, we have to assess whether or not to go forward
with the proposal. To begin, we will obtain all the required documents to understand the business model,
working plan, and other details of his new proposed business. Necessary inspections and enquires are
undertaken to validate the integrity of his documents. A TEV, i.e., Techno-Economic Viability, can also be
undertaken to get an opinion from the aviation industry experts about the plan’s viability.
When we are finally satisfied with the overall efficacy of the plan, we can discuss the securities that will
collaterally cover our loan (partly/fully). If it meets all other aspects, such a proposal can be presented for
sanction comfortably and generally enjoys good terms from the bank’s side as the risk associated with such
personalities is always assessed to be less. Mr. Sanjay Sallaya, a well-established industrialist, holds a good
reputation in the business world and, therefore, will make good recommendations.
Therefore, to conclude, Mr. Sanjay Sallaya will get a loan of $1 million approved and will go on to start his
airline business. However, what the future holds can never be predicted when a loan is sanctioned.
Conclusion
As a Credit analyst, two days in life are never the same. Credit Analysis is about making decisions while
keeping in mind the past, present, and future. The role offers a plethora of opportunities to learn and
understand different types of businesses as one engages with a multitude of clients hailing from different
sectors. The career is monetarily rewarding and helps an individual grow, along with providing good
opportunities to build one’s career.
DOCUMENTATION PROCEDURE IN LOAN ACCOUNTS
It is of utmost importance to obtain appropriate and correctly executed security documents before
disbursing an advance to borrowers. In case the borrowers fail to repay, the recovery of Bank’s dues, banks
will mainly depend upon the enforcement of the security. Banks should, therefore, take necessary care and
precaution while obtaining security documents in advance accounts and scrupulously adhere to the
instructions/guidelines laid down in this regard. It should be borne in mind that if the Bank is faced with a
situation of remedying any defects or irregularities in the security documents at the time of filing a suit, it
would be difficult to get the co-operation from the borrowers and guarantors, if any, and the Bank’s action
against them might be in jeopardy.

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WHAT IS DOCUMENTS ?
As per Sec.3 of Indian Evidence Act 1872, document means any matter expressed or described upon any
substance by means of letters, figures or by more than one of these means intended to be used or which
may be used for the purpose of recording that matter with an intention of producing the same as
evidence.
In common usage Documents are related to written record created for the purpose of evidence while
lending the bank funds. Banking relationship is a contract between the Bank & the Customer. Customer
should be legally capable of entering into a valid contract.
Need & Importance of Documents: Documents are necessary to be obtained for the following purpose;
 It identifies borrower, guarantor,
 It identifies security, nature of charge
 For creation of Bank’s charge on security.
 Written evidence of transaction & hence cannot be disputed by the executant in future.
 It is accepted as an evidence of fact in court of law in any legal proceedings against defaulter.
Documentary evidence (Section 64 of the Indian Evidence Act).
 Recording happening of an event/incident.
 Helps Bank to safeguard its interest by incorporating protective clauses as & when felt necessary.
 Under Negotiable Instruments Act 1881, Banker acquires a right to file a money suit based on
Demand Promissory Note executed by the borrower.
 Deciding period of limitation.
DIFFERENT TYPES OF DOCUMENTS
Bank obtains different types of documents during opening of accounts and financing an advance to
borrower. Documents obtains during an advance can be broadly classified as three types.
1. Demand Promissory Note (DPN): DPN is an important loan documents. It is an unconditional
promise to repay the loan on demand with agreed rate of interest where no fixed period of time
mentioned. Section 4 of the Act defines, “A demand promissory note is an instrument in writing
containing an unconditional undertaking, signed by the maker, to pay a certain sum of money to or
to the order of a certain person, or to the bearer of the instruments”. An instrument to be a
promissory note must possess the following elements:
 It must be a promise to repay a certain sum of money along with agreed rate of interest,
 It is paid on demand, no time frame for repayment mentioned,

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 Promise to pay must be unconditional,
 The promise should be to pay in money and money only,
 It should be signed by the borrower,
2. Agreements: It is defined in the Indian Contract Act 1872. Every promise and every set of promises,
forming the consideration for each other, is an agreement. An agreement enforceable by law is a contract.
All the terms and conditions are mentioned in the agreements. The loan amount, rate of interest, margin,
repayment period, moratorium period, details of securities offered are included in the agreement. The
agreement attracts a stamp duty as per Indian Stamp Act. During documentation, bankers use different
forms of agreements such as term loan agreement, Hypothecation agreement, pledge agreement,
guarantee agreement etc.
3. Forms: Forms are neither a promise nor an agreement. It is obtained for the purpose of the
intention of the borrower. Application for request of a loan by the borrower is also a type of forms. When a
loan is granted against the security of a fixed deposit standing in the joint names, one of the depositors
gives an authorization to the other to raise a loan on the deposit, such an authorization is taken in a form. If
a letter from the borrower authorizing the bank to pay the proceeds by means of drafts, is taken by means
of a form. All these forms are used as part of documentation to prove the intention of the borrowers.
STEPS AND PROCESS OF DOCUMENTATION
The following are the precautions, which should be taken care of both by the borrower as well as banker, at
the time of preparation, execution and registration of loan documents etc. The systematic process of
documentation are as follows;
1. Selection of proper set of documents and formats;
2. Stamping;
3. Filling Up;
4. Execution or signing;
5. Checking & Vetting Recording;
6. Registration;
7. Keeping documents in force.
1) Selection of proper set of documents and formats: Selection of proper set of documents is important
steps of documentation. Selection of full set of documents depending upon the nature of facility, types of
security and type of person who will execute the documents. Some documents are common for most of the
loans, but some particular documents are relevant for particular credit facility. Documents also depends
upon the types of borrowers. Banker needs to be conversant with legal provisions of various Acts.
Documents must be in proper format and vetted by the legal department.

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2) Stamping: The next important steps is stamping of documents. The loan documents should bear proper
type of stamps i.e. adhesive, embossed etc. Further value of stamp duty should be adequate, keeping in
view the laws of the State in which the documents are executed. The Non Judicial Stamp papers, if used,
should bear the date, prior to its execution and also the date should not be earlier than six months. The
text of the agreement may be written on the Stamp papers itself and plain papers (additional sheets) may
be used, if required in addition to Stamp papers.
Statutory Requirement: Stamp duty is a form of tax that is levied on documents. Let us understand
stamping duty provisions, starting with the Indian Stamp Act 1899. Any instrument which creates, transfers,
extends, extinguishes, limits or amends a right or liability is required to be stamped as per the Indian Stamp
Act. This extends to the whole of India, except Jammu and Kashmir.
Stamp Duty: Central Government Stamps applicable on the instruments including Demand Promissory
Note, Usance Bill of Exchange, Bill of lading, Letter of Credit, Share Transfer Form, Insurance Policy, Money
Receipts, the stamp duty will remain the same throughout India.
3) Filling Up: The next step of documentation procedure is filling up of the documents before execution.
The documents should be filled completely in all respect. No column of the loan documents should be left
blank. Date, place, amount, rate of interest, type of facility and security, terms etc. should be filled carefully
without any alteration, overwriting and cutting. Entire document should be filled with same ink, in same
handwriting by same person. Once the document is executed it becomes a concluded contract and any
subsequent filling by bank without the consent of the executant will invalidate it. Place of execution is very
important for deciding the jurisdiction of the court. Security documents bearing dates of execution prior to
the date affixed by the stamp authority on the special adhesive stamps are invalid.
4) Execution or signing: The next step of documentation procedure is execution or signing of the
documents. Person, executing the loan documents must be competent to enter into a contract i.e., he or
she should have contractual capacity. Thus, minor, insolvent person, lunatic etc. are not competent persons
to execute documents. During the execution of document, it should be ensured that the signature in the
documents must tallies with the signature as appearing in the application for the loan and also with the
specimen signature available in the deposit account. In case, execution in the representative capacity of
sole proprietor or partner or agent or trustee or executor etc, the capacity property should be clearly
mentioned. While executing the documents, the borrower must sign in full and in the same flow in which
his signatures are available in the bank. The cuttings & over writings must be avoided and if at all, they
become unavoidable, they should be authenticated by the borrowers by signing in full. In case the
borrowers reside at different places, the loan documents should be got executed through the branches of
the bank situated at those stations, after properly verifying the identity of the borrowers. The guarantee
form should be executed if so agreed and stipulated as a term of sanction.
5) Checking & vetting of documents: After proper signing or execution of the documents, it should be
checked that documents are in proper format, properly filled in all respect and properly executed as per
sanction term and conditions. Documents of the high value of loan amounts should be vetted by the penal
advocate. Banks should, scrupulously adhere to the instructions/guidelines laid down in this regard. It

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should be borne in mind that if the Bank is faced with a situation of remedying any defects or irregularities
in the security documents at the time of filing a suit, it would be difficult to get the co-operation from the
borrowers and guarantors, if any, and the Bank’s action against them might be in jeopardy.
6) Registration of Loan Documents: The Registration Act, 1908 was enacted to consolidate the laws
relating to the registration of documents. In case of advances of limited companies against his assets, it
should be registered to the registrar of companies within 30 days from the date of execution. Similarly, in
case of registered mortgage, the mortgage deed is presented for registration within 4 months from date of
execution of deed. Equitable mortgage should be registered with CERSAI within 30 days. If these
formalities are not done then the bank may have to lose priority over security. The documents may not be
admissible as evidence before the competent authority.
7) Keeping documents in force: After doing all the formalities, the documents should be kept in safe. But,
the documents taken by banks for a credit facility do not have perpetual life. The law of limitation as per
Limitation Act applied on the documents. For example, the period of limitation for DP Note is three years
from date of execution. It means, the bank has to get fresh documents or obtained acknowledgement of
debt for extending the period of limitation as per the provision of limitation act. After obtaining of
acknowledgement of debt the expiry period of limitation extended for further three years. According to
section 3 of Limitation Act, a suit cannot be filed for recovery on the strength of a time barred document.
Types of Credit Facilities | Short-Term and Long-Term
Broadly, there are two types of credit facilities:
1) Short term loans, mainly for working capital needs; and

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2) Long-term loans, required for capital expenditure (consisting mainly of building manufacturing facilities,
purchase of machinery and equipment, and expansion projects) or acquisition (which could be bolt-on, i.e.,
smaller in size or could be transformative, i.e., comparable size).
Short-Term Credit Facilities
The short-term borrowings can be predominantly of the following types:
#1 – Cash credit and overdraft
In this type of credit facility, a company can withdraw funds more than it has in its deposits. The borrower
would then be required to pay the interest rate, which applies only to the amount that has been
overdrawn. The size and the interest rate charged on the overdraft facility are typically a function of the
borrower’s credit score (or rating).
#2 – Short-term loans
A corporation may also borrow short-term loans for its working capital needs, the tenor of which may be
limited to up to a year. This type of credit facility may or may not be secured in nature, depending on the
borrower’s credit rating. A stronger borrower (typically of an investment grade category) might be able to
borrow on an unsecured basis. On the other hand, a non-investment grade borrower may require providing
collateral for the loans in the form of current assets such as the borrower’s receivables and inventories (in
storage or transit). Several large corporations also borrow revolving credit facilities, under which the
company may borrow and repay funds on an ongoing basis within a specified amount and tenor. These may
span for up to 5 years and involve a commitment fee and a slightly higher interest rate for the increased
flexibility than traditional loans (which do not replenish after payments are made).
A borrowing base facility is a secured short-term loan facility provided mainly to commodities trading firms.
Of course, the loan to value ratio, i.e., the ratio of the amount lent to the value of the underlying collateral,
is always maintained at less than one, somewhere around 75-85%, to capture the risk of a possible decline
in the value of the assets.
#3 – Trade finance
This type of credit facility is essential for an efficient cash conversion cycle of a company and can be of the
following types:
1. Credit from suppliers: A supplier is typically more comfortable providing credit to its customers,
with whom it has strong relationships. Negotiating the payment terms with the supplier is
extremely important to secure a profitable transaction. An example of the supplier payment term is
“2% 10 Net 45”, which signifies that the supplier’s purchase price would be offered at a 2%
discount if paid within ten days. Alternatively, the company would need to pay the specified
purchase price but would have the flexibility to extend the payment by 35 more days.

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2. Letters of Credit: This is a more secure form of credit, in which a bank guarantees the payment
from the company to the supplier. The issuing bank (i.e., the bank which issues the letter of
credit to the supplier) performs its due diligence and usually asks for collateral from the company.
A supplier would prefer this arrangement, as this helps address the credit risk issue concerning its
customer, which could potentially be located in an unstable region.
3. Export credit: This form of loan is provided to the exporters by government agencies to support
export growth.
4. Factoring: Factoring is an advanced form of borrowing. The company sells its accounts
receivables to another party (called a factor) at a discount (to compensate for transferring the
credit risk). This arrangement could help the company get the receivables removed from its
balance sheet and fill its cash needs.
Long-Term Credit Facilities
Now, let’s look at how long-term credit facilities are typically structured. Banks, private placement, and
capital markets can be borrowed from several sources and are in a payment default waterfall at varying
levels.
#1 – Bank loans
The most common type of long-term credit facility is a term loan, defined by a specific amount, tenor (that
may vary from 1-10 years), and a specified repayment schedule. These loans could be secured (usually for
higher-risk borrowers) or unsecured (for investment-grade borrowers) and are generally at floating rates
(i.e., a spread over LIBOR or EURIBOR). Before lending a long-term facility, a bank performs extensive due
diligence to address the credit risk they are asked to assume given the long-term tenor. With heightened
diligence, term loans have the lowest cost among other long-term debt. The due diligence may involve the
inclusion of covenants such as the following:
1. Maintenance of leverage ratios and coverage ratios, under which the bank may ask the corporation
to maintain Debt/EBITDA at less than 0x and EBITDA/Interest at more than 6.0x, thereby indirectly
restricting the corporation from taking on additional debt beyond a certain limit.
2. Change of control provision means that a specified portion of the term loan must be repaid if the
company gets acquired by another company.
3. Negative pledge, which prevents borrowers from pledging all or a portion of its assets for securing
additional bank loans (even for the second lien), or sale of assets without permission.
4. Restricting mergers and acquisitions or certain capex
The term loan can be of two types – Term Loan A “TLA” and Term Loan B “TLB.” The primary difference
between the two is the amortization schedule – TLA is amortized evenly over 5-7 years, while TLB is
amortized nominally in the initial years (5-8 years) and includes a large bullet payment in the last year. As

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you guessed correctly, TLB is slightly more expensive to the company due to increased tenor and credit risk
(owing to late principal payment).
#2 – Notes
These credit facilities are raised from private placement or capital markets and are typically unsecured. To
compensate for the enhanced credit risk that the lenders are willing to take, they are costlier for the
company. Hence, they are considered by the corporation only when the banks are not comfortable with
further lending. This type of debt is typically subordinated to bank loans and is larger in the tenor (8-10
years). The notes are usually refinanced when the borrower can raise debt at cheaper rates. However, this
requires a prepayment penalty in the form of a “make whole” payment in addition to the principal
payment to the lender. Some notes may come with a call option, which allows the borrower to prepay
these notes within a specified time frame in situations where refinancing with cheaper debt is easier. The
notes with call options are relatively cheaper for the lender, i.e., charged at higher interest rates than
regular notes.
#3 – Mezzanine debt
Mezzanine financing debt is a mix between debt and equity and ranks last in the payment default
waterfall. This debt is completely unsecured, senior only to the common shares and junior to the other
debt in the capital structure. The enhanced risk requires a return rate of 18-25% and is provided only by
private equity and hedge funds, which usually invest in riskier assets. The debt-like structure comes from
its cash pay interest and a maturity ranging from 5-7 years, whereas the equity-like structure comes from
the warrants and payment-in-kind (PIK) associated with it. PIK is a portion of interest, which instead of
paying periodically to the lenders, is added to the principal amount and repaid only at maturity. The
warrants may span between 1-5% of the total equity capital and provide the lenders the option to buy the
company’s stock at a predetermined low price if the lender views the company’s growth trajectory
positively. The mezzanine debt is typically used in a leveraged buyout situation. A private equity
investor buys a company with as high debt as possible (compared to equity) to maximize its returns on
equity.
#4 – Securitization
This type of credit facility is very similar to the factoring of earlier receivables. The only difference is the
liquidity of assets and the institutions involved. In factoring, a financial institution may act as a “factor” and
purchase the Company’s trade receivables; however, there could be multiple parties (or investors) and
longer-term receivables involved in securitization. Examples of securitized assets could be credit card
receivables, mortgage receivables, and non-performing assets (NPA) of a financial company.
#5 – Bridge loan
Another type of credit facility is a bridge facility, which is usually utilized for M&A or working
capital purposes. A bridge loan is typically short-term (for up to 6 months) and is borrowed for interim

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usage while the company awaits long-term financing. Thebridge loan can be repaid using bank loans,
notes, or even equity financing when the markets turn conducive to raising capital.
In conclusion, there needs to be a balance between the company’s debt structure, equity capital, business
risk, and future growth prospects. Several credit facilities aim to tie these aspects together for a company
to function well.