‘Term Loan Appraisal’ Technique

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‘Term Loan Appraisal’ technique is explained in this article.

 

Terms Loans are granted to finance Capital Expenditure like plant & machinery, land and building or setting up an entire unit. Term Loans have a specific repayment period and are generally repayable in installments.

Cash generating capacity of the unit is the main consideration while appraising Term Loan. The concern of a lending institution is whether, the unit generate sufficient cash flows to serve the Term Loan installment and interest during the repayment period.

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Term Loan Appraisal consists of following assessment:

Management Evaluation

First step in Term Loan Appraisal is evaluating the Management of prospective borrower. It is to be ascertained that whether promoters have background, experience and knowledge to implement and run the project. Experience and qualifications and expertise of Key persons working in the entity in the functional areas, such as production, purchases, sales, administration, finance etc should also be evaluated.

Technical Feasibility

It is to be analyzed that how the technical requirements of the project can be met. For example availability of infrastructural facilities, raw materials, labour and other utilities, technology required for the manufacturing process etc.

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Profitability of the unit to very large extent depends upon productivity of the unit, accordingly, it is to be assessed that if the product mix, quality and quantity can produced as projected and whether the projections are realistic and achievable with given parameters.

Economic Viability

Economic viability of a unit depends upon the sales. Accordingly, sales projections should be analyzed critically and assessed keeping in view:

a) demand and supply of the product and its substitutes

b) proposed selling price per unit (to be compared with prices of competing products)

c) quality of the product (also to be compared with quality of competing products)

Financial Viability

Determining Financial viability is a very important step in Term Loan Appraisal, since the repaying capacity of the project depends on financial viability of the project.

  1. Financial viability study is done to ascertain that whether cost of project and means of finance as envisaged are realistic, whether the profitability projections are realistic and whether the project is capable of generating sufficient cash for servicing the debt and interest.
  2. Estimates of cost of production and other establishment expenses should fully cover all items of expenditure and there should be neither understatement nor over statement of expenditure. Items of cost and expenditures should be analyzed and it should be ensured that these are reasonable.
  3. It should be ascertained that proper arrangements have been made for necessary finance to be available during the period of construction, erection of plant and machinery etc. as and when required.
  4. Profitability of the project depends upon the sale price, sales volume and cost of production and establishment and sales overheads. Sales price should be compared with the competing products and sales volume can be ascertained based on installed capacity and capacity utilization of the project. It should be seen, if sufficient raw material, labor and other utilities like power, water are available for the projected level of production. Only production is not the criteria for the profitability, rather the product should be sold in order to earn profit, hence there should be adequate marketing arrangements to sell the quantity of products which are manufactured.
  5. Items of cost/ expenditure should be analyzed according to the nature of cost, whether fixed, variable or semi variable. Fixed costs are fixed for a given period of time and will be incurred irrespective of level of production, such as rent. Variable costs varies with the production. Semi-variable costs are partly fixed and partly variable.
  6. Repayment of Term Loan should be fixed after studying Cash flow statements according to the cash accruals.
  7. Basic ratios which are to be considered are debt/Equity ratio, Debt Service Coverage ratio, Tangible Net Worth/ Outside Liabilities ratio, Profit/Sales ratio, Sales/Tangible Assets ratio, Current ratio.
  8. While examining the cost of production & profitability, the break-even point of the project should be worked out. BEP indicate the minimum level of output as percentage of full capacity at which the project starts yielding profits.
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Break-even point is calculated as under:

Break-even point =                             Total Fixed Cost .

(Sales volume in units)              (Sales price per unit – Variable Cost per unit

 

Break-even point =                          Total Fixed Cost x Sales

(Sales volume in rupees)                             (Sales) (Variable Costs)

 

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Data to be obtained from the borrower for Term Loan Appraisal:

i) Cost of project and means of financing

ii) Profitability projections (upto the period till TL repayment is completed)

iii) Cash-flow estimates (upto the period till TL repayment is completed)

iv) Projected Balance Sheets (upto the period till TL repayment is completed)

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