Credit Appraisal Process : An Ultimate Guide for beginners
Credit Appraisal is a process which require sufficient knowledge and proper due diligence. Credit involves risk of default, which can not be avoided but can be minimized. So you should minimize the risk.
The first step is to act early and act fast. If you do not start your due diligence process immediately on receiving the loan proposal, the chances are you won’t be able to complete it. Its better to have thorough knowledge in advances before going for the dip.
Here is a comprehensive step by step guide to help you in credit appraisal process:
- Customer Identification
- Understanding the business of the borrower
- Understanding credit requirements
- Selecting appropriate scheme/ credit facility
- Loan application
- Draw Credit Information Reports (CIBIL)
- RBI Defaulter List
- CERSAI Search
- MCA Search
- Visits before sanction
- Documents and information to be obtained from the borrower
- Obtaining Due Diligence Report
- Due Diligence of Immovable Property
- Credit Risk Rating (Internal)
- External Credit Risk Rating
- Confidential Reports from existing bankers
- Fixing Repayment of Term Loan
- Assessment of Eligible amount of Loan
- Appraisal Note
- Terms & Conditions
Its better, you approach the customer rather customer approaches you. Avoid middleman introducing customer to you. First thing is customer identification. Not just collecting copies of ID and address proof but actually knowing the customer. You must know, who he is, what he does, where he lives, how much he earns, what is his reputation in the society and his credit worthiness.
Remember banks extend loans to only those, who have ability to repay and intent to repay both.
Gather information by your prospective customer from different sources. Your existing customers may help you in this or his neighbors, business associates, competitors or his business community.
Understanding the business of the borrower
Understanding the business of the borrower is very important before going further in the process of extending credit. Enquire about the nature of business, the industry in which he operates, the processes of business, modus operandi of business etc. Do some research about the industry, whether the industry has going good, what are margins in that industry, are there any adverse government directives, is it regulated. It doesn’t take much time but saves you and the bank. Know the product the borrower is dealing into. Is the product viable and have a future? For example, is it wise to lend to manufacturer of trader of CDs (Compact Disks), knowing that CDs are disappearing and rarely used? Enquire about the major suppliers and buyers of the borrower and their reputation in the market.
Understanding credit requirements
Understand what type of credit facilities the borrower require. The assessment depends on the type of facilities borrower require. Further, you’ll have to head to the guidelines after you know, which credit facilities are to be sanctioned.
Requirement analysis is important because, you can not take risk of neither over financing or under financing. Both the cases are dangerous and may have adverse consequences. Over financing would lead to stress in account as borrower has been provided more funds than required, which he’ll use for non-business purposes. While in case of under financing, borrower will not be able to execute the project properly resulting into business failure.
Selecting appropriate scheme/ credit facility
Banks have different schemes for different types of borrower depending upon the nature of activity and volume of activity. These schemes have a set of guidelines for different parameters such as eligibility calculations, collateral security requirement, margins, rate of interest, service charges etc. For example there may be a scheme for traders, distributors, car dealers, tour operators, travel agents, professionals etc. Select the appropriate scheme, if applicable to the borrower before going for a conventional fund based working capital facility or term loan.
You must obtain duly filled loan application in the prescribed format of your bank from the borrower. Loan application is designed in a way so that crucial information of the borrower are obtained. Read the whole application alongwith the annexures and documents.
Yes KYC is must. You must first identify the customer. Complete the KYC norms before going further in the loan proposal. Following things are required for establishing KYC:
- Proof of Identity
- Proof of residence
- Proof of business address
Photocopies of all these must be verified with original and also get them signed by the borrower and kept on record.
Draw Credit Information Reports (CIBIL)
Draw the credit information reports like CIBIL/ Equifax/ Exparian as required by your bank’s guidelines. CIBIL is the most important and widely used CIR in India.
There are two types of CIBIL reports, personal and commercial. Commercial is for business entities be it proprietorship or a limited liability company, whereas personal is for individuals. This report contains credit history of the borrower.
Read this report carefully and specially check for any settlements, defaults, past dues and written off amounts. If any of these appear, that means the credit history of the borrower is not good. Even if there are minor amounts in default, you must ask for explanation and evidences to your satisfaction.
You’ll also come to know about the current loans the borrower is availing, that will help you analyse his repayment capacity because you need to take care the repayment of all the loans while assessing repayment of your loan.
RBI Defaulter List
The defaulter list is available on CIBIL website and can be accessed from here. Check this list to ensure that names of borrower/ proprietor/ partners/ directors/ guarantors or associate and allied concerns of the borrower are not appearing therein.
If there is any Immovable Property involved, whether as primary security or collateral security, check the CERSAI database, to ensure that the property is not mortgaged with other lenders. Further, now even particulars of movable assets like stocks and book debts are required to be registered with CERSAI, so you should also check for that, so that you get to know about the loans taken by the borrower.
If the prospective borrower is a limited liability company (private limited company or a limited company) or an LLP (Limited Liability Partnership), search the details in MCA website.
Create account of MCA website, its easy and anybody can create an account. With the payment of Rs.150, you can access all the documents of that company. Download Balance Sheets and Annual Returns of the company for atleast 3 years. Compare the balance sheets submitted by the borrower and downloaded from MCA website.
Visits before sanction
Before processing the loan, you must visit residence of borrower, all business places of the borrower such as registered office, corporate office, factories and godowns And the location of properties to be mortgaged in the account. Make enquiries from neighbors, local prominent peoples, local property dealers. This will give you an idea about the worth of your prospective borrower. Note down your observations during the visit and names and telephone numbers of the people, you have spoken and place it on record.
Documents and information to be obtained from the borrower
- Registration Certificates
Obtain the copies of necessary registrations as per nature of business. Some of the registrations are TAN (Tax Deduction Account Numner), GSTIN, IEC (Import Export Code), Registration under Shop & Establishment Act etc.
Generally, it is understood that Financial means only balance sheet and profit & loss account. But you should obtain complete financials including Annual Report/ Directors’ Report, Audit Report, cash flow, tax audit report and all the annexures.
Financial for previous three years should be obtained. If some part of the financial year is over, obtain a provisional balance sheet upto some latest date.
Analyse the financial thoroughly such as trend in sales, profitability, sources and uses of cash flows, use of capital, trend in unsecured and secured loans. (we’ll discuss the financial analysis in separate article). Check if there are any adverse remarks in audit report or annexures. Compare the loans appearing in balance sheet with those in CIBIL. Reconcile them and ask for explanation, if required.
Obtain the financials of associate and allied concerns too for previous 3 years and analyse them.
- CMA Data (for working capital limits)
CMA data contains the analysis of balance sheet of profit & loss account for previous 3 years and projected for next 2 years. The maximum permissible bank finance for working capital limits is fixed based on the projections for upcoming years.
Broadly, you should check for the trend in the projected finacials comparing with the actuals. For example, if turnover has increased with y-o-y growth of 10% during previous years, and it is projected to increase with 25% growth, you should raise question. (we’ll discuss analysis of CMA data in a separate article).
- Project Report (for Term Loan)
Project report is required in case of term loan, which contains all the details about establishing and running the project and financial projections of the project. Project report should be detailed containing the details of machineries, price, suppliers, specifications, installed capacity and capacity utilization etc. Verify the quotations of fixed assets and make direct payment to suppliers.
Read this detailed article about analyses required in case of term loan.
- Asset Liability Statement or Net worth statements
In order to establish the credit worthiness of the borrower and guarantors, you need to know about their assets and liabilities. The net worth statement should preferably be authenticated by a Chartered Accountant. But don’t simply accept the asset liability statement, verify the assets which are disclosed in the net worth statement and their value.
- Income Tax Returns
Obtain Income Tax Returns of borrower, partners, directors and guarantors for previous three years. Have them verified by a Chartered Accountant (in bank’s panel). Also verify the authenticity of ITRs independently.
- Sales Tax/ Service Tax/ Excise/ GST Returns
Obtain Sales Tax/ Service Tax/ Excise/ GST Returns. You’ll get the sales of current year, for which balance sheet is not available. Excise/ GST returns will also tell you about the installed capacity of the borrower, which will give you idea if the projected sales is achievable or not.
- Electricity Bills
Why? Electricity consumption gives you the idea about the level of operation in being undertaken in the factory.
Obtaining Due Diligence Report
Obtain due diligence report from a CA/ CS as per your bank’s policy and empanelment. CA/CS will conduct due diligence of financials, ROC charges and income tax returns and will provide a report in prescribed format. Read and analyse the due diligence report thoroughly for any adverse remarks, seek explanation from borrower if there are any.
Due Diligence of Immovable Property
IP may be a primary security in the account or collateral security. This is very crucial part because mostly decisions are taken based on the available security. Mostly frauds in loans are related to immovable property such as fake title deeds
- Visit of the Immovable Property is most crucial and important factor and should be done invariably. In most of the fraud cases, it is found that bankers did not visit the property. After sanction of loan, periodic visits should be made as per bank guidelines.
- Search Report or Non Encumbrance Certificate from advocate on bank’s panel should be obtained and analysed before grating loan. The opinion of the advocate is important if the property is not encumbered and can be mortgaged. Obtain all the documents as reported by advocate for creation of mortgage.
- Valuation should be obtained from a valuer on bank’s panel. The valuation report should be thoroughly checked and if there is any discrepancy, it should be got rectified from the valuer.
- The valuation given by valuer should be independently checked from other sources such as local property dealers, neighbours etc. Now a days there are various property websites, where you can check the price of a property in a particular locality.
- Owner of the property should be identified and efforts should be made that his guarantee is obtained.
Credit Risk Rating (Internal)
There is system of scoring and rating in almost all the banks for determining the risk involved in lending to particular borrower. Rating of the borrower depends upon the financial performance, management evaluation, industry in which it is operating, past conduct of his account, quality of books of accounts etc. Rating should be done judiciously since sometime the lending depends upon the risk rating of the borrower. Also the pricing is linked to risk rating of the borrower. There may be different models for rating depending upon the type of advance and category and level of borrower. Further there are separate models for rating of corporate loans and retail loans.
External Credit Risk Rating
Risk rating from an approved agency such as CRISIL, ICRA etc. is obtained in all the cases above Rs.5 crores. BBB and above rating is generally treated as investment grade. Purpose of this rating is for determining capital charge but sometimes the lending decision is also linked to External Credit Rating. If there is no external risk rating and the borrower is given time for getting the rating, it should be got done within the time period allowed by the sanctioning authority.
Confidential Reports from existing bankers
Obtain CRs from the existing bankers of the borrower. Also obtain bank statements for last one year and thoroughly check it. Bank statement would tell you a lot about the conduct of the borrower. If borrower does not have credit facilities from any other bank, analyse the current account statement.
Fixing Repayment of Term Loan
There is no repayment schedule in working capital limits but term loans are to be paid within a specified period. Repayment period should be fixed based on the cash flows of the borrower. If cash flows are low initially and increases gradually, instalments should be ballooning, keeping them initially low and then increasing the same in the pattern of increase in cash flows. It should be checked that at no point of time, instalment plus interest amount exceed the cash inflow. A wrong repayment schedule may stress the account, even if it is viable in totality. DSCR of each year should preferably be above 1.25 but not below 1 in any case.
Repayment schedule should clearly mention the date of instalment and servicing of interest. Instead of mentioning June 2019, it should be 1st June 2019 or 30th June 2019 as the case may be.
Assessment of Eligible amount of Loan
For working capital requirement (including LC requirement) assessment should be done as per prescribed method for assessing Maximum Permissible Bank Finance. Generally Simplified Turnover method is used for limits upto Rs.5 Crores for MSME borrowers for assessing MPBF, and second method of lending is used for limits above Rs.5 Crores.
We’ll come up with separate detailed guide about assessment of MPBF. However, you should know what is Working Capital, What is holding period and how holding periods/ levels are analysed in working capital assessment and analysis of of current assets and current liabilities before assessing MPBF.
Credit Appraisal note should be prepared on bank’s prescribed and approved format only. This ensures that complete information is presented to sanctioning authority. There should not be any concealment of information and misrepresentation of information. The borrower should not be allowed to prepare the appraisal note or part of it. All the merits and demerits of the proposal should be presented in appraisal note.
Before preparing appraisal note, have a checklist of all the bank guidelines and documents/ information required.
Terms & Conditions
Terms & Conditions should be discussed with the borrower before sanction of loan and the borrower should agree to the terms and conditions. An acknowledgement for the same should be obtained from the borrower.
Terms & Conditions should be thoroughly read and understood before incorporating them and if there are prescribed set of conditions, it should be ensured that nothing is left out. It is terms & conditions which are the basis on which legal recourse may be taken in case of default.
Disbursement should be made only after complete documentation and borrower agreeing to all the terms and conditions.
In case of term loan disbursement should be done as per schedule and against the bills/ invoices as approved by sanctioning authority. Payment should be made directly to supplier and disbursement through current account of the borrower should be avoided. Original bills may be kept in the branch against which disbursement has been made. Borrower should bring his margin upfront or in proportion to disbursement as approved by sanctioning authority but disbursement should not be made without borrower bringing his margin. Physical progress should be monitored and looked into before making further disbursements. Obtain periodic CA certificate for monitoring the funds incurred. See if there is any cost-over run or time over-run, if there is any, it should be brought to the notice of sanctioning authority and borrower should justify the same. Report of Lender’ Engineer be obtained and analysed to check cost over run and time over run.
In case of working capital limits, disbursement should be done after getting approval of competent authority. Remittances to associate/ allied/ group concerns, directors, partners should not be done. For major amount, it should be ensured that funds are being remitted for genuine trade transactions.
[The information given above is general in nature and different banks have different guidelines and procedures for extending credit. It is advised that one should refer the specific guidelines of the concerned bank and or RBI for the purpose of analysing/ assessing or sanctioning any credit]
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