Appraisal and Assessment of Credit Facilities | PAPER II – PRINCIPLES & PRACTICES OF BANKING | MODULE B: FUNCTIONS OF BANKS

Credit Appraisal and Assessment of Credit Facilities

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1. Credit Appraisal

Credit appraisal is the process by which a lender assesses the creditworthiness of a borrower before extending credit. This includes evaluating the borrower's financial health, repayment capacity, credit history, and the nature of the proposed project or requirement.

Example:

If a company applies for a term loan of ₹50 lakh to buy machinery, the bank will evaluate its past financials, repayment ability, and viability of the project before approving the loan.

2. Credit Appraisal Techniques

Common techniques include:

• Financial Statement Analysis: Examining balance sheets, income statements, and cash flow statements.
• Ratio Analysis: Analyzing liquidity, solvency, profitability, and efficiency ratios.
• Risk Assessment: Identifying industry, borrower, and external risks.
• 5 Cs of Credit: Character, Capacity, Capital, Collateral, and Conditions.

3. Methods of Assessment of Loans

Loan assessment methods vary based on the loan type. Key methods include:

• Turnover Method: Working capital is calculated as 25% of projected annual turnover (for limits up to ₹5 crore).
• Operating Cycle Method: Based on the length of the business's operating cycle.
• Cash Budget Method: Used for seasonal industries or project loans where monthly inflows/outflows are critical.

4. Assessment of Working Capital

Working capital is the capital used in day-to-day business operations. Proper assessment ensures liquidity without excess borrowing.

Illustration (Turnover Method):

Projected turnover: ₹4 crore
Working Capital = 25% of ₹4 crore = ₹1 crore
Borrower's Margin = 5% of turnover = ₹20 lakh
Bank Finance = ₹1 crore - ₹20 lakh = ₹80 lakh

5. Assessment of Term Loan

Term loans are assessed based on the total cost of the project and the borrower’s contribution. Repayment capacity is analyzed through cash flow projections.

Example:

Project Cost: ₹1 crore
Promoter’s Contribution: ₹25 lakh
Term Loan Required: ₹75 lakh
Bank checks DSCR (Debt Service Coverage Ratio) to ensure feasibility. If DSCR > 1.5, loan is usually considered viable.

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Multiple Choice Questions (MCQs)

1. What is the primary goal of credit appraisal?

To maximize bank profits To assess creditworthiness of a borrower To determine market value of securities To promote government schemes

2. The ‘Turnover Method’ is generally used for assessing working capital requirements up to:

₹10 crore ₹5 crore ₹1 crore ₹2 crore

3. Which of the following is NOT part of the 5 Cs of credit?

Collateral Character Certificate Capacity

4. Cash Budget Method is mainly used in:

Service industries Export houses Seasonal industries Government contracts

5. Debt Service Coverage Ratio (DSCR) is used in assessment of:

Working capital loans Housing loans Term loans Credit cards

6. Operating Cycle includes:

Purchase, production, sales, collection Sales, service, feedback Demand, supply, dispatch Forecast, implementation, evaluation

7. In ratio analysis, the Current Ratio is:

Current Assets / Total Assets Current Assets / Current Liabilities Total Assets / Current Liabilities Net Worth / Long Term Debt

8. Which of the following indicates a strong ability to repay loan obligations?

DSCR < 1 DSCR = 1 DSCR > 1.5 DSCR = 0.8

9. Financial statement analysis helps in:

Legal verification Understanding profit trends and financial strength Designing marketing plans Auditing internal control

10. A borrower’s contribution in term loan assessment is also called:

Gross margin Working capital Promoter’s margin Bank finance