nimisha agarwal_sip report
TRANSCRIPT
CREDIT RISK ANALYSIS AT KOTAK MAHINDRA BANK
LTD.
SIP project report submitted in partial fulfilment of the requirements for the
PGDM Programme
By Nimisha Agarwal
2013173
Supervisors: 1. Mr. Ranjan Guglani
2. Prof. Sayan Banarjee
Institute of Management Technology, Nagpur
2013-15
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ACKNOWLEDGEMENTS
This project bears imprint of all those who have directly or indirectly helped and extended
their kind support in completing this project. I find no words to express my gratitude towards
those who are constantly involved with me throughout my project at KOTAK MAHINDRA
BANK LIMITED.
I would like to thank company guide Mr. Ranjan Guglani, Associate Vice President- Large
Corporates, Corporate Banking, New Delhi for guiding me throughout the duration I was
doing my internship. He has been a central guiding force giving me all the information and
imparting his knowledge on the entire process and activities.
I would like to thank my faculty guide Professor Sayan Banerjee, who has given me the
adequate freedom and has allowed me to conduct my work and research in the field of my
interest.
I am grateful to the Wholesale Banking team in New Delhi, headed by Mr. Rajan Nanoo,
Executive Vice President, Regional Credit head, Corporate Banking, Kotak Mahindra Bank
Ltd.
And finally I would like to acknowledge the entire department and employees of Kotak
Mahindra Bank Ltd, New Delhi, for taking out time from their busy schedules to answer all
my queries and give me time for interviews and ensuring that I have all the adequate
information to complete my report.
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CERTIFICATE
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TABLE OF CONTENTS
S.No. Particulars Page No.
1 Acknowledgements 2
2 Certificate 3
3 Objectives of the study 5
4 Introduction 6-8
5 Concepts used in the study 9-54
a. Credit Appraisal 10
b. Process of credit appraisal 11
c. Assessment of Product Structure 13
d. Risk Assessment 14
e. Layman's guide to detecting financial stress 23
f. Evaluation of security 25
g. Importance of a plant visit/ management meeting 28
h. Reference checks 29
i. Assessment of limits 30
j. Credit monitoring 37
k. Review/ Renewal 38
l. Basel II & Credit risk rating 39
m. Internal guidelines 42
n. Multiple Banking/ Consortium Banking Arrangement 45
o. Loan Review Mechanism 46
p. NPA Management & Recovery 47
q. Legal documents & Procedures 51
6 Case Study Analysis 55
7 Limitations of the study 65
8 Scope for future improvements 65
9 Sources of information 66
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OBJECTIVES OF STUDY
The Summer Internship program (SIP) at IMT, Nagpur is a crucial part of the Post Graduate
Diploma in Management (PGDM) curriculum. It gives students the opportunity to observe
the professional arena and execute all the theory they have learnt in classes and put that to
practical use. I have been fortunate enough to have had the opportunity to work in the
Corporate Credit Banking department at Kotak Mahindra Bank Ltd.
The credit division of any financial institution revolves around certain key traits that the
company must evaluate. The way there are 4 P’s in Marketing, there are 4 P’s in credit as
well. They are (i) Purpose, (ii) Promoter, (iii) Pricing & (iv) Property. They can easily be
explained as firstly the Purpose being the reason why the customer wants a loan.
Understanding the requirement that borrower has. The second is evaluating the Promoter. Is
the borrower credit worthy? Does he have the intent and the ability to repay back the facility
he has taken. Thirdly involves Pricing of the facility. What amount should the bank charge
for offering the facility and fourth can be explained by the Collateral or security being offered
against the facility such as property or any other form of security or guarantee.
It is essential that the funds which are sanctioned to the customer is given on time, correctly
and efficiently. In many cases the customer may have a requirement of funds as per his
financial management plan to operate his business. It is the duty of the lender to disburse the
funds as per the requirement of the borrower.
In this report, I will be explaining the Credit procedures which are a crucial function of a
bank. The economic and environmental influences that affect credit decisions. This report
will also cover the importance of understanding risk, risk mitigation, the character of the
borrower, the government and economic environment existing and the documents and legal
implications in offering loans
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INTRODUCTION
India is one of the top 10 economies globally, with vast potential for the banking sector to
grow. The last decade witnessed a tremendous upsurge in transactions through ATMs, and
internet and mobile banking. In 2014, the country’s Rs 81 trillion (US$ 1.34 trillion) banking
industry is set for a greater change. Two new banks have already received licences from the
government. Furthermore, the Reserve Bank of India’s (RBI) new norms will provide
incentives to banks to spot potential bad loans and take corrective steps that will curb the
practices of rogue borrowers.
The Indian government’s role in expanding the banking industry has been significant.
Through the Financial Inclusion Plan (FY 10-13), banking connectivity in the country
increased more than three-fold to 211.234 villages in 2013 from 67,694 at the beginning of
the plan.
India’s banking sector has the potential to become the fifth largest banking sector globally by
2020 and the third largest by 2025. The industry has witnessed discernible development, with
deposits growing at a CAGR of 21.2 per cent (in terms of INR) in the period FY 06-13; in
FY13 total deposits stood at US$ 1,274.3 billion.
Today, banks are turning their focus to servicing clients. Banks in the country, including
those in the public sector, are emphasising on enhancing their technology infrastructure, in
order to improve customer experience and gain a competitive edge. The popularity of internet
and mobile banking is higher than ever before, with Customer Relationship Management
(CRM) and data warehousing expected to drive the next wave of technology in banks. Indian
banks are also progressively adopting an integrated approach to risk management. Most
banks already have in place the framework for asset-liability match, credit and derivatives
risk management.
Source: http://www.ibef.org/industry/banking-india.aspx
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Kotak Mahindra Bank ltd. is an Indian bank and financial service firm established in 1985.
It was previously known as Kotak Mahindra Finance Limited, a non-banking financial
company. In February 2003, Kotak Mahindra Finance Ltd., the group’s flagship company
was given the license to carry on banking business by the Reserve Bank of India (RBI).
Kotak Mahindra Finance Ltd. is the first company in the Indian banking history to convert to
bank. As of 2011 to October 2013, it has more than 500 branches, over 1,000 ATMs and a
consolidated balance sheet of approx. US$ 2.9 billion.
Kotak Mahindra Bank Limited offers transaction banking, operates lending verticals,
manages initial public offerings (IPOs) and provides working capital loans. The bank
operates in four segments: Treasury and BMU, Corporate/ Wholesale Banking, Retail
Banking and other banking business. Treasury and BMU segment includes money market,
forex market, derivatives, investments and primary dealership of government securities and
balance sheet management unit (BMU) responsible for asset liability management.
Corporate/ Wholesale Banking segment includes wholesale borrowings and lendings and
other related services to the corporate sector, which are not included under retail banking.
Retail banking includes lending, branch banking and credit cards. Lending includes
commercial vehicle finance, personal loans, home loans, agriculture finance, other loans/
services and exposures. Other banking business segment includes any other business.
Corporate banking services from Kotak Mahindra Bank include the following:
Product Suite:
This has a whole gamut of products including:
o Funded products that meet the working capital needs of the company along with other
structured products.
Source: http://www.ibef.org/industry/banking-india.aspx
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o Treasury products to mitigate risks that occur in business with products for foreign
exchange, money market and benchmark PLR.
o Amongst investment products, corporate bankers can choose term deposit, mutual
funds and bank assurance.
o Fixed income products offers highly qualified products from experienced
professionals providing plain vanilla debt issuance to Asset Backed Securities (ABS),
Mortgage Backed Securities (MBS), structured products and loan syndication.
Trade Finance: Companies that are involved in import and export have sought the expertise
of our unique trade finance solutions. These include tailor made solutions created to meet the
needs of export and import services. Apart from this, corporate are provided bank guarantees
and other unique domestic services.
Commercial Banking: This is the one stop shop for meeting the needs of corporate when it
comes to transportation, logistics and infrastructure and tractor industries.
Transactions Banking: Kotak Mahindra Bank simplifies the complex financial clearing
system in India for corporate by offering receivables and payables services while ensuring
predictability of cash flows.
Current Account: Quick and timely access to funds is provided to all corporate to meet the
demanding business environment by giving a 2 Way Sweep feature for giving liquidity and
higher returns.
Convenience Banking: To complete the gamut of services, Kotak Mahindra Bank has
ensured that all corporates have access to net banking, Kotak Payment Gateway, mobile
banking, SMS banking alerts, phone banking and wide ATM network.
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CONCEPTS USED IN THE STUDY
Credit risk arises from the inability or unwillingness of a borrower to repay his liability on
due date. The liability may be in the form of an instalment of a term loan, bullet repayment of
a short term loan or timely servicing of interest on a loan. Credit risk may also arise from lack
of churn in the working capital account for a period of more than 90 days or shortfall in
drawing power or breach of financial covenants specified or occurrence of events of default
as per contractual terms.
The credit process is designed to evaluate the borrower for standard credit risks. However, no
two borrowers are alike and therefore one needs to identify the unique risks and mitigations
of each case. While appraising a borrower, the following questions need to be answered:
1. Is the borrower credit worthy?
2. What should be the overall exposure to the borrower?
3. Whether the borrower should be extended short term facilities or long term facilities
based on his requirement?
4. What security or other credit enhancement measures should be stipulated to safeguard
our facilities in case of default?
5. What should be the key monitor able parameters to identify any deterioration in credit
profile of the borrower subsequent to our disbursement?
The relationship between a bank and a borrower is typically built over a long term although
such a relationship may have been built over a number of transactions of shorter duration.
These transactions may take place across multiple products and with multiple entities of the
borrower. Default in any one of these transactions can lead to the entire exposure being
classified as a Non performing asset. Similarly, credit risk in one entity/ product can be
mitigated by building recourse to all other related entities that have active exposures by virtue
of a cross default clause that is normally inserted in all contracts. Therefore the credit
enhancement available in one facility can also be used to improve the credit risk of another
facility to the same borrower/group.
Thus the procedure to be followed while assessing the credit risk of the borrower is to
evaluate the historic track record of the borrower and all his related entities. The regulator
provides default data across banking system which can be used as the first step for such a
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credit check. Independent credit information bureaus such as CIBIL also make default data
available across the banking system. The background check of the borrower need not be
restricted to the official data on defaulters. Informal channels need to be created to have a
regular flow of information on defaulters.
There is also a need to keep track of recent occurrences of default in the environment as well.
Given the deep linkages between various players of an industry, starting from supplier to end
user, a default event in one part of a chain can also impact a company in another part of the
chain. The credit analyst is therefore required to stay abreast of all the developments in the
economy and industry including international developments such as movement in commodity
prices, volatile exchange rates, change in monetary policy, and bankruptcies in other
countries that may have an impact on the performance of the borrower.
The company may also make new plans that may change its financial projections. Lack of
key data on such specific developments with the borrower is one of the major reasons why
credit risk may not have been evaluated correctly in the first place. One of the major reasons
for incorrect assessment of credit risk is the fraudulent intentions of the borrower who has
submitted false data. It is therefore necessary to follow a strict discipline while evaluating
credit risk in order to isolate misleading and false information.
CREDIT APPRAISAL
Before any credit appraisal we may ensure that the basic information is considered as a pre
requisite for doing a credit appraisal, is made available and this data is most recent. The
information required would include the following:
i. Latest audited financials of the borrower and his group companies and provisional
financials of past performance
ii. Background information such as date of incorporation, nature of the entity, details on
shareholders, directors, their educational and professional background
iii. Details of location of registered office, factories and corporate office
iv. Capacity and production data of the borrower’s business
v. Revenue model of the company including segmental information on his customers
vi. Key raw materials and their sources
vii. Details of existing bankers, their loan amounts and their repayment terms
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viii. Future plans of the borrower for expansion of capacity, launching new products,
making acquisitions and means of financing of the same
ix. Statement of foreign exchange/ derivative exposure outstanding with details of MTM
losses/ gains.
In addition to the above, we may require knowledge about the industry in which the borrower
operates, their direct and indirect competitors, their respective market shares etc.
The information required would also depend on the following:
1. Nature of the transaction proposed- long term or short term, secured or unsecured,
working capital or term loan
2. Size of the loan
3. Credit rating of the borrower
4. Rating outlook of the industry
5. Background of the promoters
In general more in depth information is requires if the proposal is in the nature of a term loan,
unsecured loan, emanating from a new promoter, proposal has low credit rating and there is a
rating watch on the industry.
PROCESS OF CREDIT APPRAISAL
1. Obtain all the basic information as stated in above question
2. Visit the website of the company to know more about their company and product
details
3. Check whether the borrower or its directors/ shareholders appear in the NCIF of the
bank or are classified as wilful defaulters by RBI. Also check whether the customer
appears in the CIBIL list of suit filed/ wilful defaulters
4. Check applicability for any section 20 or any statutory restrictions for the borrower
5. Check that no credit facilities are extended to promoter related entities
6. Check if the sector exposure norms, individual and group exposure norms, substantial
exposure norms are being met.
7. Check if real estate exposure, capital exposure limits are being breached, if considered
8. Do a search on capital line and obtain information on peers in the same industry
9. Compare the performance of borrower with the performance of peers and determine
whether the borrower is a market leader, major player or only a minor player
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10. Where the companies have been rated by external agencies, their rating rationale
should also be considered while appraising the company
11. In case information is not available on a company especially while evaluating risk
limits obtain the financial information from ROC
12. Evaluate the security offered by conducting an ROC search, title search, valuation
report and calculating the security cover available for the proposed transaction
13. Collect references from suppliers, customers, bankers, competitors etc.
14. Assess the information gaps and list critical queries based in the information available
above
15. Visit the plant and meet the management of the company to bridge the information
gaps
16. Prepare the financial spreadsheet based on the estimates and projections submitted by
the borrower. Adjust the assumptions underlying the projections based on your critical
assessment
17. Financial analysis must be done on standalone as well as consolidated basis. Analysis
of YTD financials may also be presented on a quarter on quarter basis
18. In case of new borrower, evaluate the borrower vis a vis the BCAC specified in the
Credit origination policy
19. In case of large investments in subsidiaries, analyse the subsidiaries
20. In case of renewal obtain the detailed account performance report from the credit
monitoring division. Obtain copies of recent stock audit reports of the company and
also check the pending documents in the account as per the latest report
21. While doing a renewal, it is a good practice to compare the stock/ book debts as
appearing in the year end stock statement with the audited annual report of the
previous year
22. Complete the rating. Go ahead with the proposal only if the rating meets the minimum
requirement based on the expected loss indicated for the proposed transaction and the
pricing being obtained vis a vis the expected loss. ROE may be computed both on risk
adjusted basis or otherwise. If it does not meet minimum requirement in both cases,
obtain Business Head approval before going ahead.
23. While preparing the credit appraisal, ensure that all relevant risks have been
highlighted along with their mitigants, wherever possible
24. Assess individual facilities that have been proposed by the borrower
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25. Prepare a draft term sheet based on the facilities being proposed for sanction. Specify
detailed terms and conditions in the term sheet by selecting the appropriate term sheet
from the term sheet bank. Care should be taken to cancel all variable conditions that
are not applicable and specify additional variable conditions if any
26. Stipulate PDC and PG if the combined rating is below BB+. Check whether facilities
recommended are in line with portfolio norms specified
27. If the proposed transaction is in the nature of a take over ensure that take over
conditions have been specified
28. The proposal may be sent for sanction to the appropriate approving authority based on
the total exposure of the bank to the borrower/ group. While determining total group
exposure we are required to obtain information from other departments of the bank
such as home loans, consumer loans, commercial vehicles, ARD, etc.
29. Prepare the final term sheet based on the specific terms of the final approval and
forward the same to CAD, Legal, Credit monitoring and operations
30. Prepare the sanction reporting document and submit it to the credit committee
secretariat.
ASSESSMENT OF PRODUCT STRUCTURE
The type of loan sanctioned to a borrower and its terms of approval should naturally meet the
requirements of the borrower. It is therefore necessary to ensure that working capital needs
are met with working capital products and long term needs are met by long term products
specific to the end use. It therefore implies that the repayment terms of the loan should be
within the actual cash flows of the borrower.
While disbursing the loan, where the security build up is in stages, care should be taken to
ensure that the disbursement of the loan should be appropriately structured in line with the
delivery of security. Thus instead of releasing the total facility at one go, the disbursement
may be in stages in line with the build up of security. It is therefore essential to understand all
aspects of how the security will be created while sanctioning the loan. Where the product
structure relies on cash flows, it is necessary to monitor these cash flows on a periodic basis
and appropriate events of default (EODs) need to built into the terms of sanction.
While structuring limits, care should be taken to design the interchangeable limits as sublimit
to the main limit. Some of the details that need to be understood while specifying the detailed
conditions of disbursement include the following:
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Mode of disbursement which involves:
1. How to pay?
2. Whom to pay- payment to vendor or borrower or a takeover?
3. On what basis to pay?(transactional documents)
4. How much to pay?- what is the margin, interest rate, processing fee?
Repayment of the loan
1. What chain of events (cycle) will lead to eventual repayment?
2. What is the source of funds for repayment?
Monitoring of the entire cycle which involves:
1. What are the transaction specific monitoring conditions?
2. What are the covenants/ events of default, if any?
RISK ASSESSMENT
I. Business risk
Business risk is unique to the customer’s specific business and depends on the product he
manufactures, technology he uses, his geographical location, key inputs/ raw material, access
to raw material and his cost structure. In a stable business model, the company has developed
barriers of entry either in the form of superior product quality as reflected by its brand equity,
its distribution network, low manufacturing cost, etc.
In order to evaluate the business model of the company, we need to understand the
composition of sales, the dependence on key raw materials, the availability of utilities such as
electricity, water, labour, etc. The value addition made by the business may be different for
different players. Business risk in service industry is different from that in a manufacturing
industry.
Business risk parameters can be broadly classified into market position factors and operating
efficiency factors. Market position implies the ranking or position of a brand, product, or
firm, in terms of its sales volume relative to the sales volume of its competitors in the same
market or industry. Operating efficiency is a measure of a management’s ability to generate
sales revenue and to control costs.
Market position factors:
1. Product quality
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2. Product range/ mix
3. Brand equity
4. Customisation of products
5. Project management skills
6. Diversity of markets
7. Long term contracts/ assured offtake
8. Distribution set up
9. Financial ability to withstand price competition
10. Composition of customer base
Operating efficiency factors:
1. Capacity utilisation
2. Availability of raw materials
3. Energy cost
4. Cost effective technology
5. Selling costs
6. Employee cost
7. Management of price volatility
8. Adherence to environmental regulation
9. R&D activities
10. Synergies with group companies
II. Industry risk
Credit risk is also a function of the industry in which the company operates. Industry risk
refers to the risk that uniformly impacts all players of an industry segment. Thus it is not
specific to a company but involves the entire industry that the company belongs to. Industry
risk encompasses all those risk factors that are external to the company but have a common
bearing on all its players.
Industry risk may be measured by certain industry characteristics such as demand supply gap,
government policies, input related risks and the extent of competition in the market. They are
explained in detail as follows:
1. Demand supply gap would critically determine the volumes, realizations and
consequently the profitability of companies operating in an industry. The
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attractiveness of an industry for fresh capital investments would depend upon the
anticipated demand supply gap. The outlook on demand-supply position would
largely be a function of:
Expected demand growth
Shifts in consumption pattern resulting in replacement demand and product
substitution
Present installed capacities and commissioning of new capacities, which would
determine the supply pattern in an industry.
2. Government policy determines the outlook of the policies and government
regulations on the industry. The impact of govt policies with respect to tariff barriers
such as import duties, quotas, sanctions, excise duty, taxes, domestic price control,
incentives for new investments, incentives for exports, legislations for pollution
control measures, laws with respect to foreign exchange on various industries need to
be examined.
3. Input related risks would involve taking a view on availability of raw material and
volatility in the prices of raw material. The volatility in prices would affect the
earnings stability, depending upon the ability of the industry to pass on increase in
raw material prices to the end users. The industries characterized by high value
addition would be less susceptible to the volatility in raw material prices. The extent
of value addition is reflected by the percentage of raw material cost in the overall cost
structure of the product.
4. Extent of competition measures the number and intensity of competition among
incumbents in the industry. The level of competition in an industry has implications
on future profitability of players in an industry. The number of players operating in an
industry would in turn depend on entry barriers in an industry. Existence of
government regulations regarding licensing requirements, levels of returns, heavy
capital investment requirements, distribution network, technology, patents and brand
equity could be significant entry barriers for prospective entrants to an industry. The
industry could be exposed to competition from the unorganised sector, as well as
imports. The increasing linkage with the global economy in a declining import duty
regime exposes domestic companies to competition from imports. The unorganised
sector also poses significant competition in industries with low entry barriers.
The following industry financials are to be measured while analysing the industry:
Growth in operating margin (%)- industry
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Operating margin(%)- industry
Return on capital employed(%)- industry
Variability of operating margins(ratio)- industry
The other factors to be analysed are the impact of change in technology, the company’s
performance relative to other players, the length of operating cycle in that industry and the
stage in life cycle of the industry. The availability of human resource is an important factor to
be analysed for service industry. While analysing the broker business, the cyclicality of the
industry and the regulatory measures should be looked into.
III. Management Risk
Management risk is the risk associated with ineffective or underperforming management
which hurts performance of the company being managed and therefore the returns generated
by the shareholders. The parameters to assess management risk are as follows:
1. Quality of information submitted by the company- Integrity
The timeliness, accuracy, adequacy of information and willingness to give
information depicts the professional quality of the management. This factor also
assesses the company’s promptness in furnishing regular information required by the
bank, such as quarterly performance data, stock statements, sales statements etc.
2. Working capital management- The lower the working capital cycle, the more
competitive the company will be. Financing requirements closely follow the actual
business cycle of the industry.
3. Corporate governance- The capability of the firm with respect to wealth creation for
all stakeholders while adopting sound corporate governance practices is judged while
analysing management risk.
4. Experience in the industry- A management with greater experience provides
comfort with respect to stability of the business model.
5. Managerial competence- Assessment of management’s competence would be based
on the quality of past decision making, as well as the general impression of the
efficiency of the company’s systems and procedures. While educational qualifications
could provide a base for good management, formal education in itself would not
guarantee exceptional management. The other dimension to be evaluated upon would
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be the track record of managing Joint Venture in the past, if joint venture is essential
for continued successful running of the business.
6. Business and Financial Policy- The management’s conservatism is judged based on
past business and financial policies relating to its leverage and would have a bearing
on future debt bearing levels. A track record characterized by large expansions in
relation to existing size or in unrelated areas is indicative of a relatively high appetite
for risk.
7. Ability to meet projections and maintain market share- This factor assesses the
management’s competence as well as its integrity in projecting performance.
Management’s competence is assessed in maintaining the market share while trying to
achieve the sales/ profit projections.
8. Management succession- This factor examines the extent of preparedness of the
company’s leadership for the future. A company with a well-groomed second line of
leadership would score highly on this parameter. Alternately a professionally
managed company would also score higher. On the other hand, a company highly
dependent on the existing leadership, and having uncertainties with respect to future
management would be placed at the lower end of the scale particularly if the existing
leadership is old.
9. Labour relations- This factor assesses the quality of industrial relations prevailing
within the company. A company characterized by peaceful labour relations is
expected to show greater stability in operations. Frequent industrial strike affects the
continuity of operations and could have implications on the debt servicing ability of
the company. Conversely a company with highly motivated labour force would be
ideally prepared to face competitive pressures.
10. Strategic initiatives- This factor assesses the company’s ability to successfully
implement its strategies. Companies, which have successfully executed major/
complex projects, or demonstrated an ability to manage strategic alliances, etc., would
score highly on this factor.
While analysing SMEs, along with the above mentioned factors the parameters to be
assessed are the Group support available to the company, the number of years of
experience the management has in the same line of business and the credentials of the
family running/ owning the business.
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While analysing stock brokers, along with the above mentioned factors the parameters to
be assessed are the legal ownership of the business and the personal net worth of the
promoter.
IV. Financial Risk
Financial risk is the risk arising from the financial profile of the borrower. It is measured by
calculating the free cash flow generation taking into account operating activities, investment
activities and financial activities including additional borrowing or repayments.
The objective of any financial analysis should therefore include the following:
1. Understand the product wise segmentation of income of the borrower’s business
2. Means of financing in the balance sheet and any mismatch between long term
liabilities and long term assets of the borrower
3. Operating profitability and cash flows of the company as distinct from the income
which is one time in nature.
4. Performance of the borrower entity on a consolidated basis
5. Working capital cycle of the borrower
6. Trend in unit sales realization, unit cost
7. Free cash flow analysis
Analysis of income statements
Analysis of profitability
Ratio Nomenclature Remarks
PBDIT/ Net Sales Operating profit margin Higher the ratio, higher is the
operational efficiency of the
company. This may be
compared with the industry
average/ other peer companies
Net Profit/ Net Sales Net profit margin Profit margin available for
shareholders of the company
for distribution. Higher the
ratio, higher is the growth
potential for the company.
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However, this should be
supported by the projected
future cash flows
PBIT/ Net Sales This is the profit margin
prior to meeting the interest
obligation
Higher the ratio, higher is the
comfort level for the lenders.
However, this should be
supported by the projected
future cash flows to ensure
that the company sustains the
level of profitability.
Cash Profit/ Net Sales Cash profit margin This is the profit available for
servicing the loan and meeting
the working capital/ capital
expenditure requirements of
the company. Higher the ratio,
higher is the comfort level for
the lenders.
Dividend/ Net profit Dividend distribution ratio Reflects the management’s
policy of profit retention and
increasing company’s net
worth
PBIT/ (Equity+ Debt) Return on capital employed Reflects the company’s overall
efficiency in utilization of total
capital employed. Higher the
ratio, higher is the comfort
level for the lenders
PBDIT/( interest on term
loan+ principal repayments)
Debt Service Coverage
Ratio(DSCR)
It indicates a company’s
ability to service its debt
obligation from earnings
generated from its operations
PBDIT/ Interest Interest Coverage ratio Interest cover is defined as the
extent of cushion or comfort
that a company has in meeting
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its interest obligations from
any surplus generated from its
operations.
Analysis of Cost Structure: The major cost components are:
- Material cost
- Labour cost
- Manufacturing overheads/ expenses
The following should be looked into while analysing the cost structure of a company:
- The behaviour of various cost components and cost composition in the overall product
cost over previous years
- How the company deals with cost increases may be studied- what kind of cost
increase can be passed to the customers, to what extent and whether the same is built
in the contract with the clients may be ascertained
- Whether the company has any supply side constraints or its raw material is subject to
price volatility and whether the company is facing any labour problems may also be
enquired.
Analysis of balance sheet ratios
The ratios generally considered as relevant for conducting credit analysis are:
1. Liquidity ratios
2. Gearing/ capitalisation ratios
3. Turnover ratios
Liquidity ratios
Current ratio: current asset/ current liabilities
The higher the ratio, the better it is for the company thereby indicating company’s strength in
meeting its short term obligations. In India, the Tandon committee had suggested that the
minimum acceptable current ratio should be 1.33. The movement of current ratio should be
read in conjuction with the movement of Net Working Capital (NWC) in order to arrive at a
proper and meaningful conclusion.
Acid test ratio/ Quick ratio= (current assets- inventory)/ current liabilities
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The rationale for computing the ratio in this manner is that inventory is the least liquid of all
the individual components of current assets.
Net Working Capital (NWC)= Total current assets- ( total current liabilities including bank
borrowing+ total repayments due within 1 year)
Net working capital indicates the company’s contribution towards its working capital gap
from its long term sources. As per the second method of lending suggested by Tandon
Committee, the ideal contribution by the promoter should be 25% of the current assets.
NWC can be negative in cases where the credit period received by the company by its
suppliers is better than the credit period it extends to its customers. In such cases, there is no
need for bank finance.
Gearing/ Capitalization ratios
1. Total Outside Liabilities (TOL)/ Tangible Net Worth (TNW) = (Long term debt+
Short term debt + other current liabilities)/ TNW
2. Total Outside Liabilities (TOL)/ Adjusted Tangible Net worth (ATNW)
ATNW= TNW- Investment in associates and subsidiaries + Borrowings from
subsidiaries (quasi equity)
3. Long term debt/ TNW
4. Long term debt/ ATNW
5. Term debt (including debentures)/ Cash profits (years)
Tangible Net Worth (TNW) = Equity Capital+ Preference Capital> 12 years+ Share premium
+ General Reserves+ other reserves &surplus – Intangible assets – Revaluation reserves
Short term credit and long term credit facilities are external sources of funding and are
therefore classified as Total Outside Liabilities (TOL). Gearing/ capitalization ratios provide
information on the position of owned funds compared to long term debts or total outside
liabilities of the enterprise.
Turnover ratios
These ratios are of great importance from a banker’s point of view as they determine the
working capital cycle and help in fixing the operating cycle of the enterprise.
Receivables Turnover (domestic)
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Receivables turnover (export)
Inventory turnover
Creditors turnover
Fixed assets turnover
Fund flow analysis
A fund flow statement provides details concerned with the change in balance sheet position
by showing the summary of changes in financial position from one period to another. The
following questions may be answered with the funds flow statement:
1. Have working capital funds been diverted into creation of fixed assets/ long term
investments?
2. Has the company funded its fixed assets/ working capital from its own internal
generation or borrowed funds?
3. Is there a mismatch between generation of long term funds and long term assets?
4. What are the sources of repayment for loans?
LAYMAN’S GUIDE TO DETECTING FINANCIAL STRESS
The problems faced by businesses get reflected in their financial statements despite the
attempts of such potential customers to mask their non-performance through creative
accounting. It is possible to see early warning signs of financial stress or even the fact that the
business is already in deep waters by following good analytical discipline. Given below are a
few of these ailments that can be detected:
1. Insolvency: A company is insolvent if its liabilities are more than its assets. Accumulated
losses, deferred expenditure, intangible assets, unquoted investments, non-moving stock/
debtors, deferred tax assets are all signs of over stated assets. Insolvency of a business is a
matter of concern to its creditors. Thus, it is important to understand the ranking of creditors
based on underlying security to evaluate the impact of such insolvency. In such businesses it
is important that there is equity infusion from the promoters since further debt will only
increase the burden of the business through interest cost.
2. Illiquidity: A business is considered illiquid if it is unable to generate sufficient cash from
its operations, raise credit against its assets and the promoters are unable to infuse cash into
the business. Signs of illiquidity can be detected if the collection period of receivables is
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high, the level of stock is non-moving or rising, the cash balances are low, sudden sharp fall
in level of creditors and debt equity ratio is high. An illiquid business may have long term
and marketable assets in the form of land and building or unquoted investments.
3. Diversion: A business may be under financial stress if it has diverted its equity/ loans into
other businesses. Diversion of funds from a performing unit to a non-performing unit within
the same entity may also lead to such stress. Diversions out of the business can be detected by
analysing the nature of investments and loans and advances made by the business. If these
diversions exceed the cash accruals generated by the business it can lead to a financial stress.
In order to detect signs of such stress it is always essential to analyse the financials of group
companies and the segmental performance within the business.
4. Working Capital mismatch: This situation arises from diversion of short term liabilities
to finance long term assets within the business. If the long term loans and net worth of the
business are less than the net fixed assets it is evident that there is a working capital
mismatch.
5. Valuation of assets: Companies tend to capitalize various types of expenses in order to
avoid a hit on their profitability. Certain one time expenditures in the nature of goodwill,
brand building expenses may also be capitalized as fixed assets. It is also possible that by a
change in accounting policy on depreciation or inventory valuation, value of fixed assets/
current assets are overstated. The only way to detect capitalization of expenses is to compare
the capital cost with those of other competitors. Amounts reflected in goodwill and in the
nature of intangibles such as brand values are always shown separately in the schedules. The
impact of change in accounting policy can be found in the notes to accounts.
6. Quality of profits: It is important to understand whether a business is generating its profits
from its core operations or through its other income. Therefore, profitability ratios are best
analysed by comparing at the operating level across accounting periods. Some businesses
have a diversified stream of operations that may provide protection from seasonalities,
business cycles etc. The quality of profits in such businesses is higher. The trend in
profitability such as rising operating margins, rising net profit margins can also indicate the
quality of profits.
7. Hidden debt: It is essential to understand the leverage of the company on a consolidated
basis. Thus, it is possible that debt in group companies or subsidiaries have been guaranteed
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by the borrower. This needs to be added to the total debt of the borrower. Mark to market
(MTM) losses on foreign currency/ commodity value fluctuations can also impact the
leverage of the company. Look for disclosures on the same in the notes to accounts.
8. Under capitalization: A company is said to be undercapitalized if its equity base is too
small in relation to its sales turnover. Typically such companies have a high level of gearing
and low profitability. A business is also under capitalized if it is unable to generate sufficient
cash accruals to meet the operational requirements as dictated by increasing sales. The
contribution of equity in expansion/ acquisition plans of the company can indicate its
changing level of capitalization.
9. High dividend: A company normally invests its cash accruals back in business and
typically allocates a percentage of profits as dividend. An aggressive dividend policy is one
which puts a company under pressure to borrow in order to meet its dividend payments.
Typically dividend rates that consume more than 50% of annual profits may be considered as
high.
EVALUATION OF SECURITY
Evaluation of security structure
Security offered in the proposal is a key determinant of the credit risk of the transaction.
Security offered may be tangible such as current assets, fixed assets, cash flows, etc or
intangible such as post dated cheques, personal guarantee, negative lien, etc. While analysing
the security offered, it is required to calculate the security cover in percentage terms of the
transaction amount. This can only be done if detailed information is provided on the nature of
security held by all lenders. Ultimately the actual security that has been created represents the
real credit risk. An incomplete security is as good as no security.
Security may be offered as specific charge or floating charge. Specific charge is created when
banks choose to lend for specific projects of the borrower against security that is created out
of their funds. For example: specific receivables discounted, machinery for a specific product
line, exclusive mortgage of immovable property etc. When a bank chooses to fund projects or
working capital requirements by taking charge on current assets as a whole or movable fixed
assets as a whole, a floating charge is created. Any asset added to this pool stands
automatically charged to the bank. Any bank willing to extend facilities on specific charge
must necessarily seek a no objection certificate (NOC) from all existing floating charge
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holders. Once such NOC request is granted the charge of floating charge holders will stand
modified to charge on current assets or fixed assets excluding those charged to specific
charge holders.
Charge on assets signifies sequence in which the realizations from liquidation will be used to
pay off creditors. Thus, we have:
Statutory dues
Exclusive charge- exclusive first right over realizations at the time of liquidation
First charge- first right over realizations at the time of liquidation
Second charge- second right over realizations at the time of liquidation
Subservient charge- right over realizations at the time of liquidation after first and
second charge but before unsecured creditors
Unsecured
It should be noted that Sales tax authority will have the first right over sales proceeds if they
have made a claim on the company before the security was created by the bank.
Security may be offered on an exclusive basis (exclusive first charge) or on a non- exclusive
basis. The sharing pattern in non- exclusive cases could either be first pari passu, second pari
passu, subservient charge, etc. where the assets may be shared by multiple creditors in the
proportions of their outstanding. It is important to understand the process of creation of
security to ensure that the security as intended in the credit appraisal has actually been
created.
The procedure for creation of security offered by a borrower is dependent on nature of entity
of the borrower. A company incorporated under the Companies Act, 1956 is safest from the
point of view of the lender/ bank. This is because the claims against a security held by the
company are verifiable with the Registrar of Companies (ROC). Thus, in the case of
company, it is possible to determine whether there are any claimants to the security and the
status of the bank’s claim with respect to seniority over other creditors. In all other cases, one
has to rely on the disclosures made by the borrower in his balance sheet as there are no
regulatory authorities for verification of partnership firms unless they are registered,
proprietorship firms, HUFs, associations, etc.
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Tangible security may also be graded into hard collateral that is more realizable against its
book value while soft collateral may not be equally realizable. In terms of gradation of
preferred security an indicative list would be as follows:
1. Property with clear marketable title
2. Legitimate control over cash flows of the borrower
3. Post dated cheque of the borrower, post dated cheque of promoter/ guarantor
4. Personal guarantee
5. Charge on the moveable fixed assets of the borrower
6. Charge over current assets
7. Negative lien
8. Other securities like listed equity shares
The 4Cs of credit- Character, Collateral, Cheque, Cash flow control
The decision to approve a loan must also be based on a qualitative assessment of the
borrower. While this is highly subjective, it can give us proper direction in structuring the
terms of the loan. The credit decision usually involves finalizing the terms of the security.
The nature of security may be tangible or intangible. Tangible security is of varying grades as
defined in the section on “Evaluation of Security”. As seen there, collateral in the form of
land and building provides the highest comfort. This may be reinforced with security of cash
flow or an intangible security such as post dated cheque. The decision to combine or drop any
of these could be aided by qualitative assessment of the borrower.
Character of the borrower is an important element of his qualitative assessment. Character is
determined by his educational background, social life, his vision/ commitment for the
business, respect for regulations, business practices as revealed by the past. The character is
also analysed based on the intention to repay. The assessment of the character has important
fallouts in terms of the decision to sanction the loan and the specific terms under which they
would be sanctioned.
Where the character profile is not strong, comfort needs to be built upon the above security
parameters. On the other hand, where the evaluation on the character is comfortable, we may
allow greater flexibility with respect to the above security parameters.
Availability of post dated cheque is important more as a deterrent rather than as a realizable
security. Cash flow control needs to be from a reliable, creditworthy counterparty with a track
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record of past performance. Availability of property is usually considered a strong comfort
provided there is adequate hair cut. The quality of property also needs to be assessed from the
point of view of its neighbourhood, ease of access, quality of construction etc.
IMPORTANCE OF A PLANT VISIT/ MANAGEMENT MEETING
The business model of the company may not be as easily apparent until one visits the factory
to understand the product mix, the technology being used, the skills of the employees and the
quality of infrastructure. In order to maximize the benefit from meeting the promoter or
visiting the plant, it is important that the basic information required for credit appraisal is
made available prior to this meeting. The analyst should go through this information and
make a note of specific points that will need to be check during the plant visit. The analyst
should understand the industry, the business cycle of the company before the plant visit. Once
in the plant or with the promoter, the analyst is suddenly exposed to a huge flow of
information on the company. It is advisable that the analyst prepare the visit report as close to
the date of meeting as possible so that he is able to capture most of the relevant information
in granular details.
A plant visit helps to understand the genuineness of the business and the pace of activity in
the company. It can also help in revealing an inventory pile up, inefficiencies in production
processes, quality of fixed assets etc. It is important to record the details of fixed assets,
utilities available at the unit, information pertaining to manpower etc which can help evaluate
requests for financing capital expenditure. One can also get a feel of whether the company
has sufficient land for its existing business or any extra land is required for capacity
expansion since land is generally not held in the books of the company but in the personal
books of the promoter.
Frequently during a plant visit it is possible to meet the factory manager/ quality manager/
research head who may talk about the strengths of the product and the company in detail.
Sometimes simple questions posed to workers on the shop floor can confirm or negate the
facts provided by the company. During a plant visit the analyst must ensure that the right
person is available to conduct the tour of the factory. Thus the CFO may not always be the
right person to explain the manufacturing process and it is necessary to get the factory
manager or the supervisor to explain the manufacturing process.
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While meeting a promoter some of the standard information collected should be the history of
the company such as reasons for entering the business, competitive position of the company,
the relationship of the company with its suppliers, customers etc, the future plans of the
company in terms of capex, sales, new products, new locations etc. The promoter may also be
the best person to seek clarification on the financials, pending litigation as mentioned in the
notes to accounts, likely movement of product prices and raw material prices, response to
changing market scenario etc.
REFERENCE CHECKS
Frauds are a major reason why credit risk cannot be taken at face value. Frequently doubts
arise when the business model appears too good to be true or the company would like to
create an impression of there being no risks. While a good credit appraisal can give us the
precise idea of the mix of various risk elements and a clear assessment of its strengths and
weaknesses, promoters routinely attempt to hide or mislead the analyst with respect to critical
information. The due diligence process is therefore not complete unless an attempt is made to
corroborate the given data through independent sources.
Some of the information that should be checked through references are the following:
1. Track record and business performance- to be checked with existing lenders
2. Business performance- to be checked with customers based on their reputation
3. Legal disputes- to be checked with trade partners such as suppliers and customers
4. Financial statements- to be based on reputation of auditors
5. Insider views- to be taken from ex-employees, other customers of the bank
The analyst needs to choose the entities from whom reference check is to be taken very
carefully. Care should be taken to ensure that the person giving reference is not too close to
the interested party. Besides, reference is usually taken from a person with whom we already
have a comfortable relationship. Reference should be taken based on materiality of the due
diligence being done. Thus, if the borrower claims a long term contract for raw material
supply, the supplier would be a key reference point. Similarly, if a large percentage of sales is
booked from a single customer, reference should be taken from this customer.
The process of taking references should be continuous rather than only at the time of credit
appraisal. Thus, an analyst should develop a network of bankers, auditors, lawyers,
government officials through whom such references can be taken.
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Sometimes, in a large transaction where the quality of information is relatively weak and the
perceived risk is relatively high it may be necessary to take more detailed references. Such
situations may also demand making discrete enquiries such as monitoring the activities of the
promoter, getting to know his regular social network, details of his personal assets, other
businesses, etc.
Tools such as Credit Information Bureau of India Limited (CIBIL) reports and Negative
Customer Information Form (NCIF) database should be used to check the customer’s past
record in defaults or if there are any suits filed against the company/ borrower while
appraising the loan.
ASSESSMENT OF LIMITS
The credit policy of the bank recommends the use of Turnover Methodology of assessment of
working capital. If the end use of a loan is for working capital purposes, then it is necessary
to conduct working capital assessment and track limits based on stock and book debts
statements. The bank recognises that Turnover method may not be suitable for all sectors like
industries of seasonal nature, manufacturing units dependent on agricultural commodities as
inputs, NBFC’s, capital market intermediaries, real estate developers etc. In case of sectors
where turnover method cannot be applied, the bank would adopt suitable method of assessing
the requirements for the sector and apply the same consistently across the portfolio.
The assessment of limits varies with each facility requested by the borrower. While assessing
the limits of a borrower, the various conditions that are considered are the nature of facility
(fund based or non-fund based), tenor of facility, other bank limits, projections of sales, cash
flows etc. Broadly we can divide assessment of limits into assessment for working capital
facilities and assessment for term loans. While assessing limits for working capital facilities
we may use the Turnover Method, Maximum permissible finance (MPBF) method or the
Cash budget Method as explained below:
Assessment for Working Capital Facilities
I. Turnover Method
Under Turnover method, working capital requirement is computed at a minimum 30% of
gross sales of which at least four-fifths should be provided by the bank and the balance one-
fifth representing the Borrowers contribution towards margin for the working capital.
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Particulars Amt (Rs. Crs)
A Projected Gross sales of borrower
B Working capital requirement (30%)
C Maximum possible working capital restricted to 4/5 of B
D Less: facilities with other working capital banks
E Maximum Permissible Bank finance from Kotak Bank
This method is applicable for clients whose working capital requirement is not subject to
seasonal fluctuations and the operating cycle remains stable throughout the year. Turnover
method would not be applicable to companies whose operating cycle is long (in excess of
100-120 days). For instance, companies with exports, sales to SEB’s, utility companies, etc.
Points to be noted under Turnover method:
It is to be ensured that the projected annual gross sales are reasonable and achievable
by the unit and the estimated growth if any over the previous year is realistic.
At the time of assessment, we may call for returns filed with statutory authorities as
useful guiding documents for verification of sales & assessment of reasonableness of
the projections.
The entire sales proceeds should be routed through the cash credit account of the
borrower in case of sole banking.
Data of actual sales pertaining to the last 2 years, estimates for the current year, and
projections for the next year, together with the trend analysis of the relative industry,
would also be useful while appraising the sales projections.
Other information regarding modernization, working capital for expansion, changes in
government policies, increase/ decrease in taxation and other relevant internal and
external factors also need to be taken into account.
Any unreasonable projected increase (say beyond 25%) of the previous year actual or
current year estimates would need a closer look.
II. Tandon Committee’s Second Method of Lending
The second method of lending constituted by the committee is used to compute the maximum
permissible finance that can be granted by a bank to a borrower.
The information system to be submitted by the borrower as suggested by the Tandon
committee consists of the following financial statements:
1. Operating statement
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2. Fund flow statement
3. Statement of current assets and current liabilities
4. Balance sheet and P&L account
These documents are collected by the bank on an annual basis.
Under this method, the borrower should provide for a minimum of 25% of total current
assets. A certain level of credit for purchases and other current liabilities will be available to
fund the build up of current assets and the bank will provide the balance (Maximum
Permissible Bank Finance). Consequently, total current liabilities inclusive of bank
borrowings should not exceed 75% of current assets.
The MPBF method is used for larger corporate and in specific cases with longer operating
cycle. The trend of current assets and current liabilities also remains similar through the
years.
III. Cash Budget Method
Cash budget method is generally used for assessing working capital finance for seasonal
industries like sugar, tea, etc, for construction activity and for service oriented concerns. In
these cases, the required finance is quantified from the projected cash flows and not from the
projected values of assets and liabilities. In this method of assessment, besides the cash
budget other aspects like the borrower’s projected profitability, liquidity, gearing, funds flow,
etc. , are also analysed. The projections drawn by the borrower may then be jointly discussed
with the bank as modified in light of the past performance and the bank’s opinions. The peak
cash deficit is ascertained from the cash budgets.
The promoter’s margin money for such requirement may be mutually arrived at by the banker
and the borrower with the balance requirement forming the bank financed part of working
capital. The cash budget analysis is also used for sanction of ad hoc working capital limits.
Thus in this method, the required finance is quantified by the bank after assessing fund flow,
profitability and other financial parameters.
In seasonal industries, the peak level requirements of the borrowers would be normally for
short periods and the borrower cannot be given peak level limits throughout the year. In such
cases, cash budget system will help the bank in funding only deficit of the cash flow budget.
While fixing the limit based on the cash budget, the following points should be considered:
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i) The cash budget is realistic and based on the operations in the business/ similar
business
ii) The cash budget statement tallies with the underlying financial statements viz.,
projected balance sheet and profit and loss account.
iii) Outstanding bank borrowings figures in the projected balance sheet tally with the
deficit as shown in the cash budget statement
iv) The closing balance of the debtors is correctly arrived at by summing up opening
balance of debtors and credit sales minus realisation of debtors.
v) The expenses as indicated in the cash budget tallies with the expenses as reflected in
the projected profit and loss account.
vi) The peak deficit level needs to be linked to the drawing power of the borrower.
Facility wise assessment: In addition to the assessment methods for working capital
facilities, it is necessary to conduct facility wise assessment for each borrower.
Assessments of limits for various products are dealt with in respective product notes.
Term loans are loans with a medium to long term repayment schedule that may be
structured with an initial moratorium period. Such requirements arise when companies
purchase fixed assets, make long term investments, or when they make a contribution to
core working capital. A term loan being long term debt signifies high risk and is generally
priced higher. Therefore it is important that the need for the term loan is understood
clearly and the viability for the underlying project is carried out. Net Present value (NPV)
and Internal rate of return (IRR) can be used to judge the viability of a project.
Features of the facility:
1. The basis of assessment of a term loan is the projections made by the company. The
company may submit this information as part of its CMA data (credit monitoring
arrangement) or as projections for a specific standalone project. It is important to
understand all the assumptions underlying these projections.
2. The basis of evaluation of a term loan could be the debt equity projections, DSCR
projections, the free cash flow projections and a sensitivity analysis of the key
assumptions. In case of an existing company undertaking capacity expansion, DSCR
for the project on a standalone basis also has to be comfortable/ acceptable to assess
whether the project on a standalone basis is viable.
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3. The fixed assets that are created in the project act as the primary security for the loan.
Banks may insist on additional collateral including existing fixed assets, other
investments of the company or in rare cases promoter’s equity shares in the company.
4. It is important that the promoter has invested adequate capital in the project to ensure
its stability. Typically the long term debt equity ratio of a company should not exceed
1. The debt equity ratio of the new project itself may be higher but not exceeding 2
times unless it is a very large infrastructure project.
5. The borrower has the option to draw down funds in a single tranche or in multiple
tranches during the implementation period.
6. The proceeds of the loan shall be credited to the current account of the borrower to be
opened with the bank or the proceeds can also be disbursed by a cheque/pay order/
DD/ RTGS to the vendor directly based on the invoices submitted. Term loan can also
be disbursed by way of reimbursement of expenditure already incurred against
production proof and other documents as stipulated.
7. The repayment of the loan may follow an approved repayment schedule. Typically the
bank restricts its term loan financing to a period of 3-5 years based on the credit rating
of the borrower.
8. A term loan sanction is typically valid for a period of 3 months unless a higher
validity has been specifically approved. However if the company has drawn down its
first tranche, the validity of further disbursements id dependent on the amount of loan
that remains to be drawn down and capitalized for the purpose of making the
repayment schedule. All such balance disbursements will be subjected to the same
repayment schedule as the first disbursement. Thus if the tenor of the loan is
beginning from the date of first disbursement, the tenor of subsequent disbursements
follow the same repayment schedule.
9. Normally a bank sanctions LC and Buyers credit limits as a sublimit to term loan to
enable procurement of the equipment and to get the benefit of suppliers credit. In such
cases the tenor of the term loan begins from the date of opening of the LC.
10. Term loans should be subjected to periodic credit reviews atleast annually. This
should initially capture the details of time overrun or cost overrun, if any. The reviews
should be based on actual inspection of the site based on the size/ risk of the loan.
11. It is essential for the schedule for implementation of the project and the date of
commencement of commercial production to be obtained from the borrower.
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Principles of assessment
The various parameters that need to be appraised for a term loan are the following:
1. Cost of the project
2. Means of financing
3. Promoters contribution
4. Nature of product and existing competition
5. Nature of industry and demand forecasts
6. Impact of technology
7. Management capabilities and track record
8. Geographical location and distribution strategy
9. Repayment terms
10. Security for the loan
Structuring of term loan can be done in following ways:
1. Buyers credit facility as sub-limit to the term loan facility
The borrower shall have an option of converting the buyer’s credit facility into a
rupee liability at an interval of every one year. Buyer’s credit against LCs is restricted
to 36 months. At the end of 36 months or as stipulated by credit, the outstanding
balance in the buyer’s credit shall be converted into a rupee term loan. The tenor of
the rupee term loan will be the balance tenor based on original approved tenor and
buyer’s credit facility already availed.
2. LC facility as sub-limit to the term loan facility
The LC is opened in favour of the supplier of machinery/ equipment etc. The LC is
paid by disbursing the term loan facility. The tenor of LC would be included in the
overall tenor of the loan. In general the total tenor of the LC and the term loan should
not exceed a period of 5 years.
3. LC facility as sub-limit to the term loan facility, buyers credit against FD
In this structure, the LC will be repaid by way of a Buyers Credit facility. Buyer’s
credit is backed by 100% cash margin and is simultaneously outstanding with the
term loan. Buyer’s credit is repaid by closure of fixed deposit and the term loan is
repaid in instalments. This structure is useful when the Buyer’s credit rates are low
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enough to justify the spread between the term loan rate and fixed deposit rate of
interest.
4. LC facility and Buyers credit facility as sub limit to the term loan
In this structure, the LC facility is repaid by way of disbursement of Buyer’s credit
facility. LC and Buyer’s credit facility are sanctioned as sub-limit to term loan. The
borrower repays by way of EMI on TL value and tenor. These EMIs are kept as fixed
deposits until the Buyer’s credit falls due for repayment. The Buyer’s credit is repaid
by fixed deposit proceeds and term loan for the shortfall. After the buyer’s credit is
repaid, the EMIs continue from the borrower till the term loan is fully repaid. As
compared to the previous structure, here only the buyer’s credit facility has been
utilised and once the buyer’s credit is repaid, the balance term loan remains
outstanding in rupee denomination.
While assessing the risk of term loans we may use techniques such as free cash flow
analysis, break even analysis, and scenario and sensitivity analysis for computing the
limits to be sanctioned to the borrower.
1. Sensitivity Analysis
Sensitivity tests are used to assess the impact of the change in one variable on another
variable. It is usually used to stress test the repayment capability on a loan as
indicated by DSCR by varying other parameters such as selling price, capacity
utilization, operating margin etc.
2. Scenario analysis
Scenario tests include simultaneous variation of a number of parameters based on an
event experienced in the past or plausible market event that has not yet happened and
assessment of their impact on the desired outcome typically repayment of a loan.
In sensitivity analysis, typically one variable is varied at a time. If variables are inter-
related it is helpful to look at some plausible scenarios, each scenario representing a
consistent combination of variables.
3. Break even Analysis
While analysing new projects the bank would be interested in knowing how many
units may be produced and sold at a minimum to ensure that the project does not lose
money. Such an exercise is called break even analysis and the minimum quantity at
which loss is avoided is known as break even point (BEP).
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CREDIT MONITORING
The objective of credit monitoring is to detect “early warning signals”, in order that necessary
corrective action could be taken before the account deteriorates.
The monitoring of credit risk would include:
Periodic review of the borrower’s operating and financial performance
Periodic review of the performance of the borrower’s account with the bank
Monitoring for early warning signals
In order to detect early warning signals in case of weak accounts and initiate remedial action
promptly some symptoms of sickness have been listed below:
Frequent change in financial year and accounting policies
Shortage in quantity of hypothecated goods
Over valuation of hypothecated goods in stock statements
Inferior quality of goods produced/ or unusually high frequency/ quantity of return of
goods
Removal of plant and machinery charged as security without bank’s prior consent
Value of hypothecated assets stated lower in insurance policies vis-à-vis values
reported in stock statements/ balance sheet
High value of receivables and inventories
Frequent return of cheques deposited for credit into the account and/ or cheques
drawn on the account
Frequent return of bills discounted/ purchased on behalf of the borrower. Large and
longer outstanding in the bill accounts. Longer period of credit allowed (vis-à-vis
industry practice) on sale documents negotiated through the bank drawn
Frequent requests for excess drawings, TODs/ Ad hocs by the borrower and/ or
outstanding balance in cash credit account remaining continuously at the maximum
Reduction in the level of turnover in the account, reduction in credit summation in
cash credit account
Elongation of working capital cycle
Delay in submission of stock statement, financial statements and other control
statements, including review/ renewal data by the borrower
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Widening difference between outstanding and drawing power/ sanctioned limit and
continuous irregularity in cash credit account
Attempt to divert sale proceeds through accounts with other banks
Inability to maintain stipulated margin on continuous basis
Periodical interest debited remaining un-serviced
Low capacity utilization
Profit fluctuation, downward trend in sales and stagnation or fall in profit as reflected
in the quarterly/ monthly data followed by contraction in the market share of the
borrower
Excess leverage relative to past and industry average
Failure to pay statutory dues
Failure to pay timely instalments of principal and interest on term loans
Financing capital expenditures out of funds for working capital purposes
A general decline in the related industry combined with many failures
Diversion of funds for purpose other than for running the unit
Attrition in key management and labour problems
Increasing number of law suits against the company
Any major negative remarks by auditor impacting profitability or regarding internal
controls of the company
Continuous change in auditors, accounting policy
Drastic fall in share price of the company
Drastic increase in raw material prices or fall in selling prices
REVIEW/ RENEWAL
It is necessary that all revolving/ non-revolving limits are renewed/ reviewed on a yearly
basis. If such renewals are not performed diligently within the expiry date of the limit, it may
lead to the facility becoming an NPA. It is possible that the review/ renewal may be delayed
due to non-submission of complete information or non-availability of latest financials or due
to pending limit enhancement requests from the borrower. In all such cases, it is necessary to
take approvals for extension of validity of limits from the appropriate authority. The
maximum extension that can be given is for a period of 180 days and the renewal not taking
place within this period will lead to classification as NPA.
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While evaluating a renewal request it is necessary to obtain the latest information on the
borrower and his group companies. It is also important to visit the factory and meet the
management to update the performance of the company during the review/ renewal period
and also the business plans for the immediate future. Based on these meeting and the
information submitted, the CMA may be revised and request for enhancement considered on
the basis of the required CMA. All review/ renewals must be backed by the performance of
the account as provided by the credit monitoring division.
It must be ensured that in case of all working capital limits above Rs.5 crores which are
secured by current assets, a stock audit is conducted on an annual basis and the stock audit
report is made available for the renewal of limits. Proper approvals need to be taken to ensure
that such deferrals remain valid. In case of a serious concern being observed in the account
by RBI/ internal auditor/ statutory auditor, the remark with details of corrective action may be
highlighted in the review/ renewal proposal.
The process of renewal must be diligently followed even for exit accounts. If the borrower is
unwilling or uncooperative, the renewal must be taken up with the information already
available.
BASEL II AND CREDIT RISK RATING
The past three decades witnessed increasing globalization of banking operations, with banks
across the world increasing their presence across countries. This led to the birth of Basel
accord, which was adopted in order to stipulate standard capital requirements for banks.
Banks need to maintain capital for meeting unexpected losses arising from their operations.
The expected losses need to be covered through risk based pricing. Basel-I stipulated a one
size fit all number of 8%, meaning thereby that banks were required to keep Rs.8 as capital
for every Rs. 100 of lending. However, the flaw of the accord was exposed as banks which
had engaged in riskier lending and those which were conservative were required to maintain
the same level of capital. This led to further refinements and Basel-II was unveiled with risk
sensitive capital requirements.
Basel-II uses a “three pillars” concept-
1. Minimum capital requirements (addressing risk)
2. Supervisory review and
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3. Market discipline- to promote greater stability in the financial system
The first pillar-The first pillar deals with maintenance of regulatory capital calculated for
three major components of risk that a bank faces- credit risk, operational risk and market risk.
The losses on the lending portfolio are dependent on:
1. The likelihood that an obligor will not repay his commitment- Technically called the
Probability of Default (PD)
2. The likely loss that will result or the proportion of exposure that will not be recovered
when a default occurs- Loss given Default (LGD)
3. Likely drawdown in the facility, at the time of default- Exposure at Default (EAD)
Basel-II takes into account the creditworthiness of the borrower (PD), the bank’s recovery
experience (LGD) and the exposure (EAD) in order to determine the capital requirement.
Thus, it also recognises reduced capital requirement wherever adequate security (collateral) is
available as a risk mitigant. Further, the accord enforces risk capital on committed but
unutilized credit lines and even off- balance sheet items. The exact risk capital required is
subject to the various approaches allowed under the accord.
Standardized approach stipulates risk capital based on external ratings of the borrower.
Wherever it is expected that the borrower along with the security offered would earn a better
rating than BB the bank may opt for getting the client rated to conserve capital. The risk
weight stipulated for varying rating grades are stipulated below:
Rating Grade Risk weight
AAA 0%
AA 20%
A 50%
BBB to BB 100%
Below BB 150%
Unrated 100%
In order to adopt the advanced approaches viz. Foundation Internal Ratings Based (IRB)
Approach and Advanced IRB; the banks need to calculate their own PD, LGD and EAD
numbers over 5 to 7 years. Thus ratings need to be inculcated in the internal decision making
process.
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The second pillar- The second pillar defines the process for supervisory review of a bank’s
risk management framework and ultimately its capital adequacy. It sets out specific oversight
responsibilities for the board and senior management, thus reinforcing principles of internal
control and other corporate governance practices established by regulatory bodies.
The third pillar- The third pillar aims to bolster market discipline through enhanced
disclosure by banks. It sets out disclosure requirements and recommendations in several
areas, including the way a bank calculates its capital adequacy and its risk assessment
methods.
KMBL has an internal credit rating model (Kotak Risk Assessment Model- KRAM) for the
comprehensive risk assessment of the wholesale banking credit exposures. All borrower
accounts (except individual borrowers) are rated on the K-RAM model at the time of
appraisal and thereafter on every renewal of the account. The rating system gives out two
levels of ratings- Obligor rating which determines the standalone rating of the borrower
(which corresponds with the PD) and the facility rating which determines the rating of the
security available for the loan (which corresponds with LGD& EAD).
The rating system has various models to rate companies of different types. Thus they have
separate rating models for large corporate (turnover> Rs. 100 crs), SMEs (turnover< Rs. 100
crs), stock brokers, traders, NBFC’s and companies providing services. The parameters to
evaluate ratings are business risk, industry risk, management risk and financial risk.
Appropriate weightage to these parameters have been decided based on past experience and
management judgement.
The rating system of the bank grades obligors into 18 categories. An indicative scale for
probability of default based on CRISIL’s experience of rating migration/ defaults has been
used to develop the rating system. The facility extended by the bank to the borrower is also
rated on a comprehensive scale of 30 categories of ratings. The obligor rating is calibrated to
indicate the probability of default over the tenor of the loan. The facility rating captures the
specific security available to that facility and therefore measures the likely loss given default.
The combination of obligor and facility rating provides combined rating which is divided into
18 categories.
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K-RAM has a process for creating the Bank’s own database on defaults. This database would
help in estimating probabilities of default for each rating category based on the Bank’s
experience.
Portfolio Management is a management tool used to minimise concentration of credit risk at
the portfolio level. This is done to avoid concentration of risk in a particular industry segment
or in a particular region. Portfolio analysis can also be done based on various parameters to
manage the duration risk at the portfolio or the unsecured component of the portfolio or based
on its linkages either in the supply chain or customer segments. It is also important to analyse
whether the risk adjusted return being generated by the portfolio is satisfactory. In order to
regulate the portfolio using the ratings as a benchmark, the bank has devised a set of norms
for escalation of sanctioning matrix by putting caps on borrower group exposures.
INTERNAL GUIDELINES
Credit Origination Process
The credit origination process (COP) is the process manual for credit origination compiled
with a view to standardize the credit origination process. The objectives of COP are to:
a) Define the process to be adopted in the origination of credit proposals in the
wholesale banking sphere (Corporate Banking., SME, FIG, TF, Agriculture,
Treasury), which can be applied consistently; and
b) Defining the responsibilities of various functionaries involved in the credit chain
Board Customer Acceptance Criteria (BCAC)
It ensures that the relationship manager would be able to segregate doable credit cases from
the non doable ones.
BCAC for Manufacturing Entities (subject to product guidelines if any)
S. No. Criteria Applicable for
corporate
customers
Applicable for SME
customers
1 Net sales/ Net profit on the growth
path
For the last two years For the last two years
2 Profitability at operating profit Minimum 10% of net Minimum 10% of net
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(PBDIT) (i.e. excluding non
operative income)
sales. No slippage in
the last two years
sales. No slippage in
the last two years
3 Total term borrowing/ Cash profit
(basis- as per last audited
financials)
Not exceeding 3 Not exceeding 4
4 Interest/ Net sales (basis- as per last
audited financials)
Not exceeding 5% Not exceeding 5%
5 TOL/ TNW ratio Not exceeding 2.00 Not exceeding 2.50
(treating unsecured
loans from promoters
clearly sub-ordinated
to the banks exposure
as part of TNW)
6 Current ratio Minimum 1.10 Minimum 1.15
7 Promoters reputation No negative reports
from the market
No negative reports
from the market
8 Industry outlook Positive Positive
9 Borrower rating Not below BBB Not below BBB
BCAC for Traders (including importers and exporters)
S. No. Criteria Applicable for
corporate
customers & SME
customers, subject
to limits being
considered is more
than Rs. 3 crs.
Applicable for SME
customers, subject
to limits being
considered is less
than Rs. 3 crs
1 Business vintage Minimum five years Minimum three years
2 Business being carried out from the
current location (to be evidenced
from electricity/ telephone bill etc.)
Minimum three years Minimum two years
3 Banking habit Should be enjoying Should be enjoying
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limits from banking
system for the last
two years
limits from the
banking system for
the last two years
4 Profit making Minimum for the last
three years
Minimum for the last
two years
5 Interest coverage (as per the last
audited financial statement)
Minimum 2 Minimum 2
6 TOL/TNW ratio Maximum 5 Maximum 5
7 Investment in other connected
entities
Not to exceed 50% of
the Tangible Net
worth (treating
unsecured loans from
promoters clearly
sub-ordinated to the
banks exposure as
part of TNW)
Not to exceed 50% of
the Tangible Net
Worth (treating
unsecured loans from
promoters clearly
sub-ordinated to the
banks exposure as
part of TNW)
Classification and declaration of borrowers as wilful defaulters
The bank would check whether the borrower and/ or its Directors/ associates appear in the
wilful defaulters list as announced by RBI from time to time. The bank would on case to case
basis extend finance to companies where the name of any its directors is reported as an
independent/ professional/ nominee director of another company appearing in wilful
defaulters list provided such director no longer continues to hold directorship in the wilfully
defaulting company. The decision to finance such companies will be taken by the respective
approving authority. In all other cases, the bank would not grant any credit facility to the
listed wilful defaulters.
A Wilful Default Assessment Note (WDAN) will be prepared containing details of:
a. The borrowers account, facilities availed and outstanding balance
b. Latest financial details
c. Comments on operations in the account
d. Details of default and follow-up action taken by the bank
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e. Reasons why the borrower is recommended for classification as wilful defaulter
f. Whether the borrower has defaulted with other banks and details thereof
g. Specific event under which the borrower should be classified as wilful defaulter
A borrower classified as ‘wilful defaulter’ would be given 15 days time after issue of the said
notice letter to make a representation against the classification.
MULTIPLE BANKING/ CONSORTIUM BANKING ARRANGEMENT
Multiple banking is a banking arrangement where a borrower avails finance independently
from more than one bank and where the rules of consortium do not apply. The borrower may
avail credit facilities from various banks providing different securities on different terms and
conditions. In such an arrangement each banker is free to do his own credit assessment and
hold security independent of other bankers. There is a regular exchange of information with
the other banks.
Consortium Banking is a banking arrangement where several banks finance a single borrower
following common appraisal, joint documentation, joint supervision and follow up exercises.
There is a lead bank known as the consortium leader that supervises this entire process. In
consortium lending, several banks pool banking resources and expertise in credit
management together and finance a single borrower. However, normally the lead bank’s
assessment and documentation is followed by member banks. Thus the borrower enjoys the
advantage of single window facility while availing credit facilities from several banks.
KMBL would take exposures under sole banking, multiple banking or becoming part of the
consortium. In all these cases the bank would appraise the credit worthiness of the business
and the support worthiness of the request and assess the requirements of facilities either itself
or would base its assessment on the assessment of any of the multiple banking members or
the leader or any member of the consortium.
In case of financing under multiple banking arrangements, the bank would be free to:
Structure the facilities
Charge interest rates/ commission based on its risk perception and the structure of the
facilities
Stipulate security as well as other terms and conditions for the exposure as deemed
necessary by the approving authorities
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Obtain credit securing documents as deemed necessary by the bank and register
charges with the appropriate authorities
Administer and monitor the credit exposure as in the case of sole banking exposures
and may share information with the other lenders as regards the facilities, conduct of
account etc on reciprocal basis.
LOAN REVIEW MECHANISM
Loan Review Mechanism (LRM) is an effective tool for monitoring borrower accounts at
regular pre-defined intervals and serves as an early warning system in identifying
potential weakness in the loan that might lead to an impact on asset quality. LRM
comprises of a periodic review of the loans and advances granted by the bank to ensure
that the advances granted are of the desired credit quality and no deterioration takes place
in them in due course of time.
The LRM procedures encompasses all areas of loans granted starting from credit
origination, credit risk assessment, credit administration, disbursement (limit
implementation) and credit monitoring. It assesses the adequacy of and adherence to
internal loan policies and procedures and helps identifying potential problem areas and
loans at an early stage.
Criteria for selection and Frequency of reviews:
Category Obligor rating Aggregate Exposure Amount Frequency of
reviews
1 K-AA- and above Rs. 50 crores and above Within 3 months of
sanction and once a
year thereafter
2 K-A and above Rs. 20 crores and above Within 3 months of
sanction and once a
year thereafter
3 K-BBB- and above Rs. 10 crores and above Within 2 months of
sanction and once in
6 months thereafter
4 K-BB+ and below Irrespective of exposure amount Within 1 month of
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sanction and once in
6 months thereafter
NPA MANAGEMENT AND RECOVERY
An NPA is an asset including a leased asset that becomes non performing when it ceases to
generate income from the bank.
A non performing asset (NPA) is a loan or an advance where;
i. Interest and/ or instalment of principal remain overdue for a period of more
than 90 days in respect of a term loan
ii. The account remains ‘out of order’ in respect of an overdraft/ cash credit
iii. The bill remains overdue for a period of more than 90 days in the case of bills
purchased and discounted
iv. The instalment of principal or interest thereon remains overdue for two crop
seasons for short duration crops
v. The instalment of principal or interest thereon remains overdue for one crop
season for long duration crops
vi. The amount of liquidity facility remains outstanding for more than 90 days, in
respect of a securitisation transaction undertaken
Banks should, classify an account as NPA only if the interest charged during any
quarter is not serviced fully within 90 days from the end of the quarter.
NPA Identification
Accounts with temporary deficiencies: The accounts will be classified as NPA based on
the temporary deficiencies in nature such as non-availability of adequate drawing power
based on the latest available stock statement, balance outstanding exceeding the limit
temporarily, non-submission of stock statements and non-renewal of the limits on the due
date as per the principles given below:
Stock statements relied upon for calculating drawing power in respect of drawing in
working capital account should not be older than three months. The outstanding in the
account based on drawing power calculated from stock statements older than three
months, would be deemed as irregular.
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A working capital borrowal account will become NPA if such irregular drawings are
permitted in the account for a continuous period of 90 days even though the unit may
be working or the borrower’s financial position is satisfactory.
An account where the regular/ ad hoc credit limits have not been reviewed/ renewed
within 180 days from the due date/ date of adhoc sanction will be treated as NPA.
Asset classification to be borrower wise and not facility wise- In respect of a borrower having
more than one facility with a bank, all the facilities granted by the bank will have to be
treated as NPA and not the particular facility or part thereof which has become irregular.
NPA classification and provisioning
Substandard assets Assets which have remained
NPA for a period less than or
equal to 12 months.
20% Capital provision for
unsecured & 10% for secured
Doubtful assets An asset would be classified
as doubtful if it has remained
in the substandard category
for a period of more than 12
months
100% Capital provision for
unsecured, 20% on secured
portion if doubtful upto 1
year, 30% on secured portion
if doubtful from 1 to 3 years,
100% on secured portion if
doubtful for more than 3
years.
Loss assets A loss asset is one which is
considered uncollectible and
of such little value that its
continuance as a bankable
asset is not warranted
although there may be some
salvage or recovery value.
100% Capital provision
Income recognition:
o Income from NPA is not recognised on accrual basis but is booked as income only
when it is actually received
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o Interest on advances against term deposits, NSCs, IVPs, KVPs and life policies may
be taken to income account on the due date, provided adequate margin is available in
the accounts.
o If any advance, including bills purchased and discounted, becomes NPA as at the
close of any year, the entire interest accrued and credited to income account in the
past periods, should be reversed or provided for if the same is not realised. This will
also apply to government guaranteed accounts.
Restructured accounts: A restructured account is one where the bank, for economic or legal
reasons relating to the borrower’s financial difficulty, grants to the borrower concessions that
the bank would not otherwise consider. Restructuring would normally involve modification
of terms of the advances/ securities, which would generally include, among others, alteration
of repayment period/ repayable amount/ the amount of instalments/ rate of interest.
Recovery policy- The bank has formulated a recovery policy with the following objectives:
Monitor standard assets to avoid slippages
To manage and control the bank’s absolute NPA by accelerating recoveries
To encourage compromise settlements and accelerate recoveries
To keep gross NPA percentage at the minimum level of gross advances excluding
ARD portfolio
The bank can take recourse in case of default through the following sources:
1. Debt Recovery Tribunals
2. SARFAESI Act,2002
3. Arbitration
4. Section 138 of Negotiable Instruments Act,1881
5. Winding up process through courts proceedings
Under all the above mentioned processes, the distribution of proceeds must follow the
guidelines given under section 539A of the Companies Act.
The bank takes advantage of the SARFAESI Act, 2002 that empowers banks/ financial
institutions to recover their non-performing assets without the intervention of the court. The
Act provides three alternative methods for recovery of non-performing assets, namely-
Securitisation
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Asset reconstruction
Enforcement of security without the intervention of the court
The provisions of this Act are applicable only for NPA loans with outstanding above Rs. 1
lakh. NPA loan accounts where the amount is less than 20% of the principal and interest are
not eligible to be dealt with under this Act.
Non-performing assets should be backed by securities charged to the bank by way of
hypothecation or mortgage or assignment. It is essential that approval is received from 75%
of all secured creditors in order to have a right over BIFR ruling in case of a BIFR company.
The bank follows the steps as given below as per the SARFAESI Act, 2002:
I. It is to be ensured that the account should be classified as NPA as per RBI guidelines
II. Demand notice should be issued by an Authorised officer of the bank calling upon the
borrower/ guarantor to pay dues within 60 days. The borrower/ guarantor is entitled to
make his representations/ objections to the bank and the bank is required to deal with
these objections and communicate the same within 7 days.
III. In case of non-compliance by borrower, the bank u/s 13(4) can take any of the
following steps:
Take possession of the secured assets of the borrower
Take over the management of the business
Appoint any person to manage the secured assets taken over
Give notice to third person who has acquired secured assets/ or from whom
money is due to borrower
IV. Gives notice to the borrower for taking possession/ affix the same on the property
V. Take possession of the properties and publish a notice in two leading newspapers of
which one should be in a vernacular language
VI. In case of refusal to hand over possession, file an application u/s 14 before the Chief
Metropolitan Magistrate/ District Magistrate for taking forcible possession.
VII. After taking possession of the assets, if they are movable assets then the bank will
make an inventory of the assets and obtain valuation through an approved valuer. The
bank will fix a reserve price and then serve a notice for sale of 30 days to the
borrower. After this notice period the bank can sell the assets by public auction or
private treaty.
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VIII. After taking possession of the assets, if they are immovable assets then the bank will
obtain valuation and fix a reserve price for the property. The bank will then give a 30
day notice for sale to the borrower. After this notice period the bank can sell assets by
public auction or private treaty.
LEGAL DOCUMENTS AND PROCEDURES
A. Basic Documents for all facilities
1. Application/ request letter for the facility: An application, wherein the prospective
borrower/ customer is applying to the bank for seeking credit facilities is required in
order to verify the intention of the borrower to avail the facilities.
2. Accepted sanction letter: Sanction letter is a formal communication from the bank to
the borrower mentioning facilities offered by the bank to the borrower, its limit, type
of facility, purpose, validity, tenor, rate of interest, disbursement method, repayment
method, security, transactional documents, covenants/ conditions etc. It also mentions
the list of documents that need to be executed/ furnished/ submitted by the borrower
to the bank.
3. Constitutional documents: The constitutional documents required depending upon the
status of the borrower are:
Sole Proprietorship: No constitutional document
Partnership firms: Partnership deed
Companies: - Memorandum and articles of association
- Certificate of incorporation
- Certificate of commencement of business in case of public
limited companies
- In case of a section 25 company, above documents and the IT
certificate confirming exemptions
Trusts: Trust deed (if the trust is registered, the bye laws and certificate of
registration of trust are verified)
Corporative societies: Bye laws (it is to be checked if the above mentioned
documents are rightly issued by the concerned registrar and duly certified)
Limited Liability Partnerships (LLP): - Incorporation document - LLP
Agreement
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4. Borrowing powers: Depending upon the legal status of the borrower i.e. if the
borrower is a company registered under Companies Act, 1956, Partnership firm or a
sole proprietor, different documentation is required. The documents depending on the
status of the borrower are given as follows:
For company registered under Companies Act, 1956: Board resolution
For partnership firms: The partnership letter
For Limited Liability Partnership (LLPs) firms: similar to partnership firms. There
will however be a certificate of registration
For Sole Proprietor: Letter from sole proprietor
5. Master facility agreement and the relevant product schedules: In order to remove the
complexities of executing a larger number of facility documents for various credit
facilities granted to our customers and to reduce and standardize the documents for
the same, the Master Facility Agreement (MFA) is executed along with relevant
schedules.
6. Form 1: This document is submitted by the borrower to the bank giving details of
credit limits enjoyed with other working capital bankers with their outstanding, based
on which the bank can decide its share in the working capital requirements of the
borrower.
B. Facility Specific Documents
1. Demand Promissory Note (DPN): It is a promise by the borrower to pay to the bank
the stipulated amount at a specific rate of interest on demand. DPN can be executed
by any borrower, irrespective of his/ her legal status.
2. Letter of continuing security: It is a document executed by the borrower in favour
of the bank stating that the DPN (with stipulated loan amount and rate of interest) will
be enforceable to the bank on the said account. According to this document, the DPN
holds good till the facility exists with the bank.
3. Facility/ product specific documents
C. Common Security documents
1. Deed of hypothecation: It is a document executed by the borrower in favour of the
bank securing the movable assets detailed in the second schedule thereto along with
the priority of charge mentioned in the third schedule, for securing the facilities
mentioned in the first schedule.
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2. Deed of Personal Guarantee: In the scenario where the bank is lending to a Mr. A,
and Mr.B is requested to stand as guarantor, the bank is the creditor, Mr.A the
principal debtor and Mr.B the surety/ guarantor. Going by the example, a Deed of
Personal Guarantee is executed by Mr. B to secure the due repayment, discharge and
redemption of the financial facility granted to Mr.A in his personal capacity.
3. Deed of Corporate Guarantee: It is a document executed by a company/ or a
partnership firm in favour of the bank with an intention to secure the due repayment,
discharge and redemption of the financial facility/ facilities granted to the borrower by
the bank. In the case of a company furnishing a guarantee, the Memorandum and
Articles of association should contain an express provision conferring the power to
guarantee advances to other parties.
4. Power of Attorney: The power given to a person to act as an attorney of the person
giving such a power to him in general or in relation to a specific scenario. The person
executing the instrument of power of attorney is called the donor and the person in
whose favour the deed is executed is called the attorney. The acts and deeds that the
attorney carries out during the term of his attorneyship, bind the donor as if the acts
were done by the donor himself. A deed of power of attorney which empowers the
attorney absolutely to act on behalf of the done is called a General Power of Attorney
and where it transfers powers with respect to a certain transaction only, it is called a
Specific/ special Power of Attorney.
5. Mortgage: A mortgage is a transfer of an interest in specific immoveable property
for the purpose of securing payment of money advanced or to be advanced by way of
loan, an existing or future debt or the performance of an engagement which may give
rise to a pecuniary liability. There are five kinds of mortgage: a simple mortgage,
mortgage by conditional sale, usufructory mortgage, registered or English mortgage,
mortgage by deposit of title deeds or equitable mortgage and anomalous mortgage.
KMBL creates the security by way of mortgage usually through mortgage by deposit
of title deeds or an equitable mortgage and in some cases by an English/ registered
mortgage. The bank does not accept agricultural land for the purpose of property for
mortgage as any security interest created over agricultural land cannot be proceeded
under SARFAESI Act.
6. Pledge: A pledge agreement is a contractual obligation on the part of the pledger to
repay the amounts owed by him to the pledge and on the part of the pledge to take
good care of the goods pledged as he would have if the goods pledged were his own.
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KMBL mainly deals with shares which currently would be in demat form and
therefore the pledge marked with the Depositary participant would have to be
accompanied with a document evidencing constructive delivery.
7. Lien: A lien may be defined as an encumbrance or a charge or a legal right arising
by virtue of possession of the stipulated property over the property so possessed. Lien
is marked by a creditor over the property of his debtor generally as a collateral
security under which the creditor becomes entitled to recover his dues by creating a
charge whereby the effective control is not with the owner any more.
D. Standard Escrow Documents
1. Power of Attorney (Receivables)
2. Power of Attorney (Bank Account)
3. Letter to KMBL from the borrower (regarding Escrow account)
4. Joint letter to the original equipment manufacturer (OEM)
5. Confirmation letter from the Original Equipment Manufacturer (OEM) to the bank
6. The Board Resolution of the borrower company should state that the board of the
company authorizes issue of power of attorneys to the bank for collecting payments
due from specified parties and to operate the escrow account of the bank.
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CASE STUDY ANALYSIS
Name of the Company: Prestige Industries Limited (PILT)
Group: Amba Group
Location: New Delhi
Year of incorporation: 1945
Constitution: Public Limited Company
Industry & Activity: Paper & wood (Manufacturer of paper & paper products)
Banking Arrangement: Multiple Banking Arrangement
Proposal for: Renewal of credit facilities
Shareholding Pattern as on 31.12.2012:
Shares held by %
Promoter and promoter group 49.42
Institutions 35.43
Non Institutions 15.15
Total 100
Prestige Industries Limited(PILT) (consolidated) operates in five segments: coated wood free
paper, uncoated hi-bright paper(maplitho), business stationary, copier paper and specially &
fine paper and rayon grade pulp. The company (on a consolidated level) accounts for over
50% of the coated wood-free paper market, 85% of the bond paper market and nearly 45% of
the hi-bright Maplitho market, besides being India’s largest coated paper exporter.
PILT’s operations were reorganised in FY08 by demerging its 3 more efficient units in a
separate company PILT Graphic and Paper Products Limited (PGPPL) and the 3
manufacturing facilities at Haryana, Orissa and Maharashtra remained in PILT. PILT since
then reported lower operating margins than PGPPL due to its older and lesser efficient plants.
In 2007, PILT acquired 97.8% stake in Maha Forest Industries (MFI) for $253.7 mn. MFI, a
step down subsidiary, operates the largest integrated paper mill in Malaysia with 144000
Page | 56
MTPA of paper and 120000 MTPA of pulp capacity. MFI holds a 99 year concession for app.
289000 ha of forestland by the state government of Maha valid till 31.12.2094.
With effect from July 1, 2012, the group did a restructuring of the existing manufacturing
facilities as depicted:
The consideration from PILT to PGPPL is Rs. 115 crores. The rationale behind restructuring
is to consolidate all the writing and printing paper manufacturing facilities under PGPPL.
Further, it is buying 24.5 MW captive power plant from APIL for Rs.55 crores (incl. Debt of
Rs. 38 crores). This has almost been paid and is reflecting in the increased loans and
advances by Rs.332 crores of PILT consolidated results for half year ended 31.12.12, which
will get reflected in gross block after the consolidation of Amba power plant.
The current raw material procurement policy of these units is as below:
Unit Wood/ Bamboo Power
Haryana Through farm forestry and farm open market Captive 24.5 MW (earlier in APIL)
AP Captive
PILT has bought back JP Morgan’s stake in its step down subsidiary PIGPH at Rs. 450
crores, funded by additional loan. The impact of this is reflecting in the increased leverage in
the projected consolidated financials for FY13.
Company Pre- arrangement Post-arrangement
PILT Orissa-72,000 MTPA Paper Haryana- 1,05,068 MTPA Paper
Haryana-1,05,068 MTPA Paper
AP- 98,550 MTPA Rayon Grade
Pulp
Maharashtra-55,000 MTPA
Paper
PGPPL Maharashtra-3,15,000 MTPA
Paper Orissa- 72,000 MTPA Paper
Maharashtra- 2,99,500 MTPA
Paper
Maharashtra- 55,000 MTPA
Paper
AP- 98,500 MTPA Rayon Grade
Pulp
Maharashtra- 3,15,000 MTPA
Paper
Maharashtra- 2,99,500 MTPA
Paper
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Business Model- Strengths and Risks
Risks Mitigants
Industry outlook is weak characterized by subdued
economic growth expected to result in modest demand,
high input costs impacting profitability and capacity
overhang adding to competitive intensity
In the absence of any significant
recovery in operating profitability
in 2013, the credit metrics of paper
companies would remain stretched
Declining profitability of the rayon grade pulp segment,
the EBIT of which has halved y-o-y due to weak
demand
Risk remains
High group leverage and impacted profitability of the
major group companies reflecting in tanking shares on
the financial bourses and eroding market capitalization.
Further, the group has investments in power sector with
delay in projects
Risk remains
Borrowers Strengths:
Brand Retail: PILT on a consolidated basis is the market leader in Indian writing and
printing paper industry
Wide distribution network
Geographic diversification
Capital Market Perception
Face Value of Share: 2
Current Market Price: 19.65
52 Week: High- 29.35 (18.04.12) Low- 16.95 (05.03.13)
P/E: 51.12
Market capitalization: Rs. 1238.63 crores (11.03.2013)
No. of share pledged by promoters: 4.85% shares pledged as on 31.12.12
Page | 58
Financial Performance
For period
ended June
30
Standalone Consolidated Standalone
2011 2012 2012 2013 2014 2011 2012 H1-13 H1-12
No. of
months 12 12 12 12 12 12 12 6 6
Rs. In
crores Aud.
Est.
Earlier Aud. Est. Proj. Aud. Aud. Actual Actual
Net Sales 1060.91 1085
1094.3
5 1023 1023 4499.84 4806.31 476.96 535.86
PBDIT 164.88 127.3 127.76 178.84 178.84 863.66 787.52 82.42 65.2
PBDIT
Margin (%) 15.54% 11.73% 11.67% 17.48% 17.48% 19.19% 16.39%
17.28
%
12.17
%
Interest 46.36 33.81 45.61 50.04 46.04 297.88 288.98 18.33 16.92
Depreciatio
n 84.04 88.52 89.83 100.1 100.7 335.13 364.01 41 43.2
Op. Profit after intt
and dep 34.48 4.97 -7.68 28.7 32.1 230.65 134.53 23.09 5.08
Non-
operating
income 15.96 10 24.3 25 25 39.14 36.87 2.33 1.43
PAT 30.15 10.14 6.57 35.7 35.7 265.6 159.07 21.28 3.44
PAT Margin
(%) 2.84% 0.93% 0.60% 3.49% 3.49% 5.90% 3.31% 4.46% 0.65%
Cash profits
Pre Dividend 118.01 98.66 97.92 135.8 136.4 587.94 528.01 62.28 47.59
Net fixed
assets 1056.89 1047.76
1034.7
2 1174.5 1123.8 5735.14 7227.56
Net worth 1618.61 1590.53
1587.0
8
1584.6
8
1582.2
8 2652.9 2807.25
Tangible
Networth
(TNW) 1575.76 1577
1540.8
3
1538.4
3
1536.0
3 2500.11 2614.08
Adjusted
TNW
(ATNW) 251.33 680.55 639.27 653.99 651.59 2385.15 2485.85
Long term
debt (A) 556.74 344.24 415.02 465.01 426.76 2871.23 3020.85
Short term
debt (STD)
(B) 0 0 0 0 0 0 0
Working
Capital Bank
Finance (C) 430.65 350 339.58 339.58 339.58 1006.37 1098.4
Total debt
(A+B+C) 987.39 694.24 754.6 804.59 766.34 3877.6 4119.25
TOL/TNW 0.92 0.75 0.76 0.78 0.76 2.58 3.09
Total
debt/TNW 0.63 0.44 0.49 0.52 0.5 1.55 1.58
Total
debt/ATNW 3.93 1.02 1.18 1.23 1.18 1.63 1.66
TOL (incl
cont.)/ 6.27 2.53 2.02 2.03 1.98 3.22 3.54
Page | 59
ATNW
Current ratio 0.7 0.94 1.02 0.91 1.02 0.8 0.7
DSCR 1.32 0.56 0.6 0.9 0.91 2.3 1.5
Interest
cover 3.56 3.77 2.8 3.57 3.88 2.9 2.73
Total debt/
PBDIT 5.99 5.45 5.91 4.5 4.29 4.49 5.23
Total debt/
Cash profits 8.37 7.04 7.71 5.92 5.62 6.6 7.8
Average
Payment
period 121.1 29.23 101.17 90.43 90.43 137.74 156.87
Average
Collection period 79.72 79.79 74.68 76.5 76.5 35.11 32.91
Average
Holding
period 89.01 89.95 79.73 79 79 75.49 79.32
CREDIT RISK ASSESSMENT
Business risk
Market leader in writing and printing paper
Restructuring in manufacturing assets
Merging CPPs of Amba group in PILT and PGPPL
Three basic risk:
a) Digitisation but penetration rate in primary markets of BILT is low
b) Production based on wood and risk of unavailability of right raw material due to
depletion of forest resources
c) Expanded capacity (30-40%) builds pressure to penetrate markets with products in
order to absorb over supply
Financial Risk
Turnover stagnant over the last 2-3 years. Will reduce in FY13 due to restructuring
PBDIT margin fell due to high power cost which company is unable to pass due to
competition
Profitability expected to improve due to incoming of more profitable AP unit
TNW fell due to dividend payment from reserves
Required to pay Rs. 115 crores to PGPPL and Rs.17 crores to APIL. In FY13, needs
refinance of TL instalments of Rs.150 crores due and further debt of Rs.50 crores
Page | 60
Group debt of Rs. 16753 crores as per info available
High capital expenditure lead to negative impact on free operating cash flows
Low repayment capacity depicted by Total debt/ Cash Profit of 7.71 as on June 30,
2012. DSCR below 1.
Management Risk
JP Morgan exited its step down subsidiary PIGPH at Rs.450 crores, funded by
additional loan. Company expects fresh PE of USD 100 mio
Selling bromine business of Sunlight Chemtech Industries ltd
Promoter’s vintage helps in raising debt to fund its expansions
The share prices of both the major group’s companies are trading at and around their
52 week lows thereby leading to higher pledge of promoter’s holding for loans against
shares.
Industry Risk
In 2012, paper companies saw a significant erosion in their profitability margins on
account of raw material price increases, partly driven by rupee depreciation as imports
account for a considerable proportion of their cost structures.
Pricing pressures due to low demand and excess capacity worsened the situation as
sale realisations remained stagnant.
As per industry estimates, the domestic demand growth slowed down to about 4% in
2012 from 6% in 2011 and double digit growth of 13.9% and 10.2% in 2009 and
2010, respectively.
Many paper companies have seen a significant increase in their power costs due to
erratic domestic coal supplies, which amid the weak rupee scenario has increased the
cost of coal imports.
Significant borrowings for capex to keep credit metrics stretched
FACILITIES ASSESSMENT
Assessment of fund based working capital limits
S. No. Particulars Amt (Rs cr)
A Turnover achieved in FY 12 1094.35
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B Turnover estimated for FY 13 1023
C Increase in turnover estimated over the previous year (%) -6.52%
D
Working capital requirement estimated @30% of estimated turnover for the current
year 306.9
E Maximum Possible Bank Funding-4/5th of working capital as assessed under D 245.52
F Working capital limits enjoyed by the borrower from other banks 740
G Buyer's credit limits availed from other banks NA
H Maximum Possible Funding from Kotak Bank (E-F-G) -
I Limits proposed 125
J Buyer's credit limits proposed if any at the end of LC tenor 15
The company enjoys fund and non fund based limits of Rs 740 crores within multiple
banking arrangement. The bank proposes the renewal of existing working capital limits of Rs.
125 crores based on the availability of sufficient drawing power.
Assessment of Purchase bill discounting
S. No. Particulars Amt. (Rs. Cr)
1 Domestic purchase estimated for FY13 249
2 Total purchase under credit (80%) 119.2
3 Maximum tenor 180 days
4 No. of rotations (360/(3)) 2.03
5 Eligible limit (2/5) 98.12
6 Proposed limits (Renewal) 100
The company requires PBD limit for purchase of wood and bamboo from the domestic
market. Nearly 80% of their total requirements are without LC. The bank proposes to renew
the existing PBD sub-limits of Rs.100 crores. Though the average payment period is around
101 days, a higher tenor is proposed to cater to occasional requirements.
Assessment of sales bill discounting
S. No. Particulars Amt. (Rs. Cr)
A Total domestic sales estimated for FY13 1023
B Average domestic debtors realization period 90 days
C Rotations in a year (365/90) 4.05
D Limit required 252.59
E Limit recommended (Renewal) 100
The company sells to its various distributors without LC with average realization period of 90
days. The bank proposes to renew the existing SBD facility of Rs.100 crores.
Assessment of Non Fund based facilities
Letter of credit: Company is projected to purchase around 20% of its raw material as
imports under LC:
Page | 62
S. No. Particulars Amt(Rs. Cr)
1 Imports estimated for FY13 53.06
2 Maximum usance period 180 days
3 Average Lead Time 30 days
4 No. of rotations (365/(2+3)) 1.74
5 Eligible limit (1/4) 30.49
6 Proposed limits (renewal) 15
Further the company also buys pulp from its group companies abroad. The average volumes
purchased is around Rs.3-4 crore per month against LC. The bank thus proposes to renew the
LC(RM) facility of Rs.10 crores favouring group companies, within the overall LC exposure
of Rs.15 crores.
Letter of Credit (Capex): The Company has projected a routine capex of Rs.11 crores for
FY13 and Rs.50 crores for FY14. For this, the bank proposes to sanction a Capex LC facility
of Rs.10 crores for a minimum tenor of 1 year.
Forex:
S. No. Particulars Amt(Rs. Cr)
1 Imports projected for FY13 50
2 Forex loan as on 30.06.12 111.21
3 Total 161.21
4 LEV 15%
5 Eligible limit (3*4) 24.18
6 Proposed limits- renewal 5
ACCOUNT MONITORING
The account conduct is satisfactory with regular outstanding in fund based facility (STL).
Income of Rs. 1.37 crores is made in FY12 and Rs. 1.31 crores in 9 months- FY13.
Compliance of EOD
EOD Present status Compliance
PBDIT/ Net sales shall be at
a minimum of 16% verifiable
at quarterly intervals
Operating margins 16.95% for the quarter
ended September 30,2012 and 17.66% for the
year ended December 31,2012 Complied
Reduction of shareholding of
promoter group below 30%.
The same should be verified
annual intervals
Promoter shareholding of 49.42% as on
December 31,2012 Complied
TOL/TNW not to exceed 2 TOL/TNW of 0.76 as on June 30,2012 Complied
Page | 63
times. The ratio be checked
at annual intervals
COMPLIANCE WITH CREDIT POLICIES
Substantial exposure- No
4 out of 9 Broad Customer Acceptance Criteria for Manufacturing Entities complied with.
The conditions not complied with are:
1. Net Sales/ Net Profit on the growth path
2. PBDIT of minimum 10% of net sales. No slippage in the last 2 years.
3. Total term borrowing/ Cash profit not exceeding 3
4. Positive industry outlook
5. CR not below 1.10
However, facilities are being proposed in view of the satisfactory past account conduct and
expected improvement in profitability of PILT standalone with the current restructuring.
RECOMMENDATION
PILT, a part of Amba group, has remained the market leader in Indian writing and printing
paper industry. The company’s management has always undertaken aggressive debt funded
capex. The company which traditionally reported EBIDTA margins of around 25%, has for
the last few years been severely impacted due to sharp uptick in pulp prices and power cost.
However, with the integration of pulp within house mills coming up in MFI and Maharashtra
unit, the consolidated profitability is expected to improve in the coming years.
There are concerns on the highly leveraged position of the group (known group debt of Rs.
16,753 crores on a TNW of Rs. 2958 crores- after adjusting for diminution). Further, the
share prices of the 2 listed entities are currently trading at/ around their 52 week’s lows. Also,
the group has made significant expansions in IPPs of 1200 MW in Phase I, which is
observing cost escalation and delay in commissioning.
However, the bank proposes renewal of the existing facilities in view of the promoter’s
vintage, its ability to raise debt to fund its expansions and satisfactory account conduct with
the bank (group relationship since 2004). KMBL’s FB facilities are disbursed based on the
company’s DP availability. KMBL is also in the process of existing its exposure in the
Page | 64
group’s power arm APIL and the chemical company, thereby consolidating KMBL’s
exposure in the group’s paper business.
Submission of quarterly stock statement and opening of LC for group companies’ upto Rs. 10
crores to continue. All other conditions to remain unchanged.
In Rs. Crore Existing Proposed
WC 130.00 130.00
Forex Forward 5.00 5.00
CMS 2.00 2.00
Total Exposure 137.00 137.00
Total Group Exposure 362.10 362.10
Security/ Comforts:
Post dated cheque for disbursed WCDL/ STL and PBD facility (beyond Rs.25 cr). UDC for
OD and disputed BG.
Page | 65
LIMITATIONS OF THE STUDY
1. Due to the confidentiality policies of the bank, not all processes and methods have
been allowed to be documented
2. No description of bank software and risk measurement tools is mentioned
3. This report is on credit appraisal process and therefore to maintain lender-borrower
confidentiality, no data has been revealed.
4. Scope of study is very vast (credit process is very long). So it can’t be studied wholly
thereby focus on particular area.
SCOPE FOR FUTURE IMPROVEMENTS
A credit analyst’s job is not complete with credit appraisal. His role should also include the
following in order to reduce credit risk:
Define parameters for monitoring at the time of the appraisal in the term sheet under
covenants/ monitoring conditions
Be conscious of all assumptions made in the projections while doing the appraisal and
regularly monitor these assumptions for any change in the environment
Monitor the environment by regularly updating himself through newspapers and
television reports
Monitor the performance of the borrower through regular reports received from the
borrower such as sales statements, stock statements, QIS, annual reports etc.
Monitor the escrow performance, non-compliance of EODs, deferrals etc.
Monitor the transactions in the account to ensure that there is regular churn and
monitor any unusual transaction.
Monitoring on regular basis to detect early warning signals for all accounts
irrespective of the amount/ type of facility or rating accorded.
Page | 66
SOURCES OF INFORMATION
http://www.ibef.org/industry/banking-india.aspx (Accessed on 25 June 2014)
http://corp.kotak.com/corporate-banking.html (Accessed on 29 June 2014)
http://www.google.com/finance?cid=678082 (Accessed on 29 June 2014)
An Intranet based service of Kotak Mahindra Bank Ltd. which provides all the
information relating to theoretical concepts involved in the study- Kredit Compass
Management of Banking and Financial Services (Second Edition) by Padmalatha
Suresh and Justin Paul. Published by Dorling Kindersley (India) Pvt ltd
Financial Accounting for Management (Third Edition) by N Ramachandran and Ram
Kumar Kakani. Published by the Tata McGraw Hills Education Private Limited