Introduction to Lending & Credit Appraisal.

Yeshan Krishnaratne

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• What is credit & its need ?

• The type of credit facilities

• Evaluation of Credit Facilities

• Taking Decisions relating to credit

• Importance of Quality Credit

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What is Credit ?
 A contractual agreement in which a borrower
receives something of value now and agrees
to repay the lender at some later date.

Lender
Credit Period
$

$
Borrower Lender

Time
Why the Credit Function is important to
Financial Institutions?
 What is the business of a Bank / F.I ?
◦ accepts deposits and channels those deposits into
lending activities
 What is the commodity traded?
◦ Money
 How do they make profits?
◦ Interest Income , Commission & Fees
 How do we achieve this?
◦ Through the lending process

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Modes of Lending
 Personal Lending
 Corporate /Commercial Lending

By way of
 Direct advances

◦ i.e. Fund based

 Indirect advances
◦ i.e. non fund based advances

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Types of Credit Facilities
 Loan ( Short – Medium – Long)
 Overdrafts
 Letters of Credit, Revolving Loans & Acceptance,
Shipping Guarantees
 Export Finance
 Pledge Loans & Trust Receipts
 Guarantee Facility
 Cheque Purchasing / factoring & Bill Discounting
 Margin Trading
 Pawning
 Leasing & hire purchase
 Overdraft
 To bridge working capital requirements.
 Interest is to be calculated daily, debited monthly.

Renewed periodically.
 Bank has no control over the usage of funds.
 Generally Used For?
 Not used for ?
Loans
 Generally used to finance Capital Expenditure
although not always. (Eg-: Fixed working
capital requirements)
 To be repaid over a an agreed period of time, i.e.
the outstanding gradually diminishes.
 To be granted for specific purposes.
 Long Term, Medium Term & Short Term.
Letters of Credit
 A contingent liability created by one bank to
another.
 Commission based.
 Mostly used for foreign trade & in dealing

with unknown parties.

◦ Acceptance facilities ( usance period)
Revolving Loans
 Revolving loans are granted to finance
particular trade or order cycles.
 They are short term in nature and coincide

with the working capital cycle of a client.

◦ Examples ?
 Importers
 Traders : Buying & Selling.
Shipping Guarantees
 S/Gs’ are required when the originals
documents are not available at the time of
clearing a shipment.
 The risk is in original documents deferring

from the copy documents.

Export Finance
 Export Bill Purchases and Export Loan
Facilities.
◦ Export Bills submitted by the exporter which are
then purchased by the bank.
◦ Export Loans are granted to facilitate the pre-
shipment requirements ( packing credit loans).
Pledge Loans & Trust Receipts
 Pledge Loans are advances made against the
pledging of a certain item as security. Either
in the total contol of the F/I or with dual
control between the borrower and the F/I.
 In Trust Receipts the title ( ownership) to the

goods are surrendered to the F/I.

Guarantee Facility
 A promise made by a bank to another bank,
lender or counterparty to pay a liability of
the borrower based on the outcome of a
particular event/activity.
 The beneficiary is always a third party.

◦ Financial Guarantees
◦ Bid Bonds
◦ Advanced Payment Guarantees
◦ Performance Guarantees
◦ Retention Guarantees.
Cheque Purchasing / Factoring & Bill
Discounting
 Advances made against post dated cheques &
approved bills.
 Commission Based, expensive to borrower ,

risky to F/Is’.
Margin Trading
 It used to facilitate share trading. ( Banker – Broker
& Customer)

 The main significance is that the shares themselves

act as security.

 Margin trading is a double-edged sword - it cuts

both ways. If the stock price rises, the investor
makes twice as much profit as with his own cash
only. Similarly, if the stock price falls, the investor
loses twice the amount.
Pawning
 Carried out against Gold in Sri Lanka.
 Different advances are made dependent on

the grade of gold, weight & design type.

 Low risk – known as safe haven.
Leasing

A lease is a contract calling for the lessee (user) to pay the
lessor (owner) for use of an asset.

 A finance lease is a commercial arrangement where:

 the lessee (customer or borrower) will select an asset
(equipment, vehicle, software);
 the lessor (finance company) will purchase that asset;
 the lessee will have use of that asset during the lease;
 the lessee will pay a series of rentals or instalments for the
use of that asset;
 the lessor will recover a large part or all of the cost of the
asset plus earn interest from the rentals paid by the lessee;
 the lessee has the option to acquire ownership of the asset
(e.g. paying the last rental)
Hire Purchase
 A method of buying goods by way of making
instalment payments over time.

 Involves a down payment.

 Rentals are paid on a periodical basis.

RECAP
Credit Evaluation
Why Credit Evaluation?
 Is a Selection Tool
◦ A standard criteria to measure creditworthiness
 Quantifies Risk
 Helps assess the viability of the proposal
 Streamlines the Lending Process
 In short “ helps us be better
lenders”
The credit evaluation Process
 Canvassing new business
 Appraisal & Preparation of credit Report –

Recommendation
 Acceptance & Completion of securities
 Granting / disbursement
 Monitoring and recovery
 Retention Or Litigation

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Canvassing new Business
 Existing & New.
 Goals of the Bank Vs. Needs of the customer.
 Profit Vs. Risk.
 Ability to ensure a proper service.
 Information Acquisition & Documentation

◦ “the first attack is half the battle”

Mitigating the 1st Risk in Credit
 Two possible risks prior to a credit
accommodation :
◦ Default due to failure
◦ Willful default.

“50% of your total risk is mitigated by

identifying a potential willful defaulter.”
Credit Appraisal

 Credit analysis is the process of assessing the

risk of lending to a business or individual.
Credit Risk assessment has both qualitative
and quantitative dimensions
 Our proposal should be in line with the credit

policies and the procedures of the bank.

 The proposal should be commercially viable.

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Credit Appraisal Process
 Background & Management Analysis
 Financial Analysis.
 The demand Vs. Need.
 Viability of the business – Capacity to repay.
 Market Analysis, Industry Analysis.
 Previous Track Record – CRIB Reports, informal
sources.
 Risk mitigates,
 Adequacy of Collateral – Security
 Pricing and special conditions

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Background & Management Analysis

 The nature of business.

 The History
 Product Range.
 Subsidiaries & Related Parties
 Present Banking Facilities.
Management Analysis
 Who the key people? ( owners & management)
 Their backgrounds.
 Educational
 Social
 Industry experience
 Financial
 Any other important disclosures eg: related
parties, known addictions.
Why Financial Analysis?
The two key factors for business survival:
 Profitability
 Solvency

 Profitability is important to measure the

viability/practicality of pursing the
business.
 The solvency of a business is important

because it looks at the ability of the

business in meeting its financial obligations
Financial Statement Analysis –
Explained
Purpose:
 To use financial statements to evaluate an
organisation’s
◦ Financial performance
◦ Financial position.
 To have a means of comparative analysis across time
in terms of:
◦ Intracompany basis (within the company itself)
◦ Intercompany basis (between companies)
◦ Industry Averages (against that particular industry’s averages)
 To apply analytical tools and techniques to financial
statements to obtain useful information to aid
decision making.
Contd….
Financial statement analysis involves
analysing the information provided in the
financial statements to:
◦ Provide information about the organisation’s:
 Past performance
 Present condition
 Future performance
◦ Assess the organisation’s:
 Earnings in terms of power, persistence, quality and
growth
 Solvency
Contd…..
Requires that you:
 Understand the nature of the industry in which the
organisation works. This is an industry factor.
 Understand that the overall state of the economy
may also have an impact on the performance of the
organisation.

Financial statement analysis is more than just

“playing with numbers”; it involves obtaining a
broader picture of the organisation in order to
evaluate appropriately how that organisation is
performing
Contd…..
 To perform an effective financial statement
analysis, you need to be aware of the
organisation’s:
◦ business strategy
◦ objectives
◦ annual report and other documents like articles
about the organisation in newspapers and business
reviews.
These are called individual organisational factors.
Thumb rules in financial statement
analysis :
 The dates and duration of the financial statements being
compared should be the same. If not, the effects of
seasonality may cause erroneous conclusions to be drawn.

 The accounts to be compared should have been prepared

on the same bases. Different treatment of stocks or
depreciations or asset valuations will distort the results.

 In order to judge the overall performance of the firm a

group of ratios, as opposed to just one or two should be
used. In order to identify trends at least three years of
ratios are normally required.
Financial Analysis
 Balance Sheet, Income Statement /P&L, Cash
Flow

Liquidity Analysis give a picture of a company's short term financial situation or

solvency.

Operational/Turnover Ratios show how efficient a company's operations and how

well it is using its assets.

Leverage/Capital Structure Ratios show the quantum of debt in a company's

capital structure.

Profitability & Performance Analysis use margin analysis and show the return on
sales and capital employed.
Liquidity Analysis

Working capital management is important

as it signals the firm’s ability to meet short
term debt obligations.

 Working Capital = Current Assets – Current

Liabilities

 Current Ratio = Current Assets / Current Liabilities

 Quick Ratio = Quick Assets / Current Liabilities

Efficiency Analysis
Efficiency of asset usage
◦ How well assets are used to generate revenues
(income) will impact on the overall profitability of
the business.

 Debtors Turnover Ratio = Net Credit Sales /

Average Debtors
 Average Collection Ratio = Months (days) in
a Year / Debtors Turnover
 Inventory Turnover Ratio = Cost of Goods
Sold / Average Inventory
Profitability & Performance
Volume – Improvement – Reduction –
Return
 Sales Growth = Change in sales / previous years sales * 100
 Gross Profit Margin = Gross Profit/ sales * 100
 Net Profit Margin = Net Profit / sales * 100
 Return on Capital Employed= (EBIT / Capital Employed) *
100
 Return on equity = (Net profit after taxes) /Shareholders'
equity *100

 EPS = Net Profits Available to Equity Holders / Number of

Ordinary Shares Outstanding
Leverage Ratios & Capital Structure
Measures the amount of risk for the business
in terms of debt gearing.
 Interest Coverage Ratio = EBIT/ Interest Expense

 Debt Service Cover Ratio =

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities

---------------------------------------------------------------------------------
Annual interest on Long Term Loans & Liabilities + Annual Installments payable on
Long Term Loans & Liabilities

 Debt to Equity Ratio = Short Term Debt + Long Term Debt / Total
Shareholders Equity

 Changes in Equity, Fixed Assets & Long Term Debt.

Activity 2
For businesses without financial
statements
Building financial backgrounds
 Account Turnover.
 Monthly Transactions.
 Tax Returns.
Demand Vs. Need (requirement
analysis)
◦ The nature of advance requested.
-Understanding the Various Types of Advances.

◦ The size of the advance requested.

What are the implications of an improper

facility?
 Inability to complete the project or carry out business.
 Inability to face volatilities.
 Hampers growth, loss of confidence.
 Excessive debt service burden.
 Loss of Efficiency.
 Over confidence.
Activity 3
 Mr. Perera an existing client wants to carry a
one off export order to manufacture 10,000
hats. The total cost per hat is Rs. 770/-
while the selling price per hat is USD 10/-.
The bank has a policy of financing a
maximum of 75% of the order. The goods
will be ready for shipping in one month form
the date of the loan being disbursed and
payment will be received within two months
from the date of shipment. What type of
credit facility and what is the total amount of
the advance that should be given.
*assume 1 USD = LKR 110
Viability of the Business
 Income Source
 Income Amount
 Income Consistency
 Income Continuity
◦ Sensitivity Analysis
 Cash Flow Statement & DSCR Calculation
Market & Industry Analysis
 Position of the Borrower in the market
(SWOT).
◦ The present standing of the business.
◦ The existing market share (local /Global).
◦ Competitors / barriers to entry.
◦ What differentiates the client from the rest.
 The industry outlook
◦ The government support
◦ General Industry.
◦ Identifying Sunshine industries.
Previous Track Record

 Previous Repayment Patterns.

 CRIB Reports.
 Status Reports from other banks.
 D & B for foreign parties.
 Informal Sources.
Collateral – “The most favourite word
of Credit Officers”
 Should be Liquid.
 Stability of Value & Durability
 Identification.
 Standardization
Types of Collateral

 Cash
 Government Securities
 Letter of Guarantee
 Life Insurance Policies
 Share Certificates
 Immovable Items – Land, Building & Fixed Machinery.
 Moveable Items- machinery, vehicles
 Lease Hold Rights.
 Stocks & Book Debts.
 Trust Receipts & Pledged Items.
 Promissory Notes.
 Personal & Corporate Guarantees.
Risk Mitiganats
 Inhernt/ Internal qualities of your client.
 Eg:-
 Additional Collateral.
 Excess Production Capacity.
 Experience & Contacts.
 Management & Financial Stability.
 Diverse Range of Products.
Pricing & Special Conditions
 The loan should be priced based on the
amount of Risk the bank takes.

 Special Conditions should be incorporated to

mitigate possible risks.
 Cash Build Ups.
 Periodical stock statements/ visits.

 Your Recommendations
Acceptance & Disbursement
 It is important to follow up and ensure the
completion of security soon.
 Avoid any changes that may affect your approved
proposal.
 To avoid the client from leaving you.
 Reputational Risk
 Activity 4
Retention Or litigation
 Either way swift action is required.

 This is what frames the future.

 Activity 5
Session III
Understanding the Implications of
Non-performing Assets.
 Provisioning on Profits.

 Affects the Image of the Bank Negatively:

Reputational Risk which may lead to other
risks.
Common Mnemonics
 CCCPARTS- Character, Capital, Capability,
Purpose, Amount, Repayment Terms and
Security
 PARSER – Person, Amount, Repayment,

Security, Expediency, Remuneration

CAMPARI - Character, Ability, Margin, Purpose,

Amount, Repayment , Insurance

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 What Bases your lending decision
 Evident Repayment Capacity.
 Quality Collateral.
 High Integrity or Previous Track Record

(unblemished trust)
 Pressure?

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5 C’s

 C - Character
 C - Capacity
 C - Capital
 C - Collateral
 C - Conditions

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Character
 The lender will form a subjective opinion as to
whether or not the borrower is sufficiently
trustworthy to repay the loan or generate a return
on funds invested in your company. The
educational background and experience in
business and industry of the borrower will be
reviewed. The quality of the borrowers references
and the background and experience levels of the
management and employees of the borrowers
business also will be taken into consideration.

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Capacity
 to repay is the most critical of the five factors. The
lender will want to know exactly how the
prospective borrower intends to repay the loan.
The lender will consider the cash flow from the
business, the timing of the repayment, and the
probability of successful repayment of the loan.
Payment history on existing credit relationships --
personal or commercial -- is considered an
indicator of future payment performance. Lenders
also want to know about the borrowers contingent
sources of repayment.

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Capital
 It is the money the borrower has personally
invested in the business and is an indication of how
much the borrower has at risk should the business
fail. Lenders expect borrowers to have contributed
from their own assets and to have undertaken
personal financial risk to establish the business
before asking them to commit any funding.

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Collateral
 Collateral or guarantees are additional forms of
security to be obtained from the borrower. Giving a
lender collateral means, pledge an asset of the
borrower, such as land, building, machinery etc, to
the lender with the agreement that it will be the
repayment source in case the borrower cant repay
the loan. A guarantee, on the other hand, is when a
3rd party signs a guarantee document promising to
repay the loan if the borrower can't. Lenders at
time try to secure themselves with both the above
options.

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Conditions
 It focuses on the intended purpose of the loan. Will
the money be used for working capital, additional
equipment, or inventory? The lender also will
consider the local economic climate and conditions
both within the borrowers industry and in other
industries that could affect his business.

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Supporting Documents to be in place prior to preparation
of the Credit Appraisal Report
 Credit application form duly perfected (Every
subsequent request should be followed by a written
request from the client)
 Company profile – nature of business, products,
Registration documents (form 13/20 & 40 duly certified ),
M & A , key people
 Borrowers Audited financial statements & the latest
management financials
 Declaration of facilities with other Financial institutions
 Visit Report

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Monitoring Process
Early warning signals can be identified from
 Early Management Warning Signals.
 Sales Returns ( quality issues).
 Staff Morale.
 Market & Industry Failures
 Receivable aging
 Early banking warning signals

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Early warning signals continued
 Cheque returns
 Regular Temporary accommodation requests
 Delaying repayments
 Operate over the approved limits
 Personal drawings
 Heavy reliance on short term debt
 Frequent change of business etc

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Case Study
- Session IV
Conclusion
 Lending is an art, You must understand the
need of the client and the need of the Bank
 No Risk No Profit – Your decisions should be

based on striking the balance between these

two.
 End of the day it should be a win win

situation for both the client and the bank.

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Points to Ponder….
 Collateral is only a spare wheel.

 Quality of your loan portfolio is more

important than volume of the loan portfolio.

 Lending is only the start.

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Remember
 The F/I are accountable for every cent that
is lent. The money lent is not your own!
 Never be in a hurry to lend, because a
defaulter will never be in a hurry to repay.
 The regulator is there to help & guide you.
It is your duty to support the stability of the
financial system.

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Thank You !

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