Appraisal of Term Loan

- Concepts, Process and Guidelines

V.S.Kaveri

Summary

The overall performance of Indian economy is quite impressive which is marching ahead to

achieve even a double digit figure of GDP in the near future. All sectors of the economy

namely, agriculture, industry, service and infrastructure are performing exceedingly well.

Enterprises in these sectors are planning to go in for expansion, modernization and

diversification for which demand for term loan would be substantially large. Hence, banks

perceive lot of potential to provide term loan in which credit risk is relatively high. Similarly,

deficiencies are being observed in credit decisions which have led to mega loan scandals.

Hence, it is necessary to improve the quality of appraisal of term loan on one hand and to

strengthen due diligence in credit, on the other. Towards this end, the present article guides

on appraisal of term loan by discussing both conceptual and operational aspects, besides

providing a list of items of due diligence in credit in terms of bank guidelines

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Appraisal of Term Loan

- Concepts, Process and Guidelines

V.S.Kaveri

Introduction:

Firms engaged in industrial and service related activities require funds for various purposes.

To commence business, they are expected to invest in fixed assets comprising land and

building, plant and machinery, furniture & fixtures etc. Initially, each firm requires minimum

fixed assets. Subsequently, additional plant capacity may be created for expansion or for

purchase of new plant and machinery for the purposes of modernization and diversification.

Besides, the firms require funds to finance other fixed assets also, which include goodwill,

trade mark and other non-current assets. To finance all these fixed assets, each firm raises

funds in the form of capital, subsidies and grants from the Government, retained earnings in

the case of existing firms, term loan from banks and financial institutions and loans received

from non-institutional sources such as friends and relatives etc. Grants and subsidy received

from the government are expected to supplement the capital of an entrepreneur and the same

are considered as part of long-term funds. Capital and reserves & surplus constitute owned

funds (equity or net worth). In general, term loan from banks and financial institutions is the

main source of funds for financing of fixed assets. Relatively speaking, for banks, risk in term

loan is high since repayment is expected to take place during the next 5-7 years during which

there could be many uncertainties in respect of performance of the firm, value of money,

erosion in the value of securities, integrity of the borrower etc. Hence, it calls for a detailed

appraisal of term loan not only to keep the entrepreneur happy but also to ensure a

professional approach in financial analysis and decision making and also to observe due

diligence of lending norms, policy guidelines and global best practices. This paper deals with

various aspects of term loan to fill up knowledge and skill gaps on the part of credit officers

and branch managers in banks and financial institutions.

Term lending – Conceptual Aspects

The essence of term loan appraisal is in assessing the ability of a firm to repay the principal

amount and the interest thereon from the cash surplus generated from operations by utilizing

fixed assets which are generally financed by banks. For sanctioning of the term loan by

banks, it is necessary to carry out financial appraisal carefully by using analytical tools,

observing due diligence, paying special attention to risk related aspects & working out

strategies to cover risk, adopting the global best practices and using common sense. A request

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for term loan is made both by newly set up firms as well as existing firms. Relatively

speaking, a detailed credit appraisal is needed in case of new firms in the absence of past

experience. For appraisal of term loan, it is necessary for the credit officer in a bank to have a

good understanding of ‘Project Finance’ since project / credit appraisal of the term loan is a

core component of the same.

‘Project Finance’ refers to the proposed plan of business activities of a firm and arrangements

to raise funds for meeting the project cost. This has four components: Project formulation,

Project appraisal, Project implementation and monitoring and Management of problem

projects. To elaborate, in ‘Project Formulation’, it is the primary responsibility of the

applicant-borrower to formulate a project proposal. The applicant-borrower first conceives an

idea to set up an industrial firm/business establishment and thereafter formulates a project

proposal which highlights technical, commercial, financial and managerial aspects of the

project. The preparation of a project proposal is a must which enables the credit officer to

assess feasibility of the project. The project proposal should be submitted to the bank along

with projected (A) Production and Profitability Statement, (B) Cash Flow Statement and (C)

Balance Sheet. The nature and contents of the project proposal depend upon the types of the

project which may include setting up a new firm, business expansion, modernization,

diversification, debt restructuring and rehabilitation of a sick firm etc. There is no standard

format for preparing the project proposal. However, a broad check list of items to be covered

in the project proposal may be provided to a potential borrower by the bank. Generally,

consultants are engaged in preparing the project proposal.

The next important component of project finance is Project / Credit Appraisal, which is done

by the bank. Project Appraisal covers term loan, working capital and non fund based credit

facilities. Project appraisal is expected to be done by using analytical tools, observing lending

norms, respecting due diligence of legal and other regulatory compliances and learning from

experiences of the bank in the related areas. The other component of Project Finance is

‘Project Implementation and Monitoring’ which is the job of both borrower and bank. The

process of implementation starts from the date of disbursement of term loan till the date of

commencement of commercial production. On the other hand, monitoring takes place during

the post commercial production period and is carried out till the term loan is paid back with

interest. Lastly, ‘Management of Problem Project’ is yet another task assigned to both

borrower and bank. Due to certain internal or external factors, a project may experience

problems in timely implementation which leads to cost overrun. In this regard, banks provide

debt restructuring support to make the project financially viable under Debt Restructuring

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Scheme for Small and Medium Enterprises (SMEs) or through Corporate Debt Restructuring

(CDR) mechanism. As part of debt restructuring, certain concessions are given to the firm in

the form of waiver of penal interest, reduction in the rate of interest, reschedulement of

unpaid loan installments, sanctioning additional loan despite loan default, conversion of debt

into equity (if applicable) etc. Besides debt restructuring, rehabilitation support to sick units

is also carried out. The present article focuses on the second component of Project Finance.

i.e. Project /Credit Appraisal with special reference to term loan.

Appraisal of Term Loan:

Purpose:

The main purpose of appraisal of term loan is to confirm whether funds are safe in the hands

of a potential borrower and whether the project would generate sufficient cash surplus from

operations to service the debt and repay the principal amount. For this purpose, a scrutiny of

the projected statements by using analytical tools is a must. Further, judgment has to be

exercised by the credit officer by taking a view on assumptions made in preparing the

projected statements and overall integrity and reputation of the borrower based on available

information. Thus, appraisal of term loan involves two major criterions to decide on the

borrower’s request: (A) Borrower’s Appraisal and (B) Project Appraisal

(A) Borrower’s Appraisal:

Borrower’s appraisal refers to assessment of a ‘Person’ behind the project, who may be a

proprietor, a key partner, a key promoter / director, etc. For appraisal of the borrower, several

aspects need to be looked into which may include his educational and professional

background, constitution - how often changed, management team consisting of professional

in key management areas, leadership qualities, credit history of the persons concerned;

compliance of KYC norms observed for a new borrower while opening an account, age and

physical health of the borrower etc. For appraisal of the borrower, attention should be paid to

5 Cs viz., character (intention to repay, reputation), capacity (ability to manage the

enterprise), capital (financial stake), collateral, and conditions (possibility to comply with the

laid down terms and conditions). To gather the required information for appraisal of the

borrower, it is necessary to refer to several sources of information such as loan application

form; past dealings with the bank by the borrower; credit report from other banks; report

from the supplier/customer of the borrower if it is an existing firm, report from the guarantor,

news paper - cuttings or personal enquiry in the market, study of annual report of a company.

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(B) Project / Credit Appraisal:

To decide on the request from the borrower for term loan, a detailed credit appraisal is called

for. In this regard, it is necessary to study various aspects of term lending which include: Cost

of the Project and Sources of Funds, Scrutiny of Projected Production and Profitability

Statement and Cash Flow Statement, Compliance of Lending Norms, Repayment Schedule,

Deferred Payment Guarantee, Securities, Pre-sanction Inspection, Documentation and

Disbursement, Schedule of Implementation, Post-implementation and Follow up, Cost

overrun, Terms and Conditions, Due Diligence in Credit Appraisal and Preparation of

Appraisal Note . These aspects are discussed in the following paragraphs.

Cost of the Project and Sources of Funds:

A broad list of items of cost of project and sources of finance is as under:

Cost of Project: Sources of Finance:

Land and site development Capital : equity, preference shares

Building Reserves & surplus/ internal cash accrual

Seed Capital, subsidies from the

Government

Plant & machineries Debentures

Misc. fixed assets Quasi equity/unsecured loans,

Technical know –how Public Deposits

Preliminary expenses Term loan

Pre-operative expenses Deferred payment credit from suppliers

Provision for contingencies Leasing finance

Margin for working capital Others

The capacity of the firm to mobilize resources to meet project cost depends upon the current

position of stock market / debt market, regulatory framework, promoters’ contribution in the

form of net worth (in case of existing firms) being sufficient to meet margin money for

working capital, project related expenses such as preliminary and pre-operative, R& D etc

for which bank finance is not available for future expansion. In other words, term loan from

banks is just meant for meeting the cost of fixed assets net of security margin or promoter’s

contribution. Hence, banks should ensure that the lending norm of Debt: equity ratio is

complied with, which is indicated in the bank scheme/loan policy. This ratio varies from time

to time and also from one scheme to another. But debt: equity norm needs to be fulfilled as

specified. There shall be some relaxation in compliance of the ratio in certain cases such as a

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firm being set up in a backward area; proposed activities of a firm are being in the priority list

of banks, hi-tech projects, etc. This ratio is decided by considering several factors including

the position of market, project cost, tax laws, etc. Regarding subsidies from the Government,

the borrower is expected to furnish an undertaking to the bank to bring in the equivalent of

funds and retain the same until the receipt of subsidies.

Scrutiny of Projected Production and Profitability Statement and Cash Flow

Statement:

The projected Production and Profitability Statement and Cash Flow Statement are very

important documents for term loan appraisal. The projected Production and Profitability

Statement helps in assessing (a) earning capacity of the firm (b) capacity of the firm to

amortise and service the borrowed cost (c) ability to service the share capital and (d) surplus

available for future expansion. This statement is useful to calculate break-even analysis,

Internal Rate of Return , inter-firm comparison, etc. For estimating cost of production,

several factors are examined which include: installed capacity, capacity utilization (generally

low in the first year), product mix, selling price, cost of sales (consisting of raw material

consumed including wastage, labor, repairs and maintenance, plant overheads, administrative

expenses, packing cost, sales expenses, financial expenses, depreciation etc). Banks have to

ensure that (a) all costs are covered (b) there is no over/under estimation (c)it is possible

to meet cost from the timely release of funds (d) margin is adequately available to raise

working capital finance and (e) arrangements are made to raise funds to implement the

project as per the schedule.

The projected Cash Flow Statement is prepared based on the projected Production and

Profitability Statement and Projected Balance Sheet. The Cash Flow Statement starts with

cash surplus from operations (net profit after tax plus depreciation) to which changes in

liabilities and assets (except cash) are adjusted to obtain the figure of net surplus or deficit.

When opening balance of cash is adjusted to net surplus or deficit, closing cash balance is

arrived at. This statement should be prepared for each year of the loan period. The projected

Cash Flow Statement helps in ascertaining the timing and adequacy of cash surplus, available

for servicing of loan and payment of term loan installments. This also helps in deciding the

moratorium period or repayment holiday, maturity of loan and repayment schedule.

Banks should ensure that projected production profitability statement and cash flow statement

are prepared on realistic basis. The credit officer should verify projected sales in terms of past

achievements, nature of competition, developments in market, etc. Raw material cost should

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be compared with sales value, raw material holding, prevailing prices of raw materials etc.

Regarding cost of sales, it should be ensured that factory overheads, repairs and maintenance,

offices expenses are around 5-10%, 2% and 5 to 10% sales respectively. The method of

depreciation on fixed assets should be as per the normal practice and interest on borrowing

and lease rent should be at agreed rates. Similarly, value of fixed assets should be as per the

invoices/quotations.

Compliance of Lending Norms:

The decision to sanction term loan depends upon compliance of lending norms which include

Debt: Equity (D:E)ratio, Debt Service Coverage Ratio (DSCR), Internal Rate of Return

(IRR), Sensitivity Analysis and Break Even (BE) Analysis. D:E ratio is already explained

earlier. DSCR should be calculated for each year of the loan period. Average DSCR for the

entire loan period is a guiding factor, which should be more than 1.0. But in practice, the

acceptable level is in the range of 1.5 to 2.0. If DSCR is reasonably high, the bank can reduce

the repayment period and vice-versa. Regarding IRR, it should be higher than the weighted

average cost of total funds for the firm. Normally, each bank sets a desired IRR for the

purpose of credit appraisal which is normally 2 to 3 per cent higher than cost of funds. The

IRR is widely in use for appraisal of high value advances. Both DSCR and IRR vary with

changes in certain variables such as capacity utilization, selling price per unit, sales volume,

cost of raw materials etc. In a dynamic world, these can not remain constant. Hence, it is

necessary to carry out sensitivity analysis by recalculating DSCR and IRR on conservative

basis by considering 5-10 per cent decline in the selling price or 5-10 per cent increase in

variable cost or when both to happen. Thus, sensitivity analysis is useful to assess the

financial soundness even under the adverse situations. Lastly, each firm is expected to break

even early (preferably within 6-12 months from the date of commencement of commercial

operations by SMEs and a little longer in respect of non SMEs) and also at lower plant

capacity (preferably at 50-60 percent of installed plant capacity).This would ensure the

margin of safety in terms of contribution per unit (selling price per unit less variable cost per

unit).

Repayment Schedule:

Usually, the maturity of term loan is ranging from 3-7 years. But in respect of capital

intensive project, it is still longer. The repayment period is fixed taking into the Projected

Cash Flow Statement, DSCR and IRR. If cash surplus is substantially larger, the repayment

period may be reduced. Moratorium period or initial repayment holiday (from the date of

disbursement till the due date of commencement of commercial production) may be granted

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based on cash losses (cash payments less receipts) that the firm may incur in the beginning.

However, the repayment holiday should not be too long (reasonable repayment holiday

ranges from 6 -12 months). But interest on term should be fixed on quarterly basis from the

date of disbursement of term loan. The payment of interest and loan installment starts after

the repayment holiday. The rate of interest on term loan should be as per the loan policy of

the bank.

Deferred Payment Guarantee:

This is essentially a non fund based facility granted to a borrower for availing a deferred

credit from suppliers for purchase of machinery, capital goods etc. As agreed upon, the bank

is liable to make the payment of installments to the suppliers or retire bills upon the

borrower’s default. To grant Deferred Payment Guarantee (DPG) by a bank, appraisal should

be done on the same lines of term loan.

Securities:

Term loan should be secured against hypothecation / mortgage of fixed assets. All charges

should be registered with the Registrar of Assurances and Registrar of Companies. Additional

collateral in the form of mortgage of land in the personal name of the promoters/ guarantors

may be obtained. Other forms of collateral securities shall include assets such as shares,

government securities, etc, which may be considered in this regard. Plant and Machinery

Register should be maintained by the bank.

Pre- Sanction Inspection:

To ensure the end use of funds, pre-sanction inspection is a must. In the case of existing unit,

inspection should be done at the site. The Inspection report should cover the position of

licenses/ registration formalities, arrangements for importing of machines, details of foreign

collaboration, particulars of land, position of power, time schedule for implementation of

project, likely date for carrying out trial run, progress made in the promoters’ contribution,

list of existing fixed assets etc. In this regard, banks have developed pre-sanction inspection

report format.

Documentation and Disbursement:

Prior to documentation, it should be ensured that all terms and conditions of term loan are

fulfilled. In respect of high value advances, documents prepared at the branch need to be

approved by the lawyer/law officer in the bank. No disbursement should be done unless all

documents are executed. Wherever mortgage of land and building is stipulated, the bank

should ensure the clear titles/lease rights of the property, marketability/ transferability of the

title, feasibility to comply legal requirements, absence of restrictions in the lease deed to

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create mortgage etc. Advocate’s opinion in these regards should be obtained. After the

documentation, the borrower has to deposit his contribution and thereafter, the bank should

make direct payments to the parties concerned such as builders, suppliers of plant and

machineries etc. Prior to this, the borrower has to approve the relevant bills or invoices.

Further, a letter from the borrower authorizing the bank to make payment should be also be

obtained. Photocopies of all such bills/ invoices should be kept on record.

Schedule of Implementation:

The project report should contain the time schedule for implementation of the project which

shall be supported by the PERT chart, wherever feasible. The borrower should submit a

letter of Date of Commencement of Commercial Operations (DCCO) to the bank. This

indicates various stages involved in construction work and time required. The progress in

implementation should be closely monitored by obtaining a periodical progress report and

conducting inspection at the site / factory. Banks have developed a prescribed format for

progress report and site/ factory inspection report which should be filled in periodically and

kept on record. Reasons for delay in implantation, if any, should be ascertained and

implications of the same on project cost should be ascertained.

Post Implementation Follow up:

After the project has been implemented and commercial operations begin, follow up of actual

performance of the firm is called for. Actual performance in production, sales, profits etc

should be compared with the budgeted performance on periodical basis. Banks have

developed Formats for follow up - such as Monthly Select Operations Data (MSOD),

Quarterly Information System (QIS), etc. The borrower has to fill in the formats and submit

to the bank monthly/ quarterly. These formats facilitate to monitor the progress in respect of

key performance areas such as efficiency of the plant, quality and quantity of production,

sales, position of inputs, level of current assets, orders in hand, pending bills, etc. In addition,

Factory Inspection should be carried out at least once a year and a copy of the visit report

should be kept on record. If a bridge loan is granted in lieu of the government subsidy, it

should be ensured that the same gets liquidated on receipt of the subsidy. It should also be

ensured that the firm is adhering to pollution/effluent control norms of the government.

Cost Over-run:

Cost over-run may occur due to delay in implementing the project, leading to increase in the

cost of assets purchased, adverse exchange fluctuation, hike in custom duties etc. Normally,

provision made for contingencies would meet the marginal cost over-run. The borrower is

expected to meet such cost over-run from his own resources. This should be stipulated in the

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terms and conditions. Any major cost over-run calls for a detailed analysis and, both the bank

and the borrower should work out suitable strategies to meet such cost over-run by raising

further funds.

Terms and Conditions:

Besides, standard terms and conditions as applicable to all borrowers, additional terms and

conditions may be considered for a specific borrower. For instance, wherever risk is

perceived to be high, personal guarantee of the borrower may be sought for. Bank should

have the right to inspect the applicant’s books of accounts in respect of new borrowers. The

property should be adequately insured. The borrower should furnish an undertaking to the

bank stating that no dividend would be declared if there are arrears in payment of

installments and/or interest. No withdrawal of deposits/ repayment of loans from the

associates/ friends & relatives are permitted during the currency of loan. Further, interest on

such deposits/ loans is not to exceed the rate of interest charged by the bank on term loan.

Legal and inspection charges should be borne by the borrower. In case of default of

installment/interest on due date, the bank may charge a penal interest. In case of consortium

financing, every bank shall share information of the borrower with other banks. The borrower

should also inform the bank about any change in the constitution. Additional terms and

conditions shall be considered, if necessary.

Credit Appraisal – Due Diligence

In terms of bank guidelines, it is necessary to observe due diligence for offering term loan. It

is difficult to prepare a long list of items of due diligence. But major items of due diligence in

credit my include:

- Fulfill the KYC norms for opening a savings / current account by a potential

borrower - obtain photograph, IT PAN, sales tax/excise registration number, shop

and establishment registration number, etc. of the person authorized to operate the

account.

- Give a loan application form only if found eligible under the bank scheme.

- Receive the loan application form if filled in properly and submitted along with:

Project proposal, financial statements both audited (for the last three years) and

Projected balance sheet, profit & loss account and cash flow statement, copies of

the relevant certificates; Bio-data of the promoter, etc. The project proposal

should contain the required details which should be verified carefully.

- Issue a receipt of the loan application form and record in the Loan Application

Received Register in case of proposals from small borrowers.

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- As part of credit appraisal, verify the documents such as partnership deed, certificate

of incorporation cum articles of association, resolution of the board to raise

borrowings, trust deed, certificate of registration, and verify the registered

office/business office address.

- Obtain market report of the borrower, credit report from the existing bankers, and

reference letters.

- Ascertain the details of existing borrowing arrangements with the present bank and

other banks, if any.

- Assess the financial status of associated companies, if any, and call for their latest

audited financial statements.

- Scrutinise the details of the guarantors which include their relationship with the

borrower, net worth, business activities, if any, securities to be offered, etc.

- Conduct pre-sanction inspection to verify information as furnished in the loan

application form and assess the antecedents of the promoters/guarantors. Verify the

details of the securities to be offered; proof of the residence, lease deed, sales deed,

rent agreement, etc. and obtain a search report

- Interview the applicant and record the conversation in brief.

- Prepare a credit appraisal/ process note

- Sanction credit facilities keeping in mind the lending powers and send a draft letter

of sanction to the borrower stating the required details including the terms and

conditions and obtain his/her a written consent. If decided not to sanction, state

reasons thereof. Observe the time limit set for loan sanction.

- Execute documents as per guidelines of the bank. Obtain documents properly stamped

and vetted. Create legal charge over the assets financed including collaterals.

- Disburse the loan amount as per bank guidelines. Promoters’ contribution should be

deposited first before disbursement of the amount. The amount should be disbursed

as per the progress made in construction work, procurement of capital assets etc.

- Conduct post disbursement inspection of the factory/business within a month from the

date of disbursement to ensure the end use of borrowed funds.

Preparation of Appraisal Note:

After going through the project proposal submitted by the borrower for term loan, carrying

out a detail of the borrower and his project, observing lending norms and bank guidelines and

carrying out pre sanction, it should be attempted to prepare appraisal note / process note. The

broad contents of the appraisal note/ credit process note include: the borrower’ request,

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background of the entrepreneur and project, present business activities, industry prospects;

feasibility of the project.; past performance and future projections; cost of project and sources

of funds, compliance of lending norms, etc. The note should conclude with the bank decision.

which could be ‘yes’ (with terms and conditions) or ‘no’ (with convincing reasons). If

decided to sanction the term loan, terms and conditions have to be indicated. There is no

standard format for preparing the appraisal / process note. But it should be ensured that the

note is carefully prepared covering all vital aspects of the borrower and his project.

Conclusion:

India is marching ahead to maintain as high as 10 percent GDP in the coming years since all

sectors of the economy are witnessing a good pick up in their performance. In particular,

firms in agriculture, industry, service and infrastructure sectors are planning to go in for

expansion, modernization and diversification. In this regard, banks have lot of potential to

provide term loan. But this should be done carefully because, non performing loan assets are

on the rise. Similarly, many loan scandals are being observed, calling for improving the

quality of due diligence in credit. In this backdrop, banks have to adopt a professional

approach in credit decisions since risk associated with term lending is perceived to be high.

Credit officers in banks have to sharpen their analytical tools. Besides collecting information

from the borrower, extra efforts have to be put in by the banks to strengthen their database by

collecting data from the market and other sources about borrower, performance of industry,

likely policy guidelines having impact on the performance of firms, etc. Above all, they have

to become more customer friendly by providing need based and timely finance despite having

shortage of staff and increasing work load in the banks. Thus, it is a challenge for the credit

officers in banks to ensure a good quality term lending. Towards this end, the present article

attempts to fill up knowledge and skill gaps on the part of credit officers in banks relating to

appraisal of term loan by discussing both conceptual and operational aspects.

References:

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1. Bank Lending – Principles: Theory – Practice, Hrishikesh Bhattacharya, Noya

Prokash Publication, Kolkata

2. Management Techniques of Bank Lending, A K Chatterjee, Himalaya Publishing

House

3. Bank Lending – Law and Practice Part I and Part II, Arun Chatterjee, Skylark

Publications

4. RBI Circular of August 7, 2004 on Deficiencies found in sanctioning of Loans and

Monitoring of Borrowal Accounts by Banks and Financial Institutions

5. Master Circular of RBI of July 1, 2010 on Loans and Advances- Statutory and Legal

Restrictions

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