Banks are financing every types of advances. It may be retail, agriculture, MSME or corporate adavance. The assessment of the finance taken up by the banks is dependent upon some parameters. The finance of the bank is as per need of the customers and guidelines of the bank. Bank will sanction term loan to borrower if the business / project of the borrower is technically feasible & economically viable and bankable. The acquisition of assets for which term loan required should be need based and their estimated cost should be reasonable.
For financing term loan for an unit the has also require to do some assessment. There is various aspect of term loan appraisal which is as under:
- Qualitative Assessment
- Quantitative assessment
The aspects are further divided as follows:
Qualitative aspects:
- Management appraisal
- Technical appraisal
- Environmental appraisal
- Commercial appraisal
- b) Quantitative aspects:
- Financial Appraisal
- Debt service coverage ratio ( DSCR)
- Sensitivity analysis
- Breakeven point (BEP) analysis
The details of various qualitative appraisals are as under:
- Management Appraisal:
First and foremost assessment by a Banker is to judge the person who is behind the project and this is very crucial and most important point to be considered in lending to prospective borrowers. The promoters should have necessary technical qualifications & adequate experience in the proposed line of activity so that he will able to set up the unit / business and run it in a profitable manner. If he does not have the some knowledge about the manufacturing process and marketing of the product then he has to totally dependent upon the some external hired person or technical consultant. But in that scenario he should at least have knowledge required for sale of the product. Sometimes borrower may not have required technical qualifications or experience in the field. For example, a trader in Fast Moving Consumer Goods (FMCG) who is doing business since couple of decades having good reputation and financially sound, may go for business diversification, say propose to set up iron powder manufacturing unit by engaging services of technical consultant. Here the reputation / credentials of consultant needs to be verified by market enquires as the critical aspect in this case for success of unit will depend on the technical consultant.
- Technical appraisal
Technical appraisal is done to assess the technical feasibility of the proposed unit / business. Feasibility means possibility of setting up the unit / business. The various aspects considered in technical appraisal in case of manufacturing unit are as under:
Site Selection: The location of unit where the borrower wants to set up its manufacturing plant is the first factor for deciding the technical feasibility. The locations selected by the borrower should such that all the basic amenities are available require for manufacturing the product. Like in case of cement plant, the location may be near to limestone mines to reduce the transportation cost. In case of perishable goods the location should be near to the market. The location is such that in one way or another that it should reduce the overall cost of product and there is no interruption of manufacturing of the product.
Land: The area of the land should be sufficient for its present requirement. The area should not only adequate for its manufacturing facilities and for storage etc. but some space is there for its future expansion. One should ensure that the title of the land should be clear and land should be marketable. The proposed land should be non agriculture and approved for industrial use. The cost regarding land development should be added in the land cost.
Building: The building proposed to be constructed should have all the government approvals and approved building plan should be there. The constructed area is enough for the installation of all the machineries and its overall manufacturing but it is to be ensured no extra construction is proposed because it is going to increase the overall cost of project. As a Banker we have to ensure that in schedule of implementation first main building is constructed then any building is constructed. Sometimes it happens that borrower first constructed its office building and all its margin is used for construction of office premises and the borrower do not have margin for carrying out any other activities.
Water: Some industries require water for manufacturing activities. Then we have to ensure the arrangement for water, bore well available, approval from local authorities, Industrial Development authority etc. and storage arrangements made so that there is no problem for the availability for water.
Power & Fuel: The electricity is required for the manufacturing and other activities. The electrical power requirement and sanction letter for power from Electricity boards to be verified. If there are power cuts in the area, then arrangements for DG Sets to be ensured for smooth production. Some the unit is proposed to be set up in remote areas in that case the approval for respective electricity company and overall cost is to be included in the project cost.
The units which are required high power consumption, the unit should be located at a place where all the time power is available and reasonable cost like mini steel or aluminium plant. In case other fuel like gas etc. is used for manufacturing activities, the location of the unit should be such that there is no problem for its availability.
Labour: Due to our country population labour availability is not a problem but when skilled or semi skilled labour is required then one should ensured its availability for setting of the unit. Besides its availability, the prevailing labour wages and labour unrest is to be studied before setting up of any industrial unit.
Raw Material: When the raw material is bulky and costly for its transportation, the unit should be set up near to its source and when the product is such that the quality may deteriorate then unit should be near to the market. The borrower should ensure the sources and availability of raw material at the location in line with overall cost in other areas to make the product more competitive. Sometimes government restriction may be there for the availability of the raw material, so the borrower to obtain the approval from the respective government department.
We have to study the business model of the borrower for making the raw material availability in sufficient quantity and in competitive rates. Availability of raw material / consumables, lead time for procurement, present prices, and arrangement for raw material storage godowns etc. needs be verified.
Manufacturing Process/Technology: The method to be used for production / manufacturing technology proposed by the borrower needs to be studied thoroughly. It is easy to use conventional method for manufacturing but at the same technological advancement taken up to be studied so that manufacturing cost is reasonable and competitive.
Sometimes the customer has proposed new technology of manufacturing but when it is not sure about successful in the market then it is always risky to finance that industry.
We have also to study the knowledge of the promoter or the consultant appointed for setting up of that plant so that at the later stage it may be possible that the plant is not successful at all due to some technical fault. We have study the agreement of the contract between the company and the consultant and it is to be ensured that the consultant will help till the final product is produced. Like in paper plant when due to some alignment problem in the machineries the product is not produced as per required specifications then setting up whole the plant and machineries will be of no use or it may leads to cost run and time over run.
Plant and Machineries: The product manufacturing is different by using the alternative raw materials and alternate processes. We have to study the manufacturing process proposed by the borrower along with any other alternative method available for its feasibility. After studying the manufacturing process the proposed plant and machineries are need to be studied in line with the prices of the various machineries, suppliers and manufacturing capacity. There is should balancing of the manufacturing capacity at its manufacturing stage so that during manufacturing no machine remain idle.
The plant & machinery should be need based and all the machinery required to manufacture the product are to be included the list of plant & machinery. The comparative quotations are to be obtained to verify cost reasonableness. The suppliers of machinery should be reputed and justification to be obtained from the borrower for selection of machinery supplier and to be verified by Bank official from similar units financed and market enquires.
When the borrower has second hand machineries then residual life certificate is to be obtained from the chartered engineer along with the cost certificate of each machine.
Government Approvals and Clearance: For setting up of a unit various government approvals and clearances are required. Like non agriculture land, building plan approval etc. Besides these approvals as per manufacturing method and effluent generated during the manufacturing pollution control board permission is required. Pollution control board first gives permission consent to establish and afterwards looking the quantity and quality of effluent generated and method for its disposal, the consent to operate is given. Sometimes environmental clearance, forest department, FDA permission of Food and Drugs, explosive use permission & explosive storage permission and boiler inspector permission are required to be obtained. We have ensure to ensure the all the approvals and permission are obtained by the borrower for its smooth functioning.
- Environment Appraisal:
If effluents are generated during the process, the consent to establish / operate is to be obtained from state pollution control board. The arrangements for effluent treatment plant / effluent disposal need to be verified. If case of boiler used in manufacturing process, the permission of Boiler Inspector needs to be obtained to ensure that necessary arrangement for air pollution control are made. In case of infra- structure projects like road and power, the Forest Dept. clearance / environment clearance, mining approval etc. needs to be ensured.
- Commercial Appraisal:
The product which the borrower is going to manufacture has to be studied from various view points. Sometimes, the product is new in the market then we cannot ensure the acceptability in the market, its durability and its competiveness with the alternative products which are already available in the market. Some products are having higher obsolescence like electronic items. Sometimes the product proposed is already outdated from the market like compact disk and type writer etc. So before sanctioning any proposal the study of the product should be there.
The demand & Supply for the products manufactured, major customers, arrangements made for market promotion, selling arrangements like direct selling to customers / selling through dealers / distributors, major competitors, strength of the firm, how competition will be overcome etc. needs be verified. The threat of cheaper imports / better substitutes is to be studied. The sales projections made by the firm should be reasonable and all the supporting information / business assurance letters etc needs to obtained to assess the reasonableness of projected sales.
Financial Appraisal:
A. Cost of the Project & Means of the Finance:
The Cost of project and means of finance are obtained from the borrower. The each head of cost of project is verified with the documents and quotations submitted by the borrower and also ensure its reasonability and acceptance. He has to take some assumptions for manufacturing cost and raw material cost etc. The cost of project is to meet out from Promoters contributor and unsecured long term loans and by bank finance by ensuring DER ratio. The indicative items of cost of the project and means of the finance in case of manufacturing unit are as under.
| Cost of the Project | Means of the Finance | ||
| Particulars | Amount | Particulars | Amount |
| Land | Promoter’s contribution | ||
| Building | Unsecured loans– Long term | ||
| Plant & Machinery | Term loan from Bank | ||
| Furniture & Fixture | |||
| Technical know- how fees | |||
| Interest during construction (IDC) | |||
| Preliminary& Pre-operative expenses | |||
| Contingencies | |||
| Margin for working capital | |||
| Total | Total | ||
The contingencies are added in the cost of project to take care the cost escalation for construction of building and cost of plant and machineries etc. i.e. increase in cost of project due cost overrun. When the borrower proposed working capital from the bank, then it is ensured at the initial stage the margin for working capital is with the borrower, so it is included in the cost of project. Further, interest during construction (IDC) is normally expected to be met out of promoter’s contribution. The Debt equity ratio, Total outside liabilities / TNW should be within the bench mark as per loan policy of Bank.
B. Assessment of Term loan quantum / limit
The term loan amount is calculated by the bank after deducting promoter contribution for each of the head mentioned in the cost of project. The margin is to be maintained as per bank loan policy
| Particulars | Cost | Margin | Term loan amount (after deducting margin) |
| Land | |||
| Building | |||
| Plant & Machinery | |||
| Furniture & Fixture | |||
| Technical know- how fees | |||
| Interest during construction (IDC) | |||
| Preliminary& Pre-operative expenses | |||
| Contingencies | |||
| Margin for working capital | |||
| Total Term loan amount | |||
| Particulars | Cost | Margin | Term loan amount (after deducting margin) |
The margin requirement may differ bank to bank and as per their schemes. The minimum margin required from borrower is 25 %. The margin for some the items may be more as per bank’s policy like for building construction and for purchase of second hand machineries.
Some time margin for purchase of the land 100% depends upon bank to bank. The intangible assets alike interest during construction, Preliminary and preoperative expenses are fully funded by promoter’s own margin.
C. Assessment of Profitability Projections
The borrower has to submit the yearly sales & profitability projections for the entire repayment period. The sales projections, estimated growth in sales in each year should be justifiable and reasonable with supporting information like orders in hand/ expected market promotion activities undertaken, capacity of the unit etc. The various items of expenditure should be reasonable and should not be underestimated. The profitability projection should be compared with similar units, industry average from various data available through internet site and as per subscription taken up by the bank like with CRISIL INDUSRY RISK and ensure that the projected profitability is reasonable and achievable.
D. Assessment of the repayment capacity (Debt Service Coverage Ratio)
The obligation to meet out the repayment for interest on term loan and installment on term loan is met out by a borrower through the future cash flow generated from the unit i.e. by net profit after tax. The repayment capacity is assessed by calculating Debt Service Coverage Ratio (DSCR) as under for the entire repayment period:
| Sr. No. | Particulars | Year I | Year II | Year III | Year IV | Year V | Year VI | Year VII |
| 1 | Net Profit After Tax | |||||||
| 2 | Depreciation | |||||||
| 3 | Term loan Interest | |||||||
| 4 | Subtotal (A)
= 1+2+3 |
|||||||
| 5 | Term loan installments | |||||||
| 6 | Term loan Interest | |||||||
| 7 | Subtotal (B)
= 5+6 |
|||||||
| 8 | DSCR = (A/B) | |||||||
| 9 | Average DSCR | Total of 5/ Total of 7 | ||||||
The minimum DSCR should be 1.2 in any of the year and average DSCR should be minimum 1.5, then the project is economically viable.
Whenever if the DSCR for the initial period is less than the minimum requirement of 1.2 and for remaining period is more than the 1.2 then for initial period the installment amount of the term loan may be reduced and installment for rest of the years may be increased to meet out minimum DSCR of 1.2 and average DSCR of min. 1.5 to make the project as a Bankable project.
SENSITIVITY ANALYSIS:
Sensitivity analysis is done assuming reduction in say by 5% in selling price or increase in raw material prices by 5 % depending upon the price fluctuations in industry and working out revised profitability and DSCR. In scenario analysis, more than one parameter viz. reduction in selling price and increase in raw material price are assumed simultaneously and DSCR is worked out. The DSCR after sensitivity analysis should be more than 1.00.
BREAKEVEN POINT (BEP) ANALYSIS:
The sales level at which there is no profit or no loss the called break even sales. The Break even quantity is calculated by the following formula.
The fixed cost is the cost which remains fixed irrespective of quantity produced viz. rent, manager’s salary, interest on term loan etc. The variable cost varies directly with quantity of production viz. raw material cost, labour cost, power cost etc. Suppose a unit has capacity to manufacture 2000 units per annum, the selling price is Rs.200 per unit, variable cost is Rs.120 per unit and fixed cost is say Rs.40000 per annum. Then the break even quantity as per above formula is 500 nos. This means breakeven is at 50 % capacity utilization and BEP sales is Rs.100000. Assuming the unit produces uniform quantity in each month throughout the year, then BEP will be reached in 6 months and after that the unit will start generating the profit. Thus BEP can be used to fix the moratorium period. In this case the moratorium period can be minimum 6 months from the commencement of commercial production. The lower the BEP, it is desirable. BEP more than 65 % is considered as risky.
Conclusion:
Credit decision is very vital study. The bank needs to finance the proposal which in long run remain standard and give earning to the bank. The credit decision is dependent upon various factors like selection of the borrower, selection of sector (industry) to be finance. The success of any project is dependent upon the capacity, character and capital contributed by the borrower. We need to study the project starting from studying the borrower, the infrastructure & inputs required to set up the manufacturing unit. After thorough study of qualitative parameters and quantitative parameters, we can analysis the project for its technical feasibility and economical viability.