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Know how to appraise  term loan proposals

Know how to appraise term loan proposals

(This post explains import ratios are to be examined while appraising a term loan project. The articlealso deals with how to compute break even point, how to calculate DSCR (Debt service Coverage ratio) for the period of repayment of the loan, how to arrive fixed asset coverage ratio and important financial indicators. The assessment of DPG/APG etc is done in the same method how term loan is assessed, as they are the substitution of the term loan.)

Term loan appraisal covers the appraisal of the borrower and appraisal of the project. The characteristics of a term loan are that term loan commitments are to be of long term. The banks and financial institutions normally offer term loans repayable in 10-15 years and beyond that period in  exceptional cases like housing loans. The repayment would be made out of cash generated from business activities. Appraisal of the borrower covers honesty and integrity of the borrower, standing of the borrower, business capacity, managerial competence, financial resources in relation to the size of the project. The sources of information for the above are the personal interview, credit investigation, trade circle enquiries, market report,  existing bank’s report, CIBIL report, assets and liabilities statements submitted by the borrowers, Income Tax assessment orders and wealth tax assessment orders of promoters. Reports from credit rating companies, assistance from ‘Venture Capitalists’ (ex: UTI ventures, ICICI ventures etc.) may also be obtained, RBI defaulter list, Newspapers and magazines, information from employees at the time unit inspection etc. Appraisal of project covers following details.

1.Commercial Viability of the project: Line of business, demand-supply, profit margin, imports, exports, list of important customers and suppliers, extent of competition, costing and pricing, mechanism of the product, dependence on single or few customers or suppliers, prevailing Government policies, embargo etc. are to be evaluated

2. Production Arrangement: Power, water supply, transport, infrastructure facilities like Proximity to the source of raw materials, stores and other production facilities, workforce etc. The Manager has to visit the place of the factory to see that the business exists at the address furnished and also to ascertain the infrastructure available,  the level of activity and make a preliminary report on his/her visit which includes inspection report on prime and collateral security offered.  The Manager has to familiarise with borrower’s business, form  opinion about adequate labour strength, maintenance of the factory, godown etc.
3. Technical feasibility (process should be contemporary): Proper layout of the  factory, quality of machinery, efficient disposal, availability of technical staff to run the factory.
4.Market conditions & marketing arrangements: Demand, supply, pricing etc., after the completion of project/ installation of new machinery. Names of the main buyers, names of major competitors and their total market shares.
5. Financial appraisal: Past financial statement like profit and loss accounts, balance sheets. The correlation between fixed assets and under charging of depreciation, operating loss position, contribution of other income to net profit, valuation of closing stock, borrowings and interest cost, extent of reserve created by revaluation of assets, unsecured loan shown as quasi-equity, movement of unsecured loans over the years, borrower’s stake in the business, investment in intangible assets, other non-current assets. Acceptability of projection and assumption considered for the assessment, profitability estimate, solvency ratio i.e. ability to service outside liabilities like TOL/TNW, Funded Debt/TNW etc. Liquidity position like networking capital and current ratio. Break Even Point and DSCR calculation. Repayment plan. The major problems concerning term finance is maturity mismatch, funding risk, Interest rate risk (IRR). These aspects are to be carefully looked into while fixing loan amount and repayment instalments.
6. Clearance from appropriate government agencies: Consents, approvals & environment clearance aspects.
7. Non-fund based facilities: Apart from the term loan, a project may also require non –fund based facilities like Deferred Payment Guarantee, Co-acceptance, Buyers credit etc. Assessment of non-fund based limits in such cases.
8. SWOT analysis  (Strength, Weakness, Opportunity and Threat)
9. Over invoicing in the case of term loan proposal to be guarded against.
10. Enquiries about suppliers of machinery.
11. The value of primary and collateral securities in relation to the amount of advance.
12. Balance sheets of group companies/firms to be analysed if there is an investment of more than 10% in that company by the borrower/loan applicant.
13. Debtors due from group companies/firms.

Financial Indicators:

Financial Indicators covers present and their projections. The following ratios are to be examined for actual and future projections for the period of repayment of the loan.
i. Sales & Profitability.
ii. Tangible net worth
iii. TOL/TNW ratios
iv. Debt Equity Ratio.
v. Fixed asset coverage ratio for term loan.
The benchmark for Debt Equity Ratio is 2:1 and variation can be made as under:
i. Technician oriented projects: 5:1
ii. Road Transport operator having national permit: 5:1
iii. Single vehicle operator: 5:1
iv. MSME up to term loan of Rs.10 lakhs: 3:1
v. High Tech Projects: 2.5:1
vi. Infrastructure projects: 3.5 to 4:1
vii. Large value projects exceeding Rs.500 crores: 3.5 to 4 : 1
viii. Risky ventures: 1:1
ix. Where civil construction work is high: 1.5:1

Calculation of DSCR (Debt Service Coverage Ratio):

DSCR= Net operating profit÷ Total debt service  or

DSCR =(Profit after Tax+ Depreciation+ Interest on Term Loan)÷ (Interest on Term Loan+ Installment amount of Term Loan).

The benchmark for Debt Service Coverage Ratio (DSCR) is average 2:1, Minimum 1.5:1
Sensitive Analysis: Sensitive analysis is to be done for term loan assessment by slightly changing the assumption in the project. This is done to see the impact of adverse changes in the assumption.
Break Even Point calculation: The break- even point is a point of sales of a company wherein total sales covers exactly its expenses. It means profit is zero at the  break- even point of sales. The company earns  the profit if the sales grow beyond break-even point, and it incurs loss if the sales do not reach the break-even point. The company has to meet its overhead expenses, irrespective of the volume of production and the sales. This expense is fixed and does not change proportionately to sales. Therefore it is named as fixed cost. Variable costs are those expense which changes with the level of sales. The company fixes the  price of each unit at  the wholesale rate at which it sells its product to its customers/distributors, taking into account of the manufacturing cost of the product, selling expenses and profit margin. The break-even point of sales can be calculated by the following formula if we know fixed cost, variable cost and price of the product.

Number units to be sold for Break Even point=Fixed Cost÷ (Price-Variable Costs) X =FC÷ (P-V)
wherein  P is the price of the unit,X is the number of the unit,V is the variable cost per unit, FC is the Fixed Cost.

Let us take an example of sales fixed expenses of a company is Rs.4800000, the unit price of the product is Rs.10 and variable cost is Rs.2 per unit. Now we know the formula to find out the number of units to be sold to reach BEP
X=FC÷ (P-V)= 4800000÷(10-2)=4800000÷8=600000 units.
Therefore X=600000
The company has to sell the minimum of  600000 units at a price of Rs.10 per unit to reach  the break-even point.

Assessment of DPG/APG: Assessment of DPG is done in the same method term loan is assessed, as it is a substitution of the term loan.Assessment of Advance Payment Guarantee (APG) is done in the same way for fund based limits. Since the borrower receives advance payment for the material to be supplied by him at future date, advance received should be reduced from working capital gap.

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