Appraisal and Assessment of Credit Facilities
Principles & Practices of Banking | Unit B · Chapter 23
How a banker judges a proposal and sizes the limit: the credit appraisal process and the 7 C's, credit risk rating, the four working capital assessment methods (turnover, operating cycle, Tandon MPBF, cash budget), CMA data, assessment of BG/LC limits, cost of project & means of finance, and DSCR.
📌 Why This Chapter Matters in JAIIB
Expect 4–5 questions, and this is one of the few PPB chapters with numericals. High-yield areas: the 7 C's of appraisal, the turnover method split (25% – 20% – 5% of projected turnover), Tandon's three methods of lending with the 1.17 vs 1.33 current ratios (Method III is academic only), the cash budget method's peak cash deficit rule, the CMA data forms, and the DSCR formula with the average 1.50 benchmark. Work through every illustration below — exam numericals follow the same steps.
All Key Numbers — Chapter 23 at a Glance
Credit Appraisal — Concept, Process & Validation of the Proposal
What Is Credit Appraisal?
Credit appraisal is the process by which the lender critically evaluates a loan request and assesses the creditworthiness of the borrower. Its primary objectives are the safety and liquidity of funds lent and profitability from the credit — appraisal is undertaken to ensure that a credit is GOOD. It is more than verification and validation of what the applicant submits: it measures the risk inherent in the proposal and reaches a judgment to sanction or reject.
Appraisal has changed in two dimensions: it has become credit RISK appraisal — the emphasis has shifted from subjective judgment of credit quality to appraising the risk in the proposal and whether it fits the lender's risk appetite. It is a continuous process that starts when the applicant walks into the branch and culminates in credit delivery.
The Credit Appraisal Process — 6 Steps
Validation of the Proposal
Getting ALL the facts before getting them right — and asking only for information essential for decision making (an information overload derails the appraisal). Validation involves:
- →Verifying applicant information against supporting documents — a company's incorporation, powers and management from its certificate of incorporation and memorandum/articles; financial details from its financial statements.
- →FIELD VERIFICATION — visiting the factory/office to verify the nature and level of activities, and to gauge the management skills/quality of the enterprise.
- →Verifying all required approvals and licences — both on record and on display at the premises.
- →The applicant's CAPACITY TO BORROW — authority to request the loan and legal capacity to sign the agreement (for a company, a Board resolution establishes the authority to borrow).
⚠️ Exam trap
For a company, the Board resolution — not the manager's request or the MoA alone — establishes the authority to borrow. A direct one-liner MCQ.
Credit Risk, Rating, Decision Criteria & the 7 C's
Credit Risk
Credit risk = the possibility of borrower/counterparty default. Default can occur from business failure or from the borrower's wilful actions (a question of integrity).
A default event can be triggered by external, internal, or combined factors. Internal factors: inefficient management, bad financial decisions, marketing failures, poor cash flow management and bad collections. Lenders judge management quality from the promoters' composition, the Board, the Directors' industry experience and the CEO's experience.
Earlier lenders relied on market reports; today they rely on credit reports for individuals and credit rating of companies/firms — by rating agencies and the bank's own internal rating.
Credit Risk Rating
A credit risk rating model assigns grades/marks to known risk components, each weighted by its importance, to arrive at a credit risk score. The borrower's financial standing and performance are scored; management quality, maintenance of accounts and similar non-statistical factors are also rated.
The score is evaluated against preset threshold standards/cut-off marks fixed by the bank's management.
Criteria for the Credit Decision — Three Tests
- →CREDIT RATING SCORE — the primary criterion. If the score is below the cut-off point stipulated by the bank's management, the proposal is not taken up for further processing.
- →CONCENTRATION LIMITS — sanction must not breach the bank's prescribed limits for group, industry or individual exposure.
- →CREDIT POLICY FIT — the loan purpose must fit the bank's credit policy, and the proposed activity must not be on the bank's banned or restricted list.
The proposal is rejected if it fails ANY ONE of these tests.
🧠 The 7 C's of Appraisal
They satisfy the FOUR cardinal parameters of lending: (a) evaluating creditworthiness, (b) considering the purpose, (c) verifying cash flows and source of repayment, (d) assessing security/collateral.
Creditworthiness
For individuals (personal/home loans): credit history from Credit Information Companies like CIBIL, plus due diligence and market enquiries into character and capacity. For partnerships and companies: financial soundness from financial statements. Cross-verification through discrete enquiries/searches in CERSAI records, ROC, RBI defaulters' list, CRILC, etc. Because of NPA norms, appraisal increasingly focuses on REPAYMENT CAPACITY, which depends on the borrower's cash-generating ability. Financial condition: income and net worth for individuals; analysed past financial statements for businesses.
Purpose (Conditions of the loan)
Business loans: capital investment (land/building, plant & machinery) at the start-up/expansion stage needs LONG-TERM funds; running the business (raw material, labour, working expenses, credit to buyers) needs WORKING CAPITAL. The banker must be convinced the customer has a well-defined purpose and a serious intention to be in business — building a business to grow it is strategy; starting one merely because others succeeded is speculative. Individuals borrow for life-stage expenditure, housing, and consumer durables/lifestyle goods repaid from future earnings.
Security / Collateral
Collateral does NOT add to the financial viability of a proposal and does not affect the quality of the credit — but it has a definite place once default occurs: it is an EXIT OPTION for recovery through enforcement. Relevant factors: enforceability, age, condition, degree of specialisation of the assets, and technological obsolescence. Legal delays make enforceability a real concern.
Cash Flow
The key question of any loan application: can the business generate enough cash to repay? Firms have limited sources of repayment — cash flow from sales/other income, sale or liquidation of assets, or fresh borrowing/capital. Lenders prefer repayment from OPERATIONS (sales-oriented cash). If a large share of inflows comes from selling assets (investing) or fresh debt (financing), future cash generation is doubtful and the loan is riskier. Fresh capital infusion is normally insisted upon at the time of reworking terms — it signals difficulties. For individuals, the source must be regular income (salary, professional earnings, rent, interest) tested for adequacy and sustainability.
Methods of Assessment — Loan Categories
Commercial loans (including long-repayment project loans) need specialised skills and are handled by specialised branches/teams at nodal points. Retail loans are standardised and technology-driven (large volume, small ticket size) — standardised application forms, terms, documentation and computerised processing. Assessment differs by purpose:
A. Business enterprises
(i) Working capital purposes; (ii) Capital expenditure
B. Individuals
(i) Vehicles / consumer durables; (ii) Housing purposes
Working Capital — Concepts, Components & the Operating Cycle
Fixed Capital vs Working Capital
Business capital falls in two categories: fixed capital — blocked on a permanent basis in land, plant & machinery, building, furniture; and working capital — funds for short-term purposes (raw material, wages, day-to-day expenses). Working capital is the total circulating funds for continuous operations of a going concern: funds used in production are recouped from sale of final products and re-used in the next cycle — hence also called operating capital or short-term capital.
Gross Working Capital
Capital invested in TOTAL current assets (tangible movable assets recoverable in cash/sold/consumed within the operating cycle, usually ≤ 1 year). A financial / going-concern concept. Merits: provides the correct amount of WC at the right time; tells management the amount invested in total current assets.
Net Working Capital (NWC)
Current assets − current liabilities: the liquid surplus, i.e. the excess of LONG-TERM funds over long-term uses. An ACCOUNTING concept — qualitative, indicating ability to meet operating expenses and short-term liabilities. Positive when CA > CL; the CA:CL ratio should be higher than 1:1 for sufficient liquidity.
⚠️ Exam trap
Gross WC = financial/going-concern concept; Net WC = accounting concept. NWC = current assets − current liabilities (Check Your Progress Q2 tests exactly this).
Components & Influencing Factors
Working capital is not static — it changes with company size, phase of operations, retained profits and other factors. Banks extend NEED-BASED finance (fund the gap): just adequate leaves little scope for diversion/misuse; inadequate finance causes production problems and eventually sickness. Factors influencing the need: nature of business, size of business, production policy, seasonal variations, and the operating cycle.
The Operating / Working Capital Cycle
The duration from purchase of raw materials → production → finished goods → sales → sales realisation is the period for which working capital is required; once proceeds are received the money funds the next cycle. Time gaps at every stage (ordering lead time, process time, despatch, payment processing, transit, credit period) force stock-holding at each stage.
Computation of Operating Cycle Components (360-day year)
| Component | Formula | Where |
|---|---|---|
| RM storage period | Average stock of RM ÷ Average daily RM consumption | Average stock = (opening + closing RM stock) ÷ 2; daily consumption = annual RM consumption ÷ 360 |
| WIP conversion period | Average stock of WIP ÷ Average daily cost of production | Cost of production = opening WIP + annual RM consumption + manufacturing expenses − closing WIP |
| FG storage period | Average stock of FG ÷ Average daily cost of sales | Cost of sales = opening FG + cost of production + excise duty + selling & distribution + general admin + finance costs − closing FG |
| Average collection period | Average sundry debtors ÷ Average daily credit sales | Average debtors = (opening + closing receivables) ÷ 2; daily credit sales = annual credit sales ÷ 360 |
| Average payment period | Average sundry creditors ÷ Average daily credit purchases | Average creditors = (opening + closing creditors) ÷ 2; daily credit purchases = annual credit purchases ÷ 360 |
Net operating cycle = RM period + WIP period + FG period + collection period − average payment period (credit enjoyed from suppliers shortens the cycle).
Assessment of Working Capital — The Four Methods
The Frame
If the overall appraisal is satisfactory, the bank finances only the residual gap in the customer's resources after all other sources. Banks are free to evolve their own systems within prudential guidelines and exposure norms; Boards lay down transparent policy per category of activity. Four methods: (i) Turnover, (ii) Operating Cycle, (iii) MPBF (projected net working capital), (iv) Cash Budget. All require projected financial statements, projected funds flow statements and projected cash flow statements/cash budgets, preceded by a detailed appraisal of past and future viability.
Method 1 — Turnover Method
25%
of projected annual turnover = working capital requirement
20%
of projected annual turnover = bank finance (four-fifths of the requirement)
5%
of projected annual turnover = borrower's margin (one-fifth, i.e. 20% OF THE REQUIREMENT)
Applies to MSE units with working capital limits up to ₹5 crore from the banking system — finance computed at 20% of projected annual turnover. The underlying premise: an operating cycle of 3 months (turnover ÷ 4 = 25%). If the actual cycle is significantly longer or shorter, the requirement is determined from the actual cycle duration instead. Limits are fixed by this assessment, but actual drawings depend on drawing power — current assets (stock and debtors) less the security margins.
💡 Illustration 1 — M/s ABC (moulded plastic goods)
FY 2021-22 turnover ₹80 lakh; targeted growth 25% → projected turnover ₹100 lakh.
WC requirement = 25% × 100 = ₹25 lakh; bank finance = 4/5 × 25 = ₹20 lakh (= 20% of turnover); borrower's margin = 1/5 × 25 = ₹5 lakh (= 5% of turnover).
💡 Illustration 2 — M/s PQR (toys) — when NWC falls short
Projected turnover ₹120 lakh → WC required = ₹30 lakh; minimum margin = 20% of 30 = ₹6 lakh; maximum bank borrowing = 80% of 30 = ₹24 lakh. Available NWC is only ₹5 lakh — ₹1 lakh short of the required margin — so the borrower must bring in the shortfall from long-term sources.
Method 2 — Operating Cycle Method
💡 Illustration — M/s ABC (ready-made garments)
RM procurement 30 days + conversion 15 + FG holding 15 + collection 30 = 90-day cycle → 360 ÷ 90 = 4 cycles a year. Annual operating expenses ₹60 lakh (turnover ₹70 lakh) → WC requirement = 60 ÷ 4 = ₹15 lakh. Note: the computation uses operating EXPENSES, not turnover.
SME borrowers often struggle to collect dues, particularly from corporates. Banks therefore adopt these relieving practices when assessing receivables finance:
- →Creditors are NOT set off against stock while assessing the requirement.
- →Only debtors outstanding up to a specified period — 180 days maximum — are considered.
- →The borrower submits age-wise lists of sundry creditors and debtors along with the stock statement.
- →Total creditors are netted from total eligible debtors: if creditors exceed debtors, the excess is deducted from the value of stocks; if debtors exceed creditors, the surplus debtors are considered for financing.
Method 3 — Maximum Permissible Bank Finance (Tandon Committee)
RBI constituted a Working Group in July 1974 under Shri P. L. Tandon (then Chairman of PNB) to improve delivery of industrial credit based on performance and projections rather than security. Key recommendations: discourage accumulation of excess current assets (lean inventories and receivables); suggested maximum inventory/receivable levels (norms) — e.g. finished goods in terms of monthly cost of sales, receivables in terms of monthly gross sales; and the concept of MPBF. Today RBI does not prescribe detailed norms, and the CA/CL classification is left to banks.
| Method of lending | Borrower's contribution (from long-term funds) | Current ratio | Notes |
|---|---|---|---|
| First Method | Minimum 25% of the WORKING CAPITAL GAP; bank finances max 75% of the gap | 1.17 : 1 | Considered suitable for new units of first-time entrepreneurs and as support for sick/weak units |
| Second Method | Minimum 25% of TOTAL CURRENT ASSETS; total liabilities incl. bank finance never exceed 75% of gross CA | 1.33 : 1 | Excess borrowing is segregated as a WORKING CAPITAL TERM LOAN repayable in instalments (bank may charge higher interest to induce repayment) |
| Third Method | Entire CORE CURRENT ASSETS (absolute minimum RM/process stock/FG/stores for continuity of production) + 25% of the balance current assets | — | NOT accepted for implementation — of academic interest only |
💡 Illustration (memorise these steps) — CL other than bank borrowings ₹150, bank borrowings ₹200, total current assets ₹370 (all ₹ lakh)
First Method: WC gap = 370 − 150 = 220; less 25% of gap = 55; MPBF = 165; excess borrowing = 200 − 165 = 35; current ratio 1.17.
Second Method: less 25% of total CA = 92 → balance 278; less OCL 150; MPBF = 128; excess borrowing = 200 − 128 = 72; current ratio 1.33.
Third Method (core CA = 95): balance CA = 275; less OCL 150 and 25% of balance CA 69; MPBF = 56.
Excess borrowing is funded through long-term sources / carved out as a WCTL.
⚠️ Exam traps
Method I take 25% of the GAP; Method II takes 25% of TOTAL current assets — Method II always yields the lower MPBF. And the Third Method was never implemented — if asked which method is "academic only", that is the answer.
CMA (Credit Monitoring Arrangement) Data — The Six Forms
Form I — Existing/proposed limits from the banking system
Existing credit from the entire banking system and term loans from institutions; max/min utilisation over the last 12 months and current outstandings. Checks: adequate utilisation, overdrawings, and BILL CULTURE — borrowers with aggregate fund-based limits of ₹5 crore and above: book-debt limits not more than 75% of limits, and 25% of aggregate limits for inland credit sales via bills.
Form II — Operating statement
Break-up of the P&L: gross/net sales, raw material cost, power & fuel, direct labour, depreciation, SG&A, interest, operating and net profit. Checks: reasonableness of projected turnover vs installed/licensed capacity, realistic trend analysis, impact of modernisation/expansion, valuation of inputs at current ruling prices, adequacy of depreciation, trend in operating profits.
Form III — Analysis of balance sheet
Two years' actuals + current-year estimates + next-year projections of CL, term liabilities, net worth, CA, fixed assets etc. Checks: proper CA/CL classification per RBI guidelines, conformity of inventory/receivable levels with norms, projected stock of SPARES not exceeding 12 months (imported) / 9 months (indigenous) consumption — beyond that treated as non-current assets; inter-corporate investments; provisions for taxes/dividends; write-off of intangibles; trends in net worth and NWC; statutory reserves such as Debenture Redemption Reserve.
Form IV — Comparative statement of CA and CL
All current assets and liabilities at one place, with inventory, receivables and creditors shown in absolute amounts AND in months (in brackets) for comparison with norms/past trends.
Form V — Computation of MPBF
MPBF calculated from the Form IV details to arrive at the credit limits. Checks include treatment of export bills (excluded from total sales/receivables where separately financed).
Form VI — Funds flow statement
How short- and long-term funds are used. Checks: adequacy of long-term sources over long-term uses (surplus = NWC margin); if long-term funds < long-term uses, SHORT-TERM FUNDS ARE BEING DIVERTED; inventory growth disproportionate to sales; matching of rise in short-term borrowing with rise in current assets.
Form VII (total cost of project and sources of finance) is obtained only when there is a term loan request. Banks also obtain formats for salient financial indicators and additional data.
Method 4 — Cash Budget Method
Most banks adopt the cash budget system for borrowers with fund-based limits in excess of ₹10 crore. It presupposes satisfactory internal MIS commensurate with the level of operations, a finance professional and a computerised environment — cash-flow-based lending is popular in developed countries.
A cash budget is a statement of cash receipts and payments — distinct from a cash flow statement (which covers cash AND non-cash funds and is historical; the budget is a projection and deals with cash only). It substitutes the operating cycle method. Transactions fall in four categories: business operations, non-business operations, cash flow from capital accounts, and sundry items — only the BUSINESS OPERATIONS statement is relevant for working capital.
The rule: the PEAK CASH DEFICIT in the projected cash budget is the total working capital finance to be provided (subject to chargeable assets). The borrower's contribution (NWC) should be at least 25% of the peak deficit, worked out from CA/CL at the peak-deficit period. Actual drawings are allowed to the extent of the MONTHLY cash deficit.
💡 Illustration — M/s ABC, 3-month cash budget (₹ lakh)
Month 1: receipts 13, payments 14 → deficit 1; opening cash 3 → closing 2. Month 2: receipts 10, payments 15 → deficit 5; closing balance −3. Month 3: receipts 15, payments 13 → surplus 2; closing −1.
Peak deficit is Month 2: cash deficit = 15 − 10 = 5; less NWC at month-end = 1 → net cash deficit financed by the bank = ₹4 lakh.
Situations where cash budgets are essential: opening letters of credit, bill financing, ad hoc working capital, construction activities, seasonal industries, tea/coffee/rubber plantations, sugar manufacturing, software development, cardamom processing, rice milling, etc.
✅ Advantages of the cash budget system
The customer plans cash requirements in advance (and can seek alternative sources in time if the bank cannot sanction more); the banker stays in close touch and can spot danger signals quickly and initiate corrective action; and the banker can plan resources to meet credit demands. (Check Your Progress Q5: all of the above.)
Assessment of Non-Fund Based Facilities (BG & LC)
Bank Guarantee Limits
A BG limit operates like a cash credit/overdraft limit — the customer operates within it, subject to yearly review. Guarantees must be classified into financial and performance guarantees, and the limit is built by assessing every purpose for which the borrower needs guarantees:
Permanent guarantees
Outstanding as long as the unit operates — e.g. favouring the State Electricity Board in lieu of security deposit (amount linked to connected load and power utilisation).
Business activity related guarantees
Linked to the main business activity — e.g. to an export promotion council for release of garment export quota, related to the quota value and proposed exports.
Guarantees for tax liabilities
Favouring Excise / Income-Tax authorities against DISPUTED liabilities — based on the disputed amount and departmental demand.
Guarantees for import of capital goods
For concessional-duty imports under Government schemes — determined case by case.
Guarantees for advance payments
In lieu of advances received from purchasers — proportional to outstanding advances, which depend on the level of sales.
💡 Illustration — PQR Ltd (government bridge-fabrication contracts), ₹ lakh
| Purpose | Basis | Amount |
|---|---|---|
| Security deposit for electricity | 2 months' supply × ₹10 lakh/month | 20 |
| Bid bond guarantees | 1% of tenders worth ₹10,000 | 100 |
| Advance payment guarantees | Expected receipts on running contracts | 2,000 |
| Retention money guarantees | 5% of completed projects worth ₹2,500 | 125 |
| Performance guarantees | 20% of expected awards: 10,000 × 3/5 = 6,000 | 1,200 |
| Import of 5 hydro platforms | 5 × ₹10 lakh | 50 |
| GST claims disputed with CBIC | Disputed amount | 20 |
| Fresh guarantees required (a–g) | 3,515 | |
| Present outstanding guarantees | 8,000 | |
| Less: expected cancellations | 3,000 | |
| Balance current guarantees | 5,000 | |
| Total guarantee limit | 5,000 + 3,515 | 8,515 |
Sanction terms protect the bank against crystallisation of the liability on the customer's default — including registration of charge with the ROC where the customer is a corporate.
Letter of Credit Limits
An L/C is a written but CONDITIONAL undertaking by the issuing bank, on behalf of its customer, to pay the beneficiary the stated amount provided the specified documents are presented in strict conformity with the credit's terms. Payment terms may be DP (documents against payment) or DA (documents against acceptance) depending on cash vs credit purchase. The L/C cycle = time for advising the credit + time for shipment/transit + the usance (credit) period.
LC limit = Annual raw material purchases on credit ÷ Number of L/C cycles in the year (360 ÷ cycle days)
💡 Illustration — PQR Ltd
Projected RM consumption ₹3,600 lakh; RM purchases on credit ₹2,400 lakh. Advising 10 days + shipment/transit 20 days + usance 30 days = 60-day cycle → 360 ÷ 60 = 6 cycles a year. LC limit = 2,400 ÷ 6 = ₹400 lakh. The usance period reckoned is the credit period agreed with the beneficiary or the period used in the MPBF computation, whichever is LESS.
⚠️ Exam trap — double financing
Stocks procured under L/C are taken under hypothecation but EXCLUDED from the stock value for computing drawing power on the funded limits — otherwise the same stocks would be financed twice. Capital goods bought under L/C are also covered by the hypothecation charge.
Assessment of Term Loans — Project Cost, Means of Finance & DSCR
The Frame
Term loans finance acquisition of capital assets (land, building, plant & machinery, modernisation, renovation) — either a full project or a standalone asset. Repayment comes from FUTURE EARNINGS (cash surplus of the business), unlike working capital which is paid out of sales realisation from operating stocks; instalments typically run 3–10 years, so credit risk is greater than in working capital finance. A new project needs assessment of project cost and means of finance; a standalone asset needs its acquisition cost — in both cases the future cash surplus available for interest and instalments must be assessed.
Cost of Project — Items and What the Appraiser Checks
Land & site development
Basic cost + leasehold premium/conveyance + levelling & development + approach/internal roads + compound wall & gates + tube wells. Varies hugely by location (urban vs rural).
Buildings
Factory, administrative, godown, canteen, guest house, staff quarters, silos, garages etc. — estimates based on plinth area and rates; plan layout approved by competent authority.
Plant & machinery
Usually the LARGEST component: FOB value of imported machinery + shipping, freight & insurance + import duty + clearing, loading/unloading & transportation. Based on latest quotations from reputed suppliers, adjusted for escalation.
Technical know-how & engineering fees
Consultants/collaborators for project report, technology choice, machinery selection, detailed engineering. Note: annually payable ROYALTY (typically a % of sales) is an OPERATING expense, not project cost.
Foreign technicians / training
Expenses for foreign technicians in India and training Indian technicians abroad — part of project cost.
Miscellaneous fixed assets
Furniture & fittings, electrical fittings, laboratory/workshop equipment, effluent treatment plants, firefighting equipment — assessed with quotations.
Preliminary & pre-operative expenses
Preliminary = before formation; pre-operative = between formation and commercial production (underwriting commission, brokerage, fees, advertising, listing fees, stamp duty). NOT funded by banks — met from the entrepreneur's own sources. Check whether interest during construction is included.
Contingencies
Divide items into FIRM (already acquired/arranged) and NON-FIRM. Provision: 5–10% of non-firm cost items if implementation is under 1 year; ADD 5% for every additional year.
Margin for working capital
Part of project cost — funded from long-term sources (it is the NWC in the system). Institutions may block a portion of the loan equal to the WC margin, releasing it on project completion, to prevent a working capital crisis at commissioning.
Initial cash losses
Most projects incur cash losses in initial years; promoters typically do not disclose them to make the project look attractive — the appraiser must provide for them.
Sources (Means) of Finance
Share capital
Equity or preference capital.
Term loans
From banks/FIs — rupee loans for land, building, civil works, indigenous machinery; FOREIGN CURRENCY loans for import of equipment and technical know-how.
Debentures
Convertible (to equity per pre-fixed conversion rates) or non-convertible (fixed rate, maturity typically 5–9 years).
Deferred credits
Offered by suppliers of plant & machinery — payment spread over time per terms.
Incentive sources
Government support: seed capital assistance, capital subsidy, tax deferment/exemption (e.g. GST) for a period.
Miscellaneous
Unsecured loans, public deposits, leasing and hire-purchase finance.
Equity vs debt is regulated by the debt-equity norm / promoters' contribution stipulated by institutions (typically around 2:1), with SEBI and other regulatory approvals where funds are raised from the public.
💡 Illustration — XYZ Ltd (plastic moulded goods), margins per asset head (₹ lakh)
Land 200 (margin 100% — banks do not fund land); site development/building/civil works 250 (margin 50% → bank 125); plant & machinery 300 (margin 25% → bank 225); miscellaneous assets 50 (margin 40% → bank 30); electrical fittings 40 (margin 50% → bank 20); preliminary & pre-operative 80, contingencies 50 and working capital margin 250 (all 100% margin — from own sources). Total project cost ₹1,220 lakh; bank term loans = 125 + 225 + 30 + 20 = ₹400 lakh. The balance comes from equity (share capital ₹350), capital subsidy (10% of eligible fixed assets, reckoned as equity), long-term funds reckoned as equity, and unsecured loans/public deposits — structured to hold the debt-equity ratio at 2:1.
Assessing Viability & Debt Servicing Capacity — DSCR
Profitability projections are prepared for the ENTIRE TENOR of the term loan (for working capital, next-year projections suffice) — from installed capacity, shifts/working days, capacity utilisation, product mix, input/output quantities and prices, labour, overheads, packing, selling and financial expenses, depreciation, income tax and inflation. From the profit statement, parameters such as profit margin on sales, net profit margin and CASH PROFIT (PAT + depreciation + provisions) are worked out.
DSCR = (Profit after tax + Depreciation + Provisions + Interest on term loan)
÷ (Interest on term loan + Instalments of term loan)
DSCR indicates the ability to service term liabilities — whether interest and instalments can be paid out of internal generation. It is computed for each year of the repayment period; an average DSCR of 1.50 is considered reasonable — the margin of safety the lender looks for. Lower payment obligations → higher DSCR.
💡 Illustration — ABC Ltd (electric fans), 7-year projections
Three term loans (P&M ₹500 lakh/50 months, building ₹420 lakh/84 months, misc assets ₹72 lakh/36 months). Year-wise DSCR works out to 1.2, 1.6, 1.7, 2.0, 4.2, 6.2, 6.7 — overall ≈ 2.3. Year 1 is below the desired 1.5 (but above 1, leaving some cushion). Options: allow a moratorium / reduce the first-year instalment (raising Year-1 DSCR), and since later years are very comfortable, there is scope to accelerate repayment — always keeping the AVERAGE DSCR over the tenor in view.
⚠️ Exam trap — what goes in DSCR
Numerator = cash accruals (PAT + depreciation + provisions) PLUS term-loan interest; denominator = term-loan interest + instalments. Working-capital interest is already an operating expense inside PAT — it does not enter the denominator. The book's benchmark is an average DSCR of 1.50.
Check Your Progress — Answers Explained
Q1 — (a) Default of repayment by a borrower
Credit risk in lending = the possibility of borrower/counterparty default — from business failure or wilful action. SLR maintenance is a regulatory obligation, not credit risk.
Q2 — (a) Current assets − Current liabilities
Net working capital is the liquid surplus — the excess of long-term funds over long-term uses.
Q3 — (d) All of the above
Working capital is sourced from trade credits, unsecured loans and deposits, bank borrowings, advance payments, and net working capital brought from long-term funds.
Q4 — (d) All of the above
Term loans are payable over one to ten years, repaid in instalments, and utilised for acquisition of fixed assets — all three statements hold.
Q5 — (d) All of the above
Cash budget advantages: the borrower plans cash requirements in advance, the banker spots danger signals quickly, and the banker can plan resources to meet credit demands.
✅ Exam Strategy — Chapter 23 (Credit Appraisal & Assessment)
- 1.Credit appraisal ensures a credit is GOOD — it measures the risk in the proposal; emphasis has shifted to credit RISK appraisal against the lender's risk appetite.
- 2.Six process steps: identification/verification → business assessment → credit requirement → due diligence → exposure/scheme selection → terms & conditions.
- 3.Validation: verify documents, FIELD VERIFICATION, approvals/licences, and capacity to borrow (Board resolution for a company).
- 4.Decision tests (fail any one = rejection): rating score vs cut-off, concentration limits (group/industry/individual), credit policy & banned list.
- 5.7 C's: Creditworthiness, Character, Capacity, Capital, Collateral, Conditions, Cash flows — satisfying 4 cardinal parameters of lending.
- 6.Collateral does NOT add to viability — it is only an EXIT OPTION after default.
- 7.Preferred repayment source = cash flow from OPERATIONS, not asset sales or fresh borrowing.
- 8.Gross WC = total current assets (financial concept); Net WC = CA − CL (accounting concept), the excess of long-term funds over long-term uses.
- 9.Operating cycle components use a 360-day year; net cycle deducts the average PAYMENT period.
- 10.Turnover method (MSE limits up to ₹5 crore): 25% requirement – 20% bank finance – 5% margin of PROJECTED turnover; premise = 3-month operating cycle; drawings still governed by drawing power.
- 11.Operating cycle method: WC = annual operating EXPENSES ÷ cycles per year. SME receivables: only debtors up to 180 days; creditors netted against eligible debtors, excess creditors cut from stock.
- 12.Tandon (July 1974, P.L. Tandon of PNB): Method I = 75% of WC gap (CR 1.17); Method II = 75% of CA − OCL (CR 1.33); Method III (core CA fully long-term funded) never implemented.
- 13.Excess borrowing over MPBF is carved out as a Working Capital Term Loan, possibly at higher interest.
- 14.CMA forms: I limits (bill culture: ≥₹5 cr limits → book debts ≤75%, 25% by bills), II operating statement, III balance sheet (spares ≤12/9 months imported/indigenous), IV CA-CL comparison (levels in months), V MPBF, VI funds flow (long-term sources < uses = DIVERSION). Form VII only with a term loan request.
- 15.Cash budget method: fund-based limits > ₹10 crore; limit = PEAK cash deficit; NWC ≥ 25% of peak deficit; drawings per monthly deficit; used for construction, seasonal industries, plantations, sugar, software.
- 16.BG limit = balance current guarantees (outstanding − expected cancellations) + fresh requirements, purpose by purpose (permanent, activity-related, tax, imports, advance payment).
- 17.LC limit = credit purchases ÷ cycles per year; cycle = advising + shipment/transit + usance (usance capped at the MPBF credit period if lower). LC stocks are hypothecated but EXCLUDED from drawing power.
- 18.Term loans: repay from FUTURE EARNINGS over 3–10 years — higher credit risk than working capital. Banks do not fund land or preliminary/pre-operative expenses; WC margin and initial cash losses are part of project cost.
- 19.Contingency provision: 5–10% of NON-FIRM costs (< 1 year implementation) + 5% per additional year.
- 20.DSCR = (PAT + depreciation + provisions + TL interest) ÷ (TL interest + instalments); computed yearly; AVERAGE 1.50 is reasonable. Low early-year DSCR → moratorium/reduced instalments; high later DSCR → scope to accelerate.
Put Theory into Practice — Credit Desk Tools
DSCR Calculator
Compute year-wise Debt Service Coverage Ratio from projected cash accruals and debt service — the key term-loan viability metric from this chapter.
Working Capital (MPBF)
Calculate MPBF using Tandon Method I, II, or the Nayak Turnover Method — the three assessment methods you just studied.
Credit Proposal Template
Free banker-grade Excel with all 9 sections of a credit proposal pre-built — DSCR, D/E, EBITDA, CMA data and more, auto-calculated.
Discussion
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