Case study on Term Loan Appraisal

A new manufacturing unit wants a term loan – How will

bank appraise it?

What will Bank look at ?

Credit Worthiness

Characterstics of the borrower

Repayment capacity of the

borrower

Willingness to repay

Management talents

Ability i.e. Results of economic activities

3 stages of any new business

Project Implementation Gestation Period Earning Profits

3 stages of any new businessStage 1: Project Implementation

ProjectImplementation

This is the period when no cash is generated from the operations. During this period the movement of money is only from bank to the borrower. The Borrower is busy in setting the project

3 stages of any new business Stage 2: Gestation Period

Gestation Period

The unit comes into operation and starts generating cash but takes time to reach the break-even point.

Interest is accrued during this period to include it into the cost of product.

No money movement takes place between the borrower and the bank (Moratorium Period)

3 stages of any new business Stage 3: Earning Profits

Earning Profits

This is the stage when enough cash flows are expected to be generated from the business to meet the instalments (including interest and principle).

The cash-flows should be at least 1.5 times the instalments amount.

At this stage the movement of money is from borrower to bank.

Evaluation of a Business

Economic Evaluation

The demand of the product is evaluated. There should be a demand-supply gap, price advantage, timing and other such benefits.

The prime attention is that the project should survive the three stages of the business (implementation, gestation and operations).

Economic EvaluationThe bank prefers lending into sector where there is a Major gap

between the supply and current demand.E.g.:Where a manufacturer of tables needs a loan:1) Demand = 10,000 Units

Supply = 12,000 UnitsNew Project = 2,000 Units

2) Demand = 10,000 UnitsCurrent Supply = 8,000 UnitsNew Project = 2,000 Units

3) Demand = 10,000 UnitsCurrent Supply = 2,000 UnitsNew Project = 2,000 Units

The market already has enough supply(prices might also fall).

Enough demand and supply gap.

Large gap, thus the product has a wide market.

Economic EvaluationCase Study #1:A company specialising in plastic engineered goods

wants to setup a plant for manufacturing large computer keyboards (back in 90’s) seeing the large market demand.

Economic EvaluationCase Study #1:A company specialising in plastic engineered goods

wants to setup a plant for manufacturing large computer keyboards (back in 90’s) seeing the large market demand.

Banks rejects it as it was found that the new types of keyboard were soon to be introduced with new additional features.

The survival of the project throughout the loan period was doubtful.

Economic EvaluationCase Study #2:A person wants to set up a mini cement plant in the

local area. However UltraTech, Ambuja etc rule the current market.

Economic EvaluationCase Study #2:A person wants to set up a mini cement plant in the

local area. However large cement plant like UltraTech, Ambuja etc rule the current market.

Cement plants are basically of three sizes, Ultra, Mega and Mini Cement Plant. The Ultra Projects have lower fixed costs per tonne but higher transportation costs.

The mini plants though higher on fixed costs have the benefit of low transport costs, thus if there is potential of cement market within 100 kilometres, then the project is economically viable.

Management EvaluationCase Study #1:A “Lalaji” from Varansi (with enough land there),

seeing the rise in IT Industry, too wants to start a new IT Company.

Management EvaluationCase Study #1:A “Lalaji” from Varansi, UP (with enough land

there), seeing the rise in IT Industry wants to start a new IT Company.

Bank might rate him good with the entrepreneur skills but rate him very low for the lack of experience in the business.

Management EvaluationCase Study #1:A “Lalaji” from Varansi, UP (with enough land

there), seeing the rise in IT Industry, too wants to start a new IT Company.

He still enthusiastic about the IT business and hires 2 IT professional (both from big Large IT companies)

Management EvaluationCase Study #1:

A “Lalaji” from Varansi, UP (with enough land there), seeing the rise in IT Industry, too wants to start a new IT Company.

“He is still enthusiastic about the IT business and hires 2 IT professional (both from big Large IT companies)

Bank still are skeptical since the main promoter is not aware of the business, however he is dependent totally on the these IT professionals. There is always a risk of these professionals leaving Lalaji’s company.

Bank needs to have safety and surety of survival throughout the three periods i.e. survival of the business

Management Evaluation

• Thus the “promoters” MUST be in the core of the business.

• Good Collaterals are often taken as enough security to skip any other evaluation.

• However a term loan is a loan where the instalments are to be paid by earning from the assets (not from selling the assets – though bank can always do so) so earning potential of business is always given prime importance.

Technical Evaluation

Technical Evaluation is closely linked to the Economic and Managerial Evaluation. The technical competencies of the Management and technicalities are evaluated in economic specifications.

These ensure the technical feasibility of a project as to whether a particular capacity machine is available in market or not and all other such technical evaluations.

Financial Evaluation

This is the ultimate part of the evaluation process where all the things are summed up in terms of money.

The cash flows are estimated, the instalments periods are fixed, the interest rate is computed and the project is made bankable.

Cash Flow StructureCash from Operations:

Profit generated by the production & sales of goods and services

+/- Adjustments for the expansion and tightening of working assets+/- Adjustments for non-cash income and expense items

Cash from Investments:Cash generated by changing the asset base

Cash from Financing:Cash associated with borrowings, dividends paid andprivate withdrawals

+ Consideration of opening cash balance

Analysis of Cash Flows

The most commonly used indicators for doing this are:

• Debt Service Coverage Ratio (DSCR); and

• net cash flow after loan repayment or “free net cash flow.”

Debt Service Coverage Ratio (DSCR);

Cumulative Net Cash Flow over Loan Period

Total Loan Repayment plus Interest> 1.5

This indicator is calculated by adding up all the monthly/quarterly balances during the envisaged loan term and comparing this figure to the total amount to be repaid (including both principal and interest). Since the cumulative net cash flow needs to be higher than the total repayment obligation which the applicant would have towards the lender, this indicator must be above 1 (recommended at 1.5).

Case StudyA new manufacturing unit which wants a four year term loan has following projected cash flows:

Loan Application Net Cash Flow before Loan repayment

200.00

69.93

Loan amountEqual annual instalments @ 15% per annum

All amounts in Rs. crores

First YearSecond YearThird YearFourth Year

50100175300

TOTAL 279.72 TOTAL 625

Case StudyA new manufacturing unit which wants a four year term loan has following projected cash flows:

Loan Application Net Cash Flow before Loan repayment

200.00

69.93

Loan amountEqual annual instalments @ 15% per annum

All amounts in Rs. crores

First YearSecond YearThird YearFourth Year

50100175300

TOTAL for 4 years 279.72 TOTAL 625

Accumulated Repayment Capacity = 625 / 279.72 = 2.23

However, it does not show whether the applicant will be able to cover every individual repayment instalment (as in first

year). Thus comes the “free net cash flow” method.

Free net cash flow methodNet Cash Flow after Repayment

Loan Repayment Instalments> 0.5

This indicator is ratio of the net cash flow after repayment and the loan repayment instalments. A “free net cash flow” indicator must be positive (recommended at 0.5).

Case StudyA new manufacturing unit which wants a four year term loan has following projected cash flows:

Loan Application Net Cash Flow before Loan repayment

200

69.93

Loan amountEqual annual instalments @ 15% per annum

All amounts in Rs. crores

First YearSecond YearThird YearFourth Year

50100175300

TOTAL 279.72 TOTAL 625

Accumulated Repayment Capacity = 625 / 279.72 = 2.23

The free Net Cash Flow is negative in the first year and too low in the second year. Thus, it is recommended to reschedule the loan and provide necessary moratorium

period.

-0.280.431.503.29

Free Net Cash Flow

Financial Evaluation

The interest rates are fixed based on the degree of risk. This risk is computed based on the concepts of probability and margin of safety.

Margin of Safety- is how much output or sales level can fall before a business reaches its breakeven point.

Thus where the margin of safety is riskier, the interest premium applied is also higher (above the Base Rate – Benchmark Lending Rate)

RISK

“The only man who sticks closer to you in adversity than a friend is a

creditor.”

RISK

Webster’s Dictionary- “exposing to danger or hazard.”

Chinese Symbol- “The first symbol is the symbol for ‘danger’, while the second is the symbol for ‘opportunity’, making risk a mix of danger and opportunity.”

Financial Terms- Risk, as we see it, refers to the likelihood that we will receive a return on an investment that is different from the return we expected to make. Thus, risk includes not only the bad outcomes, i.e. returns that are lower than expected, but also good outcomes, i.e., returns that are higher than expected. In fact, we can refer to the former as downside risk and the latter is upside risk; but we consider both when measuring risk. - From “Damodaran on Valuation” by Aswath Damodaran

RISK

There are 3 types of business decisions:1)Certainty: These are those decisions relating to

events which are bound to happen. Thus these are risk free.

The good companies (often with a very high credit rating) even bargain for loans at rates very close to the Base Rate. The reason being, they take their borrowings as almost risk free.

RISKThe second is not “Uncertainty” but “Risk”

2)Risk: These are those decisions relating to events which are risky and might not happen as expected.

These are the decisions where the profits are made. The banks give the loans on evaluation of risk and thus charge a higher interest.

This is based on the same principle as the principle of insurance business.

RISKIn insurance business the loss of few people is

distributed among a large group (via premiums).

Similarly the bank operates, based on the probability. Say that out off every 100 borrowers – 4 make a default. Thus the bank charges around 4% higher interest (i.e. above PLR) from each of the borrower. Thus these “risky” lending are more generous.

Also, if the bank is able to recover from those 4% who default, then the are the even higher super profits resulting from risks.

RISKThe third is “Uncertainty”

3)Uncertainty: The decisions relating to events which can not be predicted. These are baseless.

A gambling is an example of “Uncertainty” as the results cannot be predicted but only hoped for. The result of such is mostly LOSS.

A Good Bank ?

Overall, a good bank is not the one that rejects “not-so-good” loans, but the one that makes every loan appraisal bankable.