LOANS AND
ADVANCES
LOANS AND ADVANCES: DEFINITION
AND CONCEPTS
Lending
is the basic function of banks which involves the process of granting loans and
advances. While loans and advances essentially mean lending of money, and are
used interchangeably, there is an inherent difference between the two. The term
“advance is commonly used as a process of lending against certain underlying
security such as shares, banks own fixed deposit; whereas the term “loan”
signifies the process of granting a loan which, as per its tenor, is classified
as short-term loan, medium to long-term loan.
PRINCIPLE
OF LENDING
A
banker is always concerned with the money which he has lent, and to ensure that
what he has lent is repaid he has to follow certain cardinal principles of
lending which have evolved over a period of time. These lending principles are:
Principle
of Safety of Funds:
Safety
of funds is ensured when money lent comes back through repayment as per
sanction terms. This depends upon the willingness of the borrower to repay, his
honesty and integrity and his financial standing.
Principle
of Profitability:
The
objective of giving a loan is to earn sufficient income that will not only take
care of the cost of money raised but also the cost of operation and premium of
loan default. The pricing of loan is done keeping these aspects in mind.
Principle
of Liquidity:
If the
money lent is not received back as per terms, a bank may face liquidity problem
in meeting its commitments to depositors. The other reason affecting liquidity
is the account turning into NPA and asset-liability mismatch due to leveraging
of short-term sources for financing of long-term assets.
Principle
of Purpose:
Traditionally,
banks lend only for productive purposes so that enough surplus is generated by
the activity to repay the loan. Of late, banks have started granting loan for
consumption purposes like loan for the purchase of consumer goods, education,
housing, etc where quantum of loan is decided upon by the capacity of the
borrower to repay.
Principle
of Risk Spread:
This
risk is managed by financing borrowers of different strata of society, residing
in a wide geographical area and engaged in different types of industries and
trades.
Principle
of Security:
Here, it is attempted to make an in-built
arrangement in the loan process to fall back on, in case a borrower turns
willful defaulter or fails to repay due to failure of his business. For loans
granted to weaker sections of society or to tiny and village industry for
social consideration, banks are prohibited from insisting on security. All
loans are usually backed by third-party guarantee and collateral security,
which banks insist upon before sanctioning loans.
While
accepting security, the bank is required to satisfy itself that the security is
marketable (can be sold with least delay and / or inconvenience), stable
(non-perishable), ascertainable (can be identified) and is transferable (can be
transferred to intended buyer both physically and legally). To further
safeguard its interest, the bank generally stipulates insurance against various
risks, so that in case of any unforeseen eventuality or loss of security, the
money can be realized from the insurance company.
PRE-CREDIT
APPRAISAL STANDARDS
The
process of giving a loan is divided into four parts; pre-sanction credit
appraisal, sanction, documentation and monitoring, and follow-up. Pre-credit
appraisal is the most critical part of the lending process since it is through
this process that the bank takes a decision to accept or reject a loan
proposal. The terms and conditions, on which the loan is sanctioned, are
decided through the appraisal process. The quality of appraisal ultimately
determines the quality of loan assets.
(a)
Managerial competence, which determines the capacity and competence of the
proponent to do business. A credit officer should ascertain the background of
the proponent, his work experience, his qualification, his market report and
his past dealings with other banks, if any, so as to satisfy himself about the
honesty, integrity and business ability of the applicant borrower. In the case
of a legal person, like a limited company, the officer should examine its
charter so as to satisfy himself that the company can engage itself in a
particular line of business and has the requisite powers to borrow and execute
documents. The credit officer should examine the adequacy and suitability of
the management structure, quality of management and management capability under
stress, personnel policies including succession planning, bargaining power with
suppliers and financial strength.
b)
Technical feasibility, which involves assessment of availability of technology,
latest or proven, to produce the required quantity and quality of goods. It
also involves assessing the availability of skilled manpower, availability of
raw material, availability of machinery, pollution or environmental clearance
required, if any, so that the project can be completed without time or cost
overrun.
c)
Market appraisal, which is done through demand forecasting and simulating
demand through product promotion and selling strategies. Market appraisal also
involves assessment of competitive advantage which the unit enjoys, economic
and social trends which may have a bearing on the demand for the product, who
are the major buyers; whether the market demand is stable, seasonal or
permanent; what substitutes are already available in the market; what is the
extent of competition from abroad; what are the import restrictions; what is
the product range; what product mix is available; what distribution set up is
required for marketing the product; how government policies are likely to
impact the future of the industry; and whether raw material, skilled labour,
power, etc, are available for uninterrupted production.
d)
Financial viability, which is determined by the assessment of cost of the
project and promoter’s ability to raise requisite resources to meet the same.
This also involves analyzing the financial health of the borrower by examining
current ratio, debt equity ratio, interest coverage ratio, etc. Cash flow
statement is also analysed to ensure that a large borrower will be able to
serve his commitment for letter of credit, payment of installment and service
monthly interest.
e)
Financial requirement of the borrower for acquiring fixed assets and meeting
working capital requirement, which is the final part of the appraisal process.
Terms and conditions of loan, interest rate, margin, security – both primary
and collateral – repayment terms, period of limit and documents to be executed,
are all determined through this process.
APPRAISAL
OF TERM LOAN
A
unit requires funds for purchasing various items of fixed assets such as land
and building, plant and machinery, electrical installation and other
preliminary and pre-operative expenses. These fixed assets are used over a
period of time to produce goods or services which enable the unit to earn
profit, thereby helping it to repay the loan. The term loan is sanctioned by a
loan agreement, which specifies terms and conditions and covenants on which the
loan has been sanctioned, including repayment terms. These assets created out
of the bank loan are charged/hypothecated go the bank as security. While
determining the quantum of finance, a banker has to make assessment of actual
cost of assets to be acquired, margin to be contributed, sources of repayment,
etc. The appraisal of term loan broadly addresses the following:
1.
Financial viability
To conduct financial
viability, a credit officer is required to assess:
(a)
Cost
of project: The cost of project generally consists of :
i)
Cost
of land and its development,
ii)
Cost
of construction of sheds, building, boundary walls, go-down, etc,
iii)
Cost
of plant and machinery including electrical installation,
iv)
Miscellaneous fixed costs for effluent
collection treatment, vehicles, office tools, office furniture and fixtures,
v)
Preliminary and pre-operative expenses which
are capitalized
vi)
Margin
for working capital.
(b)
Means
of Financing: Means of financing companies:
( i) owners’
capital,
ii) reserves and
surplus,
( iii) retained
profit,
(iv) long-term loan
from bank, and
(v) subsidy
(c) Cost of Production and Profitability: All
elements of cost of production are realistically assessed on the basis of past
trend (for existing units) or industry benchmarks. Estimated profitability is thereafter
determined after deducting cost from estimated income.
(d) Cash Generation and Debt Service Coverage
Ratio: The relationship between the repayment capacity (cash generation) and
commitments is expressed in terms of debt
service coverage ratio (DSCR). DSCR is calculated using the following
formula:
DSCR = Profit after tax +
Depreciation + interest on term loan and deferred credit / repayment of
installments on term loan and deferred credit + interest on term loan and
deferred credit.
The ratio indicates the
coverage of liability of the borrower to pay interest and principal out of
expected cash generation. DSCR is used to determine
(i)
when
the repayment of the should start,
(ii)
how
many installments can be fixed,
(iii)
what
the repayment period should be.
(e) Break-Even Analysis: Break-even
analysis is also known as cost-volume-profit analysis. Knowledge of break even
point (BEP) provides an insight into the possible risk of a borrower by
conducting sensitivity analysis of change in cost or sale price per unit to
determine the level at which the unit may incur loss.
BEP is calculated as:
BEP in sales = Fixed cost x
sales value / contribution where contribution = sales price per unit – variable
cost per unit
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