How to appraise term loan proposals

(This post explains important 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 the honesty and integrity of the borrower, the standing of the borrower, business capacity, managerial competence, and 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 inquiries, 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 of unit inspection, etc.

To start with the following information shall be collected from prospective borrowers.

i) What is the cost of the project and arrangements to meet the finance for completing the project?

ii) Projected Balance sheets and profit and loss statements up to the period till TL repayment is completed.

iii) Cash flow and funds flow estimates up to the period till TL repayment is completed.

The appraisal of the project also covers the following details.

1. Commercial Viability of the project: Line of business, demand-supply, profit margin, imports, exports, list of important customers and suppliers, the 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, and the level of activity and make a preliminary report on his/her visit which includes an inspection report on prime and collateral security offered.  The Manager has to familiarise the borrower’s business and form opinions 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. It should be seen, if sufficient raw material, labour, and other utilities like power, and water are available for the projected level of production.
4. Market conditions & marketing arrangements: Demand, supply, pricing, etc., after the completion of the project/ installation of new machinery. Names of the main buyers, names of major competitors, and their total market shares.
5. Financial appraisal: Past financial statements like profit and loss accounts, and balance sheets. The correlation between fixed assets and undercharging of depreciation, operating loss position, the contribution of other income to net profit, valuation of closing stock, borrowings and interest cost, the 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 are maturity mismatch, funding risk, and Interest rate risk (IRR).

The above aspects are to be carefully looked into while fixing loan amounts and repayment installments. The repayment of the Term Loan should be fixed after studying Cash flow statements according to the cash accruals. The unit must be in a position to generate sufficient cash flows to serve the Term Loan installment and interest during the repayment period.

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  (Strengths, Weaknesses, Opportunities, and Threats)
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 cover the 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 [Profitability of the project depends upon the sale price, sales volume, and cost of production and establishment and sales overheads. Sales price should be compared with the competing products and sales volume can be ascertained based on installed capacity and capacity utilization of the project.]. While examining the cost of production & profitability, the break-even point (BEP) of the project should be worked out. BEP indicates the minimum level of output as a percentage of full capacity at which the project starts yielding profits.

(ii). Tangible net worth,

(iii). TOL/TNW ratios

(iv). Debt Equity Ratio.

(v). Fixed asset coverage ratio for a term loan.
Calculation of DSCR (Debt Service Coverage Ratio):

Calculation of DSCR (Debt Service Coverage Ratio): While sanctioning a term loan to a borrower the banks and financial institutions essentially calculate the DSCR.
The Debt-Service Coverage Ratio (DSCR) is a method of calculating the repayment ability of multiple debt obligations including proposed term loan installments. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking fund, and lease payments (total debt service).
The formula for finding out the debt service coverage ratio (DSCR)
DSCR =(Profit after Tax+ Depreciation+ Interest on Term Loan)÷ (Interest on Term Loan+ Installment amount of Term Loan). i.e. net operating income divided by total debt service.  DSCR less than 1 suggests the inability of a firm’s profits to serve its debts whereas a DSCR greater than 1 means the borrower is able to serve the debt obligations. The acceptable industry norm for a debt service coverage ratio is between 1.5 to 2. To have a conclusive idea about the debt-serving ability of the borrower, it is advisable to DSCR for the entire period of a loan instead of only for one year.

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.

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 a future date, the advance received should be reduced from the working capital gap.

Originally posted on July 21, 2014,  reviewed and edited on June 5, 2023.

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• 5 Steps of Credit Appraisal
• Computation of working capital limits under the Turn-Over method (Nayak Committee Norms)
• Cash Budget pattern of financing seasonal productions
• Things to know before starting appraisal of working capital limits 
• How the length of the operating period (Holding period for stocks and receivables) is measured?