Term Loan Appraisal

A new manufacturing
unit wants a term
loan – What to look
for?
What to look For?

Credit Worthiness
Viability
Risk
 Credit Worthiness
Repayment
Borrower- capacity of the
Background/ borrower
Credentials

Results of
Willingness to Management economic
repay talents activities
3 stages of any new business

Project
Gestation Period Earning Profits
Implementation
3 stages of any new business

This is the period when no

cash is generated from the
operations. During this
period the movement of
money is only from bank to
Project
the borrower.
Implementation
3 stages of any new business
Gestation Period
The unit comes into
operation and starts
generating cash but
takes time to reach the
Interest is accrued
break-even point.
during this period to
include it into the
cost of product.
No money movement takes place between the
borrower and the bank.
3 stages of any new business
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.
Earning Profits
The movement of money is from
borrower to bank now.
Purpose for having more cash-flows than the instalment is two-fold:
1)The borrower must also get the part of earnings (else he might not work if all proceeds go to

bank).
2)The cash flows are not actual but estimated, this provides the security to margin of error.
Evaluation of a Business
Managerial Evaluation

Economic Evaluation

Financial Evaluation

Technical Evaluation
 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 Evaluation
Thus the bank prefers loans where there is a large gap between the
supply and current demand.

E.g.:

Where a manufacturer of tables needs a loan: The market already

has enough supply
Demand = 10000 Units
1) (prices might also fall).

Supply = 12000 Units

Not enough demand
New Project = 2000 Units
supply gap.

2) Demand = 10000 Units Large gap, thus the

product has a wide
Current Supply = 8000 Units market.

New Project = 2000 Units

 Economic Evaluation
Case 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 Evaluation
Case 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 reject 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 Evaluation
Case 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 Evaluation
Case Study #2:
A person wants to set up a mini cement plant in the
local area. However 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 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 (good book orders) within
100 kilometres, then the project is economically
viable.
 Economic Evaluation
Case Study #3:
A Power Project in Himachal or in New Delhi ?
 Economic Evaluation
Case Study #3:
A Small Power Project in Himachal or in New Delhi ?

The electricity produced is supplied to the national

grid (at a fixed price). The areas such as Himachal
have very low stealing of electricity while there is
always a power crisis in Delhi due to high stealing of
electricity.

Thus a small power project in New Delhi is preferred

as the demand – supply gap increases. This is one of
those “harsh realities.”
 Management Evaluation
Case Study #1:

A “Lalaji” from Orissa (with enough land there),

seeing the rise in IT Industry, too wants to start a
new IT Company.
 Management Evaluation
Case Study #1:

A “Lalaji” from Orissa (with enough land there),

seeing the rise in IT Industry, too 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 Evaluation
Case Study #1:

A “Lalaji” from Orissa(with enough land there), seeing

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

“Lalaji” still enthusiastic

about the business hires 2
genius (one from Infosys and
another from Wipro).
 Management Evaluation
Case Study #1:

A “Lalaji” from Orissa (with enough land there),

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

“Lalaji” still enthusiastic about the business hires 2

genius (one from Infosys and another from Wipro).

Bank still rates low. Like “Lalaji” took them from

Infosys and Wipro, someone else might take them
away from him someday too.
 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).
 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 the terms of
money.

The cash flows are estimated, the instalments periods

are fixed, the interest rate is computed and the
project is made bankable.
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).
 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
PLR – Prime 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.”

Risk is-----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.
 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.(Bank
Deposits, Govt. sec.)

The good companies (often with a very high credit

rating) even bargain for loans at below the PLR (Prime
Lending Rate). The reason being, they take their
borrowings as almost risk free.
 RISK
The second is not “Uncertainty” but “Risk”
2)Risk: These are those decisions relating
to events which are risky and might not
happen as expected.(Real Estate)

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.
 RISK
In 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.
 RISK
The third is “Uncertainty”
3)Uncertainty: The decisions relating to
events which can not be predicted. These
are baseless. (Movie Production)

A gambling is an example of “Uncertainty” as the

results cannot be predicted but only hoped for. The
result of such is mostly LOSS.
 Common Practices
One of the common practices in the market is that
once a person gets a loan, he floats it in the market
at even higher rates.

Thus a person may get a loan @ 15% and he might

float it in the market at 25% as there are many who
are unable to get the loans sanctioned from the
banks.

Thus the evaluation in all the four areas needs to be

careful and well evaluated.
 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.