Christian Debt Recovery

Long Term Debt Asset Ratio

November 7th, 2008 |

Author: Gavin

Credit Appraisal and Non-Performing Assets

Credit Appraisal and Non-Performing Assets

*Dr.P.Shanmukha Rao **Dr.N.V.S.Suryanarayana

Granting of advances is the primary function of a bank. A major portion of its funds is used for this purpose and this is also the major source of bank’s income. However, lending money is not without risk and, therefore a banker must take proper precaution in this respect is discussed below.

Different forms of advances:

The advances can broadly be classified into categories. (i) Loans, cash credits and overdraft

(ii) Bills discounted and purchased.

Loans:

A loan is kind of advances made with or without security. In the case of loan the bank makes a lump sum payment to the borrower or credit his deposit with the money advanced. It is given for a fixed period at an agreed rate of interest. Repayment may be made in installment or at the expire of certain period. The customer has to pay interest on the total amount as advanced. A loan once repaid in full or in part cannot be drawn again by the borrower unless the banker sanctions a fresh loan.

The rate of interest charged by a bank in the case of loan is usually lower than in the case of cash credit and overdraft on account of the following reasons:

Ø It involves lower cost of maintenance on account of not frequent operation of the account.
Ø The bank gets interest on the total amount sanctioned whether the customer withdraws the whole money or not.

Loan may be a term loan or a demand loan. Term loan’s payment is spread over a long period. It includes a medium term loan and long-term loans. Demand loan is payable on demand. Thus it is for short period.

Advantages of Loan system:

1. Observation of the financial discipline by the borrower.

2. Periodic review of Loan account.

3. Simple and profitable.

Limitations of the Loan system:

1. Inflexibility.

2. More formalities.

3. Frequent Renewals.

Cash credit:

A cash credit is an arrangement by which a banker allows his customer to barrow money up to a certain limit. Cash credit arrangement are usually made against the security of commodities Hypothecated or pledged with the bank.

Hypothecation:

In the case of hypothecation, possession of goods is not given to the bank. The goods remain at the disposal and in the go down of the borrower. The bank is given access to goods whenever it so desires. The borrower furnishes periodically return of stock with him to the bank. Such as advances are by the bank only to a person in whose integrity it has full confidence.

Pledge:

In the case of the pledge, the goods are placed in custody of the bank with its name on the go down where they are stored. The borrower has no right to deal with them. Customer favors hypothecation to pledge because the latter is considered to lower his prestige.

Overdrafts:

The customer may be allowed to overdraw his current account, with or without security if he requires temporary accommodation. This arrangement, like the Cash credit, is advantageous from the customer’s point of view as he is required to pay interest on the actual amount used by him. A cash credit differ from the overdraft in the that the former is used for long terms by commercial, Industrial concerns doing regular business, while the latter is supposed to be a form of bank credit to be made use of occasionally and for shorter durations.

Bills discounted and purchased:

The bank also gives advances to their customers by discounting their bills. The net amount after deducting the amount of discount is credited to the account of the customer. The bank may discount the bills with or without security from the debtor in addition to the personal security of one or more parsons already liable on the bill.

Secured & Unsecured Advances:

Secured Advances: 1. An advance made on the security of tangible assets like goods, building, stock-exchange securities etc., and 2. The market value of such security must not be less than the amount of loan at any time till the loan is repaid.

Unsecured Advances: An unsecured loan or advance means a loan or advance not so security.

In case of a secured loan, charge is created in favor of the bank in respect of certain properties. In case of unsecured loan usually the banks obtain the guarantee of one or more parties in addition to personal security of the debtor. Bank grants unsecured loans without any guarantee i.e., clean advances to parties enjoying high reputation and sound financial position. Through both in case of secured and unsecured advances, the bank emphasis on credit worthiness of the borrower but in case of unsecured advances this is all the more. The bank must carefully examine the three C’s i.e, Character, Capacity & Capital.

Interest terms:

The banks were not free to fix their rates of interest. They were determined by the Reserve Bank of India. As a matter of fact the bank lending rates were “Over the Bank Rate” (OBR). In all banking documentation, the rate of interest of interest was quoted a linkage to OBR. However, as a result of deregulation of interest rates, the banks are now allowed to fix their own interest structure. After RBI fixes the floor rate, the bank fixes their Prime Lending Rate. PLR is the minimum rate at which the bank would be prepared to lend to first class and A-rated borrowers.

Interest Variation Clause in loan agreement:

The interest on advances is charged by bankers as per the schedule of interest rates prescribed by the Reserve Bank of India from time to time the rates of interest are subject to change. In order to overcome the difficulty experienced by the banks in implementing such interests, the banker usually gets the following provision inserted in the loan agreements as regards interest rates:

Provided that the interest payable by the borrower shall be subject to the interest rates made by Reserve Bank of India from time to time.

The effect of such clause is that whenever the RBI revises the interest rates they are automatically applicable.

No diversion of loan funds:

The borrower not to use the loan funds for the purposes other than those for which they were sanctioned. This clause, thus, gives right to the banker to recall the advances in case it apprehends that the borrower has violated or is violating this condition.

Recalling of Advances:

Recalling of advances sanctioned is the remedy of last resort. This may be done by a bank under the following circumstances:

If the borrower fails to renew the documents sufficiently before the expiry of period of limitation expires. The barrower/guarantor must renew the document acknowledging the debt before the expiry of the limitation period in respect of the concerned document.
If there is a material deterioration in the value of the security or the quantum of turnover.
If the barrower fails to maintain adequate margin with the bank in spite of persistent requests.
If the borrower refused to lodge with the banker additional security to cover the amount withdrawn in excess of the limit.
If the borrower is guilty of misconduct or fraud causing serious damage to his credibility.
If there is a change in the policy of bank, Reserve Bank of Government making necessary the recalling of advance.

Term loans:

Term loans are also known as term/ project financial the primary sources of such loans are financial institutions. Commercial banks also provide term finance in a limited way. The financial institutions provide term finance in limited way. The financial institutions provide project finance for new projects as also for expansion /diversification and modernization where as the bulk of term loans extended by banks is in the form of working capital term loan to finance the working capital gap. Through they are permitted to finance infrastructure projects on a long-term basis, the quantum of such financing is marginal.

Features of term loans:

Maturity: The maturity period of term loans is typically longer in case of sanctions by financial institutions in the range of 6-10 years in comparisons to 3-5 years of bank advances. However, they are rescheduled to enable corporate/borrowers tide over temporary financial exigencies.

Negotiated: The term loans negotiated loans between the borrowers and the lenders. They are kin to private placement of debentures in contrast to their public offering to investors.

Security: All term loans are secured. While the assets financed by term loans serve as primary security, all the other present and as well as future immovable properties of the borrower constituted a general mortgage, interest liquidated damages and so on. They are additionally secured by hypothitication of all movable properties subject to prior change in favor of banks in respect of working capital advances.

Covenants:

To protect their interest, the financial institution reinforce the asset security stipulation with a number of restrict terms and conditions. These are known as Convents. They are both positive /affirmative and negative

Negative Covenants In the sense of what the borrower should not in the conduct of its operations and fall broadly into four sets as respectively related to assets liabilities, cash flows and control.

Assets-Related Covenants are intend to ensure the maintenance of a minimum asset base by the borrowers. Included in this set of covenants are:

Ø Maintenance of working capital position in terms of minimum current ratio.
Ø Restriction on creation of further charge on asset.
Ø Ban on sale of fixed assets without the lenders concurrence/approval.
Ø Cash flow Related Covenants Which are intended to restrain cash outflows of the borrowers, may include:
Ø Restrictions on new projects/expansions without prior approval of the financial institution
Ø Limited on dividend payment certain amount and prior approval of the financial institutions for declaration of higher amount
Ø Arrangement to bring additional funds as unsecured loans/deposits to meet overrun/shortfall
Ø Ceiling of managerial salary and perks.

Positive covenants:

In addition to the foregoing covenants, certain positive covenants starting what the borrowing firm should do during the term of a loan included in a loan agreement. They provide, inter alia, for

1) Furnishing of periodical financial statements.

2) Maintenance of a minimum level of working Capital.

3) Creation of sinking fund for redemption of debt.

4) Maintenance of certain net worth.

Repayment Schedule / Loan Amortization:

The term loan has to be amortized according to predetermined schedule. The payment/ repayment has two components:

(i) Interest

(ii) (ii) Repayment of principal.

The interest components of loan amortization are a legally enforceable by contractual obligation. The barrower has to pay a commitment charge on the utilization amount. The interest on term loans by the financial institutions, subject to minimum prime lending rate, is risk-related and varies with the credit risk of the borrower.

Typically, the principal is repayable over 6-10 years period after an initial grace period of 1-2 years. Where as the mode of payment of term loans is equal semi-annual installments in case of institutional borrowings, the term loans from banks are repayable in equal quarterly installments. With this type of loan amortization pattern, the total debt-servicing burden declines over time, the interest burden declining and principal repayment remaining constant. In other words, common practice to amortize loan is repayable in equal installments and payment of interest on the unpaid loans.

Important Considerations

While lending money the banker has to take into account various consideration. These considerations relate to the bank itself, the borrower, and the proposal.

Parameters for the bank:

The bank while advancing money should look to its position regarding liquidity, safety and profitability.

(i) Liquidity: since banks themselves heavily depend on borrowed funds, they spread their investments in such a way that they are in a position to acquire cash with in a short period of time. Their borrowings also come from deposits, which are usually not for a long period. The banks, therefore, prefer granting of short-term loans to their customers.

(ii) Safety: The capacity of the banker to repay to its deposits depends upon its borrower’s repaying capacity. The banker has, therefore, to see the safety of the advances made by it.

(iii) Profitability: The banker earns its profits through advances and, therefore it cannot ignore the considerations of profitability while making advances. However, the bank cannot ignore the other two aspects too it has to see that the funds remain fairly liquid, safe and give a reasonable return. In order to have a proper balance, the bank keeps in its investments portfolio three types of investments: liquid, semi liquid, and income earning investments. It has to maintain them in optimum proportions.

Customer credibility:

The banker while selecting his borrower should have clear appraisal about the three C’s: Character, Capacity& Capital

Character:

Character denotes integrity of the borrower i.e., he should have willingness to repay the money borrowed.

Capacity:

Capacity denotes his ability to manage his business. The bank can judge it on the basis of education background and the experience of the entrepreneur.

Capital:

Capital denotes his financial soundness. The borrower should have his own funds also. No banker will take to lend money to a person who does not put money from his own resources. However the banker should see that he does not lack any of them in a significant way.

Evaluation of proposal:

The bank should look to the following aspects regarding the proposal.

Purpose:

The purpose for which the money is being borrowed is gaining more importance on account of increasing realization on the part of the banks about their social responsibility. The project, which will help rural upliftment, import substitutions or equitable distribution of income, has to be preferred in comparison to other projects. Similarly loan for productive purposes should be given in priority to loan for unproductive purposes, such as for marriage or other religious ceremonies.

Security:

Security is now considered to be a secondary consideration while advancing loans. However these aspects cannot be completely over looked since it is a safeguard for unexpected defaults in repayments by the borrower.

Sources of repayment:

The banker has also to see whether the project for which it is advancing loan will generate necessary cash to repay the loan and the interest as per the agreed program.

Term:

The term or the period for which the loan is required is also important banks cannot afford to lockup their funds for long periods. They, therefore, prefer granting of short-term loans to long-term loans.

Factor Limiting The Level of Advances

(i) The type of deposits.

(ii) Credit control by Reserve Bank of India.

(ii) Seasonal variations

(iii) General business conditions.

About the Author

*Dr. SHANMUKHA PADALA : The author is a well qualified and posses Vast teaching experience in Field of Management. He has great interest in the field of Human Resource Management and Accountancy. Now he is working as Faculty in the Department of Commerce and Management Studies, Andhra University Campus, Vizianagaram. He participated in several National and International Seminars, Workshops, Symposias, FDP Programmes and published rich number of articles in reputed journals. E-Mail: srpadaslaau@gmail.com and Mobile : +91 94403 23606.

**Dr. N.V.S.SURYANARAYANA : The author is an renowned personality in the field of Education. Presently he is working as Faculty in the Department of Education, Andhra University Campus, Vizianagaram. He has rich experience in the field of Teacher Education about a decade at Post Degree and PG level. He is very much fascinated to Psychology and possess much interested in Educational Psychology and Guidance & Counseling. He participated in so many National and International Seminars, Workshops, Refresher Courses, Symposia’s and published so many articles in reputed Journals. He produced a number of M.Ed and M.Phil Dissertations.He wrote so many books on recent trends in education and innovative Psychological concepts. He is having Lifetime memberships in various alleged Associations. E-Mail: suryanarayana_nvs@yahoo.com, Mobile : +91 94403 48609.