The primary objective of credit appraisal is to ensure that the money is given in right hands and the capital and interest income of the bank is relatively secured. It denotes evaluating the proposal of the loan to find out repayment capacity of the borrower. The process involves an appraisal of market, management, technical, and financial.
To be awarded a loan by a financial institution is quite difficult. This is because banks follow an extensive process of credit appraisal before sanctioning any loan. They analyse the loan proposal from all angles with an objective of ensuring that the money is given in right hands and the capital and interest income of the bank is relatively secured.
While appraising term loans, a financial institution would focus on evaluating the credit-worthiness of the company and future expected stream of cash flow with the amount of risk attached to them. Credit worthiness is assessed with parameters such as the willingness of promoters to pay the money back and repayment capacity of the borrower.
Four broad areas of appraisal by banks are a market, management, technical and management.
The very first thing a financial institution would look at is the gap between demand and supply. The bigger the demand-supply gap, the higher is the chances of the flourishing of that business. The demand versus the proposed supply by the borrower should have a ratio of 5:1 units.
Management of the company needs to be appraised for their intentions, knowledge, and dedication towards the project. By intention, it is meant to evaluate the willingness of the promoters of the company to pay the money back. It needs to evaluate the real objective of borrowing. The management needs to be strong in terms of their knowledge about business, commitment towards achieving the set goals etc.
This is subject to the kind of business and industry of the borrower. If it’s a manufacturing concern, all those parameters like project site, availability of raw materials and labour, capacity utilization, vicinity to selling market, transportation etc would be examined. A project needs to be technically very sound to be able to sustain all business cycles.
This expresses everything in terms of money.
Financial appraisal tries to assess the correctness or reasonability of the estimates of costs and expenses and also the projected revenues. These may include the estimation of the selling price, cost of machinery, the overall cost of the project and the means of financing.
Financial appraisal involves extensive financial modelling in excel. Basically, it takes the financial statements of previous periods and forecasts the future financial position for at least till the loan matures. From that, the cash flows of each year are compared with the instalment of loan because ultimately the cash flows are going to honour the payments of the bank.
Feasibility of the project is evaluated in terms of debt servicing capacity of the firm. Debt service coverage ratio is a key ratio which is calculated for each future financial period and if that ratio is satisfying the norms accepted by the bank, the loan would get another green signal.
It is difficult to explain the process of appraisal in an article or even a set of articles. It is a very extensive work being done at financial institutions. They have a separate team of professionals for conducting such project appraisals.