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5.0 OBJECTIVES

To provide an understanding of:

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than the verification and validation of the data and information that the applicant
submits to the bank.
An appraisal is undertaken for ensuring that a credit is good. What is good credit?
For convenience sake let us define a ‘good credit’ as one which is not a Non-
Performing Asset. An account will not be a NPA if repayments in the account are
regular (not overdue), the interest payments are in time and regular, the account is
not over drawn and the funds are used for the intended purposes. If the objective
of appraisal is ‘good credit’ then it should focus on evaluating the proposal to see
if the above conditions are feasible and if the proponent or the borrower has the
skill and inclination to keep it credit ‘good’.
A bank uses a number of appraisal tools including the loan officer’s judgment
sharpened out of years of experience in dealing with big/industrial borrowers.
Credit appraisal process starts when an applicant walks into the branch and culminates
in credit delivery. In view of this it is a continuous process and is more than mere
verification of antecedent of an applicant. Verification and validation are necessary
to check out the facts. For example KYC verification is important but not the whole
of credit appraisal.
The essence of credit appraisal is that it measures the risk inherent in the proposal
and comes to judgment to sanction or reject the proposal based on the assessment
of the information, the applicant and the project.
“All courses of action are risky. So prudence is not in avoiding danger (it is impossible)
but calculating risk and acting decisively” Niccolo Machiavelli
Credit appraisal which was mostly a matter of judgment some years ago has undergone
changes in two dimensions. One, it has become credit risk appraisal rather than
credit appraisal in that the emphasis has shifted from a subjective evaluation of the
quality of credit to appraising the risk inherent in the proposal and if the proposal
will be acceptable given the risk appetite of the lender. Second, the appraisal or
measurement of the quality of the credit and risk has become more objective than
judgmental.
The discussion which follows will take us through the assessment process and at
each stage the use of the objective measures to determine the quality of appraisal
will be outlined. A detailed study of these objective measures is included in separate

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units like credit rating, analysis of financial statements, working capital assessment
etc. An appraiser must use all of these in the process of credit appraisal.

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Recording of visit notes, observations, stock verification details etc in a systematic manner
and keeping the same appropriately filed is important for banks more particularly in
credit appraisal. These records, notes will help to establish the facts that have gone into
the decision making.
Credit Risk
At this point it is necessary to understand the term ‘credit risk’ before we take
up a discussion of assessing the risk and using credit rating to arrive at a decision
on whether or not to finance the venture. Credit risk is defined as the possibility
of borrower/counterparty default. Default can occur because of business failure
or because the borrower’s wilful actions. The latter is a question of integrity of
the borrower. While in the past lenders relied on market reports (credit reports1
from bankers and others) to take a call on this issue, the present day lenders rely
on credit reports for individual borrowers and credit rating of companies/firms by
the rating agencies and their own credit rating. In the absence of company or firm
rating by rating agencies and own credit rating, the ratings given to the issues of
these companies by rating agencies are taken into account.
Credit risk is not exactly a statistically measurable probability event. Let us start with
the observation that it is directly proportional to the probability of counterparty
default. So if the likelihood of default is high the credit risk is obviously high.
How do we arrive at the probability of default? A default event can be triggered by
external, internal or a combination of both external and internal factors. Internal
to the firm (borrower) are issues such as inefficient management, bad financial
decisions, marketing failures etc. The lender assessees the quality of management
by looking at the composition of the promoters, Board of Directors, experience of
the Directors in the industry, the CEO’s experience and expertise in the industry
and other key technical and managerial personnel. Poor financial management
could be caused by poor cash flow management and bad collections. At times less
than optimal financial assistance by the lender or over financing could all lead to
problems. The question is how strong are the financials? Is there a margin/cushion
left to take care of small delays in collection or a minor decrease in the operating
margins until corrective action is taken and the situation retrieved? The lender will
also look at the return on capital employed as unless this is at an acceptable level

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over a period of time the promoter will lose interest in the venture. Business risk
will be measured by the efficiency with which the company is run, and the relative
positioning of the company in the market. Market perception as reflected in the
stock price movements is also a good indicator of the operating efficiency of the
company and the general management capabilities.
Marketing related issues are lack of awareness of market trends, lag or no response
to changing market conditions and not knowing what the competition is up to and
losing track of market trends. The management must at all times be on top of the
job. If they do not have this quality, then there is credit risk. How are these risks
measured? The financial management aspects are measured through balance sheet
analysis and the management quality, etc. through a regular review of the changes
in the credit rating.
External factors are those over which the promoter or the company executives
cannot exercise control. Some of the external events are arrival of new products,
product substitutes, political events, regulatory changes, changes in the consumer
behavior etc. Further if the product has a seasonal market, say woolen garments, an
unusually warm winter will affect sales. Even if the company is performing according
to projections, external factors affecting its market could result in lower sales and
cash flow problems and eventual default. The capacity of the borrower/proponent
to think and be prepared to meet such factors should be assessed by the bank.
Credit (Risk) Rating
Credit risk rating or credit rating is one of the credit appraisal tools. In the unit on
credit rating the issue is dealt with in some detail. In this method credit risk is assessed
in the form rating by assigning marks to different parameters and evaluating on the
basis of some threshold preset standards/marks. A credit risk rating model assigns
grades/marks to known risk components. Each risk component is assigned weights
relative to the importance of the item in arriving at a credit risk score for the borrower.
The factors that decide which components need to be taken into consideration for
assignment of weighted scores fall into two categories. The measurable factors are
the ones like Current Ratio, Debt Equity ratio, etc. fall in the first category. Then
there are the items which need the judgmental inputs of a seasoned credit analyst
like the management quality or the default likelihood of the borrower. Of course,
even for the qualitative components like default mathematical models have been
developed. Some formulae for calculating the default probability and bankruptcy

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predictor model are given in the annexure to this unit. A detailed unit on credit
rating is also given elsewhere in this book.
The first step
Once the credit rating is done the next step is to see if the proponents/ borrowers
marks are at an acceptable level. The borrower’s financial standing and performance
are rated for scoring. Additionally the management, quality of maintenance of
accounts and similar factors that do not lend themselves to statistical measurements
are also rated. If the credit rating score is below the cutoff point stipulated by
the management of the lending bank the credit will not be taken up for further
processing. The lender will also check if the purpose of the loan fits in with the
credit policy of the bank and the proposed activity of the borrower is not on the
banned or restricted list of the lending bank. A third point is to determine if the
sanction of the loan will breach any of the concentration limits prescribed by the
bank in respect of group, industry or limit for individual exposure. The proposal
would be rejected if it does not pass any one of these tests.

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perform the due diligence exercise and examine the individual’s character capacity
etc. through market enquiries, or enquiries with the applicant’s employer. It should
be noted that unlike the past when the banks relied solely on market reports the
lender can now call for a credit report from a credit bureau which is arrived on a
factual basis. (More information on the appraisal of loans to individuals for non-
productive purposes is provided in the unit on Retail lending). In case of partnership
concerns, Private Limited and Limited companies, the creditworthiness from their
financial statements, would be determined among other things, by undertaking
discrete enquiries/search in CERSAI records, ROC, RBI defaulters’ list and other
sites such as Insolvency and Bankruptcy Board of India (IBBI) etc. Searches to be
conducted in respect of encumbrances on the properties proposed to be given as
mortgage
For advances to company, the banker relies on an analysis of the borrower’s financial
statements to assess its creditworthiness2. The banker has to perform a complete
analysis of the financial statements and obtain all necessary clarifications from the
applicant/borrower to ensure that the financial statements do reflect a true and fair
statement of affairs of the company. For example if in a past three year period the
sundry debtors have been on average three months’ sales, but in the latest year it is
4½ months, the banker would like to know if this is due to poor collection effort or
it is a slowdown in the market due to which the company had to offer better credit
terms to maintain sales. Possibly the company’s product no longer commands the
market share it had in the previous years and is losing market share to a competitor’s
product. Similar analysis and clarifications have to be obtained for all variations and
a typical item in the financial statements.
It is necessary that a complete analysis of financial statement is performed and the
banker obtains full information on all financial data. A lender will go through all
the ratios. Yet an understanding of the solvency, liquidity and profitability of the
borrower company is adequate to draw prima facie conclusions on the financial
soundness of a company.
Liquidity is defined as the company’s ability to meet demands made on it by its
creditors, trade creditors, other dues payable, tax dues etc. Among the first things
that the lender has to check is the liquidity position. A company’s ability to meet

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demands on it i.e. liquidity is measured by the surplus of current assets over current
liabilities. Expressed as a ratio, the Current Ratio is obtained by dividing current
assets by current liabilities. Clearly, it has to be more than one (1). A ratio less
than one will show that the company is already facing liquidity constraints. If the
company does not have adequate cash flows to meet the obligations when they
arise, it is a difficult situation. Evidently if the company’s current assets are more
than the current liabilities it has the ability to meet the demands on it by realising
the short term assets. In the normal course of business the realization/receipts from
current assets and meeting of current liabilities is a continuous process and it is an
issue of cash flow management. Given this, if the current ratio is more than 1 the
company is said to be liquid. Now the question is should it be more than 1? And
if so, by how much more than one should it be? The traditional wisdom amongst
Indian bankers, later upheld by the Tandon Committee, was that a current ratio of
1.33 is a satisfactory ratio. As against this, in Western countries for large companies
a higher current ratio between 1.5 and 2 was considered acceptable.
Lately, in the wake of financial sector reforms, all regulatory guidelines on lending
norms have been removed. In the past, with the regulator fixing the norms, the
lenders had no ownership on lending decisions. Often there was an attempt to lay
the blame at the regulators’ doors, on the plea that banks had no freedom to decide
on what is a banking risk, and that they had to follow the RBI’s norms. Banks have
been advised by the Reserve Bank of India to formulate a credit policy with their
Board’s approval and take credit decisions based on sound principles of lending.
Banks now have to draw their own conclusions on what is a good ratio and what is
a good risk based on internally developed lending models. A decision on what is a
good current ratio is one of such decisions. Although accepting a ratio of less than
1 while making a loan for whatever other reasons might be suicidal.
Debt to Equity ratio is a measure of the financial leverage of the company’s solvency.
Lower the ratio the larger the involvement of the company. A high debt is a sign of
excessive dependence on creditors over owned funds for the running of the enterprise.
Possibly the promoters are trying to achieve a high leverage keeping their own stakes
are lower. In such cases the lender would seek to know if it is an effort on the part
of the promoters to shift the risk of a new enterprise to external creditors. What
is the composition of own funds? Are there other lenders? Another indicator of
solvency is the interest coverage ratio (Operating income ÷ interest expenditure).
The interest coverage ratio seeks to measure the ability of the company to meet

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interest payment obligations. The lender will be able to ascertain if there will be
any difficulty for the company/firm to meet the payment. Both the ratios seek to
measure the impact of external borrowings on the operations of the company. If
debt is excessive, debt servicing together with interest expense becomes a burden.
The solvency ratio is measured by (After tax net profit + depreciation)÷(Short term
debt + long term debt). The lender will also look into the industry averages as also
if it is a new venture (where capital/own funds availability will be generally low)
for arriving at appropriate terms of credit.

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The essence of appraisal is to see whether the business is commercially viable. This
calls for an examination of demand in the market, product acceptance, substitute
products entry and exit barriers. Issues such as scope for further growth, Industry
prospects, industry cycles, shift in consumer demands and the regulatory environment
are also critical to establish the commercial viability.
The appraiser must be aware of current trends in the borrower’s line of work or
industry and how changing economic conditions might affect the proposal/project/
loan. A proposal may look very good on paper, only to have its value eroded by
declining sales or income in a recession or by the high interest rates occasioned by
inflation. To assess industry and economic conditions, most lenders maintain an
economic and research department. This department advises the bank on trends.
The department or bank may access the information from newspaper archives and
research reports-on the industries represented by their major borrowing customers.
Also, the Credit Rating Agencies publish periodical reports on industries.
The use of loan for the objective for which the loan was made or otherwise can be
tested by verifying the movements in networking capital of a company through
successive periods. Cash flow, funds flow analyses will throw light on movement
of funds from short term sources to long term uses and vice versa. Obviously this
exercise is performed post facto and will only help to initiate a dialogue with the
company for future financial discipline in end use of borrowed funds.

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acceptability of a proposal or project. If IRR or is more than the pre set threshold
return or industry return a proposal may be accepted.
The profitability of a firm requires to be validated. Here, we need to make a
distinction between an existing firm and a new enterprise. In the case of an existing
firm the profit and loss account over a period of three to five years gives a trend of
the profitability of the firm and inter firm comparison would tell the lender where
exactly the borrower company fits in. Another factor that would have a bearing
on the profitability is the number of years the firm has been operation and what
percentage of total capacity it is functioning. In the first few years of a firm’s operation
it cannot be expected to operate at full capacity and therefore the contribution will
be less than optimal. Once the firm operates at say 90% of capacity, the profits of the
firm have to be comparable to the industry average or better. The lender will have
to take into account factors like the mix of manufacturing with trading if trading
is a part of the company’s business and also the size of the firm. For a new project
the verification of profitability should be more rigorous as it means validation of
forecasts. (This has been dealt with in the unit on project finance).

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Sale of assets and fresh equity are definite indicators of constraints in business and
troubled loan relationships.
What is Cash Flow?
In accounting parlance cash flow is defined as follows:

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to provide adequate support for the loan? What is the status of the asset based
on its features such as age, condition, and degree of specialization of the assets?
Technology plays an important role in some assets. Are the borrower’s assets likely
to be technologically obsolete? Are the assets saleable or will they have limited value
as collateral because of the difficulty of finding a buyer for these assets should the
borrower’s income falter?

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Edward I Altman3 has developed a method (formula) for measuring fiscal fitness and
predicting bankruptcy of companies. The formula created by him is useful to predict the
probability that a firm will go into bankruptcy within a two year period. The formula
is called a Z score. The Z scores are used in predicting corporate defaults. These scores
are easy to calculate and are useful as a control measure for the financial distress status
of companies. The Z score uses multiple corporate income and balance sheet values to
measure financial health of a company.

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T2 = Retained earnings/Total assets

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Coefficient of Variation
 

Coefficient of variation is a measure used to assess the total risk per unit of return of an
investment. It is calculated by dividing the standard deviation of an investment by its
expected rate of return.
Since most investors are risk-averse, they would like to minimize their risk per unit of
return. Coefficient of variation provides a standardized measure of comparing risk and
return of different investments. A rational investor would select an investment with lowest
coefficient of variation.
Sharpe ratio is a similar statistic which measures excess return per unit of risk.
Formula
Standard Deviation of the Investment
Coefficient of Variation =
Expected Return on the Investment
Example
Indus Farms is a family owned business engaged in cultivating their land mass of a
hundred square kilometers. The season is beginning, and Akbar the family head, has a
critical decision to make: to cultivate sugarcane or cotton. He asked his eldest son Adnan
to gather some data on expected return on each crop under different scenarios and the
variation in those returns.
Adnan estimates that if there are enough rains (which has a probability of 0.7), the return
on sugar cane could be as high as 25%. However, in case of low rain, the return could be
as low as 5%. He estimates that standard deviation of return on sugarcane crop is 16%.
In case of enough rains, return on cotton could be only 12%, but in case of low rain, the
return could be 20%. Standard deviation of return on cotton is expected to be 9%. In the
risk-return perspective, which crop is better for Akbar?
Expected return on sugar cane = 0.7 × 25% + 0.3 × 5% = 19%
Coefficient of variation of sugarcane cultivation = standard deviation on sugarcane (16%)/
expected return on sugarcane (19%) = 0.84
Expected return on cotton = 0.7 × 12% + 0.3 × 20% = 14.4%

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Coefficient of variation of cotton cultivation = standard deviation on cotton (9%)/expected

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“Risk” is often thought in negative terms, something to be avoided, a threat that, hopefully
won’t materialize. In the case of investment, however, risk is inseparable from performance
and is simply necessary. Understanding risk is one of the most important parts of a financial
education.
A common definition for investment risk is deviation from an expected outcome. This can
be expressed in absolute terms or relative to something else like a market benchmark.
Deviation can be positive or negative, and relates to the idea of “no pain, no gain”. To
achieve higher returns in the long run one has to accept more short-term volatility. How
much volatility? This would depend on one’s risk tolerance. Risk Tolerance is the capacity
to assume volatility based on specific financial circumstances and the propensity to do so,
taking into account one’s comfort with uncertainty and the possibility of incurring large
short-term losses.
Measures of R
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asymmetry between how people view gains and losses. In the language of prospect theory
investor’s exhibit loss aversion - they put more weight on the pain associated with a loss
than the good feeling associated with a gain. Thus, what investors really want to know is
not just how much an asset deviates from its expected outcome, but how bad things look
way down on the left-hand tail of the distribution curve.
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IF

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for the beta risk assumed and concentrates their more expensive exposures to specifically
defined alpha opportunities. This is popularly known as portable alpha, the idea that the
alpha component of a total return is separate from the beta component.
For example a fund manager may claim to have an active sector rotation strategy for
beating the S&P 500 and show as evidence a track record of beating the index by 1.5%
on an average annualized basis. To the investor, that 1.5% of excess return is the manager’s
value - the alpha - and the investor is willing to pay higher fees to obtain it. The rest of
the total return, what the S&P 500 itself earned, arguably has nothing to do with the
manager’s unique ability, so why pay the same fee? Portable alpha strategies use derivatives
and other tools to refine the means by which they obtain and pay for the alpha and beta
components of their exposure.
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Model for Measuring Distance to

Default
KMV Corporation defined the default point as something falling between the short term
debt and the long term debt. The default point according was given as
Default point = STD + ½ LTD
STD is Short Term Debt and LTD is Long Term Debt
And the distance to default was defined in the formula
DD = E (V1) - DPT/6
Where
DD is the Distance to Default
E(V1) is the expected value of assets in a year’s time
DPT is the Default point or STD+1/2 LTD
And V is the volatility of asset values measured by the standard deviation

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