Credit Appraisal

Contents :
  • Meaning of Credit Appraisal.
  • Benefits of Credit Appraisal.
  • Types of Credit.
  • Credit Appraisal Process.

What is Credit Appraisal ?

Credit appraisal means an investigation/assessment done by the bank prior before providing any loans and advances/project finance and also cheeks the commercial, financial and technical viability of the project proposed its funding pattern and further checks the primary and collateral security cover available for recovery of such funds. Credit appraisal is a process to ascertain the risks associated with the extension of the credit facility. It is generally carried by the financial institutions which are involved in providing financial funding to its customers.
The process by which a leader appraises the creditworthiness of the prospective borrower is known as Credit Appraisal. This normally involves appraising the borrower's payment history and establishing the quality and sustainability of his income. The lender satisfies himself of the good intentions of the borrower, usually through an interview. Some requirements for credit appraisal are as follows :
  • The credit requirement must be assessed by all Indian financial institutions or specialized institution set-up for this purpose.
  • Wherever financing of infrastructure project is taken up under a consortium/syndication arrangement - bank's exposure shall not exceed 23%.
  • Bank may also take up financing infrastructure project independently exclusively in respect of borrowers promoters of repute with excellent past record in project implementation.
  • In such cases/due diligence on the inability of the projects are well defined and assessed. State Government guarantee may not be taken as a substitute for satisfactory credit appraisal.

The important thing to remember is not to be overwhelmed by marketing or profit centre reasons to book a loan but to take a balanced view when booking a loan, taking into account the risk reward aspects. Generally everyone becomes optimistic during the upswing of the business cycle, but tend to forget to see how the borrower will be during the downturn, which is a shortsighted approach. Furthermore greater emphasis is given on financials, which are usually outdated; this is further exacerbated by the fact that a descriptive approach is usually taken, rather than an analytical approach, to the credit. Thus a forward looking approach should also be adopted, since the loan will be re-paid primarily from future cash flows, not historic performance; however both can be used as good repayment indicators.
Credit appraisal is done to evaluate the creditworthiness of a borrower. The credit appraisals for any organisation basically follow these steps - assessment of credit need, financial statement analysis, and financial ratios of the company, credit rating, working capital requirement, term loan analysis, submission of documents, NPA classification and recovery.

Benefits of Credit Appraisal 

The benefits of credit appraisal are as follows :
  • Reduces risk involved in the loans provided for a project.
  • Increase confidence among the corporate bankers and improved sales decision.
  • Reduces NPA (Non-Performing Assets) and possibility of financial loss.
  • Proper assessment is done with different options.

Types of Credit 

There are four basic types of credit :
  1. Service credit is monthly payments for utilities such as telephone, gas, electricity, and water. One has to pay a deposit and late charge if payment is not on time.
  2. Loans can be for small or large amounts and for a few days or several years. Money can be repaid in one lump sum or in several regular payments until the amount one borrowed and the finance charges are paid in full. Loans can be secured or unsecured.
  3. Installment credit may be described as buying on time, financing through the store or the easy payment plan. The borrower takes the goods home in exchange for a promise to pay later. Cars, major appliances, and furniture are often purchased this way. One usually sign a contract, make a down payment, and agree to pay the balance with a specified number of equal payments called installments. The finance charges are included in the payments. The item one purchase may be used as security for the loan.
  4. Credit cards are issued by individual retail stores, banks, or businesses. Using a credit card can be the equivalent of an interest-free loan-if one pay for the use of it in full at the end of each month.

Credit Appraisal Process 

The process of credit appraisal is as follows :

1) Credit Processing : 
Credit processing is the stage where all required information on credit is gathered and applications are screened. Credit application forms should be sufficiently detailed to permit gathering of all information needed for credit assessment at the outset. In this connection, financial institutions should have a checklist to ensure that all required information is, in fact, collected.

2) Credit-Approval/Sanction : 
A financial institution must have in place written guidelines on the credit approval process and the approval authorities of individuals or committees as well as the basis of those decisions. Approval authorities should be sanctioned by the board of directors. Approval authorities will cover new credit approvals, renewals of existing credits, and changes in terns and conditions of previously approved credits, particularly credit restructuring, all of which should be fully documented and recorded. Prudent credit practice requires that persons empowered with thee credit approval authority should not also have the customer relationship responsibility.

3) Credit Documentation : 
Documentation is an essential part of the credit process and is required for each phase of the credit cycle, including credit application, credit analysis, credit approval, credit monitoring, collateral valuation, and impairment recognition, foreclosure of impaired loan and realization of security. The format of credit files must be standardized and files neatly maintained with an appropriate system of cross-indexing to facilitate review and follow-up. The Bank of Mauritius will pay particular attention to the quality of files and the systems in place for their maintenance.
Documentation establishes the relationship between the financial institution and the borrower and forms the basis for any legal action in a court of law. Institutions must ensure that contractual agreements with their borrowers are vetted by their legal advisers. Credit applications must be documented regardless of their approval or rejection. All documentation should be available for examination by the Bank of Mauritius.

4) Credit Administration : 
Financial institutions must ensure that their credit portfolio is properly administered, that is, loan agreements are duly prepared, renewal notices are sent systematically and credit files are regularly updated. An institution may allocate its credit administration function to a separate department or to designated individuals in credit operations, depending on the size and complexity of its credit portfolio.
A financial institution's credit administration function should, as a minimum, ensure that :
i) Credit files are neatly organized, cross-indexed, and their removal from the premises is not permitted.
ii) The borrower has registered the required insurance policy in favor of the bank and is regularly paying the premiums.
iii) The borrower is making timely repayments of lease rents in respect of charged leasehold properties.
iv) Credit facilities are disbursed only after all the contractual terms and conditions have been met and all the required documents have been received;
v) Collateral value is regularly monitored.
vi) The borrower is making timely repayments on interest, principal and any agreed to fees and commissions.

5) Disbursement : 
Once the credit is approved, the customer should be advised of the terms and conditions of the credit by way of a letter of offer. The duplicate of this letter should be duly signed and returned to the institution by the customer. The facility disbursement process should start only upon receipt of this letter and should involve, inter alia, the completion of formalities regarding documentation, the registration of collateral, insurance cover in the institution's favor and the vetting of documents by a legal expert. Under no circumstances shall funds be released prior to compliance with pre-disbursement conditions and approval by the relevant authorities in the financial institution.

6) Monitoring and Control of Individual Credits : 
To safeguard financial institutions against potential losses, problem facilities need to be identified early. A proper credit monitoring system will provide the basis for taking prompt corrective actions when warming signs point to deterioration in the financial health of the borrower. Examples of such waning signs include unauthorized drawings, arrears in capital and interest and deterioration in the borrower's operating environment. Financial institutions must have a system in place to formally review the status of the credit and the financial health of the borrower at least once a year. More frequent reviews (e.g. at least quarterly) should be carried out of large credits, problem credits or when the operating environment of the customer is undergoing significant changes.