INTRODUCTION

Credit Appraisal means an investigation/assessment done by the banks before providing any
Loans & advances/project finance & also checks the commercial, financial & technical viability
of the project proposed, its funding pattern & further checks the primary & 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. Credit risk is a risk related to non-repayment of the credit
obtained by the customer of a bank. Thus it is necessary to appraise the credibility of the
customer in order to mitigate the credit risk. Proper evaluation of the customer is performed this
measures the financial condition and the ability of the customer to repay back the Loan in future.
Generally the credits facilities are extended against the security know as collateral. But even
though the Loans are backed by the collateral, banks are normally interested in the actual Loan
amount to be repaid along with the interest. Thus, the customer's cash flows are ascertained to
ensure the timely payment of principal and the interest.
It is the process of appraising the credit worthiness of a Loan applicant. Factors like age, income,
number of dependents, nature of employment, continuity of employment, repayment capacity,
previous Loans, credit cards, etc. are taken into account while appraising the credit worthiness of
a person.

Small and Medium Enterprises (SME) sector is broadly a term used for small scale
industrial (SSI) units and medium-scale industrial units.
Any industrial unit with a total investment in its fixed assets or leased assets or hire-purchase
asset of up to Rs 10 million, can be considered as an SSI unit and any investment of up to Rs 100
million can be termed as a medium unit
An SME unit should neither be a subsidiary of any other industrial unit nor be owned or
controlled by any other industrial unit.
SMEs face fragmented markets in respect of their inputs as well as products and are vulnerable
to market fluctuations. SMEs lack easy access to inter-state and international markets. The access
of SMEs to technology and product innovations is also limited. There is a lack of awareness of
global best practices. SMEs face considerable delays in the settlement of dues/payment of bills
by the large scale buyers. With the deregulation of the financial sector, the ability of the banks to
service the credit requirements of the SME sector depends on the underlying transaction costs,
efficient recovery processes and available security. There is an immediate need for the banking
sector to focus on credit and SMEs

Credit Appraisal Process

When a small business applies for a business loan, a bank or other lender follows a certain
protocol when evaluating the application.
One thing the bank uses is the 5 C's of credit analysis to evaluate the application for the
loan. Bankers evaluate the small business in the context of the 5 C's in order to allocate their
limited funds.

1. Capacity : The first "C", capacity, may be the most important. Capacity refers to the
ability of the firm to repay the loan. Banks will check how and when the applicant intend
to repay the loan by checking projected cash flows, fund flows, P&L and Balance
sheets, and the timing of your cash flows with regard to repayment. Bankers will check
the technical and financial feasibility of the project, credit history, managerial
competence and past experience, etc. Capacity also refers to your credit history. The
bank will look at your past repayment history, both business and personal. As part of the
appraisal process, credit rating is also done for the proposal and is conducted either by
the bank itself or is get done by approves external agencies. The purpose of this project is
to explain, in a brief and general way, the manner in which risks are approached by

financiers in a project finance transaction. Such risk minimization lies at the heart of
project finance.
2. Collateral:
Collateral is a distinct relationship to capacity. Collateral refers to forms of security
applicant can provide to your bank or other lender. Collateral may be buildings or
equipment owned by small business or by applicant personally, including home.
Collateral may also include a guarantee by someone else that, in case applicant cannot
repay the loan, the other party will. As money gets tight in the economy, there is an
increased chance that banks will require loan guarantees in addition to collateral.
3. Capital:
Capital, in this context, represents the owner's investment in the business. Before
applying for a bank loan, the owner has to have a significant investment in the business
before a lender will even consider making a business loan. The loan officer will look
carefully at the amount and quality of capital the owner has to offer.
4. Conditions:
Conditions are two-fold. First, conditions refer to the overall economic climate and
external environment surrounding the bank and the business firm. During a recession or
periods of tight credit, it is obviously more difficult for a small business to repay a loan
and more difficult for a bank to find the funds to loan. It becomes even more important
for the small business firm to present an iron-clad loan application to the bank. The
second part of conditions refers to the intended purpose of the loan. Are you buying new
equipment for expansion? Are you replenishing working capital to prepare for seasonal
inventory buildup? Why do you need the money?
5. Character
Character is often a subjective judgment made by the banker about the prospective client.
The lender decides if the client is trustworthy with regard to repaying the loan and
generating a return on the investment. This is where the education and experience of the
client comes into the picture. References and Background of applicants industry are
considered by the financial loan officer.

Efficient management of credit portfolio is of utmost importance as it has a tremendous

impact on the Banks assets quality & profitability. The financial reforms have provided
unparallel opportunities to banks for growth, but have simultaneously exposed them to various
risks, which need to be effectively managed. Credit Risk in all exposures calls for precise
measuring and monitoring for taking considered credit decisions with suitable risk mitigants, risk
premium, etc. various projections and financial techniques for term loan like fund flow / cash
flow, profitability schedules, DSCR, sensitivity analysis, Break Even Analysis, rate of return on
the basis of various calculation techniques, etc., in arriving at a decision.

Other Factors which acts as the guidelines that banks have to consider are:
1. Credit-deposit ratio:
Banks are under an obligation to maintain certain statutory reserves like cash reserve
ratio (CRR to be kept as cash or cash equivalents), statutory liquidity ratio (SLR to
be kept in cash or cash equivalents and prescribed securities), etc.
These reserves are maintained for asset liability management (ALM) and are calculated
on the basis of demand and time liabilities (DTL).
2. Credit Policy Committee (CPC):
The CPC decides upon the quantum of credit that can be granted by the bank as a
percentage of deposits. Targeted portfolio mix: CPC has to strike balance between risk
and return. It sets the guiding principles in choosing preferred areas of lending and
sectors to avoid. It also takes into account government policies of lending to preferred /
avoidable sectors.
3. Sectoral Preferences:
The bank assesses sectors for future growth and profitability and accordingly decides its
exposure limits.
4. Hurdle ratings:
A borrower is assessed on various risk aspects to find out its suitability for extending
credit to it. Banks uses a comprehensive risk rating system on which each borrower gets a
score depending upon its strength and weaknesses. This acts as a single point reference
and uses a standardized approach for variety of borrowers. Ratings reveal the overall risk
of lending. For new borrowers, a bank usually lays down guidelines regarding minimum
rating to be achieved by the borrower to become eligible for the loan. This is also known
as the hurdle rating criterion to be achieved by a new borrower.
5. Loan pricing:
Risk-return trade-off is a fundamental aspect of risk management. Borrowers with weak
financial position and, hence, placed in higher risk category are provided credit facilities
at a higher price (that is, at higher interest). In other words, if the risk rating of a borrower
deteriorates, his cost of borrowing should rise and vice versa. At the macro level, loan
pricing for a bank is dependent upon a number of its cost factors such as cost of raising
resources, cost of administration and overheads, cost of reserve assets like CRR and SLR,
cost of maintaining capital, percentage of bad debt, etc. Loan pricing is also dependent
upon competition.

6.

RBI constraints:
The RBI lays down guidelines regarding minimum advances to be made for priority
sector advances, export credit finance, etc. These guidelines need to be kept in mind
while formulating credit policies for the Bank. Capital adequacy. If a bank creates assetsloans or investment-they are required to be backed up by bank capital; the amount of
capital they have to be backed up by depends on the risk of individual assets that the bank
acquires. The riskier the asset, the larger would be the capital it has to be backed up by.
This is so, because bank capital provides a cushion against unexpected losses of banks
and riskier assets would require larger amounts of capital to act as cushion.
As a prudential measure aimed at better risk management and avoidance of concentration
of credit risks, the Reserve Bank has fixed limits on bank exposure to the capital market
as well as to individual and group borrowers with reference to a banks capital. Limits on
inter-bank exposures have also been placed. Banks are further encouraged to place
internal caps on their sectoral exposures, their exposure to commercial real estate and to
unsecured exposures.

Finally the sequence of the above process is explained as under:

1. Receipt of Application from Applicant

2. Receipt of documents Balance Sheet; KYC; Government registration papers etc.
3. Pre-Sanction Visit by bank officers
4. Check for RBI defaulter , willful defaulters list, CIBIL data, ECGC.
5. Title clearance reports of the properties to be obtained.
6. Valuation reports of properties to be obtained from empanelled valuer.
7. Preparation of financial data.
8.

Proposal preparation.

9. Assessment of proposal Sanction/approval of proposal by appropriate sanctioning

authority.
10. Documentations, agreements, mortgages.

11. Disbursement of Loan.

12. Post sanction activities such as receiving stock statements, review of accounts, renew of
accounts, etc. (On regular basis)