TERM LOANS

 Bank loan structuring for business entities depends on the purpose for which the loan application is being entertained and the tenure of the loan. Loans for meeting the operating expenditure are given in the form of short-term loans upto 1 year and are extended as running accounts, payable on demand, whereas loans for the acquisition of fixed assets are provided for medium to long term and in the form of Term Loan amortized over the tenure of the loan. The tenure of the Term Loans is usually 8-10 years depending on the loan policy of the bank. 

 Purpose for which the Term Loans are extended:

1. Acquisition of Fixed Assets such as Land, Building, Plant & Machinery.
2. Modernisation / renovation / expansion / diversification of an existing unit.
3. Strengthening NWC
4. Other Long-Term Requirements – VRS etc
5. Purchase of second-hand machinery
6. Replacement of high-cost debt (For remaining maturity)

The loan may be drawn by the borrower either in lump sum or in instalments. 

Appraisal of term loans 

Term loan appraisal covers the appraisal on two fronts – borrower and the project. The characteristics of a term loan are that term loan commitments are to be of long term. The banks and financial institutions normally offer term loans repayable in 8 – 10 years and beyond that period in exceptional cases like housing loans. The repayment is expected out of the cash generated from business activities, meaning the asset is put into the production of goods/service and cash generated from additional sales revenue. 

Appraisal of the borrower covers honesty and integrity of the borrower, creditworthiness of the borrower, business capacity, managerial competence, financial resources in relation to the size of the project etc. The sources of information for the above are the personal interview, credit investigation, trade circle enquiries, market report, existing bank’s report, credit information report, assets and liabilities statements submitted by the borrowers, Income Tax assessment orders and wealth tax assessment orders of promoters etc. 

The purpose of term loan appraisal is to ascertain whether the project is sound -technically, economically, financially, and managerially and is ultimately viable as a commercial proposition. 

The appraisal of a project involves the examination of:

Technical Feasibility – To determine the suitability of the technology selected and the adequacy of the technical investigation, and design.

 Factors to be considered in the Technical Feasibility are:

• Location of plant & accessibility to critical inputs
• Size of the plant
• Type of technology
• Production factors (power, water, utilities, transport etc.)
• Availability of Labour (Skilled / Unskilled)

 Economic Viability - To determine the conduciveness of economic parameters to setting up the project and their impact on the scale of operations.

 Factors to be considered in Economic Viability are:

• Thorough market analysis
• Future trends in volume and patterns of Supply & Demand
• Demand forecast, Supply position Gap
• Intermediate product

 Financial Feasibility – To determine the accuracy of cost estimates, suitability of the envisaged pattern of financing and general soundness of the capital structure.

 Under financial feasibility, the examination should revolve around and comment upon the Cost of the Project, Means of Finance, Cash Surplus and Obligation servicing.

 Cost of the project: 

 The cost estimates should be scrutinized, item by item (wherever possible, by a comparative analysis of the cost estimates of similar projects in the same industry), with a view to ensuring that they have been arrived at realistically after considering all relevant cost optimization factors. It is also essential that comments on the various components of the total cost of project be given, as follows:

• Land (including site development): Examine the suitability of the site selected with reference to the surrounding topographical features, availability of transport facilities, availability of railway facilities /port, proximity to sources of water, power, labour, raw materials, and markets for finished goods. Examine the borrower’s title to the land and mention clearly whether it is freehold or leasehold.
• Buildings: Examine whether the proposed buildings will be sufficient having regard to the nature/layout, size of the plant and the proposed scale of operations. The detailed cost estimates of the proposed construction are to be obtained and examined for its reasonableness.
• Plant and machinery: Furnish a list of the items of plant and machinery, which should be classified in broad groups under two heads viz., imported items and indigenous items, together with the names of the suppliers.

Examine these items in relation to the requirements of plant and machinery recommended in the technical feasibility report or indicated in the process chart in the project report and state how they will be suitable and adequate for the envisaged production. In case of high value (individual items of Plant & Machinery), an opinion report on the supplier may be obtained.

 Means of finance: 

 Examine the proportion of debt and equity components, which is called the project Debt/Equity ratio, envisaged in the tie-up of the means of financing of the project. The stipulation of this ratio for a particular project will be based on several factors such as the nature and size of the project, location, capital intensity, gestation period, promoters’ capacity, internal credit policy etc.

 Commercial Viability – To determine the extent of profitability of the project and its sufficiency in relation to the repayment obligations pertaining to term assistance.

 Tools for evaluating Commercial Viability

 Debt Service Coverage Ratio (DSCR)

 The ultimate purpose of project appraisal is to ascertain the viability of the project, which has a direct bearing on the repayment period and the quantum of instalments. The repayment schedule should, therefore, be fixed after ascertaining the annual servicing capacity of the project, during the entire repayment period, which is indicated by the debt service coverage ratio.

 The Debt-Service Coverage Ratio (DSCR) is a method of calculating the repayment ability of multiple debt obligations including proposed term loan installments. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal (total debt service). 

The formula for finding out debt service coverage ratio

DSCR = (Profit after Tax & Depreciation & Interest on Term Loan) / (Interest on Term Loan Installment amount of Term Loan)

In simple terms, DSCR is net operating income divided by total debt service.  DSCR less than 1 suggests the inability of a firm's profits to service its debts whereas a DSCR greater than 1 means the borrower can service the debt obligations. The acceptable industry norm for a debt service coverage ratio is between 1.5 to 2. To have a conclusive idea about the debt servicing ability of the borrower, it is advisable to arrive at DSCR for the entire period of loan instead of only for one year. 

Sensitivity Analysis:

 The purpose of the Sensitivity analysis is to study the cushion available in the profitability of a project to withstand shortfalls in the expected results owing to uncertainties i.e., the sensitivity of the project and the degree of resilience available to withstand the adverse impact arising from minor/major changes/uncertainties in the profitability parameters.

 Break-Even Analysis (BEA)

 In a manufacturing unit, if at a particular level of production, the total fixed cost equals the

contribution (total sales revenue minus total variable cost), this point is known as Break Even Point (BEP). 

 The formula to calculate the Break-Even Point is as under:

 Fixed Costs / Contribution per unit * 100

(Where contribution is “Net Revenue – Variable Costs”)

 However, as a rule, it can be said that the lower the break-even level, the higher will be the

profitability. In respect of break-even sales, the level should be considerably low in relation to the projected sales as to leave a satisfactory margin of safety.

 The cash break-even (i.e. without considering ‘Depreciation’ as fixed cost) at installed capacity should normally be below 50%. Break-even range for different industries/ sectors may be different. A peer analysis may be carried out to compare the break-even level of a project with that of similar projects in the industry.

 The formula to calculate the Cash Break Even Point is as under:

 (Fixed Costs – Depreciation) / Contribution * 100

 Security Margin:

 Security Margin Coverage Ratio (SMCR) is represented in % terms and to be calculated as under:

 SMCR = WDV of Fixed Assets - Term Loan outstanding

 Managerial Competency – To ascertain that competent men are behind the project to ensure its successful implementation and efficient management after commencement of commercial production

 Environmental concern: To ascertain whether the project is in compliance with the various environmental provisions in force.

The Term Loan appraisal should normally cover the following aspects:

• the nature of the proposal
• brief account of the corporate history of the borrowing unit and its management team
• the company’s line of manufacture
• the scope of activity as per its Memorandum of Association and any limitations on its borrowing powers and operations as per its Articles of Association
• the company’s own financial position (if it is an existing one) and that of its associate/subsidiary concerns indicating the applicant company’s financial involvement in them and the overall structure of inter-corporate investments
• its capital structure and analysis of audited balance sheets and profit and loss accounts for the last 3 years

In addition to the above, the following aspects may also be discussed in the proposal:

Particulars of the project furnishing details of the technology, manufacturing process, availability of construction/production facilities etc., estimates of cost of the project detailing the itemised assets acquired/to be acquired, details of preliminary/preoperative expenses and working capital margin requirements.

Details of the proposed means of financing indicating the extent of promoters’ contribution, the quantum of capital to be brought in (if envisaged) and the sources of such capital, the composition of the borrowed capital portion with particulars of term loans.

Information on the following to be obtained & commented upon in the proposal:-

• Projected Sales Turnover (after incurrence of Capital Expenditure)
• Projected P&L & Balance Sheet for the tenure of the Term Loan
• Interest Servicing during Implementation or Moratorium Period
• If Capital goods are being imported, the stand on covering the exchange rate fluctuation.
• Sources of Project Margin to be brought in by the promoters/owners
• Debt Service Coverage Ratio
• Break Even Analysis

 Provision for contingencies: 

 This are required to take care of the following:

• Escalation in the cost of the items because of increase in prices, import duty, excise duty, sales tax, transportation charges, and fluctuations in foreign exchange rates etc.
• Delay in the implementation of the project owing to technical or other factors.
• Sundry items/expenses initially omitted, as they could not be envisaged at the time of project formulation.
• Any other unforeseen expenses crop up during project implementation, which are necessarily required for completion of the project.

 The cushion built into the cost of the project by way of contingency provision could be in the range of 5% to 15% of the cost of non-firm items in the project cost.

 Other important point(s) to be kept in mind and should be furnished in the appraisal memorandum are as follows:

 Commencement of commercial production and stabilisation of commercial production:

 Sometimes units engaged in manufacturing activity (irrespective of market segment) would have commenced commercial production but their commercial production would not have stabilised. In other words, the concerned units would not have been in a position to achieve cash break-even to service the interest and term loan instalments i.e., there is no regular cash flow to service the debt. In the cases of such units, there may be a need for examining the necessity to reschedule repayment of the term loans. It must be ensured that the loans are rescheduled only at the borrower’s request if otherwise found financially viable i.e., branches should not reschedule the relative term loans on their own.

 Repayment programme: While fixing the repayment programme, the annual cash accruals should be taken into consideration. If an initial moratorium (start-up) period is required, reasoned recommendations should be incorporated indicating the basis on which the period of moratorium has been determined. Repayment programmes should be furnished clearly mentioning the date of start of repayment, number of installments, frequency of installments etc. preferably in tabular form.

 Marketing (Acceptance of the Projected Sales):

 This constitutes a crucial aspect of project appraisal as the basic viability of the project and consequently the repayment of the Bank’s term loan depends upon the marketability of its products. This aspect should, therefore, be studied in depth. Wherever required, a specific study by an external consultant may be carried out.

 Disbursement of term loans

 After loans have been sanctioned, the loan administration department must ensure that all security/documentation formalities are completed before any part loan is disbursed.

They should check the sources of funds for margin and ensure the genuineness before disbursement in lumpsum in general and state wise sources of funds for margin at different stages if it is in tranches.

 They should check the invoices, submitted with the request for disbursement, with the quotations submitted at the time of appraisal. The payment terms of the quotations should also be checked and it is to be ensured that the disbursements are being made as per payment terms of the quotations. Ensure compliances of pre disbursement conditions and obtain approval before disbursement. Ensure direct payment to suppliers through Online Payment.

A borrower is expected to have incurred a part of the capital expenditure in implementation of the project before disbursement of the term loan. They must, therefore, ascertain the physical progress made in implementation of the project and the progress made in the mobilization of the means of financing. Site visit and detailed discussions with the borrowers should be held on record. The statement of scheduled capital expenditure submitted by the borrower for drawing funds under the Bank’s term loans should be supported by documents such as invoices in the case of purchase of plant and machinery, architect’s/contractor’s certificate in the case of construction of buildings, etc. In addition, it should preferably be certified by a reputed firm of auditors/chartered accountants. The verification of such supporting documents and direct disbursement of term loan to suppliers/contractors wherever possible would ensure that the proceeds of the term loan are utilized for the purpose for which the term loan has been sanctioned and that the funds disbursed thereunder are not diverted for any unauthorized purpose.