CREDIT APPRAISALEffectiveness of Credit Management in the bank is highlighted by the quality of its loan portfolio. Every Bank is striving hard to ensure that its credit portfolio is healthy and that Non-Performing Assets are kept at lowest possible level, as both of these factors have direct impact on its profitability. In the present scenario efficient project appraisal has assumed a great importance as it can check and prevent induction of weak accounts to our loan portfolio. All possible steps need to be taken to strengthen pre sanction appraisal as always Prevention is better than Cure. With the opening up of the economy rapid changes are taking place in the technology and financial sector exposing banks to greater risks, which can be broadly classified as under:Industry RisksGovernment regulations and policies, availability of infrastructure facilities, Industry Rating, Industry Scenario & Outlook, Technology Up gradation, availability of inputs, product obsolescence, etc.

Business RisksOperating efficiency, competition faced from the units engaged in similar products, demand and supply position, cost of labor, cost of raw material and other inputs, pricing of product, surplus available, marketing, etc.

Management RisksBackground, integrity and market standing/ reputation of promoters, organizational set up and management hierarchy, expertise/competence of persons holding key position in the organization, delegation and decentralization of authority, achievement of targets, track record in execution of project, debt repayment, industry relations etc.

Financial RisksFinancial strength/standing of the promoters, reliability and reasonableness of projections, past financial performance, reliability of operational data and financial ratios, adequacy of provisioning for bad debts, qualifying remarks of auditors/inspectors etc.

In light of the foregoing risks, the banks appraisal methodology should keep pace with ever changing economic environment. The appraisal system aims to determine the credit needs/requirements of the borrower taking into account the financial resources of the client. The end objective of the appraisal system is to ensure that there is no under - financing or over - financing. Following are the aspects, which need to be scrutinized and analyzed while appraising.1. MARKET ANALYSISThe market demand and potential is to be examined for each product item and its variants/substitutes by taking into account the selling price of the products to be marketed vis-a-vis prices of the competing products/substitutes, discount structure, arrangement made for after sale service, competitors' status and their level of operation with regard to production and products and distribution channels being used etc. Critical analysis is required regarding size of the market for the product(s) both local and export, based on the present and expected future demand in relation to supply position of similar products and availability of the other substitutes as also consumer preferences, practices, attitudes, requirements etc. Further, the buy-back arrangements under the foreign collaboration, if any, and influence of Government policies also needs to be considered for projecting the demand. Competition from imported goods, Government Import Policy and Import duty structure also need to be evaluated. 2. TECHNICAL ANALYSISIn a dynamic market, the product, its variants and the product-mix proposed to be manufactured in terms of its quality, quantity, value, application and current taste/trend requires thorough investigation.a. Location and SiteBased on the assessment of factors of production, markets, Govt. policies and other factors, Location (which means the broad area) and Site (which signifies specific plot of land) selected for the Unit with its advantages and disadvantages, if any, should be such that overall cost is minimized. It is to be seen that site selected has adequate availability of infrastructure facilities viz. Power, Water, Transport, Communication, state of information technology etc. and is in agreement with the Govt. policies. The adequacy of size of land and building for carrying out its present/proposed activity with enough scope for accommodating future expansion needs to be judged. b. Raw MaterialThe cost of essential/major raw materials and consumables required their past and future price trends, quality/properties, their availability on a regular basis, transportation charges, Govt. policies regarding regulation of supplies and prices require to be examined in detail. Further, cost of indigenous and imported raw material, firm arrangements for procurement of the same etc. need to be assessed.c. Plant & Machinery, Plant Capacity and Manufacturing ProcessThe selection of Plant and Machinery proposed to be acquired whether indigenous or imported has to be in agreement with required plant capacity, principal inputs, investment outlay and production cost as also with the machinery and equipment already installed in an existing unit, while for the new unit it is to be examined whether these are of proven technology as to its performance. The technology used should be latest and cost effective enabling the unit to compete in the market. Purchase of reconditioned/old machinery is to be dealt in terms of laid down guidelines. Compatibility of plant and machinery, particularly, in respect of imported technology with quality of raw material is to be kept in view. Also plant and machinery and other equipments needed for various utility services, their supply position, specification, price and performance as also suppliers' credentials, and in case of collaboration, collaborators' present and future support requires critical analysis. Plant capacity and the concept of economic size has a major bearing on the present and future plans of the entrepreneur(s) and should be related to the availability of raw material, product demand, product price and technology. The selected process of manufacturing indicating the adequacy, availability and suitability of technology to be used along with plant capacity, manufacturing process needs to studied in detail with capacities at various stages of production being such that it facilitates optimum utilization and ensures future expansion/ debottlenecking, as and when required. It is also to be ensured that arrangements are made for inspection at intermediate/final stages of production for ensuring quality of goods on successful commencement of production and completion, wherever required.

3. FINANCIAL ANALYSISThe aspects which need to be analyzed under this head should include cost of project, means of financing, cost of production, break-even analysis, financial statements as also profitability/funds flow projections, financial ratios, sensitivity analysis which are discussed as under:a. Cost of Project & Means of FinancingThe major cost components of any project are land and building including transfer, registration and development charges as also plant and machinery, equipment for auxiliary services, including transportation, insurance, duty, clearing, loading and unloading charges etc. It also involves consultancy and know-how expenses which are payable to foreign collaborators or consultants who are imparting the technical know-how. Recurring annual royalty payment is not reflected under this head but is accounted for under the profitability statements. Further, preliminary expenses, such as, cost of incorporation of the Company, its registration, preparation of feasibility report, market surveys, pre-operative expenses like salary, travelling, startup expenses, mortgage expenses incurred before commencement of commercial production also form part of cost of project. Also included in it are capital issue expenses which can be in the form of brokerage, commission, advertisement, printing, stationery etc. Finally, provisions for contingencies to meet any unforeseen expenses, such as, price escalation or any other expense which have been inadvertently omitted like margin for working capital requirements required to complete the production cycle, interest during construction period, etc. are also part of capital cost of project. It is to be ensured while appraising the project that cost and various estimates given are realistic and there is no under/over estimation. Further, these cost components should be supported by proper quotations, specifications and justifications of land, machinery and know-how expenses etc.Besides Banks loan, the project cost is normally financed by bringing capital by the promoters and shareholders in the form of equity, debentures, unsecured long term loans and deposits raised from friends and relatives which are not repayable till repayment of Bank's loan. Resources are raised for financing project by raising term loans from Institutions/Banks which are repayable over a period of time, deferred term credits secured from suppliers of machinery which are repayable in installments over a period of time. The above is an illustrative list, as the promoters have now started raising funds through Euro-issues, Foreign Currency loans, premium on capital issues, etc. which are sometimes comparatively cheap means of finance. Subsidies and development loans provided by the Central/State Government in notified backward districts to attract entrepreneurs are also means of financing a project. It is to be ascertained that requirement of finance has been properly tied-up for unhindered implementation of a project. The financing structure accepted must be in consonance with generally accepted levels along with adequate Promoters' stake. The resourcefulness, willingness and capacity of promoter to contribute the same have also to be investigated. In case of project finance, the promoter/borrower may bring in upfront his contribution (other than funds to be provided through internal generation) and the branches should commence its disbursement after the stipulated funds are brought in by the promoter/borrower. A condition to this effect should be stipulated by the sanctioning authority in case of project finance, on case to case basis depending upon the resourcefulness and capacity of the promoter to contribute the same. It should be ensured that at any point of time, the promoters contribution should not be less than the proportionate share.b. Profitability StatementThe profitability statement which is also known as `Income and Expenditure Statement' is prepared after considering the net sales figure and details of direct costs/expenses relating to raw material, wages, power, fuel, consumable stores/spares and other manufacturing expenses to arrive at a figure of gross profit. Thereafter, all other expenses like salaries, office expenses, packing, selling/distribution, interest, depreciation and any other overhead expenses and taxes are taken into account to arrive at the figure of net profit. The projections of profit/loss are prepared for a period covering the repayment of term loans. The economic appraisal includes scrutinizing all the items of cost, and examining the assumptions, if any, to ensure that these are realistic and achievable. There should not be any optimism or pessimism in working out profitability projections since even a little change in the product-mix from non-remunerative to remunerative or vice-versa can distort the picture. While preparing profitability projections, the past trends of performance in an industry and other environmental factors influencing the cost and revenue items should also be considered objectively.Generally speaking, a unit may be considered as financially viable, progressive and efficient if it is able to earn enough profits not only to service its debts timely but also for future development/growth.c. Break-Even AnalysisAnalysis of break-even point of a business enterprise would help in knowing the level of output and sales at which the business enterprise just breaks even i.e. there is neither profit nor loss. A business earns profit if it operates at a level higher than the break-even level or break-even point. If, on the other hand, production is below this level, the business would incur loss. The break-even point in an algebraic equation can be put as under:Break-even pointBreak-even point (Volume or Units)Total Fixed Cost / (Sales price per unit - Variable Cost per unit)

Break-even point (Sales in rupees)(Total Fixed Cost x Sales) / (Sales - Variable Costs)

The fixed costs include all those costs which tend to remain the same up to a certain level of production while variable costs are those costs which tend to change in proportion with the volume of production. As regards unit sales price, it is generally the same for all levels of output.The break-even analysis can help in making vital decisions relating to fixation of selling price make or buy decision, maximizing production of the item giving higher contribution etc. Further, the break-even analysis can help in understanding the impact of important cost factors, such as, power, raw material, labor, etc. and optimizing product-mix to improve project profitability.

d. Fund-Flow StatementA fund-flow statement is often described as a Statement of Movement of Funds or where got: where gone statement. It is derived by comparing the successive balance sheets on two specified dates and finding out the net changes in the various items appearing in the balance sheets. A critical analysis of the statement shows the various changes in sources and applications (uses) of funds to ultimately give the position of net funds available with the business for repayment of the loans. A projected Fund Flow Statement helps in answering the under mentioned points. How much funds will be generated by internal operations/external sources?How the funds during the period are proposed to be deployed?Is the business likely to face liquidity problems?e. Balance Sheet ProjectionsThe financial appraisal also includes study of projected balance sheet which gives the position of assets and liabilities of a unit at a particular future date. In other words, the statement helps to analyze as to what an enterprise owns and what it owes at a particular point of time. An appraisal of the projected balance sheet data of the unit would be concerned with whether the projections are realistic looking to various aspects relating to the same industry. f. Financial RatiosWhile analyzing the financial aspects of project, it would be advisable to analyze the important financial ratios over a period of time as it may tell us a lot about a unit's liquidity position, managements' stake in the business, capacity to service the debts etc. The financial ratios which are considered important are as follows:1. Current Ratio 2. Quick Ratio3. Debt-Equity Ratio4. Proprietary Ratio5. Fixed Assets Ratio6. Return on Assets Ratio (ROA)7. Return on Capital Employed (ROCE)8. Interest Coverage Ratio9. Gross Profit Ratio10. Net Profit Ratio11. Operating Ratio12. Stock Turnover Ratio13. Debts Turnover Ratio14. Creditors Turnover Ratio15. Fixed Obligation Income Ratio16. Installment to Income Ratio17. Debt-Service Coverage Ratio18. Total Outside Liability / Total Net Worth19. Sales Tangible Assets20. Output Investment Ratio

g. Internal Rate of ReturnThe discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Higher a project's IRR the more desirable it is to undertake the project. IRR should be higher than the Cost of the project. (Interest rate in case of project financing).

4. SENSITIVITY ANALYSISWhile preparing and appraising projects certain assumptions are made in respect of certain critical/sensitive variables like selling price/cost price per unit of production, product-mix, plant capacity utilization, sales etc. which are assigned a `VALUE' after estimating the range of variation of such variables. The `VALUE' so assumed and taken into consideration for arriving at the profitability projections is the `MOST LIKELY VALUE'. Sensitivity Analysis is a systematic approach to reduce the uncertainties caused by such assumptions made. The Sensitivity Analysis helps in arriving at profitability of the project wherein critical or sensitive elements are identified which are assigned different values and the values assigned are both optimistic and pessimistic such as increasing or reducing the sale price/sale volume, increasing or reducing the cost of inputs etc. and then the project viability is ascertained. The critical variables can then be thoroughly examined by generally selecting the pessimistic options so as to make possible improvements in the project and make it operational on viable lines even in the adverse circumstances.5. MANAGEMENT & ORGANIZATION ANALYSISAppraisal of project would not be complete till it throws enough light on the person(s) behind the project i.e. management and organization of the unit. It is seen that some projects may fail not because these are not viable but because of the ineffectiveness of the management and the organization in controlling various functions like production, marketing, finance, personnel, etc. The appraisal report should highlight the strengths and weaknesses of the management by commenting on the background, qualifications, experience, and capability of the promoter, key management personnel, and effectiveness of the internal control systems, relation with labor, working conditions, wage structure, and the other assigned essential functions. In case the promoters have interest, in other concerns as Proprietor or Partner or Director, the appraisal report should also comment on their performance in such concerns.A business is more vulnerable if decision making in all the functional areas rests with a particular person, in other words, `one man show'. Further, the management and the organization should be conducive to the size and type of business. In case it is not so, it should be ensured that professional managers are inducted to strengthen the organization.CREDIT RISKCredit risk means the possibility of loss associated with diminution in the credit quality of borrowers. In a banks portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter party to meet, commitments in relation to lending, trading, settlement and other financial transactions. A comprehensive credit risk management system, which is in place in the bank, encompasses the following processes: Identification of Credit Risk Measurement of Credit Risk Grading of Credit Risk Reporting and analysis of rating related data Control of Credit Risk

Credit Risk IdentificationIn order to take informed credit decisions, it is necessary to identify the areas of credit risk in each borrower as well as each industry. Risk Management Division HO, in coordination with other HO divisions involved in disbursal of credit and also the risk management departments of various zonal offices identifies these risks areas and develops necessary tools and processes to measure and monitor the risk.

Credit Risk MeasurementIn order to measure the credit risk in banks portfolio, the bank has developed the following models:Credit Risk Rating ModelTotal limits Applicable from the Bank

Small 2 LoansAbove Rs. 20 lacs and up to Rs. 50lacs

Small LoansAbove Rs. 50 lacs and up to Rs. 5crores

Mid CorporateAbove Rs.5 crores and up to Rs. 15crores

Large CorporateAbove Rs. 15 crores

Non-Banking Financial Corporation Model(irrespective of any limit)

New Business ModelBelow Rs. 5 crores

New Project ModelAbove Rs. 5 crores

The credit risk rating models have been developed with a view to provide a standard system for assigning a credit risk rating to all the borrowers on the basis of the overall credit risk involved in them. Inputs to the models are the financial, management, business and conduct of account, industry information. The evaluation of a borrower is done by assessment on various objective/subjective parameters. The model evaluates the credit risk rating of a borrower on a scale of AAA to D with AAA indicating minimum risk and D indicating maximum risk.

The credit risk-rating models incorporate therein all possible risk factors, which are important for determining the credit quality/ rating of a borrower. These risks could be:

Internal and specific to the company, Associated with the industry in which the company is operating or Associated with the entire economy and can influence the repayment capacity and/ or willingness of the company.

Evaluation methodology under rating models

The scores are assigned to each of the parameters on a scale of 0 to 4 with 0 being very poor and 4 being excellent. The scoring of some of these parameters is subjective while for some others it is done on the basis of pre-defined objective criteria.

The scores given to the individual parameters multiplied by allocated weights are then aggregated and a composite score for the company is arrived at, in percentage terms. Higher the score obtained by a company, the better is its credit rating. Weights have been assigned to different parameters based on their importance. Weights assigned to different parameters have been loaded in the software. After allocating/evaluating scores to all the parameters, the aggregate score is calculated and displayed by the software.

The overall percentage score obtained is then translated into a rating on a scale from AAA to D according to a pre-defined range of scores.

Wherever a particular parameter is not applicable, no score should be given and the parameter should be made Not Applicable.

For multi-divisional companies, which are involved in more than one industrial activity, evaluation should be done separately for each business. However, the management evaluation, conduct of account and financial evaluation will be done on a common basis. In such cases, for the business section, each business should be evaluated and scored separately, taking into account the different industrial activity involved.

Grading of Borrowers under the Rating systemIn order to provide a standard definition and benchmarks under the credit risk rating system, following matrix has been adopted in all the risk rating models. For the rating purpose in Credit Appraisal, Indian Overseas Bank depends on CRISIL ratings. A CRISIL rating reflects CRISIL's current opinion on the relative likelihood of timely payment of interest and principal on the rated obligation. It is an unbiased, objective, and independent opinion as to the issuer's capacity to meet its financial obligations.So far, CRISIL has rated 30,000 debt instruments, covering the entire debt market.The debt obligations rated by CRISIL include: Non-convertible debentures/bonds/preference shares Commercial papers/certificates of deposits/short-term debt Fixed deposits Loans Structured debtCRISIL Ratings' clientele includes all the industry majors - 23 of the BSE Sensex constituent companies and 39 of the NSE Nifty constituent companies, accounting for 80 per cent of the equity market capitalization.CRISIL's credit ratings are; An opinion on probability of default on the rated obligation Forward looking Specific to the obligation being ratedBut they are not; A comment on the issuer's general performance An indication of the potential price of the issuers' bonds or equity shares Indicative of the suitability of the issue to the investor A recommendation to buy/sell/hold a particular security A statutory or non-statutory audit of the issuer An opinion on the associates, affiliates, or group companies, or the promoters, directors, or officers of the issuerCRISIL ratings are based on a robust and clearly articulated analytical framework, which ensures comprehensiveness, standardization, comparability, and effective communication of the ratings assigned and of every timely rating action. The assessment is based on the highest standards of independence and analytical rigor.CRISIL rates a wide range of entities, including: Industrial companies Banks Non-banking financial companies (NBFCs) Infrastructure entities Microfinance institutions Insurance companies Mutual funds State governments Urban local bodies

CRISIL RATING:CRISIL AAA(Highest Safety)Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk.

CRISIL AA(High Safety)Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk.

CRISIL A(Adequate Safety)Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk.

CRISIL BBB(Moderate Safety)Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk.

CRISIL BB(Moderate Risk)Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligations.

CRISIL B(High Risk)Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligations.

CRISIL C(Very High Risk)Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations.

CRISIL DDefaultInstruments with this rating are in default or are expected to be in default soon.