MBA 4TH SEM.

(KMBN FM 05) FINANCIAL CREDIT RISK ANALYTICS

UNIT 1

Financial Credit: Meaning & Objectives, Credit Risk, Credit Analysis, Seven
C’s
Financial Credit means a letter of credit used directly or indirectly to cover a default in payment of any
financial contractual obligation of the Company and its Subsidiaries, including insurance-related obligations
and payment obligations under specific contracts in respect of Indebtedness undertaken by the Company
or any Subsidiary, and any letter of credit issued in favours of a bank or other surety who in connection
therewith issues a guarantee or similar undertaking, performance bond, surety bond or other similar
instrument that covers a default in payment of any such financial contractual obligations, that is classified
as a financial standby letter of credit by the FRB or by the OCC.

Objectives
• It aims to establish proper financial institutions to cater to the needs of the weaker sections of the
society.

• It intends to help people secure financial products and services at affordable prices. These include
deposits, loans, insurance, payment services, etc.

• It aims to build and maintain financial sustainability so that the poor individuals are assured of the
required funds.

• It intends to bring in mobile banking and/ or financial services to reach the weaker sections of the
society living in remote areas of India.

• It intends to have numerous institutions that would offer affordable financial assistance, giving rise
to adequate competition so that the clients have myriad options to choose from.

• It plans to improve financial awareness and financial literacy across the nation.

• It aims to bring in digital financial solutions for the economically weaker sections in the country.

Credit Risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In
the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows,
and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of
credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs
such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

Losses can arise in a number of circumstances, for example:

• A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other
loan.

• A company is unable to repay asset-secured fixed or floating charge debt.

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 • A business or consumer does not pay a trade invoice when due.

• A business does not pay an employee’s earned wages when due.

• A business or government bond issuer does not make a payment on a coupon or principal payment
when due.

• An insolvent insurance company does not pay a policy obligation.

• An insolvent bank won’t return funds to a depositor.

• A government grants bankruptcy protection to an insolvent consumer or business.

Types
A credit risk can be of the following types:

Credit default risk: The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or
the debtor is more than 90 days past due on any material credit obligation; default risk may impact all
credit-sensitive transactions, including loans, securities and derivatives.

Concentration risk: The risk associated with any single exposure or group of exposures with the potential to
produce large enough losses to threaten a bank’s core operations. It may arise in the form of single-name
concentration or industry concentration.

Country risk: The risk of loss arising from a sovereign state freezing foreign currency payments
(transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk is
prominently associated with the country’s macroeconomic performance and its political stability.

Credit Analysis
Credit analysis is the method by which one calculates the creditworthiness of a business or organization. In
other words, It is the evaluation of the ability of a company to honour its financial obligations. The audited
financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank
may analyze the financial statements of a small business before making or renewing a commercial loan.
The term refers to either case, whether the business is large or small. A credit analyst is the finance
professional undertaking this role.

One objective of credit analysis is to look at both the borrower and the lending facility being proposed and
to assign a risk rating. The risk rating is derived by estimating the probability of default by the borrower at a
given confidence level over the life of the facility, and by estimating the amount of loss that the lender would
suffer in the event of default.

Credit analysis is important for banks, investors, and investment funds. As a corporation tries to expand,
they look for ways to raise capital. This is achieved by issuing bonds, stocks, or taking out loans. When
investing or lending money, deciding whether the investment will pay off often depends on the credit of the
company. For example, in the case of bankruptcy, lenders need to assess whether they will be paid back.

Similarly, bondholders who lend a company money are also assessing the chances they will get their loan
back. Lastly, stockholders who have the lowest claim priority access the capital structure of a company to
determine their chance of being paid. Of course, credit analysis is also used on individuals looking to take
out a loan or mortgage.

Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as
well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an
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examination of collateral and other sources of repayment as well as credit history and management ability.
As mentioned, analysts attempt to predict the probability that a borrower will default on its debts, and also
the severity of losses in the event of default. The credit spread is the difference in interest rates between
theoretically “Risk-free” investments such as U.S. treasuries or LIBOR and investments that carry some risk
of default reflect credit analysis by financial market participants.

Seven C’s
Capital: Indicates your level of seriousness. What you have personally invested in the company. The net
worth figure in the business enterprise is the key factor that governs the amount of credit made available to
the borrower.

Condition: The purpose and details of your loan. The loan officer and credit analyst must be aware of
recent trends in the borrower’s work or industry and how changing economic conditions might affect the
loan.

A loan looks very good on paper, only to have its value eroded by declining sales or income in a recession
or by high-interest rates occasioned by inflation.

Capacity: How you plan of to repay the loan. For example, in most areas, a minor cannot legally be held
responsible for a credit agreement; thus, the lender would have difficulty collecting on such a loan.

Similarly, the loan officer must be sure that the representative from a corporation asking for credit has
proper authority from the company’s board of directors to negotiate a loan and sign a credit agreement
binding the company.

Collateral: A form of security that guarantees repayment. The loan officer is particularly sensitive to such
features as the borrower’s assets’ age, condition, and degree of specialization.

Technology plays an important role here as well. If the borrower’s assets are technologically obsolete, they
will have limited value as collateral because of the difficulty finding a buyer for those assets should the
borrower’s income falter.

Character: A look at your credit history, demonstrated responsibility and the integrity of your actions.

Control: The last factor in assessing a borrower’s creditworthiness status is control.

This factor centers on such questions as to whether changes in law and regulation could adversely affect
the borrower and whether the loan request meets the lender’s and the regulatory authorities’ standards for
loan quality.

Cash: This feature of any loan application centers on the question.

Does the borrower have the ability to generate enough cash to repay the loan in the form of flow. In an
accounting sense, cash flow is defined as:

Cash flow = Net profits + Noncash expenses.

This is often called traditional cash flow and can be further broken down into

Cash flow = Sales revenues – Cost of goods sold – Selling, general, and
administrative expenses- Taxes paid in cash + Noncash expenses.

Credit Analysis Process, Credit Process, Documentation

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The credit analysis process involves a thorough review of a business to determine its perceived ability to
pay. To do this, business credit managers must evaluate the information provided in the credit application
by analyzing financial statements, applying credit analysis ratios, and reviewing trade references. In
addition to the information requested in the application, it is important to consult a business credit report
from a reputable third party. The information gathered during this process allows companies to decide
whether or not to offer the customer credit, and if so, precisely how much credit to extend.

The credit analysis process refers to evaluating a borrower’s loan application to determine the financial
health of an entity and its ability to generate sufficient cash flows to service the debt. In simple terms, a
lender conducts credit analysis on potential borrowers to determine their creditworthiness and the level of
credit risk associated with extending credit to them.

Stages in the Credit Analysis Process

The credit analysis process is a lengthy one, lasting from a few weeks to months. It starts from the
information-collection stage up to the decision-making stage when the lender decides whether to approve
the loan application and, if approved, how much credit to extend to the borrower.

The following are the key stages in the credit analysis process:

1. Information collection

The first stage in the credit analysis process is to collect information about the applicant’s credit history.
Specifically, the lender is interested in the past repayment record of the customer, organizational
reputation, financial solvency, as well as their transaction records with the bank and other financial
institutions. The lender may also assess the ability of the borrower to generate additional cash flows for the
entity by looking at how effectively they utilized past credit to grow its core business activities.

The lender also collects information about the purpose of the loan and its feasibility. The lender is
interested in knowing if the project to be funded is viable and its potential to generate sufficient cash flows.
The credit analyst assigned to the borrower is required to determine the adequacy of the loan amount to
implement the project to completion and the existence of a good plan to undertake the project successfully.

The bank also collects information about the collateral of the loan, which acts as security for the loan in the
event that the borrower defaults on its debt obligations. Usually, lenders prefer getting the loan repaid from
the proceeds of the project that is being funded, and only use the security as a fall back in the event that
the borrower defaults.

2. Information analysis

The information collected in the first stage is analyzed to determine if the information is accurate and
truthful. Personal and corporate documents, such as the passport, corporate charter, trade licenses,
corporate resolutions, agreements with customers and suppliers, and other legal documents are scrutinized
to determine if they are accurate and genuine.

The credit analyst also evaluates the financial statements, such as the income statement, balance sheet,
cash flow statement, and other related documents to assess the financial ability of the borrower. The bank
also considers the experience and qualifications of the borrower in the project to determine their
competence in implementing the project successfully.

Another aspect that the lender considers is the effectiveness of the project. The lender analyzes the
purpose and future prospects of the project being funded. The lender is interested in knowing if the project
is viable enough to produce adequate cash flows to service the debt and pay operating expenses of the
business. A profitable project will easily secure credit facilities from the lender.
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On the downside, if a project is facing stiff competition from other entities or is on a decline, the bank may
be reluctant to extend credit due to the high probability of incurring losses in the event of default. However,
if the bank is satisfied that the borrower’s level of risk is acceptable, it can extend credit at a high interest
rate to compensate for the high risk of default.

3. Approval (or rejection) of the loan application

The final stage in the credit analysis process is the decision-making stage. After obtaining and analyzing
the appropriate financial data from the borrower, the lender makes a decision on whether the assessed
level of risk is acceptable or not.

If the credit analyst assigned to the specific borrower is convinced that the assessed level of risk is
acceptable and that the lender will not face any challenge servicing the credit, they will submit a
recommendation report to the credit committee on the findings of the review and the final decision.

However, if the credit analyst finds that the borrower’s level of risk is too high for the lender to
accommodate, they are required to write a report to the credit committee detailing the findings on the
borrower’s creditworthiness. The committee or other appropriate approval body reserves the final decision
on whether to approve or reject the loan.

Credit Process

The process of assessing whether or not to lend to a particular entity is known as the credit process. It
involves evaluating the mindset of the potential borrower, underwriting of the risk, the pricing of the
instrument and the fit with the lender’s portfolio. It encompasses setting objectives and guidelines based on
the lender’s credit culture, gathering necessary information of the applicant, analyzing the information
including cash flows and financial statements and presenting and documenting information in such a
manner so that a credit decision may be made.

Your commercial banking officer will review your business loan package based on criteria known as the
“Five C’s of Credit.”

Character: It involves a review of your personal honesty, integrity, trustworthiness and management skills.
A banking officer also makes a judgment of character based on your business plan, credit history and the
quality of your presentation.

Capitalization: The capital structure of your company is important to Bank of Ann Arbor because it helps
determine the level of risk associated with your loan request. An analysis of capitalization includes a review
of equity, total debt, the value of assets and permanent working capital.

Cash Flow: This is the cash your business has to pay the debt. A cash flow analysis helps us determine if
you have the ability to repay the loan.

Collateral: This provides a secondary source of repayment, thereby minimizing the risk for Bank of Ann
Arbor. The amount and type of collateral required depends on the type and purpose of the loan.

Conditions: This refers to outside conditions that may affect the ability of your business to repay the loan.
Factors such as general economic conditions or a large concentration of sales to a single customer are
evaluated during our review of your loan application.

Documentation
Credit administration and documentation are two of the critical components in managing credit and
supporting the credit process. Following proper credit administrative and documentation process allow
credit analysts to monitor accounts and identify ways to reduce default risk.
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Credit Document means any of this Agreement, the Notes, if any, the Collateral Documents, any
documents or certificates executed by Company in favour of Issuing Bank relating to Letters of Credit, and
all other documents, instruments or agreements executed and delivered by a Credit Party for the benefit of
any Agent, Issuing Bank or any Lender in connection herewith.

Loan Pricing and Profitability Analysis, Regulations

Loan Pricing

Loan pricing is the process of determining the interest rate for granting a loan, typically as an interest
spread (margin) over the base rate, conducted by the bookrunners. The pricing of syndicated loans
requires arrangers to evaluate the credit risk inherent in the loans and to gauge lender appetite for that risk.

For market-based loan pricing, banks incorporate credit default spreads as a measure of borrowers’ credit
risks. It is standard procedure in loan pricing to benchmark a loan against recent comparable transactions
(“comps”) and select the base rate on which the financing costs are pegged. A comparable deal is one with
a borrower in the same industry, country and of the same size with the same credit rating, for which a
certain market rate of return is required.

A bank’s credit rating has a direct impact on its cost of funding and, thus, the pricing of its loans. Banks
with a high credit rating generally have access to lower cost funds in debt markets and low counterparty
margins in swap and foreign exchange markets. The lower cost of funds can be passed on to borrowers in
the form of lower loan pricing.

Banks compete for lead arranger mandates on syndication strategy and pricing. Some banks are very
effective at pricing loans, while others have better bargaining power, are more effective in borrower
monitoring, or have better incentive-inducing scheme.

Benefits of Loan Pricing

This methodical approach can help ensure the best loan and terms are matched to the borrower so that the
financial institution makes the sale and keeps the customer. Loan pricing models or loan profitability models
can allow banks or credit unions to set prices based on other institution goals, too, including goals related
to profitability targets or loan portfolio composition. In talking with banks, Abrigo has learned these
institutions thought a conservative estimate was that they could pick up an additional 5 to 10 basis points in
interest if they had more structured pricing methodologies in place.

One overall benefit of effective loan pricing is that it is one of the many ways a financial institution can
optimize capital. Optimizing capital is important because it provides institutions with the ability and freedom
to deploy capital for developing new products and new markets, addressing regulatory issues or navigating
shifts in the macroeconomic environment.

Another benefit of having a loan-pricing policy or model is that it provides the institution with defensible
measures for justifying pricing changes and for avoiding charges of discriminatory pricing, which some
lenders have faced in recent years. Officials with the banking regulatory agencies recently outlined best
practices they encourage as they relate to evaluating an institution’s fair lending risk, and one of those best
practices was to document pricing and other underwriting criteria, including exceptions.

Considerations of Loan-Pricing Models

What are some considerations related to loan-pricing models for an institution’s loan origination system
(LOS)? According to James L. Adams, supervising examiner at the Federal Reserve Bank of Philadelphia,
pricing is a key underwriting factor that should be addressed as part of a sound loan policy. A simple cost-
plus loan pricing model is one method of pricing loans, he wrote in a newsletter for community banks that
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cites the Fed’s Commercial Bank Examination Manual (CBEM). A cost-plus pricing model requires that all
related costs associated with extending the credit be known before setting the interest rate and fees, and it
typically considers the following:

• Operating costs associated with servicing the loan or loans

• Cost of funds

• Risk premium for default risk

• A reasonable profit margin on capital.

Profitability Analysis

1. Probability of default

Probability of default is defined as the probability that the borrower will not be able to make scheduled
principal and interest payments over a specified period, usually one year. The default probability depends
on both the borrower’s characteristics and the economic environment.

For individuals, the default probability is determined by the FICO score, and lenders use the score to
decide whether or not to extend credit. For business entities, the default probability is implied by the credit
rating.

Usually, credit rating agencies are required to assign a credit rating to entities that issue debt instruments,
such as bonds. Borrowers with a high default probability are charged a higher interest rate to compensate
the lender for bearing the higher default risk.

2. Loss given default

Loss given default is defined as the amount of money that a lender stands to lose when a borrower defaults
on the debt obligations. While there is no accepted method for quantifying the loss given default per loan,
most lenders calculate loss given default as a percentage of total exposure to loss in the entire loan
portfolio.

For example, if ABC Bank lends $1,000 to Borrower A and $10,000 to Borrower B, the bank stands to lose
more money in the event that Borrower B defaults on repayments.

3. Exposure at default

Exposure at default measures the amount of loss that a lender is exposed to at any particular point, due to
loan defaults. Financial institutions often use their internal risk management models to estimate the level of
exposure at default.

Initially, the exposure is calculated per loan, and banks use the figure to determine the overall default risk
for the entire loan portfolio. As borrowers make loan repayments, the value of exposure at default reduces
gradually.

Types of Credit Facilities: Various types of Credit Facilities- Cash Credit, Overdrafts,
Demand Loan

At some stage, every Business needs funding for smooth operations. There are multiple funding sources
available in the market for business organizations. Credit Facility offered by Banks is one such source. It
can be understood as an agreement or arrangement between the borrower and banks where the borrower
can borrow money for an extended period. Credit Facilities are utilized by the Companies, primarily to

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satiate the funding-needs for various business Operations. Banks on the other hand earn profit from the
interest incurred on the principal amount lent to the borrower.

The different types of Credit Facilities can be broadly classified into two parts:

• Fund Based Credit

• Non-Fund Based Credit

Short-Term Credit Facilities

The short-term borrowings can be predominantly of the following types:

Cash credit and overdraft

In this type of credit facility, a company can withdraw funds more than it has in its deposits. The borrower
would then be required to pay the interest rate which is applicable only to the amount that has been
overdrawn. The size and the interest rate charged on the overdraft facility is typically a function of the
borrower’s credit score (or rating).

Short-term loans

A corporation may also borrow short-term loans for its working capital needs, the tenor of which may be
limited to up to a year. This type of credit facility may or may not be secured in nature, depending on the
credit rating of the borrower. A stronger borrower (typically of an investment grade category) might be able
to borrow on an unsecured basis. On the other hand, a non-investment grade borrower may require
providing collateral for the loans in the form of current assets such as receivables and inventories (in
storage or transit) of the borrower. Several large corporations also borrow revolving credit facilities, under
which the company may borrow and repay funds on an ongoing basis within a specified amount and tenor.
These may span for up to 5 years, and involves commitment fee and slightly higher interest rate for the
increased flexibility compared to traditional loans (which do not replenish after payments are made).

A borrowing base facility is a secured form of short-term loan facility provided mainly to the commodities
trading firms. Of course, the loan to value ratio, i.e the ratio of the amount lent to the value of the underlying
collateral is always maintained at less than one, somewhere around 75-85%, to capture the risk of a
possible decline in the value of the assets.

Trade finance

This type of credit facility is essential for an efficient cash conversion cycle of a company, and can be of the
following types:

Credit from suppliers: A supplier is typically more comfortable with providing credit to its customers, with
whom it has strong relationships. The negotiation of the payment terms with the supplier is extremely
important to secure a profitable transaction. An example of the supplier payment term is “2% 10 Net 45”,
which signifies that the purchase price would be offered at a 2% discount by the supplier if paid within 10
days. Alternatively, the company would need to pay the entire specified purchase price but would have the
flexibility to extend the payment by 35 more days.

Letters of Credit: This is a more secure form of credit, in which a bank guarantees the payment from the
company to the supplier. The issuing bank (i.e the bank which issues the letter of credit to the supplier)
performs its own due diligence and usually asks for collateral from the company. A supplier would prefer
this arrangement, as this helps address the credit risk issue with respect to its customer, which could
potentially be located in an unstable region.

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Export credit: This form of loan is provided to the exporters by government agencies to support export
growth.

Factoring: Factoring is an advanced form of borrowing, in which the company sells its accounts receivables
to another party (called a factor) at a discount (to compensate for transferring the credit risk). This
arrangement could help the company to get the receivables removed from its balance sheet, and can serve
to fill its cash needs.

Long-Term Credit Facilities

Now, let’s look at how long-term credit facilities are typically structured. They can be borrowed from several
sources’ banks, private placement, and capital markets, and are at varying levels in a payment default
waterfall.

Bank loans

The most common type of long-term credit facility is a term loan, which is defined by a specific amount,
tenor (that may vary from 1-10 years) and a specified repayment schedule. These loans could be secured
(usually for higher-risk borrowers) or unsecured (for investment-grade borrowers), and are generally at
floating rates (i.e a spread over LIBOR or EURIBOR). Before lending a long-term facility, a bank performs
extensive due diligence in order to address the credit risk that they are asked to assume given the long-
term tenor. With heightened diligence, term loans have the lowest cost among other long-term debt. The
due diligence may involve the inclusion of covenants such as the following:

Maintenance of leverage ratios and coverage ratios, under which the bank may ask the corporation to
maintain Debt/EBITDA at less than 0x and EBITDA/Interest at more than 6.0x, thereby indirectly restricting
the corporate from taking on additional debt beyond a certain limit.

Change of control provision, which means that a specified portion of the term loan must be repaid, in case
the company gets acquired by another company.

Negative pledge, which prevents borrowers from pledging all or a portion of its assets for securing
additional bank loans (even for the second lien), or sale of assets without permission Restricting mergers
and acquisitions or certain capex

The term loan can be of two types; Term Loan A “TLA” and Term Loan B “TLB”. The primary difference
between the two is the amortization schedule TLA is amortized evenly over 5-7 years, while TLB is
amortized nominally in the initial years (5-8 years) and includes a large bullet payment in the last year. As
you guessed correctly, TLB is slightly more expensive to the Company for the slightly increased tenor and
credit risk (owing to late principal payment).

Notes

These types of credit facilities are raised from private placement or capital markets and are typically
unsecured in nature. To compensate for the enhanced credit risk that the lenders are willing to take, they
are costlier for the company. Hence, they are considered by the corporation only when the banks are not
comfortable with further lending. This type of debt is typically subordinated to the bank loans, and are larger
in the tenor (up to 8-10 years). The notes are usually refinanced when the borrower can raise debt at
cheaper rates, however, this requires a prepayment penalty in the form of “make whole” payment in
addition to the principal payment to the lender. Some notes may come with a call option, which allows the
borrower to prepay these notes within a specified time frame in situations where refinancing with cheaper
debt is easier. The notes with call options are relatively cheaper for the lender i.e charged at higher interest
rates than regular notes.

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Mezzanine debt

debt is a mix between debt and equity and rank last in the payment default waterfall. This debt is
completely unsecured, senior only to the common shares, and junior to the other debt in the capital
structure. Owing to the enhanced risk, they require a return rate of 18-25% and are provided only by private
equity and hedge funds, which usually invest in riskier assets. The debt-like structure comes from its cash
pay interest, and a maturity ranging from 5-7 years; whereas the equity-like structure comes from the
warrants and payment-in-kind (PIK) associated with it. PIK is a portion of interest, which instead of paying
periodically to the lenders, is added to the principal amount and repaid only at maturity. The warrants may
span between 1-5% of the total equity capital and provides the lenders the option to buy the company’s
stock at a predetermined low price, in case the lender views the company’s growth trajectory positively. The
mezzanine debt is typically used in a leveraged buyout situation, in which a private equity investor buys a
company with as high debt as possible (compared to equity), in order to maximize its returns on equity.

Securitization

This type of credit facility is very similar to the factoring of receivables mentioned earlier. The only
difference is the liquidity of assets and the institutions involved. In factoring, a financial institution may act
as a “factor” and purchase the Company’s trade receivables; however, in securitization, there could be
multiple parties (or investors) and longer-term receivables involved. The examples of securitized assets
could be credit card receivables, mortgage receivables, and non-performing assets (NPA) of a financial
company.

Bridge loan

Another type of credit facility is a bridge facility, which is usually utilized for M&A or working
capital purposes. A bridge loan is typically short-term in nature (for up to 6 months), and are borrowed for
an interim usage, while the company awaits long-term financing

The bridge loan can be repaid, using bank loans, notes, or even equity financing, when the markets turn
conducive to raising capital.

In conclusion, there needs to be a balance between the company’s debt structure, equity capital, business
risk and future growth prospects of a company. Several credit facilities aim to tie these aspects together for
a company to function well.

Bill Finance: Drawee Bill Scheme, Bill Discounting

It is a binding short-term financial instrument that mandates one party to pay a specific sum of
money to another at a predetermined date or on-demand. Also known as a bill of exchange, it
essentially denotes, in writing, that one person (debtor) owes money to another (Creditor).

Businesses predominantly use bill finance during international trade, since the degree of
uncertainty concerning the payment is considerable in that regard. However, there’s no set law as
such, and companies can use a bill of exchange for intra-border trade as well.

Bill finance is a crucial document for businesses that carry out trade on credit. It not only
substantiates a transaction, but also provides a legal avenue to creditors, if debtors fail to make
good on their debts.

Usually, bill finance does not involve any interest payment. But, a creditor might charge a penalty
fee or interest if it does not receive the due amount by a predetermined date. In that case, the
issuer must mention these details in such a document.
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Bill Finance Working

The practice of bill of exchange issuance involves three parties primarily:

Drawer: This person issues a bill of exchange, usually before undertaking credit sales. A drawee
is obliged to pay the due amount to a drawer. This entity must sign a bill of exchange during
issuance.

Drawee: This is the person or entity on which a bill of exchange is issued, also referred to as the
debtor. A drawee needs to accept the bill, which legally binds it to pay a specific sum.

Payee: The payment ultimately goes to a payee. In most cases, a drawer, and payee are the
same entity. However, in some cases, a drawer can transfer bill finance to a third-party, in which
case that person becomes the payee.

Types Explanation

Also known as sight draft, this type of bill finance comes with an on-
Demand bill
demand payment stipulation.

Bills of exchange that feature the clause of payment by a specific date and
Usance bill
time. These are also known as time draft.

A type of bill of exchange that requires the presentation of supporting

Documentary bill
documents attesting to the legitimacy of a transaction(s).

It involves no supporting documents, and therefore, the interest that one

Clean bill
needs to pay, if any, is much higher.

Inland bill This is issued for transactions within national borders.

As opposed to the inland bill, a foreign bill of exchange is issued to debtors

Foreign bill
beyond national borders.

When a bank issues a bill of exchange, it’s called a bank draft. In this case,
Bank draft
a bank enforces bill payment as per terms.

Trade draft Bill finance issued by an individual is called a trade draft.

Accommodation
It refers to the unconditional bill finances.
bill

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Drawee is a legal and banking term used to describe the party that has been directed by the
depositor to pay a certain sum of money to the person presenting the check or draft. A typical
example is if you are cashing a paycheck. The bank that cashes your check is the drawee, your
employer who wrote the check is the drawer, and you are the payee.

Functions of a Drawee

In a financial transaction, a drawee typically serves as an intermediary. The primary purpose of the
drawee is to channel and direct funds from a payer’s account (also known as a drawer or
depositor) to the account of the payee (the receiver of the funds or the natural person to whom the
funds are payable).

In most instances, the drawee is a financial institution. In such a situation, the drawee holds the
funds from the payer in an account that it manages. The account is often a deposit account. It is a
common function for consumer and/or commercial banks. The consumer bank takes funds from
the account of the payer or depositor to meet the financial obligation set forth in accordance with
the information provided on a check.

Apart from banks, other entities that can serve as a drawee can be wire transfer and money order
companies and companies that provide check-cashing services. It is important to note that the
entities may require processing fees to facilitate and process the transaction to completion. Money
orders typically serve as a bill of exchange (the drawee role). In such a transaction, the bill of
exchange is presented to the payee and is honored by the entity that receives the funds from the
depositor or payer.

A bill of exchange is a binding agreement by one party to pay a fixed amount of cash to another
party as of a predetermined date or on demand. Bills of exchange are primarily used in
international trade. Their use has declined as other forms of payment have become more popular.
There are three entities that may be involved with a bill of exchange transaction. They are as
follows:

Drawee. This party pays the amount stated on the bill of exchange to the payee.

Drawer. This party requires the drawee to pay a third party (or the drawer can be paid by the
drawee).

Payee. This party is paid the amount specified on the bill of exchange by the drawee.

Bill Discounting

Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a
creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that
owes money in the present purchases the right to delay the payment until some future date. This
transaction is based on the fact that most people prefer current interest to delayed interest
because of mortality effects, impatience effects, and salience effects. The discount, or charge, is
the difference between the original amount owed in the present and the amount that has to be
paid in the future to settle the debt.

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The discount is usually associated with a discount rate, which is also called the discount yield. The
discount yield is the proportional share of the initial amount owed (initial liability) that must be paid
to delay payment for 1 year.

Discount Yield = Charge to delay Payment for 1 Year / Debt Liability

Stakeholders in Bill Discounting

Bill Discounting is made possible by multiple parties working together for a scenario to enable
movement of goods.

There are 3 main stakeholders:

1. Seller

Seller is the one who is selling the goods and expects the payment. in case of bill discounting,
seller takes the payment from bank earlier than the credit period and gets funds immediately but
after a discount which is charges as fee by the bank.

2. Buyer

Buyer is the one who is buying the goods and is supposed to make or initiate the payment to the
seller through letter of credit. In case of bill discounting the payment is made in full to the bank
instead of the seller.

3. Bank

Bank acts as the intermediary in the bill discounting scenario by providing funds immediately to the
seller on behalf of buyer within the credit period and collects the full amount from buyer as per
LOC terms.

Advantages of Bill Discounting

• It also helps the bank earn some revenue.

• Bill Discounting is a major trade activity. It helps the seller’s get funds earlier on a
small fees or discount.
• The borrower or (seller’s) customer can pay money on the due date of the credit
period.

Disadvantages of Bill Discounting

1. Bill Discounting is not available to everyone especially new businesses.

2. It is good for short term financing but is not a long term finance option.

Cash Delivery: Types of Facilities, Modes of Delivery

Cash Credit (CC) is a source of short-term finance for businesses and companies. Cash credits
are also called working capital loans as they fund the instant cash requirements of the
organizations, or to purchase current assets. Borrowing limits on the amount of cash available for

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credit for the company varies between commercial banks. The interest charged is on the daily
closing balance instead of the upper borrowing limit, so the repayment is only on the amount spent
from the available limit. Because it is taken for a short term, the repayment of the amount taken on
credit is also set at 12 or less months. Cash credit is a loan and banks demand collateral to
approve it. Cash credits are similar to overdraft facilities, though there are significant differences
between them. Cash credit is available for a shorter period of time and at a significantly less
interest rate than overdrafts. Cash credit is used by financial institutions and businesses and with
a collateral, which thus becomes a loan, overdraft is approved on the basis of the relationship that
the bank and customer share.

Important Features of Cash Credit

Interest on running balance

In contrast with other traditional debt financing methods such as loans, the interest charged is only
on the running balance of the cash credit account and not on the total borrowing limit.

Borrowing limit

A cash credit comes with a borrowing limit determined by the creditworthiness of the borrower. A
company can withdraw funds up to its established borrowing limit.

Minimum commitment charge

The short-term loan comes with a minimum charge for establishing the loan account regardless of
whether the borrower utilizes the available credit. For example, banks typically include a clause
that requires the borrower to pay a minimum amount of interest on a predetermined amount or the
amount withdrawn, whichever is higher.

Credit period

Cash credit is typically given for a maximum period of 12 months, after which the drawing power is
re-evaluated.

Collateral Security

The credit is often secured using stocks, fixed assets, or property as collateral.

END OF UNIT 1

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 UNIT 2

Sole Banking Arrangement, Multiple Banking Arrangement,

Consortium Lending, Syndication
Sole banking is a lending by single bank to a large borrower, subject to the resources available
with it and limited to the exposure limits imposed by the Reserve Bank of India. Many a times
when you propose to approach to new bank for funding, they propose for sole banking that their
complete banking should be transferred to their bank. This is done for two reasons one is to get
complete business and second is very important is having complete monitoring of fund flow and
cash flow of the firm.

Multiple Banking Arrangement

As looked into above example of sole banking, it is also happening that it continues with existing
bank facility and take additional from other (new) bank. When the credit requirements of a
borrower are beyond the capacity of a single bank or that the bank does not want to take more
exposure on a particular borrower, he may then resort to multiple banking. It is an arrangement
where a borrower borrows simultaneously from more than one bank independent of each other,
under separate loan documents with each bank. Securities are charged to each bank separately.

There are various loopholes in multiple banking arrangements, and also it can lead to frauds so
consortium banking is better for economy. Each banker is free to do his own credit assessment
and old security independent of other bankers.

Consortium Lending

Consortium lending also called joint financing or participation financing. It is a system of financial
emerged due to consequential increase in demand for funds of substantial magnitude and inability
of individual banks to take care of the entire fund requirement of large borrowers. The system of
consortium lending provides scope and opportunity to share risk amongst banks. The system is
considered to be mutually beneficial to the banks as well as customers. Under multiple banking,
there is no coordination among banks regarding appraisal, documentation, other terms and
advances. In such a situation borrowers got the upper hand by playing one bank against the other.
It was, therefore, necessary to formalize these credit arrangements to safeguard the interest of the
banks. It is mainly catered in case of large corporate and certain mid-sized borrowers.

As per the consortium lending approach, the group of banks would have a common agreement
wherein the lead bank (the bank that bears major risk) would assess the borrower’s fund
requirements, set common terms and conditions and share information about borrower’s
performance to other lenders.

The bank which takes the higher risk (by giving the highest amount of loan) will act as a leader
and thus it acts as an intermediary between the consortium and the borrower.

Syndication

Reserve Bank of India has permitted the banks to adopt syndication route to provide credit in lieu
of consortium advance. A syndication credit differs from consortium advance. A syndicated credit

15
differs from consortium advances in certain aspects. The salient features of a syndicated credit are
as follows:

• The prospective borrower gives a mandate to a bank, commonly referred as a lead bank
(lead manager), to arrange credit on his behalf. The mandate gives the commercial terms of
the credit and the prerogatives of the mandated bank in resolving contentious issue in the
course of the transaction of complete syndication.
• It is an agreement between two or more banks to provide a borrower a credit facility using
common documents of the borrower.
• The mandated bank prepares an information Memorandum about the borrower in
consultation with the latter and distributes the same amongst the prospective lenders,
inviting them to participate in the credit proposal.
• On the basis of information Memorandum each bank makes its own independent economy
and financial evaluation of the borrower. It may collect additional information from other
sources also. Generally, lead banker plays important role as rest just follows.
• Thereafter, a meeting of the particular banks is convened by the mandated bank and
discuss the syndication strategy relating to co-ordination communication and control with
the syndication process and to finalize the deal timing, charges for management, cost of
credit, share of each participating bank in the credit etc.
• A loan agreement is signed by all the participating banks.
• The borrower is required to give prior notice to the Lead Banker (Lead Manager) of his
agent for drawing the loan amount so that the latter may tie up disbursement with the other
lending banks.
• Under the system, the borrower has the freedom in terms of competitive pricing. Discipline
is also imposed through a fixed repayment period under syndicated credit.

Credit Appraisal: Validation of proposal, Dimensions of Credit

Appraisals, Structuring of Loan documents
Credit Appraisal is the process by which a lender appraises the technical feasibility, economic
viability and bankability including creditworthiness of the prospective borrower. Credit appraisal
process of a customer lies in assessing if that customer is liable to repay the loan amount in the
stipulated time, or not. Here bank has their own methodology to determine if a borrower is
creditworthy or not. It is determined in terms of the norms and standards set by the banks. Being a
very crucial step in the sanctioning of a loan, the borrower needs to be very careful in planning his
financing modes. However, the borrower alone doesn’t have to do all the hard work. The banks
need to be cautious, lest they end up increasing their risk exposure. All banks employ their own
unique objective, subjective, financial and non-financial techniques to evaluate the
creditworthiness of their customers.

Some requirements for credit appraisal are as follows:

• Wherever financing of infrastructure project is taken up under a consortium/syndication

arrangement – bank’s exposure shall not exceed 23%.
• The credit requirement must be assessed by all Indian financial institutions or specialized
institution set-up for this purpose.
• 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.
• Bank may also take up financing infrastructure project independently exclusively in respect
of borrower’s promoters of repute with excellent past record in project implementation.

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Validation of proposal

The quality of every proposal should be explicitly validated. This means that you should confirm
that the key aspects of the proposal are what the company wants them to be. It is nearly
impossible to do this in one sitting with everything considered all at once. Proposal Quality
Validation explicitly identifies what should be validated, allows for flexibility in how individual items
get validated, and provides a mechanism to ensure that the items chosen and methods for
validation are sufficient to achieve the quality desired.

Proposal Quality Validation ensures that your company confirms that key aspects of your proposal
are what the company wants them to be prior to submission. It is an approach that confirms that
what you have in the proposal meets your needs and expectations. It avoids disasters that result
from teams that work in isolation, creating a proposal that is not what the company wants to
submit and is only discovered too late to do anything about it.

In developing your proposal, you will:

• Make decisions
• Invent approaches
• Incorporate information
• Address requirements
• Deliver a message
• Seek a superior score

Dimensions of Credit Appraisals

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.

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.

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.

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:

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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 terms 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.

Structuring of Loan documents

Loan structure is the terms of a loan with respect to the various aspects the make up a loan,
including the maturity or tenor, repayment, and risk.

The loan structure is arrived at by taking into consideration several factors, such as the purpose,
the timeline, and the risk profile of the borrower. In the following sections, we will discuss different
structures that exist based on the above factors.

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Documents to Apply for a Personal Loan

When applying for a personal loan, you will need to submit the following documents:

• PAN Card
• Identity proof (Aadhaar Card, Driving licence, Passport, Voter ID, etc.)
• Signature Proof (Passport, PAN card, etc.)
• Address proof (Passport copy, Aadhaar card, driving licence, utility bill; Gas or electricity
bill, Voter ID, ration card, rent agreement, etc.)
• Bank statements of the past 6 months

As a salaried individual, you additionally need to submit the following:

• Salary slips for the last three months

• Income tax returns OR form 16

As a self-employed individual, you additionally need to submit the following (for self / business
entity as applicable):

• Balance sheet and profit and loss account, income computation for the last 2 years
• Income Tax Returns for the last 2 years
• Business proof (License, registration certificate, GST number)
• IT Assessment OR Clearance Certificate
• Income Tax Challans OR TDS Certificate (Form 16A) OR Form 26 AS for income declared
in ITR

Credit Risk, Credit Risk Rating, Credit Worthiness of Borrower

Credit Risk

A credit risk is risk of default on a debt that may arise from a borrower failing to make required
payments. In the first resort, the risk is that of the lender and includes lost principal and interest,
disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an
efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because
of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels
based on assessments by market participants.

Losses can arise in a number of circumstances, for example:

• A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit,
or other loan.
• A company is unable to repay asset-secured fixed or floating charge debt.
• A business or consumer does not pay a trade invoice when due.
• A business does not pay an employee’s earned wages when due.
• A business or government bond issuer does not make a payment on a coupon or principal
payment when due.
• An insolvent insurance company does not pay a policy obligation.
• An insolvent bank won’t return funds to a depositor.
• A government grants bankruptcy protection to an insolvent consumer or business.

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Credit Risk Rating

The term credit rating refers to a quantified assessment of a borrower’s creditworthiness in general
terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to
any entity that seeks to borrow money an individual, a corporation, a state or provincial authority,
or a sovereign government.

Types of Credit Ratings

All credit agency agencies use various terminology for determine credit ratings. However, the
notations are very similar. Ratings are always grouped into two: an ‘investment grade’ and also a
‘speculative grade’.

Investment grade:

These ratings mean that the investment is a solid one and the issuer will most likely meet the
repayment terms. These investments are priced less as compared to speculative grade
investments.

Speculative grade:

These investments are known to be high risk. So, they come with higher interest rates.

Importance of Credit Rating

When a credit rating agency upgrades a company’s rating, it suggests that the company has a
high chance of repaying the credit. On the other hand, when the credit rating gets downgraded, it
suggests the company’s ability to repay has reduced.

Once the company’s credit rating has been downgraded, it becomes difficult for the company to
borrow money. Lenders will consider such companies as high-risk borrowers as they have a
higher probability of turning into a defaulter. Financial institutions will hesitate to lend money to the
companies with low credit rating.

• It allows investors to make a sound investment decision after taking into consideration the
risk factor and past repayment behaviour. In other words, it establishes a relationship
between risk and return.
• Credit rating does a qualitative and quantitative assessment of a borrower’s
creditworthiness.
• In the case of the companies, credit ratings help them improve their corporate image. It is
useful especially for companies that are not popular.
• Lenders such as banks and financial institutions will offer loans at a lower interest rate if the
entity has a higher credit rating.
• The credit rating acts as a marketing tool for companies and also as a resource that is
helpful at the time of raising money. It reduces the cost of borrowing and helps in the
company’s expansion.
• Credit rating encourages better accounting standards, detailed information disclosure, and
improved financial information.

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Credit Worthiness of Borrower

Creditworthiness, simply put, is how “worthy” or deserving one is of credit. If a lender is confident
that the borrower will honour her debt obligation in a timely fashion, the borrower is deemed
creditworthy. If a borrower were to evaluate their creditworthiness on her own, it would result in a
conflict of interest. Therefore, sophisticated financial intermediaries perform assessments on
individuals, corporates, and sovereign governments to determine the associated risk and
probability of repayment.

Financial institutions use credit ratings to quantify and decide whether an applicant is eligible for
credit. Credit ratings are also used to fix the interest rates and credit limits for existing borrowers.
A higher credit rating signifies a lower risk premium for the lender, which then corresponds to
lower borrowing costs for the borrower. Across the board, the higher one’s credit rating, the better.

A credit report provides a comprehensive account of the borrower’s total debt, current balances,
credit limits, and history of defaults and bankruptcies if any. Due to high levels of asymmetries of
information in the market, lenders rely on financial intermediaries to compile and assign credit
ratings to borrowers and help filter out bad debtors or “lemons.”

The independent third parties are called credit rating agencies. The rating agencies access
potential customers’ credit data and use sophisticated credit scoring systems to quantify a
borrower’s likelihood of repaying debt. Lenders usually pay for the services, but borrowers may
also request their credit score to gauge their worthiness in the market.

A limited set of credit raters are considered reliable, and it is due to the level of expertise and data
consolidation required, which is not publicly available. The so-called “Big Three” rating agencies
are and Fitch, Moody’s, and Standard & Poor’s. These agencies rate corporates and sovereign
governments on a range of “AAA” or “prime” to “D” or “in default” in descending order of
creditworthiness.

Purpose of Loan, Source of Repayment, Collateral

Purpose of Loan

loan purpose is the underlying reason an applicant seeks a loan or mortgage. Lenders use loan
purpose to make decisions on the risk and what interest rate to offer. For example, if an applicant
is refinancing a mortgage after having taken cash out, the lender might consider that an increase
in risk and increase the interest rate that is offered or add additional conditions. Loan purpose is
important to the process of obtaining mortgages or business loans that are connected with specific
types of business activities.

Pertaining to mortgages and their risk-based pricing factors, the loan purpose factor is sub-
categorized by purchase, rate and term refinance and cash-out refinance. Lenders assess that a
purchase loan contains the least amount of risk and thus ‘price’ purchase loans most favourably
(i.e. no interest rate increase or a risk-based pricing improvement in the order of .25%).

Rate and term refinances are priced similar to purchase loans, with no interest rate increase. Cash
received by the borrower at closing may not exceed $2000 to maintain rate and term status. The
purpose is, as the name implies, to reduce the interest rate, payment, and/or overall term of the
mortgage.

21
Cash-out refinances are deemed to have a higher risk factor than either rate & term refinances or
purchases due to the increase in loan amount relative to the value of the property. Risk-based
pricing typically mandates a .25% to .5% increase in interest rate if a borrower needs to draw
equity out of the subject property.

Uses:

Consolidate debt to pay off bills

Consolidating debt is one major reason to borrow a personal loan. This approach can make sense
if you’re able to secure a low interest rate. If you pay your other debts with the money from a
personal loan, you’ll only have one fixed monthly payment, and you might be able to save money
on interest.

Cover unplanned emergency expenses

While it’s best to build an emergency fund to cover unexpected expenses, an emergency personal
loan can help if you’re not yet prepared.

Make necessary home repairs

While you might have a wish list of home updates, you might only consider a personal loan for
emergency issues impacting your health and safety.

Source of Repayment

Primary Source: The primary source of repayment should be directly related to the kind of loan
given i.e. for facilities extended (overdraft) for working capital or to finance trade the repayment
should be from the proceeds of the goods sold. If a bridge loan prior to the final allotment of a
public issue has been given, the repayment should be from the monies received after the
allotment is made. On the other hand if the bridge loan is given prior to the sale of an asset, the
proceeds from the sale of the asset should be used to extinguish the loan.

Secondary Source: Even though there may be a real and quantifiable first source of repayment,
there is always a possibility that on account of occurrences beyond the borrower’s control, the loan
cannot be repaid from the primary source. A classic example is what is presently happening in
India on account of the liquidity crunch and the demand downswing. A well-known company
purchased 41 windmills at a cost of around Rs. 1 crore each and was confident of selling them
quickly. Due to a credit squeeze the windmills were unsold and the company could not repay the
borrowings from the proceeds of the sale. The company in order to meet its credit commitments
sold some property it owned. This was its secondary source of repayment. When companies take
working capital finance in the form of overdrafts, they normally hypothecate debtors and stock. If
repayments are not made, the secondary source of repayment can be seized and sold and the
proceeds can be used to liquidate the loan.

Tertiary Source: The tertiary source is further security for a loan. This is in the form of additional
collateral that may be unconnected with the business. A director could pledge the shares that he
owns in certain blue-chip companies as additional security. Alternatively, the principal
shareholders could give their personal guarantees or a well-wisher could give his guarantee. The
comfort that a Bank would derive is that should the primary and secondary source of repayment
22
fail, they will have recourse to yet another source of repayment. It is assurances such as these
that help the Banker in supporting and recommending a request for a credit facility.

Collateral

The term collateral refers to an asset that a lender accepts as security for a loan. Collateral may
take the form of real estate or other kinds of assets, depending on the purpose of the loan. The
collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan
payments, the lender can seize the collateral and sell it to recoup some or all of its losses.

If a borrower defaults on a loan (due to insolvency or another event), that borrower loses the
property pledged as collateral, with the lender then becoming the owner of the property. In a
typical mortgage loan transaction, for instance, the real estate being acquired with the help of the
loan serves as collateral. If the buyer fails to repay the loan according to the mortgage agreement,
the lender can use the legal process of foreclosure to obtain ownership of the real estate. If a
second mortgage is involved the primary mortgage loan is repaid first with the remaining funds
used to satisfy the second mortgage. A pawnbroker is a common example of a business that may
accept a wide range of items as collateral.

The type of the collateral may be restricted based on the type of the loan (as is the case with auto
loans and mortgages); it also can be flexible, such as in the case of collateral-based personal
loans.

Marketable collateral is the exchange of financial assets, such as stocks and bonds, for a loan
between a financial institution and borrower. To be deemed marketable, assets must be capable
of being sold under normal market conditions with reasonable promptness at current fair market
value. For national banks to accept a borrower’s loan proposal, collateral must be equal to or
greater than 100% of the loan or credit extension amount. In the United States of America, the
bank’s total outstanding loans and credit extensions to one borrower may not exceed 15 percent
of the bank’s capital and surplus, plus an additional 10 percent of the bank’s capital and surplus.

Reduction of collateral value is the primary risk when securing loans with marketable collateral.
Financial institutions closely monitor the market value of any financial assets held as collateral and
take appropriate action if the value subsequently declines below the predetermined maximum
loan-to-value ratio. The permitted actions are generally specified in a loan agreement or margin
agreement.

Types of collateral loans.

Vehicle Loans

No guarantor is required for such a loan since the car itself acts as a security with the lender. A
typical car financing arrangement is different from a loan against a commercial vehicle. A car
financing arrangement is executed at the time of purchase of the vehicle; the proceeds are purely
utilized for the purchase of the vehicle only. The borrower is free to use the vehicle for any
purpose. However, commercial vehicles cannot be used for personal use by the borrower, who
has to have an existing business to be eligible for the loan.

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Loan Against Securities

A loan against securities is an extension of an overdraft facility by the financial institutions. The
financial assets like shares, bonds etc. act as collateral with the lender, against which the borrower
is issued a limit. The borrower can then take short term loans within this limit.

Loan Against Property

A loan against property financing arrangement includes a loan taken from a financial institution
with no restriction on its use by the borrower. The existing house property is kept as collateral with
the lender as a security against a probable default by the borrower. Whereas, A typical housing
loan financing arrangement is to facilitate the purchase or construction of a new home and the
proceeds are to be used for that purpose only.

Cash Flow
Cash Flow (CF) is the increase or decrease in the amount of money a business, institution, or
individual has. In finance, the term is used to describe the amount of cash (currency) that is
generated or consumed in a given time period. There are many types of CF, with various
important uses for running a business and performing financial analysis.

Types of Cash Flow

There are several types of Cash Flow, so it’s important to have a solid understanding of what each
of them is. When someone refers to CF, they could mean any of the types listed below, so be sure
to clarify which cash flow term is being used.

Types of cash flow include:

Cash from Operating Activities: Cash that is generated by a company’s core business activities
– does not include cash flow from investing. This is found on the company’s Statement of Cash
Flows (the first section).

Free Cash Flow to Equity (FCFE): FCFE represents the cash that’s available after reinvestment
back into the business (capital expenditures). Read more about FCFE.

Free Cash Flow to the Firm (FCFF): This is a measure that assumes a company has no
leverage (debt). It is used in financial modeling and valuation. Read more about FCFF.

Net Change in Cash: The change in the amount of cash flow from one accounting period to the
next. This is found at the bottom of the Cash Flow Statement.

Uses of Cash Flow

Cash Flow has many uses in both operating a business and in performing financial analysis. In
fact, it’s one of the most important metrics in all of finance and accounting.

The most common cash metrics and uses of cash flow are the following:

24
 • Net Present Value: Calculating the value of a business by building a DCF Model and
calculating the net present value (NPV)
• Internal Rate of Return: determining the IRR an investor achieves for making an
investment
• Liquidity: Assessing how well a company can meet its short-term financial obligations
• Cash Flow Yield: Measuring how much cash a business generates per share, relative to
its share price, expressed as a percentage
• Cash Flow Per Share (CFPS): Cash from operating activities divided by the number of
shares outstanding
• P/CF Ratio: The price of a stock divided by the CFPS (see above), sometimes used as an
alternative to the Price-Earnings or P/E ratio
• Cash Conversion Ratio: The amount of time between when a business pays for its
inventory (cost of goods sold) and receives payment from its customers is the cash
conversion ratio
• Funding Gap: A measure of the shortfall a company has to overcome (how much more
cash it needs)
• Dividend Payments: CF can be used to fund dividend payments to investors
• Capital Expenditures: CF can also be used to fund reinvestment and growth in the
business

Cash Flows as Profit and Components of Cash Flows

Cash flow and profit are two different financial parameters, but when you’re running a business,
you need to keep track of both. Here’s how they’re different, why they’re both important and how
they intersect with other corporate issues, especially when a company grows rapidly.

Cash Flow
Cash flow is the money that flows in and out of the firm from operations and financing and
investing activities. It’s the money you need to meet current and near-term obligations. But there
are two things to keep in mind about cash flow:

A Business Can Be Profitable and Still Not Have Adequate Cash Flow

In the worst case, insufficient cash flow in a profitable business can send it into bankruptcy. For
example, you’re making widgets and selling them at a profit. But your product goes through a long
sales chain and some of your biggest and most important wholesale customers don’t pay on
invoices for 120 days. This sounds extreme, but many large US corporations in the 21st century
don’t pay an account payable for three or four months from the receipt of the invoice.

Since you’re the little guy, the suppliers of materials you need to make those widgets often want to
be paid either upon receipt or in 15 or 30 days. Ironically, if you’re caught between suppliers who
want their money now and buyers who’re slow to pay, a successful product with increasing sales
can create a real cashflow crisis. Even though your unit sales are increasing and profitable, you
won’t get paid in time to pay your suppliers and meet payroll and other operational expenses. If
you’re unable to meet your financial obligations in a timely way, your creditors may force you into
bankruptcy at a period when sales are growing rapidly.

Your Sales May Be Growing and the Money Keeps Pouring In, but That Doesn’t Mean
You’re Making a Profit

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If you borrow money to solve the cash flow problem, for instance, the rising debt costs that result
can raise your costs above the breakeven point. If so, eventually your cash flow will dry up and
eventually your business will fail.

Profit
Profit, also called net income, is what remains from sales revenue after all the firm’s expenses are
subtracted. It’s obvious in principle that a business cannot long survive unless it is profitable, but
sometimes, as with cash flow, the very success of a product can raise expenses. It may not be
immediately apparent that this is a problem. In other cases, you may be aware of the problem, but
believe that by reducing production costs you can restore profitability in time to avoid a crisis.
Unfortunately, unless you have a clear understanding of all the relevant cost data, you may not act
effectively or promptly enough to make the firm profitable again before it runs out of money.

Components of Cash Flows

(i) Cash Flow from Operating Activities

The net amount of cash coming in or leaving from the day to day business operations of an entity
is called Cash Flow from Operations. Basically it is the operating income plus non-cash items such
as depreciation added. Since accounting profits are reduced by non-cash items (i.e. depreciation
and amortization) they must be added back to accounting profits to calculate cash flow.

Cash flow from operations is an important measurement because it tells the analyst about the
viability of an entities current business plan and operations. In the long run, cash flow from
operations must be cash inflows in order for an entity to be solvent and provide for the normal
outflows from investing and finance activities.

(ii) Cash Flow from Investing Activities

Cash flow from investing activities would include the outflow of cash for long term assets such as
land, buildings, equipment, etc., and the inflows from the sale of assets, businesses, securities,
etc. Most cash flow investing activities are cash out flows because most entities make long term
investments for operations and future growth.

(iii) Cash Flow from Finance Activities

Cash flow from finance activities is the cash out flow to the entities investors (i.e. interest to
bondholders) and shareholders (i.e. dividends and stock buybacks) and cash inflows from sales of
bonds or issuance of stock equity. Most cash flow finance activities are cash outflows since most
entities only issue bonds and stocks occasionally.

END OF UNIT 2

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 UNIT 3

Quasi Credit Facilities: Advantages of Non-Fund Facilities, Various

types of NFB Facilities, Various types Letter of Credits, Assessment
of LC limits, Bills Purchase/ Discounting under LC
The Companies Act 1986 introduced the legal term ‘quasi-loan’ in sections concerning the
restrictions on companies making loans to directors. A quasi-loan arises when the company incurs
a liability or agrees to incur such a liability in circumstances when the director is under an
obligation to reimburse the company for the amount involved. An example would be where the
company holds a credit card and that card is used in a transaction for the sole benefit of a director
personally. The company has assumed a liability through use of the card and the director, as
beneficiary of the transaction, must reimburse the company.

Quasi-Equity financing is debt that appears, in some aspects, as an equity investment.

Characteristics of quasi-equity financing would include either being an unsecured loan, or being a
flexible loan repayment schedule. Mezzanine debt and junior debt are examples of quasi-equity
financing as they are both usually unsecured and flexible when it comes to the repayment
schedule of the loan.

Quasi-equity investments are usually based on the company’s future cash flow growth. The
lender must use projected cash flow statistics of the company they are investing in, and they base
the structure of the quasi-equity investment upon what the future cash flow stream is going to be.

Quasi-equity financing is used when debt financing and share capital are not possible options of
financing. Quasi-equity is dissimilar to a loan in the sense that quasi-equity financing is dependent
upon how the company performs in the years to come.

If the company fails to reach the expected performance benchmark, the investor receives a
significantly lower return. However, if the company goes through a more profitable growth stretch
than expected, the investor receives greater financial return.

Quasi-Equity Financing is dependent upon how the company does in the future, which means the
investors must have as much data as possible in order to minimize the risk that is possible when
investing in a company.

It is also possible to place a ceiling on the possible return, if a company does exceptionally well in
the future years there will be a payment cap that does not allow the investor to receive anything
more than what the capis regardless of how well the business preforms. Quasi-equity financing is
beneficial to companies that are not looking for a direct bank or equity loan.

Advantages of Non-Fund Facilities

When the lending bank does not pledge any outflow of funds in the physical form, it is called as
non-fund-based lending. These are the Contingent Liability of the Banks. So, the banks do not
deal in cash transactions or funds. The benefits of these types of loans is that there is no
immediate outlay of funds, easy monitoring comparatively, less cost to the banker, low probability
of default, and contingent deployment of funds.

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Letter of Credit:

A written undertaking given by a bank on behalf of its customer who is a purchaser, to the supplier
promising to pay a specific amount of money is called a Letter of Credit (LC). It works as a loan
provided the supplier complies with the loan amount and conditions mentioned in the LC. This type
of loan is basically required when both the parties dealing in the import or export are unknown and
do not feel safe while trading. It is done to safeguard the interests of both the parties involved.

Types of Letters of Credit

The ‘Letters of Credit’ may be divided in two broad categories as under:

Revocable letter of credit. This may be amended or cancelled without prior warning or
notification to the beneficiary. Such letter of credit will not offer any protection and should not be
accepted as beneficiary of credit.

Irrevocable letter of credit. This cannot be amended or cancelled without the agreement of all
parties thereto. This type of letter of credit is mainly in use and offers complete protection to the
seller against subsequent development against his interest.

Letter of Comfort:

A communication from a party to a contract to the other party that shows an initial willingness to
enter into obligations without the elements of a legally enforceable contract is called a letter of
comfort. It is also referred to as a Letter of Intent. It is a mere reassurance of performance and is
used widely in commercial transactions.

Standby Letter of Credit:

A guarantee made by a bank on behalf of a client is called a Standby Letter of Credit or SBLC.
This guarantee ensures that even if the client is not able to fulfill the payment, the bank will pay on
its behalf. It is actually never meant to be used but only kept as last resort payment from the banks
based on requirement.

Bank Guarantees:

The customers often call their banks for issuing a variety of bank guarantees on their behalf. An
undertaking from a bank stating that if the buyer fails to honor or make repayments to its vendor,
the bank will compensate on the buyer’s behalf to the vendor. The main advantage of a bank
guarantee is that it allows the business to make the purchasing that they are otherwise not able to.
At the same time, it reduces the credit risk of the vendors.

Personal Loans:

An unsecured loan type for meeting your current financial needs is called as a personal loan. In
this case, the lender gives you the flexibility to use the funds as per your requirement. One does
not need to pledge any collateral or security for availing a personal loan. These loans do not
require much documentation and hence, are relatively quick.

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Mortgage Loans:

A loan collateral is kept in terms of real estate or property is called a mortgage loan. There is a risk
for the borrower in accepting these loans because a failure to pay will lead to a complete loss of
the asset. At the same time, there is no guarantee that the borrower will be able to make the
payment in the future.

Personal Finance:

The management of financial decisions and money for a family or a person including investments,
budgeting, retirement planning, and investments is called personal finance. The future life events
and financial risks are kept into consideration while making important financial decisions. This
helps to develop a balanced plan for meeting financial goals with various techniques such as
proper tax planning, careful budgeting, and prudent spending. Proper personal finance
management leads to an increase in cash flow and a subsequent rise in capital.

Assessment of LC limits

The assessment LC/LG limits are fixed by banks based on annual consumption of raw material to
be purchased against LC or LG. The raw material holding in terms of consumption is worked out
as under.

Ascertain from customer the requirement of Consumption of Material (CM) per annum, which is to
be purchased under LC or LG.

(Procurement Time or Lead time means the time taken in revving the goods including transit
period after the LC is opened)

If the material is purchased under credit, add usance period or Credit Period (CP) to procurement
time.

We get Total Time (TT) when we add credit period to procurement period. TT=PT+CP

If CM is Annual Consumption of Material to be purchased against LC or LG

We can compute the LG or LC limit required to the company by dividing the annual consumption
of raw material to be purchased against LC or LG and same is divided by 12 and multiplied by
total time. (i.e. Monthly purchases ×total time) . Note: Purchase value of goods for assessment of
LC is done on the basis of CIF (cost, insurance and freight) of goods What is EOQ-economic order
quantity which is calculated by source of supply, means of transport and any discount.

Thus, the formula for LC/LG Limit=CM×TT ÷ 12

However, if minimum quantity (EOQ-economic order quantity) to be procured is more than the limit
arrived, such request should be considered. This equation is to be adapted for LC under DA terms
as well as for inland LG. (The EOQ-economic order quantity is calculated taking into account of
source of supply, means of transport and any discount for order of larger quantity etc.).

Bills Purchase/ Discounting under LC

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Process flow of Letter of credit:

Terms of Contract: When both the parties agree, they determine the nature of business and type
of goods the seller should supply to the buyer. Given the contract, a letter of credit is being issued
between buyer and seller.

Issuance of LC: Buyer approaches the issuing bank to issue the LC in favor of seller and sellers
bank i.e. confirmation bank which will pay to the seller on behalf of the buyer.

Documents and payment: As per LC terms, the seller will submit documents to confirmation bank,
for the payment which includes Bill of Exchange, packing list, e-way bill. Then these documents
are forwarded to issuing bank if there is no discrepancy in the documents the issuing bank will
honor the LC. Finally, the documents are submitted to the buyer, only if the payment is made by
the buyer.

If the above process is clear, what if the seller requires funds immediately and not on the due date.
In that case, the discounting of LC becomes a great tool. LC discounting is a short- term credit
facility provided by the bank to the seller. In this case, LC issuing bank confirms all the original
documents and provide acceptance to the confirming bank. After the due diligence from the bank,
the seller will get the credit amount after deducting the discount. The bill discounting is categorized
into two types namely sales and purchase. If the discounting is done by the seller, it is the sales
side and the buyer will be called purchase side bill discounting. The rates of discounting vary
depending upon the amount, period and creditworthiness of the client.

Advantages of LC Discounting

• It speeds up the cash flow and helps in the smooth flow of the working capital
• LC discounting takes away the risk and gives assurance to the seller for the funds
• It is customizable and both the parties can mutually arrive at the list of clauses for the
payment
• LC assists in boosting the business through various geographies.

Disadvantages of LC Discounting

• In LC discounting, there is no physical verification of the quantity and quality of goods.

• There is a set of documentation which needs to be followed by both seller and buyer, which
can be tedious due to non-availability for the same.
• The final amount which is credit is less, due to being discounted by the bank.

Loan commitments, Un-funded lines of credit and their

Characteristics
Loan Commitments
A loan commitment is an agreement by a commercial bank or other financial institution to lend a
business or individual a specified sum of money. A loan commitment is useful for consumers
looking to buy a home or a business planning to make a major purchase.

The loan can take the form of a single lump sum or in the case of an open-end loan commitment a
line of credit that the borrower can draw upon as needed (up to a predetermined limit).

30
Financial institutions make loan commitments based on the borrower’s creditworthiness and in if
it’s a secured commitment on the value of some form of collateral. In the case of individual
consumers, this collateral may be a home. Borrowers can then use the funds made available
under the loan commitment, up to the agreed-upon limit. An open-end loan commitment works like
a revolving line of credit: When the borrower pays back a portion of the loan’s principal, the lender
adds that amount back to the available loan limit.

A loan commitment is a formal letter from a lender stating that the applicant has met all of the
qualifications for receiving a loan, and that the lender promises a specific amount of money to the
borrower.

Many loan commitments are open-ended, meaning the loan is not just a one-time, lump sum
payment that the borrower must pay back. Instead, the borrower can continue to use this amount
as long as he or she keeps paying it back. This makes it similar to a revolving line of credit, such
as a credit card. If the borrower uses a portion of the loan amount and pays it back, the lender
applies the payment to the borrower’s principal balance.

An open-ended loan commitment is contingent upon the borrower’s credit status and requires
meeting certain qualifications. A loan commitment can be either secured or unsecured. An
unsecured loan requires no collateral, but a secured loan does.

Un-funded lines of credit and their Characteristics

An unfunded line of credit is one that a bank issues to a borrower, but is not borrowed upon at the
moment it is issued. The bank or lending institution will honor any future draws upon the unfunded
line of credit, but does not need to make any money available until the moment the customer
requests it.

Borrowers Of Unfunded Lines of Credit

Borrowers of unfunded lines of credit can be either individual retail customers or businesses.
Businesses such as hedge funds and insurance companies are customers of unfunded lines of
credit, and they most commonly use them as an emergency fund. Retail customers can also
acquire unfunded lines of credit in the form of home equity lines. Unfunded loan commitments,
whether to retail or corporate clients, represent liabilities to both borrowers and banks.

Risk Of Borrower Default

A borrower can default after drawing upon the line of credit, causing a major problem for the bank
which acted as a lender. For example, if a major catastrophe happens which requires an
insurance company to pay out claims for which it does not have sufficient cash reserves, that
insurance company may draw upon its unfunded line of credit. If the insurance company is unable
to pay back what it borrowed from the bank and files for bankruptcy, the bank must count the
unrecovered money as a loss.

Risk Of Bank Default

Unfunded lines of credit pose major risks for banks. Because the bank must honour the line of
credit at any given point in the future, it must have enough cash to do so. If a bank issues too
many unfunded loan commitments, and a high number of them are unexpectedly drawn upon, the
31
bank will be unable to honour the loan commitment. Banks are required to report unfunded lines of
credit quarterly to the United States government’s Federal Deposit Insurance Corporation. Every
bank limits the number of unfunded credit lines it will issue to mitigate liability.

Typically, unfunded commitments are separated into two categories:

Multiple Advance, Closed End: This type of loan (typically a construction loan) advances
incremental amounts up to a certain limit, based upon some criteria such as inspection and
approval of a draw request. Any principal reductions received during the loan period are not
available to be drawn on, but rather have paid down the loan balance.

Revolving or Open End: This type of loan (known informally as a Line of credit) allows the
borrower to continue to borrow up to the original loan amount. Principal reductions are
immediately available for future advances.

Various types of Bank Guarantees: Performance Guarantee,

Financial Guarantees, Deferred Payment Guarantees
Performance Guarantee

Performance guarantee is used as collateral in transactions involving a buyer and a seller. A

performance guarantee is typically invoked if the buyer incurs cost and the seller does not deliver
goods or services as promised in the contract. To invoke a performance guarantee, the beneficiary
requires to declare in writing that the seller did not fulfil his or her contractual obligations properly
or on time.

The bank has to discharge the financial liability of the contract agreed in the guarantee, if the
contract is partly or fully not performed by the customer. Such type of guarantees issued by the
bank is called Performance Guarantee. Many a time the terms of the contract may be of highly
technical in nature and bank is generally not expected to know the technical aspects of the
contract. Therefore, the bank assumes only the financial liability of the contract. Since the
issuance of performance guarantee is more complicated and riskier, before issuing performance
guarantees, the bank has to ensure that the customer has sufficient experience in the line of
business and he has capacity and means to carry out the obligation under the contract.

Financial Guarantees

A financial guarantee is an undertaking from a bank to take responsibility for another company’s
financial obligation if that company does not meet its responsibility. The bank provides financial
guarantees mostly between two related parties, i.e., a partner company providing a financial
guarantee to a subsidiary company.

This cash security provided by the contractor or supplier is forfeited by the Government
Department or the company which awarded the contract, in the event the contractor or supplier
fails to comply with the terms stipulated in sanction. The customer normally will have an option to
furnish a bank guarantee in lieu of cash security, so that his working funds are not unnecessarily
blocked. The guarantees issued by banks for above purpose is called financial guarantee wherein
the banks undertake to pay the guaranteed amount during a specified period on demand from the
beneficiary. The examples of Financial Guarantee are as under.

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Deferred Payment Guarantees

Deferred payment guarantees are used when one party in a transaction undertakes to make
payment of fixed amount at corresponding times in the future. In case, the debtor is unable to pay,
then the deferred payment guarantee can be invoked to claim the money. Thereby the buyer’s
bank guarantees due payment of those drafts drawn by the seller which represents the total
consideration of the contract of sale/supply. The seller avail the refinance from his bank against
co-accepted bills. DPG involves substitution of the term loan. Hence procedure applicable for
assessment of term loan must be followed for DPG limit viz. projection under operating statement,
Funds flow statement, DSCR, BEP etc.

Types of Performance and Financial Guarantees, Assessment of

Bank Guarantees Limit, Period of Claim under Guarantee
Types of Performance Guarantees

Performance guarantee is the agreement between a client and a contractor to assure the client to
perform the contractor’s obligation as per agreement.

In this respect, the Bank gives an undertaking to its client that contractor will do their job as per
agreement. If the contractor fails to perform his duties as per contract, the bank will pay the
damage up to the guaranteed amount. This guarantee might include a clause to protect the client
against the losses incurred if the contractor fails to perform.

There are different types of guarantees that a bank will offer to its clients and parties. Following
two types of Guarantees are very familiar and commonly used in the corporate field. These two
are:

Advance Payment Guarantee

Advance taken from the buyer is a very common practice in today’s business. In this respect, the
bank provides a guarantee to the buyer that the money given by him to the seller against advance
payment to deliver the required goods. If the seller fails to comply with the requirements
mentioned in the sale agreement, the seller will be liable to back the amount to the buyer. The
Bank offered the guarantee to back the advance payment for non-compliance with the conditions.

Tender Guarantee

This guarantee is also referred to as the “Bid Bond” guarantee. Both in International Tender and
Local Tender, this guarantee is used where a contractor/supplier is obliged to comply with the
conditions as mentioned in the agreement.

Types of Financial Guarantees

A financial guarantee is a contractual promise made by a bank, insurance company, or other entity
to guarantee payment of a debt obligation of another party such as a company. Essentially, a
financial guarantee is a type of warranty attached to a debt. Individuals may also provide financial
guarantees, such as when a parent co-signs a loan for their child.

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Types:

1. Individual financial guarantees

Financial guarantees provided by individuals occur all the time. Parents with good, established
credit may become a guarantor of debt by co-signing a loan agreement or rental agreement for
one of their children who lacks an established credit history or has a poor credit rating.

1. Bond guarantees

Many bonds issued by companies are supported with a financial guarantee of the bond’s
payments to investors by an insurance company. In such cases, the insurance company may
provide either a full or partial guarantee of the bond payments due.

1. Financial guarantees from companies

Public or private companies commonly provide financial guarantees for their subsidiary
companies. The parent company of a subsidiary typically has more extensive financial resources
than the subsidiary company does. Therefore, if the subsidiary is seeking a large loan, the lender
may require the parent company to act as a guarantor of the loan.

The lender may simply require a contractual obligation by the parent company to cover the debt
repayment if necessary, or it may require that the parent company pledge assets as collateral for
the loan. A company involved in a joint venture may also act as a guarantor of a debt obligation if it
is financially much larger and financially sound than its partner in the joint venture.

1. Bank financial guarantees

Banks frequently provide a wide variety of financial guarantees for their clients. One of the most
commonly issued types of bank guarantees is a guarantee of payment to a seller by a buyer. Such
a guarantee is often used in the case of large international transactions. As the seller may not lack
sufficient knowledge about the buyer, they may require a guarantee of payment from the buyer’s
bank.

The buyer’s bank may, in turn, require the buyer to deposit the necessary funds for the purchase
with the bank. A bank may also provide what is known as a performance or warranty bond that
essentially guarantees that the goods provided to a buyer are as promised and delivered as
agreed by contract with the seller.

Banks also sometimes provide an advance payment guarantee, which is a promise to refund any
advance payment on goods made by a buyer in the event that the seller fails to deliver the goods.

Assessment of Bank Guarantee Limit

Bank Guarantee a promise made by the bank to any third person to undertake the payment risk on
behalf of its customers. Bank guarantee is given on a contractual obligation between the bank and
its customers. Such guarantees are widely used in business and personal transactions to protect
the third party from financial losses. This guarantee helps a company to purchase things that it
ordinarily could not, thus helping business grow and promoting entrepreneurial activity.

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The advantages are:

• Bank guarantee reduces the financial risk involved in the business transaction.
• Due to low risk, it encourages the seller/beneficiaries to expand their business on
a credit basis.
• Banks generally charge low fees for guarantees, which is beneficial to even
small-scale business.
• When banks analyse and certify the financial stability of the business, its
credibility increases and this, in turn, increase business opportunities.
• Mostly, the guarantee requires fewer documents and is processed quickly by the
banks (if all the documents are submitted).

Features of a Valid Guarantee

• The period until which the guarantee holds is clearly specified

• The guarantee issuance is always for a specific amount
• The purpose of the guarantee is very clear.
• The guarantee is valid for a particular period of time.
• The grace period allowed to enforce guarantee rights is also stated in the
guarantee
• Guarantee clearly states the events under which it is enforceable.

Period of Claim under Guarantee

“Exception 3; Saving of a guarantee agreement of a bank or a financial institution: This section

shall not render illegal a contract in writing by which any bank or financial institution stipulate a
term in a guarantee or any agreement making a provision for guarantee for extinguishment of the
rights or discharge of any party thereto from any liability under or in respect of such guarantee or
agreement on the expiry of a specified period which is not less than one year from the date of
occurring or non-occurring of a specified event for extinguishment or discharge of such party from
the said liability.”

That said, the banks have often been stipulating a claim period of one year, or in some instances
of less than one year.

END OF UNIT 3

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 UNIT 4

Analysis of Risk & Uncertainty

It was assumed that those investment proposals did not involve any kind of risk, i.e., whatever the
proposal is undertaken, there would not be any change in the business risk which are
apprehended by the suppliers of capital. Practically, in real world situation, this seldom happens.

We know that decisions are taken on the basis of forecast which again depends on future events
whose happenings cannot be anticipated/predicted with absolute certainly due to some factors,
e.g., economic, social, political etc. That is why question of risk and uncertainty appear before the
business world although it varies from one investment proposal to another.

For example, some proposal may not even involve any risk, e.g., investment in Government bonds
and securities where there is a fixed rate of return exists, some may be less risky, e.g., expansion
of the existing business, others may be more risky, e.g., setting up a new operation.

That is, different investment proposals have different degrees of risk. It should be remembered
that if there is any change in business risk complexion, there remains also a change in the
apprehension of the creditors and the investors about the firm as well In short, if the acceptance of
any proposal proves the firm more rising, creditors and investors will not be interested or will not
consider it with favour which, in other words, adversely affect the total valuation of the firm.

Therefore, while evaluating investment proposals care should be taken about the effect that their
acceptance may have on the firm’s business risk as apprehended by the creditors and/or
investors. As such, the firm should always prefer a less risky investment proposal than a more
risky one.

The riskiness of an investment proposal may be defined as the variability of its possible terms, i.e.,
the variability which may likely be occurred in the future returns from the project. For example, if a
person invests Rs 25,000 to short-term Government securities, carrying 12% interest, he may
accurately estimate his future return year after year since it is absolutely risk-free.

On the contrary, instead of investing Rs 25,000 m short-term Government security, if he wants to

purchase the shares of a company, then it is not at all possible for him to estimate the future
returns accurately, since the dividend rates of a company may widely vary, viz., from 0% to a very
high figure.

Therefore, as there is a high degree of variability relating to future returns, it is relatively risky as
compared to his investment in Government securities. Thus, the risk may be defined as the
variability which may likely to accrue in future between the estimated/expected returns and actual
returns. The greater is the variability between the two, the risker the project and vice-versa.

In short, risk may be defined as the degree of uncertainty about an income. Risk is a character of
the investment opportunity and has nothing to do with the attitude of investors Consider the
following two investment opportunities, viz., X and Y which have the possible payoffs presented in
Table 7.1 below depending on the state of economy.

(Assume that the three state of economy are equally likely)

36
From the table 7.1 presented above, it becomes clear that the average expected return from both
the projects are Rs. 1,000 (Rs 3,000 3). But the return from investment-X will lie between Rs. 990
and R 1,010 as compared to investment-Y which lies between Rs. 0 and Rs. 2,000, i.e., in other
words, more uncertainty arises about the return from the investment Y.

However, decision situations may be broken down into three types: Certainty, Risk and
Uncertainty.

(i) Certainly:

No Risk

(ii) Risk:

It involves situations in which the probabilities of a particular event which occurs are known, i.e.,
chance of future loss can be foreseen.

(iii) Uncertainty:

The probabilities of a particular event which occurs are not known i.e., the future loss cannot be
foreseen. The basic difference between risk and uncertainty is that variability is less in case of risk
whereas it is more in case of uncertainty although both the terms are used here interchangeably.

Financial Sector, Risk Types

Financial risk is the possibility of losing money on an investment or business venture. Some more
common and distinct financial risks include credit risk, liquidity risk, and operational risk.

Financial risk is a type of danger that can result in the loss of capital to interested parties. For
governments, this can mean they are unable to control monetary policy and default on bonds or
other debt issues. Corporations also face the possibility of default on debt they undertake but may
also experience failure in an undertaking the causes a financial burden on the business.

Financial markets face financial risk due to various macroeconomic forces, changes to the market
interest rate, and the possibility of default by sectors or large corporations. Individuals face
financial risk when they make decisions that may jeopardize their income or ability to pay a debt
they have assumed.

37
Financial risks are everywhere and come in many shapes and sizes, affecting nearly everyone.
You should be aware of the presence of financial risks. Knowing the dangers and how to protect
yourself will not eliminate the risk, but it can mitigate their harm and reduce the chances of a
negative outcome.

1. Market risk

Among the types of financial risks, one of the most important is market risk. This type of risk has a
very broad scope, as it appears due to the dynamics of supply and demand.

Market risk is largely caused by economic uncertainties, which may impact the performance of all
companies and not just one company. Variations in the prices of assets, liabilities and derivatives
are included in these sources of risk.

For example, this is the risk to which an importer company paying its supplies in dollars and then
selling the final product in local currency is exposed. In the event of devaluation, that company
may suffer losses that would prevent it from fulfilling its financial obligations.

The same applies for innovations and changes in the market. One example is the commercial
sector. Companies that have managed to adapt to the digital market to sell their products online
have experienced an increase in revenue. Meanwhile, those that have resisted these
transformations show lagging competitiveness.

1. Credit risk

In financial risk management, credit risk is of paramount importance. This risk refers to the
possibility that a creditor will not receive a loan payment or will receive it late.

Credit risk is therefore a way of determining a debtor’s capacity to fulfill its payment obligations.

There are two types of credit risk: retail and wholesale.

The first refers to the risk involved in financing individuals and small businesses, whether through
mortgages, cards or any other form of credit.

Wholesale credit, on the other hand, arises from the organization’s own investments, whether in
the form of sales of financial assets, mergers or acquisitions of companies.

The case of subprime mortgages in the United States, which led to the economic crisis of 2008,
explains how credit risk materializes when it is not managed properly.

Subprime mortgages were high-risk, high-interest loans granted to people who were unemployed
or did not have a stable income.

Banks began to broad profile´s scope of subprime mortgage applicants in order to increase
income. However, since the applicants could not pay, the delinquency of the debts increased.

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 1. Liquidity risk

Financial risk management must consider a company’s liquidity, as every organization must
ensure that it has sufficient cash flow to pay off its debts. Failing to do so may ruin investor
confidence.

Liquidity risk is just that. It is the possibility that a company will not be able to fulfill its
commitments. One of the possible causes thereof is poor cash flow management.

A company can have a significant amount of equity, but at the same time a high liquidity risk. That
is because it cannot turn those assets into money to meet its short-term expenses.

Real estate or bonds, for example, are assets that can take a long time to turn into money. That is
why each company must verify whether it has current assets to pay off short-term commitments.

2. Operational risk

Finally, among the types of financial risks there is also operational risk. There are different types of
operational risk. These risks occur due to lack of internal controls within the company,
technological failures, mismanagement, human error or lack of employee training.

Eventually, this risk almost always leads to a financial loss for the company.

Operational risk is one of the most difficult to measure objectively. In order to be able to calculate it
accurately, the company must have created a history log with the failures of this type and
recognized the possible connection between them.

These risks can be avoided if a specific risk is considered to be able to trigger further risks. A
broken-down machine, for example, not only implies the expense to repair it. It also causes losses
for production downtime, which can lead to a delay on product deliveries and even affect the
company’s reputation.

Operational Risk Management: Recruitment & Training, Work flow

Design
The term operational risk management (ORM) is defined as a continual cyclic process which
includes risk assessment, risk decision making, and implementation of risk controls, which results
in acceptance, mitigation, or avoidance of risk. ORM is the oversight of operational risk, including
the risk of loss resulting from inadequate or failed internal processes and systems; human factors;
or external events. Unlike other type of risks (market risk, credit risk, etc.) operational risk had
rarely been considered strategically significant by senior management.

Levels
Deliberate

Deliberate risk management is used at routine periods through the implementation of a project or
process. Examples include quality assurance, on-the-job training, safety briefs, performance
reviews, and safety checks.

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In Depth

In depth risk management is used before a project is implemented, when there is plenty of time to
plan and prepare. Examples of in-depth methods include training, drafting instructions and
requirements, and acquiring personal protective equipment.

Time Critical

Time critical risk management is used during operational exercises or execution of tasks. It is
defined as the effective use of all available resources by individuals, crews, and teams to safely
and effectively accomplish the mission or task using risk management concepts when time and
resources are limited. Examples of tools used includes execution check-lists and change
management. This requires a high degree of situational awareness.

Categories:
People

The people category includes employees, customers, vendors and other stakeholders. Employee
risk includes human error and intentional wrongdoing, such as in cases of fraud. Risks include
breach of policy, insufficient guidance, poor training, bed decision making, or fraudulent behavior.
Outside of the organization, there are several operational risks that include people. Employees,
customers, and vendors all pose a risk with social media. Monitoring and controlling the people
aspect of operation risk is one of the broadest areas for coverage.

Technology

Technology risk from an operational standpoint includes hardware, software, privacy, and security.
Technology risk also spans across the entire organization and the people category described
above. Hardware limitations can hinder productivity, especially when in a remote work
environment. Software too can reduce productivity when applications do increase efficiency or
employees lack training. Software can also impact customers as they interact with your
organization. External threats exist as hackers attempt to steal information or hijack networks. This
can lead to leaked customer information and data privacy concerns.

Regulations

Risk for non-compliance to regulation exists in some form in nearly every organization. Some
industries are more highly regulated than others, but all regulations come down to operationalizing
internal controls. Over the past decade, the number and complexity of rules have increased and
the penalties have become more severe.

Flow:
Step 1: Risk Identification

Risks must be identified so these can be controlled. Risk identification starts with understanding
the organization’s objectives. Risks are anything that prevents the organization from attaining its
objectives.

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Step 2: Risk Assessment

Risk assessment is a systematic process for rating risks on likelihood and impact. The outcome
from the risk assessment is a prioritized listing of known risks. The risk assessment process may
look similar to the risk assessment done by internal audit.

Step 3: Risk Mitigation

The risk mitigation step involves choosing a path for controlling the specific risks. In the
Operational Risk Management process, there are four options for risk mitigation: transfer, avoid,
accept, and control.

• Transfer: Transferring shifts the risk to another organization. The two most often means for
transferring are outsourcing and insuring. When outsourcing, management cannot
completely transfer the responsibility for controlling risk. Insuring against the risk ultimately
transfers some of the financial impact of the risk to the insurance company. A good
example of transferring risk occurs with cloud-based software companies. When a company
purchases cloud-based software, the contract usually includes a clause for data breach
insurance. The purchaser is ensuring the vendor can pay for damages in the event of a
data breach. At the same time, the vendor will also have their data center provide SOC
reports that show there are sufficient controls in place to minimize the likelihood of a data
breach.
• Avoid: Avoidance prevents the organization from entering into the risk situation. For
example, when choosing a vendor for a service, the organization could choose to accept a
vendor with a higher-priced bid if the lower-cost vendor does not have adequate references.
• Accept: Based on the comparison of the risk to the cost of control, management could
accept the risk and move forward with the risky choice. As an example, there is a risk that
an employee will burn themselves if the company installs new coffee makers in the
breakroom. The benefit of employee satisfaction from new coffee makers outweighs the risk
of an employee accidentally burning themselves on a hot cup of coffee, so management
accepts the risk and installs the new appliance.
• Control: Controls are processing the organization puts in place to decrease the impact of
the risk if it occurs or to increase the likelihood of meeting the objective. For example,
installing software behind a firewall reduces the likelihood of hackers gaining access, while
backing up the network decreases the impact of a compromised network since it can be
restored to a safe point.

Step 4: Control Implementation

Once the risk mitigation choice decisions are made, the next step is implementation. The controls
are designed specifically to meet the risk in question. The control rationale, objective, and activity
should be clearly documented so the controls can be clearly communicated and executed. The
controls implemented should focus preventive control activities over policies

Step 5: Monitoring

Since the controls may be performed by people who make mistakes, or the environment could
change, the controls should be monitored. Control monitoring involves testing the control for

41
appropriateness of design, implementation, and operating effectiveness. Any exceptions or issues
should be raised to management with action plans established.

Workflow Documentation
Workflow documentation is the process of storing, tracking, and editing business documents
that shape your workflow.

In other words, workflow documentation outlines your business processes and workflows.

Document workflow management is a system used to capture, generate, track, edit, approve,
store, retrieve, retain and destroy documents associated with business processes. Digital
document workflow helps organisations to reduce often large amounts of paperwork that slow
down day-to-day operations. Purchase orders, invoices, holiday requests, proof of delivery,
despatch, payroll, vehicle documents, supply chain information, claim forms, insurances, and
more. The majority of businesses are document-heavy and how documents are managed affects
running costs, staff productivity, profitability and customer satisfaction. Documents get passed
from one department to the next, requiring approval or changes at each stop.

Process:

Define the process

First things first, you need to outline the process of the workflow. It’ll be a top-level overview of
what you envisage the specific workflow to involve.

Review the following information:

• Where the workflow begins

• Where the workflow ends
• Any milestones to hit along the way
• What’s involved at each stage of the workflow

Confirm the output

Now you need to identify what the output should be. Will you have made a sale? Launched a new
product? Hired a new employee? Whatever it is, make sure you’re clear on what the outcome
should be. This will give you the direction you need to make sure your workflow delivers what you
want.

Document the step-by-step process

Now you know what the workflow involves and what the outputs are, you can document the entire
workflow step-by-step.

Review your data on where you need to start, where you need to finish, and what your key
milestones will be. You can then focus on filling in the gaps between each key milestone to get
you from start to finish.

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Review the workflow process

Once you’ve outlined the entire workflow, it’s time to scrutinize it. Double-check everything before
you roll it out to your team. The last thing you want is to distribute the business process
documentation only to find an error somewhere down the line.

Benefits:
Align your team

When you have a clear process, it’s easy for everyone to follow it. There’s less room for error, and
team members won’t be confused about what actions they need to take.

Improve your processes

Workflow documentation helps teams improve their business processes. Think about it. If you’re
tracking and documenting your workflow, it’s much easier to identify room for improvement.
Without workflow documentation, you simply won’t have this level of clarity.

Work more efficiently

Using digital documentation allows you to speed up your day-to-day processes and focus on tasks
that matter.

Delegation of Authority
A manager alone cannot perform all the tasks assigned to him. In order to meet the targets, the
manager should delegate authority. Delegation of Authority means division of authority and
powers downwards to the subordinate. Delegation is about entrusting someone else to do parts of
your job. Delegation of authority can be defined as subdivision and sub-allocation of powers to the
subordinates in order to achieve effective results.

Elements of Delegation

1. Authority

In context of a business organization, authority can be defined as the power and right of a person
to use and allocate the resources efficiently, to take decisions and to give orders so as to achieve
the organizational objectives. Authority must be well- defined. All people who have the authority
should know what is the scope of their authority is and they shouldn’t misutilize it. Authority is the
right to give commands, orders and get the things done. The top level management has greatest
authority.

Authority always flows from top to bottom. It explains how a superior gets work done from his
subordinate by clearly explaining what is expected of him and how he should go about it. Authority
should be accompanied with an equal amount of responsibility. Delegating the authority to
someone else doesn’t imply escaping from accountability. Accountability still rest with the person
having the utmost authority.

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 2. Responsibility

It is the duty of the person to complete the task assigned to him. A person who is given the
responsibility should ensure that he accomplishes the tasks assigned to him. If the tasks for which
he was held responsible are not completed, then he should not give explanations or excuses.
Responsibility without adequate authority leads to discontent and dissatisfaction among the
person. Responsibility flows from bottom to top. The middle level and lower level management
holds more responsibility. The person held responsible for a job is answerable for it. If he performs
the tasks assigned as expected, he is bound for praises. While if he doesn’t accomplish tasks
assigned as expected, then also he is answerable for that.

3. Accountability

It means giving explanations for any variance in the actual performance from the expectations set.
Accountability can not be delegated. For example, if ’A’ is given a task with sufficient authority, and
’A’ delegates this task to B and asks him to ensure that task is done well, responsibility rest with
’B’, but accountability still rest with ’A’. The top level management is most accountable. Being
accountable means being innovative as the person will think beyond his scope of job.
Accountability, in short, means being answerable for the end result. Accountability can’t be
escaped. It arises from responsibility.

For achieving delegation, a manager has to work in a system and has to perform following steps :
–

• Assignment of tasks and duties

• Granting of authority
• Creating responsibility and accountability

Delegation of authority is the base of superior-subordinate relationship, it involves following steps:-

(i) Assignment of Duties:

The delegator first tries to define the task and duties to the subordinate. He also has to define the
result expected from the subordinates. Clarity of duty as well as result expected has to be the first
step in delegation.

(ii) Granting of authority:

Subdivision of authority takes place when a superior divides and shares his authority with the
subordinate. It is for this reason, every subordinate should be given enough independence to carry
the task given to him by his superiors. The managers at all levels delegate authority and power
which is attached to their job positions. The subdivision of powers is very important to get effective
results.

(iii) Creating Responsibility and Accountability:

The delegation process does not end once powers are granted to the subordinates. They at the
same time have to be obligatory towards the duties assigned to them. Responsibility is said to be
the factor or obligation of an individual to carry out his duties in best of his ability as per the
directions of superior. Responsibility is very important. Therefore, it is that which gives
44
effectiveness to authority. At the same time, responsibility is absolute and cannot be shifted.
Accountability, on the others hand, is the obligation of the individual to carry out his duties as per
the standards of performance. Therefore, it is said that authority is delegated, responsibility is
created and accountability is imposed. Accountability arises out of responsibility and responsibility
arises out of authority. Therefore, it becomes important that with every authority position an equal
and opposite responsibility should be attached.

Therefore every manager,i.e.,the delegator has to follow a system to finish up the delegation
process. Equally important is the delegatee’s role which means his responsibility and
accountability is attached with the authority over to here.

Delegation: Centralization and Decentralization of Authority

A manager alone cannot perform all the tasks assigned to him. In order to meet the targets, the
manager should delegate authority. Delegation of Authority means division of authority and
powers downwards to the subordinate. Delegation is about entrusting someone else to do parts of
your job. Delegation of authority can be defined as subdivision and sub-allocation of powers to the
subordinates in order to achieve effective results.

Elements of Delegation

1. Authority: In context of a business organization, authority can be defined as the power and
right of a person to use and allocate the resources efficiently, to take decisions and to give
orders so as to achieve the organizational objectives. Authority must be well- defined. All
people who have the authority should know what is the scope of their authority is and they
shouldn’t misutilize it. Authority is the right to give commands, orders and get the things
done. The top level management has greatest authority.

Authority always flows from top to bottom. It explains how a superior gets work done
from his subordinate by clearly explaining what is expected of him and how he should go
about it. Authority should be accompanied with an equal amount of responsibility.
Delegating the authority to someone else doesn’t imply escaping from accountability.
Accountability still rest with the person having the utmost authority.

2. Responsibility: Is the duty of the person to complete the task assigned to him. A person
who is given the responsibility should ensure that he accomplishes the tasks assigned to
him. If the tasks for which he was held responsible are not completed, then he should not
give explanations or excuses. Responsibility without adequate authority leads to discontent
and dissatisfaction among the person. Responsibility flows from bottom to top. The middle
level and lower level management holds more responsibility. The person held responsible
for a job is answerable for it. If he performs the tasks assigned as expected, he is bound for
praises. While if he doesn’t accomplish tasks assigned as expected, then also he is
answerable for that.
3. Accountability: Means giving explanations for any variance in the actual performance from
the expectations set. Accountability cannot be delegated. For example, if ’A’ is given a task
with sufficient authority, and ’A’ delegates this task to B and asks him to ensure that task is
done well, responsibility rest with ’B’, but accountability still rest with ’A’. The top level
management is most accountable. Being accountable means being innovative as the
person will think beyond his scope of job. Accountability, in short, means being answerable
for the end result. Accountability can’t be escaped. It arises from responsibility.

For achieving delegation, a manager has to work in a system and has to perform following steps:
45
 1. Assignment of tasks and duties
2. Granting of authority
3. Creating responsibility and accountability

Delegation of authority is the base of superior-subordinate relationship, it involves following

steps:-

1. Assignment of Duties: The delegator first tries to define the task and duties to the
subordinate. He also has to define the result expected from the subordinates. Clarity of duty
as well as result expected has to be the first step in delegation.
2. Granting of authority: Subdivision of authority takes place when a superior divides and
shares his authority with the subordinate. It is for this reason, every subordinate should be
given enough independence to carry the task given to him by his superiors. The managers
at all levels delegate authority and power which is attached to their job positions. The
subdivision of powers is very important to get effective results.
3. Creating Responsibility and Accountability: The delegation process does not end once
powers are granted to the subordinates. They at the same time have to be obligatory
towards the duties assigned to them. Responsibility is said to be the factor or obligation of
an individual to carry out his duties in best of his ability as per the directions of superior.
Responsibility is very important. Therefore, it is that which gives effectiveness to authority.
At the same time, responsibility is absolute and cannot be shifted. Accountability, on the
others hand, is the obligation of the individual to carry out his duties as per the standards of
performance. Therefore, it is said that authority is delegated, responsibility is created and
accountability is imposed. Accountability arises out of responsibility and responsibility arises
out of authority. Therefore, it becomes important that with every authority position an equal
and opposite responsibility should be attached.

Therefore every manager,i.e.,the delegator has to follow a system to finish up the delegation
process. Equally important is the delegatee’s role which means his responsibility and
accountability is attached with the authority over to here.

Relationship between Authority and Responsibility

Authority is the legal right of person or superior to command his subordinates while accountability
is the obligation of individual to carry out his duties as per standards of performance Authority
flows from the superiors to subordinates,in which orders and instructions are given to subordinates
to complete the task. It is only through authority, a manager exercises control. In a way through
exercising the control the superior is demanding accountability from subordinates. If the marketing
manager directs the sales supervisor for 50 units of sale to be undertaken in a month. If the above
standards are not accomplished, it is the marketing manager who will be accountable to the chief
executive officer. Therefore, we can say that authority flows from top to bottom and responsibility
flows from bottom to top. Accountability is a result of responsibility and responsibility is result of
authority. Therefore, for every authority an equal accountability is attached.

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Differences between Authority and Responsibility
Authority Responsibility

It is the legal right of a person

It is the obligation of subordinate to perform the
or a superior to command his
work assigned to him.
subordinates.

Authority is attached to the Responsibility arises out of superior-subordinate

position of a superior in relationship in which subordinate agrees to
concern. carry out duty given to him.

Authority can be delegated by a

Responsibility cannot be shifted and is absolute
superior to a subordinate

It flows from top to bottom. It flows from bottom to top.

Centralization is said to be a process where the concentration of decision making is in a few

hands. All the important decision and actions at the lower level, all subjects and actions at the
lower level are subject to the approval of top management. According to Allen, “Centralization” is
the systematic and consistent reservation of authority at central points in the organization. The
implication of centralization can be:

1. Reservation of decision making power at top level.

2. Reservation of operating authority with the middle level managers.
3. Reservation of operation at lower level at the directions of the top level.

Under centralization, the important and key decisions are taken by the top management and the
other levels are into implementations as per the directions of top level. For example, in a business
concern, the father & son being the owners decide about the important matters and all the rest of
functions like product, finance, marketing, personnel, are carried out by the department heads and
they have to act as per instruction and orders of the two people. Therefore in this case, decision
making power remain in the hands of father & son.

On the other hand, Decentralization is a systematic delegation of authority at all levels of

management and in all of the organization. In a decentralization concern, authority in retained by
the top management for taking major decisions and framing policies concerning the whole
concern. Rest of the authority may be delegated to the middle level and lower level of
management.

The degree of centralization and decentralization will depend upon the amount of authority
delegated to the lowest level. According to Allen, “Decentralization refers to the systematic effort to
delegate to the lowest level of authority except that which can be controlled and exercised at
central points.

Decentralization is not the same as delegation. In fact, decentralization is all extension of

delegation. Decentralization pattern is wider is scope and the authorities are diffused to the lowest
most level of management. Delegation of authority is a complete process and takes place from
47
one person to another. While decentralization is complete only when fullest possible delegation
has taken place. For example, the general manager of a company is responsible for receiving the
leave application for the whole of the concern. The general manager delegates this work to the
personnel manager who is now responsible for receiving the leave applicants. In this situation
delegation of authority has taken place. On the other hand, on the request of the personnel
manager, if the general manager delegates this power to all the departmental heads at all level, in
this situation decentralization has taken place. There is a saying that “Everything that increasing
the role of subordinates is decentralization and that decreases the role is centralization”.
Decentralization is wider in scope and the subordinate’s responsibility increase in this case. On
the other hand, in delegation the managers remain answerable even for the acts of subordinates
to their superiors.

Implications of Decentralization

1. There is less burden on the Chief Executive as in the case of centralization.

2. In decentralization, the subordinates get a chance to decide and act independently which
develops skills and capabilities. This way the organization is able to process reserve of
talents in it.
3. In decentralization, diversification and horizontal can be easily implanted.
4. In decentralization, concern diversification of activities can place effectively since there is
more scope for creating new departments. Therefore, diversification growth is of a degree.
5. In decentralization structure, operations can be coordinated at divisional level which is not
possible in the centralization set up.
6. In the case of decentralization structure, there is greater motivation and morale of the
employees since they get more independence to act and decide.
7. In a decentralization structure, co-ordination to some extent is difficult to maintain as there
are lot many department divisions and authority is delegated to maximum possible extent,
i.e., to the bottom most level delegation reaches. Centralization and decentralization are the
categories by which the pattern of authority relationships became clear. The degree of
centralization and de-centralization can be affected by many factors like nature of
operation, volume of profits, number of departments, size of a concern, etc. The larger the
size of a concern, a decentralization set up is suitable in it.

Internal audit and Internal control

Internal Control
Internal Control can be understood as a system developed, implemented and maintained by the
company’s management, in order to ensure the achievement of objectives concerning:

• Effectiveness and efficiency of operations,

• Protecting assets,
• Prevention and detection of frauds and errors,
• Accuracy and completeness of financial reporting,
• Adherence to relevant laws.

It comprises of five elements, which are interconnected to each other and apply to all firms, but
their implementation depends on the size of the firm. The elements are control environment, risk
assessment, control activities, information and communication and monitoring.

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Objectives of Internal Control

• Examining whether the transactions are executed as per the management’s authorization.
• Checking prompt recording of transactions, in correct amount and account and that too in
the accounting period, to which it belongs.
• Ascertaining that assets are protected from unauthorized access and use.
• Comparing recorded assets with the existing ones, at various time intervals and taking
actions in case differences are discovered.

Review

The most important part of the internal control system is its review, for which the auditor can use
any of the methods: Narrative Records, Checklist, Questionnaire, and Flowchart.

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Internal Audit
Internal audit is defined as an unbiased, rational assurance and consulting function, developed by
the management, to keep a check on the activities of the organization. It involves regular and
critical analysis of the functions of an organization, for the purpose of recommending
improvements. It is aimed at assisting members of the firm in discharging their responsibilities in
an effective manner.

Internal Audit Process

The task is performed by the internal auditor, who is appointed by the company’s management.
He/she reports the management regarding the analysis, appraisal, recommendation and all
relevant information relating to the activities under study.

Objectives of Internal Audit

• To check the accuracy and authenticity of the accounting records, which are reported to
those charged with governance.
• To identify whether the standard accounting practices, which are deemed to be pursued by
the entity, are complied with or not.
• To ensure detection and prevention of fraud.
• To examine that there is an appropriate authority for the procurement and disposal of
assets.
• To verify that the liabilities are incurred only for business causes and not for any other
purpose.
• To review the activities of the internal control system, so as to report management
regarding deviations and non-compliances.

Independent Compliance Function

The compliance department ensures that a business adheres to external rules and internal
controls. In the financial services sector, compliance departments work to meet key regulatory
objectives to protect investors and ensure that markets are fair, efficient and transparent. They
also seek to reduce system risk and financial crime.

These objectives are designed to support consumer confidence in the financial system. Financial
services organizations also are subject to regulatory business rules that govern advertising,
customer communications, conflicts of interest, customer understanding and suitability, customer
dealings, client assets, and money as well as rule-breaking and errors.

50
Four elements of independence by:

Implementing a written compliance framework that is approved by the governing body and
establishes a distinct and empowered compliance function.

Naming a Chief Compliance Officer (CCO) with a functional reporting line to a committee of the
governing body that is comprised entirely of non-executive (outside) directors, in order to ensure
autonomy.

Ensuring that the CCO and staff members of the compliance function do not perform business
responsibilities.

Allowing the compliance function unfiltered access to information needed to carry out its oversight
role.

Importance:
Without a compliance function, you cannot reliably build or maintain trust with others. Trust is
fostered through three elements: (1) repeated interactions with another person; (2) honest
communication with that person; and (3) following through on commitments. Organizations cannot
ensure that they are meeting element (2) or (3) unless they have adopted rules about proper
communications and proper follow through. The head of the organization can’t be confident that
others are being honest in their interactions unless the organization has adopted rules about
honesty and trained people about the importance of honesty and candor. The leader cannot be
confident that people are following through on commitments unless there are rules and norms that
have been adopted and emphasized throughout the organization.

Compliance is part of your organization’s duties to its community and stakeholders. The first
reason is most basic. If you run a business (whether for-profit or nonprofit), you benefit from your
community’s basic services. In return, you owe duty to comply with the law. Furthermore, if you
use the resources of others (investors, creditors, donors), you need to be able to assure them that
you are regulating the conduct of your employees and that you are complying with applicable rules
and regulations.

If you have no compliance function, you invite reputational damage. I like to note Warren Buffett’s
adage that it takes 20 years to build a reputation and about five minutes to lose one. Research
shows that people want to interact with organizations that have a reputation for honest dealings.
It’s therefore no surprise that leaders consistently rank reputational risk as their number one worry.

Compliance enhances consistency. Without a compliance function, decisions are ad hoc and
made in a vacuum. Articulated values, ethics policies, and codes of conduct provide reference
points for making decisions a matter of routine. As Peter Drucker explained, “All events but the
truly unique require a generic solution. They require a rule, a policy, a principle.

Compliance can serve as a driver of change and innovation. Some people also view compliance
as inherently conservative. They think the purpose of compliance is to rein in conduct. Again,
that’s not true. Compliance instead can serve as a powerful tool of long-term change. If every day
behavior stems from training and codes of conduct, and codes of conduct stem from values,
articulation and modification of values over time can profoundly influence organizational behavior.
In the words of system theorists, values can be a leverage point, and compliance ultimately
focuses on the driving values of an organization.

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Independent Risk Management Function
Independent Risk Management is, in the context of banking regulation, a function within the
financial firm that operates (relatively) independently from the remainder of the firm (usually
denoted the business). Organizationally it falls under the direction of a Chief Risk Officer (CRO), a
senior position with sufficient stature, independence, resources and access to the management
board.

The Risk Management Function should be sufficiently independent of the business units and
should not be involved in revenue generation. Such independence is an essential component of
an effective risk management function, as is having access to all business lines that have the
potential to generate material risk to the bank as well as to relevant risk-bearing subsidiaries and
affiliates.

In the popular Three Lines of Defense paradigm of Risk Management the independent risk
function is a key component of the bank’s second line of defence. The function is responsible for
overseeing risk-taking activities across the enterprise and should have authority within the
organisation to do so.

Effective CROs are concerned with what the institution’s leaders may not know and, therefore,
must occasionally offer a contrarian point of view; otherwise, the decision-making process may
end up flawed with “group think.” In today’s environment, decision-making processes should be
driven by objective assessments of the risk/reward balance, rather than by the emotional
investment, management bias and short-termism that underlie dangerous organizational blind
spots.

Functions:

• Identifying material individual, aggregate and emerging risks (a process known as Risk
Identification
• Assessing these risks and measuring the bank’s exposure to them (a process known as
Risk Measurement
• Subject to the review and approval of the board, developing and implementing the
enterprise-wide risk governance framework, which includes the bank’s Risk Culture, Risk
Appetite and risk limits;
• Ongoing monitoring of the risk-taking activities and risk exposures in line with the board-
approved risk appetite, risk limits and corresponding capital or liquidity needs (ie Capital
Planning);
• Establishing an early warning or trigger system for breaches of the bank’s risk appetite or
limits;
• Influencing and, when necessary, challenging decisions that give rise to Material Risk;
• Reporting to senior management and the board or Risk Committee on all these items,
including but not limited to proposing appropriate risk-mitigating actions.

System Audit
The data and information generated in companies today are endless. The information that is
processed and processed within a company is incalculable. Companies, increasingly, need
technology to work, requiring complex software and computerized equipment to develop their
activity in an optimized and efficient manner.

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The audit of systems involves the review and evaluation of controls and computer systems, as well
as their use, efficiency, and security in the company, which processes the information. Thanks to
the audit of systems as an alternative to control, follow-up, and review, the computer process and
technologies are used more efficiently and safely, guaranteeing adequate decision-making.

• Verify and judge the information objectively.

• Verification of controls in the processing of information and installation of systems, in order
to evaluate their effectiveness and also present some recommendation and advice.
• Examination and evaluation of the processes in terms of computerization and data
processing. In addition, the number of resources invested, the profitability of each process
and its effectiveness and efficiency are evaluated.

Objectives of the Systems audit are:

• Improve the cost-benefit ratio of information systems.

• Increase the satisfaction and security of the users of these computerized systems.
• Guarantee confidentiality and integrity through professional security and control systems.
• Minimize the existence of risks, such as viruses or hackers, for example
• Optimize and streamline decision making.
• Educate on the control of information systems, since it is a very changing and relatively new
sector, so it is necessary to educate users of these computerized processes.

Corporate Governance
Corporate Governance refers to the way a corporation is governed. It is the technique by which
companies are directed and managed. It means carrying the business as per the stakeholders’
desires. It is actually conducted by the board of Directors and the concerned committees for the
company’s stakeholder’s benefit. It is all about balancing individual and societal goals, as well as,
economic and social goals.

Corporate Governance is the interaction between various participants (shareholders, board of

directors, and company’s management) in shaping corporation’s performance and the way it is
proceeding towards. The relationship between the owners and the managers in an organization
must be healthy and there should be no conflict between the two. The owners must see that
individual’s actual performance is according to the standard performance. These dimensions of
corporate governance should not be overlooked.

Corporate Governance deals with the manner the providers of finance guarantee themselves of
getting a fair return on their investment. Corporate Governance clearly distinguishes between the
owners and the managers. The managers are the deciding authority. In modern corporations, the
functions/ tasks of owners and managers should be clearly defined, rather, harmonizing.

Corporate Governance deals with determining ways to take effective strategic decisions. It gives
ultimate authority and complete responsibility to the Board of Directors. In today’s market- oriented
economy, the need for corporate governance arises. Also, efficiency as well as globalization are
significant factors urging corporate governance. Corporate Governance is essential to develop
added value to the stakeholders.

Corporate Governance ensures transparency which ensures strong and balanced economic
development. This also ensures that the interests of all shareholders (majority as well as minority

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shareholders) are safeguarded. It ensures that all shareholders fully exercise their rights and that
the organization fully recognizes their rights.

Corporate Governance has a broad scope. It includes both social and institutional aspects.
Corporate Governance encourages a trustworthy, moral, as well as ethical environment.

Benefits of Corporate Governance

1. Good corporate governance ensures corporate success and economic growth.

2. Strong corporate governance maintains investors’ confidence, as a result of which,
company can raise capital efficiently and effectively.
3. It lowers the capital cost.
4. There is a positive impact on the share price.
5. It provides proper inducement to the owners as well as managers to achieve objectives that
are in interests of the shareholders and the organization.
6. Good corporate governance also minimizes wastages, corruption, risks and
mismanagement.
7. It helps in brand formation and development.
8. It ensures organization in managed in a manner that fits the best interests of all.

Code of Corporate Governance

Corporate governance refers to the accountability of the Board of Directors to all stakeholders of
the corporation i.e. shareholders, employees, suppliers, customers and society in general; towards
giving the corporation a fair, efficient and transparent administration.

Following are cited a few popular definitions of corporate governance:

(1) “Corporate governance means that company managers its business in a manner that is
accountable and responsible to the shareholders. In a wider interpretation, corporate governance
includes company’s accountability to shareholders and other stakeholders such as employees,
suppliers, customers and local community.” – Catherwood.

(2) “Corporate governance is the system by which companies are directed and controlled.” – The
Cadbury Committee (U.K.)

Certain useful comments on the concept of corporate governance are given below:

Whistle Blowing and Social Responsibility

Whistle Blowing
Definition: When a former or the existing employee of the organization raise his voice against the
unethical activities being carried out within the organization is called as whistle blowing and the
person who raise his voice is called as a whistle blower.

The misconduct can be in the form of fraud, corruption, violation of company rules and policies, all
done to impose a threat to public interest. The whistle blowing is done to safeguard the interest of
the society and the general public for whom the organization is functioning.

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The companies should motivate their employees to raise an alarm in case they find any violation
of rules and procedures and do intimate about any possible harm to the interest of the
organization and the society.

Types of Whistle Blowing

1. Internal Whistle Blowing:An employee informs about the misconduct to his officers or
seniors holding positions in the same organization.
2. External Whistle Blowing:Here, the employee informs about the misconduct to any third
person who is not a member of an organization, such as a lawyer or any other legal body.

Most often, the employees fear to raise a voice against the illegal activity being carried out in the
organization because of following reasons:

• Threat to life
• Lost jobs and careers
• Lost friendships
• Resentment among workers
• Breach of trust and loyalty

Thus, in order to provide protection to the whistle blowers, the Whistle Blower Protection Bill is
passed in 2011 by Lok Sabha.

Now, the question comes in the mind that which offenses are considered valid for whistle blowing
and for which the protection is offered by the law. Following are the acts for which the voice can be
raised and are law protected:

1. Fraud
2. Health and safety in danger
3. Damage to the environment
4. Violation of company laws
5. Embezzlement of funds
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 6. Breach of law and justice

Social Responsibility
CSR is corporate social responsibility and that is the responsibility of organizations to act in ways
that protect ad improve the welfare of multiple stakeholders. A key word in this definition is
“stakeholder” where that is any group within or outside the organization that is directly affected by
the organization and has a stake in it’s performance. Stakeholders can be customers, organization
members, owners, other organizations that work with them, competitors, community members,
financial investors, any anyone else who would be effected by the organization’s actions. This
means a lot considering how the difference between a company that considers all stakeholders
and a company that considers only shareholders can heavily influence a company to be more or
less socially responsible.

Enterprise Risk Management Recommendations

Recommendation #1: Determine Board Risk Oversight Responsibility

Ultimately, it’s management who is responsible for risk management and the board is responsible
for overseeing management’s process of identifying, monitoring and mitigating risks. If there is no
established risk management framework, the board should charge management to develop a
framework that includes the board’s oversight duties. Boards can break down their responsibilities
by establishing certain directors with experience or knowledge in a particular area to oversee a
certain risk management process. For instance, the Public Policy Committee of ConocoPhillips is
responsible for overseeing risks related to health, safety and environmental issues. However,
these committees are still responsible for seeing the big picture and should come together on a
periodic basis to discuss the risks they are overseeing as well as risks the company is seeing as a
whole.

The thought paper offers recommendations for boards to develop and define their oversight
responsibilities. Boards should work with management to assign risk oversight responsibilities to
individual committees; committees should collaborate on risk-related happenings, and have
management brief the entire board on strategic risks facing the company.

Recommendation #2: Enhance Risk Intelligence

Risk intelligence is how the company, at all levels, perceives risk management and conducts itself
with regards to risk. The board should promote risk transparency at all levels of the organizations
so that day-to-day decision-makers are aware of the strategic goals and how their decisions could
impact those goals. Management should communicate and exude a risk intelligent culture for all
employees to follow. To do this, management should:

• Clearly communicate responsibilities and hold responsible parties accountable

• Develop a process for lower level employees to communicate emerging risks
• Encourage employees to challenge new initiatives that could negatively impact the greater
company

To promote an effective risk culture, boards can create a tone that allows employees to voice their
concerns without fear of loosing their jobs. They can also help to develop a process to measure
risk intelligence that management continually monitors and they should support management with
resources, training and data from the company.

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Recommendation #3: Determine Risk Appetite

Risk appetite is the amount of risk a company is willing to take. This can be defined in quantitative
or qualitative ways. Management should be the one to develop the risk appetite for the
organization and the board should understand management’s assumptions and approve or
disapprove the company’s overall level of risk appetite. Once an appetite has been defined, the
board should help management monitor emerging risks and opportunities, and evaluate whether
the risk appetite should be changed. The board should also evaluate management’s previous
decisions to see whether the risk appetite was bypassed. And finally, the board should align
management’s incentives with the company’s risk appetite. This will prevent management from
taking on too much risk.

Recommendation #4: Align Risk Management With Strategy

The board is also responsible for helping management develop a strategy that is aligned to the
company’s mission. When the company is developing its strategy, the board should at the same
time discuss the risks to the strategy and the risks of the strategy. This will help the entity identify
risks that could ultimately disrupt its ability to compete. In order to do this, the board should
challenge management on their assumptions by asking the right questions, establishing an open
dialogue, and identifying alternatives.

The board should consider whether to provide 57ctivee oversight” in these strategic settings. That
may include verifying that management has established key risk indicators and a process for
monitoring these indicators, scanning the horizon for emerging risks, and fostering flexibility at the
management level to avoid risks or seize opportunities.

Recommendation #5: Evaluate Risk Governance “Maturity”

One common measurement boards use to evaluate risk maturity is the amount of experience the
company has with risk management. Boards should dive deeper than this and consider more
criteria, such as:

• How often does management communicate to the board concerning risk management?
• Are specific risks assigned to their board committees and processes?
• Which committee is responsible for which risks?
• During strategic planning, are risks identified and analyzed, are assumptions challenged,
and are alternative options evaluated during scenario planning? Is there scenario
planning?
• How does management monitor key risk indicators and is there agreement when action
should be taken?

Depending on the level of risk governance sophistication the entity needs to effectively manage its
portfolio of risks, the entity’s maturity may fall anywhere between one of the five phases of risk
intelligence.

1. Initial: ad hoc risk management, based on individual actions.

2. Fragmented: risks are managed in isolated departments and are rarely aligned to strategy.
3. Top-down: Enterprise wide risk assessments and dedicated team to manage risks.
4. Integrated: Risk appetite defined, key indicators monitored, escalation procedures
communicated.

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 5. Risk Intelligent: Risk dialogue is a part of strategy development, linking performance
measures and incentives, risk scenarios evaluated, early warning of risk indicators used.

Recommendation #6: Communicate Risk Process and Issues to Stakeholders

The SEC now requires public companies to disclose how the board oversees risk and how it works
with management to address risks to the company. These rules were established to provide
greater transparency to investors and stakeholders. However, the thought paper states that
meeting this minimum requirement is not enough to make stakeholders comfortable with the
company’s risk management process. By explaining the company’s risk management process
and oversight clearly to stakeholders, companies attract more long-term investors. Over the past
three years, Deloitte has seen an increase in the quality of risk disclosures. Companies can
improve their risk disclosures by explaining the processes in plain English, provide insight to the
board’s oversight role and ensure risk disclosures are accurate, relevant and specific.

Enterprise risk management (ERM) has emerged as a best practice in gaining an overview of
strategic, financial and operational threats, and in determining how to mitigate and manage those
risks.

A comprehensive approach to risk management is important because it helps management

comprehend the true potential of threats and allows organizations to address the cumulative
nature of risk.

The following steps can help your company achieve the ERM objective.

1. Just Do It!
The process of creating an ERM program is valuable, revealing much about your
organization and the interrelatedness of elements within it. Document your efforts in your
board minutes and share them with any auditors. You will generally find those parties willing
to provide constructive feedback because they have a vested interest in the success of your
efforts.
2. Get a Champion
Your board of directors is accountable to shareholders and the SEC (if your company is
public)—and possibly to other entities by industry—for the adequacy of risk management
procedures, controls and ultimately for the competence of management. A logical champion
of your ERM efforts is the chairperson of your board audit or ERM committee, followed by
the chair of the board and other board members. If these individuals understand that an
ERM program can help them discharge their duties and protect them from personal
financial risk, you will likely see top-level buy-in and a trickle-down effect through senior
management.
3. Merge the Silos
If existing risk committees and sub-committees are functioning as intended and get
consistently high marks from outside auditors, it’s unlikely that fundamental changes are
needed. Yet it is important they understand where they fit in the bigger picture. A board-
level champion can help provide this perspective, and reinforce the role of the ERM
committee in setting the organization-wide level of acceptable risk.
4. Weight the Risks
Certain areas of risk have the potential to seriously harm your organization. Others,
however, are less critical. When your management team assembles an ERM framework,

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 create a logical mechanism for assigning relative weights to each area of risk, and to
selected components within those areas.
5. Create a Dashboard
A dashboard containing a high-level summary of major risk elements supported by “drill-
down” detail enables board members and senior managers to connect all the pieces of the
risk management puzzle.A dashboard need not be complex. Some managers use
Microsoft Excel to create multi-layered risk workbooks, which summarize details provided
by the risk sub-committees into a single page of high-level information.
6. Understand Risk and Reward
Some risks are worth taking, because the reward is greater than the likelihood and
consequences of failure. In other cases the reward does not outweigh the potential
consequences. Then there are risks not worth considering, when the risk is a “bet-the-farm”
proposition, or is illegal or immoral. Each risk committee and sub-committee should
understand the risk-versus-reward proposition.
7. Set Limits
One important function of the board ERM committee is to work with management to
establish limits to risk taking. Management should make recommendations to the board,
supported by reasonable data and arguments, which establish the boundaries of the
organization’s risk appetite. Management’s role is to advise and inform, with the ultimate
decision resting with the board.
8. Understand the Cumulative Nature of Risk
An organization that could sustain itself through one or two major weaknesses, or several
minor ones, will succumb under too many. For this reason, the board ERM committee
should set limits for both individual risks and cumulatively.
9. Make It Easy
In the areas of setting limits and risk weighting, management should make it as easy as
possible for board members to comprehend and participate in the process. Distill complex
regulations, and use accepted business terminology. Implementing an ERM framework
should be spread over several months, if possible. Give the board ERM committee two or
three recommendations per month, in advance, so they can be reviewed, summarized,
presented and adopted at the regular monthly meeting.

• Refine, Refine, Refine

New risks emerge every day, and your process must be flexible enough to identify, quantify
and incorporate them. The chief risk officer and other senior managers should devote time
to researching emerging risks, imagining worst case scenarios and creating stress tests to
understand the implications of critical failures.

A Top-To-Bottom Effort
It is possible for ERM practices to become part of your organizational culture. Global awareness of
the process and a rank-and-file understanding of the board’s focus on effective risk management
are critical to obtaining the buy-in of the entire organization. After all, risk management is
everybody’s job—today more than ever.

END OF UNIT 4
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 UNIT 5

Credit Analysis Process, Credit Process, Documentation

The credit analysis process involves a thorough review of a business to determine its perceived
ability to pay. To do this, business credit managers must evaluate the information provided in the
credit application by analyzing financial statements, applying credit analysis ratios, and reviewing
trade references. In addition to the information requested in the application, it is important to
consult a business credit report from a reputable third party. The information gathered during this
process allows companies to decide whether or not to offer the customer credit, and if so,
precisely how much credit to extend.

The credit analysis process refers to evaluating a borrower’s loan application to determine the
financial health of an entity and its ability to generate sufficient cash flows to service the debt. In
simple terms, a lender conducts credit analysis on potential borrowers to determine their
creditworthiness and the level of credit risk associated with extending credit to them.

Stages in the Credit Analysis Process

The credit analysis process is a lengthy one, lasting from a few weeks to months. It starts from the
information-collection stage up to the decision-making stage when the lender decides whether to
approve the loan application and, if approved, how much credit to extend to the borrower.

The following are the key stages in the credit analysis process:

1. Information collection

The first stage in the credit analysis process is to collect information about the applicant’s credit
history. Specifically, the lender is interested in the past repayment record of the customer,
organizational reputation, financial solvency, as well as their transaction records with the bank and
other financial institutions. The lender may also assess the ability of the borrower to generate
additional cash flows for the entity by looking at how effectively they utilized past credit to grow its
core business activities.

The lender also collects information about the purpose of the loan and its feasibility. The lender is
interested in knowing if the project to be funded is viable and its potential to generate sufficient
cash flows. The credit analyst assigned to the borrower is required to determine the adequacy of
the loan amount to implement the project to completion and the existence of a good plan to
undertake the project successfully.

The bank also collects information about the collateral of the loan, which acts as security for the
loan in the event that the borrower defaults on its debt obligations. Usually, lenders prefer getting
the loan repaid from the proceeds of the project that is being funded, and only use the security as
a fall back in the event that the borrower defaults.

1. Information analysis

The information collected in the first stage is analyzed to determine if the information is accurate
and truthful. Personal and corporate documents, such as the passport, corporate charter, trade
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licenses, corporate resolutions, agreements with customers and suppliers, and other legal
documents are scrutinized to determine if they are accurate and genuine.

The credit analyst also evaluates the financial statements, such as the income statement, balance
sheet, cash flow statement, and other related documents to assess the financial ability of the
borrower. The bank also considers the experience and qualifications of the borrower in the project
to determine their competence in implementing the project successfully.

Another aspect that the lender considers is the effectiveness of the project. The lender analyzes
the purpose and future prospects of the project being funded. The lender is interested in knowing if
the project is viable enough to produce adequate cash flows to service the debt and pay operating
expenses of the business. A profitable project will easily secure credit facilities from the lender.

On the downside, if a project is facing stiff competition from other entities or is on a decline, the
bank may be reluctant to extend credit due to the high probability of incurring losses in the event of
default. However, if the bank is satisfied that the borrower’s level of risk is acceptable, it can
extend credit at a high interest rate to compensate for the high risk of default.

1. Approval (or rejection) of the loan application

The final stage in the credit analysis process is the decision-making stage. After obtaining and
analyzing the appropriate financial data from the borrower, the lender makes a decision on
whether the assessed level of risk is acceptable or not.

If the credit analyst assigned to the specific borrower is convinced that the assessed level of risk is
acceptable and that the lender will not face any challenge servicing the credit, they will submit a
recommendation report to the credit committee on the findings of the review and the final decision.

However, if the credit analyst finds that the borrower’s level of risk is too high for the lender to
accommodate, they are required to write a report to the credit committee detailing the findings on
the borrower’s creditworthiness. The committee or other appropriate approval body reserves the
final decision on whether to approve or reject the loan.

Credit Process

The process of assessing whether or not to lend to a particular entity is known as the credit
process. It involves evaluating the mindset of the potential borrower, underwriting of the risk, the
pricing of the instrument and the fit with the lender’s portfolio. It encompasses setting objectives
and guidelines based on the lender’s credit culture, gathering necessary information of the
applicant, analyzing the information including cash flows and financial statements and presenting
and documenting information in such a manner so that a credit decision may be made.

Your commercial banking officer will review your business loan package based on criteria known
as the “Five C’s of Credit.”

Character: It involves a review of your personal honesty, integrity, trustworthiness and

management skills. A banking officer also makes a judgment of character based on your business
plan, credit history and the quality of your presentation.

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Capitalization: The capital structure of your company is important to Bank of Ann Arbor because
it helps determine the level of risk associated with your loan request. An analysis of capitalization
includes a review of equity, total debt, the value of assets and permanent working capital.

Cash Flow: This is the cash your business has to pay the debt. A cash flow analysis helps us
determine if you have the ability to repay the loan.

Collateral: This provides a secondary source of repayment, thereby minimizing the risk for Bank
of Ann Arbor. The amount and type of collateral required depends on the type and purpose of the
loan.

Conditions: This refers to outside conditions that may affect the ability of your business to repay
the loan. Factors such as general economic conditions or a large concentration of sales to a single
customer are evaluated during our review of your loan application.

Documentation
Credit administration and documentation are two of the critical components in managing credit and
supporting the credit process. Following proper credit administrative and documentation process
allow credit analysts to monitor accounts and identify ways to reduce default risk.

Credit Document means any of this Agreement, the Notes, if any, the Collateral Documents, any
documents or certificates executed by Company in favour of Issuing Bank relating to Letters of
Credit, and all other documents, instruments or agreements executed and delivered by a Credit
Party for the benefit of any Agent, Issuing Bank or any Lender in connection herewith.

Loan Pricing and Profitability Analysis, Regulations

Loan Pricing

Loan pricing is the process of determining the interest rate for granting a loan, typically as an
interest spread (margin) over the base rate, conducted by the bookrunners. The pricing of
syndicated loans requires arrangers to evaluate the credit risk inherent in the loans and to gauge
lender appetite for that risk.

For market-based loan pricing, banks incorporate credit default spreads as a measure of
borrowers’ credit risks. It is standard procedure in loan pricing to benchmark a loan against recent
comparable transactions (“comps”) and select the base rate on which the financing costs are
pegged. A comparable deal is one with a borrower in the same industry, country and of the same
size with the same credit rating, for which a certain market rate of return is required.

A bank’s credit rating has a direct impact on its cost of funding and, thus, the pricing of its
loans. Banks with a high credit rating generally have access to lower cost funds in debt markets
and low counterparty margins in swap and foreign exchange markets. The lower cost of funds can
be passed on to borrowers in the form of lower loan pricing.

Banks compete for lead arranger mandates on syndication strategy and pricing. Some banks are
very effective at pricing loans, while others have better bargaining power, are more effective in
borrower monitoring, or have better incentive-inducing scheme.

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Benefits of Loan Pricing

This methodical approach can help ensure the best loan and terms are matched to the borrower
so that the financial institution makes the sale and keeps the customer. Loan pricing models or
loan profitability models can allow banks or credit unions to set prices based on other institution
goals, too, including goals related to profitability targets or loan portfolio composition. In talking
with banks, Abrigo has learned these institutions thought a conservative estimate was that they
could pick up an additional 5 to 10 basis points in interest if they had more structured pricing
methodologies in place.

One overall benefit of effective loan pricing is that it is one of the many ways a financial institution
can optimize capital. Optimizing capital is important because it provides institutions with the ability
and freedom to deploy capital for developing new products and new markets, addressing
regulatory issues or navigating shifts in the macroeconomic environment.

Another benefit of having a loan-pricing policy or model is that it provides the institution with
defensible measures for justifying pricing changes and for avoiding charges of discriminatory
pricing, which some lenders have faced in recent years. Officials with the banking regulatory
agencies recently outlined best practices they encourage as they relate to evaluating an
institution’s fair lending risk, and one of those best practices was to document pricing and other
underwriting criteria, including exceptions.

Considerations of Loan-Pricing Models

What are some considerations related to loan-pricing models for an institution’s loan origination
system (LOS)? According to James L. Adams, supervising examiner at the Federal Reserve Bank
of Philadelphia, pricing is a key underwriting factor that should be addressed as part of a sound
loan policy. A simple cost-plus loan pricing model is one method of pricing loans, he wrote in a
newsletter for community banks that cites the Fed’s Commercial Bank Examination Manual
(CBEM). A cost-plus pricing model requires that all related costs associated with extending the
credit be known before setting the interest rate and fees, and it typically considers the following:

• Operating costs associated with servicing the loan or loans

• Cost of funds
• Risk premium for default risk
• A reasonable profit margin on capital.

Profitability Analysis

1. Probability of default

Probability of default is defined as the probability that the borrower will not be able to make
scheduled principal and interest payments over a specified period, usually one year. The default
probability depends on both the borrower’s characteristics and the economic environment.

For individuals, the default probability is determined by the FICO score, and lenders use the score
to decide whether or not to extend credit. For business entities, the default probability is implied by
the credit rating.

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Usually, credit rating agencies are required to assign a credit rating to entities that issue debt
instruments, such as bonds. Borrowers with a high default probability are charged a higher interest
rate to compensate the lender for bearing the higher default risk.

2. Loss given default

Loss given default is defined as the amount of money that a lender stands to lose when a
borrower defaults on the debt obligations. While there is no accepted method for quantifying the
loss given default per loan, most lenders calculate loss given default as a percentage of total
exposure to loss in the entire loan portfolio.

For example, if ABC Bank lends $1,000 to Borrower A and $10,000 to Borrower B, the bank
stands to lose more money in the event that Borrower B defaults on repayments.

3. Exposure at default

Exposure at default measures the amount of loss that a lender is exposed to at any particular
point, due to loan defaults. Financial institutions often use their internal risk management models
to estimate the level of exposure at default.

Initially, the exposure is calculated per loan, and banks use the figure to determine the overall
default risk for the entire loan portfolio. As borrowers make loan repayments, the value of
exposure at default reduces gradually.

Credit risk analysis (Debt ratios and Risk of leverage)

Credit analysis ratios are tools that assist the credit analysis process. These ratios help analysts
and investors determine whether individuals or corporations are capable of fulfilling financial
obligations. Credit analysis involves both qualitative and quantitative aspects. Ratios cover the
quantitative part of the analysis. Key ratios can be roughly separated into four groups: (1)
Profitability; (2) Leverage; (3) Coverage; (4) Liquidity.

Profitability Ratios
As the name suggests, profitability ratios measure the ability of the company to generate profit
relative to revenue, balance sheet assets, and shareholders’ equity. This is important to investors,
as they can use it to help project whether stock prices are likely to appreciate. They also help
lenders determine the growth rate of corporations and their ability to pay back loans.

Profitability ratios are split into margin ratios and return ratios.

Gross profit margin:

Gross profit margin is a metric analysts use to assess a company’s financial health by calculating
the amount of money left over from product sales after subtracting the cost of goods sold (COGS).
Sometimes referred to as the gross margin ratio, gross profit margin is frequently expressed as a
percentage of sales.

Gross Profit Margin = (Net Sales – COGS)/ Net Sales

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EBITDA margin:

The EBITDA margin is a measure of a company’s operating profit as a percentage of its revenue.
The acronym EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
Knowing the EBITDA margin allows for a comparison of one company’s real performance to
others in its industry.

EBITDA margin = (earnings before interest and tax + Depreciation + amortization)

/ Total revenue
Operating profit margin:

The operating margin measures how much profit a company makes on a dollar of sales after
paying for variable costs of production, such as wages and raw materials, but before paying
interest or tax. It is calculated by dividing a company’s operating income by its net sales. Higher
ratios are generally better, illustrating the company is efficient in its operations and is good at
turning sales into profits.

Operating Margin= Operating Earnings/ Revenue

Return Ratios include

Return on assets:

The return on assets (ROA) shows the percentage of how profitable a company’s assets are in
generating revenue.

ROA = Net Income / Average Total Assets

Risk-adjusted return:

A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes
into account the degree of risk that must be accepted in order to achieve it.

Return on equity:

Return on Equity = Net Income / Average Shareholders’ Equity

Leverage Ratios
Leverage ratios compare the level of debt against other accounts on a balance sheet, income
statement, or cash flow statement. They help credit analysts gauge the ability of a business to
repay its debts.

Common leverage ratios include:

Debt to assets ratio:

Debt to assets ratio = Total Debt / Total Assets

Total Debt = Short Term Debt + Long Term Debt

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Total Assets = The sum of the value of all the company’s assets found on a
company’s balance sheet
Asset to equity ratio:

The asset to equity ratio reveals the proportion of an entity’s assets that has been funded by
shareholders. The inverse of this ratio shows the proportion of assets that has been funded with
debt.

Debt to equity ratio:

Debt to Equity Ratio = Total Debt / Shareholders’ Equity

Long formula:

Debt to Equity Ratio = (short term debt + long term debt + fixed payment
obligations) / Shareholders’ Equity
Coverage Credit Analysis Ratios
Coverage ratios measure the coverage that income, cash, or assets provide for debt or interest
expenses. The higher the coverage ratio, the greater the ability of a company to meet its financial
obligations.

Coverage ratios include:

Interest coverage ratio:

The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how well a
company can pay the interest on its outstanding debts. The ICR is commonly used by lenders,
creditors, and investors to determine the riskiness of lending capital to a company. The interest
coverage ratio is also called the “times interest earned” ratio.

Interest Coverage Ratio = EBIT / Interest Expense

where:

EBIT = Earnings before interest and taxes

Debt-service coverage ratio:

The debt service coverage ratio (DSCR), also known as “Debt coverage ratio” (DCR), is the ratio
of operating income available to debt servicing for interest, principal and lease payments. It is a
popular benchmark used in the measurement of an entity’s (person or corporation) ability to
produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the
easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed
as a minimum ratio that is acceptable to a lender; it may be a loan condition. Breaching a DSCR
covenant can, in some circumstances, be an act of default.

DSCR = Net Operating Income / Total Debt Service

where:

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Net Operating Income = Revenue−COE

COE = Certain operating expenses

Total Debt Service = Current debt obligations

Cash coverage ratio:

The cash coverage ratio is useful for determining the amount of cash available to pay for a
borrower’s interest expense, and is expressed as a ratio of the cash available to the amount of
interest to be paid. To show a sufficient ability to pay, the ratio should be substantially greater than
1:1. The ratio is commonly used by lenders to see if existing borrowers are in financial difficulty,
and to determine whether they should loan money to new loan applicants.

Cash Coverage Ratio = (Earnings Before Interest and Taxes + Non-Cash

Expenses) ÷ Interest Expense
Asset coverage ratio:

The asset coverage ratio is a financial metric that measures how well a company can repay its
debts by selling or liquidating its assets. The asset coverage ratio is important because it helps
lenders, investors, and analysts measure the financial solvency of a company. Banks and
creditors often look for a minimum asset coverage ratio before lending money.

Though expressed as a ratio, the asset coverage ratio really requires a set of formulation steps,
which are as follows:

• Extract from the general ledger the ending balances of all assets.
• Subtract from the total of these assets the amounts recorded on the books for
any intangible assets. This deduction is made on the assumption that intangible
assets cannot be converted into cash; if this is not the case, retain those
intangibles that have a conversion value.
• Extract from the general ledger all current liabilities, not including those liabilities
associated with short-term debt.
• Subtract the net liabilities figure in step 3 from the net asset figure derived in step
2. The result should be the amount of assets available for use to pay down debts.
• Divide the net amount derived in step 4 by the ending book balance of all debt
outstanding. This includes the amount of any capital leases outstanding.

Liquidity Ratios
Liquidity ratios indicate the ability of companies to convert assets into cash. In terms of credit
analysis, the ratios show a borrower’s ability to pay off current debt. Higher liquidity ratios suggest
a company is more liquid and can, therefore, more easily pay off outstanding debts.

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Current ratio:

The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its
short-term obligations. It compares a firm’s current assets to its current liabilities, and is expressed
as follows:

Current ratio = Current Assets / Current Liabilities

Quick ratio:

In finance, the quick ratio, also known as the acid-test ratio is a type of liquidity ratio, which
measures the ability of a company to use its near cash or quick assets to extinguish or retire its
current liabilities immediately. It is defined as the ratio between quickly available or liquid assets
and current liabilities. Quick assets are current assets that can presumably be quickly converted to
cash at close to their book values.

A normal liquid ratio is considered to be 1:1. A company with a quick ratio of less than 1 cannot
currently fully pay back its current liabilities.

QR= CE+MS+AR / CL

Or

QR= CA−I−PE / CL

where:

QR = Quick ratio

CE = Cash & equivalents

MS = Marketable securities

AR = Accounts receivable

CL=Current Liabilities

CA = Current Assets

I = Inventory

PE = Prepaid expenses

Cash ratio:

The cash ratio is a measurement of a company’s liquidity, specifically the ratio of a company’s
total cash and cash equivalents to its current liabilities. The metric calculates a company’s ability
to repay its short-term debt with cash or near-cash resources, such as easily marketable

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securities. This information is useful to creditors when they decide how much money, if any, they
would be willing to loan a company.

Cash ratio = Cash + Cash equivalents / Total current Liabilities

Working capital:

Working capital is the difference between current assets and current liabilities. “Current” again
refers to the fact that these items fluctuate in the short term, increasing or decreasing along with
operating activities. Generally, these are assets that can be converted into cash within the next 12
months or operating cycle, such as inventory and accounts receivable. Current assets include
cash, short-term investments, accounts receivable and inventories.

Working capital ratio = Current assets ÷ Current liabilities

Overview of Working Capital Management

Working Capital Management implies the management of current assets and current liabilities.
Considering the importance of working capital, we can very well, say that the management of
wording capital is very significant and should be efficient to keep the business going smoothly.

To be more explicit, working capital management includes proper handling of inventories,

accounts receivable, cash and bank and liabilities such as accounts payable, outstanding
expenses etc. In a big manufacturing organization, working capital occupies a preeminent position.
Over half the total assets consists of working, capital. So its management deserves careful
consideration.

The financial management today, because of various complexities in the market and competitive
business environment, finds it necessary to deal with working capital in two parts — overall
management and management of each item separately.

Overall management of working capital requires proper estimation of working capital needed for
the business, ratios of investments on different items of current assets and proper policy as to the
rate of profit earning, possibility of loan procurement, advances etc.

One point is worth noting regarding management of working capital. Since working capital consists
of varieties of items, management of one in the desirable way may affect another. For instance,
making prompt and regular payments of bills receivable may affect cash balance and the company
may face difficulties in liquid cash.

Liquidity, flexibility is to be balanced in working capital management in such a wise and prudent
way that the over-all management of the working capital contributes to the general welfare of the
company.

Profitability, liquidity, flexibility all is important in managerial exercises but a happy compromise of
these factors is no easy task. Financial astuteness is absolutely necessary to ensure a brilliant
bright-forward management of working capital.

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A deep study of the trend of business is absolutely essential to keep the business on right track. It
is all the more important to plan the ratio of different items of working capital in the best interest of
the company.

It may be that the outside creditors are to be satisfied in the interest of the company but at the
same time requisite amount of cash balance must always be kept ready for day-to-day compliance
of various obligations. Working capital management formulates policy that is based on experience.

If the policy of the top management is to ensure more profit, then more money is blocked in
inventories and cash becomes depleted. It may create problem. Income of the company may
suffer if more money is kept always ready to meet any current obligation. Obviously, idle cash
does not earn any income.

In regard to cash in hand, working capital management is rather difficult and needs very careful
consideration. A company is likely to face an adverse situation if the principles of liquidity and
profitability are rigorously followed. Small cash in hand cripples a company to meet the obligation
of creditors on demand.

In such a situation small suppliers will be naturally reluctant to supply raw materials to such a
company and as a consequence the company will have production difficulty. This will lead to fewer
sales and less profit. Therefore, a very balanced ratio profitability and liquidity will have to be
maintained through sound management.

It emerges from the above discussion that it is rather impracticable to draw up any invariable
standard for the management of working capital. And it also transpires that cash is the major and
very sensitive component of working capital, so the working capital management is, as a matter of
fact, the management of cash (liquidity) with reference to profitability.

To conclude, working capital management is the planning and controlling of current assets (assets
convertible into cash). Working capital indicates circular flow of cash (cash flow cycle). From cash
to inventories to receivables and back to cash.

The two concepts of working capital are net working capital and gross working capital. Net working
capital is a qualitative concept; the management will also get an idea about the ease and cost of
raising working capital. Net working capital is measured by the current ratio viz. current as-
sets/current liabilities.

\Normally the current ratio should be 2: 1. A larger ratio indicates greater solvency and vice versa.
Of course, excessive current ratio would point out poor financial planning and it would reduce
income.

The concept of gross capital is a financial concept whereas that of net concept is an accounting
concept. For the management more interest is in the amount of current assets with which it has to
operate. “However, in an ever changing economy it is very difficult to secure perfect
equilibrium between inflow and outflow of cash”.

So, enough supply of working capital is the objective of sound financial management. While
aiming at sound working capital management, certain factors must always be kept in mind.

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They are:
(a) Nature of business,

(b) Size of business,

(c) Terms of purchase and sale,

(d) Turnover of inventories,

(e) Process of manufacture,

(f) Importance of labour,

(g) Proportion of raw material to total costs,

(h) Cash requirements,

(i) Seasonal variations,

(j) Banking connections,

(k) Growth and expansion.

In gross sense working capital means the total of current assets and in net sense it is the
difference between current assets and current liabilities.

Through working capital management, the finance manager tries to manage the current assets,
current liabilities and to evaluate the interrelationship that exists between them, i.e. it involves the
relationship between a firm’s short-term assets and short-term liabilities.

The aim of working capital management is to deploy such amount of current assets and current
liabilities so as to maximize short-term liquidity. The management of working capital involves
managing inventories, accounts receivable and payable as also cash.

The two steps involved in the working capital management are as follows:
(i) Forecasting the amount of working capital; and

(ii) Determining the sources of working capital.

Apart from the two mentioned above the following two additional important aspects should
be kept in mind while managing working capital:

(a) Inclusion of Profit:

There is a lot of controversy regarding inclusion of profit in working capital requirement forecast.
There are two views. The first view suggests that profit should be included in the working capital.
The second view suggests that it should not be included. Inclusion or exclusion of profit depends
primarily on the managerial policy adopted by the firm.
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From the first view, if working capital is calculated on the basis of actual cash outflow then profit
should not be included in calculating working capital because financing of profit is not required.

From the second view, where balance sheet approach is adopted for calculating working capital,
profit element is not ignored as this should be included in the amount of debtors.

(b) Exclusion of Depreciation:

Depreciation does not involve any actual cash outflow, so it should not be included in the
estimation of working capital.

Nature, Scope and Definition of Working Capital

In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-day
operations of a concern.

This is related to short-term assets and short-term sources of financing. Hence it deals with both,
assets and liabilities—in the sense of managing working capital it is the excess of current assets
over current liabilities. In this article we will discuss about the various aspects of working capital.

The nature of working capital is as discussed below:

1. It is used for purchase of raw materials, payment of wages and expenses.

2. It changes form constantly to keep the wheels of business moving.
3. Working capital enhances liquidity, solvency, creditworthiness and reputation of the
enterprise.

1. It generates the elements of cost namely: Materials, wages and expenses.

2. It enables the enterprise to avail the cash discount facilities offered by its suppliers.
3. It helps improve the morale of business executives and their efficiency reaches at the
highest climax.
4. It facilitates expansion programmes of the enterprise and helps in maintaining operational
efficiency of fixed assets.

Concept of Working Capital:

The funds invested in current assets are termed as working capital. It is the fund that is needed to
run the day-to-day operations. It circulates in the business like the blood circulates in a living body.
Generally, working capital refers to the current assets of a company that are changed from one
form to another in the ordinary course of business, i.e. from cash to inventory, inventory to work in
progress (WIP), WIP to finished goods, finished goods to receivables and from receivables to
cash.

There are two concepts in respect of working capital:

(i) Gross working capital and

(ii) Networking capital.

Gross Working Capital:

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The sum total of all current assets of a business concern is termed as gross working capital. So,

Gross working capital = Stock + Debtors + Receivables + Cash.

Net Working Capital:

The difference between current assets and current liabilities of a business concern is termed as
the Net working capital.

Hence,

Net Working Capital = Stock + Debtors + Receivables + Cash – Creditors – Payables.

Need for Working Capital:

Working capital plays a vital role in business. This capital remains blocked in raw materials, work
in progress, finished products and with customers.

The needs for working capital are as given below:

1. Adequate working capital is needed to maintain a regular supply of raw materials, which in
turn facilitates smoother running of production process.
2. Working capital ensures the regular and timely payment of wages and salaries, thereby
improving the morale and efficiency of employees.
3. Working capital is needed for the efficient use of fixed assets.
4. In order to enhance goodwill a healthy level of working capital is needed. It is necessary to
build a good reputation and to make payments to creditors in time.
5. Working capital helps avoid the possibility of under-capitalization.
6. It is needed to pick up stock of raw materials even during economic depression.
7. Working capital is needed in order to pay fair rate of dividend and interest in time, which increases
the confidence of the investors in the firm.

Importance of Working Capital:

It is said that working capital is the lifeblood of a business. Every business needs funds in order to
run its day-to-day activities.

The importance of working capital can be better understood by the following:

1. It helps measure profitability of an enterprise. In its absence, there would be neither

production nor profit.
2. Without adequate working capital an entity cannot meet its short-term liabilities in time.
3. A firm having a healthy working capital position can get loans easily from the market due to
its high reputation or goodwill.
4. Sufficient working capital helps maintain an uninterrupted flow of production by supplying
raw materials and payment of wages.
5. Sound working capital helps maintain optimum level of investment in current assets.
6. It enhances liquidity, solvency, credit worthiness and reputation of enterprise.
7. It provides necessary funds to meet unforeseen contingencies and thus helps the
enterprise run successfully during periods of crisis.

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Liquidity Ratios
A firm has assets and liabilities to its name. Some are fixed in nature and then there are current
assets and current liabilities. These are short-term in nature and easily convertible into cash. The
liquidity ratios deal with the relationship between such current assets and current liabilities.

Liquidity ratios evaluate the firm’s ability to pay its short-term liabilities, i.e. current liabilities. It
shows the liquidity levels, i.e. how many of their assets can be quickly converted to cash to pay of
their obligations when they become due.

It is not only a measure of how much cash there is but also how easily current assets can be
converted to cash or marketable securities. Now let us look at some of the important liquidity
ratios.

Current Ratio

The current ratio is also known as the working capital ratio. It will measure the relationship
between current assets and current liabilities. It measures the firm’s ability to pay for all its current
liabilities, due within the next one year by selling off all their current assets. The formula for is as
follows

Current Ratio = Current Assets/Current Liabilities

Current Assets include,

• Stock
• Debtors
• Cash and Bank Balances
• Bills receivable
• Accruals
• Short term loans that are given
• Short term Securities

Current Liabilities include

• Creditors
• Outstanding Expenses
• Short Term Loans that are taken
• Bank Overdrafts
• Provision for taxation
• Proposed Dividend

The ideal current ratio, according to the industry standard is 2:1. That means that a firm should
hold at least twice the amount of current assets than it has current liabilities. However, if the ratio
is very high it may indicate that certain current assets are lying idle and not being utilized properly.
So maintaining the correct balance between the two is crucial.

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Quick Ratio
The other important one of the liquidity ratios is Quick Ratio, also known as a liquid ratio or acid
test ratio. This ratio will measure a firm’s ability to pay off its current liabilities (minus a few) with
only selling off their quick assets.

Now Quick assets are those which can be easily converted to cash with only 90 days notice. Not
all current assets are quick assets. Quick assets generally include cash, cash equivalents, and
marketable securities. The formula is

Quick Ratio = Quick Assets/(Current Liabilities/Quick Liabilities)

Quick Assets = All Current Assets – Stock – Prepaid Expenses
Quick Liabilities = All Current Liabilities – Bank Overdraft – Cash Credit
The ideal quick ratio is considered to be 1:1, so that the firm is able to pay off all quick assets with
no liquidity problems, i.e. without selling fixed assets or investments. Since it does not take into
consideration stock (which is one of the biggest current assets for most firms) it is a stringent test
of liquidity. Many firms believe it is a better test of liquidity than the current ratio since it is more
practical.

Absolute Cash Ratio

This is an even more rigorous liquidity ratio than quick ratio. Here we measure the availability of
cash and cash equivalents to meet the short-term commitment of the firm. We do not consider all
current assets, only cash. Let us see the formula,

Absolute Cash ratio = (Cash+ Bank Balance + Marketable Securities) /Current

Liabilities
As you can see, this ratio measures the cash availability of the firm to meet the current liabilities.
There is no ideal ratio, it helps the management understand the level of cash availability of the firm
and make any changes required.

However, if the ratio is greater than 1 it indicates poor resource management and very high
liquidity. And high liquidity may mean low profitability.

Operating and Cash cycle risk

Operating risk is the risk related to a company’s cost structure. More specifically, it is the risk the
company faces due to the level of fixed costs in its operations. Together with sales risk, operating
risk is one of the two components of business risk.

Business risk is the risk related to a company’s operating income. We can break up business risk
into two components:

Operating risk: Related to a company’s cost structure and level of fixed cost.

Sales risk: Related to the uncertainty of generating sales due to the variability in the price and
volume of the goods and services sold.

The measurement of operating risk can be done through the application of the concept of
elasticity. More specifically, we can use indicators such as the degree of operating leverage
(DOL), which is a very popular indicator of operating risk.

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The degree of operating leverage measures the sensitivity of operating income to the variations in
units sold. It is measured as the percentage change in operating income divided by the
percentage change in units sold:

DOL = Percentage change in Operating Income / Percentage Change in Units

Sold
For example, if we calculated the degree operating leverage for Company A and found a value of
3, it means that Company A would experience a 3% increase in operating income for every 1% of
growth in units sold.

The DOL is a Dynamic Measure

The degree of operating leverage is not a static measure, but its value changes based on the level
of output.

• At levels of output for which operating income is negative, the degree of operating leverage
is also negative.
• At levels of output for which operating income is very close to zero, the DOL is very
sensitive to variations in units sold.
• At the level of output for which operating income is equal to 0, the DOL is undefined
because the denominator in the formula is 0.

Cash cycle risk

All cash collections must be properly identified, control totals developed, and collections promptly
deposited to limit risks associated with recording cash receipts or withholding or delaying the
recording of cash receipts. All transactions should be promptly and accurately recorded in
sufficient detail on proper accounting records and appropriate reports issued to prevent
unauthorized transaction substitution with unsupported credits or fictitious expenditures.

All transactions are properly accumulated, classified and summarized in the general ledger;
balances are correctly reconciled with bank statement balances in a timely manner to prevent
cash balance misstatement or the offsetting of unauthorized transactions.

Common risks associated with embezzlement, fraud, and your cash cycle include:

• The authorization or accuracy of cash receipts, the failure to record cash receipts or
withholding or delaying the recording of cash receipts.
• diverted cash receipts; unauthorized cash disbursements or loss of funds
• Covering unauthorized transactions by substituting unsupported credits or fictitious
expenditures to cover misappropriated collections; under or over estimating cash or
receivables.
• Misstating cash balances; covering unauthorized transactions by falsifying bank
reconciliation.

Credit Rating
A credit rating is an assessment of the creditworthiness of a borrower in general terms or with
respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that
seeks to borrow money — an individual, corporation, state or provincial authority, or sovereign
government.
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Credit assessment and evaluation for companies and governments is generally done by a credit
rating agency such as Standard & Poor’s (S&P), Moody’s, or Fitch. These rating agencies are paid
by the entity that is seeking a credit rating for itself or for one of its debt issues.

Why Credit Ratings Are Important?

Credit ratings for borrowers are based on substantial due diligence conducted by the rating
agencies. While a borrowing entity will strive to have the highest possible credit rating since it has
a major impact on interest rates charged by lenders, the rating agencies must take a balanced and
objective view of the borrower’s financial situation and capacity to service/repay the debt.

A credit rating not only determines whether or not a borrower will be approved for a loan, but also
determines the interest rate at which the loan will need to be repaid. Since companies depend on
loans for many start-up and other expenses, being denied a loan could spell disaster, and a high
interest rate is much more difficult to pay back. Credit ratings also play a large role in a potential
investor’s determining whether or not to purchase bonds. A poor credit rating is a risky investment;
it indicates a larger probability that the company will be unable to make its bond payments.

It is important for a borrower to remain diligent in maintaining a high credit rating. Credit ratings are
never static, in fact, they change all the time based on the newest data, and one negative debt will
bring down even the best score. Credit also takes time to build up. An entity with good credit but a
short credit history is not seen as positively as another entity with the same quality of credit but a
longer history. Debtors want to know a borrower can maintain good credit consistently over time.

Factors Affecting Credit Ratings and Credit Scores

There are a few factors credit agencies take into consideration when assigning a credit rating to an
organization. First, the agency considers the entity’s past history of borrowing and paying off
debts. Any missed payments or defaults on loans negatively impact the rating. The agency also
looks at the entity’s future economic potential. If the economic future looks bright, the credit rating
tends to be higher; if the borrower does not have a positive economic outlook, the credit rating will
fall.

For individuals, the credit rating is conveyed by means of a numerical credit score that is
maintained by Equifax, Experian, and other credit-reporting agencies. A high credit score indicates
a stronger credit profile and will generally result in lower interest rates charged by lenders. There
are a number of factors that are taken into account for an individual’s credit score including
payment history, amounts owed, length of credit history, new credit, and types of credit. Some of
these factors have greater weight than others. Details on each credit factor can be found in a
credit repo rt, which typically accompanies a credit score.

Short-Term vs. Long-Term Credit Ratings

A short-term credit rating reflects the likelihood of the borrower defaulting within the year. This type
of credit rating has become the norm in recent years, whereas, in the past, long-term credit ratings
were more heavily considered. Long-term credit ratings predict the borrower’s likelihood of
defaulting at any given time in the extended future.

Internal & External Rating

The existence of credit ratings is widely known. They often appear in several newspapers, and
magazines. Nevertheless, various mid-market companies cannot estimate the impact and
importance of credit ratings. Specifically, differences between internal credit and external ratings
are often unclear. This study compares internal and external credit ratings in order to see their
77
importance, and why they provide the opportunity to improve the individual financial situation of
mid-market companies. Even further, this study shows the relevant differences and similarities of
internal and external credit ratings, and explains, why external credit ratings can help German mid-
market companies in financing process. Financing is a fundamental factor in the success of a
company. Without sufficient liquidity a company cannot invest, and without investments a
company cannot grow. German mid-market companies need to ensure their financing in order to
have sustainable success.

Internal Credit Rating

Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for
the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB)
approach to capital requirements for credit risk. Only banks meeting certain minimum conditions,
disclosure requirements and approval from their national supervisor are allowed to use this
approach in estimating capital for various exposures.

Risks of Default

The advanced internal rating-based models help determine the risks of default in a variety of
fields, including:

• Loss Given Default (LGD)

• Exposure at Default (EAD)
• Probability of Default (PD)

The three fields mentioned above help determine the risk-weighted asset (RWA) that is calculated
on a percentage basis for the total required capital. They help make a structural model of credit
risk that can assist in formulating internal rating-based approaches for credit risk management
within a bank. The model aids in avoiding pitfalls and unnecessary stresses on a bank’s balance
sheet that can end up threatening the liquidity or long-term profitability of the financial institution as
a whole.

The ratings-based approaches help maintain controls within the various departments of the banks
to ensure that they do not over-leverage in any specific way.

Basel II Rule Requirement

The AIRB systems were proposed under the Basel II capital adequacy rules. Basel II is a set of
recommendations for financial institutions globally that help form banking laws and financial best
practices.

External Rating
An external rating scale is a scale used as an ordinal measure of risk. The highest grade on the
scale represents the least risky investments, but as we move down the scale, the amount of risk
gradually increases (safety decreases).

An issue-specific credit rating conveys information about a specific instrument, such as a zero-
coupon bond issued by a corporate entity. An issuer-specific credit rating, on the other hand,
conveys information about the entity behind an issue. The latter usually incorporates a lot more
information about the issuer.
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Model Credit Rating, Methodology of Rating
Risk rating models are tools used to assess the probability of default. The concept of a risk rating
model is deeply interconnected with the concept of default risk and a key tool in areas such as risk
management, underwriting, capital allocation, and portfolio management.

A risk rating model is a key tool for lending decisions and portfolio management/portfolio
construction. They give creditors, analysts, and portfolio managers a rather objective way of
ranking borrowers or specific securities based on their creditworthiness and default risk.

They also allow a bank to set and monitor the level of risk in their credit portfolio and assess
whether specific adjustments are needed.

Other factors may involve a subjective assessment of a company’s competitive strengths,

management’s reliability, political risks, and environmental risks. For these factors, it’s often
necessary to use discretion when ranking the related risks, as it’s difficult, if not impossible, to
quantify or rank them in an objective way.

1. Judgment vs. Data

The methodology used to develop the risk rating model can give more weight to judgment or
statistics. It will depend on the availability of relevant data, the integrity and accuracy of the data,
and the ease of storage and access to such data.

1. Borrower’s Financial Health

The factors that assess a borrower’s financial health generally include a variety of ratios:

• Liquidity, to determine whether a borrower is able to pay off their current obligations. Such
ratios include the cash ratio, the current ratio, and the acid ratio.
• Leverage ratios, also called solvency ratios, to assess a company’s ability to meet its long-
term financial obligations. These ratios look at a company’s capital structure and include the
equity ratio or the debt ratio.
• Profitability ratios, to determine whether the company generates profits in its ordinary
business activities. Such ratios include the operating margin, the EBITDA margin, and the
return on invested capital, to name a few.
• Cash flow ratios, which compare cash flow metrics to other financial KPIs or leverage
indicators, to assess a company’s ability to generate cash flows that can be used to pay off
its obligations. For example, such ratios include the cash flow coverage ratio or the cash
flow to net income ratio.

1. Industry Characteristics

A borrower’s ability to pay off their obligations may not just depend on company-specific factors.
Industry characteristics and macroeconomic factors can affect a company’s creditworthiness. For
example:

• In an industry with low barriers to entry, a company’s ability to generate cash flows may be
less predictable or subject to more significant risks.
• In a cyclical or commoditized industry, a company’s cash-flow generation may be
significantly more volatile than in a defensive industry or natural monopoly.
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 • For any industry, the current phase of the industry or business cycle can affect a company’s
creditworthiness. For example, in the recession phase of the macroeconomic cycle or in the
decline phase of the industry cycle, even companies that are financially healthy may face a
deterioration in creditworthiness.

1. Management’s Quality and Reliability

Many risk rating models give a score to a company’s management based on a combination of
objective and subjective factors:

• Assessment of the management’s tenure and experience, which comprise rather objective
elements, such as the management’s seniority and years of experience, and more
subjective ones, such as the relevance of the experience and qualifications.
• A deeper analysis of a management’s history of value creation, clarity of communication,
quality and frequency of information disclosed, and capital allocation decisions.

1. Political and Environmental Risks

Risk rating models also use additional categories of risk factors:

• Political risks, which consider aspects such as the risks of war, the rule of law, and the
reliability of the institutions, to name a few.
• Environmental risks related to the potential consequences of pollution or destruction of the
natural environment due to the company’s activity. It can cause financial consequences and
even adverse regulations that can limit or disrupt a company’s operations.

Methodology of Credit Rating

The process of credit rating begins with the prospective issuer approaching the rating agency for
evaluation. The experts in analyzing banks should be given a free hand and they will collect data
and informant and will investigate the business strength and weaknesses in detail. The entire
process of rating stands of confidentiality and hence even the most confidential business
strategies, marketing plans, future outlook etc., are revealed to the steam of analysis.

The rating is based on the investigation analysis, study and interpretation of various factors. The
world of investment is exposed to the continuous onslaught of political, economic, social and other
forces which does not permit any one to understand sufficiently certainty. Hence a logical
approach to systematic evaluation is compulsory and within the framework of certain common
features the agencies employ different methodologies. The key factors generally considered are
listed below:

1. Business Analysis or Company Analysis

This includes an analysis of industry risk, market position of the company, operating efficiency of
the company and legal position of the company.

• Industry risk: Nature and basis of competition, key success factors; demand supply
position; structure of industry; government policies, etc.
• Market position of the company within the industry: Market share; competitive
advantages, selling and distribution arrangements; product and customer diversity etc.
• Operating efficiency of the company: Locational advantages; labour relationships; cost
structure and manufacturing as compared to those of competition.

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 • Legal Position: Terms of prospectus; trustees and then responsibilities; system for timely
payment and for protection against forgery/fraud, etc.

1. Economic Analysis

In order to evaluate an instrument an analyst must spend a considerable time in investigating the
various economic activities and also analyze the characteristics peculiar to the industry, whose
issue the analyst is concerned with. It will be an error to ignore these factors as the individual
companies are always exposed to changing environment and the economic activates affect
corporate profits, attitudes and expectation of investors and the price of the instrument. hence the
relevance of the economic variables such as growth rate, national income and expenditure cannot
be ignored. The analysis, while doing the economic forecasting use surveys, various economic
indicators and indices.

1. Financial Analysis

This includes an analysis of accounting, quality, earnings, protection adequacy of cash flows and
financial flexibility.

• Accounting Quality: Overstatement/under statement of profits; auditors’ qualification;

methods of income recognition’s inventory valuation and depreciation policies, off balance
sheet liabilities etc.
• Earnings Protection: Sources of future earnings growth; profitability ratios; earnings in
relation to fixed income changes.
• Adequacy of cash flows: In relation to dept and fixed and working capital needs; variability
of future cash flows; capital spending flexibility working capital management etc.
• Financial Flexibility: Alternative financing plans in ties of stress; ability to raise funds asset
redeployment.

1. Management Evaluation

• Track record of the management planning and control system, depth of managerial talent,
succession plans.
• Evaluation of capacity to overcome adverse situations
• Goals, philosophy and strategies.

1. Geographical Analysis

• Location advantages and disadvantages

• Backward area benefit to the company/division/unit

1. Fundamental Analysis

Fundamental analysis is essential for the assessment of finance companies. This includes an
analysis of liquidity management, profitability and financial position and interest and tax sensitivity
of the company.

• Liquidity Management: Capital structure; term matching of assets and liabilities policy and
liquid assets in relation to financing commitments and maturing deposits.
• Asset Quality: Quality of the company’s credit-risk management; system for monitoring
credit; sector risk; exposure to individual borrower; management of problem credits etc.

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• Profitability and financial position: Historic profits, spread on fund deployment revenue
on non-fund based services accretion to reserves etc.
• Interest and Tax sensitivity: Exposure to interest rate changes, hedge against interest
rate and tax low changes, etc.

END OF UNIT 5

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