Improvements needed in Risk Rating, Credit

Appraisal and Monitoring Methods of the bank

Submitted By

ASIS KUMAR MANDAL

NARSEE MONJEE INSTITUTE OF MANAGEMENT STUDIES

Project Done At

PUNJAB NATIONAL BANK, CIRCLE OFFICE

MUMBAI

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Preface

Credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms, or in other words it is defined as the risk that a firms customer and the parties to which it has lent money will fail to make promised payments is known as credit risk The exposure to the credit risks large in case of financial institutions, such commercial banks when firms borrow money they in turn expose lenders to credit risk, the risk that the firm will default on its promised payments. As a consequence, borrowing exposes the firm owners to the risk that firm will be unable to pay its debt and thus be forced to bankruptcy. The project helps in understanding the clear meaning of credit Risk Management at Punjab National Bank. It explains about the credit risk scoring method and corresponding rating of the borrower and different lending rate. It helps to understand the fair credit policy of the Bank and Credit Recovery management of the same.

MUMBAI Asis Kumar Mandal 11th June, 2010

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ACKNOWLEDGMENT

It is indeed a matter of great pleasure and privilege to work on the project titled

Improvements needed in Risk Rating, credit appraisal and monitoring Methods of the

bank. I would like to express special thanks to Mr. B.G Pinto and Mr. Rushikesh Dhimar for

providing me an excellent opportunity to complete my summer internship at PUNJAB

NATIONAL BANK, CIRCLE OFFICE-MUMBAI.

I would like to express my Indebtedness to them for their excellent guidance and valuable

suggestions for the successful completion of the project.

I would also like to thank the entire staff of PUNJAB NATIONAL BANK, CIRCLE OFFICE-MUMBAI for providing their excellent support.

I am bound to the Honorable Prof. C. D. Sreedharan for his stimulating support and

guidance.

Without the support of everyone mentioned above, this project wouldnt have been possible.

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Executive Summary

Efficient management of loans and advances portfolio has assumed greater significance as it is the largest asset of the bank having direct impact on its profitability. At Punjab National Bank, Circle Office, Mumbai, I had the opportunity to know in detail about the various funding options provided to Corporates. Term loans or Project finance and Working capital finance are the two types of finance provided to the Corporates. There are good structured Credit Rating Tool is in place to assess the risk of lending to any kind of corporate. For different size of company different methodology is applied to assess the risk. However with this intense rating mechanism its not always possible to judge the future risk of any business. This project covers in detail the entire credit Rating procedure at Punjab National Bank. The bank follows a structured format for Project appraisal in which credit rating is one of the most important part. Different methods of credit delivery i.e. sole banking, multiple banking, loan syndication and consortium lending have been discussed. The project for which the finance is granted needs be appraised properly. Banks need to ascertain if the project is technically feasible and economically viable or not. It should be able to generate surplus so as to service the debts within a reasonable period of time. A sample Credit rating was calculated. Some confidential elements have been omitted from the report. Its capacity of repayment was ascertained based on analysis of Managerial Competence, Technical Feasibility, Commercial and Financial Viability. As recommended action items to improve the risk assessment these items have been identified-Lot of training is required for the lending officers, extensive data is required for SMEs and right information should be collected from all stakeholders. However the current credit rating tool is properly structured and strictly followed in the organization.

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Table of contents

Title Page No

Preface 2

Acknowledgements 3

Executive Summary 4

Chapter 1 Introduction and Research methodology 8

1.1 Title 8

1.2 Objectives 8

1.3 Methodology 8

Chapter -2 Banking Industry Overview 9

2.1 History 9

2.2 The Indian Banking System 10

2.3 Importance of banking sector in growing economy 10

2.4 Emerging Scenario in Banking Sector 11

2.5 Current Scenario 11

Chapter 3 Profile of Punjab National Bank 13

Chapter 4 Theoretical background of Credit Risk Management 15

4.1 Credit 15

4.2 Risk 15

4.2.1 Market Risk 15

4.2.2 Operational Risk 15

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4.2.3 Credit Risk 16

4.2.3.1 Key Elements of Credit Risk Management 16

4.2.3.2 Fundamental Approaches to Credit Risk Management 16

Chapter 5 Credit Rating 18

5.1 Definition 18

5.2 Use 18

5.3 Main Features of the Rating Tool 18

5.4 Different Ratios Used in Credit Rating Assessment 18

5.4.1 Current ratio 18

5.4.2. TOL/TNW 19

5.4.3. PBDIT/Interest (times) 19

5.4.4. ROCE or ROA (%) 19

5.4.5. Operating profits/Net sales (%) 20

5.4.6. Inventory / net sales + receivables / gross sales 20

5.5 Rating tool 21

5.5.1 Financial Parameters 21

5.5.2 Business Parameters 22

5.5.3 Management Parameters 22

5.5.4 Conduct Parameters 22

5.6 Difficulty of Measuring Credit Risk 24

5.6.1 A portfolio approach to credit risk management 24

5.6.2 Asset by asset approach 25

Chapter 6 Credit Appraisal 26

6.1 Credit Appraisal 26

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6.1.1 Managerial Competence 26

6.1.2 Technical Feasibility 26

6.1.3 Commercial Viability 26

6.1.4 Financial Viability 26

6.2 Credit investigation report 27

6.3 Credit Files 28

Chapter 7 Credit Rating of a Company 29

7.1 Financial Evaluation 29

7.2 Past Financial-Absolute Comparison 29

7.3 Subjective Assessment 30

7.4 Trend Adjustment 30

7.5 Operating Efficiency Evaluation 30

7.6 Market Position Evaluation 31

7.7 Industry Evaluation 31

7.8 Management Evaluation 32

7.9 Subjective Assessment of Management 32

7.10 Conduct of Account Evaluation 32

7.11 Total Score 33

7.12 PNB Score Card 33

Chapter 8 Recommendations and Suggestions 34

Chapter 9 Conclusion 35

Bibliography 36

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Chapter-1 Introduction and research Methodology

1.1 Title of the Project Report:

Improvements needed in Risk Rating, credit appraisal and monitoring Methods of the bank. 1.2 Objectives of Project:

1) To study the RBI guidelines and the banks limits regarding credit rating and risk analysis.

2) To know the different methods available for credit rating and understanding the credit rating procedure used in Punjab National Bank.

3) To gain insights into the credit risk management activities of Punjab National Bank.

4) To get a thorough understanding of the credit rating process by analyzing a demo proposal.

1.3 Methodology:

Data collection method:- Primary data The primary data which was required for basic understanding was obtained under the direct guidance of the Credit manager. Some internal manual has been used. Secondary data Data from the internet and textbooks has also been utilized.

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Chapter -2 Banking Industry Overview

2.1 History:

Banking in India has its origin as carry as the Vedic period. It is believed that the transition from money lending to banking must have occurred even before Manu, the great Hindu jurist, who has devoted a section of his work to deposits and advances and laid down rules relating to the interest. During the Moghal period, the indigenous bankers played a very important role in lending money and financing foreign trade and commerce. During the days of East India Company, it was to turn of the agency houses top carry on the banking business. The general bank of India was the first joint stock bank to be established in the year 1786.The others which followed were the Bank of Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued till 1906, while the other two failed in the meantime. In the first half of the 19th Century the East India Company established three banks; The Bank of Bengal in 1809, The Bank of Bombay in 1840 and The Bank of Madras in 1843.These three banks also known as presidency banks and were independent units and functioned well. These three banks were amalgamated in 1920 and The Imperial Bank of India was established on the 27th Jan 1921, with the passing of the SBI Act in 1955, the undertaking of The Imperial Bank of India was taken over by the newly constituted SBI. The Reserve Bank which is the Central Bank was created in 1935 by passing of RBI Act 1934, in the wake of Swadeshi Movement; a number of banks with Indian Management were established in the country namely Punjab National Bank Ltd, Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, The Bank of Baroda Ltd, The Central Bank of India Ltd .On July 19th 1969, 14 Major Banks of the country were nationalized and in 15th April 1980 six more commercial private sector banks were also taken over by the government. The Indian Banking industry, which is governed by the Banking Regulation Act of India 1949, can be broadly classified into two major categories, non-scheduled banks and scheduled banks. Scheduled Banks comprise commercial banks and the co-operative banks. The first phase of financial reforms resulted in the nationalization of 14 major banks in 1969 and that resulted in a shift from class banking to mass banking. This in turn resulted in the significant growth in the geographical coverage of banks. Every bank had to earmark a min percentage of their loan portfolio to sectors identified as priority sectors the manufacturing sector also grew during the 1970s in protected environments and the banking sector was a critical source. The next wave of reforms saw the nationalization of 6 more commercial banks in 1980 since then the number of scheduled commercial banks increased four- fold and the number of bank branches increased to eight fold. After the second phase of financial sector reforms and liberalization of the sector in the early nineties, the PSBs found it extremely difficult to complete with the new private sector banks and the foreign banks. The new private sector first made their appearance after the guidelines permitting them were issued in January 1993.

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2.2 The Indian Banking System:

Banking in our country is already witnessing the sea changes as the banking sector seeks new technology and its applications. The best port is that the benefits are beginning to reach the masses. Earlier this domain was the preserve of very few organizations. Foreign banks with heavy investments in technology started giving some Out of the world customer services. But, such services were available only to selected few- the very large account holders. Then came the liberalization and with it a multitude of private banks, a large segment of the urban population now requires minimal time and space for its banking needs. Automated teller machines or popularly known as ATM are the three alphabets that have changed the concept of banking like nothing before. Instead of tellers handling your own cash, today there are efficient machines that dont talk but just dispense cash. Under the Reserve Bank of India Act 1934, banks are classified as scheduled banks and nonscheduled banks. The scheduled banks are those, which are entered in the Second Schedule of RBI Act, 1934. Such banks are those, which have paid- up capital and reserves of an aggregate value of not less than Rs.5 lacs and which satisfy RBI that their affairs are carried out in the interest of their depositors. All commercial banks Indian and Foreign, regional rural banks and state co-operative banks are Scheduled banks. Non Scheduled banks are those, which have not been included in the Second Schedule of the RBI Act, 1934. The organized banking system in India can be broadly classified into three categories: (i) Commercial Banks (ii) Regional Rural Banks and (iii) Co-operative banks. The Reserve Bank of India is the supreme monetary and banking authority in the country and has the responsibility to control the banking system in the country. It keeps the reserves of all commercial banks and hence is known as the Reserve Bank. 2.3 Importance of Banking Sector in a Growing Economy: In the recent times when the service industry is attaining greater importance compared to manufacturing industry, banking has evolved as a prime sector providing financial services to growing needs of the economy. Banking industry has undergone a paradigm shift from providing ordinary banking services in the past to providing such complicated and crucial services like, merchant banking, housing finance, bill discounting etc. This sector has become more active with the entry of new players like private and foreign banks. It has also evolved as a prime builder of the economy by understanding the needs of the same and encouraging the development by way of giving loans, providing infrastructure facilities and financing activities for the promotion of entrepreneurs and other business establishments. For a fast developing economy like ours, presence of a sound financial system to mobilize and allocate savings of the public towards productive activities is necessary. Commercial banks play a crucial role in this regard. The Banking sector in recent years has incorporated new products in their businesses, which are helpful for growth. The banks have started to provide fee-based services like, treasury operations, managing derivatives, options and futures, acting as bankers to the

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industry during the public offering, providing consultancy services, acting as an intermediary between two-business entities etc. At the same time, the banks are reaching out to other end of customer requirements like, insurance premium payment, tax payment etc. It has changed itself from transaction type of banking into relationship banking, where you find friendly and quick service suited to your needs. This is possible with understanding the customer needs their value to the bank, etc. This is possible with the help of well organized staff, computer based network for speedy transactions, products like credit card, debit card, health card, ATM etc. These are the present trend of services. The customers at present ask for convenience of banking transactions, like 24 hours banking, where they want to utilize the services whenever there is a need. The relationship banking plays a major and important role in growth, because the customers now have enough number of opportunities, and they choose according to their satisfaction of responses and recognition they get. So the banks have to play cautiously, else they may lose out the place in the market due to competition, where slightest of opportunities are captured fast. Another major role played by banks is in transnational business, transactions and networking. Many leading Indian banks have spread out their network to other countries, which help in currency transfer and earn exchange over it. These banks play a major role in commercial import and export business, between parties of two countries. This foreign presence also helps in bringing in the international standards of operations and ideas. The liberalization policy of 1991 has allowed many foreign banks to enter the Indian market and establish their business. This has helped large amount of foreign capital inflow & increase our Foreign exchange reserve. Another emerging change happening all over the banking industry is consolidation through mergers and acquisitions. This helps the banks in strengthening their empire and expanding their network of business in terms of volume and effectiveness. 2.4 Emerging Scenario in the Banking Sector:

The Indian banking system has passed through three distinct phases from the time of inception. The first was being the era of character banking, where you were recognized as a credible depositor or borrower of the system. This era come to an end in the sixties. The second phase was the social banking. Nowhere in the democratic developed world, was banking or the service industry nationalized. But this was practiced in India. Those were the days when bankers has no clue whatsoever as to how to determine the scale of finance to industry. The third era of banking which is in existence today is called the era of Prudential Banking. The main focus of this phase is on prudential norms accepted internationally. 2.5 Current Scenario:

Currently overall, banking in India is considered as fairly mature in terms of supply, product range and reach-even though reach in rural India still remains a challenge for the private sector and foreign banks. Even in terms of quality of assets and capital adequacy, Indian banks are considered to have clean, strong and transparent

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balance sheets-as compared to other banks in comparable economies in its region. The Reserve Bank of India is an autonomous body, with minimal pressure from the government. The stated policy of the Bank on the Indian Rupee is to manage volatility-without any stated exchange rate-and this has mostly been true. With the growth in the Indian economy expected to be strong for quite some time especially in its services sector, the demand for banking services-especially retail banking, mortgages and investment services are expected to be strong. M&A, takeovers, asset sales and much more action (as it is unraveling in China) will happen on this front in India. In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an investor has been allowed to hold more than 5% in a private sector bank since the RBI announced norms in 2005 that any stake exceeding 5% in the private sector banks would need to be vetted by them. Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks (that is with the Government of India holding a stake), 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively.

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Chapter 3 Profile of Punjab National Bank

With its presence virtually in all the important centres of the country, Punjab National Bank offers a wide variety of banking services which include corporate and personal banking, industrial finance, agricultural finance, financing of trade and international banking. Among the clients of the Bank are Indian conglomerates, medium and small industrial units, exporters, non-resident Indians and multinational companies. The large presence and vast resource base have helped the Bank to build strong links with trade and industry. Punjab National Bank is serving over 3.5 crore customers through 4525 Offices including 432 extension counters - largest amongst Nationalized Banks. The Bank was recently ranked 21st amongst top 500 companies by the leading financial daily, Economic Times. PNB's attempts at providing best customer service has earned it 9th place among Indias Most Trusted top 50 service brands in Economic Times- A.C Nielson Survey. PNB is also ranked 248th amongst the top 1000 banks in the world according to "The Banker" London. At the same time, the bank has been conscious of its social responsibilities by financing agriculture and allied activities and small scale industries (SSI). Considering the importance of small scale industries bank has established 31 specialised branches to finance exclusively such industries. Strong correspondent banking relationship which Punjab National Bank maintains with over 200 leading international banks all over the world enhances its capabilities to handle transactions world-wide. Besides, bank has Rupee Drawing Arrangements with 15 exchange companies in the Gulf and one in Singapore. Bank is a member of the SWIFT and over 150 branches of the bank are connected through its computer-based terminal at Mumbai. With its state-of-art dealing rooms and well-trained dealers, the bank offers efficient forex dealing operations in India. The bank has been focussing on expanding its operations outside India and has identified some of the emerging economies which offer large business potential. Bank has set up representative offices at Almaty: Kazakhistan, Shanghai: China and in London. Besides, Bank has opened a full fledged Branch in Kabul, Afghanistan. Keeping in tune with changing times and to provide its customers more efficient and speedy service, the Bank has taken major initiative in the field of computerization. All the Branches of the Bank have been computerized. The Bank has also launched aggressively the concept of "Any Time, Any Where Banking" through the introduction of Centralized Banking Solution (CBS) and over 2409 offices have already been brought under its ambit. PNB also offers Internet Banking services in the country for Corporates as well as individuals. Internet Banking services are available through all Branches of the Bank

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networked under CBS. Providing 24 hours, 365 days banking right from the PC of the user, Internet Banking offers world class banking facilities like anytime, anywhere access to account, complete details of transactions, and statement of account, online information of deposits, loans overdraft account etc. PNB has recently introduced Online Payment Facility for railway reservation through IRCTC Payment Gateway Project and Online Utility Bill Payment Services which allows Internet Banking account holders to pay their telephone, mobile, electricity, insurance and other bills anytime from anywhere from their desktop. Another step taken by PNB in meeting the changing aspirations of its clientele is the launch of its Debit card, which is also an ATM card. It enables the card holder to buy goods and services at over 99270 merchant establishments across the country. Besides, the card can be used to withdraw cash at more than 25000 ATMs, where the 'Maestro' logo is displayed, apart from the PNB's over 898 ATMs and tie up arrangements with other Banks.

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Chapter 4 Theoretical background of Credit Risk

Management

4.1 Credit:

The word credit comes from the Latin word credere, meaning trust. When sellers transfer his wealth to a buyer who has agreed to pay later, there is a clear implication of trust that the payment will be made at the agreed date. The credit period and the amount of credit depend upon the degree of trust. Credit is an essential marketing tool. It bears a cost, the cost of the seller having to borrow until the customers payment arrives. Ideally, that cost is the price but, as most customers pay later than agreed, the extra unplanned cost erodes the planned net profit. 4.2 Risk: Risk is defined as uncertain resulting in adverse outcome, adverse in relation to planned objective or expectation. It is very difficult o find a risk free investment. An important input to risk management is risk assessment. Many public bodies such as advisory committees concerned with risk management. There are mainly three types of risk they are follows

Market risk

Operational risk

Credit Risk Risk analysis and allocation is central to the design of any project finance, risk management is of paramount concern. Thus quantifying risk along with profit projections is usually the first step in gauging the feasibility of the project. Once risk has been identified they can be allocated to participants and appropriate mechanisms put in place.

4.2.1 Market Risk:

Market risk is the risk of adverse deviation of the mark to market value of the trading portfolio, due to market movement, during the period required to liquidate the transactions.

4.2.2 Operational Risk:

Operational risk is one area of risk that is faced by all organizations. More complex the organization more exposed it would be operational risk. This risk arises due to deviation from normal and planned functioning of the system procedures, technology and human failure of omission and commission. Result of deviation from normal

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functioning is reflected in the revenue of the organization, either by the way of additional expenses or by way of loss of opportunity.

4.2.3 Credit Risk:

Credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms, or in other words it is defined as the risk that a firms customer and the parties to which it has lent money will fail to make promised payments is known as credit risk

4.2.3.1 Key Elements of Credit Risk Management:

Establishing appropriate credit risk environment

Operating under sound credit granting process

Maintaining an appropriate credit administration, measurement & Monitoring

Ensuring adequate control over credit risk

Banks should have a credit risk strategy which in our case is communicated throughout the organization through credit policy.

4.2.3.2 Fundamental Approaches to Credit Risk Management:

The internally oriented approach centers on estimating both the expected cost and volatility of future credit losses based on the firms best assessment. Future credit losses on a given loan are the product of the probability that the borrower will default and the portion of the amount lent which will be lost in the event of default. The portion which will be lost in the event of default is dependent not just on the borrower but on the type of loan (eg. some bonds have greater rights of seniority than others in the event of default and will receive payment before the more junior bonds).

To the extent that losses are predictable, expected losses should be factored into product prices and covered as a normal and recurring cost of doing business. i.e., they should be direct charges to the loan valuation. Volatility of loss rates around expected levels must be covered through risk-adjusted returns.

So total charge for credit losses on a single loan can be represented by ([expected probability of default] * [expected percentage loss in event of default]) + risk adjustment * the volatility of ([probability of default * percentage loss in the event of default]). Financial institutions are just beginning to realize the benefits of credit risk management models. These models are designed to help the risk manager to project risk, ensure profitability, and reveal new business opportunities. The model surveys the current state of the art in credit risk management. It provides the tools to understand and evaluate alternative approaches to modeling. This also describes what a credit risk management model should do, and it analyses some of the popular models.

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The success of credit risk management models depends on sound design, intelligent implementation, and responsible application of the model. While there has been significant progress in credit risk management models, the industry must continue to advance the state of the art. So far the most successful models have been custom designed to solve the specific problems of particular institutions. A credit risk management model tells the credit risk manager how to allocate scarce credit risk capital to various businesses so as to optimize the risk and return characteristics of the firm. It is important or understand that optimize does not mean minimize risk otherwise every firm would simply invest its capital in risk less assets. A credit risk management model works by comparing the risk and return characteristics between individual assets or businesses. One function is to quantify the diversification of risks. Well-diversified means that the firm has no concentration of risk to say, one geographical location or one counter party.

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Chapter 5 Credit Rating

5.1 Definition:

Credit rating is the process of assigning a letter rating to borrower indicating that creditworthiness of the borrower. Rating is assigned based on the ability of the borrower (company) to repay the debt and his willingness to do so. The higher is rating of company the lower is the probability of its default.

5.2 Use: Credit rating helps the bank in making many key decisions regarding credit including 1. Whether to lend to a particular borrower or not; what price to charge? 2. What are the products to be offered to the borrower and for what tenure? 3. At what level should sanctioning be done, it should however be noted that credit

rating is one of inputs used in credit decisions.

5.3 Main Features of the Rating Tool:

1. Comprehensive coverage of parameters 2. Extensive data requirement 3. Mix of subjective and objective parameters 4. includes trend analysis 5. 13 parameters are benchmarked against other players in the segment 6. Captions of industry outlook 7. 8 grade ratings broadly mapped with external rating agencies prevailing data.

5.4 Different Ratios Used in Credit Rating Assessment: Under the CRA system, financial risks in a proposal are sought to be captured through some relevant ratios. Different ratios are used for assessing risks for extending working capital finance and term loans under CRA system. Also, the ratios used for assessing risk for financing NBFCs are different.

5.4.1 Current ratio:

It is calculated by dividing current assets by current liabilities. It helps to measure liquidity and financial strength. Care should be taken in interpreting this ratio as:

i. 1. It is applied at a single point in time, implying a liquidation approach, rather than a judgment on the going concern, for it does not explicitly take into account the revolving nature of current assets and current liabilities.

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ii. 2. The seasonal character of the business resulting in fluctuating current ratio is a disturbing factor.

iii. 3. Liquidity could be severely affected if current liabilities exceed current

assets. iv. 4. The higher the ratio the better the liquidity position.

5.4.2. TOL/TNW:

Total outside liabilities divided by total net worth. The characteristics are as follows:

i. It indicates size of stake, stability and degree of solvency. ii. Indicates how high the stake of the creditors is. iii. Indicates what proportion of the companys finance is represented by the

tangible net worth iv. The lower the ratio the greater the solvency. v. The ratio is usually higher in case of SMES. Still anything over 3 or 4 should

be viewed with concern. vi. The ratio should be studied at the peak level of operations.

5.4.3. PBDIT/Interest (times):

This is called interest coverage ratio. In the current context, the servicing capability of loan is very crucial. This ratio, which indicates the number of times the gross earnings cover the interest payable is an indicator of the measure of comfort that profitability provides.

i. Higher ratio indicates comfortable debt servicing capability from the cash

accrual of the company.

ii. A ratio of more than 3 is considered comfortable, where as a ratio of 2 and

below is considered risky.

5.4.4. ROCE or ROA (%):

Profit before depreciation, interest and tax/ total capital employed multiplied by 100.

i. High ratio indicates that the business is run on profitable lines.

ii. It is a relationship between the profits made during the year and the finance

employed to make profits i.e. it shows the earning power of the business.

iii. It is a measure of the managements skill in profitably employing the funds in

the company.

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iv. It should not only compare favorably with the rate of interest on loanable funds

in the market but also compensable for the risk involved in running the

business.

5.4.5. Operating profits/Net sales (%):

It indicates operating efficiency. It should be comparable with similar industries. Trend

for the company over a period should be encouraging.

5.4.6. Inventory / net sales + receivables / gross sales:

Expressed in days, this ratio captures the turnaround period for major items of the

current asset

i. Higher the figure, the slower is the turnaround of current asset and in general

higher the risk.

ii. This ratio will vary across industries.

iii. For assessment of risk, a shorter working capital cycle can be regarded less

risky.

iv. Specific industry parameters should also be kept in mind while assessing the

risk under this ratio.

v. In general, it is expected that the working capital should be turned over at least

twice.

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5.5 Rating tool

Internal credit ratings are the summary indicators of risk for the banks individual credit exposures. It plays a crucial role in credit risk management architecture of any bank and forms the cornerstone of approval process. The rating tool for any borrower assigns the following Weight ages to each one of the four main categories: S No Parameters Weightages (%)

I. Financial performance XXXX II. Operating performance XXXX

III. Quality of management XXXX IV. Industry outlook XXXX

In the above parameters first three parameters used to know the borrower characteristics. In fourth encapsulates the risk emanating from the environment in which the borrower operates and depends on the past performance of the industry its future outlook and macro economic factors.

5.5.1 Financial Parameters

S.NO Indicator/ratio Score F1

(a) Audited net sales in last year Xxxx

(b) Audited net sales in year before last Xxxx

(c) Audited net sales in 2 year before last Xxxx

(d) Audited net sales in 3 year before last Xxxx

(e) Estimated or projected net sales in next year Xxxx

F2 NET SALES GROWTH RATE (%) Xxxx

F3 PBDIT growth rate (%) Xx

F4 Net sales (%) Xx

F5 ROCE (%) Xx

F6 TOL/TNW Xxx

F7 Current ratio Xxx

F8 DSCR Xxx

F9 Interest coverage ratio Xx

F10 Foreign exchange risk Xx

F11 Reliability of debtors Xx

F12 Operating cash flow Xx

F13 Trend in cash accruals Xx

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5.5.2 Business Parameters

S.NO Indicator/Ratio Score B1 Credit period allowed (days) Xx B2 Credit period availed (days) Xx B3 Working capital cycle (times) Xx B4 Production related risks Xx B5 Product related risks X B6 Price related risks X B7 Fixed assets turnover X B8 No. of years in business X B9 Nature of clientele base X

5.5.3 Management Parameters

Sr. No Indicator/Ratio Score M1 HR policy X M2 Track record in payment of statutory and other dues X M3 Market reports of management reputation X M4 Too optimistic projections of sales and other financials X M5 Capability to raise resources X M6 Technical and managerial expertise X M7 Repayment track record X

5.5.4 Conduct Parameters

Sr. No Indicator/Ratio Score A1 Creation of charges on primary security X A2 Creation of charges on collateral and execution of personal or corporate guarantee X A3 Proper execution of document X A4 Availability of search report X A5 Other terms and conditions not complied with X A6 Receipt of periodical data X A7 Receipt of balance sheet X B1 Negative deviation in half yearly net sales vis--vis proportionate estimates X B2 Negative deviation in annual net sales vis--vis Estimates X B3 Negative deviation in half yearly net profit vis--vis proportionate estimates X B4 Adverse deviation in inventory level in months vis--vis estimate level X B5 Adverse deviation in receivables level in months vis--vis estimated level X B6 Quality of receivable assess from profile of debtors X B7 Adverse deviation in creditors level in months vis--vis estimated level X

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B8 Compliance of financial covenants X B9 Negative deviation in annual net profit vis--vis estimates X C1Unit inspection report observations X C2 Audit report internal/statutory/concurrent/RBI X C3 Conduct of account with other banks/lenders and information on consortium X D1 Routing of proportionate turnover/business X D2 Utilization of facilities (not applicable for term loan) X D3 Overdue discounted bills during the period under review within the sanctioned terms then not applicable X D4 Devolved bill under L/c outstanding during the period under review X D5 Invoked BGs issued outstanding during the period under review X D6 Intergroup transfers not backed by trade transactions during the period under review X D7 Frequency of return of cheques per quarter deposited by borrower X D8 Frequency of issuing cheques per quarter without sufficient balance and returned X D9 Payment of interest or installments X D10 Frequency of request for AD HOC INCREASE OF LIMIS during the last one year X D11 Frequency of over drawings CC account X E1 Status of deterioration in value of primary security or stock Depletion X E2 Status of deterioration in value of collateral security X E3 Status of deterioration in personal net worth and TNW X E4 Adequacy of insurance for the primary /collateral security X F1 Labor situation/industrial relations X F2 Delay or default in payments of salaries and statutory dues X F3 Non co-operation by the borrower X F4 Intended end-use of financing X F5 Any other adverse features/non financial including Corporate governance issues such as adverse publicity, strictures from regulators, political risk and adverse trade environment not covered X

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5.6 Difficulty of Measuring Credit Risk:

Measuring credit risk on a portfolio basis is difficult. Banks and financial institutions traditionally measure credit exposures by obligor and industry. They have only recently attempted to define risk quantitatively in a portfolio context e.g., a value-at-risk (VaR) framework. Although banks and financial institutions have begun to develop internally, or purchase, systems that measure VaR for credit, bank managements do not yet have confidence in the risk measures the systems produce. In particular, measured risk levels depend heavily on underlying assumptions and risk managers often do not have great confidence in those parameters. Since credit derivatives exist principally to allow for the effective transfer of credit risk, the difficulty in measuring credit risk and the absence of confidence in the result of risk measurement have appropriately made banks cautious about the use of banks and financial institutions internal credit risk models for regulatory capital purposes. Measurement difficulties explain why banks and financial institutions have not, until very recently, tried to implement measures to calculate Value-at-Risk (VaR) for credit. The VaR concept, used extensively for market risk, has become so well accepted that banks and financial institutions supervisors allow such measures to determine capital requirements for trading portfolios. The models created to measure credit risk are new, and have yet to face the test of an economic downturn. Results of different credit risk models, using the same data, can widely. Until banks have greater confidence in parameter inputs used to measure the credit risk in their portfolios. They will, and should, exercise caution in using credit derivatives to manage risk on a portfolio basis. Such models can only complement, but not replace, the sound judgment of seasoned credit risk managers. 5.6.1 A portfolio approach to credit risk management

Since the 1980s, Banks and financial institutions have successfully applied modern portfolio theory (MPT) to market risk. Many banks and financial institutions are now using earnings at risk (EaR) and Value at Risk (VaR) models to manage their interest rate and market RISK EXPOSURES. Unfortunately, however, even through credit risk remains the largest risk facing most banks and financial institutions, the application of MPT to credit risk has lagged. The slow development toward a portfolio approach for credit risk results for the following factors:

The traditional view of loans as hold-to-maturity assets.

The absence of tools enabling the efficient transfer of credit risk to investors while continuing to maintain bank customer relationships.

The lack of effective methodologies to measure portfolio credit risk.

Data problems

Banks and financial institutions recognize how credit concentrations can adversely impact financial performance. As a result, a number of sophisticated institutions are actively pursuing quantitative approaches to credit risk measurement. While date problems remain an obstacle, these industry practitioners are making significant progress toward developing tools that measure credit risk in a portfolio context. They

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are also using credit derivatives to transfer risk efficiently while preserving customer relationships. The combination of these two developments has precipitated vastly accelerated progress in managing credit risk in a portfolio context over the past several years.

5.6.2 Asset by asset approach:

Traditionally, banks have taken an asset by asset approach to credit risk management. While each banks method varies, in general this approach involves periodically evaluating the credit quality of loans and other credit exposures. Applying a accredit risk rating and aggregating the results of this analysis to identify a portfolios expected losses. The foundation of thee asset-by-asst approach is a sound loan review and internal credit risk rating system. A loan review and credit risk rating system enables management to identify changes in individual credits, or portfolio trends, in a timely manner. Based on the results of its problem loan identification, loan review and credit risk rating system management can make necessary modifications to portfolio strategies or increase the supervision of credits in a timely manner. Banks and financial institutions must determine the appropriate level of the allowances for loan and losses (ALLL) on a quarterly basis. On large problem credits, they assess ranges of expected losses based on their evaluation of a number of factors, such as economic conditions and collateral. On smaller problem credits and on pass credits, banks commonly assess the default probability from historical migration analysis. Combining the results of the evaluation of individual large problem credits and historical. Two important assumptions of portfolio credit risk models are: 1. The holding period of planning horizon over which losses are predicted 2. How credit losses will be reported by the model. Models generally report either a default or market value distribution. The objective of credit risk modeling is to identify exposures that create an unacceptable risk/reward profile. Such as might arise from credit concentration. Credit risk management seeks to reduce the unsystematic risk of a portfolio by diversifying risks. As banks and financial institutions gain greater confidence in their portfolio modeling capabilities. It is likely that credit derivatives will become a more significant vehicle in to manage portfolio credit risk. While some banks currently use credit derivatives to hedge undesired exposures much of that actively involves a desire to reduce capital requirements.

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Chapter 6 Credit Appraisal

6.1 Credit Appraisal:

Appraisal of the firms position on basis of following parameters: 1. Managerial Competence 2. Technical Feasibility 3. Commercial viability 4. Financial Viability

6.1.1 Managerial Competence:

Back ground of promoters

Experience

Technical skills, Integrity & Honesty

Level of interest / commitment in project

Associate concerns

6.1.2 Technical Feasibility:

Location

Size of the Project

Factory building

Plant & Machinery

Process & Technology

Inputs / utilities . 6.1.3 Commercial Viability:

Demand forecasting / Analysis

Market survey

Pricing policies

Competition

Export policies

6.1.4 Financial Viability:

Whether adequate funds are available at affordable cost to implement the project

Whether sufficient profits will be available

Whether BEP or margin of safety are satisfactory

What will be the overall financial position of the borrower in coming years?

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6.2 Credit investigation report:

Branch prepares Credit investigation report in order to avoid consequence in later stage Credit investigation report should be a part of credit proposal. Bank has to submit the duly completed credit investigation reports after conducting a detailed credit investigation as per guidelines. Some of the guidelines in this regards as follow:

Wherever a proposal is to be considered based only on merits of flagships concerns of the group, then such support should also be compiled in respect of subject flagship in concern besides the applicant company.

In regard of proposals falling beyond the power of rating officer, the branch should ensure participation of rating officer in compilation of this report.

The credit investigation report should accompany all the proposals with the fund based limit of above 25 Lakhs and or non fund based of above Rs. 50 Lakhs.

The party may be suitably kept informed that the compilation of this report is one of the requirements in the connection with the processing for consideration of the proposal.

The branch should obtain a copy of latest sanction letter by existing banker or the financial institution to the party and terms and conditions of the sanction should be studied in detail.

Comments should be made wherever necessary, after making the observations/lapses in the following terms of sanction.

Some of the important factors like funding of interest, re schedule of loans etc terms and conditions should be highlighted.

Copy of statement of accounts for the latest 6 months period should be obtained by the bank to get the present condition of the party.

Remarks should be made by the bank on adverse features observed. (e.g., excess drawings, return of cheques etc).

Personal enquiry should be made by the bank official with responsible official of partys present / other bankers and enquiries should be made with a elicit information on conduct of account etc. Care should be taken in selection of customers or creditors who acts as the representative. They should be interviewed and compilation of opinion should be done.

Enquiries should be made regarding the quality of product, payment terms, and period of overdue which should be mentioned clearly in the report. Enquiry should be aimed to ascertain the status of trading of the applicant and to know their capability to meet their commitments in time.

To know the market trend branch should enquire the person or industry that is in the same line of business activity.

In depth observation may be made of the applicant as to : I. Whether the unit is working in full swing II. Number of shifts and number of employees III. Any obsolete stocks with the unit IV. Capacity of the unit

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V. Nature and conditions of the machinery installed VI. Information on power, water and pollution control etc. VII. Information on industrial relation and marketing strategy

6.3 Credit Files: Its the file, which provides important source material for loan supervision in regard to information for internal review and external audit. Branch has to maintain separate credit file compulsorily in case of Loans exceeding Rs 50 Lakhs which should be maintained for quick access of the related information.

Contents of the credit file:

Basic information report on the borrower Milestones of the borrowing unit competitive analysis of the borrower credit approval memorandum Financial statement Copy of sanction communication Security documentation list Dossier of the sequence of events in the accounts Collateral valuation report Latest ledger page supervision report Half yearly credit reporting of the borrower Quarterly risk classification Press clippings and industrial analysis appearing in newspaper Minutes of latest consortium meeting Customer profitability Summary of inspection of audit observation

Credit files provide all information regarding present status of the loan account on basis of credit decision in the past. This file helps the credit officer to monitor the accounts and provides concise information regarding background and the current status of the account

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Chapter 7 Credit Rating of a Company

1. Name of the Borrower: ABC Construction Company

2. BO/CO/HO: XYZ

3. Business Owner: Partnership 4. Industry: Construction-Civil 5. Exposure (Rs Lakh):

(i) Sanctioned Limit: Fund :400 Term: 2705 N.F.B. 650 Total : 3500 (Ceiling) (ii) Proposed Limit: Fund: 900 Term: 2705 N.F.B. 1650 Total: 5255 (Ceiling) 7.1 FINANCIAL EVALUATION

Category Parameter Co Value

LQ-(M-LQ)/2

LQ M UQ UQ + (UQ-M)/2

Rate

0 1 2 3 4

Growth Rate (3yr)

Gross Sales Growth rate(%)

56.09 -3.74 3.47 17.89 101.44 143.22 2.46

Profitability OPBDIT/Sales (%) 27.47 1.16 25.21 73.31 88.74 96.46 1.05

Short Term Bank borrowings/Net Sales (%)

15.35 14.67 9.78 0 0 0 0.00

Cash Flows Operating Cash flow/Total Debt (%)

12.24 9.23 10.58 13.28 35.84 47.12 1.61

Net operating Cash flow/Total Debt (%)

-3.38 -2.29 -0.9 1.87 30.7 45.12 0.00

7.2 PAST FINANCIAL-ABSOLUTE COMPARISON

Category Parameter Co Value

Bench Mark Values Rate

0-1 1-2 2-3 3-4 4 Solvency Debt Equity Ratio 4.86 3.00-

2.50 2.50-2.00

2.00-1.50

1.50-0.50

=2.00 1.75

Debt Coverage Interest Coverage 1.89 1.00-1.25

1.25-1.50

1.50-2.50

2.50-3.50

>=3.50 2.39

DSCR 1.60 1.00-1.15

1.15-1.25

1.25-1.75

1.75-2.50

>=2.50 2.70

Profitability Return On Capital Employed (%)

23.82 6-9% 9-12% 12-14%

14-16% >=16% 4.00

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Category Parameter Comments Rate

Future Risk

Impact of contingent liability Nil as per ABS09 4.00

Foreign Transaction Risk NA NA

Impact of merger/demerger/expansion on key financials

NA NA

Cash Flow Adequacy Cash Flow after equity is negative and deficit has to be met from short term/long term sources

2.00

7.3 SUBJECTIVE ASSESMENT

Category Parameter Comments Rate

SUBJECTIVE ASSESMENT OF FINANCIALS

Transparency in accounting E.A. Patil & Associates audited books of the company. No qualifications

2.00

Quality of inventory Expected variance may be upto 5% of book value

3.00

Realisability of debtors No bifurcation of debtors available. Expected variance 5-10% of book value

2.00

Quality of investment/advances made to group/other companies

The co. made investment of Rs. 5cr in & advances Rs.5.91 cr to Blue Star Buldg. Pvt. Ltd. Which exceeds TNW

0.00

7.4 TREND ADJUSTMENT

Category Parameters Last Last-1 Last-2 Last-3 RATE

Adjustment for financial trend

Net Sales (Rs. Crore) 29.78 22.57 18.48 7.83 4.00

PBDT Less Non recurring income/expenditure (Rs. Crore)

3.85 3.31 1.32 0.59 4.00

Operating cash flow/Total debt

0.12 0.14 0.18 0.70 0.00

Tangible net-worth (Rs. Crore)

5.90 3.45 2.51 1.70 4.00

7.5 OPERATING EFFICIENCY EVALUATION

Category Parameter Co Value

LQ-(M-LQ)/2

LQ M UQ UQ + (UQ-M)/2

Rate

0 1 2 3 4

1 Operating leverage 1.32 2.49 2.27 1.84 1.57 1.44 4.00

2 Inventory turnover 4.89 11.70 13.16 16.09 16.48 16.68 0.00 3 Net Sales/Op.

Assets 1.00 0.10 0.15 0.25 0.66 0.87 4.00

4 Raw Material Consumed/Net Sales

0.51 0.09 0.06 0.00 0.00 0.00 0.00

5 Credit Period Allowed

52.70 160.19 129.02 66.68 20.96 -1.90 2.31

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7.6 MARKET POSITION EVALUATION S. No. Parameter Comments Rate

1 Competitive position 2.00

Expected sales growth Market dominance/Market share

Sales growth of the company is expected to be positive as the co. achieved Rs. 33.13 cr upto Dec09 against projected Rs. 45 Cr for 09-10 The company is one of the average players; products are reasonably accepted in the market

2.00 2.00 2.00

2 Input Related Risk 2.50

Availability of raw material and other critical inputs Management of price volatility

Raw material and other critical inputs are easily available At par with peers

3.00 2.00

3 Production Related Risk 2.00

State of technology used Flexibility in product manufacturing

At par with peers 2.00 NA

4 Price Competitiveness 2.00

Pricing Flexibility Financing edge over competitors

The Co. being engaged in contractual work, pricing flexibility is low/ at par with peers.

2.00 NA

5 Marketing 2.00

Geographical diversity of market

The firm working with different Govt. authorities and also worked for MNCs.

2.00

6 Others NA

Threats from environmental factors Vulnerability to event risks (Problems in Acquiring Land, Getting various approvals, Geological surprises while executing contracts, Rehabilitation etc.

NA NA

7.7 INDUSTRY EVALUATION

Industry Risk Evaluation for-construction- Civil

Score under industry risk evaluation 55.00%

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7.8 MANAGEMENT EVALUATION

7.9 SUBJECTIVE ASSESSMENT OF MANAGEMENT

S. No. Parameter Comments Rate

1 Management Set up and Corporate Governance

Regd. Partnership firm. Experienced partners.

2.00

2 Commitment and sincerity

There are apparently no adverse features or reasons to doubt the commitment and sincerity of the promoters

2.00

3 Track record in execution of projects

It is reported that the co. have implemented the project with small delay. However most of the projects are running satisfactorily.

2.00

4 Track record in debt repayment

All the debts are repaid in time

5 Track record in industrial relations

Cordial industrial relations maintained 3.00

6 Financial Strength/flexibility/group support

The management is capable of arranging funds but with a time lag

2.00

7 Capital market perception NA NA

7.10 CONDUCT OF ACCOUNT EVALUATION

Category Parameter Comments Rate 1 Preventive monitoring

system rating Not Applicable NA

2 Status of account The account is running regular 3.00

3 Operations in account Operations in the account are satisfactory.

2.00

4 Submission of financial data/statements

All Stock statements and financial statements are submitted in time.

3.00

OBJECTIVE Achievements

S. No Parameter Co value 0 1 2 3 4 RATE

1 Actual Gross Sales (Rs. Crore)

29.78

95% 4.00 Targeted Gross Sales (Rs. Crore)

25.00

2 Actual PBT (Rs. Crore)

3.05

95% 4.00 Actual PBT (Rs. Crore)

2.02

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7.11 TOTAL SCORE PARAMETER % score Obtained Weight Weighted Score

Financial Evaluation 38.87% 40% 15.55%

Business& Industry Evaluation

55.01% 25% 13.75%

Management Evaluation 69.32% 25% 17.33%

Conduct Evaluation 66.67% 10% 6.67%

AGGREGATE SCORE 53.30% 7.12 PNB SCORE CARD

Score Obtained Rating Description

Above 80.00 PNB-AAA Minimum Risk

Above 77.50 up to 80.00 PNB-AA+

Marginal Risk Above 72.50 up to 77.50 PNB-AA

Above 70.00 up to 72.50 PNB-AA-

Above 67.50 up to 70.00 PNB-A+

Modest Risk Above 62.50 up to 67.50 PNB-A

Above 60.00 up to 62.00 PNB-A-

Above 57.50 up to 60.00 PNB-BB+

Average Risk Above 52.50 up to 57.50 PNB-BB

Above 50.00 up to 52.50 PNB-BB-

Above 47.50 up to 50.00 PNB-B+

Marginally Acceptable Risk Above 42.50 up to 47.50 PNB-B

Above 40.00 up to 42.50 PNB-B-

Above 30.00 up to 40.00 PNB-C High Risk

30.00 and below PNB-D Caution

Final Rating of the Company: PNB-BB

Details of any major event, if any, the effect of which are not yet cleared (major damage to plant/stocks, court judgment on environmental threats, involvement of promoters/company in excise/FERA/tax-evasion, recovery suit/winding-up petition filed by creditors/FIs/banks, any civil/criminal proceedings against the promoters/company, change of management etc.)

NA

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Chapter 8 Recommendations and Suggestions

The problems faced by the bank and the suggestions given are with regards to increase credit flow not only with respect to working capital finance but also project finance and asset finance. Problems faced by the Bank for any lending and suggestions to overcome some of these problems:

There is a critical need to devote substantial resources to improving the skills and capabilities of banks' lending officers, especially with regard to the analysis of the borrowers' financial statements. Understanding the nature of the borrower's business and the cash-flow required is paramount to preventing the creation of NPAs.

Banks are now better equipped to handle the varied needs of the SME sector due to better technology and risk management. As recommended by the Ganguly Committee, the Government has asked banks to adopt a full-service approach to cater to the diverse needs of the corporates. This, it recommends, may be achieved by extending banking services to recognize borrowers by adopting the 4-C approach: Customer focus, cost control, cross-selling and containing risk.

To enable the banks take more objective decisions, the Government plans to introduce a rating mechanism for designated industrial clusters; this may be designed jointly by Crisil, IBA, Sidbi and SSI Associations. This would enable institutional funding to be channeled through homogenous recognized clusters. This will reduce the interest rate difference in case of syndicate loans.

Another way of extending loans to the corporates is the relationship-lending rule, where the lending partly bases its decision on proprietary information about the firm and its owner through a variety of contacts over time. The information may be gathered from such stakeholders as suppliers and customers, who may give specific information about the owner of the firm or general information about the business environment in which it operates.

Insufficient data on the SMEs, the lack of credible published information about their financial health, the high vulnerability of small players in a liberalizing market and the inadequacy of risk management systems in banks are factors leading to higher NPAs and lower profitability than potential in SME lending. This can be overcome by collection of authentic data on the SME segment, educating the enterprises on the need for reliable financial data, evolving suitable risk models and close monitoring of accounts by the bank.

There is need to innovate their delivery platforms by using Internet banking, mobile banking and card-based platforms for delivery of transaction-banking as well as credit products, and enhance the service element. Companies look for convenience and simplicity in their banking requirements and banks should deliver these through an effective use of technology.

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Chapter 9 Conclusion

The study at PNB gave a vast learning experience to me and has helped to enhance my knowledge. During the study I learnt how the theoretical financial analysis aspects are used in practice during the working capital finance assessment. I have realized during my project that a credit analyst must own multi-disciplinary talents like financial, technical as well as legal know-how. The credit appraisal for working capital finance system has been devised in a systematic way. There are clear guidelines on how the credit analyst or lending officer has to analyze a loan proposal. It includes phase-wise analysis which consists of 5 phases: Financial statement analysis Working capital and its assessment techniques Credit risk assessment Documentation Loan administration Punjab National Bank of Indias adoptions of the Projected Balance Sheet method of assessment procedures are based on sound principles of lending. This method of assessment has certain flexibility required to avoid any rigid approach to fixing quantum of finance. It is superior and more rational compared to the Turnover Method; Cash Budget Method of assessment .It also facilitates the Bank to carry on follow up procedures. The PBS method have been rationalized and simplified to facilitate complete flexibility in decision-making. To ensure asset quality, proper risk assessment right at the beginning, is extremely important. That is why Credit Risk Assessment system is an essential ingredient of the Credit Appraisal exercise. The PNB was the second to formulate a Credit Risk Assessment model. It considers important parameters like profitability, repayment capacity, efficiency of the unit, historical / industry comparisons etc which were not factored in other models. It is equally efficient as the SIDBIs CART (Credit Assessment and Rating Tool) model.

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Bibliography

Books:

1. Mukherjee D. D.; 2010; Credit Appraisal, Risk Analysis and Decision Making- 5

th edition; Snow White Publications Pvt. Ltd., Mumbai

2. Dr. Chandra Prasanna ; Financial Management Theory and Practice

Websites:

1. http://www.pnbindia.in/

2. http://www.rbi.org.in/home.aspx

Punjab National Bank circulars, manuals and proposals