PROJECT FINANCING:

Introduction: The Bank Primarily involves in commercial banking activities. But subject to availability of credit line and own resources, the Bank may provide term loan specially to industries within the framework of industrial policy of the Government and credit norms set by Bangladesh Bank and the Government from time to time. Systematic analysis is required to be undertaken to provide a rational basis for decision making.  Socio-economic objectives of the country needs to be considered in addition to the soundness of the project in terms of technical, commercial, financial and management considerations while making investment decision.

Project Evaluation:

The proposal may be for a new project or an existing project requiring Balancing, Modernization, Replacement and Expansion (BMRE). The proposal to be developed in the following areas :

1. i) Cost of the project and means of financing
2. ii) Financial projections covering sales, cost of production, profitability, cashflow etc.

iii)        Analysis of past financial operation in respect of existing concerns on the basis of financial statements of the concern.

Cost of the project:

The cost of the project represents all fixed capital expenditures incurred or to be incurred for acquisition of its fixed assets and the net working capital to run the project. Proper assessment of the cost of the project is very important for fixation of debt/ equity contribution of the Bank. After determining cost of the project, financing plan shall have to be worked out on realistic basis.          

Fixed cost of the project:

The fixed cost of a project is the aggregate cost of land, building construction, plant, machinery and equipment, preliminary and pre-operative express (including interest during construction period.

Means of financing / Debt-equity ratio

Means of financing / Debt-equity ratio

Contribution from the sponsors in the form of paid up capital, director’s loan etc. form part of the equity. Contribution from the bank is considered as debt. Debt equity ratio should be set in a manner that the sponsors have reasonable stake in the project. In case of BMRE project, debt equity ratio shall be fixed on incremental cost of the project.   The maximum limit of term loan to a project is essentially depend on the debt repayment capacity / cash flow of the project. Bank’s policy, nature of business, entrepreneurs background, market condition, extent of risk associated with the business etc. influences in determining debt equity ratio. The owner’s equity should form a larger part in the following cases :

i) A speculative industry

ii) A seasonal industry with periodical swings in production

iii) An industry which is competitive domestically and internationally

iv) An industry that lacks Government encouragement for economic reasons

and

v) In case where the sponsors are new in the field and the capacity is yet to be

tested.

Project on rented premises:

In case the project is located on rented premises, advance rent (if any) shall be included in the cost of the project as prepaid expenses and adequate collateral security covering the loan amount should be obtained.

Working Capital:

Apart from the investment in the fixed assets, funds are required for investment in current assets like stocks of raw materials, work-in-process, finished goods, stores and spares, debtors etc. The portion of funds, which remain invested incurrent assets of a concern, is called working capital. A portion of working capital remains tied up in the business over the years, called funding from long term sources like other portion of working capital varies from time to time, generally met from short-term sources like commercial bank borrowing and creditors. The net working capital may also be termed as excess of current assets over current liabilities. Net working capital is a long term requirement of a project. So, it is to be met through long term sources like equity or long term loan.

Computation of working capital:

The following factors generally influence in the computation of working capital :

i) General nature and types of business

ii) Capacity utilization of the project.

iii) Span of production process

iv) Sales volume

v) Terms of sales and purchase

vi) Inventory turnover

vii) Receivable turnover

viii) Business cycle

ix) Seasonality of product

x) Seasonality of raw materials

While computing working capital requirement, apart from the above factors, Banks policy and Bangladesh Bank’s instruction from time to time to be kept in mind. However, following are the generally accepted guideline for calculation of working capital :

Capacity utilization:

(a) Existing unit     :    5% above the last year’s actual capacity                                     utilization.

(b) Net unit     :           60% of attainable capacity/ rated capacity.

(ii)        Inventory (a) Imported raw materials  :         90 days (cost at factory site)

(b) Local raw materials      :           30 days (cost at factory site)

(c)  Work-in-process          :           3 days (at production cost)

(d)  Finished goods :   15 days (at production cost)

(e)  Stores and spares         :           90 days for imported spares 30 days for local spares (cost at factory site)

(iii)  Receivables  :  15 days (at production cost)

(iv) Cash in hand  :   Cash requirement of 30 days for other day to day expenses like salary, transportation, postage, utilities etc. For computation of Bank facility, receivables and cash in hand is generally excluded and the margin from the client depends on the bank client relationship which should not be less than 20% in any case.

Credit Investigation and selection of sponsors:

The task before the bank is to choose right type of entrepreneurs who can be trusted with the money given for setting up an industrial unit. Money can be created only when it is handled by people possessing business acumen, knowledge and skill required to implement and run the industry profitably. An industrial project satisfying the requirements of technical soundness, commercial, financial and economic viability will almost invariably fall if wrong persons are chosen to execute and run the industry. It is, therefore, obvious that choice of customer constitutes one of the most important factors to which a Bank must give great emphasis. The credit investigation conducted by a banker seeks to evaluate the entrepreneurial ability, managerial experience, business acumen, integrity, reputation and financial worth of promoters applying for Bank’s financial assistance for setting up industries or BMRE of a project.

In order to judge the sources of information may be divided broadly into two categories namely documentary and non-documentary. Client’s financial worth can be assessed with reasonable accuracy based on the following documentary sources of information.

Any client who holds assets in a form other than hard cash, gold or jewelry should be in a position to produce documentary evidence.

For fixed assets there will be original Title Deeds, structural layout plan, which would give the details of the properties such as area, location, nature and value.

For deposit with bank’s there would be bank statement of deposit.

If the customer is in business, he is in a position to produce Income Tax Certificate. This document will provide reliable indication of cash flow sources of income.

Moreover, investigation often reveals that the declared properties are jointly owned  with others which necessitates scrutiny of the Title Deed. Further, the properties owned and declared by the clients may have liabilities on account of unpaid balance of purchase price of the properties or loans obtained on their security. The credit investigation of the clients also look for their individual liabilities for a realistic assessment of their worth. The particulars of assets and liabilities furnished by the sponsors should, therefore, be analyzed and assessed in the following manner:

The valuation, should be assessed keeping in view the value they are likely to fetch in a forced sale conditions.

In order to assess if the properties are free from encumbrances, a search in the office of sub Registrar, Joint Stock Companies should be conducted. Where this is not possible at all, the investigation officer/ the legal advisor of the bank should examine Title Deeds of land, and other documents.

As regard other movable assets like shares in Joint Stock Companies, share/ debentures of Public Limited Companies, Govt. securities etc. the client should have no difficulty in providing the documentary evidence.

Balance sheet and statement of accounts

The analysis of financial statements of a concern would provide information on liquidity, activity and profitability position of the concern. The financial soundness of a business can be determined by using different indicators from the Balance Sheet and Profit and Loss Account which is known as the ratio analysis.

Bank’s past experience

In many cases, the applicant may have already availed loans either for the project or for some other purposes from JBL or from different financial institutions. In such cases, the credit inquiry will provide valuable information about their worth, dealings and present status of the liabilities. Some times the sponsors may conceal their liabilities with other financial institutions. Therefore, even if, the sponsors declare their liabilities or not a confidential Credit Investigation Report should be obtained from other Banks as well as from other divisions of the same bank. The credit inquiry shall include such details as date of sanction, amount of loan sanctioned, repayment performance, outstanding as on date, overdue if any, securities available.

Report publications

There is another documentary source of information namely the official gazette, press reports regarding suits by or against persons and parties insolvency and liquidation of particular individual or enterprise, black listing and/ or similar punitive action against individuals, firms etc. by the Govt. Autonomous bodies etc. which are very valuable and reliable and which the banker can not afford to overlook.

Banking Transaction

Clients carry on normal business, maintain deposits and also avail overdraft facilities. A detailed review of these accounts will give very valuable information about the financial standing of the clients.

Report from Trade Circle

More information relating to sponsor’s worth, size of business, turnover, integrity, reputation, honesty, business morality conduct etc. of the clients can be obtained from other traders in the same line. A client engaged in a manufacturing business must invariably have constant trade links with the wholesale market. The credit investigation officer has to make an independent inquiry and talk to a cross-section of traders to collect as much unbiased opinion as possible.

Source of equity

The client may own lot of properties and assets but these do not ensure cash availability for investment within short span of time available for construction and implementation of the project. It may be necessary to raise cash either raising of equity through borrowing on the security of the sponsor’s property or through sale of property. Borrowed fund will be discouraged, if the borrowed fund thus raised is to be paid back out of earnings of the new project. The sponsors may have several other sources of mobilizing equity e.g., cash in hand, bank deposits, dividend income, marketable securities, internal cash generation of the existing business etc. All these sources should be thoroughly examined.

Technical Appraisal

Following areas to be looked into during technical appraisal :

Product, process and the capacity

Product to be identified, production process to be chalk down and capacity of the project to be determined.

Land and Location

Location of the project should be suitable with all infrastructure facilities. Other relevant issues like proximity to market, availability of raw materials and worker, environmental issues to be looked into before selecting of location. The size of the land should be the area actually required for the project keeping, however, in view the provision for future expansion according to the plan of the project. The value of land not required immediately for the project should be done on the basis of actual purchase price or the market whichever is lower. The land cost will include cost of registration and land development.

Building          

The area and nature of construction should be determined as per requirement of the project. The estimates should be based on quantitative analysis in respect of various building materials rather than on a flat rate basis. Floor space should be determined on the basis of Block Diagram of machinery of the project. During estimation of civil construction, requirement and cost of office building utility house, boundary wall and internal road etc. to be looked into.

Machinery and equipment

The cost of machinery, spares etc. constitutes the largest component of total cost of the project. All costs related to machinery including duty, tax, insurance, freight, installation etc. should be taken into consideration. The value of machinery and equipment should generally be determined on the basis of three competitive genuine price quotations. Technology, technical know-how and the installation aspect  alongwith cost to be address.

Other fixed assets

The project should include furniture, fixture, office equipment etc. as per requirement. Preliminary expenses, cost for trial production, interest during construction period should also be included in the cost of project. It should be kept in mind that no item is left out and if there is any requirement of contingencies.

Pre-operating expenses

Initial cost like survey, plan, drawing, salary allowance of the employees during implementation, promotional fee, legal documentation fee, consultant fee, commission, interest during construction period etc. are the part of project cost and to be included during preparation of project cost.    

Requirement of raw materials Item wise requirement of raw materials to be quantified and the price and duty structure to be mentioned to arrived at the actual cost of raw materials. Sources of raw materials whether imported or local to be mentioned. Requirement of packing materials should also be taken care of.

Requirement of utilities Requirement of utilities, source and the cost thereof are to be attended.

Waste disposal Wastage of raw material during processing and handling are to be determined with utmost care. Impact of wastage during calculation of raw materials and finished goods needs to be addressed properly. Necessary arrangement for disposal of wastage also to be made.

Environmental impact and pollution control

Effect on environment and pollution hazards may be taken into consideration. Measures must be prescribed regarding negative effect on environment. Steps required to control the possible pollution should be identified and mentioned in the report.

Implementation schedule

Project implementation schedule to be drawn realistically under the major head of expenditure like purchase of land and land development, civil construction, procurement of machine, installation of machinery, trial product and the commercial production.

Market Appraisal

Market in a broader sense, is termed as the sum of contracts between buyers and sellers of a product or service, the price and quantity exchanged and which are determined by the forces of demand and supply. Following areas need to attended in the market appraisal :

• Application of product and services
• Target market – Local/Export
• Target market – Local/Export
• Demand/Supply analysis
• Substitute and competitors
• Proposed marketing/Distribution Arrangements
• Proposed Buyers
• Price competitiveness
• Promotional Aspects.       
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• FINANCIAL PROJECTIONS AND ANALYSIS

Investment proposal may be for an existing unit or for a new project. In case of existing project, analysis of past performance will give some indication for undertaking the investment proposal and justification for financing from the bank. But for the proper analysis, financial forecasting is required. In case of new project, financial forecasting is a basic and widely used tool for making investment decision. Apart from cost estimation, financial forecasting basically involves developing three interest inter-related statements namely the following :

• Earning forecast
• Cash flow statement and
• Projected Balance Sheet

•  

•   Earning forecast

The earning forecasts measure cost of production and profitability relating to a particular period or a number of periods as may be used for the purpose of forecasts. A three-year period is needed to be seen by the Bank to arrive at an investment decision. The earning forecast involves the estimation of sales and estimation of associated costs that shall have to be incurred to achieve the projected sales.

Estimation of sales

In estimating sales, the quantity to be sold is to be determined first and then the selling price to be applied to estimate the sales in monetary terms. Factors influencing the physical and monetary value should be carefully examined, so that sales are not overestimated.

Estimation of cost of sales

Major items of costs should be identified and highlighted in estimating the total cost of sales. Some cost items such as those relating to raw materials, rent, tax, insurance, water, power, fuel, interest etc. can be estimated at actual with great deal of accuracy. On the other hand many of the administrative and sales expenses can be estimated only with rough approximation. Attention to be given to the effect that costs is not underestimated. The difference between the sales estimates and the cost estimates is the estimated profit.

Cash flow

One of the major tasks in financial forecasting is to assess the requirement of funds and to find out how those requirements can be met. It involves estimation of cost and sources of fund, estimation of income from future operation, liabilities that shall have to be incurred and the proposed investment in future assets.

Balance Sheet

The projected balance sheet is prepared at the end because figures for developing this statement are derived directly from the cash flow statement. At any point of time the assets of a concern must equal its liabilities. Therefore, if the calculations at the stage of preparing the earning forecasts and the cash flow forecast are correctly made then two sides of projected balance sheet must agree. In essence the projected balance sheet shows the impact of various assumptions and calculations relating to sales, costs, and uses of fund etc. upon the proposed assets, liabilities and equity of the concern.

Objectives

Financial Forecasting will suggest determining the following :

• A suitable financial structure,
• An acceptable repayment schedule, and
  • Suitable terms and conditions to guard against the weak areas so that the payments to the bank for interest and installments of the principal do not go by default and the stipulated security during the currency of the loan does not face dilution.

As a long term financier, Bank’s attention should be on the earning of the project, Earnings should be sufficient to cover the payment of interest and repayment of installments of the principal (Debt service coverage). The actual cash generation through operation should be adequate to meet not only the obligatory payments to bank but to sustain in any contingency as may arises and retain sufficient earnings to the owners.

Analysis

In case of BMRE loan proposal, the project will have relevant operating past. The analysis of the past operation of an existing concern is of great usefulness in predicting, with a fair degree of accuracy, the future results of business activity and the future ability of an enterprise to meet its credit obligation. In such cases, the financial statement of the concern for the past three consecutive years should be reviewed to form a correct opinion. An analysis of the past operation of the enterprise will give indication about the following :

• The ability of the sponsors to implement and run the project ;
• The capability of the sponsors to mobilize funds from the current operation of the enterprise or from outside sources as required for the project ;
• The basis for forecast for improved ability / or enhanced capacity of the project.
• Judging the profitability of operation during the past period ;
• Indicating the trends which may reveal future probabilities ;
• Determining the financial condition at a specific date ;
• Predicting the future ability to meet the existing or anticipated credit obligation ; and
• Judging the capability of the management in meeting the changing conditions arising out of implementation of the proposed project or on-set of a bad business time.
•  

RATIO ANALYSIS:

The financial statement of an existing concern or future projections for a proposed investment may be analyzed through calculation of a number of financial ratios. Many types of financial ratios may be calculated and used. But the purpose for which the analysis is made will suggest emphasizing one set of ratios in preference to another. For example, for short term credit, emphasis should be given on current position of the borrower. Profitability of the project is somewhat less important in such cases. For long term loan emphasis should be given on earning power of the assets rather than on the mortgage of such assets. The ratios can be classified into the following four fundamental categories :

• Liquidity ratios
• Leverage ratios
• Activity ratios
• Profitability ratios

Liquidity ratio Liquidity ratios are designed to measure the ability of the concern to meet its immediate and maturing debt obligations. Ratios in these categories will provide some indications in this regard. Following are the most commonly used ratios :

(i) Current ratio = Total current assets / Total current liabilities This ratio measures the margin of safety to allow for unevenness in the flow of funds through current assets and current liabilities. Normally the current ratio should not be below 2:1. However, fi the project enjoys rapid turnover of inventories or can collect its receivable quickly, a lower ratio of 1.5:1 may be considered satisfactory. In interpreting this ratio, reference should, however be made to the proportion of various types of current assets and their relative quality. (ii) The quick ratio = (Current Assets – Inventories) / Total current liabilities.  

Leverage ratios

• Debt-Equity ratio = Long term debt / Equity
• Debt Service Coverage Ratio = (Profit after tax + Interest on long term loan + Depreciation) / (Installment + Interest on term loan).
• Fixed Assets Coverage Ratio = Net tangible fixed assets / Long term debt.

Activity ratios

• Inventory turnover ratio = Cost of goods sold or sales/ Average inventory (Average of opening and closing stock)
• Accounts Receivable Turnover ratio = Receivables / Sales per day or per week.

Profitability ratio

1. i) Profit margin = Net profit before tax / Sales
2. ii) Return on Investment = (Profit after tax + interest on long term

loan)/(Equity +Long term loan). iii)        Return on Equity = Net profit after tax / Average Equity (Average of opening and closing equity).  

Break-Even Analysis

The basic strength of a project lies in its overall profitability. But it is equally important to know the point of sales, capacity utilization, level of production or price to cover the expenses and starts profit earning. The point of activity at which the project would neither earn profit nor incur loss is called Break-even point. Profit Volume (PV) ration = Variable cost / sales Break even point = Fixed cost / PV ratio

Financial Rate of Return (FRR)

Financial rate of return measures the potential earning power of a project considering time value of money covering entire life of the project. This is nothing but a discounting factor at which the value of total inflow of cash equates the value of total outflow of cash, i.e, net present value (NPV) is zero. The FRR is found out by interpolation of two discounting factors as under :

FRR =  Lower discounting rate + (NPV at lower discounting rate / (NPV at lower discounting rate minus NPV at higher discounting rate) x (Higher discounting rate minus lower discounting rate)).