Credit Appraisal and Assessment:

Introduction: Credit appraisal process is an essential part for investment decision and project selection. Credit appraisal may be defined as a detailed evaluation of the credit proposal to determine the technical feasibility, economic necessity, marketing prospect, financial viability of the project and managerial competence required for its successful operation. The main objectives of credit appraisal are:

a) To decide whether to accept or reject the investment proposal.

b) To recommend, if it is not designed properly, in which way it should be redesigned or formulated so as to ensure better technical, financial, commercial and economic viability. Thus credit appraisal assist to ascertain expected rate of return of the investment. It enables a person to select the proposal, which will be best suited to him in view of its managerial, financial, technical and socio-economic aspects. “Credit appraisal”, in simple terms, means pre-investment analysis of an investment proposal with a view to determining, its commercial and socio-economic feasibilities i.e. to examine as to whether a proposed project is going to take up for implementation and finance is:

commercially profitable,·

economically viable and at the same tune.·

socially desirable.·

Importance of Credit Appraisal:

From the viewpoint of Bank/Financial Institution·

Identification of right borrower with acceptable level of credit risk  Evaluation of the commercial, technical, and socio-economic feasibility of a project  Compliance with banking and legal laws of the country Study Material on Basic Level Credit for NCC Bank Limited 53 | P a g e  From the viewpoint of the Borrower·

Being sure about the overall viability of a project to be undertaken.  A way to receive suggestions to improve any shortcomings of the project.  From national point of view·

Optimum utilization of resources  Achievement of national objectives.

Different Aspects of Credit Appraisal:

The main task of the appraisal exercise is to justify the soundness of an investment proposal by the financier by means of a critical and systematic analysis of different elements of a credit proposal. There are various techniques available for appraising or evaluating a particular credit proposal. Generally financial institutions apply following techniques and feasibility tests to evaluate a particular credit proposal;

Managerial Aspect·

Technical Feasibility·

Marketing Aspect·

Financial Viability·

Socio-economic Aspect·

Environmental Aspect·

Managerial Aspect:

In credit proposal one should describe proposed arrangement for executive management of the concern both during the construction period and for regular operations thereafter. Appraisal report also includes the particulars of proposed key technical, administrative and accounting personnel. If the management is incompetent even a good project may fail. It is rightly pointed out that if the project is weak, it can be improved upon, but if the promoters are weak and lack business acumen, it is difficult to correct the situation. It is therefore, natural that the financial institution very carefully appraises the managerial and organizational aspects before sanctioning assistance for a project. For managerial and organizational appraisal it is necessary to evaluate the following matters-

Academic Qualification·

Business and Industrial Experience·

Managerial Ability·

Skills of the Manager and Management Team·

Past Performances of the Promoter·

Management Soundness·

Technical Feasibility:

The importance of technical appraisal in project evaluation needs no exaggeration. Technical appraisal of a project broadly involves a critical study of the following:

Location and Site·

Size (Plant Capacity)·

Technology, Plant and Equipment·

Building and layout·

The following questions will be answered while assessing the technical feasibility:  Is the engineering design of the project sound?·

Has the size of the project plant that is, the proposed scale of operation been·

determined on a correct assessment of the requirement of the industry vis-à-vis market size?  Has due consideration been given to alternative production process?·

Are the inputs needed by the project available at reasonable costs?·

Is the location of the project brings maximum economic advantage?·

Marketing Aspect:

Marketing aspect is very important from banker’s point of view because it is ultimately the sale of the goods in the market that will generate necessary cash flow for repayment of bank loan. Therefore, bank must carefully analyze marketing aspect of the project to understand demand and supply gap, detail marketing plan, feasibility of the projected sales, marketing channels etc. Marketing Analysis: Why?

To analyze the aggregate demand of the proposed products/services in the future·

To estimate the market share of the project under appraisal·

Marketing Analysis Generally Address the following Issues:  A brief description of the market·

Analysis of the past and present demand and supply·

Estimate future demand of the product·

Estimate projects share of the market·

Analyze structure of the competition and elasticity of demand·

Information about consumer behavior, intentions, attitudes, preferences and·

requirements  Determine distribution channel and marketing policies in use·

Two considerations are taken into account while analyzing the marketing aspect.  Company’s external or macro-environment: Industry and competitive·

conditions  Company’s internal or micro-environment: Competencies, capabilities,·

resource strengths and weaknesses, and competitiveness Industry Analysis: The main objective of the industry analysis is to identify the main sources of competitive forces that lie within the industry and strength of these forces. The key analytical tool is the ‘Portars’ five forces model of competition which are:  Assess strength of each of the five competitive forces (Strong? Moderate? Weak?)·

Bargaining power of buyers and buyer-seller collaboration  Explain how each force acts to create competitive pressure.·

Decide whether overall competition (the combined effect of all five competitive·

forces) is brutal, fierce, strong, normal/moderate, or weak Company Analysis:

The important tool that is used to analyze the company competitiveness is SWOT analysis. SWOT represents Strengths, Weaknesses, Opportunities and Threats. For a company’s strategy to be well conceived, it must be matched to both  Resource strengths and weaknesses§

Market opportunities and external threats to its well being§

Financial Viability:

The main purpose of financial appraisal is  To assess if the proposed project is viable in terms of its operation in the future years·

and its financial soundness.  To see whether the project will be able to generate sufficient surplus after meeting all·

operating costs and other day to day transactions to meet its long-term debt obligations. The financial appraisal of a project thus covers the following aspects  Preparation of Financial Statements: Income Statement and Balance Sheet·

Analysis of Income Statement and Balance Sheet·

Cash Flow Statement Analysis·

Financial Projection and Preparation of Projected Financial Statements·

Cost-Volume-Profit Analysis·

Cost of the Project and Means of Financing  Capital Budgeting Techniques·

Sensitivity Analysis·

Assessment of Working Capital Requirement·

Socio-economic Aspect:

In case of certain projects like irrigation projects, power projects, transporting projects, or other infrastructures projects national profitability or the net socio economies benefits consideration are as important as, and sometimes more important than, commercial profitability considerations. For evaluation of national or socio economic benefits, the following aspects are generally considered.  Opportunity cost.·

Shadow prices.·

Employment generation·

Income distribution·

Self-reliance·

Development of small Scale and ancillary industries·

Improvement of infrastructure·

Improvement of quality of life and well-being of the society etc.·

Environmental Aspect:

One of the basic flaws in project planning and design is the complete negligence or minimal consideration of environmental and social costs and dependence only on economic analysis for project preparation and investment. A failure to understand and internalize the adverse or negative impacts on environment during project preparation could lead to several undesirable consequences, which may ultimately jeopardize the very objectives of growth and development for which the project was proposed. It is argued that sound environment management reduces the unforeseen obstacles and bottlenecks that may otherwise hamper the delivery of project objectives while helping to improve the environmental performance of project operations. The key environmental issues resulting from agricultural, mining, manufacturing, and urban operations include:

severe degradation of air quality due to industrial and vehicular pollution·

contamination of land and water resources due to pesticides, chemical, fertilizers,·

and dumping of hazardous wastes  depletion of mineral reserves·

contamination of surface and ground water sources due to discharge of sewage and·

industrial effluents  deforestation·

Environmental impact assessment (EIA) study is suggested as a tool for formulating an environment management plan. EIA should, however, not be treated just as a tool for regulatory compliance but as an instrument for improving project management with proper expertise, time, and budget allocations made for the purpose.

Environmental Risk Management:

Guideline and Environmental Risk Rating Environmental Risk Management is for assessing environmental risks and not intended to squeeze investment; rather it is for sustainable finance. Environment management in the banking business is like risk management. It increases the enterprise value and lowers loss ratio as higher quality loan portfolio results in higher earnings.

Bangladesh Bank published first Policy Guidelines for Green Banking and Environment Risk Management in 2011. The financial sector as a whole could not comply with the implementation deadline with initial difficulties in applying those but has come forward under the umbrella of BB to promote and support green banking in Bangladesh. Traditionally, banking sector’s concern for environmentally degrading activities of clients is like interfering or meddling in their business affairs. However, now it is being perceived that environmental hazard brings risks to their business. Although the banking and financial institutions are not directly affected by the environmental degradation, there are indirect costs to banks. Due to strict environmental disciplines imposed by the competent authorities across the countries, the industries would have to follow certain standards to run their business. Credit risk can arise indirectly where banks are lending to customers whose businesses are adversely affected by the cost of cleaning up pollution or due to changes in environmental regulations. Credit risks are also associated with lending on the security of real estate whose value has diminished owing to environmental problems (additional loss in the event of default). Guidelines on Environmental Risk Management32 was prepared and circulated by BB on January 30, 2011 to support Policy Guidelines for Green Banking (2011) featuring 32 BB BRPD Circular No-1, January 30, 2011

qualitative assessment of environmental risks for the financial sector. This guideline, developed with the assistance of IFC, covers different conceptual aspects, applicability and benefits of ERM along with organizational requirements, technical manual and technical annexes for the financial sector in a consultative manner. The ERM guideline prescribes a set of sector specific ‘Environmental Due-diligence Checklist’33 for financing environmentally sensitive sectors34 by banks. Banks/FIs should conduct a preliminary environmental risk review on each credit proposal using Environmental Due Diligence (EDD) checklists. There is one General EDD checklist, ten Sector EDD checklists and a Guidance Matrix. Potential borrowers will have to submit various documents to the DOE for obtaining the Environmental Clearance Certificate. Banks/FIs need to obtain copies of these documents as the background for completing the EDD checklists. The outcomes of both the General and Sector specific EDD checklists are combined in the Overall Environmental Risk Rating (EnvRR). Finally, it is a ‘yes’ or ‘no’ decision for financing the proposed credit based on subjective judgment of ‘High’ ‘Low’ or ‘Moderate’ EnvRR. For ‘High’ EnvRR the credit risk management should ensure that additional conditions/covenants are included.

The EnvRR should be considered along with the overall credit risk rating of a proposed credit for financing decision. Environmental Risk Rating are required for all individual customers (corporate, institutional, personal, small and medium enterprise) whose aggregate facilities are above BDT 2.5 million for SME, financing; BDT 10 million for Corporate, financing and BDT 10 million for Real estate financing.

In this guideline Bangladesh bank designed 14 environmental due diligent checklists. One for general and other thirteen are sector specific. Among the thirteen sectors, six are included in red category and six in orange category in the environmental conservation act 1995. In this due diligent checklist BB focused on applicable environmental compliance certificate, location of land, protection against climate change impact, top management commitment to environmental management, potential borrower’s planning to address environmental issues, manpower’s skill in addressing environmental issue, solid waste management, air emissions prevention and control measures systems, ETP and waste water management, labor and social issues etc. are considered. 34 Agri-business, cement, chemicals, housing, engineering and basic metals, pulp and paper, tannery, Sugar and distilleries, textile and apparels, and ship-breaking.

Environmental risk rating In the green banking policy, Phase-I, the environment risk management gets a privileged in credit risk management. In 2011, Guideline for environment risk management was introduced and in green banking policy the ERM is incorporated to minimize the environment risk. According to this guideline, banks/FIs are required to measure the environmental risk considering the environment due diligence checklist (provided by this guideline). The number of rated projects is increasing over the years.

According to the ERM guideline, banks are supposed to place the high rated projects to the Board for approval. In most cases, banks do not have policies or guidelines for the approval of these high rated projects. The ERM guideline requires banks to establish and maintain a database of NPLs due to environmental reasons and to have a reporting system on an annual basis.