Learn · Credit appraisal and lending
Credit appraisal: how a bank decides whether to lend.
Credit appraisal is the bank’s structured judgement of whether a borrower can and will repay, how much to lend, on what terms and against what security. A credit officer studies the business, its accounts and its cash flows, writes a credit note with a recommendation, and a sanctioning authority or committee approves, changes or declines it.
What the appraisal looks at
A common way to organise it is the five Cs: character (track record and conduct of the promoters), capacity (cash flow to repay), capital (the promoters’ own stake), collateral (security if things go wrong) and conditions (the industry, the economy and the purpose of the loan). Security supports a loan; it does not justify one the cash flows cannot repay.
The ratios a credit officer reads first
- Current ratio: current assets ÷ current liabilities, a first look at short-term liquidity.
- Debt-equity and TOL/TNW: how much of the business is funded by borrowing against the owners’ funds.
- DSCR for term loans: (profit after tax + depreciation + interest on the term loan) ÷ (instalment + interest on the term loan). A DSCR comfortably above 1 means the project can service its debt with a cushion.
- Interest coverage: operating profit ÷ interest.
Working capital: the operating cycle
A business needs money to hold stock and give credit to customers until cash comes back. The working capital gap is current assets minus current liabilities other than bank borrowing. Under the Tandon Committee’s widely taught second method, the borrower funds at least 25% of current assets from long-term sources, and the bank’s maximum permissible bank finance (MPBF) is 75% of current assets minus other current liabilities. For smaller borrowers banks also use a simpler turnover method, setting the requirement as a share of projected sales.
After the loan: monitoring and NPAs
Appraisal does not end at sanction. Banks monitor stock statements, account conduct and covenants. An account with overdues is flagged as a special mention account (SMA-0 up to 30 days, SMA-1 31 to 60, SMA-2 61 to 90) and becomes a non-performing asset when overdue for more than 90 days.
A worked example: a working capital limit
A manufacturer asks the virtual bank for a cash credit limit. Projected figures for next year (illustrative, in lakh rupees):
| Item | Working | Lakh rupees |
|---|---|---|
| Current assets (stock, receivables, other) | From the projected balance sheet | 800 |
| Other current liabilities (creditors, provisions) | Excluding bank borrowing | 300 |
| Working capital gap | 800 − 300 | 500 |
| Borrower’s minimum margin | 25% of current assets | 200 |
| MPBF | 75% of 800 − 300 | 300 |
The bank could consider a limit up to 300 lakh, provided the borrower brings 200 lakh of long-term money into working capital. The officer still checks whether the projections are believable against past years, whether receivable and stock periods are in line with the industry, and how drawings will be controlled against stock statements.
Key terms
- Credit note: The appraisal write-up with the analysis, risks, terms and recommendation.
- Cash credit: A running working capital limit secured by stock and receivables.
- Drawing power: The amount a borrower may actually draw at a time, worked out from current stock and receivables less margin.
- Covenant: A condition in the loan agreement, such as a minimum ratio, the borrower must keep.
- Expected loss: Probability of default × loss given default × exposure at default.
Practise it in TrezCap
Reading is the start. In TrezCap you do the job in FinTreasury Bank, our virtual bank: the platform calculates every figure, you take the decision and see the consequence. Free to try.
The 100 Crore Credit Decision
Appraise a corporate loan, take it to the credit committee, and live with it 12 months later.
Open in TrezCap →Working capital: where is the money sitting?
Read the operating cycle and find the cash.
Open in TrezCap →Credit appraisal simulations
Loan officer, DSCR, working capital limits, trade finance and loan classification.
See the page →Questions
What are the 5 Cs of credit?
Character, capacity, capital, collateral and conditions. They organise a credit appraisal around the borrower's conduct, ability to repay, own stake, security and the business environment.
How is MPBF calculated?
Under the Tandon Committee's second method, maximum permissible bank finance is 75% of current assets minus current liabilities other than bank borrowing. The borrower funds at least 25% of current assets from long-term sources.
What is a good DSCR?
There is no single figure, but lenders look for a DSCR comfortably above 1 across the loan's life, so the project can pay its instalments and interest with a margin for a bad year.
When is a loan classified as an NPA?
When interest or an instalment remains overdue for more than 90 days. Before that, overdue accounts are tracked as SMA-0, SMA-1 and SMA-2.
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