Credit Manual Advance Level (PDF)

Introduction 1.1 Background The most important activity of banks is to extend loans to deficit economic units. In lending activities, money is chanelled in the manufacturing and productive sectors in line with the industrial policy which contribute most to economic development of a country. Moreover...

Introduction 1.1 Background The most important activity of banks is to extend loans to deficit economic units. In lending activities, money is chanelled in the manufacturing and productive sectors in line with the industrial policy which contribute most to economic development of a country. Moreover, economic development becomes smoother when banks disburse quality credit with appropriate amount, products & services to all types of business and all segments of the population at an affordable cost with a view to include financially excluded segment of the population. Credit is the significant revenue generating source of banks but, at the same time, the single most potentially devastating risk arises from the loan portfolio of banks i.e. risk of non-payment by the borrowers. So, managing credit portfolio is crucial for a bank in order to trade-off between risk and return. Achieving this prudent risk-return mix, demands an effective management of loan quality. Loans and advances constitute a significant part, which is around 65 percent of the total assets of all commercial banks of Bangladesh. Hence, good quality credit is a key determinant of the financial health of banks. As such, it is important to have a well-defined credit policy, sectoral preference, collateral requirement, appropriate credit concentration, credit assessment, risk grading, pricing, etc. for maintaining a good credit portfolio. As a result, managing quality loan portfolio is a multidimensional activity where all major stages in a credit cycle such as loan initiation, credit assessment and selection, credit administration, credit monitoring, recovery procedures of loan are required to be dealt with professionally and efficiently for having a strong and robust credit culture in a bank. Recently, the business environment of banks has changed as it has become much more competitive. Moreover, some new banks’ entry in the credit market has fuelled the competition yet further. The nature as well as magnitude of financial services has expanded rapidly in recent times. Banks are regularly introducing numerous new financial products considering various business requirements borrowers. Banks are now also focusing on financial inclusion and are offering extended SME banking services including women entrepreneurs. Moreover, mobile banking and online banking platform have Study Material on Advance Level Credit for NCC Bank Limited 1|Page largely changed the banking business environment and gave a new shape of banking. Besides, sharecropper financing, school banking, green banking, agent banking etc. have remodeled the banking business operation, particularly credit operation. In order to disburse quality loans, selection of good/right borrowers is a big challenge for a bank because in most of the cases banks do not know the borrowers' financial health and integrity at the very beginning of a loan application. Banks usually manage the detrimental effects of adverse selection by screening loan applications. Collateral requirement sometimes is thought as an attempt to lessen the unfavourable impact of adverse selection problem. But banks should not put too much emphasis on collateral; rather, pre-sanction assessment and proper borrower selection at the preliminary stage is badly needed to ensure quality of credit portfolio. Moreover, banking sector witnessed a number of well-publicized scams in recent time. Excessive loan concentration on single borrower or in a sector or in a geographical area and even against weak guarantees as well as difficulties in loan repayment due to the economic disruptions was also observed. Moreover, excessive profit motive of some banks, unhealthy competition to attract well off borrowers with undue benefits, absence of separation of different wings of the Credit Risk Management (CRM) department, weakness in credit appraisal system, poor internal control mechanism etc. are considered as the reasons for the poor image of credit operation in Banks. These events fueled the rise of non-performing loans which makes the banking sector unsustainable. For sustainability, a sound credit operation is a must. Sound credit practices will not only help the banks themselves, but also help ensuring financial stability in the banking sector. This manual is an endeavor to capture the sound practices or best practices related to the credit operations of a bank. 1.2 Coverage of the Manual The manual covers credit related activities of commercial bank with special reference to NCC Bank limited. The advance level manual assigned special focus on credit planning, activities of credit operations, borrower selection process, techniques of credit appraisal, credit risk rating, credit approval process, banking product pricing techniques, credit administration, credit recovery, credit risk management and structured finance products. Study Material on Advance Level Credit for NCC Bank Limited 2|Page 1.3 Organization of the Manual This manual is organized into 12 chapters including introduction and these are: Chapter–2: Credit Planning; Chapter–3: Activities of Credit Operations in Banks; Chapter–4: Credit Appraisal and Assessment; Chapter–5: Analyzing the Financial Viability; Chapter–6: Credit Risk Grading; Chapter–7: Credit Approval Process; Chapter–8: Banking Product Pricing Techniques; Chapter–9: Credit Administration; Chapter–10: Credit Recovery; Chapter–11: Credit Risk Management; and Chapter–12: Structured and Innovative Financial Products. Study Material on Advance Level Credit for NCC Bank Limited 3|Page Credit Planning Credit is a main source of earning and cash flow of a bank. Credit failure may be a reason for bank failure. Therefore, it is really important for a bank to expand credit portfolio in a planned way. 2.1 Credit Planning at the Bank Level Credit planning at bank level implies estimating total loanable fund that are likely to be available within the given period and then allocating the same amongst various alternatives uses in conformity with the guidelines issued by the central bank and priorities. Credit planning activities of a bank is important for achieving the following objectives: one, maximization of profit; two, diversification of credit portfolio; three, ensuring the best alternative use of fund; four, providing credit to right person at right time at right quantity; and five, compliance with regulatory limits and priority. Bank level credit plan should be made by giving due consideration of the following points.  Government priority set in the in 5-year plan  Government priority set in the national budget  National level credit growth target set in monetary policy  Industrial policy  Export and Import policy  Bank’s profit target  Bank’s deposit growth plan  Bank’s current portfolio structure  Prudential regulations  Regional and sectorial imbalances Due consideration on the above mentioned points or documents will help bank management to understand the regulatory limits, incentives, government priority, policy and limits. As such bank will be able to formulate plan in line with national priority and regulatory limits. An indicative summary format for bank level credit planning is given in Table 2.1 Study Material on Advance Level Credit for NCC Bank Limited 4|Page Table-2.1: Indicative Planning Sheet: Credit Planning Amount No of A/C Amount Term Loan Demand/ Working Capital No of A/C Amount No of A/C Amount 1 A. Industries A-1 Small A-2 Medium A-3 Large A-4 Others Estimated loans required to new units during budget year Term Demand/ Loan Working Capital No of A/C Loan provided during the Additional year loans required to existing units in Term Loan Demand/ budget year Working Capital 2 3 4 5 6 7 8 9 10 11 B. Agriculture B-1 Crop loan B-2 Dairy B-3 Poultry B-4 Others C. Trading (import/export) D. Services E. Others F. Total (A+B+C+D±E) 2.2 Credit Planning at Regional Level or Branch Level Credit planning at the regional or branch level usually consists of the following tasks Adherence to the policy guidelines of the head office and supplementary policy guidelines prepared by the regional/zonal office on the basis of indicative regional credit plan.  Determination and analysis of the command area of the region or branch concerned.  Finding out the major sectors of the economy of the command area such as agriculture, small, medium and large scale industry etc. Study Material on Advance Level Credit for NCC Bank Limited 5|Page  Dividing the major sectors into different sub-sectors, as for example, agriculture sector may comprise cultivators, dairy, poultry, etc.  Classification of the existing borrowers by occupation/sector wise.  Estimation of the additional requirements of funds for the existing borrowers / loan accounts.  Analysis of the chance of covering/financing new activities in the command area during the budget year on the basis of current environmental data.  Careful assessment of fund required for the purposes mentioned above.  Determination of the quantum/requirement of the incremental loanable fund.  Allocation of the said funds to different sectors and client groups during the plan/budget period by ensuring profitability of the bank and attainment of social goals.  An indicative summary of branch level credit planning format is given in Table-2.2 Table 2.2: Region or Branch level Credit Planning Summary Format (Amount in Tk.'000) Current Budget Year Year Actual 1st 2nd 3rd 4th Total (December) Quarter Quarter Quarter Quarter Tk. Tk. Tk. Tk. Tk. A. Industries A-1 Small A-2 Medium A-3 Large A-4 Others B. Agriculture B-1 Crop loan B-2 Dairy B-3 Poultry B-4 Others C. Trading (import/export) D. Services E. Others F. Total (A+B+C+D±E) Study Material on Advance Level Credit for NCC Bank Limited 6|Page 2.3 Questions with Indicative Answers 1. What are the issues/points that a bank should consider while preparing bank level credit plan? (Section-2.1) 2. Discuss the different tasks associated with branch level credit planning. (Section-2.2) Study Material on Advance Level Credit for NCC Bank Limited 7|Page Activities of Credit Operations in Banks 3.1 Introduction A bank usually has procedural guidelines indicating list and sequence of several activities associated with its credit operation. The procedural guideline is prepared in the light of Credit Risk Manual given by Bangladesh Bank. However, bank’s own credit policy, vision, mission as well as guidelines and policies given by Bangladesh Bank from time to time are also reflected in procedural guidelines. The activities of credit operations start with discussion between bank and client and end with adjustment and/or recovery of loan recovery of loan. Credit operations in banks may be centralized or decentralized. However, the overall activities of the credit operations of a bank are outlined in figure-3.1 3.2 Borrower Selection Each year the head office prepares a credit budget indicating the amount of credit to be sanctioned and disbursed in different areas, categories, products and sectors. Credit committee/CRM is entrusted to sanction and disburse the budgeted amount prudently. Generally, there is a credit committee /CRM in head office of each bank which reviews every aspect of a loan proposal to be considered in approving and sanctioning loan. Relationship Management (RM) acts as a primary bank contact with a borrower. At first, the banker and the customer discuss with each other about the credit facilities offered by the bank and required by the customer. Through discussion, RM is to ensure that proposed credit is from expected business segment/sector and for permissible and expected credit facility. He also ensures that there is a scope of lending to the client. After a successful discussion, customer is to apply for credit in a prescribed format provided by the bank. After receiving loan application from the prospective borrower, RM scrutinizes the submitted information and collects all other required information from different parties including Credit Information Bureau (CIB) report. Only sanctioning a credit will not serve the purpose of the bank. It is only good credit that will serve the purpose of the bank. It is even better not to sanction any credit rather than sanctioning a bad credit. Selection of good borrower is the starting point of the process of creation of good credit. Before sanctioning credit, a banker wants to be sure about the repayment. For ensuring loan repayment a bank can go for preventing measure or curative measure or both. But curative measures are always costlier than preventive measures in Study Material on Advance Level Credit for NCC Bank Limited 8|Page terms of both time and money. So credit investigation as a preventive measure is required for selection of good borrower. Credit investigation and selection of good borrower may substantially help a bank in the recovery of extended credit. Borrower analysis refers to the assessment of a credit proposal from different points of view to decide whether the bank should go for finance or not, i.e. the study of the borrower specially justifying credit status of the borrower. Borrower Analysis helps the banker to ensure selection of right type of loan proposals/projects/ventures/enterprise and right type of borrower. On the basis of recommendation made in the credit proposal, the responsible credit officer will re-assess the position of the borrower and may ask for further clarification from the person who has prepared the credit proposal. If the borrower seems to be prospective, he is finally selected for disbursing credit. Considering different aspects, banks select their borrower. The borrower selection process of a bank may vary from other banks. Figure-3.2.1 presents decisions flow of borrower selection pointing out different sequential stages. Bank expects that loan application from the client should be from permitted business segment and for desired types of facilities. If there is a scope for lending in this industry and to the group, then bank may appraise managerial, organizational, marketing and technical aspect of the applicant. After being satisfied, bank will collect information from different sources including CIB of Bangladesh Bank. Afterward, bank will apply different techniques on the existing and projected financial statements of the client to judge the financial feasibility. Subsequently, loan structure, price, tenure, nature, etc. will be finalized at that point where both parties agree. Bank must consider socio-economic aspect of the project before finalizing the same. If all of the aspects of the applicant are satisfactory to the bank, bank may go for documentation and making disbursement and after that applicant will be borrower. Study Material on Advance Level Credit for NCC Bank Limited 9|Page Figure-3.2.1: Decision Flow Chart of Borrower Selection 1. Expected Business Segment/Sector Loan Application Yes No No Gap 4. Single Borrower/ Group Limit Clean 7. Financial Analysis Based on Historical Data Positiv Satisfactory Accordingly Compliance Expected 12. Sanction and Documentation Reject 9. Loan Structure: Price, Tenure, Nature, etc. Unexpected Unsatisfactory Non-Compliance Reject 8. Financial Analysis on Projected Data Unsatisfactory Reject 10. Security Arrangement: Nature, Amount, Quality, etc. Reject Reject 13. Disbursement of Loan Reject Borrower Non-Compliance Flow-ChartReject 3: Line of Credit Approval Source: Siddique et al (2014) Study Material on Advance Level Credit for NCC Bank Limited Satisfactory Unsatisfactory Adverse 11. Socio-Economic and Environmental Aspects 3. Lending Target and Disbursement in the Industry Exceed Satisfactory Reject Reject Reject Gap Exceed Negative 6. CIB, Bank Statements and Contact Point Verification Reject Yes Reject 5. Managerial, Organization, Marketing and Technical Aspects 2. Expected Types of Loan Facilities 10 | P a g e 3.3 Preparation of Credit Proposal The quality of a loan proposal is a key factor in achieving the results for a business. It can make the difference between a ‘yes’ and a ‘no’ to a loan application. An effective loan proposal should be prepared such that it is a proxy for a credit submission within the financial institution. It should deliver a good understanding of the business or group, and satisfactorily address all credit risks. The structure should contain purpose of the credit, background of the business, details of the existing and proposed facilities and securities, ownership structure, management, overview of the business/project, financial analysis, debt service/repayment/security and summary & recommendations can be applied to most loan proposals. However, depending on the situation, it may be appropriate to change the order in which things flow or add sections to address issues specific to the business. The objective when writing content under each heading is to progressively build a brief wellargued financing case through critical assessment of the business and/or the transaction. “What?”, “Why?” and “How?” are the questions one should be constantly asking himself during this process. Apart from giving business the best chance of getting a ‘yes’, a good loan proposal can significantly shorten turnaround time and limit the number of extended piecemeal requests for information. The effort in putting together a well-thought out proposal is minimal compared to the benefits to all parties involved. 3.4 Credit Appraisal For selecting the right type of borrower and business, credit appraisal is a must. For this purpose, RM is to conduct appraisal of managerial, organizational, marketing, technical, socio-economic and environmental aspects. Besides, the bank assesses the credit worthiness and risk profile of the borrower. By and large, this assessment covers loan proposition and purpose, borrower analysis, industry analysis, supplier/buyer analysis, historical financial analysis, projected financial performance analysis, etc. Security offered by the customer against the proposed loan should also be considered for credit decision. Moreover, bank should grade the borrower by completing Credit Risk Grading Score Sheet (CRGS). In case of large loan, banks refer to External Credit Assessment Institution (ECAI) for credit rating according to the direction of Basel-II. The assessments are mostly done based on the information collected from the borrower. Besides, market reports, study of accounts, financial statements, on line CIB and personal interview are also worked as source of inputs for decision making. In case of corporate credits where the borrower is a group of companies, banks conduct credit assessment on a consolidated or group basis Study Material on Advance Level Credit for NCC Bank Limited 11 | P a g e known as ‘obligor’. In case of loan syndication, besides the lead bank, all participatory banks also perform their own independent assessment, analysis and review of terms of the syndicate loan. On the basis of appraisal, RM recommends the application for approval to the appropriate authority mentioning amount and type of loan proposed, purpose of loan, loan structure, security arrangement, etc. 3.5 Internal Credit Risk Rating System (ICRRs) Internal Credit Risk Rating System refers to the system to analyze a borrower's repayment ability based on information about a customer's financial condition including their liquidity, cash flow, profitability, debt profile, market indicators, industry and operational background, management capabilities, and other indicators. The summary indicator derived from the system will be called Internal Credit Risk Rating (ICRR) - a key reference for credit risk assessment and decision making. Internal Credit Risk Rating System will be an integral part of credit risk management for the banks. The key uses of these guidelines are as follows: a) To provide a granular, objective, transparent, consistent framework for the measurement and assessment of borrowers’ credit risk. b) To facilitate the portfolio management activities c) To assess the quality of individual borrower to help the banks to determine the quality of the credit portfolio, line of business, the branch or the Bank as a whole. d) To be used for individual credit selection, credit pricing, and setting credit limit and terms and conditions. The core functions of Internal Credit Risk Rating System are: a) Internal Credit Risk Rating System is a fully automated credit risk scoring system that calibrates the characteristics of different sectors and industries in one single model; b) To get the appropriate rating and score, the analyst shall select the appropriate sector or industry from the dropdown list given in the top page of the template; If the right sector or industry is not selected; the rating will not reflect the unique characteristics of the particular sector or industry. c) If the borrower is in multiple lines of business, the sector should be used assessing the line of business generating the highest portion of the revenue &/or profit. If Study Material on Advance Level Credit for NCC Bank Limited 12 | P a g e there is no particular line of businesses can be singled out- the ICRRS should be conducted using "other industry- if manufacturing" or "other service-if service". 3.6 Credit Approval The authority to sanction/approve loans is clearly delegated to senior credit executives by the Managing Director (MD)/Chief Executive Officer (CEO) and Board of Directors (BOD). Approval authority is required to be delegated to individual executives based on the executives’ knowledge and experiences. The recommending/ approving executives should take responsibility for and be held accountable for their recommendation/ approval. Delegated authority including capacity of approval must be reviewed annually and the pooling or combining of authority limits of different executives should not be permitted. Considering the size and strategy of the bank, approval function is centralized in some banks. However, approval functions are generally decentralized in zonal, divisional, and branch level. In case of centralized system, irrespective of amount, there is an approval authority in the head office level. In case of decentralized system, for example, delegation of approval limits may be such that all proposals where the facilities are up to 15% of the bank’s capital should be approved at the CRM level, facilities up to 25% of capital may be approved by CEO/MD, facilities in excess of 25% of capital to be approved by the Executive Committee (EC)/Board only after recommendation of CRM and MD/CEO according to the CRM guideline. Before approval, the Head of CRM forward the loan proposal to Risk management unit (RMU) for their observation regarding risk. After getting observations from RMU, the Head of CRM processes the proposal for approval. After following all the due process, approval authority may approve or decline the recommended proposal. 3.7 Credit Administration Getting the approval for the loan proposal, relation manager (RM) makes two copies of the proposal and sends one copy to RMU and the other to Credit Administration Department (CAD) for documentation. Then, CAD issues sanction /offer letter to the customer through RM. Customer should agree with the terms and conditions incorporated in the offer letter. Subsequently, RM completes the Loan Documentation Check List (LDCL) and forwards the acceptance to CAD. A typical CAD performs the activities relating to disbursement, custodian, monitoring and compliance. Main responsibilities of CAD are: ensuring that all Study Material on Advance Level Credit for NCC Bank Limited 13 | P a g e security documentations comply with the terms of approval and are enforceable, examining insurance coverage to ensure appropriate coverage in place over assets pledged as collateral, and is properly assigned to the bank, disbursing loan only after all terms and conditions of approval have been met, and all security documentations are in place; maintaining control over all security documentations and monitoring borrower’s compliance with covenants and agreed terms and conditions. After ensuring full compliance, CAD takes necessary steps for disbursement of the loan amount. After disbursement, RM regularly follows-up the credit. Monitoring unit under CAD alongside of zonal office monitors credit based on due-date-diary. Identification of early alert account and reporting the same to CRM are responsibility of RM. Through close monitoring, the quality of early alert account may improve but conversion of this account to regular account status is under the discretion of CRM. As per credit policy, RM is to classify the accounts and maintain required provisions. 3.8 Credit Recovery There is a separate Recovery Unit (RU) in each bank as per CRM manual. This unit should directly manage accounts with continuous deterioration. Its primary responsibilities are to determine recovery strategy, pursue all options to maximize recovery, ensure adequate and timely loan loss provisioning, etc. The management of Non-Performing Loan (NPL) must be a dynamic process, and the associated strategy together with the adequacy of provisions should be reviewed regularly. All NPLs should be assigned to an account manager within the RU, who is responsible for coordinating and administering the action plan and should serve as the primary customer contact after the account is downgraded to substandard or worse. Account manager should review all documents, meet the customer and prepare a Classified Loan Review Report (CLR). The head of credit should approve the CLR for NPLs up to certain percentage (say 15%) of the bank’s capital, and excess of 15% be approved by MD/CEO according to CRM guideline. As per CRM guideline, the CLR’s for NPLs above 25% of capital should be approved by the MD/CEO, with a copy received by the Board. Bank may wish to introduce incentive program to encourage RU to bring down the NPLs. RU should take legal action against the defaulted borrower as a last resort to recovery the credit. Study Material on Advance Level Credit for NCC Bank Limited 14 | P a g e Figure-3.1: Activities of Credit Operations of a Bank Functions of RM Origin  Discussion with Client  Receiving Request for Credit from the Client by RM  Scrutinizing/verification of Submitted Information  Collection of all Other Required Information  Collection of CIB through Credit Administration Credit Appraisal  Analysis of Loan Proposition  Purpose of Loans Analysis  Security Arrangement  Appraisal of Financial Aspect  Credit Risk Grading (CRG)  Credit Rating by ECAI, if required  Compliance with Lending Guidelines along with Environmental Compliance  Making Recommendations  Placing for Approval Post Approval Function  Receiving Approved Proposal from the Approval Authority  Sending Approved Proposal to Credit Administration  Receiving Sanction Advice/Offer Letter from Credit Administration  Getting Acceptance of the Offer Letter from Client and sending it to Credit Administration along with Complete LDC  After Disbursement, regular Follow-up of the Credit  Early Alert Process  Transfer of all accounts of substandard (SS) or worse to RU Functions of Approval      Analysis of the Recommendation of RM Seeking Comments from Risk Management Collection of Additional Information, if required, from RM Site Visit, if required Approval of Credit by Branch/Credit Committee/CEO/ Executive Committee/BoD Functions of CAD       Collection of CIB report for RM Issue and Acceptance of Offer Letter Documentation Disbursement Custodial Duties Ensure Compliance Credit Monitoring Monitoring & Recovery       Substandard (SS) or worse accounts transferred from RM to RU NPL Monitoring NPL Provisioning and Write Off Taking Precaution and Applying Some Non-Legal Measures Taking Legal Action against Defaulted Clients Source: Siddique et. al. 2014 Study Material on Advance Level Credit for NCC Bank Limited 15 | P a g e 3.9 Cases on Borrower Selection 3.9.1 Case Study on Successful Borrower JMI Syringes and Medical Devices Ltd. as a joint venture with South Korea was established as a Private Limited Company in April, 1999. But at present it is a Public Limited Company. The project is situated at Noapara, Choddogram in the district of Comilla. The project is a pioneer manufacturer of Auto Disable (AD) Syringe, Blood Transfusion Set, Intravenous Canula (IV Canula), Intrauterine Contraceptive Device (Copper T380A) in the country. Almost all main hospitals and major pharmacy of the country are the purchaser of the syringe and other products of the company. It is the only company accredited by WHO and GVI (Global Alliance for Vaccination and Immunization) to supply syringe for the EPI (Expanded Program for Immunization). It is also a member of International Association of Safe Injection Technology (IASIT), Geneva, Switzerland. It exports its products to Singapore, Thailand, Myanmar, Spain, Portugal and other different countries of Asia and Latin America. The total cost of the project now stands at BDT 500 million including BDT 125 million term loan from a stateowned commercial bank and BDT 50 million from the public issue. The project has a yearly capacity of producing Auto-disposable Syringe (228,171 pieces), Insulin Syringe (31,428 pieces), Infusion Set (39,286 pieces), Bud Set (39286 pieces), Urine Bag (31,249 pieces), IV Cannula (23,571 pieces), Needle (Blister Pack (39,286 pieces) and Auto Disable (AD) Syringe (480,571 Pieces)]. As regards loan repayments, there is no default. Payment is made without any delay. Till date BDT 135 million has been repaid. Other details of the entrepreneur and the project are given below. (i) Mr. Abdur Razzaque, M.A. in Economics from the University of Chittagong, is the main sponsor of this project. (ii) Technical know-how, practical experience in machine installation, process flow, etc. of Mr. Abdur Razzaque. (iii) Twelve (12) years working experience at Japan in a Disposable Syringe Factory. (iv) Fluency in Japanese, Korean and English languages of Mr. Abdur Razzaque. (v) Maintaining good relationship with public and government and other agencies. (vi) Giving due importance to perseverance and value of time. (vii) Extensive demand for the products of the project at home and abroad. (viii) Simple life style and no extravagancy. (ix) Personal commitment. (x) Timely sanction of required working capital by the bank. Requirement: Critically analyze the case and identify the success factors. Study Material on Advance Level Credit for NCC Bank Limited 16 | P a g e 3.9.2 Case Study on Unsuccessful Project/ Borrower In 1992 an amount of TK. 41.795 million was sanctioned in favor of Rahman Knitting and Yarn Processing Ltd. by a state owned commercial bank. The first installment of the loan was due for payment on 27.08.1994. The loan was scheduled to be repaid in eleven half yearly installments. Each installment amounted to Tk.6.288 million. The entire amount of loan was scheduled to be repaid within 27.08.1999. Afterwards an amount of TK. 45.118 million BMRE loan was disbursed on 09.02.2004 for proper balancing the project. But the borrower failed to repay the loan installments in due time and because of this, the loan account was rescheduled around thirteen times starting from December, 2001. Under these circumstances, the BB has already directed the bank to classify the loan, and take appropriate actions against the officers who are involved with re-scheduling the loan again and again. BB has also asked the bank to take immediate action to recover the overdue loans and report to them the progress thereof. The project comprises of dyeing, knitting and sweater unit. At present the sweater unit is not running. But the rest are in operation. The borrower has informed the bank that they are running the project on sub-contract basis and as such they are not in a position to repay the loan installment due to insufficient cash generation. They are not also receiving direct export L/C because they are not getting the opportunity to open Back-to Back L/C from the bank as the banks are not allowing them to open the same (Back-to-Back L/C) due to failure of payment of overdue loans. The project failed due to the following bad personal traits of the borrower and other factors:  Ill motive and ill behavior  No expenditure control and lavish life style.  Always looking for excuse whatever be the merits.  Tendency for over borrowing by exaggerating project cost.  Fund diversion.  Lack of professionalism and practical knowledge  Connectivity with political/ influential persons.  Never seeing root of problems.  Always trying to manage things for short period and in temporary basis.  The project is being run on sub-contract basis.  Insufficient cash generation. Requirement: 1. Critically analyze the case and identify the reasons for failure. 2. What the banker should do to prevent this type of borrower at pre-sanction stage and post sanction stage? Study Material on Advance Level Credit for NCC Bank Limited 17 | P a g e 3.9.3 Case Study on Large Enterprise Finance M/s. Emerald Oil Industries Ltd. registered as a private limited company with the Registrar of Joint Stock Companies and Firms (RJSCF) in July 2008, having its factory at Sherpur, is the pioneer of its kind for extracting edible oil from rice bran for 100% local utilization by substituting imported products. Mr. Syed Monowarul Islam, Chairman and Mr. Syed Hasibul Gani Galib, Managing Director of the company are looking after the overall operation, management and marketing of the project. The complete plant and machinery has been imported from India. The supplier’s experts have installed the plant and trained a group of local technicians to operate the plant under their direct and indirect supervision. At present about 350 persons are engaged in the production process of the factory. Total estimated fixed cost of the project is Tk.79.86 crore. The project is availing Tk. 50.00 crore as term loan from XYZ Bank and working capital limit of Tk.5 crore. The project is both labor & capital intensive. Rice Bran Refined Edible Oil producing factory belongs to large size manufacturing industry. The plant has bran unloading, preparatory, solvent extraction, oil refinery, & DOC packing section. The project is intensively dependent on local raw materials which are very much available. Major portion of production input is rice bran. The final output is Rice Bran Refined Edible Oil. The production capacity of the project after BMRE would be 50 MT/day i.e. 15,000 MT/year. Other information is given below.  Bangladesh, being the 4th largest rice producer in the world, has unique competitive strength in producing rice bran oil from rice bran.  As per specialist opinion, average oil consumption in daily food menu for sound health should be 30 gram per person i.e. 11 KG per year. As such, total demand for oil consumption of the country is 18 lac MT whereas M/s. Emerald Oil Industries Ltd. has a production capacity after BMRE of 15,000 MT/year which is less than 1% of the total demand for edible oil.  Being nutritionally superior, containing more micronutrients, having better protection for heart & related blood vessel, more stable at higher temperature, antiviral capability, longer shelf life, less sticky, economical, securing better taste & flavor to food items; rice bran oil have superior competitive advantages over its substitute products.  The target customers for the project are rural and urban residential and commercial users, food processing industrial sector of the countries. Besides, the project also Study Material on Advance Level Credit for NCC Bank Limited 18 | P a g e plans to export its products abroad in near future and as such market risk are relatively low for the project. Being a nontraditional project and pioneer of its kind for producing Rice Bran Refined Edible Oil from rice bran, M/s. Emerald Oil Industries Ltd. is successfully manufacturing & supplying the same in the brand name “Spondon” at its rated capacity which is substituting imported edible oils saving the huge foreign currency and creating ample opportunity for the nation to be self-dependable in edible oil production by securing alternative use of rice bran which is currently has no or little uses. Simultaneously, the project is enabling the rural and urban consumers to fulfill their demand for health-friendly and hazard-free edible oil at a competitive price. This project has also created job opportunity that is necessary for our economy. Requirement: Critically analyze the case and identify the success factors. 3.9.4 Case Study on Medium Enterprise Finance M/s. Baneco Solar Energy Ltd. is a new project incorporated in 2010 as a private limited company registered with RJSCF for assembling Solar Panel of different capacity using German Technology to fulfill the domestic demand by substituting imported products as well as to export worldwide. The company is located at Gazipur on a plot of land measuring about 167.66 decimal. Total estimated fixed cost of the project is Tk.21.18 crore. The project is availing Tk.13.28 crore as term loan from ABC Bank Limited under the refinance scheme of Bangladesh Bank for Tk.12.28 crore and composite working capital limit of Tk.7.50 crore. The main sponsors of the project are Mr. Chowdhury Mugis Uddin Mahmud –Chairman and Mr. A.K.M. Mazibur Rahman – Managing Director. Both the persons have long business experience in manufacturing, service and trading line. The project was established under direct supervision of foreign experts from Germany on TURN Key basis. The German experts have provided about 03 (three) months long training to the local technical persons regarding the technical knowhow of total operation procedure of the project. The project is a capital intensive one, highly dependent on imported raw materials such as Tampered Glass, Photovoltaic Cells, Ribbon, EVA, etc. which are being imported from various countries. The only output of the project is ‘Solar Panel’ which is the integral part of a solar system installed for household and/or industrial purpose. Study Material on Advance Level Credit for NCC Bank Limited 19 | P a g e The main attributes behind the success of the project  Bangladesh, being a country of abundant sunlight as natural resources, it has unique competitive strength in producing solar power than many other countries of the world.  Government policy support regarding installation of solar system to avail new electric line attributed significantly.  The project is pioneer in supplying ‘Solar Panel’ commercially.  Huge area of the country is still uncovered from electric supply that propagates ample opportunities for the project.  Extensive demand for the products both in home and abroad.  Enabling to provide rural and urban buyers to fulfill their demand for eco-friendly and hazard free power at a competitive price.  Personal commitment of the sponsors, marketing strategy and awareness of the people. Being a nontraditional project and almost pioneer in the industry, M/s. Beneco Solar Energy Ltd. is successfully manufacturing & supplying Solar Panel which is substituting imported equipments saving huge foreign currency and creating ample opportunity for the nation to utilize its abundant sunlight. Requirement: Critically analyze the case and identify the success factors. 3.9.5 Case Study on Small Enterprise Finance QVC was established in 2012 located in Dinajpur for manufacturing chain used for motorcycle. The whole output will be sold to the particular motorcycle assembler of the country at pre-agreed rate. The production process is small because the parts of the chain are imported and then assembled in the factory. Previously, the product was imported from different countries. As the uses of motorcycle are increasing day by day, the demand of the product will continue for a long future. The owner, Mr. Azam Khan, was a dealer of motorcycles that used to sell local and imported motorcycles. He has a good reputation in the business for the last 13 years. Total estimated investment in the project is Tk. 9.5 crore excluding land and building. The project is availing of Tk. 3.80 crore as term loan from a private bank and Tk. 1.20 crore as working capital limit. The production capacity of the project is about 15 million meter per year that satisfies only 15% of total local demand of the product. The price of the product is relatively lower than the imported price and it also Study Material on Advance Level Credit for NCC Bank Limited 20 | P a g e ensures the quality. The quality has been tested in BUET and the customers are satisfied as well. Other attributes of the project are as given below.  Bangladesh is populous and developing country. Users and uses of the motorcycle are increasing over the time and thus the demand of the product is very high.  The project is 1st mover in manufacturing this product.  Maintaining strong liaison with customers and supplier.  Extensive demand for the products both in home and abroad.  It has been possible to ensure quality and minimizing production cost.  Marketing strategy, less competition, personal commitment of the sponsor and environment friendly manufacturing process. There is a great opportunities for horizontal and vertical expansion of the project. Being a nontraditional project and 1st mover in the industry, QVC is successfully manufacturing and supplying chain which is import substitute. This may be an example for establishing such small industries of different parts of motorcycle and other auto-mobile as well. These types of project will create employment generation. Requirement: Critically analyze the case and identify the success factors. 3.9.6 Case Study on Consumer Borrower Bank has sanctioned a Card facility to Mrs. Rahela with a limit of BDT 500,000. As per application she was the director of X Group & her husband’s name was mentioned as Monir (fake). Mr. Monir has also taken a personal loan & card facility from the bank amounting to Tk. 800,000 & 500,000, respectively. Mrs. Rahela was also the supplementary card holder of Mr. Monir as a wife (fake). Mr. Monir made partial payment for all facilities when he was alive. After his death payment was stopped fully against credit cards & personal loan. Recovery team never could reach to Rahela on her mobile or mentioned resident address at Dhanmodi Dhaka. At one stage of recovery effort, the bank sent legal notice to the permanent address of Rahela at Rajshahi which was mentioned in Voter ID card. After getting the letter she communicated with the bank & refused that she had neither taken any loans from bank nor had been maintaining any accounts. She was basically involved with politics & residing at Rajshahi city. While investigating from recovery team, it was found that Mr. Monir provided false information at the time of loan application & A/C opening form. Original name of Monir would be Mr. Mazharul Islam Mahtab i.e. M.I Mahtab confirmed by his actual wife, name Ms. Rehena Mahtab. He also Study Material on Advance Level Credit for NCC Bank Limited 21 | P a g e changed his father’s name as Mr. Imran Hossain in loan application that would be Mr. Imaz Uddin. He used different address in different files. Mr. Monir has no permanent residence at Dhaka as per the statement of his wife, Ms. Rehena Mahtab. Requirement: Critically analyze the case and identify the reasons for failure. (Source: All the cases are taken from BIBM review on Credit Operations of Banks) 3.10 Questions with Indicative Answers 1. How does proper selection of borrower help to reduce the credit risk? (Chapter-3) 2. Why is delegation of approval authority important? (Section-3.6) 3. State the advantages and disadvantages of centralization of credit approval authority. (Section-3.6) 4. Which section (financial/non-financial) of the credit proposal should get more importance at the time reviewing a proposal? Why? (Chapter-3) 5. What are the functions of approval authority? (Figure-3.1) 6. Show the borrower selection process with the help of a flow chart. (Figure-3.2.1) Study Material on Advance Level Credit for NCC Bank Limited 22 | P a g e Credit Appraisal and Assessment 4.1 Introduction Credit appraisal process is an essential tool for investment decision and project selection. It is the prime step in the process of decision making in respect of sanctioning of assistance by financial institutions. However, 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 which is going to take up for implementation and finance is  commercially profitable,  economically viable and at the same tune.  socially desirable. 4.2 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 Advance Level Credit for NCC Bank Limited 23 | 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. 4.3 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 The whole appraisal exercise can therefore, be demonstrated in the following way Feasibility Study Commercial Feasibility Technical Socio-Economic/ Environmental Feasibility Marketing Financial Study Material on Advance Level Credit for NCC Bank Limited Managerial Organizational 24 | P a g e 4.3.1 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 Knowledge  Relevant Business and Industrial Experience  Managerial Ability  Skills of the Manager and Management Team  Past Performances of the Promoter  Management Soundness  Succession  Team work 4.3.2 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 4.3.3 Marketing Aspect The most critical segment of project feasibility analysis is the marketing plan. Through this the company assesses the opportunities and threats in the environment, and develops strategic responses that ultimately lead it to its set objectives. The objective of market Study Material on Advance Level Credit for NCC Bank Limited 25 | P a g e analysis is to see how much of these goods or services the community is disposed to acquire and at what prices. 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?)  Rivalry among competitors  Competition from substitute products  Competitive threat from potential entrants  Bargaining power of suppliers and supplier-seller collaboration  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 Study Material on Advance Level Credit for NCC Bank Limited 26 | P a g e 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 4.3.4 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 Financial appraisal also looks into the following issues:  Are the cost estimates exhaustive and realistic? How is the project proposed to be financed? Is the proposed capital structure financially satisfactory?  Has adequate provision been made for meeting the working capital requirements?  Does the proposed current asset structure ensure adequate liquidity?  Will the project generate sufficient cash flows to cover its debt servicing liabilities?  Will the project earn sufficient profit for its owners or sponsors Study Material on Advance Level Credit for NCC Bank Limited 27 | P a g e 4.3.5 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.  Generation of employment  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. 4.3.6 Environmental Aspect One of the basic flaws in project planning and design is the complete neglect 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 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 Study Material on Advance Level Credit for NCC Bank Limited 28 | P a g e  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. 4.4 Environmental Risk Management Guideline and Environmental Risk Rating Environmental Risk Management Guideline 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). Study Material on Advance Level Credit for NCC Bank Limited 29 | P a g e Guidelines on Environmental Risk Management1 was prepared and circulated by BB on January 30, 2011 to support Policy Guidelines for Green Banking (2011) featuring 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’2 for financing environmentally sensitive sectors3 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. 1 BB BRPD Circular No-1, January 30, 2011 2 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. 3 Agri-business, cement, chemicals, housing, engineering and basic metals, pulp and paper, tannery, Sugar and distilleries, textile and apparels, and ship-breaking. Study Material on Advance Level Credit for NCC Bank Limited 30 | P a g e 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. 4.5 Questions with Indicative Answers 1. Why is marketing aspect very important for assessing feasibility of the project? (Section-4.3.3) 2. What factors should be considered for evaluating technical feasibility of the project? (Section-4.3.2) 3. Why socio-economic aspect should be considered while assessing the viability of the project? (Section-4.3.5) 4. Which of the aspects is most important? Why? (Chapter-4) 5. What is environmental risk rating? Discuss the importance of EnvRR from credit management point of view. (Section-4.4) Study Material on Advance Level Credit for NCC Bank Limited 31 | P a g e Analyzing the Financial Viability 5.1 Analysis of Income Statement and Balance Sheet Analyzing financial statements involves evaluation of different dimensions of financial health of an organization. These dimensions may include liquidity, profitability, coverage, operating efficiency, solvency etc. For example, a short-term creditor, such as a bank, is primarily interested in the ability of the borrower to pay obligations when they come due. The liquidity of the borrower in such a case is extremely important in evaluation of the safety of a loan. A long-term creditor, such as a bondholder, however, looks to indicators such as profitability and solvency that indicate the firm’s ability to survive over a long period of time. Similarly, stockholders are interested in the profitability and solvency of the enterprise when they assess the likelihood of dividends and the growth potential of the stock. 5.1.1 Financial Statements Analysis Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company’s past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users of financial statements. Ratio Analysis Ratio Analysis is the most widely used tool of financial analysis. Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between two figures. Ratios are used to evaluate operating and financial performance of a firm. Financial ratios are designed to help one to evaluate financial performance of a firm i.e. through ratio analysis we can identify financial strength and weakness of a firm. By observing financials at a glance one cannot immediately understand the actual financial condition of a firm i.e. whether the financial condition of the firm is improving or not. Through ratio analysis we can easily understand the actual financial condition of the firm, comparing various ratios. Study Material on Advance Level Credit for NCC Bank Limited 32 | P a g e For example: Is earnings of Tk.5,00,000 actually good? If we earn Tk.5,00,000 on Tk.50,00,000 of sales (10 % profit margin ratio) that might be quite satisfactory, whereas earnings Tk.5,00,000 on Tk.5,00,00,000 could be disappointing (i.e. 1% return) Fundamental Classification of Ratio According to Financial Spread Sheet (FSS) there are six types of ratios, which are as follows: Growth Ratio: Growth ratios measure the company’s potentiality, performance. It also measures whether the company will survive. Example of growth ratios are sales growth, assets growth etc. Name of Ratio 1. Sales Growth, Sales % Components or Formula [(CY.S - PY.S) / PY.S] × 100 Implications Rule of Thumb = Higher is better, comparing with previous years or industry average 2. Net Sales Growth, [(CY.NS - PY.NS) / PY.NS] × Rule of Thumb = Higher is better, Composite % 100 comparing with previous years or industry average 3. Net Income Growth, % [(CY.NI - PY.NI) / PY.NI] × Rule of Thumb = Higher is better, 100 comparing with previous years or industry average 4. Total Assets Growth, [(CY.A - PY.A) / PY.A] × 100 % Rule of Thumb = Higher is better, comparing with previous years or industry average 5. Total Liabilities [(CY.L - PY.L) / PY.L] × 100 Growth, % Rule of Thumb = Lower is better, comparing with previous years or industry average 6. Net Worth Growth, % [(CY.W - PY.W) / PY.W] × Rule of Thumb = Higher is better, 100 comparing with previous years or industry average Note: CY= Current Year, PY= Previous Year, NS= Net Sales, A= Total Assets, L= Total Liabilities, W= Net Worth Profitability Ratio: Profitability indicates the efficiency of the unit in generating surplus. In order to have a ratio, we can compare profit to the factors, which regulate the quantum of profit directly, like sales and the total assets or equity. Profitability ratios measure the Study Material on Advance Level Credit for NCC Bank Limited 33 | P a g e income or operating success of an enterprise for a given period of time e.g., gross profit margin, operating profit margin etc. Name of Ratio Components or Formula 1. Gross Margin, Composite (GP / Sales) × 100 % Implications Rule of Thumb = 25% to 30%, higher is better 2. SG & A, % (SG & A / Sales) × 100 Rule of Thumb = Lower is better. 3. Cushion (GP-SG&A), % {(GP-SG&A) / Sales} × Rule of Thumb = Higher is better 100 4. Depreciation. (Depreciation / Sales) × Amortization,% 100 5. Operating Profit Margin, (EBITDA / Sales) × 100 % Rule of Thumb = Lower is better Rule of Thumb = 20% to 25%, higher is better 6. Interest Expense, % (Interest / Sales) × 100 Rule of Thumb = Lower is better 7. Operating Margin, % (Profit before tax & Extra Rule of Thumb = Higher is better Income / Sales) × 100 8. Net Margin, % (NP / Sales) × 100 Rule of Thumb = Higher is better 9. Return on Assets, % (NP / Assets) × 100 It measures the profitability of investments. Rule of Thumb = Higher is better 10. Return on Equity, % (NP / Net Worth) × 100 Measures earning power on shareholders’ equity Rule of Thumb = Higher is better 11. Dividend Payout Rate, % (Dividend / NP) × 100 Rule of Thumb = Lower is better to long term creditors. Note: EBITDA= Earnings Before Interest, Tax, Depreciation & Amortization, SG & A= Selling, General & Administrative Expense Coverage Ratio: These ratios measure the ability of a company to generate cash to pay interest and principal repayments e.g., interest coverage ratio. Name of Ratio Components or Formula Implications How many times the income is sufficient 1. Interest Coverage (×) (EBIT / Total Interest) to cover the interest expense. Rule of Thumb = higher is better 2. Debt Service [EBITDA / (Total Interest + It reflects the company’s ability to serve Coverage (×) CMLTD)] long-term debt. Rule of Thumb = Must be Greater than one. Note: EBIT= = Earnings Before Interest & Tax, CMLTD= Current Maturity of Long Term Debts. Study Material on Advance Level Credit for NCC Bank Limited 34 | P a g e Activity Ratio: It has been widely accepted that the profitability of an enterprise to a large extent depends on its efficient asset utilization or activity performed. Activity ratios measure how efficiently the firm employs the assets. These ratios are also called efficiency ratios or asset management ratios. Name of Ratio 1. Receivable in Days Components or Formula (AR / Sales) × 365 Implications Shows average number of days receivables are outstanding before being collected. Rule of Thumb = Lower is better. 2. Payable in Days (AP / COGS) × 365 Indicates the average length of time trade debt is outstanding. Rule of Thumb = Higher indicates the creditors are not paid in time and lower shows that the business is not taking the full advantage of credit period allowed by the creditors. 3. Inventory in Days (Inventory / COGS) × 365 Shows the average no. of days the inventory is held before it is turned into accounts receivable through sales. Rule of Thumb = Lower is better, compare with previous years. 4. Sales to Total Assets, (×) (Sales / Total Assets) Shows how efficiently assets are used to generate sales. Rule of Thumb = Higher is better. Note: Sales = Total Sales Revenue, AR = Account Receivable, AP = Account Payable, COGS = Cost of Goods Sold Liquidity Ratio: The liquidity or short-term solvency of an organization can be measured with the help of current ratio and quick ratio. Liquidity implies to the ability of an organization to pay off its short-term obligations with the current assets. Name of Ratio 1. Working Capital Components or Formula CA – CL Implications It is a measure of company’s liquidity position. Rule of Thumb= Larger is better 2. Quick Ratio Cash & Cash Equivalent + Measures ability to meet current debts with most Receivables / CL liquid (quick) assets. Rule of Thumb= 1:1, higher is better Measures ability to meet current obligations with 3. Current Ratio CA / CL current assets. Rule of Thumb= 2:1, higher is better 4. Sales to Net Sales / Net Working Working Capital Capital Rule of Thumb= Higher is better Note: CA = Current Assets, CL = Current Liabilities Study Material on Advance Level Credit for NCC Bank Limited 35 | P a g e Leverage Ratio: Ratios, which measures the extent to which a firm has been financed by debt. It is also known as debt management ratios. Examples of leverage ratios are debt ratio, etc. Name of Ratio Components or Formula Implications Indicates the extent to which debt 1. Total Liability to Net Worth (×) TL / NW financing is used relative to equity financing. Rule of Thumb= 1:1, Higher indicates less protection for lender 2. Affiliate Exposure to Net (AE / NW) × 100 Wirth (%) 3. Total Liability to (Net TL / (NW – AE) worth–Affiliate Exposure) (×) Note: TL= Total Liabilities, NW= Net Worth, AE = Affiliate Exposure Study Material on Advance Level Credit for NCC Bank Limited 36 | P a g e 5.2 Cash Flow Statement Analysis Cash Flow statement is a summary of a firm’s cash receipts and cash payments during a period of time. In fact, it reports the cash receipts, cash payments, and net change in cash resulting from the operating, investing, and financing activities of an enterprise during a particular period. When used with the information contained in the other two basic financial statements and their related disclosures, it should help the financial manager/bankers to assess and identify:  A company’s ability to generate future net cash inflows from operations to pay debts, interest, and dividends.  A company’s need for external financing  The reasons for difference between net income and net cash flow from operating activities  The effects of cash and non-cash investing and financing transactions Content of the Statement The statement of cash flows explains changes in cash (and cash equivalents) by listing the activities that increased cash and those that decreased cash. Each activity’s cash inflow or outflow is segregated according to one of the three broad categories: (i) Operating activity: operating activities include the transactions that create revenues and expenses and thus enter into the determination of net income. It is the principal revenue producing activities. Cash Received from Sale of Goods and Services - Cash Paid for Operations, and Goods & Services = Cash Flow from Operations Cash Inflows (Cash Received):  From sale of goods and services  From return on loans (interest income) and equity securities (dividend income) Cash Outflows (Cash Payment):  To pay suppliers for inventory  To pay employees for services Study Material on Advance Level Credit for NCC Bank Limited 37 | P a g e  To pay lenders (interest)  To pay government for taxes (ii) Investing activity: investing activity means the acquiring and disposing activities of long term assets and investments. Cash Received from Sale of Investments, Property, Plant & Equipment. Cash Paid for Acquisition of Investments, Property, Plant & Equipment. - Cash Flow from Investing = Cash Inflows (Cash Received):  From sale of fixed assets (Property, Plant & Equipment)  From sale of debt or equity securities of other entities  From collection of principal on loans Cash Outflows (Cash Payment):  To purchase fixed asset  To purchase debt or equity securities of other entities (iii) Financing activity: financing activities include cash from issuing debt and borrowing, repaying the amounts borrowed, obtaining cash from stockholders and providing them with a return on their investment. Cash Received from Issue of shares or debt and borrowing - Cash Paid for Dividend, repaying short and long-term borrowing and reacquisition of debt or capital = Cash Flow from Financing Cash Inflows (Cash Received):  From Borrowing (debt)  From the sale of company’s own equity Cash Outflows (Cash Payment):  To repay amounts borrowed (principal)  To pay dividends Study Material on Advance Level Credit for NCC Bank Limited 38 | P a g e Blank Format (Indirect Method) Cash Flow Statement For the year ended December 31, 20… A. Cash Flow(C/F) from Operating Activities: Net Income after tax Add: Depreciation/Amortization etc. Add/(Less): Non-operating Loss (Gain) (-)/+: Adjustment for Current Assets(C/A): (Increase)/Decrease in Accounts Receivable (Increase)/Decrease in Inventory (Increase)/Decrease in Prepaid Expenses (Increase)/Decrease in Securities (Marketable) (Increase)/Decrease in other C/A (except cash & bank) (-)/+: Adjustment for Current Liabilities(C/L): Increase/(Decrease) in Accounts Payable Increase/(Decrease) in Accrued Expenses Payable Increase/(Decrease) in Interest Payable Increase/(Decrease) in Income Taxes payable Increase/(Decrease) in Other Current Liabilities Net C/F from Operating Activities (A) B. Cash Flow from Investing Activities: (Increase)/Decrease in Land (Increase)/Decrease in Property, Plant & Equipment (Increase)/Decrease in Property, Plant & Equipment (Increase)/Decrease in Furniture & Fittings (Increase)/Decrease in Investment (Increase)/Decrease in Other Non-current Assets Net C/F from Investing Activities (B) C. Cash Flow from Financing Activities: Increase/(Decrease) in Paid up Capital Increase/(Decrease) in Long-term Loans/Bonds Payable Increase/(Decrease) in O/D, C/C Increase/(Decrease) in all other non-current Liabilities Minus: Dividend Paid Net C/F from Financing Activities (C) Net C/F from Operating, Investing & Financing Activities (A+B+C) Plus: Opening Cash & Bank Balance Cash Balance on hand at the end of the year Study Material on Advance Level Credit for NCC Bank Limited Amount Amount Tk. Tk. 21 7.5 -2.5 9 7 -7 0 0 -9.5 2 -0.5 3 0 30 -65 62 -3 18 -30 -8 -20 7 13 20 39 | P a g e Blank Format (Direct Method) Cash Flow Statement For the year ended December 31, 20… Particulars Cash Flow from Operating Activities: Cash Sales Collection from credit sales Payment for Purchases Payment for Operating Expenses Net Cash Flow from Operating Activities Cash Flow from Investing Activities: Purchase of Equipment Net Cash Flow from Investing Activities Cash Flow from Financing Activities: Borrowing Repayment Interest Payment Dividend Payment Net Cash Flow from Financing Activities Net Cash Flow from operations, Investing and Financing Activities Amount (Tk.) Amount (Tk.) 260,000 1,024,000 -760,500 -395,000 128,500 -86200 80,000 -80,000 -2,400 -45,000 -47,400 -5,100 Add: Beginning Cash Balance on Hand Ending Cash Balance on Hand 48,000 42,900 Analyzing C/F from Operating Activities Positive net operating cash flows indicate something good for the firm. Large amount of positive net operating cash flows is an indicator of economic viability of a firm. Negative net operating cash flows, on the other hand, may be a reason for being concerned. Is Negative Net Operating Cash Flow Always Gives a Bad Signal? Answer depends on the reason behind the negative net operating cash flow. Negative net operating cash flows are mainly caused by increase in inventory and account receivable. It may also become negative due to the expansion of an existing product line or for introducing new product line. It may be a result of unfavorable business conditions. Credit analyst must evaluate each possible explanation to discover what economic forces are responsible for company's negative net operating cash flows and whether positive net operating cash flows are likely to be generated in future. Another important issue is the way the operating deficit will be financed? Study Material on Advance Level Credit for NCC Bank Limited 40 | P a g e Analyzing C/F from Investing Activities Positive net investing cash flows indicate disinvestment not really expected in growing firm. Negative net investing cash flows, on the other hand, indicates that the firm increased investment during the period. Larger investment in productive assets is good for a firm. Is Negative Net Investing Cash Flow Always Gives a Good Signal? Answer depends on the quality of investment made by the firm. Credit analyst should carefully investigate the capital expenditure of the company. Is the investment made for productive assets or for speculative assets? Investment in productive assets will increase production and sale of goods in the subsequent periods provided there is a demand in the market. If so more surpluses from operating activities will be created. Higher surplus from operating activities means higher ability to repay. Moreover, care should be taken regarding consistency of the capital expenditure in line with business strategy and growth opportunities. Analyzing C/F from Financing Activities Positive net financing cash flow is good if it is the result of increase in the equity capital. Positive net financing cash flow is not so good if it is the result of excessive borrowing as it will adversely affect the debt-equity and debt servicing capacity of the firm. Negative net financing cash flow, on the other hand, indicates that the firm has either repaid existing loans or given more dividends. In this particular case a credit analyst may try to understand how efficiently the firm is managing a tradeoff between Tax Advantages from increased debt and bankruptcy cost. Identifying Good Borrower Profile Based on Cash Flows The following table summarizes the cash flow profiles of five companies and generalized comments. These comments will hold true if other things are favorable to the firm. However, real life situation may be very complex. Particulars Net C/F from Operating Activities Net C/F from Investing Activities Net C/F from Financing Activities Comments on Firm’s Position based on Cash Flows Does the firm need new bank finance for capital expenditure? A + + + Nonexistent No B + + Best (Matured) No Study Material on Advance Level Credit for NCC Bank Limited Companies C + Best (Maturing) May be D + + Best (Growing) May be E Worst No 41 | P a g e Exercise on Preparation of Cash Flow Statement Balance Sheet As at December 31, 2019 Account titles Assets Cash Accounts Receivable Inventories Prepaid Expenses Land Property, Plant, and Equipment Less: Accumulated Depreciation Total Assets Liabilities & Owner’s Equity Accounts Payable Accrued Expenses Payable Interest Payable Income Tax Payable Bonds Payable Common Stock Retained earnings Total Liabilities and Equity 2019 (Tk.) 2018 (Tk.) 23,000 24,000 20,000 20,000 40,000 200,000 (50,000) 277,000 13,000 33,000 27,000 13,000 40,000 225,000 (67,500) 283,500 9,000 9,500 1,000 3,000 50,000 123,000 81,500 277,000 18,500 7,500 1,500 2,000 80,000 105,000 69,000 283,500 Sohana Ltd. Income Statement For the year ended December 31, 2019 Sales Gain on sale of Plant Assets Total Revenues &Gains Less: Expenses: Cost of Goods Sold Operating Expenses Depreciation expenses Interest Expenses Income tax Expenses Total Expenses Net Income 600,000 2,500 602,500 500,000 60,000 7,500 5,000 9,000 581,500 21,000 Additional information: 1. Plant assets were sold at Tk.62,500 2. Additional equipment was purchased at a cost of Tk.60,000 3. Cash dividends of Tk.8,500 were declared and paid 4. Bonds were redeemed at face value 5. Common stock was issued for cash Study Material on Advance Level Credit for NCC Bank Limited 42 | P a g e Case Study on Financial Spread Sheet (FSS) AHMED TOYS (PVT.) LIMITED Balance Sheet As on 31st December Particulars ASSETS A. Current Assets Stock & Stores Advances & Deposits Prepaid Expenses Account Receivables Marketable securities Cash in hand Cash at bank Total Current Assets (A) 2019 2018 2017 90,000 35,000 16,000 200,000 76,000 54,000 93,000 564,000 88,000 32,000 14,000 70,000 40,000 4,000 29,000 277,000 88,000 5,000 10,000 25,000 nil 3,000 4,000 135,000 100,000 50,000 2566,000 n i l 2716,000 3280,000 nil 40,000 2928,000 5,000 2973,000 3250,000 nil 40,000 3238,000 10,000 3288000 3423,000 nil 161,000 7,000 21,000 36,000 20,000 245,000 10,000 142,000 38,000 9,000 26,000 15,000 240,000 20,000 300,000 40,000 29,000 17,000 11,000 417,000 1350,000 1450,000 1550,000 E. Total Liabilities (C+D) CAPITAL F. Shareholders’ Equity Share Capital (12,500 shares @ Tk.100 each) General Reserve Retained Earnings Total shareholders’ equity (F) 1595,000 1690,000 1967,000 1250,000 161,000 274,000 1685,000 1250,000 125,000 185,000 1560,000 1250,000 96,000 110,000 1456,000 A. Total Liabilities & Shareholders’ Equity (E+F) 3280,000 3250,000 3423,000 B. Non-Current Assets Investment in Associated Company Investment in Subsidiary Company Tangible Fixed Assets (As per Annex 5) Preliminary Expenses Total Non-current Assets (B) Total Assets (A+B) LIABILITIES C. Current Liabilities Due to directors Cash Credit Expenses Accruals Accounts Payable Proposed Dividend Tax Provision Total Current Liabilities (C) D. Non-Current Liabilities Long Term Loans Note: Contingent liability of the company is Tk.9.00 lac and annual installment on long term loan is Tk.1.0 lac each year. Study Material on Advance Level Credit for NCC Bank Limited 43 | P a g e AHMED TOYS (PVT.) LIMITED Income Statement For the year ended 31st December Particulars 1. Net sales 2. Cost of Goods Sold (Annex 1) 3. Gross Profit (1- 2) 4. Operating Expenses: Admn. & General ( Annex 2 ) Selling & Distribution (Annex 3) 5. 6. 7. 8. 9. 10. 11. 12. Operating profit (3 – 4) Non-operating Expense (Annex 4) Profit before tax (5 - 6) Provision for Taxation Net profit after tax (7 - 8) Add, Balance of profit b/f from previous year Surplus Available for Appropriations (9+10) Appropriations: Transferred to General Reserve Proposed Dividend 13. Balance of profit /Retained Earnings tr. to B/S (11 – 12) Study Material on Advance Level Credit for NCC Bank Limited 2019 1325,000 1072,000 253,000 2018 1245,000 1032,000 213,000 2017 1132,000 965,000 167,000 42,000 16,000 58,000 195,000 14,000 181,000 20,000 161,000 185,000 346,000 39,000 16,000 55,000 158,000 13,000 145,000 15,000 130,000 110,000 240,000 25,000 15,000 40,000 127,000 13,000 114,000 11,000 103,000 47,000 150,000 36,000 36,000 72,000 274,000 29,000 26,000 55,000 185,000 23,000 17,000 40,000 110,000 44 | P a g e Annexure Annex 1 Cost of Goods Sold Particulars 1. Opening Stock of Finished Goods 2. Cost of Goods Manufactured (Annex 1.1 3. Cost of Goods Available for Sales (1+2) 4. Closing Stock of Finished Goods 5. Cost of Goods Sold (1+2 – 3) 2019 40,000 1072,000 1112,000 (40,000) 1072,000 2018 40,000 1032,000 1072,000 (40,000) 1032,000 2017 51,000 954,000 1005,000 (40,000) 965,000 Annex 1.1 Cost of Goods Manufactured Particulars 1. Opening Stock of Work-in-process 2. Raw Materials Used (Annex 1.2) 3. Manufacturing Cost (Annex 1.3) 4. Closing Stock of Work-in-process 5. Cost of Production/Manufacturing Cost 2019 11,000 575,000 496,000 (10,000) 1072,000 2018 12,000 612,000 419,000 (11,000) 1032,000 2017 22,000 598,000 346,000 (12,000) 954,000 Annex 1.2 Cost of Materials Used Particulars 1. Opening Stock of Raw Materials 2. Add, Net Purchase of Raw Materials 3. Raw materials Available 4. Less, Closing Stock of raw Materials 5. Cost of Raw Materials Used 2019 37,000 578,000 615,000 40,000 575,000 2018 36,000 613,000 649,000 37,000 612,000 2017 36,000 598,000 634,000 36,000 598,000 Annex 1.3 Manufacturing Cost Particulars Wages, Bonus & Allowances Power, Fuel & Gas Godown Rent Repairs & Maintenance Excise Duty Depreciation Others manufacturing cost Total Study Material on Advance Level Credit for NCC Bank Limited 2019 15,000 15,000 2,000 3,000 21,000 430,000 10,000 496,000 2018 13,000 15,000 2,000 3,000 20,000 356,000 10,000 419,000 2017 13,000 15,000 2,000 3,000 20,000 284,000 9,000 346,000 45 | P a g e Annex 2 Administration and General Expenses Particulars 1. Salaries & Allowances 2. Office Rent 3. Tel., Telex & Fax 4. Stationery 5. Travelling & Conveyance 6. Donation 7. Audit & Legal Fees 8. Bad Debts 9. Misc. Expenses 10. Depreciation 11. Preliminary Expense Write-off Total 2019 13,000 4,000 2,000 2,000 3,000 1,000 1,000 2,000 3,000 6,000 5,000 42,000 2018 12,000 3,000 2,000 2,000 2,000 1,000 2,000 2,000 2,000 6,000 5,000 39,000 2017 10,000 3,000 1,000 2,000 1,000 1,000 1,000 2,000 1,000 3,000 n i l 25,000 Annex 3 Selling and Distribution Expense Particulars Sales Commission Sales Promotion Expenses Advertisement Travelling Carriage Outwards Total 2019 5,000 3,000 3,000 2,000 3,000 16,000 2018 5,000 3,000 3,000 2,000 3,000 16,000 2017 5,000 2,000 3,000 2,000 3,000 15,000 Annex 4 Non-operating Expenses: Financial Particulars Bank Interest Bank Charge & Commission Total 2019 10,000 4,000 14,000 2018 10,000 3,000 13,000 2017 10,000 3,000 13,000 Annex 5 Schedule of Fixed Assets (Tk.’000) Items W.D.V Land 125 Factory Building 378 Plant & Machinery 1838 Equipment 161 Furniture & Fixture 64 Total 2566 2019 Additi on 0 0 0 72 2 74 Acc. Dep. W.D.V 0 125 162 420 992 2198 154 117 18 68 1326 2928 2018 Additi on 0 0 23 0 29 52 20137 Acc. Dep. W.D.V 0 125 120 460 632 2383 126 225 12 45 890 3238 Acc. Dep. 0 80 424 18 6 528 Note: Cost of the Fixed Assets = W.D.V + Accumulated Dep. Written Down Value (W.D.V) = Cost – Accumulated Depreciation. Requirement: Complete the following FSS format with the above information Study Material on Advance Level Credit for NCC Bank Limited 46 | P a g e AHMED TOYS (PVT.) LIMITED Auditor Analyst FYE Period Amount DETAILED FINANCIALS REPORT AUDITED AUDITED AUDITED Year 12 Mths in (000) Taka Year 12 Mths in (000) Taka Year 12 Mths in (000) Taka TRUE TRUE TRUE CURRENT ASSETS Cash/Bank Balances L/C Margin Marketable Securities A/R-Trade A/R-Other Office Supplies Goods-in-transit Inventory Due from Affiliates - Current Other Current Assets FIXED ASSETS Tangible Fixed Assets at Cost Price Less: Accumulated Depreciation NON-CURRENT ASSETS Due from Affiliates - Non Current Deferred Charges, Pre-payments & Advances CURRENT LIABILITIES Short Term Bank Borrowings Current Funded Portion of Term Debt (CMLTD) LONG TERM LIABILITIES Term Loan NET WORTH Paid up Capital Directors Loan(subordinated) Retained Earnings Reserves BALANCE Difference (if any) Study Material on Advance Level Credit for NCC Bank Limited 0 0 47 | P a g e 0 AHMED TOYS (PVT.) LIMITED Auditor Analyst FYE Period Amount AUDITED AUDITED AUDITED Year 12 Mths in (000) Taka Year 12 Mths in (000) Taka Year 12 Mths in (000) Taka TRUE TRUE INCOME STATEMENT Gross Sales Less: VAT Add: Other Operating Income Less :Cost of Goods Sold Less: Selling. Gen. & Admin. Expenses Less: Depreciation Less: Interest Expense Add: Other Income Income Taxes Reserve Cash Withdrawals/Dividend BALANCE Difference (if any) Study Material on Advance Level Credit for NCC Bank Limited 0 0 48 | P a g e 5.3 Capital Budgeting Techniques 5.3.1 Introduction  Capital Budgeting is the process of planning expenditures on assets whose cash flows are expected to extend beyond one year.  Capital budgeting refers to the investment decision involving fixed asset of a firm.  The term capital refers to the fixed assets used in production and budget is a plan that details projected inflows and outflows during some future periods.  Thus capital budget in an outline of planned expenditures on fixed assets and capital budgeting is the process of analyzing projects and deciding which are acceptable projects. 5.3.2 Capital Budgeting Techniques 5.3.2.1 Payback Period (PBP)  Payback period is defined as the length of time or expected member of years required to recover the original investment.  To compute a projects payback period, simply add up the expected cash flows for each year until the commutative value is equal to the total amount initially invested. Example: Cash flows for projects A and B are as follows. Calculate the payback period for projects A and B Year 0 1 2 3 4 Expected cash flows (CFs) Project A Project B Tk. (3,000) Tk. (3,000) 1,500 400 1,200 900 800 1,300 300 1,500 Project A: Year Net cash flow Cumulative net cash flow 0 -3,000 -3,000 Study Material on Advance Level Credit for NCC Bank Limited 1 1,500 -1,500 2 1,200 -300 3 800 500 4 300 800 49 | P a g e Project B: Year Net cash flow Cumulative net cash flow 0 -3,000 -3,000 1 400 -2,600 2 900 -1,700 3 1,300 -400 4 1,500 1,100 The exact period can be found using the following formula:  Years before full re cov ery   Unre cov ered cos t at start of full re cov ery year      Payback   Total cash flow during full re cov ery year  of original investment    For Pr oject A, Payback  2  For Pr oject B, Payback  3  300  2.4 years 800 400  3.27 years 1500 Payback Period Decision Rule The top management will prescribe a standard (maximum) time period to recover the initial investment.  If PBP < the standard period, accept the project  If PBP > the standard period, reject the project  If PBP = the standard period, decision is indifferent So shorter the payback period, more feasible is the project. Payback is a type of “breakeven” calculation – when the project will break even. Limitations of Payback Period The payback method is very simple but ignores the time value of money. The cash flows beyond the payback period are also ignored. A project may have greater cash flow in later years, which would make it more preferable. 5.3.2.2 Discounted Payback Period (DPBP) The discounted payback period is the length of time until the sum of discounted cash flows is equal to the initial investment. Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some pre-specified number of years. Study Material on Advance Level Credit for NCC Bank Limited 50 | P a g e Example: Calculate the discounted payback period for projects A with discount rate 10% Year Cash Flow Discounted Cash Flow Cumulative net cash flow (discounted) 0 -3,000 -3,000 -3,000 For Pr oject A, Discounted Payback  3  1 1,500 1363.64 -1636.36 2 1,200 991.74 -644.62 3 800 601.05 -43.57 4 300 204.90 161.33 43.57  3.2 years 204.90 Discounted payback is better than the ordinary payback because it considers time value. The ordinary payback does not take this into account. But discounted payback period rule has a couple of other significant drawbacks. The biggest one is that the cutoff still has to be arbitrary and cash flows beyond that point are ignored. 5.3.2.3 Net Present Value (NPV) Net present value (NPV) is a measure of how much value is created or added today by undertaking an investment. Given our goal of creating value for the shareholders, the capital budgeting process can be viewed as a search for investments with positive net present values. NPV relies on discounted cash flow (DCF) techniques, which is the process of valuing an investment by discounting its future cash flows. NPV is computed using the following equation: NPV  CF1 1  k  1  CF2 1  k  2    n CFn 1  k  n  I0   t 1 CFt 1  k t  I0 where, I0 = Initial Investment CFt = Expected net cash flow at period t k= Rate of return required by the firm (generally the firm’s cost of capital) to invest in the project n= The projects duration in years An NPV of zero signifies that the project’s cash flow is just sufficient to repay the investment capital and to provide the required rate of return on that capital, which is k. Study Material on Advance Level Credit for NCC Bank Limited 51 | P a g e If a project has a positive NPV, then it generates a return that is greater than is needed to pay for the funds provided by investors. Therefore the firm’s value will be improved. Example: Considering project A when k = 10% 0 K = 10% (3,000) Cash flow 1 2 3 4 1,500 1,200 800 300 1,363.64 991.74 601.05 204.90 NPVA = Tk. 161.33 Using the formula: NPVA  1,500 1,200 800 300     3000 1 2 3 1.1 1.1 1.1 1.14 = 1363.64 + 991.74 + 601.05 + 204.90 – 3000 = Tk.161.33 Similarly, project B’s NPVB = Tk. 108.67 Decision Criteria for NPV  If NPV >0, the project should be accepted.  If NPV 1.00 Reject project if PI < 1.00 5.3.2.5 Internal Rate of Return (IRR) The internal rate of return (IRR) is defined as the discount rate that equates the present value of the initial investment outlays to the present value of the future cash inflows. In other words, IRR is the discount rate that equates the NPV of an investment opportunity with zero. IRR is calculated as follows. CF3 CF1 CF2 CFn       Initial Investment (I 0 ) 2 3 1  IRR  1  IRR  1  IRR  1  IRR n n  t 1 CFt 1  IRR t  I0  0 IRR from the above mentioned formula requires a “trial and error” solution for investment projects whose cash flows are received over a period of years. The computational procedure is as follows  Given the cash flow and investment outlay, choose a discount rate at random and calculate the project’s NPV.  If the NPV is positive, choose a higher discount rate and repeat the procedure.  If the NPV is negative, choose a lower discount rate and repeat the procedure.  Find the discount rate, which makes the NPV = 0 is the IRR. Example: Calculation of IRR for a Hypothetical Project When discount rate is 10% Year 1 2 3 Net Cash Flow 452 500 278 Discount Factor 0.909 0.826 0.751 PV of Cash Inflow Less: Initial Investment NPV Study Material on Advance Level Credit for NCC Bank Limited PV of Cash Flow 411 413 209 1033 - 1000 + 33 53 | P a g e When discount rate is 14% Year 1 2 3 Net Cash Flow 452 500 278 Discount Factor 0.877 0.769 0.675 PV of Cash Inflow Less: Initial Investment NPV PV of Cash Flow 396 385 188 969 - 1000 - 31 Discount Factor 0.893 0.797 0.712 PV of Cash Inflow Less: Initial Investment NPV PV of Cash Flow 403 399 198 1000 - 1000 0 When discount rate is 12% Year 1 2 3 Net Cash Flow 452 500 278 The above trial and error method can easily solved by using the following method  Choose a discount rate at random which makes the NPV of the project positive. This discount rate is known as lower discount rate (LDR).  Choose a higher discount rate (HDR), which makes the NPV negative.  Solve the following equation IRR  LDR  NPV @ LDR  HDR  LDR  NPV @ LDR  NPV @ HDR  For the above example, LDR = 10%, HDR = 14%, NPV @ 10% = + 33, NPV @ 14% = - 31 IRR  10%  33  (14%  10%)  12% (33  31) Decision Criteria for IRR  If IRR > Cost of Capital (k), accept the project.  If IRR < Cost of Capital (k), reject the project.  If IRR = Cost of Capital (k), the firm would be indifferent to the project. For a project to be acceptable, the IRR must exceed or at least equal to the firm’s cost of capital or opportunity cost. Study Material on Advance Level Credit for NCC Bank Limited 54 | P a g e 5.3.3 Case Study on Capital Budgeting Techniques Case-1: The Khaleque group is contemplating the purchase of a new milling machine. The machine will cost Tk.6,00,000. The machine is expected to generate earnings before depreciation and taxes of Tk.2,00,000 each year over its 5-year economic life. Mr. Khaleque is aware that the tax law will most probably be changed before acquisition of the new machine. Proposed changes would necessitate using five-year straight-line depreciation rather than the three-year MACRS schedule. Khaleque's tax rates would increase to 40% instead of current 34%. Khaleque's cost of capital is 12%. Compute the NPV and IRR of the new machine under existing depreciation and tax laws. Case-2: A plastic manufacturing company is considering replacing an older machine, which was fully depreciated for tax purposes with a new machine costing Tk. 40,000. The new machine will be depreciated over its eight years lifetime to zero on a straight-line basis. It is estimated that the new machine will reduce labor costs by Tk. 8,000 per year. The management believes that there will be no change in other expenses and revenues of the firm due to the machine. The company requires an after tax return on investment of 10%. Its rate of tax is 55%. The company's income statement for the current year is given for other information. Should the company buy the new machine? Income statement for the current year: Sales Costs: Materials Labor Factory & Admin. Overhead Depreciation Income Before Tax Less: Tax@55% Income After Tax Tk.5,00,000 Tk. 1,50,000 Tk. 2,00,000 Tk. 40,000 Tk. 40,000 Study Material on Advance Level Credit for NCC Bank Limited Tk.4,30,000 Tk.70,000 Tk.38,500 Tk.31,500 55 | P a g e Case-3: M.M Spinning Mill Ltd. is an export oriented thread manufacturer in Bangladesh. It has submitted its Loan proposal to your bank providing the following informationThe project is expected to last approximately 10 years. The total cost has been estimated by the entrepreneur is Tk.9 crore. The company has a capacity to produce 1,00,000 ton thread per year and the price per ton is Tk.300. The company incurs Tk.5,00,000 as operating cost excluding the depreciation. The financial statement of the company reveals that it pays Tk.50,000 interest on the previous loan taken from a local bank which will continue for next 3 years. At the termination of the project its equipment can be sold at Tk.1 crore and the recovery of working capital of Tk.1 crore is possible. It is known further that in the fifth year additional Tk.2,00,000 is required to maintain the machinery of the company and it follows straight line depreciation method. The company pays 40% taxes on its income and cost of capital is 15%. Requirements: 1. Determine the cash flows required to perform the CBT analysis. 2. Calculate NPV and IRR 3. Should the project be financed? 4. Perform a sensitivity analysis. 5. Is there any change in your decisions? Study Material on Advance Level Credit for NCC Bank Limited 56 | P a g e 5.4 Sensitivity Analysis The most common method of evaluating project’s source of risk is the sensitivity analysis. The net cash flow from a project depends on many variables,