Term Loan Appraisal with DSCR

Introduction:

Many younger generation officers are joining the banks like never ending waves year after year.  Unlike olden days the percentage of people joining the bank with commerce back ground is becoming a rare commodity.  Now seeing MBAs, Engineering graduates, etc. are common in the work place.  In this juncture the need for certain basic appraisal functions of banks and hidden meanings in that process is well pronounced.  Many a times the youngsters are learning banking through trial and error or turning the book and leaning the work.  Banking being the backbone of the economy of any country, when we understand the fundamentals of credit appraisal in general and term loan appraisal in particular, the future is bright for the industry and future leaders of banking.

Term Loan in commercial banks:

The Term Loan as a regular concept is inducted in the commercial bankers precisely after the landmark year in the banking industry i.e., 1990-91. The year of globalization and privatization introduced by Dr. Manmohan Singh, the then finance minister.    Earlier to that there was a clear cut demarcation between commercial bankers and term lending institutions.  The banking industry itself was clearly segmented into Term Lending institutions and Commercial Banks.  The Term Lending institutions were taking care of long term funding of term loans through their expertise in this field; the commercial bankers were happy with their bread and butter the working capital finance.   Post Liberalization, Privatization and Globalization (popularly known as LPG) the demarcation of Term Lending institutions and Commercial Banks were removed.  Introduced amidst this chaos with which banking industry was going through, the Public Private Partnership known as BOOT BOT BOLT and in other various names to fund the infrastructure specifically.    There were opened with a new concept term lending without actual security except future receivables.  While the regulator Reserve Bank of India, gradually but steadily removing the clutches of directions and control, one of the last such decontrol measures viz. decontrolling the Savings Banks Interest rate was also introduced.

In the initial period after removal of the barrier between Term Lending Institutions and Commercial Banks in their nature of financing the economy, the Term Lending Institutions started opening commercial banks and commercial banks took up to Term Lending in a big way.   While the switchover from Term Lending to Commercial banking was a cake walk for the term lending institutions, it was a double edged sword for commercial banks.  For Term Lending an institution with the advantage of computerization from day one and learning the nuances of working capital was simpler as they had the experience of foreseeing the future of the industry while scheduling their repayment.  For commercial banks the peak of computerization started during this turbulent period and forecasting for a period of 15 years a normal repayment for a PPP project was something never heard of.   Further majority of their liabilities were demand in nature viz. Current Account and Savings account (CASA)

In this background, the clear idea of Term Loan appraisal is more important for the commercial banks especially the important points about their nature and how to assess them is highly needed for the young generation.

What is Term Loan?

A Term Loan is normally for creation of assets and repayment of which starts with a minimum of 3 years period.  Other than infrastructure and core industries, the usual repayment period the commercial banks accustomed with is for 84 months.  For any business entity whether it is Manufacturing, Producing, Trading and servicing the loans are basically converted into creation of fixed assets and using those fixed assets to generate profits.  To a proper understanding let us say that this is “Starting”/”Establishing” the business and “Running” it are two different entities.  While all the term loans sanctioned by banks are generally for creation of assets, there is a distinct difference between the term loans.  One type of Term Loan is called Asset Financing and another is called Project Financing.

The basic difference between Asset Financing and Project Financing is to be seen in fixing their mode of repayment.  In simple terms if the repayment is going to be out of existing cash flows, then it is asset financing and if it is out of future cash flows, that is going to be generated out of using such assets created by our Term Loan then it is Project financing.   It can be explained in a simple example of purchasing a car for personal use and purchasing the same car for running a taxi business.   The repayment is normally decided by two factors in case of asset financing i.e., willingness to pay and capacity to pay whereas in case of project financing the entire gamut of personal integrity, technical appraisal, managerial appraisal, environmental appraisal, financial appraisal, competition etc.

This is the prime reason why normally asset financing is with Equated Monthly Installment (EMI) as an option and project financing is with moratorium and repayment of interest and installment separately.   It means only when the profit start accruing in the business after the achieving the Date of Commercial Production.

What we are going to bother about?

There are plenty of academic books to enlighten the participant about the various types of appraisal viz., Personal, Technical, Managerial, Financial, Environmental appraisals.  So, what we are going to study in this article from a banker’s point of vieware the following:

  1. Soft Cost and Hard Cost
  2. Subordination of debts other than bank’s term loan.
  3. Difference between Discounted and Non Discounted methods of repayment, its proper understanding and from whose point of view these are important.
  4. Clear understanding of DSCR the fulcrum of the appraisal when it comes to Project Financing.
  5. What actually depreciation is and how it can be used to siphon off the funds?

 

  1. Soft Cost and Hard Cost

When we see the Cost and Means or Sources and Uses of a Project, the costs are generally bifurcated in the following major heads.

  • Land and Buildings
  • Plant and Machinery
  • Furniture and Fixtures
  • Preliminary Expenses
  • Pre-Operative Expenses
  • Consultancy Costs.
  • Contingency
  • Interest During Construction
  • Margin for Working Capital.

When it comes to cost, it is segregated into Hard and Soft Costs.   The difference of these lies in the nature of security that is available for our security.  It can be said as availability of tangible security as Prime Security to the bank’s Term Loan.   The first three expenses/investments definitely create an asset which is tangible.  The assets created by other types of expenses are not generally creating any tangible assets as security for the banks.  In case of pre-operative expenses, the companies act permits certain expenses to be capitalized and other than that the rest of the expenses are not creating any tangible security.  In case of working capital all the security available for the bank finance is current assets which by nature of definition are convertible into cash at short notice. In case of Term Loan the security is the main concern of the banks when it comes to tangibility of assets.   Since these soft costs do not generate any tangible assets normally as a banker we exclude these items from the point of financing them.  This is the prime reason why the margin in the project is always higher the stipulated margin, as these soft costs are to be fully borne by the promoters.  The credit processing officer should not fall in this trap like asset financing.  In asset financing we normally see the cost and prescribe the margin for the entire costs.  Normally in big projects this will be restricted to a spread of 3 to 5% with Interest during Construction at the actuals.  In small projects like Start Up India, the guidelines are in place with a maximum of 25% of the project cost towards these soft costs.  Except for few corporate houses, normally the big Projects are never completed within the scheduled date as such it invariably results in time overrun.  When time overrun happens, it has to result by default in cost overrun.  As a limited recourse, these type of unexpected expenses are to be financed by the promoters for which bankers always take a declaration to this effect.

  1. Subordination of debts other than bank’s Term Loans:

The usual bifurcation of sources or means side of the project can be divided into three main categories:

  • Promoter’s Capital
  • Bank’s Term Loan
  • Other secured and unsecured loans

Many business entities which are applying for the Term Loan are usually in the form corporate concerns.  It may be private, closely held private, listed private or public enterprises.   There are some business activities where the entire capital cannot be brought in as shares.  With PPP module, the Special Purpose Vehicle (SPV) clearly states that once the project is over and amount recovered then it will be dismantled at the time handing over the project assets to the appropriate government authorities.  In specific cases like this, the capital is always brought in by minimum capital and rest infused as unsecured loans.   The most important factor the banker has to consider is the prioritization of the repayments.  As long as the bank’s dues are pending, the promoter should not be allowed to withdraw his loan.  This can be taken care by stipulating conditions like “Dividend” should not be declared without prior permission in the initial periods.  The best option to check early removal of profits from the system towards repayment of unsecured loans is to subordinate all unsecured loans from friends, relatives, directors or any other source to our bank’s term loan.  There cannot be any repayment of interest and/or repayment of unsecured loans when there is a due for bank’s interest and/or installments.

There is also another drawback played by the borrowers in projecting these unsecured loans as Quasi Capital.   In case of industries like Commercial Real Estate where the borrower exits the scene once the project is over this request is understandable and acceptable.  This request as routine matter of fact cannot be accepted by banks.  There are certain banks which have taken proactive and preemptive actions to check this menace.   Due to practical difficulties when the amount is introduced as unsecured loan, then the distribution of profit should be equally towards repayment of term loan interest and installments first, then to the owners.  In case of regular capital this can be declared as “dividend” and in the years where there is no profit is made then it is not possible to declare “Dividends”. Taking this fundamental principle into account some bankers introduced that the unsecured loans to be treated as Quasi Capital should not rank for any payment of interest.   If this check is not in place, then even without making any profit in the system, they will be taking out their loan on priority basis in the name of interest.

  1. Discounted and Non discounted methods of determining repayment or taking back the investment.

Any term loan by the banks is a long term investment decision which is beyond doubt.  In most of the cases the maximum contribution towards financial assistance in the form of term loan is done by the banks only.   Rather it is our investment is more in any project compared to the owner’s investment by way of capital and / or unsecured loan.  As such the psyche of bankers and borrowers are totally poles apart.  The bankers are more bothered about the repayment of their principal while interest is to be paid separately over the years.   The present money value concept is taken care by fixing appropriate interest and tenor premium into interest cost.  Resultantly the bankers prefer Non Discounted method of repayment fixing.   What is Non Discounted Method of repayment is we are taking the future cash flows projected as it is without discounting it to its real value as of today.  Say for example if the borrower says he will be making Rs.5 lakhs profit 3 years down the line, we take that amount as it is.  So for the bankers, Debt Service Coverage Ratio (DSCR) is the prime instrument in determining the repayment period with appropriate repayment holiday for principal repayment known as “Moratorium” period.   If we talk of bankers they are comfortable with Non Discounted method of repayment through the dual formulae DSCR and Fixed Assets Coverage Ratio (FACR).

For the borrower he is more bothered about his investment in the project and taking back the investment with acceptable minimum profit after meeting all his costs.  Borrower’s line of thinking is if I invest Rs.1 lakh in the project then how much future profit the investment decision gives during the total yielding period of investment.  In other words, if the borrowers invest Rs.1 lakh today in Reinvestment Certificate and he gets Rs.2 lakhs as total return over a period of 5 years he is approximately getting 12+% as interest.  To say the Rs.1 lakh today has become Rs.2 lakhs in the course of 5 years and the value of Rs.2 lakhs in future is equal to today’s investment of Rs.1 lakhs.  The yield is 12+% .  Assuming the average project cost is working out to 13% and all the future incomes discounted to today’s value is marginally equal to the cost then the unit stands no chance of worth investing.   Literally he discounts all the future income alongwith the residual value of investment to today’s investment.  This is also called as Internal Rate of Return (IRR).  If he is getting a decent return over and above the average project cost then there will be an inclination to invest in the project.  Since the borrower is discounting the future income / profit / cash flows of the project to the present value of money, this is called as discounted value of investment.

Though the investment / loan for the project is by both borrower and banks, the determination of viability of the unit in terms of loan repayment / taking back the investment through discounted and non-discounted methods of repayment are serving varied interests of the parties involved.   It is like chalk and cheese in comparison.  While the method of “Non Discounted” approach is for bankers, where the return for the bank is determined by the suitable interest cost including tenor premium, “Discounted” approach is for the borrower to determine whether he is getting real return by discounting it to today’s value of all future income.

  1. Clear understanding of DSCR formula:

The two formulae for the bankers available to fix the repayment and ensure proper loan to value ratio are Debt Service Coverage Ratio (DSCR) and Fixed Assets Coverage Ratio (FACR).  The formula for DSCR is

DSCR = Profit after Tax(PAT) + Depreciation + Interest on Term Loan

Installment of Term Loan + Interest on Term Loan

Through this formula the banker is analyzing the profit generated by the project and whether it is sufficient to meet the payment obligation of the borrower.  The PAT is without an iota of doubt is the final cash flow available with the borrower after meeting all his revenue expenses.  The Depreciation is nothing but a book entry to adjust the books of accounts as per Accounting Standards to provide for wear and tear of the plant and machinery.  Please note that there is no depreciation for land which is always appreciating.   The interest on Term Loan is added back.  There are two reasons.  In repayment terms it is clearly mentioned that “Interest” is to be paid for the term loan as and when debited whereas the installment is determined after commercial production and accrual of profits into the system.   A question may arise as to how the borrower is paying the interest till Date of Commencement of Commercial Operation, the answer is available in the fact that there is a cost called “Interest During Construction”.   This interest cost in IDC is to be checked for parlance at the time of process/disbursement of loan.  Since the borrower is paying the interest after commercial production alongwith the commencement of principal repayment only out of real profit accrued in the system, the same is added back to know the real position of the cash accruals available as inflows.  There is no difference of opinion when it comes to denominator where both interest and installment are only outflows.  The average DSCR is normally expected at 1.5 as average for the entire repayment period and a minimum DSCR of 1.2 for any particular year.  Credit Officer has to remember another basic fact that average DSCR is averages of DSCR but Total inflow / Total outflow for the entire repayment period.  DSCR is also not calculated for the moratorium period, as literally there is no inflow for the business entity.

Fixed Assets Coverage Ratio is another tool used extensively by the banker for the entire repayment period to ensure that the margin which was originally available at the time sanction of loan, is maintained till the repayment of entire time loan.

FACR = (Assets – Depreciation)/Long Term Debt outstanding (for the assets created out of the Term Loan)

  1. What is Depreciation and how it can be used for siphoning of the funds:

Depreciation is actually a book entry to account for the erosion of value of fixed uses.  The profit which is a real cash inflow is debited to the extent of depreciation and reduced profit is shown.  On the other side to the extent of provided depreciation, the value of fixed assets is reduced.  Though the balance sheet is tallied, the real profit has never come down.  In other words to know the exact profit generated in the system in real terms it is always advisable to add depreciation back to PAT which is giving the true cash accrual in the system.

Depreciation as per Accounting Standard 6, is actually an amount debited to P&L account and permitted to be written off with Fixed Assets value as per Companies Act to account for erosion of value in the Fixed Assets due to wear and tear.  This may be by way of Straight line method or Written Down Value method.  A Straight line method in simple terms is assuming a fixed percentage of depreciation after assuming the maximum period upto which the machinery is to be used without replacement.  Let us assume that if the machinery is going to serve for 5 years after which it needs replacement, then a flat 20% depreciation is provided.  Supposing if the machinery will be having a residual value then the same is reduced to fix the percentage of depreciation.   Written down value method is assuming a fixed percentage of depreciation till the machinery is replaced.  If a machinery is bought for Rs.1,00,000 and the depreciation percentage is 10% then on first year it will be provided with the depreciation of Rs.10000, next year Rs.9,000, followed by Rs.8100 etc.

While this method is playing a crucial role as per the Companies Act it also permits to change the depreciation method from one to another by the borrower.  By changing the method from Straight line to WDV his book profit will be boosted up and if he wants to reduce the profit for tax, then he will change from WDV to Straight line in bumper years of profit.  In Straight line to WDV excess depreciation provided is added back to profit and vice versa in the other method it reduces the profit.  Either way the banker should be careful while dealing with the Depreciation not only during the time of processing but also during subsequent years during the tenure of the term loan.

We should also probe a question normally we take into account only Balance Sheet and Profit & Loss account for deciding the repayment capacity of the borrower to the Term Loan.  Surprisingly in both these statements, there is no entry called as “Repayment of Term Loan Installments”.  Then the question should arise then how he is repaying the term loan installments.  If we dissect further, it will be crystal clear that “Depreciation” is nothing but the repayment of Term Loan Installments in disguise.  Now let us see through a simple example how this can be manipulated in taking away the profit from the system.

Let us assume a Term Loan with repayment period of 5 years and at aa 20% margin is sanctioned for Rs.5 lakhs which includes the margin.  Now the composition of the balance sheet at the end of various years is described as below.

Year 0 TL FA
Bank’s Term Loan

Promoters Margin

Rs.4,00,000

Rs.1,00,000

Fixed Assets Rs.5,00,000
Year 1 TL FA
Bank’s Term Loan

Promoters Margin

Rs.3,20,000

Rs.80,000

Fixed Assets Rs.4,00,000
Profit Rs.1,20,000
To Depreciation Rs.1,00,000 By Depreciation Rs.1,00,000
Surplus in P&L Rs.20,000
Year 2 TL FA
Bank’s Term Loan

Promoters Margin

Rs.2,40,000

Rs.60,000

Fixed Assets Rs.3,00,000
Profit Rs.1,60,000
To Depreciation Rs.1,00,000 By Depreciation Rs.1,00,000
Accumulated Surplus in P&L Rs.80,000
Year 3 TL FA
Bank’s Term Loan

Promoters Margin

Rs.1,60,000

Rs.40,000

Fixed Assets Rs.2,00,000
Profit Rs.1,60,000
To Depreciation Rs.1,00,000 By Depreciation 1,00,000
Accumulated Surplus in P&L Rs.1,40,000
Year 4 TL FA
Bank’s Term Loan

Promoters Margin

Rs.80,000

Rs.20,000

Fixed Assets Rs.1,00,000
Profit Rs.2,00,000
To Depreciation Rs.1,00,000 By Depreciation 1,00,000
Accumulated Surplus in P&L Rs.2,40,000
Year 5 TL FA
Bank’s Term Loan

Promoters Margin

Rs.Nil

Rs,Nil

Fixed Assets Rs. Nil
Profit Rs.2,40,000
To Depreciation Rs.1,00,000 By Depreciation 1,00,000
Accumulated Surplus in P&L Rs.3,80,000

Ideally the promoter’s margin which he would have inducted by way of Unsecured Loan is reducing in sync with the bank’s loan.  At the end of the five years he can replace the machinery with the accumulated surplus in P&L.  If the borrower wants to siphon off the money at a rate faster than the repayment of bank, of course through legal book entries, then let us see how it is going to change in the above equation.

Year 0 TL FA
Bank’s Term Loan

Promoters Margin

Rs.4,00,000

Rs.1,00,000

Fixed Assets Rs.5,00,000
Year 1 TL FA
Bank’s Term Loan

Promoters Margin

Rs.3,20,000

Rs.60,000

Fixed Assets Rs.3,80,000
Profit Rs.1,20,000
To Depreciation Rs.1,20,000 By Depreciation Rs.1,20,000
Surplus in P&L Rs.0.00
Year 2 TL FA
Bank’s Term Loan

Promoters Margin

Rs.2,40,000

Rs.20,000

Fixed Assets Rs.2,60,000
Profit Rs.1,60,000
To Depreciation Rs.1,20,000 By Depreciation Rs.1,20,000
Accumulated Surplus in P&L Rs.40,000
Year 3 TL FA
Bank’s Term Loan

Promoters Margin

Rs.1,60,000

Rs.-20,000

Fixed Assets Rs.1,40,000
Profit Rs.1,60,000
To Depreciation Rs.1,20,000 By Depreciation 1,20,000
Accumulated Surplus in P&L Rs.80,000

Now exactly at the end of three years, he would have drawn Rs.1,20,000  against his margin of Rs.1,00,000 whereas the term loan outstanding balance will be Rs.1,60,000.   This is only an example how a simple legal book entry can be used either to repay his margin faster or his other term loan outstanding faster, leaving the bank in lurch.   Exactly this is where we have an unwritten rule in fixing the repayment.   We have a golden rule, “When DSCR is high reduce the repayment period as he is making more profits, if it is low try to improve the repayment period within the permissible maximum repayment period making his DSCR to improve”.   Since we are adding back the Depreciation a disguise for repayment of Term Loan, we are exactly able to fix the correct repayment period.

Conclusion:

As a smart credit processing officer who is dealing with term loan appraisal, they have to take into account the above finer points in their mind.   The above steps are not one time measure like processing of a term loan but a continuous process till the term loan is fully repaid.  Through this we confirm to the borrower that we are working smart not working hard.  This makes him to work hard to meet the commitments than to work smart by playing with figures.


Author : V. Sundararajan