Credit analysis and lending

In short

Credit analysis is the process a bank or NBFC follows to judge whether a borrower will repay — assessing character, cash flows, security and purpose before sanctioning a loan, and monitoring it afterwards. It decides the price (interest spread), the limit, the security and the covenants. It is examined in B.Com banking papers, JAIIB/CAIIB and IIBF exams, and is the core skill tested in credit-analyst and relationship-manager interviews at SBI, HDFC Bank, ICICI, Axis, Bajaj Finance and rating agencies like CRISIL and ICRA.

Explained

What lenders assess: the 5 Cs

• Character — borrower's track record and intent to repay: CIBIL/Experian/CRIF score (300–900; roughly 750+ is treated as good by most retail lenders), past defaults, wilful-defaulter and RBI large-credit (CRILC) checks.
• Capacity — ability to repay from cash flows, not from selling assets: profits, EBITDA, DSCR for term loans, salary and FOIR for retail loans.
• Capital — the borrower's own stake (promoter contribution/margin money). More skin in the game lowers the lender's risk.
• Collateral — primary security (the asset financed, e.g. stock and receivables for working capital) and collateral security (land, building, deposits) plus personal/corporate guarantees.
• Conditions — industry outlook, economic cycle, regulatory risk, end-use of funds.

The appraisal process, step by step

1. Application and KYC — loan application, KYC under the PML Act rules, constitution documents, credit bureau report.
2. Technical and managerial appraisal — is the project feasible; are the promoters competent?
3. Financial appraisal — 3 years' audited financials plus projections; ratio analysis (current ratio, TOL/TNW, interest coverage, DSCR); sensitivity analysis on sales and margins.
4. Assessment of limits — working capital by MPBF/turnover method/cash-budget method; term loans by project cost and repayment capacity.
5. Security, margin and pricing — valuation of security, margin %, interest linked to an external benchmark (repo-linked or T-bill based EBLR for most floating retail and MSME loans; MCLR for older corporate loans).
6. Sanction, documentation and disbursement — sanction by the appropriate authority, loan agreement, hypothecation/mortgage, charge registration with ROC/CERSAI, disbursement against end-use proof.
7. Post-sanction monitoring — stock statements, drawing power calculation, QIS returns, unit visits, covenant testing; early-warning signals.

Types of credit facilities

• Fund-based: cash credit/overdraft (against stock and book debts, with drawing power), term loan, bill discounting, export packing credit.
• Non-fund-based: letter of credit, bank guarantee — no outflow unless invoked, earns commission.
• Retail: home loan (LTV capped by RBI, broadly 75–90% depending on ticket size), auto loan, personal loan, gold loan, education loan.
• Priority sector lending — RBI requires scheduled commercial banks to lend 40% of ANBC to priority sectors (agriculture 18%, micro enterprises 7.5%, weaker sections 12%); sub-targets differ for small finance banks and RRBs.

Classification, provisioning and recovery

• Asset classification (RBI IRAC norms): Standard; SMA-0/1/2 (overdue 1–30 / 31–60 / 61–90 days); NPA when principal or interest is overdue more than 90 days, or the cash credit account is "out of order"; NPAs are sub-classified Sub-standard (up to 12 months), Doubtful, Loss.
• Daily NPA tagging and upgrade only on full repayment of all arrears are current RBI practice.
• Recovery routes: Lok Adalat and DRT (Recovery of Debts Act), SARFAESI Act, 2002 (secured creditor can enforce security without court, 60-day notice), IBC, 2016 (corporate insolvency resolution, NCLT, 330-day outer limit), one-time settlement/compromise, sale to ARCs.
• Expected credit loss (ECL): Ind AS 109 applies to NBFCs and listed entities; RBI has proposed an ECL framework for banks — treat the effective date as not yet settled.

Key points

• Credit analysis - judging willingness and ability to repay before and during a loan.
• 5 Cs - Character, Capacity, Capital, Collateral, Conditions.
• Primary vs collateral security - asset financed vs additional cover.
• Drawing power - stock plus debtors minus creditors, less margin; caps actual drawals in a cash credit account.
• MPBF - maximum permissible bank finance under the Tandon Committee methods.
• DSCR - cash available for debt service ÷ (interest + principal instalment); banks typically want ≥1.5 average for projects.
• FOIR - all EMIs ÷ net monthly income; retail lenders usually cap it near 50–60%.
• TOL/TNW - total outside liabilities to tangible net worth; leverage check, often ≤3 for mid-corporates.
• NPA - overdue beyond 90 days; SMA-0/1/2 are the early-warning buckets.
• SARFAESI 2002 - enforcement of security without court, for secured loans above ₹1 lakh.
• IBC 2016 - time-bound insolvency resolution through NCLT; promoters lose control to a resolution professional.
• CIBIL score - 300 to 900; enquiries, utilisation and repayment history drive it.
• EBLR - external benchmark lending rate; floating retail/MSME loans reprice with the repo rate.
• Credit rating symbols - AAA (highest safety) down to D (default) for long-term instruments.

Formulas and examples

Example 1 — MPBF under both Tandon methods. A trading firm projects current assets ₹400 lakh and other current liabilities (creditors, provisions) ₹100 lakh.

• Working capital gap = 400 − 100 = ₹300 lakh.
• Method I: margin = 25% of gap = 75 → MPBF = 300 − 75 = ₹225 lakh.
• Method II: margin = 25% of current assets = 100 → MPBF = 400 − 100 − 100 = ₹200 lakh.
• Method II gives the lower limit, so the bank sanctions ₹200 lakh; the borrower funds the balance ₹100 lakh from long-term sources.
• Check: net working capital under Method II = 400 − (100 + 200) = 100, so current ratio = 400 ÷ 300 = 1.33 — exactly the benchmark.

Example 2 — Term loan DSCR and a retail FOIR check. A unit borrows ₹300 lakh repayable in 5 equal annual instalments of ₹60 lakh. Year 1: PAT ₹35 lakh, depreciation ₹30 lakh, interest on term loan ₹27 lakh.

• Cash available for debt service = 35 + 30 + 27 = ₹92 lakh.
• Debt service = 27 + 60 = ₹87 lakh → DSCR = 92 ÷ 87 = 1.06 — too thin; the bank would stretch the tenor to 8 years (instalment ₹37.5 lakh → DSCR = 92 ÷ 64.5 = 1.43) or seek more promoter capital.
• Retail side: a salaried applicant earns ₹80,000 net per month with an existing EMI of ₹12,000. At a 55% FOIR cap, permissible total EMI = 0.55 × 80,000 = ₹44,000, so the new EMI can be at most ₹32,000.

Where it is used

• Banks and NBFCs — credit analysts, credit processing units and relationship managers at SBI, PNB, HDFC Bank, ICICI, Bajaj Finance prepare appraisal notes and monitor drawing power.
• Rating agencies and research — CRISIL, ICRA, CARE analysts rate bonds, bank facilities and CPs using the same ratio and cash-flow framework.
• Corporate finance and treasury teams — negotiate limits, covenants and pricing with lenders; prepare CMA data.
• Recovery, ARC and insolvency practice — SARFAESI enforcement, DRT cases, IBC resolution work with NCLT and resolution professionals.

Interview questions

• Q: What are the 5 Cs of credit? A: Character, Capacity, Capital, Collateral and Conditions — intent, repayment ability, own stake, security and the external environment.
• Q: When does a loan become an NPA? A: When principal or interest stays overdue beyond 90 days, or a cash credit account remains out of order; SMA-0/1/2 are the pre-NPA buckets at 1–30, 31–60 and 61–90 days.
• Q: Difference between primary and collateral security? A: Primary security is the asset created out of the loan (stock, machinery); collateral is additional cover such as property or a guarantee.
• Q: What is drawing power and why is it recalculated monthly? A: It is eligible stock plus book debts minus creditors, less margin; monthly stock statements keep the permitted drawal in line with actual current assets.
• Q: Why do banks insist on a minimum DSCR of about 1.5? A: It leaves a cushion so that a fall in cash flows still covers interest and instalments.
• Q: How does SARFAESI differ from IBC? A: SARFAESI lets a secured creditor enforce its own security without court after a 60-day notice; IBC is a collective, time-bound insolvency resolution of the whole company before the NCLT.
• Q: Why is a high credit-card utilisation bad for a CIBIL score even with no default? A: Heavy utilisation signals repayment stress and reduces the score, lowering eligibility and raising the rate offered.

Common mistakes

• Treating collateral as the basis of sanction — repayment must come from cash flows; security is the fallback.
• Including bank borrowings in "other current liabilities" while computing the working capital gap, which inflates MPBF.
• Forgetting to add back depreciation and term-loan interest in DSCR, or mixing up interest coverage with DSCR.
• Quoting the NPA cut-off as 180 days (the pre-2004 norm) instead of 90 days.
• Confusing SMA classification with NPA sub-categories (sub-standard, doubtful, loss).

Related topics

Banking operations and the RBI · Working capital management · Financial markets and instruments · Cost of capital and capital structure · Sources of finance: equity, debt and hybrids