FINANCIAL CREDIT & RISK ANALYTICS

Code: KMBN FM 05
SOLE BANKING
Sole banking is a lending by single bank to a large borrower, subject to the resources
available with it and limited to the exposure limits imposed by the Reserve Bank of India.
Many a times when you propose to approach to new bank for funding, they propose for sole
banking that their complete banking should be transferred to their bank. This is done for two
reasons one is to get complete business and second is very important is having complete
monitoring of fund flow and cash flow of the firm.

Multiple Banking Arrangement

As looked into above example of sole banking, it is also happening that it continues with
existing bank facility and take additional from other (new) bank. When the credit
requirements of a borrower are beyond the capacity of a single bank or that the bank does
not want to take more exposure on a particular borrower, he may then resort to multiple
banking. It is an arrangement where a borrower borrows simultaneously from more than one
bank independent of each other, under separate loan documents with each bank. Securities
are charged to each bank separately.
There are various loopholes in multiple banking arrangements, and also it can lead to frauds
so consortium banking is better for economy. Each banker is free to do his own credit
assessment and old security independent of other bankers.

Consortium Lending

Consortium lending also called joint financing or participation financing. It is a system of

financial emerged due to consequential increase in demand for funds of substantial magnitude
and inability of individual banks to take care of the entire fund requirement of
large borrowers. The system of consortium lending provides scope and opportunity to share
risk amongst banks. The system is considered to be mutually beneficial to the banks as well
as customers. Under multiple banking, there is no coordination among banks regarding
appraisal, documentation, other terms and advances. In such a situation borrowers got the
upper hand by playing one bank against the other. It was, therefore, necessary to formalize
these credit arrangements to safeguard the interest of the banks. It is mainly catered in case of
large corporate and certain mid-sized borrowers.
As per the consortium lending approach, the group of banks would have a common
agreement wherein the lead bank (the bank that bears major risk) would assess the borrower’s
fund requirements, set common terms and conditions and share information about borrower’s
performance to other lenders.
The bank which takes the higher risk (by giving the highest amount of loan) will act as a
leader and thus it acts as an intermediary between the consortium and the borrower.
Syndication

Reserve Bank of India has permitted the banks to adopt syndication route to provide credit in
lieu of consortium advance. A syndication credit differs from consortium advance. A
syndicated credit differs from consortium advances in certain aspects. The salient features of
a syndicated credit are as follows:
The prospective borrower gives a mandate to a bank, commonly referred as a lead bank
(lead manager), to arrange credit on his behalf. The mandate gives the commercial terms of
the credit and the prerogatives of the mandated bank in resolving contentious issue in the
course of the transaction of complete syndication.
It is an agreement between two or more banks to provide a borrower a credit facility using
common documents of the borrower.
The mandated bank prepares an information Memorandum about the borrower in
consultation with the latter and distributes the same amongst the prospective lenders,
inviting them to participate in the credit proposal.
On the basis of information Memorandum each bank makes its own independent economy
and financial evaluation of the borrower. It may collect additional information from other
sources also. Generally, lead banker plays important role as rest just follows.
Thereafter, a meeting of the particular banks is convened by the mandated bank and
discuss the syndication strategy relating to co-ordination communication and control with
the syndication process and to finalize the deal timing, charges for management, cost of
credit, share of each participating bank in the credit etc.

A loan agreement is signed by all the participating banks. The borrower is required to give
prior notice to the Lead Banker (Lead Manager) of his agent for drawing the loan amount
so that the latter may tie up disbursement with the other lending banks. Under the system,
the borrower has the freedom in terms of competitive pricing. Discipline is also imposed
through a fixed repayment period under syndicated credit.
CREDIT APPRAISAL
Credit Appraisal is the process by which a lender appraises the technical feasibility,
economic viability and bankability including creditworthiness of the prospective borrower.
Credit appraisal process of a customer lies in assessing if that customer is liable to repay the
loan amount in the stipulated time, or not. Here bank has their own methodology to determine
if a borrower is creditworthy or not. It is determined in terms of the norms and standards set
by the banks. Being a very crucial step in the sanctioning of a loan, the borrower needs to be
very careful in planning his financing modes. However, the borrower alone doesn’t have to
do all the hard work. The banks need to be cautious, lest they end up increasing their risk
exposure. All banks employ their own unique objective, subjective, financial and non-
financial techniques to evaluate the creditworthiness of their customers.
Some requirements for credit appraisal are as follows:

Wherever financing of infrastructure project is taken up under a consortium/syndication

arrangement – bank’s exposure shall not exceed 23%.
The credit requirement must be assessed by all Indian financial institutions or specialized
institution set-up for this purpose.
In such cases/due diligence on the inability of the projects are well defined and assessed.
State Government guarantee may not be taken as a substitute for satisfactory credit
appraisal.
Bank may also take up financing infrastructure project independently exclusively in
respect of borrower’s promoters of repute with excellent past record in project
implementation.

Validation of proposal

The quality of every proposal should be explicitly validated. This means that you should
confirm that the key aspects of the proposal are what the company wants them to be. It is
nearly impossible to do this in one sitting with everything considered all at once. Proposal
Quality Validation explicitly identifies what should be validated, allows for flexibility in how
individual items get validated, and provides a mechanism to ensure that the items chosen and
methods for validation are sufficient to achieve the quality desired.
Proposal Quality Validation ensures that your company confirms that key aspects of your
proposal are what the company wants them to be prior to submission. It is an approach that
confirms that what you have in the proposal meets your needs and expectations. It avoids
disasters that result from teams that work in isolation, creating a proposal that is not what the
company wants to submit and is only discovered too late to do anything about it.
In developing your proposal, you will:

 Make decisions
 Invent approaches
  Incorporate information
 Address requirements
 Deliver a message
 Seek a superior score

Dimensions of Credit Appraisals

Service credit is monthly payments for utilities such as telephone, gas, electricity, and water.
One has to pay a deposit and late charge if payment is not on time.
Loans can be for small or large amounts and for a few days or several years. Money can be
repaid in one lump sum or in several regular payments until the amount one borrowed and the
finance charges are paid in full. Loans can be secured or unsecured.
Installment credit may be described as buying on time, financing through the store or the easy
payment plan. The borrower takes the goods home in exchange for a promise to pay later.
Cars, major appliances, and furniture are often purchased this way. One usually sign a
contract, make a down payment, and agree to pay the balance with a specified number of
equal payments called installments. The finance charges are included in the payments. The
item one purchase may be used as security for the loan.
Credit cards are issued by individual retail stores, banks, or businesses. Using a credit card
can be the equivalent of an interest-free loan-if one pay for the use of it in full at the end of
each month.

Credit Appraisal Process:

The process of credit appraisal is as follows:

1) Credit Processing:

Credit processing is the stage where all required information on credit is gathered and
applications are screened. Credit application forms should be sufficiently detailed to permit
gathering of all information needed for credit assessment at the outset. In this connection,
financial institutions should have a checklist to ensure that all required information is, in fact,
collected.

2) Credit-Approval/Sanction:
A financial institution must have in place written guidelines on the credit approval process
and the approval authorities of individuals or committees as well as the basis of those
decisions. Approval authorities should be sanctioned by the board of directors. Approval
authorities will cover new credit approvals, renewals of existing credits, and changes in terms
and conditions of previously approved credits, particularly credit restructuring, all of which
should be fully documented and recorded. Prudent credit practice requires that
persons empowered with thee credit approval authority should not also have the customer
relationship responsibility.

3) Credit Documentation:

Documentation is an essential part of the credit process and is required for each phase of the
credit cycle, including credit application, credit analysis, credit approval, credit monitoring,
collateral valuation, and impairment recognition, foreclosure of impaired loan and realization
of security. The format of credit files must be standardized and files neatly maintained with
an appropriate system of cross-indexing to facilitate review and follow-up. The Bank of
Mauritius will pay particular attention to the quality of files and the systems in place for their
maintenance.
Documentation establishes the relationship between the financial institution and the borrower
and forms the basis for any legal action in a court of law. Institutions must ensure that
contractual agreements with their borrowers are vetted by their legal advisers. Credit
applications must be documented regardless of their approval or rejection. All documentation
should be available for examination by the Bank of Mauritius.

4) Credit Administration:

Financial institutions must ensure that their credit portfolio is properly administered, that is,
loan agreements are duly prepared, renewal notices are sent systematically and credit files are
regularly updated. An institution may allocate its credit administration function to a separate
department or to designated individuals in credit operations, depending on the size and
complexity of its credit portfolio.
Structuring of Loan documents

Loan structure is the terms of a loan with respect to the various aspects the make up a loan,
including the maturity or tenor, repayment, and risk.
The loan structure is arrived at by taking into consideration several factors, such as the
purpose, the timeline, and the risk profile of the borrower. In the following sections, we will
discuss different structures that exist based on the above factors.

Documents to Apply for a Personal Loan

When applying for a personal loan, you will need to submit the following documents:

 PAN Card
 Identity proof (Aadhaar Card, Driving licence, Passport, Voter ID, etc.)
 Signature Proof (Passport, PAN card, etc.)
 Address proof (Passport copy, Aadhaar card, driving licence, utility bill; Gas or
electricity bill, Voter ID, ration card, rent agreement, etc.)
 Bank statements of the past 6 months

As a salaried individual, you additionally need to submit the following:

 Salary slips for the last three months Income tax returns OR form 16

 As a self-employed individual, you additionally need to submit the following (for self
/ business entity as applicable):

 Balance sheet and profit and loss account, income computation for the last 2 years
 Income Tax Returns for the last 2 years
 Business proof (License, registration certificate, GST number)
 IT Assessment OR Clearance Certificate
 Income Tax Challans OR TDS Certificate (Form 16A) OR Form 26 AS for income
declared in ITR
Credit Risk

A credit risk is risk of default on a debt that may arise from a borrower failing to make
required payments. In the first resort, the risk
is that of the lender and includes lost principal and interest, disruption to cash flows, and
increased collection costs. The loss may
be complete or partial. In an efficient market, higher levels of credit risk will be associated
with higher borrowing costs. Because of
this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels
based on assessments by market
participants.

Losses can arise in a number of circumstances, for example:

A consumer may fail to make a payment due on a mortgage loan, credit card, line of
credit, or other loan.
A company is unable to repay asset-secured fixed or floating charge debt.
A business or consumer does not pay a trade invoice when due.
A business does not pay an employee’s earned wages when due.
A business or government bond issuer does not make a payment on a coupon or principal
payment when due.
An insolvent insurance company does not pay a policy obligation.
An insolvent bank won’t return funds to a depositor.
A government grants bankruptcy protection to an insolvent consumer or business.

Credit Risk Rating

The term credit rating refers to a quantified assessment of a borrower’s creditworthiness in

general terms or with respect to a particular debt or financial obligation. A credit rating can
be assigned to any entity that seeks to borrow money an individual, a corporation, a state or
provincial authority, or a sovereign government.
Types of Credit Ratings

All credit agency agencies use various terminology for determine credit ratings. However, the
notations are very similar. Ratings are always grouped into two: an ‘investment grade’ and
also a ‘speculative grade’.
Investment grade:

These ratings mean that the investment is a solid one and the issuer will most likely meet the
repayment terms. These investments are priced less as compared to speculative grade
investments.
Speculative grade:

These investments are known to be high risk. So, they come with higher interest rates.

Importance of Credit Rating

When a credit rating agency upgrades a company’s rating, it suggests that the company has a
high chance of repaying the credit. On the other hand, when the credit rating gets
downgraded, it suggests the company’s ability to repay has reduced. Once the company’s
credit rating has been downgraded, it becomes difficult for the company to borrow money.
Lenders will consider such companies as high-risk borrowers as they have a higher
probability of turning into a defaulter. Financial institutions will hesitate to lend money to the
companies with low credit rating.

 It allows investors to make a sound investment decision after taking into

consideration the risk factor and past repayment behaviour. In other words, it
establishes a relationship between risk and return.
 Credit rating does a qualitative and quantitative assessment of a borrower’s
creditworthiness.
 In the case of the companies, credit ratings help them improve their corporate
image. It is useful especially for companies that are not popular.

 Lenders such as banks and financial institutions will offer loans at a lower interest
rate if the entity has a higher credit rating.

 The credit rating acts as a marketing tool for companies and also as a resource that
is helpful at the time of raising money. It reduces the cost of borrowing and helps
in the company’s expansion.
  Credit rating encourages better accounting standards, detailed information
disclosure, and improved financial information.

Credit Worthiness of Borrower

Creditworthiness, simply put, is how “worthy” or deserving one is of credit. If a lender is
confident that the borrower will honor her debt obligation in a timely fashion, the borrower is
deemed creditworthy. If a borrower were to evaluate their creditworthiness on her own, it
would result in a conflict of interest. Therefore, sophisticated financial intermediaries
perform assessments on individuals, corporate, and sovereign governments to determine the
associated risk and probability of repayment.
Financial institutions use credit ratings to quantify and decide whether an applicant is eligible
for credit. Credit ratings are also used to fix the interest rates and credit limits for existing
borrowers. A higher credit rating signifies a lower risk premium for the lender, which then
corresponds to lower borrowing costs for the borrower. Across the board, the higher one’s
credit rating, the better.
A credit report provides a comprehensive account of the borrower’s total debt, current
balances, credit limits, and history of defaults and bankruptcies if any. Due to high levels of
asymmetries of information in the market, lenders rely on financial intermediaries to compile
and assign credit ratings to borrowers and help filter out bad debtors or “lemons.” The
independent third parties are called credit rating agencies. The rating agencies access
potential customers’ credit data and use sophisticated credit scoring systems to quantify a
borrower’s likelihood of repaying debt. Lenders usually pay for the services, but borrowers
may also request their credit score to gauge their worthiness in the market.
A limited set of credit raters are considered reliable, and it is due to the level of expertise and
data consolidation required, which is not publicly available. The so-called “Big Three” rating
agencies are and Fitch, Moody’s, and Standard & Poor’s. These agencies
rate corporates and sovereign governments on a range of “AAA” or “prime” to “D” or “in
default” in descending order of creditworthiness.
CREDIT APPRAISAL

Credit Appraisal is the process by which a lender appraises the technical feasibility,
economic viability and bankability including creditworthiness of the prospective borrower.
Credit appraisal process of a customer lies in assessing if that customer is liable to repay the
loan amount in the stipulated time, or not. Here bank has their own methodology to determine
if a borrower is creditworthy or not. It is determined in terms of the norms and standards set
by the banks. Being a very crucial step in the sanctioning of a loan, the borrower needs to be
very careful in planning his financing modes. However, the borrower alone doesn’t have to
do all the hard work. The banks need to be cautious, lest they end up increasing their risk
exposure. All banks employ their own unique objective, subjective, financial and non-
financial techniques to evaluate the creditworthiness of their customers.
Some requirements for credit appraisal are as follows:

Wherever financing of infrastructure project is taken up under a consortium/syndication

arrangement – bank’s exposure shall not exceed 23%.

The credit requirement must be assessed by all Indian financial institutions or specialized
institution set-up for this purpose.

In such cases/due diligence on the inability of the projects are well defined and assessed.
State Government guarantee may not be taken as a substitute for satisfactory credit
appraisal.

Bank may also take up financing infrastructure project independently exclusively in

respect of borrower’s promoters of repute with excellent past record in project
implementation.
Validation of proposal

The quality of every proposal should be explicitly validated. This means that you should
confirm that the key aspects of the proposal are what the company wants them to be. It is
nearly impossible to do this in one sitting with everything considered all at once. Proposal
Quality Validation explicitly identifies what should be validated, allows for flexibility in how
individual items get validated, and provides a mechanism to ensure that the items chosen and
methods for validation are sufficient to achieve the quality desired.
Proposal Quality Validation ensures that your company confirms that key aspects of your
proposal are what the company wants them to be prior to submission. It is an approach that
confirms that what you have in the proposal meets your needs and expectations. It avoids
disasters that result from teams that work in isolation, creating a proposal that is not what the
company wants to submit and is only discovered too late to do anything about it.
 In developing your proposal, you will:

Make decisions
Invent approaches
Incorporate information
Address requirements
Deliver a message
Seek a superior score
Dimensions of Credit Appraisals

Service credit is monthly payments for utilities such as telephone, gas, electricity, and water.
One has to pay a deposit and late charge if payment is not on time. Loans can be for small or
large amounts and for a few days or several years. Money can be repaid in one lump sum or
in several regular payments until the amount one borrowed and the finance charges are paid
in full. Loans can be secured or unsecured. Installment credit may be described as buying on
time, financing through the store or the easy payment plan. The borrower takes the goods
home in exchange for a promise to pay later. Cars, major appliances, and furniture are often
purchased this way. One usually sign a contract, make a down payment, and agree to pay the
balance with a specified number of equal payments called installments. The finance charges
are included in the payments. The item one purchase may be used as security for the loan.
Credit cards are issued by individual retail stores, banks, or businesses. Using a credit card
can be the equivalent of an interest-free loan-if one pay for the use of it in full at the end of
each month.
Credit Appraisal Process:

The process of credit appraisal is as follows:

1) Credit Processing:

Credit processing is the stage where all required information on credit is gathered and
applications are screened. Credit application forms should be sufficiently detailed to permit
gathering of all information needed for credit assessment at the outset. In this connection,
financial institutions should have a checklist to ensure that all required information is, in fact,
collected.

2) Credit-Approval/Sanction:

A financial institution must have in place written guidelines on the credit approval process
and the approval authorities of individuals or committees as well as the basis of those
decisions. Approval authorities should be sanctioned by the board of directors. Approval
authorities will cover new credit approvals, renewals of existing credits, and changes in terms
and conditions of previously approved credits, particularly credit restructuring, all of which
should be fully documented and recorded. Prudent credit practice requires that persons
empowered with thee credit approval authority should not also have the customer relationship
responsibility.
3) Credit Documentation:

Documentation is an essential part of the credit process and is required for each phase of the
credit cycle, including credit application, credit analysis, credit approval, credit monitoring,
collateral valuation, and impairment recognition, foreclosure of impaired loan and realization
of security. The format of credit files must be standardized and files neatly maintained with
an appropriate system of cross-indexing to facilitate review and follow-up. The Bank of
Mauritius will pay particular attention to the quality of files and the systems in place for their
maintenance.
Documentation establishes the relationship between the financial institution and the borrower
and forms the basis for any legal action in a court of law. Institutions must ensure that
contractual agreements with their borrowers are vetted by their legal advisers. Credit
applications must be documented regardless of their approval or rejection. All documentation
should be available for examination by the Bank of Mauritius.

4) Credit Administration:

Financial institutions must ensure that their credit portfolio is properly administered, that is,
loan agreements are duly prepared, renewal notices are sent systematically and credit files are
regularly updated. An institution may allocate its credit administration function to a separate
department or to designated individuals in credit operations, depending on the size and
complexity of its credit portfolio.

Structuring of Loan documents

Loan structure is the terms of a loan with respect to the various aspects the make up a loan,
including the maturity or tenor, repayment, and risk.
The loan structure is arrived at by taking into consideration several factors, such as the
purpose, the timeline, and the risk profile of the borrower. In the following sections, we will
discuss different structures that exist based on the above factors.
Documents to Apply for a Personal Loan

When applying for a personal loan, you will need to submit the following documents:
 PAN Card
Identity proof (Aadhaar Card, Driving licence, Passport, Voter ID, etc.)
Signature Proof (Passport, PAN card, etc.)
Address proof (Passport copy, Aadhaar card, driving licence, utility bill; Gas or
electricity bill, Voter ID, ration
card, rent agreement, etc.)

Bank statements of the past 6 months

As a salaried individual, you additionally need to submit the following:

Salary slips for the last three months Income tax returns OR form 16

As a self-employed individual, you additionally need to submit the following (for self /
business entity as applicable):

Balance sheet and profit and loss account, income computation for the last 2 years
Income Tax Returns for the last 2 years
Business proof (License, registration certificate, GST number)
IT Assessment OR Clearance Certificate
Income Tax Challans OR TDS Certificate (Form 16A) OR Form 26 AS for income
declared in ITR
PURPOSE OF LOAN, SOURCE OF REPAYMENT, COLLATERAL

Purpose of Loan

loan purpose is the underlying reason an applicant seeks a loan or mortgage. Lenders use loan
purpose to make decisions on the risk and what interest rate to offer. For example, if an
applicant is refinancing a mortgage after having taken cash out, the lender might consider that
an increase in risk and increase the interest rate that is offered or add additional conditions.
Loan purpose is important to the process of obtaining mortgages or business loans that are
connected with specific types of business activities. Pertaining to mortgages and their risk-
based pricing factors, the loan purpose factor is sub-categorized by purchase, rate and term
refinance and cash-out refinance. Lenders assess that a purchase loan contains the least
amount of risk and thus ‘price’ purchase loans most favourably (i.e. no interest rate increase
or a risk-based pricing improvement in the order of .25%).
Rate and term refinances are priced similar to purchase loans, with no interest rate increase.
Cash received by the borrower at closing may not exceed $2000 to maintain rate and term
status. The purpose is, as the name implies, to reduce the interest rate, payment, and/or
overall term of the mortgage.
Cash-out refinances are deemed to have a higher risk factor than either rate & term refinances
or purchases due to the increase in loan amount relative to the value of the property. Risk-
based pricing typically mandates a .25% to .5% increase in interest rate if a borrower needs to
draw equity out of the subject property.

Uses:

Consolidate debt to pay off bills

Consolidating debt is one major reason to borrow a personal loan. This approach can make
sense if you’re able to secure a low interest rate. If you pay your other debts with the money
from a personal loan, you’ll only have one fixed monthly payment, and you might be able to
save money on interest.

Cover unplanned emergency expenses

While it’s best to build an emergency fund to cover unexpected expenses, an emergency
personal loan can help if you’re not yet prepared.

Make necessary home repairs

While you might have a wish list of home updates, you might only consider a personal loan
for emergency issues impacting your health and safety.
Source of Repayment

Primary Source: The primary source of repayment should be directly related to the kind of
loan given i.e. for facilities extended (overdraft) for working capital or to finance trade the
repayment should be from the proceeds of the goods sold. If a bridge loan prior to the final
allotment of a public issue has been given, the repayment should be from the monies received
after the allotment is made. On the other hand if the bridge loan is given prior to the sale of
an asset, the proceeds from the sale of the asset should be used to extinguish the loan.

Secondary Source: Even though there may be a real and quantifiable first source of
repayment, there is always a possibility that on account of occurrences beyond the borrower’s
control, the loan cannot be repaid from the primary source. A classic example is what is
presently happening in India on account of the liquidity crunch and the demand downswing.
A well-known company purchased 41 windmills at a cost of around Rs. 1 crore each and was
confident of selling them quickly. Due to a credit squeeze the windmills were unsold and the
company could not repay the borrowings from the proceeds of the sale. The company in order
to meet its credit commitments sold some property it owned. This was its secondary source of
repayment. When companies take working capital finance in the form of overdrafts, they
normally hypothecate debtors and stock. If repayments are not made, the secondary source of
repayment can be seized and sold and the proceeds can be used to liquidate the loan.
Tertiary Source: The tertiary source is further security for a loan. This is in the form of
additional collateral that may be unconnected with the business. A director could pledge the
shares that he owns in certain blue-chip companies as additional security. Alternatively, the
principal shareholders could give their personal guarantees or a well-wisher could give his
guarantee. The comfort that a Bank would derive is that should the primary and secondary
source of repayment fail, they will have recourse to yet another source of repayment. It is
assurances such as these that help the Banker in supporting and recommending a request for
a credit facility.

Collateral

The term collateral refers to an asset that a lender accepts as security for a loan. Collateral
may take the form of real estate or other kinds of assets, depending on the purpose of the
loan. The collateral acts as a form of protection for the lender. That is, if the borrower
defaults on their loan payments, the lender can seize the collateral and sell it to recoup some
or all of its losses. If a borrower defaults on a loan (due to insolvency or another event), that
borrower loses the property pledged as collateral, with the lender then becoming the owner of
the property. In a typical mortgage loan transaction, for instance, the real estate being
acquired with the help of the loan serves as collateral. If the buyer fails to repay the loan
according to the mortgage agreement, the lender can use the legal process of foreclosure to
obtain ownership of the real estate. If a second mortgage is involved the primary mortgage
loan is repaid first with the remaining funds used to satisfy the second mortgage. A
pawnbroker is a common example of a business that may accept a wide range of items as
collateral.
The type of the collateral may be restricted based on the type of the loan (as is the case with
auto loans and mortgages); it also can be flexible, such as in the case of collateral-based
personal loans. Marketable collateral is the exchange of financial assets, such as stocks and
bonds, for a loan between a financial institution and borrower. To be deemed marketable,
assets must be capable of being sold under normal market conditions with reasonable
promptness at current fair market value. For national banks to accept a borrower’s loan
proposal, collateral must be equal to or greater than 100% of the loan or credit extension
amount. In the United States of America, the bank’s total outstanding loans and credit
extensions to one borrower may not exceed 15 percent of the bank’s capital and surplus, plus
an additional 10 percent of the bank’s capital and surplus.
Reduction of collateral value is the primary risk when securing loans with marketable
collateral. Financial institutions closely monitor the market value of any financial assets held
as collateral and take appropriate action if the value subsequently declines below the
predetermined maximum loan-to-value ratio. The permitted actions are generally specified in
a loan agreement or margin agreement.
Types of collateral loans.

Vehicle Loans
No guarantor is required for such a loan since the car itself acts as a security with the lender.
A typical car financing arrangement is different from a loan against a commercial vehicle. A
car financing arrangement is executed at the time of purchase of the vehicle; the proceeds are
purely utilized for the purchase of the vehicle only. The borrower is free to use the vehicle for
any purpose. However, commercial vehicles cannot be used for personal use by the borrower,
who has to have an existing business to be eligible for the loan.

Loan Against Securities

A loan against securities is an extension of an overdraft facility by the financial institutions.
The financial assets like shares, bonds etc. act as collateral with the lender, against which the
borrower is issued a limit. The borrower can then take short term loans within this limit.

Loan Against Property

A loan against property financing arrangement includes a loan taken from a financial
institution with no restriction on its use by the borrower. The existing house property is kept
as collateral with the lender as a security against a probable default by the borrower.
Whereas, A typical housing loan financing arrangement is to facilitate the purchase or
construction of a new home and the proceeds are to be used for that purpose only.
CASH FLOWS AS PROFIT AND COMPONENTS OF CASH FLOWS

Cash flow and profit are two different financial parameters, but when you’re running a
business, you need to keep track of both. Here’s how they’re different, why they’re both
important and how they intersect with other corporate issues, especially when a company
grows rapidly.

Cash Flow

Cash flow is the money that flows in and out of the firm from operations and financing and
investing activities. It’s the money you need to meet current and near-term obligations. But
there are two things to keep in mind about cash flow:

A Business Can Be Profitable and Still Not Have Adequate Cash Flow
In the worst case, insufficient cash flow in a profitable business can send it into bankruptcy.
For example, you’re making widgets and selling them at a profit. But your product goes
through a long sales chain and some of your biggest and most important wholesale customers
don’t pay on invoices for 120 days. This sounds extreme, but many large US corporations in
the 21st century don’t pay an account payable for three or four months from the receipt of the
invoice.
Since you’re the little guy, the suppliers of materials you need to make those widgets often
want to be paid either upon receipt or in 15 or 30 days. Ironically, if you’re caught between
suppliers who want their money now and buyers who’re slow to pay, a successful product
with increasing sales can create a real cashflow crisis. Even though your unit sales are
increasing and profitable, you won’t get paid in time to pay your suppliers and meet payroll
and other operational expenses. If you’re unable to meet your financial obligations in a timely
way, your creditors may force you into bankruptcy at a period when sales are growing
rapidly.

Your Sales May Be Growing and the Money Keeps Pouring In, but That Doesn’t Mean
You’re Making a Profit
If you borrow money to solve the cash flow problem, for instance, the rising debt costs that
result can raise your costs above the breakeven point. If so, eventually your cash flow will
dry up and eventually your business will fail.

Profit

Profit, also called net income, is what remains from sales revenue after all the firm’s expenses
are subtracted. It’s obvious in principle that a business cannot long survive unless it is
profitable, but sometimes, as with cash flow, the very success of a product can raise
expenses. It may not be immediately apparent that this is a problem. In other cases, you may
be aware of the problem, but believe that by reducing production costs you can restore
profitability in time to avoid a crisis. Unfortunately, unless you have a clear understanding of
all the relevant cost data, you may not act e ectively or promptly enough to make the firm
profitable again before it runs out of money.

Components of Cash Flows

(i) Cash Flow from Operating Activities

The net amount of cash coming in or leaving from the day to day business operations of an
entity is called Cash Flow from Operations. Basically it is the operating income plus non-
cash items such as depreciation added. Since accounting profits are reduced by non-cash
items (i.e. depreciation and amortization) they must be added back to accounting profits to
calculate cash flow.

Cash flow from operations is an important measurement because it tells the analyst about the
viability of an entities current business plan and operations. In the long run, cash flow from
operations must be cash inflows in order for an entity to be solvent and provide for the
normal outflows from investing and finance activities.

(ii) Cash Flow from Investing Activities

Cash flow from investing activities would include the outflow of cash for long term assets
such as land, buildings, equipment, etc., and the inflows from the sale of assets, businesses,
securities, etc. Most cash flow investing activities are cash out flows because most entities
make long term investments for operations and future growth.

(iii) Cash Flow from Finance Activities

Cash flow from finance activities is the cash out flow to the entities investors (i.e. interest to
bondholders) and shareholders (i.e. dividends and stock buybacks) and cash inflows from
sales of bonds or issuance of stock equity. Most cash flow finance activities are cash outflows
since most entities only issue bonds and stocks occasionally.