Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Module I: Basics of Credit and Credit Process

Chapter 2 Due Diligence for Lending Decisions

Dr. M. Manickaraj

The objectives of this chapter is to highlight the importance of due diligence and to
discuss the various issues to be studied diligently before lending decisions are taken.

Structure
2.1 Introduction
2.2 Due diligence for retail loans
2.3 e-KYC
2.4 Due Diligence on Corporate Borrowers
2.4.1 Basic documents
2.4.2 RBI Wilful Defaulters List and ECGC’s Special Approval List
2.4.3 Material Contracts
2.4.4 Patents, copyrights and trademarks
2.4.5 Manufacturing
2.4.6 Sales and Marketing
2.4.7 Employees
2.4.8 Management
2.4.9 Financial due diligence
2.4.10 Legal due diligence
2.4.11 Environmental due diligence
2.5 Outsourcing Due Diligence

2.6 Summary and conclusion

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

2.1 Introduction
According to the Cambridge Dictionary, due diligence means “the detailed examination of
a company and its financial records, done before becoming involved in a business
arrangement with it”.
(Source: https://dictionary.cambridge.org/dictionary/english/due-diligence)
One major requisite for making right credit decisions is to use reliable information. If the
data used for lending decisions are incorrect or incomplete the likelihood of loan
decisions going wrong will be high. Lending institutions collect all relevant data about
prospective borrowers from variety of sources. The main source of data is always the
customers while other sources of data include credit information bureaus, rating
agencies, government, peers, industry reports and so on. However, the onus of
verification and validation of data rests with the lender. Therefore, verification and
validation of data is very critical for successful lending business.
Due diligence is the first major step in credit analysis. It is an investigation of a borrower
in order to verify and confirm all facts. It involves collection, verification and validation
of information like identity and address of prospective borrowers, financials, legal
matters and anything that are deemed essential for making lending decisions. It can also
be defined as the care to be taken before lending money. The rigor and complexity with
which due diligence to be done depends on the nature of customers and amount of loan
involved. As such, due diligence on retail borrowers and agriculture borrowers will be
simple. On the other hand, due diligence on corporate customers will be complex.
2.2 Due Diligence for Retail Loans
Information to be collected about retail borrowers are mainly regarding identity, address,
occupation, and the like. The popular term used in this regard is the KYC (Know Your
Customer). Documents to establish KYC details include Aadhar Card, PAN card, telephone
bill, electricity bill, family ration card, salary slip, IT returns, and bank statement. Aadhar
card and PAN card are used for verification of identity whereas electricity bill, and
telephone bill are used for verification of address. Documents like salary slip, IT returns
and bank statement are used for checking the customer’s source of income, and
repayment capacity. Credit history of prospective customers can be obtained from credit
information companies like CIBIL and Experian. The credit information companies do
provide complete credit report and also a score which can readily be used for deciding
on giving or not giving loans to customers. Besides, list of wilful defaulters published by
the Reserve Bank of India too can be referred to find out if a prospective customer has
defaulted to any lending institution in the past.
Recently many banks and lending institutions have started verification of basic details
about prospective customers online. It is referred to as e-KYC. For instance, by using the
Aadhar number of a customer, details regarding identity, address and the like are verified
online and there is no need for physical documents to be obtained from customers. Of
late, Aadhar number is being used as a common thread for many other item of
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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

information like PAN number, bank account, mobile phone, etc. Likewise, financial profile
and social profile of customers can also be done electronically. Credit history of
customers too can be verified online by referring to the credit reports prepared by credit
information companies like CIBIL and Experian.

2.4 Due Diligence on Corporate Borrowers

Business enterprises avail large amount of loans and hence due care should be taken
before lending to them. Moreover, as they are huge organisations having presence in
many places and some of them have pan India or even global presence, information
required for credit analysis could be huge and complex. Nevertheless, all the relevant
data should be collected and carefully studied before lending to them. The various
elements of due diligence on corporate customers are discussed hereunder.
2.4.1 Basic documents:
Basic documents to be collected from business enterprises include the following:

• Memorandum of Association, and Articles of Association including all

amendments.

• Minutes of board meetings, committees of the board and shareholders.

• Permits/licenses for conduct of business, franchises, concessions and
distributorship agreements.

• List of all states where the Company has license to do business.

• List of all countries where Company is doing business and the list of countries
where the company has license to do business.

• Details of any voting trust and shareholder agreement, if any

• Copies of all agreements relating to repurchases, redemptions, exchanges,
conversions of financial securities or similar transactions.

• Copies of all agreements containing pre-emptive rights or assigning such rights.

• Last five years annual reports and quarterly earnings reports of the company and
press releases issued by the Company within the past five years.
• List of all subsidiaries and group companies.

Documents about subsidiaries and group companies: The abovementioned basic

documents may be collected for subsidiaries and group companies.

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

2.4.2 RBI Wilful Defaulters List and ECGC’s Special Approval List:
Wilful defaulters list published by the RBI to find out if the company or its directors have
defaulted on payment of loans to banks or lending institutions. Export Credit Gurantee
Corporation of India (ECGC) publishes a list referred to as ECGC’s Specific Approval List.
The list gives the names of exporters whose risk is high. Both these lists shall
compulsorily be checked.

2.4.3 Material Contracts:

Any contract that will have significant impact can be called a material contract. The
following are few material contracts that will have substantial financial implication for
business firms:

• Credit agreements with banks and lending institutions and details of loans
outstanding

• Guarantees issued by the company

• All outstanding leases
• Material contracts with suppliers or customers and the suppliers who are sole
source, if any.

• Schedule of all insurance policies in force covering property of the Company and
other insurance policies such as ''key person'' policies, director indemnification
policies or product liability policies.

• Partnership or joint venture agreements.

• Bonus plans, retirement plans, pension plans, deferred compensation plans, profit
sharing and management incentive agreements.

• Any other material contracts outstanding.

2.4.4 Patents, copyrights and trademarks:
Many businesses today are knowledge intensive and their success hence depend to great
extent on intangible assets like patents. It is important for a bank giving loans to business
firms to study the nature and value of intangible assets. The following details about
intangible assets may be collected and scrutinised by banks.

• List of all foreign and domestic patents and patents held by the Company.
• List of trademarks, service marks and copyrights.
• Copies of all agreements for licensing of Company technology to third parties.

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

• Copies of all agreements for licensing of technology from third parties.

• Any correspondence from third parties regarding potential infringement of
intellectual property of others.

• List of proprietary processes controlled by the Company.

2.4.5 Manufacturing:

· List of products with breakdown by manufacturing locations, number of shifts,

installed capacity and personnel employed.
· List of contract manufacturers and assemblers, if any, showing type of purchases
from each contract manufacturer or assembler.

• Agreements with suppliers, manufacturers, and customers, if any.

• Agreements relating to the sale or lease of material capital equipment.
2.4.6 Sales and Marketing:

• List of the Company's products and services.

• List of the Company's competitors.
• List of 10 to 20 largest customers of the company.
• All licensing agreements, franchises, and conditional sales contracts to which the
Company is a party.

• Agreements with distributors and dealers.

• Copies of long-term sales contracts.
• Service and support contracts, if any.
• Details of orders on hand
2.4.7 Employees:

• Number of employees broken down by major types and organization chart.

Description of any significant labour problems or union activities the Company has
experienced.
2.4.8 Management:

· Copy of promoters agreement, agreements with the management,

indemnification agreements, and ''golden parachute'' agreements, if any.
Bonus plans, retirement plans, pension plans, profit sharing and management
incentive agreements.

• Agreements for loans to officers or directors of the company.

2.4.9 Financial Due Diligence

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

The ultimate objective of credit analysis is to ascertain the repayment capacity of

borrowers and to decide whether to give loan or not. It is important to find out the credit
requirements of borrowers and decide on the amount of loan. Decisions on both are
based mainly on financial statements of customers. The ability of a company to earn
profits and the value of its assets and liabilities will depend on many factors which cannot
easily be found in the balance sheet and profit and loss account of the company.
Therefore, the following need to be verified while analysing the financial statements
using tools like ratios.

• Quality of earnings & cash flows

• Quality of assets

o Fixed assets

o Working capital

• Potential liabilities & commitments

• Related party transactions

Quality of earnings & cash flows: Quality of earnings and cash flows of a company will
depend on the following:
- Seasonality in sales.
- Dependency on customers/suppliers. Higher the dependency lower the
profitability will be and vice versa.
- Assessing the impact of customers gained / lost on the bottom line. Ancillaries, for
example, will be impacted significantly if they lose just one customer.
- Trend in margins including rate of growth and sustainability
- Impact of changing costs on margins. This will depend on the company’s ability to
pass through the costs.
- Impact of exchange rate fluctuations. The impact will be substantial for those firms
involved in exports or imports. It is also relevant for those firms using substantial
amount of capital from abroad or if it has made substantial investments abroad.
- Consistency in application of accounting methods. Frequent changes in accounting
methods can be considered as an indication of trouble in the company.
- Revenue recognition. Recognition of income in advance is very common and this
will lead to inflation of profitability. There are some firms which may delay the
recognition of income for the purpose of income smoothing.

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

- Nonrecurring items. Firms playing with non-recurring items too are quite
common. One common practice is to sell idle and non-core assets and investments
in order to book profit. This is normally done during periods when a firm’s
profitability might have been too low.
- Cash flows from operations – stability and certainty
Quality of fixed assets: The following details may be verified to ascertain the quality
of fixed assets:
- List of property owned by the Company.
- Documents of title, mortgages, deeds of trust and security agreements pertaining
to the properties.
- All outstanding leases for property to which the Company is either a lessor or
lessee.
- Documents showing significant acquisitions or dispositions of assets.
- Historical capex - growth and maintenance capex. Growth capex will result in
capacity addition; whereas maintenance capex will help maintain the operating
capacity and efficiency of assets.
- Capital work in progress. Capital works in progress are those capital projects
which have not been completed and will need more capital for them to be
completed. Whether the company has already tied up capital for the purpose or
not should be ascertained.
- Depreciation policy
- Capitalization of costs like R&D expenses and other costs, if any
- Capacity constraints to attain projections. Loan amount and repayment capacity
are decided based on projected financials. However, if there are capacity
constraints and hence the projected sales cannot be achieved the projections
should be revised suitably.
- Assets used but not owned; owned but not used. This is especially true for those
companies which have sister concerns sharing common facilities.
Quality of current assets: The value of current assets may depend on the following:
- Seasonality and impact on financing considerations.
- Quality of inventory. One should check if there are slow moving and non-moving
inventory, obsolete items, and perishable items in inventory.
- Quality of receivables and inventories.
o Receivables outstanding over six months

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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

o Valuation of work in progress

- Fixed working capital - deposits with tax authorities and retention money.
Potential liabilities & commitments: It will largely depend on the following:
- Policy on provisioning for expected and unexpected liabilities
- Contingent liabilities
- Employees related obligations like EPF, ESI, gratuity, pension, etc.
Related party transactions: Study on related party transactions will throw light on
siphoning of funds and diversion of funds.
- Appropriateness of transactions within family run businesses.
- Sharing of resources and common costs.
- Financing arrangements with related parties.
Details regarding financial securities issued:
- Copies of any stock purchase agreements.
- Copies of convertible debt agreements.
- Stock option or purchase plans
- Any other agreements relating to sale of securities by the Company including any
private placement memoranda.
- Details of all issuances of shares, options and warrants by the Company and the
shareholding pattern
2.4.10 Legal due diligence
The following documents shall be verified to find out if there are any legal issues:

• Details of active litigations/disputes, if any

• Documents showing settlement of any litigation
• Any decrees, orders or judgments of courts or government authorities issued to
the company.

• Information regarding any material litigation to which the Company is a party or

in which it may become involved.
2.4.11 Environmental due diligence
There are many instances where companies have been asked to stop operations due to
pollution and damage caused to the environment or adverse impact of the business on
society. There are also many instances where projects were not allowed to be taken up
despite the necessary clearances/licenses for setting up the factory and starting the
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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

business were in place. Therefore, banks must verify the impact of projects and
operations on the environment and the society. No objection certificate from the
Pollution Control Board, clearance from department of forestry, report on environment
impact analysis, and the like as may be necessary need to be obtained by companies
before commencing businesses. Specifically, the following may be verified:

• Description of all toxic/hazardous materials used in production and manner of

storage and disposition.

• List of chemicals, toxic substances or air contaminants which are regulated by law
and present in any facility of the Company.

• All instances in the past in which the Company has corrected unsafe working
conditions.

• Details of all the facilities of the Company that discharge liquid or solid waste into
any body of water, stream or any sanitation systems.

• Permits or approvals obtained from government authorities responsible for

environmental or health regulation.
• Any notices of violation served on the company for alleged failure to comply with
applicable environmental regulations.

2.5 Outsourcing Due Diligence:

Outsourcing of due-diligence activities are done by banks through various entities, such
as surveyors, advocates, KYC verifying agencies financial analysts and other verification
agencies. At times the report may be made as a routine with little scrutiny and in some
situations the report may be drafted under the influence of unscrupulous borrowers. In
such cases where due diligence was outsourced the lender should not blindly go by the
report given by such agencies, rather the banker should go through the report and
comprehend the information.
In some cases banks send their sales force instead of credit officers to carry out due
diligence such as in-person verification, background checks, and factory visits, which is
inherently conflicting with their role of loan origination. This should be avoided.

The market also has independent agencies, either government bodies or private bodies,
which hold repository of information, like Google, Probe42, Zuba Corp, e-KYC, C-KYC,
NESL, RBI defaulters’ List, RBI Caution List, ECGC Caution list, CERSAI, CRILIC,
MCA21(ROC). The future due diligence will lie with Block Chain Technology.
2.6 Summary and Conclusion
Due diligence is a first major step in credit analysis. If due diligence is not carried out
properly loan decisions more likely to go wrong. Therefore, all the lending institutions
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Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

are supposed to carry out due diligence on prospective customers before deciding on
giving loan to them. Due diligence on small customers like retail b-borrowers, agriculture
farmers, micro enterprises will be simple and easy. Whereas, due diligence on corporate
customers demands many documents and information and hence is very complex.
However, corporate customers need huge loans and hence due diligence on them need to
be carried out more stringently. Due diligence on corporate customers involve collection
of documents and data from many sources, due diligence regarding material contracts,
patents, copyrights and trademarks, manufacturing facilities, sales and marketing
arrangements, employees, management, financials, legal issues, and environmental
issues. Given the importance and complexity it is advisable for the banks and other
lending institutions to have checklist for due diligence on different type of customers.

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