Showing posts with label banking. Show all posts
Showing posts with label banking. Show all posts

Wednesday, 23 September 2015

How does FDI affect the Currency of a country.

20:09:00
Our nation has a limited resource of Foreign reserves and we are Net Importers. Net Importers means our Imports are more than our Exports. As being Net Importers we have to shell out Foreign reserves and buy the Imports, which is a burden on our economy.

Let’s have a quick flash back of the year of 2013, Rupee had reached to a level of approximately Rs.68 per Dollar. Rupee had depreciated to an all time low. The Current Account Deficit and Inflation were the Two main culprits that caused the Rupee depreciation. The appreciation in the Crude Oil prices and the depreciation of Rupee had a very drastic effect on our economy. Since then, the UPA government had started to focus on the Foreign Direct Investment (FDI).
Now what is Foreign Direct Investment (FDI)?
FDI in simple terms means, the investing company may make its overseas investment in a number of ways - either by setting up a subsidiary or associate company in the foreign country, by acquiring shares of an overseas company, or through a merger or joint venture.
The accepted threshold for a foreign direct investment relationship, as defined by the OECD, is 10%. That is, the foreign investor must own at least 10% or more of the voting stock or ordinary shares of the investee company. An example of foreign direct investment would be an American company taking a majority stake in a company in India.
Given the current economic scenario I feel that FDI is a better option than Importing. I will tell you why….. When we Import we have to pay in terms of Foreign exchange, it leads to an outflow of Foreign exchange from our nation to the other. When this is the case, the demand of the foreign currency increases, which leads to the appreciation of the Foreign currency and obviously the depreciation of our Home currency and the depreciation of our Home currency has various disastrous effects for the Domestic economy, specially for an economy who is a Net Importer.
It is Vice Versa in case of FDI.
In FDI the foreigners come in India and bring foreign reserves along with them, this leads to appreciation of our currency. To ask the foreign businesses to come and manufacture their products in India, brings investments in infrastructure and also leads to increase in employment in the country. So what happens is, while importing we bring the foreign products and pay in foreign currency, but in FDI, we still get the foreign products as the foreign companies use their technology to manufacture in India, but we do not need to pay in Foreign currency. Thus the import bills that used to reduce our Foreign reserves would now be saved due to FDI.
In a scenario where there is a liquidity crunch in the country, development through FDI seems to be the best option rather than shelling out the Foreign reserves.
So now we understand the reason why India is focusing extensively on getting Foreign Direct Investments, as it will lead to stabilization of the currency and to bring in investments to develop our economy.
-Pratik R. Shah

Source : https://www.facebook.com/theinvestmentjargon/posts/691686247582193
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The flight and fall of Kingfisher Airlines

20:02:00
The first time the world’s biggest passenger aircraft, the Airbus A380, landed in India in 2007 it happened to be flying in Air Deccan’s founderG.R. Gopinath from the French city of Toulouse.



It was meant to be a grand show—put up by none other than Kingfisher Airlines Ltd’s Vijay Mallya, the sole Indian buyer of the $300 million super jumbo jet made by the Toulouse-based Airbus.
With its premium service, Kingfisher was then the toast of the aviation world, and the nation’s rich and famous, including leading politicians, descended on Delhi airport for a joyride on Mallya’s personal invitation.

By contrast, Air Deccan, the low-cost airline where passengers had to pay for their sandwiches and make a run for seats like in a school bus, was then struggling for funds.

At a press conference called to showcase the same A380, Mallya had announced he was interested in buying Deccan. Indeed, it was “imminent”, he declared, taking reporters who had packed an aircraft hangar in Delhi airport’s blistering heat, by surprise.

The news made headlines and Deccan’s Gopinath—like Mallya, a Bangalorean—was furious.
“We are from the opposite ends of the business spectrum, consumer models and consumer space. We are mining the bottom of the pyramid, he is picking the cream off the top. They can’t co-exist. One airline will only kill the other.”
Yet, only a few months later, as investors piled on pressure, he sold Deccan to Kingfisher, saying it was in the best interests of the airline.
The two airlines were then merged, even though Gopinath had said they would operate separately—one a premium and the other a low-cost service.

Mallya had overruled him.

Five years later, Gopinath’s dire prediction, it seemed, had come true—Kingfisher grounded its operations in October 2012 after limping on for a year and posting record losses.
Since then the airline has insisted it is on the verge of securing financing but this has failed to materialize, prompting unpaid employees to go on hunger strikes.
On Monday, Kingfisher appeared to have lost all hopes of a revival after being slapped with global damnation. Leahy, speaking at Airbus’ internationally televised annual forecast of sales, said the manufacturer had cancelled Kingfisher’s orders for five A380s, as also a similar number of A350 long-haul jets.

“The Kingfisher order—not all of it was cancelled, there are still some single aisles. Speaking with Mallya, he is still determined to sell the airline; he has an operating certificate. But even if he does sell the airline, we took the decision internally here that he probably does not need the A380s just right now so we are taking them out of the order book along with the A350s,” said the man who had flown on the first Airbus A380 sortie to Delhi.

Kingfisher was the only airline selected for this tone during the one-and-a-half hour press conference, which could make it difficult for it to lease any aircraft from the international market.
On Monday, 2005 must have seemed a long way off to Kingfisher.
Kingfisher ordered all sorts of planes when the good times began rolling in 2005, including the four-engine long-haul jet Airbus A340 to connect the two silicon valleys, San Francisco and Bangalore.
Typically, airlines order one or two class of planes to save on spare part, engineering and manpower costs.

But, like the A380 which never found full Kingfisher colours, the A340 too remained on ground for months, costing the company millions of rupees in rent.

It never even made a commercial flight, and some joked that its stylish fittings, including in its toilets, made the planes too heavy to fly non-stop between Bangalore and San Francisco.

Eventually, Airbus had to find buyers in Africa to redirect the Airbus A340 assets there.
This was just the start of Kingfisher’s problems. In 2010, the airline was hit by a major engine maintenance problem in its Airbus A320 fleet. Dozens of its aircraft had insufficient guarantees in place in the contract with the engine manufacturer (unlike rivals IndiGo, which too faced similar issues). They were grounded, and the airline started piling more costs as revenue shrank.
But the colourful Mallya refused to admit that things were going wrong even as his flagship UB Group came under strain helping Kingfisher.
“Ooo la la la le o Ooo la la la oo le o... Someone asked me why I owned a booze company and an airline...I said “both make u fly”! Cheers!” Mallya tweeted with the signature Kingfisher beer jingle on 28 April 2010.

But by the year-end things were looking really bad, and the billionaire beer baron was touring the world in search of funds.
“On a hectic road show meeting potential investors in the planned Kingfisher Airlines equity raise. Amazing to see smart Indians managing billions...Kingfisher Airlines has faced unprecedented difficulties over the past 1 year but our staff has done a superb job of maintaining quality,” he said on 9 October 2010, adding: “One by one each hurdle has been addressed squarely and resolved. Now watch Kingfisher India’s only 5 star airline REALLY fly...”
The hurdles never stopped coming his way.
Banks tightened the noose on Kingfisher to pay up loans after it was grounded; and taxmen impounded Mallya’s personal Airbus A319 jet labelled VT-VJM (after his initials)—one of the world’s most luxurious aircraft, adorned with original Picasso paintings.
The jet is still parked in an isolated corner near the Mumbai airport runway, cocooned in dust, with its nose peering over the airport’s perimeter fence onto Mumbai’s famous slums.
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Tuesday, 1 September 2015

RBI- Banks must move to marginal cost for new base lending rate

17:51:00

MUMBAI, Sept 1 (Reuters) - India's central bank has asked banks to calculate their base lending rates on the basis of the marginal cost of funds instead of the current practice of average cost and to implement the new rules by April 1, 2016.
The Reserve Bank of India wants banks' lending rates to be sensitive to policy rates, it said in a circular on draft base rate guidelines on Tuesday.
Indian banks have been reluctant to lower their base lending rates, citing high cost of funds, despite the three policy rate cuts by the RBI.
The RBI also urged banks to move to external financial benchmarks for pricing their deposits and loans in the medium term. 
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Monday, 10 August 2015

Currency Swap Basics

20:12:00


Currency swaps are an essential financial instrument utilized by banks, multinational corporations and institutional investors. Although these type of swaps function in a similar fashion to interest rate swaps and equity swaps, there are some major fundamental qualities that make currency swaps unique and thus slightly more complicated. 

A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency. Following the initial notional exchange, periodic cash flows are exchanged in the appropriate currency.

Let's back up for a minute to fully illustrate the function of a currency swap.

Purpose of Currency Swaps
An American multinational company (Company A) may wish to expand its operations into Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from Brazilian banks' unwillingness to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favorable interest rate in the U.S. market. The Brazilian Company may only be able to obtain credit at 9%.

While the cost of borrowing in the international market is unreasonably high, both of these companies have a competitive advantage for taking out loans from their domestic banks. Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their local lending authorities. (This emerging market is making strides in regulation and disclosure. See Investing In China.)

Setting Up the Currency Swap
Based on the companies' competitive advantages of borrowing in their domestic markets, Company A will borrow the funds that Company B needs from an American bank while Company B borrows the funds that Company A will need through a Brazilian Bank. Both companies have effectively taken out a loan for the other company. The loans are then swapped. Assuming that the exchange rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00 USD and that both Companys require the same equivalent amount of funding, the Brazilian company receives $100 million from its American counterpart in exchange for 160 million real; these notional amounts are swapped.

Company A now holds the funds it required in real while Company B is in possession of USD. However, both companies have to pay interest on the loans to their respective domestic banks in the original borrowed currency. Basically, although Company B swapped BRL for USD, it still must satisfy its obligation to the Brazilian bank in real. Company A faces a similar situation with its domestic bank. As a result, both companies will incur interest payments equivalent to the other party's cost of borrowing. This last point forms the basis of the advantages that a currency swap provides. (Learn which tools you need to manage the risk that comes with changing rates, check out Managing Interest Rate Risk.)

Advantages of the Currency Swap
Rather than borrowing real at 10% Company A will have to satisfy the 5% interest rate payments incurred by Company B under its agreement with the Brazilian banks. Company A has effectively managed to replace a 10% loan with a 5% loan. Similarly, Company B no longer has to borrow funds from American institutions at 9%, but realizes the 4% borrowing cost incurred by its swap counterparty. Under this scenario, Company B actually managed to reduce its cost of debt by more than half. Instead of borrowing from international banks, both companies borrow domestically and lend to one another at the lower rate. The diagram below depicts the general characteristics of the currency swap.

For simplicity, the aforementioned example excludes the role of a swap dealer, which serves as the intermediary for the currency swap transaction. With the presence of the dealer, the realized interest rate might be increased slightly as a form of commission to the intermediary. Typically, the spreads on currency swaps are fairly low and, depending on the notional principals and type of clients, may be in the vicinity of 10 basis points. Therefore, the actual borrowing rate for Companyies A and B is 5.1% and 4.1%, which is still superior to the offered international rates.

Currency Swap Basics
There are a few basic considerations that differentiate plain vanilla currency swaps from other types of swaps. In contrast to plain vanilla interest rate swaps and return based swaps, currency based instruments include an immediate and terminal exchange of notional principal. In the above example, the US$100 million and 160 million reals are exchanged at initiation of the contract. At termination, the notional principals are returned to the appropriate party. Company A would have to return the notional principal in reals back to Company B, and vice versa. The terminal exchange, however, exposes both companies to foreign exchange risk as the exchange rate will likely not remain stable at original 1.60BRL/1.00USD level. (Currency moves are unpredictable and can have an adverse effect on portfolio returns. Find out how to protect yourself. See Hedge Against Exchange Rate Risk With Currency ETFs.)

Additionally, most swaps involve a net payment. In a total return swap, for example, the return on an index can be swapped for the return on a particular stock. Every settlement date, the return of one party is netted against the return of the other and only one payment is made. Contrastingly, because the periodic payments associated with currency swaps are not denominated in the same currency, payments are not netted. Every settlement period, both parties are obligated to make payments to the counterparty.

Bottom Line
Currency swaps are over-the-counter derivatives that serve two main purposes. First, as discussed in this article, they can be used to minimize foreign borrowing costs. Second, they could be used as tools to hedge exposure to exchange rate risk. Corporations with international exposure will often utilize these instruments for the former purpose while institutional investors will typically implement currency swaps as part of a comprehensive hedging strategy.
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Sunday, 9 August 2015

Credit Card Against Fixed Deposit Explained

22:08:00
This new idea is formulating in the market virally as the banks aggressively marketing this product in the market with a new enthusiasm. There are so many features attached to this deal that will help you decide if this  is ideal for you or not. You need just an existing or new fixed deposit with a bank to have credit card of that particular bank. The deposit amount should be more than Rs. 20,000 and less than Rs. 25 lakh. You just have to remember that your credit card limit will be 80-85 percent on the deposit amount. With this the bank will be able to secure itself in handing you any kind of money and can enjoy a margin of security.
With quick processing and less complication while getting a card for you is an advantage that a customer enjoys. Even the documentation that you need to produce to the bank is minimum which turn makes the process faster and easier for both, bank and the customer. That maximum period of the fixed deposit should be more than 180 days and a lien will be marked against this fixed deposit. It would continue as normal fixed deposit and will regularly earn interest. If there will be a delay in making any credit card payments and same will be made good from your fixed deposit account. In this the bank is secure as there is a specified limit on the card and the bank will have its exposure completely covered.
The most important thing about this whole thing is that you don’t have to show your income limit to the bank and you can simply get a credit card by simply depositing minimum of Rs. 20,000 in your fixed deposit account. So there is no need for meeting the expected income bar of the bank for the bank to issue you a credit card at all. This can make things easier for the customers who are in the beginning of their career. Even in the case of debt overload you can be the owner of your own credit card. If you already have few loans running on your account banks may not be so excited about giving you another loan in the form of a credit card. But with a fixed deposit you can easily get a card for sure without much of complications. So even if your repayments behavior has been a bit bumpy still you can be carefree about the repayments if your card is against the fixed deposit.
If there arises any medical emergency, you can have benefits if your card is linked to your fixed deposit. For one you wont have to worry about foreclose your deposit and it will continue to earn interest as you can use your credit card with ease. Another benefit related to this is that you get 48-55 windows for making interest free payments of your card. So you get time to arrange liquidity for your payments through other means on time. It also comes helpful if you have lost your job, your credit card can lend you duration of 48-55 days for arranging the liquidity without closing you fixed deposit account in such emergency cases.
All this is for one purpose and one purpose only, that is to put a check on the reckless spending of the people with a specified amount to look forward too. The summary being, it is beneficial in all sense, short term as well as long. In short term it would affect your liquidity and in long term it would help in asset allocation process. All in all it can be a good idea to have a credit card against your fixed deposit account. So, if you are debt overload or have been denied a credit card you can always go for fixed deposit linked route.
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Bridge Finance – Complete Details with Features

19:19:00

Bridge finance : Introduction

Bridge finance is a type of short term loan which acts provides a financial assistance to meet the short term liquidity requirements. As the name suggests it acts as a bridge between the initial period and the time till one can get a permanent source of finance to meet his requirements.It is a gap financing arrangement.
Example :
For example , ABC Ltd is a small scale enterprise engaging in the business of oil refinery on a small scale. Suddenly as a result cof their extremely good quality they got a project worth 1 crores ,For this the company went to his banker and applied for the loan. It was said that the loan amount will be disbursed after 3 months due to the complexity of procedural aspects. Then if ABC Ltd goes to another lender/ same lender to obtain a loan which rescue them till the first loan is disbursed, it is called as bridge loan.

Features of Bridge Finance :

(1) Short term oriented :

Bridge loans are oriented for short period i.e less than a year. The main objective of bridge loan is to facilitate the financial assistance to meet short term financial requirements. When a new graduate wants to start his own enterprise then definitely he needs the financial backup to meet his working capital requirements and to facilitate the business with initial arrangements. In such case if he opts to apply bridge loans then it provides him the ability to meet above stated short term requirements.

(2) High interest costs :

As they are short term oriented and the payback period is also less compared to the long-term industrial loans , they carry higher interest costs. As they come to rescue in your financially unfavorable conditions definitely they result in high interest cost.

(3)Demands collateral security :

They demand collateral security. The top players who provide bridge loans in the economy ask for the collateral security in almost all the cases. The value of the security one can keep as collateral will directly influence the amount of loan the lender is willing to grant.

(4) Alternative modes of payment :


Bridge loans facilitate to repay the loan either before or after the actual permanent source of finance is secured. If a company wants to repay before then it improves the credit rating of the company with that lender so that they can even get long term loans from the same lender. If they choose to repay the loan after the main source of finance is granted then he can do it out of the funds granted by the permanent source of funding for which they might have been waited.
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All you need to know about Venture Capital

19:14:00

Meaning – Venture Capital :
The term Venture Capital fund is usually used to denote individual or Institutional investors who provide equity finance or risk capital to little known, unregistered, highly risky, young and small private business. They’re known for backing high-growth companies in the early stages, and many of the best-known entrepreneurial success stories in India owe their growth to financing from venture capitalists. It’s a long term financial assistance backed up by high amount of risk.
In 1980s ICICI has formed a venture capital firm as a joint venture with Unit trust of India where they procured funds mainly for financing the highly growth oriented sectoral enterprises. It is India’s first venture capital firm.

Features :

(1) Highly risky :

It’s a well known fact that the level of risk is directly related to the amount of return. The more the risk one is ready to face the more amount of return he is able gain. Venture capitalist invest in highly growth oriented business where the level of risk in the initial period is very high when compared to the well established businesses. So if you are planning to become a venture capitalist then you need to be ready to face the risk involved in the investment.

(2) High return :

Venture capital earns high amount of return once if the business becomes successful in the market. Usually venture capitalist gain a lot during the tremendous success of the startups which they financially backed up.

(3) Moderate the financial burden of the startups :

At the initial stage of starting a business one may or may not get the success so easily. So in the times of initial operations of the business which we can call as a gestation period during which the financial statement of the entity contains only cost, the investment made by the venture capitalists help the startups immensely.

(4) Chance of getting finance based on real time needs :

Unless in banks and financial institutions venture capitalists provide the business with the required amount of investment considering the real time situational needs of the business. In case of banks one may not get the sufficient amount of investment to backup the enterprise.

Advantages :

(1) Opportunity to get the business expertise of venture capitalists :

The business expertise of the venture capitalists will help the aspiring young entrepreneurs having no experience of dealing with different dimensions of a business. Many venture capitalists have professional and trained staff in their team. Thus they can get benefited from the expertise and experience of the venture capitalists immensely.

(2) Business connection :

A well established venture capitalists firm has many business connections in the market which help the startups to expand their business without incurring any additional cost to develop their connections.

Disadvantages :

(1) Probability of losing the control :

In many cases venture capitalists may exercise a significant control over the enterprise as their investment is at high risk. Sometimes they dominate the business owners in terms of decision making.

(2) Uncertainty :


Sometimes a venture capital firm may think that the decision being taken by the business owners may not worth anymore , in such circumstances they may not be willing to invest any additional funds if required to backup the business.
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All you want to know about Factoring

19:07:00

Factoring :

Factoring is an activity in receivables management system which facilitates a company to get the cash immediately on real time basis.
Factoring is an activity where a business sells its receivables to third party (factor) at against which the factor pays certain portion say 80 to 90% of the value of the receivables immediately without waiting for a period of actual credit period granted to the customers. He will reserve the balance amount till the Realisation of receivables.
The amount granted by the factor depends on

(1) Industry :

If the industry in which company is engaged is of such kind where the Realisation of receivables doesn’t take considerably much time then the factor may provide up to 90% of the value of the receivables and advances at the time of purchasing them.

(2) Credit worthiness of customers :

Factor considers the credit worthiness and repayment history of the customers of the business entity to examine the probability of recovery from the receivables. If the credit history is not good then it certainly cause to lower the amount to be granted at the time of purchasing.
After realising the debts from the receivables and advances the factor will release the reserved amount by deducting certain portion towards his commission / factoring charges.

How it happens ?

(1) A business serves its clients or supply its products to customers.
(2) Gets the invoice of sale which we can refer as receivables against a specified credit period.
(3) Company approaches the factor and sells the receivables.
(4) Factor pays the company certain % of the value of the receivables (80% to 90%) immediately. And reserves the balance.
(5) At the time maturity factor collects the debts from the customers in respect of the receivables he bought.
(6) Factor pays the company the reserved amount after deducting certain amount as his charges.

Types of Factoring :

(1) Notified factoring :

Here, the customer is given prior intimation about the assignment of debt
to a factor, also directed to make payments to the factor instead of to the company. This is invariably done by the company at the time of giving invoices and following for the payment.

(2) Non notified factoring :

No prior intimation is given to the debtors / customers about the factoring assignment.
This kind of Factoring is common when there’s a probability that the customer may break the payment terms and factor is willing to accept the risk of collecting the amount against invoices sold to him.

(3) With recourse factoring :

Here the company itself will carry the risk of non collection from the receivables. Here the factor is no way responsible for the bad debts.

(4) Without recourse factoring :

Here the factor takes the responsibility for bad debts. If any bad debts result subsequently then the company is no way responsible for that.

(5) Bank participation factoring :

In this the company creates a floating charge on the
factoring reserves in favour of banks and borrow against these reserves.

(6) Export factoring :


Export factoring provides immediate financing against your export receivables. Financing can be availed in Rupees or in foreign currency. Factor buys the foreign receivables.
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Corporate Credit Worthiness And Credit Rating

19:04:00

Traditionally, loans were granted to a company or Investments were made in the company on the basis of financial statements alone. The other essential factors for assessing the Credit Worthiness like Market Scenario, Risk Element and Industry Specific Scenario were not the part of the Investment/ Credit Assessment. The increasing defaults & failures have further led to the realization that these factors are equally or rather all the more important in Investing or Lending Decisions. Before I jump on the issue of credit rating & the role of CA’s in this context, let me cover some preliminary concepts involved here.
Before credit rating, we need to know the concepts of credit worthiness & what does it mean!

WHAT’S CREDIT WORTHINESS??

  • Credit Worthiness implies the ability to borrow money.
  • It is an assessment of the probability that a borrower will default in their debt obligations.
  • According to the most commonly prevailing practice, credit worthiness differs for an individual vis-a-vis a corporate.
  • Individual creditworthiness is measured by a *‘FICO score’ while a Corporate’s creditworthiness is measured by its credit rating.
  • Credit Worthiness is based upon factors, such as their history of repayment and their credit score.
  • Credit Worthiness is more important from the lender’s perspective & is taken into consideration to determine the possibility of default.
*FICO Score: (Fair Issac Corporation) A way of measuring an individual’screditworthiness. A FICO score ranges between 350 and 850. In general, a score of 650 is considered a “fair” credit score, while 750 or higher is considered “excellent.”

WHAT’S CREDIT RATING??

  • Credit Rating is an assessment of the credit worthiness of a borrower in general terms or with respect to a particular debt or financial obligation as well.
  • There are the agencies like CRISIL, CARE, etc. who do the Credit assessment and evaluation for companies and governments.
  • These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.
  • Credit ratings are based on substantial due diligence conducted by the rating agencies.

WHO CAN DO THE CREDIT RATING??

  • Credit Rating could be either Internal or External.
  • Internal Credit Rating is usually done by the Banks before providing loans to their clients. All banks/DFIs are required to assign internal risk ratings across all their credit activities including consumer portfolio.
  • While External Credit Rating is usually done by a Credit Rating Agency. A CRA is a company that assigns credit ratings – rating of the debtor’s ability to pay back the debt by making timely interest payments and of the likelihood of any prospective default.

ABOUT CREDIT RATING AGENCIES:

Few Global Credit Rating Agencies are:
  • Standard & Poor’s (S&P),
  • Moody’s,
  • Fitch Group.
Few Indian Credit Rating Agencies are:
  • CRISIL Limited
  • ICRA
  • ONICRA
  • Credit Analysis & Research Ltd. (CARE)
Now after knowing about the basics of credit worthiness & credit rating, let us have a look on how can we determine the credit worthiness of a corporate:
THE ‘5 C’ INDICATORS WHICH DETERMINE CREDIT RATING & CREDIT WORTHINESS ARE:
  1. capacity to generate sufficient cash flows to service the loan;
  2. collateral to secure the loan in case the borrower defaults;
  3. capital that shareholders have invested in the business;
  4. conditions prevailing in the borrower’s industry and broader economy; and
  5. character and track record of the borrower and the borrower’s management.
Let’s consider each of the five criteria’s in a little more detail:

1. Capacity:

  • Capacity to repay a loan is the most important criterion used to assess a borrower’s creditworthiness.
  • To satisfy itself of the borrower’s capacity, the lender will consider various factors including:
(i) Profitability: What are the revenues and expenses of the borrower?
(ii) Debt levels: How much debt does the borrower have? How much debt can the borrower afford to repay?
(iii) Industry evaluation: What is the normal debt/liquidity level for companies in the borrower’s industry?
(iv) Financial ratios: There are a number of financial ratios, such as debt and liquidity ratios, that lenders will evaluate before lending money: e.g. debt equity ratio, debt asset ratio, current ratio, quick (acid test) ratio, operating cash flow ratio, working capital ratio, etc.
(v) Let us have a look on some of the most important ratios:
  1. DEBT SERVICE COVERAGE RATIO:
    • One of the basic measure of a company’s creditworthiness is the debt service coverage ratio (DSCR), which shows a firm’s ongoing ability to keep in control both debt and interest.
    • The DSCR, defined as earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by a firm’s current portion of long-term debt and interest expense, is an extremely important metric for predicting default.
    • More than half of the banks in the recent Pepperdine Capital Markets Survey said this statistic was very important in their lending decisions.
  2. NET INCOME TO SALES:
    • The net income to sales ratio is a fundamental measure of how profitable your business clients are.
    • The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales.
    • Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. This ratio is also effective for measuring past performance of a company.
  3. DEBT TO EBITDA
    1. EBITDA is widely used as a proxy for pre-interest, pre-tax cash flow from operations.
    2. Comparing EBITDA to a company’s assets helps show profitability – how much income, or cash, a company can generate from its equipment, property, and other assets.
Besides these, there are many other ratios which are used to determine the capacity of an entity.

2. Collateral:

  • While cash flows are the primary source for the repayment of a loan, collateral provides lenders with a secondary source of repayment.
  • Collateral represents the assets that are provided to the lender to secure a loan.
  • In the event that the borrower fails to repay the loan, the collateral may be seized by the lender to repay the loan.

3. Capital:

  • Capital is the money that shareholders have personally invested in the business.
  • Capital represents the money that shareholders have at risk if the business fails.
  • If the business runs into a financial difficulty, then the capital of the business provides a cushion for repayment of the loan.
  • On a lighter note, the bank will lend you the finance only if you are able to prove the bankers that you don’t need the capital!!

4. Conditions:

  • Conditions refer to two factors that the lender will take into account.
  • Firstly, conditions refer to the overall economic climate, both within the borrower’s industry and in the economy generally, that could affect the borrower’s ability to repay the loan. In considering the overall economic climate a lender may consider various questions including:
    1. What are the trends for the borrower’s industry? How does the borrower fit within them?
    2. What is the short and long-term growth potential in the industry?
    3. How is the market characterized? Is it an emerging or mature market?
    4. Are there any economic or political hot potatoes that could negatively impact the borrower’s growth?
  • Secondly, conditions refer to the intended purpose of the loan.
    1. Will the money be used to replenish working capital to prepare for a seasonal inventory build-up?
    2. Will the money be used to buy new equipment for expansion?

5. Character:

  • Character refers to the general impression that the borrower makes on the prospective lender.
  • Relevant factors that a lender may consider in deciding whether the borrower is sufficiently trustworthy include:
    1. What reputation does management have in the industry and the community?
    2. What educational background and level of experience does management have?
    3. What is the overall consumer perception of the borrower?
    4. Is the borrower progressive about its waste disposal, quality of life for its employees, and charitable contributions?
    5. Does the borrower have a track record of fulfilling its obligations in a timely manner?
WHAT ARE THE ISSUES INVOLVED IN DETERMINING THE SCREDIT WORTHINESS??
  • The methodology of assigning credit ratings by an agency has a significant undisclosed part which includes expert evaluations that are often used in the reports in a non-transparent & ambiguous way.
  • The Corporate being rated may not disclose certain material facts to the agency’s investigating team. This can affect the quality of rating.
  • The rating does not always represent the real financial picture. Also, negative ratings can adversely affect the image as well as the investment decisions in a corporate.
  • Different ratings by different agencies for the same entity or instrument can cause confusion in the minds of the investor.
  • If the analysis is explained in a detailed way in the reports, these issues can be resolved in an effective way.
In spite of all these lacunas, Credit Rating is still the Talk of the Day. So the question arising here is Why Credit Rating?

‘Some of the Many’ Benefits of Credit Rating are:

  • It is important for each person to keep track of their credit score because this is the main metric used by the institutions when determining if the individual is worthy of a favorable rate.
  • Credit ratings enable an investor to save his time and effort in analyzing the financial strength of an issuer company. This is because the investor can depend on the rating done by professional rating agency, in order to take an investment decision.
  • Credit rating enables a company to grow and expand. This is because better credit rating will enable a company to get finance easily for growth and expansion.
  • A good credit rating proves the creditworthiness of a corporate & helps to build confidence among the various stakeholders.

The most important question which has still occupied a place in my mind ishow do these agencies determine the creditworthiness of a corporate?Analyzing the creditworthiness of a corporate & assigning it a suitable credit rating involves a detailed understanding of the business, the risks & rewards associated with it, the industrial & market scenario & the economy as well. The importance of credit rating today is significant; overlooking this fact can be very detrimental to your financial health. Being aware of how your credit score is calculated is essential. In this context, I believe that no one can disagree with me to the fact that CA’s are the best brains when it comes to understanding such crucial parameters. No one can beat the core competency possessed by the Chartered Accountants. Thus the CA’s have a vital role to play in this emerging aspect of Corporate Creditworthiness & Credit Rating.
Source- caknowledge
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