Term lending institutions try to assess the following in their financial appraisal of a project proposal:

a. Estimate of capital cost
b. Estimate of working results
c. Rate of return
d. Financing pattern

a. Estimate of capital cost:
The assessment of capital cost involves a vigorous check of the financial projections provided by the promoter on the following aspects:

Padding or under-estimation of costs

Proper specification of machinery

Credibility of various suppliers

Allowances for contingencies

Inflation factors

b. Estimate of working results:

The projections supplied by the promoters regarding the sales, realizations and profits are assessed by checking whether:

A realistic market demand forecast has been given

Price computations for inputs and outputs are based on current quotations and inflationary factors

An appropriate time schedule for capacity utilization is given

The cost projections are distinguished between fixed and variable costs appropriately

c. Rate of return: The norms for the financial viability are generally in the range of:

Internal Rate of Return (IRR)   15-20%

Return on Investment (ROI)   20-25%

Debt-service coverage ratio (DSCR)  1.5 to 2


The above mentioned figures are not mandatory and a certain degree of flexibility is shown on the basis of the nature of the project, risks inherent in the project, and the status of the promoter.

d. Financing pattern:
 

• A general debt-equity ratio norm of 1.5:1
• Minimum Promoters contribution 20-25% of the project cost
• Stock-exchange listing requirements in cases part of the equity is proposed to be raised from the public
• The financial capability of the promoter

The beauty of Financial Analysis is that the viability of projects can be established by effecting minor changes in assumptions such as growth rates, cost structure, residual value, etc (often at the second or third decimal!). So, achieving the cut-off IRR or coverage may not prove difficult to a person well versed with the various facilities available on spreadsheets!

However, Financial Analysis remains an extremely important step, as it is the standard that influences decision of the financiers. (especially of the public sector). Secondly, the sensitivity analysis conducted as part of such studies forms the basis for identifying the crucial parameters for the success of the project. Financiers tend to monitor the project progress through these milestones and parameters.

In day-to-day practice the financial institutions have their own independent criteria and credit rating methodology for arriving at the credit rating of each project. Financial institutions calculate the Internal Rate of Return (IRR). The Internal Rate of Return refers to the rate of return that the project is expected to generate based on its projected cash flows accruing over its expected lifespan. Institutions have a threshold IRR that the project needs to surpass to assess its viability.

Various financial ratios are calculated for the past and future data provided to them by the promoters after checking the veracity of the same. The various ratios, which are frequently calculated include:
 

• Current ratio:

[(Receivables + material and finished good inventory)/ (creditors for goods and expenses)]
• Long term debt-equity ratio

[Long Term Debt/ Networth]
• Interest coverage ratio

[(Profit Before Interest – Provision for Tax)]/(Interest payments due for the year]
• Fixed assets coverage ratio

[Fixed Assets/ (Term loan and other long term debt obligations)]
• Debt-service coverage ratio

[{(Profit before interest- Provision for taxes)+Depreciation}/  {Interest repayments + (Principle Repayments*(1-effective tax rate))}]
• Profit after tax/sales

The above values are taken as standard though a certain amount of flexibility is exercised depending on the perception and personal judgment of the appraising officer. A rating is assigned to the project based on the scores of the different ratios. A cut-off rating determines financing decision (whether the project would financed or not). Above the rating, the projects maybe categorized into excellent, good and average. Based on this and the project characteristics, the final terms and conditions of financial assistance are decided upon like:

• Moratorium
• Repayment period
• Availability period
• Security (like pari-passu charge, first charge, personal guarantee, corporate guarantee etc.)
• Interest rate

Market Appraisal
Technical Appraisal
Managerial Appraisal

We would look forward to receiving your feedback and suggestions on this module at services@indiamarkets.com