A term loan is a way of borrowing money for creation of assets. Term loan is the commonly availed facility by any borrower especially businessmen. There is a process involved in granting term loan by financial institutions. You must know about it to apply for term loan and get approval.
What is term loan?
An individual or firm or company can avail loan facility from institutions in two form – a) working capital and b) term loan.
Term loan as the name suggest is a long term loan, which has to be repaid over a period of 5 to 10 years along with interest. The repayment can be in monthly or quarterly instalments. In some cases it is allowed to pay in half yearly or yearly instalments. Car loan, house loan, personal loan, business loan are example of term loan.
Characteristic of term loan
Term loan has certain characteristic, which are as below:
- It is given for acquiring permanent assets
- It is repaid out of income or profit generated by the business
- Asset created out of the loan is given as security to lender
- It is always fund based.
- It is repaid in instalments.
How term loan is assessed?
Since term loan is given for long term, its assessment is known as appraisal. The term loan appraisal is carried out in respect of 5 areas – promoter, technology, market, finance and environment. Though it is applicable in all form of loans, it is more prominent for house and business loan.
Promoter assessment
It is very important to assess the promoter while giving a term loan. Therefore, the applicants should also furnish the right and best information about him or her. The promoter appraisal includes finding the credibility of the people behind a project or purpose of taking the loan.
It is evaluated from the perspective of 5 C’s – Character, Capacity, Capital, Collateral and conditions.
Character answer questions like what is the reputation of the person in the society. Is he trust worthy, do people like him, is he fit for taking term loan.
Capacity includes his qualification, experience in the field, support of family or professional team.
Capital includes resourcefulness of the person. Does he have money to invest.
Collateral includes whether he has assets to offer as security for the term loan.
Conditions include his capability to fulfil different terms and conditions for availing a term loan.
Technology appraisal
Now a days, technology is inseparable from business activities. Technology is changing very fast. Whenever a term loan is proposed, the technology aspect need to be thoroughly assessed. Importance of technology arise from following factors.
- Technology defines what is the capacity and how much the plant will be able to produce. The production level defines its level of income.
- It defines production and service efficiency of the unit.
- Technology also includes utilities like water, electricity, roads, skilled labour etc. and location. Inadequate utilities may become barrier to success, while a good location can enhance the success of a business venture.
Market appraisal
Any business venture requires a detail understanding of market. Financial institution will give term loan to a venture which is engaged in manufacturing a product or providing a service which has high demand. It is not sufficient to have demand alone, the firm or company should be able to provide the product service at a price suitable for the customers. Further the firm should be able to take a share of the market. What is the competition level. Will the firm be able to face the competition and take a share of the market.
Financial appraisal
This is the most important aspect to consider in giving term loan. The first thing that comes under financial appraisal is estimating the project cost. A typical project cost may have components like – land, building, Plant & Machinery, Misc. Fixed Assets, Preliminary expenses. Each of the component need to be estimated correctly with adequate cushion. The estimates should be backed by calculation by experts and invoices.
After the right estimate of project cost is followed by estimation of means of finance. How much money will be invested by the promoter and how much will be borrowed from the financial institution.
Next step is to make projections about income, expenditure, Gross profit and Net profit for at least 7 years or till the term loan tenure.
To prepare projection we need to assume certain things like what will be the capacity utilisation per year, how many units will be produced, what will be the sales price, what will be the raw material price, manpower required, other operation cost etc. It is very important to consider the assumptions correctly, because the future of the project depends on these assumptions. There is thump rule to follow – estimate income conservatively and expenses liberally. If the project still shows profitability than it will be able withstands changes in the market.
There are certain financial ratio to be followed to consider the viability of the project.
DER – Debt equity ratio. It indicates as against promoters’ money how much loan has been availed. Generally, a ratio of 1.5:1 is preferred. However, it may very both ways depending upon the project. Its acceptance is subject to norms of the institute.
DSCR – Debt service coverage ratio. It indicates the capacity of the project to repay the term loan along with interest. Generally, DSCR of 1.3:1 is acceptable. Higher is better.
Break-even point (BEP) – it indicates at what income or sales volume or capacity utilisation, the unit is at no profit no loss stage. It is calculated as per the following formula
BEP for sales = (Fixed cost X Total sales)/Total contribution.
Environmental appraisal
Any project or service offer should be environment friendly. While setting up manufacturing plant it produces many waste material. The project should have means to dispose these properly without having environmental impact. Similarly, service providing units also need to consider environmental impact if any.
In fact, there are regulators like pollution control board who provide certificate, license for such activities and these are mandatory.
Conclusion
As we see how a term loan is appraised, we must ensure these while applying for a loan. In the process of appraising as above more clarity comes about the project or venture. It gives an opportunity to fine tune the business plan for success. A right foundation and planning goes long way in availing a loan like Mudra Loan and making the project a grand success.
All these details are generally captured in a project report. Many a time we don’t put much attention to this report. If this report is prepared properly with a practical approach, it can be a guide or roadmap for conducting the business.