What are Key issues considered by the financial institutions while appraising a project for term finance?

Answer 1

Financial institutions appraise a project from the marketing, technical, financial, economic and managerial angles. The principal issues considered and the criteria employed in such appraisal are discussed below in this article.

Market Appraisal: The importance of the potential market and the need to develop a suitable marketing strategy cannot be over emphasized. Hence efforts are made to:

Examine the reasonableness of the demand projections by utilizing the findings of available surveys, industry association projections, Planning Commission projections, and independent market surveys (which may sometimes be commissioned).

Assess the adequacy of the marketing infrastructure in terms of promotional effort, distribution network, transport facilities, stock levels etc.

Judge the knowledge, experience, and competence of the key marketing personnel.

Technical Appraisal: The technical review done by financial institutions of focuses mainly on the following aspects:

1. Product mix

2. Capacity

3. Process

4. Engineering know-how and technical collaboration

5. Raw materials and consumables

6. Location and site

7. Building

8. Plant and equipments

9. Manpower requirements

10. Break even point.

The technical review is done by qualified and experienced personnel available in the institutions and/or outside experts (particularly where large and technologically sophisticated projects are involved).

Financial Appraisal: The financial appraisal seeks to assess the following:

Reasonableness of the Estimate of capital Cost: While assessing the capital cost estimates, efforts are made to ensure that (1) padding or under-estimation of costs is avoided, (2) specification of machinery is proper, (3) proper quotations are obtained from potential suppliers, (4) contingencies are provided for, and (5) inflation factors are considered.

Reasonableness of the Estimate of Working Results: The estimate of working results is sought to be based on (1) a realistic market demand forecast, (2) price computations for inputs and outputs that are based on current quotations and inflationary factors, (3) an approximate time schedule for capacity utilization, and (4) cost projections that distinguish between fixed and variables costs.

Adequacy of rate of return: The general norms for financial desirability are as follows:

Internal rate of return: 15 percent

Return on investment: 20-25 per cent after tax

Debt service coverage ratio: 1.5 to 2.0

In applying these norms, however, a certain amount of flexibility is shown on the basis of the nature of the project, the risks inherent in the project, and the status of the promoter.

Appropriateness of the Financing Pattern: The institutions consider the following in assessing the financial pattern.

1. A general debt equity ratio norm of 1:1

2. A requirement that promoters should contribute a certain percentage of the project cost.

3. Stock exchange listing requirements.

4. The means of the promoter and is capacity to contribute a reasonable share of the project finance.

Economic Appraisal: The economic appraisal looks at the project from the larger social point of view. The methodology adopted by financial institutions for the purpose of economic evaluation (also referred to as social cost benefit analysis) is labeled as Partila Little Mirrlees approach. In addition to the calculation of the economic rate of return as per this approach to the calculation of the economic rate of return as per this approach, they also look at two other economic indicators: (1) effective ate of protection, and (2) domestic resources cost. Admittedly, the economic review done by financial institutions is not very rigorous and sophisticated. Also, the emphasis placed on this review has diminished. Now it is hardly done.

Managerial Appraisal: In order to judge the managerial capability of the promoters, the following questions are raised:

1. How resourceful are the promoters?

2. How sound is the understanding of the project by the promoters?

3. How committed are the promoters?

Resourcefulness: This is judged in terms of the prior experience of the promoters, the progress achieved in organizing various aspects of the project, the skill with which the project is presented and the ability to raise committed capital and unforeseen shortfall financing.

Understanding: This is assessed in terms in terms of the credibility of the project plan (including, interalia, the organization structure, the staffing plan the estimated costs, the financing pattern, the assessment of various inputs, and the marketing programs) and the details furnished to the financial institutions.