Guidelines on Management of Problem Loans

Financial Viability Analysis Banks need to conduct a thorough financial and business viability analysis of its borrowers especially MSME NPL borrowers to determine their ability to repay their obligations. In addition, it is important to obtain sufficient insight into the business plan and projected cash flows available with the borrower for loan service. This will entail determining the borrower’s forecasted loan service capacity and assessment needs to be performed by the banks to align this with the restructured credit terms. This analysis serves as the foundation for making an informed decision on the appropriate resolution approach – restructuring, sale to a third party, change of loan type (loan-to-asset or loan-to-equity swap) or legal proceedings. This analysis is required to be conducted by WU not previously involved in the loan approval process. A. Analysis of key financial ratios Financial ratios, calculated from data provided in the balance sheet and income statement, provide an insight into a firm’s operations and are among the most readily available and easy to use indicators for determining the borrower’s viability. In case of MSME borrowers, in the absence of availability of audited and reliable financial information banks should focus on cash-flow based analysis and should also assess the reasonableness of financial information (where this information is available). Below are four categories of financial ratios that banks may consider for their initial financial analysis (being illustrated below for indicative purposes and should not be considered prescriptive): i. Liquidity ratios measure how easily a company can meet its short-term obligations within a short timeframe. a. Current ratio (total current assets/total current liabilities) measures a company’s ability to pay current liabilities by using current assets. It must be recognized that the distressed borrower’s ratios will be considerably lower. The Workout Unit should assess how the borrower can achieve a more normal ratio within a reasonable time frame. b. Quick ratio, which includes only liquid assets (cash, readily marketable securities and accounts receivable) in the numerator, is a measure of the firm’s ability to meet its obligations without relying on inventory. ii. Solvency or leverage ratios measure the company’s reliance on loan rather than equity to finance its operations as well as its ability to meet all its obligations and liabilities. iii. Profitability ratios measure the company’s growth and ability to generate profits or produce sufficient cash flow to survive, rate of sales growth, gross profit margin, and net profit margin are some of the key ratios to be considered. iv. Efficiency ratios measure management’s ability to effectively employ the company’s resources and assets. These include receivable turnover, inventory turnover, payable turnover and return on equity. Detailed financial analysis of the borrower needs is to be performed in order to ensure completeness and avoid ignoring important underlying trends. Banks should undertake detailed analysis to understand the interrelation of these financial ratios, which can enable identification of borrower’s real problems as well as probable corrective actions to restore the company’s financial health. The workout team should exercise prudence in his analysis and utilize reasonable caps and floors for certain ratios, as these ratios vary across borrower segments and sectors as well as economic conditions. B. Balance sheet analysis In addition to computing and analyzing the key ratios, the workout team should carefully review the balance sheet to develop a basic understanding of the composition of the borrower’s assets and liabilities. Primary emphasis should be placed on developing a complete understanding of all obligations outstanding to the bank and other creditors, including the purpose of the credits, their repayment terms, and current status, to determine the total debt burden of t