Internal Rating Done by Banks – Composition & Consequences

Any borrower who has taken loans for business would vouch that before sanctioning the bank loans, the banker would have asked for a host of information & documents from them. This would include all their personal documents, company documents like Annual Reports (Profit & Loss Account, Balance Sheet, Cash Flow, Schedules), Business Profile, Income Tax Returns, GST Returns, 26AS, TDS, property papers, due diligence reports, detailed management discussion, etc. and what not. Most of the time, it is a nightmare for a borrower to go through this painful journey of getting their business loan sanctioned.

When asked why the Bank needs so many documents & information? The standard answer is for their internal assessment as to whether the loan can be given or not. If yes, how much and at what terms, right?

Has it ever happened that Banks came forward by themselves and explained to you as to what all were good points in your loan proposal and in what areas you need to improve. Most likely, the answer would be “No”. Did you bother to enquire about the same. Again, the answer would be emphatically “No”.

So it is very important to understand how the Bank uses your precious documents to make their internal assessment and what all you can learn from it – which can be applied in your businesses, going forward.

Well, amongst various tasks, one of the most important steps taken by a banker is to do the Internal Rating for all the loan proposals that come to them (irrespective of the size of the loan). There are various factors which are considered while doing the internal credit rating assessment. In the meantime, let’s see what factors are considered while assessing risk factors by the bank:

1. Industry Risk
2. Business Risk
3. Financial Risk
4. Management Risk

Before we elaborate on each of them specifically, lets have an overview of what the bank’s scorecard means.

‍Industry Risk:

‍This basically refers to all the risks which the concerned industry may be facing and affecting all the participants in that industry. Such risks are external to the company. Some examples include:

1. Demand Supply position in the industry. Does the demand outweigh the overall supply or vice versa? One gets a good credit score in the former situation and less in the latter.

2. Impact of various government policies and their near future outlook on that industry. The more favorable the policies, the better the score.

3. Competitive situation in the industry. Is it a monopolistic competition or there are a large number of players (organized/unorganized) operating in the industry.

4. How much dependence on technology is there? Greater the dependence, the lower the score should be because the risk of technological obsolescence comes into play.

There could be several other external factors having a bearing on the industry prospects, as explained above.

Business Risk:

‍Business Risk, on the other hand, refers to all the risks which that particular entity may be facing and other players not (in the same industry). Such risks are specific and internal to the company. Its examples are explained hereunder:

1. Market position of the company in the market in which it operates. How is its quality, customer service, brand image, market share, etc.?‍
2. ‍How strong is the distribution network of the company? A better distribution network implies that its product can reach the end consumer and so this becomes a favorable point.

3. What is the client concentration risk? Is it dependent upon a few clients only or are the clients spread out, with no single customer contributing more than say, 20%?

4. Labor situation in the company; are there any chances of labor unrest or supply getting affected? What’s the availability of skilled, semi-skilled and unskilled manpower situation (depending upon the nature of the business)?

5. What is the existing capacity utilization of the factory? Is it working at full capacity or close to it OR is there enough idle capacity in the company?

6. Is there an easy & abundant supply of key raw materials OR is raw material availability a cause of concern?

There could be various other factors which govern the internal assessment of the company.

Financial Risk:

‍Financial Risk basically implies how the overall financial position and performance of the company is. How are the financial numbers going to be in the near future? Will it be a great or a mediocre performance? Does the promoter have enough resources to infuse funds into the company? Let’s deep dive further into this and explore what could be the different elements of financial risk: some text

Based on the Historical Profit & Loss Account and Balance Sheet submitted, the Bankers would calculate different types of Key Financial Indicators (KFIs) of the company – which shall highlight the strengths and weaknesses of the entity. This would include studying various parameters like some text

• Sales Growth
• EBIDTA & PAT Margin together with their YoY Growth
• Net Worth Position
• Debt-Equity Ratio
• TOL / TNW
• Impact of Quasi Equity
• Debt / EBIDTA
• Current Ratio
• Auditor Disclosures
• Contingent Liabilities Position
• Related Party Transactions

Not just past financials, even the projections are being seriously evaluated. The CMA data (either prepared by the company themselves or facilitated by the Banker, at times) submitted by the client are used by the Banker to determine various projected parameters – similar to above. Certain additional ratios like DSCR, etc are also factored in.

‍The bankers also evaluate whether the promoter has deep pockets / strong relationships in the investor community / strong network to infuse additional funds into the company – in case the business desires so. A positive situation leads to getting a good financial score and vice versa.‍

Management Risk:

‍Management Risk refers to the background of the Promoters and their expertise in running the affairs of the business. Several factors come into play, like:

1. Background, Qualifications, and Experience of the Promoter or their family members in running such business
2. What is the vision with which they are carrying on this activity?
3. Report on Reference Check / Background Check of the promoters.
4. Conduct of Accounts in dealing with the Banks. Are the interest paid regularly or are there any delays? Whether all the compliances are done timely & regularly or are there any gaps into it?
5. How have they handled the Success Planning issue?

And various other similar points.

Conclusion:

Once the aforesaid various types of risks are studied in detail and score provided against each of the parameters, then a Weighted Average Score is calculated to determine the Overall Credit Rating Score of the company. Such scores could be high, mediocre or low and accordingly an internal rating is assigned based on the internal score slab of the banks.

Based on the final internal rating score, the Banks thereafter decide as to how much loan can be given and at what terms, how much collateral need to be taken from the borrower, can any concession be offered in interest rates, what are the covenants to be imposed, and so on.

Hence, it is imperative that to get good & favorable cost effective terms from the lender – a borrower has to work backward and first understand & improve all the parameters (whatever possible) that goes into internal rating assessment. This is not an overnight job, but requires a lot of dedication and effort. It’s like running a marathon and not a 100 met sprint. However, once done – this has long term consequences and is sustainable as well.

To conclude, we can say that “if you work on your internal rating parameters seriously, you actually borrow from the Banks at your own terms. To Improve your credit score, Book a free Demo of BankKeeping.