Unit 1: Lending Policies and Procedures

1.1 Introduction

Bank lending is the main source of income to the bank. The bank after maintaining
adequate primary and secondary reserves uses the fund to create loans.
This unit is designed so as to introduce you about the nature of lending, lending policies
and lending procedures.
1.2 Lending – An Overview
The central business of commercial banks is the making of loans to customers. While
banks engage in a large number of other financial activities and render a wide range of
services to customers, direct lending is the primary function performed by them, the one
in which they have a natural advantage over almost all other financial institutions. Not
only is customer lending the central service performed by banks, it is their most
profitable type of business. It gives them the best available rate of return. More than that,
compensatory balances produced by customer lending are one of the most important
sources of funds for bank lending. The customer relationship in bank lending also
accounts for many other kinds of profitable business. Participation of commercial banks
in the open market of a security or a piece of commercial paper is a unilateral transaction
that generates little supplementary business. Customers held balances, out of which banks
can lend to other customers. The relationship between a bank and a customer may show
net debit balance in one period, net credit balance in another. It is a two-sided
relationship with positive advantages of both participants.
Commercial bank lending, however, involves certain problems and even some dangers.
Although banks might like to think of their borrowing customers as among the very best
of business concerns, bank lending typically involves some credit risk. In addition bank
lending involves a number of timing problems. The loan demands of customers may tend
to rise in some periods so that a bank is unable to accommodate all of its customers. In
other periods this bank might find it difficult to employ all of its funds. This alteration in
strength of loan demand is of both a short term and a long-term nature.

Loan demand has sometimes been persistently high for considerable periods of time. On
the other hand, customer demand for loans fell considerably short of the capacity of
banks to grant credit. Although customer loan demand has been generally high in recent
periods, short-term alternations in the demand for loans have persisted. The individual
bank, therefore, faces the problem of being able to satisfy the legitimate needs of its
customers for credit during periods of peak loan demands. The solution for this problem
is one of a bank's most difficult tasks.
Note that the types of loans and lending principles are discussed the course banking
practice and procedure, therefore, refer that material for the purpose of these issues.
1.3 Objectives of Lending Profitability

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While the public service character of bank lending should not be neglected, banks should
be anxious to make loans for reasons of profit. Almost every other function performed by
commercial banks could be as well done by some other agency. Banks have no profit
advantage in other lines such as investment management.
However, bank can lend. This is the business they are best fitted for by tradition,
organization and position. No other exiting agency could take their place. Without bank
credit, many small and moderate sized businesses would wither and die. Lending is not
only a good social service, it is also profitable. It is, indeed, the most profitable aspect of
commercial banking. The rates realized on loans have always been well above those
realized on investments. In the moderate sized bank, the contrast is even greater.

Even allowing for the somewhat greater cost of servicing loans, the rate of return on them
has usually been at least a half more than the rate of return on investments; sometimes it
has been nearly twice as great. Since some portion of most investment accounts is
devoted to liquidity protection, this comparison of rates of return is not altogether
equitable. However, other factors must also be considered.

Borrowing customers are also depositors and a well-managed loan account can augment
the funds available to a bank, something that is seldom attainable from investments.
Because large money market banks are generally somewhat more successful in securing
compensatory balances than are country banks, their net rate of return on loans
realistically figured is probably closer to that obtained by smaller banks an informed view
of the statistics might indicate.

1.4 Characteristics of Borrowing Businesses

The businesses to which banks may expect to extend credit have some starting
characteristics, which might be discuss as follows:

1. Borrowers tend to be of less than average profitability. A profitable business has

ample earnings with which to finance expansion or current needs. Less profitable
businesses cannot finance their expansion and companies sustaining losses may
need outside help to keep their current position form deteriorating. Many specific
circumstances lead to a tight current position (the usual signal that sends a
business on to the bank for funds), but meager earnings or losses are frequent
reasons.

For this reason bank credit must be extended with great care. Commercial banks, contrary
to popular impression, do not get their businesses from the premier business concerns but
rather form distinctly second-rate group. The financial (not moral) character of applicants
for bank credit is often shows that they could not secure funds from the investment

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markets. This means that unusual protective measures must be taken by banks to assure
that unusual protective measures must be taken by banks to assure themselves that they
are not assuming excessive risks. This is also a good pragmatic ground for the reluctance
with which banks consider some long-term credit applications. Short-term credit can
sometimes be safely extended where long-term credit would be too risky.
2. They (Business borrowers) are repeat customers Research has indicated that two
third of the business concerns indebted at any given time were likely to be
indebted to banks the following year.
3. Businesses, which seek bank credit, are relatively small. Those big businesses
finance themselves in the central capital markets whether their needs are long
term or short term. Those who cannot command credit in the central capital
markets content themselves with bank credit and adjust their affairs so that short
term borrowings fill their needs, even though they might, with more choices at
their command, prefer long term credit.
4. Business concerns using bank credit are often moderately young businesses. The
very young concerns have not yet established sufficient structure to command
bank funds. The older concerns have lived through their critical periods and have
had time to accumulate earnings to do their own financing. It is the ones in
between those that have established their position and have not yet grown old that
are the best bank customers.
5. Growing concerns are more likely to use bank credit than those well established.
Growth is one of the very best of reasons to justify the extension of bank credit. It
is a healthy sign and likely to be accompanied by other favorable characteristics.
Growth combined with a strained current position may be a safe basis for the
granting of bank credit. A dwindling business suffering losses, even though it has
the remnants of a reasonably satisfactory current position, may be a poor
customer in the long run.
1.5 Loan Policy
In the ordinary course of business, a bank awaits loan applications and then grants or
rejects them. While a bank may be active in promoting applications and in soliciting
business, it nevertheless plays a somewhat passive role in the lending operation. In the
first place, customers that are most eagerly solicited probably have been given a through
credit investigation prior to an application, and so there has already been favorable, if
tentative credit judgment made of them.
Even though a bank acts on each case as it arises, it needs to have a variety of general
lending policies. In order to discharge their (bank officers) minimum responsibility
faithfully, bank directors should establish a loan policy and delegate responsibility for its
discharge to those who will carry it out.
A written policy, spread on the minutes of the bank, has its advantages it can also have a
disadvantages. Policies may have to be changed or modified, and it is less awkward to
change an oral than a written statement of policy. Whether formalized or not, it should be

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well known to all employees and officers who have responsibilities to discharge in this
kind of work. Some of the major points that must be a part of any well integrated loan
policy shall be considered as follows.
1.5.1 Maximum Size of Loan Account
Two general standards are frequently applied in trying to determine the appropriate
maximum size of the loan account at an individual bank. The ordering of priorities
suggested that often a bank has set aside funds for primary reserves, and had established
an adequate secondary reserve account; any remaining funds might be placed in loans.
When converted into concrete terms this standard suggests that the loan account of a bank
might be as much as two thirds of its deposits or sometimes even more.

One limitation to this standard must be recognized. The capital account of a bank
represents its ability to absorb losses. Since loans represent the most likely source of
involuntary bank losses, the relationship of loans to the capital account is extremely
important. Because the quality of loans varies greatly, no fixed ratio can represent what is
considered to be a satisfactory loan to capital relationship. This margin, however, is
scrupuloresly watched by those who stand in judgment of banking solvency, such as
corporate treasurers, in choosing the banks to which they commit their working balances.
A specific standard should not be set without regard to the quality of the loan account,
but some feel that even a high quality loan account should not exceed seven or eight
times the capital account.
1.5.2 Maturity Policy
Banks have had, by tradition, a strong preference for the short term business loan. Other
things being equal, a short maturity credit instrument is more liquid than one with a long
term maturity. But the question is to what extent are "other things equal". A truly short
maturity is one thing; a speciously short maturity has no relevance to bankers problem. If
the underlying transaction is long term, the loan will tend to be long term no matter what
is written on the face of the credit instrument. One of the most constructive
characteristics of good policy is to grant maturities of a nature that borrowers can
reasonably meet, and then expect them to be met. The use of repeated but uncertain
renewals to discipline a borrower should be reserved for unusual circumstances. When
there is a change in circumstances beyond the reasonable control and expectation of the
borrower, a renewal presumably is justified. If a loan is drawn in terms of a specific plan
of payment, the borrower is much more likely to perform in a satisfactory manner than if
he/she is subject to nothing more compelling that the vague threat of a loan maturity.
The preference among commercial banks for business credits is traditional, but the
tradition is weakening. There was much commonsense in the preference for business
credit. Its great virtue was and is that, if well considered, it is truly "self liquidating", it
provides the revenues with which to retire the credit. If banks must make some maturity
concessions, the rule of tailoring each loan to the repayment prospects of the borrower is
a good one.

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A bank should make its liquidity plans on an overall basis, not just by the character of the
loan account. If a bank is so fortunate as to need no investments for income purposes but
solely for secondary reserve purposes, then it might follow some rule of self-restraint and
limit the proportion of long term credits. But, assets other than loans are better for
providing liquidity. If a bank has made good secondary reserve plans, it can probably
afford to let the maturity of its loan account reflect the basic credit needs of its borrowers.

1.5.3 Self Delusion in Maturity Policy

A bank may appropriately plan to put some portion of its funds in long term loans to
business. It is quite another matter, however, for a bank to do a great deal of long term
lending in short term form by allowing repeated renewals. Long term credit, if planned in
advance, may be made sure by a variety of protective provisions. When credit is extended
in short term form but with the implied expectation that renewal will be permitted, these
protective provisions are absent. Even more important, the moderate degree of liquidity
of term loans on which a bank can depend is absent from short-term loans for which the
time of repayment is uncertain.
If a banker extends credit to a customer without a clear cut plan for repayment of the
credit at the contraction of maturity, he can hardly blame the customer if he is unable to
repay and seeks renewal at the maturity of the loan. No real liquidity exists in such credit
and the loans not only are without the protection that may be formally provided in a term
contract, but they give rise to an ambiguity with respect to the nature of performance
expected of customers. Stagnant loans are often well secured and quite safe: their only
fault is that they may stay in a bank for an indefinite period. The best way to avoid this
problem is to have a clear understanding of the true maturity of each loan and to
encourage its refunding in some other form if long term credit is really needed. This is
particularly the case when stagnant loans are not accompanied by adequate compensatory
balances.
1.5.4 Maturity Policy May Shift
During periods of lower loan demand banks have been willing to extend term loans, but
in periods of high loan demand there has been a tendency to reduce term loans and to
engage only in very short term lending. This shift in policy is understandable: short term
lending presumably puts a bank in a somewhat more flexible position and possibly allows
it to accommodate a greater number of customers. In addition, banks feel more
comfortable by habit and tradition when engaging in short term lending. There are
reasons, nevertheless, to question whether this is necessarily the most profitable policy
over the long run. Term loans made at the height of loan demand unquestionably
command higher rates of interest than those made when loan demand is slack. Such loans
tend to stabilized earnings. Those banks that resist making term loans tend to stabilize
earnings. Those banks that resist making term loans at low rates in period of slack loan
demand may be in a position to make rather term loans at high rates when demand is

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 high, thus providing themselves with portfolios to stretch out over succeeding periods of
lesser loan demand.
1.5.5 Risk Policy in Bank Lending
All credit extensions involve some possibility of loss. Since much bank credit is granted
to marginal business borrowers, there is a sizable risk element. it is only the strategic
position of banks and their ability to supervise credit rather closely that make bank loans
tolerably collectible. Banks must constantly try to minimize losses. In spite of this, some
banks doubtless go too far and, in the process of minimizing losses, do not extend credit
which they properly should and appropriately could. The exact middle ground cannot be
defined: the banking system nevertheless has a compelling responsibility to lend
whenever there is a reasonable expectation of making the transaction pay out.
Since banks cannot, for the reasons given above, avoid incurring considerable risk in
lending, they must employ every safeguard at their command. It can be said that:
 The majority of bank loans made should be collectible without extra supervision
 Of the loans that become "distressed", a large majority must be collectible without loss.
Many loans which finally "pay out" have done so only because of skilled banking
collection.
 When losses must be taken, they should be minimized. Every bank that runs a normal
loan business is going to have distressed loans, some of which will lead to losses. A large
loss on any one loan, however, is likely to be a sign of some fault in the lending
procedure.
In order to minimize the possible loan risks, banks can use different mechanisms. Some
of them are:
 Specialization by type of loan: Specializing in certain types of loans has both advantages
and disadvantages. The advantage of being able to operate confidently in a given field is
considerable; not only is it a safeguard for the bank itself but it helps to attract business.
The disadvantage of specialization is less in diversification than is wholly desirable. This
may put a bank's loan account in a particularly concentrated and vulnerable position. The
kind of business a bank can attract is limited by its background, the interests and
connections of lending offices, and other related factors. Even if some degree of loan
concentration is unavailable, it can be offset partly by promoting business in contrasting
industries.
The risks of concentration in lending cannot be avoided or even much minimized, but
they can be held within tolerable margins if the general liquidity of a bank is ample and if
its income investment risks are not likely to cause trouble when the loan account is
having its bad days.

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 Fitting Loans to Borrowers' Application: One of the problems of general loan policy
is to lend the right amount to each customer. Some customers demand more than the
requisites of their business and others demand less than the requisites of their
business.

One of the functions of the discerning banker is to analyze the real credit needs for the
borrower and to extend the amount of credit that is appropriate to the circumstances. If
too much credit is extended, it may lead to difficulties in repayment. If too little credit is
extended, the customer may be pinched and have to come back for another extension or
curb business activities in an unnatural and probably unprofitable way.
 Maintenance of a Compensatory Balance: Bankers sometimes require and usually
expect customers borrowing on an unsecured basis to maintain a deposit balance
bearing some relationship to the aggregate amount borrowed or the maximum line of
credit. Sometimes this requirement is used as a way of differentiating among
customers: some customers are expected to observe the minimum rules without fail:
others are given more freedom. In considering a new loan application, the banker
may be influenced by the size of the applicant's prior deposit balances.
The ordinary rule is that "on the average" or "over the course of the year" the deposit
balance must equal the specified minimum. Some banks seem to apply the rule in an even
more rigid fashion and expect the balance to be maintained at the minimum or not to fall
below it while the borrower-depositor is indebted to the bank.
The compensatory balance is more often enforced in times of credit stringency. These
seem to be far from uniform view as to the desirability of the practice. Some banks view
it as a necessary practice. In order to be able to lend, they must have deposit funds, and
borrowers must be so disciplined as not to shirk their part in giving the bank lending
power.
The compensatory balance also has some advantages for a bank in dealing with a
borrower whose credit is not above reproach. The legal right of offset means that a bank
can use all the deposit balance a bank customer has with it to offset a portion of any loan
to this customer; the bank then becomes a general creditor for the remainder of the loan.
Many banks enforce compensatory balance requirements only while a loan is
outstanding. Maintenance of a compensatory balance rule while they are in debt may only
lead the borrowers to request more credit than otherwise would be needed. If this request
is granted, the bank does not have possession of any added funds.
Note: For further information on loan policies, please read your material for Banking
Practice and Procedures, Unit Three.
1.6 Lending Authorities
The authority of lending depends on numerous factors, including the character and
quality of the lending officer, the size of the bank, the size of the loan portfolio, the types
of loans to be made, and the board of director's attitude towards the amount of authority
delegated. The lending responsibility for bank lending rests with the board of directors,

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and some boards play a more important role in lending than do others. Large banks
delegate lending authority and specialize in lending more than do smaller banks. The
lending officer usually makes personal contact with the borrower, gather the relevant
information about the applicant or his surety and the project and decline whether the
applications are worthy of consideration, which may be the base for deciding that the
loan is to be granted as requested or with certain modifications. This decision may be
made by a committee or the boards of directors, depending on the size of the request –
usually large loan requests are decided by board of directors.
In small unit banks, all the officers may perform lending functions along with their other
activities. Each officer may handle all types of loan requests, whether they are for
consumer, business, or real estate purposes. Little formal specialization exists. However,
one officer may specialize in some types or type of loans because of special interest or
experience. Each officer must secure the necessary credit information and maintain the
credit files, since few small banks have a separate credit department. Each officer may
have a lending limit within which decisions can be made regarding loan requests. Loans,
above a certain amount may be submitted to a loan committee, which will make the
decision or, in smaller banks refer the request to the board of directors for further
consideration if the loan is extremely large or in any way unusual.
In medium size unit banks, there is more delegation of authority and specialization
regarding lending. Many medium size banks have credit departments. Each officer may
have an established lending limit, which is usually higher than in small banks. Sometimes
a loan committee composed of senior loan officers may exist within the bank to handle
loan requests above the lending officer's limit. Members of the board of directors may be
in this committee. In this case, only those requests requiring special attention would be
referred to the loan committee and the board of directors. As in the small banks,
supervision of the loans would be the responsibility of the lending officers.
Large unit banks may be different from both small and medium banks in
departmentalization and specialization of lending activities. Large banks may have such
lending departments as real estate, business or commercial, consumer and agricultural.
Some of these departments are broken double further. Business loans, for example, can
be divided according to industry, which a lending officer in charge of each industry or
related industries. One large bank, for example, has separate loan divisions for iron and
steel, automobiles, machinery, agricultural implements, electrical products, radio and
manufacturing products. Many banks also divide their lending activities on territorial
basis.
Lending officers in large unit banks have lending limits, which they are usually higher
than those in medium and smaller banks. Large banks make greater use of officer loan
committees than do small and medium size banks. They may be organized on a formal or
informal basis according to departments. As the request for loan is greater than the limit
of an individual loan officer, it will be referred to the committee of officers from different

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departments. Only a very large loan requests are referred to the board of directors for
action.
In lager unit banks, the credit department plays a much more important role in the lending
process than it does in smaller banks. The lending officer turns over to the credit
department all the information received from the applicant that would be used in the
preparation of a formal loan request.

The lending organization in branch banks varies considerably. Branch managers and
officers may have limited loan authority. Loan requests above this limit might be
transferred to the head office where consideration would be given to the request by the
regional superior of that particular branch and a decision reached. The regional
supervisor may also have a lending limit. Loans exceeding this limit would be referred to
a loan committee.

From a practical observation, it is not desirable to have a great deal of centralization of

lending authority in the head office. Borrowers do not like to wait for credit decisions,
and much of the personal touch important in credit evaluation is lost if many request to be
directed to the head office. When there are many branches, the head office usually
performs general policy supervision and permits branch managers' considerable
discretion in lending. This, in fact, is about the only way branches can be operated
efficiently.
1.7 Lending Procedures (Loan Processing)
Lending activities follow certain prescribed procedures by the respective bank
management. The lending activity includes groups and steps, which will be discussed
latter. The following points are given more emphasis in the lending procedures.

4 Integrity, Status, And Competence Of The Customer

This is a very important consideration. The banker from his personal experience and files
will have enough information to assess the credit worthiness of a potential borrower. It is
therefore very important to know the customer.
5 Purpose
The banker should be exactly aware of the purpose of the money he is lending. There are
two main reasons for this. They are: (1) he must assure himself that the purpose is legal,
(2) that the intended use is reasonably likely to produce profitable result which both
parties desire.
6 Source of Repayment
The lending bankers will wish to know the source of repayment, so as to ensure continues
flow and settlement of the loan account. Other sources of income should be looked out if
every possible.
7 Duration Risk

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The banker must not forget that the money he is lending is generally subject to duration
risk i.e., depositors may demand any time and if the loan is long term the bank looses
liquidity. It is not, therefore, sensible to commit it in long term loan which cannot be
repaid quickly if the need arises.
Long-term loans may also be subject to the possible effect of changing economic and
political circumstances, which needs a due consideration while lending.
8 Profitability
Naturally, any company, which is established on a joint stock company bases, aims at
maximizing its profits. In the same way, the banker wants to make profit on his lending
and the customer has also a purpose to make profit against the amount advanced by the
bank. The interest of the Banker and the customer is a dual purpose. Their common
outlooks for the growth of their respective projects must be entirely satisfied, the failure
of one cannot be the success of the other.

9 Security
Any amount lent by the banker needs to be secured. Factors regarding security to be
considered are type, value and reliability. Further points will be discussed under type of
collateral.
Others Knowledge of the customer, the potential products of the surrounding and the
managerial capacity of the borrower are factors to be considered. The lending procedure
comprises certain steps which appear to be important to the banker in order to determine
the appropriateness of the loan to be granted to the customer.
1.7.1 Loan Application
The first document to be incorporated with others is the loan application. The manager in
receipt of this application should give all the required lists that the applicant will produce.
A few of these requirements are:
- audited financial statement
- copy of renewed trading licenses from appropriate authorities
- invoice, sales contracts, etc
- feasibility study, in case of a new project indicating the pre investment, the
investment and the operational phases
- evidence of the ownership of the proposed collateral/original security certificates
(like land holding certificates, car booklets, etc)
- financial statements, audited or provisional including cash flow statements in case
of manufacturing enterprises
- receivable or payable accounts like Ikub, bank loans
- power of attorney, if applicable
- Completion of commercial credit report declaration phase assets, liabilities,
capitals, income, expense and their respective explanatory note. Most of the
points raised in the purpose of the loan application may be discovered under
interview.

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The loan application is the first image in the process of the loan and should clearly
indicate
- the purpose of the loan
- the commitment of the applicant elsewhere
- applicant's experience in the management of the same business or similar projects
- the intention of repayment proposals to pay off the debt (monthly, quarterly,
biannually or in one lump sum)
- duration of the loan in which the borrower intends to pay off the debt
- strength and dependability of the proposer collateral
- the collateral offered
- full address
The applicant as well as the mortgagor or personal guarantor should sign the application.
The consent to mortgage his/her property or to stand as a guarantor for the requested loan
should be clearly stated and signed for by the mortgage or personal guarantor.
1.7.2 Opening of an Account
If it is found out that the applicant is new to the Branch, he should be requested to open a
deposit account. This will help to:
- direct all his transactions through a bank account which will eventually hint on
the financial status of the borrower and also the activity of the business
- pay in the proceeds of the approved loan and also to debit for the periodic
installments and other charges
1.7.3 The Interview
The interview is the first contact with the would be borrower and provides an opportunity
for the Banker to explore about the applicant beyond the loan application. Most veteran
bankers strongly believe that the interview with the customer is an endless task of the
branch manager or the loan officer. It should be a friendly discussion in which the Banker
tries to see through the loan request. Some of the important issues to be raised at the time
of the interview are the followings
- the purpose of the loan
- the availability of bank accounts
- the applicant's commitment elsewhere
- his social integrity
- the intention to pay off
- strength of security
- applicant's business experiences
- the business plan

The interview should not be strict to the borrower only. The personal guarantor, if
proposed, should be interviewed for a deeper insight to determine his credit worthiness
and liabilities. Most of the factors indicated under loan application can be repeated under
interview as both discussed of the applied loan. Then comes the business site visit.

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1.7.4 Business Site Visits
The branch management staff or loan officer or the credit investigator schedules visit to
the working place of the applicant and the personal guarantor (in case the proposal is
personal guarantor).

Among other things indicated and summarized here in above, the purpose of the business
visit helps to:
- verify the declared financial position by checking physically the amount of cash
on hand, evaluation goods in stock, receivables, vehicles, buildings etc
- assess whether the applicant and the guarantor are actually operating a business
with licenses in their own name
- have an overall view of the business of the applicant guarantor by observing the
locality with regards to demands of the area, the number of employees and
machineries
- determine the addresses of the borrower or his guarantor for subsequent visits and
also to identify the security proposed to be pledged
- check the condition of the store and the surroundings, in the case of merchandise
loan
- Avoid risk at the time of default, due to conservative preparation of property
preparation.
The business visit includes state enterprise, cooperatives, private and individuals or
companies.

1.7.5 Credit Information

The most commonly used enquiries in obtaining credit information are based on the six
Cs. Capital, Capacity, Character, Credit worthiness, Collateral and all available sources
internal or external should be used to obtain credit information before deciding on the
financing of the applicant. Internal sources of information are the customer's accounts in
the Branch itself. The frequency and magnitude of the transactions as well as the cheques
bounced for lack of funds are good indicators of his business activity and credit
worthiness. Other branches where he is likely to have had loan or deposit accounts have
to be approached for credit information. Past records of settled loans should also be taken
into account to verify his repayment habits.

Other banks will also provide sources of information and should therefore be asked if
there is a belief that the customer has been doing his credit or deposits with them.

The customer's commitments within his society also has to taken into consideration.
Unpaid Ekubs, court proceedings against the applicant for failure to meet his obligations,

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etc, will warn the Banker of the risks that may lie ahead if the loan is granted without
knowing the root causes of these failures.

1.7.6 Credit Analysis

In the analysis of credit, factors already discussed in the preceding titles (under (a) loan
application and (b) interview) are included here again. Some of these factors are: the loan
application, the interview, site visit report, the type of loan to be considered, the
environmental analysis, profile of working capital, the collateral, the insurance coverage,
the procedure of lending, the financial statement, the investigation result, the follow-up,
and the project planning and analysis: the identification, project formulation, project
design, project selection, project implementation and operation, project supervision,
monitoring and control, project completion and termination, project evaluation and
follow up analysis and action.

All these and many other are part and parcel of the credit analysis and as a result of this
the investigator must play a double role i.e., to satisfy the request by the customer and to
avoided the would be risk from the point of view of the bank.

There are two sources of information for credit decision-making. They are the
commercial credit report and the loan approval form.

The commercial credit report comprises: the required information about the applicant, the
Balance sheet, statement of Income and Expenses, Analytical and comparative ratios, and
an explanatory note on the financial statement. The commercial credit report is composed
of current assets and liabilities.

The other format used by the bank is the loan approval form which indicates the
summary of the required information about the applicant and guarantor and thereby
enables the decisions at the various organs. In the first part the applicant's full
information regarding his line of business, purpose and facility applied for are explained.
Next comes the existing facilities enjoyed by the customer indicating the type of loan and
magnitude and present balance of the outstanding loans with their respective expiry dates.
The security already held and additional collateral's offered for the new request are
reflected stating the description, evidence and value of the securities. The saving and
turnover of the account of the applicant are compared for some years by showing the
highest and lowest balances and total of the withdrawals made. This will tell whether the
customer is making use of his Bank account and in the case of overdrafts, his overdraft
facilities, if he at all requires the facility, and how much use he has made of it. The
Borrower's and Guarantor's other liabilities, like guarantee liabilities in the case of the
applicant, or direct liability in the case of the guarantor, are shown separately. Debts with
other Banks are also stated indicating the amount of loan, present balance, security, and

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regularity of repayments and expiry date. This information must have been obtained from
the credit information requested earlier.

Then the past records are noted and recommendation or approval/decline of the request is
made. The preparation of LAFs is as follows.

1. Where loans are granted within the discretion lending limit of any branch, 3
copies will be prepared.
o original copy to be retained by the branch
o a copy to be forwarded to the regional office or head office
o a copy for the credit follow up department at head office
2. Where loans are to be approved by the regional office or head office, loans
committee, the LAF should be prepared in quadruplicate
o the 4th copy to be retained by the branch
o the 3 copies to be dispatched to the regional office
The regional office, after passing its decision, will
o retain a copy
o dispatch a copy to credit follow up department at head office
The credit follow up department at the head office will
o dispatch the original to the branch

3. Where the loan is to be approved at the head office level the LAF should be made
in quadruplicate and distributed in the following manner.
o branches in Addis and those in the same town as their regional offices
shall forward 4 copies to their regional offices and retain a copy
o the regional office will retain a copy and forward the three copies to credit
analysis and processing department at head office after passing its decision
o branches out of Addis and in different towns from their regional offices
shall send 3 copies to credit analysis and processing department and
forward the fourth copy to their regional office.

Note: This is an example of lending procedures used by big banks like commercial Bank
of Ethiopia. However, it is subject to revision and change.

1.7.7 Financial and Commercial Analysis

Finance relates to the money provision of the purpose of the loan. How much is required
by the customer, the terms and the incentive for all those parties. Whereas commerce
includes the arrangement for marketing of the goods or outputs, the customer is legally
engaged. It also includes such issues as if goods and products are fast moving if there is a
dependable market for the purpose of the loan applied.

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The purpose of financial analysis, therefore, will be
- to provide an adequate financing plan for the proposed investment
- to determine the profitability of the proposed loan
- to assist the customer in planning the operation and control by providing
management information.

The main statements of the financial analysis are the following:

1. The Cash Flow Statement
2. Profit and Loss Statement
3. The Balance Sheet

1. The Cash Flow Statement: this is also known by economists as a source and
application of fund statement or a fund flow statement. Its main function is to
analyze the liquidity position of the business. It records cash inflows and outflows
as and when it occurs. It is not based on the accruals concept and it does not give
an indication of profitability. It simply tells us the amount of cash available at any
one point of time.
2. Profit and Loss Statement: this is often known as an income statement. The
fundamental principles of this statement is the accruals concept which compares
sales with the actual cost of making (expenses) those sales (sales-sales cost). This
statement is most useful to assess the efficient performance of a business through
the profit and loss it makes. Profitability is the main objective of the statement.
3. The Balance Sheet: information presented on the balance sheet is drawn from a
wide range of current balances, which present a picture of the business on one day
in the year. The information is, therefore, represented, the account balances
recorded throughout the period.

The balance sheet shows the way in which a company is financed whether by sponsors,
lenders or creditors and how these funds have been employed. The source of funds even
where they represent the capital invested are regarded as liabilities and the use of such
funds have been put are the assets. The assets are always the same as the liabilities. Net
worth is the total asset value less liabilities.

The balance sheet has the following supporting document

1. Investment cost schedule (Fixed asset): it comprises details of investment cost
(fixed cost), the timing of investment and replacement and the terminal (salvage)
value at the end of the project life.
2. Depreciation schedule: depreciation is a means of charting the cost of an asset
against profit over a number of years. By making depreciation charge, the capital
cost of the asset can be charged against the profits earned over its life.

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 3. Working capital schedule (current asset/liabilities): the excess of current assets
over current liabilities is called working capital.
4. Loan interest and repayment schedule: this schedule sets out the annual value of
receipts and payments associated with a loan.

The balance sheet as a statement of condition of a given date of analysis determines,

whether an enterprise has sufficient cash, working capital, increase in earnings, need for
bank loans and financial solvency.

All the above information brought to the attention of the participant can be applied in
various degrees of evaluation of financial statement which is very important to credit
analyst, without which there could be no judgment of credits.

The following three issues are important in the analysis of credit. They could be used as
components of investigation in the financial analysis. They are:

a) the investment
b) the feasibility study
c) the terminology of ratios

a) The investment: an investment is any vehicle into which funds can be placed with the
expectation that they will be preserved or increased in value or generate positive income.

Idle cash is not an investment, since its value is likely to be eroded by information
and it fails to provide any type of return. The same cash placed in a bank saving account
would be considered as an investment, since the account provides a positive return. There
are various types of investment which can be differentiated on the basis of a number of
factors.
b) The feasibility study: this is another document to be looked out by the credit analyst
regarding projects. The project is the whole complex of activities in the understanding
that uses scarce resources to gain benefits. The sequence of analytical phase through
which a project passes is known as a project cycle. Many variations of this particular
division of the project cycle have been proposed. Among others, we will briefly look at
the following:
o The identification
o The preparation (project formulation)
o Appraisal and selection
o Implementation
o Evaluation

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Project selection, project design, project supervision, project completion and termination
are also project cycles not to be neglected. The feasibility study, in case the project is
new, the project development cycle includes the pre-investment, the investment and the
operation.

The implementation phase and stage of project development cycle necessarily requires
project and engineering design, negotiation and contracting, construction process report,
approval of construction permit and the evaluation process with emphasis on the
disciplines such as:
o justifiable demand of the product
o the availability of ingredients (inputs)
o production capacity and program like plan capacity, production capacity,
yearly working days and hours, number of shifts and initial production
capacity
o plant and equipment such as building, production equipment and other
equipment like office furniture and equipment
o production inputs such as raw and auxiliary materials and utilities
o manpower required and available
o cost and revenue estimate which may include investment on fixed assets
and working capital, annual production cost, revenue, and commercial
profitability which is calculated on the basis of annual cost and revenue
estimate at a single shift capacity.
Note: In Ethiopia, the council of state, special decree No 17/1990, entitled tax exemption
for 5 years from commencement of operation to a project with a total investment of more
than 5 million.

As you can see above the feasibility study touches many areas of a project and try to
figure out what may going on in the business in the future. Thus, in the aspiration of a
properly drawn credit analysis, the feasibility study of projects, has greater contribution
for a final decision. Ratios have similar advantages in the decision making by the credit
investigation. It will be discussed later under ratio analysis.

However, for the purpose of both financial and ratio analysis the accounts of a business
can be classified as follows.

1. Asset Accounts: asset equal to liabilities plus ownership equity. The two major
classifications of assets are fixed assets and current assets, which consists of cash
and other assets that will normally be converted into cash within a period of one
year. Cash is obviously the most liquid current asset, except for certain portions,
which may have been placed as a bond for performance of some act. Cash that has

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 been segregated as fund dedicated to a particular purpose such as construction of
a building should not be considered as a current asset. Fixed asset represents those
elements of assets of a business that can be used for relatively longer period of
time such as equipment and machinery, motor vehicles, furniture and fittings,
buildings and other similar assets.
2. Liability Accounts: liabilities equal to all creditors claims. Liability may be
classified as current and long-term liabilities. Current liability represents those
liabilities, which matures not more than one year. Whereas long-term liabilities
are those whose maturity goes beyond one year.
3. Capital Accounts: it is referred to as owner's equity in the business. It is the
residual claim after total liabilities are deducted from assets or in other ways
Capital = Assets – Liabilities.

Capital account increases from period to period into two ways:

- when new capital is invested
- when the business earns profit which the difference between total revenue and
costs of expenses
4. Revenue Account: it is a gross increase in capital due to business operation.
Example, sales of merchandise or produced goods, professional fees commission
revenue and interest income.
5. Expense Account: these are expired costs that are incurred in the process of
generating revenue for the firm. There are two categories of expenses: general and
administrative expenses which include: salaries, supplies expense depreciation,
expenses, selling expenses which include items such as sales persons salaries and
depreciation of selling equipment.

Once these analysis are made the banker can determine the feasibility or viability of the
proposed project. Based on its findings the banker then, assures the security offered
against the loan and contracts must be signed before realizing the loan. Contracts may be
of loan contracts and pledge contracts. Hence, the next step in the process of lending will
be contracts.

1.7.8 Notice to the Applicant

The decision made by the concerned bank officer must be communicated to the applicant.
If the decision is approval as per the application, contracts are appropriate to the nature
and type of loan approved such as loan contracts, security contracts, applicable annexes
and registration of these contracts with concerned authorities. If such documents are not
satisfied within a specified time, the bank can cancel the approved loan. However, any
complain on the size of the approved loan by the applicant is subject for eventual
reprocessing.

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1.7.9 Disbursement
Once the loan is approved by the bank and the necessary documentation is fulfilled, the
banker can disburse the approved loan. Disbursement of the approved loan may take
different forms depending on the nature of the loan. It might be credited to the customers
account in full value, if it is a term loan like commercial credit or disburse the amount on
different bases or according to customers withdrawal like overdraft facilities.

1.7.10 Insurance
Insurance is defined as coverage by contract whereby one party undertakes to indemnify
or guarantee another against loss by a specific contingency or peril. Properties which
must have insurance includes:
1. pledged merchandise against fire, lightening, burglary and house breaking for full
value
2. mortgaged building against fire, storm, earthquake and impact by vehicles and
aircraft
3. mortgaged plant, machinery and equipment against fire
4. chattel mortgaged vehicles against all risks and damage by sifta or guerrilla action
5. stock against fire and burglary
6. crops against fire, lightening, burglary and house breaking for all value

Check Your Progress Exercise

1. Define the words loan and lending.

________________________________________________________________________
__________________________________________________________________
2. What is the objective of lending by the commercial bank?
________________________________________________________________________
__________________________________________________________________
3. Explain the characteristics of borrower from the bank.
________________________________________________________________________
__________________________________________________________________
4. Explain the areas whereby the loan policies cover
________________________________________________________________________
__________________________________________________________________
5. Explain the lending procedures.
________________________________________________________________________
__________________________________________________________________

1.8 Summary

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The main purpose of lending by commercial banks is making profit. Lending is the
central business of commercial banks. However, bank lending involves some dangers and
certain problems. These problems and dangers are sometimes sever other times low in
effect. Therefore, commercial banks should follow certain lending procedures and
understanding the characteristics of borrowers.

In addition, in order to maintain uniformity of loan handling, banks should develop loan
policies which are guidelines in lending. The authorities in the lending hierarchy should
be identified and authority over loans must be classified for proper management of
lending activities. The lending authorities in different banks may be different depending
on the size of the bank, the operation of the bank and the specialization required.

1.9 Answer to Check Your Progress Exercise

1. Refer section 1.2

2. Refer section 1.2
3. Refer section 1.4
4. Refer section 1.5
5. Refer section 1.7 UNIT 2: CREDIT ANALYSIS
6.
7. Contents
8. 2.0 Aims and Objectives
9. 2.1 Introduction
10. 2.2 The meaning and Objective of Credit Analysis
11. 2.3 Factors considered in Credit Analysis
12. 2.4 Sources of Credit Information
13. 2.5 Analysis of Financial Statements
14. 2.6 Techniques of Credit Investigation
15. 2.7 Internal Diagnosis: Other Functional Areas
16. 2.8 Summery
17. 2.9 Answers to Check Your Progress Questions
18.
19. 2.0 Aims and Objectives
20.
21. At the end of this chapter you are expected to:
22. define what a credit analysis and identify its objectives
23. identify the factors in credit analysis and the different sources of credit
information
24. understand the role of financial statements and ratio analysis.
25. identify the techniques of credit investigation.

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26.
27. 2.1. Introduction
28.
29. Banks are credit creators. As they create loans, they are expected to undertake a
credit analysis. Banks use the public money collected in a form of deposits to
create credit back to the public. Hence, the bank is the dealer in money. As the
bank act as a dealer, it collects commission in a form of interest income- the
difference between interest collected from borrowers and interest paid to
depositors. However, this activity is not a bed of flowers. The bank takes lots of
risks in the process. Therefore, the banker should make the necessary financial
analysis using different techniques.
30. In this chapter, we will discuss the meaning and objectives of credit analysis,
factors considered in loan advancing, the credit factors to be considered, the act
of credit investigation, sources of credit information; methods of financial
analysis-etc.
31.
32. 2.2 The Meaning and objectives of credit Analysis
33.
34. The Meaning of Credit Analysis
35. In the extension of bank accommodation, nothing is more significant than the
ability and character of the borrower. Practical bankers and theoreticians alike
suggest that the safest and the most dependable security that could be obtained is
the integrity and business like dealings of the customers. It is not the tangible
collateral offered by a borrowing firm, which should govern its credit
worthiness, but rather its own promise and potential to generate earnings and
maintain solvency.
36.
37. This measurement of the overall standing of the firm and its future is what is
called “Credit analysis” or “Credit investigation”. It is in effect, financial
analysis conducted by a supplier of funds with a view to fining the position,
progress and prospects of a borrower. That is, when financial analysis is made by
a banker or some other lender, it tends to be called “Credit analysis”. It is also
defined as a detailed evaluation of the project to determine the technical
feasibility, the economic necessity, financial viability of the project and
managerial competence required for its successful operation.
38.
39. I. Technical Feasibility: it is carried out to determine:

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40. Location of the project: - which can be studied by observing suitability of the
business area and by assuming the market share of the client.
41. Technology used: - Which determines the skill required, nature of product
efficiency of the project, cost effectiveness, etc.
42. Plant and equipment: - They might be acquired through lease or purchase, which
affects the company’s ability to produce products continuously and the
commitment of the customer. If they are owned through purchase, the customer
is more committed than had it been leased.
43. Construction and installation schedules: This helps to identify the required grace
period in relation with the gestation period and to analyze the condition within
which the business starts functioning.
44.
45. II. Economic necessity: - It is studied the measure the extent to which:
46. - the market will absorb the additional production on account of the new
project.
47. - the project is expected to contribute to the national fund.
48. - the project can bring about development in the area
49. - the project will create more employment.
50. - the atmospheric and other pollutions could be contained.
51.
52. Financial Viability.
53. A study is carried out to measure the financial viability of the project, which may
include.
54. Cost of the project: Size and purpose of the loan should compromise. If the
amount requested is more than the size and purpose of the loan, clarification
should be given by the borrower or decline the loan request.
55. Source of finance: this is to determine how well or bad the business was running
in terms of finance. The promoter’s contribution and other sources of finance
should be investigated, if any.
56.
57. Managerial competence
58. The ability to run a business either in terms of education or experience or
both. This must be studied and ascertained that the money /loan to be given by
the bank will fall in good hands. If the borrower is not equipped with any of the
above that may lead to the immunization of funds.

59. This analysis is usually done twice.

60. i. By the promoter for identifying the right project
61. The promoter is required to analyze the feasibility of the business opportunities
identified - before borrowing money and commit it. That he/she must be
convinced, first, that the project is viable in all aspects, before he/she is

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 committing himself/ herself. The result of this analysis will be presented to the
financer/lender of the banker.
62. ii. By the banker or financial institution. For the purpose of determining whether
the project should be financed by it or not.
63. First of all the banker of financial institution should ascertain whether what ever
said by the customer is true or not. Then, he/it should ascertain that the project is
viable and feasible for investment.
64.
65. Objectives of Credit Analysis.
66. The purpose of Credit analysis is the same of measuring and predicting primarily
the degree of risk in financing operations based on two fundamental facts about
the firm.
67. the level of profitability and the factors which influence that profitability
68. the liquidity, and solvency.
69. The essence of financial analysis from the viewpoint of a banker both as a
present and potential supplier of capital lies in the derivation of an estimate of a
firm’s potential risk as well as its expected returns. It provides clues to the
financial security and stability of a firm and points toward the possible result of
future operations. It calls attention to the potential problem areas. Really, thought
such a methodology, the banker looks to the danger signals and seeks answers to
three basic questions:
70. What is the risk sufficiently good to be acceptable at all?
71. If the risk is satisfactory, to what extent should credit be granted i.e. what shall
be the credit limit?
72. Under what conditions on up or what terms shall the credit and the extent thereof
be granted?
73. Assessment of such a banking proposition is important, since a borrower who
desires accommodation is generally inclined to overestimate his assets and
properties and underestimate his debts and liabilities.
74. As stated above the purpose of credit analysis is measuring three major areas of
performance: profitability, solvency and liquidity of the firm.
75.
76. Profitability: - It is the ability to earn a rate of return on total investment which is
total capital employed. Ultimately, it is measured by the rate of return earned by
equity investors who are the owners of the business.
77. Solvency: It measures the firm’s long-run financial soundness and reliability. It
means that the total assets of the firm are more than the total liabilities. The test
of solvency is the firm’s ability to meet fixed cash payments.
78.

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79. Liquidity: refers to the ability to meet cash obligations as they become due. It is
the ability to meet anticipated and unanticipated demanded for funds in the short
run.
80. A company may be solvent but not liquid, in that it does not have ready cash to
pay its debts. Further, as part of interpretation, a company’s performance can be
compared to that of other companies.
81.
82. 2.3 Factors considered in Credit analysis
83.
84. The banker, before advancing loans to customers should take certain
considerations. These considerations are related to: the bank itself, the borrower
and the project. It may be also mentioned that the components of credit analysis
are often tried to be expressed through three M’s- Man, Means and Methods.
Alternatively, these could be expressed as five Ps- (i) prospects, (ii) purpose, (iii)
payment, (iv) people and v) protection or three Rs-Returns, Repayment capacity
and Risk-bearing ability. Their meaning and contents are similar to that of six
C’s (character, capital, capacity, creditworthiness, collateral and condition).
These are standard qualitative guides for determining the risk of incurring bad
debts of delays in payments and are explained as follows.
85.
86. a. Considerations about the bank itself.
87. The banker should investigate his home before advancing loans. As it is already
stated in part one of this material, a bank failure may come from both directions
i.e. from high amount of loan created and from low level of credit created. If the
banker grants all loans requested with out measuring its liquidity position, it may
eat well but sleep badly. Because it may face problems to raise liquid funds used
to pay as customers demand to withdraw from their current accounts and as
liabilities mature and may be not all borrowers pay back the loan as agreed.
88.
89. If the banker grants very few selected loans, it may sleep well but eat poor,
because granting loans is the main source of income to the banker. As the loan
granted increases its profitability increases and as the loan granted decreases its
profitability also decreases. Hence, both sides of the banker’s activities may lead
the bank towards failure. Therefore, the banker must first understand itself and
his/her home interims of liquidity, solvency and profitability.
90.
91. b) Consideration about the customer
92. Fulfilling the loan demands of all applicants is impossible to the banker. Further
more, meeting the credit demands of existing customers may also be difficult.
Hence, the banker may be forced to refuse some applicants and may distribute
(ration) among the existing customers. However, in order to do that, the banker

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 must first analyze his customer’s position using some reference points known as
the 6 C’S. They were known to be only 3C’s but these days three more C’s are
added to the list.
93. Character: - Whatever the size and security for an advance, a good personal
character of the owner and management of the enterprise is the first requirement.
This includes certain moral and mental qualities of integrity, fairness,
responsibility, temperance, trustworthiness, industry and the like. The term thus
becomes credit character, at the forefront of which is “honesty” making one
conscientious about his debts.
94. Capital: - It denotes the financial strength of risk as measured by the equity of a
business, i.e. the difference between the total assets and outside liabilities.
Capital is the “network” of the firm and serves as the ultimate means of payment.
The point to be examined here is its immediate liabilities due for retirement and
the relation the bear to its assets available. A true estimate of capital, however,
has to take market rather than the book values of the assets.
95. Capacity: - It signifies the ability to pay when a debt falls due, and is in fact
indicative of the competence to successfully use the money requested for.
Estimation of capacity, at the same time, is not simple enough: it involves so
many factors. It is primarily a question of earning power, the potential debtor’s
future income. This also influenced by the existing debt structure and the
debtor’s personal health, energy, education, experience, executive ability and
discriminating judgment.
96. Collateral: It is also often emphasized as a form of capital. A banker not satisfied
with the amount of capital possessed by a would-be debtor may extend credit if
he pledges collateral to support the debt. Ever so many goods, properties and
instruments are offered as security, but these alone should not be allowed to
justify a loan when the analysis shows poor probabilities of repayment.
97. Conditions: - These refer to the impact of several economic trends on the firm or
special developments in certain areas of the economy that may affect the
customer’s ability to meet his obligations. In a period of rising prices men with
little or no ability may succeed in business. With and address change of
conditions, however, the capital may be wholly or partially lost, and the
character also may be affected in the process.
98. Competition: It speaks of the relative strength of the borrower in relations to his
business rivals. The degree of competition is evaluated by the present share of
the borrowing firm in the total market, and the increase or decrease that is
anticipated in that share.
99.
100. C) Considerations about the proposal (project)

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101. The bank is not expected to finance all types of projects developed by
customers. It should select the type of project to be financed among alternatives
using the following focus points.
102.
103. i. Purpose: the purpose of the project to be financed must be evaluated
from different perspectives and some questions need to be raised and properly
analyzed. These questions can be: Does the project socially viable? Does it
contribute any thing to the community and the national development?
104. ii. Collateral/security: - Especially in countries like ours, loans are always
granted against collaterals. The collateral may take different forms depending
upon the nature of the loan: it can be personal, buildings, vehicles, land, credit
instruments and the like. This collateral may use to settle outstanding loan
balances in case customers default. Therefore, the collateral must be something
marketable, within short time and without loses and its market value must be
greater than the outstanding loan balance.
105. iii. Sources of Repayment: - Collaterals are held not simply to sell it to
recover the loan. It is not the main purpose of having a collateral. Hence, bankers
are required to ascertain the existence of a reliable source of repayment. The
repayment may be made from the financed project or other sources. This must be
properly identified.
106. iv. Terms of Repayment: Among other things that must be determined
while advancing loans is determining the term of repayment. It may be made on
a lump sum (at once) or on installments (periodically). If it is paid on
installments, the period of payment must be identified i.e. monthly, quarterly,
Semi annually and yearly. Knowing this will help the bank to take the necessary
action as the customer fail to be up to the contract.
107. In general, the banker must assess the credit worthiness of a business
(project). Measurement of credit worthiness may be summarized as: profitability,
liquidity, debt-equity ratio and managerial capacity of the customer.
108.
109. 2.4 Sources of Credit Information
110.
111. The most commonly used enquiries in obtaining credit information are
based on the six C’s mentioned and discussed above. These sources may be
internal or external to the banker. The different sources of credit information the
banker uses can be listed and disused as follows.
112.
113. 2.4.1. Interview with the loan Applicant
114. The interview is the first contact with the would-be-borrower and
produces an opportunity for the Banker to explore about the applicant beyond the
loan application.

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115. It should be a friendly discussion in which the borrower tries to see
through the loan request. He should touch on points like:
116. the purpose of the loan
117. the applicant’s commitments elsewhere
118. the applicant’s deposit account at other Branches
119. the applicant’s business experience
120. how he intends to pay off the loan
121. the business plan etc.
122. The interview should not be restricted to the borrower only. The personal
guarantor, if proposed, should also be interviewed for a deeper insight to
determine his credit worthiness and liabilities. All these information is supplied
with the loan application. Hence, the banker should compare these sources and
make sure that what the applicant said is the same as what is written on the
application from. This must be repeated until the banker is satisfied about the
customer.
123.
124.
125.
126.
127.
128.
129.
130. 2.4.2. The Business visit
131. The bank officer, usually the bank manager and the credit investigator
(officer), will go and visit the working place of the applicant and the personal
guarantor, if proposed. Among other things, the purpose of the business visit
helps to:
132. a) Verify the declared financial position by checking physically the
amount of cash on hand, goods in stock, receivable documents, vehicles,
buildings, machineries, and other assets.
133. b) Assess whether the applicant and guarantor are actually operating a
business that they are licensed to.
134. c) Have an overall view of the business of the applicant or guarantor by
observing the locality as regards demands of the area, the number of employees
and machinery hold.
135. d) Determine the addresses of the borrower or his guarantor for
subsequent visits and also to identify the security pledged.
136.
137. 2.4.3. Bank’s own Record
138. This is another internal source of credit information. Among the internal
sources of information are the customer’s accounts in the Branch /bank/ itself.

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 Here the banker need to see the frequency and magnitude of the transactions as
well as the cheques bounded for lack of funds which are good indicators of his
business activity and credit worthiness. If the customer is found dependable in
handling cheques and he has good financial management ability, that customer is
a good customer that can be granted with the loan.
139.
140. 2.4.4. External Sources of Credit Information
141. One of these external sources is the information acquired from other
banks, or branches. Other branches where he is likely to have had a loan or
deposit accounts have to be approached for credit information. The applicant’s
credit worthiness, paying ability regularly and according to the agreement,
arrearage recorded, cheque handling, etc. must be investigated. In Ethiopia, the
credit analysis officer writes letters to other banks in Ethiopia to collect
information about the applicant. The loan processing will be started only after
this information is collected from other banks/branch. This information also
provides the nature of collateral held by other banks and the type of the same
offered to the new loan. If the same collateral is given, the legal aspect of the
collateral must be analyzed and contact must be made with the bank/branch that
held the collateral first.
142.
143. Other external source of information can be presented as follows.
144. Trade references, such as from Trade creditors, customers and competitors
145. Brokers and other banks with which the customer has had dealings.
Banks, of course, are not commercial credit agencies. But they do deep files of
credit information. In fact, large banks maintain separate credit departments. The
collected information serves the banks own purposes in its dealings with those
businesses with which the banks may have relations. Usually, the banks will give
credit information up on enquiry by its depositors.
146. Credit reporting agencies, press comments and informed gossip.
147. Credit information bureau-if they are organized and institutionalized.
Unfortunately there is no such bureau in our country. However, the National
Bank of Ethiopia has given a direction to commercial Banks about the nature of
facility, security, and charge along with outstanding balance.
148. Public records such as:
149. i. mortgage registrations  Municipalities in Ethiopia.
150. ii. Court judgments about declarations of patent, and other legal issues
related with the business.
151. Bankruptcy petitions and discharges
152. Pending suits, etc.
153. It may be noted that most of the banks now maintain their own credit
department to gather, analyze and summarize such information. These

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 departments serve the loan officers by doing the detailed work required to
assemble and bring out the significance of data submitted by customers and
available, otherwise.
154. The customer’s commitments with in his society also have to be taken into
consideration. Unpaid ekubs, court proceedings against the applicant for failure
to meet his obligations, etc, will warn the Banker of the risks that may lie ahead
if the loan is granted without knowing the root causes of these failures.
155.
156.
157.
158.
159. 2.4.5 Financial Statements
160. Financial statements are among the major elements in credit analysis in
general and in short-term financing in particular. The short-term liquidity of an
enterprise is measured by the extent to which it can meet its short-term debts and
obligations. Liquidity implies the ready ability to convert assets into cash or
obtain cash. Short-term is conventionally considered as a time span into a year.
Sometimes, it also identified with the normal operations cycle of a business i.e.
the time span encompassing the buying-producing-selling and collecting cycle of
an enterprise. The importance of short-term liquidity can best be measured by
examining the consequential results, which stem from lack of ability to meet
short-term debts and obligations. Lack of liquidity may means that the enterprise
is unable to take advantage of profitable business opportunities as they arise.
Serious lack of liquidity, mean the enterprise is unable to pay its current debts
and obligations. This can lead to the forced sale of long-term investment and
assets and, in its most severe form, to insolvency and bankruptcy.
161.
162. The P’s and C’s that we have mentioned earlier in this chapter are
qualitative factors. They (the P’s & C’s), for explanation purpose, largely depend
upon quantitative data made available in financial statements. At the root of all
credit analysis lies the interpretation of balance sheet and profit and loss account,
the two basic financial statements or conventional accounting models.
163.
164. For an external analyst like a banker, financial facts as recorded in balance
sheet and income statement become the principal guideposts, though there could
be some other supporting schedules of information also. In between the two,
however, the relative significance has been changing. At one time, the balance
sheet was considered to be more revealing and a superior statement. The shift has
been in favor of the income statement that measures income rather than static
measurements of financial position – the balance sheet.
165.

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166. A high rate of increase in earnings is thought to be more desirable and
attribute in the firm’s ability to pay. The controversy, however, is meaningless
and confusing. Taking a medical analogy, the balance sheet is similar to physical
measurement, age and sex of a patient that the physician requires as a point of
departure. The income statement is analogous to the several tests of pulse beat,
respiration, blood pressure, and the nerves that give the physician some insight in
to the patient’s anatomy as a functioning organism.
167.
168. 2.5 Analysis of Financial Statements
169.
170. The principal financial statements of an enterprise are the income
statement (the profit and loss account), the balance sheet and the statement of
changes-financial position (funds flow statement).
171.
172. 2.5.1 Analysis of Income statement
173. The income statement is a report that shows a summary of revenues
earned and expenses incurred by a business organization during a given
accounting period. The net effect of matching revenues with expenses is either an
increase (when revenue is greater than expenses) or a decrease in owners’ equity
(when expense are greater than revenues). This implies that the net profit adds
value to owners’ wealth.
174. Profit and loss account or income statement is a motion picture, which
reports the financial result of operations for a specified period of time. It
measures the past performance of earnings and carries indications of the future
earning power.
175.
176. 2.5.2 Analysis of the Balance Sheet
177. Balance sheet is a statement that shows a list of assets, liabilities and
capital of business identified on a specific date, usually at the end of an
accounting period and one knows “ where the firm stands at a moment in time”.
It is a snap shot, a photograph the financial worth of the firm at a point of time. It
is also referred to as position of statement or statement of financial condition; it
represents a picture of the financial affairs on a particular date. While a balance
sheet is a statement of wealth of an entity at a point of time, income statement
explains the changes in this wealth between two points of time. For purposes of
analyzing a balance sheet, especially of against stock company, it should
preferably be broken down in to its current and non-current components.
178.
179. Although balance sheet and income statement are listed separately in the
annual report of a business, there is a close relation between the two. This
relationship may be described by saying that changes in balance sheet accounts

133
 may be associated with elements in income statements, such that the following
accounting equation holds good:
180. C or RE= A-L,
181. where C = stands for proprietorship funds or its equivalent
182. RE = residual equity of OE = Owner’s equity
183. A = Stands for assets
184. L = Stands for liabilities
185.
186. 2.5.3 Analysis of Funds Flow Statement
187. It is a statement that shows sources and uses of funds. It is a condensed
report of how the activities of the business have been financed and how the
financial resources have been used during the period covered by the statement. It
shows the use and flow of funds into and out of a business. Various titles are
used for the funds flow statement, i.e. Statement of Sources and Application
(utilization, employment, disposition, use) of funds, Summary of Financial
operations. Changes in Financial Position, Funds Received and Disbursed, Funds
Generated and Expended, Financial Expansion and Replacement, Changes in
Working Capital, Statement of Funds, Money provided and its Disposition, etc.
A point worth nothing is that the funds flow statement is not a statement of
financial position but it is instead a report on financial operations-changes flows
or movements during the period.
188.
189. The funds flow statement is used widely by financial analysts, credit
granting institutions, and financial managers. It is a useful tool in the financial
manager’s analytical kit. The basic purpose of this statement is to indicate on a
historical basis where cash came from and where it was used.
190.
191. The funds flow statement gives the financial aspect answers to the
following questions.
192. Why were the net current assets down though the net income was up or
vice versa?
193. How was it possible to distribute dividends in excess of current earnings
or in the presence of the net loss for the period?
194. How was the expansion in plant and equipment financed?
195. What happened to the proceeds of sale of plant and equipment?
196. How was the retirement of debt accomplished?
197. What become to the proceeds of share issue or debenture (bond) issue?
198. How was the increase in working capital financed?
199. Where did the projects go?
200. The principal material used in the preparation of a funds flow statement
ordinary consists of comparative balance sheets without changes which have

134
 taken place in the various items during the period covered by the statement. This
statement organizes the material after some elimination’s combinations and
additional analysis and reclassification in to two principal groups: Sources of
funds and Applications of funds.
201.
202. Broadly speaking, sources of funds are indicated by decrease in assets and
increase in liabilities of in the shareholder’s equity while applications of funds
are associated with increases in assets and decreases in liabilities or in the
shareholder’s equity.
203.
204. Comparative funds flow statements, covering several years of operations
in a company enable the reader to obtain useful information on the financial
methods used in the past, dividend policies followed, and the contribution of
funds derived from the operations to the growth of the company. They also
provide claims as to the future financial need.
205.
206. Funds can be generated form different sources. Some of these sources can
be presented as follows.
207. Decrease in assets by sale, depreciation, better control of inventory and
sundry debtors, reduction in cash balance;
208. Increase in liabilities, addition to current liabilities and provisions,
increase in long-term debt, issue of debentures; and
209. Increase in net worth, addition to resources and surplus, sale of additional
share, retention of earnings
210. Funds generated from different sources can be used for different purposes.
These are:
211. Increase in assets, additions to fixed assets, building up of inventory,
piling up of sundry debtors, addition to investment.
212. Decrease in liabilities as by pay- off a long or a short-term loan, reduction
of creditors; and
213. Decrease in networking capital, incurring of losses, withdrawal of funds
from a business, dividend payment in periods of no or low projects.
214.
215.
216.
217.
218.
219.
220. 2.5.4 Analysis of Cash Flows Statement
221. This statement shows the cash receipts and payments of an enterprise
during the period covered by the statement. It helps to assess the liquidity

135
 position of the enterprise. Presently it is used to replace fund flow. Funds flow is
based on working capital movement where as cash flow is limited to cash only.
222.
223. Cash flow information is highly beneficial to assess an enterprise’s
financial structure including its liquidity, solvency and its ability to affect the
amounts and timing of cash flows so as to adapt to changing business
environment, where as fund flow hides the movement relevant to the liquidity
and viability of enterprises.
224.
225. The cash flow statement is made with the following objectives in mind.
226. * Statement of cash flow as evidence of the past performance is helpful in
making forecast of the future
227. * Looking at the past performances and present position, the financial
analyst seeks answer to the following questions.
228. The ability of an enterprise to generate future positive cash.
229. The ability of an enterprise to meet its debts and obligations.
230. Financial statement analysis is carried out for the purpose of measuring
three major areas of performance. Herein, one seeks evaluation of , or gaining
insights into profitability , solvency and liquidity of the firm.
231.
232. 2.6 Techniques of Credit Investigation
233.
234. For a long time, Credit and financial analysis was equated with ratio
analysis in as much as the two were taken as synonyms. Accounting ratio was
the dominant technique and the chief component of credit investigation, though
its shortcomings and limitations have been well recognized. It has been held that
the ratio by itself does not supply the solution to a problem. It is no more than a
symptom and this symptom is as accurate as the figures from which it has been
drawn. Financial statements suffer from the defects of lack of precision,
historical values, omission of some pertinent data, e.t.c. Then, the ratios are
statistical tools, which like other statistical devices that must be used within the
range of their efficiency. Standard ratios are desirable, but these could not be so
evolved, which hold good in all industries and at all times. In this attempt, to see
behind the figures and obtain utmost useful information, therefore, the banker
has come to employ a series of techniques discussed as below.
235. Financial Ratios
236. Comparative analysis
237. Cash flow projections
238. Funds flow statement
239. Break-even analysis and project graphs
240. Performa Statements

136
241. Discounted cash flows.
242.
243. 2.6.1 Financial Ratios
244. By definition, a ratio is an abstract number obtained by dividing one
quantity by another and the divisor is the base. When one speaks of the ratio of A
to B, he means the result secured by dividing A by B where A is the numerator
and B the denominator. The ratio may be expressed as natural function,
proportions, or decimal fractions.
245. In order to gauge the financial health of a business firm, a wide variety of
ratios have been calculated. Some of these are based on the balance sheet items,
some on the profit and loss account items, while some on both of them. On this
basis, the family of ratios is classified into horizontal and vertical, depending on
whether they are derived from the figures of one financial statement or more than
one. Then, balance sheet ratios are also sometimes called “ financial”, which
profit and loss accounts ratios as “ operating”. From the banker’s viewpoints, the
most useful classification would be into the profitability, liquidity, solvency and
efficiency ratios.
246.
247. However, there is no particular ratio, which can be regarded as the “best”
or most satisfactory measure of the borrower’s capacity to meet future financial
obligations. It may be necessary for the banker to calculate all the ratios to
determine that the firm is in a good or bad position. The relation vaguely
suggested by one ratio may be corroborated by another. In most of the situations,
at the same time, few ratios will tell the whole story, and sometimes only three
may sufficient-current ratio, debt-equity ratio and return on investment ratio.
248.
249. The limitations of financial ratios can be overcome to a large extent by
observing them over a passage of time. If certain relationships are computed over
a series of statements of the same company with one of them selected as the
base, they become much more revealing than they are otherwise. Isolated
calculations for a year fail to point out areas of strength and weakness, but when
the various statement –items are put across the years, they come to provide a
dynamic picture. This trend analysis constitutes a mechanism that has been used
by statisticians’ science, the early days of the modern statistics. To the banker, a
row of trend ratios becomes especially useful to measure the movements of
various financial factors of a business. Such an analysis shows whether an item
had increased or decreased and the rates of such increase or decease.
250.
251. Profitability Ratios
252. They are very important tools to:
253. indicate management effectiveness

137
254. measure the ability of a company to earn satisfaction return on capital
employed and
255. to forecast earning
256. The following are some of the ratios used to measure the above stated
objectives.
257.
258. a) Gross profit Margin: - It gives clues to the expensiveness of purchase
price, level of efficiency in production, marketing performance in terms of
pricing and sales mix. It is based on the notion that the higher the efficiency in
purchasing, production, and marketing the higher the gross profit margin.
GrosProfit
259. Gross profit Margin = Net Sales
260. A high gross profit margin ratio is a sign of good management. A gross
margin ratio may increase by the following factors.
261. higher sales price, cost of goods sold remaining constant.
262. lower cost of goods sold, sales price remaining constant.
263. a combination of variation in both sales price & costs, the margin
widening
264. an increase in the proportionate volume of higher margin items.
265. A low gross profit margin may reflect higher cost of goods sold due to the
firm’s:
266. inability to purchase raw materials at favorable terms.
267. inefficient utilization of plant and machinery.
268. over investment in plant and machinery, resulting in higher cost of
production.
269. Significant change in this rate may provide investors with an early
indication of changing consumer demand for the company’s products.
270.
271. b). Operating Margin: it measures the return on sales before extra ordinary
expenses (notably interest and taxes). This implies the efficiency of a company
to earn operating profit by efficiently monitoring performance under the control
of the manager.
Operating Income
272. Operating Margin = Net Sales
273. * Operating income = Income before interest and taxes.
274.
275. c) Net profit Margin: it measures the net returns on sales and indicates the
quality of net profit form the company’s overall revenue.
Net Income
276. Net profit Margin = Net Sales

138
277. d) Return on Assets. It measures the profitability of a venture to the
providers of capital, both the creditors and owners. If reflects the return on total
assets employed in the organization without consideration of how they were
financed.
Operating Income
278. Return on Asset = Total Assets
279. e) Return on Investment (ROI). In deciding on the loan applications, the
past record of capital growth and net profit and the corresponding future
expectations are the critical yardsticks. By any standpoint, the earning power of
the borrowing firm is the principal indicator of solvency. The rate of profit is a
definite and comprehensive measure of operating efficiency of a business. If the
profit margin is high enough, it may justify the risk of dealing with a slow-
paying customer. If the profit margin is low related to other firms in the industry,
the banker probably will not approve of the loan proposal.
280.
281. The Return on Investment (R.O.I.), as it is popularly called, relates the
operating profit of the business to the capital employed. It is the same as return
on asset except that R.O.I is refined to take interest and taxes into account. It
measures how much net return has been obtained from assets employed in the
organization. This ratio is popularly used in many organizations as profitability
indicator.
282. Investment of capital figure refers to the long-term funds employed in the
business, which can be defined either as the total of shareholders’ and borrowed
funds, or as the net block plus working capital.
Net Income
283. Return on Investment = Total Assets
284. Note that the formula can be expressed as:
Net Sales Net Income
×
285. ROI =Total Assets Net Sales
286. = Assets Turnover x Net profit Margin
287. Hence profitability is a result of efficiency in the utilization of assets
(intensity) and the net profit coupled with the minimization of costs in realizing
the revenue will enable margin. Hence maximization of revenue by efficiently
using the assets employed a company to achieve the highest profitability.
288. It is expressed as a percentage of the average amount invested during the
period, rather than the investment at year-end. The average amount invested
usually is computed by adding the amounts invested as of the beginning and end
of the year and dividing this total by 2.
289. Return on equity (ROE). This measures the rate of net return on the
owner’s investment. No doubt the common ground of credit analysis is return on

139
 investment but return on equity is also an important indicator. It is a fair measure
of assessing the earning power of productivity of the ownership investment.
Having its roots in the notion of earnings available to the residual claimants, it
can very well be described as the net profits venture capital ratio, a specialized
version of R.O.I. This ratio obviously is bound to a higher than the ROI., since
the denominator here is not the total assets, but only the equity capital. For
manufacturing firms, a standard for R.O.E. is 10-15 percent, while for public
utilities is 6-10 percent.
290.
Net Income
291. Return on Equity (R.O.E.) = Owners equity
292.
293. Liquidity Ratios
294. It measures the degree to which a business organization meets its short-
term obligations. What will happen if a company has liquidity problem?
295. The answer for this question may be:
296. unable to take business opportunities
297. tend to sell long term investments and assets to pay short term debt and
opening an avenue for bankruptcy
298. for providers of capital, lack of liquidity could mean reduced profit and
opportunity as well as loss of their capital.
299. to creditors and suppliers, liquidity matters high as it is the source of
repayment otherwise it may mean poor collection.
300. customers of the company face problem. They would be unable to get
enough supply (credit) because the company is in difficulty.
301. The different types of ratios used to evaluate the liquidity position of a
company can be discussed as follows.
302.
303. a) Current Ratio: It represents the ability of a business to absorb losses for
a period and still have enough assets to meet the debts. It has been considered to
be the true index of the solvency of a firm and shows clearly how burdened a
particular firm is with immediate liabilities. Current ratio relates the firm’s total
current assets to total current liabilities, and the criterion of current-ness has been
taken as one year.
304.
305. These current assets are those items, which are expected to mature into
cash within a year in the normal course of operations. These typically include
cash, readily disposable investment securities, sundry debtors, bill receivables,
inventories and the prepaid expenses. Current liabilities consist of all recorded
debt becoming due in a year or less. Items typically included in this category are

140
 sundry creditors, bills payable, bank loans, customers’ deposits, accrued
expenses and the provision for income-tax dividends, etc.
306.
307. For most mercantile and manufacturing firms, a rule of thumb of 2:1 ratio
is considered satisfactory. That is, current assets should be twice the current
liabilities leaving, thus, a 100 percent margin. However, this “Standard” ratio
may be too low for some companies and may be excessively conservative for
other companies. The proper current ratio for a company depends on many
factors, including the company’s policy regarding the margin of safety to pay all
its current liabilities on time.
308.
309.
Current Assets
310. Current Ratio = Current Liabilities
311. The higher the current ratio, the more solvent the company appears to be.
312.
313. b) Quick/Acid Test ratio
314. Acid test or quick ratio is often presumed to be a better guide to the short-
term debt-paying capacity of a firm. Compared to current ratio, it is supposed to
be a more real measure of solvency and ability to honor commitments.
Concerned strictly with liquid assets, whose value is fairly certain, this ratio
supplements rather than supplants the current ratio. Liquid assets here mean all
current assets less of the inventories and prepaid expenses. There are no change
in the figure of current liabilities and other short-lived assets.
315. Acid test ratio =
Liquid Assets Current Assets−(Inventory + PrepaidExp. )
=
Current Liabilities Current Liabilities
316. Traditionally, a quick ratio of 1 to 1 is considered satisfactory, though it is
difficult to depend up on such “rules of thumb”.
317.
318. c) Average collection period (ACP)
319. There are no definite rules laid down as to the period of credit to be
offered to customers, nor to the volume of funds, which should be tied up in
debtors. This will vary according to the custom of the particularly trade and to
the terms offered by the competitors.
Total Accounts Receivable
×360
320. Average collection period = Year's Sales
321. Or
360
322. = Receivables turnover ratio

141
323.
324. This figure expresses the average time in days that receivables are
outstanding. Generally, the greater the number of days outstanding, the greater is
the probability of delinquencies in accounts receivable. A comparison of a
company’s daily receivables may indicate the extent of a company’s control over
credit and collections. The terms offered by a company to its customers,
however, may differ from terms within the industry and should be taken into
consideration.
325.
326.
327.
328. D) Average payment period (APP)
329. This shows something reverse to the Average collection period. It
measures the average daily payments of credit purchases.
Accounts Payable
×36 0 days
330. App = Net Credit Purchase
331.
332. Average collection period and Average payment period are also indicators
of efficiency.
333.
334. E). Working Capital. It is the excess of current assets over current
liabilities. This amount may vary depending on the size of the organization.
However, even negative working capital does not show the insolvency of the
organization.
335.
336. 3) Activity (Efficiency) Ratios
337. Efficiency in production, marketing, cash collection and reemploying cash
into production activity are the most important concerns of a business
organization. Being efficient in these activities would mean contributing greater
return to an enterprise. Examining the relationship between a measure of sales
and an asset account is their purpose. Different ratio analysis can be used to
measure efficiency, which can be discussed as follows.
338.
339. a) Inventory Turnover Ratio
340. It refers to the frequency at which inventory is converted to cash or
accounts receivable-the frequency of selling. This ratio also measures the number
of times inventory is turned over during the year. High inventory turnover can
indicate better liquidity or superior marketing. Conversely, it can indicate a
shortage of needed inventory for sales. Low inventory turnover can indicate poor
liquidity, possible overstocking, obsolescence, or, in contrast to these negative

142
 interpretations, a planned inventory building in preparation for future material
shortages. A problem with this ratio is that it compares one day’s inventory (at
the end of the accounting period) with cost of goods sold and does not take
seasonal fluctuations into account. One way to resolve this problem when
sufficient data are available is to calculate cost of sales and average inventory by
month to develop turnover ratios for each month. Further, it may prove
externally useful to break up cost of sales and inventory by different classes of
products.
341.
342.
Costof Goods sold
343. Inventory Turnover Ratio = Average Inventory
344.
345. b) Age of Inventory or Day’s Inventory
346. It refers to the number of days the inventory is on hand before it is sold.
Both inventory turnover and Age of inventory measure marketing efficiency.
Division of the inventory turnover ratio into 360 days yields the average length
of time units are in inventory.
360
347. Age of Inventory or Day’s Inventory = Inventory turnover ratio or
Average Inventory
×360
348. = Cost of goods sold
349. c) Receivable Turnover
350. Another familiar indicator of efficiency is the times sales are to the
receivables and the average number of days the customer take to settle their
accounts. For a banker, the classification of debtors in a balance sheet under the
heading ‘good and doubtful’ does not help much. Such terms are too indefinite to
indicate the degree of collectability. If the receivables account (debtors) are
classified as to whether they are overdue or not, they shall be fruitful in giving a
clue as to how much and how soon will be realized from them.
351. This ratio measures the number of times accounts and notes receivable
(trade) turnover during the year. The higher the turnover of receivables the
shorter is the time between sales and cash collection.
Year's Sales(Preferably creditsales )
352. Receivable Turnover = Accounts and notes receivable (trade )
353.
354. d) Assets Utilization (Capital Intensity) Ratios
355. The intensity with which assets and liabilities are utilized (Capital
Intensity) to generate revenues is also one determinant of efficiency of a

143
 company. Generally it is advantageous to maximize revenue from a given level
of investment. This situation is as good as the efficient utilization of assets.
356.
357. i. Fixed Asset Turnover: It measures the intensity at which we use our
fixed assets to generate revenue.
Net Sales
358. Fixed Asset Turnover = Net Fixed assets
359.
Net Sales
360. ii. Assets Turnover = Total Assets
361. It measures the total revenues that are generated from the total investment
(Asset).
Net Sales
362. iii. Liabilities Turnover = Total Liabilities
363. It gives some clues to liability management. Whether the liability has
contributed enough to the well being of company.
364.
365. 4. Capital Structure and Long-Term solvency Ratios
366. Different ratio analysis can be used to measure the capital structure of a
borrower such as:
367.
368. a). Debt Ratio: - It indicates the proportion of borrowed funds that are
used to finance a firms assets or the extent to which the firm relies on debt as
opposed to owner’s capital (net worth). It measures, how much the company is
indebted. Too high ratio is not advisable. It expresses the degree of protection
provided by the owners for the creditors. A lower ratio generally indicates
greater long-term financial safety. A firm with a low debt/worth ratio usually has
greater flexibility to borrow in the future.
369.
370. Debt ratio is not a measure of short term liquidity. Rather, it is a measure
of creditor’s long term risk. The smaller the portion of total assets financed by
creditors, the smaller the risk that the business may become unable to pay its
debts. From creditor’s point of view, the lower the debt ratio, the safer their
position will be.
Total Liabilities
371. Debt Ratio = Total Assets
372.
373. b) Debt (Interest) coverage: - It measures the ability of a company to cover
or pay fixed charges of interest (Interest expenses). In income statement, interest
expense comes after operating income (earnings before interest and taxes). So,

144
 when interest expense is deducted from operating income, it should be positive.
The question is by how much the operating income is in excess of interest
expense.
Operating Income
374. Debt (Interest) coverage = Interest Expense
375.
376. c) Return (before taxes) on net worth: - This ratio expresses the return on
total assets and measures the effectiveness of management in employing the
resources available to it. If a specific ratio varies considerably from the ranges
found in published sources, the analyst will need to examine the makeup of the
assets and take a closer look at the earnings figure. A heavily depreciated plant
and a large amount of manageable assets of unusual income or expense items
will cause distortions of this ratio.
Net Profitbefore Taxes
377. Return (before taxes) on net worth = Total Assets
378. d) Effective Interest Ratios: - It measures the average cost if all the
borrowed funds. Items in the liability section of the balance sheet are partly
obtained with not interest changes (e.g. mortgage payable). The issue, here, is to
answer the question of how much interest rate is paid on average on all the
liabilities.
379.
Interest Expense
380. Effective Interest Ratios = Total Liabilities
381.
382.
383. ILLUSTRATION:
384. ABC COMPANY
385. BALANCE SHEET (in ‘000s)
386.
387. 388. It 389. 1 390.
391.
392.
No. 997
393. 394. Assets 395. 396.
397.
398.

399. 400. Cash 401. 2 402.

403.
404.
1 0
405. 406. Securi 407. 1 408.
409.
410.
2 ties 0
411. 412. Accou 413. 3 414.
415.
416.
3 nt 2

145
 Receivable
417. 418. Invent 419. 8 420.
421.
422.
4 ories 8
423. 424. Total 425. 1 426.
427.
428.
5 Current 50
Assets
429. 430. Fixed 431. 432.
433.
434.
Assets
435. 436. Dross 437. 5 438.
439.
440.
6 plant 30
&Equipment
441. 442. Reser 443. - 444.
445.
446.
7 ve for 78
depreciation
447. 448. Total 449. 4 450.
451.
452.
8 Fixed Assets 52
453. 454. Total 455. 6 456.
457.
458.
9 Assets 02
459. 460. Liab 461. 462.
463.
464.
ilities
465. 466. Curre 467. 468.
469.
470.
nt Liabilities
471. 472. Accou 473. 1 474.
475.
476.
10 nt payable 8
477. 478. Accru 479. 1 480.
481.
482.
11 ed Wages & 2
Salaries
483. 484. Taxes 485. 1 486.
487.
488.
12 Payable 4
489. 490. Bank 491. 1 492.
493.
494.
13 Loan 5
495. 496. Total 497. 5 498.
499.
500.
14 Current 9
Liabilities
501. 502. Long 503. 504.
505.
506.
Term
Liabilities
507. 508. Mortg 509. 1 510.
511.
512.
15 aged loan 56
513. 514. Bonds 515. 7 516.
517.
518.

146
 16 5
519. 520. Total 521. 2 522.
523.
524.
17 Long Term 31
Liabilities
525. 526. Total 527. 2 528.
529.
530.
18 Liabilities 90
531. 532. Stoc 533. 534.
535.
536.
k Holders
Equity
537. 538. Com 539. 1 540.
541.
542.
19 mon Stock 50
543. 544. Paid 545. 5 546.
547.
548.
20 in Capital in 0
excess of par
549. 550. Retain 551. 1 552.
553.
554.
21 ed Earning 12
555. 556. Total 557. 3 558.
559.
560.
22 Stock 12
Holders
Equity
561. 562. Liab. 563. 6 564.
565.
566.
23 & Stock 02
Holders
Equity
567.
568.
569. ABC COMPANY
570. INCOME STATEMENT (in ‘000s)
571.
572. N 573. Items 574. 19 575.576.
577.
o. 97
578. 1 579. Net Sales 580. 84 581.582.
583.
0
584. 2 585. CGS 586. 69 587.588.
589.
1
590. 3 591. Gross 592. 14 593.594.
595.
Margin 9
596. 597. Operating 598. 599.600.
601.
Expenses
602. 4 603. Selling 604. 30 605.606.
607.

147
 Expense
608. 5 609. General & 610. 42 611.612.
613.
Adm. Expense
614. 6 615. Lease 616. 20 617.618.
619.
payment
620. 7 621. Total 622. 92 623.624.
625.
Operating
Expense
626. 8 627. Operationa 628. 57 629.630.
631.
l Income
632. 633. Other 634. 635.636.
637.
Revenues
638. 9 639. Income 640. 5 641.642.
643.
from securities
644. 1 645. Royalties 646. 2 647.648.
649.
0
650. 1 651. Total Other 652. 7 653.654.
655.
1 Revenues
656. 1 657. Gross 658. 64 659.660.
661.
2 Income
662. 663. Other 664. 665.666.
667.
expenses
668. 1 669. Interest on 670. 671.672.
673.
3 bank loan
674. 1 675. Interest on 676. 15 677.678.
679.
4 Mortgages
680. 1 681. Interest on 682. 7 683.684.
685.
5 bonds
686. 1 687. R & D 688. 10 689.690.
691.
6 costs
692. 1 693. Total other 694. 32 695.696.
697.
7 expenses
698. 1 699. Net Income 700. 32 701.702.
703.
8 before tax
704. 1 705. Federal 706. 16 707.708.
709.
9 Income Tax
(50%)
710. 2 711. Net Income 712. 16 713.714.
715.
0
716.

148
717.
718.
719.
720. Ratio Analysis based on the given balance Sheet and Income Statement
for the year 1996.
721. 1. Gross Profit Margin = Gross Profit
722. Net Sales
723.
724. = 149,000.00
725. 840,000.00
726.
727. = 0.18
728.
729. 2. Operating Margin = Operating Income
730. Net Sales
731.
732. = 57,000.00
733. 840,000.00
734.
735. = 0.07
736.
737. 3. Net Profit Margin = Net Income
738. Net Sales
739.
740. = 16,000.00
741. 840,000.00
742.
743. = 0.019
744.
745. 4. Return on Assets = Operating Income
746. Total Assets
747.
748. = 57,000.00
749. 602,000.00
750.
751. = 0.09
752.
753. 5. Return On Investment = Net Income or Net Sales X Net
Income
754. Total Assets Total Assets Net
Sales

149
755.
756. = 16,000.00 or 840,000.00 X
16,000.00
757. 602,000.00 602,000.00
840,000.00
758.
759. = 0.03 or 0.03
760.
761. 6. Return on Equity = Net Income
762. Owner’s Equity
763.
764. = 16,000.00
765. 312,000.00
766.
767. = 0.051
768.
769.
770. 7. Current Ratio = Current Assets
771. Current Liabilities
772.
773. = 150,000.00
774. 59,000.00
775.
776. = 2.54
777.
778. 8. Quick/ Acid Test Ratio = Liquid Assets
779. Current liabilities
780.
781. = 62,000.00
782. 59,000.00
783.
784. = 1.05
785.
786. 9. Average Collection Period = Total A/R X 360 or = 360
787. Year’s Sales Receivable
Turnover ratio
788.
789. = 32,000.00 X 360 360
790. 840,000.00
=840,000.00/32,000.00
791.

150
792. = 0.03809 X 360 = 13.71
793.
794. = 13.71
795.
796.
797. 10. Inventory Turnover Ratio = Cost of Goods Sold
798. Average Inventory( Beg. Inv. + End.
Inv.)/2
799.
800. = 691,000.00
801. (0+ 150,000.00)/2
802.
803. = 691,000.00
804. 75,000.00
805.
806. = 9.21
807.
808. 11. Age of Inventory or Day’s Inventory = 360
809. Inventory Turnover Ratio
810.
811. = 360
812. 9.21
813.
814. = 39.09
815.
816. 12. Receivable Turnover = Year’s Sales ( Credit Sales)
817. Accounts & Notes Receivable
818.
819. = 840,000.00
820. 32,000.00
821. = 26.25
822.
823. 13. Fixed Assets Turnover = Net Sales
824. Net Fixed Assets
825.
826. = 840,000.00
827. 452,000.00
828.
829. = 1.86
830.
831. 14. Assets Turnover = Net Sales

151
832. Total Assets
833.
834. = 840,000.00
835. 602,000.00
836.
837. = 1.395
838.
839. 15. Liabilities Turnover = Net Sales
840. Total Liabilities
841.
842. = 840,000.00
843. 290,000.00
844.
845. = 2.897
846.
847. 16. Debt Ratio = Total Liabilities
848. Total Assets
849.
850. = 290,000.00
851. 602,000.00
852.
853. = 0.462
854.
855. 17. Debt (Interest ) Coverage = Operating Income
856. Interest Expense
857.
858. = 57,000.00
859. 22,000.00
860.
861. =2.59
862.
863. 18. Return (before Taxes) on net worth = Net Profit Before Taxes
864. Total Assets
865.
866. = 32.000.00
867. 602,000.00
868.
869. = 0.053
870.
871. 19. Effective Interest Ratio = Interest Expense
872. Total Liabilities

152
873.
874. = 32,000.00
875. 290,000.00
876.
877. = 0.11
878.
879. Evaluating Financial Ratios
880. Evaluation of a financial ratio requires a comparison. There are three main
types of comparisons which will be discussed as follows.
881. With a company’s own historical ratios. It is also called time series
comparisons. It compares the ratios recorded by the company over a consecutive
period of time.
882. With general rules of thumb or bench marks. They are general guidelines
applicable in ratio analysis. Here, care must be taken to determine the correct
effect as the real situation of the business may differ from the general situation.
883. With ratios of other companies or with industry average. It is also called
cross sectional comparisons. Different industries may show different ratio
structure. Therefore, comparison must be made only between companies within
the same industry.
884.
885. 2.6.2. Comparative Analysis
886. It is a simple technique of studying some items or groups of items of
financial statements of an organization over a period of time. Technically the
term stands for an absolute figure comparison, but it can very well be extended
into comparison of ratios computed from balance sheet and profit and loss
account. Then different items could be expressed as percentages of the totals of
position and income statements.
887.
888. 2.6.3 Cash flow projections
889. With a view to knowing the likely forward cash position of the borrowing
firm, the banker invariably insists up on the preparation of a projected cash flow
statement. In essence, the statement is simply a cash budget or cash account
projected into the future. For the budget period (say, a month, a quarter, a year or
3 to 7 years), it records on a consistent and logical basis the likely receipts and
disbursements, and thereby the closing cash balance. For a banker, such a
statement tends to highlights the cash surpluses or shortfalls, and thus specifics
the amount of loan and the duration for which it should be granted.
890. As a forward budget, it shows in detail how the amount of the proposed
loan has been arrived at, and demonstrates convincingly that the amount will be
adequate for the purpose for which it is required.
891.

153
892. 2.6.4. Performa Statements
893. Performa statements are balance sheets and profit and loss accounts
prepared for some future period. These signify prospective financial statements.
Though hypothetical and anticipatory in character, they give a feel as to how the
business is going to behave in the years ahead with regard to its ways and means
position and generation of extra resources. The future relationships of assets,
liabilities, revenues, costs and profits enable the banker to appraise the funds
needs as of a point of time. The banker knows that in making up such projected
statements, the businessman has to plan in advance all details of his operations.
Chances of errors are inevitable, but through this homework, mistakes through
hasty judgment are largely eliminated.
894.
895. 2.6.5 Discounted Cash Flow
896. It is a technique of discounting the future receipts and expenditures into
their present values. That is, it consists in finding the time value of money. If
some predetermined rate of interest is employed for discounting the inflows and
outflows, the method is called NPV (Net Present Value). If discounting is so
made that the discounted receipts are exactly equal to the discounted outlays on a
trial and error basis, the method is called IRR (Internal Rate of Return).
897.
898. 2.6.6 Break- even Analysis
899. Bankers and credit grantors make use of “break even” technique to
discover the level of operations at which the output, costs and sales income are
equated.
900. The algebraic formula for break-even is based on dividing the aggregate
costs into fixed and variable. Fixed costs are the sunk cost that would be incurred
even under shutdown conditions of a few weeks or months. Variable costs are
those, which fluctuate, more or less in direct proportion to the changes in volume
of output.
901.
902.
903.
904.
905. The usual formula for B-E point is = FC
906. 1-(VC/S)
907. Where FC= amount of fixed costs
908. Vc = variable cost per unit of sales,
909. S = Selling price per unit of sales
910.

154
911. This will give the B.E point in terms of sales revenue. For the B-E point in
terms of units, fixed costs have to be divided simply by the unit contribution
margin (selling price – Variable cost).
912.
913. 2.6.7 Funds-Flow Analysis
914. An analysis of statement of “Sources and Application of Funds”, in belief
‘funds statement’ is in effect an examination of the changes in net working
capital-the excess of current assets over current liabilities.
915.
916. There might be instances where a business has a fairly good record of
profit generation, yet it may be critically short of liquid funds, often leading to its
closure. Contrawise, despite low profits or absence of profits, a concern may be
happily placed with regard to working funds. Little surprise is that the analysis of
funds flow statement has come up as a powerful tool reflecting obviously and
readily the reasons because of which the net working capital has changed over
the year(s). The information otherwise available in the two basic financial
statements and elsewhere is summarized at one place in the form of “where-got,
where –gone” statement.
917. Apart from portraying the position of liquidity, the fund statement shows
in unmistakable terms, the spending and financing habits of the management.
Have the increased investment expenditure been financed by internally generated
funds from operations including depreciation, externally by resorting to issue of
fresh securities and /or raising term loans? If either of these sources fails, the
management often takes resources to ad-hoc measure of selling fixed assets. This
has been referred to as the time matching concept, i.e. determining whether the
firm is using long-term and permanent funds to finance long-term and permanent
uses, and short-term funds to finance short-term uses.
918.
919. Then again, the distribution side of the funds statement shows whether the
company is expanding its scale of business by building up additional plant and
equipment, or else it is involved purely in routine affairs of disbursing dividends
and redeeming long-term debts. These historical activities become important
pointers to the future financial strength and weakness. If estimated inflows and
outflows are also presented alongside the past, that will be helpful not only for
long-term planning and control of the business, but equally well to the banker to
determine the ability of the business to meet repayment schedules.
920. Among other sources of funds; Increase in liabilities and shareholder’s
funds and reduction in assets are the major ones and funds are applied mainly for
reduction in liabilities and shareholder’s funds and increase in assets.
921.
922. 2.6.8 Cash Budget and Proforma Financial Statements

155
923. The financial impact on the firm of a strategic change is presented in
proforma (predicated) financial statements. These statements include a cash
budget, an income statement, and a balance sheet over the appropriate planning
periods. Typically, the income statement and balance sheet are projected first to
show expected sales and expenses (income statement), the level of assets
necessary to generate those sales and the way in which assets will be financed.
Then, a funds flow statement is prepared to give more detail on cash or working
capital transactions expected to be necessary for operations to proceed as
planned.
924. There are four approaches to projecting financial statements: the percent
of sales method, the statistical- relationship method, the budgets- and – ratios
method, and the break- even sales method. Many techniques are available for
predicting sales. The most popular of these for the external analyst are probably
the percentage –change, regression, and trend-line extrapolation methods. For an
analyst forecasting sales from inside a firm, the most popular techniques are
probably the sales for composite, survey of executive-opinion, and regression
approaches.
925.
926. i) Percentage- of –sales projections
927. Of the methods available for constructing pro-forma statements, the most
popular for purposes of strategic analysis is the percentage-of- sales method. The
percentage of –sales approach involves the following steps.
928. Isolate accounts that can reasonably be expected to vary directly with
sales.
929. Compute each of these accounts as a percentage of historical sales for
several accounting periods.
930. Take a simple, moving, or weighted average of each account’s
percentages to reduce them to one figure per account.
931. Multiply each account’s average percentage of sales figure by forecasted
sales for each of the appropriate periods.
932. Arrange results in statement form and reconcile totals.
933. On the income statement, cost of goods sold, total operating expenses, and
income taxes will vary with sales with relatively high consistency.
934. Balance sheet items that normally vary with sales are: cash, receivables,
inventory, plant, equipment, accounts payable and accruals. With pro-forma
income statement and balance sheet constructed, the analyst can then develop a
pro forma funds flow statement. This is a matter of isolating the changes between
the last historical statements and the pro forma statements according to the
following categories:
935. Sources of funds-either increases in liability accounts or decreases in asset
accounts.

156
936. Uses of funds –either decreases in liability accounts or increase asset
accounts
937.
938. ii). Statistical Relationship Methods.
939. Many techniques are available for making financial forecasts on the basis
of statistical relationships among variables. Normally the analyst proceeds by
first making a sales forecast and then striking a relationship, account by account,
between each statement item and forecasted sales with a regression line. Simple
linear, nonlinear or multiple regressions can be used, depending on the user’s
needs and statistical sophistication.
940.
941. iii). Budgets and ratios Methods
942. It is one technique applies to strategic management systems with
comprehensive budget programs. Essentially it involves breaking out budget
categories by financial statement account and then adding (subtracting) budget
quantities to (from) statement quantities.
943. Two other variations are appropriate to strategic planning. One calls for
constructing a cash budget first, and then factoring cash budget quantities into a
pro forma income statement and balance sheet. The other relies on past ratios.
With a sales forecast and a set of historical ratios, the balance sheet and income
statement can be constructed. Ratios with sales in either the numerator or
denominator can be converted in to dollar values by appropriate mathematical
manipulations. For example, accounts receivable for the pro forma balance sheet
is obtained by multiplying the receivable-to-sales ratio by expected sales.
944.
945. iv). Break-Even Proformas
946. Although not actually a way of predicting financial structure in the sense
of forecasting what is expected to occur, break-even proforma can be useful for
strategic analysis purpose. According to this approach, the analyst first
determines the level of sales that would be necessary for the firm to break even,
that is, to generate a precisely zero profit. Then, by using accounts as percentages
of sales, statistical relationships, or ratios, the proforma statements are developed
around the break-even sales level.
947.
948. Break-even point is especially useful for showing what the critical
financial condition would be for a firm with declining sales or deteriorating
financial position in to the break-even point. The analyst may even compute the
rate of decrease of sales and determine how much time is available for a turn
around when sales are declining. A rough estimate is obtained by using the
break-even computation on income statement data. This estimation procedure

157
 simply involves dividing the firm’s gross margin percentage into total dollar
operating expenses (which roughly approximate fixed costs.
949. It is also useful for new ventures. In this case, the important decision is
whether it is reasonable to expect that the approximate break-even sales level can
be reached and exceeded within a certain time period.
950.
951. 2.7 Internal Diagnosis; Other Functional Areas
952.
953. Most strategic operating characteristics are manifested either directly or
indirectly as symptoms in a firm’s financial statements. These symptoms must be
“dug out” of the statements and then interpreted in operational terms for strategic
analysis to begin. Through the interpretation of operational causes of financial
symptoms, the strategist can identify many of the firm’s strengths and
weaknesses.
954.
955. Financial analysis can reveal symptoms of problems or evidence of
strengths in the other functional areas. (It can also indicate that certain
environmental factors are affecting performance.)
956. Therefore, financial analysis can be viewed as a way to uncover questions
about performance to which the answers are likely to be found by analysis of
other functional areas. For example, if financial analysis showed relatively high
gross profits for a firm experiencing decline sales, the analyst would probably
turn to either its marketing function( to determine if prices charged by the firm
were too high) or its production systems ( to see if raw materials inventory costs
were leading to excessive cost of goods sold). Similarly, where gross margin is
about average but net profit margin is low, the analyst would likely find some
operating expense accounts that were unusually large. These excessive accounts
should then be traced back to the functional areas generating them to find
evidence of functional inefficiencies. Further reading is recommended on the
process of internal analysis and functional areas that need analysis.
957.
958. Check Your Progress Questions
959.
960. Define credit analysis?
961. ____________________________________________________________
_________________________________________________________________
_____________
962. List down the necessary considerations while lending and credit analysis.
963. ____________________________________________________________
_________________________________________________________________
_____________

158
964. State the different sources of information about a customer while
preparing a credit analysis.
965. ____________________________________________________________
_________________________________________________________________
_____________
966. What is a statement prepared while credit analysis in order to determine
the summary of revenues earned and expenses incurred, assets, liabilities and
capital and incomes and payments of a customer while credit analysis.
967. ____________________________________________________________
_________________________________________________________________
_____________
968. List down the techniques of credit investigation used.
969. ____________________________________________________________
_________________________________________________________________
_____________
970.
971. 2.8 SUMMERY
972.
973. The measurement of the overall standing of the firm and its future is called
“Credit analysis” or “Credit investigation”. It is in effect, financial analysis
conducted by a supplier of funds with a view to finding the position, progress
and prospects of a borrower. That is, when a banker or some other lender makes
financial analysis, it tends to be called “Credit analysis”. It is also defined as a
detailed evaluation of the project to determine the technical feasibility, the
economic necessity, financial viability of the project and managerial competence
required for its successful operation.
974.
975. The purpose of credit analysis is the same of measuring and predicting
primarily the degree of risk in financing operations based on two fundamental
facts about the firm: the level of profitability and the factors which influence that
profitability and the liquidity, and solvency (Safety) of the firm.
976.
977. Financial statements can reveal much about a firm’s operating strengths
and weaknesses. They also serve as a basis for predicting future financial
developments, to the extent that the performance of all parts of an organization is
ultimately reflected in the magnitude of entries in a firm’s financial statements,
financial analysis can structure or bound the question of how well a strategy is
working.
978. Comprehensive financial analysis consists of four elements: ratio analysis
of the firm’s historical financial performance, interpretation of cash flow

159
 position, analysis of retained earnings position, and prediction of future financial
statements.
979. All findings of the financial analysis should be reduced to strengths and
weaknesses of the firm and located accordingly in the data set for the present
time frame. Then expected changes in each item can be forecasted.
980.
981. 2.9 Answers to Check Your Progress Questions
982.
983. 1. Refer section 2.2
984. 2. Refer section 2.3
985. 3. Refer section 2.4
986. 4. Refer section 2.5
987. 5. Refer section 2.6
988.
Unit 3: Securities and Charges on Loans

Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 Meaning of Security
3.3 Types of Securities Offered against loans
3.4 Creating Charges on Securities
3.5 Summary
3.6 Answers to Check Your Progress

3.0 Aims and Objective

At the end of this unit, you are expected to:

 explain the meaning of security
 identify the different types of securities
 understand the meaning of charge, loan, pledge, mortgage and hypothecation
 list down the different securities offered against loans
 explain the difference between loan and pledge

3.1 Introduction

Loans are always advanced against securities. Securities are offered in order to guarantee
the repayment of loan already advanced. However, the purpose of holding securities is
not to sale it and impoverished the customer. Its purpose is to make sure that the loan
advanced to the customer is paid back as this money advanced to the customer is
collected from the public in a form of deposits.

160
3.2 Meaning of Security

Security is a term used by bank to represent the collateral requested in order to offset
some impression weakness or some unusual condition that may happen during the life of
a loan. It, however, can never be a substitute for assessing a credit risk as is a sound
current position of an enterprise. Therefore, it is not to be relied on the extent of ignoring
the quality factors of credit.

Commercial banks in Ethiopia in line with the credit policy of national bank of Ethiopia
accepts various kinds of securities which may be applicable variably as per the economic
sector the user of credit falls. The major economy sectors are:
1. The socialized sector like state enterprise and cooperatives
2. The private sector.
1. Security requirement for a socialized sector
This sector is not required to produce tangible collateral. However, assessment has to be
made on the following: the degree of socialization achieved and economic contribution
that may be derived from financing it.

a) Testing the degree of Socialization

A documentary evidence in the case of state enterprise testifying established as a business
concern is sufficient. In the case of co-operatives the following documents are needed to
determine the degree of socialization.
i) Certificate of registration
ii) Supporting letter from organizing bodies
iii) Articles and memorandum of Association
iv) General Assembly’s resolution to borrow from bank
v) Authority to borrow for the executive body

b) Testing the economic contribution expected

In order to test the economic contribution expected from state enterprise and
cooperatives, the following documents need investigation.

i) Financial position
In order to test the financial position of such firms, the following financial statements
must be presented and studied.
i) Audited Balance Sheet: It is used to check the soundness of the current
position, to test care attached to trade obligations, to test the level of working
capital, to test physical condition of fixed assets and to test net worth.
ii) Profit and loss statement: It is used to test the activity volume and the earning
ability of the firm.

161
 iii) Fund Flow Statement: It is also used to check the source and application of
funds
iv) Cash flow statement. It is used to depict the different sources of cash and how
this is applied in the operating process of the business.

ii) Specific Plans

Before advancing loans to state enterprises and cooperatives, it will be necessary to know
exactly what the specific plans are which may include the feasibility study and
profitability.
i) Feasibility study. It is used to assess and determine the viability of the
project, the marketability of the product to be produced, the proposed
method of distribution, the various projected supply and demand, the
technical soundness as related to product cost envisaged, the caliber of
the work force, possible problems that may crop after commencement
of the project.
ii) Profitability: The profitability of the proposed project must be
determined in order to determine the ability of the borrower to pay
back the loan granted. This can be determined from the projected
balance sheet and income statement.
iii) Cost-benefit analysis: This is used to check the project’s contribution
to the economy as related to: employment opportunity, training of
manpower, foreign exchange saving, foreign exchange earning and
degree of exploitation of domestic sources.
Balance sheet, income statements, fund flow statements, cash flow statements and
feasibility study are invaluable aids for assessing a credit risk but by themselves they
cannot and do not supply the final answer. All have their use but none replace the need
for intelligence discretion and good judgment on the part of those who would use them
wisely, each in its place, to appraise the strength of credit risk.

2. Security Requirement for Private Sector

Apart from the verification of the viability of projects, the anticipated social and
economic contribution of the projects, a private enterprise is required to propose any of
the following collaterals for any loan that it may get.

3.3 Types of Securities offered against loans

The principle of safety has assumed great significance because safety of assets of the
bank is essential for the very survival of the bank itself. That is why banks attach great
importance to the security offered while advancing credit to their customers. A prudent
banker ensures that advances given to the business persons and the industrialists are
backed by sufficient collateral securities. These securities must be tangible and easily

162
marketable so that bank may sell them to realize the debt in case of default by the
borrower. The most important types of securities lodged with bank for securing advances
are:
a) Goods e) Supply bills
b) Documents of little of goods f) Life insurance policies
c) Stock exchange securities g) Fixed deposit receipts
d) Real estates h) Other securities

3.3.1 Advances against Goods

Goods or merchandise are easily accepted as securities by the banks in approving loans to
the borrowers. The goods may be of any types as agricultural products, industrial
products and others. The essential characteristics of all these commodities are that they
are movable. The term "Goods" may be defined as "every kind of movable property other
than actionable claims and money, and includes stocks and shares, growing crops, grass
and things attached to or forming part of the land which are agreed to be severed before
sale or under the contract of sale". The term “goods” is used interchangeably with the
term "merchandise", but technically the latter term refers to the goods ready for sale.

A). Advantages of advances against goods

The following are the merits of goods or merchandise as securities against bank
advances.
i. They offer tangible securities. If the customer fails to pay, the bank can sell the goods
and recover the amount advanced along with the interest.
ii. Goods are easily marketable. Their value can be determined from the day-to-day
transactions in the market and they can be sold when the borrower makes default in
making the payment. Some commodities like oils and garments command even
international market.
iii. The prices of certain goods do not fluctuate widely. The prices are generally steady if
the goods are necessaries of life.
iv. It is easy to determine the value of the goods. As they are easily marketable, loans can
be advanced on the basis of their market value after keeping the sufficient margin.
v. Advances against goods are generally granted for short periods. The borrowers stock
the goods with a view to use them for processing or selling them in the near future. When
the stock has been sold, the borrower will repay the loans. Thus, advances against goods
are self-liquidating.

Disadvantages of Advances against Goods

The following are the demerits of goods or merchandise as securities against bank
loans.
i. Easy for fraud. There is a great scope for committing fraud by the borrowers. A
borrower may deceive a bank by fraudulent means. He may pledge the goods, which may

163
not correspond with the descriptions he may have given in the documents. In certain
cases, the bank cannot verify the quality and quantity of goods. So there is a great risk of
loss on account of fraud committed by the borrowers.
ii. Quality may decline. The quality of the goods may be spoiled in spite of best
precautions taken by the bank and the goods may depreciate in value with the passage of
time. Fruits and vegetables perish within a short period. Rubber shrinks and loses weight
if stored for a longtime. Food grains are liable to be damaged by white ants, rats, etc.
clothes may be obsolete/out of fashion/ if they are stored for long time. Thus, such goods
will lose value and will not be a good security.
iii. Price Fluctuates. Prices of certain goods fluctuate widely. When it is expected that a
particular commodity is likely to lose value, it will not be easily accepted as security.
iv. Valuation may be difficult. Valuation of certain goods is difficult because there may
be no many varieties of a product and it is difficult for the bank to determine the value of
the variety offered as security as bank does not have contact with the markets of all
products.

Precautions to be taken in Advancing Against Goods

A bank should take the following precautions while advancing loans against the security
of goods.
- The bank should accept goods as security from such parties as are trust-worthy and
credit-worthy. The honesty and integrity of the borrower must be unavoidable.
- The bank should accept commodities as securities, which are easily marketable. In case
the borrower fails to repay the loan, the bank will recover it by selling the goods.
- The bank should make proper enquiries from the market while accepting a commodity
as security.
- The bank should make itself certain that the borrower is the real owner of the goods
being pledged with it.
- The bank should take the delivery of the commodities offered as security by actual
delivery or constructive delivery depending upon the integrity of the borrower.
- The bank must see that the goods are insured against fire and other risks for fair value.
Goods should be stored properly so as to avoid any loss in their value.
- The bank must enter into a contract of hypothecation with the customer, when it is
impossible for the bank to take possession of the goods given as security.
- The bank must acquire adequate margin for loss of value of the goods. The actual
percentage of margin will depend upon the general trend of prices, amount of the loan,
steadiness and extent of demand and credit-worthiness of the customer.
- The bank must inspect periodically the store where goods have been stored or kept. A
responsible official of the bank must make the inspection. Besides, whenever the bank
releases the goods to the borrower, it should see that they are in proportion to the amount
of the loan repaid. Thus, the bank should strictly regulate the delivery of goods to the

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borrower. It should ascertain the quantity of the goods and their market value and should
enter these in the register made for the purpose at the time of granting the loan.

3.3.2 Advances against Documents of Title of Goods

Advances against the security of documents of title to goods are known as Documentary
credit. A document of title to goods is a document, which gives right to a person to take
delivery or possession of the goods. Documents of title to goods include:
i) Bill of lading
ii) Dock warrant
iii) Wharfinger's certificate
iv) Railway receipt
v) Warehouse- keeper's certificate
vi) Order for the delivery of goods, and
vii) Any other documents
a. used in the ordinary course of business as proof of the possession
or control of goods, or
b. authorizing or purporting to authorize either by endorsement or
by delivery, the possessor of the document to transfer or receive
goods thereby represented.
A document of title to goods represents goods in the possession of some body else. If
confers on the holder of the document the right to receive the goods and transfer such
right to any other person by mere delivery or by endorsement and delivery. The important
documents of title to goods are discussed as follows.

i. Bill of Lading
A bill of lading is a document by which the shipping company acknowledges the receipt
of goods accepted to be carried in a ship to the port of destination specified there in return
of the payment of freight. It serves as an official receipt for goods, a contract to carry
goods to the desired place and a document of title to goods on board the ship. The
importer cannot take the delivery of the goods without obtaining 'bill of lading'
beforehand from the exporter.

A bill of lading is a semi-negotiable instrument being a document of the title to the

goods. Although it is not negotiable like a cheque or a bill of exchange, it is freely
transferable by endorsement and delivery. To facilitate the transferability, the bill of
lading should be a "clean bill" and not unfair (foul) one, which lists some defects in the
goods.

The bill of lading is issued in a set of three. It certifies the number and weight of the
packages. It is regarded as a symbol of title to the goods in the packages. A person to

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whom a bill is endorsed is entitled to take delivery of goods from the shipping company
at the port stated in the document after paying the freight if the shipper has not paid it.

Because of these characteristics of bill of lading, banks lend money on the security of the
bill of lading. In case of a bill of lading, the bank should insist that all the copies of the
bill of lading are deposited with it. The bank should obtain the bill of lading endorsed in
blank so that the responsibility to pay the freight remains with the customer. The bank
should further ensure that the goods covered by the bill of lading have been insured and
the marine insurance policy is in order.

ii. Dock Warrant

A dock warrant is a certificate issued by a Dock Company stating that the goods
described in the warrant have been received by it and promising to deliver them to the
person entitled /stated there in or to the assignee by endorsement by such a person. A
person who is in the custody of dock warrant can go to a bank for financial
accommodation. The bank will make proper enquiries and grant the loan after the dock
warrant duly endorsed in blank is handed over to it.

iii. Warehouse Receipt

The authorized official of the warehouse where the goods of a trader have been kept
issues a warehouse receipt. It acknowledges the receipt of the goods in the warehouse
concerned. The quantity and quality of the goods deposited with the warehouse are
clearly mentioned in it. If it is not otherwise provided, a warehouse receipt is transferable
by endorsement and delivery and entitles the lawful holder to withdraw the goods from
the warehouse by paying the warehouse charges.

Warehouse receipts are very popular in financing overseas trade. The warehouse receipt
issued by the 'bonded warehouse' can be endorsed in favor of a bank from which the loan
is being taken. Banks agree to lend money against warehouse receipts because goods
stored in the warehouse back the loan.

iv. Railway Receipt

A railway receipt is also a document of title to goods. It enables the person mentioned
there in as consignee to give a valid discharge in respect of the goods to which it relates.
It is issued by the railways by which it acknowledges the receipt of goods described there
in and undertakes to deliver the goods to the consignee at the place mentioned in it.
Railway receipts can be endorsed and the endorsee can get the delivery of the goods
mentioned there in from the railway authorities.

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Advance can be taken from the bank against a railway receipt for a short period because
it has to be produced before the railway authorities within a specified time for the
delivery of the goods. It should be further noted that railway receipt is not a negotiable
instrument. Accordingly the following observations can be concluded.
i) Though a document of title, a railway receipt is not a negotiable instrument.
ii) A railway receipt is only an authority to take delivery of the goods.
iii) The possessor of an endorsed railway receipt does not necessarily have the right
or authority to dispose of the goods.

Therefore, the banker cannot have the rights of a holder in due course by being an
endorsee of the railway receipt. In practice, traders consign goods to self-first, obtain the
railway receipt and then endorse it in favor of the bank, which has agreed to provide
credit facilities. Railway receipt does not testify about the quality and quantity of the
goods packed. So, the bank asks for invoice accompanying the railway receipt. Banks
generally prefer to purchase/discount the documentary bills with railway receipt, which
are drawn by parties of good reputation. The bank becomes a holder for value or holder
in due course by negotiating the accompanying bill of exchange and not by being the
endorsee of the railway receipt which is merely a document of title and not a negotiable
instrument.

The following precautions must be taken by a bank to safeguard its interests while
accepting railway receipts as documents accompanying a bill.

i. The bank should satisfy itself about the genuineness of the railway receipt. It should
ask for the invoice accompanying the railway receipt. The railway receipt must be
endorsed in favor of the bank and also delivered to it.
ii. The bank should give a notice to the railway authorities at the destination about its
interest in the goods so that no other party may take away the goods from the railway
authorities on the basis of an indemnity bond.
iii. When considered necessary, the goods should be adequately insured against fire
and other risks.
iv. The bank should examine whether the receipt is actually paid or will be paid. "To
Pay" receipt should not be accepted because of the risk involved. In case the consignee
does not clear the goods, the bank may be computed to clear the goods after the payment
of the freight and demurrage, which may be heavy. Thus the bank should ensure that the
freight has been fully paid.
v. Old receipts should not be accepted because the goods covered by the receipt might
have by that time reached the destination and might have been delivered to the consignee
under an indemnity bond.

A. Advantages of Documentary Credit

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A document of title of goods is a 'symbol of goods'. Though it is not a negotiable
instrument, the delivery of such a document, if endorsed properly, is equivalent to the
delivery of the goods. The possession of such a document amounts to constructive
possession of the goods and so much documents are frequently used to secure the loans
advanced by the banks.

B. Disadvantages of Documentary Credit

An advance against document of title to goods becomes in effect is credit under pledge
because the bank can take possession of the goods in ease of default by the borrower.
However, there are certain risks associated with advances against documents. They can
be discussed as follows.

i) Non-negotiability of the documents

Since the documents of title to goods are not negotiable instruments, the financing bank
does not become the holder in due course. Because of this, it cannot derive a better title
than the transferor himself has. If the title of the borrower to the document is defective,
the title of the bank will also be defective which will go against the principle of safety of
investments.

ii) Chances of Fraud

The document of title to goods may be a forged one or the number of packages stated in it
may be fraudulently altered. In case of a railway receipts, the consignor may give a
wrong description of goods because railway authorities do not guarantee the contents in
the bags or packages. If the bank advances loans against such railway receipt, it may have
to incur a loss. Besides unpaid, seller of the goods has a right to stop the goods in transit.

iii) Wrongful Delivery

There is always a possibility that the borrower may take the delivery of the goods from
the railway authorities on the basis of an indemnity bond if the bank does not care to
inform the proper authorities regarding its interest under the document of title to goods.

C. Precautions in Lending Against Document of Title to Goods

Because of the risks mentioned above, involved in advancing cash credits against the
documents of title to goods, the bank has to take the following precautions while granting
credits:

The bank should grant loans only to the honest, reliable and repeated customers. This will
eliminate the chances of loss on amount of dishonesty. As it is mentioned above, loans
against documents of title to goods may lead towards fraudulent activities such as:
forgery of documents, or alteration in terms of quantity and value, and stolen one.

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  In order to be on the safe side, a bank should get an
undertaking from the borrower stating that he is the lawful
holder of the concerned document of title to goods.
Besides, so as to minimize the chances of fraud, a bank
should make advances only to the original depositor of the
goods or the firs endorsees or transferees.
 In order to know the real contents of the packages, the bank
should insist on a certificate of packing issued by a reliable
packing company. In case of railway receipts, the bank may
also insist for the original invoice of the goods.
 The holder of the document of title to goods may take the
delivery of the goods on the basis of an indemnity bond. In
order to avoid such a situation, the bank should take an
undertaking from the borrower that he will not obtain
delivery on the basis of an indemnity bond.
 Some documents of title to goods are issued in more than
one copy. For instance a bill of leading is issued in
triplicate. In such a case, the bank should ask the borrower
to submit all the documents before granting the loan so that
he may not be able to get loans against the same document
again.
 The bank should not advance credits against the documents
containing some objectionable remarks about packing. The
bank should advance loans against the clean documents
only. The bank should take care that the goods covered by
the relevant documents are fully insured against various
types of risks.
 The bank should take the delivery of the document after it
is properly endorsed by the borrower in blank. The bank
should also obtain a memorandum of charge form the
borrower authorizing the former to sell the goods covered
by the document in case of default by the latter.

3.3.3. Advances Against Stock Exchange Securities

Shares and debentures, which are regularly purchased and sold in the stock exchange,
may be accepted as security by the bank. A stock exchange market is an organized

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market where securities are purchased and sold. The securities traded on the floor of a
stock exchange market include the following:

- Bonds issued by the Central and State Governments

- Securities issued by semi government authorities
- Shares and debentures issued by the companies

A. Advantages of Advances against Stock Exchange Securities

As the bank make advances against the securities mentioned above, it will enjoy the
following advantages.

i. Better than Guarantee: -Stock exchange securities provide a better security than is
provided by a contract of guarantee because securities, even though they are paper
documents, are treated as tangible assets. In case of default by the borrower, the bank can
sell the securities in the market to recover the loan.

ii. Marketability: -Stock exchange securities have a wide and a ready market. They can
be sold easily in the stock exchange market because they are on the active list of the
recognized sock exchange market.

iii. Liquidity: -Since securities are easily marketable, they are highly liquid. A bank can
get cash by selling the securities. Moreover, if a bank does not want to sell the securities,
especially the government ones, it can get accommodation by pledging them with the
National Bank of Ethiopia.

iv. Steady price: -In normal times, the fluctuation in the prices of popular stock exchange
securities are less than the changes in the prices of commodities like cotton and oils.
More particularly, the fluctuations in the prices of Governmental Securities are very
small. So, banks can readily advance loans against the security of Government securities.

v. Income: - The stock exchange securities are not idle assets. They yield income by way
of interest or dividend. The amount of income so received can be credited to the account
of the borrower to reduce his indebtedness.

vi. Convenience: - Advancing loans on the basis of stock exchange securities is

convenient in many respects. Firstly, it is easy to know the market value of the securities
because stock exchange quotations appear in very leading newspaper. Moreover, prices
can be known over the phone from the stock exchange market. Secondly, it is very easy
to ascertain the title of the borrower to the relevant securities by writing to the issuing
authority or body. Thirdly, it is easy to transfer stock exchange securities; and lastly, it is
easy to recover the loan by selling the security in the case of default.

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vii. Quick release of Security- the securities can be easily released on discharge of the
loan. The securities can again be registered in the name of the borrower without much
expenses and formalities.

B. Risks in Advancing Against Securities

The following are the demerits of stock exchange securities as security against advances

i. Forfeiture of securities: if the bank makes advance against partly paid securities and
gets them transferred in its name, it may be called upon to pay the remaining balance. If
the customer does not pay the calls, the bank will have to pay the calls to avoid the
forfeiture of securities.
ii. Non - Negotiability - The stock exchange securities are generally not negotiable
instruments. So, the bank as a pledgee cannot get a better title than that of the pleger.
However, in case of bearer securities this risk will not be there.
iii. Fluctuation in price: -The prices of certain securities, particularly shares and
debentures of companies, fluctuate widely because of many factors. A bank will suffer
loss if it does not keep sufficient margin and the price of a share or a debenture goes
down considerably. Wide fluctuating in prices of the securities make them less liquid
sometimes, because there are no purchasers and sellers of such securities in the stock
exchange market.
iv. Company's Lien: - The articles of association of most of the companies contain a
clause that the company will have a right of lien for the calls or any other amount due by
the shareholders. The securities of such companies should not be accepted as security
against loans.
v. Forged certificates: it is difficult for a bank to distinguish between a genuine share
certificate and a forged one. If the bank advances loan against a forged certificate by
mistake, it will incur a loss.

C. Precautions to be taken in Advancing Against Securities

A bank should take the following precautions while making advances against stock
exchange securities.

i. Choice of Securities: - A bank cannot advance money blindly against each and every
security because all securities are not worth accepting. A bank should continuously
examine the approved list of securities dealt with on the stock exchange market. It must
study the progress and working of various companies whose securities are dealt with on
the stock exchange market. It must study the audited balance sheets and profit and loss
accounts of various companies and the constitution of their boards of directors. On the
basis of the study, the bank should prepare a list of securities against which advance may

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be made. This list must be revised at least after every quarter. This will reduce risk of
making advances on undesirable stock exchange securities.

ii. Valuation of Securities: - If a customer offers a security against the advance which is
in the approved list of the bank, the next step is the valuation of the security. The bank
must ascertain the value of the shares and other securities with proper care. Securities
cannot generally be taken at their face value. Market value is the deciding factor in this
case. Generally, the prices of the shares are quoted cum-dividend. Bank should not rely
completely on the stock exchange quotations. It should study the economic conditions of
the country and the industry concerned. This will help to know the reasons if the price of
the security is abnormally high or low.

iii. Adequate margins: The prices of some securities fluctuate widely because of various
reasons. A bank should keep adequate margin while lending against the securities so that
it may not suffer any loss when there is a heavy fall in the price of the concerned
securities.

iv. Debentures and Preference Shares: The bank should prefer preference shares and
debentures to equity shares because the fluctuations in the prices of debentures and
preference shares are small. Similarly, fluctuations in the market prices of the
government and semi-government securities are small. So the bank may prefer them.

v. Partly paid securities: When a security or share is offered to a bank, it should examine
whether it is partly - paid or fully-paid. Bank should not take unnecessary risk of
advancing against partly - paid shares. The company may make calls against these shares
and if the customer fails in paying the calls, the shares are likely to be forfeited.
However, if the customer is highly creditworthy, the bank may advance the loan to him
against the partly - paid shares. In such a case, it is better to take an undertaking from the
customer that he would pay the call, if made by the company.

vi. Transfer of securities: If the securities are bearer and negotiable, the bank can obtain
the title by mere delivery. If the securities are registered one, the bank must get the
transfer deed signed by the borrower.

vii. Notice to company: Whenever a bank makes an advance against shares or

debentures, it must give a notice to the concerned company stating its interest in the
shares deposited with it as security. This will prevent the issue of duplicate certificate by
the company.

3.3.4. Advances against Real Estate

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By real estate we mean all types of immovable properties. These include tangible assets
like land, buildings, factory premises, etc. Such properties are not on the first hand choice
by the commercial banks while they are advancing short-term loans because they have
certain drawbacks. However, Land Development Banks and Agricultural and Industrial
Banks make advances for long periods against the mortgage of agricultural lands.

A. Advantages of Advances Against Real Estates.

Advance against real estates has some advantages such as;
- their value appreciate form time to time
- they can be easily controlled by the bank
- in Ethiopian case they have a definite body to register and control.
B. Difficulties Associated with Real Estates
There are many drawbacks or difficulties in accepting real estates as collateral securities.
They can be discussed as follows.

Customers Title: - This is the major difficulty while advancing loans against real estate.
It is very difficult to find out the borrower's interest in the property. The property offered
as security may be a disputed one.
Valuation: - Valuation of property is another important problem. Expert valuers have to
be employed to fix the value of the property. Again the value of the property is subject to
heavy fluctuation because it depends upon many factors like location, development of the
region, political situation, etc.
Expensive: - When a bank decides to advance money against immovable property, it
must ask for a legal mortgage. But legal mortgage is both expensive and inconvenient.
The customer has to incur the whole of expenditure on execution of legal mortgage,
which will put an additional burden upon him.
Maintenance: when a customer makes default in repaying the loan, the bank has to
recover the loan by selling the mortgaged property. Prior to it or if there is no buyer to
the property, the bank has to look after the maintenance of the property as the possession
rests with it. It has to find out suitable tenants, collect rent and incur expenditure on
repairs, which will create inconvenience for the bank.
Loss of Liquidity: Borrowers require loans for long periods against the security of
immovable properties. But commercial banks cannot afford to lend for long periods
because this will effect their liquidity position adversely. Moreover, in case of default by
the borrower, the immovable properties cannot be disposed of easily in the market, as it is
very difficult to find a suitable purchaser. This leads the bank to shortage of liquidity and
lock up their short-term funds in such assets.

C. Precautions in Advancing against Real Estates.

If a bank decides to grant advances against the security of immovable properties, it
should take the following precautions:

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i) Title verification: The bank should verify the title of the customer. It is necessary to
know whether the customer enjoys a good title to the property or not. The fact that the
borrower is in possession of the property and has documents of title relating to it does not
mean that he is the undisputed owner of the property. The bank should carefully examine
the deed through its solicitors to know its genuiness. The bank should advance loan to
the customer if it is found that he has absolute right to the property.

ii) Non-encumbrance certificate: - Though second and third mortgages can be created
against the same property, a bank should always secure a first charge on the property and
take possession of the relevant title deeds. This is because, if the bank advance loans at a
second and third degree mortgage, and if the borrower fail to pay, this bank can claim his
balance only offer the first and second mortgagers. For this purpose, the bank should
obtain a non-encumbrance certificate from the right office that administers the property.

iii) Leasehold property: - If the property happens to be a leasehold property, the bank
should examine the terms of the lease and unexposed portion of the lease deed. The bank
should also ensure that no notice is served by the government for the acquisition of such
property.

iv) Expert valuation: The bank should use an expert valuation to the value of the
mortgage property. The expert value must take into account various factors while
computing the value of the property.

v). Adequate Margin: - A bank should keep sufficient margin while lending against the
real estate.

vi). Legal mortgage: A bank should obtain the legal mortgage of the property from the
borrower and the mortgage deed must be registered.

vii) Insurance: - If the real estate includes building, factory premises, etc, it must be fully
insured against fire and other calamities and the policy should be assigned in favour of
the bank.

3.3.5 Advances against Supply Bills

Supply bills are those bills, which arise out of goods supplied to or contracts undertaken
for government or semi-government department or undertaking by other industrial
enterprises. Such bills are not treated as negotiable instruments as they don't possess all
the characteristics of a bill of exchange. However, banks are prepared to offer advances
for short periods against the supply bills. Such advances are known as clean advances.

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In case of advance against supply bills, the borrower assigns the debt arising under the
supply bill to the bank. The bank undertakes a great risk as the amount claimed by the
supplier from the debtor may be reduced or the payment refused on the ground of defect
in the goods supplied or a discrepancy in past supplies. The debtor sometimes may pay
the amount of the bill direct to the creditor or may set off the bill amount against the
previous debt.

A. Advantages of advances against supply bills.

Advancing loans against supply bills enjoys some advantages such as:
- the bill can be transferred to other persons before maturity date, if need arises
- if it is collected from a reliable customer, it serves as a good source of income to
the banker
- it helps to develop good relationship with a reliable customer
However, the disadvantages outweigh the advantages of advances against supply bills.

B. Disadvantages of advances against supply bills

Advances against supply bills invites lots of disadvantages to the banker than its
advantages. The following are some of the disadvantages of advances against supply
bills.
- the supply bill is not equivalent to a bill of exchange, hence it cannot be
negotiated
- the document presented may not be reliable
- it is difficult to get reliable customer
- payment may be delayed due to lack of timely payment by the buyer
- it is difficult to determine the amount if the transaction
Therefore, the banker should take the following precautions

C. Precautions in Advancing Against supply Bills

Before advancing against supply bills, the financing banker should take the following
precautions

- It should be allowed to those borrowers only who are honest and have good
standing as advance against these documents is a clean advance.
- The supply bill or invoice should be supported by the inspection report or a
passing certificate, which certifies that the goods are in accordance with the terms
of the contract. The invoice should clearly show the particulars received, if any.
It should also show the particulars of railway receipt or the lorry receipt under
which the goods have been sent directly to the purchaser. When the goods have
been delivered personally to the purchaser, the purchaser should duly sign the
delivery note.

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 - The inspection report, must be signed and dated by the purchaser or his authorized
representative
- Every dispatch should be supported by a firm order. If the goods are sent on
consignment and the purchaser is not in need of the goods, there is likelihood of
delay in payment or of the chances of the goods being rejected.
- To have an idea of the amount and size of the transaction, the original contract,
which authorizes the supplier to supply goods should be carefully examined.
- The bill/invoice and the delivery note or the inspection report should be of a very
recent date, i.e. not more than 8-10 days should have elapsed from the time of
presentation. The date of dispatch/supply of goods must be very recent one
- Each bill/invoice should be impressed with the rubber stamp and should be signed
by the supplier or his authorized representative on appropriate revenue stamp.
- To avoid direct payment by the debtor to the supplier, the bank should get an
irrevocable power of attorney executed by the borrower in favour of the bank
authorizing it to collect the relative supply bills.
- Adequate margin should be maintained. Due regard must be given to the integrity
of borrower, the nature of the transaction and the nature of the bills i.e. interim
bills or final bills

3.3.6 Advancing Against Life Insurance Policies

A life insurance policy is a contract between the insured and the insurance company
under which the company, in consideration of premium to be paid, undertakes to pay the
specified amount of money after the expiry of ascertain period or on the occurrence of the
death of the insured.

Insurance companies may undertake this business. However, if the borrower wants to
take loan from a bank, the borrower will follow a cumbersome procedure. He will file a
"deed of assignment" with the bank along with the actual policy and give an undertaking
to the bank or the repayment of principal and interest.

A. Advantages of Advances Against Life Insurance Policies as Security

As banks make advance against the security of life insurance policies, the following are
the merits associated with such securities

- The value of the policies can be ascertained easily on the back of the life
insurance corporation
- The policy can be legally assigned to the bank and such assignment is daily
registered by the Life Insurance Corporation. So there is no risk in loan
advancing against life policies.

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 - The value of a life insurance policy goes on increasing as the time lapses if the
premium is paid regularly.
- At the time the borrower become insolvent, the official assignee or receiver
cannot claim the policy without satisfying the claims of the bank.
- The bank can further assign the policy assigned in its favour to a third party as
security for an advance.
- In case the borrower makes a default in repayment of loan, the bank can surrender
the policy to the Life Insurance Corporation and get cash easily.

B. Disadvantages of Advancing Against Life Insurance Policies as Security

Advancing loans against life insurance policies creates the following disadvantages.

- Insurance is a contract of utmost good faith. The person who is insured must
disclose all the material facts to the insurer. If the insured fail to disclose these
facts, the contract will becomes valid and nothing becomes payable under the
policy. This may lead the bank to take risk of uncollectability.
- Cases of suicide are usually not covered by insurance policy. The bank will lose
if the policy contains such a clause and the borrower commits suicide.
- If a policy has been taken by a third person, it may become valid in the absence of
an insurable interest.
- If the age of the insured is not admitted by the life insurance corporation, it will
become difficult for the bank to prove the same in the event of his death.

C. Precautions in Advancing against Life Insurance Policies

- The bank should verify whether the policyholder has an insurable interest in the
life of the assured.
- The bank should see that the age of the assured has been duly admitted and must
obtain a copy of the proof of such admission.
- The bank should prefer an endowment policy to a whole life policy endowment
policy is payable after the expiry period or on the death of the party if it occurs
earlier.
- The bank should go through the various clauses of the life policy with a view to
ascertain its own rights and liabilities. It should ensure that the policy is free from
all restrictions and conditions on assignment. It should also see if the policy
contains the suicide clause.
- The bank should ask for a legal assignment of the policy. There should be a
provision for the reassignment of the policy after the loan is repaid. The bank
should ensure that there is no previous assignment. It should ask the borrower to
give a letter to that effect.

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 - The bank should maintain sufficient margin while granting advances on the
surrender value of the life policy. There is always the fear that the borrower may
not pay the premium in future and policy will elapse and the surrender value in
such a case will be paid only after the expiry of a certain period or after the death
of the assured. While granting loan, the bank must know the surrender value of
the property and to be on the safe side, it should hold sufficient margin.

3.3.7 Advances against Fixed Deposit Receipts

When a person deposits his surplus money with the bank for a specified period, he is
issued a fixed deposit receipt by the bank. This receipt acknowledges the receipt of the
amount specified therein to be paid at the expiry of the period mentioned therein along
with interest at a specific rate per annum.

The essence of a fixed deposit account is that the amount can not be withdrawn before the
expiry of the period specified in the fixed deposit receipt. But some limes, a person is in
urgent need of money before the due date of fixed deposit. In such a case the customer
may have two options.
- Premature withdrawal of the deposit by forego the interest accrued in the deposit
- Getting loan against the security of his fixed deposit receipt.
The second option is favorable to both the bank and the customer. The bank will gain by
charging a higher interest rate than allowed on deposit and the depositor will gain by
retaining the interest accrued which he would have otherwise lost.

Precautions while granting loans against fixed deposit receipts

A bank should bear in mind the following precautions while granting advance against
fixed deposit receipt.

 The bank should advance loan on fixed deposit receipt

issued by itself as another bank as the issuing bank may
have charge over such deposit and may not register the lien
of another bank
 The bank should generally grant the loan to the person in
whose name fixed deposit receipt stands. In case the
deposit is in the name of a third party, the bank should get
the authority from the owner of the receipt and should get
the receipt duly discharged.
 The fixed deposit receipts must be duly discharged in all
the cases because it is not negotiable and not transferable.

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  If the fixed deposit receipt has been issued in the joint
names of two or more persons and the loan is desired by
any of them, the bank must get the authority letter signed
by all of them before advancing the loan. All the
depositors must also sign across a revenue stamp on the
deposit receipt to discharge it. They should also sign a
memorandum of pledge.
 The bank should discourage the loan to a minor against the
fixed deposits to avoid legal complications in the future.
 If the loan is not paid on the due date, and the fixed deposit
receipt has matured, the bank will adjust the amount of loan
against the principal amount and interest of fixed deposit
and will refund the surplus, if any, to the party concerned.

3.4 Creating Charges on Securities

Lending is an important function of commercial banks. While lending a bank has to keep
three important principles in mind, viz, liquidity, profitability and safety. In order to
make a safe investment in loans and advances, banks usually insist upon security of some
tangible assets. The various types of tangible assets on the security of which banks lend
have already been discussed in the previous section of this chapter. But a security of
tangible assets is of no use unless it is properly charge in favour of the bank. A bank can
register with the appropriate authoritative, whenever required, otherwise the bank may
jeopardize its priority therein.

3.4.1. Types of Charge

When a charge is created in favour of a bank, it confers a right on the bank over some
tangible assets of the borrower. A charge may be either a fixed charge or a floating
charge.

A fixed charge is one, which attaches to specific immovable properties such as land,
building, factory premises, plant, machinery, etc. It is a specific charge on the assets
mentioned in the registration deed. Since it is a charge on specific assets, it is also called
a crystallized charge. The borrower is prohibited from dealing with the assets so charged
in the ordinary course of business.

A floating charge is a charge on the assets, which are constantly changing, such as stock,
work-in-progress, etc. The borrower can deal with the assets in the ordinary course of
business until the floating charge is crystallized or becomes fixed on the happening of an
event. The floating charge does not relate to any specific assets and the borrower can deal

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with the assets and dispose them of in the normal course of business. A floating charge
has the following characteristics.
 It is a charge on the assets, present or future.
 It is created on the assets, which are changing from time to
time in the ordinary course of business, e.g. stock.
 The borrower can continue to deal with the assets charged
in the normal course of business until some steps are taken
by the bank to enforce the charge.

The floating charge becomes the fixed charge when the borrower makes default in
repayment of the debt and the bank intervenes to take possession of the assets to dispose
them of for the recovery of the debt.

3.4.2. Registration of Charge

Banks usually make advances to different types of borrowers against different types of
securities, both movable and immovable. If an advance is made against the legal
mortgage of immovable property, the charge must be registered with the registrar (the
authority) with in the prescribed time limit. If this is not done, the bank may be placed at
a loss because an equitable mortgage will have priority over the legal mortgage.

3.4.3 Modes of Creating charge on Securities

The various modes of creating charge on securities are as follows
Lien
Pledge
Mortgage, and
Hypothecation

Each of these types of charge has different legal implications. Rights and obligations of
the parties under each of these modes of creating charge are discussed as follows.

3.4.3.1 Lien
Lien is the right of a creditor to hold possession of the goods of the debtor till he
discharges his debt. Right of lien entitles the creditor to retain the security or goods
belonging to the debtor till the payment of debt. Lien can be either general lien or a
particular lien.

General lien entitles the creditor in possession to retain the good till all his claims against
the owner of the goods have been met. This is applicable in respect of all amounts due
from the debtor to the creditor. But a particular lien is a specific lien, which confers a
right to retain those goods for which the amount is to be paid. These types of lien have

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been discussed in detail in part I of this course under chapter two in the title "Banker and
Customer Relationship'.

3.4.3.2 Pledge
Pledge is the bailment of movable property to secure the payment of a debt or the
performance of a promise. The person who offers the security is called the pledger or
pawner and the creditor or the person who accepts the security is called the pledgee or
pawnee.

Pledge is a special kind of bailment means that delivery of goods by one person to
another for some purpose, upon a contract that they shall. When the purpose is
accomplished, be returned or otherwise disposed of according to the directions of the
person delivering them. The person who delivers the goods is called the 'bailor' and the
person to when the goods are delivered is called the 'bailee'. Bailment may be made for
any purpose like repair, storing, security, etc. But pledge is made only for a specific
purpose, i.e., as security for payment of a debt or performance of a promise. Thus,
pledge is a kind of bailment having the following essential elements.

The pledger must deliver goods to the pledgee. The delivery to the pledgee may be
actual or constructive. Delivery of the key to the warehouse where the pledged goods are
stored is a constructive delivery and is sufficient to create a pledge. A pledge involves a
transfer of possession of the goods pledged and not of title. The ownership of the title of
the goods pledged remains with the pledger.
Pledge can be made only of movable properties. Money cannot be pledged.
A contract of pledge must be supported by a valid consideration. The goods should be
offered as security for the payment of a debt or the performance of promise.

Difference between pledge and Lien

The following are the points of difference between a pledge and a lien.
1. Pledge is always created by a contract, whereas no contract is necessary
for a right of lien. In most of the cases, lien is created by law.
2. In case of a lien, the party in possession of the goods does not have in
general any right to sell the goods. In case of pledge, the creditor or the
pledgee has a right to sell the goods in his possession on the default by the
debtor. However, in both cases the possession of the goods is transferred
to the creditor.

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 3. Right of lien is lost with the loss of the possession of the goods. But
pledge is not necessarily terminated by return of goods to the owner. The
goods pledged may be redelivered to the pledger for a limited purpose.
4. Lien is purely a passive right. Lien-holder can only hold the goods till the
payment is made. Lien holder cannot enforce its claim through a court of
law, but a pledgee enjoys the right to sue, right of sale.

Who can Pledge the Goods

Generally pledge can be made by a person who is the real owner of the goods. But in the
following cases the non-owners of the goods can also make a valid pledge.

1. Pledge by a mercantile agent.

Pledge by a mercantile agent which is not authorized by the owner of the goods, will be
valid if the following conditions are fulfilled.
a. The mercantile agent is in possession of the goods or documents
of title to goods with the consent of the owner.
b. The mercantile agent acts in the ordinary course of business
while making the pledge; and
c. The pledgee has no notice of the fact that pledger has no authority to pledge and
he acts in good faith.

2. Pledge by a person in possession under Voidable contract

When the pledger has obtained possession of the goods pledged by him under a contract
voidable but the contract has not been rescinded at the time of pledge, the pledgee
acquires a good title to the goods provided he acts in good faith and without notice of
pledger's defect of title. Where goods are obtained by theft, a pledge by a thief will not
be valid and the pledgee in this case will acquire no lien over the goods

3. Pledge where the pledger has only a limited interest

When a pawner or pledge has only a limited interest in the movable goods, the pledge can
be valid only to the extent of that interest. Thus, where a person has only a mortgage's
interest or a mere lien, and he pledges the goods, the pledge will be valid only to the
extent of that interest.

4. Pledge by a co-owner in possession

When there are several co-owners of the goods and the goods are in the sole possession
of one of the co-owners with the consent of other co-owners, such a co-owner can make
valid pledge of the goods.

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5. Pledge by seller or buyer in possession after sale
A seller who has got possession of the goods even after sale can make a valid pledge
provided the Pawnee or the pledgee acts in good faith. Similarly, if the buyer obtains
possession of goods with the consent of the seller before payment of price and pledges
them, the pledgee will get good title provided he does not have the notice of seller's right
of lien or any right.

Rights and Duties of Banker as Pledgee

The rights of a banker as a pledgee can be discussed as follows
1. Right of retainer: - The pledgee has a right to retain possession of the goods
pledged with him till he is paid not only the debt but also interest thereon, and all
expenses incurred in respect of the possession or the preservation of the goods
pledged.
2. Right of particular lien: - A pledgee cannot retain the goods for any debt other
than that for which the pledge was made. But in the absence of any thing to the
contrary, he can retain the goods pledged for the subsequent advances. This right
does not extend to any previous debt to the pledgee
3. Right to extra - ordinary expenses: - The pledgee or Pawnee is in titled to recover
from the pledger or pawner extra-ordinary expenses incurred by him for the
preservation of the goods pledged. But he has no right of lien for extra - ordinary
expenses. He can only sue to recover them.
4. Right in case of default of the pledger: - When a pledger makes default in making
payment of the debt or performance of the promise at the stipulated time, the law
provides the following right to the pledgee:
a) The pledgee has a right to being a suit against the pawner upon the debt or
promise and may retain the goods pledged as a collateral security, or
b) He has a right to sell the goods pledged after giving reasonable notice of
sale to the pawnor

But in case the sale proceeds are less than the amount due, the pledger continues to be
liable to pay the balance. If the sale proceeds are greater than the amount due, the surplus
will have to be returned to the pledger.

The duties of a banker as a pledgee can be discussed as follows

- A pledgee is under a duty to take reasonable care of the goods pledged with him
as a man of ordinary prudence would under similar circumstance take care of his
own goods of the same balk, quality and value of the goods bailed.
- The pledgee is bound to return or deliver the goods pledged on the payment of
debt or performance of the promise. If it does not do so, he will be responsible to
the pledger for any loss, destruction or deterioration of the goods from that time.

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 - The pledge is not permitted to use the goods pledged and if he does so, he will be
responsible for damages for any loss caused due to such use.
- The pledge is bound to deliver to the pledger or anyone whom he directs, any
increase or project, which may have accrued from the goods pledged in the
absence of any agreement to the contrary.

3.4.3.3 Mortgage
A borrower may offer immovable property as security for a loan to be granted by the
creditor or banker. When a borrower offers his immovable property like building, land,
factory premises, etc., for a loan, a charge there on is created by means of a mortgage.

Mortgage is defined as "the transfer of an interest in the specific immovable property of

the purpose of securing the payment of money advanced or to be advanced by way of
loan, an existing or future debt or the performance of an agreement which may give rise
to the pecuniary liability." Mortgage is a type of contract. The borrower is called the
mortgagor and the lender or the person with whom the property is mortgaged is known as
mortagee. The document, which specifies the terms of the mortgage, is called the
mortgage deed.

Essential Features of a Mortgage

The essential features of a mortgage are as follows

1. There must be a transfer of interest in an immovable property. Transfer of

interest in the property means that the owner (mortgagor) transfers some of his
rights to the mortgagee and the owner is still retaining some rights, e.g., a
mortgagor retains the right of redemption in the mortgaged property. Thus,
mortgage differs from sale under which the ownership (i.e., all the rights) of the
property is transferred.
2. The immovable property intended for mortgage must be a specific one, i.e., it can
be clearly identified and described.
3. Mortgage of property must be supported by a lawful consideration. The
consideration may be either money advanced or to be advanced by way of a loan
or the performance of a contract. But a transfer for the discharge of a debt is not a
mortgage.

B. Difference between mortgage and pledge

The main difference between a mortgage and a pledge is that:
1. In case of a pledge, the possession is transferred to the creditor, while it remains
with the mortgagor in case of a mortgage unless otherwise stated in the mortgage
deed.

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 2. Delivery of possession is essential in a pledge, but the pledge has only special
interest in the property and the general interest remains with the pledger.
3. Goods must be movable in case of a pledge, but mortgage is possible only in the
case of specific immovable property.
4. A mortgage has the right of foreclosure in certain cases, which is not available to
the pledgee in any case.

Types of Mortgage
There are six types of mortgage given in the transfer of property. They are:

i) Simple Mortgage: - Under a simple mortgage, the mortgagor undertakes to bind

himself personally to pay the mortgage amount and does not hand over the possession of
the mortgaged property to the mortgage. He, however, agrees either expressly or
impliedly that in the event of his failure to pay the debt according to the terms of the
contract, the mortgage shall have the right to cause the property to be sold and to apply
the sale proceeds towards the discharge of the debt. Thus, the mortgagor is not himself
authorized to sell the property; he has to apply to the court for leave to sell the mortgaged
property.

For example, Mr. A advances Br. 10,000.00 to Mr. B on a simple mortgage, B defaults
repayment. A can sue for the sale of the property. Suppose that A gets only Br. 8,000.
00. A can sue B again for the balance amount of Br 2,000.00.

ii) Mortgage by conditional sale

As the name implies, the mortgagor ostensibly sells the mortgaged property to the
mortgage with any one of the following conditions:
the sale to shall become absolute on the default of payment of the mortgage debt on a
certain date, or
the sale shall become void if the payment is made on the stipulated
the buyer shall retransfer the property to the seller if he repays the mortgage debt on the
stipulated date.
In this type of mortgage, the sale is seemingly true and not real. Such a sale will become
absolute only if the mortgage debt is not repaid by a certain date and the mortgage gets a
decree from a court. The mortgagee can apply to the court for foreclosure of the
mortgage and not for sale. Foreclosure means the loss of the right possessed by the
mortgagor to redeem the mortgaged property. Banks usually do not prefer this type of
mortgage because there is no personal legal commitment for the repayment of debt.

iii) Usufructury Mortgage

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Under usufructury mortgage, the mortgagor who delivers the possession expressly or by
implication binds himself to deliver possession of the mortgaged property to be mortgage
to:
a) retain such possession until payment of the mortgage money,
b) receive the rents and profits according from the property or any part of such rents
and profits, and
c) appropriate the same in lien of interest or in payment of the mortgage money, or
partly in lien of interest and partly in payment of the mortgage money.

Thus, in the case of usufructuary mortgage, the mortgagor delivers possession of the
mortgaged property and the mortgagor is entitled to recover possession. When he pay
back the debt or when the debt is discharged by rent and profits received.

In the absence of a contract to the contrary, a usufructuary mortgage is entitled to enjoy

the property till the debt is discharged by appropriation of rents and profits towards the
amount due, or till the debt is paid by the mortgagor personally. However, where a time
limit is fixed by agreement, the mortgage may enjoy the property only during that period
during which the loan may be taken to have liquidated. There is no personal liability on
the mortgagor, and the mortgagee can neither sue for foreclosure nor for sale. Because of
this bankers do not like this type of mortgage as the mortgagee is not personally legally
committed.

iv. English mortgage

It is a transaction in which the mortgagor binds himself to repay the mortgage money on
a certain date and transfers the mortgaged property absolutely to the mortgage, but
subject to the provision that he will re-transfer it to the migratory upon payment of the
mortgage money as agreed.

It differs from a mortgage by conditional sale in respect of the following points:

a) It provides for a personal commitment to pay the mortgage money on a specified
date which is not the case with the mortgage by conditional sale.
b) Here, there is an absolute sale, which is subject to a provision that the property
shall be reconvened to the mortgager in the event of repayment of the mortgage
money. But in a mortgage by conditional sale, the sale becomes complete only on
the default committed by the mortgagor on the predetermined date.

v. Equitable Mortgage
When a person delivers to a creditor or his agent, documents of title to immovable
property, with the intention to create a security thereon, the transaction is called a
mortgage by deposit of title deeds."

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vi. Anomalous mortgage
It is a mortgage, which is not a simple mortgage, a mortgage by conditional sale, an
usufructuray mortgage, an English mortgage or a mortgage by deposit of little deeds.
Thus, an anomalous mortgage is a mortgage other than those discussed earlier. It
includes the customary mortgage under which the rights and liabilities of the parties are
determined by the local custom or by the contract between them.

D. Legal Mortgage Vs Equitable Mortgage

i. Legal Mortgage

It is one in which the mortgagor transfers his legal title in respect of the mortgaged
property to the mortgagee. The transfer of title can be effected only by a registered
instrument, if the mortgage money is equal to or more than a specific amount stated in the
law. When the mortgage money is paid, the title in the property is transferred back to the
mortgagor.

ii. Equitable Mortgage

In this case, the mortgagor delivers documents of title to the immovable property to the
mortgage with the intention to create a security thereon. Here, the mortgagor undertakes
through or memorandum of deposit to execute a legal mortgage in case of default by him
in the payment of mortgage money. Thus, legal title is not transferred to the mortgagee at
the time of the contract.

An equitable mortgage has the following advantages over the legal mortgage:

1. No registered deed is required to evidence the transaction under equitable mortgage,

which is a must in case of a legal mortgage. Thus, the borrower saves the stamp duty on
the mortgage deed, the registration charges and his time, which would have been wasted
in these formalities.
2. Equitable mortgage is not to be registered, so it can be created with out much publicity
and this will not affect the reputation of the debtor.
3. Equitable mortgage takes less time as compared to a legal mortgage. The transfer has
to be executed and registered under a legal mortgage, but an equitable mortgage can be
created without much delay. Thus, the borrower can secure advance quickly in the case
of an equitable mortgage.
4. In case of repayment of mortgage debt, the title deeds are returned to the mortgagor
who can redeposit the same for raising the new loan. But in case of a legal mortgage, a
new deed and registration is required every time.
5. Equitable mortgage stands on the same footing as legal mortgage and the mortgage is
entitled to the same right as conferred in case of a simple mortgage.

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Though equitable mortgage has the above-mentioned advantages, it has certain
disadvantages also due to which legal mortgage is preferred by the banks. The
drawbacks of the equitable mortgage have been discussed as follows.

1. If the debtor makes default, the mortgage under the equitable mortgage has to obtain a
decree for the sale of the property for the court, which is very expensive and time
consuming. But in case of a legal mortgage, the creditor or the mortgagee makes default
in making the payment.
2. Incase of an equitable mortgage, the creditors right over the property may
be defeated by a prior equitable mortgage or a subsequent legal mortgage.
The reason is that the right of a mortgage is determined by the two
principles, namely,
a. as between equity and law, law prevails, and
b. when equities are equal, the first in time will prevail

Thus, it is obvious that equitable mortgage is a weaker security as compared to a legal

mortgage. The equitable mortgagor may resort to legal mortgage with out the knowledge
of the first mortgagee or the banker. Sot he banker should be very careful in accepting an
equitable mortgage.

The legal mortgage is superior to the equitable mortgage because the mortgage is
registered in the name of the banker. in case of de.... of the mortgagor, the bank can sell
the property and realize the mortgage money. But in case of an equitable mortgage, the
bank will have to obtain a decree from the court for selling the mortgaged property.

E. Right of the Mortgagee or Banker

The mortgagee who may be a banker or any other creditor has the following rights
against the mortgagor.

1. Foreclosure of Mortgage: refer the detail under the title mortgage by conditional
sale
2. Suit for Mortgage Money: The mortgage has a right to sue for the mortgage money,
where;
a. the mortgagor has undertaken personally to pay the amount as incase of a simple
mortgage.
b. the mortgaged property has been destroyed, completely or
partially; and the security has become insufficient.
c. the mortgagor is not given the peaceful possession of the
mortgaged property to the mortgagee to which the latter is
entitled under the mortgage

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 d. the mortgagee is depicted of the whole or part of his security,
whether property or title deeds, due to the fault of the mortgagor
3. Sale of Property:- The mortgagee has the right to sell the property in the event of fault
by the mortgagor in the following cases:
where the mortgage is an English mortgage; and
where the right of sale to the mortgagee is given expressly by the mortgage deed

The right of sale is to be exercised after giving a written notice to the mortgagor asking
win to pay the mortgage money within forty five days of the service of the notice and
warning him that in case of default, the property would be sold. The amount so realized
can be adjusted in the payment of all costs incurred judiciously to sell the property and to
discharge the mortgage money and interest, if any. The balance amount, if any, would be
paid to the mortgagor. In case of simple mortgage, the mortgagee has to take the
permission of the court to sell the mortgaged property.

4. Possession:- A legal mortgagee can also take possession of the mortgaged property in
the event of default by the borrower. He can retain the possession (particularly in the
case of usufrctuary mortgage) until his debt is discharged out of the income from the
property. Where the mortgagor does not give the peaceful possession of the property, the
mortgagee may apply to the court for his eviction
5. Accession to mortgaged property: - In the absence of a contract to the contrary, the
mortgagee has the right to hold for the purpose of security any accession to the
mortgaged property which occurs after the date of the mortgage.

3.4.3.5 Hypothecation
Hypothecation is a mode of securing a loan by creating a charge on movable goods
without the surrender of possession or ownership. It may be described as a transaction
where by money is borrowed by the debtor on the security of the movable property
without transferring either the ownership or the possession to the creditor. Here, the
borrower continues to be the owner of the property by hypothecation as in the case of
pledge. But the possession is not transferred to the creditor or lender.

In hypothecation, the charge created is equitable. Under this arrangement, the movable
property remains in the possession of the borrower who undertakes to give the possession
to the creditor when the latter requires him to do so.

Thus, charge of hypothecation can be converted into a pledge by the lender at any time.
In such a case, the lender will enjoy all the rights of a pledgee.

Hypothecation is a device to create a charge over movable property and is the most
suitable arrangement in circumstance where the transfer of possession of the goods is

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either inconvenient or impracticable. For instance, when an industrialist provides the
security of raw materials or work in progress for a loan, transfer of possession will
hamper the production. This difficulty can be removed by hypothecating the assets with
the bank. This will enable the borrower to utilize the raw materials or work - in -
progress in the ordinary course of his business. Banks also lend against hypothecation of
automobiles. This enables the borrower to use the vehicle and earn money. Thus,
hypothecation is a floating charge on the borrower's assets, present and future. It is
crystallized when the borrower makes default in making the payment and the lender takes
steps to enforce his security.

Differences between Hypothecation and Pledge

Both in hypothecation and pledge, movable property is given by way of security for the
payment of the loan. But in case of hypothecation, the possession of the goods is not
transferred to the creditor. The debtor continues to enjoy the possession of the goods
with out obtaining a decree of the court.

Risks of Hypothecation
The facility of hypothecation is granted to honest persons only because the goods remain
in the possession of the borrower. If this facility is extended to unscrupulous persons (not
honest), the bank may suffer from the following risks.

There is no effective control of the creditor over the goods, as they remain in the
custody of the borrower
The borrower may sell the goods hypothecated and pay for other creditors
The borrower may hypothecate the same property with the other bank or may pledge it
with some other person.
The borrower may not deliver the hypothecated goods when he is required to do so by the
bank. The bank may have to go the court of law to enforce its charge over the assets.

Precautions to be Taken by the Bank in case of Hypothecation

In view of the risks involved in the creation of charge by hypothecation, a bank should
take the following precautions:
1. The bank should grant such advances to persons of unquestionable integrity and
business morality.
2. It should ensure that the goods have not been hypothecated earlier with anybody.
It must take an undertaking to this effect from the borrower.
3. The bank must make periodical inspection of the goods hypothecated by some
responsible officer
4. The bank must ask the borrower to display a board stating that the goods are
hypothecated with it

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 5. The goods covered by this arrangement must be insured against fire and other
risks
6. The bank must ask the borrower to submit periodical statements of stock and give
its valuation
7. In case of an advance to a joint stock company, the bank's charge under
hypothecation must be registered with the registrar office
While making an advance against hypothecation of movable property, the bank must
obtain a letter of Hypothecation, which serves as the hypothecation agreement and
contains several classes to protect the banks interest. The letter of hypothecation should
be examined by the legal experts of the bank to ensure that it does not contain any
loophole, which may have the effect of declare free from blame, the debtor even in case
of default made by him.

3.4.5 Other Types of Securities

1. Residential or Commercial Buildings

It may be own or third party’s property. Third party’s mortgage calls for signature of both
husband and wife. The following additional documents are necessary in this regard.
- Land holding certificate and building estimate
- Mortgage contract to be registered at the municipality
- Registration of contract is valid for 10 years but may be renewed thereafter by
joint application of both bank and mortgagor.
- Keep land holding certificate and contract in custody.
2. Chattel Mortgage or vehicles.
Use the following procedure to hold chattel mortgage or vehicles as collateral.
- Verify type, model, year or make, chassis and engine number and plate number.
- Obtain estimation of vehicle from a reliable garage. For new vehicles the
proforma invoice is adequate
- Register contract at motor vehicle registration department at the ministry of
transport and communication.
3. Foreign Bank guarantee
Banks grant loans to their customers against bank guarantees. The bank guarantee may be
given by a local bank or a foreign bank. If this guarantee is given by foreign banks, the
bank which grants credit to facilitate the trade should verify the following facts.
- genuineness of the guarantee
- approval by authority of exchange controlling bank if it is a requirement
- currency to be expressed in birr
- the safety margin provided
- safety of its custody.
4. Blocking of Deposit Account

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Bank loans may be granted against blocking of deposit accounts. As the bank grants
loans against these blocked deposit accounts, the following facts must be considered.
- Segregate the blocked amount from other balances not to make a withdrawal
payment
- Ascertain that sufficient amount is blocked for the loan granted.
5. Life Insurance Policy at surrender value
Bank loans may also be granted against life insurance policy at surrender value. As the
banker does so the following facts must be considered.
- Conform cash surrender value with the insurance company
- The policy should be free from policy loan or any other assignment
- Obtain the right to surrender the policy for its cash value
- Obtain the right for a policy loan
- Obtain the right to receive policy dividends, if any
- Obtain the right to receive death and maturity claim (but not disability claim)
proceeds in priority to the beneficiary.
6. Merchandise acceptable as security
Merchandise items accepted as security against bank loans may be export commodities or
import or local products. As commodities accepted as securities, either the product
physically or the documents which entitle ownership may be possessed. Physical
possession of the commodities may be made either by the sole control of the bank or dual
control by Bank and Borrower. Whereas the documentary possession of commodities
include possession of ownership title documents such as Trust receipts, railway receipt or
truck way bills; and submission of stock list (state enterprise only). As commodities
accepted as security, the following steps must be observed:
- Documents must be endorsed in favor of the bank
- Documents must be handed to bank by the borrower
7. Business mortgage
Business mortgage may include tangible assets as machinery and equipment and
intangible assets as goodwill and trade mark. Registration of properties must be made at
the concerned office.
8. Letter of undertaking from a state enterprise, co-operative or association.
9. Personal guarantee
Sometimes loans are granted against personal guarantees. As bankers grant loans against
personal guarantees, the background of the person who act as a guarantee must be
analyzed.
10. Treasury Bills and Insurance bonds
Bank loans are granted against treasury bills and insurance bonds. The banker must
investigate the contents of such documents as it extends loans to customers.
There are three ways in which a banker may take security for an advance. In each case
the banker does not become absolute owner of the property, but has the rights over the
property until the debt due to the bank is repaid. They are lien, pledge or mortgage.

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After evaluation of the financial analysis, the collateral granted, the safety of the bank
and the character of the borrower, the decision is left for the staff concerned as whether to
approve/recommend or disapprove the request of the applicant. In doing so, the following
things need to be determined.
- the amount compared with facts in the commercial credit report and financial
statement.
- the ability to repay/income against the proposed repayment.
- major economic role of the product or activity the applicant is engaged
- summarize investigation
- compile all information in the commercial credit report and loan approval form
and forward for approval.

Check Your Progress Questions

1. Define the word security

________________________________________________________________________
____________________________________________________________________
2. List and explain the different types of securities
________________________________________________________________________
____________________________________________________________________
3. State the precautions to be taken in advancing against goods
________________________________________________________________________
____________________________________________________________________
4. List and explain the titles of goods used as a security
________________________________________________________________________
____________________________________________________________________
5. What is a chattel mortgage?
________________________________________________________________________
____________________________________________________________________
6. List down the drawbacks of stock exchange securities offered against advances.
________________________________________________________________________
________________________________________________________________________

3.5 SUMMARY

Loans are money granted by creditor to a debtor to be paid in a future fixed period with
an interest. Loans are assets to the creditor and liabilities to the debtor. They may be
granted for long term or short term, with or without collateral, payable at ones or at
intervals and for different purposes.

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Advancing loans is one of the main functions of a bank. Banks accept deposits to create
credits or loans. However, the bank advances loans not to all applicants. As such, the
banker should take the necessary precaution about at least the following issues such as:
about the bank itself, about the project, about the customer and about the collateral
offered.

Different types of securities can be offered to secure loans granted by the banker such as:
goods, documents of title of goods, stock exchange securities, real estates, life insurance
policies and fixed deposit receipts. All forms of securities have their own advantage and
disadvantages.

3.6 Answer to Check Your Progress Exercise

1. Refer section 3.2

2. Refer section 3.3
3. Refer section 3.1 (c)
4. Refer section 3.2
5. Refer sub-section 3.4.5 (2)
6. Refer sub-section 3.3.3 (B)

Unit 4: contracts, Guarantees and Law of Suretyship

Contents
4.0 Aims and Objectives
4.1 Introduction
4.2 Formation of Contracts
4.3 Extinction of Contracts
4.4 Types of Contracts
4.5 Distinction between Contract of Guaranty and Indemnity
4.6 Meaning of Contract of Suretyship
4.7 Guidelines on Personal Guarantee
4.8 Contract of Pledge
4.9 Contract of Mortgage
4.10 Contract of Insurance
4.11 Summary
4.12 Answer to Check Your Progress Questions

4.0 Aims and Objectives

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At the end of this unit, you are expected to:
 define the meaning of contracts
 identify the types of contracts
 differentiate the contract of guarantee, indemnity and suretyship
 understand how contracts are formulated and extincted

4.1 Introduction

This unit is designed to introduce to you about the concepts of contracts of different
types, concepts of guarantee, and the law of surety ship. Bankers in order to secure their
loans granted to their customers, they seek to have a guarantee from the borrower.

This unit is also devoted to the concept of contract of guarantee, indemnity and their
related concepts. The main features of contract of guarantee contract of indemnity and
suretyship, the liability of surety, rights of the creditor and advantages and disadvantages
will also be discussed.

4.2 Formation of Contracts

A contract, as defined under article 1675 of the Ethiopian Civil Code, is an agreement
where by two or more persons as between themselves create, vary of extinguish
obligations of proprietary nature.

Pursuant to article 1675, for an agreement to give rise to contractual obligations, it must
relate to the contracting parties rights and obligations which are appreciable in money.
Public rights and personal status are extra-patrimonial and extra commercial that they are
not subject to civil transactions. The contract concluded between the creditor and the
debtor, in order to be validly has to fulfill the following conditions.
i. The consent of the party who binds himself
ii. His capacity to contract
iii. A definate object which forms the subject matter of the
obligation;
iv. The contract is made in the form prescribed by law if
any (art 1678 of the civil code).
In other words, so that the obligation created by a contract be a valid one, there must be
meeting of the minds of the contracting parties. The parties must have the capacity to
enter into legal transaction and there must be a certain object. These are indispensable
elements for formation of contracts and they are discussed as follows.

i. Consent

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The debtor and the creditor have to agree through the proper procedure of offer and
acceptance. Moreover there shouldn’t be a vice in consent. Defects which can vitiate the
consent of the parties and permit them to request the invalidation of the contract are
mistake, fraud and duress (Arts 1696 – 1707).

ii) Capacity
The parties must have the capacity to enter into contracts According to art 192 of the
Ethiopian civil code, capacity of the physical person is presumed in that every physical
person is deemed to be capable of performing all acts of civil life unless he is declared
incapable by law. People who are considered incapable by the law are, children who
haven’t reached the age of eighteen judicially and legally interdicted person (Art. 193).
iii) Object
A contract requires an object. The object of the contract can be a positive or a negative
act or a thing that is susceptible of pecuniary evolution. The act or the thing must be
neither prohibited by law, nor offensive to the morality of the society (Art 1114).

The creditor and the debtor have to sufficiently define the obligation that each undertakes
to perform. A contract whose object is not sufficiently defined doesn’t give rise to legal
consequences (1714). And moreover the object of the contract must be possible.

iv) Form
In the over whelming majority of cases, contracting parties are free to draft their contracts
in any way they wish. But in certain exceptional cases, the law provides that a contract be
made in the specified form (Art 1719 – 1730).

4.3 Extinction of Contracts

The main questions that may arise in connection with the formation of a contract are:
how long does a contract maintain its validity? How does it lose it’s validity? The
simplest and the most direct answer for both questions may be to say a contract remains
valid until it is extinguished. A contract is extinguished for any of the following causes:
a) Performance
b) Invalidation and cancellation
c) Termination and remission
d) Notation
e) Set of
f) Merger, or
g) Period of Limitation (articles 1806 and 1807)
a) Performance: - If a contract is performed in accordance with the anticipation of
the parties the obligation will extinguish.

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 b) Invalidation and Cancellation: - A contract can be invalidated for defect in
consent, incapacity, immorality or unlawfulness (Art. 1808). Defect in consent
and incapacity are personal defenses such that they may be involved by the party
whose consent has been vitiated or by the incapable person. But if the object of
the contract is immoral or prohibited by law, any interested party can request its
invalidation – this is the general rule as the question of invalidation is concerned.
c) Termination and Remission: - Termination of a contract can be made (i) by
agreement of the parties. (ii) in situations where a contract is made for an
indefinite period of time and (iii) when a special relationship that was the basis of
the contract disappears (1819 – 1825).
d) Set-off: - When the creditor and the debtor owe debts to each other the debts
could mutually cancel each other extinguishing both obligations.
e) Novation: - An existing contract can be extinguished by substituting it with
another. A contract is said to be novated when either the object or nature of the
obligations contracts that are formed later are presumed to be independent
contracts (Art 1808).
f) Merger: The union in the same person of the qualities of the debtor and creditor
for the same obligation is known as merger. This coincidence ordinarily takes
place where the creditor succeeds the debtor by universal title and inversely or
where a third person succeeds by universal title both the creditor and the debtor.
Article 1844 of the civil code provides that if the merger falls apart the contractual
relationship that existed before the merger took place will revive.
g) Period of Limitation: - It is one mode of extinction of an obligation. The law
doesn’t permit claimants to bring state cases before courts. Under the Ethiopian
law different time limitations are provided for initiating different suits.

4.4 Types of contract

Contracts may be classified as contract of guarantee and contract of indemnity.

A. Contract of Guarantee: -
A contract of guarantee is “a contract to perform the promise, or discharge the liability of
a third person in case of his default.” The person who gives the guarantee is called the
“surety”, the person in respect of whose default, the guarantee is given is called the
“principal debtor,” and the person to whom the guarantee is given is called the “creditor.”
Guarantee, therefore, is a promise or undertaking of the nature of co-obligations to an
advance. The second obligant assumes the responsibility and binds himself for the sake of
the first. This surety or guarantor is some relative, friend, partner, director or even a
company who/which undertakes to stand by the principal debtor when he is financially
embarrassed or is otherwise in difficulties. The essence of a contract of guarantee is that
the surety is only secondarily or collaterally answerable for the present or future debt, and
the original debtor is not released from his liability.

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The function of a contract of guarantee is to enable a person to secure a loan, or goods on
credit, or an employment. It may be given for (a) the repayment of a debt with which the
bank is essentially concerned, (b) the payment of the price of the goods sold on credit,
and (c) the good conduct or honesty of a person employed in a particular office, called a
fidelity guarantee.

Salient Features of a Contract of Guarantee

As a species of the general contract, a contract of guarantee has some distinguishing
features as below:

i. Oral or in Writing. The contract of guarantee may be either oral or in writing. However,
an action to enforce such a promise cannot be maintained unless there is written note or
memorandum signed by the guarantor or his agent. But sometimes a contract of guarantee
may also be implied from the circumstances.
ii. Specific vs. Continuing. The guarantee may be for a specific debt or for a specific
period, or else, it may be a continuing guarantee extending to a series of transactions. In
the latter case, it covers repayment for all advances made or to be made, up to an agreed
limit during the continuance of the guarantee. It is designed answerable for the final debit
balance. For banks, it is the running guarantee, which is of importance; specific
guarantees in ordinary circumstances are clearly valueless.
iii. Consideration. In common with other simple contracts, a contract of guarantee to be
operative must be supported by consideration. It is sufficient that the debtor has the
benefit of the consideration in that something has been done or some promise made to
him. Anything done, or any promise made for the benefit of the principal debtor may be a
sufficient consideration to the surety for giving the guarantee. The surety may be a
complete volunteer without any benefit having resulted to him.
iv. Distinct Primary Liability. In a contract of guarantee, the primary liability is of the
principal debtor; the responsibility of the guarantor or surety is only secondary. This
contract arises only when there is some distinct liability in respect of which the surety
makes himself collaterally answerable. The guarantee may be given for an existing or a
future debt or obligation called respectively retrospective guarantee.
v. Not a Contract of Utmost Good Faith. As a general rule, a guarantee is not a contract
uberrimae fidie, that is to say, of utmost good faith. The creditor is not under an
obligation to disclose to the guarantor information, which he has about the debtor, which
makes it probable for him to pay. The banker is not bound to make a full disclosure of the
debtor’s dealings with him. Even fraud on the part of the principal debtor is not enough to
set aside the contract, unless the surety can show that the creditor or his agent knew of the
fraud and was a party to it. But if the guarantee is in the nature of insurance, as in a
fidelity guarantee, all material facts must be disclosed; otherwise the surety can avoid the
contract.

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vi. Avoidance by Misrepresentation or Mistake. Since a guarantee is not a contract of
utmost good faith, there is no duty upon the bank to disclose the details relating to his
customers’ account. But if the prospective guarantor asks for some specific information,
the banker as a creditor is under obligation to make statements, which are accurate and
not capable of being misconstrued. A contract of guarantee, like any other contract, is
liable to be avoided if induced by material misrepresentation of an existing fact even if
made innocently. Likewise, where a person signs a document embodying a contract that
is fundamentally different from that which he contemplated, the contract is void for
mistake. The thrust is that a contract of guarantee should be entered into with the free
consent of parties competent to contract, and there should not be concealment of any
material fact affecting the transaction between the banker and his customer.

B. Contract of Indemnity: -
A contract of indemnity is defined as a” contract by which one party promises to save the
other from loss caused to him by the conduct of the promisor himself or by the conduct of
any other person.” Thus, the indemnifier’s liability is primary, but contingent. If Alemu
contracts to indemnify Belete against the consequences of any proceedings, which
Cherinet may take against Belete in respect of a certain sum of Br 2,000, it is a contract
of indemnity. Alemu’s liability arises only on Cherinet starting some proceedings against
Belete. A contract of indemnity may be express or implied. An implied contract of
indemnity may be inferred from the circumstances of the case or relationship of the
parties. It may be noted that all general insurance contracts, i.e., fire, marine, theft, etc.
are contracts of indemnity. A life insurance policy, however, is a contract of guarantee as
the payment of the sum assured is to be made either on the death or survival of the
assured.

4.5 Distinction between a Contract of Guarantee and Indemnity

Contracts of indemnity and guarantee are specific examples of a general contract.

However, from the above explanation of a contract of guarantee and indemnity the
distinction between the two would have become evident. But for the sake of clarity, the
following points could be listed.
 Primary Vs. Secondary Liability. The guarantor is only
collaterally answerable for the debt or default; the primary
responsibility is that of the original debtor. But the liability,

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 of the indemnifier to the indemnified is primary and
independent. Thus, the indemnity is a much harder bond
than the guarantee. Even though the principal debtor may
escape, the indemnifier remains liable. If a company
borrows ultra virus, it cannot be made to repay, but its
indemnifier will remain liable.
 Bipartite Vs Tripartite Agreement. In a contract of
indemnity, there are only two parties, viz, the indemnifier
(promisor) and the indemnified (promisee). But in a
contract of guarantee, there are three parties to the contract,
viz, the creditor, principal debtor and the guarantor or
surety.
 One Vs Three Contract. It follows from (ii) above that there
is only one contract in case of contract of indemnity, i.e.,
between the indemnifier and the indemnified. But in a
contract of guarantee, there are three contracts: one
between the principal debtor and the creditor, the second
between the creditor and the surety, and the third between
the surety and the principal debtor.
 At the Request. It is not necessary for the indemnifier to act
at the request of the indemnified. But it is necessary that the
surety should give the guarantee at the request of the
principal debtor.
 Contingent vs. Existing Debt. The liability of the
indemnifier arises only on the happening of a contingency.
But there is normally an existing debt or duty, the
performance of which is guaranteed by the surety.
 Sue a Third party. An indemnifier cannot sue a third party
for loss in his own name since there is no privacy of
contract. He can do so only if there is an assignment in his
favor. But a surety on discharging his liability due by the
principal debtor steps into the shoes of the creditor. He can
proceed against the principal debtor in his own right.

4.6 Meaning of Contract of suretyship

Suretyship is to undertake guarantee of an obligation toward the creditor to discharge the

obligation, should the debtor fail to discharge it. A guarantee shall not be presumed. It
can be express and may not be extended beyond its contractual limits.

4.6.1 Liability of the Surety

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In respect of liability of the surety the following points may be noted:

i. Extent of the Liability. The surety is liable for what the principal debtor is liable. The
liability of the surety can be neither more nor less than that of the principal debtor. By a
special contract, this liability could be made less than that of the original debtor but never
more. The rule is that the surety must not be made liable beyond the terms of his
engagement. A guarantees to B the payment of a bill of exchange by C, the acceptor. The
bill is dishonored by C. Then, A is liable not only for the amount of the bill but also for
any interest and charges which may have become due on it.”
ii. The Time Liability Arises. The liability of the surety arises as soon as the principal
debtor makes a default. The creditor need not exhaust all remedies against the principal
debtor before recovering the amount due from the surety. The creditor can proceed
straightaway against the surety, after default, without first proceeding against the
principal debtor.
iii. Liability of Co-sureties. Two or more persons called co-sureties may also execute
guarantees. In all cases of co-surety ship the banker should take care that all the proposed
guarantors duly execute the contract, and no advance should be made on a guarantee until
all the parties have signed. When several persons cooperate in the giving of a guarantee,
their liability may be (a) several, i.e. separate,(b) joint, or (c) joint and several. In a
guarantee each of the sureties may be sued separately for the whole of the guaranteed
debt to the amount of guarantee. In a joint and several guarantees, each guarantor is liable
for the whole amount, but all of them have to be sued together. In a joint and several
guarantee, the sureties may be sued in the way the banker deems fit, and the remedy
against them is not satisfied until the whole debt has been recovered.

4.6.2 Rights of Surety

The Surety in law is a favored debtor and he has many implied rights. These are;
i. Right of Subrogation. The general rule is that when a guarantor pays or performs all
that he is liable for upon default of the principal debtor, he is entitled to be subrogated to
all the rights possessed by the creditor (bank) in respect of the debt. After discharging this
liability under the guarantee, the surety at once steps into the banker’s shoes and becomes
a creditor of the principal debtor and succeeds to all the bank’s rights.
One result of this rule is that the guarantor is entitled to any securities deposited with the
bank by its customer. The right extends to all securities, which the bank has received,
from its customer before, contemporaneously with, or after the execution of the
guarantee. It is immaterial whether or not the guarantor knew of their existence at the
time when he signed the guarantee. If the creditor loses or parts with the securities with
out the consent of the surety the liability of the surety is reduced to the extent of the value
of the penalties. Further, if the principal debtor cannot pay and is adjudicated insolvent,
the surety is entitled to prove on his estate, either for the sum he has actually paid to the
banker or for his contingent liability if he has not actually parted with the money.

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ii. Right to be indemnified by the principal Debtor. In every contract of guarantee, there
is an implied promise by the principal debtor to indemnify the surety, and the surety is
entitled to recover from the principal debtor all payments properly made.
iii. Right to Revoke Continuing Guarantee. In the absence of an agreement to the
contrary, a surety is entitled to revoke a continuing guarantee as to future transactions by
giving a specified period of notice. But the surety cannot revoke a specific guarantee if
the liability has already accrued. The surety remains liable for transactions already
entered into. A continuing guarantee is automatically determined (i.e., ended) by the
death of the guarantor.

4.6.3 Obligations of the Creditor towards Surety

The guarantee protects the creditor so long as he does not overstep in any way the letter
of his contract. If he does, the effect is of destroying the contract. That is why the bankers
have worked out, with assistance of their legal advisers, elaborate standard forms of
guarantee contracts. The following are the principal obligations of the creditor in a
guarantee arrangement.

i. Not vary the Original Terms. The courts are very jealous in preserving a surety’s rights
and therefore any material alteration of the terms of the contract between the creditor and
the principal debtor will be a ground for discharging the surety. Whenever there is any
variation, unless if is unsubstantial for the surety, the surety himself is the sole judge
whether to assent or not to such variation and remain liable. But if any alterations are
mutually agreed upon, these must also be reduced to writing.
ii. Not Release the Principal Debtor. A creditor should not prejudice the surety’s position
by releasing the principal debtor or doing any act or commission, the legal consequence
of which is his discharge. But if the creditor releases the principal debtor from his
liability, the surety is also discharged. Anything, which discharges the debtor, discharges
the guarantor.
It rarely happens that a bank releases its customer from liability. But cases of implied
release are not uncommon, e.g., a customer makes a voluntary composition with his
creditors outside the bankruptcy law. Such a composition would discharge the surety, but
bank forms of guarantee contain an express provision to the contrary.

iii. Not to give any Indulgence to the Debtor. The creditor has the obligation not to
compound, give time, and agree not to sue the principal debtor or to do some other
indulgence. By such indulgence the surety will be discharged unless he has given his
assent to it or the banker has reserved his rights against the surety.
iv. Not do any Act Inconsistent with the Right of the Surety. If the banker does
negligently or improperly deals with such securities and loss to the surety ensues, the

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surety will be released pro rata. The creditor’s act or omission impairing surety’s eventual
remedy discharges the surety.

4.6.4 Rights of the Creditor

If the principal debtor (i.e., the customer) fails to discharge his liability, the bank may
find it necessary to enforce its security. Most forms of guarantee provide that the bank
shall made a written demand to the surety for payment, and that a demand in writing shall
be deemed to have been properly made if sent to the surety at the address given in the
guarantee. The requirement for giving notice has the advantage of preventing possible
difficulties, because time cannot begin to run in favor of the surety until the necessary
notice has been sent to him. Bank guarantees do four main things:
(a) Precisely state the liabilities of the guarantor,
(b) Prevent the operation of the rules that leads to the bank’s
detriment,
(c) Specify the circumstances under which the guarantee can
be determined, and
(d) Exclude all the guarantor’s important common law rights
and remedies against both the principal debtor and the
bank.
The last of these four characteristics is the most important, the guarantor being left only
with the right to know the extent to which his guarantee is being relied upon and the right
to avoid the contract for misrepresentation.

4.6.5 Advantages and Disadvantages of guarantee as Security

Advantages of guarantee as Security

Guarantee as a security has the following advantages.
i. A guarantee is a very simple security to take. No registration is involved, and no
complications concerning proof of title arise.
ii. A guarantee can easily and immediately be enforced by court action.

Disadvantages of guarantee as security

i. Unless supported by a cash deposit or other security, a guarantee is always of an
uncertain value as a security. A guarantor’s financial position can change very quickly. A
banker should only accept an unsupported guarantee after careful investigation into the
proposed guarantor’s financial circumstances.

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ii. Court action may necessary to realize the security, and a technicality may possibly
defeat the bank’s claim.

4.7 Guidelines on Personal Guarantees

It has been found that banks have insisted upon the personal guarantees from directors
and other managerial personnel of the borrowing concerns as a matter of routine. In some
cases, they have been obtained to make good the deficiency in the tangible security
offered, or because of the weak financial position of the borrower. Banks have carried the
notion that once the guarantees are furnished, the directors and the managerial personnel
take a personal interest in the concerns and thus promote sound management. However,
the Reserve Bank does not feel that the practice of asking for the guarantees in all cases is
necessary, especially in view of the following.

i. There has been steady growth of an entrepreneurial class in place of the old Managing
Agency System and the managerial cadres have been professionalized;
ii. Financially sound concerns are able to offer adequate security for meeting their
banking needs; and
iii. The techniques of financial and technical appraisal by the lending institutions have
improved.
Guarantees should be obtained only in circumstances absolutely warranted after a careful
examination of the circumstances of each case and not as a matter of course. It has
suggested that a detailed credit analysis should be undertaken by the banks to determine
the need for guarantee. The following broad considerations may be taken into account in
this connection:

A. Guarantees need not be considered necessary in the following cases:

i. Ordinarily in case of public limited companies no personal guarantee need be insisted
upon if the lending institutions are satisfied about the management, its stake in the
concern, economic viability of the proposal and the financial position and capacity for
cash generation. In case of widely owned public limited companies, which may be rated
as first class and which satisfy the above conditions, guarantees may not be necessary
even if the advances are unsecured.
ii. In case of companies—private or public—which are under professional management,
guarantees may not be insisted upon from persons who are connected with the
management solely by virtue of their professional/ technical qualifications and not
consequent upon any significant shareholding in the company concerned.
iii. Where the lending institutions are not convinced about the above-mentioned aspects
of loan proposals they should seek to stipulate conditions to make the proposals
acceptable without such guarantees. In some cases, more stringent forms of financial
discipline like restrictions on distribution of dividends, further expansion, aggregate

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borrowings, and creation of further charge on a sets and stipulation of maintenance of
minimum net working capital may be necessary. The parity between owned funds and
capital investment and the overall debt-equity ratio might have to be taken into account.

B. Necessity of Guarantee.

Guarantees may be considered helpful in the following cases:

i. Closely held companies—the guarantee should preferably be that of principal members

of the group holding shares in the borrowing company;
ii. In case of other companies to ensure continuity of management;
iii. Public limited companies other than first class companies where the advance is on an
unsecured basis;
iv. Public limited companies, whose financial position and/or capacity for cash
generation is not satisfactory even though the advances are secured;
v. In case where considerable delay in the creation of a charge on assets is likely;
vi The guarantee of parent companies in the case of subsidiaries, whose own financial
condition is not considered satisfactory; and
vii. Where the balance sheet or other financial statements of a company discloses
interlocking of funds between the company and other concerns owned or managed by a
group.

C. Other instructions.
i. The guarantees should bear reasonable proposition to the estimated worth of the person.
ii. Banks should obtain an undertaking from the borrowing company as well as from the
guarantor that no consideration in the form of commission, brokerage fees, etc. will be
paid by the company to the guarantor directly or indirectly.

4.8 Contracts of Pledge

Contracts of pledge is a contract where by a debtor undertakes to deliver a thing, called

the pledge, to his creditor as security for the performance of an obligation. A contract of
pledge may be made between the creditor and a third party to secure the debt of another
person. The maximum amount of the debt guaranteed shall in all cases be specified in the
contract of pledge or contract shall be void. Where the amount exceeds five hundred
Ethiopian birr, the contract of pledge shall not be valid except where it is evidenced by
writing and as from the day when such deed acquires undisputed date. The pledge may
consists of a chattel, a totality of effects, a claim or another right relating to movable
property. It must be capable of being sold separately by public auction. The creditor shall
be deemed to be in possession of the pledge where the document of title without which
the pledge can not be disposed of has been delivered to him. It is also applied, in

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particular, where a voucher for goods wave housed, or the bill of lading or way-bill, in
the case of goods in transport, has been endorsed in his favor.

Rights and Duties of Pledger

The pledger shall have on his debtor’s property the rights of a creditor. The creditor shall
return the pledger to the pledge or to the person designated by him, where the contract of
pledge is extinguished by payment of the debt or any other reason. Any agreement, even
subsequent to the furnishing of the pledge, authorizing the creditor, in the event of non-
payment on the due-date, to take possession of the pledge or to sell it without complying
with the formalities required by law shall be of no effect. Before causing the pledge to be
sold, the pledgee shall call upon the pledger to discharge his obligations and give him the
notice that upon default, he will cause the pledge to be sold. The pledge may be paid out
of the proceeds of the sale of the pledge before all other creditors. The pledge may not
enforce his priority rights arising out of the contract of pledge beyond the maximum
amount specified therein.

4.9 contract of Mortgage

A mortgage may result from the law or a judgment or be created by a contract or other
private agreement. Who so ever sells an immovable property shall have a legal mortgage
on such immovable as a security for the payment of the agreed price and for the
performance of any other obligation laid down in the contract of sale. A court or
arbitration tribunal may secure the execution of its judgments, orders or awards by
granting one party a mortgage on one or more immovable properties of the other party.
The judgment or award shall specify the amount of the claim secured by the mortgage
and the immovable or immovable to which such mortgage applies. The contract or other
agreement creating a mortgage shall be no effects unless it is made in writing. It shall be
of no effect unless it specifies in Ethiopian currency the amount of the claim secured by
mortgage. A mortgage may charge an immovable property only.

A mortgage may be created by the debtor or by some other person in favor of the debtor.
A person may not secure his debt by mortgage unless he is entitled to dispose of the
immovable gratuitously. A mortgage shall be valid where it is created by a person who is
the owner of the immovable under a title deed issued to him by the competent authorities.
It shall be valid not with standing that title deed was issued on the basis of the mortgage
is shown to be in bad faith. A mortgage, however, created shall not produce any effect
except from the day when it is entered in the registrar of immovable property at the place
where the immovable mortgaged is situate.

The registration of a mortgage shall be effective for ten years from the day when the
entry was made. The effect of such registration shall continue where, prior to the expiry

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of the period of ten years, a new entry is made with a view to renewing the first
registration. In such cases, the first registration shall be effective for ten years from the
day when the new entry was made.

Where the immovable mortgaged is attached by the creditors of the mortgagor, the
mortgagee may demand to be paid out of the proceeds of the sale of the immovable in
priority to any other creditor.

Grounds for cancellation of mortgage

Any interested party may require the registration to be cancelled where
a) The claim secured by the mortgage is extinguished, or
b) The mortgagee has renounced his mortgage, or
c) The immovable mortgage has been sold by auction and the proceeds of the sale
have been distributed among the creditors, or
d) The amount accepted by the creditors in cases of an offer or redemption has been
distributed among the creditors. Where the creditors renounces his mortgage such
renunciation shall be of no effect unless it is made expressly and in writing unless
and otherwise agreed such renunciation shall not empty that mortgage who
renounces his claim.

4.10 Contract of Insurance

An insurance policy is a contract where by a person called the insurer undertakes against
payment of one or more premiums to pay to a person called the beneficiary, a sum of
money where a specified risk materializes. Where damages are insured, the insurance
policy shall extend to the risks affecting property or arising out of the insured person’s
civil liability. Where persons are insured, the insurance policy shall extend to risks
arising out of death or life, or to risks arising out of injury to the person or illness. The
contract of insurance shall be supported by a document called an insurance policy. The
insurer and beneficiary shall be bound where prior to the signature of the policy or
endorsements, the insurer hands to the beneficiary a document setting up a provisional
guarantee until the policy or endorsement is signed.

The insurance policy shall show:

a) The place and date of the contract
b) The names and addresses of the parties
c) The item, liability or person insured
d) The nature of the risks insured
e) The amount of the premium
f) The term of which the contract is made

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Unless otherwise expressly specified, the insurance policy shall come into force on the
day when the policy is signed provisions may be made to the effect that the policy shall
only come into force after the first premium has been paid.

Rights and Duties of the Parties

The insurer shall guarantee the beneficiary against the risks specified in the policy unless
otherwise agreed, risks arising out of unforeseen events or the negligence of the
beneficiary shall be covered by the insurance. Notwithstanding, any provision to the
contrary, risks arising out of the intentional default of the beneficiary shall not be covered
by the insurance. The insurer shall pay the agreed sum within the time specified in the
policy when the risk insured against occurs or at the time specified in the policy. The
insurer’s liability shall not exceed the amount specified in the policy. The beneficiary
shall pay the agreed premium at the time specified in the policy.

Notwithstanding any provision to the contrary, the policy shall not terminate as of right
when the premium is not paid in due time. The insurer shall demand payment not
withstanding any provision to the contrary; the policy shall be suspended after one month
from a demand where the premium is not paid. Where the period of one month has
expired, the insurer may claim payment of the premium or require the termination of the
policy. Where the premium is paid, the policy shall re-enter into force on the day of
payment.

Check Your Progress Exercise

1. Explain the distinction between a guarantee and an indemnity.

________________________________________________________________________
______________________________________________________________
2. What are the salient features of a guarantee and the points to be born in
mind by a banker in granting an advance on security of a guarantee?
________________________________________________________________________
______________________________________________________________
3. Explain the basic elements of a contract.
________________________________________________________________________
______________________________________________________________
4. State the causes of extinction of contracts.
________________________________________________________________________
______________________________________________________________
5. Explain the liabilities and rights the surety.
________________________________________________________________________
______________________________________________________________

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4.11. Summery

After loan requests are approved by the bank officials contracts must be signed between
the banker and the borrower and the banker and the guarantor, if any. The contract may
be a contract of advance, a contract of guarantee, a contract of suretyship, contract of
pledge, contract of insurance, and contract of indemnity. A contract is an agreement
where by two or more persons as between themselves create an obligation of a property
nature. A contract of guarantee is a contract to perform the promise, or discharge the
liability of a third person in case of his default. A contract of indeminity is a contract by
which one party promises to save the other from loss caused to him by the conduct of the
promissory himself or by the conduct of any other person.

Suretyship is to undertake guarantee of an obligation towards the creditor to discharge the

obligation, should the debtor fail to discharge it. A guarantee shall not be pressured. It
shall be express and may not be extended beyond its contractual limits.

Contracts of pledge is a contract where by a debtor undertakes to deliver a thing called

the pledge to his creditor as security for the performance of an obligation. An insurance
policy is a contract where by a person called the insurer undertakes against payment of
one or more premiums to pay to a person called the beneficiary a sum of money where a
specified risk materializes.

4.8 Answer to Check Your Progress Exercise

1. Refer section 4.5 (A)

2. Refer section 4.5 (B)
3. Refer section 4.2
4. Refer section 4.3
5. Refer section (A&B)
Unit 5: Credit Follow up and Supervision

Content
5.0 Aims and Objectives
5.1 Introduction
5.2 Some Characteristics of Loan Losses
5.3 Supervision of Outstanding Loans
5.4 Need for Follow-up or Supervision
5.5 Measures for Effective Supervision
5.6 Recovery of Advances
5.6.1 Precautions for Better Recovery
5.6.2 Recovery Procedure

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 5.6.3 Sale of Security
5.6.4 Recovery in Case of Death of Borrower
5.6.5 Recovery in Case of Insolvency of Borrower
5.7 Summary
5.8 Key to Check Your Progress

5.0 Aims and Objectives

At the end of this unit, you are expected to:

 understand meanings and methods of loan supervision
 identify the characteristics of loan losses
 identify measures for effective supervision
 understand methods and precautions of recovery of advances.

5.1 Introduction

It has been said that a bank never makes a bad loan, that loans get bad only after they are
made. This is of course, partly true; but the moral implied by it is important: banks cannot
make loans and then forget them. A necessary part of their lending function is to keep
abreast of the loans outstanding.

The supervision of loans, like the making of them, is usually the responsibility of more
than one department of the bank. The credit department continues to secure and analyze
the statements of customers indebted to the bank. The lending officer keeps track of his
clients. When special problems in connection with outstanding credits arise, they may
have to be referred to the higher officials of bank management, just as in the case of new
credits.

The process of statement analysis, which is so important at the time a credit is granted, is
equally important after the loan is made and the funds are disbursed. Budgets are
necessarily flexible instruments of estimating the activities and performances of the
borrower. Banks cannot expect their customers to follow them precisely. In the review of
actual events a line must always be drawn between the elements of activity that are
within the control of the borrowing customer and those that are not. If the estimate of
sales in a budget does not pan out, the sales forces of the borrower may be exhorted to
more activity: but sales cannot be forced. On the other hand, an estimate of expenses or
of capital outlay is fully or largely within the control of the borrower. Large variations
from budget plans should not only be explained but corrected, if possible. The intervals at
which statements are secured from borrowing customers naturally depend on the prior
arrangements made with them and the state of their accounting records. One of the
common practices in the case of distressed credits is that of requiring financial statements

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to be filed with the bank at frequent intervals, often monthly. If this is good practice for
distressed credits, it is almost as good for credits that are still in good standing. No hard
and fast rule can be stated, but a bank is doing its customers no disfavor if it requires the
preparation and analysis of statements at an interval no greater than the bank itself feels
necessary for proper review of the credit.

The handling of these periodic statements is carried out in the credit department and is
not unlike the routine followed for customers from whom loan applications are
anticipated.

When a loan starts to show signs of distress, a difficult choice arises: to collect it, or such
part as in recoverable by strong-arm tactics, or to arrange a “workout” of the credit. This
is one of the hard-bitten choices that all bankers face sooner or later. It is a choice for
which there is no satisfactory answer, only a range of more or less unsatisfactory
compromises. If the primary art of commercial banking is that of finding ways to make
loans, then an art of hardly less important is that a working out distressed credits without
loss to the creditor bank and in the best interests of competent and conscientious
customers. This unit is devoted to deal with loans supervision, follow-up and recovery of
loans.

5.2 Some characteristics of loan Losses

In order to be active and aggressive in lending, commercial banks must face the
probability of some loans of losses. The very best and most profitable banks expect such
losses. The route to profitability, however, requires that losses be held within relatively
small margins. Only by this means is it possible to have an active lending programs
without exposure to excessive risk.

Researches on bank losses supported the idea that a proper loan policy is to expect some
loan difficulties but to curb the losses that result from them. These studies showed that
the two types of credit most likely to give rise to sosses or charge-offs were consumer
loans and business loans. Loans on farm lands and mortgage loans had quite good
records. However, this may not be true in Ethiopian case where agricultural productivity
and marketability of its outputs is very poor and the sales proceeds of mortgages on
auction bases is very low. Losses on consumer credit were concentrated primarily in
banks that engage actively in such business and did a large volume of it.

The successful institutions, however, kept the frequency of loss within small margins by
alert collection procedures and other protective devices. In the case of business loans the
range of loss was somewhat greater. Some banks’ losses on business loans were
negligible, but at a few banks they were quite large. Business loans may expose a bank to

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larger losses than almost any other type of credit if not carefully safeguarded. Successful
banks did not avoid losses altogether but rather contained them with in relatively small
margins. A further interesting fact revealed is that banks with a high degree of
specialization in lending tended to have moderate-sized but carefully controlled losses in
their lines of specialization. One further points of some interest revealed by studies was
that the loss rates of very small banks averaged somewhat less than those of large banks;
however, greater variation among loan loss rates was found at small banks. Some had
negligible losses but a few had fairly sizable ones. Large banks tended to cluster more
around the average.

Loan losses are clearly related to the character of external economic developments. In the
absence of a severe depression, bank lending policies have not been vigorously tested for
almost a generation. However, public policy would probably never again permit banking
liquidity to drop to the point at which banks were forced to put pressure on borrowers
beyond those consonant with the requirements of good banking and collection policies.
Without such unreasonable pressure, the chances of ultimate loses probably can be kept
within tolerable margins by the standards of credit quality now enforced.

5.3 Supervision of Outstanding Loans

Many of the agonies and frustrations of slow and distressed credits can be avoided by the
proverbal “ounce of prevention” – good loan supervision. A good loan is not only made
good; it is kept good. Supervision of outstanding loans is not a one time activity rather it
is a continuous process aimed at insuring observance of signals on the status of the
customers position. It involves the following activities.

1. Visiting the Borrower

It is suggested that a visit to the premises of the applicant is a good idea. It is fully as
useful to visit the premises of those customers already on the books. It helps an
experienced observer to appreciate just how things are going. A good borrower whose
affairs are in fine shape is almost always glad to see his banker, proud to show him how
things are going. He appreciates the interest in his affairs and often makes use of the
occasion to seek advice. The visit is a good-will builder.

A visit to a customer whose affairs are not going so well may be a bit chillier but this is
just the situation a banker needs to inspect. If he can find out early just how his
customers’ affairs are developing, he can often avoid the more strenuous problems of
workouts and liquidations. All the aid saws about “a stitch in time” and the like apply to
this case.

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The following are what the banker expect to look for on a visit. These conditions may not
be reflected in the financial statements prepared by the customer.
i. The general state of repairs and maintenance of plant and equipment.
Inadequate maintenance is often an early sign of distress.
ii. The state of employee and junior officer morale. Those inside a business
know, partly by intimacy, partly by instinct, just how a business is going.
Morale is often a product of this situation.
iii. The physical evidences of materials and finished goods inventories. Interim
statements of concerns are usually not audited or certified and, sometimes it
must be admitted, fraud is restored to under the pressure of difficulties. The
overstated inventory is one frequent way of inflating financial statements.
Highly trained observers soon get to have a “feel” for discrepancies between
the claims of statements and the actual affairs.

2. General Business Policy and Advice

In supervising credits already outstanding, a banker may find that this process is one of
the very best sources of “feel” for the state of business. These findings may be useful in
dealing with other customers. If a bank is in constant and intimate touch with its
customers it may soon develop a sensitivity to the state of business.

In the process the banker can understand the following situations. Such as: how fast are
current orders coming in? How are credit collections? What are price prospective? What
is the current state of market demand?

If a bank is sensitive to business developments, it can: (1) revise its own loan and credit
policies, and (2) advise its customers similarly. Borrowers are not always (though
sometimes) ungrateful for being restrained in their periods of high optimism. A flexible
bank policy is likely not only to save the bank trouble and headaches, but also to save its
customers similarly.

3. Keeping Track of Deposit Balances

Once a bank has granted a credit, it can learn a great deal by inspecting the deposit
balance maintained by the borrowing customer. Since an agreement on the minimum
balance that should be maintained by the customer is good lending practice, the way in
which this agreement is observed gives some closes to his affairs. A bare minimum
balance may be a bad sign: some surplus over it is to be considered a good sign.

The bank can also often tell by activity in the account the rather general progress of the
borrower. Though it is not the business of a bank to snoop into the affairs of its
borrowers, it has a legationate right to keep posted on them through these channels.

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4. Checking with other Creditors
Checking with other creditors was taken as an important part of the process of the
granting of a credit. This continues to be an important test after the credit has been
granted.

The checking of other creditors is useful and important, but it should not be overdone. A
formal credit check puts a burden on other concerns and should be made carefully.
Informal checking is always adequate. Formal checking often is to be avoided because it
may start to cast doubts on a quite satisfactory debtor. When other creditors receive
repeated requests for credit information, they may be disposed to start wondering just
what it is that prompt this frequency of inquiry.

5. Special Supervision for Term Loans

The supervision of ordinary short-term bank loans has many problems. This will be even
more in case of term loans. In this case the need for careful scrutiny of the business
reports as they are received is important, because the time involved is longer. Since the
analysis of term credits emphasizes earnings more and current position less, the analysis
of earnings factors is to be emphasized. When a term loan is accompanied by a loan
agreement, one of the specific supervisory tasks is that of checking to be sure that the
agreement is being observed. The maintenance of current position, the payment of taxes,
the maintenance of property in good condition, the agreed limitation of dividends or other
distribution of profits all will be verified.

Minor deviations from the exact terms of the loan agreement are sometimes found. Even
though minor, it is usually desirable to secure a remedy of such deviations. There are
exceptions, hence a loan agreement should contain a provision spelling out the fact that
forgiveness of some lapses from the contracted conditions of the loan does not accept
other defections or continues defection of a given sort.

5.4 Need for follow-up or supervision

A banker before sanctioning a loan carefully appraises the loan application of the
borrower. The basic idea behind such appraisal is to eliminate the possibility of lending
money to borrowers, who may fail to repay the loans or who are likely to divert loan
money for inappropriate purposes. However, simply an appraisal of a loan application is
not a guarantee against such risk. The banker has to take appropriate supervisory or
follow-up measures after disabusing the loan to protect himself against these risks. It is

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correct to say that supervision or follow-up measures will provide the banker much
needed information about the following:

1. Operations
i) Have the terms and conditions stipulated for the advance been observed?
ii) Is the borrower keeping to the original plan of operations, and are costs, sales,
profits, and funds flow of according to plan?
iii) Is the security in order?
iv) Are there any danger signals and, if so, what remedial action can be taken to
cover the deficiencies and restore operations to normal health?

2. Management
i) Is the company properly managed?
ii) Have there been any changes in the ownership or management pattern?

3. Environment
i) Have there been any changes in the business environment or in governmental
laws and regulations affecting the customer or the banker?
ii) Any other considerations which may adversely affect the banker’s position in
future such as arrears of payment.

5.5 Measures for effective supervision

In order to ensure an effective supervision it is necessary for the banker to take care of
the following factors:

1. End-use of Funds
The banker has to see that the funds lent to the borrower are used for the purpose for
which they have been given. In case the funds lent are allowed to be diverted for
purposes other than those stated in the loan application, the very purpose of providing
finance to the borrower would be defeated.

The funds may be lent either in the form of term-loan or a working capital advance. In
order to ensure end-use of term loan funds, it will be appropriate to disburse the money
directly to the dealer who has supplied the fixed assets and not to the borrower. In case of
a working capital advance the objective to acquire current assets, supervision of end-use
of funds is comparatively difficult. The possibility of diversion of funds in case of
working capital advance is more. The most effective mechanism to control the uses of
funds advanced for working capital is to make the borrower compute his/her working
capital requirements based on certain standards and withdraw only accordingly.

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2. Management’s Efficiency
The capacity of the borrowing unit to generate internal additional funds to repay the bank
loan depends on the efficiency with which the affairs of the borrowing unit are being
managed. One index of managerial competence is the level of profitability of the
borrowing firm. The banker has to see not only the current profitability but also the future
profitability of the business unit which depends to a great extent upon the farsightedness
of the management. The banker can make inter-firm comparison for determining the
efficiency in use of resources, men, money, machines and materials by computing the
following ratios:
i) Labour Efficiency
ii) Capital Efficiency
iii) Fixed assets efficiency

3. Operations in the Party’s Ledger Account

The banker should keep a constant and careful watch over the party’s ledger account. It
will be appropriate for the banker to obtain in advance a list of usual suppliers of goods to
the borrower. This will help in ensuring that all payments to parties from cash-credit or
overdraft account are made only for approved purposes. All movements in stocks should
be reflected in the party’s ledger account by way of payments and receipts. The banker
should ask for an appropriate explanation from the party in case of unusual payments.

4. Security
Though a banker is now expected to give more emphasis to the purpose of borrowing
rather than the security offered, he/she cannot afford to ignore the security aspect
altogether. She/he has to see that the security offered is safe and continues to remain
available for repayment of the loan. Security may be in the form of fixed assets, goods or
bills of exchange. The banker should take the following precautions in respect of each of
these securities:

i. Fixed Assets: The physical inspection of these assets should be done

on a quarterly or at the most half-yearly basis. In case of mobile fixed
assets, such as motor vehicles, the banker should impose a condition
that the asset is brought as his office at least once a month or quarter.
The banker should see that the fixed assets given by way of security
are properly maintained, and adequately insured. She/he should also
see that taxes in respect of these assets are paid in time to the
appropriate authorities.
ii. Goods: They may be hypothecated or pledged with the banker. In both
cases physical verification should be carried out once a month. Incase
it is not possible to check each item individually, it will be appropriate
to check then on a selective basis, wherein the costly items will be

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 checked first. In any case the physical verification system should be so
devised that each item is checked at least once a year. The value of
goods must be determined and double financing must be removed. The
inspection of goods should not be carried on fixed dates rather surprise
inspections should be carried out to ascertain the real position. The
banker should also keep a watch over the turnover ratios in respect of
different items of stocks to ensure that the goods do not comprise
obsolete items.
iii. Bills of Exchange: In case of bills of exchange, the banker should keep
a watch over the ratio of bills returned. In case the bills are frequently
returned, it shows that either the bills are not genuine trade bills or
there is something wrong with the goods supplied. It may be
appropriate for the banker to fix a maximum drawing limit in respect
of different drawees whose resources position is unknown or
uncertain. The banker may also visit the drawee’s business premises to
verify whether the bills are arising out of real movement of goods.

5. Storage of Goods
The banker should take the following precautions in respect of goods pledged with him
and lying in his go down.
i) The goods lodged should tally with the lodgment memo and delivery orders.
ii) The goods should be taken out for the go down on first-in-first-out bases to ensure
that the goods do not become obsolete as they remain in the go down for a
long time.
iii) The party should be asked to produce original purchase invoice which shows
actual payment or payment in transit through banks.
iv) Proper record of inventory should be maintained by the go down keeper. She/he
should sign both the delivery order as well as the lodgment memos.
v) Proper control should be kept over the go down keys and locks.

6. Maintenance of Accounts
The borrower should be required to maintain proper books of accounts and submit to the
banker stock statements as required from time to time. The banker may also supply some
printed literature to his customer for their guidance.

7. Industrial Relations and the Market Reports

The nature of industrial relations prevailing in the borrower’s organization give an idea
about the things likely to happen. Bad industrial relations may result in strikes and lock-
outs and adversely affect the borrower’s financial position. Harmonious industrial
relations increase the profitability and productivity of the organization and improve the
financial position. Similarly, the market reports about the borrower give an idea about the

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financial position of the borrower. The banker should, therefore, keep his or her ears and
eyes open and take appropriate steps as may be necessary in the circumstances.

8. Miscellaneous Factors
There will be no complete list of factors that should be taken care of for effective
supervision. However, the banker should consult the customer on the following matters:
i) Making other borrowing arrangements
ii) Taking up new projects or large scale expansion
iii) Effecting mergers and acquisitions
iv) Making investment in or loans to others
v) Giving guarantees on behalf of third parties
vi) Disposal of the whole or substantially the whole of the business
vii) Premature repayment of loans and discharge of other liabilities
viii) Payment of dividends.
The banker may examine his own position against the borrower’s in respect of each of
these matters and take appropriate steps for protecting his/her interest.

The intention behind all these measures is to see that the borrower is not harmed but he is
restrained from going astray – which is neither in his interest nor in the interest of the
banker. At times a banker has act as a friend, philosopher and guide to the borrower.
Sometimes particularly in case of small borrowers counseling may be more helpful than
providing cash to the borrower.

Arthur Lewis has remarked "… Lending money to inexperienced small business people
without supervision is often equivalent to pouring it down the drain. What these people
need is first supervision and advice and only secondly capital … And when money is
lent, its uses should be supervised carefully. The officers of the institution should have
powers to enforce changes in managerial practices as a prior condition of the loan and to
check unprofitable practices at least until the loan has been repaid."

In order to have effective supervision over advances and make adequate provision for bad
and doubtful debts, it is necessary that the health of advances is judged well in advance.
Accordingly, advances can be classified into eight categories and discussed as follows.

1. Satisfactory
This category covers all borrowers where conduct of the account is satisfactory, all the
terms and conditions are completed with, all accounts of the borrowers are in order and
the safety of the advance is not in doubt.

2. Irregular

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This category of borrowers covers those accounts where the safety of the advance is not
suspected, though there may be occasional irregularities which may be considered as a
short-term phenomenon. For example, the accounts are overdrawn beyond the drawing
power, instilments in respect of term loans overdue for less than six months, some of the
bills are overdue for payment by less than three months and/or refund in respect of
unpaid bills is not forthcoming immediately.

3. Sick: Viable/Under Nursing

Units in respect of which nursing/revival programmes are taken up should be included
under this category. The banker may assign its officers to supervise the operation of the
borrowers business.
4. Sick: Non-Viable/Sticky
Accounts of borrowers under this category are those where the irregularities mentioned
above persist, say, for a period of six months and over and are no immediate prospects of
regularization. Sick units, which are considered potentially viable and put under a nursing
programme by the bank, should not come under this category.

5. Advances Recalled
This category consists of those accounts where the repayment is highly doubtful and
nursing is not considered worthwhile. If a decision has been taken (or likely to be taken)
to recall the advance, such borrowers will be classified under this category.

6. Suit Filed Accounts/Accounts in Legal Department (ACD) or Loans in Legal (LIL)

This category consists of accounts where legal action or recovery proceedings have been
initiated. But decisions or settlements are not made.

7. Decreed Debts
The advances where suits have been filed and decreed obtained will come under this
category.

8. Doubtful/Bad Debts
All advances appearing under this category are those whose recovery has become
doubtful on account of shortfalls in value of security, difficulty in enforcing and realizing
the securities, or inability/ unwillingness of the borrowers to repay the bank’s dues partly
or wholly.

N.B. Other way of classifying loans can be used by bankers

5.6 Recovery of Advances

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A banker has to see that money advanced by him is also recovered. He has to keep a
close watch on the borrower and to take adequate follow-up measures, for ensuring that
recovery of advances is smooth and timely. The banker's liquidity and profitability
depends to a greate extent on the recovery of his advances. The banker should take
certain precautions to ensure better recovery and the procedure to be followed for
recovery.

5.6.1 Privations for Better Recovery

The precautions to be taken by a banker for better recovery can be classified into two
categories:
1. Precautions at the appraisal stage and
2. Precautions after disbursement of advance

1. Precautions at the Appraisal Stage

If the following precautions are taken at the time of appraisal of the application for
advance, the chances of recovery of the advances will definitely improve,
i) Proper selection of the borrower: The banker should be careful in selecting his
borrower. He should have clear appraisal about the three Cs’ – Character,
Capacity, and Capital of the borrower before advancing money to him.
ii) Viable Project: The project should be physically and technically viable. It should
generate enough surplus to repay the loan.
iii) Proper assessment: The banker should have a proper assessment of both the
fixed and the working capital requirements of the borrower. He should satisfy
himself that the borrower will have sufficient funds to run his business. Over-
finance and under-finance, are both dangerous. In case of over-financing the
possibility of misutilization of funds increases while in case of under-
financing borrower may have to rush to money lenders for meeting his
financial requirements and pay a heavy cost.
iv) Consumption Needs: In case of small borrowers the bankers should see that
some provision is also made out of the incremental income to meet their
consumption requirements. The repayment amount should be fixed keeping in
view of this fact.
v) No-dues certificate: In order to avoid double financing the borrower should be
asked to bring “no dues certificate” or clearance from other financial
institutions, if he has business dealings with them.
vi) Provision for Repayment: In order to ensure that the banker gets back the
funds from the borrower for better utilization, he should inculcate a sense of
repayment in the borrower.

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 vii) Proper Repayment Schedule: The repayment schedule should be fixed
keeping in view the time periods during which case will be available with the
borrower. This is necessary because fixation of unrealistic repayment
schedules will result in inconvenience to the borrower and finally he will
default in repayment.

2. Precautions after Disbursement of Loan

In case the banker is satisfied with the appraisal of the loan applications, he sanctions and
disburses the advance to the borrower. In order to ensure that the recovery of the loan is
satisfactory, the banker should take steps for effective supervision and follow-up. The
banker must, in particular, check the end-use of borrowed funds and also keep an eye on
the conduct of the borrower’s account. In case the borrower is making unauthorized use
of funds, the banker should give appropriate notice to the borrower asking him to stop
such practice. The banker may recall the advance if necessary.

5.6.2 Recovery Procedure

In case the banker is facing difficulties in getting repayment of advance, he may take the
following steps:
1. Exerting Moral Pressure: - The banker should visit the borrower’s place of
business and find out the causes of non repayment of the banker’s dues. The
banker may also request some influential parties of the area to exert pressure on
the borrower to clear the bank's due.
2. Notice Recalling Advance: - In case persuasion fails the banker should give a
notice to the borrower stating clearly that since the borrower has failed to clear his
account in spite of repeated requests he is finally requested to pay the dues within
30 day of the receipt of the notice. The notice should state that failure to be up to
the request, will lead the bank to dispose of the borrower’s security/securities
laying with the banker and take legal action for recovery of the advance.
3. Filing of a Suit: - In case the notice does not have any effect on the borrower, the
banker may have to file a suit against the borrower in a law court. The following
points are relevant in this connection:
i) The suit should be filed only as a remedy of the last resort.
ii) Before filing the suit the banker should exercise any right of set of
available to him and also dispose off the security, if any.
iii) Incase of default in payment even after the expiry of the notice period.
a) The amount outstanding in the loan account should be transferred to ALD
(Accounts in Legal Department) or LIL (Loans in Legal)
b) Any interest now due on the account should be debited to LIL account and
credited to interest suspense account
c) The borrower should not be allowed to withdraw any money against such a loan
account

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 d) Any recovery from the borrower should be credited to the ALD
iv) In case of hypothecation of stock in trade, vehicles etc, the banker
should apply to the court for issue of order. The effect of this order is
that the banker will be in a position to have the possession of the
security even before final judgment of the court.
v) In case of adverse judgment by the court, an appeal to the higher court
should be filed by the banker within the stipulated period.
vi) A separate file for each defaulting account should be maintained by
the banker from the date of filing of a suit. The file should contain the
copy of every paper filed in the court Vs plaint, written statement of
the dependent, copy of the judgment, appeal, etc.

5.6.3 Sale of Security

As discussed, the banker is entitled to sell the security in the event of the borrower’s
failure to repay the loan. The following points are relevant in this context:
1. Only that much security should be sold away which should be sufficient to repay
the dues from the borrower. However, if the security is indivisible the entire
security may have to be sold away.
2. A proper notice for sale of security has to be given by the banker to the borrower
through a registered letter – the place, time and date must be mentioned.
3. Sale of security may be arranged either through auction or by inviting tenders. A
proper record of the sale transactions has to be maintained and the borrower has to
be informed accordingly.
4. The sale of pledged goods does not create much problem since they are already in
the possession of the banker. However, in case of hypothecated goods, the banker
can claim the possession of the goods from the borrower, as per the usual clause
in the contract. This will require a demand by the banker asking the borrower to
surrender the possession of the goods hypothecated to the banker within 24 hours
of the receipt of the notice from the banker. The time given is short so that the
borrower may not tamper with the goods.

In case the borrower is willing to give the possession of the goods, an inventory list is to
be prepared. The list is signed by the borrower, the branch manager and two independent
witnesses. On surrender of possession of the goods by the borrower, the hypothecation
will get converted into a pledge. In case the borrower refuse to surrender the possession
of the goods the banker should apply to the court for issuing necessary attachment order.
5. In case some immovable property has been given by way of security of the loan,
the banker should obtain a preliminary decree from the court against the
mortgagor in the first instance giving the mortgagor some time to redeem the
mortgaged property. In case the mortgagor fails to clear his dues, the banker

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 should obtain the final decree against the borrower which will permit the sale of
mortgaged property through the court.
6. In case some life insurance policy has been obtained as security for a loan, the
banker may surrender the policy to the life insurance corporation if the surrender
value is sufficient to cover the dues. The banker may at his option pay the
premium on life policy to keep it alive till its maturity or surrendering at
appropriate time.
7. In case of unsecured advance the banker may ask the borrower to provide
adequate security for the advance, In the event of his failure to do so the banker
may recall the advance. If the borrower fails to repay the advance a suit will have
to be filed against him in a court of law.

5.6.4 Recovery incase of Death of Borrower

In the event of death of a borrower before or after filing a suit or after obtaining the
decree, the banker will have to proceed against the legal representative of the decease.
The following points are relevant in this respect.
1. The banker will have to trace the legal representative in case the details
have not been given in the loan application form. The banker should
appeal to the court within a prescribed days of death of the defaulting
borrower for appointment of legal representative(s) against whom the
case can be carried on or filed. In case this has not been done the case
automatically stands withdrawn against the deceased borrower. However,
if the banker does not come to know of the death of the borrower within
the prescribed time limit, he may appeal to the court for relaxing the time
limit.
2. In case no legal representative is available, the court may appoint its own
official or such other person as it deems fit to represent the estate of the
deceased.
3. In case the defaulting borrower dies before the full satisfaction of the
decree the banker should apply to the court for grant of permission to
execute decree against the legal representative. It may be noted, that the
legal representative will be liable only to the extent of the estate left by
the deceased which comes to his hands. The court may also order the
legal representative to produce the relevant accounts in this respect.

5.6.5 Recovery incase of Insolvency of Borrower

Incase of insolvency of the borrower, the property of the insolvent is taken over by the
official assignee or the official receiver. The creditors of the insolvent have to submit
adequate proof of their debts to the court issuing the order of adjudication declaring the
borrower as insolvent.

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The banker will also have to submit a proof of debt due by the defaulting borrower
(insolvent) to the concerned court. The official assignee or the receiver will, from time to
time, make payment to the various creditors of the insolvent (including banker)
depending upon the property realized and the priority of claims as per the insolvency
laws. The banker at his level should stop operations in the account of insolvent as soon as
he comes to know that the borrower or his partner or his guarantor has become insolvent.
This is necessary to save the banker from additional loss on account of continued
operations in the account.

Check Your Progress Questions

1. Identify the characteristics of loan losses

________________________________________________________________________
____________________________________________________________________
2. Enumerate any precautions which the banker should take at the loan application
appraisal stage.
________________________________________________________________________
____________________________________________________________________
3. Explain the procedure the banker should adopt for recovering an advance in case
of death of borrower.
________________________________________________________________________
____________________________________________________________________
4. Explain what can be supervised account
________________________________________________________________________
____________________________________________________________________
5. Explain the need for follow-up and supervision of advances.
________________________________________________________________________
____________________________________________________________________

5.7 Summary

Bankers appraise the loan applications carefully with the idea of eliminating such
borrowers who may fail to keep their promises by not repaying the loans or diverting
money to inappropriate uses. But an appraisal alone can never guarantee protection
against such type of future risk. In any business, forecasting future performance on the
basis of present plans and conditions and past performance is subject to wild errors.
These errors may take place as the future is full of uncertainties and many changes may
occur in various fields, for example, economic conditions, management capabilities,
technology, consumer test, motivation etc. In order to take care of these changes and thus,
project oneself against such future risks, post allocation supervision or following

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becomes imperative. It should be kept in mind by bankers that the loan left to itself is
lost, unless properly followed up.

To this effect bankers use different mechanisms of loan supervision and follow-up. Loans
are classified into different categories based on their repayment status for proper follow-
up purposes.

5.8 Key to check your progress question

1. Refer section 5.2 4. Refer section 5.5

2. Refer section 5.6.1 5. Refer section 5.4
3. Refer section 5.6.4

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