Page 91 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Character: Measure of reputation of the firm, its willingness to repay and the repayment
history.

Capital: The adequacy of equity capital of the owners so that the owner’s interest remains
in the business. Higher the equity capital betters the creditworthiness.
Capacity: The ability to repay is measured by the expected volatility in the sources of
funds intended to be used by the borrower for the repayment of loan along with interest.
Higher the volatility of this source, higher the risk and vice versa.
Collateral: Availability of collateral is important for mitigating credit risk. Higher the
value of the collateral, lower would be the risk and vice versa.
Cycle or (economic) Conditions: The state of the business cycle is an important element in
determining credit risk exposure. Some industries are highly dependent on the economic
condition while the others are less dependent or independent. Higher the dependence,
higher the risk as during recessionary period of the economy, the cyclic industries would
suffer and vice versa. Industries such as FMCG, pharmaceuticals, etc. are less dependent on
economic cycles than industries such as consumer durable, steel, etc.
The expert view on the above would finally influence the decision to lend or not. Although
many banks still use expert systems as part of their credit decision process, these systems face
two main problems (Saunders, 1999):

Consistency: There may not be a consistent approach followed for different types of
borrowers and industries. Thereby the system would be person-dependent.
Subjectivity: As weights applied to different factors are subjective, comparability across
time may not be possible.
5.4.2 Credit Rating

Credit Rating is the most popular method at present among banks. Rating is the process by
which an alphabetic or numerical rating is assigned to a credit facility extended by a bank to a
borrower based on a detailed analysis of his character and matching it with the characteristics of
facility that is extended to him.
The rating carried out by a bank is very much similar to the credit rating carried out by external
rating agencies such as CRISIL, ICRA, etc. The only difference is that while the rating by the
external agency is available in the public domain for any one to use, the internal ratings carried
out by a bank is confidential and is used for specific purpose only. Moreover, the internal ratings
of banks are usually finer than the ratings of rating agencies. This is to facilitate better distinction
between credit qualities and pricing of loan in an accurate manner.

5.4.3 Credit Scoring

A major disadvantage of a rating model is the subjectivity of weight to be applied to different
segments in the rating exercise. This drawback can be avoided in a scoring model which is based
on rigorous statistical techniques.
This approach combines a number of ratios into a single numerical score which is used to
determine the credit quality or default. The basic assumption of the method is that combination
of a number of ratios explains the success (no default) or failure (default) of a facility extended to
a borrower. Starting with the historical data with known outcome of success or failure, a set of
ratios that differentiate the successful cases from the failed ones along with the weights to be
applied for each ratio is arrived at by multiple discriminant analysis. The most popular among
the models is the one by Altman’s (1968) Z-score model, which is a classificatory model for
corporate borrowers.

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