Three ‘R’s Of Credit

There are three basic considerations, which must be taken into account before a lending agency decides to agency decides to advance a loan and the borrower decides to borrow:

1. returns from the Proposed Investment,
2. repaying capacity, it will generate and
3. The risk bearing ability of the borrower.

These are known as the Three R’s of credit.

Returns: The First Test

Emphasis here should be on additional returns and additional costs involved in utilizing the borrowed funds. It involves working out the optimum combination of farm enterprises and the returns thereof, resulting from the additional availability of resources made possible through borrowed funds. The following points

1. Estimates of returns should be made on the basis of resources including borrowed funds.
2. Estimates of returns and costs should be made at the margin, not on an average.
3. Not only the MR=MC principles be kept in view while deciding the amount of credit but the law of equi-marginal returns must be fully exploited.
4. The level of other resources should be considered before deciding upon the amount of working capital tobe used. The possibilities of enhancing the level of other most limiting resources to farm production should also be examined.
5. Due care should be taken that more than the required amount of money is not advanced or obtained. At the same time, an inadequate amount of funds would not serve the purpose. Funds should, therefore, be advanced neither inadequately or excessively, but just the amount that can be profitably used.
6. Money needed for consumption purposes should also be considered for their marginal value to the farm-family satisfaction against the marginal productivity of the production loans.

Repaying Capacity-The Second Test

Although necessary, it is not sufficient to only analyse the productivity or the additional returns that will accrue due to the borrowed funds. A loan may be productive but still it may not generate sufficient income to leave funds sufficient enough to repay the loan. Repaying capacity is the portion of the amount that a farm family will earn from a year’s operation, which shall be available for the repayment of the loan. It should be based on an estimate of anticipated income from all sources of the borrower during the year. Repaying capacity, is therefore, worked out as a residual after meeting the requirements of the family consumption and payment of other dues, debts and repayments.

There can be two types of loans

Self liquidating,

Non-liquidating or partially self-liquidating loans.

The repaying capacity should be determined separately for self-liquidating and non-liquidating loans.

In case of the self-liquidating loans the amount gets absorbed in the production process in one year or production period and the formula here is:

Repaying capacity= Gross Income- [Living expenses+Working expenses (not including loan) + taxes + other loans and payments].

In case of non-liquidating or partially liquidating loans, the resource acquired with the funds are not directly consumer or are consumed over a number of years. They do not become completely a part of the first year’s costs and the returns from the investment are spread over a period of several years. For non-liquidating or partially liquidating loans, the repaying capacity is worked out as

Repaying capacity= gross cash income- (all working expenses+ other loans+taxes and payments due).

Risk Bearing Ability-The Third Test

It is necessary but again not sufficient that the credit should be productive and generate sufficient repaying capacity. It is also essential that the borrower should be able to withstand the shocks of probable financial losses. This is known as the risk-bearing ability of the borrower. Assessment of risk-bearing ability is necessary because the returns and repaying capacity analysis are made on the basis of averages. i.e., estimated production, prices and costs etc. but these averages seldom hold true. Agricultural business is subject to the vagaries of nature ad is exposed to many other hazards such as pest attacks, diseases and price fluctuations. Variations in income occur as a rule rather than an exception. The variability in income has, therefore, to be counted for in order to arrive at a fairly stable and reliable estimate of the repaying capacity.

The overall variability in returns has been estimated to be 21% in Ludhiana district. Such variability coefficients are needed especially by the financial organizations in all parts of the country where they wish to operate. The gross income should be deflated by this coefficient and the analysis should the follow the same pattern as for repaying capacity.