Vinu: Hi Manu, I’ve heard the term “sensitivity analysis” used when appraising term loans, but I’m not quite sure what it means. Could you explain it to me?

Manu: Of course, Vinu. Sensitivity analysis is a way for lenders to assess how changes in key variables or assumptions will affect a borrower's ability to repay a loan. It’s crucial in term loan appraisal because it helps the bank understand the potential risks if things don’t go exactly as planned.

Vinu: Interesting! What kind of variables or assumptions are we talking about here?

Manu: The most common variables we look at in a sensitivity analysis are:

Revenue or Sales: What happens if the borrower’s revenue is lower than projected? For example, instead of growing at 10%, what if it only grows by 5% or even declines?

Vinu: So, does this mean we’re stress-testing their financial projections?

Manu: Exactly! We’re essentially running “what-if” scenarios to see how resilient the borrower’s business model is to adverse conditions. For example, what if their sales drop by 10%, or raw material costs go up by 15%—can they still service the loan comfortably?

Vinu: That makes sense. How does this sensitivity analysis help in the decision-making process for a term loan?

Manu: Sensitivity analysis helps the bank in multiple ways:

Risk Assessment: It gives us a clear picture of the risk involved. If the borrower’s financials are too sensitive to small changes in revenue or costs, the bank may consider the loan riskier and adjust the terms or even reconsider the loan.

Loan Structuring: If a project is highly sensitive to certain variables, the bank might suggest structuring the loan in a way that minimizes risk, such as longer tenures, step-up repayments, or a mix of floating and fixed interest rates.

Vinu: Could you give me an example of how sensitivity analysis is applied in a real loan appraisal?

Manu: Sure! Let’s take the example of a manufacturing unit seeking a term loan for plant expansion.

The borrower has projected a revenue growth of 8% per year for the next five years, and the loan is structured based on this projection.

In the sensitivity analysis, we assume a 2% drop in revenue growth, so instead of growing by 8%, it grows by only 6%. We then recalculate the cash flow to see if the borrower can still meet their EMI payments with this lower revenue.

Next, we test for cost increases. Let’s say their operating costs go up by 10% due to higher raw material prices. We check how that affects their profit margins and, ultimately, their ability to service the loan.

Finally, we look at interest rate sensitivity. If the interest rate on their loan increases by 1%, we recalculate their EMI and see whether they can comfortably manage the increased payment.

Based on this analysis, if the borrower can still maintain a healthy DSCR and cash flow in all scenarios, the loan is considered safer.

Vinu: I see. So, how do banks typically react if the sensitivity analysis shows the borrower might struggle with even minor changes?

Manu: If the analysis reveals that the borrower is highly sensitive to small changes in critical variables, banks usually take action to mitigate the risk. They might:

Ask for More Collateral: To reduce the risk of loss, the bank might ask for additional security or personal guarantees from the borrower.

Lower the Loan Amount: They may reduce the loan amount to keep the borrower’s repayment capacity within a safer range.

Shorten the Loan Tenure: By shortening the loan tenure, the bank ensures quicker repayment and reduces the borrower’s long-term exposure to risk.