Understanding Non Performing (NPA) Asset and different ways to handle NPA

A non performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days. When a principal or interest payments are late or missed, the loan falls under arrears. A loan is in default when the lender considers the loan agreement to be broken or the debtor is unable to meet his obligations. 

Non performing assets (NPAs) are recorded on a bank’s balance sheet after a prolonged period of non-payment by the borrower. NPAs place a financial burden on the lender, a significant number of NPAs over a period of time may indicate to regulators that the financial fitness of the bank is at risk. NPAs can be classified as substandard assets, doubtful assets, or loss assets, depending on the overdue period and the probability of repayment. Lenders have options to recover their losses, including taking possession of any collateral or selling off the loan at a significant discount to a collection agency.

How Non Performing Assets Work

The balance sheet of a bank or other financial institution includes non performing assets. The lender will force the borrower to liquidate any assets pledged as part of the loan agreement after an extended period of non-payment. The lender might write off the asset as a bad debt if no assets were pledged, and then sell it to a collection agency at a discount. 

In most cases, if loan payments have not been made for a period of 90 days, the debt is classified as nonperforming. While 90 days is the standard, the amount of estimated time may be shorter or longer depending on the terms and conditions. The debt can be classified as a non performing asset at any point during the term of the loan or at its maturity. 

Example

For instance, assume a company has taken a loan of Rs 10 lakh with interest-only payments of Rs 50,000 per month, and the company fails to make a payment for three consecutive months. Now to meet the regulatory requirements, the lender may require to categorize the loan as a non-performing asset. Otherwise, a loan can also be categorized as non performing if a company makes all interest payments but cannot repay the principal at maturity. 

Carrying non performing assets, also referred to as non performing loans, on the balance sheet places a significant burden on the lender. Nonpayment of interest or principal reduces the lender’s cash flow, which can disrupt budgets and decrease earnings. Loan loss provisions reduce the capital available to make subsequent loans to other borrowers because they are set aside to cover potential losses. Once the actual losses from defaulted loans have been calculated, they are deducted from profits. When a bank accumulates a sizable amount of NPAs on its balance sheet over time, regulators can infer that the bank’s financial stability is at risk. 

Types of Non Performing Assets 

Although term loans are the most common non performing assets, there are other forms of non performing assets as well.

• Overdraft and cash credit (OD/CC) accounts left out-of-order for more than 90 days
• Agricultural advances whose interest or principal installment payments remain overdue for two crop/harvest seasons for short duration crops or overdue one crop season for long duration crops. 
• Any type of account where the anticipated payment is overdue by more than 90 days

Recording Non Performing Assets 

Banks are required to categorize non performing assets into three categories based on the length of time the asset has been nonperforming: sub-standard assets, doubtful assets, and loss assets. 

Assets that have been designated as NPAs for less than a year are considered substandard assets. An asset that hasn’t been performing for more than a year is considered a doubtful asset. Loss assets are loans with losses identified by the bank, auditor, or inspector that need to be fully written off. It is reasonable to assume that they won’t be repaid because they typically have a long period of non-payment. 

Special Considerations

Recovering Losses

Lenders generally have four options to recover some or all losses resulting from non performing assets. They may proactively restructure loans when businesses have trouble paying off their debt to preserve cash flow and prevent the loan from being labeled as non performing altogether. Lenders may seize the collateral and sell it to recoup losses.

When defaulted loans are collateralized by the assets of borrowers, lenders can take possession of the collateral and sell it to recoup losses.  Lenders can also convert bad loans into equity. As a last resort, banks can sell bad debts at steep discounts to companies that specialize in loan collections. Defaulted loans that are not secured by collateral are typically sold by lenders.

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