A non-performing asset (NPA) is a classification used by financial institutions for loans and advances on which the principal is past due and on which no interest payments have been made for a period of time. In general, loans become NPAs when they are outstanding for 90 days or more, though some lenders use a shorter window in considering a loan or advance past due.
A loan is classified as a non-performing asset when it is not being repaid by the borrower. It results in the asset no longer generating income for the lender or bank because the interest is not being paid by the borrower. In such a case, the loan is considered “in arrears.”
Sub-Classifications for Non-Performing Assets (NPAs)
Lenders usually provide a grace period before classifying an asset as non-performing. Afterward, the lender or bank will categorize the NPA into one of the following sub-categories:
1. Standard Assets
They are NPAs that have been past due for anywhere from 90 days to 12 months, with a normal risk level.
2. Sub-Standard Assets
They are NPAs that have been past due for more than 12 months. They have a significantly higher risk level, combined with a borrower that has less than ideal credit. Banks usually assign a haircut (reduction in market value) to such NPAs because they are less certain that the borrower will eventually repay the full amount.
3. Doubtful Debts
Non-performing assets in the doubtful debts category have been past due for at least 18 months. Banks generally have serious doubts that the borrower will ever repay the full loan. This class of NPA seriously affects the bank’s own risk profile.
4. Loss Assets
These are non-performing assets with an extended period of non-payment. With this class, banks are forced to accept that the loan will never be repaid, and must record a loss on their balance sheet. The entire amount of the loan must be written off completely.
How NPAs Work
Loans, as addressed above, are not switched into the NPA category until a considerable period of non-payment has passed. Lenders consider all of the factors that may make a borrower late on making interest and principal payments and extend a grace period.
After a month or so, banks typically consider a loan overdue. It is not until the end of the grace period (typically, 90 days of non-payment) that the loan then becomes a non-performing asset.
Banks may attempt to collect the outstanding debt by foreclosing on whatever property or asset has been used to secure the loan. For example, if an individual takes out a second mortgage and that loan becomes an NPA, the bank will generally send notice of foreclosure on the home because it is being used as collateral for the loan.
Significance of NPAs
It is important for both the borrower and the lender to be aware of performing versus non-performing assets. For the borrower, if the asset is non-performing and interest payments are not made, it can negatively affect their credit and growth possibilities. It will then hamper their ability to obtain future borrowing.
For the bank or lender, interest earned on loans acts as a main source of income. Therefore, non-performing assets will negatively affect their ability to generate adequate income and thus, their overall profitability. It is important for banks to keep track of their non-performing assets because too many NPAs will adversely affect their liquidity and growth abilities.
Non-performing assets can be manageable, but it depends on how many there are and how far they are past due. In the short term, most banks can take on a fair amount of NPAs. However, if the volume of NPAs continues to build over a period of time, it threatens the financial health and future success of the lender.
Thank you for reading CFI’s guide to Non-Performing Asset. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: