Banking Strategy, Credit Appraisal, and Lending Decisions

A Risk-Return Framework

Second Edition

Hrishikes Bhattacharya

UNIVERSITY PRESS

Contents

List ofAppendices
List ofAnnexures

xi
xii

Preface to the Second Edition Acknowledgements Introduction

xiii xv xvii

1 . C a p i t a l R e g u l a t i o n a n d R i s k Management S t r a t e g y Introduction Inter-relationship among capital, assets, ROA, and ROE Competition for funds Rise in losses < > Risk management: A strategic issue Concluding remarks 2. Liquidity Management and Assets-Liabilities Strategy Introduction Liquidity management theories Fluctuations in the economy Liquidity planning > Liquidity ratios Balance sheet approach > Deployment strategies Maturity matching strategy Concluding remarks 3 . Banking Strategy Introduction Financial sector reforms Decline of traditional banking > Changing savings and investment behaviour Liquidity newly denned Securitisation Strategic planning Capital planning Growth model Banking strategy: The case of ABC Bank Strategic planning exercise of ABC Bank Cost allocation < Risk component Asset allocation Cost of funds Operational plan forfiveyears < > Concluding remarks 4. Lending Strategy and Loan Policy Introduction Need for a loan policy Credit-deposit ratio The threat of dilution in the quality of loans Policy emphasis on non-fund business Interest rate policy Loan portfolio and exposure policy Loan-to-value ratio Repayment policy Concluding remarks

32

65

105

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Contents

5. Fixed Assets 125 Introduction Definition > Land and buildings > Factory shed location Plant and machinery Depreciation Appreciation Capital work-in-progress Furniture and fixtures Motor vehicles Concluding remarks 6 . Working Capital: A Techno-Financial Approach 133 Introduction < > Should we hate current assets? < > Currentness concept and operating cycle theory < > Natural business year Negative operating cycle < > Limitations of operating cycle theory Mathematical fallacy Reversibility test An alternative theory of working capital o Discrete operating inventories Other discrete current assets Techno-financial approach Core working capital Projection of working capital Characteristics of Core Working Capital Control mechanisms Concluding remarks 7 . Current Assets and Fictitious Assets Introduction Cash and bank balances Sundry debtors/receivables Inventory Valuation of inventories Various types of stocks/inventories Loans and advances Intangible and fictitious assets Fictitious assets Concluding remarks 152

8 . Long-term Liabilities 165 Introduction Definition Equity or share capital Contribution of promoters Authorised capital Issued and paid-up capital Fear of takeover Reduction of capital Limited liability: Banker s problem Preference share capital Financing the redemption Share premium Dividend versus reserves Free reserves: The problem Bonus shares Capital reserve Banker's viewpoint Debentures Term loan Loans from friends and relatives Loans from subsidiaries Modern financial instruments Concluding remarks 9 . Current Liabilities 190 Introduction Origination Danger of overtrading Safety margin Trade creditors Deposits from customers and public Inter-corporate loans and investments Bridge loans Commercial paper Registration of charges Concluding remarks 1 0 . Profit and Loss Account Introduction Accounting concepts Nature of costs Wages Production overheads Maintenance and repairs Administrative costs Marketing and distribution costs Controllable versus uncontrollable cost Trading, manufacturing, and profit and loss account Gross profit Operating profit PBIT versus PBT Trading companies Manufacturing companies Absorption costing versus direct costing Difference in profit measurement Cost of goods sold Operating profit approach o Unusual incomes Concluding remarks 207

Contents ix

11. Understanding the Balance Sheet 230 Introduction Trial balance Treatment of closing stock Classification of accounts Balance sheet Net worth Gearing of capital Shareholders versus banker o Format of a balance sheet Non-corporate borrowers Percentage balance sheet > Preliminary observations A business with no formal accounting system Concluding remarks 12. New E r a o f L e n d i n g : T a n d o n C o m m i t t e e a n d I t s A f t e r m a t h Introduction
I. TANDON COMMITTEE

267

The norms Methods of lending System mechanics End-use t Classifications of current assets and current liabilities
II. CHORE GROUP

Review of the lending system Cash credit system < > Loan system Bill system Proposed scheme Drawee bill system < > Restructuring of financial statements, credit appraisal, and lending decisions Lending decision: An example Credit appraisal Lending decisions: Problems with the MPBF system Concluding remarks 1 3 . Business Forecasting and Credit Decisions 323 Introduction The basic theory Variables Regression analysis Standard error of estimate t-Distribution Coefficient of correlation Illustration Checking the assumptions Projection of sales Projected operating expenses Projection of gross working capital t Projection of trade and expense liabilities Bank finance for working capital Concluding remarks 14. Funds Flow a n d C a s h Flow A n a l y s i s
I. FUNDS FLOW ANALYSIS

341

Introduction Financing the total operation: Fourth concept Sources and uses of funds Generation of funds from operations Recommendations of IAS C < > Acquisition or disposal An illustration Suggested approach < > Calculation of bank finance for working capital
II. CASH FLOW ANALYSIS

Clearing the ground Value and obligation Cash and funds flow Cash book summary Detailed cashflowstatement Cash inflows o Motives for holding cash Cash outflows Concluding remarks 15. C o s t , P r o f i t a b i l i t y , a n d B r e a k - E v e n A n a l y s i s Introduction Dilemma of an entrepreneur Full cost versus marginal cost Variable cost Fixed cost Semi-variable cost Margin of safety Profit-volume ratio - Further problems of Pankaj Verma Problem of multiple products A simple method for a break-even analysis Financial break-even point Financial margin of safety Limitation and laws of marginal analysis Concluding remarks 383

Contents

16. Appraisal and Monitoring through Ratios Introduction Presentation and uses of ratios Manipulability of ratios Objectivity in ratio analysis Difficulties with ratios Classification of ratios Efficiency of operational management Efficiency offinancialmanagement Net working capital A situation with zero net working capital Implicit credit Treatment of contingent liabilities Efficiency of debt-service management < > Standards of comparison < > Concluding remarks

403

1 7 . Project Appraisal: Methods and Techniques 433 Introduction Banks' involvement in project financing > Policy changes > Non-financial appraisal Technical and managerial viability Financial appraisal Cost structure Depreciation Taxation < > Interest Discounted cash flow Risk element Net present value Opportunity cost Internal rate of return Payback method Average and effective rate of return Profitability index Repayment capacity Concluding remarks 1 8 . Project Appraisal and Lending Decisions Introduction Summary of the project Financial analysis of the project Cost structure Life of the project Salvage value Estimating projected revenue Relevant cash flows Working capital and term loan > Cash flow from operations Profitability index and internal rate of return NPV versus IRR Break-even point Debt-service coverage ratio Concluding remarks 1 9 . S m a l l B u s i n e s s Loan Introduction The case The need of the borrower Appraisal Alternative scenarios Concluding remarks 2 0 . Credit Risk Analysis Introduction Business risk Measurement of sales risks Coefficient of variation Evaluation of sales forecast Sales risk index < > Measurement of operating risks o Measurement offinancialrisks Measurement of industry risk Methodology and results of analyses Industry risk category > Borrower risk Character Lending decisions based on Cs Comprehensive borrower risk analysis Determination of final risk category Interest rate determination and margin requirement Concluding remarks 463

486

491

Bibliography Index

536 541