INTRODUCTION

Businessmen need loans for their businessess. There are many instances when the
applicant (businessman), unaware of the bank’s needs, does not present all the details
required or presents it in a manner that causes the Bank to reject the application. At other
times, as the information given is incomplete, the applicant is harassed by demands for
more information and then after he has submitted that asked for for yet some more. Time
drags on while the bedeviled applicant runs hither and thither exasperated, frustrated and
harrowed. The banker is also exasperated, frustrated and harrowed. He exists to make
loans but before he approves the application and permits disbursal, as a responsible
professional, he has to be convinced that the borrower has the capacity and the
willingness to repay. Nothing thrills him more than a well presented detailed application
that addresses all the concerns that he may have.

This course seeks to reveal to the borrower the banker’s mind. It attempts to enlighten
him on what a banker looks for, the issues that he thinks are important and to explain how
he arrives at the lending decision.

This course is also for the banker to remind him of the issues that are important when
assessing the credit worthiness of a prospective borrower. It is also intended to also help
students of banking, management sciences and finance.

THE BUSINESS OF LENDING

Raman Menon is an exporter of garments. He has received a large order from the United
States and the finished goods have to be exported within 90 days. In order to fulfill the
order he requires approximately Rs. 50 lakhs to purchase raw materials and meet
production costs. He has never sought a bank loan and is unclear on how he should
approach a bank and which bank he should approach. Rusi Daruwalla, on the other hand,
is the Managing Director of Unisulphur Ltd., a company that manufactures chemicals and
needs to expand capacity in his factory to meet growing demand. He has approached the
company’s bankers - The Manufacturers Bank for a loan. However, even after two
months, they were still raising several queries and Mr. Daruwalla is at his wit’s end. He
was even forming a belief that the bankers were raising queries in order to find a way out
of not lending him the funds that he needs. Vinod Desai is a young professional. He has
just qualified as a Doctor and wishes to set himself up as a Medical Practitioner. He needs
essential seed capital of around Rs. 10 lakhs to rent and equip a clinic. Unfortunately he
has no funds nor can he give any collateral apart from the assurance that he would work
hard and repay the amount borrowed within a year or two. Raman Menon, Rusi
Daruwalla and Vinod Desai have several commonalties. They require money now. They
need this money essentially from a bank. They are unclear on how to approach the bank
and what information they need to furnish. This is a problem many in need of finance face
and often they believe, misguidedly, that banks do not want to lend to them.

I state misguidedly because banks exist in order to lend. They avidly and aggressively
seek persons or corporates to whom they can lend monies to. However, as the downside
of a bad debt is very high the banker has to be convinced that he is actually not throwing
away good money and that he will be repaid in full and in time. To this end he will ask
questions, seek answers and documentary evidence. This is natural. He has to always
remember that a bad loan is a loss. It must be remembered that the return that a banker
normally earns on a loan is about 2% to 3% per annum. If the Manufacturers Bank
advanced a loan of Rs. 2,000,000 to Unisulphur Limited, it could expect a net return/
earning of Rs. 40,000. If however, the loan becomes uncollectable and by extension bad,
the Bank would need to lend Rs.100,000,000 at 2% per annum to another company in
order to recoup the loss. This is an enormous amount. In short, considering the cost of a
bad loan, it is safer to refuse advancing a loan (from a banker’s perspective) than advance
one in the hope of earning an income. The downside risk is enormous. This is the reason
that bankers prefer to lend only to those companies who are growing, profitable, running
and well regarded. This is why it appears that Banks are desperately trying to lend to
those who do not need money and refuse to “give the time of day” to those who do.

One must bear in mind that the non performing asset recognition norms now imposed by
the Reserve Bank on banks are becoming increasingly stringent. If interest is not paid for
two quarters on a loan, the loan has to be deemed/ recognised as a non performing asset
(NPA). Interest then cannot be accrued on this advance by the Bank and Banks are also
required to state in the financials the quantum of non performing assets they have at the
year end. Provisions too would need to be made - the amount depending on how good the
advance I, the amount of collateral the bank has and the period it has been outstanding.
This is a direct charge on profits. The enormous emphasis placed on non performing
assets and the scrutiny it is subjected to (quite rightly) is one of the main reasons that
bankers are reluctant to lend when there is even a shred of concern on the viability of a
project or the creditworthiness of a borrower. The dictum they follow is “when in doubt,
don’t”.

In conclusion it must always be remembered that the business of banking is lending. The
banker takes a risk whenever he approves a loan. This is accepted. His job, as a prudent
person, is that he has to ensure that the risk is minimal on any monies lent. The borrower,
on the other hand, if he wishes to receive the monies he needs for his enterprise has to
satisfy the banker that he is competent, the monies lent are safe and will be repaid.

In this course the participant will be enlightened on the factors bankers look at when
reviewing a credit proposal - give the borrower a peep into a banker’s mind. These are
essentially:

The nature of the loan sought.

The period within which it would be repaid.

The manner it would be repaid.

The security or collateral that is given for the loan.

The economic conditions and the industry conditions that might affect the
creditworthiness of the borrower.

The viability of the project.

This would include knowing the industry and the relationship of its performance with
the economic/ business cycle.

The competence and integrity of management and its intention to repay the loan in the
manner agreed.

The past record. How successful has the particular business/ businessman been.

Should the borrower address these issues, the chances are that the loan would indeed be
paid in record time.

THE PURPOSE

The pivotal question upon which the lending decisions rests is the purpose for which the
loan is sought. and this is usually the first issue that a Banker ascertains when approached
for a loan or any other credit facility. In regard to this there are a few factors that must be
remembered as these are critical.

1. The nature of the credit facility sought must be consistent with the borrower’s
activities. Raman Menon is an exporter of garments. It would be inconsistent and illogical
to advance him a loan to purchase a chemical agitator.

2. It must be for a matching need. In regard to this I mean that short term funding should
be sought for a short term need. Raman Menon, as an exporter of garments should not
seek a term loan to finance preshipment expenses. Alternatively, a manufacturer should
not seek to finance a factory expansion with an overdraft. in short:

A company that needs working capital to purchase inventories (stocks) and pay
expenses should seek an overdraft.

An exporter who needs finance to purchase goods to export should seek a pre shipment
packing loan.

An exporter who needs finance on goods exported under a usance letter of credit
( payment is made after 90 to 180 days after the acceptance of the documents by the
buyer) should seek an export bill discount facility.

An industrialist on the other hand who needs a large loan to finance an expansion or
build a factory or buy some very expensive machinery should seek a term loan. This is a
loan that is payable over a period of time. Often, due to the gestation period, banks would
give a moratorium regarding payment of interest and principal for a year or so.

At times a loan may be required for a short period to ‘bridge two events”. This is
known as a bridge loan. A company may have had a public issue to finance its expansion.
In order not to hold up work until the final allotment is made and the monies are available
to the company, it may seek a bridge loan.

Certain companies and industries require facilities seasonally. A classic example is the
sea food industry. It requires finance soon after the monsoons to purchase and process
seafood for export. During the monsoons no finance is usually required. Similarly the tea
industry requires finance when there is no picking of tea - to replant tea and to maintain
the tea gardens.

It is imperative that the nature of the facility sought is compatible with the reason the
facility is sought. If it is not there could be horrendous repercussions as did happen soon
after the liberalisation initiatives announced after 1992. At that time the capital markets
were booming and most industrialists believed that they could access the markets at will.
Many accessed the markets, began projects and utilised the monies for other purposes too.
They did not foresee the virtual death of the capital market. When they found issues being
under subscribed and devolving, short term funds such as overdrafts were utilised to
complete projects begun. I can understand and sympathise with this though I think it is
dangerous. If a company has spent Rs. 10 crores and needs another Rs. 2 crores to
complete an installation, it is better to complete it so that it can begin producing and
earning profits as opposed to allowing it to be a non productive white elephant. However,
in practice, (although at the time it may appear to be a stroke of genius and a way out of a
dangerous situation) it is fool hardy to finance a long term asset with a short term loan.
The two are incompatible and there is a maturity mis match. Consequently when short
term funds begin to become tight, as did happen in 1997 and 1998 in India, several
companies began to resort to accommodation financing (discounting of bills that were not
backed by genuine trade transactions). Once begun one usually gets sucked into the
situation and it has a snow balling effect. Once in the spiral it becomes difficult to get out.
A bill maturing is paid by another bill that is discounted. At each stage charges have to be
paid. The result is one pays much, much more than one would have had one taken a term
loan. Additionally, one would have saved oneself from a tremendous amount of tension.
Additionally, the accommodation financing route can lead to lack of liquidity (if the next
bill is not discounted) , loss of credibility and can, as has happened in several cases
recently, lead to the closure of the concern.

It is important that a prospective client is honest and open with his banker. If he needs to
utilise a loan for a particular purpose, he should tell the banker exactly what the purpose
is. He should advise his banker his concerns and his problems. Bankers are there to help
and not to hinder. If the banker has a full appreciation of his clients’ concerns; his
strengths and his weaknesses and he is convinced of the person’s integrity, the banker will
go out of his way if required to sanction the loan. It is always better to apprise the banker
of all the issues at the outset - especially the more crucial ones. It would be very difficult
to explain at a later stage why something of crucial importance was not mentioned. An
omission of an important issue may also make the banker wonder whether there are any
others that have not been mentioned which may be critical. Honesty and transparency is
without doubt the best policy.

SOURCES OF REPAYMENT

The main concern that a banker has when facilities are extended is on the repayment of
the monies advanced. This is the question that he will invariably zero in on and it would
be prudent for the prospective borrower to advise him upfront on how he intends to repay
the facility. As prospective borrowers Raman Menon, Rusi Daruwalla and Vinod Desai
should be able to demonstrate to their respective bankers with facts and figures the
repayment plan.

In ideal circumstances there should be more than one source of repayment so that should
there be, for some reason, a delay or a problem, the repayment commitment can still be
honored. Bankers too, if presented with a well structured plan/ plans of repayment would
be more willing to listen and even advance facilities.

Primary Source

The primary source of repayment should be directly related to the kind of loan given i.e.
for facilities extended (overdraft) for working capital or to finance trade the repayment
should be from the proceeds of the goods sold. In Raman Menon’s case, the primary
repayment must be from the sale of garments. If a bridge loan prior to the final allotment
of a public issue has been given, the repayment should be from the monies received after
the allotment is made. On the other hand if the bridge loan is given prior to the sale of an
asset, the proceeds from the sale of the asset should be used to extinguish the loan.

Secondary Source

Even though there may be a real and quantifiable first source of repayment, there is
always a possibility that on account of occurrences beyond the borrower’s control, the
loan cannot be repaid from the primary source. A classic example is what is presently
happening in India on account of the liquidity crunch and the demand downswing. A well
known company purchased 41 windmills at a cost of around Rs. 1 crore each and was
confident of selling them quickly. Due to a credit squeeze the windmills were unsold and
the company could not repay the borrowings from the proceeds of the sale. The company
in order to meet its credit commitments sold some property it owned. This was its
secondary source of repayment. When companies take working capital finance in the
form of overdrafts they normally hypothecate debtors and stock. If repayments are not
made, the secondary source of repayment can be seized and sold and the proceeds can be
used to liquidate the loan. Raman Menon would have, when taking the loan, hypothecated
his goods. If he was unable to repay the monies borrowed the bank could seize his goods
and then sell them.

Tertiary Source

The tertiary source is further security for a loan. This is in the form of additional collateral
that may be unconnected with the business. A director could pledge the shares that he
owns in certain blue chip companies as additional security. Alternatively the principal
shareholders could give their personal guarantees or a well wisher could give his
guarantee. The comfort that a Bank would derive is that should the primary and secondary
source of repayment fail, they will have recourse to yet another source of repayment. It is
assurances such as these that help the Banker in supporting and recommending a request
for a credit facility. As additional security Raman Menon could mortgage his factory or
give as additional security shares that he owns. Similarly Rusi Daruwalla could, for the
term loan given to Unisulphur Ltd., give his own personal guarantee.

Refinancing

Another method of repaying a loan is by refinancing - procuring a second loan out of

which the existing loan is repaid. This may be either by:

Taking another loan.

Accepting fixed deposits. This is not particularly easy presently owing to the credit/
liquidity crunch and the fact that several good companies have defaulted on the payment
of principal and/or interest.

Issuing debentures. Debentures are an acknowledgment of debt and this is a very

popular form of raising funds to repay existing loans. The convenience of a debenture is
that it is usually repayable only after a minimum of three years. It gives the borrower
some time to arrange his finances.

The banker will seek to ensure that the charge is properly registered so that should the
need arise, the banker can take possession of the asset. There are two kinds of charges -
specific and floating. A specific charge is a charge on a specific asset. A floating charge,
on the other hand, is a charge on all the assets both present and future of the company. A
specific charge has a prior charge however and a banker would always prefer a specific
charge.

There are times when the asset to be charged is already hypothecated. In such instances
the bank can only get a second charge for the facility given. This means that the banker’s
rights are subordinate to the entity that holds the first charge. In other occasions where
there are a number of lending banks as in a consortium, the borrower would be able to
give the bank only a “pari passu” charge. In this instance the bank’s rights are on the same
footing as the other lending banks.
No banker will issue facilities unless it knows and checks the sources of repayment
because he is in the business of lending, and not in the business of giving away.

COVENANTS

Raman Menon was worried and concerned. He had received a call a short while earlier
from his banker congratulating him on his loan request being approved. The sanction
letter that was faxed shortly afterwards contained various conditions and the disbursal of
the loan was contingent on the conditions being met. The concern Menon had was on the
nature of these stipulations. He wondered whether he should accept a loan that is
conditional.

Conditions imposed on facilities extended by banks, also known as covenants are

imposed by bankers upon a borrower to:

Preserve the financial strength of the borrower.

Maintain the borrower’s ability to refinance itself - the borrower (being a limited
company or a business) continuing as a going concern.

Control the assets - prevent the borrower from selling assets thereby ensuring that
assets are not dissipated,

Ensure that the borrower does not do something that would be detrimental to the
interests of the Bank.

Covenants, therefore, are from a banker’s perspective extremely important in the

structuring of a loan. While a risky, unsound loan will not become good by covenants,
they will afford some comfort and a degree of control including providing warning signs
should the financial position of the company deteriorate. The amount of covenants that
can be imposed on a borrower would depend on:

The antecedents of the borrower. Has the borrower borrowed before and what has his
repayment history been .

The need of the borrower for the facility/loan.

The kind of facility required.

The nature of the borrower’s business and the industry wherein he operates..

The borrower’s financial health

The risks involved.

Covenants imposed are always negotiable and negotiated. Banks will always attempt to
impose very exacting covenants. Some may be too exacting and impractical. Therefore a
borrower must, at the time the facilities are being accepted ensure:

The covenants are reasonable and realistic

The covenants will not affect the growth or stability of the company. Very restrictive
covenants can retard growth.

The borrower, while appreciating the banker’s need must also consider his own. He would
be extremely shortsighted if he accepts conditions that are detrimental to his interests or
restricts his ability to function freely.

Covenants do not serve any purpose if they are not effective. The banker will therefore
make certain that action can be taken for non compliance of the covenants. The remedies
that are available are to a banker :

Taking an additional collateral, thereby strengthening the loan.

Seizing the assets secured and selling them.

Procuring further collateral such as a mortgage on another asset or a guarantee

(preferably another bank guarantee)

Restructuring the loan

Increasing the rate of interest on the loan (The risk/ return factor).

Covenants may be positive or negative.

Positive covenants are requirements made on the borrower to do certain acts. Some of the
more common ones are:

1. The borrower must present a monthly statement or as often as required information on

stocks and debtors. This is usually required if stocks and debtors have been hypothecated
for an overdraft working capital facility. The banker uses the monthly statement to check
drawing power and to ensure that the items hypothecated exist and are adequate.
Periodically bankers inspect the clients’ factories and offices to physically verify the
existence of the assets.

2. The borrower must insure and maintain the assets that have been given as collateral for
the loan. This is to ensure that if there is a fire or other catastrophe, the borrower does not
lose anything.

3. The borrower must comply with all laws and regulations.

4. The borrower must pay taxes regularly.

Negative covenants while they don’t force the borrower to perform certain actions,
require him to ensure certain things and restrict him from certain acts. A requirement
could be that no assets may be pledged or no dividend declared without the permission of
the Bank. These are designed to protect the lender from the dissipation of assets, to
protect his security and to an extent preserve the financial strength of the borrower.

Negative covenants usually:

1. Restrict actions such as:

Payment of dividend

Sale of assets

Limitations on additional loans

Purchase of investments and the giving of additional loans.

Purchase of investments and the giving of advances.

Mortgaging of assets.

2. Maintenance of financial strength (usually in the form of ratios) such as:

Leverage

Liquidity

3. Specific restrictions:

Ensure existing management remains

On the sale of debtors.

On lending to subsidiaries or group companies.

On investing in group companies.

Covenants are, in short, safeguards and are always tailor-made to the requirements of
borrowers and lenders based on their respective weaknesses and strengths.

Covenants must therefore be viewed as safeguards imposed on a borrower to preserve the

borrower’s ability to repay the loan.

COLLATERAL

Soon after the initial talk Raman Menon had with his banker, Mr. Buch of the
Manufacturers Bank, Mr. Buch asked him on the collateral he could offer the bank for the
facilities required. Bank’s seldom extend any facility without collateral and the more
liquid, the more realisable (encashable) and the more tangible a collateral is the greater
the chances are of the facility being granted easily. This is why a loan against the security
of a fixed deposit is the facility that is easiest to procure. Banks literally take no risk as
they have with them, in their possession, the entire advance extended in the form of actual
cash.

Collateral is the security given to the bank as a safeguard for the facility/ facilities
advanced. This is effectively the Bank’s insurance that should there be a default, the bank
has something to fall back on to either recover in part or full the amount advanced.

It is important for a prospective borrower to realise that there is no such thing as a

standard collateral. The nature of the collateral, the amount and the percentage of the
facility advanced that it covers will vary from borrower to borrower and from bank to
bank.

However, there are some standard collaterals.

The collateral sought for an overdraft and working capital facilities is the
hypothecation of book debts and stocks. The amount advanced will be usually a
percentage of the total value - the percentage held back being known in banking
connotation as the margin. This is an additional safeguard for a bank as often when goods
are sold in a hurry - a quick, forced or distress sale the real, fair value is not realised. The
margin on stocks is usually between 25% and 40% and this depends on the company and
the industry it operates in. This means that if the total value of stocks held are Rs.
100,000, the amount that the Bank would permit the borrower to draw on an overdraft (if
the margin is 25%) is Rs. 75,000. This is known as the drawing power. In regard to
debtors the margin is usually higher and can be as high as 50%. In calculating the drawing
power banks will insist on a debtors’ aging list and debts over 90 days are excluded from
the calculation.

If funds have been advanced to purchase machinery or some other fixed asset, the asset
purchased is usually hypothecated/ mortgaged to the Bank.

In regard to unfunded facilities such as the issuance of a guarantee or a letter of credit,

banks usually ask for a cash collateral or margin money. This varies from nil to 20% of
the value of the facility - the amount depending on the intrinsic strength of the borrower
and the need of the borrower for the facility.

Additional collateral are often sought by banks in the form of shares of good blue chips
from companies for additional comfort.

Banks, often ask too, in case the borrowing company is part of a larger entity (a
subsidiary or an associate company or a branch of a multinational), for a guarantee or at
worst a letter of comfort from the parent company as additional comfort. This is more for
a moral commitment than for any other as it often is difficult to hold the parent down on
this or take it to court.

In regard to guarantees as collateral, banks ask for the personal guarantees of directors
too. In the case of private limited companies, directors often give their personal
guarantees supported (at times) by a statement of their net worth. Directors of public
limited companies have also been known to give guarantees. This is not common though
as these directors often submit that the company is a legal entity in its own right with
several thousand shareholders. The directors often are paid employees. In such a
circumstance they argue that there is no reason why they should be personally committed
to pay all the debts of the company.
In order to be able to enforce on the collateral, banks will insist on their being registered.
This is to lay claim to their right and to put on notice any subsequent lender that the
particular asset has already been hypothecated/ mortgaged.

In some cases the asset (such as stocks are already hypothecated ) to another lender. In
these cases the new lending bank would seek a pari passu charge with the other lender/
lenders. This is to make the new lending bank’s rights equal to that of the banks who have
already got the assets as collateral.

Banks will always check whether the collateral’s value fluctuates widely as in the case of
shares. If it does periodic valuations will be insisted upon and topping up may be required
from time to time if there is a deterioration in value. In cases where the collateral is at the
clients’ premises like stocks or machinery, periodic collateral checks will be undertaken
by banks to satisfy itself on the existence and the value of the collateral.

A borrower must always remember collaterals are viewed by bankers as additional

comfort and they would never, unless forced to do so and until after every other method
has failed, seek to enforce their right as that could affect the viability of the concern.

KNOW YOUR CLIENT

A cardinal rule in banking is the concept of “Know your client.” This means exactly what
is says. The banker will do all he can to find out as much as he can about the company
and the client. In this no information is too small or too immaterial since they will fit into
a larger picture and the fate of the facilities extended may depend upon it. It has to be
always remembered that the project may appear sound, the documentation perfect and the
financials impeccable. However, if the intent is to cheat, it could cause severe losses to
the Bank. Banks are always aware that a dishonest man is also a very clever person.
Additionally the dishonest person has the advantage in that the innocent banker believes
him to be a good, honest soul. He knows he is not; he knows he intends to cheat the
banker and he has a scheme to cheat him.

A few years ago an apparently wealthy businessman approached the Bangkok branch of a
large foreign bank to open a letter of credit to import certain items from Hong Kong. The
amount was large. The person appeared respectable. The young banker, in his eagerness
to capture additional business to meet the demands of a very tough budget, complied with
his request. The banker convinced himself that the risk was small as the goods would not
be handed over till it had been paid for. Additionally the facility was short term and self
liquidating. The seller from Hong Kong exported the goods and on his presenting the
documents was paid (as the Hong Kong branch had confirmed the letter of credit). The
documents arrived in Bangkok and when the client was sought, he was nowhere to be
found. Inquiries revealed that he had left the country a day after the exporter had been
paid. It was further found that the businessman had no business any longer. The bank took
possession of the goods and when the cartons were opened, it was found that the goods
were not what they were purported to be. In fact, they were of practically no value at all.
The Bank suffered a significant loss. It was later discovered that the “businessman of
Bangkok” and the “exporter from Hong Kong” were in fact brother in law and partners in
crime.

This incident reveals the importance of knowing to whom monies are lent. A person intent
on cheating a Bank can do so however tight or foolproof the documentation appears to be.
Bankers therefore, quite rightly, follow a simple rule. If there is a doubt - even a very
slight doubt on the integrity and the honesty of a client they will not lend. The risks are
too great.

It is because of this crying need of knowing the client that Banks insist on a client being
introduced. The banker works on the supposition that if the prospective client has been
introduced by another whose credentials are above reproach then by extension the
prospective client’s credentials are also by extension, above reproach. If Raman Menon
was approaching the Manufacturers Bank for the first time, the Bank would ask for an
introduction from an existing client. Additionally the Bank will seek to find out whether
Mr. Menon had been banking with some other bank. If he had, a reference from that Bank
would also be sought.

In addition a banker will always attempt to verify facts and try to find out more. This is to
establish the credibility of the client. A prospective borrower, optimistic of his future, may
give information that may be too ambitious or hopeful. Conversely, with the intent of
defrauding the Bank the information given may be totally false. The banker will check all
statements made. The acceptance of an unverified statement destroys the credibility of the
analysis and bankers are aware that such an action can put the entire exposure at risk.

Several years ago a well spoken gentleman approached the Manager of a large branch of a
private sector bank and informed him that a mutual friend had recommended the bank to
him for a loan to finance working capital. This was not checked because the person
appeared so genuine and respectable. The facilities were arranged securing them to the
hypothecation of stocks, book debts and fixed assets. There appeared to be adequate
cover. A few years passed. The demand for the Company’s goods fell. The inventory
became obsolete. The client became bankrupt. When the Bank took steps to seize the
inventory and fixed assets it was found that another bank had a first charge on the fixed
assets. The Manager was not aware of his inferior collateral as he accepted the clients
word without verifying. It was later found that the client was not a friend of the person the
Manager knew. He had merely dropped a name and the Manager had bitten the bait. In
this case failure to verify facts lad the Bank to lose a large sum of money.

Bankers verify facts and information given by:

Bank checkings - the opinion of the bank where the new customer is known and the
dealings he has had. Banks asked for this information are often non committal as they
expose themselves to law suits and the like if they reveal more than they should.
However, the wordings used are usually enough to give the querying banker adequate
information.

Trade checkings - the person’s standing among his peers and his reputation.

Customer checks - the opinion customers of the prospective borrower has of him.

On site visits and asset verification - does the factory/ plant/ business actually exist and
the value of the assets.

Collateral Audit - does the collateral actually exist and can it be pledged (has it been
pledged to someone else).

Verification of other statements made by whatever means.

Good bankers will always “keep their ears to the ground” to listen to information and
gossip because this can be very valuable as it is sometimes surprisingly accurate. Bankers
will invariably react quickly to negative news as it often is the harbinger of very very bad
news. A good banker will not however react without checking the information that he has
received because it may be untrue.

As borrowers clients must always tell the truth. Even one small inexactitude puts the
whole relationship in jeopardy as it would make the banker doubt the integrity and
honesty of the client.

MANAGEMENT

The single most important factor that a banker considers when he considers an
application/ proposal for credit facilities is the management. It is upon the quality, the
competence and the vision of the management that the future of a company rests. A good,
competent management can make a company grow while a weak, inefficient management
can destroy a thriving company. Corporate history is riddled with examples. The Ambanis
with their vision and acumen have made Reliance a global giant. Others who tried to
emulate them with grandiose plans are heard of no more. Chrysler was, in the early
eighties, an ailing giant. Iacocca, with tough competent management turned the company
round. In the first quarter of 1993 the big blue - IBM dismissed its Chief Executive
Officer Akers who was blamed for the companys dismal performance. Lou Gerstner who
was at one time President of American Express and who took charge of R.J.R. Nabisco
after it had been taken over after a multibillion dollar leveraged buy out was invited to
become the Chief Executive Officer of IBM. Mr. Gerstner has successfully turned the
company round. Metal box, Killick Nixon, Nirlon, The Gadgil Western Group, the
Kamanis and many others have been brought down from their positions of eminence and
their management has to bear the guilt for this.

The Banker when Rusi Daruwalla or Raman Menon approaches him for facilities will
initially determine their competence as managers. If they are not blessed with ability,
foresight, tenacity, professionalism and integrity the enterprise will most likely not be a
success.

In India, management can be broadly divided into two :

o Family Management

o Professional Management
Family Management

Family managed companies are those that have at the helm a member of the controlling
family. The Chairman or the Chief Executive Officer is usually a member of the ruling
family and the Board of Directors are peopled by either members of the family or their
friends and rubber stamps. Mr. T. Thomas, a former Chairman of Hindustan Lever Ltd.,
describes the family business structure most eloquently in his memoir To Challenge and
to Change. He speaks of an Indian family business having a series of concentric circles
emanating from a core - the core being made up of the founder and his brothers or sons.
The next circle is the extended family of cousins and relatives followed by people from
the same religious or caste group. The fourth circle comprises of people from the same
language group and the outermost circle has people from the same region. Mr. Thomas
says that to go beyond this was like going out of orbit - unthinkably risky.

There has been some change in the way family controlled families have been managed. In
the beginning there were often orthodox, autocratic, traditional, rigid and averse to
change. This is no longer true. The sons and the grandsons of the founding fathers have
been educated at the best business schools abroad and they have been exposed to modern
methods. Consequently, in many family managed companies, although the man at the
helm is a scion of the family, his subordinates are graduates of business schools -
professional managers. This combines, to an extent the best of two worlds and many such
businesses are very successful. The frustration for the professional manager in such
companies is that he knows that he will never, ever run the company - that privilege will
always be with a member of the family.

Professional Management

Professionally managed companies are those that are managed by employees. In these
companies the Chief Executive Officer does not have, very often, a financial stake in the
company. He is at the helm of affairs because of his ability and experience. The
professional manager is a career employee and he remains at the seat of power so long as
he meets his targets. Consequently he is always results oriented and his aim is often short
term - the meeting of the annual budget. He is not necessarily influenced by loyalty to the
company. As a professional he usually is aware of the latest trends in management
philosophy and tries to introduce these. He tries to run his company like a lean, effective
machine striving for increased efficiency and productivity. As a consequence
professionally managed companies are usually well organized, growth oriented and good
performers. Investors are the recipients of regular dividends and bonus issues. However,
there is often a lack of long term commitment and sometimes a lack of loyalty. This is
because in time the professional manager has to step down - to retire and he cannot
therefore enjoy the fruits of his labour forever. Nor will his sons succeed him although
some may try to see that this happens in time. In many professionally managed
Companies there is also a lot of infighting and corporate politics. This is because
managers are constantly trying to rise up the corporate ladder and the end is often what
matters not the means. Often too as a consequence the best person does not get the top job
- it is the person who plays the game best. This does not always happen in family
managed companies as one is aware that the mantle of leadership will always be worn by
the son or daughter of the house.

What does a banker look for

It would be unfair to state that one should banker’s prefer only professionally managed
companies or family managed companies. There are well managed, profitable companies
in both these categories. There are also badly managed companies in both these
categories. What then are the factors bankers look for?

1. The most important aspect is the integrity of management. This must be beyond
question. it is often stated that however good the systems and controls are, an employee,
if he is intent, can perpetrate a fraud. Similarly the management, if it so desires, can
juggle figures and cause great harm and financial loss to a company (for their own
personal gain). Bankers tend to if they are not too certain of the integrity of management
will leave that company well alone. I had the privilege once to listen to Mr. C.S. Patel
who was at one time the Chief Executive of Unit Trust of India. He recounted an advice
he was given by his mentor, Mr. A.D. Shroff who was once the Chairman of the New
India Assurance If you have the slightest doubt of management do not touch the company
with a pair of tongs. Seldom have I heard truer words. Thus the first thing a banker does
when considering a loan to Unisulphur Ltd. Is to check the competence, integrity and
honesty of Rusi Daruwalla.

2. Another point bankers consider is proven competence - the past record of the
management. How has the management managed the affairs of the company during the
last few years? Has the company grown? Has it become more profitable? Has it grown
more impressively than others in the same industry?
Bankers are usually a little wary of new management and new companies as they have a
very high level of mortality. This is why they normally ask for three to five years figures.
Past performance can be an accurate predictor of future events.

3. Bankers often try to ascertain how highly the management is rated by its peers - by
others in the same industry? This is a very telling factor. The ones that are aware of nearly
all the strengths and weaknesses of the management are the competitors and if they hold
the management in `high esteem - the management is worthy of respect.

4. At good times everyone does well. The steel of the management is tested at times of
adversity? Bankers consider performance at a time of recession or depression. Did it
streamline its operations? Did it close down its factories? Did it (if it could) get rid of
employees? Was it able to sell its products? Did the company perform better that its
competitors? How did sales fare? A management that can steer its company in difficult
days will normally do well always.

5. The depth of knowledge of the management - its knowledge of its products, its markets
and the industry is of paramount importance because upon this can depend the success of
the company. Often the management of the company that has enjoyed a preeminent
position sits back thinking that it will always be the dominant company and it loses its
touch with its customers, its markets and its competitors. The reality sinks in only when it
is too late. The management must be in touch at all times with the industry and customers
and be aware of the latest techniques and innovations. Only then can it progress and keep
ahead. A quick way bankers check this is by determining what the market share of the
companys products are and whether the share is growing or is being maintained.

6. The management must be open - innovative and must have a strategy. It must be
prepared to change if that is required. it must essentially know where it is going and have
a plan on how to get there. It must be receptive to ideas and be dynamic. A company that
has many layers of management and is top heavy tends to be very bureaucratic and
ponderous. There are many chiefs and few braves They do not want change and often
stand in the way of change. Their strategy is usually a personal one - on how to hold onto
their jobs.

7. Bankers do not like to lend to a company that is yet to professionalise because in such
companies decisions are made on the whims of the Chief Executive and not with the good
of the company in mind. In such companies the most competent are not given the
positions of power. There may be nepotism with the nephews, nieces, cousins and
relatives of the Chief Executive holding positions not due to proven competence but
because of blood ties.

8. Bankers tend to avoid lending to family controlled companies where there is infighting
because the companies suffer.

In India, most of our larger Companies are family controlled. They are on a day to day
basis managed however by professional managers. There are also several professionally
managed companies too. It is not possible nor would it be fair to generalize which is
better - some are good and some are not so good. A banker, before he risks his monies,
makes a determination on whether he is comfortable with the management of the
company and this is a determination that he makes because on this will determine his
lending decision.

POLITICS AND GOVERNMENT POLICY

The political stability of a country a key factor in determining the risk a bank is prepared
to take on that country. It is this situation that determines whether and if so the quantum
foreign institutions and companies would invest in a country. In January 1998 when
Moodys the international credit agency stated that India is being placed on a watchlist and
that it may possibly be downgraded from investment quality to speculative due to a
variety of reasons of which one of the main reasons was political instability, the Bombay
Stock Exchange Sensitivity Index (Sensex) fell by 75 points. Moodys initially
downgraded the country in early 1996 due again to political instability as it felt that the
fall of the Deve Gowda government was imminent. As political stability is critical to a
country’s growth and by extension to companies, the Bharatiya Janata Party (BJP) took
stability as their central point in their 1997 election manifesto. After the nuclear explosion
by India and with the threat of sanctions Moodys downgraded India’s foreign currency
rating to below investment quality. Apart from he fact that the Sensex fell, foreign
currency loans will be more expensive and the rupee is under threat. If Mr. Daruwalla has
to import raw materials, his cost of production will rise and this will threaten his
profitability.

Let us look at this in more detail.

THE POLITICAL EQUATION

A stable political environment is necessary for steady, balanced growth. If the country is
ruled by a majority government and takes decisions for the long term development of the
country, industries and companies will prosper. Instability causes insecurities especially if
there is the possibility of a government being ousted and replaced by another that holds
diametrically different political beliefs. Moodys downgraded India initially during Mr.
Deve Gowda term of office on the issue of instability. It proved true and Mr. Gowda’s
government collapsed to be followed by Mr. Gujral’s tenure which also had a quick
demise. Such instability shakes the very foundation of investor/ international/ national
confidence. This is why, as was mentioned earlier, that the BJP has made stability the
central issue of its campaign.

Another example is Sri Lanka - a country in the grips of civil war. The north of that
country was once thriving and prosperous. No longer. That part of the country is
controlled by the Tamils - there is no industry and little economic activity. For several
years the economy of Sri Lanka suffered as tourists went elsewhere and exports fell.

Kenya had a disastrous 1997. There was violence in Mombasa. It was also election year
and there was an acknowledgement that President Daniel arap Moi may not get elected.
Consequently aid was held back - the shilling depreciated and inflation rose. Tourist
revenues too fell significantly to the detriment of the country.

No industry or company can grow and prosper in the midst of political turmoil.

Restrictive Practices

Restrictive practices or cartels imposed by countries can affect companies and industries.
The United States of America has restrictions regarding the imports of a variety of articles
like textiles etc. Licenses are given and amounts that may be imported from companies
and countries are clearly detailed. India has a number of restrictions on what may be
imported and at what rate of duty. This, to an extent determines the prices at which goods
can be sold. If domestic industry is to be supported, the duties levied may be increased
resulting in imports becoming unattractive. Alternatively the reduction of duties can result
in imports becoming cheaper to the possible detriment of Indian industry. The lowering of
duties in the first phase of liberalisation led to the near demise of the mini steel industry
in India. It is this fear that prompted the formation of the celebrated Bombay Club which
wants restrictive protection for Indian industry. Bankers, on account of the effect
restrictive practices or its removal can have on a company, always check how sensitive
the company is to these.

The threat of Nationalisation

The threat of nationalisation is a real threat in many countries - the fear that a company
may become nationalised. Historically (with very few exceptions), nationalised
companies are less efficient than their private sector counterparts. Nationalisation in India
ruined coal, insurance and banking If one is dependent on a company for certain supplies,
nationalisation could result in supplies becoming erratic and the likes. Similarly, if this
fear exists industries will not attract investment and there could be a flight of capital to
other industries/ countries.

At present the issue is the reverse in India - the possibility of privatisation. This, by large,
tends to the belief that both employee and company profitability will improve as was
demonstrated by British Airways which when Government owned was a loss making
behemoth. It turned round and is being acclaimed as efficient and excellent after it
became privatised.

Taxation

The level of taxation in a country has a direct effect on both companies and the economy.
If tax rates are low, corporate profitability rises as the cost of their purchases will be lower
and their after tax income higher. Additionally as people consequently have more
disposable income they have an incentive to work harder and earn more money. And an
incentive to buy which results in greater demand for goods. This is good for the economy
and for companies. It is interesting to note that in every economy there is a level between
35% to 55% where tax collection will be the highest. While the tax rates may go up
collection will decline. This is why it was argued that the rates in India must be lowered
and why at the 1997 budget the rates of taxation were reduced by Mr. Chidambaram.
Taxes have been lowered, an amnesty scheme was offered and tax collection has never
been higher.
Governmental Policy

Governmental policy has a direct impact on companies. A government that is perceived to

be proindustry will attract investment. The liberalisation policies of the Narasimha Rao
government excited the developed world and they were keen to invest in India and
increase their existing stakes in companies. The instability that followed, the Enron
fiasco, Cogentrix et al have made the same foreigners adopt a wait and watch stance.

Budgetary Deficit

A budgetary deficit occurs when governmental expenditure exceeds its income.

Expenditure stimulates the economy as work is created and demand will increase.
However, this can lead to deficit financing and inflation. India has had deficits for several
years and this has not been good for the country as it can lead to disaster. It would be wise
to remember this. At present the Government is trying to keep the deficit at 4.5 percent of
GDP and cutting back on expenditure for the infrastructure. The result has been disastrous
for several industries such as steel, cement and construction and for companies in these
industries.

All these factors have an effect on the performance of a company - the extent being on
how sensitive a company’s profitability is to the particular factor. This is why bankers pay
special emphasis to political stability and a company’s sensitivity to governmental policy
as it affects a company’s profitability and its credit worthiness.

THE ECONOMIC FACTOR

Bankers are becoming increasingly aware of the importance of the economy and its effect
on individual industries and companies. Soon after the liberalisation process began in
1992/93, there was tremendous activity and industries mushroomed. Many international
companies came into India and invested. GDP growth averaged over 7%. In earlier years
it was very low . Exports grew at 28% and industrial growth was at 11%. Companies
made tremendous profits. The situation changed from the end of 1995. 1996 was a
difficult year and 1997 more so. There was tremendous liquidity problems - partially due
to the squeezing of cash by the Reserve Bank to contain inflation and many industries,
with a contraction of activity, began to face a difficult time - construction, steel, cement et
al. Industrial growth in 1997-98 was a meagre 4.6 % while export growth was a shameful
2.6%. GDP growth fell to 5 %. Most companies were badly affected.

The banker will always look at the economic scenario when making the lending decision.
If the economy is going through a difficult period, the Manufacturers Bank will think
thrice before it extends facilities to Rusi Daruwalla or Raman Menon as the economic
downturn can affect the profitability of their ventures negatively.

There is usually a time lag between the downturn or upturn in an industry and its effect on
a company. This is why bankers look at the economic scenario when making the lending
decision.

In looking at the economy there are specifics the Banker looks at.

Growth

Growth in the economy has a wider impact on industry and individual; companies. An
economy that is growing at 7 percent creates jobs, demand and industrial activity. This
leads to higher consumption and thus increase in expenditure leading to bigger profits for
companies. At the end of 1997-98, the situation in India was the reverse. Industrial
growth had fallen to 4.6 percent from 11 percent and GDP growth was lower at 5 percent
from 7 percent. The mainstay of the previous year, agricultural growth had fallen from 5
percent to 3 percent. Export growth had fallen from 28 percent to 2.6 percent. These
translated to a lower level of activity and worse corporate results. In such circumstances
only the stronger survive and this is why bankers delve into the economic condition and
attempt to determine how exposed a company would be should a slide occur..

Foreign Exchange Reserves

A country needs foreign exchange reserves to meet its commitments, pay for its imports
and service foreign debts. If it cannot, the country would not be able to import materials
or goods for its development and there will be a loss of confidence in the country which
would be detrimental. India, was in 1991, forced to devalue as foreign exchange reserves
were at around half a billion dollars very low (equal to a three weeks imports). The crisis
was averted at that time by an IMF loan, the pledging of gold and the devaluation of the
rupee. The liberalisation initiatives reversed this and India was, with foreign exchange
inflows (foreign direct investment, foreign institutional investor investment, foreign
currency deposits and booming exports) able to accumulate reserves in excess of $30
billion. These fell in the wake of the foreign exchange rating of India being downgraded,
the nuclear explosions in May 1998 and the selling of shares by foreign institutional
investors. The rupee has also depreciated thereby making those companies that are
dependant on imports exposed.

In the eighties and in the early nineties several American banks had to write off large
loans advanced to South American countries as these countries were unable to pay.
Mexico too had a crisis. Certain African countries have very low foreign exchange
reserves. Companies exporting to these countries have to be careful as the importing
companies may not be able to pay for their purchases because the country does not have
adequate foreign exchange. I know of an Indian company which had exported machines
to an African company (Nigerian) a few years ago. The importing company paid the
money to the bank. It lies there still. The payment could not be sent to India as the central
bank refused the foreign exchange to make the payment.

The 1997 crisis in South East Asia has seen the collapse of several Tiger economies.
Many currencies are only worth a fraction of what they were earlier. Some countries are
being bailed out by large loans from the IMF. Many companies have collapsed due to
high foreign currency (dollar) debts or due to their inability to import raw materials. In
Indonesia the currency fell from Rupiah 2,300 to a dollar in May 1997 to Rupiah 10,500
to a dollar in January 1998 and to over Rupiah 15,500 to a dollar in June 1998. There was
however not (and there cannot be) a similar movement domestically within Indonesia.
The prices of articles did not go up fivefold. Consequently it was no longer viable to
import anything as it could not be sold at anywhere near cost price. I know of a large
Indian exporter of peanuts. He sent as usual large consignments to Indonesia to one of his
regular buyers. The buyer, for various trumped up reasons refused to accept the goods.
The real reason was that the Indonesian Rupiah had fallen so much in value that it was no
longer viable to accept the consignment as he would have to sell it at a loss. In the end the
Indian exporter had to sell the goods at a much lower price. He did this as the commodity
was perishable and he did not want to risk bringing it back to sell. He made a loss.

Balance Of Trade

If exports exceed imports a favourable balance of trade results. This stimulates industry.
Most developing economies have unfavourable balances whereas developed countries
such as Japan have very favourable balances. India’s exports have been lower both in
amount and in growth to imports and this widens the trade deficit. A wide deficit would
eventually result in devaluation of the currency. The implications to industry are then
obvious - the costs of imports will go up and the realisation of its exports in dollar terms
will be lower. A banker will therefore while evaluating a company examine this aspect.

Foreign exchange Risk

This is a real risk and one must be cognisant of the effect of a revaluation or devaluation
of the currency either in the home country or in the country/ countries the company deals
in. A devaluation in the home country would make the products the company makes more
attractive in other countries. It would also make imports more expensive and if a
company is dependent on imports, margins can reduce. A devaluation in the country to
which one exports would make the companys products more expensive and this can
adversely impact sales. A method by which foreign exchange risks can be hedged is by
entering into forward contracts (either purchase or sale) thereby crystallising the
exposure. Ever since the Deputy Governor of the RBI, Dr. Reddy mentioned that the
rupee was devalued in July/ August 1997 the rupee has been under pressure and the
concern most exporters and importers had was to what extent the rupee would depreciate
and the stands they should take. I know of a diamond exporter who kept a large open
position in dollars initially firmly of the opinion that there will be a depreciation to Rs.
39.50 or thereabouts at the very least. Many companies on the other hand who had taken
large foreign currency loans converted them back (even at a cost) to rupee loans. In June
1998 Moodys the international credit rating agency, downgraded India’s foreign exchange
rating to below investment quality. This will make the cost of foreign loans to Indian
corporates higher plus the Indian rupee will be under threat.

The fall in the currencies of South Eastern Asian countries has played havoc for India’s
export trade and by extension to companies/ entities that export. When a currency has
depreciated by nearly 5 times as it did in Indonesia’s case, all goods manufactured there
become ridiculously cheap and by extension extremely attractive. The foreign buyer
would naturally buy from a country such as that as in dollar terms the article would be at
a throwaway price.

Foreign Debt

Foreign debt, especially if it is very large can be a tremendous burden. India has to pay
around $ 7 billion a year in interest payments. This is no small sum. This money could
have been used to develop the country. It is to attract foreign exchange that the
government is promoting tourism and exports.

Inflation

Inflation has an enormous effect in the economy. Within the country it erodes purchasing
power. As a consequence demand falls. If the rate of inflation in the country is high then
the cost of production will automatically go up. This might reduce the cost
competitiveness of the product finally manufactured. Conversely if the rate of inflation in
the country to which one exports to is high, the products become more attractive resulting
in increased sales. The USA and Europe have fairly low inflation (about 5%). Inflation in
India has been falling steadily in recent times and is presently between 4% and 6%. . In
South America on the other hand it has been over 1000%. Money had no real value.
Exports from South America are attractive as on account of galloping inflation and the
consequent devaluation of their currency, their products are cheaper.

Low inflation within a country indicates stability and companies and industries prosper at
such times. One must also remember that price increases are behind inflation and
therefore companies margins are squeezed at times of high inflation.

Interest Rates

A low interest rate stimulates investment and industry. High interest rates result in higher
cost of production and lower consumption. When the cost of money is high, a companys
competitiveness decreases as its cost of production increases. This has been the reason for
industry clamouring for lower interest rates ( in order to be able to compete
internationally). The Reserve Bank of India accepted this contention and in its
pronouncements and its credit policies brought down the cash reserve ratio and the bank
rate and urged banks to lower lending costs. Soon after liberalisation, in order to take
advantage of lower rates, companies went overseas to borrow money - the leader being,
of course, Reliance.

Domestic Savings and its utilisation

Domestic Savings if utilised productively can accelerate economic growth. India as a

country has one of the largest rate of savings (22%). In USA it is only 2% whereas in
Japan it is as high as 23%. Japans growth was on account of the savings invested
profitably and efficiently. Although Indias savings are high, these savings have not been
invested wisely or well. Consequently there has been little growth. It is to be remembered
that all investments are born out of savings. Borrowed funds invested have to be returned.
Investments from savings leads to greater consumption in the future. This has been
recognised by the Government and it was in order to divert savings to industry that the
1992 Finance Act declared that the productive assets of individuals (shares, debentures
etc.) would not be liable for wealth tax.

The Infrastructure

The development of an economy is dependent on its infrastructure. There must be

electricity for the factories to manufacture and roads to transport goods. Bad
infrastructure leads to inefficiencies, poor productivity, wastage and delays. This is the
reason for the emphasis this issue is being given. Unfortunately India’s infrastructure
development is still at a very nascent stage and it has been determined that an immediate
expenditure of around $200 million is required to bring the economy on par with other
countries.

Most foreign banks and many Indian banks are very pro infrastructure. This is because
they recognise the need and the imperativeness. A properly prepared and well researched
viable infrastructure project will, at this juncture receive a fair hearing and most likely a
loan.

Budgetary Deficit

A budgetary deficit occurs when governmental expenditure exceeds its income.

Expenditure stimulates the economy as work is created and demand will increase.
However, this can lead to deficit financing and inflation. India has had deficits for several
years. The deficit is expected to be about 4.5 percent of GDP and in order to contain it at
this level the Government is curtailing several expenditure (developmental and
infrastructural). Though necessary this leads to a slowdown as economic activity reduces.

Monsoons

The Indian economy is essentially an agrarian one and it is therefore extremely dependent
on the monsoons. Economic activity often comes to a stay still during the end of March
/early April as individuals wait to see whether the monsoon is likely to be good or not. A
good monsoon results in improved agricultural growth leading to increased demand as
agriculturists have more disposable income.

Employment

High employment is required to achieve a good growth in national income. As the

population growth is faster than the economic growth unemployment is increasing. This is
not good for the economy. However, in countries where there is high unemployment
labour costs are low. In such countries companies that are labour intensive have an edge
over their peers/ competitors.

All these factors have an effect on the performance of a company - the extent being on
how sensitive a company’s profitability is to the particular factor. This is why many banks
have lending or exposure limits on countries. As company performance is dependent on
both the economy and the political scenario.

THE ECONOMIC CYCLE

Bankers, while ,making the lending decision, normally look into the business or economic
cycle and the stage at which the country is in as it has a direct impact on industry and
individual companies. It affects investment decisions, employment, demand and the
profitability of individual companies. While some industries such as construction, cement,
steel, shipping and consumer durable goods are very affected, others such as the food or
health industry are not so affected. This is because in regard to certain industries
consumers can postpone demand (buy later), whereas in certain others they cannot. If a
person is ill and needs medicine, it has to be bought. Similarly one has to eat. However, a
television purchase or an automobile buy can be delayed indefinitely.

Bankers always examine the economic cycle a country is in as it is crucial in the lending
decision and can affect the realisability of the loan

The four stages of an economic cycle are

o Depression

o Recovery
o Boom

o Recession

Depression

At the time of depression, demand is low and falling. Inflation is often high and so are
interest rates. Companies, crippled with high borrowing and falling sales are forced to
close down plants (plants built at times when the demand could not be met) and let
workers go. India went through in 1997 a period that could be arguably called a
depression. Interest rates were high, medium sized companies were closing down. Interest
rates were high and they were crippling several companies and industries. Banks though
flush with funds were not lending to corporates as they were concerned about whether
they would be repaid. Corporate performance was so bad.

The United States went through a depression in the late seventies. The economy
recovered and the eighties was a period of boom. A downturn occurred at the late eighties
and early nineties (especially after the Gulf War). The recovery of the US economy and
that of the rest of Western Europe began again in 1993.

Recovery

During this phase, the economy begins to recover. Investment, that was at a standstill,
raises its head once again. Demand grows. Companies begin to post profits. Conspicuous
spending begins once again. As the recovery stage sets in fully, profits begin to grow at a
higher proportionate rate. More and more companies are formed / floated to meet the
increasing demand in the economy.

In India we went through this stage immediately after the liberalisation process began. It
is hoped that once the country has a stable government the economy will begin its
recovery again.

Boom

At the boom phase demand reaches an all time high. Investment is also high. Interest rates
are low. Gradually as time goes on supply begins to gradually exceed demand. Prices that
had been rising begin to fall. Inflation begins to increase. In India we had a situation very
similar to a boom in 1993 and 1994 when everyone was euphoric about the country and
the economy was opening up. China has been going through a period of boom for several
years now and is attracting huge investments.

Recession

The economy slowly begins to downturn. Demand begin to fall. Interest rates begin to
increase and inflation also begins to increase. Companies begin to find it difficult to sell
their goods. Companies fold up due to a fall in demand, high interest costs and a cash
crunch.

It is difficult to lend at this stage as even though the company may have been good in the
past it may not be able to service its debts.

The Lending Decision

Bankers will always attempt to determine at which stage of the economic cycle the
country is in. They would normally aim to lend at the end of a depression when the
economy begins to recover and at the end of a recession. Bankers would aim to try and
get repaid either just before or during the boom or at the worst just after the boom. If Mr.
Daruwalla approaches the Manufacturers Bank at a time when the country is in recession,
the Bank would most usually not extend facilities unless ofcourse the project is very
viable and the Bank is adequately collateralised.

It must however be noted that there is no rule or law that states that a recession would be
for a certain number of years or that a boom would be for a definite period of time. Hence
the length of previous cycles should not be used as a measure to forecast the length of an
existing cycle. Bankers accept this and they are cognisant that that governmental policy or
other happenings can reverse a stage and it is because of this that they also analyse the
impact of governmental and political decisions on the economy before making the final
lending decision. Joseph Schumpeter once said Cycles are not, like tonsils, separable
things that might be treated by themselves but are, like the beat of the heart, of the
essence of organism that displays them.

INDUSTRY ANALYSIS

Industry analysis is critical in banking. Bankers will always attempt to determine how an
industry is faring and how it is likely to fare in both the short and the long term before
they commit funds or agree to lend. The very existence of companies in troubled
industries are threatened. In 1997 and 1998, in India due to the contraction of credit, steel,
cement, construction and property have gone through very difficult times. Several have
closed down or nearly closed down. On the other hand the software industry had done
extremely well with profits doubling and quadrupling. In 1988 laptop computers were the
in thing. Everyone raved about the invention - of how technology could compress a huge
computer into such a small box. These early models did not have a hard disk but two
fixed disk drives. A few months later hard disks were incorporated. These were initially
with a capacity of 20 megabytes. The memory was increased to 40 megabytes. In
eighteen months, the laptop became obsolete with the creation of the notebook. These
notebooks are no longer the last word in compressed computing. The palm tops have
arrived. I have used this illustration to illustrate how technological advances make a
highly regarded product obsolete. In the same way technological advances in one industry
can affect another industry. The Jute industry went into decline when alternate and
cheaper packing materials began to be used. The popularity of cotton clothes in the West
affected the manmade (synthetic) cloth industry. This is why bankers always examine the
industry within which a company operates because this can have a tremendous effect on
its results and its existence. A companys management may be superior, its balance sheet
strong and its reputation enviable. However, the company may not have diversified and
the industry within which it operates may be in a depression. This could result in a
tremendous decline in revenues and can threaten the viability of the company.

Cycle

The first step in industry analysis is to determine the cycle it is in or the stage of maturity
of the industry. All industries evolve through the following stages:

1. Entrepreneurial or sunrise or nascent

2. Expansion or growth

3. Stabilization or stagnation or maturity

4. Decline or sunset.

At the first stage the industry is new and it can take some time for it to properly establish
itself. In the early days it may actually make losses. At this time there may not be many
companies in the industry. It must be noted that the first 5 to 10 years are the most critical
period as at this time companies have the greatest chance of failing. It takes time to
establish companies and new products. There may be losses and the need for large
injections of capital. At this time if a company or an industry is not nurtured or husbanded
it can collapse. A good journalist I know began a business magazine. His intention was to
start a magazine edited by journalists without interference from industrial magnates or
politicians. It was an exceptionally readable magazine. However, it did not have the
finance needed in those critical years to keep it afloat and it folded up. Had it, at that time,
had the finance it needed it may have survived and thrived. In short at this stage investors
take a high risk with the promise of great reward should the product succeed.

Once the industry has established itself it enters a growth stage. At this time there is
growth and many new entrants enter the industry. At this time there is high reward and
low risk as demand outstrips supply. A good example at this time is the pharmaceutical
industry. At this time products are improved by those companies that have survived the
first stage and companies are able to even lower their prices. Bankers are not averse to
lend at this time as companies would have demonstrated their ability to survive.

The industry then matures and stabilizes. Rewards are low and so is risk. Growth is
moderate. Though sales may increase it will be at a slower rate than before. Products are
more standardized and less innovative and there are several competitors.

The industry then declines. This occurs when the products are no longer popular. This
may be on account of several factors such as a change in social habits (the film and video
industry has suffered on account of cable and Star TV), changes in laws and increase in
prices. The risk at this time is high but the returns are low. Returns can even be negative.

The various stages can be likened to the four stages in the life cycle of a human being -
childhood, adulthood, middle age and old age. Bankers would begin to lend when the
industry is at the end of the entrepreneurial or nascent stage (they would normally try not
to lend at the first stage as mortality is high) and the growth stage and would begin to exit
when an industry is at the end of the mature stage as it will begin to go on the decline.

The industry in relation to the economy

Bankers will always try to ascertain how an industry reacts to changes in the economy.
Some industries do not perform well during a recession or as well as other industries
during a boom. On the other hand certain industries are unaffected in a depression or a
boom. What are the major classifications?
1. Industries that are unaffected in general during economic changes are the evergreen
industries. These are those that individuals need like the food or agrobased industries
(dairy products etc.)

2. Cyclical industries are the ones that are volatile. They do extremely well when the
economy is doing well and do badly when depression sets in. The prime examples are
durable goods, consumer goods and shipping. During hard times individuals postpone the
purchase of consumer goods until better days.

3. Interest sensitive industries are those that are affected by interest rates. When interest
rates are high industries such as real estate and banking do not do well.

4. Growth industries are those whose growth is higher than other industries and growth
occurs even though the economy may be suffering a setback.

Competition

Another factor that bankers consider is the competition companies in an industry are
likely to face. The need to do this is because competition in an industry initially leads for
efficiency, improvements in products and innovation. As competition increases cut throat
price cuts set in resulting in lower margins, smaller profits and finally companies begin to
make losses. The more inefficient companies even close down. To properly understand
this phenomenon it is to be appreciated that if the return is high, newcomers will invest
into the industry and there will be an inflow of funds. Existing companies may also
increase their capacity. However, if the returns are low or lower than that which can be
procured elsewhere, the reverse will occur. Funds will not be invested and there will be an
outflow.

It is the competitive forces in an industry that determines the extent of the inflow of funds
and the return and the ability of companies to sustain these returns. These forces are the
barriers to entry, the threat of substitution, the bargaining power of buyers, the bargaining
power of suppliers and the rivalry among competitors.
1. Barrier to entry

New entrants increase the capacity in an industry and the inflow of funds. The question
that arises is how easy is it to enter an industry. There are some barriers.

a) Economies of scale In some industries it may not be economical to have small

factories. This is especially true if there are already in existence comparatively large units
producing a vast quantity. The products produced will be markedly cheaper.

b) Product differentiation A company whose products have product differentiation has

more staying power. Its products may be preferred because of its name or because of the
quality of its products - Mercedes Benz cars; National VCRs or Reebok shoes.
Individuals are prepared to pay more for the product and consequently the products are at
a premium and above competition.

c) Capital requirement Easy entry industries require little capital and technological
expertise. As a consequence there are a multitude of competitors, intense competition,
low margins and high costs. On the other hand capital intensive industries have few
competitors as entry is difficult. The automobile industry is a prime example of such an
industry.

d) Switching costs Another barrier to entry is the switching costs from one suppliers
product to another. This may include employee retraining costs, cost of equipment and the
likes. If the switching costs are high, new entrants have to offer a tremendous
improvement for the buyer to switch.

e) Access to Distribution Channels The difficulty to secure access to distribution channels

can be a barrier to entry especially if existing firms have already secured strong channels.

f) Cost disadvantages independent of scale This barrier occurs when established firms
have advantages new entrants cannot replicate. These include:

o Proprietary product technology

o favorable access to raw materials

o Government subsidies

o long learning curves

g) Government Policy Government policy can limit entrants into an industry. This is
usually done by not issuing licenses. The motor car industry was for nearly 40 years the
monopoly of two companies. Even though others sought licenses these were not given.

h) Expected retaliation The expected retaliation by existing competitors will also be a

barrier to potential entrants especially if the existing competitors aggressively try to keep
new entrants out.

i) Large investments, capital base and cost structure Companies with large investments
and a large capital base and a high fixed cost structure will not have many competitors. Its
high fixed costs have to be serviced and a fall in sales can result in a more than
proportionate fall in profits. Large investments and a big capital base will be barriers to
entry.

j) Cost of capacity additions If the cost of capacity additions are high there will be fewer
competitors and fewer will enter the industry.

k) International cartels There may be international cartels that will make it unprofitable
for new entrants.

2. The Threat of Substitution

New inventions are always taking place and new and better products are replacing
existing ones. An industry that can be replaced by substitutes or is threatened by
substitutes is normally an industry one must be careful of investing in. An industry where
this occurs constantly is the packaging industry - bottles replaced by cans; cans replaced
by plastic bottles and the likes.

To ward off the threat of substitution companies have to often spend large sums of money
in advertising and promotions. Those industries that have to be the most worried are those
where the substitutes are cheaper or better or are products by industries earning high
profits. It should be noted that substitutes limit the potential returns of a company.

3. Bargaining Power of Buyers

In an industry where buyers have control (a buyers market), buyers are constantly forcing
prices down or demanding better services or higher quality and this often erodes
profitability. The factors one should check are whether:

a) A particular buyer buys most of the products (large purchase volumes). Such buyers
can if they withdraw their patronage, destroy the industry. They can also force prices
down.

b) Buyers can in buyer dependent industries play one company against another to bring
prices down.

One should also be aware that :

o If sellers face large switching costs the buyers power is enhanced. This is especially true
if the switching costs for buyers are low.

o If buyers are partially backwardly integrated, sellers face a threat as they may become
fully integrated.

o If buyers are well informed about trends and details they are in a better position vis a vis
sellers as they can ensure they do not pay more than they need to.

o If the product represents a significant portion of the buyers cost. Buyers would
vehemently attempt to reduce prices.

o If the product is standard and undifferentiated, the buyers bargaining power is

enhanced.

o If the buyers profits are low, the buyer will try to reduce prices as much as possible.

In short, an industry that is dictated by buyers is usually weak and its profitability is under
constant threat.

4. Bargaining Power of Suppliers

An industry controlled by its suppliers is under threat. This occurs when :

a) The suppliers have a monopoly or if there are few suppliers.

b) Suppliers control an essential item.

c) Demand for the suppliers product exceeds supply.

d) The supplier supplies to various companies.

e) The switching costs are high.

f) The suppliers product does not have a substitute.

g) The suppliers product is an important input to the buyers business.

h) The buyer is not important to the supplier.

i) The suppliers product is unique.

j) The supplier supplies to various companies.

5. Rivalry among Competitors

Rivalry among competitors can cause an industry great harm. This occurs mainly by price
cuts, heavy advertising, additional services or offers at high costs to the company and the
likes. This rivalry occurs mainly when:

a) There are many competitors and supply exceeds demand. Companies resort to price
cuts and advertise heavily to attract customers and sell their goods.

b) The growth in the industry is slow and companies are competing with each other for a
greater market share.

c) The economy is at a recession and companies cut the price of their goods and offer
better service to stimulate demand.

d) There is a lack of differentiation between the product of one company and that of
another. The buyer determines his choice on price and / or service.

e) In some industries economies of scale will necessitate large additions to existing

capacities in a company. The increase in production could result in over capacity and
price cutting.

f) Competitors may have very different strategies in selling their goods and in competing
they may be continuously trying to stay ahead of another resulting in each of the
companies in the industry trying to stay ahead of each other in competitiveness be it by
price cuts or improved service.

g) Rivalry increases if the stakes are high.

h) Firms will compete with one other intensely if the costs of exit are great i.e. the
payment of gratuity, unfunded provident fund, pension liabilities and the likes.
Companies would remain in the business even if the margins are low and little or no
profits are being made. Additionally companies tend to remain in business at low margins
if there are strategic interrelationships between the company and others in the group ;
there are government restrictions (the government may not allow a company to close
down); or the management does not for pride or employee commitment wish to close
down the company.

If the exit barriers are high excess capacity does not leave the industry but companies lose
their competitive edge. And as companies do not close down, profitability erodes and it
will as a consequence be low.

This can be summarized in the ensuing manner. If the barriers are high the return is low
but risky. If entry barriers are low the returns are high but stable. High entry barriers
result in high, risky returns.

Lending to an Industry

When Rusi Daruwalla or Raman Menon approach the Manufacturers Bank for facilities
some of the more important points the Bank will bear in mind on lending to an industry
are:

1. Investments in industries should be made at a time when it is at the growth stage.

2. The faster the growth of a company or industry the better. The software industry in
India for example has been growing at the rate of over 200 percent per annum.
3. It is safer to lend to industries that are not subject to governmental controls.

4. Cyclical industries should be avoided if possible.

5. Export oriented industries are presently in a favoured position due to incentives and
encouragements made. On the other hand import substitution companies are not doing
very well. presently due to relaxations and lower duties on imports.

6. It is important to check whether an industry is right for investment at a particular time.

There are sunrise and sunset industries. There are capital intensive and labour intensive
industries. Each industry goes through a life cycle.

In conclusion bankers are cognisant of the fact that the industry phenomenon actually
determines the existence of companies and by extension their ability to repay. Therefore,
great care is taken in understanding the industry before the lending decision is taken.

COUNTRY OUTLOOK

Apart from the purpose of the loan, the feasibility of the project, the collateral/ security
for the loan and the management of the company Banks would always examine the
country risks. This essentially is with respect to how much of their funds they are
prepared to place at risk in a country. Losses could occur or the loan may be endangered
owing to no fault of the borrower but due to the environment within which the borrower
operates. As mentioned earlier a Mumbai based company several years ago exported
certain engineering goods to Nigeria.. The goods were sent on the strength of a letter of
credit opened in Nigeria. The buyer accepted the goods and paid for it. His bank was
however estopped from remitting the money as the country’s foreign exchange position
was very precarious. The seller did not get his money not because of the buyer but due to
the country’s inability to pay. It was on account of episodes like this that sellers insisted
during such situations that letters of credit be in hard currency and confirmed by a Bank
in the United Kingdom, Europe or the United States.

The points that bankers will always consider when assessing the risks associated with a
country are::

The political stability of the country.

The rate of inflation.

The balance of payments and the balance on current account.

The country’s exports and imports (and its respective growth).

The growth in GNP.

The possibility of nationalisation.

Restrictive Practices.

The Strength of the currency (possible devaluation or appreciation).

As discussed earlier it was on account of the political instability that the international
credit agency Moodys downgraded its rating on India. A few months later Deve Gowda’s
government collapsed. South America in the seventies and eighties, Mexico in the early
nineties and the South East Asia catastrophe of 1997 illustrate the fragility of countries. In
the latter the economies of several countries - Korea, Indonesia, Malaysia, Philippines
and Thailand collapsed. The currency depreciated dramatically, the most pathetic being
that of Indonesia which fell from Rupiah 2,500 in April 1997 to nearly Rupiah 16,000 to a
United States dollar in June 1998. Several companies collapsed and the losses of
individual banks were in the tens of millions of dollars. After the nuclear explosion in
May 1998 and the imposition of sanctions against India, Moodys downgraded India’s
foreign exchange rating. The result is that the cost of borrowing abroad will be more
expensive and the rupee would be under threat.

Rusi Daruwalla had been exporting for several years chemicals to Indonesia. He had in
1995 approached his bank and through them arranged a foreign currency loan and
established a company there. This company procured hard currency financing and bought
machinery from the United States. The company prospered. When the currency collapsed
in late 1997/1998 the dollar exposure of the company quadrupled and the company had to
be liquidated. The country risk was that grave.

Raman Menon received an order for garments from the United States. The order required
his buying certain cloth from the Australia.. The order was large but the pricing was very
fine and the order was denominated in United States dollars. A depreciation of the rupee
against the Australian dollar and an appreciation of the rupee vis a vis the United States
dollar resulted in a large profit about turning to a loss.
Thus when there is an exposure, banks will also look at::

The dependence of the company to the import of raw materials.

The company’s foreign currency exposure in regard to loans.

The strength of the currency.

As it can bring down the Bank. During the recent Indonesian crisis, a very respected
Hong Kong based investment bank went into liquidation on account of a loan in excess of
$250 million given to an Indonesian taxi company.

Most banks therefore have cross country limits. This limit is the exposure that they are
prepared to take on a country. In order to determine this, they grade or rate companies -
the main criteria being the risk of default. The gradings are usually A, B, C, D and E.. A
rated countries are those of the industrialised West and Japan. B rated countries are those
that are not as well developed but safe. C rated countries are developing countries whose
fundamentals are reasonably strong. India belongs to this category. D and E rated
countries are economically undeveloped where there are grave risks such as some African
countries and South American countries. The risk is considered that grave that when a
Bank requests for a letter of credit to be confirmed by a Bank in a A rated country it is not
unusual for the confirming bank to demand a 100% cash cover before it confirms the
letter of credit.

In conclusion banks are extremely concerned if exposures have to be taken in another

currency and they will without question assess the strength of the country and the risks of
the exposure before they lend.

THE PROJECT REPORT

Bankers are financial experts. They can analyze figures. They can project economic
likelihoods regarding what is likely to happen to interest rates, currency values and
industry. They are in the business of lending and want to lend. However they are not
technical persons and cannot really evaluate projects being conceived. They cannot
usually differentiate between the different methods of production or even opine which is
more efficient or cost effective. It is because of this that they rely heavily on project
reports in making the lending decision as they are effectively looking for the endorsement
of an expert on the viability of the project. Therefore when Rusi Daruwalla meets his
bankers - The Manufacturers Bank he would be wise to take with him a project report
which would submit a project report that supports his intention to expand and proves that
his company would become more efficient. Similarly if Mr. Singh plans a new project to
farm black tiger prawns, his proposal would be studied more seriously if he submits a
detailed project report on the manner he intends to farm the prawns in detail. It should
detail the land, the kind of ponds that will be constructed, safeguards against diseases, the
water available, the soil and the harvests. The report should also state how the prawns will
be marketed - whether it will be sold live (for the Japanese market) or frozen and the
financial projections of the enterprise. The conclusions arrived at should be supported by
an acknowledged authority on the subject. This makes the lending decision for the Banker
relatively easy as he is comfortable in relying on the expertise and wisdom of an expert.
He needs this lifeline too for his comfort too as if things do go wrong he could state that
by basing his decision on the submissions and endorsement of an expert he did what any
prudent banker would do and has not therefore been negligent.

While submitting a project report both Rusi Daruwalla and Mr. Singh should be aware
that the banker is not a technical man (usually) and technicalities and engineering niceties
usually go above his head (though he would never readily admit it). While the tome must
be impressive there are several issues that the Banker will zero in on and these must be
addressed and addressed in detail if the loan is to be given the nod.

The project report should address the need for the project and how by implementing it
there will be profits for the company. Ideally, it should also state there are very few
downsides.

It must speak of the suitability of the land chosen for the project - accessibility to either
raw materials or to the end user market or tax concessions and the likes.

It must detail the cycle of production and explain why the method recommended is
superior or more cost effective than others.

It must speak or dwell on comparative advantages such as forward or backward

integration or import substitution or even the high demand. This must be supported by
statistics. Bankers love statistics and will use these in putting up their proposal for
approval.

The project report should also speak of strengths and weaknesses and then prove in a
logical manner how the strengths far outweigh the weaknesses.

The project report should clearly show the costs of the project, the gestation period and
the time it would take for it to start repaying the loans taken.

The report should also mention whether the project is exposed to the vagaries of the
economic cycle or industry cycles and the effect this will have on the project.

The financials should be given in detail. It should begin with the cost of the project
stating from where (and why) the machines will be bought, the maximum cost, the cash
flow, leverage and the projects debt service capacity. The banker has to be convinced that
even in the worst situation the company can service the debt. I know of a cement
manufacturer who, being ambitious, presented a report for the construction of three
medium cement plants simultaneously. The projects were good and they were viable.
Being ambitious he decided to construct the three plants simultaneously. It was after he
began the construction that the primary markets collapsed and he began to experience
cash problems. Bank finance stopped as he was unable to service loans. At present he has
three unfinished plants into which he has sunk a lot of money. The Company is also
bankrupt and likely to remain so.

Above all the project report should also clearly state who will run the project and the
capability, experience and competence of the persons entrusted with the project. If they
have already implemented and successfully run similar projects the banker will derive
considerable comfort.

In conclusion it has to be emphasised that the project report is at the core of the lending
decision. No banker (unless he is a buccaneer) will finance a green field venture without a
project report that clearly shows how feasible the project is. It has to address the concern
that is dearest to his heart - the repayment and servicing of the funds that he will be
lending (placing at risk). If Rusi Daruwalla’s project report does not address these issues
he will find it difficult to get the loan approved.

THE AUDITORS REPORT

One of the first documents that his bankers, Manufacturers Bank asked Mr. Rusi
Daruwalla when he approached them for a loan was for audited financials. This was
sought more for the sake of the Auditor’ Report than any other single reason. And why is
that?

The auditor represents the shareholders and it is his duty to report to the shareholders and
the general public on the stewardship of the Company by the directors. Auditors are
required to report whether the financial statements presented do, in fact, present a true and
fair view of the state of the company. Bankers will go through the auditors report
carefully as the auditors are, to a degree, their representative and they are bound to, and
required by law to, qualify their statement if the financial statements are not true and fair.
The auditors are also required to report any change such as changes in accounting
principles or the non provision of charges that result in an increase or decrease in profits.
It is really the only impartial report that the outside public and the banker has access to
and this reason alone makes it imperative that he reads it carefully and analyses the report
including if necessary reconstructing the financials in order to get the true facts and the
state of the company’s state of affairs.

There can be interesting contradictions. In one Auditors’ Report it was stated,. As at the
year end, the accumulated losses exceed the net worth of the Company and the Company
has suffered cash losses in the financial year as well as in the immediately preceding
financial year. In our opinion, therefore the Company is a sick industrial company within
the meaning of clause (O) of Section 3(1) of the Sick Industrial Companies (Special
Provisions) Act 1985. The Directors report however states The financial year under
review has not been a favourable year for the Company as the Computer Industry in
general continued to be in the grip of recession. High input costs as well as resource
constraints hampered operations. The performance of your Company must be assessed in
the light of these factors. During the year manufacturing operations were curtailed to
achieve cost effectiveness. Your directors are confident that the efforts for increased
business volumes and cost control will yield better results in the current year. The auditors
are of the opinion that the company is sick whereas the directors speak optimistically of
their hope that the future would be better (they probably cannot do otherwise).

When reading Auditors Reports the effect of their qualification may not be apparent. The
Auditors Report of another company reads In our opinion and to the best of our
information and explanation given to us, the said accounts subject to Note No. 3
regarding doubtful debts, No. 4 regarding balance confirmations, No. 5 on custom
liability and interests thereon, No 11 on product development expenses, No. 14 on
gratuity, No.8, 16 (C) and 16(F) regarding stocks, give the information in the manner as
required by the Companies Act 1956, and give a true and fair view - It is necessary
therefore to go to the specific notes. In this case

1. Note 3 states that no provision has been made for doubtful debts.

2. It is noted in note 4 that balance confirmation of sundry debtors, sundry creditors and
loans and advances have not been obtained.

3. It is stated that customs liability and interest thereon worth Rs. 3,14,30,073 against the
imported raw materials lying in the ICF / Bonded godown as on the balance Sheet date
has not been provided in note 5.

4. Note 11 drawn attention to the fact that product development expenses worth Rs.
17,44,049 are being written off over ten years from 1991-92. Rs. 2,16,51,023 has been
capitalised under this head relating to the development of CT142, Digital TV, Cooler,
CFBT which shall be written off in 10 years.
5. The companys share towards past gratuity liabilities as at the year end has neither been
ascertained nor provided for except to the extent of premiums paid against a LIC group
gratuity policy taken by the trust. This is in Note 14.

6. Note 16C states that the raw material consumed has been estimated by the management
and this has not been checked by the auditors.

The company made a profit of Rs. 1,07,51,537. If the product development expenses,
customer duty and interest and provision for bad debts had been made as is required
under generally accepted accounting principles, the profit may have turned into a loss.

It must be remembered that at times accounting principles are changed or creative,

innovative accounting is resorted to by some companies to show a better result. The effect
of these changes are at times not detailed in the notes to the accounts. The Auditors
Report will always draw the attention of the reader to these changes and the effect that it
has on the financial statements. It is for this reason that the careful reading of an Auditors
Report is not only necessary but mandatory for the banker.

It is for these reasons that Bankers insist on the submission of audited results prior to the
sanctioning of facilities. An external confirmation - an unbiased, impartial opinion on the
financials is an absolute necessity.

CASH FLOW

In this age of creative accounting accounting principles are changed, provisions are
created or written back and generally accepted accounting principles are liberally
interpreted or ignored by companies to show profits. Shareholders do not realise this
when they look at the profits made as published in the financial statements. It comes
therefore as a surprise when a regular profit making company suddenly downs its shutters
and goes into liquidation. The reason usually lies in the fact that the company has no cash
and is unable to get finance and is unable to pay its creditors. This is an area that is not
often considered - the company’s cash flow and yet it is, for a company, its very life
blood. A community of successful money handlers - the Marwari community of India are
an exception. They have always recognised its importance and their celebrated “Partha”
system deals entirely with cash inflows and outflows. This is their strength and the reason
for their growth. Unfortunately most others do not pay heed to cash flows, concentrating
entirely on the “bottom line”. History is strewn with corporations that have closed down
because of its inability to pay. In recent times in India, in the first flush of liberalisation
and buoyancy in the capital markets, many companies embarked on very ambitious
expansion plans. Their plans went awry in 1995 -96 when , in order to contain inflation,
money supply was restricted. A liquidity crunch followed. The primary market collapsed.
Many companies identified as the blue chips of the future were in very difficult situations
and some became bankrupt. Bankers, aware that loans advanced can go bad if the
company does not have operating cash flows that are positive will always check.as they
have to be satisfied that the company has adequate funds to meet interest and capital
repayments.

o How much cash earnings is the company making

o How is the company being financed

o How is the company using its finance?

The answer to the above can be determined by preparing a sources and uses of funds
statement. Its importance has been recognized in the United States and in many European
and Asian countries where it is mandatory for a company to publish with its Annual
Report, a statement of changes in financial statements which is in effect a cash flow
statement.

A sources and uses statement begins with the profit for the year to which are added the
increases in liability accounts (sources) and from which are reduced the increases in asset
account (uses). The net result shows whether there has been an excess or deficit of funds
and how this was financed.

A Company published a profit before tax of Rs. 10.81 crores a few years ago, This
included however, other nonrecurring income of Rs. 24.77 crores, profit on the sale of
fixed assets of Rs. 11.29 crores and an amount of Rs. 3.86 crores was withdrawn from a
revaluation reserve. If these are adjusted for the operating profit changes to a loss of Rs.
29.11 crores - a very material difference. The company had declared a dividend on its
preference shares. This was, as the company had made a loss, in effect paid from reserves.
Its inventories and other current assets had increased. As the company is in reality not
doing well, the possibility of the company being unable to get rid of its surplus stock
cannot be ignored.

Another company published a profit of Rs. 14.17 crores. It was a fall from its previous
years profits of Rs. 71.34 crores. It was construed as a reasonable profit in hard times.
However, a sources and application of funds statement reveals that the company raised
Rs. 75.15 crores from loans and that it effectively paid its dividends from borrowed funds.
It poses the question that when the time comes to repay loans will the company have
adequate monies to do so.

The charm or utility of the cash flow or sources and uses of funds statement strips the
accounting creativeness from financial statements. While figures can be doctored to show
high profits/ losses, the cash flow shows how much cash has actually been generated from
operations and how much has been sourced from external sources. If a company has a
negative cash flow from operations a banker will ask serious questions on how the
company will meet its interest obligations and its capital repayments - both of which
should come from operations. If it is continuously raising monies from other sources to
meet day to day obligations, a sources and applications statement will reveal that in no
uncertain terms and the banker will need to be satisfied that there will be inflows from
operations before he would actually consider lending monies.

The importance and effectiveness of the Cash flow cannot be over emphasised and the
banker aware of this will always examine the cash flow to determine the viability of the
project and the ability of a company to repay its loans and service its interest.

THE FINANCIALS

The Banker after he has satisfied himself on the political imbroglio, the economic
situation, industry, the company, the management and other related factors would then
examine the financials as it is upon this that he will base the final decision. He will
examine the financials from all aspects aware as Abraham J. Briloff says, “Whenever ants
swarm, the pot will not only contain a bit of money, but will also be filled with accounting
gimmicks.”

The financials are the pivot on which the lending decision rests as it details the
fundamental strengths and weaknesses of the company and its ability to repay the loans
and advances given to it.
When Mr. Daruwalla or Mr. Mistry meet their bankers the banker will normally ask for
their financials in order to determine whether it is indeed viable to lend to them. The
banker will also seek to ascertain whether the financials prepared are audited. If it is so it
would afford him more comfort. It is also imperative that upto date figures are given. No
banker worth his salt would arrive at a business decision based on old figures as many,
many things could have happened in the interregnum.

What are the factors that the banker will look at in order to arrive at a decision?

The banker will attempt to make sure that the unit, based on its financials, is a going
concern.. This means that it is conducting its business normally and that it is not unviable
or loss making..

Bankers will look at the capital base of a company. The larger the base the greater the
company’s ability to withstand and bear losses. Capital in this instance would also include
reserves.

Another important issue bankers will look at is profit ploughback. Profit ploughback is to
enable the company to expand, make it stronger and replace assets. If profits are not
reinvested, the company will have to borrow in order to replace worn out assets or to
purchase new machines and this will erode its strength.

Bankers will always examine the quantum of borrowing - whether they are short term or
long term, whether they are secured or unsecured. If the borrowings are large, in a boom
year shareholders will benefit whereas in a bad year it would be the reverse. It is of prime
importance to a banker whether the company can service its borrowing.

Fixed assets are important as in most cases fixed assets are employed to earn the income
for the Company. The composition of fixed assets will be examined in detail and the
nature of the fixed assets employed. There could be instances where there are hidden
reserves such as land purchased sixty or seventy years ago which are still shown at cost.
On the other hand there may be obsolete assets or unproductive assets and no clear policy
to upgrade assets.
Some companies have intangible assets on their Balance Sheets such as deferred revenue
expenditure or preliminary expenses not written off. These are expenses and have no asset
value and bankers will recast the Balance Sheet deducting these from the Company’s net
worth.

Many company’s have investments. The banker will always ascertain the nature for these
investments and the reasons for them. If it is not crucial for the business it would be better
to liquidate and use the funds thus generated to reduce borrowings.

Bankers will invariably check current assets including stocks and debtors He will
examine how they have been valued and how old they are. This is in order to ascertain
how real they are. Obsolete stocks and bad or doubtful debts should be written off or
adequately provided for.

Sales turnover is another aspect that the Banker will examine. How has sales grown?
How much are the sales? The volume indicates the Company’s position in the industry
and its sustainability.

A company’s other income is also examined especially its composition and whether it
would be recurring. Normally other income should be less than five percent of turnover
though there is no hard and fast rule. The Banker examines this to determine income
streams and its dependability.

Expenses would normally be, when being examined, broken down to fixed costs and
variable costs. Fixed costs would be those costs that would be incurred irrespective of any
other factor. These will include rent, administration costs and the likes. Variable costs are
those normally linked with the level of activity such as sales commission. The banker
would check whether the growth in these costs are in tandem with the increase in income.
If not the Company’s profitability might be under threat.

Financing costs is a cost bankers will pay great heed to as the viability of the company
could depend on it. The issue here is whether the Company can pay the interest on the
facilities it enjoys from operating profits. If not there will be concern unless if the
company can demonstrate that in the near term it would be able to.

The Banker would also look at the profits made before and after tax because the profits a
company makes is the final deciding factor on the lending decision. No one will, in their
right mind, lend more to a loss making company. On the other hand bankers fall over
backwards to lend to one that is making more and more profits every year.

Another aspect bankers will look at are the contingent liabilities of a company.
Contingent liabilities are by definition a liability that may arise should an event occur
such as a bill discounted being dishonored or a guarantee issued being called up.

However sheer numbers by themselves are not adequate to make a decision. Bankers tend
to reduce numbers to ratios in order to compare strengths and weaknesses with other
companies and between years. We will examine ratio analysis and the manner it should be
computed in the next few articles.

RATIO ANALYSIS

No banker would lend or advance facilities to a company until he has analyzed its
financial statements and compared its performance to that it achieved in previous years
and with that of other companies. This can be difficult at times because:

(a) The size of the companies may be different.

(b) A companys Balance Sheet composition may have changed significantly. It may have
issued shares or increased/reduced borrowings.

It is in the analysis of financial statements that banker find ratios most useful because
they help him to compare the strengths, weaknesses and performance of companies and to
also determine whether it is improving or deteriorating in profitability or financial
strength.
Ratios express mathematically the relationship between performance figures and/or
assets/liabilities in a form that is easily understood and interpreted. Otherwise one may be
confronted by a battery of figures that are difficult to draw meaningful conclusions from.
It should be noted that figures by itself will not enable one to arrive at a conclusion on a
companys strengths or performance. Sales of Rs. 500 crores a year or a profit of Rs. 100
in a year may appear impressive but one cannot be impressed until this is compared with
other figures such as its assets or net worth. It must be remembered that when comparing
one figure with another that the relationship is clear and logical. Otherwise no useful
conclusion can be arrived at. A ratio expressing sales as a percentage of trade creditors or
investments is meaningless as there is no commonality between the figures. On the other
hand a ratio that expresses the gross profit as a percentage of sales indicates the mark up
on cost or the margin earned.

There is no point in computing just one ratio as it will not give the whole picture but just
one aspect. It is only when all the different ratios are calculated and arranged that the
complete state of the company emerges and good bankers would always check to make
sure that he has as much information as possible before he actually makes the lending
decision..

Ratios can be broken out into four broad categories:

A) Profit and Loss Ratios

These show the relationship between two items or groups in a Profit and Loss Account or
Income Statement. The more common of these are :

1. Sales to cost of goods sold

2. Selling expenses to Sales

3. Net Profit to Sales

4. Gross Profit to Sales

B) Balance Sheet Ratios

These deal with the relationship in the Balance Sheet such

as :

1. Shareholders equity to Borrowed Funds

2. Current assets to Current Liabilities

3. Liabilities to Net Worth

4. Debt to Assets

5. Liabilities to Assets

C) Balance Sheet and Profit and Loss Account Ratios.

These relate an item on the Balance Sheet to another in the Profit and Loss Account such
as:

1. Earnings to shareholders funds

2. Net Income to assets employed

3. Sales to Stock

4. Sales to Debtors

5. Cost of Goods sold to creditors

D) Financial Statements and Market Ratios

These are known normally as market ratios and are arrived at by relating financial figures
to market prices

1. Market value to earnings.

2. Book value to market value

These are not particularly important from a bankers perspective as he is not really
concerned with market value.

In this study, ratios have been grouped into categories ranked in importance to a lending
banker that will enable him to easily determine the strengths or weaknesses of a company.

a) Debt Service Capacity

b) Profitability

c) Liquidity

d) Leverage

e) Asset Management/Efficiency

f) Margins

g) Earnings

It must be ensured that the ratios being measured are consistent and valid. The length of
the periods being compared should be similar. Large non recurring income or expenditure
should be omitted when calculating ratios calculated for earnings or profitability.
Otherwise the conclusions arrived at will be incorrect.

Ratios do not provide answers. They suggest possibilities. Bankers examine these
possibilities along with general factors that would affect the company such as its
management, management policy, government policy, the state of the economy and the
industry to arrive at a logical conclusion and he must act on such conclusions.

Ratios are a tremendous tool in interpreting financial statements but their usefulness is
entirely dependant on their logical and intelligent interpretation.

DEBT SERVICE CAPACITY

A banker’s concern when he extends credit facilities to a client is whether that client can
service its debts from internally generated funds. Can it meet principal and interest
payments out of its profits? This is ofcourse based on the assumption that the company is
a profitable going concern and that debt will not be repaid by additional borrowings or
rights/ public issues.

Debt Coverage

This ratio is used to determine the time it would take for a company to repay its short and
long term debt from income or internally generated funds. This is relevant if the debt is
not to be extinguished by the sale of assets or by the issue of fresh capital or debt.

Internally generated funds for this ratio is income after tax plus non cash expenses
(depreciation) and non operating income and expenses. Debts will comprise of bank
overdrafts, term loans and debentures. The ratio is calculated by dividing internally
generated funds by the average debt.

debt coverage ratio = internally generated funds

average debt

Liability Coverage

The liability coverage ratio is an extension of the debt coverage. It is used to check
whether a company can through internal generations repay all liabilities. This ratio is
calculated by dividing internally generated funds by average total liabilities.

Liability coverage ratio = Internally generated funds

average total liabilities

It is possible too to calculate this ratio on liabilities at the date of the Balance Sheet on the
argument that the factor to be considered is the time it would lend to repay total liabilities
at a particular time.

Interest cover

An extremely important factor that bankers must ascertain is whether a companys profits
are adequate to meet its interest dues.

If profits are insufficient, this will have to be paid out either from reserves, additional
borrowings or from a fresh issue of capital and these are a sure sign of financial
weakness.

The interest cover ratio is calculated by dividing earnings before interest and tax by
interest expense. The ratio must always be in excess of 1 - the higher the better. If it is
below this figure, any small reduction in profit would result in the company being forced
to pay interest out of retained earnings or capital.

Interest cover ratio = earnings before interest and tax

interest expense

Fixed Charge Cover

The last decade has witnessed the birth and the development of several financing and
leasing companies. These companies have offered corporations the opportunity of leasing
equipment as opposed to purchasing them. Leasing is also being looked upon increasingly
as an alternative to actually purchasing an asset. This has the following benefits. The
rentals paid are entirely tax deductible. Secondly, funds do not need to be deployed for the
purchase of assets. This is known as off balance sheet financing i.e. neither the real cost
of the asset nor the liability is reflected in the Balance Sheet. The fixed charge cover
considers off balance sheet obligations such as rental expenses and checks whether a
company earns enough income to meet its interest and rental commitments.
Fixed charge cover = Earnings before interest and taxes plus rental expense

interest and rental expense

It is argued at times that the dividend payable on preferred shares should also be
accounted for in this ratio as it is a fixed charge that has to be paid. In that case the fixed
charge cover is calculated in 2 stages. In the first stage the fixed charge cover is
calculated and from this the preferred dividends paid are ratiod.

Net Income + (1-tax rate)(interest and rental expenses)

(1-tax rate) (Interest and rental expense)+preferred dividends

This is a better ratio than the interest cover ratio as it considers all the fixed expenses that
a company has and examines whether its earnings are sufficient.

Cash flow surplus

The cash flow surplus ratio is based on the going concern concept and assumes that
companies will normally grow and therefore will incur capital expenditure and that there
will be an increase in net working capital. The submission is that a companys ability to
pay its debt should be determined only after increases in capital expenditure and net
working expenditure. Cash flow is net income plus non cash charges (depreciation etc.)
less capital expenditure and increases in net working investments. The ratio is calculated
by dividing the cash flow surplus by total debt.

Cash flow surplus = cash flow surplus

Total average debt

This ratio is often negative. This is because that when a company is growing rapidly it is
purchasing assets of a capital nature and its net working investments are also increasing
and this increase is usually more than its internally generated funds. This is usually
funded by loans or short term facilities.

Summary

Bankers will always consider debt service ratios as it enables them to determine whether
the company under consideration has the capacity or the ability to service its debts and
repay its liabilities. This becomes all the more critical at times of high inflation and
recession when an inability to service debt can plunge a company to bankruptcy. And the
loan the Bank extends becomes a Non Performing Asset (NPA).

PROFITABILITY

The profitability of a company is of prime importance to a banker. Unless a company is

profitable, it cannot grow; it cannot pay dividends; its value will not increase and it
cannot survive in the long run. Additionally and more importantly it may not be able to
repay its loan

Profitability ratios assist the banker in determining how well a particular company is
doing vis a vis other companies within the same industry and with reference to previous
years. A banker can, with the help of these ratios, evaluate the managements effectiveness
on the basis of the returns generated on sales and investments.

While calculating and evaluating profitability a banker ensures that:

o As far as possible ratios are calculated on average assets and liabilities and not on the
assets or liabilities on a particular date. This is because there can be large variations in
these figures during the year and these can distort results quite materially. Companies
have been known to windowdress their Balance Sheets by either reducing or increasing
assets or liabilities. Additionally as profits are earned not on a particular date but over a
year ratios calculated on average assets/liabilities would portray a truer indication of the
results achieved by the company.

o Bankers take into account the rate of inflation and the cost of capital and borrowings.
When evaluating the ratio banker should consider whether a better return would have
been received elsewhere. And whether the return has kept pace with the rate of inflation.

o Ratios are, it must be remembered, indicators and these should be considered as an

indication or as a suggestion of future development.

Return on total assets

The first ratio checked is the return on total assets. This is an extremely important
indicator as it would help the banker determine whether:

o The company has earned a reasonable return on its sales.

o The companys assets have been effectively and efficiently used and

o The cost of the companys borrowings are too high.

This ratio is used to compare the performance of a company with other companies within
the industry and with previous years. It is also used to project the performance of future
years.

Return on Equity

Another important measure of profitability is the return on equity or ROE as it is often

termed. The purpose of this ratio is to determine whether the return earned is as good as
other alternatives available. This return is calculated by expressing income (net profit
after tax) as a percentage of the share holders equity. It is to be noted that the income
figure should not include extraordinary, unusual or non recurring items as that would
distort the results arrived at. Additionally, the net income on which this ratio is calculated
should exclude dividends on preference shares. Shareholders equity is the stake ordinary
shareholders have in the company and will include reserves and retained earnings.

ROE = Net income after tax-dividend on preference shares

Average shareholders equity

It must be remembered that if there are other investments that earn a higher return with
lower risks then the profitability is low. The ROE should be compared with other
alternatives taking into account the risks of the investment. The normal rule is usually the
higher the return, the higher the risk.

Pre interest return on assets

It is often said that the preinterest return on assets is a purer measure of profitability since
on account of interest and taxation, it is difficult to compare the actual performance of
companies. This is because the interest paid will vary from company to company and will
depend on its borrowings. Similarly the tax liability of companies will differ and will
depend on the manner it has planned its tax. This ratio therefore suggests that the return
be on operating income and is arrived at by dividing earning before interest and tax by the
average total assets.

Pre interest return on assets = earning before interest and tax

average total assets

A banker must compare the return earned with other companies (preferably in the same
industry) to determine whether the return earned is high or low.

Pre-interest after tax return of assets

The purpose of calculating this ratio is to determine the managements performance in

deploying assets effectively without financing. Tax is included in the calculation as it is
deducted before arriving at the profits. Interest too is not considered as it will vary from
company to company and is a payment for capital or funds. The ratio is arrived at by
expressing net return after tax but exclusive of interest as a percentage of average total
assets.

pre interest after tax return on assets

net income after tax + interest expense net of income tax saving

average total assets

Return on total invested capital

The ratio that is used to determine whether the capital has been efficiently used is the
return on total invested capital. A banker can, by using this ratio, check whether he could
have earned more elsewhere. It therefore gives him an opportunity to compare
alternatives and between companies. Invested capital in this ratio includes all liabilities
that have a cost associated with them such as debentures, share capital and loans. The
ratio is arrived at by dividing a companys earnings before interest and tax by average total
invested capital.

Return on total invested capital=earnings before interest & tax

average total invested capital

A banker will check whether the return on capital is higher than the prevailing interest
rate of interest and the weighted average cost of borrowings. If the rate of interest is
higher than then the return on the capital may be considered inadequate.

Summary
The profitability ratios are arguably the most important of the ratios to an banker as they
indicate whether the enterprise is viable and better or worse than other similar ones. These
ratios however should not be seen in isolation. One should remember that a lower ratio is
not necessarily bad. In order to increase sales and profits companies may sell goods at
lower prices (volume driven businesses). These ratios are, like all ratios, indicators and
they should be considered as such.

LIQUIDITY

Liquidity is one of the cornerstones of lending. It is important for companies to be liquid

in order for it to meet its currently maturing financial obligations and to have enough
funds to meet its operational requirements. If a company is unable to, it may be forced to
sell its more important assets at a loss and can, in extreme cases, be forced into
liquidation. After the securities scam in 1992, many mutual funds were forced to sell their
blue chip shares for liquidity as they were not able to sell their large holdings of securities
in Public Sector Undertakings (PSU). As a consequence of the liquidity crunch that began
in 1996/97 many promising companies went down under due to a lack of liquidity.

Current Ratio

The current ratio is the most commonly used ratio to measure liquidity and its purpose is
to check whether a companys current assets are enough to meet its immediate liabilities
i.e. those that mature within one year. The ratio is arrived at by dividing current assets by
current liabilities.

Current ratio = current assets

current liabilities

Normally the ratio is around 1 or even a little below 1. This in itself is not bad. Today, all
companies are aware of the cost of capital, the opportunity cost of tying up capital
unproductively and just in time (JIT) inventory control. Consequently there is an effort to
keep current assets low (stock levels, debtors and cash). Thus often the ratio is well below
1. This does not necessarily mean that the company is illiquid - it could merely be using
its assets effectively.

Quick Or Acid Test

The acid test is a favorite with bankers and creditors. This is used to check whether the
company has enough cash or cash equivalents to meet its current obligations or liabilities.
The reason for this is there is usually no conversion cost when cash or cash equivalents
are used to pay debts. Other assets such as inventories (stocks) if sold at a distress or
emergency sale may realise less than its book value i.e. the company could lose when
converting to cash.

This ratio is arrived at by dividing cash, marketable investments and debtors by current
liabilities. It is to be noted that investments, though strictly not a current asset is used in
calculating this ratio. This is because they are easily realisable.

Quick ratio = cash and cash equivalents

current liabilities

It should be remembered that stocks have not been considered in calculating this ratio as
it is not a cash equivalent and if one wishes to sell it in a hurry there can and will be a loss
(dumping of goods).

Net Current Assets

Net current assets or net working investments are arrived at by deducting current
liabilities from current working assets (trade assets). This is clearly not a ratio. Its
usefulness is in one being able to quickly ascertain whether a company has adequate
current assets to meet its current liabilities. Net current assets is really the working capital
of a company. Consequently several derivatives can be calculated from this figure such as
its relationship to sales, income and even to capital.
Net current assets can also be used as a base to determine the quantum of working capital
that must be kept to support a level of sales. A ratio of 20% could suggest that if sales
increases by 20% , net current assets would also need to increase proportionately. It is, in
this context, better to have a low ratio as the increase in working capital needed will be
less. The company can therefore grow quite rapidly.

Net Trade Cycle

It is important to determine the time companies take to convert goods purchased to cash
after it has been paid for. This is a very good tool to determine its liquidity and it is
computed by adding the debtors turnover in days to the stock turnover in days and
deducting from it the creditors turnover in days.

Debtors turnover = average debtors x 365

sales

Stock turnover = average stocks x 365

sales

Creditors turnover = average creditors x 365

sales

Net trade cycle debtors turnover + stock turnover

- creditors turnover

If this ratio improves, it indicates an improvement in the management of net current

working assets. Ofcourse it can also indicate that there is difficulty being experienced in
paying creditors. Bankers will go beyond the figures to determine the reasons for a
change in the cycle. It must be remembered the longer the cycle, the greater the need for
financing. This should, as much as possible, be brought down. And this can be achieved
by reducing debtors and stock levels and efficiently managing these.
Defensive Interval

This ratio indicates the number of days a company can remain in business without any
additional financing or sales. It can be likened to a worker on strike. How many days can
he survive on the assets that he has before he becomes bankrupt?

This ratio is calculated by dividing a companys average daily cash operating expenses by
its most liquid assets. It is important to note that only the most liquid assets are used such
as cash and cash equivalents. Debtors and stocks are not to be considered as they are not
cash equivalents.

Defensive ratio = average daily cash operating expenses

most liquid assets

Current Liability Coverage

The current liability ratio enables the banker to examine the relationship between cash
inflows from operations and current liabilities and to determine whether the company can
meet its currently maturing obligations from internally generated funds. At times of
creative accounting and cash crunches this is an extremely important ratio.

Current liability coverage = cash inflow from operations

average current liabilities

Summary
Liquidity is becoming increasingly important to companies and this factor alone has
resulted in companies becoming sick - an inadequacy of funds to finance operations. It is
crucial that investors examine liquidity of the company and whether it is improving or
deteriorating.

As companies begin to have financial difficulties, they begin to pay bills (creditors) later.
Current liabilities begin to build up. As current liabilities build up, suppliers become more
and more reluctant to sell goods. This affects production and then sales and this has a
snowballing effect. Therefore if these ratios are deteriorating, a banker will be concerned.

However, negative liquidity ratios need not necessarily be bad. Many companies in strong
positions keep low current assets and are able to get long credit from suppliers especially
those that operate with extremely low margins.

Historically companies have excellent liquidity ratios before a crash. This is because fixed
assets and stocks are sold and become converted into cash. Current liabilities decrease at
that time as creditors are paid off. So good liquidity is also not always wonderful.

Bankers will always check the quality of the assets that make up current assets. It should
be ascertained whether they are at current realisable value. Additionally current assets
should not include deferred revenue expenditure like advertising costs as they do not have
any encashable value. It must be remembered that Balance Sheets can be windowdressed.
Therefore the figures should be scrutinised properly.

The liquidity required will vary from company to company and from industry to industry.
It will depend on market conditions and the prominence of the company. The investor
must, while viewing these ratios check whether the company is adequately liquid and
whether this has deteriorated. If it has and there does not seem a likelihood of it
improving in the imminent future, then the will not extend facilities..

LEVERAGE
Leverage indicates the extent a Company is dependent on outside funds or borrowings to
finance its business. These borrowings may be debentures, term loans, short term loans
and bank overdrafts. Bankers will pay specific heed to this as the viability of the facilities
it extends to companies may depend on how leveraged a company is.

In highly leveraged firms, the owners funds are minimal and the owners are able to
control the business with a fairly low stake. The main risks are borne by the lenders.
These Companies, in good times, make large profits (especially if they are high margin
businesses). However, in times of recession the reverse occurs. Interest costs are
exorbitant and the large profits made in boom times turn to large losses. At these times the
cost of borrowings often exceed the profits made and results in losses and the Company
that makes the highest profits is the one that has no borrowings.

One can safely conclude therefore that though companies with very little or no
borrowings are safer and can be depended upon for some returns, highly leveraged
companies are risky and earnings can in bad years be negative. Conversely in good years
it can be very good.

Liabilities to Assets Ratio

This ratio indicates the total borrowings provided to finance the company and the extent
to which these external liabilities finances the assets of the company. Liabilities in this
connection includes both current and long term liabilities. Assets include all assets
excluding intangibles such as deferred revenue expenditure (preliminary expenses,
goodwill, deferred advertising expenditure and the likes). This is calculated by dividing
total liabilities by total assets.

Liabilities to assets ratio = total liabilities

total assets
Bankers would also examine the companys contingent liabilities too such as guarantees,
legal suits and the likes as should these be material and likely to crystallise, the ratio
would change dramatically.

Debt to Assets Ratio

The debt to assets ratio is a more specific ratio. It determines the extent debt or borrowed
funds are covered by assets and measures how much assets can depreciate in value and
still meet debt commitments. Debts are defined as borrowed funds and will include bank
overdrafts. Assets exclude intangibles such as goodwill and deferred assets. The ratio is
calculated by dividing debt by total tangible assets.

Debt to Assets ratio = total debt

total tangible assets

Debt to Net Worth Ratio

The debt to net worth ratio shows the extent funds are sourced from external sources and
the extent a company is dependant on borrowings to finance its business. It is arrived at
by dividing debt by net worth. Net worth is defined as shareholders equity less intangible
assets.

Debt to Net Worth = Debt

Net Worth

Liabilities to Net Worth

The liabilities to net worth is a larger measure than the debt to net worth ratio and
attempts to determine how dependant a company is on liabilities to fund its business. It is
calculated by dividing total liabilities by net worth. Net worth will be arrived at after
deducting intangible assets.

Liabilities to net worth ratio = total liabilities

net worth

Incremental Gearing

The incremental gearing ratio attempts to determine the additional borrowings required to
finance growth. It is to an extent similar to the net working investments ratio. The ratio is
calculated by dividing net increase in debt by the increase in net income after tax but
before dividend.

Incremental gearing = net increase in debt

increase in net income after tax but before dividend

Other Ratios

There are several more ratios for gearing but these are seldom used such as the long term
debt ratio which seeks to determine how important borrowings are to total long term
liabilities and shareholders equity. This ratio is enlarged by the liability to equity issue.
Liabilities in this calculation includes total liabilities and shareholders equity.

Summary

The gearing ratios illustrate the dependence companies have on external funds and the
extent to which liabilities finance the company and are extremely important and bankers
will consider these while evaluating a company.

ASSET MANAGEMENT / EFFICIENCY

It is by the efficient management of assets that companies make profits.

Bankers therefore will always analyse the financials to determine whether the assets a
company has are adequate to meet its needs and whether the returns are reasonable. It
must be remembered that assets are acquired either from capital or from borrowings. If
there are more assets than necessary, the company is using funds it could have used more
profitably or conversely paying interest needlessly. If there are less assets than it requires
the companys operations would not be using its resources as productively and effectively
as possible.

Asset management ratios, in short, enable bankers to determine whether a company:

o is utilizing its assets efficiently.

o has adequate assets.

It is assumed that sales volumes are affected by the utilization of assets. Asset ratios are
used to assess trends and to determine how well assets have been utilized. Comparisons
can be made between one year and the next, between one company and another in the
same industry and in other industries. These ratios help enormously in making forecasts
and budgets too.

It must be remembered however that these ratios, like others, are pointers. A high asset
turnover does not necessarily suggest great efficiency or a high return on investments.
This may be because a company does not maintain adequate assets and this can affect its
performance in time. Bankers therefore always look beyond the indications. It is
important to bear in mind that a deterioration in asset ratios are a sign of decline and
should be greatly heeded.

Stock Utilization

The stock utilization ratios measure how efficiently stocks are handled. With the cost of
borrowings being high managers are constantly alert to the need to keep stocks low. In
these days of companies propounding the Just In Time principle, these ratios are always
carefully scrutinized and evaluated.
Stock utilization can be measured by two ratios

a) The Stock Turnover Ratio. This ratio indicates the number of times stocks (inventory)
were turned over in a year and is calculated by dividing the cost of goods sold in a year
by the average stocks held in a year.

Stock Turnover = Cost of goods sold

average stock

b) Stock Holding Ratio. The stock holding ratio measures the number of days of stocks
(in relation to sales) held by a company. In these days of companies attempting to keep as
little stocks as possible, this is an important efficiency indicator. It is calculated by
expressing the stock held in days of cost of good sold.

Stock holding Ratio = average stock

cost of goods sold divided by 365

Bankers will attempt to ascertain the reason for an improvement in the ratio i.e. is it
because stocks have been dumped on dealers or due to difficulties in procuring stocks or
due to a strike in the manufacturing plants? As companies close down stock levels fall.
Purchases are not made and existing stocks are sold. The banker would seek to ascertain
the reasons for the improvement in this ratio and especially whether the existing level of
stocks can support the level of sales a company has.

Average Collection Period

Most companies sell to their customers on credit. To finance these sales, they need to
either block their own internal funds or resort to bank finance. The cost of finance is
therefore usually built into the sale price and companies offer a cash discount to
customers who pay in cash either at the time of sale or soon thereafter.

The average collection ratio is calculated by dividing average trade debtors by the average
sales per day.
Average collection period = average track debtors

average sales per day

An increasing average collection period ratio is an early warning indicator of large bad
debts and financial sickness and by controlling it one can improve efficiencies and reduce
borrowings and save on interest.

A falling ratio is not however always wonderful. Just before companies fold up, they
begin collecting on their debts and they sell for cash. The result is falling average
collection period ratios.

Average Payment Period

The average payment period ratio or the creditor ratio indicates the time it takes a
company to pay its trade creditors i.e. how many days credit does it enjoy. The ratio is
calculated by dividing trade creditors by the average daily cost of goods sold.

Average Payment Period = Trade Creditors

Average daily cost of goods sold

While examining this ratio the banker will seek to determine whether :

o The company is availing of all the credit that it can.

o The company is having difficulty in procuring credit.

o The company is having difficulty in paying its creditors.

If the company is strong and in a commanding position, it can command longer credit
terms. This is good as the company is effectively using creditors to finance working
capital and to that extent the cost of finance falls.

Net Working Investments Ratio

Net working investments are those assets that directly affect sales such as trade debtors,
stocks and trade creditors. The ratio is calculated by dividing the net working assets by
sales.

Net working investments ratio = Stocks + Debtors - Creditors

Sales

This ratio highlights the working capital requirements of a company and helps the banker
to determine whether the companys working capital is controlled efficiently.

Total Asset Utilization

The total asset utilization ratio is calculated to determine whether a company is generating
enough sales taking into account its investment in assets. It indicates how efficiently
assets are being utilized and is an extremely useful ratio for preparing forecasts. The ratio
is calculated by dividing sales by average total assets.

Total asset utilization = Sales

average total assets

Fixed asset utilization

The fixed asset utilization ratio measure how well a company is utilizing its fixed assets.
bankers can compare this with the utilization of other companies in the same industry to
determine how effectively fixed assets are being used. It should be remembered that this
ratio should be calculated on net fixed assets i.e. cost less accumulated depreciation. It is
arrived at by dividing sales by average net fixed assets.

Net Fixed Asset Utilization = Sales

Net Fixed Assets

An increasing ratio suggests that sales have fallen and the efficiency in the handling of net
fixed assets has deteriorated.

It must be borne in mind that this ratio is not truly reflective of performance as fixed asset
costs when comparing companies will differ. A new company with recently acquired fixed
assets will show a worse ratio than one that has assets that are old. In such a scenario it
would be unfair to label the older company inefficient.

Summary

Asset management ratios are calculated to assess the competence and the effective of
management; to determine how efficiently assets have been managed. It also highlights
how effectively credit policy has been administered and whether the company is availing
of all the credit it is entitled to and is offered by its suppliers. It can also indicate whether
a company is encountering difficulties.

MARGINS

It is not uncommon to read in Annual Reports that although sales have increased by 24
percent in the year profits have fallen due to increases in the cost of production causing
margins to erode.

Margins indicate the earnings a company makes on its sales - its mark up on the cost of
the items it manufactures / buys to sell. The higher the mark up the greater the profit per
item sold and vice versa. Margins are so important that they determine the success or
failure of a business. And the mark up or margin made by the seller is based usually on
what he believes the market can bear or that which he thinks will fuel sales. Usually low
volume businesses are high margin businesses as goods often have to be held for some
time. Others such as supermarkets or for that matter brokers work at very low margins
because volumes are very high.

Margins help to determine the cost structures of businesses i.e. are they high cost or low
cost and whether the business is a high volume low margin business or otherwise. This is
important as it will indicate how dependent the company is on margins. If the company
operates with low margins a small increase in costs can result in large losses.

The performance between companies within an industry or a group can also be compared
with the help of margins. Let us assume that the gross margin earned by Unisulphur Ltd.
is 20 percent whereas the industry average is 18 percent. It can be argued in this instance
that Unisulphur Ltd. is more efficient and that its products command a greater premium.

Management trends can also be assessed by margins. Efficient and strong managements
will work to improve or keep margins constant.

Margins help an investor to determine whether increases in costs (possibly on account of

inflation or governmental levies) have been passed onto customers in part or in full.
Should there be a demand for the product, companies will pass on the entire cost increase
to customers who will bear it and be grateful (though they may not grin). On the other
hand, if the demand is not very much, the company would often bear a part of the cost
increases because if it does not, the customer would not purchase the product. A good
example of falling margins is the TV industry. As competition is intense and the buyer has
a choice between several makes, manufacturers have been bearing a portion of cost
increases and in some instances dropped their prices in order to be competitive.

Product mix has an effect on margins. A company may be selling several products - each
of them priced differently. Some may be high margin products and others low margin
ones. If more high margin products are sold, the margin earned by the company would be
high. Then should there be a change and more low margin products begin to be sold, the
average margin earned on sales will reduce. It must be remembered that low margin
businesses are not bad. Some of the most successful businesses in the world are low
margin businesses that operate with very high turnovers and produce an impressive return
of capital employed.

Gross Margin

The gross margin is the amount earned expressed as a percentage of cost of sales. It is the
excess earned to meet the expenses of the company. It is calculated by dividing the
difference between sales and the cost of goods sold by sales and expressing it as a
percentage of sales.

Sales - cost of goods sold X 100

Sales

Margins could fall due to several reasons such as :

o Due to increased competition, the company has reduced margins to boost sales.

o The company has taken a conscious decision to reduce its margins to improve sales.

o The margin has reduced because there has been a deterioration in the product mix.

o The company has been unable to pass on cost increases to customers.

The banker will not normally come to a conclusion on seeing an improvement or a

deterioration in the gross margin. He will go beyond the figures and seek the reasons for
the change. An increase in the margin may be due simply to an increase in price whereas
a fall could be due either as a consequence of a conscious decision to increase sales or an
inability of the company to pass inflationary cost increases onto customers.

Operating Margin
The profitability of a company before the cost of tax, miscellaneous income and interest
costs is indicated by the operating margin. The operating margin can be arrived at by
deducting, selling, general and administrative expenses from the gross profit and
expressing it as a percentage of sales.

Gross profit - selling,general & admin expenses x 100

sales

An improvement in the operating margin could be because operating expenses have not
risen as much as the increase in sales. Conversely the gross margin could have decreased
(although sales may have gone up) and costs increased resulting in a fall in the operating
margin. Normally this margin should improve since costs do not usually rise at the same
rate as sales. In a recession or at a time of high inflation the reverse will be true. Costs
may increase at a faster rate than sales and gross margins may also fall.

The investor must always examine this ratio as it indicates the likely reasons for an
improvement or a deterioration in profitability and he must ascertain the actual causes.

Breakeven Margin

Every organisation has certain expenses (selling, administration and other miscellaneous
expenses) that it has to bear even if there are no sales. The breakeven margin indicates the
number of units that a company would have to sell to be able to meet these expenses.
When a company states that its breakeven is at 50% of its capacity it means that the
company would be in a no profit no loss position if it produces and sells half its capacity.
Any unit sold above this would yield a profit and vice versa. The ratio is arrived at by
dividing expenses including financing costs by the gross income per unit. Non recurring
or unusual profits must be excluded from the calculation.

Expenses plus financing costs

Gross income/Number of units sold

Some bankers prefer to calculate this by deducting from the gross profit selling costs to
arrive at the gross profit per unit. This is because selling costs are connected with sales
and no selling expenses would be incurred if no sales are incurred. In my opinion this is
an important measure as it indicates exactly how many units need to be sold by a
company before it can begin to be profitable. This is an important management ratio too
in decision making when alternatives are being considered.

Prefinancing Margin

The prefinancing margin is the rate of profit earned prior to the costs of financing. The
reason for excluding financing costs is because this would vary from organisation to
organisation. It would also vary on account of the method of financing too. This margin is
therefore calculated by dividing earnings before interest and tax by sales and expressing
this as a percentage.

Earnings before interest and tax x 100

Sales

This is a good measure to compare the profitability of organisations.

Pretax Margin

The pretax margin indicates the rate earned on sales after accounting for the cost of
financing but before tax. In short this is calculated on the income before tax and expresses
it as a percentage of sales.

Pretax Income

Sales

As was mentioned earlier non recurring income or expense should not be included in the
calculation as it would distort comparison.

This is not a fair measure of profitability and comparison as the manner of funding (and
thus financing costs) will vary from company to company. It can however be used
effectively to compare performance between years of a company.

Net Profit Margin

This margin shows the rate of earnings a company earns after tax on sales. It indicates the
rate on sales that is available for appropriation after all expenses and commitments have
been met. To facilitate comparison and to get a true rate non recurring income and
expense should be excluded in the calculation.

Net income excluding non recurring items after tax

sales

The margin enables a shareholder to determine the earnings available to him on increases
in sales.
Summary

Margins help therefore in characterizing cost structures in businesses and comparing

performance. A banker always remembers however that low margins are not always bad
nor are high margins always good. A company may opt for volumes and to achieve this
work on very low margins. On the other hand a company earning high margins may have
falling demand for its products. Bankers always check into the reasons for variations and
the various measures mentioned in this chapter points out to the banker the possible
reasons.

EARNINGS

Earnings is the yardstick by which companies are finally judged-the earnings the equity
holder earns on his investment. The earnings ratios are often used to determine the fair
market price of shares and to value investments and the company. These ratios are, as a
consequence, worth looking at from a bankers perspective though the lending decision is
rarely based on these.

Earnings per share

The earnings per share (EPS) ratio indicates the earning of a common share in a year. This
ratio enables investors to actually quantify and know the income earned by a share. This
ratio enables the banker to determine whether the shares are reasonably priced. The ratio
is arrived at by dividing the income attributable to common shareholders by the weighted
average of common shares.

Earnings per share Income attributable to common shareholders

Weighted average number of common shares

Abroad, in countries such as the United States of America where employees are given
stock options bankers and analysts check a companys fully diluted earnings per share.
This is the earnings per share of a company after all share options, warrants and
convertible securities outstanding at the end of the accounting period are exchanged for
shares. This becomes relevant to India nowadays as many companies issue convertible
debentures and bonds.

Many value a share as a multiple of the earnings of the company. If the earning per share
is Rs. 5 and a yield of 10% is considered reasonable, the share is priced at Rs. 50.

Cash Earnings per share

It is often argued that the earnings per share is not a proper measure of the earning of a
company as depreciation, tax and the cost of finance varies from one company to another
and that true earnings should be calculated on the earning before depreciation, interest
and tax. The cash earning per share is arrived at by dividing earning before depreciation,
interest and tax (EDBIT) by the weighted average number of shares issued.

Cash earnings per share = EDBIT

Weighted average number of shares issued.

Dividend Per Share

The dividend per share is often used to determine the real value of a share. Proponents of
this school of thought argue that the earning per share is of no real value to anyone but
those who can determine the policies of the company. It is submitted that the value of a
share should be a multiple of the dividend paid on that share.
How does one value the share? If one assumes that the earnings made would include an
increase in the price of the share (capital appreciation) and income (dividend per share),
the price would depend on the capital appreciation one expects. If the share has regularly
appreciated by 30% every year, a low dividend yield would be acceptable.

Conversely, if the share does not appreciate by more than 5% and a 30% return is
required, a high dividend yield would be expected.

Dividend Payout Ratio

The dividend payout ratio measures the quantum or amount of dividend paid out of
earnings and attempts to determine how much of the earnings of a year is paid out as
dividend to shareholders and how much is ploughed back into the company for its long
term growth. This is an important ratio when assessing a companys prospects because if
all its income is distributed there would be no internal generation of capital available to
finance expansion and to nullify the ravages of inflation and to achieve these the company
would have to borrow. This ratio is calculated by dividing dividend by net income after
tax.

Dividend Payout Ratio = Dividend

Net Income after tax

Normally young, aggressive companies that are growing have low dividend payout ratios
as they plough back their profits for growth. Mature companies on the other hand have
high payouts. This is of concern as they may not be retaining capital to renew assets or
grow. Investors must also ensure that the dividend is being paid out of current income and
not out of retained earnings because that tantamounts to reducing the monies set aside for
growth, expansion and replacement of assets.

Summary
It is important to remember that earnings ratios are not indicators of profitability. They
advise an investor on the earnings made per share, the dividend policy of the company
and the extent of income ploughed back into the company for its expansion, growth and
replacement of assets.

It is useful to examine these ratios especially the earnings per share and the dividend
payout. The earnings per share would help one determine whether the market price is
reasonable. If the dividend payout ratios are very high there will be concern as it can
indicate that the management of the company is not particularly committed to the long
term growth and prospects of the company.

APPROVAL

Once the Banker has gone through the request for credit facilities and studied all the
relevant information about the client and he is satisfied that the need is genuine and that
the customer has the ability to repay the advances extended, he would recommend the
facilities for approval.

The procedures for approval vary from bank to bank.

In most foreign banks a member of the marketing staff makes the proposal or
recommendation. This is so because the marketing person is closest to the client. He
would then pass it on to the marketing manager or the head of marketing who would, if he
is satisfied with the proposal, support and recommend it. Important proposals may even
be prepared and recommended by the head of marketing himself. The proposal with the
recommendations would then be forwarded to a credit officer or credit manager who
would then vet the proposal from a credit viewpoint. The approval responsibility or power
is based on the amount of the facility required. If the amounts are small, the marketing
officer and a credit officer within their approval authority could probably do the approval.
As the facilities required increases in value the person/ persons approving would be
higher in the hierarchy. Large facilities would need to be approved by the Credit
Committee or the Board of Directors.
In several nationalised senior officers have discretionary authority upto a certain limit.
Branch managers have fairly small authorities, often upto only Rs. 100,000. Regional
heads or zonal heads are authorised to approve upto Rs. 50,00,000 or even Rs.
100,00,000. The Chairmen of Banks have authority to approve facilities of upto several
crores. The procedure is that when facilities are approved under unilateral powers of an
officer (whatever be the rank) the next higher authority should ratify the proposal within a
reasonable time. The weakness in this system is that there is no credit officer separately
from a credit point of view vetting the proposal and even if there is a credit officer, a
person in authority can still approve the facilities unilaterally even if the credit officer/
manager does not approve or support the facilities being given.

Private banks, by and large work, in a manner similar to foreign banks and require
facilities to be approved by two persons – a marketing or relationship person and a credit
person. However, often in private banks, approval authorities are not sometimes delegated
to branch managers or senior branch officers. This results in all proposals having to be
sent to Head Office for approval and this sometimes takes considerable time.

The approving of a credit by two persons is, from a control purpose, very good. The
relationship person knows the client intimately and can therefore make a recommendation
based on a detailed knowledge of the strengths and weaknesses of a client. However, he
can be partial as he has a vested interest to the extent that he would like the individual/
company (if new) to become a customer. His judgement and recommendation, is to that
extent, colored. The credit officer/ manager does not know the prospective client at all
and he would either support or reject the proposal based on the financials, the
management, the external environment and other relevant details. It would be an impartial
decision based on facts.

Once the facilities are approved the Bank would send the client a letter advising that the
facilities that have approved subject to the prospective client complying with certain
stipulations and conditions governing the approval. This letter would also normally detail
the collateral that would have to be given.

The prospective client would normally sign the offer letter and return it to the Bank. This
is in effect an acceptance by the prospective client of the terms of the approval. Then he
would work with the Bank to get the security documentation complete. Drawdown is
usually permitted after all documentation has been perfected. It is then that the
prospective client will, in fact become a client.
POST DISBURSAL

The saga of a loan does not end on its disbursal and a borrower will be wise to remember
that. Disbursals, as mentioned earlier, take place after the documentation required by the
Bank has been executed. The disbursal may be in one or two or more tranches in the case
of a term loan or continuous as in the case of overdrafts.

However, when a loan is approved there are usually several conditions that borrowers are
expected to, on an ongoing basis comply with such as ensure that the assets collateralised
are adequately insured, statements on these assets (especially stocks and debtors) are
submitted regularly (usually monthly), interest payments are made on time and the likes.
Borrowers would be wise to comply with these requirements as bankers would base their
judgement on how good or bad a borrower is on the basis of how he complies with the
conditions that had been laid down at the time the loan is disbursed.

What does a banker look for?

Let us look at overdrafts. Usually overdrafts are collateralised by debtors and stocks.
When the banker receives the statement of debtors and stocks he checks the following:

In regard to debtors he would look at the aging of debtors and the provisions made for
bad and doubtful debts. He would normally, in his assessment for adequacy, not take into
account those debtors that are long overdue. In this test he would normally omit debtors
who are overdue for more than 90 days. Let us imagine that Raman Menon has debtors
aggregating Rs. 40,00,000. Of these Rs. 2,00,000 are overdue for more than 6 months, Rs.
8,00,000 are due for periods ranging between 90 days and 180 days and of the others
there is a possibility that debtors totaling Rs. 5,00,000 may not pay at all (bad debts). In
determining the value of the collateral, Mr. Menon’s banker will assume the value of the
collateral to be Rs. 33,00,000. This is on the assumption that those borrowers whose
outstandings are between 90 and 180 days would pay.
 The banker, when he examines stocks will check the nature of the stocks held – both
raw materials and finished goods and examine how long they have been held. In this case
if an item has been held for more than three months it does not necessarily mean that the
article concerned is bad. It may just be slowmoving. The banker will however examine
the stocks for obsolete items and exclude these from the value of the collateral held. If
Mr. Daruwalla has chemicals that are over six months old and the shelf life of the
chemical is only three months then that chemical is clearly of no use. Its value will not be
taken into account when determining the value of stocks. In certain industries there is a
high obsolescence factor (computers etc.). The banker, while examining collateral values
in these industries will take special care.

There are usually margins kept by the banker to protect the bank from any deterioration
in the value of the collateral. The terms of approval may stipulate that the margin on
stocks would be 60 percent. This means that the banker would permit the borrower to
borrow only upto 60 percent of the value of the stocks held at any time. There would be
margins for debtors also. The banker on receipt of the stock statements will work out,
based on the margin requirements, how much the borrower can borrow. This is known as
the borrower’s “drawing entitlement.” Bankers pay special heed to this and as they have
to work this out every month it is imperative that this is submitted in time and regularly.

The banker will also periodically visit the factories or godowns of the borrower to
satisfy himself that the stocks do in fact exist. He will test check quantities with bin cards
and even do a test count of some items. He would also go through debtor records to
satisfy himself that these are correctly stated both in terms of amounts and that they have
been aged correctly.

In regard to term loans for the purchase of machinery the banker will after he is
satisfied that the price is reasonable will sight the machinery – actually go the factory to
see the machinery and see it installed and working. He will also go periodically to the site
to satisfy himself that the machines installed are still working well and doing what they
are supposed to. In regard to the machines imported by Rusi Daruwalla, the banker
would, on its installation, go to the factory to see it. He would also examine the invoices
and customs papers and other relevant documents to satisfy himself that the values are
correctly stated.

The banker will also, on a day to day basis examine the manner the borrower operates his
account. If there are frequent excesses in the overdraft due to the borrower issuing
cheques without ensuring that there are adequate funds the banker may even be forced to
dishonour the cheques. If Raman Menon had issued such cheques, in the first few
instances his banker may have called him and told him that there are inadequate funds and
asked him to deposit cash to enable him to honour the cheques. After a while, if this
continues the banker would dishonour the cheques.
Rusi Daruwalla, in regard to the term loan he has taken, would be expected to pay interest
and principal installments on due dates. If he does not do so there would be reminders and
yet more reminders.

Borrowers would be wise to honour the commitments they have made and adhere to the
conditions laid down as they would then be able to establish a good credit record with
their bank. This would enable them should they require to get additional loans from their
bankers at future dates. If a borrower is tardy and lackadaisical and if at a later date he
wishes to increase his loan/ credit facilities, his banker may not be receptive.

As far as the banker is concerned post disbursal monitoring is as important, if not more
important than the credit appraisal process itself because upon this depends whether he
gets repaid.

CONCLUSION

Presentation is extremely important. First impressions count enormously. One tends to be

favorably impressed and more inclined to view a person or proposal favorably if the first
sighting of the person/ proposal is good. A well presented, well researched credit
application inspires confidence. A credit application that addresses all the issues and
concerns that a banker may have will usually go a long way in convincing the banker of
the professionalism and competence of the intending borrower and on the borrower’s
ability and intention to repay. On the other hand if it is badly presented the impression
that the banker would have is that the prospective borrower does not know his business, is
confused, is disorganised or may be unable to repay. Such an impression could result in
the loan being rejected.

The presentation must be direct. It must detail the risks and the strengths of the project/
company that seeks the facility and explain how the loans will be serviced and repaid. It
must communicate forcefully and unambiguously. It must not meander or be verbose.

It must be remembered that the banker who reads the proposal is a busy man. He has
several proposals to read and the last thing he wants is a badly presented report that has
several gaps. He has to make a decision quickly and if there are issues that have not been
addressed his initial reaction would be to place it aside to look at when he has time. More
often than not he will forget it. On the other hand if all the issues are addressed he will be
inclined to look at the proposal favorably.

It must however be remembered that a well presented well structured application cannot
make an unviable project viable or a bad loan good. The presenter will therefore be wise
to detail all the possible risks as this will underline the prospective borrower’s integrity
and transparency.