Banking Strategy, Credit Appraisal, and Lending Decisions

A Risk-Return Framework

Second Edition

Hrishikes Bhattacharya

UNIVERSITY PRESS

Lending Strategy and Loan Policy Introduction • Need for a loan policy ° Credit-deposit ratio ° The threat of dilution in the quality of loans • Policy emphasis on non-fund business «Interest rate policy • Loan portfolio and exposure policy » Loan-to-value ratio • Repayment policy • Concluding remarks 1 32 65 105 . C a p i t a l R e g u l a t i o n a n d R i s k Management S t r a t e g y Introduction • Inter-relationship among capital. assets. Banking Strategy Introduction • Financial sector reforms • Decline of traditional banking • > Changing savings and investment behaviour • Liquidity newly denned • Securitisation • Strategic planning • Capital planning • Growth model ° Banking strategy: The case of ABC Bank • Strategic planning exercise of ABC Bank • Cost allocation < • Risk component ° Asset allocation • Cost of funds • Operational plan forfiveyears < > Concluding remarks 4. ROA. Liquidity Management and Assets-Liabilities Strategy Introduction • Liquidity management theories • Fluctuations in the economy • Liquidity planning • > Liquidity ratios • Balance sheet approach • > Deployment strategies • Maturity matching strategy • Concluding remarks 3 .Contents List ofAppendices List ofAnnexures xi xii Preface to the Second Edition Acknowledgements Introduction xiii xv xvii 1 . and ROE • Competition for funds » Rise in losses < > Risk management: A strategic issue • Concluding remarks 2.

Long-term Liabilities 165 Introduction • Definition • Equity or share capital • Contribution of promoters • Authorised capital • Issued and paid-up capital • Fear of takeover ° Reduction of capital • Limited liability: Banker s problem « Preference share capital ° Financing the redemption • Share premium • Dividend versus reserves • Free reserves: The problem • Bonus shares • Capital reserve • Banker's viewpoint • Debentures » Term loan • Loans from friends and relatives • Loans from subsidiaries ° Modern financial instruments • Concluding remarks 9 . Current Liabilities 190 Introduction • Origination • Danger of overtrading ° Safety margin « Trade creditors • Deposits from customers and public • Inter-corporate loans and investments « Bridge loans • Commercial paper • Registration of charges « Concluding remarks 1 0 .viii Contents 5. manufacturing. Current Assets and Fictitious Assets Introduction • Cash and bank balances • Sundry debtors/receivables • Inventory • Valuation of inventories • Various types of stocks/inventories ° Loans and advances • Intangible and fictitious assets • Fictitious assets • Concluding remarks 152 8 . Fixed Assets 125 Introduction • Definition •> Land and buildings •> Factory shed location • Plant and machinery» Depreciation • Appreciation ° Capital work-in-progress • Furniture and fixtures • Motor vehicles • Concluding remarks 6 . and profit and loss account • Gross profit • Operating profit • PBIT versus PBT « Trading companies • Manufacturing companies • Absorption costing versus direct costing ° Difference in profit measurement» Cost of goods sold • Operating profit approach o Unusual incomes ° Concluding remarks 207 . Profit and Loss Account Introduction • Accounting concepts • Nature of costs • Wages • Production overheads • Maintenance and repairs • Administrative costs • Marketing and distribution costs • Controllable versus uncontrollable cost • Trading. Working Capital: A Techno-Financial Approach 133 Introduction < > Should we hate current assets? < > Currentness concept and operating cycle theory < > Natural business year • Negative operating cycle < > Limitations of operating cycle theory« Mathematical fallacy« Reversibility test • An alternative theory of working capital o Discrete operating inventories ° Other discrete current assets • Techno-financial approach • Core working capital • Projection of working capital ° Characteristics of Core Working Capital • Control mechanisms • Concluding remarks 7 .

E v e n A n a l y s i s Introduction • Dilemma of an entrepreneur ° Full cost versus marginal cost • Variable cost • Fixed cost • Semi-variable cost» Margin of safety • Profit-volume ratio . Funds Flow a n d C a s h Flow A n a l y s i s I. CHORE GROUP Review of the lending system • Cash credit system < > Loan system » Bill system • Proposed scheme • Drawee bill system < > Restructuring of financial statements. C o s t . Business Forecasting and Credit Decisions 323 Introduction • The basic theory • Variables « Regression analysis « Standard error of estimate • t-Distribution • Coefficient of correlation ° Illustration ° Checking the assumptions • Projection of sales • Projected operating expenses « Projection of gross working capital t Projection of trade and expense liabilities • Bank finance for working capital • Concluding remarks 14. CASH FLOW ANALYSIS Clearing the ground ° Value and obligation • Cash and funds flow • Cash book summary • Detailed cashflowstatement ° Cash inflows o Motives for holding cash • Cash outflows • Concluding remarks 15. New E r a o f L e n d i n g : T a n d o n C o m m i t t e e a n d I t s A f t e r m a t h Introduction I.Further problems of Pankaj Verma • Problem of multiple products • A simple method for a break-even analysis • Financial break-even point • Financial margin of safety • Limitation and laws of marginal analysis • Concluding remarks 383 . P r o f i t a b i l i t y .Contents ix 11. a n d B r e a k . TANDON COMMITTEE 267 • The norms • Methods of lending» System mechanics • End-use t Classifications of current assets and current liabilities II. and lending decisions • Lending decision: An example « Credit appraisal • Lending decisions: Problems with the MPBF system • Concluding remarks 1 3 . credit appraisal. FUNDS FLOW ANALYSIS 341 Introduction • Financing the total operation: Fourth concept • Sources and uses of funds • Generation of funds from operations • Recommendations of IAS C < > Acquisition or disposal • An illustration • Suggested approach < > Calculation of bank finance for working capital II. Understanding the Balance Sheet 230 Introduction • Trial balance ° Treatment of closing stock • Classification of accounts • Balance sheet • Net worth » Gearing of capital ° Shareholders versus banker o Format of a balance sheet • Non-corporate borrowers • Percentage balance sheet • > Preliminary observations • A business with no formal accounting system • Concluding remarks 12.

Project Appraisal: Methods and Techniques 433 Introduction « Banks' involvement in project financing • > Policy changes • > Non-financial appraisal • Technical and managerial viability • Financial appraisal • Cost structure • Depreciation • Taxation < > Interest • Discounted cash flow» Risk element • Net present value • Opportunity cost ° Internal rate of return ° Payback method « Average and effective rate of return • Profitability index • Repayment capacity« Concluding remarks 1 8 . Project Appraisal and Lending Decisions Introduction • Summary of the project ° Financial analysis of the project • Cost structure • Life of the project • Salvage value » Estimating projected revenue ° Relevant cash flows • Working capital and term loan •> Cash flow from operations « Profitability index and internal rate of return • NPV versus IRR • Break-even point • Debt-service coverage ratio • Concluding remarks 1 9 . S m a l l B u s i n e s s Loan Introduction • The case • The need of the borrower • Appraisal ° Alternative scenarios • Concluding remarks 2 0 . Credit Risk Analysis Introduction • Business risk • Measurement of sales risks • Coefficient of variation • Evaluation of sales forecast« Sales risk index < > Measurement of operating risks o Measurement offinancialrisks • Measurement of industry risk ° Methodology and results of analyses • Industry risk category • > Borrower risk « Character • Lending decisions based on Cs • Comprehensive borrower risk analysis • Determination of final risk category • Interest rate determination and margin requirement • Concluding remarks 463 486 491 Bibliography Index 536 541 .x Contents 16. Appraisal and Monitoring through Ratios Introduction » Presentation and uses of ratios • Manipulability of ratios » Objectivity in ratio analysis » Difficulties with ratios « Classification of ratios « Efficiency of operational management ° Efficiency offinancialmanagement • Net working capital • A situation with zero net working capital • Implicit credit • Treatment of contingent liabilities • Efficiency of debt-service management < > Standards of comparison < > Concluding remarks 403 1 7 .