TERM LOAN APPRAISAL

Term Loan Vs Working Capital

Term loan has to be distinguished from working capital.

 Working capital is required for the day-to-day operations of a business unit.
 The necessity of working capital arises only at the time of going in for the
commercial production of the unit.
 Working capital requirements generally increase due to the growth of the
unit and are therefore, a continuous requirement once the business starts its
operations.
 Working capital is generally required for acquisition and holding of raw
materials, holding of work-in-process, holding of finished goods, extending
credit to customers and for meeting day to day expenses.
 Working capital expenses find their place in the profit and loss account of the
business
In contrast,
 Term loan requirement arises for purchasing items of assets like building,
machinery, furniture, vehicles etc. that go to increase the earning capacity
of the business.
 Once the term loan is obtained, it has to be repaid over a period of time and
closed at a point of time. Thus, the term loan balance goes on reducing and
becomes nil after its repayment.

FEATURES OF A TERM LOAN

(Relevant portions extracted and Reproduced from Loan Policy Document 2015
Reader is encouraged to go thru the Policy Document in detail)
TERM LOAN/PROJECT FINANACING:
a) Purpose Term loans are extended for acquisition of fixed assets like land,
building, plant and machinery, vehicles, furniture and fixtures.
b) While appraising the Term loan requirements, Bank will endeavour to appraise
both term loan and Working capital requirements at the time of initial stage of
appraising the proposal.
c) The appraisal of term loan is a one-time exercise, but more detailed, rigorous
and complicated as the repayment ranges over a longer period.

d) The following four critical factors will be looked into in depth.

1. Managerial Competence,
2. Technical Feasibility,
3. Commercial Viability and
4. Financial Feasibility
(Each of these dealt at length later)
e) The maximum period for repayment of term loans shall not generally exceed
120 months including the holiday period. This may however be increased upto
180 months for large projects involving longer gestation period.
f) Banks are providing now-a-days more term loans with longer duration. As
consortium has become optional, banks may even take care of the project
funding without any ceiling subject to compliance with the prudential norms.
Hence the bank would involve in funding the term loan requirements.

Repayment

g) Term Loan / DPG will normally be considered with a maturity not exceeding
10 years including moratorium / holiday period and, under specific
circumstances, extended for longer periods upto 15 years.

In respect of housing loans and infrastructure projects, the repayments may

however be extended beyond 180 months. In such cases endeavour should be
made for tie up or take out finance .It is not practicable to fix uniform
gestation/holiday period as it varies from project to project.

Holiday/gestation

i) Gestation/Holiday period for various project loans will vary from 3 months to 36
months. However on any account the gestation period should not go above 36
months. GM Corporate Credit is empowered for sanctioning exceptions.
j) In case of Consortium lending, the holiday period as decided by the leader
Bank /institution may be considered for acceptance.
k) In case of Multiple Banking, the holiday period, as permitted by the
Bank/Institution, with major share, may be accepted.
l) In term loan appraisal, besides other factors, Debt Service Coverage Ratio
(DSCR) and Debt Equity Ratio will be given more importance.

DEBT SERVICE COVERAGE RATIO (DSCR):

This ratio is to be computed only after thoroughly scrutinizing various projected

financial statements.

Net profit after tax (before dividend) + Depreciation and other non-cash
charges +Interest on term loan
Interest on term loan + Instalment of term loan

(Discussed in detail later in this material)

Bench marks for DSCR

While the desirable ratio would be above 2:1, average DSCR of 1.5 : 1 with
minimum DSCR of 1.2: 1 can be accepted on merits.

MSME Units

For MSME units located in backward areas an average DSCR of 1.5 with a
minimum of 1.2 in any year can be accepted.

OTHER BENCH MARK RATIOS:

a)DEBT EQUITY RATIO

It is very difficult to evolve industry-wise bench marks for debt-equity ratios and
profitability ratios or any other specific ratios.
However, in general, debt equity ratio of less than 2:1 and Total outside Liabilities
to Tangible Net Worth (TOL/TNW) ratio of less than 4:1 will be considered as
reasonable requirements for any credit proposal. These bench marks will
generally be observed for new connections.
b) Relaxation in the bench mark ratios may, however, be considered by
respective sanctioning authorities on merits of the case.

TECHNO-ECONOMIC VIABILITY (TEV) STUDY:

TEV study facilitates the sanctioning authority in arriving at an informed
judgment as to the viability/acceptability of the Project before lending. Bank
has extant guidelines in place on identification of the projects for which TEV
Study is required. The TEV policy is detailed in Bank’s Valuation Policy –Please
see Credit Monitoring Policy for reference in this regard. List of consultants for
Techno Economic Viability Study is also available on line under Other Links.
PROJECT FINANCE PORTFOLIO OF BANKS

a) While extending credit facilities under project financing, it should be ensured

that the promoters‟ fund / equity is brought in to the project as agreed upon at
the time of appraising the proposal.
b) Borrowed funds of the parent/associate companies shall not be used for
equity contribution of wholly owned subsidiaries/Special Purpose Vehicles/Joint
ventures/Associates. Chartered Accountant‟s / Company Auditor‟s Certificate
shall be obtained to ensure compliance. Gearing ratio of the consolidated
financial statements of the Group shall be monitored.

PROMOTER’S EQUITY

c) While determining the level of promoters‟ equity, Bank may accept any one
of the following methodologies.
i. Promoters bring their entire contribution upfront before the Bank starts
disbursing its commitment.
ii. Promoters bring certain percentage of their equity (40%-50%) upfront and
balance is brought in stages.
iii. Promoters agree ab-initio that they will bring in equity funds proportionately as
and when the Bank releases the loan in stages.

Caution to be exercised

d) In view of the greater equity funding risk associated with the last method, at
the time of appraising the project, the source of promoter‟s contribution should
be called for and the funding sequence as to how and when the same will be
infused into the project should be ascertained.

e) It should be ensured that stipulated level of DER is maintained at all times for
the project for which finance is sanctioned.

f) In this connection the following procedure will be adopted.

i. That the method of bringing in equity on pro-rata, can be accepted on case-

to-case basis in respect of top borrowers whose capability to raise the equity at
the appropriate time is indisputable.
ii. A certificate from the Auditor who will audit / be appointed (by the (by the
borrower) to audit the books of accounts of the concern/firm/ company should
be called for, to ensure that the stipulated DER is maintained at any point of
time, whenever pro-rata infusion of promoters equity in the project is
acceptable to us at the time of appraisal of the project.
SECURITY

It takes the form of first charge on the assets created out of the term loan with or
without collateral securities and personal guarantees of third parties. If there is
already a charge existing on the fixed assets of the unit in respect of existing
borrowings, then the fresh term loan may rank for pari passu charge along with
other existing loans on the entire fixed assets including the fresh assets subject to
the existing charge holders being prepared to cede pari passu charge in favour
of the new lenders.

MARGIN

a) Bank recognizes margin as the borrower‟s share in the assets or security and
therefore the Bank will endeavour to prescribe a suitable margin in most cases
of lending by taking into account various factors.
b) The margin norms stipulated in the table below does not cover the following
advances. These advances are covered in the respective schemes/policy
elaborately.
(i) Loan against Deposits.
(ii) Priority Credit.
(iii) MSE advances.
(iv) Special Credit Schemes.

c) The margin stipulated below is minimum margin only and subject to RBI
guidelines.
d) Sanctioning authorities can prescribe higher margin depending upon the
market conditions, nature of industry, internal & external rating and security
coverage etc.
Sl. Type of advances Minimum margin to be stipulated
1 Generally for all advances (Term
loan and Cash Credit) 25% (Desired level)
2 CAPITAL MARKET EXPOSURE
a. Advances against shares 50% (RBI guidelines)

b. Advances against G-Sec/Treasury Bills 20%

c. Loans to Stock brokers & Market
Makers 50% Out of which
Cash margin not less than -
25% Cash/near cash securities
like NSC, LIC - 25%
(RBI guidelines)
d. Loans to Stock brokers & Market
Makers – against G-Sec/Treasury Bills
(only at Capital Market Branches) 20%
REAL ESTATE
Housing & CRE Projects (other than
individual housing loans)
a. Cost of land (for public agencies only) 40%
b. Cost of construction or amenities in
case of layout etc 30%

If the term loan is being sanctioned by having recourse to any Refinance

assistance from some institution, then the margin will be stipulated as per terms
of the Refinance assistance.

The Refinance Schemes also stipulate certain conditions regarding debt-equity

ratio and this has also to be complied with. For the purpose of calculating debt-
equity ratio, seed capital assistance, soft loan, unsecured loans etc. that are
pegged could be treated as own funds.

CEILING:

As per the earlier norms in force, there is no limit for banks‟ participation in big
projects subject to prudential exposure norms. As per prudential exposure norms,
banks cannot sanction more than 15% of capital funds to a single borrower
company (20% for the purpose of infrastructure project) and more than 40% to a
group of borrowers. This 40% is extended to 50% in case of infrastructure projects
provided the extra 10% is only for the purpose of infrastructure projects.

As per recent loan policy document brought out on 28th MAY 2015 the exposure
norms have been revised to a maximum in the range of 5% to 20% of capital
funds of the bank (with the approval of the board).For other exposure limits (with
out the need for approval of the board) a reference may be made to Loan
Policy Document available on line.

TERM LOAN PROPOSAL

A term loan proposal may be received for various types of projects as illustrated
below:

(a) expansion of capacity

(b) modernization of machinery
(c) diversification of product
(d) new project
(e) rehabilitation
(f) backward integration i.e. manufacturing the raw material itself
(g) forward integration i.e. manufacturing the final product
Before taking up the proposal for detailed scrutiny it is customary for the banks
to first extend an „in principle’ sanction. The factors to be considered at this
stage may be stated as under:

1. Bank‟s long term funds position

2. Extent of refinance available
3. Loan policy and credit budget
4. Whether the borrower is under priority sector
5. Extent of exposure to other units in the same industry
6. Whether the borrower is having any experience in the proposed activity
7. Bank‟s experience in dealing with similar units in the past.

Term loan appraisal requires a careful approach because the proposal involves
capital expenditure that has attached risks like the following:

a. Uncertainty of success
b. Irreversibility of decision on spending
c. Prolonged gestation period
d. Risk of obsolescence of the product
e. Delay in implementation due to hold up at various stages.

The appraisal of term loan as already indicated is a one-time exercise, but very
detailed, rigorous and complicated as the repayment ranges over a longer
period. Bank will have to ensure that the working results projected for the entire
period of repayment are reliable, reasonable and realistic. This entails a very
careful and pragmatic analysis of critical factors that determine the success of
any business venture. The focus in a term loan appraisal is on the extent of
projected cash generation and its deployment.

CRITICAL FACTORS OF APPRAISAL

We have seen earlier that broadly, there are four areas of appraisal viz.,
managerial, technical, commercial and financial.
We shall see each of these aspects in detail .

MANAGERIAL ASPECTS

What we generally look into in this area may be stated as under:

1. Background of promoter/borrower
2. His experience in the area of proposed activity
3. Technical Skill
4. Entrepreneurial talent and leadership qualities
5. Integrity and honesty
6. Financial standing
7. Associate concerns and their area of operations.
8. Initiative and intelligence
9. Self-confidence and involvement
10. Risk taking capabilities and capacity to endure adverse times
11. Drive and energy
12. Organisational set up

TECHNICAL ASPECTS

The following may be looked into under technical appraisal:

1. Location of the project with reference to infra-structural facilities like
availability of raw materials, labour, market, power, transport, communication
etc. The land chosen should be without any encumbrances and should be
suitable from the angle of pollution control, which has gained lot of importance
in recent times. Other factors to be considered are the State Govt. sponsored
incentives like seed capital, soft loans, sales tax deferral etc. Further, there
should be in-built scope for expansion at a future date.
2. The project size should be such as to make it viable. For example, small
projects may not be viable at times taking into account the size of its operations.
Economies of scale require a project to be of a certain minimum size.
3. The layout of the factory building should allow smooth flow of operations
there should not be any production bottlenecks. The business should provide for
all basic requirements like shop floors, godowns, administrative block, staff
quarters, security, canteen etc.
4. The plant and machinery has to be very carefully selected. It should be cost
effective, efficient and of good quality. The aspects to be examined may be
stated as basis of selection, cost benefit analysis of alternative machinery,
details of suppliers, technical reports from consultants/agencies etc.
5.The production process and technology should not be obsolete. It should
involve least wastage of men and materials. There should be a control on
quality. The byproducts should be collected and sold or disposed off profitably.
There should be a system for disposal of effluents. The company should go in for
the best product mix. If possible, there should be scope for substitution of
available capacity for a different product. The schedule of implementation
should be examined to ensure that it is reasonable and realistic.

COMMERCIAL ASPECTS:

The various points to be examined while assessing the commercial viability may
be stated as follows:
Demand for the product, market survey, consumer tastes and preference,
pricing policy, distribution network, packaging, transportation, after-sales
service, competition, advertising and sales promotion, substitutes, import, export
potential, life cycle of the product, buying arrangement, SWOT analysis of the
product, costing of the product etc.

FINANCIAL ASPECTS:

In the capacity of a banker, we have to assess this area very thoroughly. This
does not, however, mean that the other aspects of a term loan appraisal are
not so important. Ultimately, the entire project is going to be assessed on the
basis of financial projections and performance. In other words, all other areas of
appraisal viz. managerial, technical and commercial find themselves quantified
and reduced to financial terms for the sake of presentation to the lenders to
enable the businessman to successfully sell his idea to the lenders and obtain
necessary financial accommodation for the project. The essential aspects that
may be looked into at the time of carrying out financial appraisal may be
stated as under:

COST OF THE PROJECT

Land and building

Plant and machinery
Miscellaneous fixed assets
Technical know-how
Preliminary and pre-operative expenses
Provision for contingencies
Margin for working capital

Care should be taken to ensure that the estimated cost of the project takes into
account all the aspects of cost that may be incurred. It should be checked that
there is no over-statement or under-statement of costs.
Over-estimation of project costs results in excess finance and siphoning off of
funds from the business.
Under-estimation results in shortage of funds, which leads to delay in
implementation and need for more finance from lenders without matching
contribution from the promoters.
Another possibility is that the working capital margin may be used up for
meeting the shortfall in project funding throwing the normal working of the
company out of gear due to shortage of working capital.

The costs estimated should be compared with another similar case of recent
past. The costs should also be corroborated with other data available from
various other sources. The preliminary, pre-operative and contingencies cost
should bear some relationship to the total cost of the project.

The margin for working capital gives an idea regarding the company’s total
requirement of working capital at the time of going into commercial production.
This should be linked to the projected level of holdings of working capital as on
the commercial production date.

MEANS OF FINANCING

Share capital
Reserves and surplus (in the case of existing units)
Debentures
Unsecured loans (which are required to be pegged)
Term loans from banks and institutions
Deferred payment credits
Leasing finance
Foreign currency loans

The financial projections should be checked to see the plan of financing the
project. Particularly, the owner‟s stake or margin is a must. The release of the
term finance should bear a proportion to the amount of owner‟s margin brought
in from time to time.

It should be seen whether all necessary arrangements have been made for
timely implementation of the project like mobilization of various means of
finance, obtention of clearances/approvals from various Govt. authorities,
placement of orders for plant and machinery, completion of legal and statutory
formalities, supervision of civil work, strict control on expenditure, adherence to
delivery schedules for miscellaneous fixed assets, plant erection, power
connection etc.

Failure in these will lead to

time over-run which in turn leads to
cost (over run)escalation.

This necessitates fresh funding arrangements that may result in further time over-
run.

PROJECTED PROFITABILITY STATEMENT

The points that may be examined while studying this statement are as under:
A)Probability of achievement of the projected level of sales with reference to
quantity and price realisation
B)Capacity utilization
C)Break-even level of operations and margin of safety.

It is possible that the initial operations result in cash losses till the unit stabilizes
in its operations. It is to be also seen how the initial cash losses are planned to
be financed. Initially, the capacity utilization will normally range from 40 to 60%
and gradually move upwards to the optimum level of say, around 80 to 90%.

All the items of costs are to be scrutinized carefully to see whether they are
realistic. The cost of raw materials should be based on market movements. In
respect of production overheads like power, fuel, wages etc. an increase of 5%
to 10% *may be acceptable annually based on inflation tendencies. Repairs
and maintenance cost should bear relationship with the cost of plant and
machinery held in the balance sheet. In respect of other costs like insurance,
rent, stationery, selling expenses, travelling expenses, transportation charges,
administrative salaries etc. an increase of 5 to 10%* may be acceptable on
yearly basis.

(*Please Note that these are all by way of guidance and depending upon the
unique needs of an industry and based on sound justifications there could be
deviations which are to be spelt out clearly in the note so that sanctioning
authorities could make a well informed decision.)

The cost of depreciation should bear relation to the level of investment in fixed
assets. Wherever preoperative and contingency expenses are allocated to the
fixed assets, the depreciation charge should take into account this also.

The interest cost should be related to the level of borrowings over the projected
time period and the pricing of the funds in question.

RELEVANCE OF THE CONCEPT OF CASH GENERATION

In this context, we have to distinguish between working capital and term loan.
Whereas working capital is effectively a continuous fund available in the system,
term loan is to be repaid over a period of say (MAX) 10 to 15 years.

Thus, the balance outstanding under term loan stands at a reduced figure every
year in the balance sheet. Interest on working capital and term loan has to be
paid IRRESPECTIVE OF whether the unit earns profit or incurs loss. These two
appear as charge in the profit and loss account of the business.
But, the term loan instalment cannot be paid unless there is cash generation in
the business. Thus, it is very important to ensure that the projected cash
generation is realistic and achievable.

Cash generation refers to the figure of net profit after tax + depreciation +other
non-cash charges. The reason for adding back depreciation and other non-
cash charges is because they do not represent any cash outgo from the
business and to that extent the amount is retained in the form of cash in the
business itself which is available for any use.

In fixing the instalment amount for repayment of term loan, granting moratorium
for repayment of term loan etc. the amount of projected cash generation is
borne in mind.

DEBT SERVICE COVERAGE RATIO (DSCR)

The concept of cash generation is also useful in computing the DSCR. This ratio
helps us to measure the number of times the cash generation before interest
payment covers the total of term loan interest and the instalment thereof.

The DSCR is generally calculated year-wise till the repayment of the term loan
and also on the average basis taking into account the total of the yearly DSCRs
and dividing by the number of years in question.

This ratio is to be computed only after ensuring that the projected financial
statements have been fully adjusted for the observations made and the
modifications required to be made on the basis of the observations made.

The DSCR is worked out as follows:

Net profit after tax (before dividend) + Depreciation and other non-cash
charges +Interest on term loan
Interest on term loan + Instalment of term loan

Note:
If there are any existing obligations like instalments of Term loans/ DPGs/ Lease
rentals, such amounts should also be added up with instalments of the proposed
term loan and then the ratio should be computed. This is because cash
generation is the only source of servicing all such kinds of payments. However,
correspondingly interest amounts have also to be taken into account.

In case the DSCR is much greater than 2, then there exists sufficient scope for
advancing the proposed repayment structure of the term loan. The DSCR is to
be reckoned for every year. Average DSCR is only a broad measure. The
decision should not be based on average DSCR.
The ratio thus, helps in fixing moratorium period, the repayment period and the
amount of installment.

The projected financial statements also include projected cash flow statement,
projected balance sheets etc. besides projected profitability. The basis for all
these statements is the projected profitability statement and accordingly, the
projected profitability statement has to be examined very thoroughly.

The projected cash/funds flow statement enables us to know the various sources
of funds contemplated by the unit and the various applications intended. This
also enables us to know the position of the promoter‟s margin in the business for
working capital as well as term loan at any point of time. Any plan for expansion
without consolidation will have to be discouraged. The projected balance sheet
statement shows the balance sheet structure till the repayment of the proposed
term loan.
It will be generally observed that the figures of the next 3 years‟ projection will
vary and thereafter the projections will be kept constant. If the company is likely
to generate substantial surplus in the meantime, then the cash accrual will be
shown in the form of current assets.

When the term loan is ultimately sanctioned, it has to be released only after
ensuring the existence of promoter‟s margin. It has to be released to the supplier
directly in proportion to the availability of promoter‟s margin. Periodical site
inspection should be carried out to check the progress. Wherever applicable,
endeavor should be made to get the value of completed work certified by
approved engineers.

The question of release of working capital will arise only at the time of
commencement of commercial production.

BREAK-EVEN ANALYSIS:

Another term which is relevant to term loan appraisal is the break-even

concept. Break-even is the point or level of activity at which the unit‟s working
results in neither loss nor profit.
In other words, it is the point of operations before which the unit incurs losses and
after which it starts earning profits. i.e Point of No Profit-No Loss
Fixed and variable costs

The proposal would be attractive if the break-even level is low and would be
rejected if the break-even level is very high. For the purpose of break-even
analysis, it is necessary to classify all the expenses into fixed and variable.
Variable costs are those costs which vary directly with production while fixed
costs are those which are not influenced by production and hence remains
fixed.
Sales minus variable costs (which are proportionate to the level of activity) will
give the contribution amount to cover fixed costs.
The more the contribution, the more the profits because fixed costs remain the
same for a range of level of activity. The break even level of sales will be the
same but, as a percentage will vary along with the extent of capacity utilization.
Break Even Point

Break-even point refers to a level of a concern‟s operations where there is no

profit or loss i.e. total revenue equal total expenditure. Break-even point may
either relate to volume in units or sales in rupees or capacity utilization in
percentage terms.

Break Even Analysis

The study of costs- volume-profit relationship is referred to as Break-even analysis.

Basic assumptions underlying break-even concept

Costs can be resolved into fixed and variable components

Fixed costs remain constant

Total variable cost varies in proportion to volume(Production).

Selling price does not change as volume changes.

In the case of multiple products, sales mix remains constant.

There will be no change in general price level.

There is synchronization between production and sales.

The efficiency of plant and machinery can be predicted.

Productivity per worker remains constant.

Production is measurable easily in terms of quantity in units.

Classification of Costs

The first step in the Break Even Analysis is the segregation of costs into fixed and
variable ones.

Fixed cost is the item of cost that remains fixed irrespective of the change in the
level of operation or the number of units produced.

Variable cost will remain constant per unit and keeps on changing directly in
proportion to actual achievement or units produced.

Example: In a taxi business, petrol consumed is a variable cost, while wages to

driver, interest on term loan, vehicle tax etc., are fixed costs.

Semi variable expenses represent expenses which display both fixed and
variable characteristics e.g. repairs and maintenance, advertising, sales
promotion etc. Semi-variable costs should be bifurcated into variable and fixed
components and added up under two respective classifications viz. variable
and fixed.

(Such segregation as above may require few assumptions and also an

understanding of the business to be financed and hence to be done with great
care )

Various methods of calculation of break-even point

Example: A pen manufacturing company projects the following:

What is the break-even point?

Fixed cost - Rs.2.50 lacs

Variable cost per unit - Rs.3/-

Selling price per unit - Rs.5/-

Installed capacity - 2 lacs units.

Equation Technique

Sales = variable cost + fixed cost + net income(Read Net profit/loss)

At break-even point net income is zero. Let A be the number of units to be sold
to break even.
In the above example,

5xA = 3 x A + 2,50,000 + 0

i.e. 5A – 3A = 2,50,000

i.e. 2A = 2,50,000

A = 1,25,000 units.

Break even volume (in units) = 1,25,000

Which is 62.5% of installed capacity.( i.e 125000/200000 x 100)

In terms of break even sales (in rupees) it would be 1,25,000 units x per unit sale
price Rs.5 = Rs.6.25 lacs.

Mathematical formula

BEP = _________

1 – v/p

BEP - Break even point F - Fixed cost

V - variable cost per unit p - selling price per unit

In the above case

BEP (sales in Rs)

= 2,50,000

1 – 3/5

2,50,000 = 2,50,000 x 5

= ---------- ----------------

5-3/5 2

BEP (SALES) Rs.6.25 lacs

Contribution Method

Contribution = Unit sale Price – Unit variable cost

In the above case contribution per unit = Rs.5 – Rs.3 = Rs.2/-

BEP (Volume in units) = Fixed cost = 2,50,000

------------- ----------

contribution 2

= 1,25,000 units.

i.e. 62.5% of installed capacity of 2 lacs units

Profit / Volume Ratio

It is the ratio that establishes relationship between contribution and turnover.

The formula used is

PV ratio = Contribution / Sales

= Sales – variable cost

-------------------------

Sales

Break even sales = Fixed cost / PV ratio

In the above case

PV ratio = Rs.5 – Rs.3

-------------- = 2/5

Rs.5

Break even sales = 2,50,000 =2,50,000 x 5

----------- ---------------- = Rs 6.25lacs

2/5 2
A comparison of break even level with installed capacity immediately highlights
the cushion available. If break even point of a project, for instance, ranges
between 90 and 95 of its capacity, the project will be “high risk” venture in as
much as even a slight reduction in the output would throw the project out of
gear.

The lower the break even level the higher will be profitability of project and
naturally the margin of safety will be higher.

BEP technique may be applied in deciding about the optimal product mix as
illustrated below.

E.g. A company manufactures product A & B and has got a fixed cost of
Rs.80,000/-. The variable cost and selling price of products A & B are as under:

Rs.

Per Unit Product A Product B

Selling price 1.00 2.00

Variable cost 0.50 1.40

Contribution 0.50 0.60

If products A & B are sold in equal proportion, Break Even Point would be

Rs.2, 00,000 as below:

Product PV Ratio Mix PV Ratio

Weighted by mix

A 50 1 50

B 30 1 30

80
(PV Ratio = Contribution / sales)

Weighted average = 80/2 = 40%

BEP = 80000 / 40% = Rs.200000

If products A & B are sold in 3:2, BEP would be Rs.1, 90,476.19 under:

A 50 3 150

B 30 2 60

-----
210

Weighted average = 210/5 = 42%

BEP = 80000/ 42% = 1,90,476.19

If the mix were kept as 2:3, BEP would be Rs.2, 10,526.31 as under:

A 50 2 100

B 30 3 90

-----
190

Weighted average = 190/5 = 38%

BEP = 8000/38 = Rs.210526.31

The product mix at 3:2 (b as above) is preferable as the concern would break
even at lower level viz. Rs.1, 90,476.19.

Margin of SAFETY:

The greater the margin, greater is the profitability.

Margin of Safety = Capacity utilization - BEP capacity

Sensitivity Analysis

Sensitivity Analysis is nothing but Testing sensitivity of profitability of the project to

a range of changes in cost volume and the following illustration shows the
extent of changes in the break even point and profit arising an account of
changes in cost, volume of sales value and selling price.
Example (same as given else where in this reading Material)

Unit Selling Price Rs.5/-

Variable cost per unit Rs.3/-

Total fixed cost Rs.2,50,000

Normal sales volume 1,50,000 units

Contribution per unit Rs.2/-

Now let us calculate the break-even point, the total amount of sales and the
amount of operating profit under the following circumstances.

If variable cost increases or decreases by 10%

If volume of sales increases or decreases by 10%

If selling price increases or decreases by 10%

If variable cost increase or decrease by 10%

Amt. in Rs.

Change in variable cost with all

Normal level Other factors remaining

Constant

10% increase 10% decrease

Sales

a. Units 1,50,000 1,50,000 1,50,000

b. Amount 7,50,000 7,50,000 7,50,000

2. Variable cost 4,50,000 4,95,000 4,05,000

3. Contribution (1(b) –2) 3,00,000 2,55,000 3,45,000

4. Fixed Cost 2,50,000 2,50,000 2,50,000

5. Operating profit (3-4) 50,000 5,000 95,000

6. Break even sales 1,25,000 1,47,058 1,08,695

Here fixed costs, selling price and volume of sales remain constant and an
increase in variable cost automatically pushes up the break-even point lowering
profit steeply and a decrease therein brings down break-even point increasing
profit.

If volume of sales increase or decrease by 10%

Amt. in Rs.

Change in Sales

Normal level 10% increase 10% decrease

Sales

a. Units 1,50,000 1,65,000 1,35,000

b. Amount 7,50,000 8,25,000 6,75,000

2. Variable cost 4,50,000 4,95,000 4,05,000

3. Contribution (1(b) –2) 3,00,000 3,30,000 2,70,000

4. Fixed Cost 2,50,000 2,50,000 2,50,000

5. Operating profit (3-4) 50,000 80,000 25,000

6. Break even sales 1,25,000 1,25,000 1,25,000

Here fixed cost and selling price remain constant.

An increase or decrease in volume of sales will proportionately increase or

decrease the variable cost.

As such there is no change in break-even point.

Because while there are changes in volume of sales, the variable cost also
changes proportionately and hence the break even point in terms of sales
remains constant.

However profits vary because with increase or decrease in SALES VOLUME

contribution changes .
If selling price increases or decreases by 10%

Amt. in Rs.

Change in Selling Price only

Normal level 10% increase 10% decrease

Sales

a. Units 1,50,000 1,50,000 1,50,000

b. Amount 7,50,000 8,25,000 6,75,000

2. Variable cost 4,50,000 4,50,000 4,50,000

3. Contribution (1(b) –2) 3,00,000 3,75,000 2,25,000

4. Fixed Cost 2,50,000 2,50,000 2,50,000

5. Operating profit (3-4) 50,000 1,25,000 (-) 25,000

6. Break even sales 1,25,000 1,00,000 1,66,667

As the selling price of per unit increases, the lower number of units can share
fixed costs, conversely, when the selling price per unit decreases as the higher
number of units are required to share the same fixed costs the break even point
is pushed up.

Here 10% decrease in selling price at the normal level of operations has resulted
in loss of Rs 25000.

Hence in the analysis of term loan proposal analysis of BREAK EVEN SALES plays
a vital role in estimating the relationship between cost, selling price and volume
and in satisfying oneself about the ability of the borrowing entity to generate
sufficient cash flows/profit .
Utility

Break-even analysis is generally used for evaluating soundness of projects,

determining pricing policies and optimal product mix, manipulating fixed and
variable costs to obtain maximum contribution and to make or buy decisions
etc.

k.s.sampathkumar/9/2015
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