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TECHNIQUES OF FINANCIAL APPRAISAL

FOR BANK LENDING


SLIDE 11
TECHNIQUES OF FINANCIAL APPRAISAL
Let us imagine you have been recruited by a new generation
Bank or a PSU Bank or an Asset Financing NBFC into one of
the following positions/roles :
Manager Credit Appraisal
Manager Credit Analyst
Manager Corporate Banking
Manager SME Banking
Then what are your role expectations ?
You should have, inter-alia, the basic knowledge of
Techniques of Financial Appraisal for Bank Lending
OUTLINES/LEARNING OBJECTIVES
INTRODUCTION
Balance Sheet (Statement of Assets and Liabilities)
Profit & Loss A/C ( Operating or Income Statement)
REQUIREMENT OF AUDITED FINANCIAL
STATEMENTS
REARRANGEMENT OF BALANCE SHEET ITEMS AS
PER RBI GUIDELINES
REARRANGEMENT OF PROFIT & LOSS ACCOUNT
FINANCIAL /RATIO ANALYSIS OF A BUSINESS ENTITY

INTRODUCTION - 1
Whenever a bank considers a loan proposal,
apart from integrity and KYC aspects, banks
keenly find out the financial details of the
prospective borrower. The extent of details
depends on the type of loan, type of the
borrower, purpose of loan etc.
Financial details are collected with a view to
assess the followings :

INTRODUCTION - 2
Net Worth of the Applicant : Helps the bank
in deciding the level of activity which may be
desirable by that applicant and the amount of
money which can be lent to him.
Repayment Capacity : Helps the bank to
assess the surplus available for repayment of
instalment and interest on banks loan.
Net Worth of the Guarantor :


INTRODUCTION - 3
Viability/Bankability : A scrutiny of the
financial records/statements of the existing
and proposed business activity helps bank in
assessing whether the proposed bank loan will
result in a viable increase in operations and
profit.
Availability of Unencumbered Securities :
Such information is normally available from
the financial statements of a business
enterprise. For individuals weve to call for
such information.
BASIC FINANCIAL STATEMENTS
BALANCE SHEET
INCOME STATETEMENT (PROFIT & LOSS A/C)
DIRECTORS AND AUDITORS REPORT,
EXPLANATORY SCHEDULES AND NOTES ON
ACCOUNTS
CASH FLOW STATEMENT
BASIC DIFFRENCE B/W BALANCE SHEET &
INCOME STATEMENT
BASIC FINANCIAL STATEMENTS
ITEMS OF BALANCE SHEET : ASSETS AND
LIABILITIES & EQUITY OR CAPITAL
CONCEPTS OF ASSETS AND LIABILITIES (DEBT)
AND EQUITY
CLASSIFICATION OF ASSETS (CA & FA) :
CONCEPTUAL DISTINCTION
CLASSIFICATION OF LIABILITIES (CL & FL OR TL)
: CONCEPTUAL DISTINCTION
REQUIREMENTS FOR AUDITED FINANCIAL
STATEMENTS


AUDITED FINANCIAL STATEMENTS - 1
Companies : All Limited Companies have to
submit audited financials.
Turnover above Rs.60 lakh/Gross Receipt
exceeding Rs.15 lakh : Non-Corporate
borrowers other than Professional & Self-
employed persons with annual sales turnover
of above Rs.60 lakh and Professional & Self-
employed persons with annual gross receipts
of above Rs.15 lakh are required to submit
audited financials to banks for loan proposals
as per sec. 44AB of IT act.
AUDITED FINANCIAL STATEMENTS - 2
RBI Guidelines : Non-Corporate borrowers
with aggregate fund-based working capital
limit of Rs.25 lakh and above are required to
submit audited financials to banks as per RBI
guidelines.
Format for Financial Statements : A company
is required to prepare its B/S as per or similar
to the format given in Schedule VI of the
Companies Act. No format is prescribed for
Profit & Loss A/c.
PUBLISHED BALANCE SHEET
Liabilities Amount Assets Amount
Capital , Reserves & Surplus
(Net Worth)
Fixed Assets (Net)


Term Liabilities
(Secured Loans +
Unsecured Loans)
Investments
Current Liabilities & Provisions

Current Assets, Loans &
Advances


Misc. Exp. & losses not yet
Written-off
Total Liabilities Total Assets
REARRANGED BALANCE SHEET
Liabilities Amount Assets Amount
Capital , Reserves & Surplus
(Net Worth)
Fixed Assets

Intangible Assets
Term Liabilities Other Non-Current Assets
Current Liabilities
(OCL + STBB)
Current Assets
(Inventory + Receivables+
OCA)
Total Liabilities Total Assets

REASONS FOR REARRANGEMENT
OF BALANCE SHEET ITEMS - 1

Liabilities Side : As per Companys published Balance Sheet,
liabilities are grouped on the basis of Security and Liquidity.
The objective of a banker in analysing the B/S is to find out
the liabilities which are payable in short term and to
compare the same with the short term assets for ensuring
that all short term liabilities are covered by sufficient short
term assets because Banks traditionally provide Short Term
loans/Working Capital Loans. The classification like Secured
and Unsecured Loans does not serve this purpose.
The Banker wants to reclassify the liabilities strictly on the
basis of their time for payment.

REASONS FOR REARRANGEMENT
OF BALANCE SHEET ITEMS - 2

Asset Side : As per Companys published Balance Sheet,
assets are grouped on the basis of Purpose or use of
resources.
A Banker for the purpose already stated wants to reclassify
the assets strictly on the basis of comparative liquidity (short
term assets) and realisability (convertibility to cash).
For example in the companys B/S, items like patents, goodwill
etc. find place u/r FA but a banker likes to classify them as IA
on the conservative assumption that they would realise
nothing in case of forced sale, for payment of bank debts.
Similarly certain items classified as CA may not be liquid and
banker likes to classify them as Non-Current assets.

REARRANGEMENT OF BALANCE SHEET ITEMS
AS PER RBI GUIDELINES

Liabilities Side : A. Net Worth : Representing contribution of
the promoters/owners of the concern towards business. It
consists of Paid-up Capital, Free Reserves and Surplus. It is
also known as the Shareholders Funds or Owners Equity.
B. Term or Deferred Liabilities : Representing those
liabilities which are payable after one year from the balance
sheet date. They represent long term sources of funds for the
business and should be utilised for financing Fixed Assets.
Examples : (i) Term Loan from Fis/Banks excluding Instalments
payable within 1 year, (ii) Debentures payable after 1 year, (iii)
Deferred Payment Credits excluding Instalments payable
within 1 year, (iv) Term Deposits payable after 1 year. The
portion of such liabilities which are payable within a year is
classified as Current Liability.


REARRANGEMENT OF BALANCE SHEET ITEMS
AS PER RBI GUIDELINES

C. Current Liabilities : Representing those liabilities
which are generally payable within one year from the
balance sheet date. They represent short term
sources of funds for the business and should be
utilised for financing Current Assets.
Examples : (a) Trade Creditors including Bills Payable
(Credit available on purchases of Raw Materials,
Consumables & Spares), (b) Creditors for Expenses
(Rent payable, wages payable and other
outstanding/accrued expenses)

REARRANGEMENT OF BALANCE SHEET ITEMS
AS PER RBI GUIDELINES

C. Current Liabilities (.. Contd..) : (c) Short Term Bank
Borrowings for Working Capital (in short STBB) like
Cash Credit (CC), Overdraft (OD) or Working Capital
Demand Loan (WCDL), Bill Finance, (d) Provisions for
payment of taxes, dividends, bonus and other
statutory dues, (e) Advance payment from
Customers for supply of Finished Goods and (f)
Instalments of Term Loan, Debentures, Deferred
Credits and Deposits etc. falling due within 1 year.
All Items except (c) are collectively known as Non-
Banking /Spontaneous CL or Other Current Liabilities
(OCL or CLOTSTBB).

REARRANGEMENT OF BALANCE SHEET ITEMS
AS PER RBI GUIDELINES

Asset Side : A. Fixed Assets : Representing assets of fixed
nature such as land, building, plant and machinery etc. (for a
Manufacturing Concern) permanently required by the
concern to carry out its business, aka Capital/Block Assets.
Net Fixed Asset or Net Block = Gross Fixed Asset or Gross
Block Accumulated Depreciation
B. Intangible Assets : Representing assets which have no
physical existence or certain fictitious assets which are in fact
capitalised expenses/accumulated losses such as goodwill,
patents, preliminary expenses and Miscellaneous
expenditures and losses not yet written off etc.


REARRANGEMENT OF BALANCE SHEET ITEMS
AS PER RBI GUIDELINES

C. Current Assets : Representing those assets which are likely
to be converted to cash or used up in the business within one
operating cycle (working capital cycle) of the business or a
maximum period of 12 months. The main constituents are
Inventory and Receivables. These two items are combinedly
known as Chargeable Current Assets. Current Assets also
includes items like Cash and bank balance, short term liquid
investments, fixed deposits with banks, advance tax paid,
prepaid expenses and advance payment to suppliers of raw
materials etc. These miscellaneous items are known as Other
Current Assets (OCA) or Non-Chargeable Current Assets.
Current Assets are also known as Liquid Assets, Circulating
Assets or Floating Assets or Gross Working Capital.

REARRANGEMENT OF BALANCE SHEET ITEMS
AS PER RBI GUIDELINES

D. Other Non-Current Assets : Which represent miscellaneous
assets not realisable during the current operating period
such as non-consumable stores and spares, investments,
loans and advances etc. to other group concerns/employees
or for activities not directly related to the business of the unit.
It also includes debtors outstanding for more than 6 months,
dead/non-moving inventory, Security deposit, Advances to
suppliers of Capital goods and Fixed deposits with banks held
as margin for LC/LG etc.


REARRANGEMENT OF P & L ACCOUNT
1. Gross Sales (Net of Returns)
2. Less Excise duty
3. Net Sales
4. Cost of goods Sold or Cost of Sales
(i) Raw Materials consumed
(II) Other Spares
(iii) Power & Fuel
(iv) Direct Labour
(v) Repairs & Maintenance
(vi) Other manufacturing expenses
(vii) Depreciation
(viii) Sub-Total of (i) to (vii) i.e., Factory Cost
(ix) Add Opening stock of Work in Process (WIP)
(x) Deduct Closing stock of WIP
(xi) Sub-Total/ Cost of Production of goods available for Sale (COP)
(xii) Add Opening stock of finished goods (FG)
(xiii) Deduct Closing stock of FG
(xiv) Sub-Total/Cost of goods Sold (COGS)


REARRANGEMENT OF P & L ACCOUNT- Contd :

5. Gross Profit (3 4)
6. Less Operating Expenses
(i) Office/General & Administrative Overheads
(ii) Selling & Distribution Overhead
7. Operating Profit Before Interest & Tax (OPBIT)
8. Add/Deduct Non-Operating or Other Income/Expenses
9. Profit or Earning Before Interest & Tax (PBIT or EBIT)
10. Financing or Interest Expenses (both for Working Capital & Term Loan)
11. Profit or Earning Before Tax (PBT or EBT)
12. Tax paid/provision
13. Net Profit/Profit After Tax (PAT)
Rearrangement of Balance Sheet and P&L a/c is to be done for a number of
operating years and also on the basis of estimates for the current year followed
by projections for the next year. This enables the banks to study the trend and
draw conclusions regarding the operations of the concern on year to year basis.

OBJECTIVES OF STUDYING
FINANCIAL STATEMENTS
Study of financial statements involves study of the following five major
aspects of the business enterprise :
- SOLVENCY
- LIQUIDITY
- LEVERAGE
- PROFITABILITY
- ACTIVITY (TURNOVER/UTILISATION/EFFICIENCY)
- COVERAGE Ratios
TREND ANALYSIS/TIME SERIES ANALYSIS
INTRA-FIRM COMPARISION
INTER-FIRM COMPARISION`
FINANCIAL & RATIO ANALYSIS
OF A BUSINESS ENTITY - 1
(A) Financial Stake of the Promoters/Owners and Solvency of the Concern :
Solvency Ratios measure ability of the firm to meet its long
term obligations
Tangible Net Worth (TNW) : TNW = NW IA. Also, TNW =
Total Tangible Assets (TTA) Total Outside Liabilities (TOL).
Positive TNW i.e., when total tangible assets exceed total
outside liabilities, would mean the concern is solvent.
Asset Coverage Ratio : (a) Total Asset Coverage Ratio (TACR)
or Solvency Ratio = [Total Tangible Assets (TTA)/Total Loans
or TOL], (b) Fixed Asset Coverage Ratio: FACR (Tangible Fixed
Assets/Long Term Loans). It measures the solvency/ability of
the firm to pay for the loans by disposing of its assets, in case
of need. Generally used by Term Lenders/Project Financiers
to judge the Solvency of the borrowing firm.
FINANCIAL & RATIO ANALYSIS
OF A BUSINESS ENTITY - 1
(B) FINANCIAL LEVERAGE
Debt Equity Ratio (DER) : DER = Long Term
Debt/Equity ; or, Debt to Assets Ratio, High DER
also known as Trading on (Thin) Equity.
Total Indebtedness Ratio (aka Total Debt to Equity)
(TOL : TNW), TOL = CL + TL, TNW= NW IA
Asset to Equity (A/E) = EM is called Financial
Leverage Ratio
FINANCIAL & RATIO ANALYSIS
OF A BUSINESS ENTITY - 2
(B) Liquidity : Liquidity ratios measure the ability of the firm
to meet its short term obligations, the solvency of the firm in
short term. Fixed assets are required by any going concern for
long-term use and are not available to meet its obligations for
short-term or immediate liabilities. These liabilities are to be
met from Current assets. The value and realisability of current
assets into cash is thus an important indicator of the capacity
of the concern to meet its current liabilities to ensure smooth
day to day functioning of the unit. The most important aspect
of financial appraisal by banks is to study the liquidity position
of the concern which is very relevant for assessment of
working capital requirements of a firm. The following two
ratios are important in this regard.
(a) Current Ratio (b) Liquid/Quick/Acid Test Ratio
FINANCIAL & RATIO ANALYSIS
OF A BUSINESS ENTITY - 3
Current Ratio : It is the ratio of Current Assets to Current
Liabilities. From lenders point of view, a higher current ratio
is preferable. In other words, the larger the excess of current
assets over current liabilities, the better. This is because, the
company could then ward off even a drastic fall in the value
of current assets, without defaulting on its commitment to
creditors. On the contrary, if the ratio falls below 1, the
company would be in serious liquidity problems, finding it
difficult to meet the financial commitments in time. A
minimum current ratio of 1:1 indicates that CL are just
matched by CA. In India, the benchmark for CR adopted by
banks is 1.33, pursuant to the recommendations of the
Tondon and Chore committees. This means that the CL
should Not exceed 75% of CA.
FINANCIAL & RATIO ANALYSIS
OF A BUSINESS ENTITY - 4
Current Ratio (CR) : It needs to be added that an unduly high
CR need not be an unmixed blessing. A very high CR would
indicate that the company is unable or unwilling to raise
adequate CL to finance a part of the CA. Excluding the
prospect of inability to raise funds/CL, even unwillingness to
do so would, in many cases, point to faulty financial planning
(a) conservative CA management policy leading to excess
holding of Inventory and/or very liberal credit policy/poor
debt collection policy resulting in high Receivables; both the
factors leading to higher level of CA and hence high CR; (b)
conservative CA financing policy by using higher proportion
of long term funds instead of short term sources/CL in
funding the CA which increases the cost and reduce the
profitability. For, CL are usually less costlier than TL and NW
and every trading/manufacturing concern should raise
adequate quantum of CL.

FINANCIAL & RATIO ANALYSIS
OF A BUSINESS ENTITY - 5
Current Ratio (CR) : Also a very high CR of 2:1 or 3:1 does
not necessarily signify a very high liquidity position of the
firm, instead a firm with a CR of even 1:1 may have a
comfortable liquidity condition. The moot point here is that
one should be aware of the limitation of ratios and one
should not be guided by the quantity of CR alone, one
should see and analyse the quantity as well as the quality
of the CA/each component of CA to ensure that no
dead/non-moving/ obsolete inventory or no bad
debtors/receivables are included in the CA which results in
higher level of CA/CR and therby giving false impression of
high liquidity.

FINANCIAL & RATIO APPRAISAL
Liquid/Quick/Acid Test Ratio : The CR refers to firms ability to meet its
short term obligations within one year. However, it does Not precisely
indicate the firms ability or otherwise in meeting the immediately
pressing liabilities. Inventory and prepaid expenses are not quickly
realisable and thus may not be available to meet the current dues of the
firm. To ascertain a firms preparedness for meeting the immediate
demands on its liquidity, current assets of such nature are thus excluded
to find the real liquidity position of the concern on a very short term basis,
i.e., another ratio called the liquid/quick/acid test ratio is computed by
comparing the relationship b/w current liabilities and immediately
realisable current assets (quick/liquid assets) such as cash, receivables and
highly liquid marketable investments.
Quick/Liquid Ratio = (CA (Inventory + Prepaid Exp.))/CL = (Cash +
Receivables + Investments)/CL
A quick ratio of 1:1 is considered desirable.
FINANCIAL & RATIO APPRAISAL
(C) Profitability Ratios : The important ratios are Gross Profit Margin
(GPM), Operating Profit Margin (OPM), Net Profit Margin (NPM), Return
on Net Worth (RONW) and Return on Investments (ROI), Return on assets
(ROA) and Du Pont Analysis of ROE (5 Factor Analysis).
ROE = PAT/E = PAT/PBT x PBT/EBIT x EBIT/S x S/A x A/E = Tax Mgmt
Efficiency x Interest Mgmt Efficiency x Operating Efficiency x Asset
Utilisation x Equity Multiplier or Financial Leverage
(D) Coverage Ratios: Interest Coverage Ratios like I/EBIT, EBIT/I and
I/EBITDA and EBITDA/I.
Debt Service Coverage Ratio (DSCR): Well study in Term Loan and Project
Appraisal, = Cash Flow available to service LT Debt/LT Debt Service
Commitment or Burden.
FINANCIAL & RATIO APPRAISAL
(E) Activity Aspects : Activity or Turnover/Utilisation/Efficiency ratios
come under this category; such as Fixed Asset TO (NS/FA), Inventory TO
(COGS/Inv), Debtors TO (Total Cr. Sales/Avg. Debtors), Creditors TO ( Total
Cr. Purchase/Avg. Creditors). Also following holding periods are usually
computed over successive years for the unit itself (intra-firm comparison)
and with that of similar units (inter-firm comparison) for assessment of
Working Capital Requirement of the Business Unit. They are RM holding
Period = (Avg. stock of RM/Avg. daily consumption of RM during the year),
WIP holding Period=(Avg. stock of WIP/Avg. daily Cost of Production (COP)
of goods produced during the year), FG holding Period=(Avg. stock of
FG/Avg. daily Cost of goods sold (COGS)during the year), Debtors or
Receivables holding Period=(Avg. Debtors and Receivables/Avg. daily Cr.
Sales during the year) - this is Avg, Credit period extended or Avg. debt
collection period, Creditors or Payables holding Period=(Avg. Creditors
and Payables/Avg. daily Cr. Purchases during the year) this is Avg. Credit
period enjoyed or Avg. Credit payment period.

KEY WORDS/TERMINOLOGIES/GLOSSARY
CA, CL, FA, FL or TL, Net Worth, Tangible Net Worth
(TNW), Tangible -vs- Intangible Asset, Chargeable
CA, TOL, Current Ratio, Liquid/Quick/Acid Test
Ratio, Debt Equity Ratio, TOL : TNW ratio or Total
Indebtedness Ratio, RM, WIP, FG, Receivables &
Payables Holding Period, Other CL or Spontaneous
or Non-Bank CL, Avg. Debt Collection Period, Avg.
Credit Period Enjoyed.
Home Task for Next Class
Activity : Collect the latest annual report of a
Manufacturing Company and rearrange the
Balance Sheet as per Bankers Requirement
and calculate the following ratios etc.
Current Ratio, Liquid/Quick/Acid Test Ratio,
Debt Equity Ratio, TOL : TNW ratio or Total
Indebtedness Ratio, RM, WIP, FG,
Receivables & Payables Holding Period, Other
CL or Spontaneous or Non-Bank CL, Avg. Debt
Collection Period, Avg. Credit Period Enjoyed.


Topics for Next Class All of you Should get prepared before coming
to the class

Working Capital Appraisal
Term Loan Appraisal