Commercial credit analysis

8/7/2019 Commercial credit analysis

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INTRODUCTION

Businessmen need loans for their businessess. There are many instances when theapplicant (businessman), unaware of the bank’s needs, does not present all the detailsrequired 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. Timedrags on while the bedeviled applicant runs hither and thither exasperated, frustrated andharrowed. The banker is also exasperated, frustrated and harrowed. He exists to makeloans 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 thewillingness to repay. Nothing thrills him more than a well presented detailed applicationthat addresses all the concerns that he may have.

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

This course is also for the banker to remind him of the issues that are important whenassessing the credit worthiness of a prospective borrower. It is also intended to also helpstudents 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 UnitedStates and the finished goods have to be exported within 90 days. In order to fulfill theorder 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 shouldapproach 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 andneeds to expand capacity in his factory to meet growing demand. He has approached thecompany’s bankers - The Manufacturers Bank for a loan. However, even after twomonths, they were still raising several queries and Mr. Daruwalla is at his wit’s end. Hewas even forming a belief that the bankers were raising queries in order to find a way outof 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 needsessential 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, RusiDaruwalla and Vinod Desai have several commonalties. They require money now. Theyneed 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 financeface 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 aggressivelyseek persons or corporates to whom they can lend monies to. However, as the downsideof a bad debt is very high the banker has to be convinced that he is actually not throwingaway 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 alwaysremember 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 inorder 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 advanceone in the hope of earning an income. The downside risk is enormous. This is the reasonthat bankers prefer to lend only to those companies who are growing, profitable, runningand well regarded. This is why it appears that Banks are desperately trying to lend tothose 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 bythe 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 alsorequired to state in the financials the quantum of non performing assets they have at theyear end. Provisions too would need to be made - the amount depending on how good theadvance 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 performingassets 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 tosatisfy 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 whenreviewing a credit proposal - give the borrower a peep into a banker’s mind. These areessentially:

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 withthe economic/ business cycle.

The competence and integrity of management and its intention to repay the loan in themanner 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 theloan is sought. and this is usually the first issue that a Banker ascertains when approachedfor a loan or any other credit facility. In regard to this there are a few factors that must beremembered 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 illogicalto 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 notseek a term loan to finance preshipment expenses. Alternatively, a manufacturer shouldnot seek to finance a factory expansion with an overdraft. in short:

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

An exporter who needs finance to purchase goods to export should seek a preshipment 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 aloan that is payable over a period of time. Often, due to the gestation period, banks wouldgive 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 isknown 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 thesea food industry. It requires finance soon after the monsoons to purchase and processseafood for export. During the monsoons no finance is usually required. Similarly the teaindustry requires finance when there is no picking of tea - to replant tea and to maintainthe 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 soonafter the liberalisation initiatives announced after 1992. At that time the capital marketswere 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 beingunder subscribed and devolving, short term funds such as overdrafts were utilised tocomplete projects begun. I can understand and sympathise with this though I think it isdangerous. 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 andearning 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 adangerous 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 shortterm funds begin to become tight, as did happen in 1997 and 1998 in India, severalcompanies began to resort to accommodation financing (discounting of bills that were not

backed by genuine trade transactions). Once begun one usually gets sucked into thesituation 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 termloan. 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 casesrecently, lead to the closure of the concern.

It is important that a prospective client is honest and open with his banker. If he needs toutilise a loan for a particular purpose, he should tell the banker exactly what the purposeis. He should advise his banker his concerns and his problems. Bankers are there to helpand not to hinder. If the banker has a full appreciation of his clients’ concerns; hisstrengths 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 verydifficult to explain at a later stage why something of crucial importance was notmentioned. 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 andtransparency 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 repaythe facility. As prospective borrowers Raman Menon, Rusi Daruwalla and Vinod Desaishould be able to demonstrate to their respective bankers with facts and figures therepayment plan.

In ideal circumstances there should be more than one source of repayment so that shouldthere 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 repaymentshould be from the proceeds of the goods sold. In Raman Menon’s case, the primaryrepayment must be from the sale of garments. If a bridge loan prior to the final allotmentof 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 anasset, 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 isalways a possibility that on account of occurrences beyond the borrower’s control, theloan cannot be repaid from the primary source. A classic example is what is presentlyhappening in India on account of the liquidity crunch and the demand downswing. A wellknown company purchased 41 windmills at a cost of around Rs. 1 crore each and wasconfident of selling them quickly. Due to a credit squeeze the windmills were unsold andthe company could not repay the borrowings from the proceeds of the sale. The companyin order to meet its credit commitments sold some property it owned. This was itssecondary source of repayment. When companies take working capital finance in theform of overdrafts they normally hypothecate debtors and stock. If repayments are notmade, the secondary source of repayment can be seized and sold and the proceeds can beused to liquidate the loan. Raman Menon would have, when taking the loan, hypothecatedhis goods. If he was unable to repay the monies borrowed the bank could seize his goodsand then sell them.

Tertiary Source

The tertiary source is further security for a loan. This is in the form of additionalcollateral that may be unconnected with the business. A director could pledge the sharesthat 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 hisguarantee. The comfort that a Bank would derive is that should the primary andsecondary 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 andrecommending a request for a credit facility. As additional security Raman Menon couldmortgage his factory or give as additional security shares that he owns. Similarly RusiDaruwalla could, for the term loan given to Unisulphur Ltd., give his own personalguarantee.

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 paymentof 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 isthat 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 theneed 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. Aspecific charge has a prior charge however and a banker would always prefer a specificcharge.

There are times when the asset to be charged is already hypothecated. In such instancesthe bank can only get a second charge for the facility given. This means that the banker’srights are subordinate to the entity that holds the first charge. In other occasions wherethere are a number of lending banks as in a consortium, the borrower would be able togive the bank only a “pari passu” charge. In this instance the bank’s rights are on thesame 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 sanctionletter 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 thenature of these stipulations. He wondered whether he should accept a loan that isconditional.

Conditions imposed on facilities extended by banks, also known as covenants areimposed 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 limitedcompany or a business) continuing as a going concern.

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

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

Covenants, therefore, are from a banker’s perspective extremely important in thestructuring 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 signsshould the financial position of the company deteriorate. The amount of covenants thatcan be imposed on a borrower would depend on:

The antecedents of the borrower. Has the borrower borrowed before and what has hisrepayment 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 toimpose 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 restrictivecovenants can retard growth.

The borrower, while appreciating the banker’s need must also consider his own. Hewould be extremely shortsighted if he accepts conditions that are detrimental to hisinterests 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 remediesthat 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 themore common ones are:

1. The borrower must present a monthly statement or as often as required information onstocks and debtors. This is usually required if stocks and debtors have been hypothecatedfor 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 theexistence 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 notlose 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 requirementcould 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 theManufacturers Bank, Mr. Buch asked him on the collateral he could offer the bank for thefacilities required. Bank’s seldom extend any facility without collateral and the moreliquid, 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 securityof a fixed deposit is the facility that is easiest to procure. Banks literally take no risk asthey 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/ facilitiesadvanced. 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 astandard collateral. The nature of the collateral, the amount and the percentage of thefacility 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 thehypothecation of book debts and stocks. The amount advanced will be usually a

percentage of the total value - the percentage held back being known in bankingconnotation as the margin. This is an additional safeguard for a bank as often when goodsare sold in a hurry - a quick, forced or distress sale the real, fair value is not realised. Themargin on stocks is usually between 25% and 40% and this depends on the company andthe 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 todebtors the margin is usually higher and can be as high as 50%. In calculating thedrawing power banks will insist on a debtors’ aging list and debts over 90 days areexcluded from the calculation.

If funds have been advanced to purchase machinery or some other fixed asset, theasset 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 bluechips from companies for additional comfort.

Banks, often ask too, in case the borrowing company is part of a larger entity (asubsidiary or an associate company or a branch of a multinational), for a guarantee or atworst 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 onthis or take it to court.

In regard to guarantees as collateral, banks ask for the personal guarantees of directorstoo. In the case of private limited companies, directors often give their personalguarantees supported (at times) by a statement of their net worth. Directors of publiclimited companies have also been known to give guarantees. This is not common thoughas these directors often submit that the company is a legal entity in its own right withseveral thousand shareholders. The directors often are paid employees. In such a



circumstance they argue that there is no reason why they should be personally committedto 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. Inthese 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 havealready 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 requiredfrom time to time if there is a deterioration in value. In cases where the collateral is at theclients’ 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 additionalcomfort and they would never, unless forced to do so and until after every other methodhas 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 whatis says. The banker will do all he can to find out as much as he can about the companyand the client. In this no information is too small or too immaterial since they will fit intoa larger picture and the fate of the facilities extended may depend upon it. It has to bealways remembered that the project may appear sound, the documentation perfect and thefinancials impeccable. However, if the intent is to cheat, it could cause severe losses tothe 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 believeshim 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 alarge foreign bank to open a letter of credit to import certain items from Hong Kong. Theamount was large. The person appeared respectable. The young banker, in his eagernessto capture additional business to meet the demands of a very tough budget, complied withhis 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 thedocuments was paid (as the Hong Kong branch had confirmed the letter of credit). Thedocuments arrived in Bangkok and when the client was sought, he was nowhere to befound. 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 thegoods were not what they were purported to be. In fact, they were of practically no valueat all. The Bank suffered a significant loss. It was later discovered that the “businessmanof Bangkok” and the “exporter from Hong Kong” were in fact brother in law and partnersin crime.

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

It is because of this crying need of knowing the client that Banks insist on a client beingintroduced. The banker works on the supposition that if the prospective client has beenintroduced by another whose credentials are above reproach then by extension the

prospective client’s credentials are also by extension, above reproach. If Raman Menonwas approaching the Manufacturers Bank for the first time, the Bank would ask for anintroduction 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 toestablish 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 allstatements made. The acceptance of an unverified statement destroys the credibility of theanalysis 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 tohim for a loan to finance working capital. This was not checked because the personappeared so genuine and respectable. The facilities were arranged securing them to thehypothecation of stocks, book debts and fixed assets. There appeared to be adequatecover. 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 theinventory and fixed assets it was found that another bank had a first charge on the fixedassets. The Manager was not aware of his inferior collateral as he accepted the clientsword without verifying. It was later found that the client was not a friend of the person theManager knew. He had merely dropped a name and the Manager had bitten the bait. Inthis 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 thedealings he has had. Banks asked for this information are often non committal as theyexpose 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 adequateinformation.

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 andthe 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 andgossip because this can be very valuable as it is sometimes surprisingly accurate. Bankerswill invariably react quickly to negative news as it often is the harbinger of very very badnews. A good banker will not however react without checking the information that he hasreceived because it may be untrue.

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

MANAGEMENT

The single most important factor that a banker considers when he considers anapplication/ proposal for credit facilities is the management. It is upon the quality, thecompetence 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 managementcan destroy a thriving company. Corporate history is riddled with examples. The Ambaniswith their vision and acumen have made Reliance a global giant. Others who tried toemulate them with grandiose plans are heard of no more. Chrysler was, in the earlyeighties, an ailing giant. Iacocca, with tough competent management turned the companyround. In the first quarter of 1993 the big blue - IBM dismissed its Chief ExecutiveOfficer Akers who was blamed for the companys dismal performance. Lou Gerstner whowas at one time President of American Express and who took charge of R.J.R. Nabiscoafter 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 thecompany round. Metal box, Killick Nixon, Nirlon, The Gadgil Western Group, theKamanis and many others have been brought down from their positions of eminence andtheir management has to bear the guilt for this.

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

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 controllingfamily. The Chairman or the Chief Executive Officer is usually a member of the rulingfamily 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 andto Change. He speaks of an Indian family business having a series of concentric circlesemanating 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 fromthe same religious or caste group. The fourth circle comprises of people from the samelanguage group and the outermost circle has people from the same region. Mr. Thomassays 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. Inthe beginning there were often orthodox, autocratic, traditional, rigid and averse tochange. 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 modernmethods. Consequently, in many family managed companies, although the man at thehelm 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 suchcompanies is that he knows that he will never, ever run the company - that privilege willalways be with a member of the family.

Professional Management

Professionally managed companies are those that are managed by employees. In thesecompanies the Chief Executive Officer does not have, very often, a financial stake in thecompany. 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 ashe meets his targets. Consequently he is always results oriented and his aim is often shortterm - 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, effectivemachine 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 cannottherefore enjoy the fruits of his labour forever. Nor will his sons succeed him althoughsome may try to see that this happens in time. In many professionally managedCompanies there is also a lot of infighting and corporate politics. This is becausemanagers are constantly trying to rise up the corporate ladder and the end is often whatmatters 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 familymanaged companies as one is aware that the mantle of leadership will always be worn bythe 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 managedcompanies or family managed companies. There are well managed, profitable companiesin both these categories. There are also badly managed companies in both thesecategories. What then are the factors bankers look for?

1. The most important aspect is the integrity of management. This must be beyondquestion. 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 managementwill leave that company well alone. I had the privilege once to listen to Mr. C.S. Patelwho was at one time the Chief Executive of Unit Trust of India. He recounted an advicehe was given by his mentor, Mr. A.D. Shroff who was once the Chairman of the NewIndia Assurance If you have the slightest doubt of management do not touch the companywith a pair of tongs. Seldom have I heard truer words. Thus the first thing a banker doeswhen considering a loan to Unisulphur Ltd. Is to check the competence, integrity andhonesty of Rusi Daruwalla.

2. Another point bankers consider is proven competence - the past record of themanagement. How has the management managed the affairs of the company during thelast 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 avery 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 - byothers in the same industry? This is a very telling factor. The ones that are aware of nearlyall the strengths and weaknesses of the management are the competitors and if they holdthe 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 itstreamline 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 itscompetitors? How did sales fare? A management that can steer its company in difficultdays will normally do well always.

5. The depth of knowledge of the management - its knowledge of its products, its marketsand 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 itstouch with its customers, its markets and its competitors. The reality sinks in only when itis too late. The management must be in touch at all times with the industry and customersand be aware of the latest techniques and innovations. Only then can it progress and keepahead. A quick way bankers check this is by determining what the market share of thecompanys 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 havea plan on how to get there. It must be receptive to ideas and be dynamic. A company thathas 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 oftenstand in the way of change. Their strategy is usually a personal one - on how to hold ontotheir jobs.



7. Bankers do not like to lend to a company that is yet to professionalise because in suchcompanies decisions are made on the whims of the Chief Executive and not with the goodof 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 andrelatives 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 professionallymanaged 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 thecompany and this is a determination that he makes because on this will determine hislending decision.

POLITICS AND GOVERNMENT POLICY

The political stability of a country a key factor in determining the risk a bank is preparedto take on that country. It is this situation that determines whether and if so the quantumforeign institutions and companies would invest in a country. In January 1998 whenMoodys the international credit agency stated that India is being placed on a watchlist andthat it may possibly be downgraded from investment quality to speculative due to avariety of reasons of which one of the main reasons was political instability, the BombayStock Exchange Sensitivity Index (Sensex) fell by 75 points. Moodys initiallydowngraded the country in early 1996 due again to political instability as it felt that thefall of the Deve Gowda government was imminent. As political stability is critical to acountry’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 currencyrating to below investment quality. Apart from he fact that the Sensex fell, foreigncurrency loans will be more expensive and the rupee is under threat. If Mr. Daruwalla hasto 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 isruled by a majority government and takes decisions for the long term development of thecountry, industries and companies will prosper. Instability causes insecurities especially if there is the possibility of a government being ousted and replaced by another that holdsdiametrically 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’sgovernment collapsed to be followed by Mr. Gujral’s tenure which also had a quick demise. Such instability shakes the very foundation of investor/ international/ nationalconfidence. This is why, as was mentioned earlier, that the BJP has made stability thecentral issue of its campaign.

Another example is Sri Lanka - a country in the grips of civil war. The north of thatcountry was once thriving and prosperous. No longer. That part of the country iscontrolled by the Tamils - there is no industry and little economic activity. For severalyears 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. Touristrevenues 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 articleslike textiles etc. Licenses are given and amounts that may be imported from companiesand countries are clearly detailed. India has a number of restrictions on what may beimported and at what rate of duty. This, to an extent determines the prices at which goodscan 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 resultin 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 industryin India. It is this fear that prompted the formation of the celebrated Bombay Club whichwants restrictive protection for Indian industry. Bankers, on account of the effectrestrictive practices or its removal can have on a company, always check how sensitivethe company is to these.

The threat of Nationalisation

The threat of nationalisation is a real threat in many countries - the fear that a companymay become nationalised. Historically (with very few exceptions), nationalisedcompanies are less efficient than their private sector counterparts. Nationalisation in Indiaruined 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 thisfear exists industries will not attract investment and there could be a flight of capital toother 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 wasdemonstrated 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 belower and their after tax income higher. Additionally as people consequently have moredisposable income they have an incentive to work harder and earn more money. And anincentive to buy which results in greater demand for goods. This is good for the economyand for companies. It is interesting to note that in every economy there is a level between35% to 55% where tax collection will be the highest. While the tax rates may go upcollection will decline. This is why it was argued that the rates in India must be loweredand 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 Raogovernment excited the developed world and they were keen to invest in India andincrease their existing stakes in companies. The instability that followed, the Enronfiasco, 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 severalyears and this has not been good for the country as it can lead to disaster. It would be wiseto 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 disastrousfor several industries such as steel, cement and construction and for companies in theseindustries.

All these factors have an effect on the performance of a company - the extent being onhow 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 effecton individual industries and companies. Soon after the liberalisation process began in1992/93, there was tremendous activity and industries mushroomed. Many internationalcompanies 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%. Companiesmade tremendous profits. The situation changed from the end of 1995. 1996 was adifficult year and 1997 more so. There was tremendous liquidity problems - partially dueto 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 etal. Industrial growth in 1997-98 was a meagre 4.6 % while export growth was a shameful2.6%. 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 economicdownturn 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 ona company. This is why bankers look at the economic scenario when making the lendingdecision.

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. Aneconomy that is growing at 7 percent creates jobs, demand and industrial activity. Thisleads 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. Industrialgrowth had fallen to 4.6 percent from 11 percent and GDP growth was lower at 5 percentfrom 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. Thesetranslated to a lower level of activity and worse corporate results. In such circumstancesonly the stronger survive and this is why bankers delve into the economic condition andattempt 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 materialsor goods for its development and there will be a loss of confidence in the country whichwould be detrimental. India, was in 1991, forced to devalue as foreign exchange reserveswere at around half a billion dollars very low (equal to a three weeks imports). The crisiswas averted at that time by an IMF loan, the pledging of gold and the devaluation of therupee. The liberalisation initiatives reversed this and India was, with foreign exchangeinflows (foreign direct investment, foreign institutional investor investment, foreigncurrency 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 institutionalinvestors. The rupee has also depreciated thereby making those companies that aredependant on imports exposed.

In the eighties and in the early nineties several American banks had to write off largeloans advanced to South American countries as these countries were unable to pay.Mexico too had a crisis. Certain African countries have very low foreign exchangereserves. Companies exporting to these countries have to be careful as the importingcompanies may not be able to pay for their purchases because the country does not haveadequate foreign exchange. I know of an Indian company which had exported machinesto an African company (Nigerian) a few years ago. The importing company paid themoney 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 tohigh foreign currency (dollar) debts or due to their inability to import raw materials. InIndonesia the currency fell from Rupiah 2,300 to a dollar in May 1997 to Rupiah 10,500to a dollar in January 1998 and to over Rupiah 15,500 to a dollar in June 1998. There washowever 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 toimport anything as it could not be sold at anywhere near cost price. I know of a largeIndian exporter of peanuts. He sent as usual large consignments to Indonesia to one of hisregular 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 nolonger viable to accept the consignment as he would have to sell it at a loss. In the end theIndian exporter had to sell the goods at a much lower price. He did this as the commoditywas 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 countriessuch as Japan have very favourable balances. India’s exports have been lower both inamount and in growth to imports and this widens the trade deficit. A wide deficit wouldeventually result in devaluation of the currency. The implications to industry are thenobvious - the costs of imports will go up and the realisation of its exports in dollar termswill 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 devaluationof the currency either in the home country or in the country/ countries the company dealsin. A devaluation in the home country would make the products the company makes moreattractive in other countries. It would also make imports more expensive and if acompany is dependent on imports, margins can reduce. A devaluation in the country towhich one exports would make the companys products more expensive and this canadversely impact sales. A method by which foreign exchange risks can be hedged is byentering into forward contracts (either purchase or sale) thereby crystallising theexposure. Ever since the Deputy Governor of the RBI, Dr. Reddy mentioned that therupee was devalued in July/ August 1997 the rupee has been under pressure and theconcern most exporters and importers had was to what extent the rupee would depreciateand 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 takenlarge foreign currency loans converted them back (even at a cost) to rupee loans. In June1998 Moodys the international credit rating agency, downgraded India’s foreignexchange rating to below investment quality. This will make the cost of foreign loans toIndian 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’sexport trade and by extension to companies/ entities that export. When a currency hasdepreciated 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 ata throwaway price.

Foreign Debt



Foreign debt, especially if it is very large can be a tremendous burden. India has to payaround $ 7 billion a year in interest payments. This is no small sum. This money couldhave been used to develop the country. It is to attract foreign exchange that thegovernment 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 thenthe cost of production will automatically go up. This might reduce the costcompetitiveness of the product finally manufactured. Conversely if the rate of inflation inthe country to which one exports to is high, the products become more attractive resultingin increased sales. The USA and Europe have fairly low inflation (about 5%). Inflation inIndia has been falling steadily in recent times and is presently between 4% and 6%. . InSouth 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 theconsequent devaluation of their currency, their products are cheaper.

Low inflation within a country indicates stability and companies and industries prosper atsuch times. One must also remember that price increases are behind inflation andtherefore 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 companyscompetitiveness 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 competeinternationally). 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 takeadvantage 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 inJapan 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 beeninvested wisely or well. Consequently there has been little growth. It is to be rememberedthat 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 beenrecognised by the Government and it was in order to divert savings to industry that the1992 Finance Act declared that the productive assets of individuals (shares, debenturesetc.) would not be liable for wealth tax.

The Infrastructure

The development of an economy is dependent on its infrastructure. There must beelectricity for the factories to manufacture and roads to transport goods. Badinfrastructure leads to inefficiencies, poor productivity, wastage and delays. This is thereason for the emphasis this issue is being given. Unfortunately India’s infrastructuredevelopment is still at a very nascent stage and it has been determined that an immediateexpenditure 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 becausethey recognise the need and the imperativeness. A properly prepared and well researchedviable infrastructure project will, at this juncture receive a fair hearing and most likely aloan.

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 severalyears. The deficit is expected to be about 4.5 percent of GDP and in order to contain it atthis level the Government is curtailing several expenditure (developmental andinfrastructural). 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. Agood monsoon results in improved agricultural growth leading to increased demand asagriculturists 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. Thisis not good for the economy. However, in countries where there is high unemploymentlabour costs are low. In such countries companies that are labour intensive have an edgeover their peers/ competitors.

All these factors have an effect on the performance of a company - the extent being onhow 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 isdependent on both the economy and the political scenario.

THE ECONOMIC CYCLE

Bankers, while ,making the lending decision, normally look into the business or economiccycle and the stage at which the country is in as it has a direct impact on industry andindividual 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 thefood or health industry are not so affected. This is because in regard to certain industriesconsumers 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, atelevision 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 lendingdecision 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 areinterest rates. Companies, crippled with high borrowing and falling sales are forced toclose down plants (plants built at times when the demand could not be met) and letworkers go. India went through in 1997 a period that could be arguably called adepression. Interest rates were high, medium sized companies were closing down. Interestrates were high and they were crippling several companies and industries. Banks thoughflush 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 economyrecovered and the eighties was a period of boom. A downturn occurred at the late eightiesand early nineties (especially after the Gulf War). The recovery of the US economy andthat 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. Conspicuousspending begins once again. As the recovery stage sets in fully, profits begin to grow at ahigher proportionate rate. More and more companies are formed / floated to meet theincreasing demand in the economy.

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

Boom

At the boom phase demand reaches an all time high. Investment is also high. Interest ratesare low. Gradually as time goes on supply begins to gradually exceed demand. Prices thathad 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 andthe economy was opening up. China has been going through a period of boom for severalyears now and is attracting huge investments.

Recession

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

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 thecountry is in. They would normally aim to lend at the end of a depression when theeconomy begins to recover and at the end of a recession. Bankers would aim to try andget 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 veryviable and the Bank is adequately collateralised.

It must however be noted that there is no rule or law that states that a recession would befor 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 anexisting 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 theimpact of governmental and political decisions on the economy before making the finallending decision. Joseph Schumpeter once said Cycles are not, like tonsils, separablethings that might be treated by themselves but are, like the beat of the heart, of theessence of organism that displays them.

INDUSTRY ANALYSIS

Industry analysis is critical in banking. Bankers will always attempt to determine how anindustry is faring and how it is likely to fare in both the short and the long term beforethey commit funds or agree to lend. The very existence of companies in troubledindustries 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 haveclosed down or nearly closed down. On the other hand the software industry had doneextremely 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 hugecomputer into such a small box. These early models did not have a hard disk but twofixed disk drives. A few months later hard disks were incorporated. These were initiallywith a capacity of 20 megabytes. The memory was increased to 40 megabytes. Ineighteen months, the laptop became obsolete with the creation of the notebook. Thesenotebooks are no longer the last word in compressed computing. The palm tops havearrived. I have used this illustration to illustrate how technological advances make ahighly regarded product obsolete. In the same way technological advances in one industrycan affect another industry. The Jute industry went into decline when alternate andcheaper packing materials began to be used. The popularity of cotton clothes in the Westaffected the manmade (synthetic) cloth industry. This is why bankers always examine theindustry within which a company operates because this can have a tremendous effect onits results and its existence. A companys management may be superior, its balance sheetstrong and its reputation enviable. However, the company may not have diversified andthe industry within which it operates may be in a depression. This could result in atremendous 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 maturityof 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 establishitself. In the early days it may actually make losses. At this time there may not be manycompanies 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 toestablish companies and new products. There may be losses and the need for largeinjections of capital. At this time if a company or an industry is not nurtured or husbandedit can collapse. A good journalist I know began a business magazine. His intention was tostart 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 investorstake 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 isgrowth and many new entrants enter the industry. At this time there is high reward andlow risk as demand outstrips supply. A good example at this time is the pharmaceuticalindustry. At this time products are improved by those companies that have survived thefirst stage and companies are able to even lower their prices. Bankers are not averse tolend 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 ismoderate. Though sales may increase it will be at a slower rate than before. Products aremore standardized and less innovative and there are several competitors.

The industry then declines. This occurs when the products are no longer popular. Thismay be on account of several factors such as a change in social habits (the film and videoindustry 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 theindustry is at the end of the entrepreneurial or nascent stage (they would normally try notto lend at the first stage as mortality is high) and the growth stage and would begin to exitwhen 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 industriesduring 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 evergreenindustries. 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 theeconomy is doing well and do badly when depression sets in. The prime examples aredurable 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 interestrates 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 growthoccurs even though the economy may be suffering a setback.

Competition

Another factor that bankers consider is the competition companies in an industry arelikely 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 tomake losses. The more inefficient companies even close down. To properly understandthis phenomenon it is to be appreciated that if the return is high, newcomers will investinto the industry and there will be an inflow of funds. Existing companies may alsoincrease 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 fundsand 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 questionthat 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 smallfactories. 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 hasmore staying power. Its products may be preferred because of its name or because of thequality 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 ata premium and above competition.

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

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 andthe likes. If the switching costs are high, new entrants have to offer a tremendousimprovement for the buyer to switch.

e) Access to Distribution Channels The difficulty to secure access to distribution channelscan 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 firmshave 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 isusually done by not issuing licenses. The motor car industry was for nearly 40 years themonopoly 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 keepnew entrants out.

i) Large investments, capital base and cost structure Companies with large investmentsand a large capital base and a high fixed cost structure will not have many competitors. Itshigh 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 toentry.

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 unprofitablefor new entrants.

2. The Threat of Substitution

New inventions are always taking place and new and better products are replacingexisting ones. An industry that can be replaced by substitutes or is threatened bysubstitutes is normally an industry one must be careful of investing in. An industry wherethis 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 moneyin advertising and promotions. Those industries that have to be the most worried are thosewhere 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 buyerscan if they withdraw their patronage, destroy the industry. They can also force pricesdown.

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 trueif the switching costs for buyers are low.

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

o If buyers are well informed about trends and details they are in a better position vis a vissellers 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 wouldvehemently attempt to reduce prices.

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

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 pricecuts, heavy advertising, additional services or offers at high costs to the company and thelikes. This rivalry occurs mainly when:

a) There are many competitors and supply exceeds demand. Companies resort to pricecuts 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 agreater 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 existingcapacities 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 competingthey may be continuously trying to stay ahead of another resulting in each of thecompanies 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 marginsif there are strategic interrelationships between the company and others in the group ;there are government restrictions (the government may not allow a company to closedown); or the management does not for pride or employee commitment wish to closedown the company.

If the exit barriers are high excess capacity does not leave the industry but companies losetheir competitive edge. And as companies do not close down, profitability erodes and itwill 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 barriersresult in high, risky returns.

Lending to an Industry

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

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 andencouragements made. On the other hand import substitution companies are not doingvery 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 intensiveindustries. Each industry goes through a life cycle.

In conclusion bankers are cognisant of the fact that the industry phenomenon actuallydetermines 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/ securityfor 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 endangeredowing 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 exportedcertain 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 washowever estopped from remitting the money as the country’s foreign exchange positionwas very precarious. The seller did not get his money not because of the buyer but due tothe country’s inability to pay. It was on account of episodes like this that sellers insistedduring 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 acountry 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 internationalcredit agency Moodys downgraded its rating on India. A few months later Deve Gowda’sgovernment collapsed. South America in the seventies and eighties, Mexico in the earlynineties and the South East Asia catastrophe of 1997 illustrate the fragility of countries. Inthe latter the economies of several countries - Korea, Indonesia, Malaysia, Philippinesand Thailand collapsed. The currency depreciated dramatically, the most pathetic beingthat of Indonesia which fell from Rupiah 2,500 in April 1997 to nearly Rupiah 16,000 to aUnited 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 inMay 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 moreexpensive and the rupee would be under threat.

Rusi Daruwalla had been exporting for several years chemicals to Indonesia. He had in1995 approached his bank and through them arranged a foreign currency loan andestablished a company there. This company procured hard currency financing and boughtmachinery from the United States. The company prospered. When the currency collapsedin 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 requiredhis buying certain cloth from the Australia.. The order was large but the pricing was veryfine and the order was denominated in United States dollars. A depreciation of the rupeeagainst the Australian dollar and an appreciation of the rupee vis a vis the United Statesdollar 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 respectedHong 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.. Arated countries are those of the industrialised West and Japan. B rated countries are thosethat are not as well developed but safe. C rated countries are developing countries whosefundamentals are reasonably strong. India belongs to this category. D and E ratedcountries are economically undeveloped where there are grave risks such as some Africancountries and South American countries. The risk is considered that grave that when aBank requests for a letter of credit to be confirmed by a Bank in a A rated country it is notunusual for the confirming bank to demand a 100% cash cover before it confirms theletter 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 economiclikelihoods regarding what is likely to happen to interest rates, currency values andindustry. They are in the business of lending and want to lend. However they are nottechnical persons and cannot really evaluate projects being conceived. They cannotusually differentiate between the different methods of production or even opine which ismore efficient or cost effective. It is because of this that they rely heavily on projectreports 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 reportwhich would submit a project report that supports his intention to expand and proves thathis company would become more efficient. Similarly if Mr. Singh plans a new project tofarm black tiger prawns, his proposal would be studied more seriously if he submits adetailed project report on the manner he intends to farm the prawns in detail. It shoulddetail the land, the kind of ponds that will be constructed, safeguards against diseases, thewater available, the soil and the harvests. The report should also state how the prawnswill be marketed - whether it will be sold live (for the Japanese market) or frozen and thefinancial projections of the enterprise. The conclusions arrived at should be supported byan 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 awarethat the banker is not a technical man (usually) and technicalities and engineering nicetiesusually 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 beaddressed 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 itthere will be profits for the company. Ideally, it should also state there are very fewdownsides.

It must speak of the suitability of the land chosen for the project - accessibility toeither 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 issuperior or more cost effective than others.

It must speak or dwell on comparative advantages such as forward or backwardintegration or import substitution or even the high demand. This must be supported bystatistics. 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 alogical manner how the strengths far outweigh the weaknesses.

The project report should clearly show the costs of the project, the gestation period andthe 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 theeconomic 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 projectstating from where (and why) the machines will be bought, the maximum cost, the cashflow, leverage and the projects debt service capacity. The banker has to be convinced thateven in the worst situation the company can service the debt. I know of a cementmanufacturer who, being ambitious, presented a report for the construction of threemedium 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 experiencecash problems. Bank finance stopped as he was unable to service loans. At present he hasthree 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 thecapability, experience and competence of the persons entrusted with the project. If theyhave already implemented and successfully run similar projects the banker will deriveconsiderable comfort.

In conclusion it has to be emphasised that the project report is at the core of the lendingdecision. 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 concernthat is dearest to his heart - the repayment and servicing of the funds that he will belending (placing at risk). If Rusi Daruwalla’s project report does not address these issueshe will find it difficult to get the loan approved.

THE AUDITORS REPORT

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

The auditor represents the shareholders and it is his duty to report to the shareholders andthe general public on the stewardship of the Company by the directors. Auditors arerequired to report whether the financial statements presented do, in fact, present a true andfair view of the state of the company. Bankers will go through the auditors reportcarefully as the auditors are, to a degree, their representative and they are bound to, andrequired 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 toand this reason alone makes it imperative that he reads it carefully and analyses the reportincluding if necessary reconstructing the financials in order to get the true facts and thestate of the company’s state of affairs.

There can be interesting contradictions. In one Auditors’ Report it was stated,. As at theyear end, the accumulated losses exceed the net worth of the Company and the Companyhas suffered cash losses in the financial year as well as in the immediately precedingfinancial year. In our opinion, therefore the Company is a sick industrial company withinthe meaning of clause (O) of Section 3(1) of the Sick Industrial Companies (SpecialProvisions) 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 ingeneral continued to be in the grip of recession. High input costs as well as resourceconstraints hampered operations. The performance of your Company must be assessed inthe light of these factors. During the year manufacturing operations were curtailed toachieve cost effectiveness. Your directors are confident that the efforts for increased

business volumes and cost control will yield better results in the current year. Theauditors 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 dootherwise).

When reading Auditors Reports the effect of their qualification may not be apparent. TheAuditors 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. 3regarding doubtful debts, No. 4 regarding balance confirmations, No. 5 on customliability and interests thereon, No 11 on product development expenses, No. 14 ongratuity, No.8, 16 (C) and 16(F) regarding stocks, give the information in the manner asrequired by the Companies Act 1956, and give a true and fair view - It is necessarytherefore 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 andloans and advances have not been obtained.

3. It is stated that customs liability and interest thereon worth Rs. 3,14,30,073 against theimported raw materials lying in the ICF / Bonded godown as on the balance Sheet datehas 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 beenascertained nor provided for except to the extent of premiums paid against a LIC groupgratuity policy taken by the trust. This is in Note 14.

6. Note 16C states that the raw material consumed has been estimated by the managementand 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 requiredunder 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 effectof these changes are at times not detailed in the notes to the accounts. The AuditorsReport will always draw the attention of the reader to these changes and the effect that ithas on the financial statements. It is for this reason that the careful reading of an AuditorsReport 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 thesanctioning of facilities. An external confirmation - an unbiased, impartial opinion on thefinancials is an absolute necessity.

CASH FLOW

In this age of creative accounting accounting principles are changed, provisions arecreated or written back and generally accepted accounting principles are liberallyinterpreted or ignored by companies to show profits. Shareholders do not realise thiswhen they look at the profits made as published in the financial statements. It comestherefore as a surprise when a regular profit making company suddenly downs its shuttersand goes into liquidation. The reason usually lies in the fact that the company has no cashand is unable to get finance and is unable to pay its creditors. This is an area that is notoften 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 arean 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 reasonfor their growth. Unfortunately most others do not pay heed to cash flows, concentratingentirely 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 liberalisationand buoyancy in the capital markets, many companies embarked on very ambitiousexpansion 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 situationsand some became bankrupt. Bankers, aware that loans advanced can go bad if thecompany does not have operating cash flows that are positive will always check.as theyhave to be satisfied that the company has adequate funds to meet interest and capitalrepayments.

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 fundsstatement. Its importance has been recognized in the United States and in many Europeanand Asian countries where it is mandatory for a company to publish with its AnnualReport, a statement of changes in financial statements which is in effect a cash flowstatement.

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

A Company published a profit before tax of Rs. 10.81 crores a few years ago, Thisincluded 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 arevaluation 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 notdoing 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 previousyears 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 raisedRs. 75.15 crores from loans and that it effectively paid its dividends from borrowedfunds. It poses the question that when the time comes to repay loans will the companyhave adequate monies to do so.

The charm or utility of the cash flow or sources and uses of funds statement strips theaccounting creativeness from financial statements. While figures can be doctored to showhigh profits/ losses, the cash flow shows how much cash has actually been generated fromoperations and how much has been sourced from external sources. If a company has anegative cash flow from operations a banker will ask serious questions on how thecompany will meet its interest obligations and its capital repayments - both of whichshould come from operations. If it is continuously raising monies from other sources tomeet day to day obligations, a sources and applications statement will reveal that in nouncertain terms and the banker will need to be satisfied that there will be inflows fromoperations 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 economicsituation, industry, the company, the management and other related factors would thenexamine the financials as it is upon this that he will base the final decision. He willexamine the financials from all aspects aware as Abraham J. Briloff says, “Whenever antsswarm, the pot will not only contain a bit of money, but will also be filled withaccounting gimmicks.”

The financials are the pivot on which the lending decision rests as it details thefundamental strengths and weaknesses of the company and its ability to repay the loansand 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 itwould 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 goingconcern.. This means that it is conducting its business normally and that it is not unviableor loss making..

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

Another important issue bankers will look at is profit ploughback. Profit ploughback is toenable the company to expand, make it stronger and replace assets. If profits are notreinvested, 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 boomyear shareholders will benefit whereas in a bad year it would be the reverse. It is of primeimportance 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 incomefor the Company. The composition of fixed assets will be examined in detail and thenature of the fixed assets employed. There could be instances where there are hiddenreserves 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 policyto upgrade assets.

Some companies have intangible assets on their Balance Sheets such as deferred revenueexpenditure or preliminary expenses not written off. These are expenses and have no assetvalue and bankers will recast the Balance Sheet deducting these from the Company’s networth.

Many company’s have investments. The banker will always ascertain the nature for theseinvestments 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 willexamine how they have been valued and how old they are. This is in order to ascertainhow 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 industryand its sustainability.

A company’s other income is also examined especially its composition and whether itwould 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 incomestreams and its dependability.

Expenses would normally be, when being examined, broken down to fixed costs andvariable costs. Fixed costs would be those costs that would be incurred irrespective of anyother factor. These will include rent, administration costs and the likes. Variable costs arethose 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 companycould depend on it. The issue here is whether the Company can pay the interest on thefacilities it enjoys from operating profits. If not there will be concern unless if thecompany 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 acompany 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 tendto 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 becomputed in the next few articles.

RATIO ANALYSIS

No banker would lend or advance facilities to a company until he has analyzed itsfinancial statements and compared its performance to that it achieved in previous yearsand 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 haveissued 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 toalso determine whether it is improving or deteriorating in profitability or financialstrength.

Ratios express mathematically the relationship between performance figures and/or assets/liabilities in a form that is easily understood and interpreted. Otherwise one may beconfronted 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 acompanys strengths or performance. Sales of Rs. 500 crores a year or a profit of Rs. 100in a year may appear impressive but one cannot be impressed until this is compared withother figures such as its assets or net worth. It must be remembered that when comparingone figure with another that the relationship is clear and logical. Otherwise no usefulconclusion 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 upon cost or the margin earned.

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

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 suchas:

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 figuresto 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 reallyconcerned 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 expenditureshould 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 itsmanagement, management policy, government policy, the state of the economy and theindustry 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 isentirely 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 canservice 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 isa 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 andlong term debt from income or internally generated funds. This is relevant if the debt isnot 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 internallygenerated 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 iscalculated 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 theargument that the factor to be considered is the time it would lend to repay total liabilitiesat a particular time.

Interest cover

An extremely important factor that bankers must ascertain is whether a companys profitsare 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 financialweakness.

The interest cover ratio is calculated by dividing earnings before interest and tax byinterest 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 forcedto 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 andleasing companies. These companies have offered corporations the opportunity of leasingequipment as opposed to purchasing them. Leasing is also being looked upon increasinglyas an alternative to actually purchasing an asset. This has the following benefits. Therentals 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 realcost 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 acompany 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 beaccounted for in this ratio as it is a fixed charge that has to be paid. In that case the fixedcharge cover is calculated in 2 stages. In the first stage the fixed charge cover iscalculated 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 thata 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 thatcompanies will normally grow and therefore will incur capital expenditure and that therewill 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 networking 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 increasingand this increase is usually more than its internally generated funds. This is usuallyfunded 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 andrepay its liabilities. This becomes all the more critical at times of high inflation andrecession when an inability to service debt can plunge a company to bankruptcy. And theloan 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 itcannot survive in the long run. Additionally and more importantly it may not be able torepay its loan

Profitability ratios assist the banker in determining how well a particular company isdoing vis a vis other companies within the same industry and with reference to previousyears. A banker can, with the help of these ratios, evaluate the managements effectivenesson 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 theassets or liabilities on a particular date. This is because there can be large variations inthese figures during the year and these can distort results quite materially. Companieshave been known to windowdress their Balance Sheets by either reducing or increasingassets or liabilities. Additionally as profits are earned not on a particular date but over ayear ratios calculated on average assets/liabilities would portray a truer indication of theresults 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 anindication 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 importantindicator 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 withinthe industry and with previous years. It is also used to project the performance of futureyears.

Return on Equity



Another important measure of profitability is the return on equity or ROE as it is oftentermed. The purpose of this ratio is to determine whether the return earned is as good asother alternatives available. This return is calculated by expressing income (net profitafter tax) as a percentage of the share holders equity. It is to be noted that the incomefigure should not include extraordinary, unusual or non recurring items as that woulddistort the results arrived at. Additionally, the net income on which this ratio is calculatedshould exclude dividends on preference shares. Shareholders equity is the stake ordinaryshareholders 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 withlower 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 thehigher 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 sinceon 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 willdepend on its borrowings. Similarly the tax liability of companies will differ and willdepend 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 theaverage 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 sameindustry) 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 indeploying assets effectively without financing. Tax is included in the calculation as it isdeducted before arriving at the profits. Interest too is not considered as it will vary fromcompany to company and is a payment for capital or funds. The ratio is arrived at byexpressing net return after tax but exclusive of interest as a percentage of average totalassets.

pre interest after tax return on assets

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


Return on total invested capital

The ratio that is used to determine whether the capital has been efficiently used is thereturn on total invested capital. A banker can, by using this ratio, check whether he couldhave earned more elsewhere. It therefore gives him an opportunity to comparealternatives and between companies. Invested capital in this ratio includes all liabilitiesthat have a cost associated with them such as debentures, share capital and loans. Theratio is arrived at by dividing a companys earnings before interest and tax by average totalinvested 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 interestrate 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 theyindicate whether the enterprise is viable and better or worse than other similar ones. Theseratios however should not be seen in isolation. One should remember that a lower ratio isnot necessarily bad. In order to increase sales and profits companies may sell goods atlower prices (volume driven businesses). These ratios are, like all ratios, indicators andthey should be considered as such.

LIQUIDITY

Liquidity is one of the cornerstones of lending. It is important for companies to be liquidin order for it to meet its currently maturing financial obligations and to have enoughfunds to meet its operational requirements. If a company is unable to, it may be forced tosell its more important assets at a loss and can, in extreme cases, be forced intoliquidation. 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 securitiesin Public Sector Undertakings (PSU). As a consequence of the liquidity crunch that beganin 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 isto check whether a companys current assets are enough to meet its immediate liabilitiesi.e. those that mature within one year. The ratio is arrived at by dividing current assets bycurrent 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, allcompanies are aware of the cost of capital, the opportunity cost of tying up capitalunproductively and just in time (JIT) inventory control. Consequently there is an effort tokeep current assets low (stock levels, debtors and cash). Thus often the ratio is well below1. This does not necessarily mean that the company is illiquid - it could merely be usingits assets effectively.

Quick Or Acid Test

The acid test is a favorite with bankers and creditors. This is used to check whether thecompany 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 equivalentsare 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 whenconverting to cash.

This ratio is arrived at by dividing cash, marketable investments and debtors by currentliabilities. It is to be noted that investments, though strictly not a current asset is used incalculating 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 asit 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 currentliabilities from current working assets (trade assets). This is clearly not a ratio. Itsusefulness 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 capitalof a company. Consequently several derivatives can be calculated from this figure such asits relationship to sales, income and even to capital.

Net current assets can also be used as a base to determine the quantum of working capitalthat must be kept to support a level of sales. A ratio of 20% could suggest that if salesincreases by 20% , net current assets would also need to increase proportionately. It is, inthis context, better to have a low ratio as the increase in working capital needed will beless. The company can therefore grow quite rapidly.

Net Trade Cycle

It is important to determine the time companies take to convert goods purchased to cashafter it has been paid for. This is a very good tool to determine its liquidity and it iscomputed by adding the debtors turnover in days to the stock turnover in days anddeducting 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 currentworking 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 achange 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 anyadditional financing or sales. It can be likened to a worker on strike. How many days canhe survive on the assets that he has before he becomes bankrupt?

This ratio is calculated by dividing a companys average daily cash operating expenses byits most liquid assets. It is important to note that only the most liquid assets are used suchas cash and cash equivalents. Debtors and stocks are not to be considered as they are notcash 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 cashinflows from operations and current liabilities and to determine whether the company canmeet 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 hasresulted in companies becoming sick - an inadequacy of funds to finance operations. It iscrucial 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 moreand more reluctant to sell goods. This affects production and then sales and this has asnowballing 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 especiallythose that operate with extremely low margins.

Historically companies have excellent liquidity ratios before a crash. This is because fixedassets and stocks are sold and become converted into cash. Current liabilities decrease atthat 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 assetsshould not include deferred revenue expenditure like advertising costs as they do not haveany 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 andwhether this has deteriorated. If it has and there does not seem a likelihood of itimproving in the imminent future, then the will not extend facilities..

LEVERAGE

Leverage indicates the extent a Company is dependent on outside funds or borrowings tofinance its business. These borrowings may be debentures, term loans, short term loansand bank overdrafts. Bankers will pay specific heed to this as the viability of the facilitiesit 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 tocontrol 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 areexorbitant and the large profits made in boom times turn to large losses. At these timesthe cost of borrowings often exceed the profits made and results in losses and theCompany 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 leveragedcompanies are risky and earnings can in bad years be negative. Conversely in good yearsit can be very good.

Liabilities to Assets Ratio

This ratio indicates the total borrowings provided to finance the company and the extentto which these external liabilities finances the assets of the company. Liabilities in thisconnection includes both current and long term liabilities. Assets include all assetsexcluding intangibles such as deferred revenue expenditure (preliminary expenses,goodwill, deferred advertising expenditure and the likes). This is calculated by dividingtotal 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 ratiowould change dramatically.

Debt to Assets Ratio

The debt to assets ratio is a more specific ratio. It determines the extent debt or borrowedfunds are covered by assets and measures how much assets can depreciate in value andstill 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 iscalculated 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 andthe 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 intangibleassets.

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 andattempts to determine how dependant a company is on liabilities to fund its business. It iscalculated 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 tofinance growth. It is to an extent similar to the net working investments ratio. The ratio iscalculated 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 termdebt ratio which seeks to determine how important borrowings are to total long termliabilities 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 theextent 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 acompany has are adequate to meet its needs and whether the returns are reasonable. Itmust 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 requiresthe companys operations would not be using its resources as productively and effectivelyas 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 areused to assess trends and to determine how well assets have been utilized. Comparisonscan be made between one year and the next, between one company and another in thesame industry and in other industries. These ratios help enormously in making forecastsand budgets too.

It must be remembered however that these ratios, like others, are pointers. A high assetturnover 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 isimportant to bear in mind that a deterioration in asset ratios are a sign of decline andshould 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. Inthese days of companies propounding the Just In Time principle, these ratios are alwayscarefully 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 aslittle stocks as possible, this is an important efficiency indicator. It is calculated byexpressing 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 ascertainthe 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 toeither block their own internal funds or resort to bank finance. The cost of finance istherefore usually built into the sale price and companies offer a cash discount tocustomers 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 averagesales 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 baddebts 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 averagecollection period ratios.

Average Payment Period

The average payment period ratio or the creditor ratio indicates the time it takes acompany to pay its trade creditors i.e. how many days credit does it enjoy. The ratio iscalculated 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 creditterms. This is good as the company is effectively using creditors to finance workingcapital 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 bysales.

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 generatingenough sales taking into account its investment in assets. It indicates how efficientlyassets are being utilized and is an extremely useful ratio for preparing forecasts. The ratiois calculated by dividing sales by average total assets.



Total asset utilization = Sales


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 todetermine how effectively fixed assets are being used. It should be remembered that thisratio should be calculated on net fixed assets i.e. cost less accumulated depreciation. It isarrived 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 netfixed assets has deteriorated.

It must be borne in mind that this ratio is not truly reflective of performance as fixed assetcosts when comparing companies will differ. A new company with recently acquiredfixed assets will show a worse ratio than one that has assets that are old. In such ascenario 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 highlightshow effectively credit policy has been administered and whether the company is availingof 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 causingmargins 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 onwhat he believes the market can bear or that which he thinks will fuel sales. Usually lowvolume businesses are high margin businesses as goods often have to be held for sometime. 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 lowcost and whether the business is a high volume low margin business or otherwise. This isimportant as it will indicate how dependent the company is on margins. If the companyoperates 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 comparedwith 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 instancethat Unisulphur Ltd. is more efficient and that its products command a greater premium.

Management trends can also be assessed by margins. Efficient and strong managementswill 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 increaseto 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 costincreases because if it does not, the customer would not purchase the product. A goodexample 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 costincreases 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 - eachof them priced differently. Some may be high margin products and others low marginones. If more high margin products are sold, the margin earned by the company would behigh. Then should there be a change and more low margin products begin to be sold, theaverage 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 lowmargin businesses that operate with very high turnovers and produce an impressive returnof capital employed.

Gross Margin

The gross margin is the amount earned expressed as a percentage of cost of sales. It is theexcess earned to meet the expenses of the company. It is calculated by dividing thedifference 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 adeterioration 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 whereasa fall could be due either as a consequence of a conscious decision to increase sales or aninability 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 interestcosts is indicated by the operating margin. The operating margin can be arrived at bydeducting, selling, general and administrative expenses from the gross profit andexpressing 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 notrisen 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 operatingmargin. Normally this margin should improve since costs do not usually rise at the samerate as sales. In a recession or at a time of high inflation the reverse will be true. Costsmay 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 animprovement or a deterioration in profitability and he must ascertain the actual causes.

Breakeven Margin

Every organisation has certain expenses (selling, administration and other miscellaneousexpenses) that it has to bear even if there are no sales. The breakeven margin indicates thenumber 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 thecompany 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 recurringor 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 toarrive at the gross profit per unit. This is because selling costs are connected with salesand no selling expenses would be incurred if no sales are incurred. In my opinion this isan important measure as it indicates exactly how many units need to be sold by acompany before it can begin to be profitable. This is an important management ratio tooin decision making when alternatives are being considered.

Prefinancing Margin

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

Pretax Income

Sales

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

This is not a fair measure of profitability and comparison as the manner of funding (andthus financing costs) will vary from company to company. It can however be usedeffectively 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 andexpense 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 increasesin 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 badnor are high margins always good. A company may opt for volumes and to achieve thiswork on very low margins. On the other hand a company earning high margins may havefalling demand for its products. Bankers always check into the reasons for variations andthe various measures mentioned in this chapter points out to the banker the possiblereasons.

EARNINGS

Earnings is the yardstick by which companies are finally judged-the earnings the equityholder 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 aconsequence, worth looking at from a bankers perspective though the lending decision israrely 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. Theratio is arrived at by dividing the income attributable to common shareholders by theweighted 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 givenstock 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 andconvertible securities outstanding at the end of the accounting period are exchanged for shares. This becomes relevant to India nowadays as many companies issue convertibledebentures and bonds.

Many value a share as a multiple of the earnings of the company. If the earning per shareis 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 acompany 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, interestand 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 butthose who can determine the policies of the company. It is submitted that the value of ashare 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 anincrease 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 regularlyappreciated 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 isrequired, 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 asdividend to shareholders and how much is ploughed back into the company for its longterm 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 tofinance expansion and to nullify the ravages of inflation and to achieve these the companywould 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 havehigh 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 andnot 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. Theyadvise an investor on the earnings made per share, the dividend policy of the companyand the extent of income ploughed back into the company for its expansion, growth andreplacement 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 isreasonable. If the dividend payout ratios are very high there will be concern as it canindicate that the management of the company is not particularly committed to the longterm growth and prospects of the company.

APPROVAL

Once the Banker has gone through the request for credit facilities and studied all therelevant information about the client and he is satisfied that the need is genuine and thatthe customer has the ability to repay the advances extended, he would recommend thefacilities 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. Hewould then pass it on to the marketing manager or the head of marketing who would, if heis 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 therecommendations would then be forwarded to a credit officer or credit manager whowould 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 marketingofficer 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 behigher in the hierarchy. Large facilities would need to be approved by the CreditCommittee 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. Regionalheads 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 severalcrores. The procedure is that when facilities are approved under unilateral powers of anofficer (whatever be the rank) the next higher authority should ratify the proposal within areasonable time. The weakness in this system is that there is no credit officer separatelyfrom 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 requirefacilities 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 delegatedto branch managers or senior branch officers. This results in all proposals having to besent 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. Therelationship 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, hecan 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 thatextent, colored. The credit officer/ manager does not know the prospective client at alland he would either support or reject the proposal based on the financials, themanagement, the external environment and other relevant details. It would be an impartialdecision 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 certainstipulations and conditions governing the approval. This letter would also normally detailthe collateral that would have to be given.

The prospective client would normally sign the offer letter and return it to the Bank. Thisis in effect an acceptance by the prospective client of the terms of the approval. Then hewould work with the Bank to get the security documentation complete. Drawdown isusually 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 theBank has been executed. The disbursal may be in one or two or more tranches in the caseof a term loan or continuous as in the case of overdrafts.

However, when a loan is approved there are usually several conditions that borrowers areexpected to, on an ongoing basis comply with such as ensure that the assets collateralisedare adequately insured, statements on these assets (especially stocks and debtors) aresubmitted 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 theconditions 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 intoaccount those debtors that are long overdue. In this test he would normally omit debtorswho are overdue for more than 90 days. Let us imagine that Raman Menon has debtorsaggregating 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 othersthere is a possibility that debtors totaling Rs. 5,00,000 may not pay at all (bad debts). Indetermining the value of the collateral, Mr. Menon’s banker will assume the value of thecollateral to be Rs. 33,00,000. This is on the assumption that those borrowers whoseoutstandings are between 90 and 180 days would pay.

The banker, when he examines stocks will check the nature of the stocks held – bothraw materials and finished goods and examine how long they have been held. In this caseif an item has been held for more than three months it does not necessarily mean that thearticle concerned is bad. It may just be slowmoving. The banker will however examinethe 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 thechemical is only three months then that chemical is clearly of no use. Its value will not betaken into account when determining the value of stocks. In certain industries there is ahigh obsolescence factor (computers etc.). The banker, while examining collateral valuesin 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 themargin 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. Therewould be margins for debtors also. The banker on receipt of the stock statements willwork out, based on the margin requirements, how much the borrower can borrow. This isknown as the borrower’s “drawing entitlement.” Bankers pay special heed to this and asthey have to work this out every month it is imperative that this is submitted in time andregularly.

The banker will also periodically visit the factories or godowns of the borrower tosatisfy himself that the stocks do in fact exist. He will test check quantities with bin cardsand even do a test count of some items. He would also go through debtor records tosatisfy 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 issatisfied that the price is reasonable will sight the machinery – actually go the factory tosee the machinery and see it installed and working. He will also go periodically to the siteto satisfy himself that the machines installed are still working well and doing what theyare 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 invoicesand 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 hisaccount. If there are frequent excesses in the overdraft due to the borrower issuingcheques without ensuring that there are adequate funds the banker may even be forced todishonour the cheques. If Raman Menon had issued such cheques, in the first fewinstances his banker may have called him and told him that there are inadequate funds andasked him to deposit cash to enable him to honour the cheques. After a while, if thiscontinues the banker would dishonour the cheques.

Rusi Daruwalla, in regard to the term loan he has taken, would be expected to pay interestand principal installments on due dates. If he does not do so there would be reminders andyet more reminders.

Borrowers would be wise to honour the commitments they have made and adhere to theconditions laid down as they would then be able to establish a good credit record withtheir 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 hewishes 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 moreimportant than the credit appraisal process itself because upon this depends whether hegets repaid.

CONCLUSION

Presentation is extremely important. First impressions count enormously. One tends to befavorably impressed and more inclined to view a person or proposal favorably if the firstsighting of the person/ proposal is good. A well presented, well researched creditapplication inspires confidence. A credit application that addresses all the issues andconcerns 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’sability and intention to repay. On the other hand if it is badly presented the impressionthat 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 inthe 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. Itmust 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 hasseveral proposals to read and the last thing he wants is a badly presented report that hasseveral gaps. He has to make a decision quickly and if there are issues that have not beenaddressed his initial reaction would be to place it aside to look at when he has time. Moreoften than not he will forget it. On the other hand if all the issues are addressed he will beinclined to look at the proposal favorably.

It must however be remembered that a well presented well structured application cannotmake an unviable project viable or a bad loan good. The presenter will therefore be wiseto detail all the possible risks as this will underline the prospective borrower’s integrityand transparency.

Documents

Commercial credit analysis