Project Report -Union bank

Analysis of Credit Appraisal

at

UNION BANK OF INDIA

BY

APOORVA GHOSH

4108024024

MBF 2008-2010

UNDER THE ESTEEMED GUIDANCE OF

Mr. Ramesh Vege

Senior Manager, UBI, Bhopal

DECLARATION

I hereby declare that the project report titled “Analysis of Credit Appraisal in Union

Bank of India” has been prepared by under the guidance of Mr. Ramesh Vege,

(Senior Manager), Mr. K.D. Lalwani(Senior Manager), Mr. Vinod Mathur,

Assistant Manager, Credit Division, Union Bank of India and Prof.

J.D.Agarwal, Director, Indian Institute of Finance, New Delhi.

I also declare that this project has not been submitted nor shall it be

submitted in future to any other University or Institution for the award of any

other Degree or Diploma.

Dated: 12/06/2009

(Apoorva Ghosh)

APOORVA GHOSH4108024024MBF 2008-2010 2

ACKNOWLEDGEMENT

This project is the result of my deep interest in the Banking sector. First of all, I would like to

thank Mr. Raman (General Manager, Zonal Office, Union Bank of India, Bhopal) for giving me

this opportunity and allowing me to work in the Finance Division of Regional Office of Union

Bank of India.

I would express my gratitude to my guide Mr. Ramesh Vege(Senior Manager,

Regional Office, Union Bank of India, Bhopal), for giving me an opportunity to undertake this

project, as a part of my requirement of Summer Training during my MBF Program. His valuable

advice and guidance has been a major factor in completion of this project.

I am also indebted to Mr. Khushal D. Lalwani (Asst. Manager, Union Bank of India,

Bhopal Branch), for giving his precious time in making me understand the practical difficulties

in Credit Appraisal and its management.

I would also thank Mr.Ramnathan (Assistant General Manager, Regional Office,

Bhopal), Mr. Rakesh Khare (Chief Manager, Regional Office, Union Bank of India) and Mr.

Vinod Mathur (Assistant Manager, Regional Branch), for lending out their helping hand in

making me understand the basics of Credit appraisal.

My deep sense of obligation goes to Prof. J. D. Agarwal, Chairman, Indian Institute of

Finance, and Prof. Aman Agarwal, Director, IIF, whose words of wisdom and motivation has

inspired me to come this long way.

Last but not the least, I would thank the faculty and staff members of Indian Institute

of Finance, who have extended their helping hand by sharing their knowledge and experiences.


Date: 21/07/2009

Apoorva Ghosh

EXECUTIVE SUMMARY

Project title : Credit Appraisal

Duration : 20th April to 13th June

Place of work : Bhopal

Institution : Union Bank of India

Project Guide : Mr. Ramesh Vege

Senior Manager,Union Bank of India

Summary

As a part of MBF programme, a student has to pursue a project duly approved by the Director of

the institute . I had the privilege of undertaking the project on Credit Appraisal. Credit Appraisal

is a process through which institutions like banks etc. try to continue giving quality loan to its

customers. One of the basic tenets of the loan policy is to ‘ensure continuous growth of loan

assets while endeavouring that they remain secure, performing and standard’. Loans and

advances constitute significant portion of a banks Balance Sheet. But lending activity is

associated with various risks, the most predominant being default risk. While default risk is

unavoidable/inescapable, risk mitigation is recognized as a significant technique.

This report also compares the strategies to deal with Credit Appraisal and to check the credit

worthiness of the customers. It further looks into the effect of the different techniques used for

Credit appraisal and suggests mechanisms to handle the problem by drawing on experiences

from different techniques used.


My project is divided into 5 chapters.

The first chapter deals with the introduction to the organization I have worked with and the current scenario of retail loans.

The second chapter deals with the review of literature related to credit appraisal.

The third chapter gives a brief account of the objective of the study, research methodology and a brief review of other related literature.

Chapter four has all the analysis and interpretations.

Chapter five deals with the summary of major findings, discussions of results, suggestions and limitations of the study.


CONTENTS

CHAPTER I

About Union Bank of India Pg 8

The Genesis of Banking in India Pg 13

Retail Loans Offered By Union Bank Pg 17

- Union Home

- Union Top Up

- Union Miles

- Union Comfort

- Union Education

- Union Mortgage

- Union Smiles

- Union Shares

CHAPTER II

Review of Literature Pg 49

CHAPTER IIIAPOORVA GHOSH4108024024MBF 2008-2010 6

Risk Management Pg 51

Significance Pg 54

Credit Risk Pg 57

Credit Risk Management Pg 60

General procedure to Compile a credit report Pg 63

Sources of Information Pg 68

CHAPTER IV

Objective Pg 71

Asset Liability Management Pg 72

Computation Of Net Worth Pg 75

Compliance with Accounting Standards Pg 77

Balance Sheet Analysis Pg 81

Profit and Loss Analysis Pg 99

Common Window Dressing Techniques Pg 117

Ratio Analysis Pg 118

Break Even Point Pg 128

Fund Flow Analysis Pg 134

Cash Flow Analysis Pg 142

Term Loan Assessment Pg 151


Technical Appraisal Pg 156

Project report Analysis Pg 166

Working Capital Assessment Pg 172

Letter Of Credit Pg 175

Letter Of Guarantee Pg 176

CHAPTER IV

Analysis Pg 178

CHAPTER V

Findings Pg 196

Limitations Pg 197

Suggestion Pg 198

Conclusion Pg 198

BIBLIOGRAPHY


CHART INDEX

Bank of India Pg 17

Balance sheet as per schedule vi Pg 83

Balance Sheet for non- corporate entity Pg 85

Proforma of P and L Pg 89

Working Pool of Sources Pg 142


CHAPTER

I


ABOUT UNION BANK OF INDIA

The dawn of twentieth century witnesses the birth of a banking enterprise par excellence-

UNION BANK OF INDIA- that was flagged off by none other than the Father of the Nation,

Mahatma Gandhi. Since that the golden moment, Union Bank of India has this far

unflinchingly traveled the arduous road to successful banking........ A journey that spans 88 years.

The Union Bank of India, reiterates the objective of their inception to the profound thoughts of

the great Mahatma... "We should have the ability to carry on a big bank, to manage

efficiently crores of rupees in the course of our national activities. Though we have not

many banks amongst us, it does not follow that we are not capable of efficiently managing

crores and tens of crores of rupees."

Union Bank of India is firmly committed to consolidating and maintaining its identity as a

leading, innovative commercial Bank, with a proactive approach to the changing needs of the

society. This has resulted in a wide gamut of products and services, made available to its

valuable clientele in catering to the smallest of their needs. Today, with its efficient, value-added

services, sustained growth, consistent profitability and development of new technologies, Union

Bank has ensured complete customer delight, living up to its image of, “GOOD PEOPLE TO

BANK WITH”. Anticipative banking- the ability to gauge the customer's needs well ahead of

real-time - forms the vital ingredient in value-based services to effectively reduce the gap

between expectations and deliverables.

The key to the success of any organization lives with its people. No wonder, Union Bank's

unique family of about 26,000 qualified / skilled employees is and ever will be dedicated and


delighted to serve the discerning customer with professionalism and wholeheartedness.

Union Bank is a Public Sector Unit with 55.43% Share Capital held by the Government of India.

The Bank came out with its Initial Public Offer (IPO) in August 20, 2002 and Follow on Public

Offer in February 2006. Presently 44.57 % of Share Capital is presently held by Institutions,

Individuals and Others.

Over the years, the Bank has earned the reputation of being a techno-savvy and is a front runner

among public sector banks in modern-day banking trends. It is one of the pioneer public sector

banks, which launched Core Banking Solution in 2002. Under this solution umbrella, All

Branches of the Bank have been 1135 networked ATMs, with online Telebanking facility made

available to all its Core Banking Customers - individual as well as corporate. In addition to this,

the versatile Internet Banking provides extensive information pertaining to accounts and facets of

banking. Regular banking services apart, the customer can also avail of a variety of other value-

added services like Cash Management Service, Insurance, Mutual Funds and Demat.

The Bank will ever strive in its Endeavour to provide services to its customer and enhance its

businesses thereby fulfilling its vision of becoming “THE BANK OF FIRST CHOICE IN

OUR CHOSEN AREA BY BUILDING BENEFICIAL AND LASTING RELATIONSHIP

WITH CUSTOMERS THROUGH A PROCESS OF CONTINUOUS IMPROVEMENT”.


The Vision Statement

To become the bank of first choice in our chosen area by building beneficial

and lasting relationship with the customers through a process of continuous

process.

The Mission Statement

A logical extension of the Vision Statement is the Mission of the Bank,which is

to gain market recognition in the chosen areas.

To build a sizeable market share in each of the chosen areas of business

through effective strategies in terms of pricing, product packaging and

promoting the product in the market.

To facilitate a process of restructuring of branches to support a greater

efficiency in the retail banking field.

To sustain the mission objective through harnessing technology driven banking

and delivery channels.


To promote confidence and commitment among the staff members, to address

the expectations of the customers efficiently and handle technology banking

with ease

BOARD OF DIRECTORS

SHRI M.V.NAIR

Chairman & Managing Director

SHRI T.Y. PRABHU

Executive Director

SHRI S.Raman

Executive Director Government of India Nominee

SHRI K.V. EAPEN

Government of India nominee on the recommendation of RBI.

SHRI K. SIVARAMAN

Chartered Accountant Director

K.S. SREENIVASAN

Director representing Workmen Employees

SHRI N. SHANKAR


Director representing Officer Employees

DEBASIS GHOSH

Government Nominee Director under General Category

SMT. RANI SATISH

Government Nominee Director under General Category

SHRI ASHOK SINGH


Genesis of banking in India

Banking in India organized in the first decade of 18th century with The General bank of India

coming into existence in 1786. This was followed by Bank of Hindustan. Both these banks are

now defunct. The oldest bank in existence in India is the State Bank of India being established as

“The Bank of Calcutta” in Calcutta in June 1806. Couple of decades later, foreign banks like

HSBC and Credit Lyonnais started their Calcutta operations in 1850s. At that point of time,

Calcutta was the most active trading port, mainly due to the trade of the British Empire, and due

to which banking activity took roots and prospered. The first fully Indian owned bank was the

Allahabad Bank set up in 1865.

By the 1990s, the market expanded with the establishment of banks like Punjab National Bank,

in 1895 in Lahore; Bank of India in 1906, in Mumbai- both of which were founded under private

ownership. Indian banking sector was formally regulated by Reserve Bank of India from 1935.

After India’s independence in 1947, the Reserve bank of India was nationalized and given

broader powers.

Structure of the organized banking sector in India. Number of banks is in brackets.


RESERVE BANK OF INDIA

Central bank and supreme monetary authority

Scheduled banks

Commercial banks Cooperatives

Foreign Banks[40] Regional Rural Bank[196]

Urban Cooperatives[52] State Co-Op[16]

Public Sector Banks [27] Private Sector Banks [30]

Old [22] New [8]

State Bank of India & Associate banks[8] Other nationalized banks [19]


SBI Group

The Bank of Bengal, which later became the State Bank of India. SBI with its seven associate

banks command the largest banking resources in India, SBI and its associates banks are :

State Bank of India

State Bank of Bikaner and Jaipur

State Bank of Hyderabad

State Bank of Indore

State Bank of Mysore

State Bank of Patiala

State Bank of Saurashtra

State Bank of Travancore

Nationalization

The next significant milestone in Indian banking happened in the late 1960s when the then Indira

Gandhi Government nationalized, on 19th July, 1964. 14 major commercial Indian banks,

followed by nationalization of 6 more commercial Indian banks in 1980. The stated reason for

the nationalization was more control of credit delivery. After this, until the 1990s, the

nationalized banks grew at a leisurely pace of around 4% also called as the Hindu growth of the

Indian economy. Currently there are 19 nationalized banks.

Liberalization

In the early 1990s the then Narsimha Rao government embarked on a policy of liberalization and

gave license to a small number of private banks, which came to be known as New Generation

tech-savvy banks, which included banks like ICICI Bank and HDFC Bank. This move along


with the rapid growth with strong contribution from all the three sectors of banks, namely,

government banks, private banks and foreign banks. However, there had been a few hiccups for

these new banks with many either being taken over like Global Trust Bank have found the going

tough.

The next stage for the India banking has been setup with the proposed relaxation in the norms for

Foreign Direct Investment, where all Foreign Investors in banks may be given voting rights

which could exceed the present cap of 100%.


Retail loans Offered by the Union Bank of India

Union Home:

Eligibility

Indian Citizen - 21 years and above.

Either single account or joint account with other family members viz., father, mother,

wife, son or daughter with regular source of income.

Individuals who may be employed/self-employed in business having regular income.

A minimum of 40% marks as per investment grade scoring chart.

Purpose

Purchase of independent house/flat.

Construction of independent house/flat.

Repair/Improvement/Extension.


Repayment of loan availed from another agency/Bank/NBFC.

For purchase/ construction of 2nd property (independent house/flat)

Plot sold by a Government-recognized agency viz., HUDA, HOUSEFED and such

others.

Quantum

Max. Rs. 100 lacs for major 'A' class cities; for other cities Rs.50 lacs

Max. Rs. 10 lacs for repair.

Margin

For purchase/construction, 20% of the value of independent house/flat.

For repairs, 20% of total cost of repair.

For purchase of plot, 20% of the value of the plot.

Repayment

Moratorium up to 18 months wherever loan is taken for under construction flat or

building.

By EMI.

The maximum repayment period should not exceed 20 years for construction / purchase

of house/ flat and 10 years for repair.

Option of Flip/Step-up/Balloon methods of repayments for the convenience of the

borrowers.

Special Package (w.e.f. 16.12.2008)

Free Life Insurance Coverage for outstanding loan


No processing Charges

No Prepayment Charges

Loan up to 5 Lac : 8.50% (reset After 5 year)

Margin : 10% by borrower

Loan from 5 Lac to 20 Lac : 9.25% (reset After 5 year)

Margin : 15 % by borrower

Special Combo Offer for Home Loan effective from 15.05.2009 to 30.09.2009

Special Combo Offer is applicable for loan upto 50 lacs

Loan upto Rs. 30 Lacs

Tenor Upto 5 year >5 Year to 10

Year

>10 Year to 20 Year

Ist Year 8.00% 8.00% 8.00%

2nd Year till final

repayment

BPLR -

2.75%

i.e . 9.25 %

BPLR - 2.50 %

I .e. 9.50 %

BPLR - 2.25 %

i.e 9.75 %


Loan over Rs 30 Lacs upto 50 Lacs

Tenor Upto 5 year >5 Year to 10

Year

>10 Year to 20 Year

Ist Year 8.00% 8.00% 8.00%

2nd Year till final

repayment

BPLR -

2.50%

i.e . 9.50 %

BPLR - 2.25 %

I .e. 9.75 %

BPLR - 2.00 %

i.e 10.00 %

Features

Applicable for the borrowers who availed loan up to Rs. 50 lacs only.

Free life insurance policy will not be availed to the

borrower.

No takeover account from other bank/ institution to be permitted.

All other terms and conditions of Union Home Loan scheme will remain unchanged


Rate of Interest (w.e.f. 01.04.2009 )

Up to Rs 30 Lacs Above Rs 30 lacs upto Rs 50 Lacs Above Rs 50 lacs

As on 01.04.2009 As on 01.04.2009 As on 01.04.2009

Floating Floating Floating

Upto 5 Yrs.

BPLR-2.75% = 9.25%

Upto 5 Yrs.

BPLR-2.50% =9.50%

Upto 5 Yrs.

BPLR-2.25% =9.75%

>5 Yrs to 10 Yrs

BPLR-2.50% = 9.50%

>5 Yrs to 10 Yrs

BPLR-2.25% =9.75%

>5 Yrs to 10 Yrs

BPLR-1.75% =10.25%

>10 Yrs to 15 Yrs

BPLR-2.25% = 9.75%

>10 Yrs to 15 Yrs

BPLR-2.00% =10.00%

>10 Yrs to 15 Yrs

BPLR-1.50% =10.50%

>15 Yrs to 20 Yrs

BPLR-2.25% = 9.75%

>15 Yrs to 20 Yrs

BPLR-2.00% = 10.00%

>15 Yrs to 20 Yrs

BPLR-1.50% = 10.50%

Fixed rates - upto Rs 30 lacs - 9.75% (upto 5 years)

Above Rs 30 lacs - 10.75% (upto 5 years)


BPLR = 12.00% with effect from 01.04.09

Processing Charges inclusive of applicable service tax

0.50% of loan amount subject to a maximum of Rs.15000/- plus service tax as applicable

0.25% of the loan amount at the time of application plus service tax as applicable

0.25% of loan amount on acceptance of sanction plus service tax as applicable

Insurance

Free Building Insurance.

Natural Death (other than accidental death) may be covered under Union Home Plus,

which is optional and additional loan can be sanctioned.

Free Personal accident coverage (in case of death).

Value Added Services

Credit Card will be issued (free of admission fees and annual fees during first year)

Triple Insurance benefit

No hidden or built-in costs

Quick processing and disposal of loan applications

Flexible repayment options

Guarantee Third party guarantee is not mandatory. HOME LOAN FOR PURCHASE OF 2nd

PROPERTY (HOUSE/FLAT/BETTER ACCOMMODATION) Co-Applicant

Prospective borrower can include spouse or any other co-owner as a co-applicant.


To enhance the loan amount, co-applicant's income can be taken into account while

calculating repayment capacity.

Eligibility

Loan can be availed for the second property even while the existing house/flat is under

mortgage to Banks/Financial Institutions (subject to conditions).

Quantum

Depends on the repayment capacity as well as the cost of the property.

80% of the cost (cost will include cost of house, stamp duty, registration fees, transfer

fees, if any, and all such charges.) subject to maximum of Rs.50,00,000 or 4 times the

gross annual income, whichever is less.

Repayment

Maximum repayment period is 20 years (including moratorium) OR permissible up to the

retirement age of the borrower OR 65 years (in case of professionals/businessmen)

whichever is earlier.

The existing house to be disposed off in 12 months time (optional) and sale proceeds to

be deposited in the loan account.

The EMI would be fixed on balance amount outstanding in the account.

Margin

If money from the sale proceeds of the existing house is deposited in the account, the

same would be treated as margin.

Security


Similar to Home Loan.

Processing Charges ( Processing charges excluding applicable service tax ) 0.50% of loan

amount subject to a maximum of Rs.15000/- and payable -

0.25% of the loan amount at the time of application plus service tax as applicable

0.25% of loan amount on acceptance of sanction plus applicable as applicable

Other Attractive Features

No prepayment penalty

Free Insurance facility against Fire, allied perils including Earthquake, Personal Accident

(Death)

Flexible repayment schedule

Easy and convenient EMIs

Loan sanctioned within 72 hours of receipt of application in full as per requirement.

Option to pay interest on a daily reducing balance basis.

Other Conditions: No Prepayment penalty if the loan is adjusted by the borrower from his own

verifiable legitimate sources or genuine sale. However, 2% charged on an average o/s. balance of

last 12 months if loan is closed on take over by other Banks / Financial Institutions.

Union Top up:

ELIGIBILITY


Existing home loan borrowers (Standard Assets with regular EMI repayment) who

Are salaried/professional & self employed, agriculturists or business men having regular

source of Income.

Have repaid minimum 24 EMIs in Home loan account and

Where net take home pay/monthly income is not be less than 35% of gross monthly

income/earnings after considering all deductions including the EMI of the proposed TOP-up

Loan.

PURPOSE

To meet any type of expenditure in respect of the House viz. repairs/renovation/ remodeling /

furnishing etc.

NATURE OF FACILITY

Term Loan (Floating)

QUANTUM

The maximum amount of loan can be extended upto 50% of EMIs repaid subject to minimum of

Rs.50,000/- to Maximum of Rs.5,00,000/-

RATE OF INTEREST (w.e.f. 01.04.2009)

Union (Original Housing Loan (Original Housing Loan APOORVA GHOSH4108024024MBF 2008-2010 28

Top-Up Limit upto Rs.30 lacs) Limit Above Rs.30 lacs)

Term

Loan

BPLR – 1.75% i.e. 10.25%

(Floating)

BPLR –1.00% i.e. 11.00%

(Floating)

MARGIN

50% [i.e. only 50% of the amount already repaid will be considered as top-up loan

subject to maximum cap].

PROCESSING CHARGES

0.50% of the Top-up Loan amount.

SECURITY

Existing Mortgaged House will continue as security (the house for which housing loan is

extended and is secured by EM.).

GUARANTEE

Guarantee is applicable wherever guarantee is taken in the existing Home Loan.

REPAYMENT

The maximum repayment period is of 5 years or left over period for the borrower before he

attains retirement or 60 years of age which ever is earlier. Term loan is subject to review every

year

TAX BENEFITS

Accrued interest on Top-up loan is eligible for exemption under section 24 of Income Tax Act,

provided the loan is granted for the purposes of renovation, additions, repairs or reconstructions


of house property. However, if the loan is granted for furnishing of house, such exemption is not

available. (The Installments towards repayment of Principal is not eligible for exemption under

Income Tax).

Union Miles:

Union Miles Scheme is offered to individuals /frims for vehicle finance for thier personal use.

ELIGIBILITY

Individuals of the age 18 years and above

Permanent employee of Central/State/Defence/Police Force/Public or Joint Sector

Undertaking/reputed firms/ established Educational Inst.

Professional/Businessmen having regular income.

Borrower has at least minimum services to liquidate the loan 1 year prior to retirement.

Firms / Companies.

A Minimum of 40% marks as per investment grade scoring chart

PURPOSE


For Purchase of new two/four wheelers, for personal or professional use

Second hand vehicles upto 3 years old also eligible.

QUANTUM

4 Wheeler- 4 times the net income /net annual salary subject to a maximum loan of Rs 25 lacs

for new vehicle and Rs 10 lacs for old vehicle

2 Wheeler- 4 times the net income /net annual salary

subject to a maximum loan of Rs 1 lacs for new vehicle

MARGIN

15% of cost of vehicle.

50% of old vehicle.

Under tie-up - 10%. or agreed upon

REPAYMENT

4 Wheelers - A Maximum of 60 months in Equated Monthly Installments(EMIs).

2 Wheelers - A Maximum of 36 months in Equated Monthly Installments(EMIs).

Under Tie-up

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

4 Wheelers - A Maximum of 84 EMIs (Ford India)

2 Wheelers - A Maximum of 60 EMIs (Bajaj Auto Ltd.)



Period Rate Of Interest

4 wheelers

Upto 3 Years 11.00% p.a

Above 3 Years 11.25% p.a

Rate of Interest (w.e.f 01.04.2009)

2 Wheelers

Upto 3 Years 12.75% p.a

Above 3 Years 13.25% p.a

Old Cars(< 3 Years) 13.25% p.a

PROCESSING CHARGES (EXCLUDING SERVICE TAX)

Two Wheelers Rs. 250

Four Wheelers Rs. 500 per vehicle for Loan upto Rs. 2 Lacs.

Four Wheelers Rs. 1000 per vehicle for Loan over Rs. 2 Lacs.

SECURITY

Hypothecation of vehicle financed by the Bank.

Bank's lien to be got noted with the Transport Authorities.


GUARANTEE

Guarantee of the spouse. In case unmarried, third party guarantee with sufficient means.

OTHER CONDITIONS

No Pre-Payment penalty if the loan is adjusted by the borrower from his own verifiable

legitimate sources or genuine sale. However, 2% charged on an average o/s. balance of

last 12 months if loan is closed on take over by other Bank/Financial Institutes

Comprehensive Insurance with Bank Clause.

Salary Certificate/proof of income and proof of residence to be obtained and held on

record.

Union Comfort:

ELIGIBILITY

Age 18 yrs completed.

Permanent employee of Central Government / State Government/ Defence / Police

Force / Autonomous bodies / Public / Joint Sector undertaking / Corporations / Limited

Companies / Firms / Established Educational Institutions.

Individuals having regular income.

Tax payers, Non-I-T permissible if annual pay Rs.1 lac or more and net take home annual

pay Rs.0.40 lac - after deducting EMI of present loan.

Salary accounts with financing branch.

Min. 40% marks as per investment grade scoring chart.


PURPOSE

To meet personal expenses or purchase of consumer durables.

QUANTUM

6 months net salary not exceeding Rs. 1 lac for salaried class.

For others, 50% of annual income as per last 2 IT returns (not exceeding Rs.1 lac.)

MARGIN Nil.

REPAYMENT

In 36 Euated Monthly Instalments(EMIs). Repayment starts from the nest month of disbursement

of loans.


15.00%.

Concession in the rate of interest can be considered by Regional Head in case of group

borrowers.

10% under HCL Tie-up scheme for purchase of PCs.


Rs. 100 upto Rs. 10,000/-

Rs. 250 upto Rs. 50,000/-

Rs. 500 above Rs. 50,000/-

SECURITY


One Guarantor having means equivalent to the loan amount, Hypothecation Of Asset wherever

applicable.

OTHER CONDITIONS

Proof of Income (Salary Certificate).

Proof of Residence (latest Tel. Bill/Electricity Bill/Employer's Certificate)

Irrevocable undertaking letter from the employer for recovery of installment from salary

every month and to remit to bank directly.

Irrevocable undertaking by the borrower authorising the Bank to recover the loan

installments from his/her salary A/c./SB A/c. with the Branch.

* Prevailing Rate of Interest will be applicable as on date of sanction.

Union Education:

The scheme aims at providing financial assistance on reasonable terms:

To the poor and needy students that they may undertake basic education

To meritorious students that they may pursue higher or professional or technical

education

ELIGIBILITY

The student applying for UNION EDUCATION Loan ought to:

Be an Indian National


Has secured admission to professional or technical courses through an appropriate

Entrance Test or selection process

Has secured admission to a foreign University

Has passed an appropriate qualifying examination

a. Studies in India

School education up to +2

Graduation/Post-Graduation

Professional course

Management course

Special Education Loan Scheme for Students pursuing courses from

approved institutions like IITs/IIMs/ /NIT XLRI/BITS/VIT/IISc/S.P. Jain

Institute Of Management/Symbiosis Institute Of Management and T.S.

Chanakya, Navi Mumbai- Nautical Science and MERI, Calcutta, Marine

Engineering, MERI, Mumbai, Maritime Science.

b. Studies Abroad :

Graduation: For job-oriented professional or technical courses offered by

reputed universities

Post-Graduation: MCA, MBA, MS and such other courses

Courses conducted by CIMA, London, CPA, USA., and such other institution

PURPOSE


To the poor and needy students to undertake basic education. To meritorious students to pursue

higher or professional or technical education.

CONDITIONS

The Parent/Guardian of the student who is availing loan from our bank shall be made co-

obligator/joint borrower irrespective of the age of such students.

The Loan Accounts of students applying through college/institutions will be

sanctioned/disbursed at the branch nearest to permanent residence/place of domicile of

the borrower student.

Loan will be disbursed directly to the college/institute.

Student to produce mark list of previous term/semester before availing next installment.

Student /Parent to provide latest mailing address before availing next installment.

In case of parents with transferable job, new address to be provided before availing installments.

QUANTUM OF LOAN

Need-based finance subject to repayment capacity of the parent or student with margin and upto

the following ceilings

For studies in India - Up to Rs. 10 lacs

For studies abroad - Up to Rs. 20 lacs

MARGIN


No margin for loans up to Rs. 4.00 lacs . However, for loan of higher amounts, the margin

requirement is 5% for inland studies and 15% for studies abroad.

Scholarship/assistance to be included in margin.

Margin maybe brought in on pro-rata basis as and when disbursement is made

REPAYMENT

Repayment holiday or Moratorium on loan: Course period + 1 year OR 6 months after job

placement, whichever is earlier. Starting from this point, the loan is to be repaid in 5-7 years after

completion of course period/moratorium.

RATE OF INTEREST(w.e.f 01.04.2009)

For Male Student :

Up to Rs. 4.00 lakhs : 11.75% (Fixed)

Above Rs. 4.00 lakhs upto Rs.7.50 lakhs : 12.50% (Fixed)

Above Rs. 7.50 lakhs : 12.00% (Fixed)

For Female Student:

Up to Rs. 4.00 lakhs : 11.25% (Fixed)

Above Rs. 4.00 lakhs upto Rs.7.50 lakhs : 12.00% (Fixed)

Above Rs. 7.50 lakhs : 11.50% (Fixed)

For Special Education Loan Scheme :


Special scheme For IIM students : 10.50% for Male

: 10.25 % for Female

Special Scheme for BSc in Nautical Science,Marine Engg,Maritime Science : 11%

Special Scheme IIT/NIFT students: 10.50% for male

: 10.25% for Female

Special Scheme for XLRI.BITS/VIT/IISC/SYMBOISIS/SP JAIN/NIT : 11.00%

Special Scheme for students of ISB(Indian School of Business) only for Hyderabad :

10.50% for male

10.00% for Female

Special scheme for students of Asian Institute of Management : 11.00%

Simple interest will be calculated during repayment holiday/moratorium period.Interest rate is

fixed and will not undergo any change till the loan amount is repaid in full

PROCESSING CHARGES NIL

SECURITY

Upto Rs. 4 lakh : No security

Above Rs 4 Lakh & upto Rs 7.5 lakh : a suitable third party / personal guarantee

However for loans above Rs 7.5 lakh, Collateral security of suitable value along with co-

obligation of parents / guardian / third party / accompanied by assignment of future income of

student for the payment of installments is required. A Life insurance policy from Insurance


company for a sum not less than the loan amount is required to be taken in the name of the

student and duly assigned in favour of Union Bank.

OTHER CONDITIONS

Loans can be considered for eligible students in case they approach the Bank in the subsequent

year of the commencement of the course. Branches can issue Bank Guarantee, for payment seats

wherever required.

No Prepayment penalty if the loan is adjusted by the borrower from his own verifiable legitimate

sources or genuine sale. However, 2% charged on an average o/s. balance of last 12 months if

loan is closed on take over by other Banks / Financial Institutions. The Loan Accounts of

students applying through college/institutions will be sanctioned/disbursed at the branch nearest

to permanent residence/place of domicile of the borrower student.

No Pre-Payment penalty for self-closure. However, 2% charged on an average o/s. balance of

last 12 months if loan is closed on take over by other Bank/FIs.

Union Education Scheme for Commercial Pilot Training Programme / Course Nature of

course/training programme Commercial Pilot Training / Course Eligibility Should be

Indian National.

Should have secured admission to the relevant course through admission test.

Should have secured admission to the foreign institutions for studies abroad. Duration of the

Course 12-24 months Type Of Institution


1. For Course / Training programme in India:

Government or recognized Private Institute approved by Director general Of Civil aviation,

Government Of India.

2. For course/training programme abroad:

The course/ training programme should have been offered by recognized institutions abroad

approved by competent authority in that country eg. in U.S.A the Federal Aviation

Administration, Govt. Of U.S.A.

The licenses issued by such institution should be convertible into corresponding Indian Licences

in case the applicant desires to take up employment in India after completion of course/ training

abroad, as per directives of Director General Of Civil aviation, Government of India.

Quantum Of Loan

Nil margin up to Rs.4 lacs.

Min.5 % margin for loans above Rs. 4.lacs in India.

Min.15% Margin for loans above Rs. 4 lacs for studies abroad.

Scholarships/ assistance to be included in Margin.

Margin to be brought in year to year whenever disbursement made on pro rata basis.

Rate Of Interest

Male Female

For loans up to Rs. 4 lacs 11.75% 11.25%

For Loans above Rs.. 4 lacs and Below 7.5 lacs 12.50% 12.00%

For Loan above Rs. 7.5 lacs 12.00% 11.50%

(1% concession if interest is serviced during moratorium period) Security


No security up to Rs. 4 lacs.

Loan above Rs. 4 lacs and upto Rs. 7.50 lacs- personal guarantee to the satisfaction of the bank.

For loans above Rs. 7.50 lacs- suitable collateral security/third party guarantee acceptable to the

bank.

Life insurance policy for a sum not less than the loan to be taken on the life of the student/

applicant and assigned in favor of the BanK.

Union Mortgage:

ELIGIBILITY

Any qualified medical practitioner / Dentist in the age group of 25 to 60 years with minimum

three years experience and in the age group of 25 to 60 years.

Firms / Companies engaged in medical profession in which Doctors / Dentist are Partners or

Directors or the Proprietor.

QUANTUM

An amount equivalent to 75% of the equipment cost and other Assets to be financed.

MARGIN

Minimum 25% of cost of equipments and other assets to be financed.

REPAYMENT

Maximum 7 years including initial moratorium period of 3/6 months - By Equated Monthly Instalments.

RATE OF INTEREST (w.e.f. 01.04.2009) (BPLR=12.00%)


A Fixed Interest rate of 12.50% for Individuals and 12.50% for others. Interest rate will not

undergo any change till full repayment of the loan .

PROCESSING CHARGES(EXCLUDING SERVICE TAX)

0.50% of loan amount.

SECURITY

Hypothecation of equipment / items purchased out of Bank finance.

Collateral security 50% of loan amount.

EM of premises in case the loan is for acquiring premises

OTHER CONDITIONS

Third Party gurantee is not mandatory

No Prepayment penality if the loan is adjusted by the borrower from his own verifiable

legitimate sources or genuine sale. However, 2% charged on an average o/s. balance of last 12

months if loan is closed on take over by other Banks / Financial Institutions.

* Rate of Interest prevailing on the date of sanction shall be applicable.

Union Mortgage Scheme

[Scheme for financing against Mortgage of immovable property] ELIGIBILITY

Any Individual in the age group of 18-60 years of age owning residential/ commercial property

(land/plot/ building) and who are Income-Tax assesses having net monthly income of

Rs.10,000/- pm in the case of salaried persons and an annual income of Rs.1.20 lacs p.a. in the


case of non salaried perosns. Earning family members income can also be clubbed to arrive the

eligibility criteria.

Individuals who are not Income Tax assessees also eligible for this scheme, subject to production

of proof of income acceptable to the Bank.

A minimum 40 points as per investment grade scoring chart.

PURPOSE

To meet any personal expenditure of varied needs like marriage of children, higher education,

medical expnses or any unforeseen expnses and also as liquidity finance.

QUANTUM OF LOAN

Metro/Urban Semi Urban

- Minimum Rs. 1 lac. Rs.1 lac

- Maximum Rs. 50 Lac. Rs.25 lacs

subject to 36 times of gross monthly income of salaried persons(Net of all deductions including

TDS etc.) whichever is less

OR

- 2 times the Net annual Income in case of others (Income as per the latest IT return less taxes

payable) whichever is lesser.

NATURE FACILITY

Facility can be given in the form of Term Loan or Secured Overdraft. However, SOD Facility

will not be considered for salaried persons


MARGIN

50% of the fair market value of the property mortgaged as per the latest valuation report not

older than six months from an approved valuer of the Bank.

Fresh valuation at the cost of the borrower(s) once in three years required during currency of

advance.

REPAYMENT

Loan amount together with interest is to be repaid in maximum 60 equal monthly installments.

Post-dated cheques fot the 60 EMIs will be collected up-front.

Subject to closure of the loan with full adjustment prior to the retirement in case of salaried class

RATE OF INTEREST (LATEST RATE OF INTEREST WILL BE APPLICABLE)

- Fixed Rate ---- 15.25%

- Floating rate ---- BPLR + 2.50% i.e.. 14.50%

- 2% penal interest to be levied on overdue installment.

[ Present BPLR is 12.00% ]


One time fee of 0.50% of the loan amount, collected up front.

SECURITY

Equitable Mortgage of non-encumbered residential house/flat, commercial or industrial property

situated in Metro, Urban & Semi-urban centres only in the name and possesion of the borrower

and/or his/her family member.


SOD limit is subject to review/renewal every year.

SOD interest to be serviced every month

OTHER CONDITIONS

No Prepayment penalty if the loan is adjusted by the borrower from his own verfiable legitimate

sources or genuine sale. However, 2% charged on an average outstanding balance of last 12

months if loan is closed on take over by other Banks/Financial Institutions.

UNION SHARES

ELIGIBILITY

Individuals holding shares/debentures/bonds either in their name or jointly.

PURPOSE

Personal purposes like Education, Housing, Consumer Goods and such other needs.

QUANTUM OF ADVANCE

The maximum amount that can be granted is up to Rs.20.00 Lacs for security held ONLY in

DEMAT Form.

PERIOD

3 years for Loan repayable in installments.

SOD facility to be renewed/reviewed every year.

RATE OF INTEREST (w.e.f. 01.04.2009) (BPLR = 12.00%)

Rate of Interest BPLR+4.50% i.e. 16.50%


SECURITY

Pledge of shares of those companies approved by the Bank (Please refer to nearest branch of

Bank for the list of approved companies)

OTHER CONDITION

No PrePayment penalty for self-closure. However, 2% charged on an average o/s. balance of last

12 months if loan is closed on take over by other Bank/Financial Insitutions

Union Cash

ELIGIBILITY

Retired employees of Government / Semi Government undertakings, Banks and other reputed

private organisations etc. who draw fixed income / pension through our Bank.

PURPOSE

To meet financial requirements.

TYPE OF LOAN:

Demand Loan repayable in installments with a maximum repayment tenure of 36 months

Term Loan with repayment tenure of above 36 months and maximum upto 48 months.

QUANTUM

Upto Rs.1,00,000/- or 12 times the monthly pension, whichever is less.

MARGIN


25% in case of Deposit Receipts / NSC / Bonds issued by Government of India / Financial

Institutions.

50% in case of Shares & Debentures.

REPAYMENT

12 – 36 EMIs in case of Demand Loan repayable in Installments

Above 36 to 48 EMIs in the case of Term Loan


A fixed interest rate of 13.75% (Fixed)


NO Processing charges.

SECURITY

Pledge of Deposit Receipts / Shares / Debentures of corporates of good standing, NSCs Bonds

issued by Government of India / Financial Institutions etc.

Where sufficient security is not available, personal guarantee of spouse or a person who is the

nominee under pension scheme is to be obtained.

In genuine cases, the Bank may consider this facility on a clean basis.

OTHER CONDITIONS

Declaration is required from the spouse who is eligible for family pensio

UNION SMILE

Pensioners & salaried class who are drawing their pension/ salary throu


gh Union Bank of India.

PURPOSE

To meet unforeseen medical expenses, timely payment of dues to State Electricity Board,

Telephone, School fees and water charge and other such needs.

QUANTUM

Maximum 90% of one month’s pension/salary credited in the account

MARGIN 10%

REPAYMENT

Entire amount of overdraft and interest should be recovered while crediting next pension/salary.

Otherwise, it can be recovered in installments within a period of 3 months, if so required by

borrower.

RATE OF INTEREST (w.e.f. 01.04.2009) (BPLR=12.00%)

2% of the amount of overdraft in the account every month.

Interest to be recovered as and when the pension /salary is credited.

PROCESSING CHARGES Nil.

SECURITY Nil.

OTHER CONDITIONS


The facility can be allowed on an ongoing basis by liquidating earlier dues. Pensioners of Union

Bank of India are also eligible.


CHAPTER

II

REVIEW OF LITERATURE


This chapter basically deals with all the important research works done in the same field as that

of the projects topic. Credit appraisal is not something new, right from the olden days, men has

appraised people, places etc. so that he can bring them to his own personal use and profit from

them. Behavioral science explains rating scales used to measure if not gauge the human psyche

to a certain extent. The same way credit appraisal too has its own procedure. Some of the

important findings and researches are…

This study was conducted to evaluate the effectiveness of a decision support system

(DSS) for credit management. This study formed a part of a larger initiative to assess the

effectiveness of IT-based credit management processes at the State Bank of India (SBI). Such a

study was necessitated since credit appraisal has emerged to become a critical sub-function in

Indian banks in view of growing incidence of non-performing assets. The DSS that we assessed

was a credit appraisal system developed in Quattro Pro® at SBI. This system helps in the

analysis of balance sheets, calculation of financial ratios, cash flow analysis, future projections,

sensitivity analysis and risk evaluation as per SBI norms. We used a strong quasi-experimental

design, called the Solomon's four-group design, for our assessment. In our experiment, managers

of SBI who attended training programs at the SBI training college, were the subjects. The

experiment consisted of measurements that were taken as pre- and post-tests. An experimental

intervention was applied between the pre-tests and the post-tests. The intervention, or stimulus,

consisted of DSS training and use. There were four groups in our experiment. The stimulus

remained constant as we took care to ensure that the course contents as well as the instructors

remained the same during the course of our experiment. Two were experimental groups and two

were the control groups. All four groups underwent training in credit management between the

pre- and post-tests. Results from our research show that while the DSS is effective,

improvements need to be made in the methodology to assess such improvements. Moreover,

such assessment frameworks, while being adequate from a DSS-centric viewpoint, do not

respond to the assessment of a DSS in an organizational setting. In our concluding section, we

have discussed how this evaluative framework can be strengthened to initiate an activity that will

allow the long-term, and possibly the only meaningful, evaluation framework for such a system.


Pension fund industry in India grew at a CAGR of 122.44% from 1999-00 to 2006-07.In terms of

ownership, debit cards are more in number than credit cards but in terms of transactions, use of

credit cards is more prevalent than debit cards.

The ATM outlets in India increased at a rate of 28.09% from March 2006 to March

2007.Outstanding Education loan segment is expected to grow at 36.41% till March 2009 from

March 2007 onwards to cross Rs. 27000 Crore Mark.Two-wheeler finance industry is projected

to forge ahead at a CAGR of 14.21% till 2009-10 from 2005-06.Indian Mutual Fund industry

witnessed a growth of 49.88% from May 2006 to May 2007, and a higher 215.61% growth was

recorded in closed ended schemes. Increasing number of millionaires in India is increasing the

scope of Wealth Management Services. Bankable households in India are estimated to move up

at a CAGR of 28.10% during 2007-2011.

Information Sources

Information has been sourced from books, newspapers, trade journals, and white papers, industry

portals, government agencies, trade associations, monitoring industry news and developments,

and through access to more than 3000 paid databases.

This section covers the key facts about the major players (including Public, Private, and Foreign

sector) in the Indian Banking Industry, including Bank of Baroda, State Bank of India, Canara

Bank, Punjab National Bank, HDFC Bank, ICICI Bank, Kotak Mahindra Bank, Citibank,

Standard Chartered Bank, HSBC Bank, ABN AMRO Bank, American Express, etc.


CHAPTER

III

INTRODUCTION TO THE

PROJECT


In today’s scenario, it is very important to understand that every industry needs to brace itself

and hedge itself against risks. Risks are of various kinds and in different magnitude. No matter

which industry or sector the company belongs it needs to update every day itself to the various

things happening all over the world which may directly or indirectly affect its business, growth

and potential in the market.

With banks the scene is no different, whenever there comes some slowdown or the market

slouches the banks are effected too. Banks are directly related to people and industry and market.

In the recent times, we have seen that the retail loan section of the banks have come up as one of

the important areas. All the big industry, small and medium enterprises and individuals, avail

loans for all their purposes.

The important thing in this case is that, banks can’t give loans to everyone. They need to check

the credit worthiness of the borrower. To rate the worthiness of an individual to that of a

company there are various methods. From checking their market image, their past record,

potential and security provided, it is decided whether they are worthy enough or not. To talk in

more financial terms, for corporate loans there are various methods like balance sheet analysis,

fund flow and cash flow analysis, working capital management, ratio analysis etc.

Every bank also has their own credit rating system; they take into consideration a number of

things, apart from financial workings. All this and more is discussed at length in the coming

chapter.


RISK MANAGEMENT

ENTERPRISE- WIDE RISK MANAGEMENT-EXPECTATIONS FROM THE FIELD

Introduction :

Risk is an integral part of any business environment, more so in the case of Banks, which are in

the business of financial intermediation. The word Risk is derived from the Italian word

‘Risicare’ which means to dare. Risk can be identified, measured and managed while uncertainty

remains altogether unknown and hence unmanageable.

The first step to be recognized is that risk has two distinct phases : risk as opportunity and risk as

hazard. Risk as opportunity is implicit in the relationship that exists between risk and return.

Risk as hazard is what most of us mean by the term.

The second characteristic is that risk is always in future. It always pertains to what can happen

but not what has happened.

The third characteristic of risk Is that it keeps changing with time. Risk management tus is a

process which manages and controls all the three activities.

How does risk matter to the bank?

Banks and Financial Institutions perform the essential function of channelizing funds from those

with surplus funds to those with shortage of funds. Broadly, the risks by the banks today can be

classified as under:

I. Credit Risk : it’s one of the major risks faced by the banks on account of the nature of

their business activity, which includes dealing with or lending to a corporate, individual,

another bank, financial institution or a country. Credit risk includes borrowers risk and


portfolio risk. Borrower risk may be defined as the possibility that a borrower will fail to

meet his obligations in accordance with agreed terns. It may also be reflected in the

downgrading of the standing of the borrower making him more vulnerable to possibility

of defaults. Portfolio risk arises due to credit concentration/investment concentration etc.

II. Market Risk : market risk is the potential of erosion in income or market value of an

asset arising due to changes in market variables, such as interest rate, foreign exchange

rate, equity prices and commodity prices.

a) Transaction Rate Risk : The risk in the erosion of earnings due to variation in

interest rate within a given time zone is referred to as interest rate risk. Interest rate

risk may itself arise on account of gap or mismatch risk, basis risk, embedded options

risk, yield curve risk etc.

b) Exchange Rate Risk : this risk is of two types viz. transaction risk and translation

risk.

Transaction risk – it is observed when movements in price of a currency, upward or

downward, results in a loss of a particular transaction. Transaction risk also

destabilizes the anticipated cash flows.

Translation risk – in a situation of translation, the Balance Sheet of a Bank, when

converted in home currency, undergoes a drastic change, chiefly owing to exchange

rate movements and changes in the level of investments or borrowings in foreign

currency even without having translation at a particular point of time.

Forex risk arises when a bank is holding foreign exchange assets or liabilities that have not been

hedged against movement in exchange rates. This position is referred to as open position. Forex

risk affects both spot and forward position of the bank. Banks are also exposed to movement in

forward premium rates, which is a manifestation of interest rate movements, when there is a

mismatch in the maturity pattern of forward transactions.


c) Equity Price Risk : the risk arises from the potential of an institution to suffer

losses on its exposure to capital markets, from adverse movements in prices of

equity.

d) Commodity Price Risk : the risk arises from the potential of movements in prices of

physical products, which are or can be traded in the secondary market. These

products include agricultural products, minerals, oils and precious metals.

III. Liquidity Risk : it arises due out of the possibility that a bank maybe unable to meet its

liabilities as they become due for payment or may be to find the liabilities at a cost much

higher than normal cost. The risk arises due to mismatch in the timing of inflows and

outflows of funds, and from funding of long term assets by short- term liabilities. Surplus

liquidity could also represent a loss to the bank in terms of earnings missed and hence an

earning risk.

Operational Risk – it arises out of malfunctioning of information systems or service delivery

process or internal sabotage. In all these cases, the losses are similar and even can generate losses

of unknown magnitude.

Systemic Risk – banks are highly inter-related with mutual commitments. Hence the failure of

one institution generates a risk of failure for those other banks which have committed funds with

defaulting bank.

Solvency Risk – it occurs when the bank is landed in a chronic situation of not able to meet its

obligation. This type of risk gives the ultimate impression that the bank has failed.

Other Risks – there are some other categories of risks also such as compliance risk, tax risk etc.


WHY RISK MANAGEMENT IS GAINING

SIGNIFICANCE:

Risk Management is not new to bank, as banking has always been associated with risk. But risk

environment that was prevalent in pre- reform period was much different than what it is today.

The emphasis then was on achieving ‘reasonable’ level of profits instead of maximizing profits

and share holder value. In other words, risks in the normal course of business were taken by

banks, but without much emphasis on managing them. Interest rates then were totally

administered; credit ceilings were in place and allocation of credit was done as per the directives.

All these practically ensured that the banks had no incentives whatsoever in risk management.

However the ongoing financial sector reforms have changed the ball game of banking today. As

compared to the practice of focusing only on achieving higher deposit growth, in the current

context the need for proper management of assets and liabilities has gained importance,

heightened by the need for containment of non – performing assets and attendant provisioning.

Generating internal surplus has assumed critical importance as meeting the prescribed capital,

standard has become inevitable. This calls for allocating the resources optimally and managing

the attendant risk suitably. Here lies the major change in the risk environment for banks.

With tighter prudential accounting norms and higher capital standards, banks have to reckon the

risks they are assuming and returns there on. In other words, while funding costs will have to be

reduced by sourcing funds at the lowest cost, income has to be maximized by allocating the

resources optimally between various assets depending upon the risk return trade off and taking

into account the constraints in maintaining and improving the capital standard. In other words,

the sources and uses of funds will have to be seen in a holistic manner and not in isolation as

hitherto.


Besides, the paradigm shifts, in the operating environment, the major and minor banking failures

during the last decade, has brought into sharp focus the need for risk management. The east

Asian melt down has especially proved that banks have to per se relate their profitability to risks

being assumed and managed by them and sustain a prescribed level of capital standard. The

focus has further shifted to generating adequate level of profits, so that it will ensure not only

future growth but also lead to increase in capital which is critical in ensuring the confidence of

depositors and other stake holders.

In essence, the foundation of risk management lie in the following –

- Banks should exercise control on their assets and liabilities, on the return and costs, to

achieve the desired goal.

- Such controls in turn, should be coordinated and integrated so as to accommodate

attendant priorities and risks and should help in maximizing interest rate spread.

- Cost and yield arise from both the sides of the balance sheet and our policies should be to

maximize the spread and minimize the burden.

Management of risk and profitability are therefore inextricably linked. As various risks are

interdependent, an integrated approach to all the risks faced by a bank is considered most

appropriate.

Initiatives by Reserve bank of India

In a view of the important role banks play in the economy and in the payment and settlement

system, banks are always subject to more regulation by the Central Bank.

RBI has taken various supervisory initiatives to induce better operating standards in banks,

greater transparency and sensitivity towards risk management. Various guidelines, on the subject

matter are outlined below:


Guidelines on Asset Liability Management in banks which includes

Liquidity and Interest Rate Risk

February 1999

Guidelines on Risk Management Systems in Banks October 1999

Guidelines Notes on Credit Risks and Market Risks March 2002

October 2002

Discussion paper on ‘Move towards Risk Based Supervision’ August 2001

Detailed risk profile template to assist banks in undertaking self

assessment of risks.

July 2002

Guidelines on Risk based Internal Audit December 2002

Action points include :

- Identifying gaps in existing risk management practices and procedures and chart out

policies and strategies and road map for addressing the gaps.

- Putting in place required Organization Structure.

- Articulate “Risk Management philosophy, policy and risk limits.

- Put in place robust credit rating system covering all risk issues for rating the borrower.

- Inter Bank limits and exposures.

- Country and transfer risk management.

- System to measure and monitor liquidity and interest rate risk.

- Policy and limits for operational risks. Develop internal processes and expertise in risk

aggregation and capital allocation.

- Develop methodology for estimating and maintaining economic capital.

RBI is closely monitoring the progress in implementation of risk management systems in banks

through periodical review, individual assessment, meetings with management etc.


Credit Risk

Lending involves a number of risks. In relation to the risks related to credit worthiness of the

counter party, the banks are also exposed to interest rate, forex and country risks.

What is credit risk?

Credit Risk is the possibility of losses associated with changes in the credit profile of the

borrowers or counter parties. These losses could take the form of outright default or alternatively,

losses from changes in portfolio value arising from actual or perceived deterioration in credit

quality, short of default.

Credit Risk of a bank has two distinct facts i.e. risk inherent to the individual business unit/loan

account and risk from macro credit portfolio perspective. Credit Risk emanates from banks

dealings with an individual, corporate, bank, financial institution or a sovereign. Credit Risk may

take the following forms:

In the case of direct lending : principal/and or interest amount may not be repaid;

In the case of guarantees or letters of credit : funds may not be forth coming from the

constituents upon crystallization of the liability;

In the case of treasury operations : the payments or series of payments due from the

counter parties under the respective contracts may not be forthcoming or cease;

In the case of securities trading business : funds/securities settlement may not be

effected;

In the case of cross – border exposure : the availability and free transfer of foreign

currency funds may either cease or restrictions may be imposed by the sovereign.

How to quantify Credit Risk?


Credit Risk has got two components : ‘quantity of risk’ which is nothing but the outstanding loan

balance as on the date of default and the ‘quality of risk’ i.e. “severity of losses” which is defined

by both default probability and the receivers that could be effected in the event of default.

Credit Risk is therefore, a combined outcome of –

Default Risk – it is the probability of the event of default i.e. missing a payment obligation. In

today’s parlance, payment default is declared when a scheduled payment has not been made

within regulatory time from laid down.

Exposure Risk – the outstanding balances at the time of default are not known in advances

particularly under facilities like committed lines of credit, ODs, project financing, off balance

sheet items like guarantees/LC facilities etc. this uncertainty prevailing with future amounts at

risk, generates exposure risk.

Recovery Risk – the losses in case of default is the amount outstanding at default time less

recovery. Normally, once a borrower defaults, banks resort to enforcement of security. But

recoveries are not predictable as they depend upon the type of default, availability of risk

mitigators like guarantors, collaterals etc. and their nature/worth besides the prevailing legal

system. It thus involves great amount of uncertainties. These uncertainties can be traced to :

Value of Collateral Security :

Recovery risk depends on the nature of charged assets, their location and possession,

marketability/appeal, legal status etc. At times, the economic value of assets charged may erode

over a period and may even go below the value of outstanding debt. Contrarily, where collaterals

are of high value and are capable of generating buyer’s interest may even cancel the loss.

Guarantor’s value : the net worth of guarantors and in turn their ability to discharge liabilities

upon invocation of guarantee may undergo changes affecting the ultimate realization amount.


Enforceability of Securities : the very ability of a bank to access the securities/collaterals charged

to a bank in order to dispose them off may itself be doubtful. Secondly, enforcement of

securities/contracts is also defined by the prevailing legal system.

In view of this, it becomes difficult to predict the recoverable amount in advance.

The combine outcome of all three elements ultimately defines the credit risk of a bank. Once

these estimates are made, the loss in case of default can be measured by using the formula –

EL= PD × EAR × LGD

Where,

EL= Expected Loss

PD= Probability of Default

EAR= Exposure at Risk

LGD= Loss Given Default i.e. (1-Recovery Rate)

Now the moot question is how to assign values to the formulae and that is where ‘risk’

identification and measurement assumes greater significance.


What is Credit Risk Management?

Credit Risk Management covers the systems and processes in place to

Identify and measure the risk involved both at the individual transaction level and portfolio

level.

Evaluate the impact of exposure on Banks balance sheet/profit.

Assess the capacity of risk – mitigators.

Design an appropriate strategy to arrest risk – mitigators leading to deterioration in credit

quality/default risk.

It is to be emphasized that Credit Risk Management is not NPA management. NPAs are a legacy

of the past in the present. Credit Risk management is action in present for the future. In an NPA

account, the Credit Risk has crystallized. Credit Risk Management is more concerned with

quality of credit portfolio before default. The Credit Risk approach monitors worsening credit

quality by tracking migration of assets down the rating ladder, with each rating downgrade

representing a higher Credit Risk. This approach enables bank management to take timely action

to stem deterioration in credit portfolio quality much before actual default, which is the last step

in the rating ladder.

Credit Risk Management is also not merely credit management. Credit Management, as is

understood conventionally, is confined to selection, limitation, and diversification and includes

management of NPAs also. In selection i.e. granting a loan or making an investment, borrower’s

financial condition, profitability, cash flows, nature of borrower’s industry, his competitive

position therein, quality of management, presences of collaterals etc. are assessed to ascertain the

repaying capacity. Limitation ensures that individual or group borrower concentrations are not


very large and is within the prescribed exposure limit. Diversification is related to limitation and

is based on the age-old principle of not putting all the eggs in one basket. This age-old concept of

Credit Management is necessary and would continue to hold good but it is not proving adequate

for management of credit risk in today’s deregulated environment.

It may be appreciated that the traditional Credit Management focuses on probability of

repayment. Credit Risk Management, on the other hand, focuses on probability of default. It is

more sophisticated than the simple credit management techniques. Some of the differences in the

existing Credit Management approach and the Credit Risk management. Approach as envisaged

by RBI are given in the following table:

CREDIT MANAGEMENT CREDIT RISK MANAGEMENT

It is based on Asset-by-Asset or Stand-alone

approach to credit management. The risks in

the portfolio as a whole are not captured.

It is based on Portfolio approach to risk.

Expected Loss [EL] and Unexpected Loss

[UL] are not measured. Losses are recognized

in the accounting sense or as per the regulatory

guidelines.

Measurement of EL and UL is carried out as an

integral credit risk management process.

The concentration risks are identified on the

basis of owned funds/industry/geographical

area etc.

The concentration of risks are measured in

terms of additional portfolio risk arising on

account of increased exposure to a

borrower/group of correlated borrowers.

The correlations among constituent assets are

captured to arrive at a measure of Portfolio.

The strategy under this approach is to originate

The loan and hold the loan till maturity.

Credit risk management techniques allow

active credit risk through securitization/credit


derivatives etc.

RBI in its Guidelines of 1999 and the subsequent Guidelines Note on Credit risk management

has outlined the broad framework on various facets of Risk Management. It includes, in main,

the framework of following instruments of Credit Risk Management:

1. Organizational Structure

2. Credit Risk Measurement that includes appraisal, rating and pricing.

3. Appropriate Credit Administration

4. Limit Structure

5. Documentation Standards

6. Loan Review Mechanism

7. Portfolio Management and System Infrastructure


GENERAL PROCEDURE TO COMPILE A CREDIT REPORT

While compiling a credit report there are certain things one has to include, which are very

necessary for any bank to process a loan or advance. Every bank requires the borrower to

submit all the legal documents with the report, this makes the banks work considerably easy, in

order to process a loan. The following are the steps required to file a credit report;

1. Take the party’s letter head.

2. Take the visiting card of the person is interviewed.

3. Constitution : Whether it is a worthy partnership or proprietorship.

Date of being established – at which place

Any changes thereafter due to entry/exit

Of some partners.

4. Capital : Authorized Capital :

Paid-up Capital :

Reserve & Surplus :

5. Partners /Directors : Name :

Address Residential :

Bio-data in brief.

6. Establishment : Name & Address of Head Office or Registered Office. Also of

branches/ offices, if any.

7. Banking with which branch. Limits enjoyed. Address of that branch.


Materials required : Name of the materials and policy of purchase.

8. Nature of Business : Credit given to buyers for how many days – credit received for

how many days.

9. Factory : Location/ Address

Household /Freehold – Ownership in whose name

Rent / Outgoing paid (amount and to whom)

10. Associate concern

11. Residential details : Address – Area – ownership/rental details in whose name – any

other property.

12. Godown : Details address – Area – ownership/rental – keys with

13. Other bankers details : Name – address – limits enjoyed at present

14. Bio-data of partners: They are partners/director in other companies/firms, if any and

qualifications – educational, previous experience.

15. Market opinion

16. Capital reserve – (advance tax paid on asset side, miscellaneous exp.)

17. Balance Sheet : Latest completed year- should be audited, , if not provisional.

Amount Paid to directors/partners.

18. Profit & Loss : stock, purchase, gross profit, closing stock, sales.

19. Observations on final Accs : Capital loan to/from sister concerns – interlocking of

funds – major items of expenses

20. Income declared/ assessed.

21. Wealth Tax: Copy sheet of wealth of partners – also assessment orders of WTO

(1)Exempted (2)Taxable (3)Total

22. Enclosures 1) Final Accs (audited)

2) Assessment orders of income of firm/partners and of wealth of

partners

3) Sales/ purchases monthly figures of latest years.

4) Copies of Challan of income tax/ wealth tax.

23. Information given by whom?


24. Reference given by whom?

25. Mention what specifically could not be obtained to help forming or compiling the

credit report.

The procedure relating to submission of data is explained below:

A) TIME DEPOSITS INCLUDING CUMULATIVE DEPOSITS

For submission of data relating to time deposits Union bank Branches have been classified into following

categories:

TYPES OF BRANCHES PROCESS

a) PBA BRANCHES WHERE TERM

DEPOSIT PACKAGE IS RUNNING

LIVE AND TBA BRANCHES

The ALM program which has been supplied by

the central accounts department facilitates

transfer of data directly from the deposit

package to ALM system. Therefore, branches

are only required to transfer the data to ALM

system at the month end and forward the same

to their RCCs by email latest by 5th working

day of the next month.

Branches where cumulative deposit is not line

on the deposit package should update the

details relating to these in ALM data entry

module and forward the relevant (soft copy) to


RCC.

b) PBA BRANCHES WHERE TERM

DEPOSIT PACKAGE IS NOT LIVE

These branches would continue to update the ALM

data through the data entry program supplied

by central accounts department. Ideally, details

of deposits accepted, renewed and closed

should update on the daily basis to avoid delay

in reporting. The data base should be

forwarded to respective RCC by e-mail latest

by 5th working day of the next month.

c) MANUAL BRANCHES These branches are not required to update the

data base on monthly basis. Therefore, RCC

would continue to generate turn around

statements for these branches on a quarterly

basis. The turnaround sheets will be updated by

these branches and submitted to RCCs on a

quarterly basis.

B) TERM LOANS

FOR SUBMISSION OF ALM DATA RELATING TO TERM LOANS, BRANCHES HAVE BEEN CLASSIFIED AS

UNDER:

TYPES OF BRANCHES PROCESS

a) PBA/TBA BRANCHES The data entry packages for term loans has

already been installed at these branches by

RCCs. The data base has been created for all

loans as of 31st march, 2001. Therefore, these


branches are only required for new accounts

and pre payments, if any, in the system. The

accounts which have been adjusted are also

required to be updated in the system.

b) MANUAL BRANCHES These branches are not required to update the

data base on monthly basis. Therefore, RCC

would continue to generate turn around

statements for these branches on a quarterly

basis. The turnaround statements will be

updated by these branches and submitted to

RCCs on quarterly basis.

C) MATURITY PROFILE OF BILLS

Maturity profile of bills will continue to be worked out branches on quarterly basis.

D) MATURITY PROFILE OF BORROWINGS

This statement will also be submitted at quarterly intervals by the branches which are controlling

the refinance from SIDBI and RBI.


SOURCES OF INFORMATION

1. CUSTOMERS OF THE BANK

2. BUYERS/SELLERS OF THE BORROWERS

3. COMPETITORS

4. OTHER BANKS

5. NON BANKING FINANCE COMPANIES (BLACK LISTING BY LEASING

ASSOCIATION)

6. INDUSTRY/TRADE ASSOCIATIONS

7. GOVERNMENT CELLS/DEPARTMENTS i.e. DEPARTMENT OF INDUSTRY

ETC.

8. NEWSPAPERS/PRESS REPORTS AND FINANCIAL JOURNALS

9. ANNUAL REPORTS/ FINANCIAL STATEMENTS

10. DATA BASE/ CLIPPING AGENCIES

11. CREDIT AGENCIES (EG. CRISIL), Cybercline 2000 etc.



CHAPTER

IV

RESEARCH METHODOLOGY


OBJECTIVE :

The basic objective behind joining UBIs Credit department was to learn about how retail loans are sanctioned.

The process behind every small and big loan

The credit rating system and the methodologies applied.

The way balance sheet and other financial techniques are used in deciding whether or not to approve the loan.

The other important aspects apart from the financial techniques which are of equal importance.


ASSET LIABILITY MANAGEMENT

ALM can be defined as the management of Net Interest Margin (NIM is ratio of net

interest income or spread to total earnings) to ensure that its level and riskiness are

compatible with the risk – return objective of the institutions.

ALM is more than just managing asset and liability categories. It is an integrated

approach to financial assets and liabilities both mix and volume with the complexities of

the financial markets in which the institution operates.

ALM function informs the management as to what the current market risk profile of the

bank is and the impact that various alternate business decisions would have on the future

risk profile.

Assume that the structure of the existing assets and liabilities is such that at the aggregate,

the maturity of assets is longer than the maturity of liabilities. This would expose the bank to

interest rate risk as the interest rate can increase or decrease. Thus the interest income can suffer

in the process. This has to be set right either by reducing the maturity of assets or increasing the

maturity of the liabilities.


Importance of ALM in the present scenario:

Prior to introduction of financial sector reforms all activities undertaken by the bank were

subjected to RBI regulations, which included,, minimum lending rates, regulated deposit interest

rates etc. The products available to the users were also limited and banks had wide spreads. The

introduction of reform process however brought phased deregulation, new market players with

new products at competitive rates. With all these came a number of risks which include credit

risk, liquidity risk, foreign exchange risk, market risk etc. in view of these developments

necessity was felt to develop some system which should help achieve the organizational

objectives while effectively managing the assets and liabilities. ALM is that system to take care

of the above.

ALM Process:

Data is the key raw material for ALM and hence the system should be able to provide

accurate and reliable information.

ALM is a comprehensive and dynamic frame work for (a) measuring (b) monitoring and

(c) managing the market risk which is required to be built around a foundation of sound

methodology, human and technological infrastructure and risk philosophy.

ALM has to be closely integrated with the bank’s business strategy as this affects the

future risk profile of the bank.

Constituents of a sound ALM system:

ALM information system

ALM organization (ALCO, Board and ALM desk)

ALM process i.e. risk parameters, risk identification, risk management, risk

measurement, risk policies and tolerance levels.


ASSET LIABILITY MANAGEMENT IN UNION BANK:

The Asset Liability Management system in the bank has fairly stabilized. Union Bank is one of

the few public sector banks who are leading in implementation of ALM and risk management

guide lines of reserve bank of India. Apart from the regulatory requirements, ALM information

is frequently used by the top management and Assets and Liability Committee (ALCO) for

taking strategic decisions with regard to pricing of assets liabilities , investments, funding etc.

We describe below some of the major functions of ALCO. The decisions of ALCO are based on

data furnished by branches with regard to maturity profile of major items of assets and liabilities

like term deposits, term loans, bills etc.

Functions of ALCO

Fixation of interest rates on deposits and advances

Strategy for business growth and desired maturity profile of such incremental assets

and liabilities

Funding plan including source and mix of such funds

Hedging of ALM gaps based on interest rate view.

At present the following details are captured from branches under the ALM information system:

a) Details of time deposits including cumulative deposits

b) Details of all standard term loan

c) Maturity profile of bills

d) Maturity profile of borrowings


METHODOLOGY FOR COMPUTATIONS OF “NET WORTH” OR

“MEANS” OF VARIOUS TYPES OF BORROWERS

TYPE OF BORROWER

1. Individual/Proprietary Concern

Following factors may be taken into account for computing the “Net Worth” or “Means”

a) Capital investment in the business including investment in other partnership firms

b) Moveable assets such as Bank Deposits, Gold Ornaments/ Jeweleries, Investment in

shares/ debentures/Securities, Company Deposits etc.

c) Personal unencumbered immovable properties

Self – acquired properties of an individual

The share in the ancestral properties acquired on division of HUF

2. Partnership Firms/ Joint Hindu family Concerns:


Capital invested in the business by all the partners (figures to be obtained

from Balance Sheet of the firm)

Undivided profits

Drawing by the partners

Investment in subsidiary firms

Accumulated losses

Net estimated worth of the firm will be :-

Total of (a) & (b) less total of (c), (d) & (e).

3. Limited Liabilities Companies


a) Paid-up capitalAPOORVA GHOSH4108024024MBF 2008-2010 80

b) Free Reserve (including balance in share premium account, capital and other

debenture redemption reserves and any other reserves not being one created for

repayment of any future liability or for depreciation in assets or for bad debts or a

reserve created by revaluation of the assets)

c) Accumulated balance of loss, balance of deferred revenue expenditure as also other

intangible assets

d) Investments in subsidiary or branch companies and loans/advances due from

subsidiary companies/affiliates, other than those of a trading nature.

Net estimated worth of the company will be:-

Total of (a) & (b) less total of (c) & (d).

COMPLIANCE WITH ACCOUNTING STANDARDS


Accounting as a ‘language of business’ communicates the financial results of an enterprise to

various interested users by means of financial statements. Financial statements summarize the

financial results and activities of an enterprise during an accounting period. Financial activities

should be presented in such a manner so that there is an optimum flow of information. Therefore,

how to present it in financial statements is a significant issue at a point of time. In today’s

complex business environment, the measurement and presentation of financial information is

critical. Like any other language, accounting has its own set of rules that have been developed on

the basis of general acceptance and experience of the users of the financial statements.

Accounting standards are formulated with a view to bring uniformity in the treatment of various

accounting policies and practices existing for the preparation and presentation of the financial

statements. The objective of accounting standards Is to make financial statements of different

enterprises comparable to provide meaningful information to various users of financial

statements. Accounting standards make the information provided by the financial statements

useful, transparent and comparable for the users if the financial statements.

In our country, the Institute of chartered Accountants of India [ICAI] issues the accounting

standards to harmonize the diverse accounting policies and practices at present use in India. The

ICAI constituted the Accounting Standards Board [ASB], the composition of which is broad

based with a view to ensuring wider participation of all interest groups in the standard setting

process.

It needs to be understood that the Accounting standards cannot be absolutely rigid like those of

the physical sciences. These rules, accordingly, should provide a reasonable degree of flexibility

in line with the requirements and technological developments. It may also be noted that the

treatment as specified by the Accounting standards.


Every business enterprise needs money constantly for its operations and such money is provided

by the owners themselves, the gap, if any, being bridged by outsiders, viz., creditors. These funds

are constantly in movement, involved in various financial transactions, thus continuously altering

their form and content. A periodical assurance about their safety is, therefore, required by both

the owners and the creditors. Further, if the enterprise happens to be limited company-the owners

are the shareholders who do not exercise any direct control over the day-to-day affairs or

administration of the Company, this being entrusted to the Board of Directors or the

Management team. The management is, therefore, bound by law as well as contractual

obligations to use such funds in accordance with the mandate of the purveyors of funds and

produce evidence of having done so at periodical intervals. Financial Accounting is the manner

of recording all financial transactions so as to enable extraction of the evidence mentioned

above.

Financial Accounting is the “art of recording, classifying and summarizing, in a significant

manner and in terms of money, transactions and events, which are, in part at least, of a financial

character and interpreting the results thereof. Financial Accounting, therefore produces a

significant summary of all recorded financial operations for the purpose of interpreting the end-

result of such operations. Such a summary is called the Financial Statements, which comprise the

Balance Sheet and the Profit and Loss Statement.

American Institute of Public Accounts describes Financial Statements as under:

“Financial Statements are prepared for the purpose of presenting a periodical

review or report on the progress by the Management. They deal with the status of

investment in the business as also with the results achieved during the period. They

reflect a combination of recorded facts, accounting conventions and personal judgments.

And, the judgments and conventions applied affect them materially. The soundness of

judgment necessarily depends upon the competence and integrity of those who make them

and on their adherence to generally accepted accounting principles and conventions.”


This definition is very appropriate as it succinctly but nonetheless effectively brings out the

characteristic features of Financial Statements, their strengths and weaknesses and their

reliability and limitations. This understanding is very important to us since the reliability or

authenticity of the Analysis of the Financial Statements would, it will be appreciated, be just as

much as that of the Financial Statements themselves. This definition indicates the following

characteristic features of the Financial Statements:

I) They are periodical review of the status of investment and progress made by the

Management

ii) They contain facts recorded on the basis of accounting conventions and exercise

of personal judgments.

iii) Integrity and competence of accountants who prepare them have a vital bearing on the ultimate results furnished by them.

A major weakness of Financial Statements is its lack of objectivity, being influenced largely by

subjective exercise of judgments. For instance, in the hands of unscrupulous management with

fraudulent intentions, manipulations are possible, which could distort, to a large extent, the

ultimate results, thus camouflaging the real picture. Nevertheless, if the accountant compiles the

statements diligently and without personal bias and on the basis of established and generally

accepted accounting conventions, the Financial Statements do reflect the financial conditions of

the limited companies to examine, among others, the accounting practices, and procedures and

comment on whether the Financial Statements give a ‘true and fair view’ of the state of affairs

and the net result. The Auditor’s Report is, therefore, an independent professional guarantee for

compliance with the generally accepted accounting principles and to that extent, takes care of

lack of objectivity, and an intelligent scrutiny of the Annual Report is bound to bring out

Auditors reservations, if any, on this subject.


To ensure the genuineness of the financial statements and that of the signatures of the chartered

accountants therein, in case of large borrowers, viz. borrowers whose fund based limits are Rs.1

cr and above, a confirmation is to be obtained by sending a letter by Post/ e-mail regarding

certification of financial statements from the Chartered Accountant who has signed the balance

sheet / financial statements of the borrowers and this confirmation will be kept with the files of

correspondence pertaining to the borrower.


Balance Sheet Analysis

Balance Sheet, as the name indicates, is a statement of balances, depicting the state of affairs or

position of a business enterprise. Since it is an aggregation of balances, it pertains obviously to a

particular date. As on the date of reckoning, it discloses to the user of the statement of the

investment of funds made by the enterprise on various classes or categories of assets and the

various sources from which funds have been drawn to enable such investment. It would be useful

to visualize a Balance Sheet essentially in terms of the resources of an enterprise and claims held

against such resources provided to it. Clearly every person or organization providing funds to the

enterprise (either directly as investors and lenders or indirectly by providing credit or deferring

payments due to them) will have claims against the assets or resources of the enterprise and will

expect such claims to be met at appropriate times, inevitably there is a cost attached to claims,

which needs to be reimbursed to all outsiders either in a Lump sum at the time of repayment of

the principal amount of the claim or in installments at the option of the providers of funds. Thus,

it behaves of the manager of the enterprise to conduct the affairs of the business in such a way

that the following objectives are met

i) the funds provided to the manager by the owners/shareholders and lenders/other

creditors are judiciously invested to create certain assets,

ii) the assets so created should be capable, through their operation and use by the

manager, of yielding the highest return in terms of the net income after meeting

all expenses and charges incurred in earning that income.

iii) the net income so earned should be adequate to service the cost of funds, viz,

interest on loans and dividend on capital, in addition to redemption of the capital

funds (principal) where stipulated, and to leave a surplus for future growth.

iv) the surplus funds should be so invested as to enable their prompt and ready

encashment to meet maturing claims against the enterprise.


The Balance Sheet of an enterprise is basically analysed to test the above hypotheses and can,

therefore, be deemed to reflect the financial condition of the enterprise. It was for this reason that

some of the U.S. accountants and business organisations refer to Balance Sheet as ‘ A Statement

of Financial Condition’. While this is so, the Balance Sheet has certain limitations and cannot be

treated as the sole indicator of financial position of a unit.

Format of Balance Sheet:

The Balance Sheet can be presented either in a ‘ T’ form or in a vertical order, beginning with

assets. While the Companies Act, 1956, prescribes the form in which the Balance Sheet has to be

presented by the limited liability corporations, there is no such standard form for non-corporate

organisations.

Schedule VI Companies Act, 1956 contains the format in which limited companies should

present the Balance Sheet to the shareholders. The format has been devised by the framers of the

Act, keeping essentially the interests of the shareholders in view, though there are provisions in

the Act to protect the interests of all classes of persons or organisations who transact business

with the Company.

The grouping of the various assets and liabilities in Schedule VI follows the familiar dictum that

assets and liabilities should be detailed in their order of permanence. For instance, assets start

from fixed assets-the near permanent assets - and go down to current assets, loans and advances

which are regarded as being closest to cash in terms of their convertibility to cash within a short

period. Similarly, the liabilities start with share capital - the near permanent source of funds to an

enterprise - and travel through long term loans down to current liabilities and provisions, the last-

mentioned items requiring layout of funds by the enterprises at short notice.

In accountant’s parlance, current assets, could, therefore, be converted into cash within a period

of 12 months and current liabilities are those liabilities that mature for payment within 12

months. Thus “advances to staff and group companies” for instance can be a current asset, if they

satisfy the test of conversion to cash within one year.APOORVA GHOSH4108024024MBF 2008-2010 87

Balance Sheet: Format As Per Schedule VI Of Company’s Act,

1956

For Corporate Entities

LIABILITIES ASSETS

1 SHARE CAPITAL

- Authorized Capital (Preference and

Equity Separately )

- Issued Capital

- Subscribed Capital

- Paid- up capital

- Less: Calls Unpaid

Add: Forfeited Shares

(Only Paid-up Capital is added into

the total of the liabilities)

Add: Share Application Money

2 RESERVES AND SURPLUSES

- General reserves

- Share Premium Amount

- Other reserves

- Sinking Funds

- Retained Profits

3 SECURED LOANS

- Cash Credits

- Term loans

- Debentures

4 UNSECURED LOANS

1 FIXED ASSETS

- Gross Block

- Less: Depreciation

Net Block

- Capital working in progress

- Distinguishing as far as possible

between various items of

expenditure i.e. goodwill, land and

building etc.

2 INVESTMENTS

- Investment in Govt. or trustee

securities

- Investment in shares/debentures of

subsidiary companies

- Investment of capital of partnership

firms

3 CURRENT ASSETS

- Cash and Bank Balances

- Stock

- Sundry Debtors

a) O/s for a period exceeding 6

months


- Loans from Associates and

Subsidiaries

- Fixed Deposits

- Other Loans and Advances

5 CURRENT LIABILITIES AND

PROVISIONS

- Acceptance

- Sundry Creditors

- Unclaimed dividends

- Subsidiary Companies

- Interest Accrued but not due

PROVISIONS

- For Taxations

- For Providend Funds

- For Proposed Dividend

- For Contingencies

- For Other Provisions

b) Other debts

4 LOANS AND ADVANCES

- Advances for capital goods

- Advances to staff

- Loans to sister concern

5 MISCELLANEOUS EXPENDITURE

- Preliminary expenses

- Expenses including commission,

brokerage etc.

- Discount on shares and debentures

- Interest paid out of capital during

construction

- Development expenditure not

adjusted

6 PROFIT AND LOSS ACCOUNT

- Debit balance of profit and loss

account carried forward

TOTAL TOTAL


FOR OF BALANCE SHEET (FOR NON - CORPORATE)

TRADING ENTITIES

Name of Entity/Entities

Balance Sheet as at

Figures for Capital and Figures for Figures for Properties Figures For

Previous year liabilities Current year Previous year and Assets Current Year

1. CAPITAL (In case of partnership, these 1. FIXED ASSETS

particulars to be given separately for each Under each head the original cost the

partner and if possible the fixed capital addition thereto, deductions three from

accounts may be segregated from the the year and the total depreciation

current accounts) as at the beginning written off or provided up to the end of the

of the year. Year to be stated.

Where the assets have been revalued, the

Add/ Deduct net profit /Net Loss during revalued figures to be shown. Each balance

the year. Sheet for the first five years. Subsequent to

Interest on Capital the date of revaluation to state the amount

Drawings of revaluation.

Any other items (give details) distinguishing as far as possible between

Expenditure upon.

a) Goodwill

b) Land

c) Building

d) Leasehold

e) Railway sidings

f) Plant and machinery

g) Furniture and fittings

h) Development of property


i) Patents, trademarks and designs

j) Livestock

k) Vehicles etc.

1. Cost

2. Less : depreciation

2 RESERVES (give details under each head) 2 ADVANCES AND DEPOSITS ON

Capital reserves (if any) CAPITAL ACCOUNT

1. Other reserves (including retained profits

To the extent not already added to the

Capital, given details )

3 LOANS AND BORROWINGS 3 INVESTMENTS

Interest accrued and due on each category Investments in shares, debentures or bonds

To be shown separately. In case of secured (Note: Investments in concerns wherein

Loans the bature of security to be specified. Proprietor, partner or their relatives are

Amounts due for payments within one year interested to be shown separately)

From the balance sheet date to be shown Immovable properties

Separately. Loan from partners, relatives of Investments in the capital of partnership

The proprietor or partners to be shown separately firms.

Loans from financial institutions. Other Investemnts.

Loans and borrowings from banks (specify the

Name of the nature of the borrowing e.g. cash

Credit term-loans, overdraft, packing credit etc.)

Fixed deposits (from public and others)

Others (give details)

5 CURRENT ASSETS

a) Investories

Stock in trade.


Supplies and sundries (if the trading

Organization is also involved in any

processing activity/ies other

categories of inventories e.g. raw

material and work in progress

should be separately disclosed.

b) Recievables

Debts due and outstanding for a

period exceeding six months

Installments of deferred recievables

due within one year to be shown

separately.

Amount due from proprietors,

partners or associated concerns

On account of sales deferred

payment basis.

On account of exports

Others.

Total receivables

Less : provision for bad and

doubtful debts

c) Bills of exchange

d) Advances on current Account

Advances of suppliers of raw

material and

stores/spares/consumables;

Advance payment of taxes

Pre-paid expenses

Others


e) Cash and bank balance

Fixed deposit account

Current and saving account

Cash in hand

f) Miscellaneous expenditure

To the extent not written off or

adjusted

g) Accumulated losses

If any before depreciation

Depreciation.

TOTAL RUPEES


PROFORMA OF PROFIT AND LOSS ACCOUNT FOR A

TRADING ENTITY

Name of the entity

Profit & Loss Account for the year ending……

Last year

Rs. Rs.

1. SALES (NET OF SALES TAX)

(income for services may be shown separately)

2. Cost of goods sold

I) Opening stock

Add: Purchases (less returns)

Less: Closing stock

II) Other Direct expenses

3. Gross Profit (1-2)

4. sales and administrative expenses

5. Other Income expenses* net (+)

6. interest

7. Profit before depreciation and tax

[item 3 minus item (4+5+6)]

8. Depreciation

9. Taxation (for example for registered firms)

10. Profit after depreciation & taxation item minus item (8+9)


NOTE: Any item which forms a significant proportion, say 5% or more of the total sales or has

special significance otherwise should be shown separately under appropriate heads for example

(I) salary (II) commission (III) perquisites and money value thereof.

**registered firms are subject to tax, before the profit is apportioned amongst partners.


CLASSIFICATION OF CURRENT ASSETS & LIABILITIES

ASSETS

CURRENT ASSETS: Also called Liquid Assets/ Circulating Assets/ Floating Assets/ Gross

Working Capital

Definition: those assets which are reasonably expected to be converted into cash during the

operating cycle of the business. Assets however liquid which do not form a part of operating

cycle are not classified as current assets by bankers.

Three categories:

Inventories (stock in trade)

Receivables (trade debtors)

Other current assets

Examples:

Inventory:

a) Stock of raw materials on hand-indigenous, imported

b) Stock of work-in-process (semi finished goods)

c) Stock of finished goods on hand

d) Goods at stores and spares – indigenous and imported

Receivables:

a) Sundry debtors (trade debts/book debts)

b) Bills receivables (bills accepted by sundry debtors)

- Inland bills up to 6 months, including deferred receivables maturing within one year.

c) Export


OTHER CURRENT ASSETS

a) Cash & Bank balance

b) Investment

- In government and trustee securities

- Investment in fixed deposits with banks/MMFS/CPS/CD

Investment in quoted securities

c) Advance Tax Payment after adjusting reserves for taxation

d) Advance given to suppliers

e) Advance recoverable in cash or kind

f) Advance accrued on investment

g) Pre-paid expenses

h) Cash margin on LG/LC

OTHER NON CURRENT ASSETS

These assets cannot be included in Current assets as they are slow moving or as they are not

acquired for normal business purpose.

1) Dead inventory – slow moving inventory – obsolete items/slow – moving items not

readily realizable.

2) Deferred receivables – other than those maturing beyond/after one year

3) Amounts due from Associates/subsidiaries/affiliates

4) Other loans and advances

5) Security deposits- balance/deposit with govt. Dept./Statutory Bodies/Tender deposit

irrespective of their maturity period.

6) Receivables not related to trade-

a) Advances given to staff members

b) Advances given to directors, partners.

c) Advances given to companies not connected with business


d) Advances for purchase of fixed assets or advance to supplier or contractor for capital

expenses.

e) Investments in companies not related to trade.

7) Unquoted investments/ gratuity funds/ sinking funds for long term purpose.

8) Other Miscellaneous assets/CD etc.

FIXED ASSETS

Also known as block assets/capital asset/Capital goods/Productive assets/tolls of business.

Definition: Assets which are acquired for long term use and are not meant for sale in the normal

course of business. They are least liquid.

Examples:

1) Land

2) Building

3) Plant and machinery

4) Furniture, fixtures & vehicles etc.

5) Construction – awaiting completion

6) Other assets of long term nature

7) Other fixed assets

Gross Block- The total value of all fixed assets before depreciation.

Net Block- Value of fixed assets after depreciation.

Net Block= Gross block – Depreciation

Valuation of fixed assets = Fixed assets are valued at original cost less depreciation.

Revaluation – Where assets have been revalued the increase in their value due to revaluation

should be set off with revaluation reserve to make comparisons meaningful.


Depreciation – A company is free to charge depreciation on straight line method or written down

value method or any other method. The depreciation amount in straight-line method is higher

compared to that in W.D.V. method. The income tax liability of the company is calculated after

providing depreciation in W.D.V. method at rates given in the I.T. act

INTANGIBLE ASSETS (FICTITIOUS ASSETS)

Definition: Assets which have no tangible existence or certain fictitious assets which are in fact

capitalized expenses are classified as intangible assets.

Examples:

Good Will (value of reputation associated to a business)

Copyright (amount paid to the author to obtain copy right of a book)

Patents (amount paid towards obtaining patent over a new product)

Trade Mark

Franchise (amount paid towards getting exclusive right for using a brand)

Preliminary expenses (company formation expenses capitalized)

Deferred Revenue Expenditure

Debit Balance in profit and loss account (adverse profit & loss account)

Drawings by partners (withdrawal of capital) in partnership firm

Bad & Doubtful debts not provided for

Pre – operative expenses/developments expenses etc. to the extent not written off.

Nature of these assets –

A banker presumes that these assets are a drain on the capital. The assets are not available for

payment of debts as long as the business runs and they are not realizable at the time of

liquidation.


LIABILITIES

RECLASSIFIED INTO 3 GROUPS

Net Worth

Term Liability

Current liability

Net worth - Also known as Share holders, funds or owners equity.

Items are almost permanent source of fund (need not be paid back as long as the business runs)

Items represent the amount of funds (resource) given (or not drawn) by the owner (share holders)

of the business.

They are permanent source of funds.

They represent the owners’ stake in the business.

They do not carry any fixed charge by way of interest.

They are not outside liabilities.

NETWORTH ARE THREE CATEGORIES:

Paid up capital [equity & preference]

Free Reserve

Surplus

Examples:

Ordinary share capital [paid up]

General Reserves

Revaluation reserves

Share premium amount

Balance of profit

Preference share capital maturity after 12 years


Other reserves

TERM LIABILITY – also known as long term liability or Deferred Liability

Definition: Liabilities which mature for payment after a period of one year from the date of

balance sheet are called term/deferred liabilities.

Examples :

Term loan from financial institutions, bank [excluding installment payable within one year]

Debentures payable after one year [not maturing within one year but maturing within 12 years]

Deferred payments credits[excluding installments payable within one year]

Term deposits payable after one year.

Preference Share redeemable after one year but before 12 years

Working Capital Term Loan

Deposits from dealers – which are refundable only on termination of dealership are to be treated

as term liability.

Other term liability [including ECB/ADR/GDR/FCNR, loans etc.]

Debentures

CURRENT LIBILITY:

Definitions: liabilities payable in short term (within a year) from the date of balance sheet are

classified as current liabilities. They represent short term source of fund and should be utilized

for financing current assets.

Examples:

Short term bank borrowing against stock, stores etc. (cash credits, overdrafts)

Sundry creditors for trade (creditors on account of supply of raw materials)

Advance/ progress payment from customers for supply of finished goods.

Sundry creditors for expenses


Bills payable (bill accepted on account of sundry creditors)

Outstanding/Accrued expenses (expenses like rent, insurance due/accrued but not paid)

Provisions (made towards payment of taxed, bonus etc.)

Dividend payable within one year of provision

Deposits from dealers (not accepted with a condition to be repayable on cancellation of

dealership or agency)

Other statutory liability like PF dues etc.

Installment of term loan, debentures, deferred payment, deposits or preference share capital,

DPG/DEB/RP shares/ECB/ADR/GDR due within one year.

Working capital term loan – term liability

Unsecured borrowings from the bank including bills discounted.

Unsecured borrowings from others, where no period of repayment is mentioned. Deposits

maturing within one year.

Interest and other charges accrued but not due for payment.

Other current liability/provision, such as gratuity liability due within one year of provision.

TOTAL OUTSIDE LIABILITY = CURRENT LIABILITIES + LONG TERM LIABILITIES

TOTAL TANGIBLE ASSETS = CURRENT ASSETS + FIXED ASSETS + OTHER NON-

CURRENT ASSETS

NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES

TANGIBLE NET WORTH = NET WORTH – INTANGIBLE ASSETS

Limitations of a Balance Sheet

While the above analysis of the Unit’s Balance Sheet does disclose certain important indicators

to the analyst, he will do well to remember that conclusions based purely on the Balance Sheet

may quite be misleading, due to its inherent limitations. The Balance Sheet is often likened to a

snapshot of a moving train and hence reveals just as much about the financial condition as the

photograph does of the moving train, capturing only a particular position. Hence, any undue

reliance on Balance Sheet is fraught with risks. The limitations of balance sheets are four-fold.


i) Exactness owing to personal bias of the accountant in exercise of his judgment: e.g.

valuation of stocks, provision for bad debts etc.

ii) Non-recognition of diminishing value of rupee and treating all assets only in terms of their

recorded rupee value: inflation accounting is the answer

iii) Exclusion of all non-monetary transactions and factors, howsoever important they may be.

iv) Pertains to a date and hence liable to abuse like window-dressing.

In order to eliminate at least some of these limitations, the analyst could examine a series

of balance sheets and discern a trend of the various financial and performance indicators. Such a

comparison could be internal i.e. with past performance or external i.e., with those of similar

units. A Balance Sheet analysis, it will be appreciated, is only the first step in the whole analysis,

an indicator ordering a further probe, but definitely not the final conclusion.


PROFIT AND LOSS STATEMENT ANALYSIS

Importance of the Profit and Loss Statement

The profit and loss statement summarises the transactions which together result in a profit (or

loss) for a specific period of time. This profit or loss is shown on the balance sheet as an increase

or decrease in owners’ equity. People who invest in securities believe that a study of the profit

and loss statement of a business enterprise will give them information regarding future

expectations of profits and dividends. It is in this context that the profit and loss statement has

gained importance.

The profit and loss statement reports the results of operations and indicates areas

contributing to profitability or otherwise of the business enterprise. Analysis of profit and loss

statements for several years may reveal desirable or undesirable trends in the profit earning

capacity of a business enterprise.

Revenues, Expenses and Changes in Owners’ Equity

Defined more precisely, revenues are increases in owners’ equity that result from

operations of a business enterprise while decreases in owners’ equity are expenses. Revenues

take the form of an inflow of assets like cash and sundry debtors from customers or clients to

whom products have been sold or services rendered. Revenues might also be earned from

investments, for instance, interest on Govt. securities or dividends. It should be noted that

revenues are not the only source for increase in owners’ equity. An inflow of capital funds

invested by owners increases owners’ equity but it is not revenue.

Expenses connote “sacrifice made”, “cost of services or benefits received”, or

’resources consumed’ during a specified period. Expenses are costs incurred for generating

revenue and are therefore related to the operations of a business enterprise. As stated earlier,

expenses decrease owners’ equity, however they are incurred in the expectation that the revenues


generated will more than offset the decrease in owners’ equity. The excess of earned revenues

over the incurred expenses in a specific period is called profit or income. If expenses exceed

revenues the difference is called a loss resulting in net decrease in owners’ equity.

The Format of the Profit and Loss Statement can be seen from the Exhibit A furnished below:

Exhibit ‘A’

DHRUPAD COMPANY

Profit and Loss Statement for the year ended March 31, 2006

Rs.

Sales of goods and service 1,44,73,526

Cost of goods sold 79,88,956

Gross Profit 64,84,570

Operating Expenses

Staff Expenses 31,64,830

Sales and Administration Expenses 18,64,390

Depreciation 3,56,971

Managerial remuneration 80,169

Operating Profit 10,18,210

Other Income 4,35,326

Net Profit before taxes 14,53,536


Provision for Taxes 7,90,000

Net Profit after Taxes taken to General Reserves

6,63.536

Exhibit A’ is a profit and loss statement for Dhrupad Company. The statement shows the results

(in Rupees) of operations of this company for the year ended March 31,2006.

As seen from the exhibit “A”, Dhrupad Company made a profit of Rs.6,63,536. This profit will

be included as a net increase under ‘general reserve’ in owners’ equity section of the balance

sheet of Dhrupad Company.

Instead of the format outlined in Exhibit ‘A’, some published annual statements in India follow

the practice of listing revenues on the right hand and expenses on the left hand side of the profit

and loss statement. This format is an outcome of the practice to represent the profit and loss

account as it appears in the detailed accounting records (ledgers). Generally, additional schedules

giving details of cost of goods sold and operating expenses are appended to a published profit

and loss statement. Generally the format given in the exhibit facilitates easy analysis of the profit

and loss statement. Comparison of results of operations for several years and calculation of ratios

and percentages is easily done if the vertical format is followed.

The first item on the profit and loss statement in Exhibit “A” is sales of goods and services. This

item represents the revenues from operations for Dhrupad Company. Revenue might also be

derived from exchange or sale of assets, interest on dividends from ‘other investments’. The

usual practice however is to distinguish the two kinds of revenues. Revenue arising out of normal

operations is designated as sales revenue whereas revenue arising out of investments and sale or

exchange of assets is called ‘other income’


The second item of the profit and loss statement is cost of goods sold. Cost of goods sold is an

item of expense and results in a decrease in owners’ equity. The difference between ‘sales and

cost of goods sold’ is called ‘gross profit’ which in our case amounts to Rs.64,84,570. From

gross profit several other items of expenses called operating expenses are deducted, the

difference between gross profit and operating expenses is called operating profit. The operating

profit figure is very important since it discloses the profitability and operating efficiencies of

Dhrupad Company.

The next item on the profit and loss statement is ‘other income.’ Other income is a net figure and

includes interest on investment and securities paid or received, and profit or loss on sale and

exchange of assets, etc. The total of operating profit plus other income gives the figure of net

profit before taxes. Provision for taxes calculated according to income tax rules is deducted

leaving a figure for net profit after taxes. Net profit after taxes represents the net increase in

owners’ equity for Dhrupad Company during the year ended March 31, 2006.

The accounting period:

The profit and loss statement illustrated in Exhibit ‘A’ pertains to one year’s operations of

Dhrupad Company. Ideally, an exact measurement of the net profit or loss of a business

enterprise can only be made after the enterprise has ceased doing business and sold all its assets

and paid off its liabilities. Management however cannot wait until the business operations have

ended to determine the profit or loss from operations. In practice, therefore, accountants attempt

to determine profits or losses for intervals of time shorter than the total life of a business entity.

Accounting transactions that have occurred during a specified period of time are collected,

summarised and a report is made of all the material changes in owners’ equity during this

specific period. This specific period which is chosen to report profits or losses is called the

Accounting period.

Although published statements for reporting to owners and outside agencies are prepared at

annual intervals (quarterly performance reports should be furnished to stock exchange by the

listed companies), management often needs interim profit and loss statements prepared for


shorter intervals of time. This interval might be a quarter, a month, a week or even daily. Over

the life of a business enterprise, a profit and loss statement and balance sheet are prepared at the

end of each accounting period. The profit and loss statement presents the results of operations

during an accounting period. It might also be said that a profit and loss statement covers the

period between two balance sheet dates and explains the changes in owners’ equity during the

accounting period.

Sales

Cost of Goods Sold and Operation Expenses:

Profit and loss statement will give the figure of gross sales. Net sales is arrived at by deducting

from gross sales, sale returns and allowances and sales discounts, excise duly and Sales tax.

Gross Sales

Gross Sales is total sales revenue measured by multiplying goods delivered into unit price per

item. State and local sales taxes and octroi and excise duties charged to a consumer are to be

excluded from net sales as they are not revenue for the unit but are collected by a business

enterprise on behalf of the Central, State and Local authorities. Until such time as they are passed

on to the government, they represent a liability of the business enterprise to Government.

Sales returns are part of goods sold to customers but returned by them to the business because

the goods are not of a kind of quality ordered by a customer. Goods returned are called sales

returns. Instead of returning the goods customers may sometimes claim an allowance on the

price. In such a case, the allowance on price is called sales allowance.

Sales discounts are deductions from sale price allowed to customers to induce them to pay

promptly. For example, a business may sell goods on terms 2/15, n/45 which means that

customer will get a 2 percent deduction from the billed amount if payment is made within 15

days, after 15 days no discount will be given but the customer will be required to pay the billed

amount within 45 days. Since sales discounts reduce the revenues received from sales it is


deducted directly from gross sales instead of being shown as an expense item. Another kind of

discount, trade discount does not appear on the profit and loss statement at all, trade discount is

the amount deductible from published or catalogue price in order to arrive at actual sales price.

Sales Revenue and the Realisation concept

The realisation concept is one of the most important concepts influencing modern day

accounting practices. This concept states that as a general rule, sales revenue is recognised in the

accounting period in which revenue is realised. Realisation occurs when goods are shipped or

delivered to the customers. For services, revenue is recognised in the period in which services

are rendered. It is important to emphasise that revenue recognition occurs not when a sales order

is received, not when a contract is signed but when the goods are shipped or delivered. Payment

for goods shipped or services rendered may be made immediately or after a period of time, the

timing of payment is quite immaterial to the realisation concept. The crux of revenue recognition

is performance of the contractual obligation through shipment or delivery of goods or rendering

of services.

Cost of Goods Sold and Operating Expenses

At the same time as owners equity is increased by the sales value of goods shipped or delivered

or services rendered it is also reduced by the cost of goods sold and operating expenses. In this

section we shall explain how cost of goods sold and operating expenses are measured but before

we do so it should be emphasised that cost of goods and operating expenses are both expenses

and have the same effect on owners’ equity, a decrease. But a distinction is made between these

two items since gross profit (difference between sales revenue and cost of goods sold or services

rendered) constitutes very important and useful information to management and other users of

financial statements. Published statements are required to state all three items, that is, sales

revenue, cost of goods sold and gross profit.

Measuring Cost of Goods Sold


The problem of measuring cost of goods sold arises because a business does not sell all the

goods that it purchases during an accounting period. For example, a business may purchase

10,000 units of a product at Rs.5 per unit during an accounting period. If 5,000 units are sold

during the accounting period at Rs.6 per unit, what is the cost of goods sold? The problem can be

explained as follows: The purchase of 10,000 units can be regarded as inventory of Rs.50,000, an

asset available for sale during the accounting period. Since only 5,000 units were sold, the cost

of goods sold is Rs.25.000 (5,000 units x Rs.5 per unit), the balance of 5,000 is inventory

available for sale during the next accounting period. If during the next accounting period another

3,000 units were purchased at Rs.5 per unit and 7,000 units were sold at Rs. 6 per unit partial

profit and loss statements and balance sheets for operations for the two accounting periods would

be -

Profit and Loss statement Balance Sheet at the end

for Account Period 1 of Accounting Period 1

Sales 30,000 Assets

Cost of Goods sold 25,000 Current Assets

______

Gross Profit 5,000 Inventories 25,000

_____

Profit and Loss Statement Balance Sheet at the end

for Accounting Period 2 of Accounting Period 2


Sales 42,000 Assets

Cost of Goods sold Current Assets

Opening Inventories 5,000

Inventory 25,000

Purchases 15,000

Goods available for sales 40,000

Less Closing Inventory 5,000

Goods sold 35.000

Gross Profit 7,000

During the two accounting periods, a total of 13,000 units were purchased at Rs.5 per unit of

which 12,000 units were sold leaving a balance of 1,000 units at the end of the second

accounting period. The cost of this inventory which is the closing inventory is Rs.5,000.

In the above example, we were concerned with measuring cost of goods sold in a business which

was primarily engaged in buying and selling goods without any processing. In manufacturing

businesses, where materials are processed and converted into finished goods before sale, the

measurement of cost of goods sold is slightly more complicated.

There are two distinct methods of calculating cost of goods sold. The first method called the

perpetual inventory method is commonly used by businesses which are buying and selling high

unit price, low volume items (like refrigerators and air conditioners.) In such businesses, a record

is kept of the cost of each item sold, and cost of goods sold is determined by simply adding up

the cost associated with individual items sold. The total cost of goods sold is subtracted from the


asset inventory so that at all times the asset inventory represents cost of goods still available for

sale.

The other method called the physical inventory method is generally used by businesses engaged

in buying and selling high volume low unit price items (like provision stores). In this case, no

track is kept of costs associated with each item that has been sold, but a physical inventory of

goods remaining unsold is taken at the end of each accounting period. Costs are associated with

the physical inventory on hand which results in the value of inventory not yet sold. The cost of

goods sold is then determined through a process of deduction. To the inventory available for sale

at the beginning of an accounting period (or remaining unsold at the end of the previous

accounting period) is added the value of purchases made during the accounting period for which

the profit and loss statement is being prepared. From this, the value of physical inventory not yet

sold is deducted, giving the cost of goods sold during the current accounting period.

Until now the figure used for “purchases” represented the gross value of purchases. To determine

the net purchases during an accounting period certain adjustments to gross purchases are nec-

essary. A part of the purchase may be returned to the supplier because the goods supplied were

not of the kind or quality ordered. Purchases returns will thus be deducted from gross purchases.

Similarly, where an allowance on purchase price is claimed for non-standard goods, purchase

allowance is also deducted from gross purchases. Purchase discount is next deducted from gross

purchases. If any freight charges are incurred on the purchases of goods, this is added to gross

purchases. To summarise by using an example, cost of goods sold for an accounting period will

be calculated thus,

Opening Inventory Rs. 500

Purchases Rs. 300

Add : Freight in Rs. 30

Rs. 330


Less : Purchases Return

and allowances. Rs. 50

Less : Purchase Discounts Rs. 20

Add : Net purchases Rs. 260 As. 260

Goods available for Sales Rs. 760

Less : Closing Inventory Rs. 250

Cost of goods sold Rs. 510

It should be noted that under the physical inventory method, we are assuming that if goods are

not found in physical inventory at the end of an accounting period, they must have been sold.

This is perhaps an erroneous assumption, since goods might have been pilfered or lost instead of

being sold. Unless steps are taken to determine such shrinkages in physical inventory, the cost of

goods sold calculation might be misleading. On the other hand, in the perpetual inventory

method an actual count of inventory on hand can be made to check the accuracy of perpetual

inventory records.

Measuring Operating Expenses

Earlier in this note, we defined expenses as ‘sacrifice made’, ‘cost of services or benefits re-

ceived’, or ‘resources consumed’ during a specific accounting period. It might now be useful to

distinguish between expenditures and expenses. An expenditure takes place when an asset, re-

source or service is acquired in exchange for cash, another asset or by incurring a liability.

Expense is incurred only when the asset, resource or reserves is used or consumed. During the

total life of a business all expenditures must become expenses. Within a single accounting period

however, there is no necessary correspondence between expenditures and expenses. The

relationship between expenditures and expenses is illustrated with examples in the next few para-

graphs.


Expenditure incurred during an ‘accounting period’ which become expenses in the same

‘accounting period.’

If a resource, service or asset is acquired and consumed during the same accounting period, it is

both an expenditure and expenses for that accounting period. There is an exact correspondence

between expenditure and expense in the current accounting period in so far such items are

concerned.

Illustration: In Dec 2005, goods worth Rs.5,000 were purchased for cash. There was thus an

expenditure of Rs. 5,000. One asset ‘inventory’ or ‘stocks’ being acquired in exchange for

another asset ‘cash’. Out of this amount of Rs 5,000, how would be accounted for as expense for

the year ended 31 March 2006? If all these goods were sold before 31 Mar 2006, there was an

expense of Rs.5,000 in the year 2005-06. If none of the goods were sold in 2005-06, there was no

expense in 2005-06. If the goods were sold subsequently in April 2006, there was an expense of

Rs.5,000 in the year ending 31 March 2007. If only Rs,3,000 worth of goods were sold in 2005-

06, there was an expense of only Rs.3,000 in 2005-06.

Expenditure incurred during an accounting period that become expenses in that same accounting

period are the simplest types of accounting transactions. However, as can be seen from the next

three sections, not all expenditures become expenses in the same accounting period in which

they are incurred,

Expenditures incurred in previous accounting periods that will become expenses in ‘current ac-

counting period’.

In the last part of the previous illustration we saw that out of an expenditure of Rs.5,000 in 2005-

06 only Rs.3,000 became an expense during the same year. What happened to the difference of

Rs. 2,000? The expenditure of Rs.2,000 would have been shown as an asset on the balance sheet

as on March 31, 2006 and may be used up and transformed into expenses in 2006-07 in or future

years. Three major types of such assets are described below:


Current assets include inventories of products which have not been sold at the end of the

previous accounting period- these will become expenses in the ‘current accounting period if the

products are sold in this period.

Another kind of asset is prepaid expenses and deferred charges. These assets represent cost of

services purchased in previous accounting periods but not used up until the commencement of

the current accounting period. Such assets become expenses in the period in which they are used

up or consumed. Insurance premium provides an example of prepaid expense. Premiums on most

insurance policies are payable in advance and the amount paid as premium remain as assets until

the accounting period in which the protection becomes effective at which time the proportionate

premium is treated as expense.

Illustration: - A company paid Ps,3,000 for rent in advance for 3 years on March 31, 2006. The

balance sheet prepared on March 31, 2006, should show an asset ‘prepaid rent’. However, in the

next three years, one-third of the prepaid rent, that is, Rs.1,000 would be regarded as an expense

each year..

The third type of assets that become expenses are Long-lived assets. Fixed assets are acquired by

a business enterprise in the expectation that they would be used in generating revenue over a

period of time. Fixed assets would therefore, become expenses in future accounting periods

when the assets are used. The conversion of fixed assets into expenses parallels the examples of

insurance premium. One important difference is that in case of insurance premium the life of the

policy is definite whereas in case of fixed assets, like plant and machinery, the asset life has to be

estimated. Because of the estimation involved, the process of determining the portion of the plant

and machinery cost that will be regarded as an expense for the current accounting period is quite

a difficult task. Although difficult, the concept of depreciation has been devised to estimate the

expense for each accounting period.

Expenditure incurred in “current accounting period” that are not yet expenses


In the preceding section, it was described how assets become expenses in the current accounting

period. Using the current accounting period as our reference point, there are some expenditures

incurred in the “current accounting period” which are not expenses in the “current accounting

period” but will become so in future accounting periods when the assets or resources are

consumed or used up. Such expenditures include not only assets that are purchased for future use

but also expenditures on the manufacture or purchase of products that are to be sold in future

accounting periods. Thus using the illustration from the preceding section, the expenditure of

Rs.3,000 in March 2006 on insurance premium, is an expenditure that is not yet an expense in

the accounting period for the year ended March 2006.

Expense for ‘current accounting period’ that will be paid for in subsequent accounting periods:

This category of operating expense is called accrued expense. The characteristic of accrued

expense is that although services might have been used or benefits received in the current

accounting period, payment for these services or benefits will be made in future accounting

period. Owners’ equity is reduced when these expenses are incurred. Subsequent payment of the

liability does not affect ‘owners’ equity’

An example, of this type of expense is wages and salaries that are earned by employees but have

not yet been paid. Some firms follow the practice of paying wages and salaries for a month in the

first week of the following month, that is, wages and salaries for March 2006 are paid by the first

week of April 2006. So far as the accounting period for the year ending March 2006 is

concerned, wages and salaries for March 2006 are expenses for the period, although they will be

paid only in April 2006.

Another example of accrued expense is interest expense. Interest is the cost of borrowed money

and is an expense for the accounting period in which borrowed money is used. Quite often,

interest is payable quarterly. If the annual accounting period ends on March 31, interest for the

period Jan to March 31 has been incurred, although the obligations to pay will arise only in


April. The obligation to pay interest is shown as a liability in the balance sheet prepared on

March 31.

For all expenses of this type, transactions involved are essentially the same, the expense is shown

as operating expense in the accounting period in which the services were used or benefits

received. The obligation which results from this expense is shown as a liability in the balance

sheet at the end of the current accounting period.

The ‘Accrual concept’ - Cash Versus Accrual Accounting

The essence of the accrual concept is that net profit (or net loss) arises from revenue and

expenses transactions during an accounting period and that net profit (or net loss) is not synony-

mous with cash increase or cash decrease.

Earlier we have seen that the process of revenue recognition is not necessarily associated with

the collection of cash. For example when products or services are sold on credit the increase in

revenue leads to a corresponding increase in the asset, sundry debtors. At a later date when cash

is collected from customers, increase in asset ‘cash’ is offset by decrease in the asset ‘sundry

debtors’, revenue is not increased at the time of collection but rather at the time when the

products or services were delivered and billed on credit terms.

Occasionally, customers make advance payments for products or services to be delivered or sold

in future years. Revenue is not recognised at the time of receipt of advance payment, although a

liability to sell products or render services in future periods has been created at the time of

advance payment. Revenue will be recognised only when products or services are actually

delivered and billed. The liability would be removed at the time when revenue is recognised.

In a like manner, expenses are not necessarily represented by cash transactions. Expenses occur

when benefit is received from or use is made of an expenditure or asset. The payment for the

expenditure or asset may be in quite a different period than the one in which the expense is

recognised. For example when supplies are purchased on credit, an asset account is created and

liability to the creditor is recorded. Expense is recognised in the accounting period in which these


supplies are used or consumed. When payment is made to the creditor, the liability is reduced but

it does not affect expense recognition.

It is extremely important to recognise that net profit or loss is associated with changes in

owner’s equity through revenue and expense transactions and that net profit or loss is not

necessarily synonymous with cash increase or decrease. Generally speaking, the larger the net

profit, the better off are the owners. An increase in cash, however, is no indication that the

owners are better off. The increase in cash may merely be offset by a decrease in another asset or

by an increase in a liability, with no effect on equity at all. Net profit will exactly correspond

with net cash increase only if the following four conditions are met

a) All sales are made for cash during the current accounting period.

b) Any sales made on credit terms during the current accounting period are realised

in cash in the current accounting period itself.

c) All cash expenditures become expenses during the current accounting period, and

d) All expenditures made on credit terms are paid off during the current accounting

period, such expenditures being transformed into expenses during the current

accounting period.

In short, for net profit to be synonymous with net cash increase, there must be complete

correspondence between sales revenue and cash receipts, between cash payments and

expenditures and between expenditures and expenses.

It is rare indeed for all the four conditions to be fulfilled in any business enterprise. Accrual

accounting based on the accrual concept ignores the timing of cash receipts and payments in

determining net income for an accounting period, the timing of revenue realisation and expense

incurrence is the fundamental basis of accrual accounting.

Matching Expenses with Revenues


An accurate measurement of net profit or net loss during an accounting period depends consid-

erably on the proper matching of expenses with revenues. The matching concept means that in

determining net profit for an accounting period, all expenses associated with revenue generation

should properly be regarded as expenses for that period. If revenue is recognised on the billing

and delivery of a particular product, then the cost of products sold should include all expenses

associated with the sale of that product.

Similarly costs incurred for manufacturing a product that has not been sold but remains as

closing stock at the end of the accounting period should not be included in operating expenses.

Quite often the expenses to be matched with revenues need to be estimated. For example,

products are sometime sold under a repair and service guarantee scheme. The concept of

matching expenses with revenues gives rise to the problem of estimating the portion of the future

repair and service guarantee costs.

Sometimes the expenses needed to earn revenues are quite certain, but the likely revenues are

uncertain. Taking another example, a company might spend a considerable sum of money on

development of a new product to be launched. Over how many years should the cost of

development be spread? This would depend amongst other factors on product life and its ability

to generate revenues over a number of years.

For practical reasons, accountants are sometimes forced to relax the concept of matching

expenses with revenues. One reason is that a very exact matching of revenues and expenses may

not be significantly useful and also the work and cost involved in achieving accuracy may not

justify the results achieved.

The profit and loss appropriation statement

The profit and loss appropriation account shows how the net profit for the current accounting

period has been disposed of. The statement starts with the balance in the P&L appropriation

account at the end of the previous period, to which is added the net profit of the current

accounting period. From this sum any dividends that might have been declared or any specific


appropriations from the P&L appropriation account are deducted and any excess left over is

added to the general reserves.

Sometimes the net profit in an accounting period might be less than the profits required for

declaration of dividends. In such a case the general reserve available at the end of the previous

accounting period is used to cover the deficit between declared dividends and net profit. The

profit and loss appropriation statement would then show general reserve available at the end of

the previous accounting period., to which is added the net profit for the current accounting

period. In other words there would be a reduction in the general reserves by an amount equal to

the deficit between dividends and net profit.

The profit and loss appropriation statement forms the link between the profit and loss statement

and the balance sheet. This is done through the process of additions to and subtractions from

general reserves.

The profit and loss statement and the accounting equation

It must be emphasized that all transactions shown on the profit and loss statement can be

represented in terms of the accounting equation. When revenue from sales is received, owners’

equity increases by the amount of revenue from sales, this increase is offset by an increase either

in cash or sundry debtors or some other asset. Similarly when an expenditure is incurred on

purchase of products for sale and asset stock increases this increase is offset either by a decrease

in cash or by an increase in liability to a creditor. When the products are sold owner’s equity

decreases to the extent of the use of products for sale and stock of products for sale decreases

correspondingly.


You will therefore see that revenues and expenses result in increase and decrease in owner’s

equity and that such increase and decrease is accompanied by a corresponding change in another

asset or liability item. So far as the balance sheet is concerned one could directly record the

revenue and expense transactions in terms of their effect on owner’s equity, however, for

management information purpose it is quite useful to separate the increases and decreases in the

owner’s equity in the form of revenues and expenses.

In some cases business enterprises report to owners a net profit figure which is quite different

from the one reported for tax purposes. There is nothing unethical about this practice since

income tax regulations might in some cases prescribe a treatment for certain revenues and

expenses which is quite different from that justified by sound business management policies.

For example, income-tax regulations require companies to use the Written Down method of

depreciation for tax reporting purposes. However, the Companies Act and Accounting Standards

permit companies to choose either the written down method or the straight line method of

depreciation for purposes of reporting to owners. In fact, some companies do follow straight line

method of depreciation resulting in different net profit figures for tax returns and reporting to

owners.

Almost every business enterprise attempts to pay the least amount of tax on its taxable profit

both in the short and long runs. A company will hire experts to advise management in how best

to comply with tax laws, and pay the least amount of tax. This aspect of management policy may

be more properly designated as tax avoidance rather than tax evasion. Tax avoidance is perfectly

legal and ethical provided it is done in compliance with tax laws.

In actual practice, several companies pattern their accounting policies for reporting to owners on

the same line as the tax provisions. This is a very convenient procedure since it obviates the


necessity of having separate accounting records for the two purposes. However, complete depen-

dence on tax regulations for reporting to owners might result in serious distortion of financial

reports presented to them. Tax regulations should not be substituted for clear and sound thinking

on profit reporting practices.


COMMON WINDOW DRESSING PRACTICES

Date of Balance Sheet - If coinciding with end of season, the balance sheet size and liabilities may be smaller than during peak season.

Indicating Current expenses as Capital in Balance Sheet.

Resorting to heavy billing of sales on date of Balance Sheet – leading to increased sales & increased profit.

Preparing Balance Sheet on different dates for associate concerns. (making it difficult to ascertain the extent of interlocking of funds/stocks)

Temporary reduction in CL (for a day or so); Setting off CL against CA, Issuing cheques in payment of CL but not despatching them (reduces

S.Crs. and shows a better current ratio)

Maximising collection of receivables on Balance Sheet date thus showing a large cash balance (including cheques yet to be realised)

Resorting to heavy billing of sales on the date of Balance Sheet, leading to increased sales and profits

Changing the method of Valuation of Stocks

(In an inflationary situation change from weighted average cost of current assets to First in First out method (FIFO) leads to increase in profit).

Changing the method of Depreciation - particularly with retrospective effect

Booking unrealised income as revenue.


RATIO ANALYSIS

Ratio is the relationship between two variables. It can be expressed as ratio or as a percentage or

so many times. The purpose of ratio analysis is to facilitate comparisons with reference to time

periods or with the average of industry. An investor who is intending to invest money in a

company may like to know the risk and returns associated with the investment. As this involves

future activity, a doubt may arise as to how the analysis of the statements based on past

performance will be useful. However, past performance and trend do play a part, rather a

significant part in the future performance also.

The various ratios may be grouped under the following categories:

Liquidity Ratios

Activity or Efficiency Ratio

Leverage or Stability Ratio

Profitability Ratio

Although it is possible to calculate a number of ratios under each category, we shall discuss only

some of the important ratios both from the management and bankers.

Liquidity Ratios:

1) Current Ratio = Current Asset/ Current Liability

In a balance sheet it Is very important that the assets and liabilities be correctly identified.

It is necessary that current assets should be sufficient to meet the current liabilities.

Another question is whether a current ratio of 1:1 is adequate. Here it is to be seen that

the value given to the assets in the balance sheet is matter of estimate. Although the

current assets valued at the realizable cost unlike fixed assets, it is possible that the


estimates may go wrong and the realizable value may be less than the estimated one. It is

therefore, desirable that CA are more than CL to keep a good margin of safety for the

current creditors. Another question may arise, namely , what is the need to have more CA

in relation to CL as long as total assets are more than the total outside liabilities. This can

be easily answered considering the fact that fixed assets are intended for long term use in

business and if companies were to pay its current creditors from the sale proceeds of

fixed assets, it will be virtually in a state of bankruptcy – liquidation. Commercial

solvency of the company depends upon the adequacy of current assets in relation to

current liabilities. To what extent CA should exceed CL depends on the operating cycle

of the company. If it has a faster turnover, it may be able to manage with a high margin

of safety. Bankers now insist that current ratio should be at least 1.33:1. However, a very

high current ratio also does not indicate a very healthy management pattern.

Ways of improving current ratios

Sale of fixed assets to pay CL

Sale of fixed assets for investments in CA

Long term borrowing to pay CL

Long term borrowing to invest CA

2) Quick Ratio or Acid test Ratio = CA- Inventory/ CL- Short term bank borrowing

It has to be recognized that some assets are more liquid than others. Inventory is the most

illiquid of the CA because it might have to be firstly, converted into receivables. It is

therefore, deducted from the CA. Similarly, short term bank borrowings though legally

payable on demand, are generally renewed if the company is doing alright and hence is

treated as long term liability. The acid test ratio will indicate whether liquid current assets

are adequate to meet current liabilities. Here again, the duration of the operation cycle is

a crucial factor to examine the magnitude of the standard ratio which is 1:1.


Activity Ratios:

1) Inventory Turnover Ratio = cost of goods sold/ Average inventory

Inventory comprises of raw material, work-in-progress, finished goods and consumable

stores and packaging materials. Inventory turnover ratio indicates how fast production

cycle operates. If the ratio is high, it indicates higher volume of sales per rupee invested

in inventory. If for example, this ratio is going down, it means that the company’s

production operation is being lengthened and inventory is getting accumulate. In such a

situation, it is necessary to examine the portfolio further. If there is accumulation of

finished goods, it required a careful analysis of the reasons for this build up. It may be the

result of a decline in the demand for the product of the firm resulting from price,

competition, availability of substitute or changes in tastes, fashions, etc. the situation may

not be so alarming if it is arising from the buildup of raw materials inventory unless it is

obsolete.

Inventory buildup entails several costs-interested, rent, insurance, salaries and loss due to

obsolescence and pilferage. All these costs can be avoided if there is no inventory.

However, business cannot run without a minimum of inventory. To ensure uninterrupted

production and sales, a reasonable amount of inventory has to be maintained. The

inventory turnover further is sub-divided into the three following categories with a

different pattern.

Raw Material Storage Period:-

Average Inventory of R.M./R.M. consumption x 365

This will indicate, on an average, how many days consumption of raw material is held by

the company.


Work in progress period:

Average work in progress/cost of production x 365

This will indicate the amount of money involved in the semi finished goods by giving the

number of days inventory is held in the form of semi finished goods.

Finished goods storage period:

Average inventory of finished/cost of sales x 365

This ratio maybe used to find out the period for which the company before sale holds

finished goods.

2) Accounts Receivable (Debtors) Turnover Ratio = Total sundry debtor + bills

Receivable

+ Bills Discounted outstanding/Credit sales x 3665

The accounts receivable turnover ratio indicates at what interval the debtors of the

company pay the amounts due by them to the company. If a company is extending credit

for sixty days against the industry average of 30 days, it may imply anyone of the

following:

The company has liberal credit policies to increase its sales.

Its customers are not having high credit rating and hence are not prompt in meeting their

obligations.

The realization department of the company is not efficient to realize the debts in time.

The company’s products are inferior so that they are forced to extend credit to buyers.

The company is facing customers who can dictate terms to the company.

The age of the debts is also a significant consideration. The older the age of the debt,

farther it will be from being realized and hence the profits of the company may be

eroded.


3) Payables or Creditors Turnover Ratio = Bills Payable + Sundry Creditors for

purchases x 365

This ratio indicates the time taken by the company to pay off the creditors. If the credit

period increases it means that the company is taking longer time to pay the creditors. It

may be strength of the company. If it is a strong and reputed company, many may be

willing to extend credit longer and therefore, the company is enjoying the cost free

finance for a longer period.

On the other hand, it may be a weakness of company. The longer period of credit may be

owing to the inability of the company to meet its obligations at the appropriate time

because of liquidity problems. Specially, if the current ratio is poor and the debtors and

inventory period is declining. This situation may arise following the investment of

current funds for acquisition of fixed and non-current assets.

4) Assets Turnover Ratio = Sales/ Net Operating Assets

The assets turnover ratio will indicate the efficiency with which the assets are used. If the

ratio is increasing, it will mean increasing efficiency and vice versa. An enterprise invests

in assets with a view to increase the turnover. In case of growth of turnover to less than

marginal increase in assets, the ratio will come down which will indicate that the

performance has been less than budgeted

5) Expense Ratio

Another measure for efficiency of an enterprise may be the way various expenses are

behaving.

The following may be more pertinent:


Raw material to cost of production: This will indicate the efficiency of raw material

usage. If it is increasing it may be either because of more wastage, rejection etc. or

because of a rise in raw material price. In the former case, there is a decline in efficiency.

Cost of production to sales: This will indicate the overall production efficiency.

Selling and distribution expenses to sales: This will indicate the efficiency of the selling

and marketing wing of the enterprise.

Administrative expenses to sales: The will indicate the efficiency of general

administration.

6) Leverage Ratios

1] Debt /Equity Ratio = Debt / Tangible net worth

Debt represents the long term liabilities and preference share capital due for payment

Within the next 12 years. Another concept of debt is both short term and long term debt.

Equity on the other hand, refers to the tangible net worth.

The ratio indicates the proportion in which the financing of the company has been done.

If it works to 2:1, it means that the long term creditors have provided Rs.200 for every

Rs.100 of the owners contribution. If a company has more of debt and less of capital, it

May face problems with regard to repayments of installments and payments if interest

when it does not have enough profits. On the other hand, if the entire amount is in the

form of equity the return (dividend) to shareholders will be on the basis of profits.

However, by borrowing a part the funds, the shareholders stand to gain if the rate of

return in the business is higher than the rate of interest on borrowings.

2] Fixed Assets Coverage Ratio = net fixed assets/ long term debt secured by fixed

assets

The fixed assets coverage ratio indicates to what extent the funds of the long term


Creditors secured by fixed assets. If it is 2:1, it means that even if the fixed assets are

sold for half their book value.

3] Debt service coverage ratio = interest + PAT + Depreciation + Other non-cash

Expenses/ interest + installment of term loan

If an enterprise has borrowed funds, it is required to repay the same and also pay the

Interest . For this, the company has opening profits; in addition, it also has funds from

Depreciation and other non-cash expenses, which are not cash outflows. Some

Authorities exclude depreciation from the numerator arguing that, after all, it is an

Expense for fixed assets and should not be included here. The above formula is based

On the concept that while interest rate is an admissible deduction, principle repayment

will be done only after payments of tax. The ratio therefore shows to what extent the

profits of the company will be adequate to meet the fixed charges of the interest and

repayment of the borrowed funds. If this ratio works out to 2:1, it will mean that even

if there is 50% fall in profits, the company will still be able to meet its commitments.

However, if it were very near to 1:1, then even a slight fall in profits may result in the

Inability of the company to meet the obligations. Before comparing the debt service

coverage ratio, the various items should be consolidated into aggregates as under:

Net Funds Generated 1st Year 2nd Year 3rd Year……… etc.

(a) Net profit after Tax

(b) Interest on Term Loans

(c) Depreciation Charged

Net Funds Generated

( a + b + c )


Term Debt Obligations:

1st Year 2nd Year 3rd Year.. .. .. etc.

SBI Others Total SBI Others Total SBI Others Total

(a) Term Loan Instalments

(b) Instalments under DPGs

(c) Interest on Term Loans/ DPGs

Total Term Obligations

( a + b + c )

Debt Service Coverage Ratio (Gross DSCR):

1st Year 2nd Year 3rd Year………. etc.

A Net Funds Generated

B Maturing term obligations

Gross DSCR ( ‘A’ divided by ‘B’ )


A debt service coverage ratio (Gross DSCR) of 1.75 is taken as the bench mark.

Net Debt service coverage ratio (Net DSCR):

1st Year 2nd Year 3rd Year………. etc.

A Net Funds Generated less

Interest on term debt

B Maturing term obligations

Less interest on term debt

Net DSCR ( ‘A’ divided by ‘B’ )

An ideal position would be a uniform pattern of the net debt service coverage ratio of 2 : 1 during the entire repayment period. A ratio more than 2 :1 will indicate surplus servicing cushion available. The level of the ratio between 1.7 5 : 1 to 2 : 1 will be the moderate risk range. The level of the ratio below 1.75 : 1 will indicate that the element of risk is on the high side.

Finally, comment on the pattern of the debt service coverage ratios available during the repayment period as worked out above and state whether the margin of safety and the extent of risk coverage available in the debt servicing capacity of the project are satisfactory and acceptable.


7) Profitability Ratio

1] Gross profit ratio = gross Profit / sales x 100

It is an indicator of the production efficiency as discussed earlier with slight difference.

In the production efficiency, we had taken the percentage of cost of production to sales

Whereas share we have deducted from the sales the cost of sales to arrive to gross profit.

q

A low ratio may high manufacturing expenses, low price or inability to push up sales. An

increasing ratio, on the other hand may indicate a higher sales volume, low

manufacturing expenses or ability to increase the selling price.

2] Operating Ratio (Net Sales Margin) = PAT/ Net Sales x 100

This ratio indicates the net margin on sales after taking into account all expenses, except

financial expenses (interest) and taxes. A higher margin will indicate that the company

has higher percentage of profit on sales to meet the payment of interest, dividends and

other corporate needs

3] Return on investment (ROI) = Return/ Investment x 100

This is the most widely used ratio to measure the profitability of a company specially by

The management and creditors. Here the return is not profit before tax, interest on term

Loan and interest on debenture and investment means net worth of the shareholders and

term liabilities.

Return on Tangible net worth : Return on owners fund

Net Profit After taxes/ Net worth of share holders funds x 100


BREAK – EVEN ANALYSIS

Definition of BEP

Break – even point is the amount of sales at which a unit makes no profit no loss. In other words

it is the level of sale at which sales revenue is equal to the costs of units sold. A unit can earn

profit only if its level of sale is above the break – even point.

Why is BEP calculated?

A term loan should be serviced out of profits. If the unit functions at a level of sale at which

there is no profit, it is natural that it cannot repay the term loan installments. This brings the

necessity for calculating the level of sale above which profits are earned by the unit. In other

words we need to calculate Break – even point.

Once the BEP is calculated, the sale projection made at the profitability statement is compared

with BEP sale. In case the difference between the projected sale and BEP sale is very low, it is

risky to finance the project. A minor deviation in some elements of projected cost may result in a

loss and thus non – payment of the term loan.

On the other hand, where the projected sale is appreciably higher than the BEP, the probability of

earning some profit is still there even if there are some deviations in projections. A unit with

comparatively low BEP is generally preferred for finance. The difference between projected sale

and BEP sale is known as margin of safety. Banks for finance generally prefer a unit with higher

Margin of Safety.


Step by step procedure for calculating BEP

Optimum Capacity

Where projected profitability statements for many years are given, one should chose the first

year of optimum capacity utilization for calculating BEP.

Classification of costs

All costs relevant to this year should be taken into consideration and they should be classified

into FIXED COSTS AND VARIABLE COSTS.

Fixed Cost: is one which is incurred irrespective of the level of production. It is there, even if

there is no production or sale. It is a sort of PERIOD COST – a cost be compulsorily incurred

Whether there is sale or no sale. Examples of fixed cost are depreciation, rent, manager’s salary,

interest on term loan etc.


Variable Cost: it is one with directly varies with Sales/ Production. Sales / production increases

thus cost also increases. If there is NIL Sales/Production then cost should also be NIL. Examples

of variable cost are raw material, wages, fuel, interest on working capital etc.

Semi variable cost: there are certain costs which cannot be classified strictly as fixed or as

variable cost. They increase with increase in volume of sales/production increase is not directly

proportional to the increase in sales/production. Examples, semi variable costs are – telephone

charges, selling expenses, power/electricity etc. For banks consider Semi- variables costs as

fixed costs.

Items of fixed and variable cost

Raw material – Variable

Consumable stores – variable

Power and Fuel – Consumption

Generally varies with output however minimum charges on power consumption should be

treated as fixed cost.

Labor and Supervision Cost- Normally labor is a variable expense. But distinction is to be made

as regards permanent direct labor and other workers whose number varies with production.

Repairs and maintenance – Semi variable / fixed

Salaries and wages – fixed

Interest – A distinction would require that while interest on term borrowings and bank

borrowings for core working capital should be treated as fixed cost, Interest on working capital

borrowing which varies with production should be variable cost.

Depreciation – Fixed

Selling Expenses, sales commission etc related to unit of sale is variable but expenses like

advertising, sales promotion etc. may semi variable or fixed.


Contribution

After classifying the cost one should find out the contribution which is done by deducting the

total variable cost from sales.

Contribution = Sales – Variable Cost

Contribution per unit is calculated by deducting variable cost per unit from sales per unit.

Contribution per unit of product = Sale price per unit – Variable cost per unit

Contribution (as the name suggests) means the surplus left from sales, revenue meeting variable

Cost and which is contributed towards the recovery of fixed cost.

[Note: contribution increases as sale increases and falls down as sale fails. At zero of sale, the

amount of loss is equal to fixed cost as there is no contribution.]

Calculating of BEP

BEP can be expressed in three ways:

1) In terms of number of units of sale

2) In terms of amount of sale in rupees

3) In terms of capacity utilization

Depending upon the requirement in which BEP is to be expressed, different formulae are used

for calculating BEP.

BEP in units of sale: Anyone of the three formulae can be used depending on the availability of

data.

(I)BEP in units = Fixed cost or

Contribution per unit

BEP in units = Fixed Cost or

Sale price per unit – Variable cost per unit

(II) BEP in rupees: Any one of the following two formulae can be used.


BEP in rupees = BEP in units X sales Price per unit

BEP in rupees = Fixed Cost X Total sale in Rs.

Total contribution

(III) BEP in terms of capacity utilization

BEP in capacity = No. of units at BEP X 100

Total Capacity

Calculation of BEP when PV ratio is given

PV ratio [profit volume ratio] is equal to Total contribution

Total sales

Break Even point = Fixed Cost

P/V Ratio

Margin of safety = actual Sale – BEP (Sales)

It is the measure of cushion available in the given level sale. More the margin of safety, stronger

is the unit. Where the margin of safety is low, the possibility of the unit coming to loss is quite

high and banks avoid financing such units.

Margin of safety is also calculated in the form of ratio as given below

Margin of safety = Actual sale – BEP (sale) X 100

Actual sale

Uses of Break Even Point Analysis

To study the viability of the project – (projects having BEP above 75% of capacity utilization

should not be accepted for finance)


To decide the optimum product mix, products with higher contribution should be chosen.

To decide the required level of production in order to attend a desired level of profit.

Cash – Break Even Point

It is the point of sale at which the unit does not incur cash loss or cash profit. While calculating

costs non cash expenses like depreciation are not taken into account.

Significance of BEP

One of the tools of profitability analysis along with DSCR.

Determines the lowest production and price levels at which the project would cover all its costs.

Helps at realistic fixation of repayment schedule.

Tells how sensitive is the project towards adverse situations like decline in sales/profit /capacity

utilization.

Utilized to determine the volume of sale, necessary to achieve the target profit.

Determines ‘product mix’ and ‘make or buy’ decision.

Limitations of BEP

Based on many unrealistic assumptions.

It assumes that volume of sales and volume of production are equal. In reality this situation

seldom happens.

It assumes that all revenues are perfectly variable with the physical volume of production.

It assumes that all the costs are neither perfectly variable or absolutely fixed over the entire range

of volume of production.


FUND FLOW ANALYSIS

According to Roy A. Foulka, Funds Flow Statement is “a statement of the sources and

application of funds, is a technical device designed to highlight the changes in the financial

condition of a business enterprise between two dates”. In India, the funds flow analysis, in its

present form, was not extensively used by the commercial banks for their working capital

appraisal, until late sixties, when the National Credit Council Study Group No.11, popularly

known as Dehejia Committee came out with its report.. This committee, asked to determine “to

what extent credit needs of the industry are likely to be inflated”, pointed out that the banks did

not seek to link credit with industrial output, with the result that end-use of bank credit was not

property followed up. As a sequel to this the commercial banks and RBI started looking into

their appraisal procedures and thus the funds flow statement came to be regarded as an important

component of appraisal for working capital advances.

Stated simply, a funds flow statement captures movement of funds to and from the company’s

coffers. Thus, sources include cash generated by the business after meeting the expenses,

increase in owners’ equity, contracting of additional debt, sale of assets or reduction thereof.

Increase in assets, liquidation of loans/other liabilities and reduction in owners’ equity denote

uses. As a management tool for decision making, it discloses to the management, at a glance, as

to what its committed outlays are in a given period of time and what the funds availability is for

meeting such outlays. It is quite essential for the management to have an idea of the funds flow

as, without which, management of capital expenditure and operational expenditure will become a

haphazard exercise, leading to defaults in payment obligations of the business or sub – optimal

utilisation of funds.


It is pertinent to mention here about the confusion that may arise about profit and liquidity. Many

presume that adequacy of profit is tantamount to an automatic liquidity and vice versa. Nothing

can be farther from reality.

If maximisation of profit is the corporate goal or objective, the consistency of flow of funds into

the system can be regarded as a precondition for reaching the goal. While profit generates

additional funds, optimum deployment of funds forms the nucleus of the operating cycle in a

business which generates additional profits. Despite good amount of profits, a situation of

disequilibria can still arise due to wrong financial management decisions affecting the inflow and

outflow of funds. A surfeit of this liquidity (funds) affects also the profitability, no doubt, due to

non-utilisation, but if the ‘funds tank’ gets dry, it leads to potential dangers, which, in turn, are

capable of forcing the business eventually to insolvency. Thus, sound or prudent management

principles dictate measures aimed at optimising profit, but simultaneously, they also enjoin upon

the management to properly use the funds such that sufficient liquidity is available to the unit to

meet its creditors in time, with neither an overdose of liquidity nor a depletion thereof with all

the attendant difficulties.

What are funds?

Very broadly, funds are described as total resources. However, most commonly funds are

defined as working capital or cash.

Working capital [here refers to] = Current Assets – Current liabilities

FUNDS FLOW STATEMENT – TOTAL RESOURCE BASIS

The preparation of funds flow statement on total resource basis is fairly simple. The successive

balance sheets are compared and changes in each of the balance sheet items are noted and

classified as sources of funds.


SOURCES USES

Increase in owner’s equity Decrease in owner’s equity

Increase in a liability Decrease in liability

Increase in an asset Decrease in an asset

Funds flow on total resource basis is prepared on two parts – part A shows the changes under

various balance sheet items & part B classifies these changes into sources of funds and uses of

funds. It may be noted that when funds are defined as total resources, the sources of funds are

equal to the use of funds due to the double entry principle of book keeping. It may also be

appreciated that under the total resources method, only the successive balance sheets are used

and the income statements/ profit and loss account are not put to use.

Amplified Funds flow

The statement of sources and use of funds shown in the above table may be amplified, drawing

on the information contained in income statement. The amplification consists of providing

details of underlying changes in (I) reserves and surplus and (II) net fixed assets. This is done as

follows:

Changes in reserves and surplus is essentially out of retained earnings as shown below :-\

Profit before tax and interest

- Interest

- Taxes

- Dividends

Now, profit before tax and interest is shown as source of funds while taxes, interest and

dividends are shown as use s of funds.

Now the funds flow statement on a working capital basis presentsAPOORVA GHOSH4108024024MBF 2008-2010 142

1) Sources of working capital

2) Uses of working capital

3) The net change in working capital

These can be depicted as under

SOURCES USES


OPERATIONS DIVIDEND PAYMENT TAX, INTEREST

ISSUE OF SHARE CAPITAL REPAYMENT OF LONG- TERM BORROWINGS

WORKING POOL

SALE OF NON CURRENT ASSETS

LONG TERM BORROWING PURCHASE OF NON-CURRETN ASSSETS

Sources of Working Capital

1. Operations

The operations of the business generates revenues and entail expenses. While revenues

augment working capital, expenses other depreciation and other amortization decreases

working capital. Hence, the working capital increases on account of operations is equivalent

to:

Net Income + Depreciation

2. Issue of share capital

As issue of share capital results in an inflow of working capital because it brings a cash

inflow.

3. Long – term Borrowings

When a long term loan is taken, there is an increase in working capital because of cash

inflow. The short term loan, however, does not have any effect on working capital. The

reason being a short term loan increases a current asset (cash) and a current liability (short

term loan) by the same amount, leaving the working capital position unchanged.

4. Sale of Non-current asset

When a fixed asset or a long term investment or any other long term asset is sold, there is

working capital inflow represented by cash or short term receivables.


Uses Of Working Capital

I) Payment of taxes, dividends, interest etc.

These transactions result in cash (working capital) outflow.

II) Repayment of long term Liability

The repayment of long term loan, debentures and other long term liabilities involves cash

outflows and hence a use of working capital. The repayment of a current liability, it may be

noted does not affect the working capital position because It entails an equal reduction in

current liabilities and current assets.

III) Purchase of non-current assets

When a firm purchases fixed assets, long term investments or other non-current assets; it

pays cash or incurs a short term debt. Hence, working capital decreases.

The funds flow statement – on working capital basis shown at the above table Part A shows

the sources, uses and net change in working capital and Part B shows the changes in the

internal content of working capital.

Funds Flow Statement : Cash Basis shows,

a) Sources of cash

b) Uses of cash and

c) Net change in cash.

The sources of cash are the sources of working capital plus changes within the working

capital account which augment the cash resources of the business. The change in working

capital which augment the cash flow of the business are accounted for by decrease in

current assets other than cash. The uses of cash are changes that use working capital plus,


changes within the working capital account, which depletes the cash resources of the

business. These latter changes are simply increase in current assets other than cash.

These sources and uses of cash are illustrated below:

Sources of cash

- Operations net income, depreciation

- Issue of share capital

- Long term borrowings

- Sale of non-current asset

- Increase in current liabilities

- Decrease in current assets other than cash

Uses of cash

- Payment of dividend

- Purchase of non-current assets

- Repayment of long term borrowings

- Decrease in current liabilities

- Increase in current assets other than cash

The net effects of the movements of funds is easily discernible in each of the three methods

under which funds flow statements have been prepared. The funds flow system in a business

is often likened to a hydraulic system. The concept of flows implies an inflow, an outflow and

storage where the level is determined by the rate of inflow and outflow.


To summaries, the funds flow statement we observe, is very closely related to the financial

statements, the balance – sheets and profit and loss accounts, the funds flow statement is

related to a time span say one year or six months as the case may be. Thirdly, the funds flow

analysis is very closely related to the normal decision making process in the business –

decisions relating to investment, operations and finance.

Projected Fund Flow Statement

A fund flow statement can be prepared either on the basis of the past data or for a future

period of time provided the time span is specified. All the questions for which the answers are

sought on the basis of past data can also be answered for future period of time provided the

projections are based on realistic assumptions. In fact, projected funds flow statement is of

great practical relevance to bankers, as some of the important questions pertaining to the

financial position, profitability and servicing of working capital/ term loan etc. extended by

banks can be answered with a fair degree of reliability. This to a great extent relives the

banker of his anxiety as to whether a credit decision to be taken at present is worth while from

a commercial point of view.

As bankers funds flow analysis is used mainly to find answers to:

a) How the long term and short term resources will be raised and used?

b) When and how much finance the unit will require?

c) When and how the business will repay the loans?

d) Are the financial policies followed by the unit proper and financial planning

acceptable?

e) What is the dividend policy of the company?

f) What is the contribution of funds provided by internal sources to the growth of

business? (in the past and in future)


A funds flow statement as a third financial statement in addition to the balance sheet and

profit and loss account has a distinct role to play in evaluating the use of resources and the

pattern of financing them.


CASH FLOW STATEMENTS

The following I the text of the revised Accounting Standard (AS) 3, ‘Cash Flow Statements’,

issued by the Council of the Institute of Chartered Accountants of India. This standard

supersedes Accounting Standard (AS) 3, Changes in financial position’, issued in June, 1981.

In the initial years, this accounting standard will be recommendatory in character. During this

period, this standard is recommended for use by companies listed on a recognized stock

exchange and other commercial, industrial and business enterprises in the public and private

sectors.

Objectives

Information about the cash flows of an enterprise is useful in providing users of financial

statements with a basis to assess the ability of the enterprise to generate cash and cash

equivalents and the needs of the enterprise to utilize those cash flows. The economic decisions

that are taken by the users require an evaluation of the ability of an enterprise to generate cash

and cash equivalents and the timing and certainty of their generation.

The statement deals with the provision of information about the historical changes in cash and

cash equivalents of an enterprise by means of a cash flow statement, which classifies cash flows

during the period from operating, investing and financing activities.

Scope

An enterprise should prepare a cash flow statement and should present it for each

period for which financial statements are presented.

Users of an enterprise’s financial statement are interested in how the enterprise

generates and uses cash and cash equivalents. This is the case regardless of the


nature of the nature of the enterprise’s activities and irrespective of whether cash

can be viewed as the product of the enterprise, as may be the case with financial

enterprise. Enterprises need cash for essentially the same reasons, however

different their principal revenue producing activities might be. They need cxash

to conduct their operations, to pay their obligations , and to provide returns to

their investors.

Benefits of Cash Flow Information

A cash flow statement in conjunction with other financial statements provides information that

enables users to evaluate the changes in net assets of an enterprise, its financial structure and its

ability to affect the amounts and timing of cash flows in order to adapt to changing

circumstances and opportunities. Cash flow information is useful in assessing the ability of the

enterprise to generate cash and cash equivalents. It also enhances the comparability of the

reporting of operating performance by different enterprises because it eliminates the effects of

using different accounting treatments for the same transactions and events.

Historical cash flow information is often used as an indicator of the amount, timing and certainty

of future cash flows. It is also useful in checking the accuracy of past assessments of future cash

flows and in examining the relationship between profitability and net cash flow and the impact of

changing prices.

Definitions

The following statements are used in this statement with the meanings specified:

Cash comprises of cash in hand and demand deposits with the bank.

Cash equivalents are short term, highly liquid investments that are readily convertible into

known amounts of cash and which are subject to insignificant risk of changes in value.

Cash flows are inflows and outflows of cash equivalents.


Operating activities are the principal revenue – producing activities of the enterprise and other

activities that are not investing or financing activities.

Investing activities are the acquisition and disposal of long term assets and other investments not

included in each equivalents.

Financing activities are activities that result in changes in the size and composition of the

owner’s capital (including preference share capital in the case of a company) and borrowings of

the enterprise.

Cash and Cash Equivalents

Cash equivalents are held for the purpose of meeting short term cash commitments rather than

for investments and other purposes. For an investment to qualify as a cash equivalent, it must be

readily convertible to a known amount of cash and be subject to an insignificant risk of changes

in the value . Therefore, an investment normally qualifies as a cash equivalent only when it has

short term maturity of, say, three months or less from the date of acquisition. Investments in

shares are excluded from cash equivalents unless they are, in substance, cash equivalents; for

example, preference shares of a company acquired shortly before their specified redemption date

(provided there is only an insignificant risk of failure of the company to repay the amount at

maturity).

Cash flows exclude movements between items that constitute cash or cash equivalents because

these components are part of the cash management of an enterprise rather than part of its

operating, investing and financing activities. Cash management included in the investment of

excess cash in cash equivalents.

Presentation of Cash Flow Statement

The cash flow statement should report cash flows during the period classified by operating,

investing and financing activities.


An enterprise presents its cash flows from operating, investing and financing activities in a

manner which is most appropriate to its business. Classification by activity provides information

that allows users to assess the impact of those activities on the financial position of the enterprise

and the amount of its cash and cash equivalents. This information may also be used to evaluate

the relationships among those activities.

A single transaction may include cash flows that are classified differently. For example, when

the installment paid in respect of a fixed asset acquired on deferred payment basis includes both

interest and loan, the interest element is classified under financing activities and the loan element

is classified under investing activities.

Operating Activities

The amount of cash flows arising from operating activities is a key indicator of the extent to

which the operations of the enterprises have generated sufficient cash flows to maintain the

operating capability of the enterprise, pay dividends, repay loans and make new investments

without recourse to external sources of financing. Information about the specific components of

historical operating cash flows is useful, in conjunction with other information, in forecasting

future operating cash flows.

Cash flows from operating activities are primarily derived from the principal revenue producing

activities of the enterprises. Therefore, they generally result from the transaction and other events

that enter into the determination of net profit or loss.

Examples of cash flows from operating activities are;

Cash receipt from sale of goods and the rendering of services;

Cash receipts from royalties, fees, commissions and services;

Cash payments to suppliers for goods and services;

Cash payments to and on behalf of employees


Cash receipts and cash payments of an insurance enterprise for premiums and claims,

annuities, and other policy benefits;

Cash refunds or payments of income taxes unless they can be specifically identified with

financing and investing activities; and

Cash receipts and payments relating to futures contract, forward contracts, option

contracts and swap contracts when the contracts are held for dealing or trading purposes.

Some transactions, such as the sale of an item of plant, may give rise to gain or loss which is

included in the determination of net profit or loss. However, the cash flows relating to such

transactions are cash flows from investing activities.

An enterprise may hold securities and loans for dealing on trading purposes, in which case they

are similar to inventory acquired specifically for resale. Therefore, cash flows arising from the

purchase and sale of dealing or trading securities are classified as operating activities. Similarly,

cash advances and loans by financial enterprises are usually classified as operating activities

since they relate to the main revenue – producing activity of that enterprise.

Investing Activities

The separate disclosure of cash flows arising from investing activities is important because the

cash flows represent the extent to which expenditures have been made for resources intended to

generate future income and cash flows. Examples of cash flows arising from investing activities

are:

a) Cash payments to acquire fixed assets (including intangibles). These payments include those

relating to capitalized research and developing costs and self – constructed fixed asset.

b) Cash receipts from disposal of fixed assets (including intangibles);


c) Cash payments to acquire shares, warrants or debt instruments of other enterprises and

interests in joint ventures (other than payments for those instruments considered to be cash

equivalents and those held for dealing or trading purposes) ;

d) Cash receipts from disposal of shares, warrants or debt instruments of other enterprises and

interests in joint ventures (other than receipts from those instruments considered to be cash

equivalents and those held for dealing or trading purposes);

e) Cash advances and loans made to third parties (other than advances and loans made by a

financial enterprise);

f) Cash payments for future contracts, forward contracts, option contracts and swap contracts

except when the contracts are held for dealing or trading purposes, or the payments are

classified as financing activities; and

g) Cash receipts from futures contracts, forward contracts, option contracts and swap contracts

except when the contracts are held for dealing or trading purposes, or the receipts are

classified as financing activities; and

h) Cash receipts from futures contracts, forward contracts, option contracts and swap contracts

except when the contracts are held for dealing or trading purposes, or the receipts are

classified as financing activities.

When the contract Is accounted for as an hedge of an identifiable position, the cash flows of the

contracts are classified in the same manner as the cash flows of the position being hedged.

Financing Activities

The separate disclosure of cash flows arising from financing activities is important because it is

useful in predicting claims on future cash flows by providers of funds (both capital and

borrowing) to the enterprise.


Reporting Cash Flows from Operating Activities

An enterprise should report cash flows from operating activities using either;

The direct method, whereby major classes of gross cash receipts and gross cash

payments are disclosed; or

The indirect method, whereby net profit or loss is adjusted for the effects of transactions

of non-cash nature, and deferrals or accruals of past or future operating cash receipts or

payments, and items of income or expense associated with investing or financing casgh

flows.

The direct method provides information which may be useful in estimating future cash flows and

which is not available under the indirect method and is, therefore, information about major

classes of gross cash receipts and gross cash payments may be obtained either.

a) From the accounting records of the enterprise; or

b) Bu adjusting sales, cost of sales, (interest and similar income and interest expense and

similar charges for a financial enterprise) and other items in the statement of profit and loss

for:

Changes during the period in inventories and operating receivables and payables;

Other non-cash items; and

Other items for which the cash effects are investing or financing cash flows.

Under the indirect method, the net cash flow from operating activities is determined by

adjusting net profit or loss for the effects of:

a) Changes during the period in inventories and operating receivables and payables;

b) Non – cash items such as depreciation, provision, deferred taxes, and unrealized foreign

exchange gains and losses; and


c) All other items for which the cash effects are investing or financing cash flows.

Alternatively, the net cash flow from operating activities may be presented under the indirect

method by showing the operating revenues and expenses excluding non – cash items disclosed in

the statement of profit and loss and the changes during the period in inventories an doperating

receivables and payables.

Reporting Cash Flows from Investing and Financing Activities

An enterprise should report separately major classes of gross cash receipts and gross cash

payments arising from investing and financing activities, except to the extent that cash flows

described above are reported on a net basis.

Reporting Cash Flows on a Net Basis

Cash flows arising from the following operating, investing or financing activities may be

reported on a net basis.

a) Cash receipts and payments on behalf of customers when the cash flows reflect and the

activities of the customer rather than those of the enterprise; and

b) Cash receipts and payments for items in which the turnover is quick, the amounts are large,

and the maturities are short.


Examples of cash receipts and payments referred to in above are:

a) The acceptance and repayments of demand deposits by bank;

b) Funds held for customers by an investment enterprise; and rents collected on behalf of, and

paid over to, the owners of properties

Examples of cash receipts and payments referred to in above paragraph are advances made for,

and the repayments of:

a) Principal amounts relating to credit card customers;

b) The purchase and sale of investments; and

c) Other short – term borrowings, for example, those which have a maturity period of three

months or less.

Cash flows arising from each of the following activities of a financial enterprise may be

reported on a net basis:

a) Cash receipts and payments for the acceptance and repayment of deposits with a fixed

maturity date;

b) The placement of deposits with and withdrawal of deposits from other financial enterprises;

and

c) Cash advances and loans made to customers and the repayment of those advances and loans.

Thus, along with fund flow, the cash flow statements gives us a very broad and explicit idea of

the state of an enterprise.


TERM LOAN ASSESSMENT

COST OF PROJECT

Funds required for –

Acquisition of land and its development

Constitution of building

Acquisition and erection plant & machinery

Acquisition of other assets

Preliminary & pre – operative expenses

Margin for working capital

Project cost – sources

Own funds (capital and reserve)

Unsecured long term loans from friends, relatives and others

Term loans from banks and financial institution

Subsidies from government if any

ANALYSIS OF COST OF PROJECT & SOURCES OF FINANCE

Land:

Is the location suitable for the project?

How land is acquired?

Is it adequate for the project?

Is it planned for future expansion?

How is it valued, excessive or reasonable?

In case of loan the cost to be released along with the borrowers margin

Is it developed or to be developed; if so, whether cost properly assessed?

Whether required infrastructure available or not?


Buildings:

Are the buildings needed for the actual productions justified?

Are there any unnecessary constructions like guest houses?

Are the estimates enclosed from an authorized architect?

Does the cost assessed is reasonable and justified?

Plant and machinery:

Are these really needed for actual production?

Are they brand new or second hand?

Are all quotations given for new machineries which are latest and relevant

If second hand, any competent authority assessed the value?

Are the prices reasonable and realizable with similar types?

If the technical knowhow is to be acquired from outside is the cost included in

quotations?

Margin is normally @ 25%

Miscellaneous Assets:

What are included miscellaneous assets?

Do these items are genuinely required or provided for future contingencies?

Are quotations given or these are assessed approximately?

Are all electrical fittings and fixtures properly and reasonably assessed with relevant

quotations?

Preliminary / pre- operative expenses:

What are they?

Are they properly classified?


Whether all these are justified?

Is interest cost during construction period arranged for by borrower?

What is their accounting system to capitalize/ absorb the expenditure?

Margin for working capital:

Is it properly assessed?

Is there enough NWC in the system as on date and on projected basis?

What are the sources? Are they really on long term basis or arranged or on short term

basis?

Whether undertakings can be obtained from contributors that they shall not be withdrawn

during currency of banks finance?

Sources of finance:

Capital – is it properly arrived at?

Whether personal balance sheets are given to know actual capital contribution?

Whether the capital investment in the project is correctly related to the credit reports of

the individuals?

Are the unsecured loans properly planned?

Is there any interest and at what rate and interest?

Management Appraisal:

Proprietary concern – one man show

Partnership firm – more than one person could be at the helm of the affairs

Joint stock companies – public or private

Board of directors

Managing directors

Committee of board of directorsAPOORVA GHOSH4108024024MBF 2008-2010 160

Middle level officers

Line officers

Functional Management

Planning

Organizing

Directing

Coordinating

Controlling

Reviewing


Other things to be kept in mind are that there are certain factors to judge integrity, managerial

capacity, and judgment of borrowers’ vision and mission. This is a very crucial factor and one

should always keep in mind the role that they play and their importance. The diagram below will

help in throwing light over the issue;


POINTS OF STUDY IN TECHNICAL APPRAISAL

1) LOCATION : The location of a project is highly relevant to its technical feasibility and

hence special attention will have to be paid to this feature. Projects whose technical

requirements could have been well taken care of in one location sometimes fail because

they are established in another place where conditions are less favourable. One project

was located near a river to facilitate easy transportation by barge but lower water level in

certain seasons made essential transportation almost impossible. Too many projects have

become uneconomical because sufficient care had not been taken in the location of the

project, e.g. a woollen scouring and spinning mill needed large quantities of good water

but was located in a place which lacked ordinary supplies of water and the limited water

supply available also required expensive softening treatment. The accessibility to the

various resources has meaning only with reference to location. Inadequate transport

facilities or lack of sufficient power or water for instance, can adversely affect an

otherwise sound industrial project

2) INFRASTRUCTURE FACILITY: confirm that the needed infrastructure facilities are

available in the area. Power, water , fuel required are available or not. Sources of water

etc.

3) LAND AND BUILDINGS: whether owned or rented or leased. Scope of future

expansion, is the building adequate, is it well protected etc.


4) MANUFACTURING PROCESS: study the flow chart and identify the critical process on

which quality of finished products rely. Duration of the process, input and output, is it

mechanized or labor intensive? Etc.

5) TECHNICAL KNOW HOW: important feature of the feasibility relates to the type of technology to be adopted for the project. A new technology will have to be fully examined and tried before it is adopted. It is equally important to avoid adopting equipment or processes which are obsolete or likely to become outdated soon. The principle underlying the technological selection is that “a developing country cannot afford to be the first to adopt the new nor yet the last to cast the old aside”. Is it indigenous or imported? Can it be easily adopted?

6) PLANT AND MACHINERY: is it appropriate to the production process? Condition of

machinery, installation process, servicing etc.

7) LICENSES AND PERMITS: are they current and valid? Any restrictions imposed, if yes

then why?

8) PRODUCTIVITY CAPACITY: licensed capacity, installed capacity, any expansion

undertaken etc.

9) TYPE OF PRODUCT: product and its uses, who are going to use it, is it in demand etc.

10) RAW MATERIALS: what are the raw material? Their availability, supply, time needed

for arranging supply, payment terms etc.

11) STORAGE FACILITIES: has provision been made for future or not?


12) MARKETTING ARRANGEMENTS: by whom is it done? Any permanent

arrangements, is their any volatility in their prices etc.

13) MANAGEMENT /LABOR ARRANGEMENTS: who manages it, are they qualified, is it

labor oriented, any unresolved problem till now etc. The labour requirements of a project,

need to be assessed with special care. Though labour in terms of unemployed persons is

abundant in the country, there is shortage of trained personnel. The quality of labour

required and the training facilities made available to the unit will have to be taken into

account.

14) COSTING AND PROFITABILITY: how well the profitability has been assessed based

on the cost.

15) OTHERS: specific benefits available like in the case of 100% EOU, units located in EPZ.


PROJECT REPORT ANALYSIS

TOTAL PROJECT COST

SOURCE OF FINANCE

PROMOTERS

ECONOMIC VIABILITY

TECHNICAL FEASIBILITY

SURPLUS GENERATION/PROFITABILITY

PROJECT IMPLEMENTATION SCHEDULE

CAPACITY TO SERVICE THE DEBT

Payback Method

The method determines the period needed to recover the initial cash investment through annual

cash flows estimated to be generated.

Payback period = Cash investment/ Annual cash inflow

Cash Inflow = net PAT + Depreciation + Other non-cash write offs (intangible)

Term Loan Appraisal

Term loan characteristics

For acquiring assets

Repayable in installments


Repayment out of profits

Term loan appraisal

Term loans can be granted for:

Working capital/ fixed assets under schematic finance

Bank’s branded loan products

Industry or any other projects

Schematic Loans

Appraisal

Appraisal of term loan in schematic finance and our products is purely depending on DSCR and

the repaying capacity respectively.

Economics is required to be prepared for viability study in cases other than the bank’s brand

products.

Quantum

Quantum of loan is the cost of asset less margin subject to repaying capacity.

Repayment Schedule

Repayment schedule may be planned considering DSCR.

Repayment period

Repayment period may be decreased in case of high DSCR and increased in deserving cases

Where DSCR is below 1.5 subject to maximum period permitted in the scheme after keeping a

cushion for delay/default for reason beyond control.

Repayment should start immediately after cahs generation.

Delay in starting of repayment will affect adversely.


Appraisal of term loans in cases of an industry or a project is long term investment decision. It

requires detailed study/appraisal.

Project Appraisal

Assessment of project

Study of project report

Feasibility study

Financial viability

Cost of project

Sources of finance

Project Report

Cost of the project

Sources of finance

Proforma balance sheet and projections

Financial highlights with ratios

Cash flow and fund flow statements

Project implementation schedule

Debt service coverage ratio

Cost of production and profitability

Technical report

Feasibility Study

Generally the entrepreneurs submit a project report & it is duty of appraising officer to cross

check the reliability of assumptions made in the project report.

Managerial CompetenceAPOORVA GHOSH4108024024MBF 2008-2010 168

Technical Feasibility

Commercial Viability

Ecological Analysis

Managerial Competence

Capability of the entrepreneur in implementing & managing the project.

Technical Feasibility

Study of aspects relevant to production of finished goods of proper quality like permits,

machinery, availability of spare parts, infrastructure facility, power, water, fuel etc.

Commercial Viability

Whether the goods can be sold in the quantity and prices as projected. Projection and forecasting,

capacity utilization, price levels etc.

Ecological Analysis

Environmental damage

Restoration measures

Sources of finance

Capital / equity

Reserves/ subsidies

Unsecured loans

Term loans from financial institution


Cost of project

Land and site development

Building

Plant and machinery

Miscellaneous assets

Consultancy fees

Contingencies

Financial Viability

Financial projections

Fund flow and cash flow statements

Ratio Analysis

BEP

Non discounted cash flow technique

Discounted cash flow technique

Debt Service Coverage Ratio (DSCR)

DSCR = NPAT +Intt on TL + Depreciation/ Intt on TL + installment of TL

Ideal DSCR is 2:1

For SSI it is 1.5:1

Repayment period can be reduced where DSCR is high.

Repayment period can be increased up to permissible limit where DSCR is low.

Average Rate of Return

ARR = Average profit after tax/Average book value of investment x 100

It is comparable with the rate of return in market in other investments


Discounted Cash Flow Techniques

Net Present Value [NPV]

Cost Benefit Ratio [CBR]

Internal Rate of Return [IRR]

NPV

The entire cash inflow is discounted at the rate of interest to arrive at present value of

return.

NPV = present value of cash inflow minus present value of cash outflow.

The project Is accepted if NPV is positive and rejected if NPV is negative.

BCR

The entire cash inflow is discounted at the rate of interest to arrive at present value of

return.

BCR = Present worth of benefit/ Present worth of costs

The project is accepted if BCR is more than one and rejected if less than one.

IRR

IRR is the rate of discount at which present value of cash inflows is equal to the present

value of cash outflows.

The project is accepted if IRR is more than the expected rate of return.

Higher the IRR, better is acceptability of the project.


Working Capital Assessment

Working capital, also known as net working capital, is a financial metric which represents

operating liquidity available to a business. Along with fixed assets such as plant and equipment,

working capital is considered a part of operating capital. It is calculated as current assets minus

current liabilities. If current assets are less than current liabilities, an entity has a working

capital deficiency, also called a working capital deficit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot

readily be converted into cash. Positive working capital is required to ensure that a firm is able to

continue its operations and that it has sufficient funds to satisfy both maturing short-term debt

and upcoming operational expenses. The management of working capital involves managing

inventories, accounts receivable and payable and cash.

Current assets and current liabilities include three accounts which are of special importance.

These accounts represent the areas of the business where managers have the most direct impact:

accounts receivable (current asset)

inventory (current assets), and

accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-

term claim to current assets and is often secured by long term assets. Common types of short-

term debt are bank loans and lines of credit.

An increase in working capital indicates that the business has either increased current assets (that

is received cash, or other current assets) or has decreased current liabilities, for example has paid

off some short-term creditors.


http://en.wikipedia.org/wiki/Debt

http://en.wikipedia.org/wiki/Current_assets

Implications on M&A : The common commercial definition of working capital for the purpose

of a working capital adjustment in an M&A transaction (ie for a working capital adjustment

mechanism in a sale and purchase agreement) is equal to:

Current Assets - Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus

assets and/or deposit balances.

Cash balance items often attract a one-for-one purchase price adjustment.

Decisions relating to working capital and short term financing are referred to as working capital

management. These involve managing the relationship between a firm's short-term assets and its

short-term liabilities. The goal of working capital management is to ensure that the firm is able to

continue its operations and that it has sufficient cash flow to satisfy both maturing short-term

debt and upcoming operational expenses.

CONCEPTS FOR WORKING CAPITAL ASSESSEMENT

Gross Working Capital [GWC] = Total of Current Assets

Net Working Capital [NWC] = CA - CL

Working Capital Gap [WCG] = [CA –CL {Excl STBB}]

Permissible Bank Finance [PBF] = WCG – [Higher of stipulated NWC or available NWC]

METHODS OF ASSESSMENT OF WORKING CAPITAL

TURNOVER METHOD : under this method, the WC limit shall be computed at 20% of the

projected sales turnover accepted by the Bank. 5% of projected sales should be available as


http://en.wikipedia.org/wiki/Operations_management

http://en.wikipedia.org/wiki/Current_liability

http://en.wikipedia.org/wiki/Asset#Current_assets

http://en.wikipedia.org/wiki/M%26A

margin. In the case of SSI borrowers seeking/enjoying fund based working capital facilities up to

Rs. 5 Lacs, the limits shall be assessed on the basis of turnover method.

FLEXIBLE BANK FINANCE METHOD: it is an extension of Maximum Permissible Bank

Finance [MPBF] with customer friendly approach in as much as the scope of current assets is

made broad based and for evaluating projected liquidity, acceptable level of current ratio is taken

at 1.17:1 against benchmark of 1.33:1. this method is applicable for accounts with credit limits of

more than Rs. 5 crores.

CASH BUDGET METHOD : this method may be adopted in case of specific

Industries/Seasonal activities such as software, construction, film, sugar, fertilizers etc. the

required finance is arrived at from the projected cash flows and not from the projected values of

assets and liabilities.

NET OWNED FUNDS METHOD: the credit needs of NBFCs shall be assessed based on this

method, rescribed by the RBI.

Dangers of inadequate Working Capital

1. It stagnates growth

2. Fixed assets remain underutilized

3. operating inefficiencies creeps in

4. Difficulty in achieving targets of business for production and profit

5. Business reputation at stake

6. Situation of tight credit terms

7. Difficulty in meeting payment commitments


Letter of Credit

The customers in the course of their business, to run business transactions smoothly, have to

make efforts like participation in tenders for expanding market, deposit security deposits for

participation in tenders, give guarantees for their capacity to perform contracts, avail concessions

in duty on imports when tagged to some exports obligations etc. These business requirements for

goods and services can be met by them with the help of non-fund based facility known as

‘guarantees’ given/issued by the banks.

Sec. 126 of Indian Contract Act, 1872 defines guarantees as a contract to perform the promise or

discharge the liability of a third person in case of his default. During the course of business,

banks are often required to furnish guarantee on behalf of their own customers in lieu of their

obligations, performance or engagement.

The parties involved:

Beneficiary, creditor, lendor

Borrower, debtor

Guarantor, surety

There are different types of guarantees, depending upon the kind of financial favor the customer

is asking from the bank. But certaing issues should be kept in mind, precaution should be taken

while accepting a guarantee or guaranteeing on some other parties behalf. Expiry of guarantee

should be kept in mind and accordingly the acknowledgement should be given. In a letter of

guarantee clarity should be maintained, as far as the amount and dates are concerned, the name

of the customer etc.


Letter of Guarantee

Traders are required to acquire fixed assets and purchase different types of raw materials and

finished goods or make payments for services availed in the course of business. Some of the

purchases of goods and services are possible only if the buyer makes payment in advance.

However, the suppliers in such circumstances also allow the buyers to make purchases with the

help of letter of credit issued by the banker.

The letter of credit is a commercial instrument of assured payment and widely used by the

business community for its various advantages. All parties to credit deal only with the documents

and not the goods. It is an instrument by which a bank undertakes to pay a seller for his goods,

provided he complies with the conditions laid down in the credit. The credit specifies as to when

payment is to be made which maybe either when the documents are presented to the paying bank

or at some future date, depending upon the use of draft as stipulated in the creit.

There are different types of credit like revocable an irrevocable credits, transferable, back to

back, red clause, standby etc. and the letter of credit proves to be a very useful and helpful

facility for the customers.


CHAPTER

IV

ANALYSIS


The whole project is based on the process of advancing loans to a company or an organization,

which has now become a very crucial part of every bank. I had learned how to advance loans of

various kinds, right from comfort loans, vehicle loans, housing loans, education loans etc. to

corporate lending. Corporate lending play important role because these are huge lending and so

they need to be taken care of. As in, when a company or an organization asks for loan then the

bank needs to check a number of things. There is a long process, at the end of which the bank

decides whether to lend the money or not.

In this chapter, I would like to analyze the complete process with the help of a case study. Taking

a hypothetical company and its balance sheet as used by the bank, I would like to analyze

whether or not the company should be given the loan or not.

BRIEF BACKGROUND:

The firm was established in 1991 by the proprietor Mr. G H Pal. The unit is engaged in

processing of cotton seed oil and trading of soyabean, groundnut and various grains according to

season. Initially, the unit was started with three oil expellers. Thereafter they installed three more

oil expellers in the year 2004. Again they installed six more high capacity machines in 2006.

Therefore, presently they are working with 12 expellers/machines. Now they proposed to install

12 new machines in the newly constructing building. However, they proposed to sell the oldest

six machines within very short time. Mr. Sumit Pal S/o Shri G H Pal has recently completed

MBA and looking after financial matters of the firm. The account was taken over in August 2003

from XYZ Bank where they were enjoying credit facilities at lower level.


FINANCIAL INDICATORS :

( Rs. In Lac)

Year Ending

31.3.05

(Aud.)

31.3.06

(Aud.)

31.3.07

(Aud.)

31.3.08

(Aud.)

31.3.08

(Proj.)

31.3.09

(Est.)

Paid up Capital 31.63 33.19 37.09 47.54 66.50 161.01

Reserves & Surplus - - - - - -

Intangible Assets - - - - - -

Tangible Net Worth 31.63 33.19 37.09 47.54 66.50 161.01

Long Term Liabilities 81.87 85.48 121.10 89.45 137.00 230.00

Capital Employed 113.50 118.67 158.19 136.99 203.50 391.01

Net Block 16.15 18.93 33.70 33.34 26.64 220.00

Investments 6.47 7.61 13.70 15.10 10.00 15.10

Non Current Assets 11.35 3.01 4.37 5.92 9.37 8.83

Net Working Capital 79.53 89.12 106.42 82.63 157.49 147.08

Current Assets 206.38 267.52 571.58 573.98 712.49 684.08

Current Liabilities 126.85 178.40 465.16 491.35 555.00 537.00

Current Ratio 1.63 1.50 1.23 1.17 1.28 1.27

D E Ratio (TL/TNW) 1.12 3.23 3.26 1.89 2.96 1.43


DER (TOL/TNW) 6.58 7.95 15.81 12.22 10.40 4.76

DER (TOL/TNW) Excl.

U/sec. loans as quasi-

capital 1.50 3.28 3.592.56

Net Sales 200.99 600.46 1720.71 2097.75 2500.0 2600.00

Other Income 0.43 0.52 1.28 3.19 1.00 8.00

Net Profit Before tax 1.72 2.67 4.73 11.01 12.22 40.78

Net Profit After Tax 1.71 2.67 4.02 9.35 10.72 29.80

Depreciation 2.17 2.06 4.60 4.28 3.75 9.70

Cash Accruals 3.88 4.73 8.62 13.63 14.47 39.50

Capital of the firm is showing increasing trend due to retention of part of net profits in the

system. The proprietor has infused additional funds of Rs. 3.45 lacs as capital apart from

balance net profits of Rs. 7.00 lacs as of 31.03.2008, which resulted it has increased from Rs.

37.09 lacs as of 31.03.07 to Rs. 47.54 lacs as of 31.03.08. The proprietor has estimated to

induct Rs. 100.00 lacs additional funds apart from plough back of profit to raise the capital to

Rs. 161.01 lacs as of 31.03.2009.

Unsecured loans are continuously increased year after year. The same are mainly raised from

family members/relatives. An undertaking from the party should be obtained that these

unsecured loans will be retained in the system till currency of bank finance, as NWC and

DER are depend upon these loans.

NWC in the system as of 31.03.08 stands at Rs. 82.63 lacs, which provide the margin (25%)

for availing the fund based limit upto Rs. 380.00 lacs.


CR of 1.17 as of 31.03.08 has come down from 1.23 as of 31.03.07, which is due to

repayment of T/L and reduction in unsecured loans i.e. short term sources are used for long

term uses, which is internal diversion of funds and should be avoided by the firm. Though it

is still within the acceptable level.

DER in normal condition is above the bench mark level, showing the firm’s high dependency

on outside liabilities. The firm should reduce the outside liabilities or raise capital/family

deposits. However, if unsecured loans raised from family members/relatives are taken as

quasi-capital, the DER as of 31.03.08 is worked out to 3.59, which is within acceptable level.

An undertaking from the party to be obtained that these unsecured loans will be retained in

the system till currency of bank finance.

Sales turnover of the firm has increased substantially from Rs. 600.46 lacs as of 31.03.06 to

Rs. 1741.28 lacs (190%) as of 31.03.2007 and Rs. 2097.75 lacs (21.91%) as of 31.03.08

reflecting the good progress of the unit during last two years. The same are estimated at Rs.

2600.00 lacs as of 31.03.09 with the growth of 24%, which looking to their past performance,

can be considered achievable.

The firm is earning net profits continuously. As of 31.03.08 the firm has registered 132%

growth in net profit as against 21.91% growth in net sales over the last year. The firm has

estimated much improved profit margin due to reduction in manufacturing/power expenses

on account of installation of new plant & machinery.

Cash accruals are sufficient to service the interest on WC.

Overall financials can be considered as satisfactory as of 31.03.2006.


COMMENTS ON ASSESSMENT OF LIMITS :

a) PROJECTED LEVEL OF SALES:

PARTICULAR SALES (IN LACS)

MAR-05 200.99

MAR-06 600.46

MAR-07 1720.71

MARCH 2008 2097.75

Sales turnover of the firm is showing increasing trend. The firm has achieved sales

turnover of Rs. 2097.75 lacs against projected sales of Rs. 2500.00 lacs i.e. 84%. The

firm has achieved 22% growth in sales from Rs. 1720.71 lacs to Rs. 2097.75 lacs as of

31.03.08. During this fiscal, the firm has projected sales of Rs. 2600.00 lacs. From April

to September 08, the firm has registered sales of Rs. 595.25 lacs, which is slightly

decreased by 3.2% as compared to last year correspondence period sales of Rs. 614.90

lacs. However, it is marginal difference, which can be filled during peak season starting

from October to May. Looking to their last 3 years performance and proposed expansion

of unit, we may consider sales of Rs. 2500.00 lacs during 2008-09 achievable with about

20% growth over the previous year.


b) INVENTORY & RECEIVABLE NORMS

The major raw material of the unit is cotton seeds, soya seeds, etc., which are processed

and converted into oil. These raw materials are purchased from Mandi and Cotton

Ginning & Processing Mills. During last 3 years, the actual stock holding & receivables

level remained as under:

Particulars 2005-06 2006-07 2007-08

Total Inventory 173.22 356.69 447.13

Receivables 91.97 183.25 92.93

Sundry Creditors 108.61 236.61 88.85

The level of stock holding and debtors as of March 2006, March 2007 and March 2008

indicate working capital cycle of peak season of 8 months. In view of the fact that it is a

seasonal unit and the firm is required to make bulk purchases of cotton/soya seeds during

the crop season to ensure regular production/working of the unit, the holding can be

considered reasonable. Looking to the situation, it is required to make Peak Level and

Non-Peak level limits i.e. during the peak season & off-season of the crop.


c) WORKING CAPITAL ASSESSMENT

Based on projected sales of Rs. 2500.00 lacs for 2008-09, the WC requirement of the

party as per turnover method can be worked out as under:

Projected Sales achievable during 2008-09 : 2500.00

25% of Sales : 625.00

5% of sales as margin : 125.00

Available margin (NWC) : 82.63

o MPBF : 500.00

Further, based on FBF method of assessment, the WC requirement is worked out as

under:

(Rs. in lacs)

MAR-07 MAR-08

Total Current Assets. 581.26 712.49

Less: Current Liabilities

(Other than Bank Borrowings)

241.90 150.00

Working Capital Gap 339.36 571.86

NWC 95.21 157.49

Flexible Bank Balance (FBF) 244.15 414.37

Net Sales 1741.28 2500.00

NWC to TCA % 16% 22%


MAR-07 MAR-08

Flexible Bank Finance to TCA % 42% 58%

Sundry Creditors to TCA % 40% 21%

Therefore, C.C.(Hyp) limit of Rs. 380.00 lacs as recommended by the branch, can be

considered. However, looking to past trend and seasonal business – crop season from

October to May, it will be justified to renew Peak-Season & Non-Peak Season limits at

25% margin as under:

Rs. 380.00 lacs – From October to May.

Rs. 135.00 lacs – From June to September

d) TERM LOAN ASSESSMENT

The firm was sanctioned T/L of Rs. 17.90 lacs for purchase/installation of 6 jumbo

expellers to expand the capacity of the unit in June 2006. Presently they are working with

12 expellers/machines. Also they proposed to sell the oldest six machines within very

short time. Expected sale proceeds of six old machines about Rs. 18.00 lacs will be

utilized for adjustment of existing Term Loan and other long term uses.

The firm has now proposed to construct new building shed and to install advanced

technology 12 new oil expellers alongwith remaining 6 existing expellers out of 12.

Therefore, the firm intend to work with total 18 expellers to increase the production with

improved quality at reduced cost.


The cost of project & means of finance as per Technical Inspection Report dated 30.09.2008

are as under:

Cost of project Means of funding

Land & Site development owned by the

firm.

0.00 Promoter’s contribution 61.00

Construction cost of shed& building 106.28 Term Loan from Bank 118.80

Electric Installation 14.62

Plant & Machinery 58.52

Misc./Sundry exp. 0.38

TOTAL 179.80 TOTAL 179.80

LAND:

CONSTRUCTION OF BUILDING:

The firm has obtained construction permission from the competent authority. Out of own

contribution, the firm has already started/completed construction of building & civil works as

under:

Particulars Construction area

(In sq.ft.)

Works completed till

19.09.2008

Oil Mill Shed 4300 90%

Raw Material godown 4300 90%


Finished material godown 4300 90%

Shed for overhead tank 2800 60%

Platform No.1 10500 25%

Platform No. 2 10500 25%

As per abstract dtd. 21.04.08 & 23.04.08 obtained from M/s abc, Chartered Engineer, xyz city,

estimated construction cost are given as under:

Oil Mill Shed : Rs. 2589800

Overhead Water Tank : Rs. 917500

Khal Godown Shed : Rs. 2109800

Sarki Godown Shed : Rs. 2109800

Cotton Seed drying platform No.1 : Rs. 1450600

Cotton Seed drying platform No.2 : Rs. 1450600

TOTAL : Rs. 10628100 (Say Rs. 106.28 lacs)

As per certificate of Chartered Engineer, xyz city, the construction works of around Rs.85.75

lacs are already completed. The technical inspecting officials have also confirmed the above

stage of completion. The construction cost is varied from Rs. 150/- to Rs. 600/- depending upon

the works, which is considered reasonable and justified.

ELECTRIC INSTALLATION

Electric installation is mainly consisting of 14 TEFC Motors, 36 pieces Start Delta starter, main

switch, other accessories, etc. These items will cost Rs. 10.20 lacs as per quotation obtained from

Allied Electric Stores, xyz city. Transformer of 500 KVA costing Rs. 4.42 lacs as per quotation

of M.P. Transformer Pvt. Ltd. is to be installed for smooth and adequate supply of power.


PLANT & MACHINERY

The firm has been working with 12 oil expellers with about 100% capacity utilization. To

improve the quality and enhance the capacity, they have decided to purchase 12 new expellers

and install them alongwith existing 6 out of 12 expellers in a new building adjacent to existing

one. Particulars of P&M, cost & manufacturers/suppliers are proposed as under:

(Rs. in lacs)

PARTICULARS Manufacturer/Supplier No. Rate Total Cost

‘Sona’ Oil Expellers M/s xyz 1 12 2.50 30.00

Chainlink convear with

gearbox & chin fitting

M/s xyz 2 1 6.65 6.65

Wash Tank 7 ton with 3

HP Motor

1 1.05 1.05

Filter with pump 1 1.65 1.65

Elevator 30’ 1 1.05 1.05

Dicordicator complete

automatic plants

1 7.50 7.50

Underground tank with

cover & partition

1 0.40 0.40

Storage tank 10 0.264 2.64


Motor stand (6 no.),

foundation bolt (6 no.) &

pipe fitting,

0.56

VAT 2.68

Expeller Spare parts Xyz 3 - - 4.34

TOTAL 58.52

12 pieces of are to be purchased from @ Rs. 2.50 lacs each total costing Rs. 30.00 lacs as per

their quotation dated 14.04.2008. Other supporting items like, wash tank, filter, elevator,

dicordicator complete automatic plant, etc. are proposed to be purchased from.

Keeping in view the volume of project, projected misc./sundry expenses of Rs. 0.38 lac are

reasonable. Therefore, total cost of project Rs. 179.80 lacs is acceptable.

The firm has proposed to contribute 40% margin towards construction of building and 25%

margin for plant & machinery.

As per technical report, the firm has acquired 6 new machines, elevator and conveyor and these

machines are installed in new mill shed alongwith 12 old machines. When in near future 6 more

new machines are supplied, old 6 machines will be sent back to the supplier under buyback

arrangement. The other items are also expected to receive very soon. With the installation and

implementation of all the plant & machinery as proposed herein above, the quality and capacity

of the unit are expected to increase. The capacity will be increased from 80000 quintal to 129000


quintals per season i.e. 540 quintals per day for 240 days working in 2 shifts of 12 hrs. During

the current year i.e. 2008-09, capacity utilization is projected at 75% i.e. 90000 quintals with

working of 18 oil expellers (12 new & 6 existing).

The firm has requested for Term Loan of Rs. 130.00 lacs for the above project. But due to

totaling mistake in one quotation and repeatation of some electrical parts & machineries, total

project cost has been assessed at reduced level of Rs. 179.80 lacs instead of Rs.194.63 as per

technical report dated 30.09.2008. Accordingly, the term loan of Rs. 118.80 lacs can be taken for

financial assistance. The loan is proposed in 6 years after moratorium period upto March 2009.

The following details & analysis are given as per the project report submitted by the Society:

PROFITABILITY DETAILS: (Rs. in lacs)

PARTICULARS

Actual 2007-08

Est.

08-09

PROJECTED

09-10 10-11 11-12 12-13 13-14 14-15

RECEIPTS

Net Sales 2097.75 2600 2725 2850 2975 3100 3225 3300

EXPENDITURE

Raw material consumption

1937.16 2388.03 2500 2615 2725 2840 2955

3025

Purchase & Processing exp

87.9595.00 97.00

100.00

103.00

107.00

110.00

110.00

Selling & Admn. Exp.

9.6915.00 16.00 17.00 18.00 19.00 20.00

21.00


Total Expenditure2034.8 2498.

03 2613 2732 2846 2966 30853156

Profit Before Dep. Int. & Tax

62.95 106.97

117.00

123.00

134.00

139.00

145.00

149.00

Interest on Proposed T/L @ 12% 6.19 13.09 10.61 8.16 5.71 3.26

Interest on CC 38.33 40.00 40.00 40.00 40.00 42.00 44.00

Existing T/L 1.91 132 0 0 0 0 0

Intt. to others 10.62 10.50 10.50 10.50 10.50 10.50 10.50

Total Interest 50.86 58.01 63.59 61.11 58.66 58.21 57.76

Depreciation 4.22 9.70 16.46 15.71 14.14 12.72 11.45

55.08 67.71 80.05 76.82 72.8 70.93 69.21

Profit Before Tax 5.77 12.04 15.95 21.18 30.20 39.07 45.79

Income Tax Provn. -1.25 -1.99 -2.34 -3.11 -4.45 -5.78 -6.78

Profit After Tax 4.52 10.05 13.61 18.07 25.75 33.29 39.01

Interest calculated @ 12% p.a.

As per IC 8088 dtd. 26.08.08 interest rate for food & agro based processing units with investment in plant & machinery upto Rs. 10.00 crores for the amount of advance above Rs. 1.00 crore with CR-5 will be applicable @ BPLR-1.75% i.e. 12.25% at present.


CALCULATION OF DSCR -

(Rs. in lacs)

Year 08-09 09-10 10-11 11-12 12-13 13-14

PAT 10.05 13.61 18.07 25.75 33.29 39.01

Depreciation 9.70 16.46 15.71 14.14 12.72 11.45

Interest 58.01 63.59 61.11 58.66 58.21 57.76

Sub total (A) 77.76 93.66 94.89 98.55 104.22 108.22

Interest 58.01 63.59 61.11 58.66 58.21 57.76

Installments 0 19.80 19.80 19.80 19.80 19.80

Sub total (B) 58.01 83.39 80.91 78.46 78.01 77.56

DSCR 1.34 1.12 1.17 1.26 1.34 1.39

Average DSCR

e) ASSESSEMENT OF NON-FUND LIMITS N. A.

f) CONSORTIUM ARRANGEMENT


N. A.

g) ANY OTHER MATTER

CREDIT RATING :

a)

Year Previous yr. Current yr.

Total score obtained 72% 71%

Grade CR-5 CR-5

b)

Parameters Marks obtained

Previous yr. Current yr.

Max. Obtained Max. Obtained

Borrower rating 67 48 46 34

Facility rating 21 16 29 22

Risk Mitigators 5 5 20 12

Business aspects 4 1 5 3

Total Marks with grade 97 70 100 71

As per Rating Model-II, the firm has secured 71% marks, which comes under investment grade with acceptable risk.

Thus we can see, that in terms of financial assessment this is what is done in a broad scale. Although banks use many different models and ways to assess a borrower. Another important


thing to keep in mind is that credit appraisal consists of many different kinds of appraisal that is the borrowers market worth and the like, which are also very crucial part.


CHAPTER

V


FINDINGS :-

That the banks have their own credit rating system and that they try to update it with the

latest method available.

The ratios have a very important role to play; a thorough understanding of them leads one

to the future prospects of the borrower and also tells a lot about its financial soundness.

Another important thing is the balance sheet, its break up and the study of it, tells a lot

about any organization.

Retail loan sector in india has a long way to go, a steady growth is projected in the

coming years.

LIMITATIONS :-

The time given for the summer internship i.e. 8 weeks, was not sufficient enough to

study and understand the retail loans approval process of the Union bank of India.

The banks have their own confidential information and it was very difficult to make the

project and analyze it on the basis of hypothetical information.


SUGGESTIONS :-

UBI has this time ranked 5th among all the Nationalized banks. The reason for its ranking

was the number of NPAs it had. It was found that a number of retail loans ended up in

NPAs . UBI needs to develop a competitive edge and the managers and the assistants

need to keep a tab on the loans given.

Usually the managers would only fulfill their required target and then would forget about

more borrowers. They need to have more borrowers both for small and big loans.

Many times they pass a loan without the proper appraisal, i.e. the client may lack either

the projected and estimated balance sheet or the proper documents. In such cases there

should be a strict protocol followed.

CONCLUSION :-

As discussed in the project above, Credit Appraisal appears to be the back bone of the banking

institution. It is equally important and dangerous, as there is always the chance of default or

some other risk. After dealing with almost every aspect of loans and advances one can

summarize that with a little bit of strict measures and a keen eye and understanding of a

company’s balance sheet one can very well save the institute the risk other than the default risk.

Even the default risk can be to a certain limit mitigated, if we before sanctioning the amount

check the profile of the customer. Industry Report, bank’s own experiences and the ability of the

borrower to run his enterprise professionally are certain things one can check.

A very crucial aspect of credit appraisal is the credit rating, Union bank has introduced their

own Internal Rating system of all borrowers enjoying/seeking credit limits above Rs. 2 lacs. The

rating grades range from CR1 to CR8. Credit ratings up to CR5 are investment grade. CR6 to


CR8 are non-investment grade as per the loan policy of the bank. Migration in credit rating,

especially downward migration should be discussed in detail and road map to improve the credit

rating has to be drawn up/implemented. A lot of times for some reasons, credit report is not

submitted and the submission of the proposal and its sanctioning is done without it, while

keeping in mind other necessary factors. It is to be seen and made mandatory that the credit

report must accompany the proposal as it gives a very clean and clear picture of the borrowers

credit worthiness.

In order to potential NPAs it is significant to have a fair understanding of the borrower’s

financial health. Thus, at least last three years balance sheet and Profit and loss accounts should

be obtained, in addition to projections of next 2 years. Now, most of the time customers to prove

their credit worthiness make the estimated balance sheets unrealistic, such areas should be

stressed and it should be checked whether the borrower has the ability to go as per the projected

Balance Sheet. The important factors which should be given special consideration are trend in

sales, both quantity and quality, it should be positive with the industry trend. Disparities in the

sales pattern should be analyzed properly. Profitability should be critically analysed, it should be

checked with the existing norms of the balance sheet.

The distribution of profits and its impact at the reserve and surplus along with the tangible net

worth should be seen. Increase/decrease in the term liabilities and its effect on capital employed

should be scrutinized too. Increase or decrease in the investments of the borrower also needs to

be looked at, it should be seen that the investments that the borrower is making should yield

some income. The non – current assets is another important aspect, it should be seen and

commented upon. The debt equity ratio should be seen, if the debts are increasing and equity

decreasing then such case should be discussed.

Working Capital and its assessment should be done before taking a decision about the borrower.

Credit rating is a very important step in deciding whether to sanction or decline a proposal. All

the stages should be vetted and the necessary action should be taken while making any decision.


The other important things to be kept in mind is the security offered, the documents submitted

and the market reputation of the borrower.

It is true that the fear of NPAs looms large whenever a borrower new or old comes for the loan,

but if the all the steps are properly followed and all the aspects looked at, then the banks should

not have any problem in giving out loans and advances of any kind.

BIBLIOGRAPHY


Bessis Joel, ‘Risk Management in Banking’

RBI guidance notes on Credit Risk Management.

Credit Risk Models and Management, 2nd edition by David Shimko.

Credit scoring and its applications by Lync.Thomas, David B. Ederman and Jonathan N.

Crook.

Credit Risk Valuation: Methods, Models and applications by Manuel Ammann.

M.Y.Khan’s, Corporate Finance and its basic usage.

Credit Appraisal, Risk Analysis And Decision Making book, by DD Mukherjee

Banking Strategy, Credit Appraisal and Lending Decisions: A Risk-Return Framework.

By Bhattacharya, Hrishikesh

Financial Statement Analysis: A Practitioner's - by Martin S Fridson, Fernando Alvarez

Analysis of Financial Statements - by Leopold A Bernstein, John J Wild

Financial Analysis: Tools and Techniques a ... - by Erich A Helfert

Credit Risk Management & Basel II - An Implementation Guide. . Mohan Bhatia.

Credit Risk Management by Andrew Fight

The Essentials of Risk Management by Michel Crouhy, Dan Galai, Robert Mark

Framework for Credit Risk Management: Credit by Alastair Graham, Brian Coyle

Risk management and capital adequacy by Reto R. Gallati

The risk management process: business strategy and tactics by Christopher L.

Culp

Credit and collection principles and practice by Albert Franklin Chapin, George E.Hassett

The Appraisal journal by American Institute of Real Estate Appraisers, Appraisal Institute (U.S.)


http://books.google.co.in/books?id=KkM9AAAAIAAJ&q=books+on+credit+appraisal&dq=books+on+credit+appraisal&ei=NjRlSri-J4H4kASb863mAg

http://books.google.co.in/books?id=mdtAAAAAIAAJ&q=books+on+credit+appraisal&dq=books+on+credit+appraisal&ei=NjRlSri-J4H4kASb863mAg

http://books.google.co.in/books?id=2A81gjG9swMC&pg=PA372&dq=books+on+credit+risk+management&ei=WjNlSvbCBYyKlQSu2NDXAg

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http://books.google.co.in/books?id=sD0PNeDmHmgC&dq=books+on+credit+risk+management&printsec=frontcover&source=in&hl=en&ei=wjJlSumxIKiK6AOHn-kk&sa=X&oi=book_result&ct=result&resnum=12

http://books.google.co.in/books?id=wd15dswnQWgC&dq=books+on+credit+risk+management&printsec=frontcover&source=in&hl=en&ei=wjJlSumxIKiK6AOHn-kk&sa=X&oi=book_result&ct=result&resnum=11

Financial statement analysis: a practitioner's guide by Martin S. Fridson, Fernando Álvarez –

Finance and accounting for nonfinancial managersby William G. Droms

Corporate Finance by Scott B Smart, William L Megginson

The analysis of financial statements by Harry George Guthmann, Harry Lewis

Financial statement analysis: a new approach by Baruch Lev

Principles of corporate finance by Richard A. Brealey, Stewart C. Myers

Sites Referred:

www.defaultrisk.com

www.cmie.com

www.crisil.com

www.unionbankofindia.com

www.unionbankofindia/aboutus.co.in

www.unionbankofindia/retailloans/unionshare.co.in

www.unionbankofindia/retailoans/unioncomfort.co.in

www.unionbankofindia/retailloans/unionsmile.co.in

www.unionbankofindia/retailloans/unionhealth.co.in

www.unionbankofindia/retailloans/unioneducation.co.in

www.unionbankofindia/retailloans/unionvehicle.co.in

www.wikipedia.com

www.google.com

www.amazon.com

Inter – office and Intra- Office Circulars.


http://www.amazon.com/

http://www.google.com/

http://www.wikipedia.com/

http://www.unionbankofindia/retailloans/unionvehicle.co.in

http://www.unionbankofindia/retailloans/unioneducation.co.in

http://www.unionbankofindia/retailloans/unionhealth.co.in

http://www.unionbankofindia/retailloans/unionsmile.co.in

http://www.unionbankofindia/retailoans/unioncomfort.co.in

http://www.unionbankofindia/retailloans/unionshare.co.in

http://www.unionbankofindia/aboutus.co.in

http://www.unionbankofindia.com/

http://www.crisil.com/

http://www.cmie.com/

http://www.defaultrisk.com/

http://books.google.co.in/books?id=Iha4OzyPN48C&pg=PA302&dq=books+on+ratio+analysis&ei=0jRlSoyZH42wkgSc-9m8Ag


Documents

Project Report -Union bank