Techniques of Financial Appraisal

8/11/2019 Techniques of Financial Appraisal

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TECHNIQUES OF FINANCIAL APPRAISAL

FOR BANK LENDING

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TECHNIQUES OF FINANCIAL APPRAISAL

Let us imagine you have been recruited by a new generationBank or a PSU Bank or an Asset Financing NBFC into one of

the following positions/roles :

ManagerCredit Appraisal

ManagerCredit Analyst

ManagerCorporate Banking

ManagerSME Banking

Then what are your role expectations ?

You should have, inter-alia, the basic knowledge of

Techniquesof Financial Appraisal for Bank Lending


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OUTLINES/LEARNING OBJECTIVES

INTRODUCTION

Balance Sheet (Statement of Assets and Liabilities)

Profit & Loss A/C ( Operating or Income Statement)

REQUIREMENT OF AUDITED FINANCIALSTATEMENTS

REARRANGEMENT OF BALANCE SHEET ITEMS AS

PER RBI GUIDELINES

REARRANGEMENT OF PROFIT & LOSS ACCOUNT

FINANCIAL /RATIO ANALYSIS OF A BUSINESS ENTITY


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INTRODUCTION - 1

Whenever a bank considers a loan proposal,apart from integrity and KYC aspects, bankskeenly find out the financial details of theprospective borrower. The extent of details

depends on the type of loan, type of theborrower, purpose of loan etc.

Financial details are collected with a view to

assess the followings :


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INTRODUCTION - 2

Net Worth of the Applicant :Helps the bankin deciding the level of activity which may bedesirable by that applicant and the amount ofmoney which can be lent to him.

Repayment Capacity : Helps the bank toassess the surplus available for repayment ofinstalment and interest on banksloan.

Net Worth of the Guarantor :


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INTRODUCTION - 3

Viability/Bankability : A scrutiny of thefinancial records/statements of the existingand proposed business activity helps bank inassessing whether the proposed bank loan will

result in a viable increase in operations andprofit.

Availability of Unencumbered Securities :

Such information is normally available fromthe financial statements of a businessenterprise. For individuals weve to call forsuch information.


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BASIC FINANCIAL STATEMENTS

BALANCE SHEET

INCOME STATETEMENT (PROFIT & LOSS A/C)

DIRECTORS AND AUDITORS REPORT,

EXPLANATORY SCHEDULES AND NOTES ONACCOUNTS

CASH FLOW STATEMENT

BASIC DIFFRENCE B/W BALANCE SHEET &INCOME STATEMENT


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BASIC FINANCIAL STATEMENTS

ITEMS OF BALANCE SHEET : ASSETS ANDLIABILITIES & EQUITY OR CAPITAL

CONCEPTS OF ASSETS AND LIABILITIES (DEBT)

AND EQUITY CLASSIFICATION OF ASSETS (CA & FA) :

CONCEPTUAL DISTINCTION

CLASSIFICATION OF LIABILITIES (CL & FL OR TL): CONCEPTUAL DISTINCTION

REQUIREMENTS FOR AUDITED FINANCIAL

STATEMENTS


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AUDITED FINANCIAL STATEMENTS - 1

Companies : All Limited Companies have tosubmit audited financials.

Turnover above Rs.60 lakh/Gross Receipt

exceeding Rs.15 lakh : Non-Corporateborrowers other than Professional & Self-employed persons with annual sales turnoverof above Rs.60 lakh and Professional & Self-

employed persons with annual gross receiptsof above Rs.15 lakh are required to submitaudited financials to banks for loan proposalsas per sec. 44AB of IT act.


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AUDITED FINANCIAL STATEMENTS - 2

RBI Guidelines : Non-Corporate borrowerswith aggregate fund-based working capitallimit of Rs.25 lakh and above are required tosubmit audited financials to banks as per RBI

guidelines.

Format for Financial Statements : A companyis required to prepare its B/S as per or similar

to the format given in Schedule VI of theCompanies Act. No format is prescribed forProfit & Loss A/c.


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PUBLISHED BALANCE SHEET

Liabilities Amount Assets Amount

Capital , Reserves & Surplus

(Net Worth)

Fixed Assets (Net)

Term Liabilities

(Secured Loans +

Unsecured Loans)

Investments

Current Liabilities & Provisions Current Assets, Loans &

Advances

Misc. Exp. & losses not yet

Written-off

Total Liabilities Total Assets


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REARRANGED BALANCE SHEET

Liabilities Amount Assets Amount

Capital , Reserves & Surplus

(Net Worth)

Fixed Assets

Intangible Assets

Term Liabilities Other Non-Current Assets

Current Liabilities

(OCL + STBB)

Current Assets

(Inventory + Receivables+

OCA)

Total Liabilities Total Assets


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REASONS FOR REARRANGEMENT

OF BALANCE SHEET ITEMS - 1

Liabilities Side : As per Companys published Balance Sheet,liabilities are grouped on the basis of Security and Liquidity.

The objective of a banker in analysing the B/S is to find outthe liabilities which are payable in short term and to

compare the same with the short term assets for ensuringthat all short term liabilities are covered by sufficient shortterm assets because Banks traditionally provide Short Termloans/Working Capital Loans. The classification like Securedand Unsecured Loans does not serve this purpose.

The Banker wants to reclassify the liabilities strictly on thebasis of theirtime for payment.


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REASONS FOR REARRANGEMENT

OF BALANCE SHEET ITEMS - 2

Asset Side : As per Companys published Balance Sheet,assets are grouped on the basis of Purpose or use ofresources.

A Banker for the purpose already stated wants to reclassify

the assets strictly on the basis of comparative liquidity (shortterm assets) and realisability (convertibility to cash).

For example in the companysB/S, items like patents, goodwilletc. find place u/r FA but a banker likes to classify them as IA

on the conservative assumption that they would realisenothing in case of forced sale, for payment of bank debts.Similarly certain items classified as CA may not be liquid andbanker likes to classify them as Non-Current assets.


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REARRANGEMENT OF BALANCE SHEET ITEMS

AS PER RBI GUIDELINES

Liabilities Side : A. Net Worth : Representing contribution ofthe promoters/owners of the concern towards business. Itconsists of Paid-upCapital, Free Reserves and Surplus. It isalso known as the ShareholdersFunds or OwnersEquity.

B. Term or Deferred Liabilities : Representing thoseliabilities which are payable after one year from the balancesheet date. They represent long term sources of funds for thebusiness and should be utilised for financing Fixed Assets.Examples : (i) Term Loan from Fis/Banks excluding Instalments

payable within 1 year, (ii) Debentures payable after 1 year, (iii)Deferred Payment Credits excluding Instalments payablewithin 1 year, (iv) Term Deposits payable after 1 year. Theportion of such liabilities which are payable within a year isclassified as Current Liability.


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C. Current Liabilities : Representing those liabilitieswhich are generally payable within one year from thebalance sheet date. They represent short termsources of funds for the business and should be

utilised for financing Current Assets.

Examples :(a) Trade Creditors including Bills Payable(Credit available on purchases of Raw Materials,Consumables & Spares), (b) Creditors for Expenses(Rent payable, wages payable and otheroutstanding/accrued expenses)


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C. Current Liabilities (.. Contd..) : (c) Short Term BankBorrowings for Working Capital (in short STBB) likeCash Credit (CC), Overdraft (OD) or Working CapitalDemand Loan (WCDL), Bill Finance, (d) Provisions for

payment of taxes, dividends, bonus and otherstatutory dues, (e) Advance payment fromCustomers for supply of Finished Goods and (f)Instalments of Term Loan, Debentures, Deferred

Credits and Deposits etc. falling due within 1 year. All Items except (c) are collectively known as Non-

Banking /Spontaneous CL or Other Current Liabilities(OCL or CLOTSTBB).


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Asset Side : A. Fixed Assets : Representing assets of fixednature such as land, building, plant and machinery etc. (for aManufacturing Concern) permanently required by theconcern to carry out its business, aka Capital/Block Assets.

Net Fixed Asset or Net Block = Gross Fixed Asset or GrossBlockAccumulated Depreciation

B. Intangible Assets : Representing assets which have nophysical existence or certain fictitious assets which are in fact

capitalised expenses/accumulated losses such as goodwill,patents, preliminary expenses and Miscellaneousexpenditures and losses not yet written off etc.


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C. Current Assets : Representing those assets which are likelyto be converted to cash or used up in the business within oneoperating cycle (working capital cycle) of the business or amaximum period of 12 months. The main constituents areInventory and Receivables. These two items are combinedly

known as Chargeable Current Assets. Current Assets alsoincludes items like Cash and bank balance, short term liquidinvestments, fixed deposits with banks, advance tax paid,prepaid expenses and advance payment to suppliers of rawmaterials etc. These miscellaneous items are known as Other

Current Assets (OCA) or Non-Chargeable Current Assets.

Current Assets are also known as Liquid Assets, CirculatingAssets or Floating Assets or Gross Working Capital.


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D. Other Non-Current Assets : Which represent miscellaneousassets not realisable during the current operating periodsuch as non-consumable stores and spares, investments,loans and advances etc. to other group concerns/employeesor for activities not directly related to the business of the unit.

It also includes debtors outstanding for more than 6 months,dead/non-moving inventory, Security deposit, Advances tosuppliers of Capital goods and Fixed deposits with banks heldas margin for LC/LG etc.


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REARRANGEMENT OF P & L ACCOUNT 1. Gross Sales (Net of Returns)

2. Less Excise duty

3. Net Sales

4. Cost of goods Sold or Cost of Sales

(i) Raw Materials consumed

(II) Other Spares

(iii) Power Fuel

(iv) Direct Labour

(v) Repairs Maintenance

(vi) Other manufacturing expenses

(vii) Depreciation

(viii) Sub-Total of (i) to (vii) i.e., Factory Cost

(ix) Add Opening stock of Work in Process (WIP)

(x) Deduct Closing stock of WIP

(xi) Sub-Total/ Cost of Production of goods available for Sale (COP)

(xii) Add Opening stock of finished goods (FG)

(xiii) Deduct Closing stock of FG

(xiv) Sub-Total/Cost of goods Sold (COGS)


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REARRANGEMENT OF P & L ACCOUNT- Contd :

5. Gross Profit (34)

6. Less Operating Expenses

(i) Office/General & Administrative Overheads

(ii) Selling & Distribution Overhead

7. Operating Profit Before Interest & Tax (OPBIT)

8. Add/Deduct Non-Operating or Other Income/Expenses

9. Profit or Earning Before Interest & Tax (PBIT or EBIT)

10. Financing or Interest Expenses (both for Working Capital & Term Loan)

11. Profit or Earning Before Tax (PBT or EBT)

12. Tax paid/provision

13. Net Profit/Profit After Tax (PAT)

Rearrangement of Balance Sheet and P&L a/c is to be done for a number ofoperating years and also on the basis of estimates for the current year followed

by projections for the next year. This enables the banks to study the trend anddraw conclusions regarding the operations of the concern on year to year basis.


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OBJECTIVES OF STUDYING

FINANCIAL STATEMENTS Study of financial statements involves study of the following five major

aspects of the business enterprise :

- SOLVENCY

- LIQUIDITY

- LEVERAGE

- PROFITABILITY

- ACTIVITY (TURNOVER/UTILISATION/EFFICIENCY)

- COVERAGE Ratios

TREND ANALYSIS/TIME SERIES ANALYSIS

INTRA-FIRM COMPARISION

INTER-FIRM COMPARISION`


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FINANCIAL & RATIO ANALYSIS

OF A BUSINESS ENTITY - 1(A) Financial Stake of the Promoters/Owners and Solvency of the Concern :

Solvency Ratios measure ability of the firm to meet its longterm obligations

Tangible Net Worth (TNW) : TNW = NW IA. Also, TNW =

Total Tangible Assets (TTA) Total Outside Liabilities (TOL).Positive TNW i.e., when total tangible assets exceed totaloutside liabilities, would mean the concern is solvent.

Asset Coverage Ratio : (a) Total Asset Coverage Ratio (TACR)

or Solvency Ratio = [Total Tangible Assets (TTA)/Total Loansor TOL], (b) Fixed Asset Coverage Ratio: FACR (Tangible FixedAssets/Long Term Loans). It measures the solvency/ability ofthe firm to pay for the loans by disposing of its assets, in caseof need. Generally used by Term Lenders/Project Financiers

to judge the Solvency of the borrowing firm.


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OF A BUSINESS ENTITY - 1(B) FINANCIAL LEVERAGE

Debt Equity Ratio (DER) : DER = Long TermDebt/Equity ; or, Debt to Assets Ratio, High DERalso known as Trading on (Thin) Equity.

Total Indebtedness Ratio (aka Total Debt to Equity)(TOL : TNW), TOL = CL + TL, TNW= NWIA

Asset to Equity (A/E) = EM is called Financial

Leverage Ratio


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OF A BUSINESS ENTITY - 2 (B) Liquidity : Liquidity ratios measure the ability of the firm

to meet its short term obligations, the solvency of the firm inshort term. Fixed assets are required by any going concern forlong-term use and are not available to meet its obligations forshort-term or immediate liabilities. These liabilities are to be

met from Current assets. The value and realisability of currentassets into cash is thus an important indicator of the capacityof the concern to meet its current liabilities to ensure smoothday to day functioning of the unit. The most important aspectof financial appraisal by banks is to study the liquidity position

of the concern which is very relevant for assessment ofworking capital requirements of a firm. The following tworatios are important in this regard.

(a) Current Ratio (b) Liquid/Quick/Acid Test Ratio

&


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OF A BUSINESS ENTITY - 3Current Ratio : It is the ratio of Current Assets to CurrentLiabilities. From lenderspoint of view, a higher current ratiois preferable. In other words, the larger the excess of currentassets over current liabilities, the better. This is because, thecompany could then ward off even a drastic fall in the value

of current assets, without defaulting on its commitment tocreditors. On the contrary, if the ratio falls below 1, thecompany would be in serious liquidity problems, finding itdifficult to meet the financial commitments in time. Aminimum current ratio of 1:1 indicates that CL are just

matched by CA. In India, the benchmark for CRadopted bybanks is 1.33, pursuant to the recommendations of theTondon and Chore committees. This means that the CLshould Not exceed 75% of CA.

C & O S S


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OF A BUSINESS ENTITY - 4Current Ratio (CR) : It needs to be added that an unduly highCR need not be an unmixed blessing. A very high CR wouldindicate that the company is unable or unwilling to raiseadequate CL to finance a part of the CA. Excluding theprospect of inability to raise funds/CL, even unwillingness to

do so would, in many cases, point to faulty financial planning (a) conservative CA management policy leading to excessholding of Inventory and/or very liberal credit policy/poordebt collection policy resulting in high Receivables; both thefactors leading to higher level of CA and hence high CR; (b)

conservative CA financing policy by using higher proportionof long term funds instead of short term sources/CL infunding the CA which increases the cost and reduce theprofitability. For, CL are usually less costlier than TL and NWand every trading/manufacturing concern should raise

adequate quantum of CL.



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OF A BUSINESS ENTITY - 5Current Ratio (CR) : Also a very high CR of 2:1 or 3:1 doesnot necessarily signify a very high liquidity position of thefirm, instead a firm with a CR of even 1:1 may have acomfortable liquidity condition. The moot point here is thatone should be aware of the limitation of ratios and one

should not be guided by the quantity of CR alone, oneshould see and analyse the quantity as well as the qualityof the CA/each component of CA to ensure that nodead/non-moving/ obsolete inventory or no baddebtors/receivables are included in the CA which results in

higher level of CA/CR and therby giving false impression ofhigh liquidity.


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FINANCIAL & RATIO APPRAISAL

Liquid/Quick/Acid Test Ratio : The CR refers to firmsability to meet itsshort term obligations within one year. However, it does Not precisely

indicate the firms ability or otherwise in meeting the immediatelypressing liabilities. Inventory and prepaid expenses are not quicklyrealisable and thus may not be available to meet the current dues of thefirm. To ascertain a firms preparedness for meeting the immediatedemands on its liquidity, current assets of such nature are thus excludedto find the real liquidity position of the concern on a very short term basis,

i.e., another ratio called the liquid/quick/acid test ratio is computed bycomparing the relationship b/w current liabilities and immediatelyrealisable current assets (quick/liquid assets) such as cash, receivables andhighly liquid marketable investments.

Quick/Liquid Ratio = (CA (Inventory + Prepaid Exp.))/CL = (Cash +

Receivables + Investments)/CL

A quick ratio of 1:1 is considered desirable.


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(C) Profitability Ratios : The important ratios are Gross Profit Margin(GPM), Operating Profit Margin (OPM), Net Profit Margin (NPM), Return

on Net Worth (RONW) and Return on Investments (ROI), Return on assets(ROA) and Du Pont Analysis of ROE (5 Factor Analysis).

ROE = PAT/E = PAT/PBT x PBT/EBIT x EBIT/S x S/A x A/E = Tax MgmtEfficiency x Interest Mgmt Efficiency x Operating Efficiency x AssetUtilisation x Equity Multiplier or Financial Leverage

(D) Coverage Ratios: Interest Coverage Ratios like I/EBIT, EBIT/I andI/EBITDA and EBITDA/I.

Debt Service Coverage Ratio (DSCR): Wellstudy in Term Loan and ProjectAppraisal, = Cash Flow available to service LT Debt/LT Debt Service

Commitment or Burden.


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(E) Activity Aspects : Activity or Turnover/Utilisation/Efficiency ratioscome under this category; such as Fixed Asset TO (NS/FA), Inventory TO

(COGS/Inv), DebtorsTO (Total Cr. Sales/Avg. Debtors), CreditorsTO ( TotalCr. Purchase/Avg. Creditors). Also following holding periods are usuallycomputed over successive years for the unit itself (intra-firm comparison)and with that of similar units (inter-firm comparison) for assessment ofWorking Capital Requirement of the Business Unit. They are RM holdingPeriod = (Avg. stock of RM/Avg. daily consumption of RM during the year),

WIP holding Period=(Avg. stock of WIP/Avg. daily Cost of Production (COP)of goods produced during the year), FG holding Period=(Avg. stock ofFG/Avg. daily Cost of goods sold (COGS)during the year), Debtors orReceivables holding Period=(Avg. Debtors and Receivables/Avg. daily Cr.Sales during the year) - this is Avg, Credit period extended or Avg. debtcollection period, Creditors or Payables holding Period=(Avg. Creditorsand Payables/Avg. daily Cr. Purchases during the year) this is Avg. Creditperiod enjoyed or Avg. Credit payment period.


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KEY WORDS/TERMINOLOGIES/GLOSSARY

CA, CL, FA, FL or TL, Net Worth, Tangible Net Worth(TNW), Tangible -vs- Intangible Asset, Chargeable

CA, TOL, Current Ratio, Liquid/Quick/Acid Test

Ratio, Debt Equity Ratio, TOL : TNW ratio or Total

Indebtedness Ratio, RM, WIP, FG, Receivables &Payables Holding Period, Other CL or Spontaneous

or Non-Bank CL, Avg. Debt Collection Period, Avg.

Credit Period Enjoyed.


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Home Task for Next Class

Activity : Collect the latest annual report of aManufacturing Company and rearrange the

Balance Sheet as per Bankers Requirement

and calculate the following ratios etc. Current Ratio, Liquid/Quick/Acid Test Ratio,

Debt Equity Ratio, TOL : TNW ratio or Total

Indebtedness Ratio, RM, WIP, FG,Receivables & Payables Holding Period, Other

CL or Spontaneous or Non-Bank CL, Avg. Debt

Collection Period, Avg. Credit Period Enjoyed.


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Techniques of Financial Appraisal