Commercial credit analysis

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Businessmen need loans for their businessess. There are many instances when the applicant (businessman), unaware of the bank’s needs, does not present all the details required or presents it in a manner that causes the Bank to reject the application. At other times, as the information given is incomplete, the applicant is harassed by demands for more information and then after he has submitted that asked for for yet some more. Time drags on while the bedeviled applicant runs hither and thither exasperated, frustrated and harrowed. The banker is also exasperated, frustrated and harrowed. He exists to make loans but before he approves the application and permits disbursal, as a responsible professional, he has to be convinced that the borrower has the capacity and the willingness to repay. Nothing thrills him more than a well presented detailed application that addresses all the concerns that he may have.

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

This course is also for the banker to remind him of the issues that are important when assessing the credit worthiness of a prospective borrower. It is also intended to also help students of banking, management sciences and finance. THE BUSINESS OF LENDING

Raman Menon is an exporter of garments. He has received a large order from the United States and the finished goods have to be exported within 90 days. In order to fulfill the order he requires approximately Rs. 50 lakhs to purchase raw materials and meet production costs. He has never sought a bank loan and is unclear on how he should approach a bank and which bank he should approach. Rusi Daruwalla, on the other hand, is the Managing Director of Unisulphur Ltd., a company that manufactures chemicals and needs to expand capacity in his factory to meet growing demand. He has approached the company’s bankers - The Manufacturers Bank for a loan. However, even after two months, they were still raising several queries and Mr. Daruwalla is at his wit’s end. He was even forming a belief that the bankers were raising queries in order to find a way out of not lending him the funds that he needs. Vinod Desai is a young professional. He has just qualified as a Doctor and wishes to set himself up as a Medical Practitioner. He needs essential seed capital of around Rs. 10 lakhs to rent and equip a clinic. Unfortunately he

has no funds nor can he give any collateral apart from the assurance that he would work hard and repay the amount borrowed within a year or two. Raman Menon, Rusi Daruwalla and Vinod Desai have several commonalties. They require money now. They need this money essentially from a bank. They are unclear on how to approach the bank and what information they need to furnish. This is a problem many in need of finance face and often they believe, misguidedly, that banks do not want to lend to them.

I state misguidedly because banks exist in order to lend. They avidly and aggressively seek persons or corporates to whom they can lend monies to. However, as the downside of a bad debt is very high the banker has to be convinced that he is actually not throwing away good money and that he will be repaid in full and in time. To this end he will ask questions, seek answers and documentary evidence. This is natural. He has to always remember that a bad loan is a loss. It must be remembered that the return that a banker normally earns on a loan is about 2% to 3% per annum. If the Manufacturers Bank advanced a loan of Rs. 2,000,000 to Unisulphur Limited, it could expect a net return/ earning of Rs. 40,000. If however, the loan becomes uncollectable and by extension bad, the Bank would need to lend Rs.100,000,000 at 2% per annum to another company in order to recoup the loss. This is an enormous amount. In short, considering the cost of a bad loan, it is safer to refuse advancing a loan (from a banker’s perspective) than advance one in the hope of earning an income. The downside risk is enormous. This is the reason that bankers prefer to lend only to those companies who are growing, profitable, running and well regarded. This is why it appears that Banks are desperately trying to lend to those who do not need money and refuse to “give the time of day” to those who do.

One must bear in mind that the non performing asset recognition norms now imposed by the Reserve Bank on banks are becoming increasingly stringent. If interest is not paid for two quarters on a loan, the loan has to be deemed/ recognised as a non performing asset (NPA). Interest then cannot be accrued on this advance by the Bank and Banks are also required to state in the financials the quantum of non performing assets they have at the year end. Provisions too would need to be made - the amount depending on how good the advance I, the amount of collateral the bank has and the period it has been outstanding. This is a direct charge on profits. The enormous emphasis placed on non performing assets and the scrutiny it is subjected to (quite rightly) is one of the main reasons that bankers are reluctant to lend when there is even a shred of concern on the viability of a project or the creditworthiness of a borrower. The dictum they follow is “when in doubt, don’t”.

In conclusion it must always be remembered that the business of banking is lending. The banker takes a risk whenever he approves a loan. This is accepted. His job, as a prudent

person, is that he has to ensure that the risk is minimal on any monies lent. The borrower, on the other hand, if he wishes to receive the monies he needs for his enterprise has to satisfy the banker that he is competent, the monies lent are safe and will be repaid.

In this course the participant will be enlightened on the factors bankers look at when reviewing a credit proposal - give the borrower a peep into a banker’s mind. These are essentially: The nature of the loan sought. The period within which it would be repaid. The manner it would be repaid. The security or collateral that is given for the loan. The economic conditions and the industry conditions that might affect the creditworthiness of the borrower. The viability of the project. This would include knowing the industry and the relationship of its the economic/ business cycle. performance with loan in the been.

The competence and integrity of management and its intention to repay the manner agreed. The past record. How successful has the particular business/ businessman

Should the borrower address these issues, the chances are that the loan would indeed be paid in record time. THE PURPOSE

The pivotal question upon which the lending decisions rests is the purpose for which the loan is sought. and this is usually the first issue that a Banker ascertains when approached for a loan or any other credit facility. In regard to this there are a few factors that must be remembered as these are critical. 1. The nature of the credit facility sought must be consistent with the borrower’s

activities. Raman Menon is an exporter of garments. It would be inconsistent and illogical to advance him a loan to purchase a chemical agitator. 2. It must be for a matching need. In regard to this I mean that short term funding should be sought for a short term need. Raman Menon, as an exporter of garments should not seek a term loan to finance preshipment expenses. Alternatively, a manufacturer should not seek to finance a factory expansion with an overdraft. in short: A company that needs working capital to purchase inventories (stocks) and expenses should seek an overdraft. An exporter who needs finance to purchase goods to export should seek a packing loan. pay pre shipment

An exporter who needs finance on goods exported under a usance letter of credit ( payment is made after 90 to 180 days after the acceptance of the documents by the buyer) should seek an export bill discount facility. An industrialist on the other hand who needs a large loan to finance an expansion or build a factory or buy some very expensive machinery should seek a term loan. This is a loan that is payable over a period of time. Often, due to the gestation period, banks would give a moratorium regarding payment of interest and principal for a year or so. At times a loan may be required for a short period to ‘bridge two events”. This is known as a bridge loan. A company may have had a public issue to finance its expansion. In order not to hold up work until the final allotment is made and the monies are available to the company, it may seek a bridge loan. Certain companies and industries require facilities seasonally. A classic example is the sea food industry. It requires finance soon after the monsoons to purchase and process seafood for export. During the monsoons no finance is usually required. Similarly the tea industry requires finance when there is no picking of tea - to replant tea and to maintain the tea gardens.

It is imperative that the nature of the facility sought is compatible with the reason the facility is sought. If it is not there could be horrendous repercussions as did happen soon after the liberalisation initiatives announced after 1992. At that time the capital markets were booming and most industrialists believed that they could access the markets at will. Many accessed the markets, began projects and utilised the monies for other purposes too. They did not foresee the virtual death of the capital market. When they found issues being under subscribed and devolving, short term funds such as overdrafts were utilised to complete projects begun. I can understand and sympathise with this though I think it is dangerous. If a company has spent Rs. 10 crores and needs another Rs. 2 crores to

complete an installation, it is better to complete it so that it can begin producing and earning profits as opposed to allowing it to be a non productive white elephant. However, in practice, (although at the time it may appear to be a stroke of genius and a way out of a dangerous situation) it is fool hardy to finance a long term asset with a short term loan. The two are incompatible and there is a maturity mis match. Consequently when short term funds begin to become tight, as did happen in 1997 and 1998 in India, several companies began to resort to accommodation financing (discounting of bills that were not backed by genuine trade transactions). Once begun one usually gets sucked into the situation and it has a snow balling effect. Once in the spiral it becomes difficult to get out. A bill maturing is paid by another bill that is discounted. At each stage charges have to be paid. The result is one pays much, much more than one would have had one taken a term loan. Additionally, one would have saved oneself from a tremendous amount of tension. Additionally, the accommodation financing route can lead to lack of liquidity (if the next bill is not discounted) , loss of credibility and can, as has happened in several cases recently, lead to the closure of the concern.

It is important that a prospective client is honest and open with his banker. If he needs to utilise a loan for a particular purpose, he should tell the banker exactly what the purpose is. He should advise his banker his concerns and his problems. Bankers are there to help and not to hinder. If the banker has a full appreciation of his clients’ concerns; his strengths and his weaknesses and he is convinced of the person’s integrity, the banker will go out of his way if required to sanction the loan. It is always better to apprise the banker of all the issues at the outset - especially the more crucial ones. It would be very difficult to explain at a later stage why something of crucial importance was not mentioned. An omission of an important issue may also make the banker wonder whether there are any others that have not been mentioned which may be critical. Honesty and transparency is without doubt the best policy. SOURCES OF REPAYMENT

The main concern that a banker has when facilities are extended is on the repayment of the monies advanced. This is the question that he will invariably zero in on and it would be prudent for the prospective borrower to advise him upfront on how he intends to repay the facility. As prospective borrowers Raman Menon, Rusi Daruwalla and Vinod Desai should be able to demonstrate to their respective bankers with facts and figures the repayment plan.

In ideal circumstances there should be more than one source of repayment so that should there be, for some reason, a delay or a problem, the repayment commitment can still be

honored. Bankers too, if presented with a well structured plan/ plans of repayment would be more willing to listen and even advance facilities.

Primary Source The primary source of repayment should be directly related to the kind of loan given i.e. for facilities extended (overdraft) for working capital or to finance trade the repayment should be from the proceeds of the goods sold. In Raman Menon’s case, the primary repayment must be from the sale of garments. If a bridge loan prior to the final allotment of a public issue has been given, the repayment should be from the monies received after the allotment is made. On the other hand if the bridge loan is given prior to the sale of an asset, the proceeds from the sale of the asset should be used to extinguish the loan.

Secondary Source Even though there may be a real and quantifiable first source of repayment, there is always a possibility that on account of occurrences beyond the borrower’s control, the loan cannot be repaid from the primary source. A classic example is what is presently happening in India on account of the liquidity crunch and the demand downswing. A well known company purchased 41 windmills at a cost of around Rs. 1 crore each and was confident of selling them quickly. Due to a credit squeeze the windmills were unsold and the company could not repay the borrowings from the proceeds of the sale. The company in order to meet its credit commitments sold some property it owned. This was its secondary source of repayment. When companies take working capital finance in the form of overdrafts they normally hypothecate debtors and stock. If repayments are not made, the secondary source of repayment can be seized and sold and the proceeds can be used to liquidate the loan. Raman Menon would have, when taking the loan, hypothecated his goods. If he was unable to repay the monies borrowed the bank could seize his goods and then sell them.

Tertiary Source The tertiary source is further security for a loan. This is in the form of additional collateral that may be unconnected with the business. A director could pledge the shares that he owns in certain blue chip companies as additional security. Alternatively the principal

shareholders could give their personal guarantees or a well wisher could give his guarantee. The comfort that a Bank would derive is that should the primary and secondary source of repayment fail, they will have recourse to yet another source of repayment. It is assurances such as these that help the Banker in supporting and recommending a request for a credit facility. As additional security Raman Menon could mortgage his factory or give as additional security shares that he owns. Similarly Rusi Daruwalla could, for the term loan given to Unisulphur Ltd., give his own personal guarantee.

Refinancing Another method of repaying a loan is by refinancing - procuring a second loan out of which the existing loan is repaid. This may be either by: Taking another loan. Accepting fixed deposits. This is not particularly easy presently owing to the credit/ liquidity crunch and the fact that several good companies have defaulted on the payment of principal and/or interest. Issuing debentures. Debentures are an acknowledgment of debt and this is a very popular form of raising funds to repay existing loans. The convenience of a debenture is that it is usually repayable only after a minimum of three years. It gives the borrower some time to arrange his finances.

The banker will seek to ensure that the charge is properly registered so that should the need arise, the banker can take possession of the asset. There are two kinds of charges specific and floating. A specific charge is a charge on a specific asset. A floating charge, on the other hand, is a charge on all the assets both present and future of the company. A specific charge has a prior charge however and a banker would always prefer a specific charge.

There are times when the asset to be charged is already hypothecated. In such instances the bank can only get a second charge for the facility given. This means that the banker’s rights are subordinate to the entity that holds the first charge. In other occasions where there are a number of lending banks as in a consortium, the borrower would be able to give the bank only a “pari passu” charge. In this instance the bank’s rights are on the same footing as the other lending banks.

No banker will issue facilities unless it knows and checks the sources of repayment because he is in the business of lending, and not in the business of giving away. COVENANTS

Raman Menon was worried and concerned. He had received a call a short while earlier from his banker congratulating him on his loan request being approved. The sanction letter that was faxed shortly afterwards contained various conditions and the disbursal of the loan was contingent on the conditions being met. The concern Menon had was on the nature of these stipulations. He wondered whether he should accept a loan that is conditional.

Conditions imposed on facilities extended by banks, also known as covenants are imposed by bankers upon a borrower to: Preserve the financial strength of the borrower. Maintain the borrower’s ability to refinance itself - the borrower (being company or a business) continuing as a going concern. Control the assets - prevent the borrower from selling assets thereby assets are not dissipated, a limited

ensuring that to the

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

Covenants, therefore, are from a banker’s perspective extremely important in the structuring of a loan. While a risky, unsound loan will not become good by covenants, they will afford some comfort and a degree of control including providing warning signs should the financial position of the company deteriorate. The amount of covenants that can be imposed on a borrower would depend on: The antecedents of the borrower. Has the borrower borrowed before and what repayment history been . The need of the borrower for the facility/loan. The kind of facility required. has his

The nature of the borrower’s business and the industry wherein he The borrower’s financial health The risks involved.


Covenants imposed are always negotiable and negotiated. Banks will always attempt to impose very exacting covenants. Some may be too exacting and impractical. Therefore a borrower must, at the time the facilities are being accepted ensure: The covenants are reasonable and realistic The covenants will not affect the growth or stability of the company. Very covenants can retard growth. restrictive

The borrower, while appreciating the banker’s need must also consider his own. He would be extremely shortsighted if he accepts conditions that are detrimental to his interests or restricts his ability to function freely. Covenants do not serve any purpose if they are not effective. The banker will therefore make certain that action can be taken for non compliance of the covenants. The remedies that are available are to a banker : Taking an additional collateral, thereby strengthening the loan. Seizing the assets secured and selling them. Procuring further collateral such as a mortgage on another asset or a (preferably another bank guarantee) Restructuring the loan Increasing the rate of interest on the loan (The risk/ return factor). guarantee

Covenants may be positive or negative.

Positive covenants are requirements made on the borrower to do certain acts. Some of the more common ones are: 1. The borrower must present a monthly statement or as often as required information on stocks and debtors. This is usually required if stocks and debtors have been hypothecated for an overdraft working capital facility. The banker uses the monthly statement to check drawing power and to ensure that the items hypothecated exist and are adequate. Periodically bankers inspect the clients’ factories and offices to physically verify the existence of the assets. 2. The borrower must insure and maintain the assets that have been given as collateral for the loan. This is to ensure that if there is a fire or other catastrophe, the borrower does not lose anything. 3. The borrower must comply with all laws and regulations. 4. The borrower must pay taxes regularly.

Negative covenants while they don’t force the borrower to perform certain actions, require him to ensure certain things and restrict him from certain acts. A requirement could be that no assets may be pledged or no dividend declared without the permission of the Bank. These are designed to protect the lender from the dissipation of assets, to protect his security and to an extent preserve the financial strength of the borrower. Negative covenants usually: 1. Restrict actions such as: Payment of dividend Sale of assets Limitations on additional loans Purchase of investments and the giving of additional loans. Purchase of investments and the giving of advances. Mortgaging of assets. 2. Maintenance of financial strength (usually in the form of ratios) such as:

Leverage Liquidity 3. Specific restrictions: Ensure existing management remains On the sale of debtors. On lending to subsidiaries or group companies. On investing in group companies. Covenants are, in short, safeguards and are always tailor-made to the requirements of borrowers and lenders based on their respective weaknesses and strengths.

Covenants must therefore be viewed as safeguards imposed on a borrower to preserve the borrower’s ability to repay the loan.


Soon after the initial talk Raman Menon had with his banker, Mr. Buch of the Manufacturers Bank, Mr. Buch asked him on the collateral he could offer the bank for the facilities required. Bank’s seldom extend any facility without collateral and the more liquid, the more realisable (encashable) and the more tangible a collateral is the greater the chances are of the facility being granted easily. This is why a loan against the security of a fixed deposit is the facility that is easiest to procure. Banks literally take no risk as they have with them, in their possession, the entire advance extended in the form of actual cash. Collateral is the security given to the bank as a safeguard for the facility/ facilities advanced. This is effectively the Bank’s insurance that should there be a default, the bank has something to fall back on to either recover in part or full the amount advanced.

It is important for a prospective borrower to realise that there is no such thing as a standard collateral. The nature of the collateral, the amount and the percentage of the

facility advanced that it covers will vary from borrower to borrower and from bank to bank.

However, there are some standard collaterals. The collateral sought for an overdraft and working capital facilities is the hypothecation of book debts and stocks. The amount advanced will be usually a percentage of the total value - the percentage held back being known in banking connotation as the margin. This is an additional safeguard for a bank as often when goods are sold in a hurry - a quick, forced or distress sale the real, fair value is not realised. The margin on stocks is usually between 25% and 40% and this depends on the company and the industry it operates in. This means that if the total value of stocks held are Rs. 100,000, the amount that the Bank would permit the borrower to draw on an overdraft (if the margin is 25%) is Rs. 75,000. This is known as the drawing power. In regard to debtors the margin is usually higher and can be as high as 50%. In calculating the drawing power banks will insist on a debtors’ aging list and debts over 90 days are excluded from the calculation. If funds have been advanced to purchase machinery or some other fixed purchased is usually hypothecated/ mortgaged to the Bank. asset, the asset

In regard to unfunded facilities such as the issuance of a guarantee or a letter of credit, banks usually ask for a cash collateral or margin money. This varies from nil to 20% of the value of the facility - the amount depending on the intrinsic strength of the borrower and the need of the borrower for the facility. Additional collateral are often sought by banks in the form of shares of from companies for additional comfort. good blue chips

Banks, often ask too, in case the borrowing company is part of a larger entity (a subsidiary or an associate company or a branch of a multinational), for a guarantee or at worst a letter of comfort from the parent company as additional comfort. This is more for a moral commitment than for any other as it often is difficult to hold the parent down on this or take it to court. In regard to guarantees as collateral, banks ask for the personal guarantees of directors too. In the case of private limited companies, directors often give their personal guarantees supported (at times) by a statement of their net worth. Directors of public limited companies have also been known to give guarantees. This is not common though as these directors often submit that the company is a legal entity in its own right with several thousand shareholders. The directors often are paid employees. In such a circumstance they argue that there is no reason why they should be personally committed to pay all the debts of the company.

In order to be able to enforce on the collateral, banks will insist on their being registered. This is to lay claim to their right and to put on notice any subsequent lender that the particular asset has already been hypothecated/ mortgaged. In some cases the asset (such as stocks are already hypothecated ) to another lender. In these cases the new lending bank would seek a pari passu charge with the other lender/ lenders. This is to make the new lending bank’s rights equal to that of the banks who have already got the assets as collateral.

Banks will always check whether the collateral’s value fluctuates widely as in the case of shares. If it does periodic valuations will be insisted upon and topping up may be required from time to time if there is a deterioration in value. In cases where the collateral is at the clients’ premises like stocks or machinery, periodic collateral checks will be undertaken by banks to satisfy itself on the existence and the value of the collateral.

A borrower must always remember collaterals are viewed by bankers as additional comfort and they would never, unless forced to do so and until after every other method has failed, seek to enforce their right as that could affect the viability of the concern. KNOW YOUR CLIENT

A cardinal rule in banking is the concept of “Know your client.” This means exactly what is says. The banker will do all he can to find out as much as he can about the company and the client. In this no information is too small or too immaterial since they will fit into a larger picture and the fate of the facilities extended may depend upon it. It has to be always remembered that the project may appear sound, the documentation perfect and the financials impeccable. However, if the intent is to cheat, it could cause severe losses to the Bank. Banks are always aware that a dishonest man is also a very clever person. Additionally the dishonest person has the advantage in that the innocent banker believes him to be a good, honest soul. He knows he is not; he knows he intends to cheat the banker and he has a scheme to cheat him.

A few years ago an apparently wealthy businessman approached the Bangkok branch of a large foreign bank to open a letter of credit to import certain items from Hong Kong. The amount was large. The person appeared respectable. The young banker, in his eagerness

to capture additional business to meet the demands of a very tough budget, complied with his request. The banker convinced himself that the risk was small as the goods would not be handed over till it had been paid for. Additionally the facility was short term and self liquidating. The seller from Hong Kong exported the goods and on his presenting the documents was paid (as the Hong Kong branch had confirmed the letter of credit). The documents arrived in Bangkok and when the client was sought, he was nowhere to be found. Inquiries revealed that he had left the country a day after the exporter had been paid. It was further found that the businessman had no business any longer. The bank took possession of the goods and when the cartons were opened, it was found that the goods were not what they were purported to be. In fact, they were of practically no value at all. The Bank suffered a significant loss. It was later discovered that the “businessman of Bangkok” and the “exporter from Hong Kong” were in fact brother in law and partners in crime.

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

It is because of this crying need of knowing the client that Banks insist on a client being introduced. The banker works on the supposition that if the prospective client has been introduced by another whose credentials are above reproach then by extension the prospective client’s credentials are also by extension, above reproach. If Raman Menon was approaching the Manufacturers Bank for the first time, the Bank would ask for an introduction from an existing client. Additionally the Bank will seek to find out whether Mr. Menon had been banking with some other bank. If he had, a reference from that Bank would also be sought.

In addition a banker will always attempt to verify facts and try to find out more. This is to establish the credibility of the client. A prospective borrower, optimistic of his future, may give information that may be too ambitious or hopeful. Conversely, with the intent of defrauding the Bank the information given may be totally false. The banker will check all statements made. The acceptance of an unverified statement destroys the credibility of the analysis and bankers are aware that such an action can put the entire exposure at risk.

Several years ago a well spoken gentleman approached the Manager of a large branch of a

private sector bank and informed him that a mutual friend had recommended the bank to him for a loan to finance working capital. This was not checked because the person appeared so genuine and respectable. The facilities were arranged securing them to the hypothecation of stocks, book debts and fixed assets. There appeared to be adequate cover. A few years passed. The demand for the Company’s goods fell. The inventory became obsolete. The client became bankrupt. When the Bank took steps to seize the inventory and fixed assets it was found that another bank had a first charge on the fixed assets. The Manager was not aware of his inferior collateral as he accepted the clients word without verifying. It was later found that the client was not a friend of the person the Manager knew. He had merely dropped a name and the Manager had bitten the bait. In this case failure to verify facts lad the Bank to lose a large sum of money.

Bankers verify facts and information given by:

Bank checkings - the opinion of the bank where the new customer is known and the dealings he has had. Banks asked for this information are often non committal as they expose themselves to law suits and the like if they reveal more than they should. However, the wordings used are usually enough to give the querying banker adequate information.

Trade checkings - the person’s standing among his peers and his reputation. Customer checks - the opinion customers of the prospective borrower has of him. On site visits and asset verification - does the factory/ plant/ business actually exist and the value of the assets.

Collateral Audit - does the collateral actually exist and can it be pledged (has it been pledged to someone else). Verification of other statements made by whatever means.

Good bankers will always “keep their ears to the ground” to listen to information and gossip because this can be very valuable as it is sometimes surprisingly accurate. Bankers will invariably react quickly to negative news as it often is the harbinger of very very bad

news. A good banker will not however react without checking the information that he has received because it may be untrue.

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

The single most important factor that a banker considers when he considers an application/ proposal for credit facilities is the management. It is upon the quality, the competence and the vision of the management that the future of a company rests. A good, competent management can make a company grow while a weak, inefficient management can destroy a thriving company. Corporate history is riddled with examples. The Ambanis with their vision and acumen have made Reliance a global giant. Others who tried to emulate them with grandiose plans are heard of no more. Chrysler was, in the early eighties, an ailing giant. Iacocca, with tough competent management turned the company round. In the first quarter of 1993 the big blue - IBM dismissed its Chief Executive Officer Akers who was blamed for the companys dismal performance. Lou Gerstner who was at one time President of American Express and who took charge of R.J.R. Nabisco after it had been taken over after a multibillion dollar leveraged buy out was invited to become the Chief Executive Officer of IBM. Mr. Gerstner has successfully turned the company round. Metal box, Killick Nixon, Nirlon, The Gadgil Western Group, the Kamanis and many others have been brought down from their positions of eminence and their management has to bear the guilt for this.

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

In India, management can be broadly divided into two : o Family Management o Professional Management

Family Management

Family managed companies are those that have at the helm a member of the controlling family. The Chairman or the Chief Executive Officer is usually a member of the ruling family and the Board of Directors are peopled by either members of the family or their friends and rubber stamps. Mr. T. Thomas, a former Chairman of Hindustan Lever Ltd., describes the family business structure most eloquently in his memoir To Challenge and to Change. He speaks of an Indian family business having a series of concentric circles emanating from a core - the core being made up of the founder and his brothers or sons. The next circle is the extended family of cousins and relatives followed by people from the same religious or caste group. The fourth circle comprises of people from the same language group and the outermost circle has people from the same region. Mr. Thomas says that to go beyond this was like going out of orbit - unthinkably risky.

There has been some change in the way family controlled families have been managed. In the beginning there were often orthodox, autocratic, traditional, rigid and averse to change. This is no longer true. The sons and the grandsons of the founding fathers have been educated at the best business schools abroad and they have been exposed to modern methods. Consequently, in many family managed companies, although the man at the helm is a scion of the family, his subordinates are graduates of business schools professional managers. This combines, to an extent the best of two worlds and many such businesses are very successful. The frustration for the professional manager in such companies is that he knows that he will never, ever run the company - that privilege will always be with a member of the family.

Professional Management

Professionally managed companies are those that are managed by employees. In these companies the Chief Executive Officer does not have, very often, a financial stake in the company. He is at the helm of affairs because of his ability and experience. The professional manager is a career employee and he remains at the seat of power so long as he meets his targets. Consequently he is always results oriented and his aim is often short term - the meeting of the annual budget. He is not necessarily influenced by loyalty to the company. As a professional he usually is aware of the latest trends in management philosophy and tries to introduce these. He tries to run his company like a lean, effective

machine striving for increased efficiency and productivity. As a consequence professionally managed companies are usually well organized, growth oriented and good performers. Investors are the recipients of regular dividends and bonus issues. However, there is often a lack of long term commitment and sometimes a lack of loyalty. This is because in time the professional manager has to step down - to retire and he cannot therefore enjoy the fruits of his labour forever. Nor will his sons succeed him although some may try to see that this happens in time. In many professionally managed Companies there is also a lot of infighting and corporate politics. This is because managers are constantly trying to rise up the corporate ladder and the end is often what matters not the means. Often too as a consequence the best person does not get the top job - it is the person who plays the game best. This does not always happen in family managed companies as one is aware that the mantle of leadership will always be worn by the son or daughter of the house.

What does a banker look for

It would be unfair to state that one should banker’s prefer only professionally managed companies or family managed companies. There are well managed, profitable companies in both these categories. There are also badly managed companies in both these categories. What then are the factors bankers look for? 1. The most important aspect is the integrity of management. This must be beyond question. it is often stated that however good the systems and controls are, an employee, if he is intent, can perpetrate a fraud. Similarly the management, if it so desires, can juggle figures and cause great harm and financial loss to a company (for their own personal gain). Bankers tend to if they are not too certain of the integrity of management will leave that company well alone. I had the privilege once to listen to Mr. C.S. Patel who was at one time the Chief Executive of Unit Trust of India. He recounted an advice he was given by his mentor, Mr. A.D. Shroff who was once the Chairman of the New India Assurance If you have the slightest doubt of management do not touch the company with a pair of tongs. Seldom have I heard truer words. Thus the first thing a banker does when considering a loan to Unisulphur Ltd. Is to check the competence, integrity and honesty of Rusi Daruwalla.

2. Another point bankers consider is proven competence - the past record of the management. How has the management managed the affairs of the company during the last few years? Has the company grown? Has it become more profitable? Has it grown more impressively than others in the same industry?

Bankers are usually a little wary of new management and new companies as they have a very high level of mortality. This is why they normally ask for three to five years figures. Past performance can be an accurate predictor of future events.

3. Bankers often try to ascertain how highly the management is rated by its peers - by others in the same industry? This is a very telling factor. The ones that are aware of nearly all the strengths and weaknesses of the management are the competitors and if they hold the management in `high esteem - the management is worthy of respect.

4. At good times everyone does well. The steel of the management is tested at times of adversity? Bankers consider performance at a time of recession or depression. Did it streamline its operations? Did it close down its factories? Did it (if it could) get rid of employees? Was it able to sell its products? Did the company perform better that its competitors? How did sales fare? A management that can steer its company in difficult days will normally do well always.

5. The depth of knowledge of the management - its knowledge of its products, its markets and the industry is of paramount importance because upon this can depend the success of the company. Often the management of the company that has enjoyed a preeminent position sits back thinking that it will always be the dominant company and it loses its touch with its customers, its markets and its competitors. The reality sinks in only when it is too late. The management must be in touch at all times with the industry and customers and be aware of the latest techniques and innovations. Only then can it progress and keep ahead. A quick way bankers check this is by determining what the market share of the companys products are and whether the share is growing or is being maintained.

6. The management must be open - innovative and must have a strategy. It must be prepared to change if that is required. it must essentially know where it is going and have a plan on how to get there. It must be receptive to ideas and be dynamic. A company that has many layers of management and is top heavy tends to be very bureaucratic and ponderous. There are many chiefs and few braves They do not want change and often stand in the way of change. Their strategy is usually a personal one - on how to hold onto their jobs.

7. Bankers do not like to lend to a company that is yet to professionalise because in such

companies decisions are made on the whims of the Chief Executive and not with the good of the company in mind. In such companies the most competent are not given the positions of power. There may be nepotism with the nephews, nieces, cousins and relatives of the Chief Executive holding positions not due to proven competence but because of blood ties.

8. Bankers tend to avoid lending to family controlled companies where there is infighting because the companies suffer.

In India, most of our larger Companies are family controlled. They are on a day to day basis managed however by professional managers. There are also several professionally managed companies too. It is not possible nor would it be fair to generalize which is better - some are good and some are not so good. A banker, before he risks his monies, makes a determination on whether he is comfortable with the management of the company and this is a determination that he makes because on this will determine his lending decision. POLITICS AND GOVERNMENT POLICY

The political stability of a country a key factor in determining the risk a bank is prepared to take on that country. It is this situation that determines whether and if so the quantum foreign institutions and companies would invest in a country. In January 1998 when Moodys the international credit agency stated that India is being placed on a watchlist and that it may possibly be downgraded from investment quality to speculative due to a variety of reasons of which one of the main reasons was political instability, the Bombay Stock Exchange Sensitivity Index (Sensex) fell by 75 points. Moodys initially downgraded the country in early 1996 due again to political instability as it felt that the fall of the Deve Gowda government was imminent. As political stability is critical to a country’s growth and by extension to companies, the Bharatiya Janata Party (BJP) took stability as their central point in their 1997 election manifesto. After the nuclear explosion by India and with the threat of sanctions Moodys downgraded India’s foreign currency rating to below investment quality. Apart from he fact that the Sensex fell, foreign currency loans will be more expensive and the rupee is under threat. If Mr. Daruwalla has to import raw materials, his cost of production will rise and this will threaten his profitability. Let us look at this in more detail.


A stable political environment is necessary for steady, balanced growth. If the country is ruled by a majority government and takes decisions for the long term development of the country, industries and companies will prosper. Instability causes insecurities especially if there is the possibility of a government being ousted and replaced by another that holds diametrically different political beliefs. Moodys downgraded India initially during Mr. Deve Gowda term of office on the issue of instability. It proved true and Mr. Gowda’s government collapsed to be followed by Mr. Gujral’s tenure which also had a quick demise. Such instability shakes the very foundation of investor/ international/ national confidence. This is why, as was mentioned earlier, that the BJP has made stability the central issue of its campaign. Another example is Sri Lanka - a country in the grips of civil war. The north of that country was once thriving and prosperous. No longer. That part of the country is controlled by the Tamils - there is no industry and little economic activity. For several years the economy of Sri Lanka suffered as tourists went elsewhere and exports fell.

Kenya had a disastrous 1997. There was violence in Mombasa. It was also election year and there was an acknowledgement that President Daniel arap Moi may not get elected. Consequently aid was held back - the shilling depreciated and inflation rose. Tourist revenues too fell significantly to the detriment of the country.

No industry or company can grow and prosper in the midst of political turmoil.

Restrictive Practices

Restrictive practices or cartels imposed by countries can affect companies and industries. The United States of America has restrictions regarding the imports of a variety of articles like textiles etc. Licenses are given and amounts that may be imported from companies and countries are clearly detailed. India has a number of restrictions on what may be imported and at what rate of duty. This, to an extent determines the prices at which goods can be sold. If domestic industry is to be supported, the duties levied may be increased resulting in imports becoming unattractive. Alternatively the reduction of duties can result in imports becoming cheaper to the possible detriment of Indian industry. The lowering of

duties in the first phase of liberalisation led to the near demise of the mini steel industry in India. It is this fear that prompted the formation of the celebrated Bombay Club which wants restrictive protection for Indian industry. Bankers, on account of the effect restrictive practices or its removal can have on a company, always check how sensitive the company is to these.

The threat of Nationalisation

The threat of nationalisation is a real threat in many countries - the fear that a company may become nationalised. Historically (with very few exceptions), nationalised companies are less efficient than their private sector counterparts. Nationalisation in India ruined coal, insurance and banking If one is dependent on a company for certain supplies, nationalisation could result in supplies becoming erratic and the likes. Similarly, if this fear exists industries will not attract investment and there could be a flight of capital to other industries/ countries.

At present the issue is the reverse in India - the possibility of privatisation. This, by large, tends to the belief that both employee and company profitability will improve as was demonstrated by British Airways which when Government owned was a loss making behemoth. It turned round and is being acclaimed as efficient and excellent after it became privatised.


The level of taxation in a country has a direct effect on both companies and the economy. If tax rates are low, corporate profitability rises as the cost of their purchases will be lower and their after tax income higher. Additionally as people consequently have more disposable income they have an incentive to work harder and earn more money. And an incentive to buy which results in greater demand for goods. This is good for the economy and for companies. It is interesting to note that in every economy there is a level between 35% to 55% where tax collection will be the highest. While the tax rates may go up collection will decline. This is why it was argued that the rates in India must be lowered and why at the 1997 budget the rates of taxation were reduced by Mr. Chidambaram. Taxes have been lowered, an amnesty scheme was offered and tax collection has never been higher.

Governmental Policy

Governmental policy has a direct impact on companies. A government that is perceived to be proindustry will attract investment. The liberalisation policies of the Narasimha Rao government excited the developed world and they were keen to invest in India and increase their existing stakes in companies. The instability that followed, the Enron fiasco, Cogentrix et al have made the same foreigners adopt a wait and watch stance.

Budgetary Deficit

A budgetary deficit occurs when governmental expenditure exceeds its income. Expenditure stimulates the economy as work is created and demand will increase. However, this can lead to deficit financing and inflation. India has had deficits for several years and this has not been good for the country as it can lead to disaster. It would be wise to remember this. At present the Government is trying to keep the deficit at 4.5 percent of GDP and cutting back on expenditure for the infrastructure. The result has been disastrous for several industries such as steel, cement and construction and for companies in these industries.

All these factors have an effect on the performance of a company - the extent being on how sensitive a company’s profitability is to the particular factor. This is why bankers pay special emphasis to political stability and a company’s sensitivity to governmental policy as it affects a company’s profitability and its credit worthiness. THE ECONOMIC FACTOR

Bankers are becoming increasingly aware of the importance of the economy and its effect on individual industries and companies. Soon after the liberalisation process began in 1992/93, there was tremendous activity and industries mushroomed. Many international companies came into India and invested. GDP growth averaged over 7%. In earlier years it was very low . Exports grew at 28% and industrial growth was at 11%. Companies made tremendous profits. The situation changed from the end of 1995. 1996 was a difficult year and 1997 more so. There was tremendous liquidity problems - partially due

to the squeezing of cash by the Reserve Bank to contain inflation and many industries, with a contraction of activity, began to face a difficult time - construction, steel, cement et al. Industrial growth in 1997-98 was a meagre 4.6 % while export growth was a shameful 2.6%. GDP growth fell to 5 %. Most companies were badly affected.

The banker will always look at the economic scenario when making the lending decision. If the economy is going through a difficult period, the Manufacturers Bank will think thrice before it extends facilities to Rusi Daruwalla or Raman Menon as the economic downturn can affect the profitability of their ventures negatively.

There is usually a time lag between the downturn or upturn in an industry and its effect on a company. This is why bankers look at the economic scenario when making the lending decision.

In looking at the economy there are specifics the Banker looks at.

Growth Growth in the economy has a wider impact on industry and individual; companies. An economy that is growing at 7 percent creates jobs, demand and industrial activity. This leads to higher consumption and thus increase in expenditure leading to bigger profits for companies. At the end of 1997-98, the situation in India was the reverse. Industrial growth had fallen to 4.6 percent from 11 percent and GDP growth was lower at 5 percent from 7 percent. The mainstay of the previous year, agricultural growth had fallen from 5 percent to 3 percent. Export growth had fallen from 28 percent to 2.6 percent. These translated to a lower level of activity and worse corporate results. In such circumstances only the stronger survive and this is why bankers delve into the economic condition and attempt to determine how exposed a company would be should a slide occur..

Foreign Exchange Reserves A country needs foreign exchange reserves to meet its commitments, pay for its imports and service foreign debts. If it cannot, the country would not be able to import materials or goods for its development and there will be a loss of confidence in the country which would be detrimental. India, was in 1991, forced to devalue as foreign exchange reserves

were at around half a billion dollars very low (equal to a three weeks imports). The crisis was averted at that time by an IMF loan, the pledging of gold and the devaluation of the rupee. The liberalisation initiatives reversed this and India was, with foreign exchange inflows (foreign direct investment, foreign institutional investor investment, foreign currency deposits and booming exports) able to accumulate reserves in excess of $30 billion. These fell in the wake of the foreign exchange rating of India being downgraded, the nuclear explosions in May 1998 and the selling of shares by foreign institutional investors. The rupee has also depreciated thereby making those companies that are dependant on imports exposed.

In the eighties and in the early nineties several American banks had to write off large loans advanced to South American countries as these countries were unable to pay. Mexico too had a crisis. Certain African countries have very low foreign exchange reserves. Companies exporting to these countries have to be careful as the importing companies may not be able to pay for their purchases because the country does not have adequate foreign exchange. I know of an Indian company which had exported machines to an African company (Nigerian) a few years ago. The importing company paid the money to the bank. It lies there still. The payment could not be sent to India as the central bank refused the foreign exchange to make the payment.

The 1997 crisis in South East Asia has seen the collapse of several Tiger economies. Many currencies are only worth a fraction of what they were earlier. Some countries are being bailed out by large loans from the IMF. Many companies have collapsed due to high foreign currency (dollar) debts or due to their inability to import raw materials. In Indonesia the currency fell from Rupiah 2,300 to a dollar in May 1997 to Rupiah 10,500 to a dollar in January 1998 and to over Rupiah 15,500 to a dollar in June 1998. There was however not (and there cannot be) a similar movement domestically within Indonesia. The prices of articles did not go up fivefold. Consequently it was no longer viable to import anything as it could not be sold at anywhere near cost price. I know of a large Indian exporter of peanuts. He sent as usual large consignments to Indonesia to one of his regular buyers. The buyer, for various trumped up reasons refused to accept the goods. The real reason was that the Indonesian Rupiah had fallen so much in value that it was no longer viable to accept the consignment as he would have to sell it at a loss. In the end the Indian exporter had to sell the goods at a much lower price. He did this as the commodity was perishable and he did not want to risk bringing it back to sell. He made a loss.

Balance Of Trade If exports exceed imports a favourable balance of trade results. This stimulates industry.

Most developing economies have unfavourable balances whereas developed countries such as Japan have very favourable balances. India’s exports have been lower both in amount and in growth to imports and this widens the trade deficit. A wide deficit would eventually result in devaluation of the currency. The implications to industry are then obvious - the costs of imports will go up and the realisation of its exports in dollar terms will be lower. A banker will therefore while evaluating a company examine this aspect.

Foreign exchange Risk This is a real risk and one must be cognisant of the effect of a revaluation or devaluation of the currency either in the home country or in the country/ countries the company deals in. A devaluation in the home country would make the products the company makes more attractive in other countries. It would also make imports more expensive and if a company is dependent on imports, margins can reduce. A devaluation in the country to which one exports would make the companys products more expensive and this can adversely impact sales. A method by which foreign exchange risks can be hedged is by entering into forward contracts (either purchase or sale) thereby crystallising the exposure. Ever since the Deputy Governor of the RBI, Dr. Reddy mentioned that the rupee was devalued in July/ August 1997 the rupee has been under pressure and the concern most exporters and importers had was to what extent the rupee would depreciate and the stands they should take. I know of a diamond exporter who kept a large open position in dollars initially firmly of the opinion that there will be a depreciation to Rs. 39.50 or thereabouts at the very least. Many companies on the other hand who had taken large foreign currency loans converted them back (even at a cost) to rupee loans. In June 1998 Moodys the international credit rating agency, downgraded India’s foreign exchange rating to below investment quality. This will make the cost of foreign loans to Indian corporates higher plus the Indian rupee will be under threat.

The fall in the currencies of South Eastern Asian countries has played havoc for India’s export trade and by extension to companies/ entities that export. When a currency has depreciated by nearly 5 times as it did in Indonesia’s case, all goods manufactured there become ridiculously cheap and by extension extremely attractive. The foreign buyer would naturally buy from a country such as that as in dollar terms the article would be at a throwaway price.

Foreign Debt Foreign debt, especially if it is very large can be a tremendous burden. India has to pay around $ 7 billion a year in interest payments. This is no small sum. This money could

have been used to develop the country. It is to attract foreign exchange that the government is promoting tourism and exports.

Inflation Inflation has an enormous effect in the economy. Within the country it erodes purchasing power. As a consequence demand falls. If the rate of inflation in the country is high then the cost of production will automatically go up. This might reduce the cost competitiveness of the product finally manufactured. Conversely if the rate of inflation in the country to which one exports to is high, the products become more attractive resulting in increased sales. The USA and Europe have fairly low inflation (about 5%). Inflation in India has been falling steadily in recent times and is presently between 4% and 6%. . In South America on the other hand it has been over 1000%. Money had no real value. Exports from South America are attractive as on account of galloping inflation and the consequent devaluation of their currency, their products are cheaper.

Low inflation within a country indicates stability and companies and industries prosper at such times. One must also remember that price increases are behind inflation and therefore companies margins are squeezed at times of high inflation.

Interest Rates A low interest rate stimulates investment and industry. High interest rates result in higher cost of production and lower consumption. When the cost of money is high, a companys competitiveness decreases as its cost of production increases. This has been the reason for industry clamouring for lower interest rates ( in order to be able to compete internationally). The Reserve Bank of India accepted this contention and in its pronouncements and its credit policies brought down the cash reserve ratio and the bank rate and urged banks to lower lending costs. Soon after liberalisation, in order to take advantage of lower rates, companies went overseas to borrow money - the leader being, of course, Reliance.

Domestic Savings and its utilisation Domestic Savings if utilised productively can accelerate economic growth. India as a country has one of the largest rate of savings (22%). In USA it is only 2% whereas in Japan it is as high as 23%. Japans growth was on account of the savings invested

profitably and efficiently. Although Indias savings are high, these savings have not been invested wisely or well. Consequently there has been little growth. It is to be remembered that all investments are born out of savings. Borrowed funds invested have to be returned. Investments from savings leads to greater consumption in the future. This has been recognised by the Government and it was in order to divert savings to industry that the 1992 Finance Act declared that the productive assets of individuals (shares, debentures etc.) would not be liable for wealth tax.

The Infrastructure The development of an economy is dependent on its infrastructure. There must be electricity for the factories to manufacture and roads to transport goods. Bad infrastructure leads to inefficiencies, poor productivity, wastage and delays. This is the reason for the emphasis this issue is being given. Unfortunately India’s infrastructure development is still at a very nascent stage and it has been determined that an immediate expenditure of around $200 million is required to bring the economy on par with other countries.

Most foreign banks and many Indian banks are very pro infrastructure. This is because they recognise the need and the imperativeness. A properly prepared and well researched viable infrastructure project will, at this juncture receive a fair hearing and most likely a loan.

Budgetary Deficit A budgetary deficit occurs when governmental expenditure exceeds its income. Expenditure stimulates the economy as work is created and demand will increase. However, this can lead to deficit financing and inflation. India has had deficits for several years. The deficit is expected to be about 4.5 percent of GDP and in order to contain it at this level the Government is curtailing several expenditure (developmental and infrastructural). Though necessary this leads to a slowdown as economic activity reduces.

Monsoons The Indian economy is essentially an agrarian one and it is therefore extremely dependent on the monsoons. Economic activity often comes to a stay still during the end of March /early April as individuals wait to see whether the monsoon is likely to be good or not. A

good monsoon results in improved agricultural growth leading to increased demand as agriculturists have more disposable income.

Employment High employment is required to achieve a good growth in national income. As the population growth is faster than the economic growth unemployment is increasing. This is not good for the economy. However, in countries where there is high unemployment labour costs are low. In such countries companies that are labour intensive have an edge over their peers/ competitors.

All these factors have an effect on the performance of a company - the extent being on how sensitive a company’s profitability is to the particular factor. This is why many banks have lending or exposure limits on countries. As company performance is dependent on both the economy and the political scenario. THE ECONOMIC CYCLE

Bankers, while ,making the lending decision, normally look into the business or economic cycle and the stage at which the country is in as it has a direct impact on industry and individual companies. It affects investment decisions, employment, demand and the profitability of individual companies. While some industries such as construction, cement, steel, shipping and consumer durable goods are very affected, others such as the food or health industry are not so affected. This is because in regard to certain industries consumers can postpone demand (buy later), whereas in certain others they cannot. If a person is ill and needs medicine, it has to be bought. Similarly one has to eat. However, a television purchase or an automobile buy can be delayed indefinitely.

Bankers always examine the economic cycle a country is in as it is crucial in the lending decision and can affect the realisability of the loan The four stages of an economic cycle are o Depression o Recovery

o Boom o Recession

Depression At the time of depression, demand is low and falling. Inflation is often high and so are interest rates. Companies, crippled with high borrowing and falling sales are forced to close down plants (plants built at times when the demand could not be met) and let workers go. India went through in 1997 a period that could be arguably called a depression. Interest rates were high, medium sized companies were closing down. Interest rates were high and they were crippling several companies and industries. Banks though flush with funds were not lending to corporates as they were concerned about whether they would be repaid. Corporate performance was so bad. The United States went through a depression in the late seventies. The economy recovered and the eighties was a period of boom. A downturn occurred at the late eighties and early nineties (especially after the Gulf War). The recovery of the US economy and that of the rest of Western Europe began again in 1993. Recovery During this phase, the economy begins to recover. Investment, that was at a standstill, raises its head once again. Demand grows. Companies begin to post profits. Conspicuous spending begins once again. As the recovery stage sets in fully, profits begin to grow at a higher proportionate rate. More and more companies are formed / floated to meet the increasing demand in the economy. In India we went through this stage immediately after the liberalisation process began. It is hoped that once the country has a stable government the economy will begin its recovery again. Boom At the boom phase demand reaches an all time high. Investment is also high. Interest rates are low. Gradually as time goes on supply begins to gradually exceed demand. Prices that had been rising begin to fall. Inflation begins to increase. In India we had a situation very similar to a boom in 1993 and 1994 when everyone was euphoric about the country and the economy was opening up. China has been going through a period of boom for several

years now and is attracting huge investments. Recession The economy slowly begins to downturn. Demand begin to fall. Interest rates begin to increase and inflation also begins to increase. Companies begin to find it difficult to sell their goods. Companies fold up due to a fall in demand, high interest costs and a cash crunch. It is difficult to lend at this stage as even though the company may have been good in the past it may not be able to service its debts. The Lending Decision Bankers will always attempt to determine at which stage of the economic cycle the country is in. They would normally aim to lend at the end of a depression when the economy begins to recover and at the end of a recession. Bankers would aim to try and get repaid either just before or during the boom or at the worst just after the boom. If Mr. Daruwalla approaches the Manufacturers Bank at a time when the country is in recession, the Bank would most usually not extend facilities unless ofcourse the project is very viable and the Bank is adequately collateralised. It must however be noted that there is no rule or law that states that a recession would be for a certain number of years or that a boom would be for a definite period of time. Hence the length of previous cycles should not be used as a measure to forecast the length of an existing cycle. Bankers accept this and they are cognisant that that governmental policy or other happenings can reverse a stage and it is because of this that they also analyse the impact of governmental and political decisions on the economy before making the final lending decision. Joseph Schumpeter once said Cycles are not, like tonsils, separable things that might be treated by themselves but are, like the beat of the heart, of the essence of organism that displays them. INDUSTRY ANALYSIS

Industry analysis is critical in banking. Bankers will always attempt to determine how an industry is faring and how it is likely to fare in both the short and the long term before they commit funds or agree to lend. The very existence of companies in troubled industries are threatened. In 1997 and 1998, in India due to the contraction of credit, steel, cement, construction and property have gone through very difficult times. Several have closed down or nearly closed down. On the other hand the software industry had done extremely well with profits doubling and quadrupling. In 1988 laptop computers were the in thing. Everyone raved about the invention - of how technology could compress a huge computer into such a small box. These early models did not have a hard disk but two

fixed disk drives. A few months later hard disks were incorporated. These were initially with a capacity of 20 megabytes. The memory was increased to 40 megabytes. In eighteen months, the laptop became obsolete with the creation of the notebook. These notebooks are no longer the last word in compressed computing. The palm tops have arrived. I have used this illustration to illustrate how technological advances make a highly regarded product obsolete. In the same way technological advances in one industry can affect another industry. The Jute industry went into decline when alternate and cheaper packing materials began to be used. The popularity of cotton clothes in the West affected the manmade (synthetic) cloth industry. This is why bankers always examine the industry within which a company operates because this can have a tremendous effect on its results and its existence. A companys management may be superior, its balance sheet strong and its reputation enviable. However, the company may not have diversified and the industry within which it operates may be in a depression. This could result in a tremendous decline in revenues and can threaten the viability of the company.


The first step in industry analysis is to determine the cycle it is in or the stage of maturity of the industry. All industries evolve through the following stages: 1. Entrepreneurial or sunrise or nascent 2. Expansion or growth 3. Stabilization or stagnation or maturity 4. Decline or sunset.

At the first stage the industry is new and it can take some time for it to properly establish itself. In the early days it may actually make losses. At this time there may not be many companies in the industry. It must be noted that the first 5 to 10 years are the most critical period as at this time companies have the greatest chance of failing. It takes time to establish companies and new products. There may be losses and the need for large injections of capital. At this time if a company or an industry is not nurtured or husbanded it can collapse. A good journalist I know began a business magazine. His intention was to start a magazine edited by journalists without interference from industrial magnates or politicians. It was an exceptionally readable magazine. However, it did not have the finance needed in those critical years to keep it afloat and it folded up. Had it, at that time, had the finance it needed it may have survived and thrived. In short at this stage investors

take a high risk with the promise of great reward should the product succeed.

Once the industry has established itself it enters a growth stage. At this time there is growth and many new entrants enter the industry. At this time there is high reward and low risk as demand outstrips supply. A good example at this time is the pharmaceutical industry. At this time products are improved by those companies that have survived the first stage and companies are able to even lower their prices. Bankers are not averse to lend at this time as companies would have demonstrated their ability to survive.

The industry then matures and stabilizes. Rewards are low and so is risk. Growth is moderate. Though sales may increase it will be at a slower rate than before. Products are more standardized and less innovative and there are several competitors.

The industry then declines. This occurs when the products are no longer popular. This may be on account of several factors such as a change in social habits (the film and video industry has suffered on account of cable and Star TV), changes in laws and increase in prices. The risk at this time is high but the returns are low. Returns can even be negative.

The various stages can be likened to the four stages in the life cycle of a human being childhood, adulthood, middle age and old age. Bankers would begin to lend when the industry is at the end of the entrepreneurial or nascent stage (they would normally try not to lend at the first stage as mortality is high) and the growth stage and would begin to exit when an industry is at the end of the mature stage as it will begin to go on the decline.

The industry in relation to the economy

Bankers will always try to ascertain how an industry reacts to changes in the economy. Some industries do not perform well during a recession or as well as other industries during a boom. On the other hand certain industries are unaffected in a depression or a boom. What are the major classifications?

1. Industries that are unaffected in general during economic changes are the evergreen industries. These are those that individuals need like the food or agrobased industries (dairy products etc.)

2. Cyclical industries are the ones that are volatile. They do extremely well when the economy is doing well and do badly when depression sets in. The prime examples are durable goods, consumer goods and shipping. During hard times individuals postpone the purchase of consumer goods until better days.

3. Interest sensitive industries are those that are affected by interest rates. When interest rates are high industries such as real estate and banking do not do well.

4. Growth industries are those whose growth is higher than other industries and growth occurs even though the economy may be suffering a setback.


Another factor that bankers consider is the competition companies in an industry are likely to face. The need to do this is because competition in an industry initially leads for efficiency, improvements in products and innovation. As competition increases cut throat price cuts set in resulting in lower margins, smaller profits and finally companies begin to make losses. The more inefficient companies even close down. To properly understand this phenomenon it is to be appreciated that if the return is high, newcomers will invest into the industry and there will be an inflow of funds. Existing companies may also increase their capacity. However, if the returns are low or lower than that which can be procured elsewhere, the reverse will occur. Funds will not be invested and there will be an outflow.

It is the competitive forces in an industry that determines the extent of the inflow of funds and the return and the ability of companies to sustain these returns. These forces are the barriers to entry, the threat of substitution, the bargaining power of buyers, the bargaining power of suppliers and the rivalry among competitors.

1. Barrier to entry New entrants increase the capacity in an industry and the inflow of funds. The question that arises is how easy is it to enter an industry. There are some barriers. a) Economies of scale In some industries it may not be economical to have small factories. This is especially true if there are already in existence comparatively large units producing a vast quantity. The products produced will be markedly cheaper. b) Product differentiation A company whose products have product differentiation has more staying power. Its products may be preferred because of its name or because of the quality of its products - Mercedes Benz cars; National VCRs or Reebok shoes. Individuals are prepared to pay more for the product and consequently the products are at a premium and above competition. c) Capital requirement Easy entry industries require little capital and technological expertise. As a consequence there are a multitude of competitors, intense competition, low margins and high costs. On the other hand capital intensive industries have few competitors as entry is difficult. The automobile industry is a prime example of such an industry. d) Switching costs Another barrier to entry is the switching costs from one suppliers product to another. This may include employee retraining costs, cost of equipment and the likes. If the switching costs are high, new entrants have to offer a tremendous improvement for the buyer to switch. e) Access to Distribution Channels The difficulty to secure access to distribution channels can be a barrier to entry especially if existing firms have already secured strong channels. f) Cost disadvantages independent of scale This barrier occurs when established firms have advantages new entrants cannot replicate. These include: o Proprietary product technology o favorable access to raw materials o Government subsidies o long learning curves g) Government Policy Government policy can limit entrants into an industry. This is usually done by not issuing licenses. The motor car industry was for nearly 40 years the

monopoly of two companies. Even though others sought licenses these were not given. h) Expected retaliation The expected retaliation by existing competitors will also be a barrier to potential entrants especially if the existing competitors aggressively try to keep new entrants out. i) Large investments, capital base and cost structure Companies with large investments and a large capital base and a high fixed cost structure will not have many competitors. Its high fixed costs have to be serviced and a fall in sales can result in a more than proportionate fall in profits. Large investments and a big capital base will be barriers to entry. j) Cost of capacity additions If the cost of capacity additions are high there will be fewer competitors and fewer will enter the industry. k) International cartels There may be international cartels that will make it unprofitable for new entrants.

2. The Threat of Substitution

New inventions are always taking place and new and better products are replacing existing ones. An industry that can be replaced by substitutes or is threatened by substitutes is normally an industry one must be careful of investing in. An industry where this occurs constantly is the packaging industry - bottles replaced by cans; cans replaced by plastic bottles and the likes.

To ward off the threat of substitution companies have to often spend large sums of money in advertising and promotions. Those industries that have to be the most worried are those where the substitutes are cheaper or better or are products by industries earning high profits. It should be noted that substitutes limit the potential returns of a company.

3. Bargaining Power of Buyers

In an industry where buyers have control (a buyers market), buyers are constantly forcing prices down or demanding better services or higher quality and this often erodes profitability. The factors one should check are whether: a) A particular buyer buys most of the products (large purchase volumes). Such buyers can if they withdraw their patronage, destroy the industry. They can also force prices down. b) Buyers can in buyer dependent industries play one company against another to bring prices down.

One should also be aware that : o If sellers face large switching costs the buyers power is enhanced. This is especially true if the switching costs for buyers are low. o If buyers are partially backwardly integrated, sellers face a threat as they may become fully integrated. o If buyers are well informed about trends and details they are in a better position vis a vis sellers as they can ensure they do not pay more than they need to. o If the product represents a significant portion of the buyers cost. Buyers would vehemently attempt to reduce prices. o If the product is standard and undifferentiated, the buyers bargaining power is enhanced. o If the buyers profits are low, the buyer will try to reduce prices as much as possible.

In short, an industry that is dictated by buyers is usually weak and its profitability is under constant threat.

4. Bargaining Power of Suppliers

An industry controlled by its suppliers is under threat. This occurs when :

a) The suppliers have a monopoly or if there are few suppliers. b) Suppliers control an essential item. c) Demand for the suppliers product exceeds supply. d) The supplier supplies to various companies. e) The switching costs are high. f) The suppliers product does not have a substitute. g) The suppliers product is an important input to the buyers business. h) The buyer is not important to the supplier. i) The suppliers product is unique. j) The supplier supplies to various companies.

5. Rivalry among Competitors

Rivalry among competitors can cause an industry great harm. This occurs mainly by price cuts, heavy advertising, additional services or offers at high costs to the company and the likes. This rivalry occurs mainly when: a) There are many competitors and supply exceeds demand. Companies resort to price cuts and advertise heavily to attract customers and sell their goods. b) The growth in the industry is slow and companies are competing with each other for a greater market share. c) The economy is at a recession and companies cut the price of their goods and offer better service to stimulate demand. d) There is a lack of differentiation between the product of one company and that of another. The buyer determines his choice on price and / or service. e) In some industries economies of scale will necessitate large additions to existing capacities in a company. The increase in production could result in over capacity and

price cutting. f) Competitors may have very different strategies in selling their goods and in competing they may be continuously trying to stay ahead of another resulting in each of the companies in the industry trying to stay ahead of each other in competitiveness be it by price cuts or improved service. g) Rivalry increases if the stakes are high. h) Firms will compete with one other intensely if the costs of exit are great i.e. the payment of gratuity, unfunded provident fund, pension liabilities and the likes. Companies would remain in the business even if the margins are low and little or no profits are being made. Additionally companies tend to remain in business at low margins if there are strategic interrelationships between the company and others in the group ; there are government restrictions (the government may not allow a company to close down); or the management does not for pride or employee commitment wish to close down the company.

If the exit barriers are high excess capacity does not leave the industry but companies lose their competitive edge. And as companies do not close down, profitability erodes and it will as a consequence be low.

This can be summarized in the ensuing manner. If the barriers are high the return is low but risky. If entry barriers are low the returns are high but stable. High entry barriers result in high, risky returns.

Lending to an Industry

When Rusi Daruwalla or Raman Menon approach the Manufacturers Bank for facilities some of the more important points the Bank will bear in mind on lending to an industry are: 1. Investments in industries should be made at a time when it is at the growth stage. 2. The faster the growth of a company or industry the better. The software industry in India for example has been growing at the rate of over 200 percent per annum.

3. It is safer to lend to industries that are not subject to governmental controls. 4. Cyclical industries should be avoided if possible. 5. Export oriented industries are presently in a favoured position due to incentives and encouragements made. On the other hand import substitution companies are not doing very well. presently due to relaxations and lower duties on imports. 6. It is important to check whether an industry is right for investment at a particular time. There are sunrise and sunset industries. There are capital intensive and labour intensive industries. Each industry goes through a life cycle.

In conclusion bankers are cognisant of the fact that the industry phenomenon actually determines the existence of companies and by extension their ability to repay. Therefore, great care is taken in understanding the industry before the lending decision is taken. COUNTRY OUTLOOK

Apart from the purpose of the loan, the feasibility of the project, the collateral/ security for the loan and the management of the company Banks would always examine the country risks. This essentially is with respect to how much of their funds they are prepared to place at risk in a country. Losses could occur or the loan may be endangered owing to no fault of the borrower but due to the environment within which the borrower operates. As mentioned earlier a Mumbai based company several years ago exported certain engineering goods to Nigeria.. The goods were sent on the strength of a letter of credit opened in Nigeria. The buyer accepted the goods and paid for it. His bank was however estopped from remitting the money as the country’s foreign exchange position was very precarious. The seller did not get his money not because of the buyer but due to the country’s inability to pay. It was on account of episodes like this that sellers insisted during such situations that letters of credit be in hard currency and confirmed by a Bank in the United Kingdom, Europe or the United States.

The points that bankers will always consider when assessing the risks associated with a country are:: The political stability of the country. The rate of inflation.

The balance of payments and the balance on current account. The country’s exports and imports (and its respective growth). The growth in GNP. The possibility of nationalisation. Restrictive Practices. The Strength of the currency (possible devaluation or appreciation).

As discussed earlier it was on account of the political instability that the international credit agency Moodys downgraded its rating on India. A few months later Deve Gowda’s government collapsed. South America in the seventies and eighties, Mexico in the early nineties and the South East Asia catastrophe of 1997 illustrate the fragility of countries. In the latter the economies of several countries - Korea, Indonesia, Malaysia, Philippines and Thailand collapsed. The currency depreciated dramatically, the most pathetic being that of Indonesia which fell from Rupiah 2,500 in April 1997 to nearly Rupiah 16,000 to a United States dollar in June 1998. Several companies collapsed and the losses of individual banks were in the tens of millions of dollars. After the nuclear explosion in May 1998 and the imposition of sanctions against India, Moodys downgraded India’s foreign exchange rating. The result is that the cost of borrowing abroad will be more expensive and the rupee would be under threat.

Rusi Daruwalla had been exporting for several years chemicals to Indonesia. He had in 1995 approached his bank and through them arranged a foreign currency loan and established a company there. This company procured hard currency financing and bought machinery from the United States. The company prospered. When the currency collapsed in late 1997/1998 the dollar exposure of the company quadrupled and the company had to be liquidated. The country risk was that grave.

Raman Menon received an order for garments from the United States. The order required his buying certain cloth from the Australia.. The order was large but the pricing was very fine and the order was denominated in United States dollars. A depreciation of the rupee against the Australian dollar and an appreciation of the rupee vis a vis the United States dollar resulted in a large profit about turning to a loss.

Thus when there is an exposure, banks will also look at:: The dependence of the company to the import of raw materials. The company’s foreign currency exposure in regard to loans. The strength of the currency. As it can bring down the Bank. During the recent Indonesian crisis, a very respected Hong Kong based investment bank went into liquidation on account of a loan in excess of $250 million given to an Indonesian taxi company.

Most banks therefore have cross country limits. This limit is the exposure that they are prepared to take on a country. In order to determine this, they grade or rate companies the main criteria being the risk of default. The gradings are usually A, B, C, D and E.. A rated countries are those of the industrialised West and Japan. B rated countries are those that are not as well developed but safe. C rated countries are developing countries whose fundamentals are reasonably strong. India belongs to this category. D and E rated countries are economically undeveloped where there are grave risks such as some African countries and South American countries. The risk is considered that grave that when a Bank requests for a letter of credit to be confirmed by a Bank in a A rated country it is not unusual for the confirming bank to demand a 100% cash cover before it confirms the letter of credit.

In conclusion banks are extremely concerned if exposures have to be taken in another currency and they will without question assess the strength of the country and the risks of the exposure before they lend. THE PROJECT REPORT

Bankers are financial experts. They can analyze figures. They can project economic likelihoods regarding what is likely to happen to interest rates, currency values and industry. They are in the business of lending and want to lend. However they are not technical persons and cannot really evaluate projects being conceived. They cannot usually differentiate between the different methods of production or even opine which is more efficient or cost effective. It is because of this that they rely heavily on project reports in making the lending decision as they are effectively looking for the endorsement of an expert on the viability of the project. Therefore when Rusi Daruwalla meets his bankers - The Manufacturers Bank he would be wise to take with him a project report

which would submit a project report that supports his intention to expand and proves that his company would become more efficient. Similarly if Mr. Singh plans a new project to farm black tiger prawns, his proposal would be studied more seriously if he submits a detailed project report on the manner he intends to farm the prawns in detail. It should detail the land, the kind of ponds that will be constructed, safeguards against diseases, the water available, the soil and the harvests. The report should also state how the prawns will be marketed - whether it will be sold live (for the Japanese market) or frozen and the financial projections of the enterprise. The conclusions arrived at should be supported by an acknowledged authority on the subject. This makes the lending decision for the Banker relatively easy as he is comfortable in relying on the expertise and wisdom of an expert. He needs this lifeline too for his comfort too as if things do go wrong he could state that by basing his decision on the submissions and endorsement of an expert he did what any prudent banker would do and has not therefore been negligent. While submitting a project report both Rusi Daruwalla and Mr. Singh should be aware that the banker is not a technical man (usually) and technicalities and engineering niceties usually go above his head (though he would never readily admit it). While the tome must be impressive there are several issues that the Banker will zero in on and these must be addressed and addressed in detail if the loan is to be given the nod. The project report should address the need for the project and how by implementing it there will be profits for the company. Ideally, it should also state there are very few downsides. It must speak of the suitability of the land chosen for the project - accessibility to either raw materials or to the end user market or tax concessions and the likes. It must detail the cycle of production and explain why the method superior or more cost effective than others. recommended is

It must speak or dwell on comparative advantages such as forward or backward integration or import substitution or even the high demand. This must be supported by statistics. Bankers love statistics and will use these in putting up their proposal for approval. The project report should also speak of strengths and weaknesses and then logical manner how the strengths far outweigh the weaknesses. The project report should clearly show the costs of the project, the the time it would take for it to start repaying the loans taken. prove in a

gestation period and

The report should also mention whether the project is exposed to the vagaries of the economic cycle or industry cycles and the effect this will have on the project. The financials should be given in detail. It should begin with the cost of the project

stating from where (and why) the machines will be bought, the maximum cost, the cash flow, leverage and the projects debt service capacity. The banker has to be convinced that even in the worst situation the company can service the debt. I know of a cement manufacturer who, being ambitious, presented a report for the construction of three medium cement plants simultaneously. The projects were good and they were viable. Being ambitious he decided to construct the three plants simultaneously. It was after he began the construction that the primary markets collapsed and he began to experience cash problems. Bank finance stopped as he was unable to service loans. At present he has three unfinished plants into which he has sunk a lot of money. The Company is also bankrupt and likely to remain so. Above all the project report should also clearly state who will run the project and the capability, experience and competence of the persons entrusted with the project. If they have already implemented and successfully run similar projects the banker will derive considerable comfort.

In conclusion it has to be emphasised that the project report is at the core of the lending decision. No banker (unless he is a buccaneer) will finance a green field venture without a project report that clearly shows how feasible the project is. It has to address the concern that is dearest to his heart - the repayment and servicing of the funds that he will be lending (placing at risk). If Rusi Daruwalla’s project report does not address these issues he will find it difficult to get the loan approved. THE AUDITORS REPORT

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

The auditor represents the shareholders and it is his duty to report to the shareholders and the general public on the stewardship of the Company by the directors. Auditors are required to report whether the financial statements presented do, in fact, present a true and fair view of the state of the company. Bankers will go through the auditors report carefully as the auditors are, to a degree, their representative and they are bound to, and required by law to, qualify their statement if the financial statements are not true and fair. The auditors are also required to report any change such as changes in accounting principles or the non provision of charges that result in an increase or decrease in profits. It is really the only impartial report that the outside public and the banker has access to

and this reason alone makes it imperative that he reads it carefully and analyses the report including if necessary reconstructing the financials in order to get the true facts and the state of the company’s state of affairs.

There can be interesting contradictions. In one Auditors’ Report it was stated,. As at the year end, the accumulated losses exceed the net worth of the Company and the Company has suffered cash losses in the financial year as well as in the immediately preceding financial year. In our opinion, therefore the Company is a sick industrial company within the meaning of clause (O) of Section 3(1) of the Sick Industrial Companies (Special Provisions) Act 1985. The Directors report however states The financial year under review has not been a favourable year for the Company as the Computer Industry in general continued to be in the grip of recession. High input costs as well as resource constraints hampered operations. The performance of your Company must be assessed in the light of these factors. During the year manufacturing operations were curtailed to achieve cost effectiveness. Your directors are confident that the efforts for increased business volumes and cost control will yield better results in the current year. The auditors are of the opinion that the company is sick whereas the directors speak optimistically of their hope that the future would be better (they probably cannot do otherwise).

When reading Auditors Reports the effect of their qualification may not be apparent. The Auditors Report of another company reads In our opinion and to the best of our information and explanation given to us, the said accounts subject to Note No. 3 regarding doubtful debts, No. 4 regarding balance confirmations, No. 5 on custom liability and interests thereon, No 11 on product development expenses, No. 14 on gratuity, No.8, 16 (C) and 16(F) regarding stocks, give the information in the manner as required by the Companies Act 1956, and give a true and fair view - It is necessary therefore to go to the specific notes. In this case 1. Note 3 states that no provision has been made for doubtful debts. 2. It is noted in note 4 that balance confirmation of sundry debtors, sundry creditors and loans and advances have not been obtained. 3. It is stated that customs liability and interest thereon worth Rs. 3,14,30,073 against the imported raw materials lying in the ICF / Bonded godown as on the balance Sheet date has not been provided in note 5. 4. Note 11 drawn attention to the fact that product development expenses worth Rs. 17,44,049 are being written off over ten years from 1991-92. Rs. 2,16,51,023 has been capitalised under this head relating to the development of CT142, Digital TV, Cooler, CFBT which shall be written off in 10 years.

5. The companys share towards past gratuity liabilities as at the year end has neither been ascertained nor provided for except to the extent of premiums paid against a LIC group gratuity policy taken by the trust. This is in Note 14. 6. Note 16C states that the raw material consumed has been estimated by the management and this has not been checked by the auditors.

The company made a profit of Rs. 1,07,51,537. If the product development expenses, customer duty and interest and provision for bad debts had been made as is required under generally accepted accounting principles, the profit may have turned into a loss.

It must be remembered that at times accounting principles are changed or creative, innovative accounting is resorted to by some companies to show a better result. The effect of these changes are at times not detailed in the notes to the accounts. The Auditors Report will always draw the attention of the reader to these changes and the effect that it has on the financial statements. It is for this reason that the careful reading of an Auditors Report is not only necessary but mandatory for the banker.

It is for these reasons that Bankers insist on the submission of audited results prior to the sanctioning of facilities. An external confirmation - an unbiased, impartial opinion on the financials is an absolute necessity. CASH FLOW

In this age of creative accounting accounting principles are changed, provisions are created or written back and generally accepted accounting principles are liberally interpreted or ignored by companies to show profits. Shareholders do not realise this when they look at the profits made as published in the financial statements. It comes therefore as a surprise when a regular profit making company suddenly downs its shutters and goes into liquidation. The reason usually lies in the fact that the company has no cash and is unable to get finance and is unable to pay its creditors. This is an area that is not often considered - the company’s cash flow and yet it is, for a company, its very life blood. A community of successful money handlers - the Marwari community of India are an exception. They have always recognised its importance and their celebrated “Partha” system deals entirely with cash inflows and outflows. This is their strength and the reason for their growth. Unfortunately most others do not pay heed to cash flows, concentrating entirely on the “bottom line”. History is strewn with corporations that have closed down

because of its inability to pay. In recent times in India, in the first flush of liberalisation and buoyancy in the capital markets, many companies embarked on very ambitious expansion plans. Their plans went awry in 1995 -96 when , in order to contain inflation, money supply was restricted. A liquidity crunch followed. The primary market collapsed. Many companies identified as the blue chips of the future were in very difficult situations and some became bankrupt. Bankers, aware that loans advanced can go bad if the company does not have operating cash flows that are positive will always they have to be satisfied that the company has adequate funds to meet interest and capital repayments. o How much cash earnings is the company making o How is the company being financed o How is the company using its finance? The answer to the above can be determined by preparing a sources and uses of funds statement. Its importance has been recognized in the United States and in many European and Asian countries where it is mandatory for a company to publish with its Annual Report, a statement of changes in financial statements which is in effect a cash flow statement.

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

A Company published a profit before tax of Rs. 10.81 crores a few years ago, This included however, other nonrecurring income of Rs. 24.77 crores, profit on the sale of fixed assets of Rs. 11.29 crores and an amount of Rs. 3.86 crores was withdrawn from a revaluation reserve. If these are adjusted for the operating profit changes to a loss of Rs. 29.11 crores - a very material difference. The company had declared a dividend on its preference shares. This was, as the company had made a loss, in effect paid from reserves. Its inventories and other current assets had increased. As the company is in reality not doing well, the possibility of the company being unable to get rid of its surplus stock cannot be ignored.

Another company published a profit of Rs. 14.17 crores. It was a fall from its previous years profits of Rs. 71.34 crores. It was construed as a reasonable profit in hard times.

However, a sources and application of funds statement reveals that the company raised Rs. 75.15 crores from loans and that it effectively paid its dividends from borrowed funds. It poses the question that when the time comes to repay loans will the company have adequate monies to do so.

The charm or utility of the cash flow or sources and uses of funds statement strips the accounting creativeness from financial statements. While figures can be doctored to show high profits/ losses, the cash flow shows how much cash has actually been generated from operations and how much has been sourced from external sources. If a company has a negative cash flow from operations a banker will ask serious questions on how the company will meet its interest obligations and its capital repayments - both of which should come from operations. If it is continuously raising monies from other sources to meet day to day obligations, a sources and applications statement will reveal that in no uncertain terms and the banker will need to be satisfied that there will be inflows from operations before he would actually consider lending monies.

The importance and effectiveness of the Cash flow cannot be over emphasised and the banker aware of this will always examine the cash flow to determine the viability of the project and the ability of a company to repay its loans and service its interest.


The Banker after he has satisfied himself on the political imbroglio, the economic situation, industry, the company, the management and other related factors would then examine the financials as it is upon this that he will base the final decision. He will examine the financials from all aspects aware as Abraham J. Briloff says, “Whenever ants swarm, the pot will not only contain a bit of money, but will also be filled with accounting gimmicks.”

The financials are the pivot on which the lending decision rests as it details the fundamental strengths and weaknesses of the company and its ability to repay the loans and advances given to it.

When Mr. Daruwalla or Mr. Mistry meet their bankers the banker will normally ask for their financials in order to determine whether it is indeed viable to lend to them. The banker will also seek to ascertain whether the financials prepared are audited. If it is so it would afford him more comfort. It is also imperative that upto date figures are given. No banker worth his salt would arrive at a business decision based on old figures as many, many things could have happened in the interregnum.

What are the factors that the banker will look at in order to arrive at a decision?

The banker will attempt to make sure that the unit, based on its financials, is a going concern.. This means that it is conducting its business normally and that it is not unviable or loss making..

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

Another important issue bankers will look at is profit ploughback. Profit ploughback is to enable the company to expand, make it stronger and replace assets. If profits are not reinvested, the company will have to borrow in order to replace worn out assets or to purchase new machines and this will erode its strength.

Bankers will always examine the quantum of borrowing - whether they are short term or long term, whether they are secured or unsecured. If the borrowings are large, in a boom year shareholders will benefit whereas in a bad year it would be the reverse. It is of prime importance to a banker whether the company can service its borrowing.

Fixed assets are important as in most cases fixed assets are employed to earn the income for the Company. The composition of fixed assets will be examined in detail and the nature of the fixed assets employed. There could be instances where there are hidden reserves such as land purchased sixty or seventy years ago which are still shown at cost. On the other hand there may be obsolete assets or unproductive assets and no clear policy to upgrade assets.

Some companies have intangible assets on their Balance Sheets such as deferred revenue expenditure or preliminary expenses not written off. These are expenses and have no asset value and bankers will recast the Balance Sheet deducting these from the Company’s net worth.

Many company’s have investments. The banker will always ascertain the nature for these investments and the reasons for them. If it is not crucial for the business it would be better to liquidate and use the funds thus generated to reduce borrowings.

Bankers will invariably check current assets including stocks and debtors He will examine how they have been valued and how old they are. This is in order to ascertain how real they are. Obsolete stocks and bad or doubtful debts should be written off or adequately provided for.

Sales turnover is another aspect that the Banker will examine. How has sales grown? How much are the sales? The volume indicates the Company’s position in the industry and its sustainability.

A company’s other income is also examined especially its composition and whether it would be recurring. Normally other income should be less than five percent of turnover though there is no hard and fast rule. The Banker examines this to determine income streams and its dependability.

Expenses would normally be, when being examined, broken down to fixed costs and variable costs. Fixed costs would be those costs that would be incurred irrespective of any other factor. These will include rent, administration costs and the likes. Variable costs are those normally linked with the level of activity such as sales commission. The banker would check whether the growth in these costs are in tandem with the increase in income. If not the Company’s profitability might be under threat.

Financing costs is a cost bankers will pay great heed to as the viability of the company

could depend on it. The issue here is whether the Company can pay the interest on the facilities it enjoys from operating profits. If not there will be concern unless if the company can demonstrate that in the near term it would be able to.

The Banker would also look at the profits made before and after tax because the profits a company makes is the final deciding factor on the lending decision. No one will, in their right mind, lend more to a loss making company. On the other hand bankers fall over backwards to lend to one that is making more and more profits every year.

Another aspect bankers will look at are the contingent liabilities of a company. Contingent liabilities are by definition a liability that may arise should an event occur such as a bill discounted being dishonored or a guarantee issued being called up.

However sheer numbers by themselves are not adequate to make a decision. Bankers tend to reduce numbers to ratios in order to compare strengths and weaknesses with other companies and between years. We will examine ratio analysis and the manner it should be computed in the next few articles. RATIO ANALYSIS

No banker would lend or advance facilities to a company until he has analyzed its financial statements and compared its performance to that it achieved in previous years and with that of other companies. This can be difficult at times because:

(a) The size of the companies may be different. (b) A companys Balance Sheet composition may have changed significantly. It may have issued shares or increased/reduced borrowings.

It is in the analysis of financial statements that banker find ratios most useful because they help him to compare the strengths, weaknesses and performance of companies and to also determine whether it is improving or deteriorating in profitability or financial strength.

Ratios express mathematically the relationship between performance figures and/or assets/liabilities in a form that is easily understood and interpreted. Otherwise one may be confronted by a battery of figures that are difficult to draw meaningful conclusions from. It should be noted that figures by itself will not enable one to arrive at a conclusion on a companys strengths or performance. Sales of Rs. 500 crores a year or a profit of Rs. 100 in a year may appear impressive but one cannot be impressed until this is compared with other figures such as its assets or net worth. It must be remembered that when comparing one figure with another that the relationship is clear and logical. Otherwise no useful conclusion can be arrived at. A ratio expressing sales as a percentage of trade creditors or investments is meaningless as there is no commonality between the figures. On the other hand a ratio that expresses the gross profit as a percentage of sales indicates the mark up on cost or the margin earned.

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

Ratios can be broken out into four broad categories: A) Profit and Loss Ratios These show the relationship between two items or groups in a Profit and Loss Account or Income Statement. The more common of these are : 1. Sales to cost of goods sold 2. Selling expenses to Sales 3. Net Profit to Sales 4. Gross Profit to Sales

B) Balance Sheet Ratios

These deal with the relationship in the Balance Sheet such as : 1. Shareholders equity to Borrowed Funds 2. Current assets to Current Liabilities 3. Liabilities to Net Worth 4. Debt to Assets 5. Liabilities to Assets

C) Balance Sheet and Profit and Loss Account Ratios. These relate an item on the Balance Sheet to another in the Profit and Loss Account such as: 1. Earnings to shareholders funds 2. Net Income to assets employed 3. Sales to Stock 4. Sales to Debtors 5. Cost of Goods sold to creditors

D) Financial Statements and Market Ratios These are known normally as market ratios and are arrived at by relating financial figures to market prices 1. Market value to earnings. 2. Book value to market value

These are not particularly important from a bankers perspective as he is not really concerned with market value. In this study, ratios have been grouped into categories ranked in importance to a lending banker that will enable him to easily determine the strengths or weaknesses of a company. a) Debt Service Capacity b) Profitability c) Liquidity d) Leverage e) Asset Management/Efficiency f) Margins g) Earnings

It must be ensured that the ratios being measured are consistent and valid. The length of the periods being compared should be similar. Large non recurring income or expenditure should be omitted when calculating ratios calculated for earnings or profitability. Otherwise the conclusions arrived at will be incorrect.

Ratios do not provide answers. They suggest possibilities. Bankers examine these possibilities along with general factors that would affect the company such as its management, management policy, government policy, the state of the economy and the industry to arrive at a logical conclusion and he must act on such conclusions.

Ratios are a tremendous tool in interpreting financial statements but their usefulness is entirely dependant on their logical and intelligent interpretation. DEBT SERVICE CAPACITY

A banker’s concern when he extends credit facilities to a client is whether that client can service its debts from internally generated funds. Can it meet principal and interest

payments out of its profits? This is ofcourse based on the assumption that the company is a profitable going concern and that debt will not be repaid by additional borrowings or rights/ public issues.

Debt Coverage

This ratio is used to determine the time it would take for a company to repay its short and long term debt from income or internally generated funds. This is relevant if the debt is not to be extinguished by the sale of assets or by the issue of fresh capital or debt.

Internally generated funds for this ratio is income after tax plus non cash expenses (depreciation) and non operating income and expenses. Debts will comprise of bank overdrafts, term loans and debentures. The ratio is calculated by dividing internally generated funds by the average debt. debt coverage ratio = internally generated funds average debt

Liability Coverage

The liability coverage ratio is an extension of the debt coverage. It is used to check whether a company can through internal generations repay all liabilities. This ratio is calculated by dividing internally generated funds by average total liabilities.

Liability coverage ratio = Internally generated funds average total liabilities

It is possible too to calculate this ratio on liabilities at the date of the Balance Sheet on the argument that the factor to be considered is the time it would lend to repay total liabilities

at a particular time.

Interest cover

An extremely important factor that bankers must ascertain is whether a companys profits are adequate to meet its interest dues.

If profits are insufficient, this will have to be paid out either from reserves, additional borrowings or from a fresh issue of capital and these are a sure sign of financial weakness.

The interest cover ratio is calculated by dividing earnings before interest and tax by interest expense. The ratio must always be in excess of 1 - the higher the better. If it is below this figure, any small reduction in profit would result in the company being forced to pay interest out of retained earnings or capital.

Interest cover ratio = earnings before interest and tax interest expense

Fixed Charge Cover

The last decade has witnessed the birth and the development of several financing and leasing companies. These companies have offered corporations the opportunity of leasing equipment as opposed to purchasing them. Leasing is also being looked upon increasingly as an alternative to actually purchasing an asset. This has the following benefits. The rentals paid are entirely tax deductible. Secondly, funds do not need to be deployed for the purchase of assets. This is known as off balance sheet financing i.e. neither the real cost of the asset nor the liability is reflected in the Balance Sheet. The fixed charge cover considers off balance sheet obligations such as rental expenses and checks whether a company earns enough income to meet its interest and rental commitments.

Fixed charge cover = Earnings before interest and taxes plus rental expense interest and rental expense

It is argued at times that the dividend payable on preferred shares should also be accounted for in this ratio as it is a fixed charge that has to be paid. In that case the fixed charge cover is calculated in 2 stages. In the first stage the fixed charge cover is calculated and from this the preferred dividends paid are ratiod.

Net Income + (1-tax rate)(interest and rental expenses) (1-tax rate) (Interest and rental expense)+preferred dividends

This is a better ratio than the interest cover ratio as it considers all the fixed expenses that a company has and examines whether its earnings are sufficient.

Cash flow surplus

The cash flow surplus ratio is based on the going concern concept and assumes that companies will normally grow and therefore will incur capital expenditure and that there will be an increase in net working capital. The submission is that a companys ability to pay its debt should be determined only after increases in capital expenditure and net working expenditure. Cash flow is net income plus non cash charges (depreciation etc.) less capital expenditure and increases in net working investments. The ratio is calculated by dividing the cash flow surplus by total debt.

Cash flow surplus = cash flow surplus Total average debt

This ratio is often negative. This is because that when a company is growing rapidly it is purchasing assets of a capital nature and its net working investments are also increasing and this increase is usually more than its internally generated funds. This is usually funded by loans or short term facilities.


Bankers will always consider debt service ratios as it enables them to determine whether the company under consideration has the capacity or the ability to service its debts and repay its liabilities. This becomes all the more critical at times of high inflation and recession when an inability to service debt can plunge a company to bankruptcy. And the loan the Bank extends becomes a Non Performing Asset (NPA). PROFITABILITY

The profitability of a company is of prime importance to a banker. Unless a company is profitable, it cannot grow; it cannot pay dividends; its value will not increase and it cannot survive in the long run. Additionally and more importantly it may not be able to repay its loan

Profitability ratios assist the banker in determining how well a particular company is doing vis a vis other companies within the same industry and with reference to previous years. A banker can, with the help of these ratios, evaluate the managements effectiveness on the basis of the returns generated on sales and investments.

While calculating and evaluating profitability a banker ensures that:

o As far as possible ratios are calculated on average assets and liabilities and not on the assets or liabilities on a particular date. This is because there can be large variations in these figures during the year and these can distort results quite materially. Companies have been known to windowdress their Balance Sheets by either reducing or increasing assets or liabilities. Additionally as profits are earned not on a particular date but over a year ratios calculated on average assets/liabilities would portray a truer indication of the

results achieved by the company.

o Bankers take into account the rate of inflation and the cost of capital and borrowings. When evaluating the ratio banker should consider whether a better return would have been received elsewhere. And whether the return has kept pace with the rate of inflation.

o Ratios are, it must be remembered, indicators and these should be considered as an indication or as a suggestion of future development.

Return on total assets

The first ratio checked is the return on total assets. This is an extremely important indicator as it would help the banker determine whether: o The company has earned a reasonable return on its sales. o The companys assets have been effectively and efficiently used and o The cost of the companys borrowings are too high. This ratio is used to compare the performance of a company with other companies within the industry and with previous years. It is also used to project the performance of future years.

Return on Equity

Another important measure of profitability is the return on equity or ROE as it is often termed. The purpose of this ratio is to determine whether the return earned is as good as other alternatives available. This return is calculated by expressing income (net profit after tax) as a percentage of the share holders equity. It is to be noted that the income figure should not include extraordinary, unusual or non recurring items as that would

distort the results arrived at. Additionally, the net income on which this ratio is calculated should exclude dividends on preference shares. Shareholders equity is the stake ordinary shareholders have in the company and will include reserves and retained earnings.

ROE = Net income after tax-dividend on preference shares Average shareholders equity It must be remembered that if there are other investments that earn a higher return with lower risks then the profitability is low. The ROE should be compared with other alternatives taking into account the risks of the investment. The normal rule is usually the higher the return, the higher the risk.

Pre interest return on assets

It is often said that the preinterest return on assets is a purer measure of profitability since on account of interest and taxation, it is difficult to compare the actual performance of companies. This is because the interest paid will vary from company to company and will depend on its borrowings. Similarly the tax liability of companies will differ and will depend on the manner it has planned its tax. This ratio therefore suggests that the return be on operating income and is arrived at by dividing earning before interest and tax by the average total assets.

Pre interest return on assets = earning before interest and tax average total assets A banker must compare the return earned with other companies (preferably in the same industry) to determine whether the return earned is high or low.

Pre-interest after tax return of assets

The purpose of calculating this ratio is to determine the managements performance in

deploying assets effectively without financing. Tax is included in the calculation as it is deducted before arriving at the profits. Interest too is not considered as it will vary from company to company and is a payment for capital or funds. The ratio is arrived at by expressing net return after tax but exclusive of interest as a percentage of average total assets.

pre interest after tax return on assets

net income after tax + interest expense net of income tax saving average total assets

Return on total invested capital

The ratio that is used to determine whether the capital has been efficiently used is the return on total invested capital. A banker can, by using this ratio, check whether he could have earned more elsewhere. It therefore gives him an opportunity to compare alternatives and between companies. Invested capital in this ratio includes all liabilities that have a cost associated with them such as debentures, share capital and loans. The ratio is arrived at by dividing a companys earnings before interest and tax by average total invested capital.

Return on total invested capital=earnings before interest & tax average total invested capital A banker will check whether the return on capital is higher than the prevailing interest rate of interest and the weighted average cost of borrowings. If the rate of interest is higher than then the return on the capital may be considered inadequate.


The profitability ratios are arguably the most important of the ratios to an banker as they indicate whether the enterprise is viable and better or worse than other similar ones. These ratios however should not be seen in isolation. One should remember that a lower ratio is not necessarily bad. In order to increase sales and profits companies may sell goods at lower prices (volume driven businesses). These ratios are, like all ratios, indicators and they should be considered as such. LIQUIDITY

Liquidity is one of the cornerstones of lending. It is important for companies to be liquid in order for it to meet its currently maturing financial obligations and to have enough funds to meet its operational requirements. If a company is unable to, it may be forced to sell its more important assets at a loss and can, in extreme cases, be forced into liquidation. After the securities scam in 1992, many mutual funds were forced to sell their blue chip shares for liquidity as they were not able to sell their large holdings of securities in Public Sector Undertakings (PSU). As a consequence of the liquidity crunch that began in 1996/97 many promising companies went down under due to a lack of liquidity.

Current Ratio

The current ratio is the most commonly used ratio to measure liquidity and its purpose is to check whether a companys current assets are enough to meet its immediate liabilities i.e. those that mature within one year. The ratio is arrived at by dividing current assets by current liabilities.

Current ratio = current assets current liabilities

Normally the ratio is around 1 or even a little below 1. This in itself is not bad. Today, all companies are aware of the cost of capital, the opportunity cost of tying up capital unproductively and just in time (JIT) inventory control. Consequently there is an effort to keep current assets low (stock levels, debtors and cash). Thus often the ratio is well below

1. This does not necessarily mean that the company is illiquid - it could merely be using its assets effectively.

Quick Or Acid Test

The acid test is a favorite with bankers and creditors. This is used to check whether the company has enough cash or cash equivalents to meet its current obligations or liabilities. The reason for this is there is usually no conversion cost when cash or cash equivalents are used to pay debts. Other assets such as inventories (stocks) if sold at a distress or emergency sale may realise less than its book value i.e. the company could lose when converting to cash.

This ratio is arrived at by dividing cash, marketable investments and debtors by current liabilities. It is to be noted that investments, though strictly not a current asset is used in calculating this ratio. This is because they are easily realisable. Quick ratio = cash and cash equivalents current liabilities It should be remembered that stocks have not been considered in calculating this ratio as it is not a cash equivalent and if one wishes to sell it in a hurry there can and will be a loss (dumping of goods).

Net Current Assets

Net current assets or net working investments are arrived at by deducting current liabilities from current working assets (trade assets). This is clearly not a ratio. Its usefulness is in one being able to quickly ascertain whether a company has adequate current assets to meet its current liabilities. Net current assets is really the working capital of a company. Consequently several derivatives can be calculated from this figure such as its relationship to sales, income and even to capital.

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

Net Trade Cycle

It is important to determine the time companies take to convert goods purchased to cash after it has been paid for. This is a very good tool to determine its liquidity and it is computed by adding the debtors turnover in days to the stock turnover in days and deducting from it the creditors turnover in days.

Debtors turnover = average debtors x 365 sales Stock turnover = average stocks x 365 sales Creditors turnover = average creditors x 365 sales Net trade cycle debtors turnover + stock turnover - creditors turnover

If this ratio improves, it indicates an improvement in the management of net current working assets. Ofcourse it can also indicate that there is difficulty being experienced in paying creditors. Bankers will go beyond the figures to determine the reasons for a change in the cycle. It must be remembered the longer the cycle, the greater the need for financing. This should, as much as possible, be brought down. And this can be achieved by reducing debtors and stock levels and efficiently managing these.

Defensive Interval

This ratio indicates the number of days a company can remain in business without any additional financing or sales. It can be likened to a worker on strike. How many days can he survive on the assets that he has before he becomes bankrupt?

This ratio is calculated by dividing a companys average daily cash operating expenses by its most liquid assets. It is important to note that only the most liquid assets are used such as cash and cash equivalents. Debtors and stocks are not to be considered as they are not cash equivalents.

Defensive ratio = average daily cash operating expenses most liquid assets

Current Liability Coverage

The current liability ratio enables the banker to examine the relationship between cash inflows from operations and current liabilities and to determine whether the company can meet its currently maturing obligations from internally generated funds. At times of creative accounting and cash crunches this is an extremely important ratio.

Current liability coverage = cash inflow from operations average current liabilities


Liquidity is becoming increasingly important to companies and this factor alone has resulted in companies becoming sick - an inadequacy of funds to finance operations. It is crucial that investors examine liquidity of the company and whether it is improving or deteriorating.

As companies begin to have financial difficulties, they begin to pay bills (creditors) later. Current liabilities begin to build up. As current liabilities build up, suppliers become more and more reluctant to sell goods. This affects production and then sales and this has a snowballing effect. Therefore if these ratios are deteriorating, a banker will be concerned.

However, negative liquidity ratios need not necessarily be bad. Many companies in strong positions keep low current assets and are able to get long credit from suppliers especially those that operate with extremely low margins.

Historically companies have excellent liquidity ratios before a crash. This is because fixed assets and stocks are sold and become converted into cash. Current liabilities decrease at that time as creditors are paid off. So good liquidity is also not always wonderful.

Bankers will always check the quality of the assets that make up current assets. It should be ascertained whether they are at current realisable value. Additionally current assets should not include deferred revenue expenditure like advertising costs as they do not have any encashable value. It must be remembered that Balance Sheets can be windowdressed. Therefore the figures should be scrutinised properly.

The liquidity required will vary from company to company and from industry to industry. It will depend on market conditions and the prominence of the company. The investor must, while viewing these ratios check whether the company is adequately liquid and whether this has deteriorated. If it has and there does not seem a likelihood of it improving in the imminent future, then the will not extend facilities.. LEVERAGE

Leverage indicates the extent a Company is dependent on outside funds or borrowings to finance its business. These borrowings may be debentures, term loans, short term loans and bank overdrafts. Bankers will pay specific heed to this as the viability of the facilities it extends to companies may depend on how leveraged a company is.

In highly leveraged firms, the owners funds are minimal and the owners are able to control the business with a fairly low stake. The main risks are borne by the lenders. These Companies, in good times, make large profits (especially if they are high margin businesses). However, in times of recession the reverse occurs. Interest costs are exorbitant and the large profits made in boom times turn to large losses. At these times the cost of borrowings often exceed the profits made and results in losses and the Company that makes the highest profits is the one that has no borrowings.

One can safely conclude therefore that though companies with very little or no borrowings are safer and can be depended upon for some returns, highly leveraged companies are risky and earnings can in bad years be negative. Conversely in good years it can be very good.

Liabilities to Assets Ratio

This ratio indicates the total borrowings provided to finance the company and the extent to which these external liabilities finances the assets of the company. Liabilities in this connection includes both current and long term liabilities. Assets include all assets excluding intangibles such as deferred revenue expenditure (preliminary expenses, goodwill, deferred advertising expenditure and the likes). This is calculated by dividing total liabilities by total assets.

Liabilities to assets ratio = total liabilities total assets

Bankers would also examine the companys contingent liabilities too such as guarantees, legal suits and the likes as should these be material and likely to crystallise, the ratio would change dramatically.

Debt to Assets Ratio The debt to assets ratio is a more specific ratio. It determines the extent debt or borrowed funds are covered by assets and measures how much assets can depreciate in value and still meet debt commitments. Debts are defined as borrowed funds and will include bank overdrafts. Assets exclude intangibles such as goodwill and deferred assets. The ratio is calculated by dividing debt by total tangible assets. Debt to Assets ratio = total debt total tangible assets

Debt to Net Worth Ratio

The debt to net worth ratio shows the extent funds are sourced from external sources and the extent a company is dependant on borrowings to finance its business. It is arrived at by dividing debt by net worth. Net worth is defined as shareholders equity less intangible assets. Debt to Net Worth = Debt Net Worth

Liabilities to Net Worth

The liabilities to net worth is a larger measure than the debt to net worth ratio and attempts to determine how dependant a company is on liabilities to fund its business. It is calculated by dividing total liabilities by net worth. Net worth will be arrived at after deducting intangible assets. Liabilities to net worth ratio = total liabilities

net worth

Incremental Gearing

The incremental gearing ratio attempts to determine the additional borrowings required to finance growth. It is to an extent similar to the net working investments ratio. The ratio is calculated by dividing net increase in debt by the increase in net income after tax but before dividend. Incremental gearing = net increase in debt increase in net income after tax but before dividend

Other Ratios

There are several more ratios for gearing but these are seldom used such as the long term debt ratio which seeks to determine how important borrowings are to total long term liabilities and shareholders equity. This ratio is enlarged by the liability to equity issue. Liabilities in this calculation includes total liabilities and shareholders equity.


The gearing ratios illustrate the dependence companies have on external funds and the extent to which liabilities finance the company and are extremely important and bankers will consider these while evaluating a company. ASSET MANAGEMENT / EFFICIENCY

It is by the efficient management of assets that companies make profits.

Bankers therefore will always analyse the financials to determine whether the assets a company has are adequate to meet its needs and whether the returns are reasonable. It must be remembered that assets are acquired either from capital or from borrowings. If there are more assets than necessary, the company is using funds it could have used more profitably or conversely paying interest needlessly. If there are less assets than it requires the companys operations would not be using its resources as productively and effectively as possible.

Asset management ratios, in short, enable bankers to determine whether a company: o is utilizing its assets efficiently. o has adequate assets.

It is assumed that sales volumes are affected by the utilization of assets. Asset ratios are used to assess trends and to determine how well assets have been utilized. Comparisons can be made between one year and the next, between one company and another in the same industry and in other industries. These ratios help enormously in making forecasts and budgets too.

It must be remembered however that these ratios, like others, are pointers. A high asset turnover does not necessarily suggest great efficiency or a high return on investments. This may be because a company does not maintain adequate assets and this can affect its performance in time. Bankers therefore always look beyond the indications. It is important to bear in mind that a deterioration in asset ratios are a sign of decline and should be greatly heeded.

Stock Utilization

The stock utilization ratios measure how efficiently stocks are handled. With the cost of borrowings being high managers are constantly alert to the need to keep stocks low. In these days of companies propounding the Just In Time principle, these ratios are always carefully scrutinized and evaluated.

Stock utilization can be measured by two ratios a) The Stock Turnover Ratio. This ratio indicates the number of times stocks (inventory) were turned over in a year and is calculated by dividing the cost of goods sold in a year by the average stocks held in a year. Stock Turnover = Cost of goods sold average stock

b) Stock Holding Ratio. The stock holding ratio measures the number of days of stocks (in relation to sales) held by a company. In these days of companies attempting to keep as little stocks as possible, this is an important efficiency indicator. It is calculated by expressing the stock held in days of cost of good sold. Stock holding Ratio = average stock cost of goods sold divided by 365

Bankers will attempt to ascertain the reason for an improvement in the ratio i.e. is it because stocks have been dumped on dealers or due to difficulties in procuring stocks or due to a strike in the manufacturing plants? As companies close down stock levels fall. Purchases are not made and existing stocks are sold. The banker would seek to ascertain the reasons for the improvement in this ratio and especially whether the existing level of stocks can support the level of sales a company has.

Average Collection Period

Most companies sell to their customers on credit. To finance these sales, they need to either block their own internal funds or resort to bank finance. The cost of finance is therefore usually built into the sale price and companies offer a cash discount to customers who pay in cash either at the time of sale or soon thereafter.

The average collection ratio is calculated by dividing average trade debtors by the average sales per day.

Average collection period = average track debtors average sales per day

An increasing average collection period ratio is an early warning indicator of large bad debts and financial sickness and by controlling it one can improve efficiencies and reduce borrowings and save on interest.

A falling ratio is not however always wonderful. Just before companies fold up, they begin collecting on their debts and they sell for cash. The result is falling average collection period ratios.

Average Payment Period

The average payment period ratio or the creditor ratio indicates the time it takes a company to pay its trade creditors i.e. how many days credit does it enjoy. The ratio is calculated by dividing trade creditors by the average daily cost of goods sold.

Average Payment Period = Trade Creditors Average daily cost of goods sold

While examining this ratio the banker will seek to determine whether : o The company is availing of all the credit that it can. o The company is having difficulty in procuring credit. o The company is having difficulty in paying its creditors.

If the company is strong and in a commanding position, it can command longer credit terms. This is good as the company is effectively using creditors to finance working capital and to that extent the cost of finance falls.

Net Working Investments Ratio

Net working investments are those assets that directly affect sales such as trade debtors, stocks and trade creditors. The ratio is calculated by dividing the net working assets by sales. Net working investments ratio = Stocks + Debtors - Creditors Sales

This ratio highlights the working capital requirements of a company and helps the banker to determine whether the companys working capital is controlled efficiently.

Total Asset Utilization

The total asset utilization ratio is calculated to determine whether a company is generating enough sales taking into account its investment in assets. It indicates how efficiently assets are being utilized and is an extremely useful ratio for preparing forecasts. The ratio is calculated by dividing sales by average total assets. Total asset utilization = Sales average total assets

Fixed asset utilization

The fixed asset utilization ratio measure how well a company is utilizing its fixed assets.

bankers can compare this with the utilization of other companies in the same industry to determine how effectively fixed assets are being used. It should be remembered that this ratio should be calculated on net fixed assets i.e. cost less accumulated depreciation. It is arrived at by dividing sales by average net fixed assets. Net Fixed Asset Utilization = Sales Net Fixed Assets

An increasing ratio suggests that sales have fallen and the efficiency in the handling of net fixed assets has deteriorated.

It must be borne in mind that this ratio is not truly reflective of performance as fixed asset costs when comparing companies will differ. A new company with recently acquired fixed assets will show a worse ratio than one that has assets that are old. In such a scenario it would be unfair to label the older company inefficient.


Asset management ratios are calculated to assess the competence and the effective of management; to determine how efficiently assets have been managed. It also highlights how effectively credit policy has been administered and whether the company is availing of all the credit it is entitled to and is offered by its suppliers. It can also indicate whether a company is encountering difficulties. MARGINS

It is not uncommon to read in Annual Reports that although sales have increased by 24 percent in the year profits have fallen due to increases in the cost of production causing margins to erode.

Margins indicate the earnings a company makes on its sales - its mark up on the cost of the items it manufactures / buys to sell. The higher the mark up the greater the profit per

item sold and vice versa. Margins are so important that they determine the success or failure of a business. And the mark up or margin made by the seller is based usually on what he believes the market can bear or that which he thinks will fuel sales. Usually low volume businesses are high margin businesses as goods often have to be held for some time. Others such as supermarkets or for that matter brokers work at very low margins because volumes are very high.

Margins help to determine the cost structures of businesses i.e. are they high cost or low cost and whether the business is a high volume low margin business or otherwise. This is important as it will indicate how dependent the company is on margins. If the company operates with low margins a small increase in costs can result in large losses.

The performance between companies within an industry or a group can also be compared with the help of margins. Let us assume that the gross margin earned by Unisulphur Ltd. is 20 percent whereas the industry average is 18 percent. It can be argued in this instance that Unisulphur Ltd. is more efficient and that its products command a greater premium.

Management trends can also be assessed by margins. Efficient and strong managements will work to improve or keep margins constant.

Margins help an investor to determine whether increases in costs (possibly on account of inflation or governmental levies) have been passed onto customers in part or in full. Should there be a demand for the product, companies will pass on the entire cost increase to customers who will bear it and be grateful (though they may not grin). On the other hand, if the demand is not very much, the company would often bear a part of the cost increases because if it does not, the customer would not purchase the product. A good example of falling margins is the TV industry. As competition is intense and the buyer has a choice between several makes, manufacturers have been bearing a portion of cost increases and in some instances dropped their prices in order to be competitive.

Product mix has an effect on margins. A company may be selling several products - each of them priced differently. Some may be high margin products and others low margin ones. If more high margin products are sold, the margin earned by the company would be high. Then should there be a change and more low margin products begin to be sold, the average margin earned on sales will reduce. It must be remembered that low margin

businesses are not bad. Some of the most successful businesses in the world are low margin businesses that operate with very high turnovers and produce an impressive return of capital employed.

Gross Margin

The gross margin is the amount earned expressed as a percentage of cost of sales. It is the excess earned to meet the expenses of the company. It is calculated by dividing the difference between sales and the cost of goods sold by sales and expressing it as a percentage of sales. Sales - cost of goods sold X 100 Sales

Margins could fall due to several reasons such as : o Due to increased competition, the company has reduced margins to boost sales. o The company has taken a conscious decision to reduce its margins to improve sales. o The margin has reduced because there has been a deterioration in the product mix. o The company has been unable to pass on cost increases to customers.

The banker will not normally come to a conclusion on seeing an improvement or a deterioration in the gross margin. He will go beyond the figures and seek the reasons for the change. An increase in the margin may be due simply to an increase in price whereas a fall could be due either as a consequence of a conscious decision to increase sales or an inability of the company to pass inflationary cost increases onto customers.

Operating Margin

The profitability of a company before the cost of tax, miscellaneous income and interest costs is indicated by the operating margin. The operating margin can be arrived at by deducting, selling, general and administrative expenses from the gross profit and expressing it as a percentage of sales.

Gross profit - selling,general & admin expenses x 100 sales

An improvement in the operating margin could be because operating expenses have not risen as much as the increase in sales. Conversely the gross margin could have decreased (although sales may have gone up) and costs increased resulting in a fall in the operating margin. Normally this margin should improve since costs do not usually rise at the same rate as sales. In a recession or at a time of high inflation the reverse will be true. Costs may increase at a faster rate than sales and gross margins may also fall. The investor must always examine this ratio as it indicates the likely reasons for an improvement or a deterioration in profitability and he must ascertain the actual causes.

Breakeven Margin

Every organisation has certain expenses (selling, administration and other miscellaneous expenses) that it has to bear even if there are no sales. The breakeven margin indicates the number of units that a company would have to sell to be able to meet these expenses. When a company states that its breakeven is at 50% of its capacity it means that the company would be in a no profit no loss position if it produces and sells half its capacity. Any unit sold above this would yield a profit and vice versa. The ratio is arrived at by dividing expenses including financing costs by the gross income per unit. Non recurring or unusual profits must be excluded from the calculation.

Expenses plus financing costs Gross income/Number of units sold

Some bankers prefer to calculate this by deducting from the gross profit selling costs to arrive at the gross profit per unit. This is because selling costs are connected with sales and no selling expenses would be incurred if no sales are incurred. In my opinion this is an important measure as it indicates exactly how many units need to be sold by a company before it can begin to be profitable. This is an important management ratio too in decision making when alternatives are being considered.

Prefinancing Margin

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

Earnings before interest and tax x 100 Sales

This is a good measure to compare the profitability of organisations.

Pretax Margin

The pretax margin indicates the rate earned on sales after accounting for the cost of

financing but before tax. In short this is calculated on the income before tax and expresses it as a percentage of sales.

Pretax Income Sales

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

This is not a fair measure of profitability and comparison as the manner of funding (and thus financing costs) will vary from company to company. It can however be used effectively to compare performance between years of a company.

Net Profit Margin

This margin shows the rate of earnings a company earns after tax on sales. It indicates the rate on sales that is available for appropriation after all expenses and commitments have been met. To facilitate comparison and to get a true rate non recurring income and expense should be excluded in the calculation.

Net income excluding non recurring items after tax sales

The margin enables a shareholder to determine the earnings available to him on increases in sales.


Margins help therefore in characterizing cost structures in businesses and comparing performance. A banker always remembers however that low margins are not always bad nor are high margins always good. A company may opt for volumes and to achieve this work on very low margins. On the other hand a company earning high margins may have falling demand for its products. Bankers always check into the reasons for variations and the various measures mentioned in this chapter points out to the banker the possible reasons. EARNINGS

Earnings is the yardstick by which companies are finally judged-the earnings the equity holder earns on his investment. The earnings ratios are often used to determine the fair market price of shares and to value investments and the company. These ratios are, as a consequence, worth looking at from a bankers perspective though the lending decision is rarely based on these.

Earnings per share

The earnings per share (EPS) ratio indicates the earning of a common share in a year. This ratio enables investors to actually quantify and know the income earned by a share. This ratio enables the banker to determine whether the shares are reasonably priced. The ratio is arrived at by dividing the income attributable to common shareholders by the weighted average of common shares.

Earnings per share Income attributable to common shareholders Weighted average number of common shares

Abroad, in countries such as the United States of America where employees are given stock options bankers and analysts check a companys fully diluted earnings per share.

This is the earnings per share of a company after all share options, warrants and convertible securities outstanding at the end of the accounting period are exchanged for shares. This becomes relevant to India nowadays as many companies issue convertible debentures and bonds.

Many value a share as a multiple of the earnings of the company. If the earning per share is Rs. 5 and a yield of 10% is considered reasonable, the share is priced at Rs. 50.

Cash Earnings per share

It is often argued that the earnings per share is not a proper measure of the earning of a company as depreciation, tax and the cost of finance varies from one company to another and that true earnings should be calculated on the earning before depreciation, interest and tax. The cash earning per share is arrived at by dividing earning before depreciation, interest and tax (EDBIT) by the weighted average number of shares issued.

Cash earnings per share = EDBIT Weighted average number of shares issued.

Dividend Per Share

The dividend per share is often used to determine the real value of a share. Proponents of this school of thought argue that the earning per share is of no real value to anyone but those who can determine the policies of the company. It is submitted that the value of a share should be a multiple of the dividend paid on that share.

How does one value the share? If one assumes that the earnings made would include an increase in the price of the share (capital appreciation) and income (dividend per share), the price would depend on the capital appreciation one expects. If the share has regularly appreciated by 30% every year, a low dividend yield would be acceptable.

Conversely, if the share does not appreciate by more than 5% and a 30% return is required, a high dividend yield would be expected.

Dividend Payout Ratio

The dividend payout ratio measures the quantum or amount of dividend paid out of earnings and attempts to determine how much of the earnings of a year is paid out as dividend to shareholders and how much is ploughed back into the company for its long term growth. This is an important ratio when assessing a companys prospects because if all its income is distributed there would be no internal generation of capital available to finance expansion and to nullify the ravages of inflation and to achieve these the company would have to borrow. This ratio is calculated by dividing dividend by net income after tax.

Dividend Payout Ratio = Dividend Net Income after tax

Normally young, aggressive companies that are growing have low dividend payout ratios as they plough back their profits for growth. Mature companies on the other hand have high payouts. This is of concern as they may not be retaining capital to renew assets or grow. Investors must also ensure that the dividend is being paid out of current income and not out of retained earnings because that tantamounts to reducing the monies set aside for growth, expansion and replacement of assets.


It is important to remember that earnings ratios are not indicators of profitability. They advise an investor on the earnings made per share, the dividend policy of the company and the extent of income ploughed back into the company for its expansion, growth and replacement of assets.

It is useful to examine these ratios especially the earnings per share and the dividend payout. The earnings per share would help one determine whether the market price is reasonable. If the dividend payout ratios are very high there will be concern as it can indicate that the management of the company is not particularly committed to the long term growth and prospects of the company. APPROVAL

Once the Banker has gone through the request for credit facilities and studied all the relevant information about the client and he is satisfied that the need is genuine and that the customer has the ability to repay the advances extended, he would recommend the facilities for approval.

The procedures for approval vary from bank to bank.

In most foreign banks a member of the marketing staff makes the proposal or recommendation. This is so because the marketing person is closest to the client. He would then pass it on to the marketing manager or the head of marketing who would, if he is satisfied with the proposal, support and recommend it. Important proposals may even be prepared and recommended by the head of marketing himself. The proposal with the recommendations would then be forwarded to a credit officer or credit manager who would then vet the proposal from a credit viewpoint. The approval responsibility or power is based on the amount of the facility required. If the amounts are small, the marketing officer and a credit officer within their approval authority could probably do the approval. As the facilities required increases in value the person/ persons approving would be higher in the hierarchy. Large facilities would need to be approved by the Credit Committee or the Board of Directors.

In several nationalised senior officers have discretionary authority upto a certain limit. Branch managers have fairly small authorities, often upto only Rs. 100,000. Regional heads or zonal heads are authorised to approve upto Rs. 50,00,000 or even Rs. 100,00,000. The Chairmen of Banks have authority to approve facilities of upto several crores. The procedure is that when facilities are approved under unilateral powers of an officer (whatever be the rank) the next higher authority should ratify the proposal within a reasonable time. The weakness in this system is that there is no credit officer separately from a credit point of view vetting the proposal and even if there is a credit officer, a person in authority can still approve the facilities unilaterally even if the credit officer/ manager does not approve or support the facilities being given.

Private banks, by and large work, in a manner similar to foreign banks and require facilities to be approved by two persons – a marketing or relationship person and a credit person. However, often in private banks, approval authorities are not sometimes delegated to branch managers or senior branch officers. This results in all proposals having to be sent to Head Office for approval and this sometimes takes considerable time.

The approving of a credit by two persons is, from a control purpose, very good. The relationship person knows the client intimately and can therefore make a recommendation based on a detailed knowledge of the strengths and weaknesses of a client. However, he can be partial as he has a vested interest to the extent that he would like the individual/ company (if new) to become a customer. His judgement and recommendation, is to that extent, colored. The credit officer/ manager does not know the prospective client at all and he would either support or reject the proposal based on the financials, the management, the external environment and other relevant details. It would be an impartial decision based on facts.

Once the facilities are approved the Bank would send the client a letter advising that the facilities that have approved subject to the prospective client complying with certain stipulations and conditions governing the approval. This letter would also normally detail the collateral that would have to be given.

The prospective client would normally sign the offer letter and return it to the Bank. This is in effect an acceptance by the prospective client of the terms of the approval. Then he would work with the Bank to get the security documentation complete. Drawdown is usually permitted after all documentation has been perfected. It is then that the prospective client will, in fact become a client.


The saga of a loan does not end on its disbursal and a borrower will be wise to remember that. Disbursals, as mentioned earlier, take place after the documentation required by the Bank has been executed. The disbursal may be in one or two or more tranches in the case of a term loan or continuous as in the case of overdrafts.

However, when a loan is approved there are usually several conditions that borrowers are expected to, on an ongoing basis comply with such as ensure that the assets collateralised are adequately insured, statements on these assets (especially stocks and debtors) are submitted regularly (usually monthly), interest payments are made on time and the likes. Borrowers would be wise to comply with these requirements as bankers would base their judgement on how good or bad a borrower is on the basis of how he complies with the conditions that had been laid down at the time the loan is disbursed.

What does a banker look for?

Let us look at overdrafts. Usually overdrafts are collateralised by debtors and stocks. When the banker receives the statement of debtors and stocks he checks the following: In regard to debtors he would look at the aging of debtors and the provisions made for bad and doubtful debts. He would normally, in his assessment for adequacy, not take into account those debtors that are long overdue. In this test he would normally omit debtors who are overdue for more than 90 days. Let us imagine that Raman Menon has debtors aggregating Rs. 40,00,000. Of these Rs. 2,00,000 are overdue for more than 6 months, Rs. 8,00,000 are due for periods ranging between 90 days and 180 days and of the others there is a possibility that debtors totaling Rs. 5,00,000 may not pay at all (bad debts). In determining the value of the collateral, Mr. Menon’s banker will assume the value of the collateral to be Rs. 33,00,000. This is on the assumption that those borrowers whose outstandings are between 90 and 180 days would pay.

The banker, when he examines stocks will check the nature of the stocks held – both raw materials and finished goods and examine how long they have been held. In this case if an item has been held for more than three months it does not necessarily mean that the article concerned is bad. It may just be slowmoving. The banker will however examine the stocks for obsolete items and exclude these from the value of the collateral held. If Mr. Daruwalla has chemicals that are over six months old and the shelf life of the chemical is only three months then that chemical is clearly of no use. Its value will not be taken into account when determining the value of stocks. In certain industries there is a high obsolescence factor (computers etc.). The banker, while examining collateral values in these industries will take special care. There are usually margins kept by the banker to protect the bank from any deterioration in the value of the collateral. The terms of approval may stipulate that the margin on stocks would be 60 percent. This means that the banker would permit the borrower to borrow only upto 60 percent of the value of the stocks held at any time. There would be margins for debtors also. The banker on receipt of the stock statements will work out, based on the margin requirements, how much the borrower can borrow. This is known as the borrower’s “drawing entitlement.” Bankers pay special heed to this and as they have to work this out every month it is imperative that this is submitted in time and regularly. The banker will also periodically visit the factories or godowns of the borrower to satisfy himself that the stocks do in fact exist. He will test check quantities with bin cards and even do a test count of some items. He would also go through debtor records to satisfy himself that these are correctly stated both in terms of amounts and that they have been aged correctly. In regard to term loans for the purchase of machinery the banker will after he is satisfied that the price is reasonable will sight the machinery – actually go the factory to see the machinery and see it installed and working. He will also go periodically to the site to satisfy himself that the machines installed are still working well and doing what they are supposed to. In regard to the machines imported by Rusi Daruwalla, the banker would, on its installation, go to the factory to see it. He would also examine the invoices and customs papers and other relevant documents to satisfy himself that the values are correctly stated.

The banker will also, on a day to day basis examine the manner the borrower operates his account. If there are frequent excesses in the overdraft due to the borrower issuing cheques without ensuring that there are adequate funds the banker may even be forced to dishonour the cheques. If Raman Menon had issued such cheques, in the first few instances his banker may have called him and told him that there are inadequate funds and asked him to deposit cash to enable him to honour the cheques. After a while, if this continues the banker would dishonour the cheques.

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

Borrowers would be wise to honour the commitments they have made and adhere to the conditions laid down as they would then be able to establish a good credit record with their bank. This would enable them should they require to get additional loans from their bankers at future dates. If a borrower is tardy and lackadaisical and if at a later date he wishes to increase his loan/ credit facilities, his banker may not be receptive.

As far as the banker is concerned post disbursal monitoring is as important, if not more important than the credit appraisal process itself because upon this depends whether he gets repaid. CONCLUSION

Presentation is extremely important. First impressions count enormously. One tends to be favorably impressed and more inclined to view a person or proposal favorably if the first sighting of the person/ proposal is good. A well presented, well researched credit application inspires confidence. A credit application that addresses all the issues and concerns that a banker may have will usually go a long way in convincing the banker of the professionalism and competence of the intending borrower and on the borrower’s ability and intention to repay. On the other hand if it is badly presented the impression that the banker would have is that the prospective borrower does not know his business, is confused, is disorganised or may be unable to repay. Such an impression could result in the loan being rejected.

The presentation must be direct. It must detail the risks and the strengths of the project/ company that seeks the facility and explain how the loans will be serviced and repaid. It must communicate forcefully and unambiguously. It must not meander or be verbose.

It must be remembered that the banker who reads the proposal is a busy man. He has

several proposals to read and the last thing he wants is a badly presented report that has several gaps. He has to make a decision quickly and if there are issues that have not been addressed his initial reaction would be to place it aside to look at when he has time. More often than not he will forget it. On the other hand if all the issues are addressed he will be inclined to look at the proposal favorably.

It must however be remembered that a well presented well structured application cannot make an unviable project viable or a bad loan good. The presenter will therefore be wise to detail all the possible risks as this will underline the prospective borrower’s integrity and transparency.

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