Credit Analysis and Formulae

of 6

Content

Cooperative Banking Operations – Credit Management - Ratio Analysis & Break Even Analysis Ratio analysis is the relationship between two variables. It can be expressed as a percentage (Profit of 20%) or as a simple ratio (li e 2!"). #henever we recast the fig\$res shown in the balance sheet or Profit and %oss &cco\$nt' only the recasted fig\$res sho\$ld be ta en into acco\$nt for analysis. &ny n\$mber of ratios can be obtained from a (alance )heet and Profit and %oss &cco\$nt. *owever' a ban er mainly foc\$ses on ey ratios falling \$nder three main gro\$ps vi+. %i,\$idity' )olvency and -fficiency. Important ratios to be incorporated in proposal . appraisal are given below! 1 Current Ratio: /he c\$rrent ratio is arrived at by dividing' total val\$e of c\$rrent assets by c\$rrent liabilities i.e. 0\$rrent Ratio 1 0\$rrent &ssets.0\$rrent %iabilities /his ratio reflects the c\$rrent assets cover the c\$rrent liabilities ,\$antitatively at any point of time. It is the barometer of short term li,\$idity of the company. In other words' the wor ing capital reso\$rces position is reflected in c\$rrent ratio and hence higher the ratio' better the li,\$idity. )lip bac or fall in c\$rrent ratio wo\$ld generally indicate diversion of short term f\$nds (either for ac,\$isition of fixed assets or for o\$tside investment) or cash loss. *ence' any adverse trend in c\$rrent ratio sho\$ld be caref\$lly examined. It sho\$ld be ept in mind that it does not reflect the ,\$ality of non2cash c\$rrent assets that is the fre,\$ency of non2cash c\$rrent assets t\$rning over to cash. 3enerally ban ers consider a c\$rrent ratio of ".44!" as satisfactory. 5\$ic ratio indicates the ability of the firm to meet its \$rgent financial obligations. 5\$ic Ratio 1 5\$ic &ssets . 0\$rrent %iabilities. Inventories are ded\$cted from the c\$rrent assets. /his is beca\$se' at times' it may not be possible to convert inventories into cash ,\$ic ly. /he bench mar of this ratio is ". 2 e!t-E"uity Ratio: /he debt e,\$ity ratio is arrived at as \$nder! 6ebt2-,\$ity Ratio 1 /otal 6ebt 7 -,\$ity 6-R indicates relationship between the external borrowings and the own f\$nds of the concern. In certain cases' only the long term debt is ta en into acco\$nt whereas in certain other cases all debts incl\$ding c\$rrent liabilities are ta en into acco\$nt. -,\$ity means net worth of the concern after ma ing d\$e provision for bad.do\$btf\$l debts in advances' intangible and fictitio\$s assets. & debt2e,\$ity ratio of 2!" is generally considered reasonable. In certain cases li e traders and )8- advances a higher debt2e,\$ity ratio is generally allowed.

# \$i%ed Assets Coverage Ratio: /his shows the n\$mber of times the val\$e of fixed assets (after providing depreciation) covers term liabilities. 9ixed &ssets 0overage Ratio 1 :et 9ixed &ssets.%ong.8edi\$m /erm 6ebts /his sho\$ld be more than ". & e!tors 'urnover Ratio: /his refers to the borrower . client;s credit policy as a part of its overall financial management. <\$tstanding debtors signify that a part of the financial reso\$rces of the concern are made available to o\$tsiders. /he larger the amo\$nt o\$tstanding there2\$nder' the more the depletion of f\$nds for the concern. 6ebtors /\$rnover Ratio 1 <\$tstanding 6ebtors x 4=> (:\$mber of days) 0redit )ales /his shows the average period of credit extended by the concern. %ower fig\$re wo\$ld indicate that the concern is extending less credit and conse,\$ently more reso\$rces are available for its operations. 3enerally' the o\$tstanding of " to 4 months is reasonable? vario\$s factors which affect this ratio are to be borne in mind. ( Creditors 'urnover Ratio: /his is arrived at as \$nder! 0reditors /\$rnover Ratio 1 <\$tstanding 0reditors x 4=> (:\$mber of days) 0redit P\$rchases %arge creditors may not be a healthy sign. #hen a concern is facing financial stringency' there is a tendency to postpone payment to creditors. )\$ch sit\$ations sho\$ld be disting\$ished from other \$s\$al sit\$ations. In s\$ch cases creditors o\$tstanding will be m\$ch beyond contracted period. &lso liberal creditors may cost the concern either in the form of inflated prices for p\$rchases or by way of payment of interest. /his can be [email protected]\$rio\$s in the interest of the concern. (ranches sho\$ld note that there can be fra\$d\$lent transactions on the part of the firm thro\$gh debtors and creditors \$ndermining the overall interests of the firm. In the name of retaining the c\$stomers the firm may offer longer credit to nown.interested parties or agree to pay higher rate of interest or higher prices to creditors \$nder the g\$ise of [email protected] larger credit terms. /hese ind of dealings can be observed only if mar et trends are analysed and p\$rchases and sales portfolios of the concern are critically examined. /he desirable level will be anything between half to two months p\$rchase. *owever' depending \$pon the ind\$stry trend' the levels may vary. ) Material Management Ratio: /he basic ratio falling \$nder this head is Inventory /\$rnover Ratio. Inventory means raw materials' stores' stoc s2in2process and finished goods. &ll these items p\$t together are related to cost of goods sold for the year. 0ost of sales is calc\$lated as \$nder ! 0ost of )ales 1 0ost of Prod\$ction A <pening )toc (93 B )IP) C 0losing )toc (93 B )IP)

93 1 9inished goods

)IP 1 )toc in Process.)emi2finished goods

/he cost of prod\$ction is arrived at by adding all direct costs' vi+. raw materials cons\$med' power and f\$el' direct labo\$r' cons\$mable stores' repairs and maintenance to machinery and other man\$fact\$ring expenses. 0ost of sales reflects the ability.prod\$ction efficiency and as s\$ch has an important bearing on the performance of a concern. /his ratio is calc\$lated in n\$mber of daysD cons\$mption. Inventory /\$rnover Ratio 1 Inventory x 4=> (:\$mber of days) 0ost of 3oods )old /his shows the inventory held for n\$mber of days. /he lower the ratio' the more efficient is the inventory management. Raw 8aterial /\$rnover Ratio 1 Raw 8aterials on hand x 4=> (:\$mber of days) Raw 8aterials 0ons\$med d\$ring the year /his shows stoc of raw materials on hand in n\$mber of months. *ere also the endeavo\$r sho\$ld be on a lower ratio \$nless of co\$rse' the raw materials are imported items or canalised items' in which case larger raw materials holding may be permitted. 9inished 3oods /\$rnover Ratio 1 (:\$mber of days) 9inished 3oods on hand E 4=> 0ost of 3oods )old d\$ring the year

/his shows how many months finished goods are on hand. (ranches sho\$ld st\$dy the reason for holding the finished goods and especially beware of [email protected] goods' defective goods and \$nsaleable goods being incl\$ded in the val\$e of finished goods. &ll the above ratios give an indication abo\$t the material management by the concern. * e!t +ervi,e Coverage Ratio - +CR.: &bility of a concern to service its term liabilities can be ga\$ged from this ratio. /his ratio is applied while appraising all term loan proposals and investment decisions. /his ratio is st\$died when meas\$res for rehabilitation of sic ind\$strial \$nits are examined and also while fixing. resched\$ling the repayment sched\$le for term loans. 6ebt servicing means payment of interest and installments on term loans. 6)0R meas\$res whether interest and installments can be paid o\$t of internal generation of f\$nds. /he ratio is wor ed o\$t as \$nder! 6)0R 1 P&/ A 6-PR-0I&/I<: A I:/-R-)/ <: /-R8 %<&: I:/-R-)/ <: /-R8 %<&: A /-R8 %<&: I:)/&%%8-:/) & ratio of 2 wo\$ld indicate the concernDs internal generation of f\$nds wo\$ld be twice of its commitments towards term loan obligations and interest thereon. /his ratio sho\$ld be more than one in order to ta e care of any event\$alities in the profits position of the concern and also to leave certain s\$rpl\$s with the concern for its normal growth and withdrawal.

/

Break Even Analysis: (rea even point ((-P) of a firm refers to that level of sales at which' it recovers all its costs. /his is the point where the \$nit neither ma es profit nor loss. It is important while assessing the performance or processing a credit proposal to ascertain the level at which the firm brea s even' so as to now its shoc absorbing capacity. /h\$s' brea even analysis is an important tool in the hands of a credit officer while analysing a credit proposal. /o calc\$late the (-P' as a first step' the total cost has to be bif\$rcated into fixed and variable items. #hile fixed costs refer to those costs which are inc\$rred regardless of the operation and.or level of activity of the \$nit. /he examples are rent' taxes' ins\$rance' depreciation' maintenance of b\$ilding' machinery' etc. *owever' the fixed costs also \$ndergo change over a period of time. /he variable costs on the other hand are expenses which vary directly in proportion to level of activity or sales or prod\$ction. /he variable costs are also nown as marginal costs and example in this respect is raw materials' power B f\$el' octroi' cons\$mables etc. #hile going thro\$gh the profit and loss acco\$nt' based on above classification' the expenses sho\$ld be analysed and following form\$la be applied to ascertain the (-P. (-P in 5\$antity 1 9ixed 0osts . (Fnit )ale Price 2 Fnit Gariable 0ost) <R (-P in Gal\$e (Rs.) 1 9ixed 0ost x )ales . ()ales 2 Gariable 0ost (G0)) )ales mean :et )ales. )ales 2 G0 1 0ontrib\$tion If a \$nit brea s even at a very high level of activity' there is every possibility of the \$nit inc\$rring loss' if any of the variables li e fixed cost' variable cost' sales change even marginally. /herefore' the proposal sho\$ld be scr\$tinised very caref\$lly whenever (-P is reached at a very higher level of activity instead of at a lower level.

Ratios at a glance! Ratio 0\$rrent Ratio 9orm\$la 0\$rrent &ssets 0\$rrent %iabilities (".44 is desirable) )olvency Ratio 6ebt2-,\$ity Ratio :et /angible assets /otal <\$tside %iabilities /6-1 /otal <\$tside %iab../angible :et worth. -,\$ity 6- 1 /erm %iabilities . /. :. #. &ssets 0overage Ratio 6ebt2)ervice 0overage Ratio Inventory /\$rn over Ratio <R Inventory (:o. of days) 6ebtor t\$rnover Ratio (:o of 6ays) 0reditor /\$rnover Ratio (:o. of days) &ssets t\$rnover ratio. :et (loc of 9ixed &ssets /erm %iability P&/ A 6ep. A Int. on %oan Instal. of /% A Int. on %oan :et )ales Inventory Inventory x 4=> 0ost of goods sold &verage <.) 6ebtors x 4=> 0redit )ales &verage <.) 0reditors x 4=> 0redit P\$rchase :et )ales :et <perating &ssets 0redit policy of the \$nit. firm. &verage Period of the credit extended. &bility to get goods on credit. &bility to repay -fficient \$se of assets :et <perating &ssets means 9& A 0& A :on 0&2 Investments. 8\$st have increasing trend. -xtent to which 9& covers /erm %iabilities. 8ore than " is desirable. 6ebt )ervicing &bility /o wor o\$t repayment sched\$le is desirable. -fficiency of Inventory 8anagement *olding Period of Inventory. Interpretation and benchmar &bility to meet c\$rrent liabilities *igher the ratio better the li,\$idity )hortfall indicates diversion of short term f\$nd. &bility to repay debt from assets. *igher the ratio betters the solvency. 0overage of o\$tside liabilities to own f\$nd. %ower the ratio higher the safety.

3ross Profit 8argin :et profit 8argin 6ividend per shares Ret\$rn on -,\$ity Price earnings Ratio (rea -ven analysis (-P in 5ty. (-P in Gal\$e

3ross profit E "00 :et )ales :et Profit &fter tax E "00 :et )ales /otal distrib\$table profit to -,\$ity holders :o of e,\$ity shares -,\$ity -arning :et #orth 8ar et Price of the share -arnings Per share 9ixed 0ost Fnit sales price2 Fnit variable cost. 9ixed 0ost x )ales )ales2 Gariable 0ost (0ontrib\$tion)

8argin available after meeting man\$fact\$ring cost. -fficiency of Prod\$ction and Pricing. :et Profit margin on b\$siness. <verall efficiency of the \$nit. -arning left for 6ividend. /otal dividend payable to per shares

8eas\$res profitability on -,\$ity -,\$ity -arning1P&/CPreference 6ividends. Price earning on present mar et val\$e. (-P of the Fnit. *igh (-P is ris y 0ontrib\$tion of Profit to meet 9ixed cost of the Fnit. )ales 8eans net )ales. % of variance s\$stainable by the \$nit. 0\$shion available in case of variance.

8argin of )afety 8<)

)ales Gal\$e 2 (-P )ales &ct\$al )ales

P&/ 1 Profit after /ax' 9& 1 9ixed &ssets' (-P 1 (rea -ven Point' 8<) 1 8argin of )afety.

Recommended

Credit Analysis

Or use your account on DocShare.tips

Hide

Or register your new account on DocShare.tips

Hide

Back to log-in

Close