Credit Analysis and Formulae

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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.

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