RMPG Learning Series CRM Workshop Day 2 session 1

IMaCS 2010Printed 11-May-11

Page 1For Classroom discussion only

Agenda for Day 2

Financial & Ratio Analysis

Subjective Analysis

Lunch Break

Case Studies

Open Session/ Q&A



Context of today’s discussion

� Analysing financial statements is the starting point for credit risk

assessments, and at times, it is the core of an assignment

� Therefore a sound grasp of financial terminology and presentation is

required

� Also, one needs to understand � which figures to use;

� where to find them; and

� how to judge the result



Fundamental accounting concepts

� A company is a legal entity - it own assets and liabilities

� Money qualification� If it is impossible to place a monetary value on a transaction it cannot be

recorded in the books of account

� New concepts - human asset accounting, brand value, etc

� Fixed asset valuation� Fixed assets are generally shown at their historic cost less depreciation

� They are not shown at their scrap or resale value

� Going concern� There is no attempt in the balance sheet to set out the current market value

or disposal value of assets

� Assets are valued on the basis of the going concern assumption




� Prudence rules� When in doubt take the lower of two values e.g., cost or market

value;� When in doubt write it off. � For example,

� inventory should be valued at the lower of cost or market value;� potential bad debts should be written off immediately, not when all hope of

collecting the money has evaporated;� if there are any doubts about revenue receipts recognise it only when it is

collected in cash;� include only profits in the income statement that have been realised during

the year; it is not prudent to anticipate events;� take care to provide for all known or anticipated liabilities and losses to date,

although not to the extent of creating hidden reserves;� recognise future losses as soon as they are known, not when they happen




� Realisation� Until an event or transaction has actually taken place it should not be taken

into account in arriving at the profit or loss for the year� A customer’s promise for a large order is not a transaction� Increase in asset values cannot be treated as profit unless sold

� Accrual and matching� Income and expenditure should be included in the income statement at the

time the transaction or event took place, which is usually when it is invoiced, not when the cash relating to the transaction is received or paid.

� E.g., Advance cannot be regarded as income

� The income statement shows the revenue generated during the year and matches it with the costs and expenses incurred in producing it.

� E.g., adjustment for accretion or depletion to stocks




� Consistency� Policies should not be changed frequently� Profits can be increased or decreased by change in accounting

policies, e.g., inventory valuation or depreciation

� Materiality� Whatever is material should be disclosed



Annual Accounts - looking at detailed heads

LIABILITIES 31-Mar-01 31-Mar-00Equity Share Capital 561.50 561.5Capital Reserve 2.00 0.00Share Premium Reserve 0.00 0.00General Reserve + P & L A/c 3556.28 1651.59GROSS RESERVES 3558.28 1653.29Less: Miscellaneous Expenditure NET RESERVES 3558.28 1653.29

TANGIBLE NET WORTH 4,119.8 2,214.8

Preference Share Capital 250.00 250.00DebenturesRupee Term Loans 4405.18 3344.72Deffered payment credit 0.00 0.00Other deposits ( trade) 74.25 102.51TOTAL LONG TERM DEBT 4,761.6 3,731.6

31-Mar-10 31-Mar-09




Bank Borrowings 2238.81 1223.14Commercial Paper Fixed DepositsIntercorporate BorrowingsLoans & Advances from Subsidiaries Loans & Advances from Affiliate CosShort Term Loans from Bank & FIs 1965.40 0.00TOTAL SHORT TERM DEBT 4,204.2 1,223.1

Creditors for Goods 622.31 556.28Creditors for ExpensesInterest Accrued but Not Due 26.85 11.62Other Current Liabilities 4.50 2.59TOTAL OTHER LIABILITIES 675.1 594.9

Provision for Dividend 3.31 112.30Provision for Taxes Provisions for prefrence dividend 32.50Provision for dimunition in value of investmentsTOTAL PROVISIONS 35.8 112.3




ASSETS 31-Mar-01 31-Mar-00Gross Block 2478.5 2145.0Gross Block 2478.5 2145.0Less : Accumulated Depreciation -437.0 -655.7Net Block 2041.4 1489.3Capital Work in Progress 366.3 176.7NET FIXED ASSETS 2407.7 1665.9

Investments in Subsidiaries 214.1 214.1Investments in Affiliate Companies 0.0 0.0Other Investments 0.4 0.3TOTAL INVESTMENTS 214.5 214.4

31-Mar-10 31-Mar-09




Raw and Packing Materials 1236.2 760.6Work-in-Process 549.0 498.9Finished Goods 2243.4 1098.9Stores and advertising materials 397.7 364.4TOTAL INVENTORIES 4426.3 2722.8 Receivables (More than 6 months) 90.7 31.1Receivables (Less than 6 months) 4060.9 1173.6TOTAL RECEIVABLES 4151.5 1204.6

Loans & Advances to SubsidiariesLoans & Advances to Affiliate CompaniesAdvances Recoverable in Cash or kind 1683.5 1243.4Advances to group companies/ property purchaseCash and Bank Balances 93.1 38.8Interest Accrued on deposits and investmentsDeposits with others 798.0 785.4TOTAL OTHER ASSETS 2596.5 2069.1



A sample Profit & Loss Account

For the year ended 31-Mar-01 31-Mar-00

Sales receipts 21,009.4 14,718.5Other SalesLess : Excise duty (223.7) (365.9)Net Sales 20,785.7 14,352.6Other Related Income

OPERATING INCOME 20,785.7 14,352.6Material costs 12,242.7 6,813.8Traded goods purchasedAccretion/ Decretion to stocks (1,194.6) (491.2)Consumable stores 18.4 16.6Power and fuel 70.6 43.9Employee costs 769.4 542.3Other manufacturing expenses 251.4 144.7Other expenses 505.2 382.7Selling expenses 5,253.2 4,913.7Miscellaneous Expenses Written OffLess : Expenditure CapitalisedCOST OF SALES 17,916.3 12,366.5OPERATING PROFIT BEFORE DEP2,869.4 1,986.1

31-Mar-10 31-Mar-09



A sample Profit & Loss Account

OPERATING PROFIT BEFORE DEP2,869.4 1,986.1INTEREST AND TAXInterest and Finance Charges 846.0 457.2OPERATING PROFIT BEFORE DEP2,023.4 1,529.0AND TAXDepreciation 101.9 105.5OPERATING PROFIT BEFORE TAX1,921.6 1,423.5Non - operating Income 142.1 361.8Other Adjustments (0.2) 0.23Extraordinary Income 0.0 0.0Extraordinary Expenses 0.0 0.0ADJUSTED PROFIT BEFORE TAX 2,063.5 1,785.5Tax 0.0 80.0ADJUSTED PROFIT AFTER TAX 2,063.5 1,705.5Dividend - Equity 128.0 129.1Dividend - Preference 32.5 32.5

ACCRETION TO RESERVES 1,903.0 1,544.0NET CASH ACCRUALS 2,004.9 1,649.5



Important areas to focus upon

� Operating profit before interest, depreciation and tax� It is positive or negative?

� Profit is not cash - check the debtors figures

� Trend

� Depreciation� Straight line method

� Reducing balance method

� Accelerated depreciation method or sum of digits method (5/15,

4/15…for a 5 year assets)

� Each method will result into different depreciation figures for each

year

� Check if there is any change in policy



Important areas to focus upon

� Interest� Is it netted with interest received?

� Has interest been capitalised?

� What is the amount of capitalised interest?

� Has implications on interest coverage ratio

� Tax� Is actual tax paid rate different than the standard rate?

� Deferred taxation� Is the company claiming depreciation benefit?…leads to apparent distortion

in the reported after-tax profits due to timing differences



Analysis of financial statements is necessary to gauze the financial health of a borrower

Method of Analysis:

� Percent of Sales method

� Trend analysis

� Ratio analysis

� Funds flow analysis

� Cash flow analysis

� Break even analysis etc



Ratio Analysis

Most important generic ratios of relevance in credit analysis

� Liquidity ratios / indicators

� Gearing levels

� Profitability ratios

� Leverage ratios

� Coverage ratios

� Return on Capital / Investments / Assets

� Turnover / Holding ratios (Activity)



Applicability of Financial Analysis

� Financial analysis should be uniformly applicable to all accounts

� This analysis should be uniformly applicable to all borrowers

irrespective of nature of business i.e. both

� Manufacturing

� Trade and Services



To ensure comprehensive financial analysis, examine the following additional financial indicators

� Profitability :� Gross Profit: PBDIT [change current formula]

� Gross Profit Margin: PBDIT/ Sales [change current formula]

� Return on Capital Employed (ROCE)

� Efficiency Ratio :� (Inventory+Receivable)/ Sales

� Fixed Assets Turnover

� Coverage Ratio : Debt Service Coverage ratio for all term loans

� Solvency Ratio : Total Debt/ Tangible Net Worth

� Cash Flow Based Analysis: � Cash Interest Coverage

� Cash DSCR



Trend analysis and comparison with peers will provide further insights into the performance of the entity…1

� Sales Analysis� Causes for growth/decline in sale� Composition of future sales� Compare company growth rate with industry growth rate� Impact of growth on profitability and liquidity

� Profitability analysis� Whether profitability parameters are comparable with the peers� Causes for changes in profit margins ( NPM/GPM), ROCE & RONW.



Trend analysis and comparison with peers will provide further insights into the performance of the entity…2

� Liquidity Analysis� Analyse reasons for variation in current ratio� Analyse reasons for change in NWC/Sales

� Efficiency Analysis� How efficiently is company in managing inventory, account receivables

and creditors as compared to peer group?� Analyse fixed assets turnover ratio as it indicates capital intensity and

vulnerability to business volatility.� Coverage Analysis

� Conduct sensitivity analysis to estimate whether DSCR is adequate to cover loan obligation

� Leverage Analysis� Compare TOL/TNW & Total Debt/TNW of the company with peer group



Cash Flow and sensitivity analysis should be a must for Large Corporate Loans

� Is the business generating enough cash to meet its loan obligation?� What were the major sources of cash?� How were the cash inflows used?

Cash flow analysis will reveal

•Sensitivity analysis will provide further insights into the operations of the company

� Identify the key risk factors that could impact the performance of the firm

� What would be the impact of changes in these risk factors on financial position of

the firm?

� Set limits for risk factors during sensitivity analysis and build it into the loan

covenants for monitoring the performance of the account

Questions:

Objective:



Case Study: Cash flow analysis

Financial Position (Rs. Lacs)2007-08(A) 2008-09(A) 2009-10 (E)

�Net Sales 859.3 964.5 1012.0�Net Profit 17.3 14.4 16.0�Current Ratio 1.3 1.3 1.5 �Cash Accruals 48.4 47.9 47.5

Would you lend to the client?

�Net Cash after Operation 57.7 35.9 -6.9�Cash Interest Coverage 1.7 1.3 -0.3



Financial Ratios

Growth

Liquidity

Leverage

Profitability

Coverage

Efficiency



Growth - how it affects credit risk

� Importance of growth in assessing credit risk

� Growth is essentially measured by increase in revenues over previous year.

� Growth in revenue is the basic driver for increase in profits and value of a firm

� Growth in revenue is a measure of the ability of the borrower to maintain market

share.

� Growth needs financial resources (most of the time), and banks need to assess the

appropriate level of financing for a given growth

� Watch points

� Too much of growth in revenues is not necessarily good

� Growth needs to be assessed in conjunction with margins and cash flow

� Inadequate financing (especially for small companies) could be dangerous



Profitability

� Importance of measuring profitability for risk analysis

� Profit is a measure of efficiency of operations and finance in a business

� Profitability can be measured in more than one way - what is relevant?

� Watch points

� Profitability measure has to be measured against an appropriate benchmark (e.g.

industry average, Cost of capital)

� Profit is not cash flow



Leverage - the reason for a bank’s business, and the main cause for default

� Importance of leverage

� An indicator of financial risk of a borrower

� Watch points

� How to define leverage? - total borrowings only or should we include other

liabilities?

� Understanding net worth



Liquidity - the determinant of short term solvency

� Importance

� What is the ability of a borrower to meet its obligations in the short run, usually one

year?

� Theoretically, higher the current/ acid test ratio, the greater is the short-term

solvency

� Watch points

� A higher current ratio or acid test ratio does not necessarily mean a good thing



Case Study: Liquidity analysis

Financial Position (Rs. Lacs)

2007-08(A) 2008-09 (A) 2009-10 (E)

Net Sales 859.3 964.5 1012.0

Gross Profit 80.7 76.6 73.0

Gross Margin (%) 9.4 7.9 7.2

NWC 217.2 229.2 283.6

NWC/Sales(%) 25 24 28

Change in NWC/Sales(%) -1 4

Current Ratio 1.3 1.3 1.5

Inventory Days 68 66 67

Debtor Days 71 70 83

Is liquidity position improving?



Cashflow - Cash is king

� Importance of cash flow

� Need to measure how much cash flow does a firm generate internally from

operations

� Internal cash flow generation turning negative is the first sign of operating distress,

particularly if it recurs

� Internal cash flow is a combination of three parameters - sales growth, operating

profitability and working capital intensity

� Watch points

� Internal cash flow measures need to be interpreted in conjunction with leverage and

working capital requirements and measures of financial flexibility of firm



Coverage

� Importance of coverage indicators

� Coverage indicators point to debt servicing ability of a borrower.

� Low coverage parameters indicate higher dependence of the borrower on external

sources of funds to meet its interest commitments

� Good predictors of default

� Watch points

� Historical DSCR is prone to lumpiness of principal repayments

� Coverage should be assessed from a cash perspective



Sales Growth

• Weighted average of the companies growth in operating income over the last two years.

• The non montonicity displayed in the curve is very strong and very intuitive

• Low sales growth imply high risk (weak prospects)

• High sales growth imply high risk (firm is rapidly expanding most likely because of additional

financing and the future would not be as good as the current year)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-1-0

.25

-0.15 0

0.03 0.06 0.

1

0.15

0.19

0.25 0.

3

0.32

0.52

Sales Growth

Def

ault

Fre

qu

ency



Gearing ratio

� Indicates stability

� TOL / TNW

� Debt Equity ratio (TTL / TNW)

Gearing ratio - Stability

TOL

TNW

TOL

TNW

Stable Unstable



Gearing

• Computed as the ratio of the borrowers Total Debt to his Tangible Networth

• The higher the gearing the more leveraged a borrower is and the lesser cushion he has for

adverse circumstances

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0.00

0.15

0.40

0.62

0.90

1.10

1.30

1.70

1.90

2.40

3.40

5.00

7.50

Gearing

Def

ault

Fre

qu

ency



Interest Coverage

• Computed as the ratio of the borrowers Operating Cash flows available for servicing interest

• An indication of the comfort that he has in servicing his debt obligations

0.00

0.20

0.40

0.60

0.80

1.00

1.20

-10 -3

0.06

0.18

0.57

0.81 1.

2

1.27

1.55

1.85 2.

4 3

3.75

5

7.5

Coverage

Def

ault

Fre

qu

ency



Important Coverage ratios

� Debt Service Coverage ratio= PAT+ Depn+ Amortisation+ (INTT)

Loan Repayment + (INTT)

� Interest Coverage ratio= PBDIT

Interest

� DSCR measures ability to service debt of the borrower.

� DSCR should be calculated for all borrowers irrespective of

� Source of Term Loan

� Type of Loan



PROFITABILITY RATIOS

� Gross Profit ratio = GP/Sales

� Net Profit ratio = PAT/Sales

� Operating Expense ratio = OE/Sales

� ROCE = PBDIT/Total Capital Employed

� EPS = PAT/No of shares

� PE Ratio = MV/EPS



Case Study: Coverage analysis

Financial Position (Rs. Lacs)

2007-08(A) 2008-09(A) 2009-10 (E) � Net Sales 15069.3 16150.5 14255.9� Interest 1093.3 1021.6 923.6� EBIT 1629.8 1647.6 1071.9� Debt/TNW 1.4 1.2 1.6

Would you lend to the client?



Return on Capital Employed

• ROCE – PBIT to the Average capital employed

• Better ROCE would improve the value of equity, indicate better firm prospects and also

imply more cushion against losses

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-1.5 -0.2 -0.1 0 0.05 0.1 0.15 0.2 0.29

ROCE

Def

ault

Fre

qu

ency



Du Pont Analysis

� Du Pont pyramid of ratios� To get an understanding of not only the level of a company’s profitability

but also how the profit is being made

� Du Pont pyramid of ratios� To get an understanding of not only the level of a company’s profitability

but also how the profit is being madeA B

Sales 300 100PAT 25 40Assets 125 200RoA 20% 20%

� Both A and B have a 20% return. What conclusions can be drawn?

� Introduce the asset or capital turn� To form a view on the company’s efficiency in the use of its assets or capital

� Asset turn = Sales divided by Assets

� Capital turn = Sales divided by Capital



Du Pont Tree



Free Reserves to Equity

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-10 -3 -1 0.25 0.75 1.25 2.5 3.5 4.5 6.5 9.5 10 14

Free Reserves/ Equity

Def

ault

Fre

qu

ency

• Free Reserves – Adjusted for free reserves not coming out of internal earnings

• Equity – Paid up capital

• An indication of the financial resilience of the borrower in face of downturn and historical

profitability



Liquidity Indicators

� Current ratio

� Acid test / Quick ratio

� NWC (Net Working Capital)

� Cash Generation



Quick Ratio

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

0 0.25 0.5 1 1.1 1.4 1.6 1.8 2.3 2.45 2.8 3.2

Quick Ratio

Def

ault

Fre

qu

ency

• Quick assets to quick liabilities - A measure of Short-term liquidity. A higher proportion

shows greater net current assets available for meeting current liabilities

• Quick assets shows no clear relation to default based on the database

• Consequently the QR impact on the model is based on a subjective notch up/ down to the

financial score based on management score and QR value



Important Ratios and Benchmark



Qualitative Financial Risk Drivers

Retention of Profits

Access to Credit in Other Banks

Accounting Quality

Ranking of Auditor

Restructuring History



Important ground rules

� Analysing a company’s profitability without any reference to its financial

position is of little value

� Never judge a company on the basis of one year’s figures. Always look at � three or ideally, five years’ figures

� Never judge a company in isolation. Always compare its performance with

others of � the same size and/or the same business sector and/or Country

� When comparing companies always make sure, as far as you can, that you are

comparing like with like - in other words, that the basis of the data being

analysed is consistent



Financial Ratios…important points to remember

Consistency

Never rely on a single ratio

Accounting periods



Financial Ratios…important points to remember

Don’t forget to annualise

Average, median or mode?

Investigate variations



DISCUSSIONS



All the contents of the presentation are confidential and

should not be published, reproduced or circulated without the

written consent of IFC, Bangladesh Bank and IMaCS.

Economy & Finance

RMPG Learning Series CRM Workshop Day 2 session 1