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 (like 2:1). Whenever we recast the figures shown in the
balance sheet or Profit and Loss Account, only the recasted figures should be taken into account
for analysis.
Any number of ratios can be obtained from a Balance Sheet and Profit and Loss Account.
However, a banker mainly focuses on key ratios falling under three main groups viz. Liquidity,
Solvency and Efficiency. Important ratios to be incorporated in proposal / appraisal are given
below:

1 Current Ratio:
The current ratio is arrived at by dividing, total value of current assets by current liabilities
i.e.
Current Ratio = Current Assets/Current Liabilities
This ratio reflects the current assets cover the current liabilities quantitatively at any point of
time. It is the barometer of short term liquidity of the company. In other words, the working
capital resources position is reflected in current ratio and hence higher the ratio, better the
liquidity. Slip back or fall in current ratio would generally indicate diversion of short term
funds (either for acquisition of fixed assets or for outside investment) or cash loss.
Hence, any adverse trend in current ratio should be carefully examined. It should be kept in
mind that it does not reflect the quality of non-cash current assets that is the frequency of
non-cash current assets turning over to cash. Generally bankers consider a current ratio of
1.33:1 as satisfactory.
Quick ratio indicates the ability of the firm to meet its urgent financial obligations.
Quick Ratio = Quick Assets / Current Liabilities.
Inventories are deducted from the current assets. This is because, at times, it may not be
possible to convert inventories into cash quickly. The bench mark of this ratio is 1.

2 Debt-Equity Ratio:
The debt equity ratio is arrived at as under:
Debt-Equity Ratio = Total Debt _
Equity
DER indicates relationship between the external borrowings and the own funds of the
concern. In certain cases, only the long term debt is taken into account whereas in certain
other cases all debts including current liabilities are taken into account. Equity means
net worth of the concern after making due provision for bad/doubtful debts in advances,
intangible and fictitious assets.
A debt-equity ratio of 2:1 is generally considered reasonable. In certain cases like traders and
SME advances a higher debt-equity ratio is generally allowed.
3 Fixed Assets Coverage Ratio:
This shows the number of times the value of fixed assets (after providing depreciation)
covers term liabilities.
Fixed Assets Coverage Ratio = Net Fixed Assets/Long/Medium Term Debts
This should be more than 1.
4 Debtors Turnover Ratio:
This refers to the borrower / client’s credit policy as a part of its overall financial
management. Outstanding debtors signify that a part of the financial resources of the concern
are made available to outsiders. The larger the amount outstanding there-under, the more the
depletion of funds for the concern.
Debtors Turnover Ratio = Outstanding Debtors x 365
(Number of days) Credit Sales

This shows the average period of credit extended by the concern. Lower figure would
indicate that the concern is extending less credit and consequently more resources are
available for its operations. Generally, the outstanding of 1 to 3 months is reasonable;
various factors which affect this ratio are to be borne in mind.
5 Creditors Turnover Ratio:
This is arrived at as under:
Creditors Turnover Ratio = Outstanding Creditors x 365
(Number of days) Credit Purchases

Large creditors may not be a healthy sign. When a concern is facing financial stringency,
there is a tendency to postpone payment to creditors. Such situations should be distinguished
from other usual situations. In such cases creditors outstanding will be much beyond
contracted period. Also liberal creditors may cost the concern either in the form of inflated
prices for purchases or by way of payment of interest. This can be injurious in the interest of
the concern. Branches should note that there can be fraudulent transactions on the part of the
firm through debtors and creditors undermining the overall interests of the firm. In the name
of retaining the customers the firm may offer longer credit to known/interested parties or
agree to pay higher rate of interest or higher prices to creditors under the guise of enjoying
larger credit terms. These kind of dealings can be observed only if market trends are analysed
and purchases and sales portfolios of the concern are critically examined. The desirable level
will be anything between half to two months purchase. However, depending upon the
industry trend, the levels may vary.
6 Material Management Ratio:
The basic ratio falling under this head is Inventory Turnover Ratio. Inventory means raw
materials, stores, stocks-in-process and finished goods. All these items put together are
related to cost of goods sold for the year. Cost of sales is calculated as under :
Cost of Sales = Cost of Production + Opening Stock (FG & SIP) – Closing Stock (FG & SIP)
 FG = Finished goods SIP = Stock in Process/Semi-finished goods
The cost of production is arrived at by adding all direct costs, viz. raw materials consumed,
power and fuel, direct labour, consumable stores, repairs and maintenance to machinery and
other manufacturing expenses. Cost of sales reflects the ability/production efficiency and as
such has an important bearing on the performance of a concern. This ratio is calculated in
number of days' consumption.
Inventory Turnover Ratio = Inventory x 365
(Number of days) Cost of Goods Sold

This shows the inventory held for number of days. The lower the ratio, the more efficient is
the inventory management.
Raw Material Turnover Ratio = Raw Materials on hand x 365
(Number of days) Raw Materials Consumed during the year

This shows stock of raw materials on hand in number of months. Here also the endeavour
should be on a lower ratio unless of course, the raw materials are imported items or canalised
items, in which case larger raw materials holding may be permitted.
Finished Goods Turnover Ratio = Finished Goods on hand X 365
(Number of days) Cost of Goods Sold during the year

This shows how many months finished goods are on hand. Branches should study the reason
for holding the finished goods and especially beware of rejected goods, defective goods and
unsaleable goods being included in the value of finished goods.
All the above ratios give an indication about the material management by the concern.
7 Debt Service Coverage Ratio (DSCR):
Ability of a concern to service its term liabilities can be gauged from this ratio. This ratio is
applied while appraising all term loan proposals and investment decisions. This ratio is
studied when measures for rehabilitation of sick industrial units are examined and also
while fixing/ rescheduling the repayment schedule for term loans. Debt servicing means
payment of interest and installments on term loans. DSCR measures whether interest and
installments can be paid out of internal generation of funds. The ratio is worked out as
under:
DSCR = PAT + DEPRECIATION + INTEREST ON TERM LOAN
INTEREST ON TERM LOAN + TERM LOAN INSTALLMENTS
A ratio of 2 would indicate the concern's internal generation of funds would be twice of its
commitments towards term loan obligations and interest thereon. This ratio should be more
than one in order to take care of any eventualities in the profits position of the concern and
also to leave certain surplus with the concern for its normal growth and withdrawal.
8 Break Even Analysis:
Breakeven point (BEP) of a firm refers to that level of sales at which, it recovers all its costs.
This is the point where the unit neither makes profit nor loss. It is important while assessing
the performance or processing a credit proposal to ascertain the level at which the firm
breaks even, so as to know its shock absorbing capacity. Thus, break even analysis is an
important tool in the hands of a credit officer while analysing a credit proposal.
To calculate the BEP, as a first step, the total cost has to be bifurcated into fixed and variable
items. While fixed costs refer to those costs which are incurred regardless of the operation
and/or level of activity of the unit. The examples are rent, taxes, insurance, depreciation,
maintenance of building, machinery, etc. However, the fixed costs also undergo change over
a period of time. The variable costs on the other hand are expenses which vary directly in
proportion to level of activity or sales or production. The variable costs are also known as
marginal costs and example in this respect is raw materials, power & fuel, octroi,
consumables etc. While going through the profit and loss account, based on above
classification, the expenses should be analysed and following formula be applied to ascertain
the BEP.
BEP in Quantity = Fixed Costs / (Unit Sale Price - Unit Variable Cost) OR
BEP in Value (Rs.) = Fixed Cost x Sales / (Sales - Variable Cost (VC))
Sales mean Net Sales.
Sales - VC = Contribution
If a unit breaks even at a very high level of activity, there is every possibility of the unit
incurring loss, if any of the variables like fixed cost, variable cost, sales change even
marginally. Therefore, the proposal should be scrutinised very carefully whenever BEP is
reached at a very higher level of activity instead of at a lower level.
Ratios at a glance:

Ratio Formula Interpretation and benchmark

Current Ratio Current Assets Ability to meet current liabilities
Current Liabilities Higher the ratio better the liquidity
(1.33 is desirable) Shortfall indicates diversion of short
term fund.
Solvency Net Tangible assets Ability to repay debt from assets.
Ratio Total Outside Liabilities Higher the ratio betters the solvency.
Debt-Equity TDE= Total Outside Coverage of outside liabilities to own
Ratio Liab./Tangible Net worth/ fund. Lower the ratio higher the safety.
Equity
DE = Term Liabilities /
T. N. W.
Assets Coverage Net Block of Fixed Assets Extent to which FA covers Term
Liabilities.
Ratio Term Liability
More than 1 is desirable.
Debt-Service PAT + Dep. + Int. on Loan Debt Servicing Ability
Coverage Ratio Instal. of TL + Int. on Loan To work out repayment schedule is
desirable.
Inventory Turn Net Sales Efficiency of Inventory Management
over Ratio OR Holding Period of Inventory.
Inventory
Inventory Inventory x 365
(No. of days) Cost of goods sold
Debtor turnover Average O/S Debtors x 365 Credit policy of the unit/ firm.
Ratio (No of Average Period of the credit extended.
Credit Sales
Days)
Creditor Average O/S Creditors x 365 Ability to get goods on credit.
Ability to repay
Turnover Ratio Credit Purchase
(No. of days)
Assets Net Sales Efficient use of assets
turnover ratio. Net Operating Assets means FA + CA +
Net Operating Assets
Non CA- Investments.
Must have increasing trend.
Gross Profit Gross profit X 100 Margin available after meeting
Margin manufacturing cost.
Net Sales
Efficiency of Production and Pricing.
Net profit Net Profit After tax X 100 Net Profit margin on business.
Margin Overall efficiency of the unit.
Net Sales
Earning left for Dividend.
Dividend per Total distributable profit to Total dividend payable to per shares
shares Equity holders
No of equity shares
Return on Equity Equity Earning Measures profitability on Equity
Equity Earning=PAT–Preference
Net Worth
Dividends.
Price earnings Market Price of the share Price earning on present market value.
Ratio Earnings Per share
Break Even Fixed Cost BEP of the Unit.
analysis Unit sales price- Unit variable High BEP is risky
BEP in Qty. cost. Contribution of Profit to meet Fixed
Fixed Cost x Sales cost of the Unit.
BEP in Value Sales- Variable Cost Sales Means net Sales.
(Contribution)

Margin of Safety Sales Value - BEP Sales % of variance sustainable by the unit.
MOS Cushion available in case of variance.
Actual Sales
PAT = Profit after Tax, FA = Fixed Assets, BEP = Break Even Point,
MOS = Margin of Safety.