“A study on credit appraisal for

working capital finance to

SME’s at ING Vysya bank”
Objectives:

 To study the credit policy of the bank and the credit appraisal process as a whole.
 To study the credit appraisal system for working capital finance to SME’s
 To suggest the bank to improve the credit appraisal policy

Methodology:
Secondary data are those, which have already been collected by some one else. Secondary
Data

Sources those helpful in research were:-

1. Balance sheet of the company

2. Credit policy book of the bank
3. Bank website
4. Various articles on banking

Tools :

1. Ratios to be used
 Liquidity ratio
 Capitalization ratio
 Activity ratio
 Profitability ratio
2. Working capital assessment of the company
Under Projected balancesheet method (PBS)
Profile of ING Vysya Bank

ING Vysya Bank Ltd., is an entity formed with the coming together of erstwhile, Vysya Bank Ltd, a premier
bank in the Indian Private Sector and a global financial powerhouse, ING of Dutch origin, during Oct 2002.
The origin of the erstwhile Vysya Bank was pretty humble. It was in the year 1930 that a team of visionaries
came together to form a bank that would extend a helping hand to those who weren't privileged enough to
enjoy banking services.

It's been a long journey since then and the Bank has grown in size and stature to encompass every area of
present-day banking activity and has carved a distinct identity of being India's Premier Private Sector Bank.

In 1980, the Bank completed fifty years of service to the nation and post 1985; the Bank made rapid strides
to reach the coveted position of being the number one private sector bank. In 1990, the bank completed its
Diamond Jubilee year. At the Diamond Jubilee Celebrations, the then Finance Minister Prof. Madhu
Dandavate, had termed the performance of the bank ‘Stupendous’. The 75th anniversary, the Platinum
Jubilee of the bank was celebrated during 2005

ING Vysya bank has always been committed to making a positive contribution to Society. Promoting
education for under-served children is one such cause which has been very close to the bank. Through the
ING Vysya Foundation, it seeks to provide less advantaged children an opportunity to secure a better future
by providing them with education. 

Born out of three business entities of ING in India, ING Vysya Bank, ING Life Insurance, and ING
Investment Management, the Foundation has been able to strike the right balance between supporting
organizations financially and contributing time and effort of the employees to nurture and mentor these
children, for a better future. 

ING Vysya Foundation commenced its activities in December 2004 with a water-harvesting project in the
Udaipur and Rajasmand districts of Rajasthan, North India. The initiative provided villagers with access to
clean water and recharged ground-water wells which in turn support the local agricultural industry. 

The Foundation has also been actively involved in relief efforts following the Tsunami that hit the South
Indian coast on 26 December 2004. In cooperation with the regional headquarters of ING at Hong Kong,
ING Vysya Foundation supported a number of projects, including the rebuilding of homes and schools, and
other facilities for a number of villages. Another project included the micro-financing for 40 fishing boats
and the attendant equipment for the villages of Mudaliyarkuppam and Arcotuthurai, in Tamilnadu. 

As part of the ING Chances for Children programmed, the Foundation signed a five-year agreement to
support 100 orphans' living and schooling expenses. Additional funds, set up enabled of a day-care centre
with training facilities which is used by the community at large. 

Other initiatives include ING Investment Management's auctions of paintings drawn by street children for
the NGO Pratham and ING Vysya Bank's 'Run Ricky Run' in which the bank sent a child back to school for
each run the Australian cricket captain Ricky Ponting scored in international one-day matches during a one-
year period ending September 2008. 

Today, Foundation partners with thirteen local charity organizations in India. It helps children to be in the
primary schools to realize their right to education as the first step towards breaking the cycle of poverty.

Introduction of the topic

Working Capital Finance

ING Vysya offers working capital finance to meet the entire range of short-term fund
requirements that arise within a corporate’s day-to-day operational cycle.

The ING Vysya working capital loans can help company in financing inventories, managing
internal cash flows, supporting supply chains, funding production and marketing operations,
providing cash support to business expansion and carrying current assets.

ING Vysya working finance products comprise a spectrum of funded and non-funded facilities
ranging from cash credit to structured loans, to meet the different demands from all segments of
industry, trade and the services sector. Funded facilities include cash credit, demand loan and bill
discounting. Demand loans are considered also under the FCNR (B) scheme. Non-funded
instruments comprise letters of credit (inland and overseas) as well as bank guarantees
(performance and financial) to cover advance payments, bid bonds etc.

Lending continues to be a primary function in banking. In the liberalized Indian economy,

clientele have a wide choice. External Commercial Borrowings and the domestic capital markets
compete with banks. In another dimension, retail lending- both personal advances and SME
advances- competes with corporate lending for funds and for human resources. But lending by
nature cannot be an aggressive selling activity, disregarding the risks involved. Bank has to be
competitive without compromising on the basic integrity of lending. The quality of the Bank’s
credit portfolio has a direct and deep impact on the Bank’s profitability.

Review of literature
FICCI’S ANNUAL SURVEY ON BANKING
BANKING SECTOR FOR CONSOLIDATION

January , 2010. Faced with intensifying competition, the Indian banking sector is all for
consolidation of the financial sector now and is fully endorses the need for creating six or seven
banks of the size of the State Bank of India, while bulk of the public sector banks lament lack of
sufficient autonomy to offer attractive incentive packages to their employees to ensure
commitment and raise productivity.
 

These and other prescriptions revealed by FICCI’s annual survey on the Indian Banking
System: The Current State and the Road Ahead.

 The FICCI Survey, which zeroes in on the potential offered by Indian banking system and
achievement of global competitiveness by Indian banks, throws up key areas that need focused
attention and immediately tackled for future growth. These areas, pinpointed by the survey
respondents include: Diversification of markets beyond big cities (84.2% of the respondents),
HR Systems (63.15%), Size of Banks (52.63%) High Transaction Costs (47.3%), Banking
Infrastructure (42%) and Labor Inflexibilities (42%).

The following are the major highlights of the FICCI Survey:

 

   Some of the major strengths of the Indian banking industry, which have helped mark its
place on the global banking scene as highlighted by our survey respondents were
Regulatory Systems (84.21%), Economic Growth Rate (63.15%), Technological
Advancement (52.63%), Risk Assessment Systems (47%) and Credit Quality (42.1%)
 Some of the areas that need to be geared up for future growth, identified by the survey
respondents are Diversification of markets beyond big cities (84.2%), HR Systems
 (63.15%), Size of banks (52.63%) High Transaction Costs (47.3%), Banking
Infrastructure (42%) and Labor Inflexibilities (42%).
 To a question on achieving global competitiveness, Consolidation in the financial sector
has emerged to be the most significant measure required to create world class banking
system followed by Strict Corporate Governance Norms, Regional Expansion, Higher
FDI limits and FTA’s.
 On being asked to rate India on certain essential banking parameters (Regulatory
Systems, Risk Assessment Systems, Technological Systems and Credit Quality) in
comparison with other countries i.e. China, Japan, Singapore, Russia, UK and USA, the
following results emerged:
 Regulatory systems of Indian banks were rated better than China and Russia; at
par with Japan and Singapore but less advanced than UK and USA.
 Respondents rated India’s Risk management systems more advanced than China
and Russia; at par with Japan, and less advanced than Singapore, UK and USA.
83% of our respondents highlighted that Basel II implementation would take us a
step ahead in global competitiveness.
 Technological systems of Indian banks have been rated more advanced than
China and Russia; at par with Japan, but less advanced than Singapore, UK and
USA.
 Majority of respondents quoted credit quality of Indian banks better in
comparison with China, Japan and Russia; at par with Singapore but below par
with UK and USA.
 75 per cent of the foreign bank’s respondents rated their working experience in India as “
extremely good”. Given India’s potential over the next decade and beyond, 100 per cent
foreign banks respondents stated that they have formulated strategies for future expansion
in India.
 55 per cent of the respondents highlighted that the FTA’s signed by India till now have
helped enhance global trade and thus been of help to banks in their global expansion
strategy.
  On possible Comprehensive Economic Co-Operation Agreement (CECA) with EU, 85
per cent of domestic banks respondents also emphasized that India should not give full
domestic status to EU based banks under the proposed India-EU CECA.
 69 per cent of respondents stated that 20 – 30 % proportion of their total Income is
constituted by fee-based incomes. Banc assurance and selling of mutual funds were
recognized as the most tapped business opportunities by the bankers closely followed by
Forex Management. Out of these selling of mutual funds was identified as the most
profitable venture by 47 per cent of respondents.
 The penetration of banking services to Indian households stands at a mere 35.5%. Some
of the efforts highlighted to increase this penetration level were: Tapping the Rural
markets (87.5 per cent respondents) and Opening more branches in Tier II and Tier III
towns (62.5 per cent respondents)
 On the question on the state of preparedness of Indian banking sector to tackle the
challenges being faced by them, the following results emerged:

SME SECTOR SHINES

Mr. K.G.Mallya

We must congratulate the Small and Medium Enterprise Sector, popularly known as SME sector
for getting due attention and recognition from all quarters. Now the SMEs are on the centre stage
stealing the show basking in the limelight. So in the fitness of things, the year 2009, in India
should be designated as the SME YEAR to further the cause of this particular sector.

The SME Sector:

This sector has a very important role to play in the economy of any country Labour
intensive, it is a small industrial enterprise to manufacture items needed in a small locality,
making use of locally available resources. Basically it is a low-tech industry catering to the needs
of a small market without much capital outlay, overheads or economies of scale. Even though
this is the portrait of a typical enterprise, there are sizeable SMEs that have links with large
industries to manufacture and supply parts and components or to undertake sub-contracts or job
work. Then there are SMEs that exclusively concentrate on exports also. Yet, all of them have
one thing in common: That is, small size. Scope for employing people, investment in plant and
machinery and the problem of access to institutional finance these are more or less the same for
all the units in the entire sector as they have smaller capital base, lower production capacity,
limited technical capabilities and smaller markets. In spite of these odds, the performance of the
sector as a whole has stunned every one!

Is the sector a new find?

Is our approach to SME Sector is an innovation or something like a new

invention? Going by the literature and books available on SMEs, in many countries, both the
developed and developing, the SMEs have been regarded and respected for their significant
contribution towards the GDP. They have beaten large industries in respect of innovations and
inventions on account of hard work, personal interest and the spirit of enterprise of the owners
that is normally not available with the joint stock companies.

Finance, a major handicap:

The mention of joint stock companies take us to the arena of finance. The main
handicap of the SMES is finance and unfortunately, unless they are big enough or have earned a
name and fame they cannot enter the capital market to raise the requisite finance through the
issue of stocks and shares. Sometimes to raise the loans from the banks also they do not have
good collateral or money to provide safety margin. They will thrive only if right quantity of
finance is available at right time and at right price. Yes, in the world full of competition, the rate
of interest plays a dominant role in costing and pricing.

SMEs Abroad:

Going back to the SMEs abroad, in some countries, they are encouraging the SMEs to
grow international (transnational is the term used) and spread their wings by strategic alliance,
joint ventures, having affiliates or making direct investment in capital. In some quarters loans are
granted for this purpose at nominal rate of interest. Developed countries prefer developing
countries in view of the latter having cheaper manpower and also natural resources. They also
transfer technical know-how, impart training and hold conferences and seminars to pass on the
knowledge.

Indian Context:

In the Indian context, financing SMEs is not something new or unknown. All that we have done
recently is the renewal of our pledge to serve the SME Sector with a greater vigour.

The Finance Minister during his Budget Speech on 28th February 2010 set the ball rolling. The
relevant portion of his speech is as follows: “SMALL & MEDIUM ENTERPRISES. In recent
years our approach to small scale industry has evolved and now we are inclined to treat the
sector as the small and medium enterprises sector…Small Industries Development Bank of India
(SIDBI) has established this year a SME Growth Fund with a corpus of Rs.500 Crores. Small
and medium units in knowledge based industries such as Pharma, Biotech and IT will be
provided equity support through this Fund. There is a need for a new legislation that will provide
a supportive environment for small and medium enterprises…” He concludes that the Minister of
Small Scale Industries will introduce the Small and Medium Enterprises Development Bill.
Three things are distinctly clear here. From the Small Scale Industries we have moved to a
broader SME sector. And this integrated sector is going to get a good legal and legal support
from the authorities. In fact these words have given a good fillip to move in the right direction.

SME Sector: We must now acquaint ourselves with two definitions. SSI & SME. Historically
our commercial banks started financing Small Scale Industrial Units way back in the year 1960
with a credit guarantee scheme by the Central Government administered by the Reserve Bank as
the Agent. (Presently this scheme is not available). The SSI is defined as an industrial unit whose
original investment in plant and machinery should not exceed Rs.7.50 lakhs (raised to Rs.10
lakhs on 10.9.75 and now it is Rs.1 Crore and in the case of Ancillary Unit investment in fixed
assets should not exceed Rs.3 crores) And the unit should engage itself, in manufacturing,
processing and preservation of goods. Mining and quarrying, servicing and repairing and custom
service units are also treated as SSI units. There is a Tiny Sector where the investment in plant
and machinery should be less than Rs.25 lakhs and in the case of Village and & Cottage
Industries the credit requirement should not be above Rs.50,000/-
While determining the scale of industry in our country we have gone by the investment in plant
and machinery but in some countries they base on the number of employees, say up to 200 for
the SSI. Beyond SSI limit the industry would fall under the category of Medium Scale or Large
Scale. We have now integrated Small Scale and Medium Scale under a single category SME.

Official Definition: At this juncture it is worth mentioning that Reserve Bank has come out with
guidelines to the banks in respect of SME sector. They are reproduced in their monthly
publication, Monetary & Credit Information Review (MCIR) issues for Aug & September 2010
which are very relevant both to the bankers and the borrowers. August issue gives guidelines for
lending to the sector and September relates to the restructuring of overdue and irregular debts
besides one time settlement of the dues of SME. We shall first acquaint ourselves with the
definition given on page 2 of Sept 2005 issue:

“At present, a small scale industrial (SSI) unit is an undertaking in which investment in plant and
machinery, does not exceed Rs.1 Crore, except in respect of certain specified items under
hosiery, hand tools, drugs and pharmaceuticals, stationery items and sports goods, where this
investment limit has been enhanced to Rs.5 Crore. A comprehensive legislation which would
enable the paradigm shift form small-scale industry to small and medium enterprises is under
consideration of the Parliament. Pending enactment of the legislation, current SSI/Tiny
Industries definition may continue. Units with investment in plant and machinery in excess of
SSI limit and up to Rs.10 Crore may be treated as medium enterprises (ME).”

Credit Flow to SME Sector: From the issue of MCIR for August 2010 we can note the anxiety
and concern of the Monetary Authorities to step up the flow of credit with a substantial increase
from the present levels. Among other things banks are asked to a) Formulate policies for
extending credit to this sector b) Have a cluster approach to reduce the cost of finance c) Each
and every Urban and Semi-urban branch of a bank should finance at least 5 new units per year.
Similarly from the issue for September 2010, we can note the guidelines for Debt Restructuring
and Relief besides One Time Settlement (OTS) of NPAs below Rs.10 Crore classified as
Doubtful or Loss Assets as on 31.3.09 and so also for the debts classified as Sub-standard on
31.3.09 but subsequently become Doubtful or Loss Assets. The OTS is also applicable to all
debts under litigation subject to obtaining a consent decree.
The Biggest Attraction:
In the whole scheme the cost of credit is not lost sight of and that is the biggest attraction. The
RBI has advised the banks to take necessary steps to rationalise the cost of loans by adopting a
transparent rating system with cost of credit being linked to the credit rating of the enterprise. It
asks the banks to take advantage of the models developed by the SIDBI in respect of Credit
Appraisal and Rating besides Risk Assessment. The National Small Industries Corporation has
evolved a scheme whereby the SMEs can get themselves rated by reputed credit rating agencies.
The RBI has advised the banks to take these rating also into consideration while fixing the rate of
interest on the borrowings. RBI has asked banks to give wide publicity to all the above through
their notice board and also through the web-site of each one of the banks so that all will get to
know the facilities available.

SIDBI: This write up will not complete unless we make a mention of the pivotal role played by
SIDBI in developing the SME sector. It commenced operations from 1990 by financing,
promoting and developing industries in the small-scale sector. Basically it is a develop bank and
also a term lending institution but it provides bill discounting and working capital finance also
and the units in the sector can avail of credit facilities from SIDBI at a reasonable rate of interest.
The Budget has provided funds to the Corporation for equity support and more than that the
Economic Survey 2009-10 under Policy Initiatives in the SSI sector during 2009-10, gives us a
very heartwarming indication that, “The Small & Medium Enterprises (SME) Fund of Rs.10,000
crore was operationalised by the SIDBI since 2004. Eighty percent of the lending from this fund
will be for SSI Units at interest rate of 2% below the prevailing PLR of the SIDBI.”

Conclusion: The financial and banking system has placed before the SME sector a fully dressed
up cake in a silver platter. It is not a birthday cake but a cake in appreciation of the efforts and
also as an incentive to work hard. The sector should avail of the opportunities and scale new
heights. With this the sector will be benefited and the society too.
ANALYSIS AND INTERPRETATION

1. ING VYSYA’S LOAN POLICY

The basic tenets of ING Vysya Loan Policy include the following:
 Optimum exposure levels are set out in the Policy to different sectors in order to ensure
growth of assets in an orderly manner.
 The policy sets out minimum scores/hurdle rates
 The policy lays down norms for take over of advances from other banks/ financial
institutions
 As a matter of policy the bank does not take over any Non-performing Asset(NPA) from
other banks.

CREDIT APPRAISAL STANDARDS

QUALITATIVE:

At the outset, the proposition is examined from the angle of viability and also from the bank
prudential levels of exposure to the borrower, group and industry. Thereafter, a view is taken
about bank’s past experience with the promoters, if there is a track record to go by. Where it
is a new connection for the bank but the entrepreneurs are already in business, opinion
reports from existing bankers and published data if available are carefully perused. In case
of a maiden venture, in addition to the drill mentioned heretofore, an element of subjectivity
has to be perforce introduced as scant historical data would be available and weightage has
to be placed on impressions gained out of the serious dialogues with the promoters and his
business contacts.

QUANTITATIVE

1. Working capital: the basic quantitative parameters underpinning the Bank’s

credit appraisal are as follows:
 I. Liquidity: current ratio (CR) of 1.33 will generally be considered as a benchmark level of
liquidity. However, the approach has to be flexible. Cr of 1.33 is only indicative and may
not be deemed mandatory. In cases where the Cr is projected at a level lower than the
benchmark or a slippage in the CR is proposed, it alone will not be a reason for rejection of
the loan proposal or for sanction of loan. In such cases, the reasons for low CR should be
carefully examined and in deserving cases the CR as projected may be accepted. In cases
where projected CR is found acceptable, working capital finance as requested may be
sanctioned.
II. Net working capital: although this is a corollary of current ratio, the movements in Net
working capital are watched to ascertain whether there is a mismatch of long term sources
via-a-vis long term uses for purposes which may not be readily acceptable to the Bank so
that corrective measures can be suggested.
III. Financial Soundness: this will be dependent upon the owner’s stake or the leverage. Here
again the benchmark will be different for manufacturing, trading, hire purchase and leasing
concerns. For industrial ventures Total Outside Liability/Tangible Net Worth ratio of 3.0 is
reasonable but deviations in selective cases for understandable reasons may be accepted by
the sanctioning authority.
IV. Turn –over: the trend in turn-over is carefully gone into both in terms of quantity and value
as also market share wherever such data are available. What is more important is to establish
a steady output if not a rising trend in quantitative terms because sales realization may be
varying on account of price fluctuations.
V. Profits: while net Profit is the ultimate yardstick, cash accruals, i.e. profit before
depreciation and taxation conveys the more comparable picture in view of changes in rate of
depreciation and taxation which may have taken place in the intervening years. However, for
the sake of proper assessment, the non-operating incomes are excluded, as these are usually
one time or extraordinary income. Companies incurring net losses consistently over 2 or
more years will be given special attention, their accounts closely monitored, and if
necessary, exit options explored.
VI. Credit Rating: wherever a Credit Rating Agency for any instrument has rated the company,
this will be taken into account while arriving at a final decision. However, as the credit
 rating involves additional expenditure, bank would not normally insist on this tool if such an
agency had already looked into the company finances.
VII. Capital Market: where the company’s shares are listed in stock exchanges, the movement
of the price of its share, the market value of shares like those of competitors in the same
industry, response to public/right issues are also kept in view as these are reflective of the
corporate image in the eyes of the investors’ community.
2. Term Loan / Deferred Payment Guarantees
I. In case of term loans and deferred payment guarantees, the project report is obtained from
the customer, which may have been compiled either in-house or by a firm or consultants/
merchant bankers. The technical feasibility and economic viability is vetted by the Bank and
wherever it is felt necessary.
II. Promoter’s contribution of at least 20% in the total equity is what bank normally expects.
But the promoter contribution may vary largely in mega projects. Therefore, there cannot be
a definitive benchmark. The sanctioning authority will have the necessary discretion to
permit deviations.
 2. FINANCIAL RATIOS USED FOR CREDIT RISK ASSESSMENT

Under the CRA system, financial risks in a proposal are sought to be captured through some
relevant ratios. Different ratios are used for assessing risks for extending working capital finance
and term loans under CRA system. Also, the ratios used for assessing risk for financing NBFC’s
are different.

Working capital finance (all segments except NBFC’s)

The following are the ratios used for working capital finance:

1. Current ratio: it is calculated by dividing current assts by current liabilities. It helps to

measure liquidity and financial strength.

2. Care should be taken in interpreting this ratio as:

a. It is applied at a single point in time, implying a liquidation approach, rather than a

judgment on the going concern, for it does not explicitly take into account the revolving nature
of current assets and current liabilities.

b. The seasonal character of the business resulting in fluctuating current ratio is a disturbing
factor.

3. Liquidity could be severely affected if current liabilities exceed current assets.

4. The higher the ratio the better the liquidity position.

2. TOL/TNW: total outside liabilities divided by total net worth.

i. It indicates size of stake, stability and degree of solvency.

ii. Indicated how high is the stake of the creditors.
iii. Indicated what proportion of the company’s finance is represented by the tangible net
worth
 iv. The lower the ratio the greater the solvency.
v. The ratio is usually higher in case of SME’S. Still anything over 3 or 4 should be viewed
with concern.
vi. The ratio should be studied at the peak level of operations.

3. PBDIT/interest (times): this is called ‘interest coverage’ ratio. In the current context, the
servicing capability of loan is very crucial. This ratio, which indicates the number of times the
gross earnings cover the interest payable is an indicator of the measure of comfort that
profitability provides.

i. Higher ratio indicates comfortable debt servicing capability from the cash accrual of
the company.
ii. A ratio of more than 3 is considered comfortable, where as a ratio of 2 and below is
considered risky.

4. ROCE or ROA (%): profit before depreciation, interest and tax/ total capital employed
multiplied by 100.

i. High ratio indicates that the business is run on profitable lines.

ii. It is a relationship between the profits made during the year and the finance
employed to make profits i.e. it shows the earning power of the business.
iii. It is a measure of the management’s skill in profitably employing the funds in the
company.
iv. It should not only compare favorably with the rate of interest on loanable funds in
the market but also compensable for the risk involved in running the business.

5. Operating profits/Net sales (%): indicates operating efficiency. It should be comparable with
similar industries. Trend for the company over a period should be encouraging.
6. Inventory / net sales + receivables / gross sales: expressed in days, this ratio captures the
turnaround period f major items of the current asset

i. Higher the figure, the slower is the turnaround of current asset and in general
higher the risk.
ii. This ratio will vary across industries.
iii. For assessment of risk, a shorter working capital cycle can be regarded less risky.
iv. Specific industry parameters should also be kept in mind while assessing the risk
under this ratio.
v. In general, it is expected that the working capital should be turned over at least
twice.

For NBFCs , the ratios are:

1. Current ratio

2. TOL/NOF: total outside liabilities/ net owned funds ratio represents the extent to which
the company is leveraged. Net owned RBI uses funds as a reference for registration and
acceptance of deposits from public. NOF represents total net worth, less investment in
excess of 10% of owned funds as stipulated by RBI.
i. Higher ratio indicates increased dependence on borrowings and other liabilities.
ii. A ratio of 3 and below is considered very healthy, while a ratio above 7 is
considered risky.

3. PBDT/ Total Assets: this ratio is a measure of gross profitability or gross return from the
activity of the company. In the CPA models, for manufacturing company, the numerator
is PBDIT but in NBFCs interest payment is a major component. So, it is more relevant to
take PBDT for NBFCs.
i. A percentage of more than 10 is considered healthy whereas below 2 is
considered risky.
 4. PAT/ Total Income: total income= income minus other than non-recurring income. This
ratio represents the profitability of operations. Total income from operations may be
considered as equal to total sales of a manufacturing company.
i. a percentage of 11% and above is considered healthy and below 3 is considered
risky.

5. (Total income – other non-recurring income)/interest expenses: the interest coverage

ratio in respect of NBFCs is calculated by dividing total income less non-recurring
income with interest expenses. This ratio measures the cushion available for meeting
interest liability.
i. A ratio of 3 or more is considered healthy while less than 1 is considered highly
risky.

6. Overdue/ demand raised ratio: this ratio measures collection efficiency. The term “over
dues” represents claim amounts which have not been received till due date.
i. A ratio of 1 and below is considered very healthy and more than 5 is
considered very risky.

7. NPA/ total working assets ratio: NPAs in this context refer to lease rentals and hire
purchase installments overdue for more than 12 months.

Following are some examples of Balance Sheet Analysis and calculation of ratios which are
important for analyzing the financial trend of the business
REARRANGED STATEMENT OF ASSET AND LIABILITIES OF BALA HARI
METALS(Rs. In. 000’s)

LIABILTIE 2009 2010 ASSESTS 2009 2010

S

Current Current
Liabilities: Assets:

Creditors 40 32 Cash 31 52

Bills Payable 26 13 Stock 112 99

Debtors 23 23

66 45 166 174

Deferred
Liabilities:

Debentures 200 200 Fixed

Assets:

Capital & Block 434 440

Surplus

Capital 200 200

Reserves 134 169

334 369

600 614 600 614

Liquidity ratios:
i. Current ratio : CA/ CL
2006: 166/66 = 2.5:1

2007: 174/45 = 3.9:1

 ii. Quick Ratio or Acid Test Ratio: Q.A/ C.L
2006: 54/66 = 0.8:1

2007: 75/45 = 1.7:1

Capitalization Ratios:

i. Term liabilities/ net worth (Funded Debt)

2006: 200/334 = 0.6:1

2007: 200/369 = 0.5:1

ii. Total liabilities / net worth:

2006: 266/334 = 0.8:1

2007: 245/369 = 0.6:1

Activity Ratios:

i. Sales/ capital employed:

2006: 360/534 = 0.67:1

2007: 390/569 = 0.7:1

ii. Stock /sales:

2006: 112/30 = 3.7 months

2007: 99/32 = 3 months

iii. Debtors/sales:
2006: 23/30 = 3/4th month

2007: 23/32 = less than 3/4th month.

Comments:
 i. Liquidity: Current ratio for 2009 is satisfactory; but it is rather high for 2010. Perhaps the
unit is building up cash for meeting some commitments.
ii. Capitalization: the long term debt and the total outside liabilities are quite low compared
to equity. Hence, the financial position of the unit if good.
iii. Activity Ratios:
a. The sales/capital employed ratio is rather low. The reasons for the same have to
be ascertained.
b. Debtor’s management and Inventory management have marginally improved in
2010. Overall, the financial position and liquidity position of the unit are
considered satisfactory.
Following is the summarized balance Sheet and Income Statement of Bala hari metals:

Income Statement for the year ending 31-3-2010 (Rs. In 000’s)

Sales 1600

Less cost of goods sold 1310

290

Less Selling and Administrative 40

expenses

250

Less Interest 45

Earnings before Tax 205

Less Tax paid 82

Earnings After Tax 123

Balance sheet as on 31-3-2010 (Rs. In 000’s)

Liabilities Rs. Assets Rs .

Paid up capital 400 Net Fixed assets 800

(40000 shares of Rs.
 10 fully paid)
Retained Earnings 120 Inventory 400

Debentures 700 Debtors 175

Creditors 180 Marketable 75

securities

Bills Payable 20 Cash 50

Other current 80
liabilities

1500 1500

The unit has approached the bank for credit limit of Rs. 5 lacs against the security of stocks and
debtors. Following is the evaluation of firm’s financial position by calculating ratios useful for
bank’s evaluation and problem areas suggested by ratio analysis.

Ratios Unit’s ratios Industry Comment

average

1. Liquidity position:

a. Current ratio 700/280 =2.5 2.4 Satisfactory

b. Quick ratio 300/280 = 1.07 1.5 Low

2.Capitalization
ratios:

a. Funded 700/1500 = 46.7% 40% Rather high

debt/assets

b. Funded 700/520 = 1.3:1 N.A Satisfactory

debt/equity

c. Total liabilities / 980/520 = 1.9:1 N.A Good

 equity

3. Profitable Ratios:

a. Net profit/sales * 123/1600 * 100 = 7% Satisfactory

100 7.7%

b. N/P / total sales * 123/1500 * 100 = 11% Low

100 8.2%

c. N/P / capital 123/1220 * 100 = N.A Satisfactory

employed * 100 10.1%

4. Activity ratios:

a. sales to inventory 1600/400 = 4 8 Very low

b. average collection 175/4.4 = 40 days 36 days Marginally high

period: debtors/avg.
daily sales

Comments:

Liquidity Ratios: liquidity ratios are satisfactory. They also compare favorably with industry
average except that the acid test ratio is low.

Activity Ratios: the sales to inventory ratio is half of the industry average. The sluggishness in
turnover of stocks has to be probed into. Collection efficiency (debtors management) is
marginally higher than the industry average

Capitalization Ratios: the capital base ratios are satisfactory; but funded debt/assets ratio is
higher than the industry average.

Profitability: though the profitability on sales is better than the industry average the earnings on
assets is low compared to the industry average. Thus due to lower turnover of stocks. Net profit
after tax can also be used for working out the ratio. As tax rates may change from year to year a
more uniform basis will be provided by NPBT.

Conclusion:

The unit’s overall liquid, financial and profitability positions are satisfactory. The precise reasons
for the low turnover of stocks have to be ascertained to find out whether the company will face
any marketing problems. The unit’s NWC position is very comfortable ; hence there is no need
for WC finance.

3. WORKING CAPITAL AND ITS ASSESSMENT

The objective of running any industry is earning profits. An industry will require funds to acquire
“fixed assets” like land and building, plant and machinery, equipments, vehicles etc… and also
to run the business i.e. its day to day operations.

Working capital is defined, as the funds required carrying the required levels of current assets to
enable the unit to carry on its operations at the expected levels uninterruptedly.

Thus working capital required (WCR) is dependent on

i. The volume of activity (viz. level of operations i.e. Production and Sales)
The activity carried on viz. manufacturing process, product, production programme, and the
materials and marketing mix
Though there are various methods used for assessing the quantum of working capital
requirement for an industry, the following are commonly used.

Operating cycle method

Any manufacturing activity is characterized by a cycle of operations consisting of purchase of

raw materials for cash, converting them into finished goods and realizing cash by sale of these
finished goods. The time that lapses between cash outlay and cash realization by sale of finished
goods and realization of sundry debtors is known as length of operating cycle. That is , the
operating cycle consists of:

i. Time taken to acquire raw materials and average period for which they are in store.
ii. Conversion process time
iii. Average period for which finished goods are in store and
iv. Average collection period of receivables (sundry debtors).
Operating Cycle is also called cash-to-cash and indicates how cash is converted into raw
materials, stocks in process, finished goods, bills (receivables) and finally backs to cash.
Working capital is the total cash that is circulating in this cycle. Therefore, working capital
can be turned over or deployed after completing the cycle.

Factors, which influence working capital requirement, are:

i. Level of operating expenses and

ii. Length of operating cycle.
Any reduction in either of the both will mean reduction in working capital requirement or
indicate an efficient working capital management.

It can thus be concluded that by improving that by improving the working capital turnover ratio
(i.e. by reducing the length of operating cycle) a better management (utilization) of working
capital results. It is obvious that any reduction in the length of the operating cycle can be
achieved only by better management only by better management of one or more of the individual
phases of the operating cycle period for which raw materials are in store, conversion process
time, period for which finished goods are in store and collection period of receivables. Looking
at whole problem from another angle, we find that we can set up extremely clear guidelines for
working capital management viz. examining the length of each of the phases of the operating
cycle to assess the scope for reduction in one or more of these phases.

The length of the operating cycle is different from industry to industry and from one firm to
another within the same industry. For instance, the operating cycle of a pharmaceutical unit
would be quite different from one engaged in the manufacture of machine tools. The operating
cycle concept enables to assess working capital need of each enterprise keeping in view the
peculiarities of the industry it is engaged in and its scale of operations. Operating cycle is an
important management tool in decision –making.

Traditional method of assessment of working capital requirement

The operating cycle concept serves to identify the areas requiring improvement for the purpose
of control and performance review. But, as bankers, we require a more detailed analysis to assess
the various components of working capital requirement viz., finance for stocks, bills etc.

Bankers provide working capital finance for holding an acceptable level of current assets viz.
raw materials, stock-in-process, finished goods and sundry debtors for achieving a predetermined
level of production and sales. Quantification of these funds required to be blocked in each of
these items of current assets at any time will, therefore provide a measure of the working capital
requirement of an industry.

Raw material: any industrial unit has to necessarily stock a minimum quantum of materials used
in its production to ensure uninterrupted production. Factors, which affect or influence the funds
requirement for holding raw material, are:

i. Average consumption of raw materials.

ii. Their availability – locally or form places outside, easy availability / scarcity, number of
sources of supply
iii. Time taken to procure raw materials (procurement time or lead time)
iv. Imported or indigenous.
v. Minimum quantity supplied by the market (Minimum Order Quantity (MOQ)).
 vi. Cost of holding stocks (e.g. insurance, storage, interest)
vii. Criticality of the item.
viii. Transport and other charges (Economic Order Quantity (EOQ)).
ix. Availability on credit or against advance payment in cash.
x. Seasonality of the materials.
This raw material requirement is generally expressed as so many months requirement
(consumption).

Stock in process: barring a few exceptional types of industries, when the raw material get
converted into finished products within few hours, there is normally a time lag or delay or
period of processing only after which the raw materials get converted into finished product.
During this period of processing, the raw materials get converted into finished goods and
expenses are being incurred. The period of processing may vary from a few hours to a
number of months and unit will be blocked working funds in the stock-in-process during this
period. Such funds blocked in SIP depend on:

i. The processing time

ii. Number of products handled at a time in the process
iii. Average quantities of each product, processed at each time (batch quantity)
iv. The process technology
v. Number of shifts.

Finished goods: all products manufactured by an industry are not sold immediately. It will be
necessary to stock certain amount of goods pending sale. This stock depends on:

i. Whether the manufacture is against firm order or against anticipated order

ii. Supply terms
iii. Minimum quantity that can be dispatched
iv. Transport availability and transport cost
v. Pre-dispatch inspection
vi. Seasonality of goods
vii. Variation in demand
viii. Peak level/ low level of operations
ix. Marketing arrangement- e.g. direct sale to consumers or through dealers/ wholesalers.
The requirement of funds against finished goods is expressed so many months’ cost of
production.

Sundry debtors (receivables): sales may be affected under three different methods:

i. Against advance payment

ii. Against cash
iii. On credit
A unit grants trade credit because it expects this investment to be profitable. It would be
in the form of sales expansion and fresh customers or it could be in the form of retention
of existing customers. The extent of credit given by the industry normally depends upon:

i. Trade practices
ii. Market conditions
iii. Whether it is bulky by the buyer
iv. Seasonality
v. Price advantage
Even in cases where no credit is extended to buyers, the transit time for the goods to
reach the buyer may take some time and till the cash is received back, the unit will
have to be cut out of funds. The period from the time of sale to receipt of funds will
have to be reckoned for the purpose of quantifying the funds blocked in sundry
debtors. Even though the amount of sundry debtors according to the unit’s books will
be on the basis of Sale Price, the actual amount blocked will be only the cost of
production of the materials against which credit has been extended- the difference
being the unit’s profit margin- (which the unit does not obviously have to spend)
The working capital requirement against Sundry Debtors will therefore be computed
on the basis of cost of production (whereas the permissible bank finance will be
computed on basis of sale value since profit margin varies from product to product
and buyer to buyer and cannot be uniformly segregated from the sale value).

The working capital requirement is expressed as so many months’ cost of production.

 Expenses: it is customary in assessing the working capital requirement of industries,
to provide for 1 month’s expenses also. A question might be raised as to why
expenses should be taken separately, whereas at every stage the funds required to be
blocked had been taken into account. This amount is provided merely as a cushion, to
take care of temporary bottlenecks and to enable the unit to meet expenses when they
fall due. Normally 1-month total expenses, direct and indirect, salaries etc. are taken
into account.

While computing the working capital requirements of a unit, it will be necessary to

take into account 2 other factors,

i. Is the credit received on purchases- trade credit is a normal practice in trading

circles. The period of such credit received varies from place to place, material
to material and person to person. The amount of credit received on purchases
reduces the working capital funds required by the unit.
Industries often receive advance against orders placed for their products. The buyers, in certain
cases, have to necessarily give advance to producers e.g. custom made machinery. Such funds
are used for the working capital of an industry.

Projected Annual Turnover Method for SME units (Nayak Committee)

For SME units, which enjoy fund based working capital limits up to Rs.5 crore, the minimum
working capital limit should be fixed on the basis of projected annual turnover. 25% of the
output or annual turnover value should be computed as the quantum of working capital
required by such unit. The unit should be required to bring in 5% of their annual turnover as
margin money and the Bank shall provide 20% of the turnover as working capital finance.
Nayak committee guidelines correspond to working capital limits as per the operating cycle
method where the average production/ processing cycle is taken to be 3 months.
Tandon and Chore Committee Recommendations

Till year 1996-97, banks in India were following the concept of Maximum Permissible Bank
Finance (MPBF) for working capital limits, as enunciated in Tandon and Chore committee
reports. In the monetary and credit policy for the first half-year of 97-98, RBI announced
withdrawal of their guidelines on assessment of working capital finance based on the MPBF
concept. State Bank of India felt that many aspects of the Credit Monitoring Arrangement
(CMA) followed till then were based on sound principles of lending. Hence, while there was a
need to continue to adopt these, certain flexibility was required to be brought into the method to
avoid any rigid approach to fixing the quantum of finance. In the area of supervision, there was a
need to rationalize the existing financial follow up procedure. As a consequence, the bank
adopted the projected Balance Sheet method in the second half of the year 1997-98 onwards.

MPBF METHOD

The Tandon Committee was appointed o suggest a method for assessing the working capital
requirements and the quantum of bank finance. Since at that time, there was scarcity of bank’s
resources, the Committee was also asked to suggest norms for carrying current assets in different
industries so that bank finance was not drawn more than the minimum required level. The
Committee was also asked to devise an information system that would provide, periodically,
operational data, business forecasts, production plan and resultant credit needs of units. Chore
Committee, which was appointed later, further refined the approach to working capital
assessment. The MPBF method is the fall out of the recommendations made by Tandon and
Chore Committee.
Approach to lending
Regarding approach to lending: the committee suggested three methods for assessment of
working capital requirements.

First method
The quantum of bank’s short-term advanced will be restricted to 75% of working capital gap
where “working capital gap” is equal to “current assets” minus “current liabilities other than
bank borrowings”. Remaining 25% is to be met from long-term sourced.

Second method
Net working Capital should at least be equal to 25% of total value of acceptable level of current
assets. The remaining 75% should first be financed by Other Current Liabilities and the bank
may finance balance of the requirements.

Third method
The borrower should provide for entire core current assets and 25% balance current from the
Net working Capital.

To compute the level of working capital requirement of the unit, the analyst has to assess the
level of current assets it has to carry, consistent with its projected level of production and sales.
Inventory and receivables constitute most of the current assets.

Projected Balance Sheet Method (PBS)

The PBS method of assessment will be applicable to all C&I borrowers who are engaged
in manufacturing, services and trading activities who require fund based working capital
finance of Rs. 25 lacs and above. In case of SSI borrowers, who require working capital
credit limit up to Rs. 5 cr, the limit shall be computed on the basis of Nayak Committee
formula as well as that based on production and operating cycle of the unit and the higher
of the two may be sanctioned.. The assessment will be based on the borrower’s projected
balance sheet, the funds flow planned for current/ next year and examination of the
profitability, financial parameters etc. unlike the MPBF method, it will not be necessary in
 this method to fix or compute the working capital finance on the basis of a stipulated
minimum level of liquidity (Current Ratio). The working capital requirement worked out
is based on the following:

i. CMA assessment method is continued with certain modifications.

ii. Analysis of the Profit and Loss account, Balance Sheet, Funds flow etc. for the
past periods is done to examine the profitability, financial position, and financial
management etc of the business.

iii. Scrutiny and validation of the projected income and expenses in the business and
projected changes in the financial position (sources and uses of funds). This is
carried out to examine whether these parameters are acceptable from the angle of
liquidity, overall gearing, efficiency of operations etc.

In the PBS method, the borrower’s total business operations, financial position,
management capabilities etc. are analysed in detail to assess the working capital
finance required and to evaluate the overall risk.

There will not be a prescription like mandatory minimum current ratio or maximum
level of a current asset. Under the method, assessment of WC requirement will be
carried out in respect of each borrower with proper examination of all parameters
relevant to the borrower and their acceptability. The assessment procedure is as
follows:

i. Collection of financial information from the borrower

ii. Classification of current assets / current liabilities

iii. Verification of projected levels of inventory/ receivables/ sundry creditors

iv. Evaluation of liquidity in the business operation

v. Validation of bank finance sought

ASSESSMENT UNDER MPBF METHOD :

(Rs. in Lacs)

2008-09 2009-10

Total Current Assets 1335.52 1420.20

Less: CL excl.Bank borrowings 445.79 272.66

Working Capital Gap 889.73 1147.54

Less: 25% of CA 333.88 335.05

OR Projected NWC 334.13 347.54

[whichever is higher]

MPBF 555.60 792.49

Limits Sought 555.60 800.00

As shown in the above, the actual bank borrowing as on 31.03.09 is within assessed MPBF. The

liquidity position. (C.A. certificate is submitted in this regard).

Though, the company achieved 50.88% of originally estimated sales, they have utilized the
sanctioned limits to the full extent. The company has now requested for renewal of existing FB
& NFB limits pleading that there is substantial increase in the level of inventories (raw material)
and book debts. The company is not expecting major turnaround during the CFY and has
estimated almost the same holding level during the CFY ’10. However, the company is
expecting a growth of 30% in sales volume during the CFY ’10.