Contents

1.

Financial Statements: ................................................................................................................ 2

2.

Financial Analysis ....................................................................................................................... 3

3.

Obtaining Financial Statements: ............................................................................................. 4

4.

Understanding Balance Sheet items: ..................................................................................... 5

5.

Understanding Profit & Loss account: ................................................................................. 16

6.

Contingent Liabilities: ............................................................................................................. 18

7.

Directors Report: ..................................................................................................................... 19

8.

Auditors Report:........................................................................................................................ 19

9.

Chairmans Speech:.................................................................................................................. 20

10.

Ratio Analysis: ....................................................................................................................... 20

11.

FUND FLOW ANALYSIS: ........................................................................................................ 33

12.

Cash flow statement: ........................................................................................................... 36

13.

Loan Policy: ............................................................................................................................ 36

14

Financial Indicators in Executive Summary:. ................................................................ 39

Page 1 of 40

UNDERSTANDING FINANCIAL STATEMENTS

1. Financial Statements:
1.1 Whether the business organization is a sole proprietary concern, partnership
or a Joint Hindu Family firm or a company registered under the Companies
Act, it has to maintain a record of all its assets and liabilities. They should
also maintain proper records of all transactions, receipts and payments. All
these transactions are written up and the accounts are finalised as at the
end of a twelve month period which will be the concern's accounting year.
The accounting year of a concern need not necessarily synchronize with the
calendar year. The period of the accounting year can be reduced or
increased with the permission of the appropriate authority. On finalizing the
accounts, a statement of profit & loss account and balance sheet is drawn
up.
1.2 Balance sheet and profit & loss account are different in character. Profit &
loss account shows the result of operations of the concern for a given period,
whereas balance sheet depicts the position of assets and liabilities of the
concern as on a particular day. The position of assets and liabilities of a
concern is influenced by its operations during a given period.
1.3 Financial statements are the most important supplier of data and information
about borrowers financial affairs. Financial statements enable a banker to
get a fair view about financial health of the borrower and working results.
Good lending decision essentially means lending to an enterprise with
sound financial health while persons behind it have strong personal qualities
like integrity, drive, foresight, wisdom and experience. A prudent Branch
Manager will not only know customers and their personal qualities but must
have a good knowledge about financial affairs of customers business in terms
of its operational efficiency, financial stability, liquidity and profitability.
Financial statements are statements showing financial figures but in Bank we
generally use the term to mean profit & loss account and balance sheet.
1.4 A set of financial statements includes
1.4.1 Profit and Loss account for a period, generally a year
Page 2 of 40

1.4.2 Balance Sheet at the end of such period

1.4.3 Cash flow statements
1.4.4 Explanatory schedules or notes forming part of the above statements
1.4.5 Auditors report and Directors report
2. Financial Analysis
2.1

Financial analysis is a tool for making objective decision on bank lending.

Such analysis would cover both past and futuristic financial data. Analysis is
a process of breaking down a complex set of facts and figures into simple
elements and interpretation involves their critical examination and drawing
of conclusions from the simplified statements. The various steps in
analysing and interpretation of Financial Statements are as follows:

2.1.1 Obtaining Financial Statements.

2.1.2 Understanding various items in Financial Statements.
2.1.3 Computation of various Financial Ratios.
2.1.4 Preparation of Funds Flow/Cash flow Statement.
2.1.5 Critically examining the Ratios and Funds/Cash Flow Statement in
conjunction with other relevant information and drawing conclusions.
2.2

A critical analysis of financial statements of a business enterprise is of

crucial importance for the lenders to assess the prospects of the enterprise
both from a short term and long term perspective.

2.3

It is not only to ensure that the short term liquidity prospects of the
company are strong, but also to assess the soundness of debt equity
structure, long term solvency and long term debt servicing capabilities of
the company.

2.4

Analysis of Balance sheet and Profit & Loss Account over a period of years is
an important tool in the hands of the lending institutions to assess the
financial position of the borrower and his requirements.

2.5

The auditors certificate and the report of the Board of Directors (in case
of limited companies) together with the notes of the auditors on the
financial statement should be carefully examined as it has bearing on the
borrowers financial position.

Page 3 of 40

2.6

Audited Balance Sheet of the applicant/borrower for the last 3 years should
be obtained and analyzed. If the latest audited balance sheet is not yet
ready, a certified unaudited provisional Balance Sheet and Profit and Loss
account of the company may be obtained together with all schedules.

2.7

If break up of any item in the Balance Sheet and Profit and Loss Account is
not available, the borrower/applicant is to be requested to furnish the
required information.

2.8

While studying the balance sheet, the report of the auditor on the same
must be carefully gone through, particularly for any qualifications by
auditor. Many a time, the qualifications may be the result of certain
observations in the 'Notes to Accounts'. The qualification of the auditor in
his report would mainly cover matters like change in accounting
policy/accounting treatment of a particular item, no/under provisioning of
certain items of expenses etc. A study of accounting policies of the entity
in the annual accounts like method of valuation of stock, calculation of
depreciation etc, thus would provide better appreciation of the auditor's
report. The credit officer, who is analysing the balance sheet, should
therefore look into 'Notes to Accounts' as well together with 'Audit Report'
to form proper judgment on the financial position of the entity. While
gauging the impact of 'Notes to Accounts' and 'Audit Report' on the overall
financial position and bottom line of the entity the 'Concept of Materiality'
must be considered. If the observations have material bearing on the
annual accounts, then it must be remembered to consider the aspect
before interpreting financial statements and other ratios.

3. Obtaining Financial Statements: The first step is to obtain the Financial

Statements for at least last three years. Before accepting the Balance Sheet
for analysis, the following points may be observed:
3.1

It is set out in such a way that it is possible to work out the value of
different classes of assets and liabilities.

3.2

It indicates basis of valuation of assets.

3.3

It contains a certificate from Auditors to the effect that it gives true &
fair view of financial affairs of the company.
Page 4 of 40

3.4

The Auditors who have examined the Balance Sheet and certified it are
qualified Chartered Accountants and have a good reputation

3.5

It has been signed by Directors

3.6

The Directors who have signed it have a good reputation.

3.7

It should be accompanied by the Auditors Report and the Report should be

carefully examined. If there is any significant or qualifying remark made by
auditors which may have a bearing on the assessment of the Balance Sheet,
a note should be made of it and used appropriately while analysing.

3.8

The Directors Report should be carefully gone through. Any material

information given therein which has not been stated in Balance Sheet
should be carefully noted. For example, any plan for expansion or for
renovation and modernization of the plant will find a mention in the
Directors Report. As the execution of plans will require additional funds,
these should be taken into consideration in relation to lending propositions
being considered by bank. Similarly, changes in the composition of Board of
Directors and other changes at the top managerial level are indicated in
the Directors Report and the bank should assess their possible repercussions
on the management and financial position of the company. In brief, the
Directors Report should be carefully gone through and all material
information contained therein used both for analysis as well as
interpretation.

4. Understanding Balance Sheet items:

4.1

The Balance Sheet is the main document which the bankers take into
account to examine the financial position of the business organization.

4.2

It is a statement of Assets and Liabilities on a given date.

4.3

The Assets are what the business organization owns. The Liabilities are
what the business organization owes.

4.4

The concept of current assets and current liabilities occupies a very

important position in the analysis of financial statements by a lending
banker.

Page 5 of 40

4.5

The assets and liabilities are divided into the following convenient groups
for the purpose of proper analysis of the Balance Sheet:
Liabilities

Assets

1.Owned Funds

1.Fixed Assets

2.Long Term Liabilities

2.Non Current Assets

3.Current Liabilities

3.Current assets
4.Intangible Assets

4.6

LIABILITIES:

4.6.1 Owned funds:

4.6.1.1

Capital or Paid-up Share Capital:

4.6.1.1.1 These are the funds which the promoters of the business or the
shareholders bring in to start with or which may be increased
subsequently by fresh additions.
4.6.1.1.2 In case of non corporate organizations, the profits earned by the
business are also added to the capital and the losses incurred reduce
the level of funds.

The withdrawals made by the promoters are

deducted and what is left is the capital. The additional fund infused
during the financial year is added to the capital.
4.6.1.1.3 The increase or decrease in capital is indicative of the health of the
concern as well as interest, which the promoters are taking in the
business. Any increase is indicative of the continued interest and the
personal financial strength and any reduction may signal lack of interest
and problems in managing the business. The decrease of capital by way
of withdrawal also increases the leveraging of the unit.
4.6.1.1.4 In respect of corporate organizations, types of capital could be
Authorized Capital (the extent upto which the capital can be raised),
Issued Capital (the extent upto which it is intended to be raised),
Subscribed Capital (the extent upto which the issued capital has been
subscribed) and Paid Up Capital (the extent upto which it has actually
been called and received against subscription)

Page 6 of 40

4.6.1.1.5 The paid-up capital once added cannot be reduced, although indirectly
erosion thereof may take place because of losses.
4.6.1.1.6 Capital is the most important liability signifying the promoters stake.
4.6.1.2

Share Application Money:

4.6.1.2.1 It is the money collected from the subscribers along with the application
form. The amount so held under the head share application money is
transferred to the paid up capital/share premium to the extent of the
shares allotted and the balance is to be returned back to the subscribers
if not allotted.
4.6.1.2.2 As per SEBI guidelines, in case of public limited companies, the share
application money is to be either allotted or returned with a specified
period of 4 to 8 weeks. However, this guideline is not applicable to the
private limited company.
4.6.1.2.3 Since share application could be returned any time, hence same is to
be treated as Current Liability, if it is not converted to share capital
within a justified time period.
4.6.1.3

Reserves: The reserves represent the surplus of income from the

business over the years, or earmarking of funds out of the profits for
particular purpose, or the funds received as premium or subsidy, etc.

4.6.1.3.1 Share Premium reserve: This reserve is applicable only to companies

and its existence in the books of an organization is a positive
indication. The corporate bodies, because of their better financial
standing in the market, go in for an issue of capital on premium. The
amount reflecting par value is placed under the paid up capital and the
amount of premium collected is shown as share premium reserve.
4.6.1.3.2 Capital subsidy Reserve: Government in order to develop certain areas
into industrial belts provides incentives to the promoters by way of
subsidy on the investment in fixed assets for creation of manufacturing
facilities. Such subsidy is not returnable once it is received and it forms
permanent part of the owned funds of the promoters.

Page 7 of 40

4.6.1.3.3 Revaluation Reserve: In the Balance Sheet, fixed assets are shown on
a historical cost basis. At times the business entity goes in for
revaluation of its assets to reflect their true value at that particular
time. While showing the assets at higher value than the existing book
value, the liability in the shape of revaluation reserve is created. It is
not a direct result of profits earned by the organization and it does not
in any manner enhance the actual funds available to the business. It is
only a notional item created as a result of book entries. Since, the
increase in the book value of fixed assets is on account of
revaluation under the assets side and also the revaluation reserve
under the liability side (notional entries), therefore it is not
considered for Net Worth calculation purpose.
4.6.1.3.4 Share/Debenture/Bonds Redemption reserve: As a prudent policy, the
concerns make provision for payment of debenture or bonds or
redeemable preference shares whenever redemption thereof falls due.
This is also called a Sinking Fund and it is generally invested in specific
securities to get good return. The balance left out of sinking fund can
be treated as part of the free reserves.
4.6.1.3.5 General Reserve: The reserves created out of profit without
earmarking for any specific purposes, are known as free/ general
reserves which are freely available to the shareholders. The free
reserves can be capitalized either by making partly paid-up shares as
fully paid-up or by issuing bonus shares subject to fulfillment of certain
conditions.
4.6.2 Long Term Liabilities:
4.6.2.1

Term Loans raised from Banks /Financial Institutions: Term loans are
very popular mode of finance for meeting long term business
requirements. The amount which falls due within 12 months from the
date of balance sheet, are taken as part of the current liabilities.
The balance amount after carving out the current liability portion as
above is considered as long term liabilities.

Page 8 of 40

4.6.2.2

Unsecured Loans from friends & relatives: Sometimes there may be

unsecured borrowings from friends and relatives. The treatment of this
entry whether as a long term liability or short term liability or as a
quasi capital, depends on the nature of the entry and also the
repayment terms. If such loan is taken to tie-up temporary liquidity
problems of the business and is to be repaid within the next financial
year i.e. within next 12 months period, then the loan is to be classified
as current liability. If such loan is repayable beyond the period of 12
months, then the loan is to be classified as long term liability.
Generally, the margin money is brought in by the promoters by way of
equity. However, sometimes, it is proposed to be brought in by way of
unsecured loans by promoters/ family members. Such unsecured loans
shall be treated as quasi equity in compliance with guidelines
enumerated in Loan Policy of the Bank.

4.6.2.3

Debentures: Debenture is a document acknowledging a debt by the

company tradable in the capital market. As a source of finance, the
business organizations may resort to borrowing in the shape of
debentures. It may be secured or unsecured. Depending on redemption
it may be Redeemable (Specific date of redemption) or Irredeemable.
Depending on convertibility it may be Non-convertible, partially
convertible, fully convertible or optionally convertible. It is in the
nature of loans raised by companies from the general public and
institutions. A private company cannot issue debentures by making an
invitation to general public through prospectus. They can raise funds
by issuing debentures through private placements. The redemption of
such debentures whenever falls due, has to be made and the interest is
continuously paid without any default till the principal is repaid. The
debentures become redeemable after a particular specified time which
may be at par, discount or premium. Any portion of such debentures
which falls due within 12 months from the date of the balance sheet
need to be taken as part of the current liabilities.

Page 9 of 40

4.6.2.4

Preference Share Capital: Preference share capital is a source of longterm funds available to companies for financing their operations.
Preference shares must be redeemed within a period of 20 years or
within the period for which the preference shares have been issued,
whichever is earlier. The amount of preference share capital to be
repaid within one year should be treated as current liability. The
preference shares maturing after 12 years could be added for the
purposes of computation of Net Worth. The arrears of cumulative
preference dividends can be treated as a contingent liability and this
crystallizes and becomes a current liability only when the company has
a distributable profit and decides to declare dividends to its equity
shareholders.

4.6.3 Current or Short-term Liabilities:

4.6.3.1

Current liabilities are those repayment of which is usually to be made

shortly i.e. within 12 months.

4.6.3.2

Current liabilities provide a source of funds and help the business to

tie-up short term liquidity problems. At the same time they could also
cause liquidity crunch since they have to be repaid within a short span
of time.

4.6.3.3

Various short term (current) liabilities are as under:

4.6.3.3.1 Short term borrowings from banks/others in the form of cash credit /
Pre shipment credit /Bills purchases or discounted.
4.6.3.3.2 Unsecured loans of short term nature from friends, relatives, business
associates, private financiers or by way of commercial paper
4.6.3.3.3 Public deposits maturing within one year
4.6.3.3.4 Sundry trade creditors or bills payable for raw material/consumable
stores/spares and services.
4.6.3.3.5 Bills purchase limit under LC
4.6.3.3.6 Advances received against goods to be supplied
4.6.3.3.7 Inter corporate deposits (ICDs) taken

Page 10 of 40

4.6.3.3.8 Installments of term loans, deferred payment credit, debentures,

preference shares etc, payable in the period of 12 months from the
date of the balance sheet.
4.6.3.3.9 Expenses payable
4.6.3.3.10 Statutory liabilities like PF dues, provision for taxation, sales tax etc.
4.7

ASSSETS:

4.7.1 Fixed Assets:

4.7.1.1

These are the assets which are of relatively permanent nature and it is
with the help of these assets the business is carried on.

4.7.1.2

They are carried over from year to year and put to use to produce
merchandise.

4.7.1.3

A small portion of these assets is written off every year in the shape of
depreciation.

4.7.1.4

Whether the asset is a fixed asset for a concern is determined by the

nature of its business i.e. for a vehicle dealer, vehicle is a current asset
and for SSI unit it may be a fixed asset.

4.7.1.5

The financing of fixed asset should be from long term funds.

4.7.1.6

Gross Block represents the original cost of fixed assets and increase and
decrease in fixed assets is in reference to Gross Block.

4.7.1.7

Depreciation is calculated against each category of fixed assets. The

net of gross block after adjustment of depreciation is Net Block.

4.7.1.8

Examples of fixed assets are:

4.7.1.8.1 Land: This asset can be on ownership basis or on leasehold basis and
with the passage of time it appreciates in value. The land should be
adequate not only to meet the present requirement but near future
expansion purpose also.
4.7.1.8.2 Buildings and structures: Buildings and other structures are needed for
installation of Machinery and equipment, storage of raw material, etc.
4.7.1.8.3 Machinery, Tools and equipments: The machinery and equipment
selection is important from the aspect of balancing as well as optimum
use thereof. The extent of use of the capacity and further expansion are

Page 11 of 40

to be studied. Plant & machineries and equipments are subject to

depreciation.
4.7.1.8.4 Furniture and fixtures: These items also are subject to depreciation.
The amount spent on these assets should be as per actual requirement.
4.7.1.8.5 Capital work in progress or advance against fixed assets: The building
under construction or machineries under installation are basically fixed
assets which will be put to use on completion of process of construction
or erection or testing. The process to be completed as per the pre
determined schedule.
4.7.1.8.6 Leaseholds/leased assets: The term leasehold usually refers to
immovable property taken on lease. Mostly contract for the leasehold
immovable properties tends to cover a fairly long period and lease
contracts covering 99 years are quite common. The leasehold period
covering land and sheds leased out by the Industrial Area Development
Authorities are usually 33 years in a majority cases. These assets are
shown in the balance sheet at the cost of acquisition of the assets and
are treated as properties owned by the enterprise. Some of the lease
deeds confer the right to the leaseholders to mortgage, sub lease and
such other rights which can be exercised only by the owner.
4.7.2 Non-Current Assets (Including Investments):
4.7.2.1

These assets are neither current nor fixed assets going by their use.
Many a times they may be unrelated to the day to day business
operations.

4.7.2.2

The non-current assets normally include:

4.7.2.2.1 Various deposits with Government Authorities, e.g. electricity deposit,

telephone deposit, security deposit with ST authorities, etc
4.7.2.2.2 Various advances granted to employees under staff welfare measures.
4.7.2.2.3 Obsolete , non consumable spare parts and stores
4.7.2.2.4 Investment in non-marketable securities, in Government securities,
loans/investments to/in sister or allied or associate firms.
4.7.2.2.5 Investments in shares quoted or unquoted and debentures. (Other than
temporary investment in Money market instruments)
Page 12 of 40

4.7.2.2.6 Inter corporate deposits

4.7.2.2.7 Advances to suppliers of capital goods.
4.7.2.2.8 Deferred receivables other than those maturing within one year etc
4.7.2.3

There may be cross-holding investment i.e. the investment made by

a company in its subsidiaries and the subsidiary has also made any
investment in the holding company. It is necessary to net out the
cross holdings in order to get a clearer picture of a group of
enterprises.

In

case

of

substantial

investment

in

group

concerns/subsidiaries, the solvency of the borrower may also be

evaluated on adjusting such investment from TNW.
4.7.3 Current Assets:
4.7.3.1

These are the assets which are required by the business for the purpose
of re-sale and arise out of usual business dealings.

4.7.3.2

These are held temporarily for subsequent conversion into cash within a
short period of say, not exceeding 12 months.

4.7.3.3

These are liquid assets which determine the ongoing solvency position
of the business.

4.7.3.4

The financing of current assets should partly be from the long term
funds and partly the current liabilities.

4.7.3.5

For a land developer, a plot of land is a current asset while for others it
may be a fixed asset.

4.7.3.6

Following are the some of the current assets:

4.7.3.6.1 Cash and Bank Balances: The cash being the most liquid asset for any
business may be a very genuine requirement, but its holding must be
reasonable, as otherwise, there would be either shortage of ready cash
or idle cash lying unused. The cash and bank balances and the fixed
deposits (whether under lien or not) with banks are classified as
quick/current assets along with margins deposited for LCs and
Guarantees relating to Working Capital.
4.7.3.6.2 Receivables / Book Debts / Sundry Debtors: It is a common practice in
most of the industries to allow certain credit on the goods sold. There
are two types of receivables i.e. bills receivables where the payment is
Page 13 of 40

due on a particular day and general receivables where payment is not

fixed on a particular maturity date. Though overall quantum of
receivables is important, the details of age-wise individual debtors is to
be analysed since some debtors might not have been paid for long.
Debtors outstanding for more than 6 months are to be generally
considered as non-current assets. Details of debtors should be
examined and comparison from year to year should be made with
regard to the efficiency of the organization in management of its
debtors. Where the debtor is a government department, there may be
long receivable cycle, but the payment would generally not be in
doubt. In such cases, with proper justification, even though receivable
is more than 6 months old, the same can be treated as current assets.
Increase in debtors without increase in sale indicates poor management
of receivables or change in business model.
4.7.3.6.3 Installment of deferred receivables due within one year: The
business concerns engaged in sale of items of capital nature such as
manufacturers or dealers in vehicles, sellers or manufacturers of
machinery etc. have to supply the goods on a longer credit basis at
times extending over several years. In such cases, the amount of
receivable

due for payment within 12 months would be considered as

part of the current assets while the balance would be taken as noncurrent assets. These transactions are generally covered by guarantees
from banks or financial institutions.
4.7.3.6.4 Raw materials / other consumable spares: Certain items of stock like
raw material and other components used in the process of
manufacturing have to be held in sufficient quantity to ensure
uninterrupted manufacturing process. Holding of excess inventory of
raw material may not be of any use to the business concern and at
times it may result into avoidable carrying cost. However, due
weightage should be given to the seasonal availability and overall
conditions of availability of the items, for instance, the raw material is
imported from other countries, then there has to be storage of large
quantity as compared to indigenous one. Raw material available on
Page 14 of 40

quota basis will have higher holding as compared to the one available
in the open market. Similarly, the raw material having longer Lead
period has to be in bigger quantity than the one having shorter lead
period. The age of the stock of raw material may also to be examined
and if it is obsolete and unusable then the value of such stocks should
be considered as non-current assets.
4.7.3.6.5 Stock in process / semi finished goods: The raw material which is
fed into machines for processing in order to manufacture a final
product is accounted as stock in process. The valuation of stock in
process takes into account the other manufacturing expenses such as
wages, power and fuel, etc. incurred in connection with the process of
manufacture. The level of stock in process at a given point of time
would relate to the level of operations or utilisation of the machinery
for manufacturing.
4.7.3.6.6 Finished goods: The maintenance of a minimum level of finished goods
at a level commensurate to the size of operations is necessary to run
the business smoothly. The level should not be unduly high as that
would bring the element of old stocks with the passage of time. Any
old stocks or obsolete stock or non moving stock are to be considered
and classified as non current asset. The valuation of raw material,
stock in process and finished goods is to be done at cost price or
market price whichever is lower.
4.7.3.6.7 Advance payment of tax: The business entities pay tax as per self
assessment which is shown as advance payment against the final
liability.
4.7.3.6.8 Other items under current assets: It includes advances for purchase of
raw materials, components and consumable spares, Pre paid expenses,
Receivables in the form of bills drawn under LCs, Dues from associate
and subsidiary companies in the form of receivables for genuine trade
transactions and Short term investments, temporary investments in
money market instruments like Commercial Paper, Certificate of
Deposits, etc. which are for the purpose of parking short term surplus.

Page 15 of 40

4.7.4 Intangible / Fictitious Assets:

4.7.4.1

There are certain expenses like preliminary expenses to the extent not
charged to the profit & loss account, discount allowed on issue of
shares or debentures, etc. which appear in the asset side of the
balance sheet.

These are fictitious assets which do not carry any

intrinsic value. These expenses are not charged to the profit & loss
account either fully or in part during the year in which such expenses
are incurred, as it can be carried forward over a period and charged
only a portion of it to profit & loss account every year.
4.7.4.2

Another category of items like goodwill, patents, copyrights, trademark

rights, brand equity, etc. are also shown under Intangible assets. These
items represent monetary values of different rights enjoyed by the
business enterprise and are therefore considered as assets. These are
qualitatively better assets than the fictitious assets which represent
nothing but expenses carried forward by a company. Goodwill, Patents,
etc. are shown under the fixed asset head in the balance sheet. Hence
it becomes necessary to verify the fixed assets break up also to ensure
whether there are any intangible assets in the balance sheet.

4.7.4.3

Branches should take the value of both intangible and fictitious items
and subtracted them from the net worth of the concern.

5. Understanding Profit & Loss account:

5.1

Profit & Loss account provide information on the operations of the

enterprise.

5.2

A business organization not set up for the purpose of earning profit should
prepare an Income & Expenditure statement instead of Profit & Loss
account.

5.3

A profit and loss account is prepared under following heads:

5.3.1 Trading/Manufacturing Account: Its object is to derive Gross Profit after

charging all variable costs and depreciation to income arising out of sale of
goods - net of sales return and excise duty payable.
5.3.2 Profit & Loss Account: Its object is to derive surplus or deficit generated
from the operation of the enterprise after charging all other costs of
Page 16 of 40

business for the year as for example, administrative and general expenses,
selling and marketing expenses, distribution expenses, interest on
borrowings, provision for bad or doubtful debt etc. to the Gross Profit
derived above.
5.3.3 Profit & Loss Appropriation Account: Management has to decide how
much they would like to set apart from profits for different purposes
before transferring the balance of profit to Balance Sheet.
5.3.3.1

Provision for repayment of capital/term liabilities,

5.3.3.2

Provision for taxes,

5.3.3.3

Provision for different contingencies,

5.3.3.4

Asset replacement reserves and other specific reserves and general

reserves etc.,

5.3.3.5
5.4

To pay dividend to the owner of business etc.

The manufacturing/trading account will show manufacturing/trading

income on right side and expenses as well the resultant gross profit on the
left side. The general profit and loss account will open with the gross
profit/loss and end with the net profit/loss. The appropriation account will
show the appropriation of net profit under various heads.

5.5

The P&L statement prepared by the business units may serve the purpose
of the shareholder, the government and the tax authorities.

Hence,

rearrangement of the various items of income and expenses is necessary for

the purpose of undertaking a meaningful analysis and taking a credit
decision.
5.6

The real protection to the lender is the ability of the concern to perform
well and make a reasonable profit and this information will be available
only in the profit and loss account. A weak balance sheet may not
necessarily represent a bad credit risk if profitability is good and is
improving from year to year. Conversely, a concern with a sound balance
sheet may not be a good credit risk, if it is incurring losses consistently.

5.7

Branches should ensure that amounts of expenditure shown in profit and

loss account are not exorbitant or unduly high in relation to the nature of
the activity. It may so happen that there is a spurt in office expenditure in
a particular year, which drains away the profit of the concern. If the
Page 17 of 40

interest paid appears to be rather high in relation to the interest charged

by the Bank, reasons therefore should be ascertained, particularly when
there are covenants and non-interest/low interest bearing deposits should
be brought in and/or the concern should not resort to outside borrowings.
5.8

The Tandon Committee (1974) had prescribed a format for operating

statement in which the various items of profit and loss items are shown in
tune with the bankers priority. This form is incorporated in CMA (Credit
Monitoring Arrangement), under Form- II. The main purpose of structuring
the operating statement is to standardize the calculation of annual
consumption of raw material & consumable, Cost of Production, Cost of
Sales, Operating profit etc. Operating profit is calculated in two stages
before and after charging interest.

5.9

A careful scrutiny of the profit and loss account will also reveal, whether
all the usual expenses are accounted for or not. Otherwise enquiries should
be made with the borrower. Adjustments at the yearend play a vital role in
determining the net profit. Usual adjustments are as under:

5.9.1 Basis of valuation of inventory should be consistent and as per accepted

mode.
5.9.2 Rate and mode of depreciation should be consistent and full amount should
be provided for.
5.9.3 Adequate provision for accrued liabilities and outstanding expenses should
be made.
5.9.4 Provision for Bad and Doubtful Accounts should be adequate.
5.9.5 Efficiency of operations should also be assessed by study of various ratios.
5.9.6 Different groups of expenses like financial expenses, Selling and
distribution expenses, Administrative expenses etc. should also be studied.
6. Contingent Liabilities:
6.1

These items are indicated by way of a foot-note in the balance sheet as

they are not prima facie crystallised liabilities affecting the overall liability
position.

6.2

Hence, very often sufficient attention is not paid to study them carefully.
However, a closer look at these items may, many a times, reveal that they
Page 18 of 40

often include liabilities/commitments with serious financial implications,

which may have adverse impact later on.
6.3

For example, claims not acknowledged as debts, payment for capital

contracts not provided for, Bank Guarantee etc.

6.4

Similarly, issues of far-reaching implications like change in the accounting

practices and procedures, as also special accounting treatment given to
certain transactions are quite often included under this heading.

6.5

Each and every special comment should be carefully and critically analysed
to understand its implications for the amounts included in the balance
sheet e.g. liabilities under leasing agreement etc.

6.6

Particular care should be taken to fully satisfy that the company has made
satisfactory arrangements for meeting capital commitments in case of
crystallization of contingent liabilities.

7. Directors Report: Under Companies Act, the Directors of the company are
obliged to make a report on the companys performance for the year under
review. It will offer explanation to the qualification raised by the auditors in
their report, material changes having financial implications which might have
taken place after the date of Balance Sheet but before the date of Annual
General Meeting. Examples of such changes are change in capital structure,
decline in market value of investment, purchase and sale of plant & machinery
etc. Besides, they are also expected to comment on technology absorption by
the company during the year, energy conservation measures taken by the
company and its impact on cost of production as well as steps taken to
augment export sales.
8. Auditors Report: On the conclusion of audit of financial statements, the
auditors are statutorily required to study as to whether the financial
statements present true and fair picture of the financial position of the
company and its profit. Their report will be qualified if it is otherwise. Auditors
report would be qualified if there is a change in method of depreciation,
change in basis of valuation of inventories, violation in accounting standards
and practices etc. Besides, they are also required to quantify the effects of
Page 19 of 40

such change on profit or loss of the year. Furthermore, under Companies Act,
many class of companies engaged in production, processing manufacturing,
mining activities are required to keep proper books of accounts (cost records)
relating to utilisation of material, labour, overheads, etc. Auditors are also
required to comment whether or not cost records, as prescribed, have been
maintained. Any adverse comments on cost classification and cost records is to
be taken seriously while scrutinising and accepting the operating statements of
the company.
9. Chairmans Speech: Though not statutorily required, companies have
developed a good practice of enclosing an extract of Chairmans speech to be
delivered in the Annual General Meeting. The contents of such speech mostly
centre around the external environment and the economy and its impact on
the business performance of the company, State of affairs of the industry and
the class of business to which the company belongs and the companys future
plan, prospects and programme in general terms.
10.
10.1

Ratio Analysis:
Ratio analysis is of prime importance in the analysis and interpretation of
balance sheet and Profit and Loss Account. Any study thereof, will be
incomplete without ratio analysis.

10.2

Generally, the financial statements are compiled and presented with a

focus to the information needs of the owners and Government.

10.3

On the other hand, a lender looks at the financial statements from the
entirely different angle to derive meaningful conclusion, to test the
sustainability of figures under different stress conditions and to compare
with the figures of other similar enterprises, to ascertain the level of
strength and capacity to repay the borrowed funds.

10.3.1 Intra Firm Comparison: A single financial ratio of any one year does not
provide a meaningful basis for its evaluation. Rather when any individual
financial ratio or group of such ratios as at a particular date is compared
against or similar financing ratio or group of ratios of previous years for the
same business enterprise (intra firm), a clearly discernible trend emerges
Page 20 of 40

in respect of those parameters under study. It is possible then to comment

whether performance of the enterprise in the relative year in relation to
that particular parameter is showing increasing trend, decreasing trend or
erratic trend or stagnation.
10.3.2 Inter-Firm Comparison: On the other hand, a particular parameter for a
particular year may be compared with similar type of business enterprise(s)
dealing in similar types of goods and services called average industry
group. Average industry group ratio provides a rational basis to adjudge the
financial performance of the individual business enterprises. While
processing the proposal, the processing officer may compare units
performance with Industry average on certain important financial
parameters like sales growth, PBDIT/Net Sales, PAT/Net Sales, Debt equity
ratio, current ratio etc. and the working capital needs of the company
being assessed should also compare reasonably well with Industry average.
In case of deviations, if any, should be identified and recorded in the note
with proper justification.
10.4

The financial statement analysis is the process of selection, relation and

evaluation of the information to examine the financial soundness in terms
of long term viability (net worth), short term viability (liquidity position),
the profitability and growth.

10.5

The ratio analysis is considered to be one of the most appropriate methods

for analysis by banks.

10.6

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.

10.7

Before going in for such analysis in detail, Tangible Net Worth of the
business unit is to be calculated based on the Balance sheet, in the
following manner:
Net Worth (NW) =

Capital + Reserves & Surplus (Excluding

Revaluation Reserve.)

Tangible Net Worth (TNW) =

Net Worth - Intangible Assets

Page 21 of 40

10.8

The various types of ratios computed by the lenders are discussed herein
below:

10.8.1 LIQUIDITY RATIO: Working capital requirements are treated as short term
credit requirements and it is to be examined whether the loan is likely to
be repaid on demand. This is possible only if the current assets are liquid
enough or proceeds of the current assets are adequate to repay the dues of
the bank on demand. Liquidity ratio indicating an innate relationship
between the current assets and current liabilities of an enterprise.
10.8.1.1 Current Ratio:
10.8.1.1.1 Current Ratio is expressed as under:
Current Ratio

Current Assets / Current liabilities

10.8.1.1.2 Current ratio is not only a measure of the companys liquidity but also
shows the margin the company has for its current assets to shrink
before it gets into difficulty in meeting its current obligations.
10.8.1.1.3 If the company has a rapid turnover of inventory and can easily collect
its receivables, the ratio can be somewhat lower.
10.8.1.1.4 Since minimum contribution by way of NWC from long term sources
of funds is normally not contemplated in respect of export
receivables, the current ratio may be lower in case of export
accounts.
10.8.1.1.5 If the ratio drops to less that 1:1, caution should be exercised since
current liabilities are greater than current assets, the company is in an
unstable situation. In many such cases, the company may be only
marginally profitable or unprofitable. Furthermore, the company
might be following the unsound practice of buying fixed assets with
short-term sources. Caution should also be exercised if the current
ratio has been dropping over a successive period of several years.
10.8.1.1.6 However, slippage of current ratio within permissible limits during the
commissioning and initial years of operation may not be adversely
looked upon.
10.8.1.1.7 As a Bench Mark level, the Current Ratio should normally be 1.33:1
which would reasonably take care of the short term liquidity. This
means that the promoters margin by way of Net Working Capital
Page 22 of 40

should be atleast 25% of the current assets. However, as per the Loan
Policy, the acceptable level of Current Ratio is taken as minimum of
1.17:1.
10.8.1.1.8 In some cases, the lower current ratio may be due to large amount
of term loan installments falling due in next year which is classified
as current liability. In such cases, the low current ratio need not
be seen as a problem, if the borrowers cash generations are
adequate to service the installments due next year.
10.8.1.1.9 For an existing borrower, where a lower current ratio is projected,
there is a need to examine further the overall quality of liquidity in
the business and where warranted sanction can be accorded with a
condition that the borrower should bring in additional long term funds
to a specified extent by a given future date and suitable written
commitment should be obtained from the borrower.
10.8.1.1.10 The movement of Current Ratio (CR) should be read in conjunction
with the movement of Net Working Capital (NWC) in order to arrive at
a proper and meaningful conclusion.
10.8.1.2 Acid Test or Quick Ratio:
10.8.1.2.1 This is a refinement of current ratio and here "Quick Assets" are
related to "Quick Liabilities".
10.8.1.2.2 The former include all current assets excluding inventory and the
latter include all current liabilities excluding bank borrowings and
quick ratio is arrived at as under:
Quick Ratio = (Current Assets Inventory)/(Current Liabilities - Bank
Borrowings)
10.8.1.2.3 It may be seen from the relationship that debtors are included in
Quick Assets and hence care should be taken to exclude debtors of
longer maturity. Sometimes for arriving at the quick ratio the total
current liabilities, including bank borrowings, are also taken into
account.

Page 23 of 40

10.8.1.2.4 If the quick ratio is low but current ratio is high, it may mean that the
company is carrying too high an inventory and is not able to sell its
finished products.
10.8.1.2.5 In interpreting liquidity ratio, consideration of the proportion of
various types of current assets is also important. It is, therefore,
necessary that proportion of different current assets to their total as
well as their condition should be taken into account before concluding
that the liquidity of the concern is favorable.
10.8.2 LEVERAGE OR SOLVENCY RATIOS: These ratios throw light on the long
term solvency of the business unit reflected in its ability to assure the long
term creditors with regard to periodic payment of interest and principal at
due dates. These ratios help to answer as to what is the stake of the
owners in the business in relation to stake of long term lenders. If the ratio
is abnormally high, it means creditors (including Bank) have invested in
business more than owners, hence may suffer more in terms of distress
than owners. Following are the various important ratios.
10.8.2.1 Debt Equity Ratio: (DER)
10.8.2.1.1 It shows the dependency of the unit on outside long term borrowed
finance.
10.8.2.1.2 An organization can have a good current ratio and liquidity position,
but this liquidity might have come from the long term borrowed funds,
the repayment of which along with the interest may put the liquidity
under pressure.
10.8.2.1.3 The higher the ratio, the more strain on the liquidity of the
organization.
10.8.2.1.4 DER is worked out as under:
Debt Equity Ratio

= Total Long Term outside liabilities /

Tangible Net worth

10.8.2.2 TOL/TNW ratio:

10.8.2.2.1 It shows the dependency of the organization on the total outside
borrowings i.e. both long term as well as short term borrowings.
Page 24 of 40

10.8.2.2.2 It is worked out as under:

TOL

TNW

ratio (Total Long Term outside liabilities +

Current Liabilities) / Tangible Net worth

10.8.2.3 TOL/TNW ratio along with contingent liability:

10.8.2.3.1 It shows the solvency of the organization in term of total outside
liability including NFB liability.
10.8.2.3.2 It is worked out as under:
TOL/TNW ratio along with (Total Long Term outside liabilities +
contingent

liabilities Current Liabilities + Credit Conversion

Factor X Non-Fund Based facility) /

Tangible Net worth

10.8.3 COVERAGE RATIO: These ratios indicate the amount of borrowed funds
utilized to the proportion of shareholders funds to finance the assets.
Following are the various ratios:
10.8.3.1 Debt Service Coverage Ratio: (DSCR)
10.8.3.1.1 It is a comprehensive ratio indicating the capability of the unit for
servicing both the interest and principal installments of the long term
debt.
10.8.3.1.2 It is used in the appraisal of long term credit facilities.
10.8.3.1.3 It may be calculated for individual term loans as well as all the term
loans taken together. The overall DSCR for all the term loans taken
together would show a more realistic picture.
10.8.3.1.4 Since the term loan proposals are assessed on the basis of accepted
projections for a number of years, DSCR is to be calculated for the
individual years. Then average DSCR to be worked out by dividing the
total cash accrual over the entire period of the project by the total
repayment obligation.
10.8.3.1.5 The average DSCR should not be calculated by averaging the yearly
DSCRs.
Page 25 of 40

10.8.3.1.6 In the event of average DSCR being on higher side, it may be suggested
that the repayment period of the proposed term loan can be reduced,
as the borrower has capacity to pay increased amount as installment.
10.8.3.1.7 DSCR is computed as follows:
DSCR

(Profit after tax + Depreciation + interest on term loan) /

(Annual Principal installments + interest on term loan)

10.8.3.1.8 In some industries like real estate, wherein cost of project funded
by term loan/advance from customer/promoters contribution is
adjusted from profit and loss account, than Debt repaying capacity
of the borrower can be calculated based on net cash flows from the
project.
10.8.3.2 Interest Coverage Ratio:
10.8.3.2.1 This ratio indicates the companys capacity to service the total
interest burden of the company.
10.8.3.2.2 Normally all interest pertaining to various creditors, charged to the
profit & loss account are included in computing this ratio to get a
broader picture of the servicing capability of the unit.
10.8.3.2.3 It is calculated as under:
Interest
Ratio

coverage (Profit before tax + Depreciation + interest) /

=

Interest

10.8.3.3 Fixed Assets Coverage Ratio:

10.8.3.3.1 Term loans are usually secured by Fixed Assets.
10.8.3.3.2 The excess of fixed assets over term loans secured by them provides
margin on security.
10.8.3.3.3 The ratio is useful to find out the available security cover for the term
loan i.e. the number of times the value of the Fixed Assets cover the
amount of loan.
10.8.3.3.4 It is computed as under:
Fixed

Assets (Net Fixed Assets (i.e. after providing for

Coverage Ratio

depreciation) + Capital work-in-progress)/ Long

Page 26 of 40

term debts secured by Fixed Assets

10.8.4 Profitability / return ratios: Profitability indicates the efficiency of the

organization in generation of income and surplus out of the operations of
main business. These ratios provide information on whether the profits
earned are adequate. Following are some important profitability ratios:
10.8.4.1 Return on Capital employed:
10.8.4.1.1

This ratio helps us know as to how much the organization is earning

on its capital employed.

10.8.4.1.2

The higher return in the short run as well as in the long run would
keep the interest of the management in the project and keep them
tied to the project.

10.8.4.1.3

This is also important and significant from inter-firm comparison

point of view and opportunity cost aspect.

10.8.4.1.4

This ratio is calculated as under:

ROCE

(Net Profit after Tax + Interest on Interest on Long

Term Loan)/ (Tangible Net Worth + Long Term
Liabilities) x 100

10.8.4.2 Return on Equity:(ROE)

10.8.4.2.1

This ratio provides information about the earnings, which is

generated by the funds put in by the promoters.

10.8.4.2.2

The continuation of the interest of the promoters in the business or

expanding it further is dependent on the fact that they are getting
reasonable return on the funds invested by them in the business.

10.8.4.2.3

It is worked out as under:

ROE

Net Profit /Tangible Net Worth

x 100

10.8.4.3 Gross Profit, Net Profit, Operating Profit Ratios:

10.8.4.3.1

These ratios reflect the income being generated by the organization,

with regard to level of sales.

10.8.4.3.2

The Operating Profit ratio denotes the margin of profit on the

operations revealing the operational efficiency of the unit. Operating
Page 27 of 40

profit ratio is calculated to see that the main activity remains viable
for a long time.
10.8.4.3.3

These are calculated as under:

Gross Profit Ratio

Gross Profit /Net Sales

Net Profit Ratio

Net Profit

Operating Profit= Ratio =

x 100

/ Net Sales x 100

Operating Profit /Net Sales

x 100

10.8.5 Activity and holding ratios:

10.8.5.1 The Activity Ratios measure the efficiency of the organization in
deploying the available funds particularly short term funds.
10.8.5.2 These ratios indicate how effectively the funds have been utilised in the
business. If the business keeps large funds idle, there is no return on
these funds. It is also dangerous to invest the entire resources without
maintaining sufficient amount in the form of cash balance to meet
various contingencies in future as and when they occur. A balance is,
therefore, to be struck between liquidity and profitability. The Activity
Ratios help to answer such questions: Does the company hold
excessive/lower inventory? Does the company enjoy credit from the
suppliers or does the company pay to suppliers in reasonable time? Does
the company extend credit to its customers or do the customers pay
their dues in a reasonable time? How efficiently the company has
utilized its resources made available to it by shareholders and creditors?
10.8.5.3 The turnover ratio of the major components of current assets and
current liabilities are calculated.
10.8.5.4 The major components of current asset are Raw material, Stock in
process, Finished Goods, Debtors and those of current liabilities is
creditors.
10.8.5.5 Holding ratios are expressed in terms of days / months.
10.8.5.6 A sum of the individual holding periods of various components of
current assets gives a fairly reasonable estimate of the Gross Operating
Cycle.
10.8.5.7 Holding period of these components are computed to determine the
working capital cycle and then the total working capital requirement in
monetary terms can be arrived at.
Page 28 of 40

10.8.5.8 The holding periods are best utilized in making a meaningful

comparison with the corresponding holding periods for the same
enterprise over a period of time.
10.8.5.9 Similarly, comparison can also be made with the corresponding industry
average or with the other enterprises in the same line of activity.
10.8.5.10 The turnover ratio and holding period are calculated as under:
Particulars

Formula

Raw material Turnover

Ratio (RTR)
=
Stock
in
process
Turnover Ratio
(STR)
=

Raw Material consumed / closing

stock of raw material
(Cost of Production + Opening
stock in process Less closing
stock in process)/ closing stock
in process

Holding
period in
days
365 / RTR
365 / STR

Finished goods Turnover Cost of sales / closing stock of

Ratio (FTR)
= finished goods

365 / FTR

Debtors Turnover Ratio Credit Sales / Debtors

(DTR)
=
Creditors Turnover Ratio Credit Purchases / Creditors
(CTR)
=

365 / DTR
365

/
CTR

10.8.5.11 Inventory Turnover Ratio:

10.8.5.11.1 The rate of inventory turnover would depend upon the type of
business and also the nature of stocks. For example, it will be high in
case of consumer goods and low in case of industrial goods.
10.8.5.11.2 The quicker the rate of turnover of inventory, the greater will be the
return on the amount invested in it. Therefore, the faster the stock is
turned over the better, for it is financially unsound to have capital
tied up in stock to a greater extent than necessary.
10.8.5.11.3 However inventory holding should satisfy all likely needs, so that
there is no occasion to tell any customer Sorry, we are out of
stock. In such case, loss of profit on sales and of goodwill will be

Page 29 of 40

much more than the company will save by cutting the quantity of
stocks maintained.
10.8.5.11.4 High turnover ratio may suggest that there is good demand for
products of the company. But when turnover is much higher than that
of the companies of similar size in the industry or is increasing from
year to year, it may indicate that the company is short of funds and
cannot afford to invest in inventory. This may cause the company to
forego sales opportunities.
10.8.5.11.5 Low turnover ratio may be due to sales resistance which may be due
to a variety of reasons such as un-popularity of products, cheap
quality or product out of fashion or management being not able to
control inventory.
10.8.5.11.6 Stock may also consists of obsolete or unsalable items. In such cases,
it would be prudent to get a statement of age of stock also.
10.8.5.12 Debtors Turnover Ratio: This refers to the concern'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, more is
the depletion of funds for the concern. This ratio brings out the
relationship between sales and outstanding amounts to be collected in
respect of sales. It reveals whether the relationship between selling
operations of business and book debts is proper or otherwise. If debtor
turnover/holding is lower/higher than is customary in the trade, it may
be due to one or more of the following reasons:
-

Proper selection of customers is not made indicating inefficiency of

Sales Department.

Products of company are losing market.

Larger credit period is being allowed to push up sales.

If there are a large amount of overdue and sticky outstanding, it

would be prudent to scrutinize statement of aging of debtors, in
detail.

Page 30 of 40

The older the receivable becomes the more remote is the chance of
its realization.

10.8.5.13 Creditors Turnover Ratio: This ratio brings out the relationship
between purchases and outstanding amounts to be paid in respect of
purchases. Large creditors level may not be a healthy sign. When a
concern is facing financial stringency, there is a tendency to postpone
payment to creditors. Also liberal creditors may cost the concern either
in the form of inflated prices for purchases or by way of payment of
interest. Similarly, a low creditors level may either be due to inability
of the company to obtain goods on credit or due to prompt payment of
supplies to obtain cash discount. The latter situation is possible only if
the liquidity position of the company is good. However, above
situations should be distinguished in terms of usual practices prevailing
in the industry.
10.8.6 Break Even Analysis:
10.8.6.1 Breakeven point (BEP) refers to that level of sales at which, it recovers
all its costs.
10.8.6.2 This is the point where the unit neither makes profit nor loss.
10.8.6.3 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.
10.8.6.4 Thus, break even analysis is an important tool in the hands of a credit
officer while analysing a credit proposal.
10.8.6.5 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. 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
Page 31 of 40

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 means Net Sales & Sales - VC = Contribution)
10.8.6.6 If a unit breaks even at a very high level of activity, there is every
possibility that the unit may start incurring loss, if any of the variables
like fixed cost, variable cost, sales change even marginally. Therefore,
the proposal should be scrutinized very carefully whenever BEP is
reached at a very higher level of activity instead of at a lower level.
10.9

Limitations of Ratio Analysis: Ratio analysis is a tool. Like any other tool
it has also certain limitation, as given below, of which the user must be
aware of while using the tool:

10.9.1 Accounting ratios can only be correct, if the data on which they are based
are correct. Hence, the reliability of data must be ensured.
10.9.2 Ratios do not provide explanation to observed changes. Banker must insist
on extra information to interpret the ratios correctly. Ratio analysis is the
first stage in diagnosis of management problems and further investigation
is always necessary.
10.9.3 All businesses are affected by general economic conditions, competition,
local factors, policies adopted by management etc. Ratios must be
evaluated with these factors in mind.
10.9.4 One particular ratio without reference to others may be misleading.
Changes in many ratios are closely associated with another and produce
similar conclusions.
10.9.5 Each ratio plays its part and must be supplemented by rigorous
investigations before conclusions could be drawn from them.
10.9.6 Ratios arrived at on figures of past financial statements are primarily
concerned with analysis of past and can be guide for future action only

Page 32 of 40

when coupled with other factors like policies adopted by Management and
general economic conditions etc.
10.10 Notwithstanding above, standard/prescribed ratios must be calculated,
studied, analysed and commented properly for evaluation of financial
health of the borrower. Bankers everywhere use this analysis for appraisal
of a credit proposal. Assessment would be more objective, if this tool is
supplemented with other tools/information.
11.
11.1

FUND FLOW ANALYSIS:

Funds flow analysis has assumed great importance in the study of the
financial position of a business concern. A standalone analysis of financial
statements for a period may not be helpful in the decision making process
unless the changes in the financial position of the enterprise are also
analyzed. Change in the financial position of an enterprise is brought about
by "Flow" of funds from time to time and in different segments. While funds
flow statement is complementary to balance sheet, its use is part and
parcel of financial analysis. In India, preparation of this statement is
optional for a Company while finalizing its annual accounts as per
Companies Act. The format for funds flow analysis is the form VI of CMA
Data.

11.2

While studying the proposal, the banker has to scrutinise Funds flow for its
correct preparation and study it for interpretation. Primarily, funds flow
statement is useful to a financing Banker in determining whether the
Company has adopted a wise policy in the matter of raising fund from
various sources and whether the funds so obtained are properly deployed.
The ultimate objective of this analysis is to judge the effectiveness of the
management of the Company in the area of investment, financing and
financial operation.

11.3

As in the case of ratio analysis, this tool can be used for

11.3.1 Diagnostic purpose - To comment on as to what happened in the past

11.3.2 Predictive purpose - To comment on as to what are likely to happen in
future.

Page 33 of 40

11.4

The statement of changes in the financial position is constructed from two

balance sheets. This statement is also known as statement of funds flow or
the statement of sources and application of funds. Capital and liabilities of
the balance sheet represent various sources of funds (fund inflow) while
asset side of it represents its different uses (fund outflow). The movement
of funds (flow) takes place when the fund is raised from any of the
available sources and used thereafter for any particular purpose. One has
to find out changes in the fund flow operation by comparing the changes in
the relative items in two or more consecutive balance sheets.

11.5

Both the sources and uses are further classified into two broad categories
each i.e. long term and short term sources / uses.

11.6

Fund flow analysis throws light on the movement of NWC. Hence, it is an

may be used as decision making tool while considering the working capital
limits.

11.7

It is to be ensured that adequate amount of long term surplus (long term

source long term use) representing promoters margin towards working
capital requirements, has flown into the system. A positive long term
surplus indicates an increase in NWC thereby the margin against formation
of current assets from long term sources.

11.8

Funds: Funds do not mean only cash. Assets may be acquired by paying
cash, on credit or by borrowings. There is a common factor in all the said
methods of finance, viz. economic value or purchasing power. This is
equivalent to cash but not cash itself. Credit obtained is a source of
purchasing power and it is a source of "Funds". Funds flow analysis is the
study of generation of purchasing power and its usage. Funds flow means
inflow and outflow of funds. Inflow of funds takes place from different
sources and outflow through various uses. Funds flow analysis is an
evaluation of sources and use of funds. A statement showing the different
"sources" and "uses" of funds during a particular period is termed as funds
flow statement.

11.9

Sources of Funds: Funds can be raised by issue of capital, by contracting

credit, by issue of debentures, by accepting fixed deposits and also from

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the profits of the concern. Funds can be raised by disposing off of assets,
realization of debts, reduction in other assets/ advances etc.
11.10 Uses of Funds: Funds raised can be deployed in many ways, such as
acquisition of fixed assets, increase in inventory/debtors, reduction in
liabilities, payment of dividend etc. Losses suffered by a concern result in
usage of funds. There may not be equal relationship between any item of
source and any item of use. When a loan or advance is to be granted, use of
funds for the specified purpose should be insisted upon. There should be
relationship between certain specified items of sources and uses, e.g. if
term loan is granted, there should be an increase in fixed assets i.e. long
term assets. When a liability is created, it is a source of funds and when it
is reduced, it reflects the usage of funds. Increase in assets is usage of
funds, conversely decrease in assets results in availability of funds. In funds
flow analysis, we compare the position of each item of asset and liability as
on a given balance sheet date, with the corresponding item as on the
previous balance sheet date to ascertain the changes in various assets and
liabilities or various sources and uses of funds. This will be balanced by the
funds generated internally or lost in business.
11.11 Computation: The computation will start with profits before tax. Net profit
shown in Profit & Loss A/c is not exactly the funds generated, as many book
adjustments like depreciation, investment allowance etc. are made. These
are to be added back to the net profit. Taxes/Dividend paid or payable
should be subtracted from the said figure. Other items like profit or loss on
sale of fixed assets or investments, income from investments etc. are to be
deducted from or added to net profit, as the case may be, if they are not
already accounted for. After this, each item of liability and asset should be
examined for ascertaining the sources and uses for computing fund flow
statement.
11.12 Uses of Funds Flow Analysis: Funds flow statement is analysed to study,
whether the working capital finance provided by the Bank for acquiring
current assets has resulted in the increase in value of current assets. If
working capital finance is used for long term uses, such as for acquiring of
fixed or non-current assets, it indicates diversion of funds which may have
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serious implications for the concern and also for the Bank. Funds flow
statement also indicates increase in the value of various assets and the
sources of finance for the same. In addition, we get a vivid picture of
various sources and uses of funds by the concern.
12. Cash flow statement:
12.1

Securities & Exchange Board of India (SEBI) has made it obligatory for the
listed companies to include cash flow statement in the audited balance
sheet.

12.2

The cash flow statement is segregated into three parts, namely

12.2.1 Cash Flow from operating activities

12.2.2 Cash Flow from investing activities and
12.2.3 Cash Flow from financing activities.
12.3

Cash Flow from the above three activities are added or deducted from the
Cash and Cash equivalent as on the date of the Balance Sheet of the
previous year to arrive at the cash and cash equivalent as on the date of
the Balance Sheet of the current year.

12.4

Cash Flow from operating activities is an important parameter. It may

happen that a business unit has earned a net profit of, say, Rs. 10crores
whereas the operating cash flow is only, say, Rs. 5crores. This may be due
to increase in Sundry Debtors which actually means that though the
account shows net profit, it has not been realised. Cash flow from investing
activities shows the purchase and sale of various fixed assets and
investments. Cash flow from financing activities shows the inflow and
outflow of cash from various financing activities of the company such as
issue of share capital, debentures, borrowings, dividend payout etc.

13. Loan Policy: As per Loan Policy 2014-15, following guidelines are also advised
by the Bank under the head Borrower Standards:
13.1 Financial strength / Bench Mark Ratios:
13.1.1 The financial strength of the borrower client shall be considered adequate,
in relation to the

project size/volume of operations proposed to be

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undertaken and risks involved therein in the light of acceptable

parameters.
13.1.2 Though it is very difficult to evolve industry-wise bench marks for Current
and Debt Equity Ratio, Profitability Ratios and Debt Service Coverage Ratio
or any other specific ratios, in general, Current Ratio (CR) of 1.17 and
above, Debt Equity Ratio (DER) < 2.00:1, Total Outside Liabilities to Net
Worth Ratio (TOL/TNW) of < 4:1 and average DSCR of 1.5:1 with minimum
DSCR of 1.2:1 will be considered as reasonable requirement for any credit
proposal. These bench marks will generally be observed for new
connections. Relaxation may however be considered on merits of the case
by respective sanctioning authority. However, in case the sanctioning
authority is upto scale III, the concurrence of RLCC I / RLCC II for allowing
deviation in bench marks should be obtained before release of any credit
facility. CR less than 1 (one) should generally not be accepted. However in
exceptional cases, CR less than 1 (one) may be permitted by authority not
less than RLCCs after recording proper justification in the proposal.
13.1.3 In depth analysis of Audited Profit & Loss Statement shall be done and
detailed comparative comments on EBIDTA margins and cash flows from
Operation (Actual & Projected) shall be included in the Executive
Summary.
13.1.4 FB limits only are taken into account in outside liabilities while arriving at
DER. Industry such as construction and other industry where NFB form a
major source of finance such as NFB facilities such as LC, LG. Such huge
commitments are not reflected in DER. In such cases, NFB liabilities should
also be factored while arriving at DER. Details of guarantees / LCs /
contract-wise performance should be furnished in Executive Summary to
evaluate the performance vis--vis guarantees / LCs issued.
13.2

Brand as Security - The strength of the borrowers also depends upon the
Brand Equity created by them due to reputation, quality products/services,
and is recognized through Trade Marks etc. Such Brand Equity is built up in
companies especially in categories of FMCG, White Goods, Multinational
companies, etc. The brand has a value and the same can be considered as
security/collateral security for the loans and advances extended to a
Page 37 of 40

borrower company. While accepting the brand as security the following

broad parameters are to be followed:
13.2.1 The borrower should be a limited company incorporated under provisions
of the Companies Act 1956 or PSU/Semi-PSU company or a Corporation
13.2.2 The valuation of the brand should be got done from atleast two valuers
empanelled with the bank. The lower of the two may be accepted as value
of security.
13.2.3 The owners of the brand should be a highly reputed corporate in existence
for atleast 10 years.
13.2.4 The brand must have been patented alongwith the trade mark and
registered with the competent authority.
13.2.5 The charge of the bank should be created on the brand through a
document vetted by banks empanelled legal advisor and should be
registered with ROC.
13.2.6 Acceptance of Brand as security will be decided on case to case basis.
13.3

Quasi-Equity - The promoters of the Infrastructure Projects / other

projects under the Corporate Structure are required to bring in their own
contribution, upfront as well as proportionately with disbursement of Term
Loans. Own contribution is generally brought in by the promoters by way of
equity. However sometimes it is proposed to be brought in by way of
unsecured loans by the promoters/family members/associate concerns.
Such unsecured loans shall be accepted as promoters contribution and
treated as Quasi Equity provided;

13.3.1 It is subordinated to the banks loan. The unsecured loan should not be
repaid during the currency of the bank loan or without prior concurrence of
the bank.
13.3.2 As far as possible it should not carry an interest at least up to COD. If such
loan carries interest, it should be only with prior consent of the bank and
servicing of interest would also be subordinated to interest on the bank
loan.
13.3.3 An undertaking to the effect as above should be obtained from both, from
the borrower company as well as from lenders of the unsecured loans.

Page 38 of 40

13.3.4 Out of the promoters contribution, at least 50% should come by way of
equity.
13.4

Corporate Guarantee - Wherever corporate guarantees are stipulated,

valuation of the same has to be assessed by ascertaining TNW of the
company (After adjusting inter associate concerns deposits/investments)
and

total

outstanding

obligation

created

by

extending

corporate

guarantees.
13.5 As a policy guideline, mandatory guarantee of shareholders should be
stipulated as one of the terms and conditions in cases, where shareholders
hold equity of 20% and more, as in such cases they shall have a say in
management. However, sanctioning authority shall have the authority to
waive such guarantee, on case to case and based on merits of each case.
13.6 The aforesaid benchmarks/norms shall however not be applicable to any
scheme specially formulated as per laid down procedure. For example
UNION RENT will be out of the purview of the financial discipline as
CR/DER/DSCR etc are not applicable for financing of future rent receivables
under the scheme.
13.7 In respect of Small Enterprises and capital intensive industries, relaxation in
DER would be considered. However relaxation of DER shall be considered on
case to case basis with proper justification.
14

Financial Indicators in Executive Summary: Once the balance sheet is

regrouped based on the norms and guidelines on classification of current
assets and current liabilities, the entire data is transformed in the following
format appearing in the Executive Summary. While processing through LAS,
this form is generated automatically. Normally, last 3 years audited financial
statements with one or two years projected financials are entered in the
format for meaningful comparison.

S.
No.
1.
2.
3.
4.
5.

YEAR ENDED / ENDING

Paid-Up Capital
Reserves & Surplus
Intangible assets
Tangible Net Worth (1+2-3)
Long Term Liabilities
Page 39 of 40

6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23
24.
25.
26.

Capital Employed (4+5)

Net Block
Investments
Non Current Assets
Net Working Capital (6-7-8-9)
=(11-12)
Current Assets
Current Liabilities
Current Ratio
DER (LTL/TNW)
TOL/TNW Ratio
TOL/TNW along with Contingent
Liabilities
Net Sales
Cost of sales
Operating Profit/EBITDA
Other Income
Finance charges/Interest cost
Depreciation
Tax
Net Profit after Tax
Depreciation
Cash Accruals

Page 40 of 40