Financial Management

QUIZ 2
SUBMITTED TO AND UNDER THE GUIDANCE OF -
PROFESSOR VINEET SWAROOP

Yash Parikh
PGDM CORE DIVISION B Roll No. 143

Yash Parikh - 143

Financial Management

"Who can figure bankers?" Amit mumbled as he returned to the office of his small candy
manufacturing business, Indian Confectioners. "They're willing to lend money only to
those business owners who don't really need it. If you can prove you don't need it,
theyll throw it at your feet. Unfortunately, we need it, and we need it fast."

Amit called Sanjeev, the company's part-time bookkeeper, to see if he could explain
what the banker had been talking about when he rejected Amits request for Rs. 200,000
to purchase new candy-making equipment and to boost the company's working capital
base. "They turned down my loan request," Amit explained to Sanjeev and showed him
a page sent by the banker.

Sanjeev looked at the page and saw that the banker had calculated several financial
ratios based on Indian Confectioner's most recent financial statements and had
compared them to the industry average. Here's what he saw:

Ratio Last Year This Year Industry Average

Current Ratio 2.3:1 1.7:1 2.4:1
Quick Ratio 0.7:1 0.4:1 0.8:1
Debt Ratio 0.81:1 0.89:1 0.65:1
Debt to Net Worth Ratio 2.6:1 2.9:1 1.9:1
Inventory Turnover Ratio 4.9 times/year 4.3 times/year 7.1 times/year
Average Collection Period 36 days 43 days 34 days
Net Sales to Working
Capital Ratio 10.4:1 9.7:1 12.6:1
Net Profit on Sales Ratio 4.1% 3.8% 9.4%
Net Profit to Equity Ratio 17.6% 18.3% 13.4%

"Can you tell me what this means, and more importantly?

How will we be able to get the Rs.200,000 right now?
Answer Amits question to Sanjeev.

Yash Parikh - 143

Financial Management

Solution

Introduction
Amit the owner of Indian confectioners was looking to avail a loan of Rs. 200,000 from
the bank. However, the bank rejected the loan and provided a list of financial ratios
which they considered as their basis for rejection of the loan. Amit wants to understand
what these ratios mean and why the loan has been rejected. He also wants to know
what Indian Confectioners needs to do in order to qualify for a loan from the bank.

Method followed
In order to understand this, we will analyze each ratio and conclude its meaning and
then we will further try and understand why the loan was not given. After that we will
try and see what can be done to avail funds at the moment.

The bank rejected Amits request for granting a loan of Rs.2,00,000/- to his company
Indian Confectioners because looking at the latest financial statements they concluded
that the financial position of the company was not strong enough to repay the loan.

The purpose of the loan was to buy a new candy making machine and to boost working
capital base.

The bank would have considered the following reasons in order to reject the request
1. Slowdown in sales
We see that a significant proportion of the current assets of Indian confectioners is
inventories. We conclude this by comparing the Current ratio with the quick ratio.

Current Ratio 2.3:1 1.7:1 2.4:1

Quick Ratio 0.7:1 0.4:1 0.8:1

As liabilities remain the same in Current ratio and quick ratio we can see that for year 1
1.6 out of 2.3 is inventories which for the year drops to 1.3 of 1.7. The industry average
is 1.6 out of 2.4 which is 66%.

However, we see that the inventory turnover ratio has also reduced from 4.9 times per
year to 4.3 times per year which is well below the industry average.
From the situation of the company it can be analyzed that since they are looking for cash
majority of QR is accounts receivable. This is based on the logic that if they had cash or
marketable securities they would not be trying to get a cash loan.

Yash Parikh - 143

Financial Management

With AR, Inventory turnover ratio reducing and Average collection period increasing it
can be concluded that the sales are slowing down. AR is falling and the collection period
for the same has increased by 7 days from last year.

2. Poor solvency situation

The Solvency ratios, i.e., indicate that in the industry the common debt ratio is 0.65. This
means that for every 1 rupee of assets 65 paise has been financed by debt and
remaining 35 paise by equity. For this company the Debt ratio was 0.81 and has now
reached alarming levels of 0.89. This just goes to show that with the drop in sales and
fall in net profit to sales if the company makes even a small loss the equity will be
eroded in no time. The direct claims of AP will fall on assets which are bought against
debt. The debt financers will lose their claim in the situation.
It is understandable that the bank has refused the loan as the claim on assets of the firm
is very less.

3. Reducing net profit

The net profit as a percentage of sales is falling from an already low 4.1% to 3.8%. Which
is much lesser than the industry average of 9.4%.
The net profit to equity is high but that is on account of the high financial leverage and is
in no way a good indicator from a lending perspective.

So, What can be done to raise the Rs.2,00,000/- ?

Since the company is in immediate needs of funds and the bank has turned them down,
it looks very difficult to raise debt at the moment. The company would take time to raise
equity.

The following can be done to raise 2L

1. Early settlement of accounts receivables The AR can be collected earlier by

offering them discounts to make payments immediately. This is an expensive
method of financing however we are in a situation where we need funds
immediately.
2. Discounting of bills For all the AR who refuse to pay early and accept the
discount offered in option 1. We can get the bills discounted from finance
companies. We may have to bear a loss by giving a discount of upto 5% for 90
days.
3. NBFCs- NBFCs such as Micro Finance companies often give short term loans to
supplement working capital requirements however here the interest rates shoot
up to over 2-3% per month at times.

Yash Parikh - 143

Financial Management

4. Slow moving items Since the inventory is moving slowly there must be some
proportion of inventory going either unsold or else takes more time than average
to see. Such inventory should be sold off at a high discount or else at scrap value.

Since we have a large amount of inventory, the company should try and convince
some of the debt holders to take over the inventory this can reduce the debt for the
firm.

Yash Parikh - 143