Credit Management Lecture 24

Financial Appraisal for the Credit Decision Though several qualitative factors play a role in a credit decision, a major influencing factor is the financial health of the borrower as brought out by the financial appraisal. We will study as to how the credit officer uses techniques such as ‘financial ratio analysis’, ‘cash flow analysis’ and ‘sensitivity analysis’ to assess the credit worthiness of the borrowing companies.

FINANCIAL RATIO ANALYSIS Standard Ratios The relationship between items, or group of items, appearing on the financial statements can be expressed mathematically in the form of Proportions, ratios, rates or percentages. Think of the combination of ASSETS & LIABILITIES i.e. Is it the Current assets 2 times the current liabilities or else!!!

Important Points to Consider The necessity of expressing the relationship between related items in the form of ratios or percentages arises from the fact that absolute Rupee data are incapable of revealing the soundness or otherwise of a company's financial position or performance. Net sales of Rs M may appear satisfactory, but no positive conclusions can be drawn unless they are compared with the total assets.

Continued… Finding a ratio between the Net Sales and total Assets used to achieve the sales shows the efficiency of the company in utilizing the assets and Industry comparison shows if the particular enterprise is well managed or not as per industry standards. A single ratio in itself is meaningless because it does not provide a complete picture of a company's financial position, What it exactly reveals???

Methods of Comparison Ratios and percentages have little significance unless they can be compared with, or matched against, appropriate standards. 1) Historical Comparison. Historical standards are based on the record of the past financial and operating performance of individual subject business concern. Comparison of historical ratios throws more light on the company’s performance than just one year’s data.

Continued… 2) Industry Comparison. Horizontal, Peer Group, or Industry standards represent ratios and percentages of selected competing companies, especially the most progressive and successful ones, or of the industry averages of which the individual company is a member. Comparisons with Industry averages are most valuable for judging the Financial health of a Company.

Continued… 3) Regulatory Requirements. Sometimes Regulators lay down standards which must be met before financing is allowed by supervisors. State Bank Prudential regulations lay down Minimum Current Ratio that should appear at the time a finance is granted.

Continued… 4) Budget Comparison. Budgeted standards, or "goal ratios" as they are sometimes called. These are developed by Senior Company Management and monitored by them to judge the Company Performance. Such ratios are based on past experience modified by anticipated changes during the account period. Actual ratios are accomplishment of the anticipated targets. Study of the Budgeted and Actual Ratios is also helpful to the credit analyst.

4-Broad Categories Most credit analysts use four broad categories of ratios—liquidity, profitability, leverage, operating. Liquidity ratios indicate the borrower’s ability to meet short-term obligations, continue operations and remain solvent. Profitability ratios indicate the earnings potential and its impact on shareholder returns. Leverage ratios indicate the financial risk in the firm as evidenced by its capital structure, and the consequent impact on earnings volatility. Operating ratios demonstrate how efficiently the assets are being utilised to generate revenue.

Thank-You