Financial Analysis For Lending Purpose

In any enterprise, the most important thing for determination is the total cost of the enterprise consisting of investment in fixed assets, current assets and miscellaneous assets, and also the means by which the cost has been met. For example, if a project costing about Rs.17 lacs consisting of investment in block Rs.10 lacs, current assets Rs.6 lacs and miscellaneous assets Rs.1 lac, was proposed to be financed by shareholder's capital Rs.10 lacs, long term liability Rs.3 lacs and current liability Rs.4 lacs, the base Balance Sheet at the commencement of the project may be cast as under:-

This may also be expressed in Form B as

The sum of Rs.10 lacs derived above is called the tangible net worth of the company and indicates the stake of the proprietors in the enterprise. The sum of Rs.2 lacs indicating the excess of current assets over current liabilities, is the net working capital, used for purposes of operations, and may also be called the liquidity surplus.

The classification in form B indicates the quantum of tangible net worth of the enterprise and the way it is divided into three portions, namely block, liquid and miscellaneous assets.

This form of casting a Balance Sheet has obvious advantages over the traditional form A indicated above, and would be desirable to be extensively used as by casting the Balance Sheet in the form, it is possible to draw a straight financial inference.

The method employed for purposes of analysis and interpretation of the Balance Sheet is fairly uniform, namely classification of Assets and Liabilities into various categories as detailed above, but the degree of importance attach to various formations, group studies, strength or weakness of positions, depends upon the particular view point of the analyst.

It is important to understand at the first instance that the

Shareholder of any enterprise is concerned primarily with the size and consistency of dividend payments.

A creditor is mainly interested in the liquidity of the concern and the certainty of his debt being repaid.

The management is interested in the trends which disclose the efficiency of operation and a

Banker is interested in the continued safety of the advance, and prospects of its repayment according to agreement. He in short is interested in the general financial health of the enterprise, and would like to take a comprehensive view on all the above points.

The concept of account analysis signifies an analytical study of the figures contained in a Balance Sheet and Profit and Loss statement. The purpose is to assess the financial health and operating efficiency. The study involves in the assessment of the following positions :-

(a) A study of the relationship among various figures representing assets and liabilities and their variations over a period of time.

(b) A study of the consequences of these variations as represented by the Profit and Loss account.

The following are the suggested groups under which the study is made :-

• Current assets related to outside liabilities indicate the ease with which a company can meet its commitments. The greater the proportion of current assets, the lesser the risk of enforced liquidation.
• Shareholder's funds related to fixed as sets. Shareholder's funds should exceed the fixed assets, the margin being shareholder's contribution towards financing current assets. The balance is usually provided by supplier's credit and bank overdraft.
• Shareholder's funds related to outside liabilities. Shareholder's funds should ex ceed outside liabilities. Greater the shareholder's funds lesser the influence of creditors.
• Profit related to shareholder's funds. Trend should be consistent and after provision for taxation, should permit reasonable dividend payments as well as additions to reserves. This provides indication of future prospects.

Let us take a few simple examples and illustrate the points mentioned above

(1) A.B.C & COMPANY LIMITED

An examination of the relationship of various groups indicate :-

(a) Shareholders' funds are more than the investment in block Rs.8,500 > Rs.7,500

As the shareholders are expected to provide funds for fixed and intangible assets, the position here is satisfactory.

(b) Shareholders' funds are comfortable over outside liabilities :- Rs.8,500 > Rs. 1,500

As it is desirable for the proprietors' investment in the undertaking to be greater than the outside liabilities, the position here also is satisfactory.

Now we shall examine what happens if the reverse is the position as indicated in the following example :-

(2) A.B.C & COMPANY LIMITED

A comparison between (1) and (2) Balance Sheets above indicates that for the same quantum of asset holding Rs.10,000/- the composition of nature of funds is different.

In this case, the current liabilities CANNOT be comfortably met from current assets,

If a substantial portion of creditors in (2) are to demand payment, the company here would be in a most embarrassing position, as it would not be convenient to sell the block at short notice to meet current liabilities.

The emphasis on the relationships mentioned in the previous para should be quite obvious from these examples

The genera! requirements of a sound Balance Sheet may be stated here briefly as under:

• That the proprietor's funds should compare favourably with the fixed assets investment including intangibles.
• That the proprietor's funds should comfortably cover the outside liabilities.
• That the working capital should be sufficient to meet the normal trading requirements of the particular concern.
• That a reasonable state of liquidity should be maintained.

These are no doubt, ideal conditions, and the latitude that may be permitted in any individual case would depend upon the particular merits of any enterprise to which the Balance Sheet relates. The technique of measuring the relationships of various groups in a Balance Sheet and Profit and Loss account and a study of the variations in those relationships is termed as ratio analysis.

We shall study the same in depth separately with a few case-studies.

M/s. A. Raghunath & Co., Balance sheet as at 31.12.2021

The liquid assets in the business aggregate to Rs.64,100/- (48,000 + 10,000 + 6,100) as against current liabilities of Rs.82,900/-(Rs.55,700 + 10,000 + 17.200).

Consequent to excess of liabilities over assets, the liquidity position appears insufficient and the prevalance of debt pressure may be presumed.

The partner's capital has been reduced from Rs.42,000/-to Rs.28,200/- by withdrawal of large sum of Rs.20,200/-, the purpose of withdrawal is not known.

As against the addition of Rs.6,400/- by way of profits, withdrawal of capital Rs.20,200/- is not a healthy sign and is a step calculated to weaken the organisation. A sum of Rs. 10,000/- was paid towards goodwill.

Why was the amount paid and to whom was the amount paid and why no yearly write-off's are made to reduce the intangibles are not known. The business is holding share investment of Rs.20,000/- in a subsidiary company. This investment may be worth the book value indicated in the Balance Sheet, or it may not be worth anything at all.

It is difficult to express any opinion on the financial position of the enterprise without examining the financial position of the subsidiary. In relation to the size of the company, investment in furniture and Motor Car at Rs.17,000/- appears large.

On the whole, it can be seen that the capital of Rs. 28,200/- has been fully utilised in acquiring goodwill Rs.10,000/- and shares in subsidiary company Rs.20,000/- i.e. fully drawn from the business, and as such it is possible to infer that the whole range of current assets, furniture and Motor Car have been held by Current borrowings. The position is not healthy and financially very weak. Trade creditros at Rs. 55,700/- in relation to sales of Rs.2.40 lacs shows that dues of the company are not paid promptly but delayed. In comparison to Sundry Debtors Rs. 10,000/- the position appears vulnerable

The above inferences have been drawn from only one Balance Sheet as at 31.12.21. This position in this Balance Sheet has evolved as a result of several transactions that have taken place during the calendar year 2021, each one of which had its own effects upon the resultant position disclosed in the Balance Sheet as at 31.12.21. It would, therefore, be pertinent to examine with care with what Balance Sheet the year commenced and with what Balance Sheet the year ended.

Balance Sheet of a Sample Company for purpose of comparative study

The following inferences are possible from the above Balance Sheet

1. Own capital Rs.42,000/- is far in excess of the investments of a fixed nature, namely Rs. 19,000/- in furniture and Motor Cars.

2. Own capital is also showing a comfortable position in relation to total liabilities at Rs.50,500/-

3. The current assets at Rs.73,500/- are far in excess of the current liabilities Rs.50,500/-

4. Debt pressure may not be there.

5. Earned profit of Rs. 14,500/- in relation to partner's capital Rs.36,000/-is good and withdrawal of only Rs.8,500/- from the same indicates sound management policy, in retaining a portion of the profit earned in the business to promote developments. The stocks held are not more than 2 months sale which may be termed as good.

On the whole, this Balance Sheet of 2020 may be considered from every standpoint reflecting a satisfactory state of affairs.

How then could the Balance Sheet as at 31.12.2020 of the enterprise be assessed as a good position, could be termed bad as at 31.12.2021. What happened in between these two dates which could have contributed to this adverse position?

In order to correctly assess one position, we shall compare each relative position to arrive at the truth.

From the above statements, it may be seen that the firm has, during the course of the year, brought in considerable sums of money by way of increase in sundry creditors, increase in loans and Bank Overdrafts and decrease in stocks and other assets, which moneys have been expended, by way of withdrawal of capital and payment to goodwill and depleted by way of investment in subsidiaries. The overall position would become more clear if we cast the net inflow and outflow of cash during the period, which is being attempted here below

Cash Inflow and outflow between 31.12.20 and 31.12.21

This statement which has flowed out of the above two Balance Sheets clearly indicates that during the period under review a sum of Rs.41,400/-has been raised from the business by sundry ways and a sum equal to Rs.43,800/- has flown out of the business and perhaps permanently lost.

Losing so much money in the course of one year, cannot but have a detrimental effect on the resultant Balance Sheet as at 31.12.21. Retaining the Sundry Creditors position at an inordinately high level of Rs.55,700/-cannot but have its own adverse effects, as this could be done only by keeping the suppliers bills waiting, which in turn may mean loss of business prestige, standing and credit.

Why has so much money gone out of the business during one year? Investigations revealed that A. Raghunath & Co., was a partnership of two persons A. Raghunath and B. Bhupathy. Early in the year 2020-21, A Raghunath desired that an advance of Rs.20,000/- be made in a business in which he was a partner which was resisted by B.Bhupathy. In spite of the opposition, A. Raghunath, being the senior partner diverted the funds, consequent to which B. Bhupathy declared his intention to leave the partnership. Funds had to be paid to B. Bhupathy Rs. 13,800/- towards capital and Rs.10,000/-towards goodwill. It has thus happened that in the course of a single year, funds to the extent of Rs.43,800/- were withdrawn from the business and created liquidity shortage.

It is necessary here to pause for a while and review what we have done by way of analysis in the above Balance Sheets. We have started with the Balance Sheet as at 31.12.21 and arrived at by analysis that the position disclosed by it was not sound. In order to arrive at how this position has flowed out of the previous year's transactions, we analysed the Balance Sheet as at 31.12.20 and found that the Balance Sheet position as at 31.12.20 was good.

We, therefore, concluded that the vulnerable position has happened in between the period. We, therefore, calculated the inflow and outflow of cash during the in between period and came to the conclusion that an outflow of cash for Rs.43,800/- has taken place during the period, which cash has been permanently lost to the business. This outflow has caused perhaps great liquidity shortage to the business

To understand the reality between the figures representing any business ail these three steps are necessary if the Balance Sheet is to be properly analysed, for the current year and previous year, and the flow of funds also be assessed. The inferences drawn above could also be more easily drawn if we cultivate the habit of casting the- Balance Sheets in the vertical form indicated in the para 6 here above.

A. Raghunath & Company's Balance Sheet as at 31.12.20 and 31.12.21 are cast here below in the vertical form to enable drawing of some straight financial inferences.

Same Balance Sheet in Vertical Form

It may be particularly noted how the tangible net worth of the business at Rs.42,000/- in 31.12.20 has been reduced to Rs.18,200 in 31.12.21. Also, it may be seen how the working capital at Rs.23,000/- has been reduced to a working capital debt of Rs.-18,800/- in 2021.

It is, therefore, reasonable to presume that the resultant position has become considerably weak and potentially dangerous. Continuation of a clean overdraft under the Balance Sheet of 2020 by the bank is possible, but not so from the Balance Sheet of 2021.

Running any business today, requires a great many skills. Purchasing of merchandise or raw materials demand a technical skill. Production also demands another technical skill. Selling requires yet another skill. Permeating all these skills, is the financial skill, which enables one to understand the financial realities behind any business situation.

Positions such as 'not enough sales' 'high operating costs' 'too many fixed assets' 'too much wrong inventory' 'too much intangibles', 'too much debt', are the pressure points which faithfully reflect their presence in the Balance Sheet and Profit and Loss Statement and it would be worthwhile to subject these statements to proper analysis and understand the financial realities behind the business they represent.

1. Here below we propose to give certain principles governing the static analysis of any Balance Sheet. From the point of view of sound financial management in any enterprise, be it a small scale industry or a large enterprise, there should be a proper balance between the funds provided by the shareholders or proprietors and those provided by other sources such as creditors. In what proportion exactly depends upon the nature of its business, need to repay its liabilities, its profitability and its determination to retain in the business. It also depends upon the composition of the assets of the enterprise.

2. The Company's financial flexibility is ascertained by the relationship between its current assets and current liabilities, which determine the degree of safety and liquidity of the enterprise, and conse quently the ability to carry on as a going concern, meet liabilities as they fall due, withstand economic reverses and take advantage of profit earning opportunities. Stability is indicated by a good earning record, which will enable the company to attract additional capital when needed, and enables to sus tain a well balanced capital structure, providing safety for the suppliers, lenders, bankers and lastly to the shareholders.

3. Among the functions mentioned above, the ability of the Company to remain as a going concern and meet all liabilities as they fall due is of prime importance. As per Section 434 (a) of the Com panies Act, a company shall be deemed to be unable to pay its debts, if a creditor by assignment or other wise, to whom the company is indebted in a sum exceeding Rs.500/- then due, has served on the company a demand requesting the company to pay the sum so due, and the company has for three weeks thereafter neglected to pay the sum so due, then the company may be considered as unable to pay its debts, and according to Section 433 may be considered as a ground for winding up. In determining whether the company is unable to pay its debts, the court shall take into account, the contingent and prospective liabilities of the company

4. The relationship of current assets to outside liabilities indicates the case with which any company can meet its commitments. Greater the proportion of current assets, lesser the risk of enforced liquida tion. Normally the shareholders funds should exceed the outside liabilities, the proportion indicating the financial stability. Shareholders funds should also exceed the fixed assets, the excess being the shareholders contribution towards financing current assets. Any business to be considered financially sound, should take care of some of these basic positions. A large number of enterprises shut down within a few years of their working, not because they lacked in technical skill, but many of them are financial suicides owing to ignorance of the basic ground rules under which finances operate

Even though a Balance Sheet is produced and audited for the information and ultimate adop tion by the shareholders of a Public Company, it receives the most searching examination in the hands of creditors and Banks. This examination may be two fold, namely :-

1. The static analysis on the structural position presented by one Balance Sheet.

2. The prognostications or study of trends presented by a series of continued Balance Sheets.

Here below in this note we propose to examine the structural position presented by some imaginary Balance Sheets to evaluate financial strength, and to enable the reader to grasp in an easy manner the principles of static analysis.

A. Narayanan & Company Limited, is a small scale industry manufacturing bolts and nuts. Most of its supplies are made to the Railways and its operations for the past few years have been profitable. It is in enjoyment of a clean overdraft limit of Rs.30,000/- with Bank A which limit from small beginnings has now been raised to this level. Bank A has now received a proposal to renew the limit for a further period of one year. An examination of the company's accounts with the bank indicated, that the facility has been occasionally utilised by the company, indicating by and large that the arrangement has been utilised by the company only as a standby arran gement. The company has given an undertaking to the Bank, that it will not open and maintain any other Bank account with other Banks and will not create any charges on its property without the specific consent of the bank. The balance sheet of the company received with the renewal proposal is summarized below

A clearer picture of the Balance Sheet position would become more perceptible, if we cast the Balance Sheet in the vertical form as indicated in our last note. In the vertical form, the position of the Balance Sheet would emerge out as follows :-

The survey of figures represented by the above break-up reveals the following points :-

(a) On the date of the Balance Sheet, the Company had total assets of Rs.2.51 lacs consisting of fixed assets Rs.1.37 lacs and liquid assets Rs.1.14 lacs.

(b) On the same day, the company had out side liabilities Rs.0.60 lacs.

(c) The company's assets are more than four times the company's outside liabilities. Even if there were to be a fall in value of assets, say, by about 25% still the compnay's creditors could be paid in full.

(d) The company's own funds aggregate to Rs.1.91 lacs and outside liabilities Rs.0.60 lacs. The own funds were three times the outside liabilities. The creditors position, therefore, was quite safe

(e) Out of the totai assets of Rs.2.51 lacs, Rs.1.14 lacs were such assets as were regularly turned into cash. In comparison to the outside liabilities of Rs.0.60 lacs, the company could meet all the demands of the creditors without having to sell or liquidate its fixed assets. The liquid position, therefore, may be presumed as good.

(f) The stocks in hand were not high in relation to company's sales. The company's monthly sales were Rs.0.44 lacs. The stocks held on the date of the Balance Sheet, therefore, amounted to only 15 days sale. It appeared that the entrepreneurs were managing to conduct the business with a minimum holding of stocks and inventory, and buying only just what is necessary for immediate requirements. This is certainly advantageous to the company, and it is probably in this connection, the clean overdraft as a standby arrangement has been utilised by the company

(g) The sundry debtors Rs.0.65 lacs are about 1 1/2 months sale. As the Government departments, Public Enterprises and even market parties are paying bills not before 45 days, the outstanding may be considered as normal

(h) Profits have been earned and retained in business in the past as indicated by the reserves

Conclusion: As the liquid position of the company was good, the whole of the liabilities including the Bank Overdraft under review in relation to the company's own worth was something less than 1.1 i.e. the total of the liabilities including the Bank overdraft was less than the company's own funds invested in business, profitability and management records were good, and as the company has given an undertaking to the Bank not to open any account with other Banks and refrain from creating any charges on the property of the company, and as the overdraft was used only occasionally for temporary periods, which indicated mostly that the company was depending upon its own resources for finance, it appeared to be a proper case for renewal of the limit without any special stipulations.

The Bank should be happy to retain the custom of such a well managed enterprise

Let us now examine the case of another company working under different circumstances :-

Financial Analysis (2) - Case Study 2