Ratio
Analysis
The bedrock of financial assessment. Looking beyond ratios to detect data manipulation, financial control, and the hidden forensic risks in banking credit decisions.
Looking Beyond the Ratios
Financial analysis depends to a large extent on the use of Ratio analysis. However, Ratio analysis is only meaningful if the underlying data is correct. A banker must be certain of the figures giving rise to the ratios. What appears to be a strong case on paper can be very weak when reckoned with non-financial and physical factors.
Common Data Manipulations
Examples of manipulations in figures resorted to show an exaggerated view of the financial position:
Inflating the value of inventory to mask liquidity strain.
Recording future cash receipts as current year's sales.
Hiding inventory liabilities to polish the balance sheet.
Treating current debts as long-term to improve Current Ratio.
Pushing expenses or replenishments to next accounting year.
Location, managerial ability, and technical skill are equally vital.
The Banker's Forensic Lens
Super-sensitive areas and non-financial factors are the true indicators of a company's health. Below are live cases where looking beyond the figures saved the bank from potential credit catastrophes or enabled strategic growth.
LMN Transports (P) Ltd. (Worthy Diversion)
Fleet owners and transport contractors dealing exclusively with our bank. Renewal proposal for 2018 envisaged enhancement from Rs. 12 Lacs to Rs. 16 Lacs.
Balance Sheet Audit Summary (Rs. in Lacs)
| Item | 31.3.17 | 31.3.18 |
|---|---|---|
| Net Block (Less Deferred) | 55.00 | 54.00 |
| Investments (Shares) | nil | 6.00 |
| Net Working Capital | 16.00 | 11.50 |
| Tangible Networth (TNW) | 71.00 | 71.50 |
| Net Sales | 400.00 | 480.00 |
| Net Profit (Before Tax) | 19.00 | 21.00 |
Diagnostic Analysis
Turnover Growth
Sales increased by 20% along with a corresponding rise in NPBT.
Leverage & Liquidity
Debt-to-TNW was favourable and Current Ratio was satisfactory at 1.35.
Apparent Diversion
Conclusion was drawn that Rs. 6 Lacs were diverted into shares, necessitating the loan request.
Strategic Motive
Actually, shares were purchased in large companies to secure transport contracts from them.
Banker's Verdict: Worthy Investment
The so-called 'culpable' diversion was a business promotion expense that drove Rs. 80 lacs in new revenue. Decision: Approved as strategic growth expense.
Y Ltd (Mineral Exporter) (Quality of Assets)
A leading mineral exporter requested ad-hoc packing credit enhancement with 'nil' margin despite showing a healthy 1.33 current ratio.
Diagnostic Analysis
Stock Quality
Bulk of held stock were quarried items rejected and unfit for export, yet included in inventory.
Receivables Fraud
Buyer claims and deductions were hidden as 'receivables' instead of 'current liabilities'.
Actual Liquidity
Adjusting for bad stock and true liabilities, the actual CR was below 1.0.
Banker's Verdict: Hidden Liquidity Strain
The quality of current assets was compromised. Sound current ratio on paper was a facade. Moral: Asset Quality is more relevant than the Ratio itself.
ABC Ltd (Associate Shell Capital)
A take-over proposal with impressive networth and good current ratio. Detailed investigation of the 4 associates revealed a circular manipulation.
Diagnostic Analysis
Staggered Closing
Associates M, N, O, P closed accounts at different dates (Dec, March, June, Sept).
Circular Capital
A single Rs. 10 lacs investment was transferred unit-to-unit sequentially to show capital in all five.
Leverage Fraud
Bank finance was availed by all units disproportionate to the actual single investment.
Banker's Verdict: Capital Recycling Detected
The manipulation was exposed only by consolidating Balance Sheets of all five units as on a single common date. Outcome: Proposal Rejected.
XYZ Ltd (Round-Tripping Sales)
Company achieved the projected turnover with a steep rise in current assets, but scrutiny showed abnormal patterns.
Diagnostic Analysis
Profitability Lag
Despite steep increase in sales, overall profitability was only marginally higher.
Shadow Associate
An undisclosed associate company was found engaged in Rs. 3 crores of trading with nil stock.
Round Tripping
Parent company passed entries to associate, who later gave them back to inflate turnover.
Banker's Verdict: Artificial Sales Inflation
Fake entries were used purely to negotiate larger credit facilities. Conclusion: High credit risk / Integrity failure.
PQR Ltd (Contracting Logic)
While sales increased from 100 to 200 lacs over 3 years, net profit declined from 12 to 10 lacs. A rash conclusion would suggest poor margin management.
Diagnostic Analysis
Input Costs
Possible increase in input costs without matching selling price hike.
Admin Overheads
Increase in selling and administration expenses not fully absorbed.
Accounting Basis
Company books profits only on realization, بينما expenses are accrual-based.
Banker's Verdict: Proper Evaluation Policy
Aggregate profits over 5 years showed a healthy increasing trend. Outcome: Credit support maintained despite short-term profit dip.
KLM Ltd (Policy Distortion)
Sanctioned for enhancement based on projected sales of 275 lacs. Actual turnover was 225 lacs and utilized full limit. A serious anomaly on the surface.
Diagnostic Analysis
Revenue Deferral
Company changed policy: did not book sales worth Rs. 50 Lacs (moved to next year).
Conservative Provisions
Higher provision for bad and doubtful debts was made on a conservative basis.
Banker's Verdict: Strategic Conservatism
Change in accounting policy distorted the Ratios but indicated prudent management. Moral: Study policy implications before rash conclusions.
SM Textiles Ltd (Strategic Asset Renewal)
Net Profit dropped by Rs. 1 Crore while sales and prices were favourable and costs remained static. A puzzling trend at first glance.
Diagnostic Analysis
Physical Upgradation
Replaced old ring frames with efficient ones to improve quantity and quality of yarn.
Revenue vs Capital
Company charged 100% of purchase to 'Renewals, Repairs & Maintenance' as per IT Act.
Tax Arbitrage
By treating as revenue, company arrested tax outflow while utilizing surplus funds.
Banker's Verdict: Actual Liquidity Strong
Healthy asset renewal was masked as profit decline for tax efficiency. Conclusion: Actual position was superior to the reported Ratio.
VRS Ltd (Strategic Ad Promotion)
Meagre profits for three years despite high margins. The large advertisement spend appearing in P&L was the primary drag.
Diagnostic Analysis
Marketing Intensity
Massive ad campaigns across Indian and International popular dailies/magazines.
Deferred Benefit
Current year growth was directly tied to the brand-building exercises of the past 3 years.
Banker's Verdict: Growth Poincaré
Short-term profit dip was a strategic investment for rapid market capture. Outcome: Limit Sanctioned.
X Ltd (Shadow Receivables)
A transport company booking revenue on realization but expenses on accrual. Critical assets were missing from the Balance Sheet.
Diagnostic Analysis
Hidden Assets
1.5 to 2 months of freight charges (receivables) were missing from the financial statements.
Tax Deferral
By using cash basis for income, company deferred incidence of advance-tax and income-tax.
Banker's Verdict: Forensic Scrutiny
Bank finance required relying on certified auditor statements of unbooked receivables. Moral: Go behind the financial statements.
Financial Control & Structural Ratios
Ratio analysis of financial statements is the process of calculating structural relations. It helps locatetrouble spots and suggest effective courses for action.
Example: ABC Ltd (1993 Control Audit)
| Liabilities | Rs Lacs |
|---|---|
| Paid up capital | 1.50 |
| Long term liabilities | 2.50 |
| Short term funds | 1.00 |
| Total | 5.00 |
| Assets | Rs Lacs |
|---|---|
| Net Fixed Assets | 3.50 |
| Inventory | 1.00 |
| Receivables + Cash | 0.50 |
| Total | 5.00 |
Total Current Assets / Total Current Liabilities.
ABC Ltd Result: 1.50 : 1
(Cash + Receivables) / Current Liabilities.
ABC Ltd Result: 0.50 : 1
Shareholders' Funds / Total Assets.
ABC Ltd Result: 0.30 : 1
Net Fixed Assets / (Net Worth + Term Debt).
ABC Ltd Result: 0.87 : 1
Current Liabilities / Tangible Net Worth.
Should not exceed 0.80:1. ABC Ltd: 0.6: 1
Inventory / Net Working Capital.
Should not exceed 80%. ABC Ltd: 2: 1 (Very High)
Standard Safe Norms
| Ratio Descriptor | Standard Benchmark |
|---|---|
| Current Ratio | 2.00 : 1 |
| Quick Ratio | 1.00 : 1 |
| Current Liabilities to TNW | 0.75 : 1 |
| Total Liabilities to TNW | 1.00 : 1 (Max 2.5:1) |
| Collection Period | < 42 Days |
| Inventory Turnover | > 3 Times |
| Sales to TNW | 8 Times (Mfg) |
Public vs Private Sector Comparison
| Metric | Public Sector | Private Sector | ||||
|---|---|---|---|---|---|---|
| 2019 | 2020 | 2021 | 2019 | 2020 | 2021 | |
| Sales / Total Assets | 0.619 | 0.590 | 0.587 | 1.131 | 1.123 | 1.073 |
| Current Ratio | 2.45 | 2.39 | 2.19 | 2.13 | 2.13 | 2.11 |
| Avg Days: RM Stocks | 71 | 72 | 68 | 74 | 75 | 70 |
| Debt Equity Ratio | 1.43 | 1.51 | 1.57 | 1.40 | 1.37 | 1.40 |
| Return on Net Worth (%) | 6.72 | 5.44 | 4.68 | 12.60 | 14.37 | 12.33 |
Source: CMIE Corporate Data Recast
Interpretation Of Ratios: Unit A vs Unit B
Comparing two small-scale units with similar balance sheets. Which unit is the better credit risk?
Banker's Decision: Unit A is Preferred
Despite a lower current ratio (0.54), Unit A shows higher liquidity (Quick Ratio), superior earning power (24.9%), and overall efficient capital management. A is more desirable for lending.
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