ANALYSIS OF BALANCE SHEET

AND RATIO ANALYSIS

For a lending agency, the Balance Sheet of a corporate forms one of the basic and critical
documents while taking a credit decision be it for working capital or project finance. The
Balance sheet and the Profit & Loss account statements of an enterprise gives a treasure of
information if properly analysed. These statements which reflect the financial soundness and
operating efficiency of a corporate greatly facilitates the lending agencies to take the credit
decision. It is therefore, considered necessary to critically analyse the Balance Sheet and the
operating statement of a corporate and stipulate certain financial benchmarks before the credit
decision is taken as the present system of analysing the financial data requires some more fine
tuning. The Balance Sheet of an enterprise is a snap shop indicating the financial health on a
particular date and does not throw any light on the current state of affairs as mostly the time
difference between the close of the book of accounts and its disclosure will be relatively too long
barring a few exceptions. Further, the Balance Sheet has certain limitations and does not disclose
some of the following critical factors:

a) Managerial Competence
b) Technical Competence
c) Turnover of People
d) Obsolence of Technology
e) Competition
f) Marketing

It is desirable that in the appraisal memorandum in addition to commenting on the financial

parameters of the corporate, the above off the Balance Sheet informations should be detailed in
order to make the appraisal exercises more meaningful. Further, the profit and loss statement of
the corporate which discloses the sales, production, profitability, performance and the cash flows
during the accounting period will be of more relevance to the lending agencies to determine the
operating efficiency of the corporate in managing its resources for maximisation of returns. As it
is now mandatory for the corporate to publish the quarterly operating results, the lenders can
have access to the operating statement within a reasonable time from the close of every quarter.
This will facilitate the lenders to evaluate the operating efficiency of the corporate on an ongoing
basis which can be compared with the QIS returns submitted by the corporates at the stipulated
intervals to ensure proper end use of working capital funds. The lending agencies normally rely
more on the following ratios while assessing the working capital and the project finance to a
corporate borrower.

a) Current Ratio:- This ratio indicates the solvency of the company to meet the liabilities,
which are due for payment within the next 12 months from out of the current assets. Though
the lending agencies derive a lot of comfort from this ratio, in reality the ratio may not reflect
the true picture about the solvency of the company as the realisable value of the current
assets in the event of the forced sale cannot be determined as against the current liability
which are clearly quantified. It is not uncommon that even many going concerns having
comfortable current ratio will be struggling to meet the day to day commitments due to
 improper cash management. Like - wise, a corporate not having comfortable current ratio
will be meeting all its maturing obligations without much delay due to efficient cash
management policies pursued. The ratio is calculated based on the current assets and current
liabilities as on the last date of the accounting year and it is quite possible that this can be
easily managed even on the last date of the Balance Sheet by any corporate. As the
assessment of working capital requirement is done based on the projected Balance Sheet
keeping the audited Balance Sheet as a base , it is desirable for the lending agencies to relate
this ratio with other operating ratios which give qualitative analysis on the cash management
efficiency of the corporate.

b) Debt Equity Ratio(Total Outside Liabilities to Tangible Net Worth):-

This ratio is calculated by dividing the total liabilities of the company with the tangible net
worth of the company. This ratio reflects the financial soundness and the solvency of the
corporate. Lower the ratio indicates the high degree of solvency and higher the ratio indicates
the over extended financial position of the company. Normally, the Bankers feel comfortable
as long as this ratio does not go beyond 3:1 for any corporate.

c) Funded Debt Ratio (Total Outside Term Liabilities to Tangible Net Worth):-

This ratio is calculated by dividing the long term loans with the tangible net worth of the
company. The ratio signifies the financial soundness of the corporate. Lower the ratio
indicates the high solvency and higher the ratio indicates high debt gearing of the corporate.
Mostly, the term lending institutions use this ratio as a yardstick for the purpose of appraisal
of the term loan requirements of the corporate. Normally, the term lending institutions insist
on the corporate to maintain a ratio of 2:1 as a benchmark for any project finance.

d) Debt Service Coverage Ratio (DSCR):-

This ratio is calculated by dividing the cash accruals with the term loan obligations, which
falls due during the accounting period. This ratio will enable the term lending institutions to
evaluate the viability of the proposal and determine the period of the term loan and also to fix
up a suitable repayment schedule depending on the cash accruals during the tenor of the term
loan. Normally, the minimum average DSCR of 1.5:1 is considered desirable while
considering the term loans to any corporate.

Normally, Current Ratio and the Debt Equity Ratio are relied for the 'Working Capital
Assessment' and the Funded Debt Ratio and Debt Service Coverage Ratio are relied for the
'Project Appraisals'. While these ratios are quite useful in judging the financial soundness as
well as the short term and medium term solvency of any corporate, it is equally expedient on
the part of the lending agencies to rely more on certain other Balance Sheet and operating
ratios which will reflect more transparency on the ability/efficiency of the corporate in the
funds management.
e) Capacity utilisation to installed capacity Ratio :-

This ratio will indicate the following:-

i) Extent of the capacity utilisation.

ii) Whether the growth in sales is on account of increase in the production or increase
in the selling price per unit of production or increase in the production and
decrease in the selling price per unit of production etc. It is possible that the
company can always maintain the growth in sales not be increase in the volume of
production but mere increase in the selling price per unit of production also.

iii) Reason for decrease/stagnation in the production in terms of quantity can be

ascertained like fall in demand, introduction of new substitutes in the market by its
competitors, production bottlenecks, labour problems etc.

iv) Future capacity expansion can always be subjected to a closer scrutiny in the event
of any increase in the fixed assets being reflected in the CMA.

f) Net Block to Long Term Debt Ratio:-

In most of the Working Capital Advances, there is a practice of stipulating second charge on
the fixed assets of the company where the same are charged to the term lending institutions.
The above ratio will indicate the asset coverage ratio for the term lenders which in turn will
indicate the cushion available for the working capital bankers also being the second charge
holders. Further, this ratio will also highlight the investment made in the fixed assets for
expansion/diversification and redemption/rescheduling of long term debts depending on the
increase/decrease in the ratio on an ongoing basis.

g) Inventory and Receivables to Total Current Assets Ratio:-

This ratio will indicate the extent of funds that are deployed in the form of production linked
assets like inventory and receivables. Notwithstanding the fact that the corporate has brought
in the required margin on the total current assets as per the assessment made in the CMA, the
bankers always regulate the drawings in the cash credit account based on the fully paid stock
declared in the stock statement less margin to arrive at the drawing power. Normally, there
should be a proper match in building up the production linked assets to the other current
assets depending on the specific requirement of the corporate. Normally, the carry of
inventory is influenced by the level of activity/availability of the raw material and the
receivables depending on the trade practices/supply and demand. At the same time any
unreasonable level of carry of inventory and receivables are not desirable, as it would
unnecessarily block the working capital resulting into cash flow problems. In any given
situation, it is always comfortable for the working capital bankers if the ratio indicates
sufficient cushion for the drawings in the working capital limits as otherwise the working
capital limits will throw irregularity for want of adequate level of inventory and receivables.
Further, no yardstick can be fixed for carry of inventory and receivables and the other current
assets which should be normally based on the past trend and depending on the various other
 factors like production cycle, availability of raw materials, transit time for the procurement of
the raw materials, the trade practices with regard to availability of credit in the market and
collection of receivables etc. However, any abnormal increase/decrease in the composition of
current assets(whether inventory and receivables or other current assets) should attract closer
scrutiny by the lenders.

h) Closing stock of Raw Materials to Raw Materials Consumed Ratio:-

This ratio will compare the extent of raw materials holding as closing stock with reference to
the raw materials consumed during the accounting year. The ratio will indicate how many
times the raw materials have been turned over during the accounting period. By multiplying
the ratio with 365 days, the holding period comes. If the holding period is less, it will
contribute to lowering the net operating cycle. There cannot be any bench marking of the
same. It varies from industry to industry and again within the industry, unit to unit depending
upon the competence of the person responsible for the business.

i) Total Assets (net of intangibles) to Net Worth Ratio : -

This ratio will indicate the extent to which the owned funds are invested in building up the
assets of the corporate. A low ratio indicates the lesser dependence on the outside borrowings
and plough back of cash accruals into the system. A high ratio indicates the increased
dependence on the outside borrowings to run the business. This will indicate the prudence of
the management in conserving the internal cash generation for building up the assets of the
company.

j) Cost of Production to Net Sales Ratio:-

This ratio will indicate the operating efficiency of the corporate and the increasing ratio will
indicate the inability of the corporate to pass on the rising cost of inputs to the end users of
the product. This will indicate the falling/rising profit margin of a corporate, which will put
the lenders on guard while making further financial commitments to the corporate.

k) Interest to Total Borrowings (including Sundry Creditors):-

This ratio will indicate the average cost of the funds borrowed by the company to run its
business. This will enable the lender to determine the rate at which the corporate is
borrowing from outside sources. High ratio indicates the desperate attempt of the borrower to
manage its funds requirement by resorting to high cost borrowings, which will have direct
impact on the bottom line of the corporate.

l) Net Sales to Total Current Assets Ratio :-

This ratio will indicate the number of times the company has been able to turnover the total
working capital employed by the company. Normally, if the ratio settles between 4 and 8, it
can be inferred that there is a healthy turnover in the working capital. If the ratio goes
beyond 8, there is a possibility of the corporate indulging in over trading.
m) Net Sales to Bank Borrowings Ratio :-

This ratio will indicate whether the increase in the Bank Borrowings is proportionate to the
increase in the sales or not. If the corporate is not able to reach the level of activity as
envisaged at the time of appraisal of the working capital limits and avails the limits assessed
to the full extent or beyond the limits assessed, it should put the lenders on guard about the
possible diversion of funds. This ratio can be used to ascertain the cause of such action and
refrain the corporate from indulging in such diversions.

n) Interest Coverage Ratio (PBIT/Interest) :-

This ratio will indicate the ability of the corporate to service the interest on the loan taken
from the lenders. If the ratio is increasing, it gives an indication that corporate is generating
sufficient profit to service the interest on the loans borrowed. It will increase the comfort
level of the lenders in taking higher exposure to the corporate.

o) Net Profit Margin ( Net Profit i.e. PBT/Net Sales) :

This ratio will indicate the profitability of the corporate in relation to the volume of the sales
achieved. Even though the profit of the corporate in absolute terms may be increasing but in
terms of the percentage to sales it may be shrinking. This ratio will reflect whether the
corporate is able to maintain the profitability in relation to the growth in the sales.

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