1 FINANCIAL STATEMENTS - ANALYSIS OF BALANCE SHEET Basically, depositors provide the funds used by a banker for his loaning

operations and consequently the interests of the depositors should be the major factors determining the criteria for good lending. The depositors primarily are interested in : 1.Safety of their funds 2.Liquidity of their funds or the ease with which the deposit could be encashed in times of need 3.Yield. In order to ensure the interests of the depositors, before considering any credit decision, banker is interested in the above principles i.e., the principles of good lending. Since the yield, now-adays, is determined by RBI/Market forces, Bankers are mainly interested in safety and liquidity of their advance. These things can be effectively ensured by proper analysis of financial statements. What are financial statements? 1. 2. 3. 4. 5. 6. Audited Operating statement/Profit and Loss account Audited Balance Sheet Audit Report Form 3CD, 3CB including auditors report Annual report Provisional / Projected Balance Sheets Income tax/Sales tax assessment orders etc.

The Balance Sheet is the most important financial statement prepared annually. It is a statement of balances, depicting the assets and the liabilities at a stated point of time. The Profit and Loss account indicates the working results of the company during a specified period of time, which is usually one year. ASSETS: Asset should satisfy three attributes for accounting: 1. Capacity to generate an economic benefit 2. Ownership 3. Measurement of cost FIXED ASSETS: These assets are Productive assets and are permanent in nature and are operated by the enterprise to produce certain goods for sale at a profit. Eg: Land, Building, P&M, Furniture and Fixtures, Vehicles etc. The continued utilization of these assets reduces the life period of these assets. The said notional wear and tear of the asset is known as Depreciation. Although there are many methods of depreciation, only two of them are in use in India. 1. Straight line method: Under this method, a fixed amount is written off every year 2. Written Down Value method: A fixed percentage of the outstanding net block is written off in each year Depreciation thus, is a notional charge on the profit, beneficial to the enterprise as it reduces tax liability.

2 CURRENT ASSETS: The assets, which would be converted into cash during next 12 months, are called Current Assets. Eg: Inventory, bills receivables / book debts, stores and spares, prepaid expenses, cash / bank balances. These assets are also called as Circulating Assets. MISCELLANEOUS ASSETS/NON-CURRENT ASSETS: Apart from the above assets there are other classes of assets, which are called miscellaneous or non-current assets. Ex: investments in associate concerns, money lent to other corporate bodies, book debts over six months, loans to employees etc. INTANGIBLE / FICTITIOUS ASSETS: Intangible assets, also called fictitious assets, do not represent any material assets or property. These assets we cant see with naked eyes and cant touch physically. These assets have no realizable value and the Tangible Net Worth of an enterprise is reduced by the amount of such intangible assets. Eg: Goodwill, patents, Preliminary expenses, trademarks, designs etc. LIABILITIES: These are claims against enterprise requiring payment at a point of future. The three sources from which funds are drawn are: Proprietor / Share holders contribution towards capital The lenders/banks/others who grant debt capitals Outsiders/Creditors, who defer payments due to them for materials delivered or services rendered to enterprises 1.a. Shareholders contribution/Capital: It constitute, the capital of the enterprises, the capital structure is as under: Authorized Capital: Divided into -----------equity and --------------preference shares of Rs.-------(face value) Issued Capital: --------------shares -----------equity and preference ----------issued for subscription, either by prospectus or otherwise Subscribed Capital------------------shares subscribed to by the public and others --------------equity and preference---------------

Paid up Capital:-------------shares -----------equity and preference------------paid up (fully or partly) For a Corporate Unit, its Memorandum fixes the ceiling up to which capital can be raised, which is called the authorized capital. The memorandum also stipulates the class, number, face value of shares that can be issued. For the enterprise, the last mentioned item represents the funds made available through share capital, while the others indicate cushion for further raising of capital in future. 1.b. Reserves and Surplus: Reserves Reserves are of two kinds, Capital Reserves and Revenue

3 Capital Reserves arises in the following assets: Surplus due to revaluation of Fixed Assets Issue of shares at a premium Profit on sale of assets Redemption of shares or bonds or debentures at a discount Capital Subsidy by the State/Central Governments Revenue Reserves are created out of accumulated past profits, arises in the following assets: General Reserve Development Rebate Reserve Dividend equalization Reserve Investment allowance Reserve 2. TERM LIABILITIES: These are the borrowings, which need not be paid during the next year. These are Term Loan borrowings from banks/financial institutions and Term Lending Institutions like ICICI, IDBI, IFCI etc. Eg: Debentures. Redeemable Preference Shares, Term loans, Unsecured loans payable beyond 1 year etc. 3. CURRENT LIABILITIES: These liabilities are to be payable as demand or within a maximum period of 12 months. Eg: Bank CC limits; Unsecured loans payable within a year, Sundry/Trade creditors, Advances and deposits from dealers/customers, Provision for tax, Statutory liabilities, installments of term loans payable within 12 months etc. IMPORTANT TERMINOLOGIES Authorized Capital: This is the maximum amount of capital that a company can raise as per its memorandum of association. It is expressed in terms of number of shares, face value of the share and total amount. Issued Capital: It is that part of the authorized capital for which subscription is invited from the prospective shareholders by the company. It is not necessary that the company should issue the entire amount of authorized capital at a time. Subscribed Capital: The face value of those shares that are subscribed by the shareholders out of the issued capita is called subscribed capital. This can be equal to the amount of issued capital. If oversubscription situation arises, the company will either refund the excess amount or will exercise green shoe option in case the terms of issue permit. Paid-up capital: The amount of capital actually paid by the share holder towards the called/subscribed capital. If amount is not fully called by the company, the amount will be less that subscribed capital. Green Shoe Option: The option with the company to retain a part of the oversubscribed amount as per terms of the issue

Bonus Shares: These are issued by a company to the debit of general reserves. These do not affect the net worth. Rights issue: These are new shares issued to the existing shareholders on a rights basis. With rights issue, change takes place in net worth since there is fresh infusion of funds as net worth. Net worth: The net worth stands for the paid up capital + reserves of the company. These are the funds owned by the promoters of the business. Capital Reserve: The reserves which are not available for distribution among shareholders. These reserves are built out of such earnings of the company that do not come from normal trading activities (ex: share premium reserve) General reserves: The reserves available for distribution among the shareholders. These reserves are created out of undistributed profits Tangible Net worth: To see the exact worth of the business, the bankers take into account the tangible net worth which is calculated as net worth intangible assets Contingent liability: These are the liabilities which may or may not arise. For example if a firm gives guarantee to bank for the loan of its allied firm. If the allied firm defaults, the guarantee given will be converted into an actual liability. This is shown as footnote of balance sheet. Intangible assets: The assets which have notional value only. These assets are written off by the firms out of the future profits. These may include pre-operative expenses, patents etc. Non-Current assets: The assets that are neither current assets nor fixed or fictitious assets. The special feature of such assets is that these do not become cash in the next 12 months. These may include loans given, security deposits, investments etc. Cash Profit: When net profits are seen without taking into account the amount of depreciation. In other words these are profits before depreciation. These are calculated as net profit + depreciation Cash loss: When the net losses are calculated without taking into account the amount of depreciation. In other words these are the losses before depreciation and are calculated as net loss depreciation.

Gross Profit: The gross profits are calculated as net sales less cost of sales Long term sources: These are the liabilities which will continue with a firm for a long time period. These are calculated as net worth + long term liabilities Short term sources: These are the liabilities which will continue with the firm for a short period up to 12 months. These are also known as current liabilities Long term uses: The funds that have been invested on a long time basis. These include fixed assets + non current assets + intangible assets Short term Uses: The funds that have been invested in short term assets. These are represented by current assets Quick assets: Assets which are either ready cash or can be converted into cash quickly (cash and bank balances, fixed deposits in banks, current receivables or book debts, marketable and quoted govt. or non-govt securities). These are also calculated as current assets less stocks and prepaid expenses. Net Block: Original cost of fixed assets less depreciation is known as net block. Net Sales: Net sales are gross sales minus returns, discounts, excise duty. Raw Material Consumption: Raw material purchased plus opening stock of raw material minus closing stock of raw material Cost of Production: Cost of raw material consumed, stores and spares consumed, power and fuel, direct labour, repairs and maintenance, other manufacturing expenses and depreciation plus opening stock of stock in process less closing stock of stock in process . Cost of Sales: Cost of production plus opening stock of finished goods minus closing stock of finished goods

BALANCE SHEET FORMAT (Non-corporate entities) LIABILITIES A. NET WORTH:

1. Equity/share capital 2. Reserves 3. Surplus/profit

ASSETS E. FIXED ASSETS

1.Gross Block 2. Depreciation 3. Net block

B. TERM LIABILITIES:
1. Term loans(excl. installments payable within 1 yr) 2. Deferred payment credits 3. Debentures (not maturing within one year) 4. Unsecured Loans (not maturing within one year)

F. NON-CURRENT ASSETS
1. Investment in associates 2. Statutory Deposits held

3.Other investments like chits etc.

C. CURRENT LIABILITIES
(excl: statutory liabilities) 1. Short term borrowings from banks (unsecured loans payable within 1year) 2. Short term borrowings from others 3. Trade creditors. 4. Provisions (due within 1 year) 5. Installments payable on T Ls(payable within 1 yr) 6. Advances / Deposits received

G. CURRENT ASSETS
1. Cash and Bank balance 2. Inventory/stock 3. Book-debts 4. Deposits (maturing within 1 year) 5. Advances to staff (maturing within 1 year) 6. Advance payment of taxes 7. Advance payments to suppliers 8. Pre-paid expenses

D. STATUTORY LIABILITIES
(due within one year) 1.Provisions for income-tax, 2.Dividend payable 3.Provident Fund Dues 4. Sales tax, Excise duty etc

H. INTANGIBLE ASSETS
1. Patents, Goodwill, Preliminary exp., 2. Bad and Doubtful debts not provided for etc. 3. Debit balance of P&L account

GRAND TOTAL FOR LIABILITIES

GRAND TOTAL FOR ASSETS

Contingent liabilities / Off-Balance Sheet items: These liabilities may or may not accrue as liability; Even if they turn against the enterprise later, the quantum is certain. They are shown as footnote to the Balance Sheet. The banker should take note of such liabilities and ascertain whether the amount of the contingent liabilities is large in proportion to the financial resources of the business. Eg: Pending(law) suits; Claims not acknowledged as debts, Guarantees issued by the Firms, Bills/Cheques discounted with banks; Taxes/Duties under appeal/dispute Quasi Equity: Some times promoters bring in funds as unsecured loans in the names of his friends and relatives to avoid tax complications. This amount can be treated as Quasi Equity subject to obtention of an undertaking from the promoters/unsecured creditors stating that these funds would not be withdrawn during the currency of bank loans. These loans are also known as Sub-ordinate Debts. This concept is applicable only in case of non-corporate entities.

7 SOME IMPORTANT TERMINOLOGIES 1.Gross Working Capital: The total of Current Assets 2.Working Capital Gap: Gross Working Capital Current Liabilities excl. Bank W.C.finance 3.Net Working Capital / Liquid Surplus : Surplus of long term funds over long term uses or Total Current Assets Total Current Liabilities 4.Tangible Networth: Net Worth Intangible assets i.e, (A) (H) 5.Total Outside Liabilities: Total Current Liabilities + Total Term Liabilities i.e., (B) + (C) COMMON WINDOW DRESSING PRACTICES BALANCE SHEET: 1. Date of Balance Sheet coinciding with end of season 2. Indicating current expenses as Capital in Balance Sheet 3. Preparing Balance Sheet on difference dates for associate concerns(leads to manipulation of account by paper entries leads to non-detection of interlocking of funds/stocks) 4. Temporary reduction in Current Liabilities (for a day or so); setting off CL against CA Ex: Issuing cheques in payment of CL but not dispatching them (reduction in sundry creditors) 5. Maximising collection of receivables on Balance Sheet date thus showing a large cash balance (including cheques yet to be realized) 6. Withdrawal of intercorporate investments on Balance Sheet date 7. Delaying declaration of commencement of production 8. Revaluation of fixed assets leading to inflating the Fixed Assets value and improvement in Net Worth position 9. Capitalization of interest on term loans P&L ACCOUNT: 1. Resorting to heavy billing of sales on date of balance sheet leading to increase in sales, reduction in closing inventory and increase in profit 2. Changing the method of depreciation Particularly with retrospective effect 3. Booking unrealized income (eg: Export incentives) as revenue 4. Changing the method of valuation of stocks (in an inflationary situation) FIFO LIFO leads to decrease in profit & LIFO FIFO leads to increase in profit LIMITATIONS OF BALANCE SHEET 1. Balance Sheet is as on a specified date a snap shot not always representative in character it can be window-dressed to achieve certain purposes 2. Unless it is audited cannot be relied upon. But auditing too has its limitations. 3. Balance sheet is based on Facts, Accounting Conventions, Opinions of the Auditor/Accountant/Management/Balance Sheet excludes all non-monetary transactions and factors, howsoever important they are. Eg: Skilled labour, technical know-how, Industrial relationship, competent management etc.

RATIO ANALYSIS Ratio may be defined as a fixed relationship in degree or number between two numbers. Ratios act as an important and useful device for control. Ratios in themselves have no meaning unless compared with other ratios for suitable analysis. To make ratios more meaningful and increase their utility a financial analyst should not the following: To compare ratios of a firm with some standard industry ratios accepted as the norms. Compare ratios of one firm with ratios of other firms to know whether the firm is strong or weak, overvalued or undervalued (inter-firm comparison) Compare ratios of one firm with ratios of similar firms from other industries Compare ratios of the same firm for different time periods (intra-firm comparison) Financial ratios may broadly be classified in the following categories: 1. LIQUIDITY RATIOS: A) CURRENT RATIO: Current Assets / Current Liabilities A low ratio may indicate that a firm may not be able to pay its obligations on time. A high ratio may indicate an excessive amount of current assets and possibly a failure to Properly utilize the firms resources. The ideal ratio is 1.33:1 B) QUICK RATIO / ACID-TEST RATIO: Current Assets-Inventory / Current Liabilities A high quick ratio indicates that cash and or receivable are excessive, both possible signs of lax management. A low quick ratio indicates the possibility of difficulties in prompt payment of bills in the near future. The ideal ratio is 1:1 2. SOLVENCY RATIOS: A) DEBT-EQUITY RATIO: Long Term Debt / Equity, the ideal ratio is 2:1 This ratio shows the extent to which the term liabilities are covered by the owned funds or the tangible net worth of the business. It depends on the nature of industry also. In a capital intensive industry with prospects of higher profitability, high debt ratio should not be considered undesirable. B) GEARING RATIO: Total Outside Liabilities / Tangible Networth , the ideal ratio is 3:1 A high ratio represents a greater risk to creditors, especially, if business conditions turn adverse. A low ratio represents security to creditors. However, a very low ratio can also indicate that the company is not using debt to its best advantage. C) GROSS DSCR (DEBT-SERVICE COVERAGE RATIO): Net Profit after tax + Depreciation + Int. on TL / Int. on Term Loan + Installment on TL The ideal ratio, as per our loan policy is 1.75:1 D) NET DSCR: Net Profit after tax + Depreciation / Installment on Term Loan The ideal ratio, as per our loan policy is 2:1 This ratio is useful for fixing up the repayment schedule of a term loan. This ratio also denotes whether the cash accruals generated out of the asset(s) financed by the Bank are adequate to cover the repayment obligations or not. Thus, it represents the repaying capacity of the unit from out of the cash accruals made by the Unit. E) INTEREST SERVICE COVERAGE RATIO: PBDIT / INTEREST

9 3. PROFITABILITY RATIOS: A) GROSS PROFIT RATIO: Gross Profit / Net Sales x 100 B) NET PROFIT RATIO: Net Profit / Net Sales x 100 C) RETURN ON CAPITAL EMPLOYED RATIO (ROCE) %: Profit Before Depreciation, Interest, Tax / Total Assets x 100 4. ACTIVITY RATIOS: A) INVENTORY TURN-OVER RATIO (NO. OF TIMES) : Cost of goods sold / Average Stocks (Avg. Stocks = Opening Stocks + Closing Stocks / 2) Cost of goods sold is arrived at by deducting gross profit from the sales figure This ratio indicates how many times the inventory is turned over. A higher ratio indicates efficient use of working capital funds. A low ratio indicates that sales are falling or that there are inventory holdups B) DEBTORS TURN-OVER RATIO (IN DAYS) : Sundry Debtors + Bills Receivable / Annual Credit Sales x 365 This ratio indicates the time taken for realization in respect of credit sales. C) CREDITORS TURN-OVER RATIO (IN DAYS): Sundry Creditors + Bills Payable / Annual Credit Purchases x 365 It reflects the number of days the purchases remain unpaid. A longer period indicates that The Cos liquidity is under pressure and is unable to meet its creditors within normal credit due to cash flow problem or The Co. being a dominant unit dictates terms to its suppliers, by extending period of credit allowed by the market. A shorter period indicates that The units liquidity is comfortable or Reluctance of suppliers to grant the normal credit Limitations of ratio analysis: 1.Inconsistency in accounting procedures and window dressing in balance sheet may distort the analysis. 2.The ratios are calculated at a particular point of time since the balance sheet relates to the position as a particular date. The corresponding position in the various months of the year may be different and hence ratios suffer from short-term changes. 3.Seasonality is not reflected in balance sheet and therefore ratios dont convey correct picture. 4.Balance sheet can take into account only items which can be expressed numerically in terms of money; it cannot take into account factors that accounts for stability or profitability of the ex: skills, know-how, labour relationship, competent management 5.Any analysis requires Standards or yardsticks for comparison/measurements. They are not always available in case of SSI units. .