Lesson No. 17 – Discussion on Ratio Analysis

Good morning my y gen F B friends

Wed 17/02/2016

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Let us continue our discussion on Ratio Analysis. Ratios in themselves are mere numbers, but their interpretation can revel the true financial position of the borrower. For the Working Capital finance we seek Financial Statements ie Balance Sheets ,Profit and Loss statements for last 2 years actuals,current year provisional and projected for next year. For term loan appraisal we seek these statements and funds flow and cash flow for the entire period of proposed repayment period.We also obtain the Audit Reports and IT,CST/GST /Wealth tax returns to cross verify the data.

Working Capital finance can be broken into Pre Production stage,production stage(this is called as Pre Sales Finance) and Post Sales finance.
Pre sales finance starts from procuring RM and Stores.For these steps facilities may be
1 BG/LC or Bill Discounting/Acceptance for RM.
2 CC/OD/DL/ST loan or Pre Shipment finance.(Including manufacturing and other expenses for production).
3 Post Sales finance include BP/BD/OD against the Supply Bills/OD against the Debtors or Receivables (Post Shipment finance is of this nature)/CC or OD against the Ware housing bills to the entrepreneurs and Agriculturist also falls under this category.
We will now learn two important glitches (technical words) LIQUIDITY and SOLVENCY.
Let us go back our discussion on B/S
Liabilities are Sources of Funds 
Can be divided as 
LIABILITIES
CL. = Short Term Source STS
TL+ NW = Long TermSource LTS
the other method of looking at them are
CL+TL = Out side liabilities
NW. = Payable at winding of unit(inside)

ASSETS
CA= Short Term uses STU
FA= Long Term Uses LTU
NCA = LTU but not liquid at all.
Financial strength of a unit is measured by its ability to repay its borrowing.
LIQUIDITY is the ability to pay off its current liabilities.
1. We study The Ratio called as Net Working Capital NWC = CA - CL ,It should show an increasing trend showing that profits are retained or ploughed back.It is in fact the margin provided by the borrower. Decreasing figures tell the reverse story and it should be studied.
The concept is all CA be financed from CL (STS) plus some part fro LTS.It is the strength as LTS arevto be repaid in long term say 3/5 years but being utilized for CA which are easily encashable.
2 CURRENT Ratios= CA/CL The thumb rule is a ratio of 2:1; but we accept it to the level of 1.33: 1 or even sometimes 1.17:1.
It means the borrower has Paisa 133 in his pocket whereas he has to pay Paisa 100. So there should be a study rise or at least maintainance of this ratio. If there is a downward trend correction steps is the requirement.
3 Acid Test or Quick Ratio = 
CA-Inventory/ CL
Or 
CA - Inventory/ CL- Ex ban borrowing
The ratio of 1:1 or near by it, is supposed to be satisfactory. It is in a way stress test of liquidity.
It is assumed that the inventory is least liquid. Similarly the BB, Bank Borrowing are more or less are of the continued nature.
Remember while working these ratios not only the figurative Assets but its quality is also important. Consider the RM or FG stock which is outdated or beyond shelf life or say Debtors are over 90 or 180 days old (are they not NPA's) and unrecoverable; in such cases better reclassify them as NCA ,but do it prudently (and not rudely).
The high CR of 4 OR 5 is also not healthy for manufacturing organization s as it may mean exploration of assets and shortage of WC .
However for retailers/distributors it is common.
I may pen off the real stories are not Numbers alone but the constituents of it.
Thanks.

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