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Banking Strategy,Credit Appraisal, andLending DecisionsA Risk-ReturnFramework

Second Edition

Hrishikes Bhattacharya

U N I V E R S I T Y P R E S S

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Contents

Li s t o fA p p e n d i c e s xiList ofAnnexures xiiPre face to t he Se c ond Ed i t i on xiiiA c k n o w l e d g e m e n t s xvIn t roduc t i on xvii

1 . Capi ta l Regu la t ion andRisk Management S t r a t e g y 1Introduction Inter-relationship among capital, assets, ROA, and ROE Competition for funds Rise in losses Risk management: A strategic issue Concluding remarks2 . Liquidity Management and Assets-Liabilities Strategy 32Introduction Liquidity mana gem ent theories Fluctuations in the economy Liquidity planning > Liq uidity ratios Balance shee t approach > D ep loy m ent strategies Maturity matching strategy Co nclu ding rem arks3 . Banking Strategy 65Introduction Financial sector reform s Decline of traditional banking > Ch angin g sav ingsand inv estment behav iour Liquidity newly denn ed Securitisation Strategic planning Capital planning Gr ow th m ode l Banking strategy: The case of AB C B ank S trategicplanning ex ercise of ABC Bank Cos t allocation

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viii Contents

5. Fixed Assets 125Introduc tion Definition > Land and buildings > Factory shed location Plant andmachinery D epreciation Appreciation Capital work-in-progress Furn iture and fix tures Motor v ehicles C oncluding remarks6 . Working Capital: ATechno-Financial Approach 133Introduction Should we hate c urrent assets? Curren tness con cept and o perating cycletheory Natural business year Negativ e op erating cycle Lim itations of operating cycletheory Mathematical fallacy Reversibility test An alternative theory of working capitalo Discrete opera ting inv entories Oth er discrete curre nt assets Techno-financial app roach Co re working capital Projection of working capital Characteristics of Core WorkingCapital Control mechanism s Concluding remarks7 . Current Assets and Fictitious Assets 152Introduction Cash and bank balances Sundry debtors/receiv ables Inv entory Valuation of inv entories Various types of stocks/inv entories Loans and adv ances Intangible and fictitious assets Fictitious assets C onc ludin g rem arks

8 . Long-term Liabilities 165Introduction Definition Equity or share capital Contr ibutio n of prom oters Auth orised capital Issued and paid-up capital Fear of takeov er Reduction ofcapital Limited liability: Banker s problem Preference share capital Financing theredemption Share premium Div idend v ersus reserv es Free reserves: The problem Bonus shares Capital reserv e Banker's v iewpoint Deben tures Term loan Loans from friends and relativ es Loans from subsidiaries Modern financial instruments Concluding remarks

9 . Current Liabilities 190Introduction Origination Dange r of ov ertrading Safety margin Trade creditors Deposits from customers and public Inter-corporate loans and inv estments Bridge loans Commercial paper Registration of charges Concluding remarks

1 0 . Profit andLoss Account 207Introduction Acco unting concepts Nature of costs Wages Prod uction ov erheads Maintenance and repairs Adm inistrative costs M arketing and distribution costs Controllable versus uncontrollable cost Trading, manufacturing, and profit and lossaccount Gross profit O pera ting profit PBI T v ersus PB T Trading companies Manufacturing comp anies Absorption costing v ersus direct costing Difference inprofit mea surem ent Cost of goods sold Ope rating profit app roach o Unusual incomes Concluding remarks

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Contents ix

11. Understanding the Balance Sheet 230Introduction Trial balance Treatment of closing stock Classification of accounts Balance sheet Net worth Gearing of capital Shareholders versus banker o Format ofa balance sheet Non-corporate borrowers Percentage balance sheet > Preliminary observations A business with no formal accounting system Concluding remarks

1 2 . New Era of Lending:Tandon Commit tee and I t sA f t e r m a t h 267Introduction

I . TANDON COMMITTEE The norms Methods of lending System mechanics End-uset Classifications of current assets and current liabilities

I I . CHORE GROUPReview of the lending system Cash credit system Loan system Bill system Proposed scheme Drawee bill system Restructuring of financial statements, creditappraisal, and lending decisions Lending decision: Anexample Credit appraisal Lending decisions: Problems with the MPBF system Concluding remarks

1 3 . Business Forecasting and Credit Decisions 323Introduction The basic theory Variables Regression analysis Standard error of estimate t-Distribution Coefficient of correlation Illustration Checking the assumptions Projection of sales Projected operating expenses Projection of gross working capitalt Projection of trade and expense liabilities Bank finance for working capital Concluding remarks

1 4 . Funds Flow and C a sh Fl ow A n a l y s i s 341I. FUNDS FLOW ANALYSIS

Introduction Financing the total operation: Fourth concept Sources anduses of funds Generation of funds from operations Recommendations of IAS C Acquisition or disposal An illustration Suggested approach Calculation of bank finance for working capital

II . CASH FLOW ANALYSISClearing the ground Value and obligation Cash and funds flow Cash book summary Detailed cashflowstatement Cash inflows o Motives for holding cash Cash outflows Concluding remarks

15. Cos t , P ro f i t ab i l i t y , andBreak-Even Analys is 383Introduction Dilemma of an entrepreneur Full cost versus marginal cost Variable cost Fixed cost Semi-variable cost Margin of safety Profit-volume ratio - Further problemsof Pankaj Verma Problem of multiple products A simple method for a break-even analysis Financial break-even point Financial margin of safety Limitation and laws of marginalanalysis Concluding remarks

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x Contents

16. Appraisal and Monitoring through Ratios 403Introduction Presentation and uses of ratios Manipulability of ratios Objectivity inratio analysis Difficulties with ratios Classification of ratios Efficiency of operationalmanagement Efficiency offinancialmanagement Net working capital A situation withzero net working capital Implicit credit Treatment of contingent liabilities Efficiency ofdebt-service management Standards of comparison Concluding remarks

1 7 . Project Appraisal: Methods and Techniques 433Introduction Banks' involvement in project financing > Policy changes > Non-financialappraisal Technical and managerial viability Financial appraisal Cost structure Depreciation Taxation Interest Discounted cash flow Risk element Net present value Opportunity cost Internal rate of return Payback method Average and effective rate ofreturn Profitability index Repayment capacity Concluding remarks1 8 . Project Appraisal and Lending Decisions 463Introduction Summary of the project Financial analysis of the project Cost structure Life of the project Salvage value Estimating projected revenue Relevant cash flows Working capital and term loan > Cash flow from operations Profitability index andinternal rate of return NPV versus IRR Break-even point Debt-service coverage ratio Concluding remarks1 9 . Small Business Loan 486Introduction The case The need of the borrower Appraisal Alternative scenarios Concluding remarks2 0 . Credit Risk Analysis 491Introduction Business risk Measurement of sales risks Coefficient of variation Evaluation of sales forecast Sales risk index Measurement of operating riskso Measurement offinancialrisks Measurement of industry risk Methodology andresults of analyses Industry risk category > Borrower risk Character Lending decisionsbased on Cs Comprehensive borrower risk analysis Determination of final risk category Interest rate determination and margin requirement Concluding remarks

Bibliography 536Index 541