UNIT-III

FNANCIAL ANALYSIS

Financial Appraisal:
One of the foremost considerations for granting of credit facilities for any project is the financial
position of a concern. Banks employ various techniques for financial appraisal. However, there is
neither any uniformity in appraisal nor any standard norms are fixed for such appraisal. The
position may be different from bank to bank and from project to project within the same bank
depending upon the nature and the size of the project. There are, however, some important
common features of financial appraisal, which will be discussed in this chapter.

Financial appraisal revolves round two important financial statements, which are required to be
submitted to the bank with the loan application. These financial statements are:
· Balance Sheet.
· Profit & Loss a/c (short form of Manufacturing, Trading and Profit & Loss a/c).

Balance sheet reveals the financial position of a concern at a particular point of time (usually the
closing date of the operating year) while profit and loss a/e is the summary of operations during
the operating year.

Balance sheet is generally prepared on the basis of 'business entity' concept under which the
concern is taken as a separate entity than its promoter and will have its separate assets and
liabilities. The capital contributed by the, Promoter is a liability for the concern though it is an
asset of the promoter. The balance sheet gives particulars of assets and liabilities of a concern as
on the date of closing and must also reveal the manner in which these are distributed. Total assets
of any concern will be matched by its total liabilities at all the times.

Profit and loss a/c is the statement of working results of the concern for its operations during the
year and is an important indicator of the way the business is being conducted by the concern and
its financial results.

Financial appraisal is an important tool in the hands of bankers and forms the very basis of the
credit decision to be taken by them. The credibility of the financial statements submitted to the
banks is thus very important. It is preferable that audited balance sheet and profit and loss a/c are
submitted as these are generally considered more reliable.

Another important point to be noted here is that financial statements of a single year may not be
considered sufficient to form any opinion about the financial position of a concern as the banks
are interested to establish the trend in which the business is being conducted from year to year.
The financial statements of at least last three years are analysed simultaneously to draw
comparisons on year to year basis of the important financial indicators of a concern. The financial
analysis is thus followed with 'trend analysis' which assumes more significance in as much as the
concern with comparative weak financial base but improving trend may get favourable response
from banks.
Ratio Analysis:
Ratio Analysis enables the business owner/manager to spot trends in a business and to compare
its performance and condition with the average performance of similar businesses in the same industry.
To do this compare your ratios with the average of businesses similar to yours and compare your own
ratios for several successive years, watching especially for any unfavorable trends that may be starting.
Ratio analysis may provide the all-important early warning indications that allow you to solve your
business problems before your business is destroyed by them.

Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to pay its bills as they
come due) and leverage (the extent to which the business is dependent on creditors' funding). They
include the following ratios:

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio,
and Working Capital.

Current Ratios

The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:

Current Ratio = Total Current Assets / Total Current Liabilities

The main question this ratio addresses is: "Does your business have enough current assets to meet the
payment schedule of its current debts with a margin of safety for possible losses in current assets, such
as inventory shrinkage or collectable accounts?" A generally acceptable current ratio is 2 to 1. But
whether or not a specific ratio is satisfactory depends on the nature of the business and the
characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1,
but that relationship is usually playing it too close for comfort.

If you feel your business's current ratio is too low, you may be able to raise it by:

• Paying some debts.

• Increasing your current assets from loans or other borrowings with a maturity of more than one
year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.

Quick Ratios

The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is
figured as shown below:

Quick Ratio = Cash + Government Securities + Receivables / Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it
concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: "If all
sales revenues should disappear, could my business meet its current obligations with the readily
convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in accounts
receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current
liabilities.

Working Capital

Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a
positive number. It is calculated as shown below:

Working Capital = Total Current Assets - Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's ability to weather financial
crises. Loans are often tied to minimum working capital requirements.

A general observation about these three Liquidity Ratios is that the higher they are the better, especially if
you are relying to any significant extent on creditor money to finance assets.

Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing
(creditor money versus owner's equity):

Debt/Worth Ratio = Total Liabilities / Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business,
making it correspondingly harder to obtain credit.

Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:

Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It
measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold)
available to pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will reveal the relative strengths or
weaknesses in your business. The Gross Margin Ratio is calculated as follows:

Gross Margin Ratio = Gross Profit / Net Sales

Reminder: Gross Profit = Net Sales - Cost of Goods Sold

Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses,
except income taxes. It provides a good opportunity to compare your company's "return on sales" with the
performance of other companies in your industry. It is calculated before income tax because tax rates and
tax liabilities vary from company to company for a wide variety of reasons, making comparisons after
taxes much more difficult. The Net Profit Margin Ratio is calculated as follows:

Net Profit Margin Ratio = Net Profit Before Tax / Net Sales

Management Ratios

Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and
Statement of Income information.

Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important because the more times inventory
can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated
as follows:

Inventory Turnover Ratio = Net Sales / Average Inventory at Cost

Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If receivables are not collected
reasonably in accordance with their terms, management should rethink its collection policy. If receivables
are excessively slow in being converted to cash, liquidity could be severely impaired. Getting the
Accounts Receivable Turnover Ratio is a two step process and is is calculated as follows:

Daily Credit Sales = Net Credit Sales Per Year / 365 (Days)

Accounts Receivable Turnover (in days) = Accounts Receivable / Daily Credit Sales

Return on Assets Ratio

This measures how efficiently profits are being generated from the assets employed in the business when
compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages
indicates an inefficient use of business assets. The Return on Assets Ratio is calculated as follows:

Return on Assets = Net Profit Before Tax / Total Assets

Return on Investment (ROI) Ratio

The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the
business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business
has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such
as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings
instrument, and avoid the daily struggles of small business management. The ROI is calculated as
follows:

Return on Investment = Net Profit before Tax / Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify
trends in a business and to compare its progress with the performance of others through data published
by various sources. The owner may thus determine the business's relative strengths and weaknesses.

Investment Process: