accounting ratio

Accounting ratios for risk evaluation

S. K. Bagchi W

Internationally, there are no prescribed Accounting Ratios for Risk evaluation.In the Indian context also, Banking Regulatory Authorities have left such mattersto the judgement and discretion of concerned Banks/Financial Institutions.However, it is quite logical to expect that a Bank/Financial Institution will go bythe established Financial Practice and frame its Accounting Ratio Policy relevantfor its Credit Risk evaluation purpose.

Ratio conveys quantitativeinter-relationship betweentwo attributes/variables for

eventual comparison against a'benchmark' and for trend analysis.Accounting Ratios facil i tatemeaningful and purpose-orienteddecision-making in a businesssituation. In that respect, its utilitywill be determined on the basis of thepurpose of computation of the Ratio.A Commercial Bank may lay higherstress on some ratios (e.g. CurrentRatio, Acid Test) for working capitalf inance, while a DevelopmentFinancial Institution may considerthe other ratios more relevant (e.g.Debt Service Coverage Ratio, CashFlow Ratios, etc. ). An investor may,on the other hand, place both suchratios as equally important. A would-be employee (especially in seniorposition) may evaluate a companybefore deciding to join, mainly fromProfit & Loss Ratios (e.g. Net Profit/Sales, Operating Profit, Margin, etc.).

From Credit Risk evaluationangle, Accounting Ratios have

significant bearing for a lending/investing bank, since overallcomputation of "Credit Rating" oftheir account/exposure is aided/supported by the outcome of RatioAnalysis also. Hence, not only it isnecessary to identify relevant andmore impacting ratios depending onthe purpose, quantum and tenure ofexposure, etc. but also to attachweight variant between/amongstratios e.g. for short term investmentin marketable securities (Rated by anApproved External Rating Agency),one may attach higher focus onCurrent Ratio/Net Profit/Sales ratiosthan on long term solvency ratios.

Internationally, there are noprescribed Accounting Ratios forRisk evaluation. In the Indian contextalso, Banking Regulatory Authoritieshave left such matters to thejudgement and discretion ofconcerned Banks/Financial Institu-tions. However, it is quite logical toexpect that a Bank/FinancialInstitution will go by the establishedFinancial Practice and frame itsAccounting Ratio Policy relevant forits Credit Risk evaluation purpose.

Some specific ratios for credit risk

evaluation :

(For identification criteria, e.g..items of Current Assets, CurrentLiabilities, etc., one is to be guidedby Standard Accounting Practice.)

1. Short Term Solvency Angle:

a) Current Ratio:

Current AssetsCurrent Liabilities

Minimum Expected Level: 1.3:1

(For financing working capitalrequirement based on "Turnover"Method for Small & MediumEnterprises (SME) and others as maybe decided, Minimum Expected Levelmay be 1.10: 1.

b) Acid Test Ratio:

Quick AssetsQuick Liabilities

Minimum Expected Level 1: 1

(For SME, etc. as stated in (a)above, Minimum Expected Level maybe 0.8:1.)

c) Cash Ratio :

Cash + Bank Balance + Marketable SecuritiesCurrent Liabilities


Finance

W M.Com. CAIIB Cert, IndustrialFinance, Mumbai

(For SME, etc. the minimum maybe lower)

2)

a) Long Term Solvency Angle:

Total External LiabilitiesEquity (Owned Funds)

Maximum Allowable Level: 2:1

(As per Institute of CharteredAccountants of India, there can beno maximum debt equity ratio, when'debt' represents only Long Termborrowed funds. It varies from caseto case.)

(Higher levels may be allowed forInfrastructure Sector (5:1), PrioritySector, e.g. SSI/SME, etc. (4:1) andother sectors having specific factors,e.g. Ship-breaking Units, etc.)

b) Debt Service Coverage Ratio :

Earnings available for Debt Service* *

One Year Debt Instalment Payment +Interest thereon

**Earnings Net Profitinclude: Plus

• Depreciation onFixed Assets

• Loss, if any, on saleof Fixed Assets

• Interest on Debt forone year


(For Priority Sector, SME, etc. asstated above, this minimum may beallowed at 1.30:1).

3) Profitability Angle:

a) Operating Profit Ratio :

Profit before deduction ofDepreciation, Tax & Finance ChargesSales/Income

Expected Level will be dependentupon the nature of industry/business, operational area, size of theunit, period since when business isbeing carried on, trend analysis andother relevant factors. However, it islikely that a good unit will show atleast a margin of 25% -30%.

b) Return on Capital Employed Ratio(ROCE)

Operating Profit

Owned Fund + Long Term Loan Fund

Expected Level aspect will bebased on factors as stated in 3(a)above. However, ordinarily it is likelyto be at least 15% -20%.

c) Interest Coverage Ratio:

Operating ProfitInterest Liability

Minimum Expected Level: 2: 1

(Subject to factors as stated in3(a) above).

d) Profit-Asset Ratio.

Operating ProfitTotal Tangible Assets

Minimum Expected Level will bedependent upon factors as stated in3(a) above.

e) Indirect Overhead Ratio:

Finance Charges + Depreciation(on Fixed Assets used forAdministrative/Office purposes +Selling & Administrative Cost

Sales/Income

Maximum allowable level is to bedecided on case to case basis basedon 3(a) above. However, it may be10% -15%.

4. From Asset Movement Angle:

a) Inventory holding × 300 days **Sales

b) Trade Debtors × 300 days * *

(preferably average outstandingin a year)

Sales/Income

5. Trade Credit Payment Angle:

Trade Creditors × 300 days **

(preferably average outstandingin a year)

Credit Purchase of Current Assets-(preferably average level in ayear)

**Computation based on 300

days in a year is advisable in Indiancontext keeping in view usual 52weekly off + National holidays, etc.

Expected Level depends on case tocase factors as stated in 3(a) above.However, generally, maximum level interms of days may be between 90-120days.

6. From 'Stress" Angle.

(BASEL Committee has stated asunder. "Stress Testing has beenadopted as a generic term describingvarious techniques used by Banksto gauge their potential vulnerabilityto exceptional, but plausible,events").

Stress Tested Cash Flow

Debt Payments + PreferenceDividend + Interest

Cash Flow for the purpose wouldcover only Operating Cash Flow(Investing Cash Flow & FinancingCash Flow to be ignored). As a pointof Stress Testing Scale, a reductionof certain % in income/sales withsimultaneous increase in expenses,e.g. direct costs, etc. which mayresult in charge (reduction) in CashFlow. There is no minimum ormaximum. Stress % depends onIndustry, operating environment, etc.It depends on the overall situationin business environment at the timeof analysis.

The above cluster of ratios is onlyindicative which a Commercial Bank/Financial Institution may find usefulfrom Credit Risk Evaluation angle.There may be other important ratiosas well such as :

• Finished Goods Holding

• Cash Flow Interest Coverage

• Capital Gearing Ratio

• Proprietory Ratio

Wise advice from Rally & Brown:

"You can envision a large numberof potential financial ratios throughwhich to examine almost everypossible relationship. The trick is not

Finance

to come up with more ratios but toattempt to limit the number of ratiosso that you can examine them in ameaningful way."

(Page 429 "Investment Analysisand Portfolio Management", 6thEdition.)

Practical Implication of AccountingRatios in Credit Risk Evaluation

Accounting Ratios are usuallycomputed on year-end position ofAssets, Liabil i t ies, Profit/LossAccount Components (over aposition of generally 12 months) asreflected in Financial Statements.This is based on "going concern"approach. However, one limitationhere is that the' static' data of Assets& Liabilities on year -end data maynot reflect a true and correct view.The alternative, however, is to collectspecific position of various itemsfrom the concerned party, say, onmonth end basis (or as frequently asmay be possible) and average thesame on 12 month basis. This inputmay then for Credit Risk Evaluationpurposes be more effective, as adynamic tool.

Irrespective of whether a Bank/Financial Institution chooses tocontinue to follow year-end methodor average method of computation,the implications from Credit RiskEvaluation angle will be dependingupon:

• Adoption of an appropriate CreditRating System with generallylarge number of grades, whereone of the ' inputs' would beAccounting Ratios.

• Bank/Financial Institution willhave to decide as a CorporateFinance Policy the nature ofAccounting Ratios to be used forCredit Risk Evaluation (e.g. theremay be different focus forassessment of Working Capitalvis-a-vis Loan for Fixed Assetsor for Non-funded facilities/Investment in securities, etc.).

• Specific tool 'Weight' forAccounting Ratios (from CreditRating angle) is to be allocated,say, 20 out of total 100 marks forentire Credit Rating structure.

• Benchmarking is to be madeconsistent with Bank ' s/FinancialInstitution' s Corporate FinancePolicy for each Ratio.

• Maximum marks for eachComponent of Ratio is to be fixed,say, 4 out of 20 marks (being total20 for all accounting ratios puttogether).

• Ratios conforming to Benchmarkshould be awarded highest marksand accordingly those belowBenchmark should be rankedwith varying marks down to evenzero.

• Total marks awarded for alladopted ratios should then becarried forward to the overallcredit rating structure so as toarrive at final grade for eachaccount/exposure

In sum, Accounting Ratio is aninseparable arm of Credit RiskEvaluation and actual implication willrest upon the purpose, quantum andtenure of exposure on case by casebasis.

Is Ideal Ratio an Insurance AgainstCredit Risk?

Ratio analysis -although apowerful tool in Credit RiskEvaluation, is not, however, the onlymeans in the process. There are anumber of other parameters on whichCredit Risk aspects are analysed, e.g.Asset Cover (Credit Mitigants as perBASEL terminology), ManagementQuality of borrowing party, Macro-economic indicators having impacton the exposure, etc. It, thus, cannotoperate as an 'Insurance' againstCredit Risk in view of the following:

• Each ratio is indicative of certainaspects of the organisation, e.g.Current Ratio is with respect of

Current Assets and CurrentLiabilities only and as such,totality is not possible to be drawn.

• High quality of one ratio may indi-cate poor signals on another dimen-sion, e.g. Current Ratio consider-ably over 2:1 ( say 3.1 ) may showManagement inefficiency in hold-ing current assets idle with carry-ing costs.

• Ratio analysis has over-bearingreflection of past position. Thesame mayor may not subsist (goodor bad) in future which is fraughtwith uncertainty especially inbusiness environment

• Computation of ratio is dependentupon the analyst's views,approach, perception andobjectivity, particularly inconnection with identification ofcomponents forming a ratio, e.g. inidentifying Current Assets, someanalysts may ignore certain assetsas 'Current', e.g. Inventory lying instock beyond a particular period ortreat some liabilities 'Current',although classified as TermLiability, e.g. Sundry UnsecuredLoan without any specificrepayment schedule.

• Ratio Test may have an analogywith Medical Pathology, e.g. BloodReport of an individual may showideal level of Haemoglobin as onthe date of test which maydrastically change soon with someadverse physiological develop-ments. In the same way, Ratioanalysis may not guarantee aboutquality of credit assets on acontinuous basis.

With the aforesaid limitations ofRatio indicators, it may be stated thatCredit Risk protection can come from ahost of factors in combination but notin isolation of one 'Input' (Ratio) only.Nevertheless, Accounting Ratios arestill dominant factors in the matter ofCredit Risk Evaluation. q

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