clean fwwb training module on financial literacy for dre ...€¦ · chapter 3: financial statement...

TrainingManualon

FinancialLiteracyfor

DecentralisedRenewableEnergyEnterprises

Preparedby

FriendsofWomen’sWorldBanking,India(FWWB)

for

CleanEnergyAccessNetwork(CLEAN)

Disclaimer: This report is made possible by the support of the American People through the United States Agency for International Development (USAID). The contents of this report are the sole responsibility of S3IDF and do not necessarily reflect the views of USAID or the U.S. Government. This report was prepared under the Clean Energy Access Network (CLEAN) project, Award Number AID-386-A-14-00013

i

Preface This manual on Financial Literacy for Decentralised Renewable Energy Enterprises has been compiled by Friends of Women’s World Banking.

As one of its mandates, CLEAN seeks to address financing challenges faced by energy enterprises in India. Financing (Debt, equity or grant), by far has been one of the most critical barriers to scale up for most of the DRE enterprises as most of them lack fixed assets that are considered acceptable forms of collateral by Financial Institutions (FIs). Financing to such enterprises is perceived to be risky due to the market segment they cater to (often poor and underserved).

Even where finance is available and accessible, there is a mismatch between project proposals by the DRE enterprises and the expectations of financial institutions as well as investors. This is primarily because many of them (especially new and fledgling enterprises) understand the market potential, business strategy, marketing and sales aspects etc. but face difficulty in understanding and preparing financials – financial statements, financial modelling, sensitivity analysis etc. In addition, they also do not have a holistic understanding on what kind of finance (financial instrument) would be best suited to their needs and how they should pitch their proposals/business to the investors to raise capital. A study on Debt Finance Needs of the sector, conducted by CLEAN last year, supported the above findings and recommended that financial literacy of the DRE entrepreneurs is a prerequisite to develop confidence among the financiers to consider the proposals.

This manual seeks to address some of the above knowledge gaps and provide information on fundamentals key financial concepts, fund raising sources and process, expectations and perspective of funders/financiers and assessing the financial risks and respective mitigation strategies. The objective is to enable DRE enterprises to effectively communicate and present their business proposal to banks and investors.

We hope that this manual will act as a useful reference material for DRE enterprises seeking to access funds for scaling up their businesses.

ii

TableofContents

Chapter1:FundamentalsofDREEnterprise........................................................................................1

1.1 OverviewofDREEnterprises....................................................................................................1

1.2 DifferenttypesofDREenterprises...........................................................................................1

1.3 BusinessmodelsofDREEnterprises(Valuechain)..................................................................1

1.4MajorchallengesfacedbyDREenterprises............................................................................4

1.5FinancialplanningandfinancialmanagementforDREenterprises.......................................6

Chapter2:IntroductiontoFinancialStatements...............................................................................10

2.1 IntroductiontoFinancialstatements.....................................................................................10

2.2 IncomeStatement/Profitandlossstatement.....................................................................11

2.3 BalanceSheet.........................................................................................................................14

2.4 Cashflowstatement...............................................................................................................18

2.5 DifferencebetweenFundsFlowandcashflowstatement...................................................24

Chapter3:FinancialStatementAnalysis............................................................................................25

3.1 ToolsforFinancialstatementsanalysis:................................................................................25

3.2 RatioAnalysis..........................................................................................................................28

Chapter4:CapitalBudgeting..............................................................................................................55

4.1MeaningofCapitalBudgeting...............................................................................................55

4.2NeedsandImportance...........................................................................................................55

4.3MethodsofEvaluationofCapitalBudgeting.........................................................................56

4.4RiskandUncertaintyinCapitalBudgeting............................................................................60

Chapter5:WorkingCapital.................................................................................................................62

5.1ConceptandComponentofWorkingCapital........................................................................62

5.2NeedsofWorkingCapital......................................................................................................64

5.3EffectsofExcessiveandInadequateWorkingCapital..........................................................64

5.4FactorsDeterminingtheWorkingCapitalRequirement.......................................................65

5.5EstimationofWorkingCapitalRequirement.........................................................................66

Chapter6:FinancialPlanningandForecasting...................................................................................69

6.1WhatisFinancialPlanningandNeedofFinancialPlanning.................................................69

6.2ValuationofEnterprise..........................................................................................................70

6.3MeaningofForecasting..........................................................................................................73

6.4MethodsofForecasting.........................................................................................................74

Chapter7:FundraisingforaDREEnterprise......................................................................................77

7.1 Sourcesoffinance...................................................................................................................77

7.2MajorSchemesforenergyprogrammes................................................................................80

iii

7.3 Factorstobeconsiderationbeforeborrowing......................................................................86

7.4 ApplicationandDocumentsRequired...................................................................................89

7.5 Criteriaconsideredfordue-diligence.....................................................................................91

Chapter8:IntroductiontoBusinessandFinancialRisk.....................................................................93

8.1Riskanditsdifferenttypes....................................................................................................93

8.2RiskManagement...................................................................................................................95

8.3RiskMeasurementandMonitoringtool...............................................................................96

8.4RiskMitigationStrategies......................................................................................................98

Annexures

Annexure-ITemplate-forADBprojectproposals……………………………………………………….………….104Annexure-IITemplate-LoanApplication…………………………………………………………………………………107

iv

TableofFiguresFigure1:ParticularsofIncomeStatement....................................................................................11

Figure2:ParticularsofBalanceSheet...........................................................................................14

Figure3:ParticularsofCashFlowStatement................................................................................18

Figure4:ToolsforFinancialStatementAnalysis...........................................................................25

Figure5:Earningsfor2012-16......................................................................................................27

Figure6:CashFlowsfor2012-16..................................................................................................27

Figure7:ComponentsofTotalAssetsTurnoverratio....................................................................40

Figure8:TypesofCapital..............................................................................................................62

Figure9:ConceptofWorkingCapital............................................................................................63

Figure10:ComponentsofWorkingCapital...................................................................................63

Figure11:OperatingCycle............................................................................................................65

Figure12:ValuationofEnterprise................................................................................................70

Figure13:TypesofRisk................................................................................................................94

Figure14:RiskManagementprocess............................................................................................95

Figure15:Systemtomeasureriskintheorganisation..................................................................97

ListofTablesTable1:SegmentationofDREEnterprise........................................................................................3

Table2:IncomeStatementofABCCo...........................................................................................13

Table3:BalanceSheetofABCCo.................................................................................................17

Table4:CashFlowStatementofABCCo......................................................................................21

Table5:DifferencebetweenFundFlowandCashFlowStatement...............................................24

Table6:HorizontalAnalysis..........................................................................................................26

Table7:VerticalAnalysis..............................................................................................................26

Table8:P&LofExcelManufacturingLimited..............................................................................28

Table9:ProfitabilityRatioofExcelManufacturingLimited...........................................................30

Table10:OperatingExpenseofExcelManufacturingLimited:......................................................30

Table11:EPSofExcelManufacturingLimited...............................................................................31

Table12:Y-o-YGrowthRatio........................................................................................................33

Table13:DividendPolicyratios....................................................................................................34

Table14:LiquidityRatiosofExcelManufacturingLimited............................................................36

Table15:DebtEquityRatioofExcelManufacturingLimited.........................................................37

v

Table16:FixedAssetstoLong-termDebtsofExcelManufacturingLimited..................................37

Table17:InterestCoverageRatioofExcelManufacturingLimited................................................38

Table18:DebtServiceCoverageRatio..........................................................................................39

Table19:TurnoverRatiosofExcelManufacturingLimited...........................................................41

Table20:TheinventoryturnoverratioandaverageholdingperiodforExcellimited…………………..43

Table21:TheReceivableTurnoverRatioandDays’SalesOutstandingforExcelLimited...............43

Table22:TheaveragepaymentperiodofExcelManufacturingLimited........................................44

Table23:LengthofCashCycleofExcelManufacturingLimited....................................................44

Table24:ReturnonAssetofExcelManufacturingLimited...........................................................45

Table25:TheROCEforExcelManufacturingLimited....................................................................46

Table26:TheROEforExcelManufacturingLimited......................................................................46

Table27:Du-PontAnalysis............................................................................................................47

Table28:ThemarketratiosforExcelManufacturingLimited.......................................................49

Table29:SummarizedfiguresrelatetoTullaLtd,abusinessoperatingintheretailsector...........49

Table30:SummarizedfiguresrelatetoABCLtd.,abusinessoperatingintheretailsector............52

Table31:PaybackPeriodCalculation...........................................................................................57

Table32:NetpresentValueCalculation.......................................................................................58

Table33:InternalRateofReturnCalculation...............................................................................59

Table34:WorkingCapitalCalculation..........................................................................................67

Table35:SourcesofFinance.........................................................................................................77

Table36:EndUserFinance...........................................................................................................80

Table37:MeasuringofRisk..........................................................................................................97

Table38:RiskMitigationStrategies..............................................................................................98

vi

ACRONYMSANDABBREVIATIONS

DRE DecentralisedRenewableEnergySPLs SolarPortableLanternsSHSs SolarHomeSystemsSWPs SolarWaterPumpsCP ConsumerproductsBO BuildonlyBOM Build-own/operate-maintainBM Build-maintainRRBs RegionalRuralBanksNCEF NationalCleanEnergyFund

COGS CostofGoodsSoldG&A GeneralandAdministrativeEBITDA EarningsbeforeInterest,Tax,Depreciation,andAmortizationPP&E Plant,PropertyandEquipmentFCF FreeCashFlowUFCF UnleveredFreeCashFlowCAPEX CapitalExpendituresEPS EarningsperShareCAGR CompoundAnnualGrowthRateY-o-Y Year-on-Year

DPS DividendPerShareDSCR DebtServiceCoverageRatioROA ReturnonAssetsROCE ReturnonCapitalEmployedROE ReturnonEquityNPV NetpresentvalueIRR InternalrateofreturnGWC GrossWorkingCapitalNWC NetWorkingCapitalDCF discountedcashflowZBB Zero-basedbudgetingEV EnterpriseValue

CGTSME CreditGuaranteeFundTrustforMicroandSmallEnterprisesREEEP RenewableEnergyandEnergyEfficiencyPartnership

IREDA TheIndianRenewableEnergyDevelopmentAgency

MNRE TheMinistryofNewandRenewableEnergyCMA CreditMonitoringArrangement

vii

SessionPlan

Sessions MethodologyFundamentalsofDREEnterprise• OverviewofDREEnterprises• DifferenttypesofDREEnterprises• BusinessModelsofDREEnterprises• MajorchallengesfacedbyDREenterprises• FinancialplanningandfinancialmanagementforDREenterprises

PPT+Discussions

IntroductiontoFinancialStatements• Introductionoffinancialstatements• Incomestatement• Balancesheet• Cashflowstatement• Differencebetweenfundflowandcashflowstatement

PPT,Exercise,Discussions,Videos

FinancialStatementAnalysis• Typesandtechniquesoffinancialstatementanalysis• RatioAnalysis

PPT,Exercise–Case-letDiscussion,Discussions,Videos

CapitalBudgeting• Meaningofcapitalbudgeting,itsneedsandimportance• Methodsofevaluationofcapitalbudgeting• Riskanduncertainlyincapitalbudgeting• Methodsofevaluationofcapitalbudgetingrisk

PPT,Exercise–Case-letDiscussion,Discussions,Videos

Workingcapital• Conceptandcomponentofworkingcapital• Needofworkingcapital• Factorsdeterminingworkingcapitalrequirement• Estimationofworkingcapital

PPT,Exercise,Discussions,Videos

FinancialPlanningandForecasting• What&Why-FinancialPlanning• ValuationofEnterprises• MeaningofForecastingandmethodsofforecasting• Financialmodellingusingspreadsheet-ProformastatementofP

&L&BalanceSheet

PPT,Exercise,Discussions

FundraisingforaDREEnterprise • Sourcesoffinance• MajorSchemesforenergyprogrammes• Factorstobeconsiderationbeforeborrowing• LoanApplicationandDocumentsRequired• Criteriaconsideredfordue-diligence

PPT+Discussions

Introductiontobusinessandfinancialrisk• Riskanditsdifferenttypes• RiskManagement• Riskmeasurementandmonitoringtool• Riskmitigationstrategies

PPT,Discussions,Exercise

1

Chapter1:FundamentalsofDREEnterprise

TopicsCovered LearningObjectives

FundamentalsofDREEnterprise

• OverviewofDREEnterprises• DifferenttypesofDREEnterprises• BusinessModelsofDREEnterprises• MajorchallengesfacedbyDREenterprises• Financialplanningandfinancialmanagementfor

DREenterprises

• DifferentmodelsofDREenterprises• Overview of challenges faced by DREenterprises

• Importance of financial managementandplanning

1.1 OverviewofDREEnterprises

EnsuringenergyaccessforallinasustainablemannerisacriticalprerequisiteforIndiatobeabletoempowereachofitscitizenstotransformtheirlives.Scalingupaccesstorenewableenergy(RE)canenable themillionsof India’s energypoorpopulation to improve their livelihoods ina sustainablemanner.Itcanhelpthemtopowerlightstohelpkeeptheirbusinessesopenlate,toenablewomentocook incleanerandsmokelessenvironments,and tohelp farmers reapmoreprofits fromtheirlandbydecreasingtheircostof irrigation.DREenterprises,primarilyMicroandSmallandMediumEnterprisesarethosewhohavelongbeeninvolvedinthissector,andmosthaveanexclusivefocuson identifying innovativeandcost-effectiveways tobringenergy topopulationswhodonothaveaccess to sustainableenergyusingvarious renewableenergy sources. Theydo so in twoways:bysettingupoff-gridordecentralizedrenewableenergy(DRE)utilitieswhichprovidepowertoasmallcommunityorcollectionofvillages,orbyprovidingconsumerproducts suchascleancook-stoves,solar portable lanterns (SPLs), solar home systems (SHSs) or solar water pumps (SWPs) to helpindividualsincreasetheiraccesstoenergysources.

1.2 DifferenttypesofDREenterprises

TheDecentralizedRenewableEnergy(DRE)enterprisecanbebroadlycategorizedintotwotypes.

1. Off-gridordecentralizedrenewableenergy(DRE)utilitieswhichprovidepowertoasmallcommunityorcollectionofvillages

2. Consumer products (CP) such as clean cook stoves, solar portable lanterns (SPLs), solarhomesystems(SHSs)orsolarwaterpumps(SWPs)tohelpindividualsincreasetheiraccesstoenergysources.

1.3 BusinessmodelsofDREEnterprises(Valuechain)

1.3.1BusinessmodelsforDREutilitiessegment

There are a number of business models that are prevalent in the market and they each have adistinct impactonthefinancingneedsofplayers,particularlywhenpairedwiththetechnologyforthesourceofRE.Reviewingthemarket,threebusinessmodelsemergestronglyacrossMSMEsintheDREutilitiessegment:

2

Buildonly: thesebusinessesareonly focusedonbuilding the componentsor the structureof theutilitythatwillbeused,buthavenoroletoplayintheongoingoperationsbeyondmaintenanceforalimitedwarrantyperiod(lessthan2years).Build-own/operate-maintain (BOM): RE enterprises with this business model build and own theplantandarealsoinvolvedinoperationsandmaintenanceoverthedurationoftheplant’slifetime.Build-maintain(BM):Inthisbusinessmodel,theMSMEwillbeinvolvedinsettinguptheutilitybutwilloutsourceoperationstoanothercompanyorindividual(sometimesavillage-levelentrepreneuroraVLE), thatwillowntheplant.Thetransferofplantownershipcanbeat thetimeofset-uporover3-5years,i.e.thetimerequiredfortheMSMEtorecoupitsinitialinvestment.

1.3.2BusinessmodelsforConsumerProducts

AswithDREutilities, the typeofbusinessmodelhasa significant impacton the typeof financingrequired.AreviewofthemarketrevealedthatMSMEsfollowoneofthreeprimarybusinessmodels:Design,procurement,andsales(“cross-marketplayers”):theseplayers,whichformthemajorityofthecookstoveandSPL(SolarPortableLantern)market,willownthedesignoftheproductbutwillprimarily outsource the actual manufacturing of the product to a medium/large manufacturer.8They will then procure the finished good and work through both their own as well as partnerdistributionnetworks,micro-franchiseesorVLEstoselltheproduct.Theseplayersworkacrossthemarket (from the R&D stage at the beginning to the distributions points at the end) but are notinvolved in themiddlemanufacturingstage;assuchtheyworkacross thetwoendsof themarketchain.Procurement and sales: these players, primarily prevalent in the SWP (Solar water pump) space(although they also exist as a smallminority of SHS players), are different from the first businessmodel in that theydonotdesign theirownproducts– rather they source finalizedproducts fromexistingmanufacturersandsell themonthroughdistributionandsalesnetworksof theirownandthroughpartnerships.Theycanalsobereferredtoas“systemintegrators”.Distributiononly: theseplayersfocusondistributingmultipleREproducts(SPLs,SHS,cookstoves,etc.) to rural and urban areas and supplement the work of enterprises whodevelop/design/assemble the products. These distributors often undertake rural marketingcampaigns, educate future consumers on the benefits and use of RE products, or providedemonstrationsof theproducts.While thereareanumberof large-scaledistributorsoperating inthisspace,thefocushereisonMSMEdistributorswhofocusexclusivelyonREproducts.

1.3.3SegmentationoftheDREenterprises

ThetwobroadcategoriesofDREenterprisescanbefurthersegregatedbasisdifferentcriteria.ForMSMEswhoarecurrentlyinvolvedintheoff-gridDREutilitiesspace,threecriteriawereapplied:(i)theRE fuel source of the plant, (ii) the size of plant1, and (iii) the businessmodel employed. ForMSMEswhoareinvolvedintheCPspace,twocriteriawereused:(i)theprimarytechnologythatisthefocusoftheenterprise,and(ii)thebusinessmodeloftheMSME.Applyingthesecriteriatothecurrentlandscapeofplayersresultedinthefollowingtensegments:

3

Table1:SegmentationofDREEnterprise

SegmentTitle DescriptionDRE1Technology:SolarCapacity:<2kW(Pico)BusinessModel:BOM

MSMEsownandoperatesolar-Picoplantsthatprovidebasicamountofpowertohouseholdsinruralareas–usuallyjustenoughtopower1-2 lights and a cell phone charger. Themajority of players in thissegmenthavebeenoperatingforlessthan3years.

DRE2Technology:SolarCapacity:2–10kW(micro)BusinessModel:BOM

MSMEsownandoperatesolar-microplantsthatprovidelightingandotherhouseholdappliances(e.g.TV, fan)solutionstohouseholds inrural areas.MSMEs in the segment are amix of new entrants andsomeestablishedplayerswithmorethan3yearsofoperations.

DRE3Technology:Solar/wind-solarCapacity:11–25kW(mini)BusinessModel:BM

MSMEs build and maintain micro and mini wind-solar plants toprovide lighting + ‘products’ (e.g. TV, fan) solutions to consumers,usuallyinsemi-urbanorhigherincomeruralareas.TheseMSMEsarediversified across different RE technologies. Some are early-stageenterprises, whereas some are mature, having transitioned frompuresolarorwindtechnologies,andhavesomemoreexperienceinthesector.However,thetechnologyisstillnotverywidespread.

DRE4Technology:BiomassCapacity:26–100kW(small)BusinessModel:-BOM

MSMEsownandoperatemicrobiomassprojects,toserveupto250households for part or all of the day for lighting and appliances.Playershavebeeninthesectorforsometime(5-7years).

DRE5Technology:HydroCapacity:<100kWBusinessModel:–All

MSMEsmanufactureturbinesandprovideturnkeysolutionstoruralcommunities,alongwithsmallbusinessesandindividualsinruralandsemi-urban areas.Most actors have been active for 3-5 years, butstillhavealowturnoverandgrowthrate.

SegmentTitle DescriptionCP1Technology:cleancookstovesRole:cross-marketplayersPricerange:<$120

Enterprisesfocusedonthedesign,assembly,anddistributionofcleancookstoves(frombasictoadvancedmodels)throughoutIndia–thereareover15playersinthisspaceandthemajorityofthemarerecententrants(<3years).

CP2Technology:SPLsRole:cross-marketplayersPricerange:<$120

Enterprises that derive majority of their revenue from design,assembly,andsalesofSPLs.MostMSMEshavebeenoperational for5-6years,butaselectfewarewellestablishedatthispointoftime.

CP3Technology:SHSsRole:cross-marketplayersPricerange:$120-$600

Enterprisesthatdesign,assembleanddistributeSHSs–frombasictoadvanced models – to provide lighting solutions to individualhomes/businesses. These MSMEs are more mature and many havebeenoperationalfor5+yearsandaregrowingfairlyquickly.

CP4Technology:SWPsRole:ProcurersPricerange:acrossprice$1000

Consists of 10 MSMEs involved in the procurement of SWPs; mosthave been around on average for 3 years and are undergoingsignificantgrowth.

4

SegmentTitle DescriptionCP5Technology:MultipleRole:DistributiononlyPricerange:<$120(acrosspriceranges)

Comprises a limited number of RE-focused distributorswho procureanddistributeREproducts– they focuson lightingproducts suchasSPLsandtherangeofSHSsacrossIndia;afewplayersalsodistributeimproved cook stoves. Players in this segment are fairly wellestablished,andonaveragehavebeenoperationalforoveradecade.

1.4 MajorchallengesfacedbyDREenterprises

1.4.1Supplyofandaccesstoenterprisefinance

Theprimaryunmetneedformostenterprisesisdebtfinancingtosupporteithergrowthorworkingcapitalneeds.Thereisagenerallackofaccesstodebtfinancing,particularlywithpreferredtermsasoneof theirprimarychallenges.MostDREutilityplayers’preferred formofdebt is in the formoflong-termdebtorsoftloanstofinancegrowthandexpansionofthebusiness.Ontheotherhand,forCPcompaniesandbiomassutilities,primaryobjectiveofdebtfinancingwastocoverworkingcapitalandoperational costs.However, debt is difficult to access because they lack fixed assets that areconsidered acceptable forms of collateral by FIs (such as land or property) , the tenure of loansavailable is often too short,most enterprises lack three-year positive cash flows, and the cost oftraditional debt products is often too high for them. Financial institutions also have challengessupplyingdebt– inaddition to theriskinessofmanyof thesegmentsdueto the lackofcollateraland financinghistory,many financial institutionsarewaryofextending creditbecause there isnocustomized assessment framework to assess DRE enterprises effectively and they may not beequippedwiththetechnicalexpertiseandqualitymarket informationtobeabletoevaluatetheseinvestments fully. In addition, even government credit schemes designed to speed up access tounsecuredloanshavehadlimitedimpactbecausemanyfinancialinstitutionsarewaryofthelengthyrepaymenttimeline(inthecaseofdefault)andareconcernedabouttheavailabilityoffundsinthelonger-termtosupporttheseschemes.

Equityproductsare indemand,but increasingaccessandsupplydependsprimarilyon investing ininformationandawareness.Equityfinancing–primarilythroughpatientcapitalsources–wasstatedasaneedbyenterprises,buttendedtobeasecondaryprioritytodebtfinancing.Mostenterprisesdeprioritizeequityinfavourofdebtprimarilyduetomisperceptionsontherolethatequitycanplay–manybelievethatexternalinvestorstypicallylooktocontrolthebusinesscompletelyanddonotwanttocedeownership.Inaddition,manyenterpriseareunawareofthevarietyofhybridfinancingproducts thatareavailable in themarket (suchas convertibledebtormezzanine financing)whichcouldbeusefulfortheirneedsgiventheirmoreflexibletermsforinvestment.Fromtheperspectiveof an investor, there is reluctance to play a more active role in the sector because there is aperceptionthatmanyenterprisesdonothavewellestablishedbusinessmodels,andthereremainchallengesindeterminingappropriatereturnsfrominvestmentsgiventhenatureofthesectorandtheearlystageoftheenterprises.Forimpactinvestorsinparticular,thenatureofthesocialimpactcreatedalsoremainsanissueasothersectors(e.g.health,education,etc.)arenotedtohavemoredirect impacton the livesof thepeople (in termsofhealthbenefits, incomegenerationpotential,etc.)thantheenergysector.

Enterprisesinthreesegments–solarmicroutilities,biomassutilities,andSWPprocurers–continuetorequiresubsidiestomaintaintheircurrentbusinessmodelastheirsetupand/oroperationalcosts

5

can be quite capital-intensive. However, many enterprises face difficulties in accessing thesesubsidiesbecause theyareusuallynotdisbursed ina timelymanner.As such, this creates furtherconstraintsontheiravailabilityofworkingcapitalfinancingwhichinturnslimitstheiroperationsandgrowthprospects.Ontheotherhand,fromtheperspectiveofthegovernment,maintainingtimelydisbursementsischallengingbecausethereislimitedexistingcapacitytocheckfortheeligibilityandqualityoftheapplicationsthataresubmitted.

Inadditiontothefinancialproduct-specificbarriersnotedabove,thereareadditionalchallengesinthepolicyenvironmentthatlimitgreatersupplyoffinancingtothesector.ForDREutilitysegments,financial institutions stated their primary challenge was the uncertainty associated withunderstandingwhenandwheregridextensionwouldoccur,andwhatopportunitiestherewouldbeforexistingoff-gridsolutionstointeractwiththegridifandwhenitdidextend.Thisuncertaintywasakeyreasonthatmanyfinancial institutionswereconcernedaboutthe long-termviabilityoftheirinvestment.ForCPsegments, theprimaryconcern for financial institutionswasa lackofclarityofwhat was considered to be a “quality product” – in the absence of institutional quality ratingssystemformanyREconsumerproducts,financialinstitutionswereunwillingtobackaproductwhichcouldpotentiallyhavealackofuptakeandmartheirreputationinthesector.

1.4.2Supplyofandaccesstoconsumerfinance

Thereisverylimitedaccesstoformalconsumerfinancingproductsinthemarkettoday.

Theneedformicro-loansandsavingsproductsisstrongestacrosssegmentsbutthereareanumberof barriers limiting access and supply. Micro-loans and savings – either through microfinanceinstitutions (MFIs), self-help groups (SHGs), or regional rural banks (RRBs) – would be welcomeacrossmarket segments as away toenhanceaffordability for theend consumer.However,manyenterprisesandtheirconsumersfacebarriersinaccessingthisbecausethereisalimitedpenetrationofMFIs in someof the key geographies of operation, andRRBs –which have a stronger nationalpresence – have a strong emphasis on credit history which many consumers cannot provide. Inaddition,linkedtotheconsumerawarenesschallengenotedabove,consumersdonotbelievethatthecostoftheloan(andoftheREproduct)matchesthevalueandbenefitsthattheREproductcanbringthem.However,fromthesupplysideitisnotsimpleeither:manyMFIsconsidertheticketsizeofsmallREproductstoosmalltomatchthetransactioncostsandMFIsdonotwishtobeinvolvedinlastmiledistribution.Finally,micro-savingsproductsareinparticularnotofferedbecausemanyFIsare not yet aware of how to roll-out a product along those lines as theywere until recently, notallowedunderthestandardregulations.

Fortwosegments,subsidiesandvariationsonthepay-as-you-gomodelsarealsoinneed.Subsidiesare indemand fromthose segments thatparticularlybenefit fromconsumer subsidies (e.g.undertheJawaharlalNehruNationalSolarMissionscheme)today–SHSsandSWPs.Forplayers inthesesegments,themajorbarrieristofindwaystospeedupthedisbursementofsubsidiessoitdidnotcreate constraints to growing the market. Pay as you go models are also highlighted as havingpotential,buttherearetwoprimarychallengesinscalingupthismodel.Thefirstisthattheydependonthesupplierordistributorhavingadequateworkingcapitalrequirements inordertobeabletoextendcredittotheconsumer–somethingmostMSMEsdonotcurrentlyhave.Thesecond,isthatsomeofthesemodels,suchasamobilebasedpaymentplatform,requireanenablingenvironment(intermsofregulationandtechnology)whichdoesnotyetexistintheIndiancontext.

6

Therearealsoecosystemwidebarriersthataffectthesupplyandaccesstoconsumerfinance.Mostimportantlyisalackofawarenesswhichexistsacrossstakeholders.Mostproductsareconsideredtoberelativelynewonthemarketandconsumersareusuallynotawareoftheproductoritsbenefits.Fromtheperspectiveofthefinancial institution,manyarenotawareofthesectorandthosewhoare awaremay not have the technical skills necessary to evaluate this newer industry. Supply ofconsumer financing isalsohinderedbya lackofconsistentquality standards to rateproductsandinconsistentafter-salesserviceforproducts.Asaresult,FIsarewaryofengagingtoodeeplyinthemarketastheymayfacenegativereputationalrepercussions.

1.4.3Otherchallenges:

Policylevelchallenges

NegativeimplicationsofGSTincludingincreasedcostofimprovedcook-stovesanddisruptedflowofbusiness requiring reorganization of accounting systems and ensuring all input providers are alsopartofthesystem(withoutwhichinputcreditcannotbeclaimed);Onapositivenote,overtimeGSTis likely to spur more organised operations and this could then improve the long-term financingprospectsforthesector.

ProposeddiversionofNCEEFresourcesandreducedresourceavailabilityforcleanenergyR&Dandinnovation

Technologyrelatedchallenges

Inadequate resources to experimentwith technology solutionson the field and lowavailability ofefficient appliances, particularly for livelihood applications in themarket that can be powered onDRE

LimitedbenefitsreapedbytheDREsectorfromtheSuryamitraprogrammeowingtogapsintermsof training location (where the training is undertaken vs. where the trainees are required),remunerationexpectations(higherthanpayingcapacityofDREenterprises)andinadequatedemandmapping.

Information

There is a lack of strong data management systems and limited data availability in smallerenterprises,primarilyowingtotheorganization’s internalcapacityandthe lackofclarityonusageandvalueaddofdatasharing.

There have been limited attempts to evaluate improvements in electricity and cooking energyaccess, beyond connections and number of systems installed or disseminated, mainly owing toresourceintensiveprocessesforimpactevaluation(particularlyfortheDREsector).Multiplefactorsabout theenablingenvironmentalsoneed tobe consideredwhiledetermining if energyaccess isabletobringabouteconomicimprovements.

1.5FinancialplanningandfinancialmanagementforDREenterprises

FinancialManagement

FinancialManagementmeansplanning,organizing,directingandcontrolling the financialactivitiessuch as procurement and utilization of funds of the enterprise. It means applying generalmanagementprinciplestofinancialresourcesoftheenterprise.

7

ObjectivesofFinancialManagement

The financial management is generally concerned with procurement, allocation and control offinancialresourcesofaconcern.Theobjectivescanbe-

1. Toensureregularandadequatesupplyoffundstotheconcern.

2. To ensure adequate returns to the shareholders. Thiswill depend upon the earning capacity,marketpriceoftheshare,expectationsoftheshareholders.

3. To ensure optimum funds utilization.Once the funds are procured, they should be utilized inmaximumpossiblewayatleastcost.

4. Toensuresafetyoninvestment,i.e.,fundsshouldbeinvestedinsafeventuressothatadequaterateofreturncanbeachieved.

5. Toplanasoundcapitalstructure-Thereshouldbesoundandfaircompositionofcapitalsothatabalanceismaintainedbetweendebtandequitycapital.

FinancialPlanning

Financialplanningisanimportantpartoffinancialmanagement.Itistheprocessofdeterminingtheobjectives; policies, procedures, programs and budgets to deal with the financial activities of anenterprise.

Financial planning reflects the needs of the business and is integrated with the overall businessplanning. Proper financial planning is necessary to enable the business enterprise to have rightamount of capital to continue its operations efficiently. Financial planning involves taking certainimportant decisions so that funds are continuously available to the company and are usedefficiently.Thesedecisionshighlightthescopeoffinancialplanning.

InthewordsofGerestenbugfinancialplanningincludes:

• Determination of amount of finance needed by an enterprise to carry out its operationssmoothly.

• Determinationofsourcesoffunds,i.e.,thepatternofsecuritiestobeissued.

• Determinationofsuitablepoliciesforproperutilizationandadministrationoffunds.

ElementsofFinancialPlanning

• DeterminationofFinancialObjectives

For effective financial planning, it is essential to clearly lay down the financial objectivessoughttobeachieved.Thefinancialobjectivesshouldbebasedontheoverallobjectivesofthecompany.Theobjectivesoffinancialmanagementmaybesetup intheareas,namely,investment,financinganddividend.

• EstimationofCapitalRequirements:

Capitalisrequiredforvariousneedsofthebusiness.Separateassessmentistobemadeofthe requirements of fixed andworking capital. Fixed capital is needed for acquiring fixedassetssuchaslandandbuilding,plantandmachinery,furniture,etc.Itisblockedforalongtime.Workingcapital is required forholding currentassets like stock,bills receivable,etc.andcashformeetingday-to-dayexpensesinrunningthebusiness.

8

• DeterminationoftheKindsofSecuritiestobeissued:

A company can issue equity shares, preference shares and debentures to raise long-termfunds.Thetypesandproportionofsecuritiestobeissuedshouldbeproperlydetermined.

• FormulationofFinancialPolicies:

Financial planning leads to formulationof policies relating toborrowing and lending, cashcontrolandotherfinancialactivities.Suchpolicieswillhelp intakingvitaldecisionsfortheadministrationofcapitalandachievingcoordinationinfinancialactivities.

• Estimationofcapitalrequirements:Afinancemanagerhastomakeestimationwithregardstocapital requirementsof thecompany.Thiswilldependuponexpectedcostsandprofitsandfutureprogramsandpoliciesofaconcern.Estimationshavetobemadeinanadequatemannerwhichincreasesearningcapacityofenterprise.

• Determination of capital composition:Once the estimation has been made, the capitalstructurehavetobedecided.Thisinvolvesshort-termandlong-termdebtequityanalysis.This will depend upon the proportion of equity capital a company is possessing andadditionalfundswhichhavetoberaisedfromoutsideparties.

• Choice of sources of funds:For additional funds to be procured, a company has manychoiceslike-

a. Issueofsharesanddebenturesb. Loanstobetakenfrombanksandfinancialinstitutionsc. Publicdepositstobedrawnlikeinformofbonds.

Choiceof factorwilldependon relativemeritsanddemeritsofeachsourceandperiodoffinancing.

• Investment of funds:The financemanager has to decide to allocate funds into profitableventuressothatthereissafetyoninvestmentandregularreturnsispossible.

• Disposalofsurplus:Thenetprofitsdecisionshavetobemadebythefinancemanager.Thiscanbedoneintwoways:

d. Dividenddeclaration-Itincludesidentifyingtherateofdividendsandotherbenefitslikebonus.

e. Retainedprofits-Thevolumehastobedecidedwhichwilldependuponexpansion,innovation,diversificationplansofthecompany.

• Management of cash:Finance manager has to make decisions with regards to cashmanagement. Cash is required for many purposes like payment of wages and salaries,payment of electricity and water bills, payment to creditors, meeting current liabilities,maintenanceofenoughstock,purchaseofrawmaterials,etc.

• Financialcontrols:Thefinancemanagerhasnotonlytoplan,procureandutilizethefundsbuthealsohastoexercisecontroloverfinances.Thiscanbedonethroughmanytechniqueslikeratioanalysis,financialforecasting,costandprofitcontrol,etc.

9

ImportanceofFinancialPlanning&Management:

Soundfinancialplanningisessentialforsuccessofanybusinessenterprise.Itsneedisfeltbecauseofthefollowingreasons:

• ItFacilitatesCollectionofOptimumFunds

The financial planning estimates the precise requirement of funds whichmeans to avoidwastageandover-capitalizationsituation.

• ItHelpsinFixingtheMostAppropriateCapitalStructure:

Fundscanbearrangedfromvarioussourcesandareusedforlongterm,mediumtermandshort term. Financial planning is necessary for tapping appropriate sources at appropriatetimeas longtermfundsaregenerallycontributedbyshareholdersanddebentureholders,mediumtermbyfinancialinstitutionsandshorttermbycommercialbanks.

• HelpsinInvestingFinanceinRightProjects:

Financialplansuggestshowthefundsaretobeallocatedforvariouspurposesbycomparingvariousinvestmentproposals.

• HelpsinOperationalActivities:

Thesuccessorfailureofproductionanddistributionfunctionofbusinessdependsuponthefinancialdecisionsasrightdecisionensuressmoothflowoffinanceandsmoothoperationofproductionanddistribution.

• BaseforFinancialControl:

Financialplanningactsasbasisforcheckingthefinancialactivitiesbycomparingtheactualrevenuewithestimatedrevenueandactualcostwithestimatedcost.

• HelpsinProperUtilizationofFinance:

Financeisthelifebloodofbusiness.Sofinancialplanningisanintegralpartofthecorporateplanningofbusiness.Allbusinessplansdependuponthesoundnessoffinancialplanning.

• HelpsinAvoidingBusinessShocksandSurprises:

By anticipating the financial requirements financial planning helps to avoid shock orsurpriseswhichotherwisefirmshavetofaceinuncertainsituations.

• LinkbetweenInvestmentandFinancingDecisions:

Financialplanninghelps indecidingdebt/equity ratioandbydecidingwhere to invest thisfund.Itcreatesalinkbetweenboththedecisions.

• HelpsinCoordination:

Ithelpsincoordinatingvariousbusinessfunctionssuchasproduction,salesfunctionetc.

• ItLinksPresentwithFuture:

Financial planning relates present financial requirement with future requirement byanticipatingthesalesandgrowthplansofthecompany.

10

Chapter2:IntroductiontoFinancialStatements


IntroductiontoFinancialStatements

• Introductiontofinancialstatements• Incomestatement/Profit&lossstatement• Balancesheet• Cashflowstatement• Differencebetweenfundflowandcashflow

statement

• Purposeoffinancialstatements• Typesoffinancialstatements• Components of each financialstatement.

2.1 IntroductiontoFinancialstatements

Whyshouldwepreparefinancialstatements?1If you are wondering whether or not you really need to prepare financial statements when youalready knowyourbusiness is profitable, theanswer is definitely yes. Youmaybe convinced thatyour business is doing fine, but you will need proof for investors, creditors, shareholders,government agencies, and essentially you will also need it for your own peace of mind. Feelingsuccessful is great, but seeing the facts and figures in front of you that prove your success isempowering!

• BetterDecisionMakingFinancial statements are vital for making crucial business decisions. You should be reviewingmore than just your bank statementswhenever you are consideringwhether or not you canafford to investmoneyback intoyourbusiness. Financial statementswill giveyoua clearandaccuratevisualofhowyourbusinessiscurrentlyperforming,soyouhaveameansofmonitoringitsprogressandidentifyingopportunitiesforgrowth.

• MoreOn-timePaymentsFinancialreportslikeaccountsreceivablesareessentialforensuringcustomerspayontimeandaccountpayablereportswillmakesurethatyourvendorsarepaidontime.Itwillalsogiveyouareferencepointtopredictyourfuturecashflow.

• PreparedforTaxTimeRegularlyupdatedfinancialstatementswillkeepyourinformationneatlyorganizedfortaxtime.Youdon’twant to realize thatall youhave isa shoebox fullof receiptsonApril14th.Regularfinancialreportingmeansyouraccountingsoftwareisalsobeingupdatedregularly.

• ProvideProofofYourSuccessFinancialstatementswillactasahistoricalrecordoftheoverallsuccessofabusiness,ifthereiseveradecisiontosellthebusinessorobtainnewinvestors.Newclientsandsuppliersmayalsorequestfinancialstatementswhiletryingtodetermineiftheyshouldconductbusinesswithyourcompany.

1Video-https://www.investopedia.com/terms/f/financial-statements.asp

11

• CatchCostlyMistakes

Asetscheduleforreviewingyourfinancialstatementswillhelpcatchmistakesearlier.Theycanalsohelpanownerdetecttheft, fraud,or illegalactivitieswithintheirbusiness.Youcanhireaprofessional accountant or a bookkeeper, or an entire finance department, but that doesn’tmean you still don’t need to be involved. As much as you want to trust the person who ishandlingyourfinances,youneedtobewatchfulforanydiscrepancies.

2.2 IncomeStatement/Profitandlossstatement

WhatistheIncomeStatement?2

The IncomeStatement isoneofa company’s core financial statements that show theirprofit andlossoveraperiodoftime.Theprofitorlossisdeterminedbytakingallrevenuesandsubtractingallexpensesfromoperatingandnon-operatingactivities.Theincomestatementisoneofthreestatementsusedinbothcorporatefinance(includingfinancialmodeling)andaccounting.Thestatementdisplaysthecompany’srevenue,costs,grossprofit,sellingand administrative expenses, other expenses and income, taxes paid andnet profit in a coherentandlogicalmanner.

Figure1:ParticularsofIncomeStatement

Thestatementisdividedintotimeperiodsthatlogicallyfollowthecompany’soperations.Themostcommonperiodicdivisionismonthly(forinternalreporting),althoughcertaincompaniesmayuseathirteen-period cycle. Theseperiodic statementswill be aggregated into total values for quarterlyandfullyearresults.

2Video-https://www.investopedia.com/terms/i/incomestatement.asp

12

This statement is a great place to begin thefinancial model, as it requires the least amount ofinformation from the balance sheet and cash flow statement. Thus, in terms of information, theincomestatementisapredecessortotheothertwocorestatements.

ComponentsofanIncomeStatement

The income statementmay haveminor variations betweendifferent companies, as expenses andincomewill be dependent on the type of operations or business conducted. However, there areseveralgenericlineitemsthatarecommonlyseenintheincomestatement.Themostcommonincomestatementitemsinclude:• Revenue/Sales:SalesRevenueisthecompany’srevenuefromsalesorserviceisdisplayedatthe

verytopofthestatement.Thisvaluewillbegrossofthecostsassociatedincreatingthegoodssold,or inprovidingtheservice.Somecompanieshavemultiplerevenuestreamsthataddtoatotalrevenueline.

• CostofGoodsSold(COGS):CostofGoodsSold(COGS)isaline-itemthataggregatesthedirectcostsassociatedwithsellingproductstogeneraterevenue.ThislineitemcanalsobecalledCostofSalesifit’saservicebusiness.Directcostscanincludelabor,parts,materials,anallocationofotherexpensessuchasdepreciation

• GrossProfit:GrossProfitGrossprofitiscalculatedbysubtractingCostofGoodsSold(orCostofSales)fromSalesRevenue.

• Marketing,Advertising,andPromotionExpense:Mostbusinesseshavesomeexpensesrelatedto selling good and/or services. Marketing, advertising, and promotion of often groupedtogetherastheyaresimilarexpenses,allrelatedtoselling.

• General and Administrative (G&A) Expense: SG&A Expenseincludes the selling, general andadministrativesectionwillcontainallotherindirectcostsassociatedwithrunningthebusiness.Thisincludessalariesofmanagement,rentandofficeexpenses,insurance,travelexpenses,andsometimes depreciation and amortization, among others. Entities may, however, elect toseparateoutdepreciationandamortizationinitsownsection.

• OtherExpenses:Businessesoftenhaveotherexpensesthatareuniquetotheirindustry.Otherexpenses that are common but not listed above include fulfillment, technology, research anddevelopment(R&D).

• EBITDA:EBITDA,whilenotpresentinallincomestatements,standsforEarningsbeforeInterest,Tax, Depreciation, and Amortization is calculated by subtracting SG&A expenses (excludingamortizationanddepreciation)fromgrossprofit.

• Depreciation & Amortization Expense: Depreciationand amortization arenon-cashexpensesthatarecreatedbyaccountantstospreadoutthecostofcapitalassetssuchasProperty,Plant,andEquipment(PP&E).

• OperatingIncome(orEBIT):OperatingIncomerepresentswhat’searnedfromregularbusinessoperations. In other words, it’s the profit before anynon-operating income, non-operatingexpenses, interest or taxes.EBITis a term commonly used in finance and stands for EarningsbeforeInterestandTax.

• Interest:InterestExpense.Itiscommonforcompaniestosplitoutinterestexpenseandinterestincomeasaseparatelineitemintheincomestatement.ThisisdonetobeabletoreconcilethedifferencebetweenEBITandEBT.Interestexpenseisdeterminedbythedebtschedule.

• EBT (Pre-Tax Income): EBTstands for Earnings before Tax, also known as pre-tax income, isfoundbysubtracting interestexpensefromOperating Income.This is the finalsubtotalbeforearrivingatnetincome.

13

• IncomeTaxes: IncomeTaxesrefer to the relevant taxeschargedonpre-tax income.The totaltaxexpensecanconsistofbothcurrenttaxesandfuturetaxes.

• Net Income:Net Incomeis calculatedbydeducting income taxes frompre-tax income. This isthe amount that flows into retained earnings on the balance sheet, after deductions for anydividends.

ExampleofanIncomeStatementBelow is an example of ABC Co.’s statement of operations or income statement for years endedDecember31,2017–2015.TakealookattheP&Landthenreadabreak-downofitbelow.

Table2:IncomeStatementofABCCo.

(in‘000INR,exceptpersharedata) YearendedMarch30,

2017 2016 2015

Netproductsales 70080 79268 94665

Netservicesales 18908 27738 41322

Totalnetsales 88988 107006 135987

Operatingexpenses

Costofsales 62752 71651 88265

Fulfilment 10766 13410 17619

Marketing 4332 5254 7233

Technologyandcontent 9275 12540 16085

Generalandadministrative 1552 1747 2432

Otheroperatingexpenses,net 133 171 167

Totaloperatingexpenses 88810 104773 131801

Operatingincome 178 2233 4186

Interestincome 39 50 100

Interestexpense (210) (459) (484)

Otherincome(expense),net (118) (256) 90

Totalnon-operatingincome(expense) (289) (665) (294)

Income(loss)beforeincometaxes (111) 1568 3892

Provisionforincometaxes (167) (950) (1425)

Equity-methodinvestmentactivity,netoftax 37 (22) (96)

Netincome(loss) (241) 596 2371

Basicearningspershare (0.52) 1.28 5.01

Dilutedearningspershare (0.52) 1.25 4.9

Weighted average shared used in computation ofearningspershare

Basic 462 467 474

Diluted 462 477 484

14

StartingatthetopweseethatABCCo.hastwodifferentrevenuestreams,products,andservices,which combine to form total revenue. There is no gross profit subtotal, as the cost of sales isgroupedwillallotherexpenses,which include fulfillment,marketing, technology,content,generalandadministration(G&A),andotherexpenses.After deducting all the above expenses we finally arrive at the first subtotal on the incomestatement,OperatingIncome(alsoknownasEBITorEarningsbeforeInterestandTaxes).EverythingbelowOperatingIncomeisnotrelatedtotheongoingoperationofthebusinesssuchasnon-operatingexpense,provisionforincometaxes(i.e.futuretaxes)andequity-methodinvestmentactivity,netoftax(profitsorlossesfromminorityinvestments).Finally, we arrive at the net income (or net loss) which is then divided by theweighted averagesharesoutstandingtodetermineEarningsperShare(EPS).

2.3 BalanceSheet

WhatisaBalanceSheet?3Thebalancesheetisoneofthethreefundamentalfinancialstatementsandiskeytobothfinancialmodelling and accounting. The balance sheet displays the company’s total assets, and how theseassets are financed, through either debt or equity. It can also sometimes be referred to as astatementofnetworth,orastatementoffinancialposition.Thebalancesheetisbasedonthefundamentalequation:Assets=Liabilities+Equity

Figure2:ParticularsofBalanceSheet

Assuch,thebalancesheetisdividedintotwosides(orsections).Theleftsideofthebalancesheetoutlinesallacompany’sassets.Ontherightside,thebalancesheetoutlinesthecompany’sliabilitiesand shareholders’ equity. On either side, themain line items are generally classified by liquidity.More liquidaccounts like Inventory,Cash,andTradesPayablesareplacedbefore illiquidaccounts

3Video-https://www.investopedia.com/terms/b/balancesheet.asp

15

suchasPlant,PropertyandEquipment(PP&E)andLong-TermDebt.Theassetandliabilitiesarealsoseparatedintotwocategories:currentasset/liabilitiesandnon-current(long-term)assets/liabilities.HowtheBalanceSheetisstructuredBalancesheets,likeallfinancialstatements,willhaveminordifferencesbetweenorganizationsandindustries.However, thereareseveral“buckets”and line itemsthatarealmostalways included incommonbalance sheets.Webrieflygo throughcommonly found line itemsunderCurrentAssets,Long-TermAssets,CurrentLiabilities,Long-TermLiabilitiesandEquity.CurrentAssets

• Cash and Equivalents: Themost liquid of all assets, cash appears on the first line of thebalancesheet.CashEquivalentsarealsolumpedunderthislineitem,andincludeassetsthathaveshort-termmaturitieslessthanthreemonthsorassetsthatthecompanycanliquidateon short notice, such asmarketable securities. Companies will generally disclose whatequivalentsitincludesinthefootnotestothebalancesheet.

• AccountsReceivable:Thisaccount includes thebalanceofall sales revenuestilloncredit,net of any allowances for doubtful accounts (which generate a bad debt expense). Ascompanies recoveraccounts receivables, thisaccountdecreasesandcash increasesby thesameamount.

• Inventory: Inventory includes amounts for raw materials, work-in-progress goods andfinished goods. The company uses this account when it makes sales of goods, generallyundercostofgoodssoldintheincomestatement.

• Pre-paidexpenses:Prepaidexpensesare futureexpensesthathavebeenpaid inadvance.Youcanthinkofprepaidexpensesascoststhathavebeenpaidbuthavenotyetbeenuseduporhavenotyetexpired.Theamountsofprepaidexpenses thathavenot yet expiredare reportedona company'sbalance sheet as an asset.As the amountexpires, the asset is reducedandanexpense isrecordedfortheamountofthereduction.Hence,thebalancesheetreportstheunexpiredcosts and the income statement reports the expired costs. The amount reported on theincome statement should be the amount that pertains to the time interval shown in thestatement'sheading.A common prepaid expense is the six-month premium for insurance on a company'svehicles. Since the insurance company requires payment in advance, the amount paid isoften recorded in the current asset account Prepaid Insurance. If the company issuesmonthly financial statements, its income statement will report Insurance Expense that isone-sixthoftheamountpaid.ThebalanceintheaccountPrepaidInsurancewillbereducedbytheamountthatwasdebitedtoInsuranceExpense.

Non-CurrentAssets

• Plant, Property and Equipment (PP&E): Property, Plant and Equipment (also known asPP&E) captures the company’s tangible fixed assets. This line item is noted net ofdepreciation.SomecompanieswillclassouttheirPP&Ebythedifferenttypesofassets,suchasLand,Building,andvarioustypesofEquipment.AllPP&EisdepreciableexceptforLand.

• Intangible Assets: This line itemwill include all of the company’s intangible fixed assets,whichmayormaynotbeidentifiable.Identifiableintangibleassetsincludepatents,licenses,andsecretformulas.Unidentifiableintangibleassetsincludebrandandgoodwill.

16

CurrentLiabilities

• AccountsPayable:AccountsPayables,orAP, is theamountacompanyowessuppliers foritemsorservicespurchasedoncredit.AsthecompanypaysofftheirAP,itdecreasesalongwithanequalamountdecreasetothecashaccount.

• CurrentDebt/NotesPayable:Includesnon-APobligationsthatareduewithinoneyeartimeorwithin oneoperating cycle for the company (whichever is longest).Notes payablemayalsohavealong-termversion,whichincludesnoteswithamaturityofmorethanoneyear.

• CurrentPortionofLong-TermDebt:Thisaccountmayormaynotbelumpedtogetherwiththeaboveaccount,CurrentDebt.Whiletheymayseemsimilar,thecurrentportionoflong-term debt is specifically the portion due within this year of a piece of debt that has amaturityofmorethanoneyear.Forexample,ifacompanytakesonabankloantobepaidoffin5-years,thisaccountwillincludetheportionofthatloandueinthenextyear.

Non-CurrentLiabilities

• BondsPayable:Thisaccountincludestheamortizedamountofanybondsthecompanyhasissued.

• Long-TermDebt:This account includes the total amountof long-termdebt (Excluding thecurrentportion, if thataccount ispresentundercurrent liabilities).Thisaccount isderivedfrom thedebt schedule, which outlines all the companies’ outstanding debt, the interestexpenseandtheprincipalrepaymentforeveryperiod.

Shareholders’Equity

• ShareCapital:Thisisthevalueoffundsashareholderhasinvestedinthecompany.Whenacompany isborn,shareholderswillgenerallyput incash.Forexample,an investorstartsacompany and seeds it with $10M. Cash (an asset) rises by $10M, and ShareCapital (anequityaccount)risesby$10M,balancingoutthebalancesheet.

• Retained Earnings:This is the total amount of net income the company decides to keep.Everyperiod,acompanymaypayoutdividendsfromitsnetincome.Anyamountremaining(orexceeding)isaddedto(deductedfrom)retainedearnings.

ImportanceoftheBalanceSheetThebalancesheetisaveryimportantfinancialstatementformanyreasons.Itcanbelookedatonits own, and in conjunction with other statements like the income statement and cash flowstatementtogetafullpictureofacompany’shealth.

Thisstatementisagreatwaytoanalyseacompany’sfinancialposition.Ananalystcangenerallyusethe balance sheet to calculate a lot offinancial ratiosthat can determine howwell a company isperforming,howliquidorsolventacompanyis,andhowefficientitis.

Changesinbalancesheetaccountsarealsousedtocalculatecashflowinthecashflowstatement.For example, a positive change in plant, property, and equipment is equal to capital expenditureminusdepreciationexpense.Ifdepreciationexpenseisknown,capitalexpenditurecanbecalculatedandincludedasacashoutflowundercashflowfrominvestinginthecashflowstatement.

17

ExampleBalanceSheetBelowisanexampleofABCCo.’s2017balancesheet.Asyouwillsee,itstartswithcurrentassets,then non-current assets and total assets. Below that is liabilities and stockholders’ equity whichincludescurrentliabilities,non-currentliabilities,andfinallyshareholders’equity.

Table3:BalanceSheetofABCCo.(In'000INR,exceptpersharedata) March30,

2017 2016

ASSETS CurrentAssets:

Cashandcashequivalents 15890 19334Marketablesecurities 3918 6647Inventories 10243 11461Accountsreceivable,netandother 5654 8339

Totalcurrentassets 35705 45781Propertyandequipment,net 21838 29114Goodwill 3759 3784Otherassets 3445 4723

Totalassets 64747 83402

LIABILITIESANDSTOCKHOLDERS'EQUITY Currentliabilities:

Accountspayable 20397 25309Accruedexpensesandother 10372 13739Unearnedrevenue 3118 4768

Totalcurrentliabilities 33887 43816Longtermdebts 8227 7694Otherlongtermliabilities 9249 12607Commitmentandcontingencies

Stockholders'equity: Preferredstock,INR0.01parvalue: Authorizedshares-500 Issuedandoutstandingshares-None - -

Commonstock,INR0.01parvalue: Authorizedshares-5000 Issuedshares-494and500 Outstandingshares-471and477 5 5

Treasurystock,atcost (1837) (1837)Additionalpaid-incapital 13394 17186Accumulatedothercomprehensiveloss (723) (985)Retainedearnings 2545 4916

Totalstockholders'equity 13384 19285Totalliabilitiesandstockholders'equity 64747 83402

18

2.4 Cashflowstatement

A Cash Flow Statement4 (also called the Statement of Cash Flows) shows how much cash isgeneratedandusedduringagiven timeperiod. It isoneof themain financial statementsanalystsuseinbuildingathreestatementmodel.Themaincategoriesfoundinacashflowstatementarethe(1) operating activities, (2) investing activities and (3) financing activities of a company and areorganized respectively asmentioned. The total cash provided fromor used by each of the threeactivitieswill be summed toarriveat the total change in cash for theperiod, and then combinedwiththeopeningcashbalancetoarriveat thecash flowstatement’sbottom line, theclosingcashbalance.

Figure3:ParticularsofCashFlowStatement

One of the primary reasons cash inflows and outflows are observed is to compare the cash fromoperations to net income to gauge howwell a company is running its operations. The cash flowstatement reflects theactualamountofmoney the company receives from itsprofits. The reasonforthedifferencebetweencashandprofit isbecausetheincomestatementispreparedundertheaccrualbasisofaccounting,where itmatches revenuesandexpenses,even though revenuesmayactuallynothavebeencollectedandexpensesmaynothavebeenpaid.HowtosetuptheCashFlowStatement?

Belowisabreakdownofeachofsectioninastatementofcashflows.Whileeachcompanywillhaveits own unique line items, the general setup is usually the same. This guidewill give you a goodoverviewofwhattolookforwhenanalysingacompany.

#1OperatingCashFlow

Thecashflowstatementiscommonlypresentedusingtheindirectmethod.Itstartswithnetincomeorloss,followedbyadditionstoorsubtractionsfromthatamounttoadjustthenetincometoatotal

4Video-https://www.investopedia.com/video/play/what-is-cash-flow/

19

cashflowfigure.Whatisaddedorsubtractedarechangesintheaccountbalancesofitemsfoundincurrentassetsandcurrent liabilitiesonthebalancesheet,aswellasnon-cashaccounts(i.e.stock-basedcompensation).Wethenarriveatthecashversionofacompany’snetincome.

NetEarnings:Thisamountisthebottomlineofanincomestatement.Netincomeorearningsshowsthe profitability of a company over a period of time. It is calculated by taking the revenues andsubtracting from itCOGSand total expenses, whichincludesSG&A,DepreciationandAmortization,interest,etc.

Plus:DepreciationandAmortization(D&A):Thevalueofvariousassetsdeclinesovertimewhenusedin abusiness.As a result,D&Aareexpenses that allocate the costof anassetover itsuseful life.Depreciation involves tangible assets such asbuildings, machinery, and equipment, whereasamortization involvesintangible assetssuch as patents, copyrights, goodwill, and software. D&Areducesnetincomeintheincomestatement.However,weaddthisbackinthecashflowstatementtoadjustnetincome,becausethesearenon-cashexpenses.Inotherwords,nocashwasinvolved.

Less: Changes inworking capital:Working capitalrepresents the difference between a company’scurrent assets and current liabilities. Any changes in current assets (other than cash) and currentliabilitiesaffectthecashbalanceinoperatingactivities.

Forinstance,whenacompanybuysmoreinventories,currentassetsincrease.Thispositivechangeininventoryissubtractedfromnetincome,becauseitisseenasacashoutflow.It’sthesamecaseforaccountsreceivable.Whenitincreases,itmeansthecompanysoldtheirgoodsoncredit.Therewasnocashtransaction,soaccountsreceivableisalsosubtractedfromnetincome.

Ontheotherhand,ifacurrentliabilityitemsuchasaccountspayableincreases,thisisconsideredacashinflow,becausethecompanyhasmorecashtokeepinitsbusiness.This isthenaddedtothenetincome.

Cashfromoperations:Whenalltheadjustmentshavebeenmade,wearriveatthenetcashprovidedby thecompany’soperatingactivities.This isnota replacement fornet incomebuta summaryofhowmuchcashisgeneratedfromthecorebusiness.

#2InvestingCashFlow

This category on the statement of cash flows is referred to as investing activities and reports thechangesincapitalexpenditures(capex)andlong-terminvestments.Capexcanbereferredtoasthepurchase of property, plant or equipment. Long-term investments can bedebtand equityinstruments of other companies. Another important item found here are acquisitions of otherbusinesses. A key to remember is that a change in the long-term assets in the balance sheet isreportedintheinvestingactivitiesofthecashflowstatement.

InvestmentsinPropertyandEquipment:Inourexample,theseinvestmentscouldmeanpurchasesofnewoffice equipment such as computers andprinters for a growing number of employees and apurchaseofanewlandandabuildingtohousethebusinessoperationsandlogisticsofacompany.Theseitemsarenecessarytokeepthecompanyrunning.Theseinvestmentsareacashoutflow,andthereforewillhaveanegativesignwhenwecalculatethenetincreaseincashforallactivities.

Cashfrominvesting:Thisisthetotalamountofcashprovidedby(usedin)investingactivities.Inourexample,wehaveanetoutflowforeachandeveryyear.

20

#3FinancingCashFlow

Thiscategoryisalsocalledfinancingactivitiesandreportsanyissuanceorrepurchasesofstocksandbonds of the company, as well as the dividend payments it makes. The changes in long-termliabilitiesandstockholders’equityinthebalancesheetarereportedinfinancingactivities.

Issuance(repayment)ofdebt:Acompanywillissuedebtasawaytofinanceitsoperations.Themorecashithasthebetter,asitwillbeabletoexpandrapidly.Unlikeequity, issuingdebtdoesn’tgrantany ownership in the company, so it doesn’t dilute the ownership of existing shareholders. Theissuance of debt is a cash inflow, because a company finds investors willing to act as lenders.However,whentheseinvestorsarepaidback,thenadebtrepaymentisacashoutflow.

Issuance (repayment) of equity: This is another way of financing a company’s operations. Unlikedebt,equityholderswillhavesomeownershipstakeinthebusinessinexchangeformoneygiventothe company for use. Future earnings must be shared with these equity holders or investors.Issuance of equity is an additional source of cash, so it’s a cash inflow. Conversely, an equityrepayment is a cash outflow. This is buying back, through cash payment, the equity from itsinvestors,andtherebyincreasingthestakeheldbyexistingequityholders.

Cash from financing: This is also called thenet cashprovidedby (used in) financingactivities.Thecashfromfinancingiscalculatedbysummingupallthecashinflowsandoutflowsrelatedtochangesinlong-termliabilitiesandshareholder’sequityaccounts.

#4CashBalance

The lastsectiononthestatementofcashflows isareconciliationofthetotalcashposition,whichconnectstothebalancesheet.This is thefinalpieceof thepuzzlewhenlinkingthethreefinancialstatements.

NetIncrease(decrease)inCash:Oncewehaveallnetcashbalancesforeachofthethreesectionsofthecashflowstatement,wesumthemalluptofindthenetcashincreaseordecreaseforthegiventimeperiod.Wethentakethisamountandaddittotheopeningcashbalancetoeventuallyarriveattheclosingcashbalance.

Openingcashbalance:Theopeningcashbalanceislastyear’sclosingcashbalance.Wecanfindthisamountfromlastyear’scashflowstatementandbalancesheetstatement.

Closingcashbalance:Theclosingcashbalanceistakenbyaddingtogethernetincreaseordecreasein cash and opening cash balance. This amount will be reported in the balance sheet statementunderthecurrentassetsection.

ExampleofaCashFlowStatement

Below is an example of ABC Co.’s 2017 statement of cash flows. As you can see by the orangerectangles, there are three clear sections that add to the total change and end of period cashposition.

21

Table4:CashFlowStatementofABCCo.(In'000INR) YearendedMarch30,

2017 2016 2015CASHANDCASHEQUIVALENTS,BEGINNINGOFPERIOD 8658 14557 15890OPERATINGACTIVITIES:

Netincome(loss) (241) 596 2371Adjustmenttoreconcilenetincome(loss)tonetcashfromoperatingactivities: Depreciationofpropertyandequipment,includinginternal-use

softwareandwebsitedevelopment,andotheramortization,includingcapitalizedcontentcosts

4746 6281 8116

Stock-basedcompensation 1497 2119 2975 Otheroperatingexpense,net 129 155 160 Otherexpense(income),net 59 250 (20) Deferredincometaxes (316) 81 (246) Excesstaxbenefitsfromstock-basedcompensation (6) (119) (829)Changesinoperatingassetsandliabilities: Inventories (1193) (2187) (1426) Accountsreceivable,netandother (1039) (1755) (3367) Accountspayable 1759 4294 5030 Accruedexpensesandother 706 913 1724 Additionstounearnedrevenue 4433 7401 11931 Amortizationofpreviouslyunearnedrevenue (3692) (6109) (9976)Netcashprovidedby(usedin)operatingactivities 6842 11920 16443

INVESTINGACTIVITIES:

Purchasesofpropertyandequipment,includinginternal-usesoftwareandwebsitedevelopment,net

(4893) (4589) (6737)

Acquisition,netofcashacquiredandother (979) (795) (116)Salesandmaturitiesofmarketablesecurities 3349 3025 4733Purchasesofmarketablesecurities (2542) (4091) (7756)Netcashprovidedby(usedin)investingactivities (5065) (6450) (9876)

FINANCINGACTIVITIES:

Excesstaxbenefitsfromstock-basedcompensation 6 119 829Proceedsfromlongtermdebtandother 6359 353 621Repaymentsoflongtermdebtandother (513) (1652) (354)Principalrepaymentsofcapitalleaseobligations (1285) (2462) (3860)Principalrepaymentsoffinanceleaseobligations (135) (121) (147)Netcashprovidedby(usedin)financingactivities 4432 (3763) (2911)Foreigncurrencyeffectoncashandcashequivalents (310) (374) (212)Netincrease(decrease)incashandcashequivalents 5899 1333 3444CASHANDCASHEQUIVALENTS,ENDOFPERIOD 14557 15890 19334

22

Whatis'FreeCashFlow-FCF'

Freecashflowrepresents5thecashacompanycangenerateafterrequiredinvestmenttomaintainor expand its asset base. It is a measurement of a company's financial performance and health.Therearetwoothertypesoffreecashflow:freecashflowforthefirmandfreecashflowtoequity.Thisarticlefocusesonthemoresimplifiedfreecashflowalsoknownasleveredfreecashflow.

BREAKINGDOWN'FreeCashFlow-FCF'

Free cash flow is the cash flowavailable to all investors in a company, including commonstockholders.FCFprovidesausefulvaluationtechnique investorsoftenusetoderiveafirm'svalueor the value of a firm's common equity. Often, investors will calculate afirm's value usingFCFvaluation model techniques and subtract net debt to arrive at a company's equity value in asimplecapitalstructure.

FreeCashFlow-FCFinCompanyAnalysis

FCFmeasuresthelevelofcashavailabletoacompany'sinvestorsnetofallrequiredinvestmentsinworking capital and fixed capital, includingplant, property and equipment, otherwise known ascapital expenditures, plus any expenses required to remain agoing concern. FCF is an importantmeasure because it allows a company to pursue opportunities that enhanceshareholder value.Excess cash can expand production, develop new products,make acquisitions, pay dividends andreducedebt.

As FCF increases, balance sheet strength and health rises; however, it is important to note thatnegative FCF is not a bad indicator. If FCF is negative, it could be a sign a company is makingsignificantinvestments.Iftheseinvestmentsearnhighreturns,thestrategyhasthepotentialtoaddvalueinthelongrun.

FreeCashFlow-FCFCalculations

One can calculate FCFmultiple ways.Most commonly, the FCFcalculation begins withCash FlowfromOperatingActivities,butitcanalsostartfromrevenueorNetOperatingProfitafterTaxes.

OnecancalculateFCFusingthefollowingequations:

FreeCashFlow

= 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑓𝑟𝑜𝑚𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠= 𝑁𝑒𝑡𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑇𝑎𝑥𝑒𝑠 − 𝑁𝑒𝑡𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑖𝑛𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙= 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝐶𝑜𝑠𝑡𝑠𝑎𝑛𝑑𝑇𝑎𝑥𝑒𝑠 − 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠𝑖𝑛𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Where:

NetOperatingProfitafterTaxes=Revenue-OperatingCostsandTaxesRequiredInvestmentsinOperatingCapital=NetInvestmentinOperatingCapital

5Video-https://www.investopedia.com/terms/f/freecashflow.asp

23

Netinvestmentinoperatingcapital

Ifcalculatedproperlywithall thesame inputs,all threeequationsshouldproducethesameresultforFCF.

Whatis'UnleveredFreeCashFlow-UFCF'

Unlevered free cash flow (UFCF)6 is a company's cash flow before taking interest payments intoaccount.Unleveredfreecashflowcanbereportedinacompany'sfinancialstatementsorcalculatedusingfinancialstatementsbyanalysts.Unleveredfreecashflowshowshowmuchcashisavailabletothefirmbeforetakingfinancialobligationsintoaccount.

BREAKINGDOWN'UnleveredFreeCashFlow-UFCF'

Unleveredfreecashflow is thegross freecashflowgeneratedbyacompany.Leverage isanothernamefordebt,andifcashflowsareleveredthatmeansthey'renetofinterestpayments.Unleveredfreecashflowisthefreecashflowavailabletopayallstakeholdersinafirmincludingdebtholdersaswellasequityholders.

Like levered free cash flow, unlevered free cash flow is net of capital expenditures and workingcapitalneeds–thecashneededtomaintainandgrowthecompany'sassetbaseinordertogeneraterevenueandearnings.Non-cashexpensessuchasdepreciationandamortizationareaddedbacktoearningstoarriveatthefirm'sunleveredfreecashflow.

UnleveredFreeCashFlowFormula

The formula for unlevered free cash flow usesearnings before interest, taxes, depreciation andamortization(EBITDA) and capital expenditures (CAPEX), which represents the investments inbuildings,machines,andequipment.Italsousesworkingcapital,whichincludesinventory,accountsreceivableandaccountspayable.

Theformulaforunleveredfreecashflowis:

𝑈𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇𝐷𝐴 − 𝐶𝐴𝑃𝐸𝑋 − 𝑊𝑜𝑟𝑘𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑇𝑎𝑥𝑒𝑠

InvestmentConsiderationsforUnleveredFreeCashFlow

A company that has a large amount of outstanding debt, beinghighly leveraged,ismore likely toreport unlevered free cash flow because it provides a rosier picture of the company's financialhealth.Thefigureshowshowassetsareperforming inavacuum,because it ignoresthepaymentsmade for debt incurred to obtain those assets. Investors have to make sure to consider debtobligations,sincehighlyleveragedcompaniesareatgreaterriskforbankruptcy.

Companies lookingtoshowbetternumberscanmanipulateunlevered freecash flowby layingoffworkers, delaying capital projects, liquidating inventory or delaying payments to suppliers. All oftheseactionshaveconsequences,andinvestorsshoulddiscernwhetherimprovementsinunleveredfree cash floware transitoryor genuinely convey improvements in theunderlyingbusinessof thecompany.

6Video-https://www.investopedia.com/terms/u/unlevered-free-cash-flow-ufcf.asp

24

Unlevered freecash flow isbefore interestpayments,soviewing it inabubble ignores thecapitalstructureofafirm.Afteraccountingforinterestpayments,theleveredfreecashflowofafirmmayactuallybenegative,apossiblesignofnegativeimplicationsdowntheroad.Analystsshouldassessbothunleveredandleveredfreecashflowovertimefortrendsandnotgivetoomuchweightingtoasingleyear.

2.5 DifferencebetweenFundsFlowandcashflowstatement

Funds flow statement is one of the important tools, which is used in many ways. It helps tounderstandthechangesinthefinancialpositionofabusinessenterprisebetweenthebeginningandendingfinancialstatementdates.Itisalsocalledasstatementofsourcesandusesoffunds.

Institute of Cost and Works Accounts of India, funds flow statement is defined as “a statementprospectiveorretrospective,settingoutthesourcesandapplicationofthefundsofanenterprise.The purpose of the statement is to indicate clearly the requirement of funds and how they areproposedtoberaisedandtheefficientutilizationandapplicationofthesame”.

DifferencebetweenFundsFlowandCashFlowStatement

Table5:DifferencebetweenFundFlowandCashFlowStatementFundFlowStatement CashFlowStatement1. Fund flow statement is the report on the

movementoffundsorworkingcapital2. Funds flow statement explains how working

capital is raised and used during theparticular

3. Themainobjectiveoffundflowstatement isto show the how the resources have beenbalancedmobilizedandused.

4. Funds flow statement indicates the result ofcurrentfinancialstatement.

5. In the fun flow statement increase ordecreaseofworkingcapitalisrecorded.

6. Thereisnoopeningandclosingbalances.

1. Cash flow statement is the report showingsourcesandusesofcash.

2. Cash flow statement explains the inflow andoutflowofcashduringtheparticularperiod.

3. Themainobjectiveofthecashflowstatementis to show the causes of changes in cashbetweentwobalancesheetdates.

4. It indicates the factors contributing to thereductionofcashbalance inspiteof increaseinprofitandvice-versa.

5. Inacashflowstatementonlycashreceiptandpaymentsarerecorded.

6. Cashflowstatementstartswithopeningcashbalanceandendswithclosingcashbalances.

25

Chapter3:FinancialStatementAnalysis


FinancialStatementAnalysis

• Toolsandtechniqueforfinancialstatementsanalysis

• Ratioanalysis

• Thenatureandlimitationsoffinancialanalysis.• Varioustoolsoffinancialanalysis.• Computeandinterpretvariousfinancialratios.• Carryoutdetailedanalysisoffinancialstatementsofcompanies.

3.1 ToolsforFinancialstatementsanalysis

Figure4:ToolsforFinancialStatementAnalysis

1. Comparative Financial Statement Analysis (Horizontal Analysis):As the name suggests,comparative analysis provides a year-on-year review of the various financial statements. Forexample, in the Income Statement, the Sales figure may be compared over a period ofconsecutiveyearstounderstandhowthesalesfigureshavegrown(ordeclined)overtheyear.Itshouldbenotedthathorizontalanalysiscomparestheinternalperformanceofthecompany.BelowisanexampleofaComparativeIncomeStatement.ComparativeIncomeStatement(AllfiguresareinINR‘000)

FinancialStatementsAnalysis

HorizontalAnalysis

VerticalAnlysis

RatioAnalysis

GraphicalAnalysis

TrendAnalysis

RegressionAnalysis

26

Table6:HorizontalAnalysis

FY2016-17 FY2015-16 Change %ChangeRevenue 1224 1140 84 7.4%CostofGoodssold 554 519 35 6.7%GrossProfit 670 621 49 7.9%General,selling&administrativeexpenses 436 392 44 11.2%Operatingprofit 234 229 5 2.2%Interestexpense 16 14 2 14.3%ProfitbeforeTax 218 215 3 1.4%ProvisionforTax 66 72 -6 -8.3%ProfitafterTax 152 143 9 6.3%

2. Common-sizeFinancialStatementAnalysis(VerticalAnalysis):Verticalanalysisisapplicableforinternalperformancereviewaswellas forcomparisontopeersandbench-marking. Inverticalanalysisall the items inaparticularstatementarerepresentedasapercentageofaparticularitem.Forexample,OperatingExpenses,Depreciation,Amortization,Profitbeforetax,Tax,Profitaftertax,etc.mayberepresentedasapercentageofSalesintheIncomeStatement.Commonstandard base can easily reveal the internal make-up of financial statements and anyproportionateincreaseanddecreaseofthesame.

Verticalanalysisisalsoputtouseforcomparisonacrosscompaniesasfinancialstatementsareconverted to common-size format, which can then be used to compare with competitor orindustryaverages,highlightingkeydifferenceswhichcanthenbeanalyzed.

Below is an example of a Common Size Income Statement. Values are expressed as %age ofRevenue.

Table7:VerticalAnalysis

Commonsizeincomestatementfortheyear

FY2016-17As%

FY2015-16As%

Revenue 100.0 100.0CostofGoodssold 45.2 45.6GrossProfit 54.8 54.4General,selling&administrativeexpenses 35.6 34.4Operatingprofit 19.2 20.0Interestexpense 1.1 1.2ProfitbeforeTax 18.1 18.8ProvisionforTax 4.7 5.6ProfitafterTax 13.4 13.2Similar observations can be made by preparing the Indexed financial statements. In thistechnique, thebaseyear figuresare takenas100andsubsequentyearsareexpressedasapercentagethereof.

27

3. RatioAnalysis:Ratioanalysisisthemostwidelyusedtooloffinancialstatementanalysis.Aratiogives relationshipbetween twonumbers, in this case items in the financial statements.Ratiosarepopularbecause they readilyallow internalevaluationaswellas comparisonacross firms.Theratiosarecategorizedaccording toactivitiesor functions theyperformor the informationthey provide. For example, profitability ratios measure the profit making capability of thecompany.Note:Ratiosareexplainedindetailinanothermodule/session.

4. GraphicalAnalysis:Graphsprovidevisualrepresentationoftheperformancethatcanbeeasilycomparedovertime.Thegraphsmaybelinegraphs,columngraphsorpiecharts.

Figure5:Earningsfor2012-16

Figure6:CashFlowsfor2012-16

5. TrendAnalysis:Trendanalysisisusedtorevealthetrendofitemswiththepassageoftimeand

is generally used as a statistical tool. Trend analysis is used in conjunctionwith ratio analysis,

₹0

₹20,000

₹40,000

₹60,000

₹80,000

₹100,000

₹120,000

₹140,000

₹160,000

2012 2013 2014 2015 2016

Earnings (2012 - 2016)

Revenue Gross Profit Earning Before Tax

-₹50,000

₹0

₹50,000

₹100,000

₹150,000

₹200,000

2012 2013 2014 2015 2016

Cash Flows (2012 - 2016)

Operating Investing FInancing

28

horizontalandverticalanalysistospotaparticulartrend,explorethecausesofthesameandifrequiredpreparefutureprojections.

6. Regression Analysis:Regression analysis is a statistical tool used to establish and estimaterelationship among variables. Generally, the dependent variable is related to one or moreindependentvariables. Incaseof financialstatementanalysis, thedependentvariablemaybe,say, sales, and it is required to estimate its relationshipwith the independent variable, say, amacroeconomicfactorlikeGrossDomesticProduct.

Forexample,intheTopDownapproachofsalesforecasting,ananalystwouldfirstforecastGDPgrowth and then establish a relationship between GDP and industry growth rate throughregressionanalysis.Hemaythenestimatethefuturesalesgrowthbasedontheindustrygrowth.Assuch,regressionanalysisiswidelyusedinforecastingmodels.

The various tools and techniques are there to enable the decision making. It should beunderstoodthatanyparticulartechniqueshouldnotbeviewedinisolation.Differentcompaniesmay have different accounting methods and hence, comparison with peers has to be donecarefully. Moreover, a holistic use of various techniques should be done to arrive at anyconclusion.

3.2 RatioAnalysis

Theratioscanbedividedintovariouscategoriesdependinguponthefocusofanalysis—profitability,growth,dividendpolicy,efficiency,liquidity,capitalstructure,returnandmarketrelated.

1. ProfitabilityRatios

Profitabilityratios—expressingvariousmeasuresofprofitsinrelationtothesalesorincomefortheaccountingperiod.

Wehavedefined variousmeasures of profits—gross profit, operatingprofit, net profit, etc.GrossProfit represents the excess of sales over cost of goods sold. From gross profit other operatingexpenses are deducted to arrive at earnings before interest, tax, depreciation and amortization(EBIDTA). EBITDA is often referred to as cashoperatingprofit as non-cash expenses (depreciationand amortization) and non-operating expenses (interest and tax) are yet to be deducted. FromEBITDA non-cash expenses, that is, depreciation and amortization are deducted to get anothermeasurecalledEBIToroperatingprofit.Oncewesubtract interestand financecharges fromEBIT,wearriveatprofitbeforetax(PBT)orpre-taxprofit.Aftermeetingthetaxexpenses,thebottomlineor the profit after tax is ascertained. Thesemeasures of profits for Excel Industries are given asfollows:

Table8:P&LofExcelManufacturingLimited

Particulars 2017 2016 2015 2014Sales 13888 14002 12546 10643Costofgoodssold 8084 9368 7749 6967

GrossProfit 5804 4634 4797 3676Administrativeandmarketingexpenses 1543 1573 1307 1210

EBITDA 4261 3061 3490 2466

29

Particulars 2017 2016 2015 2014Depreciationandamortization 513 405 277 321

EBIT 3748 2656 3213 2145Interest(Net 724 523 504 346

PBT 3024 2133 2709 1799Tax 1008 712 907 598

PAT 2016 1421 1802 1201Theexpression‘profit’isarupeetermwhereasprofitabilityisarelativeterm,thatis,profitearnedinrelation to the sales or operating income. Profitability ratios are always expressed in percentageterms.Accordingly,wecandefinevariousratiosmeasuringprofitabilityofanenterprise.GrossProfitRatioGrossprofitratio,alsocalledgrossmargin,istheratioofgrossprofitmadebytheenterpriseduringanaccountingperiodtothesales.Itisanindicatoroftheinherentprofitabilityoftheenterpriseandpricing power that the enterprise enjoys in the market before considering other expenses andincome.Theratiomaybecalculatedas:

𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑜𝑓𝐺𝑜𝑜𝑑𝑠𝑠𝑜𝑙𝑑𝑆𝑎𝑙𝑒𝑠

Adecrease ingrossprofitmargin indicatesthatthecostofproducinggoodsfortheenterprisehasincreasedbutitisnotinapositiontopassontheincreasedcosttothecustomerduetocompetitivepressure.Orasastrategy,theenterprisehasdecidedtoabsorbtheincreasedcostresultinginlowermargin. Itmay also indicate that the firm has cut down themargin to capture increasedmarketshare.Trendofgrossmarginratiooveraperiodoftimeaswellasacomparisonwithothersimilarfirmsmaythrowmorelightonthesame.OperatingProfitRatioThe operating profit ratio or operatingmargin is the ratio of operating profit to sales. OperatingprofitiscommonlydefinedeitherasEBITDAorEBIT.CashoperatingmarginistheratioofEBITDAtosales. It captures theprofitability of theenterprisebefore chargingdepreciation andamortizationandnon-operatingexpensesofinterestandtax,whereasoperatingmargin,thatis,theratioofEBITtosales,indicatetheperformanceoftheenterpriseattheoperatinglevel.Theoperationalefficiencyofanenterprisecanbemeasuredatvariouslevels.Cashoperatingmargin:

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑏𝑒𝑓𝑜𝑟𝑒𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑇𝑎𝑥, 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑎𝑛𝑑𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛𝑆𝑎𝑙𝑒𝑠

Operatingmargin:𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑏𝑒𝑓𝑜𝑟𝑒𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑇𝑎𝑥

𝑆𝑎𝑙𝑒𝑠

NetProfitRatioorNetMarginThenetmarginisthefinalmeasureofprofitability.Itisthemarginleftfortheshareholdersafteralltheexpenses—operatingandnon-operating,depreciationandtaxhasbeenprovidedfor.

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑇𝑎𝑥𝑆𝑎𝑙𝑒𝑠

30

Table9:ProfitabilityRatioofExcelManufacturingLimited

Particulars % 2017 2016 2015 2014

Grossmargin 41.8 33.1 38.2 34.5Cashoperatingmargin 30.7 21.9 27.8 23.2Operatingmargin 27.0 19.0 25.6 20.2Pre-taxmargin 21.8 15.2 21.6 16.9Netmargin 14.5 10.1 14.4 11.3Thegrossmarginof41.8%fortheyear2017indicatesthatthecostofgoodssoldforExcelIndustriesis58.2%ofsales.Thedifferencebetweengrossmargin(41.8%)andcashoperatingmargin(30.7%)isduetootheroperatingexpenses.Thedepreciationeffectiscapturedbythedifferencebetweencashoperatingmarginandoperatingmargin(27.0%).Forcapital-intensiveindustrieslikemanufacturing,thegapbetweencashoperatingmarginandoperatingmarginislikelytobehighercomparedtosaytrading and service organization. The difference between operating margin and pre-tax margin(21.8%) is due to the presence of interest and finance charges. For a zero debt company, theoperatingmarginandpre-taxmarginwillbealmostthesameduetoabsenceofinterestcharges.Foran enterprise relyingheavily onborrowed funds, the gapwill be larger. The gapbetweenpre-taxmargin and net margin is due to presence of tax. Enterprises enjoying tax-free income (export-orientedunitsor in special economic zones)will suffer relatively lower incidenceof tax. ForExcelIndustries Limited, the grossmargin has improved substantially, whereas the netmargin has notgoneup inthesameproportion. It indicatesthatthe indirectexpenses(administrative,marketing,depreciation,interestandtax)haveincreasedatafasterpacethanthegrossprofit.

A high gross margin with a low net margin is indicative of higher operating expenses, interest,depreciationortax.Thissteppedapproachtoanalysishelpsustoidentifythemajorcontributorstotheprofitabilityoftheenterprise.

OperatingExpensesRatio

Theprofitabilityanalysis,asdiscussedearlier,canbefurthersupplementedbyworkingouttheratioofvariousoperatingexpensestosales.Theoperatingexpenseratiomaybecalculatedasfollows:

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠𝑆𝑎𝑙𝑒𝑠

Table10:OperatingExpenseofExcelManufacturingLimited:

Particulars % 2017 2016 2015 2014

Materialconsumed 46.3 55.3 49.6 51.8Othermanufacturingexpenses 11.9 11.6 12.2 13.7Administrativeexpenses 4.5 4.9 4.7 5.1Marketingexpenses 6.6 6.4 5.8 6.3Depreciationandamortization 3.7 2.9 2.2 3.0Interest 8.3 5.4 4.9 4.1Taxexpenses 7.3 6.1 7.9 5.6

31

Expense ratio helps us to identify the reasons for improvement or decline in profitability. Forexample,thenetmarginofExcelIndustriesLimitedfellsharplyduringtheyear20016.Theexpenseratioindicatesthatitwaslargelyduetosubstantialincreaseinthecostofmaterialconsumed(from49.6%inthepreviousyearto55.3%during2016).During2017,thereissubstantialdeclineincostofmaterialconsumed(from55.3%to46.3%)butithasbeenpartiallyoffsetbyincreaseininterestcost(from5.4%to8.3%).Therehasbeenagradualdecline inthe ‘othermanufacturingexpenses’overtheyears. Interestandtaxexpensesthoughhave increasedoveraperiodof time,andasaresult,thegapbetweenoperatingmarginandnetmarginhasgonewider.

EarningsperShare(EPS)

EPS is the most widely tracked indicator of profitability from shareholders point of view. Itrepresentstheprofitmadebytheenterpriseduringanaccountingperiodforeachshare.TheEPSiscalculatedasfollows:

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑇𝑎𝑥𝑁𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑆ℎ𝑎𝑟𝑒𝑠

Ifthecompanyhaspreferencesharesinitscapitalstructure,theEPSmaybecalculatedasfollows:

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑇𝑎𝑥 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑜𝑛𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑠ℎ𝑎𝑟𝑒𝑠𝑁𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝐸𝑞𝑢𝑖𝑡𝑦𝑆ℎ𝑎𝑟𝑒𝑠

In the denominator, we usually take the number of equity shares outstanding at the end of theaccounting period. If, however, the number of shares outstanding have changed during theaccountingperiod,aweightedaverageofnumberofsharesoutstandingismoreappropriate.

If there is no change in thedenominatorover aperiodof time, EPSwillmirror change in thenetprofit. Ifthenumberofshareshaschanged,thecombinedeffectofchangeinprofitandchangeinnumberofshareswillbereflectedintheEPS.

Table11:EPSofExcelManufacturingLimitedParticulars 2017 2016 2015 2014

Profitaftertax(₹million) 2016 1421 1802 1201Numberofequityshares(Weightedaverage) 100 75 75 75EarningsPershare(₹) 20.2 18.9 24.0 16.0TheEPSofthecompanyhasincreasefrom 16.0to 20.2inthelastfouryears.Duringtheyear2017,theincreaseinEPSis lessthanproportionateto increaseinPAT.Asthecompanyhas issuedfresh capital during the year, the number of equity shares has increased. The weighted averagenumberofsharesoutstandinghasbeencomputedassumingthatthefreshshareswereissuedinthebeginningoftheyear.

2. GrowthRatios

Oneofthebasicpurposesoffinancialanalysis istobeabletopredictthefutureperformance.Forthat, understanding the growth achieved by the enterprise on the key variables is helpful. Thegrowthrateachievedinthepastcanthenbeusedtoextrapolatethefuture.

32

CompoundAnnualGrowthRate(CAGR)

One popular measure of growth is the CAGR achieved over a period of time in respect of keyfinancialindicators.TheCAGRindicatestheaverageannualgrowthrateachievedbytheenterpriseoveradefinedperiodoftime(usually4–5years).TheCAGRiscalculatedbyusingthecompoundingFormula12.8:

A=P*(1+g)n

WhereAisthecurrentyearvalueofthevariableforwhichthegrowthrateistobemeasured,Pisthevalueinthebaseyearandnisthenumberofyearsbetweenthecurrentyearandthebaseyear.Solvingtheaboveequationfor‘g’,theCAGRofthevariableinquestioncanbeascertained.

ExcelIndustriesLimitedachievedasaleof 10,643millionduringtheyear2014whichgrewto13,888 million during the year 2017. The CAGR of sales can be calculated by solvingthe aboveequationasfollows:

13,888million= 10,643million×(1+g)3

Solvingforg,theCAGRofsalescomesto9.3%.Similarly,theCAGRofnetprofitcomesto18.9%.Asthe profits have grown at a rate higher than the sales, it is an indication that the expenses havegrown less thanproportionately. Itcouldbeduetoeconomiesofscaleoroperationalefficiencies.On theother hand, if the growth rate of profit is less than the sales growth, it indicates that theexpenseshavegrownfasterthanthesales.

Awordofcaution,asCAGRjustconsidersthebaseyearandcurrentyear, thechoiceofbaseyearmay have significant impact on the computed value of CAGR. The base year chosen must be anormalyearofoperationsandprofitability.

3. Year-on-Year(Y-o-Y)Growth

The CAGR gives the long-term average rate of growth of the key financial variable. It must besupplementedbyshort-termtrendofgrowthtogetabetterpictureofthegrowthprospects.TheY-o-Ygrowthiscomputedbycomparingthecurrentvalueofvariableswiththeimmediatelyprecedingperiod.ThefollowingequationcanbeusedforcomputingY-o-Ygrowthofsales:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑦𝑒𝑎𝑟𝑠𝑎𝑙𝑒𝑠 − 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠𝑦𝑒𝑎𝑟𝑠𝑎𝑙𝑒𝑠𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠𝑦𝑒𝑎𝑟𝑠𝑎𝑙𝑒𝑠

Similarly, the Y-o-Y growth of other key variables like operating profits, net profit, etc. can becomputed.Y-o-Ygrowthismorehelpfulinfindingthecurrenttrendinthegrowthrate.

33

Table12:Y-o-YGrowthRatio

Particulars (₹million) 2017 2016 2015 2014

Sales 13888 14002 12546 10643PAT 2016 1421 1802 1201YoYgrowth(sales) -1% 12% 18% YoYgrowth(PAT) 42% -21% 50%

Thedeclininggrowthrateofsalesisacauseofconcern.Theprofitgrowthisalsovolatilewithwidefluctuations. Themanagement needs to analyse the same and take steps to arrest the decliningtrend in sales growth.Also, the reasons for volatile profit growthneed tobe identified for takingappropriatecorrectiveactions.

4. DividendPolicyRatiosDividend ratios help in understanding company’s policy relating to rewarding theshareholdersbywayofcashdividendsandalsoofretentionofprofit.

Apartoftheprofitearnedduringtheyearisdistributedtoshareholdersascashdividend,whereasthe balance is retained within business for funding the future needs for funds for expansion.Dividendonequitysharesisadiscretionarypayment,thatis,theboardofdirectorsrecommendsthedividendtobepaidandthesameisapprovedbytheshareholdersintheannualgeneralmeeting.Bylooking at the information in the financial statements, dividend policy of the enterprise can beinferred.

DividendRate

The rate atwhich the dividend is paid to the equity shareholders is called the dividend rate. It isalwaysappliedtothepaidupcapitalofthecompany.Thedividendpershare(DPS)canbecalculatedasfollows:

𝑇𝑜𝑡𝑎𝑙𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠𝑁𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑒𝑞𝑢𝑖𝑡𝑦𝑠ℎ𝑎𝑟𝑒𝑠

AlternativelyDPScanbecalculatedas:DPS=Facevaluepershare×Dividendrate

Thedividendratecanalsobeascertainedasfollows:

𝑇𝑜𝑡𝑎𝑙𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠𝑃𝑎𝑖𝑑𝑢𝑝𝑐𝑎𝑝𝑖𝑡𝑎𝑙

DividendPay-outRatio

Thedividendpay-outratioindicatestheproportionoftheprofitaftertaxthathasbeenusedtopaycash dividends to the shareholders. As dividends in India attract a distribution tax, the total pay-outon account of dividends will also include the corporate tax on dividends. The ratio can beexpressedasfollows:

34

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑡𝑎𝑥𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑡𝑎𝑥

Ifthereisnotaxondividenddistribution,thisratiomayalsobecomputedasfollows:

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑝𝑒𝑟𝑆ℎ𝑎𝑟𝑒(𝐷𝑃𝑆)𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑝𝑒𝑟𝑆ℎ𝑎𝑟𝑒 𝐸𝑃𝑆

A supplementary ratio to the pay-out ratio isRetention Ratio.The retention ratio indicates theproportionofthenetprofitretainedandploughedbackinthebusiness.Itcansimplybecalculatedasfollows:

Retentionratio=1−Dividendpay-outratioThe growing companies with aggressive expansion plans usually have a lower pay-out ratio andconversely a high retention ratio. Themanagement of such enterprises will be keen to conserveresourcesratherthandistributingasdividends.Ontheotherhand,cash-richcompanieswithoutanyimmediate need of cash for investments will adopt a more liberal dividend pay-out and lowerretention.Likewise,companieswithhighborrowedfundswillkeepthepay-outratiolowandusethecashsoconservedtorepaytheborrowings.

Table13:DividendPolicyratios


Profitaftertax 2016 1421 1802 1201Dividends 150 75 75 75Dividenddistributiontax 23 11 11 11DividendPershare(₹) 1.5 1 1 1Dividendrate 15% 10% 10% 10%DividendPay-outratio 9% 6% 5% 7%Retentionratio 91% 94% 95% 93%Thecompanyisfollowingaconservativedividendpolicywithapay-outratiooflessthan10%andaretention ratioofover90%.As thecompany isgrowingby investing in fixedassetsand long-terminvestments,suchadividendpolicyisjustified.

DividendYield

The return for an investor in equity shares ismade up of two components—dividend and capitalappreciation.Thereturnbywayofdividendsismeasuredbydividendyield.Dividendyieldmeasuresthereturntotheinvestoronhisinvestmentbywayofdividend.Theratioiscalculatedas:

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑝𝑒𝑟𝑆ℎ𝑎𝑟𝑒(𝐷𝑃𝑆)𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑀𝑎𝑟𝑘𝑒𝑡𝑝𝑟𝑖𝑐𝑒

In the denominator, we take the currentmarket price rather than the price actually paid by theinvestor. The current market price is the opportunity cost of investing in the shares of theenterprise—themoneythatcouldbeinvestedelsewhere.

35

AtthecurrentmarketpricepershareofExcelIndustriesLimitedat 240,thedividendyieldworksout to be 0.54%. It clearly indicates that primarily the investors in shares of the company areexpectingmostofthereturnbywayofcapitalappreciation.

5. Short-termLiquidityRatios

Shorttermliquidityratiosindicatemeasureadequacyofcompany’scurrentassetstomeetitscurrentobligations.

The suppliers of short-term credit to an enterprise are interested in assessing the ability of theenterprisetorepaytheirdues.Thecentralquestionthattheyseektofindanansweris,whethertheenterprise has sufficient liquidity to pay them off. Obviously, the enterprise will pay its currentobligationsoutof its liquidassets.Thecurrent ratioandquickratiosdescribedbelow,areusedtoassesstheshort-termsolvencyoftheenterprise.

CurrentRatio

Thecurrentratiomeasurestheadequacyofshort-termassetstomeettheshort-termobligationofthe enterprise. By definition, the current assets are expected to be converted into cash shortly—withinaperiodof12months.Likewise,currentliabilitiesareexpectedtobepaidwithinashorttime.Thecurrentratioistheratioofcurrentassetstocurrentliabilitiesandiscomputedas:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑎𝑠𝑠𝑒𝑡𝑠𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Current assets includes cash in hand, balance with banks, inventories, sundry debtors and othercurrent assets. Short-term investments often called marketable securities are also classified ascurrent assets. Current liabilities include all short-term obligations, for example, sundry creditors,outstandingexpenses,provisionsandshort-termloans.Theinstalmentsforrepaymentoflong-termloansfallingduewithinnext12months,shouldalsobeincludedinthecurrentliabilities.

A high current ratio, though, may be desirable from liquidity point of view but also indicatesinefficientuseofresources.So,abalanceneedstobeachieved—thecurrentratioshouldneitherbetoo high nor too low. The implementation of modern inventory management techniques, forexample,just-in-timeinventorymanagementsystemandsupplychainmanagementhaveresultedindeclineincurrentratio.

QuickRatio

Quick ratio is often used as a supplementarymeasure of short-term liquidity. Out of the currentassets, inventories are not considered to be liquid enough. Somewhat more strict measure ofliquiditycalledquickratiooracidtestratioisoftenused.Forthepurposeofquickratio,weexcludeinventories from the current assets to arrive at liquid assets and compare the samewith currentliabilities.Thequickratiocanbecalculatedasfollows:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Forenterprisesintheservicesector,thecurrentratioandquickratiowillalmostbeidenticalduetonegligible inventory, whereas enterprises engaged in construction, manufacturing or tradingactivities,theseratioswillsignificantlydifferdependinguponthelevelofinventoriestheycarry.

36

Table14:LiquidityRatiosofExcelManufacturingLimited


Currentassets 8741 7640 6406 3999Currentliabilities 5341 5074 3957 3337Inventories 1299 1522 1487 1021Currentratio(Times) 1.64 1.51 1.62 1.20Liquidratio(Times) 1.39 1.21 1.24 0.89

Both thecurrent ratioandquick ratio forExcel IndustriesLimitedhave improvedoveraperiodoftime.Intheyear2017,thecurrentratioisat1.64timesandthequickratioisat1.39timesindicatingthatthecompanyhassufficientliquiditytomeetitsshort-termobligations.

6. CapitalStructureRatios

Capitalstructurereferstotheproportionofborrowedfundsandshareholders’ funds inthetotalcapitalemployed.

An enterprisemay finance its operations either by using owners’ capital (shareholders’ funds) orborrowed funds. The composition of funds raised, is referred to as the capital structure. Onshareholders’ funds, there is neither any obligation to pay any fixed return nor to repay theprincipal.Ontheotherhand,theprovidersofloanfundsareentitledtogetafixedreturnandalsorepayment of capital upon maturity. The capital structure, therefore, has significant implicationupon the ability of the firm to meet its long-term obligations. The focus of analysis is on theproportions of long-term funds—debt and equity and adequacy of enterprise’s profit tomeet itsobligationsassociatedwithdebtfunds.

Debt-EquityRatio

It is the ratio of long-term borrowings to shareholders’ funds. An enterprise relying more onborrowedfunds ismorepronetodefaults indebtservicingcomparedtoanenterprisewithhighershareholders’funds.Thedebt-equityratioiscalculatedasfollows:

𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚𝑑𝑒𝑏𝑡𝑠𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠v𝑓𝑢𝑛𝑑

Whilearrivingatshareholders’fundsanyfictitiousassets,forexample,miscellaneousexpendituretothe extent not written-off or adjusted and profit and loss account (Debit Balance) should bededucted. From long-term debts, if the information is available, the loan repayment falling duewithinnextoneyearshouldbededucted.Ahighdebtequityratiosignifiesahigherobligationtopayinterest and repay the principal. The firms operating in volatile environment often rely less onborrowedfunds,whereasfirmsconfidentofstableoperatingresultscanaffordtotakemoredebts.Thereisnoidealdebt-equityratiothougharatioinexcessof2:1isusuallyconsideredaggressive.Ontheotherhand,afirmoperatingwithnodebtorlowdebtisnottakingbenefitsoffinancialleveragewhich has a positive effect on the return on equity. This aspect has been considered later in thechapter.

37

Table15:DebtEquityRatioofExcelManufacturingLimited


Longtermdebts 5987 4312 2980 2014Shareholders’funds 11924 8831 7496 5780Debtequityratio(Times) 0.50 0.49 0.40 0.35Fromtheabove, it isclearthattheExcel IndustriesLimited is takingadvantageofborrowedfundsbutatthesametime, isnotverycomfortablewitha largedebt-equityratio.Thedebt-equityratioforthefirmhasgraduallyincreasedto0.50timessignifyingthatforfinancingitsexpansionplansthefirmhasreliedmoreonborrowedfundsintherecentpast.

FixedAssetstoLong-termDebts

Thisisratiowhichisoftencalculatedforthesafetyofthelong-termlenders.Asthetermloansareoftensecuredagainstsecurityoffixedassets,itisanindicationofthecushionavailabletothedebtproviders. Higher the ratio, more secured the lenders will feel. As the ratio approaches one (orbelow)thedegreeofsafetyforlendersgoesdown.Theratiocanbecalculatedasfollows:

𝐹𝑖𝑥𝑒𝑑𝑎𝑠𝑠𝑒𝑡𝑠𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚𝑑𝑒𝑏𝑡𝑠

Table16:FixedAssetstoLong-termDebtsofExcelManufacturingLimited


Fixedassets 10761 8841 6881 6357Longtermdebts 5987 4312 2980 2014Fixedassetstolongtermdebtratio 1.78 2.05 2.31 3.16Theratioforthecompanyat1.78timesindicatesthatthefixedassetsare1.78timesthelong-termloans.Thoughtheratiohasdeclinedovertheyears,butstillthefixedassetsareadequatelycoveringthelong-termloans.Awordofcautionthough—theratioisbeingcalculatedusingthebookvalueofthefixedassets,whichmaybesignificantlyhigheror lowerthantherealizablevalueoftheassets.Likewise, certain assets included in fixed assets may be worthless on a stand-alone basis, forexample,goodwillandthereforemayhavetobeexcludedfromthefixedassets.Thelenderswilldobettertokeepthisaspect inmindwhile interpretingthisratio. If the liquidationvalueofthefixedassetsisusedinthenumerator,itwillgiveabetterideaastotheadequacyofsecurityavailabletothelendersoflong-termloans.

InterestCoverageRatio

Asdiscussedearlier,borrowedfundshaveafixedobligationattachedtothemintheformofpayinginterestatafixedrate.Thelenderwillbeconcernedabouttheborrower’sabilitytopayinterestontheborrowings.Oneofthemostcommonlyusedmeasuresforthesameisinterestcoverageratio.Itmeasures theadequacyofenterprise’sprofits to cover its interestobligations.As interest is a taxdeductibleexpenseand ispaidbeforepaymentof tax, EBIT isusedasanappropriatemeasureofprofit.Theratioiscalculatedasfollows:

38

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑏𝑒𝑓𝑜𝑟𝑒𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑎𝑛𝑑𝑡𝑎𝑥 𝐸𝐵𝐼𝑇𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

Highertheratio,betteristheabilityoftheenterprisetomeetitsinterestobligation.Iftheratiofallstowardsone, it is clearly an indication that theenterprise is not earning enoughat theoperatingleveltomeetitsinterestobligationsandmayneedtobringitslevelofdebtdown.

Table17:InterestCoverageRatioofExcelManufacturingLimited


Earningsbeforeinterestandtax 3748 2656 3213 2145Interest 724 523 504 346Interestcoverageratio(Times) 5.18 5.08 6.38 6.20

TheICRisalwaysexpressedas‘numberoftimes’.ExcelIndustriesLimited’sEBITcoverstheinterestexpenses5.18timeswhichisahealthysign. ItcanalsobeinterpretedasthatevenifEBITofExcelIndustriesLimitedfallstoone-fifth,itstillwillbeabletomeetitsinterestobligation.

AnalternatewaytocomputeICRistouseEBITDAasadenominator.Theargumentinfavourofthistreatmentisthatdepreciationandamortizationarenotcashexpensesandtotheextentthecashisavailabletomeettheinterestobligation.

DebtServiceCoverageRatio(DSCR)

DSCR—abilityoftheenterprisetomeetitsobligationrelatingtoborrowedfunds–bothinterestandprincipal.

Inadditiontopaymentofinterest,thereisanobligationtorepaytheprincipalonborrowedfundsaswell.Theinterestcoverageratiodescribedabovedoesnotconsiderthelatter.Toincorporateboththeobligationfordebtservicing—interestandprincipalrepayment—analternatemeasuremaybeneeded.Thedebtservicecoverageratio(DSCR)assessestheadequacyofcashflowgeneratedbytheenterprisetomeetitsdebtobligations.TheDSCRiscomputedasfollows:

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑏𝑒𝑓𝑜𝑟𝑒𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑎𝑛𝑑𝑡𝑎𝑥 𝐸𝐵𝐼𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑜𝑡ℎ𝑒𝑟𝑛𝑜𝑛𝑐𝑎𝑠ℎ𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + wxyz{z|}y~~��z}(��}y��y}�)

Inthenumerator,wehaveoperatingcashprofit,thatis,EBITDA.Inthedenominator,bothinterestaswell as repayment of loan has been considered. As loan repayment is not a tax deductible, itneedstobegrossedupbydividingby(1−Taxrate).Forexample,anenterprisehasanobligationtopay interestamounting to 100millionandprincipal repaymentof 140million.Theapplicabletaxratefortheenterpriseis30%.Torepayprincipalof 140million,theenterpriseneedtoearn200millionasEBITDA,that is, 140million/(1−0.3).Accordingly,thedenominatorforDSCRwillbe 300million.

Astheinformationforprincipalrepaymentisnotdirectlyavailableinthefinancialstatements, it isoftendifficult to computeDSCR.But an insideror someonehaving access to this information, for

39

example, bank or other lenders can use this ratio to assess the debt servicing capacity of theenterprise.

Example:

Table18:DebtServiceCoverageRatio

Particulars INR(Inmillion)

NetIncome 490million

InterestExpense 50million

Non-cashExpenses 40million

Taxrate 30%

PrincipalRepayments 20million

LeaseRepayments 5million

Tax=490millionx30%=147million

NetOperatingIncome=NetIncome+Interest+Non-cashExpense+Tax

NetOperatingIncome=490million+50million+40million+147million=727million

TotalDebtService=Interest+Principal+LeasePayments

TotalDebtService=50+20+5=75million

DSCR=NetOperatingIncome/TotalDebtService=727million/75million=9.69

7. AssetsUtilizationRatios

Assetsutilizationratiosrelatethesalesorincomegeneratedinagivenperiodtothefundsdeployedinvarioustypesofassets.

Bycarefulanalysisofthefinancialstatements,itispossibletocommentupontheefficiencyinassetsutilization. Ifanenterprise isable togeneratehigher revenuewith thesameamountofassets,orsamerevenuewithloweramountofassets,itisanindicationofefficiencyinassetsutilization.Thisset of ratios relates the output (usually sales)with the assets base. These ratios are called assetsutilization ratios or efficiency ratios or simply turnover ratios and are expressed as ‘number oftimes’.Theanalysisgenerallystartswiththetotalassets turnoverandgraduallybreaks itdowntovariouscomponentsofthetotalassets.

In these ratios, the sales figure is for theperiod,whereas the assetbase is onaparticularday. Iftherehasbeenasubstantialchangeintheassetsbase,itispossibletotakeaverageassets{(OpeningBalance of Assets + Closing Balance of Assets)/2} in the denominator. If, however, only year-endstatementsareavailable,itispossibletoworkwiththosenumbersaswell.

40

TotalAssetsTurnoverRatio

Thisratiorelatesthesalesachievedbyanenterpriseduringaperiodtothetotalassetsdeployed.Ahigherratio indicatesthattheenterprise isabletogeneratemoresalesrelativetothetotalassetsdeployedinthebusiness.Theratiomaybecalculatedasfollow:

𝑆𝑎𝑙𝑒𝑠𝑇𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡𝑠

As the total assets of an enterprise may also include investments and loans and advances givenwhicharenotdirectlydeployedinthebusiness,theyshouldbeexcludedwhilecomputingthisratio.Varioussub-ratiosthatwillbeusefulareshownintheFigurebelow.

ConstituentsofTotalAssetsTurnoverRatio:

Figure7:ComponentsofTotalAssetsTurnoverratio

FixedAssetsTurnoverRatio

This is the ratio of sales achieved during an accounting period to fixed assets deployed. A higherratio indicates better utilization of the long-termassets,whereas a lower ratio is an indication ofinefficiencies in theutilizationof fixedassets.Thefixedassets turnoverratiomaybecalculatedasfollows:

𝑆𝑎𝑙𝑒𝑠𝐹𝑖𝑥𝑒𝑑𝑎𝑠𝑠𝑒𝑡𝑠

Thefixedassetsturnoverratiocanbeimprovedbyanenterpriseinavarietyofways.Forexample,amanufacturing entity operating on a double shift basis or reducing the down time for scheduledmaintenanceofplant,improvementisroomoccupancyinahotelorbedutilizationinahospitalaresomeofthemeasuresthatwillresultinimprovedfixedassets’utilization.Outsourcingsomeofthenon-coreactivitiestothirdpartyvendorsmayalso improvethisratio.Awordofcaution—ahigherratio than the industry norms may also indicates that the enterprise in not investing enough in

41

capacity expansion and modernization. As there is a time lag between the investment and theresultant sales, underinvestment in the current period will adversely affect the growth of theenterpriseinfuture.

Alowerordecliningratiomaybeanindicationofwastagesintheutilizationoffixedassets.Itmaybe due to excess capacity or underutilization of certain facilities due to slack demand. The sameneeds to be investigated to take corrective steps to either improve utilization or dispose-off theassetsnotneeded.Arecentlargescalecapacityexpansionorlargeamountsincurredtowardscapitalwork-in-progressarealsopossiblereasonsforadeclineinfixedassetsturnoverratio.

CurrentAssetsTurnoverRatio

Inadditiontothefixedassets, largeamountsareblocked incurrentassetsparticularly inventoriesanddebtors.Anenterprisemaybehighlyefficientinutilizingitsfixedassetsbutduetopoorworkingcapitalmanagement, itmaybeexperiencingundueblockageoffunds.Thecurrentassetsturnoverratioaimatassessingthemanagementofshort-termassetsbytheenterprise.Theratioiscalculatedasfollows:

𝑆𝑎𝑙𝑒𝑠𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑎𝑠𝑠𝑒𝑡𝑠

Adeclineintheratiowillindicateproportionatelylargeamountsblockedininventoriesordebtorsorlargecashandcashequivalentsbeingkept.On theotherhand,an improvement in the ratio isanindicationofmoreefficientworkingcapitalmanagement.

Asapartofthecurrentassetsisoftenfinancedbycurrentliabilities,thenetcurrentassetsmaybecomparedwithsales.Theexcessofcurrentassetsovercurrentliabilitiesisoftenreferredtoasnetcurrentassets,orsimply,theworkingcapital.Theworkingcapitalturnoverratiomaybecalculatedasfollows:

𝑆𝑎𝑙𝑒𝑠𝑁𝑒𝑡𝑐𝑢𝑟𝑟𝑒𝑛𝑡𝑎𝑠𝑠𝑒𝑡𝑠

Table19:TurnoverRatiosofExcelManufacturingLimited


Sales 13888 14002 12546 10643Totalassets 24020 18771 14856 11434Fixedassets 10671 8841 6881 6357Currentassets 8741 7640 6406 3999Totalassetsturnoverratio(Times) 0.58 0.75 0.84 0.93Fixedassetsturnoverratio(Times) 1.30 1.58 1.82 1.67Currentassetsturnoverratio(Times) 1.59 1.83 1.96 2.66

ItcanbeobservedthatthetotalassetturnoverratioforExcelIndustriesLimitedhasdeclinedfromahigh of 0.93 times to 0.58 times in the year 2017. It is an indication that the asset base of thecompany has grown more than proportionately compared to its sales. A break-up of the ratiobetween fixed assets and current assets indicates that both fixed assets turnover ratio aswell as

42

current assets turnover ratio has declined though the decline in the latter has been sharper. Thecurrentassetsturnoverratiocanbefurtherinvestigatedbycomputinginventoryturnoverratioanddebtorturnoverratio.

InventoryTurnoverRatioandAverageHoldingPeriod

Inventoryturnoverindicatesabilityoftheenterprisetorotateitsinventoriesfaster.

In certain businesses, inventory constitutes a major portion of the assets. Inventories, for thispurpose, include rawmaterial, consumable stores,work-in-progress and finished goods.Ability torotate the inventory faster helps the enterprise in keeping blockage of funds low. How well theinventory is beingmanaged canbeascertainedbyusing the inventory turnover ratio. The ratio iscalculatedasfollows:

𝐶𝑜𝑠𝑡𝑜𝑓𝑔𝑜𝑜𝑑𝑠𝑠𝑜𝑙𝑑𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

Inthenumerator,insteadofusingsales,itispreferabletousecostofgoodssoldtoensurethatboththenumerator anddenominator are at cost. The above ratio indicates the efficiencyof inventorymanagementonanoverallbasis.Similar ratiocanbecomputedforeachcomponentof inventory.Higher the ratio, more efficient the inventory management is considered to be. Higher turnoverensureslowerblockageoffundsaswellasreducedprobabilityofobsolescence.However,ahigherturnovermayalsoindicatethattheenterpriseisnotmaintainingsufficientstockofrawmaterial,orfinishedgoodsleadingtopossibleproductionstoppageorlossofpotentialsale.

The inventory turnover ratio is presented as the ‘number of times’, that is, how many timesinventorygot rotatedduring theyear. This ratio canbe converted into ‘numberofdays’ toarriveatAverageHoldingPeriodasfollows:

365𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟𝑟𝑎𝑡𝑖𝑜

Higherthe inventoryturnoverratio, lowerwillbetheaverageholdingperiod.Theaverageholdingperiodmayalsobecalculatedas:

365 ∗ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝐶𝑜𝑠𝑡𝑜𝑓𝑔𝑜𝑜𝑑𝑠𝑠𝑜𝑙𝑑

Table20:TheinventoryturnoverratioandaverageholdingperiodforExcelManufacturingLimited.


Costofgoodssold 8084 9368 7749 6967Inventory 1299 1522 1487 1021Inventoryturnoverratio(Times) 6.22 6.16 5.21 6.82AverageholdingPeriod(Days) 59 59 70 53

During2017,theinventoryturnoverratiois6.22timesandconsequentlytheaverageholdingperiodis at 59 days. Business units are using inventory management techniques like just-in-time (JIT)inventory and supply chain management to improve their inventory turnover and consequentreductioninaverageholdingperiod.

43

TradeReceivableTurnoverRatioandDays’SalesOutstanding

Receivableturnoverindicatesefficiencyoftheenterpriseincollectingitsreceivables.

Intoday’scompetitiveenvironment,mostoftheenterprisesareforcedtosellgoodsoncreditbasis.Theyallowacertainnumberofdayscalledthe‘creditperiod’totheircustomerstopaytheamountsdue.Sundrydebtorsortradereceivablerepresenttheamountduefromthecustomersinrespectofsales made. How efficiently the enterprise is able to collect its receivables can be measured byreceivable turnover ratio. The ratio relates to the salesmade during a particular periodwith thetradereceivablesoutstandingattheendoftheperiod.Asthesereceivablesariseoutofcreditsales,itispreferabletousethecreditsalesfigureforthecomputationofthisratio.If,however,thebreak-upofthesalesisnotavailable,totalsalesfigurecanbeused.Theratioiscalculatedasfollows:

𝑆𝑎𝑙𝑒𝑠𝑇𝑟𝑎𝑑𝑒𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

Thenumeratorshouldbenetofsalesreturnsandtradediscountbutinclusiveofexcisedutyandanyother amount recoverable from the customer as a part of the invoice value. Obviously, highertheturnover,fasteristhecollectionofreceivables.Theratioisexpressedas‘numberoftimes’andcan be converted into an alternate measure called days’ sales outstanding (DSO) or averagecollectionperiod’.TheDSOiscalculatedasfollows:

365𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟𝑟𝑎𝑡𝑖𝑜

TheDSOisexpressedinnumberofdays.Itexpressesthenumberofdays’salesthatisoutstandingtobecollectedattheendoftheaccountingperiod.TheDSOsocomputed,canbecomparedoveraperiodoftimetoanalyzethetrendandalsowiththeDSOofothercompetingenterprises.Itcanalsobecomparedwiththecreditperiodactuallygrantedtothecustomers.Forexample,ifthecomputedDSOissay69days,whereasthefirmonlyallows45daystoitscustomerstopay,itisanindicationofslacknessincollection.Anysuchdelayhasopportunitycostoffundsblockedandmayalsoindicatesomedisputewiththecustomerresultingindelayedpayments.

Table21:TheReceivableTurnoverRatioandDays’SalesOutstandingforExcelManufacturingLimited


Sales 13888 14002 12546 10643Tradereceivables 5004 4786 3449 1785Receivablesturnoverratio(Times) 2.78 2.93 3.64 5.96Dayssalesoutstanding(Days) 132 125 100 61

TheturnoverratiohasdeclinedsubstantiallyinthelastfouryearsresultingintheDSOgoingupfrom61daysto132days.Itmaybeduetodeliberatepolicyofthemanagementtogiveextendedcreditperiodtomeetcompetitionandtoacquirenewcustomers.Ontheotherhand, itmayalsoreflectpoorcollectioneffortsonthepartofthecompany.

AveragePaymentPeriod

44

As the enterprise sells goods on credit, the sameway it alsomay be enjoying credit termson itspurchases.Tothatextent,theblockageofitsownfundsbytheenterprisegoesdown.Byrelatingthepurchases made by the enterprise during a given accounting period with the trade payables forpurchases, it is possible to ascertain the average credit period enjoyed by the enterprise. Theaveragepaymentperiodcanbecalculatedasfollows:

365 ∗ 𝑇𝑟𝑎𝑑𝑒𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

Ahigher ratiomay indicate favourablecredit termsenjoyedby theenterprise,and to thatextent,lowerblockageofitsownfundsinthecurrentassets.Onthenegativeside,ahigherandincreasingratioalsomaymeanthat the firm isdelayingpayments to itssuppliers. Itmaynotbeavailing thecash discount being offered by its suppliers for prompt payment. Itwill eventually lead to higherpricebeingdemandedbythesuppliersordeclineofcredittermstotheenterprise.

Table22:TheaveragepaymentperiodofExcelManufacturingLimited


Materialconsumed 6434 7745 6218 5512TradePayables 1587 1615 1447 1225AveragePaymentPeriod(Days) 90 76 85 81Itcanbeobservedthatthecompany isconsistent inmakingpaymentsto itssuppliers. Intheyear2017,thepaymentperiodhasgoneupwhichneedstobeanalysedfurtherastothereasonsthereof.

LengthofCashCycle

By comparing the average holding period of inventories, average collection period for receivablesand average payment period for payables, the length of cash cycle for the enterprise may beascertained.Thelengthofcashcycleindicatestheaveragetimetakenbytheenterprisetoconvertthecashtocashagain.Thecashcyclemaybecalculatedbyusingthefollowingequation:

AverageHoldingPeriod+AverageCollectionPeriod−AveragePaymentPeriod

Table23:LengthofCashCycleofExcelManufacturingLimited

Particulars (Numberofdays) 2017 2016 2015 2014

AverageholdingPeriod 59 59 70 53AveragecollectionPeriod 132 125 100 61AveragePaymentPeriod 90 76 85 81Cashcycle 100 108 85 34Thecashcycleforthecompanyhasgoneupfrom34daysto100daysinthelastfouryearslargelyduetoanincrease intheaveragecollectionperiod. Itsignifiesthatthecompanyistakinga longerperiod for cash conversion, and therefore, higher blockage of funds. This will necessitatearrangementofadditionalfinancing,eitherbyusinglong-termorshort-termsourcesoffunds.

45

8. ReturnRatios

Returnratiosexpressprofitearnedasapercentagetofundsdeployedtoearnthatprofit.

In addition to comparing the profit earned during an accounting periodwith the revenue earned(profitabilityratios),ananalystmayalsoliketocomparetheprofitwiththefundsdeployedtoearnthatprofit.Morespecifically,computationofprofitsearnedasapercentageoffundsdeployed,isausefulwaytounderstandefficiency infundsutilization. It ispossibletodefinefundsdeployedinavarietyofways.Itmaymeanthetotalassetsusedorthelong-termcapitalemployedinthebusiness.Alternatively,it is possible to look at the return from shareholders’ funds point of view. As theseratioscompareprofitfortheyear(aprofitandlossaccountnumber)withfundsdeployed(abalancesheetnumber),itispossibletotakeaverageforthelatter{(OpeningBalance+ClosingBalance)/2}.If, however, only year-end statements are available, it is possible toworkwith those numbers aswell.

ReturnonAssets(ROA)

ROAistheratioofprofitstotheassetsdeployedinthebusiness.Asinthedenominatorweareusingthetotalassets,thecorrespondingfigureofprofittakenis,therefore,beforeinterest.Thefollowingformulamaybeusedforcomputingtheratio:

𝐸𝐵𝐼𝑇 1 − 𝑡𝑎𝑥𝑟𝑎𝑡𝑒𝑇𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡𝑠

The numerator may be referred to as net operating profit after tax (NOPAT) and can also becalculatedasfollows:

Profitaftertax+Interest(1−Taxrate)

NOPAT istheaftertaxprofitattributabletotheassetsdeployed inthebusiness.Theratiomaybecomparedoveraperiodoftime,withcompetitorsandwithindustryaggregates,tounderstandtherelativeefficiency inuseofassets forgeneratingreturns.Assumingataxrateof33%,theROAforExcelIndustriesisdepictedasfollows:

Table24:ReturnonAssetofExcelManufacturingLimited


Earningsbeforeinterestandtax 3748 2656 3213 2145EBIT(1-taxrate) 2511 1780 2153 1437Totalassets 24020 18771 14856 11434ROA(%) 10.45% 9.48% 14.49% 12.57%

TheratioimprovesiftheincreaseinNOPATismorethatproportionatethantheincreaseinassetsdeployed.

46

ReturnonCapitalEmployed(ROCE)

ROCE is the ratio of profits to the capital employed or funds invested in the business. The fundsinvested here means the long-term sources—both debt and equity used in the business. Thefollowingformulamaybeusedforcomputingtheratio:

𝐸𝐵𝐼𝑇 1 − 𝑡𝑎𝑥𝑟𝑎𝑡𝑒𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Table25:TheROCEforExcelManufacturingLimitedParticulars (₹million)

2017 2016 2015 2014Earningsbeforeinterestandtax 3748 2656 3213 2145EBIT(1-taxrate) 2511 1780 2153 1437Capitalemployed 17911 13143 10476 7794ROCE(%) 14.02% 13.54% 20.55% 18.44%TheratioimprovesiftheincreaseinNOPATismorethatproportionatethantheincreaseincapitalemployed.AdecliningROCEisanindicationofinefficientuseofcapital.

ReturnonEquity(ROE)

ROE7isthemostimportantratiofromshareholders’perspective.Itindicatestheprofitsearnedasapercentageofshareholders’funds.Theratiomaybeexpressedasfollows:

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑡𝑎𝑥𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠v𝑓𝑢𝑛𝑑

Table26:TheROEforExcelManufacturingLimited


Profitaftertax 2016 1421 1802 1201Shareholdersfund 11924 8831 7496 5780ROE(%) 16.9% 16.1% 24.0% 20.8%

TheROEforthecompanydeclinedfrom20.8%to16.1%duringtheyear2016duetodeclineinPATand increase inshareholders’ funds.Duringtheyear2017,bothPATandshareholders’ fundshavegoneup, thoughthe increase inPAT ismorethanthe increase inshareholders’ funds.Asa result,ROEimprovedfrom16.1%to16.9%.ItmayalsobenotedthatPATfortheyear2017ishigherthanthatof2015butduetomuchsharper increase inequity, i.e. shareholders’ funds, theROEfor theyear2017ismuchlowerthanthatof2015.

7https://www.investopedia.com/terms/r/returnonequity.asp

47

DuPontAnalysis

Returnonequityisexpressedasamultipleofprofitability,assetsturnoverandleverage.

DuPontAnalysisisausefultechniquetobreakdowntheROEintoitsconstituentelements.IthelpstounderstandthereasonsforanincreaseordecreaseinROEbyidentifyingtheunderlyingvariables.TheROEasdefinedabovemaybebrokendownasfollows:

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟𝑡𝑎𝑥𝑆𝑎𝑙𝑒𝑠

∗𝑆𝑎𝑙𝑒𝑠

𝑇𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡𝑠∗

𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡𝑠𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟v𝑠𝐹𝑢𝑛𝑑

TheaboveequationindicatesthattheROEisafunctionofthreeimportantratios—netmarginratio(PAT/Sales), total assets turnover ratio (Sales/Total Assets) and Financial Leverage (TotalAssets/Shareholders’Funds).Thethirdcomponentdependsuponthepresenceofdebtinthecapitalstructure of an enterprise. For a zero debt company, the financial leveragewill be one as all theassetshavebeenfundedbyshareholders’funds,andtherefore,thenumeratoranddenominatorforthe third component will be the same. ROE can be increased by increasing the net margin bycontrollingcostsandofferinghighmarginvalueaddedproductsandservicestothecustomers.Theassetsturnovercanbeimprovedbyusingtheassetsmoreefficiently,fastercollectionofreceivables,efficient turnoverof inventories,etc.Thebenefitof financial leveragecanbe takenbya judiciousmix of debt (borrowed funds) and equity (shareholders’ funds) in the capital structure of theenterprise.

Thethreecomponentsdiscussedearlier,multiplywitheachothertogenerateROE.Forexample,anenterprise in a low margin business with a net margin of 4%, asset turnover of two times andfinancialleverageofthreetimeswillreturnaROEof24%(4%×2×3).Thebreak-upofROEforExcelIndustriesLimitedusingDuPontAnalysisisgivenasfollows:

Table27:Du-PontAnalysis


PAT/Sales(%) 14.5% 10.1% 14.4% 11.3%Sales/Assets(Times) 0.58 0.75 0.84 0.93Assets/Shareholdersfund(Times) 2.31 2.30 2.24 3.96

From theaboveanalysis, it is clear that theROEof the companyhasdeclinedbetween2015and2017largelyduetodeclineintheassetsturnoverratio.Thenetmarginhasmarginallyimprovedandfinancially leveragehasdeclinedbut the assets turnover ratiohas significantlydeclined from0.93times to 0.58 times. This can be analysed further by using the other turnover ratios as discussedearlier.

9. MarketRatios

Astheequitysharesofacompanyaretraded in thestockmarket, the investorsbothexistingandprospectivewouldbe interested inassessing theperformanceof the stock in themarket. For thispurpose, themarket price of the sharemay be combinedwith some variables from the financialstatementsinameaningfulmanner.

48

MarketCapitalization

Themarket capitalizationof a company represents the totalmarket valueof all the sharesof thecompany.Itcanbecalculatedasfollows:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑚𝑎𝑟𝑘𝑒𝑡𝑝𝑟𝑖𝑐𝑒𝑋𝑁𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑒𝑞𝑢𝑖𝑡𝑦𝑠ℎ𝑎𝑟𝑒𝑠

As the current market price of a company keeps on fluctuating, the market capitalization alsofluctuates many times a day. A higher market capitalization is an effective defence mechanismagainstanytypeoftakeoverbid,astheacquirerwillberequiredtopayalargersumtoacquirethecontrollingstake.

10. PricetoBookValueRatio

Thebookvalue8ofacompanycanbecalculatedbydividingtheshareholders’fundsbythenumberof equity shares. The book value per share can be comparedwith themarket price per share tocalculatepricetobookvalueratio:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑚𝑎𝑟𝑘𝑒𝑡𝑝𝑟𝑖𝑐𝑒𝐵𝑜𝑜𝑘𝑣𝑎𝑙𝑢𝑒𝑝𝑒𝑟𝑠ℎ𝑎𝑟𝑒

Ahigher ratio indicates that themarket is paying ahigherpremium for the sharesover thebookvalue.Itmaybeduetohigherprofitabilityorbetterfutureprospects.Ahighratiomayalsobetakenasanindicatorofoverpricingofthestock.

PriceEarningsRatio9

The price earnings ratio or P/Emultiple is one of themost widely used indicator of the relativepricingofastock.Thecurrentmarketpriceofthestockiscomparedwiththeearningpersharetoarrive at the ratio. The ratio indicates prevailing market price of the stock as a multiple of theearningpershare.Theratioiscalculatedasfollows:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑚𝑎𝑟𝑘𝑒𝑡𝑝𝑟𝑖𝑐𝑒𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑝𝑒𝑟𝑠ℎ𝑎𝑟𝑒

TheP/Eratioisexpressedasnumberoftimes.Ahigherratiomeansthattheinvestorsarewillingtopay a higher price in relation to the earnings of the company. It may be due to better futureprospectsofthecompany.

PriceEarningstoGrowth(PEG)Ratio

ThePEGratio10isanattempttorelatetheP/Eratioofacompanywithitsgrowth.OftenfirmswithhighergrowthratioenjoyhigherP/Emultipleandviceversa.ThevariationintheP/Eratiomaybejustifiedbydifferentgrowthrates.Theratiomaybecalculatedasfollows:

𝑃𝑟𝑖𝑐𝑒𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑟𝑎𝑡𝑖𝑜𝐺𝑟𝑜𝑤𝑡ℎ𝑟𝑎𝑡𝑒

8https://www.investopedia.com/terms/p/price-to-bookratio.asp9https://www.investopedia.com/terms/p/price-earningsratio.asp10https://www.investopedia.com/terms/p/pegratio.asp

49

APEGratioofone isan indicationof fairpricing.A ratiohigher thanone isan indication that thestock isovervalued,whereasa ratio less thanone indicates that thegrowthprospectsof the firmhavenotbeenfullyfactoredinthecurrentmarketpriceandconsequentlythestockisundervalued.

Table28:ThemarketratiosforExcelManufacturingLimited

Particulars (₹million)Profitaftertax 2016Shareholdersfund 11924Numberofshares(million) 100MarketPrice(₹) 280BookvaluePershare(₹) 119.2Marketcapitalisation 28000Marketpricetobookvalueratio(Times) 2.3EarningsPershare 20.2Priceearningsratio(Times) 13.9Thecompanyhasmarketcapitalizationof 28,000millionwithaprice tobookvalue ratioof2.3times.Itindicatesthatthemarketcapitalizationofthecompanyis2.3timestheshareholders’funds.Thecompany’ssharesaretradingataP/Emultipleof13.9times.ThepricetobookvalueratioandP/Emultipleofthecompanycanbecomparedwithothercompaniesinthesameindustrytoassesstheextentofovervaluationorundervaluation.

Example1:

Table29:SummarizedfiguresrelatetoTullaLtd,abusinessoperatingintheretailsector

2017 2016Revenue 35,000 32,000GrossProfit 6,000 5,800Operatingexpenses (2,850) (2,300)Interestondebenturedebt (500) (500)Taxation (1,100) (1,400)Profitaftertax 1,550 1,600Equitycapitalplusreservesatyearend 17,500 17,000Debenturesinissuethroughouttheperiod 6,250 6,250

Note: Someequipmentwas sold in2017at a lossof INR300. This losswas included inoperatingexpenses.Nosuchtransactionoccurredin2016.

Required: Analyse the profitability of the above business in as much detail as the informationpermits.

Commentary:

Itisrecommendedtoreadtherequirementfirst,thenreadingtheinformationwiththerequirementinmind.Asyouread,tryandnoticethekeypoints.Someofthesemightbeasfollows:

• Revenuehasincreasedfrom2016to2017.

50

• Grossprofithasalsoincreased,probablybyasmallerpercentage.• Netprofit has reduced. This is unusual aswenormally expectmoreprofit ifwe sellmore

goods.• Operatingexpenseshaveincreasedsignificantly.

Checkifthereisanyadditionalinformationthatmightaffectyouranalysis.Let’staketheincreaseinoperating expenses. A simple analysismight suggest that the companywas less efficient in 2017thanin2016.Butconsidertheeffectofthedisposalofequipmentin2017,withamaterial lossondisposalincludedinexpenses.Itwouldbeusefultorecalculatethefigureswithouttheone-offitemtoseeifunderlyingperformancewasactuallythatdifferent.

Then calculate some appropriate ratios to assist your analysis. Finally, proceed to analyse theprofitabilityofthecompanyinaccordancewiththerequirement.

There is no “correct” figure for GrossMargin or NetMargin. Usually, the higher the better. Thenormallevelsvaryfromoneindustrytoanother.Usefulcomparisonscanbemadefromoneperiodto the next or against the industry average. Pay particular attention to trends. It is important toknowthedifferencebetweenmarginandmark-up.Mark-upisalwaysbasedoncostpriceswhereasmarginisbasedonsellingprices.

ROCEisaverypowerfulratiowhenusedcorrectly.Ingeneral,investinginabusinessisriskierthanbankdeposits,sothebusinessshouldearnaROCEsufficientlyinexcessofthereturnavailablefromdepositaccountstocompensatefortheriskbeingtaken. Inaddition, ifabusinesshasborrowings,theROCEshouldexceedthecostofborrowing.

ROE isanarrowerwayofassessingprofitability. It takesprofitattributable toequity shareholdersdividedbytheequity investment in the firm.Thisexcludespreferencesharesand interestbearingdebt (which iswhy the top line excludes interest and preference dividends), therefore it ismorerelevant for shareholders.We often take closing equity as the denominator,whereas an averageequityfigurecouldbemoreaccurate.Howeveraslongastheformulaisconsistent,comparisonsandtrendsshouldremainvalid.

Suggestedsolution:

Ratiocalculation 2017 2016

Grossmargin 6,000/35,000 5,800/32,000 =17.1% =18.1%

Netmargin (1,550+1,100+500) (1,600+1,400+500) 35,000 32,000 =9.0% =10.9%

ReturnonCapitalEmployed (1,550+1,100+500) (1,600+1,400+500) (17,500+6,250) (17,000+6,250) =13.3% =15.1%

ReturnonEquity 1,550 1,600 17,500 17,000 =8.9% =9.4%

51

Weakanalysisofprofitabilityratios(notadequateforprofessionallevel)

• Grossmarginandnetmarginhavebothdeclined,althoughnotbymuch.Thecompanyshouldwatchoutincasetheseratiosdeclinefurther.

• ROCE and ROE have also declined. Again, the decline is not massive but if it continues thecompanywillfinditselfunabletocontinueinbusiness.

• Overall the company is quite profitable, although profitability according to every measure isdecliningmarginally.

• Itisrecommendthecompanylookatimprovingcostcontroltoimproveprofits.

[Thisansweristypicalofwhatispresentedatprofessionallevel,butoffersalmostnovalueadded.Theratiocalculation,ifcorrect,wouldwinthebulkofmarksawardedhere.Thelastpointisthebest,as it offers some concrete analysis of the reason for the profit decline (costs have risendisproportionately)andapotentialsolution(controlcostswell).]

Betteranalysisofprofitability(professionallevel)

• Overallitappearstheprofitabilityofthisbusinesshasdeclinedyearonyear,despitea9.4%salesincreasefromINR32,000toINR35,000.Toascertainthelikelycauseofthisletusexaminesomepopularprofitabilityratios.

• Grossmarginhasdeclined from18.1%to17.1%whilegrossprofit itself increasedby3.4%.Asgrossprofitismadeupofsaleslesscostofsales,thismustmeaneitherthatsalespricesfellorcostofsales(essentiallypurchaseprices)increasedrelativetoeachotherfrom2016to2017.Itseems highly possible that the company'smanagement engaged in price cutting strategies toincrease sales. If so, they succeeded in increasing sales (by 9.4%), but the additional margincontributedbytheextrasaleswasalmostoutweighedbythe lostmarginover thetotalgoodssold,resultinginamuchsmallerincreaseingrossprofit(3.4%).

• Thiscouldstillbegoodbusinessstrategy,as it is thetotalprofit thatcountsat theendof theday.Howeverweneedtoconsideriftheincreasedactivitylevel(highersales)causedanyothercosts(e.g.overheads).Iftheextrasalescausednoextraoverheads,thenweareINR200betteroff.

• Thenetmarginanalyses thenetprofit fromoperationsonly (excluding interestandtax).Herewe see thenet profit%has declined from10.9% to 9%, and the actual expenses figure is upfromINR2,300toINR2,850.ThissuggeststhattheextrasalesactivitymayhavecostINR550inextraoverheads.TheINR200inextragrossprofitdoesnotcompensateforthis,thereforethestrategywouldappeartohavefailed.Notethatwedonotknowwhattheoperatingcostswouldhave been in 2014 had sales remained unchanged. We are assuming they would have beensimilarto2016.

• However,weareinformedthattheexpensesfigurein2017wasincreasedbyalossondisposalof INR300.Thisdistortsthecomparisonwith2016.Recalculatingthenetmarginexcludingtheone-off loss givesa figureof9.9%,andaPBITof INR3,450.This is still adis improvementon2016 but not as bad as superficial analysis suggests. Crucially, the operating expenses wouldhavebeen INR2,550 in2017had this lossnotoccurred.Hence thedecision to cutpricesandincreasedvolume(ifindeedthiswasthecase)nearlybrokeeven.

52

• ROCEdeclinedmarginallyfrom15.1%to13.3%.Iftheone-offlossondisposalwereexcludedtheROCEin2017wouldhavebeen14.5%(3,450/23,750),amuchlesserdecline.

• ROCEshouldbeadequate to reward the investor for investing theirmoney ina riskybusinessover playing it saferwith bonds or deposits.On this basis, 14.5% is still a respectable pre-taxreturnonmoneyinvested.Howeverthisshouldbejudgedinthecontextoftheriskinessofthebusiness.Thereislittlemeansofassessingthisriskgiveninthequestion.

• ROEisanalternative,narrower,measureofreturn.Itfocusesonequityholdersonly,andgivesan after-tax return on equity. The decline from 9.4% to 8.9% is within normal businessfluctuations, and would not be considered alarming. However the longer term trend in bothratiosshouldbeobservedandifthedeclinehaspersistedforafewyears,remedialactionshouldbeconsidered.

• The exclusion of the one-off expense in 2017would affect the ROE ratio, but it is difficult toquantify this. The reason for thedifficulty is that the loss ondisposal is likely to havehad aneffectonthetaxcharge.Itisnotpossibletoassessthisfromtheinformationgiven.AsROEisanafter-taxcalculation, it ismeaningless toadjust theexpenses figurewithoutalsoadjusting thetaxfigure.ROCEisbasedonprofitbeforetax,thereforethisissuedoesnotarise.

• Itisrelevanttonotethatthecostofdebtappearstobe8%(500/6,250).ItisimportantthattheROCEexceedsthecostofdebt.There is,afterall, littlesense inborrowingmoneyat8% if thereturnoncapital isonly6%.Inthiscase,theROCEcomfortablyexceedsthecostofdebt.Bothareassessedonapre-taxbasissoarecomparable.

[The above answer contains several points of analysis, explained beyond exam standard inmanycases. It would not be possible to give them all in an examination setting, and it should not beassumedthatallthesewouldberequiredtogainfullmarks.However,theydogiveaflavourofthedepth of analysis expected. It is important to demonstrate a thorough understanding of theinformationpresented in theaccounts, the informationgivenby the ratios, and the limitationsofthis information. Note also the use of terms like “it appears” and “It is likely that” rather thanstatementsoffact.Theuseofreasonablehypothesisandopinionisacceptable,butdonotpresentastatement as fact unless it is fact. It is important to acknowledge that financial analysis is animperfectscience,andnottoclaimotherwise.]

Example2:

Table30:SummarizedfiguresrelatetoABCLtd.,abusinessoperatingintheretailsector.

2017 2016Revenue 45,000 32,000Profitaftertax 1,550 1,600Currentassets(total) 5,600 4,400Currentliabilities(total) 5,100 2,900Inventories 5,100 2,750Receivables 200 100Cash 0 1,550Payables 3,500 1,500Taxdue 1,100 1,400Overdraft 500 0

Note:TheCompanyopenedathirdstoreduring2017.

53

Required:Analysetheliquidityoftheabovebusinessinasmuchdetailastheinformationpermits.

Commentary:

• Somekeypointsworthnotingatfirstglance:• Revenuehasincreasedsubstantially.• Profithasdeclined.• Cashpositionhasdeterioratedsignificantly.

Inventoryshowsanincreasehigherthanwouldbejustifiedbytheincreasedrevenue.

Theideallevelforthecurrentratioisoftensaidtobeintheregionof2:1.Aratiobetween1.5and2.5wouldbeconsiderednormal.Atthislevelcurrentassetsarearoundtwicecurrentliabilities.Thisgivesgoodassurancethatthecashwillbetheretomeetcurrentliabilitiesastheyfalldue.Anylowerandweruntheriskofnotbeingabletopayourdebtsontimewiththeconsequentlossofgoodwill.

Anexcessive current ratiomeans thatmoney is sitting in current assets (receivables, inventoryorcash)earningverypoorreturns.Thisisaninefficientuseofcapital.Itmaybebetterinvestedinmoreproductiveassets,usedtopaydowndebt,orreturnedtoshareholders.

If thecurrentratioappearstobeproblematicweshouldanalysethesituationfurthertoascertainthe reason for theproblem.Possible causescouldbeexcessive inventory levels (poorpolicy, slowmoving goods, obsolete stock etc.), poor trade receivable control (leading to increased bad debtrisk),orexcessivecashlevels.

Theacidtestratio(alsocalledthequickratio)isastrictertestofliquidityasinexcludestheeffectofinventoryfromcurrentassets.Thisisbecauseinventoryistheleastliquidofcurrentassets.Anideallevel for this ratio is1:1or thereabouts.This levelmeans short termassetsare sufficient tomeetshorttermliabilitieswithoutneedingtosellanymoreinventory.Inventoryistheleastliquidcurrentassetastherearetwostepsrequiredtoturnitintocash:(1)sellit,and(2)getpaid.

Adverse liquidity ratiosmay indicateovertrading. This iswhere a firm is carrying on a volume ofbusinessforwhichitdoesn'thavethecapital.Requirementtopurchaseinventoryisincreasingfasterthan cash is coming in from sales. Trade payables and bank overdrafts are bridging the gap. Thiscannotcontinue,as lendersandsupplierswillcallahalt.At thatstagethefirmwillnotbeabletomeetitspaymentsandsowillcollapse.

Suggestedsolution:

Ratiocalculation 2017 2016

CurrentRatio 5,600/5,100 4,400/2,900 1.1:1 1.52:1

AcidTestRatio (5,600–5,100)/5,100 (4,400-2,750)/2,900 0.098:1 0.57:1

54

Weakanalysismightcontainthefollowingpoints:

• Currentratiohasdeclinedfrom1.52:1to1.1:1from2016to2017.Thisfigureshouldbe2:1.• Thereforeitisinadequateinbothyears.• Acidtestratiohasdeclinedfrom0.57:1to0.098:1.Thisisextremelypoorasitshouldbe1:1.• Overalltheliquidityofthiscompanyisterrible.

Betteranalysismightconsiderthefollowing:

• Itisclearthatbothliquidityratioshavedeclinedsignificantlyyearonyear.• Asthecompanyisintheretailtrade,andtradereceivablesareinsignificant,itwouldappear

thatmostofitssalesareforcash,withlittlesalesoncredit.• Thiswouldnormallymeanliquidityratioscouldbemaintainedmoretightlythanthenormal

2:1forthecurrentratioand1:1fortheacidtest.• However the present levels of 1.1:1 and 0.098:1 respectively are at crisis levels and are

indicativeofasevereliquidityproblemwiththiscompany.• Inadditiontotheratios,theactualcashpositionhasdeterioratedfrompositiveINR1,550to

negativeINR500.• Thequestionsare:whatisthecauseandwhatneedstobedonetorectifyit.• Weareinformedthatthecompanyopenedathirdretailoutletduringtheyear2017.Thisis

likelytobethecauseoftherevenueincreasingby41%fromINR32,000toINR45,000.• HoweverprofitabilityhasactuallydeclinedbyINR50aftertax.Thisindicatesthatthereare

problems turning the extra revenues into profits. This may be due to one-off costs inopeningthenewstore.Furtherinvestigationmayrevealifthisisthecase.

• ThemostobvioussymptomofthetroubleistheincreaseininventorylevelsfromINR2,750to INR 5,100, an increase of 85%. Normally an increase in line with turnover would bereasonable or even 50% increase as the number of outlets increased by 50%. An 85%inventoryincreaseonarevenueincreaseof41%indicatesaproblem.

• Thecauseofthiscouldbeinventoryobsolescence.Inotherwordswemaybeexperiencingdifficultysellingtheinventorywearecarrying.Ifthisisthecase,alargewrite-downcouldberequiredinthefuture.Thiswouldcausealargeloss,plusitwouldhaveadetrimentaleffectonthealreadypoorcurrentratio(itwouldofcoursehavenoeffectontheacidtestratio).

• Alternatively thebuild-upcouldbecausedbybulkbuyingatadiscount. If this is thecase,theexcessinventoryshouldunwindovertime.

• Meanwhile,currentliabilitiesneedtobepaid,anditseemsunlikelythattheinventorycanbesoldquicklyenoughtoachievethis.

• It is possible that we may be able to negotiate longer credit terms with our suppliers.Howeverthereisusuallyahiddencosttothisintermsofhigherpurchaseprices.Inanycase,tax creditors will not countenance extensions to payment dates without hefty interestcharges.

• Hence, it would seem that the company needs to raise some longer term finance, eitherthroughbankloansoradditionalequity.

55

Chapter4:CapitalBudgeting


CapitalBudgeting

• Meaningofcapitalbudgeting• Needsandimportance(Video:capital

budgeting11)• Methodsofevaluationofcapitalbudgeting• Riskanduncertainlyincapitalbudgeting

(Video:sensitivity12andbreak-evenanalysis13)

• Methodsofevaluationofcapitalbudgetingrisk

• Learnaboutcapitalbudgetingand

the importance of careful capitalbudgeting

• Different considerations that areneededtobetakenforinvestmentdecision

• Identifyingtheriskassociatedwithcapital budgeting and how toanalyse the involved risk as a riskmitigationmeasure

4.1MeaningofCapitalBudgeting

Whenoneplaninadvanceforthecapitalexpenditureslikepurchaseofmachineries,landetc.itiscalledcapitalbudgeting.Inotherwords:“Capitalbudgetingisalong-termplanningformakingandfinancingproposedcapitaloutlays.Itis concernedwith the allocation of the firms’ source financial resources among the availableopportunities. The consideration of investment opportunities involves the comparison of theexpectedfuturestreamsofearningsfromaprojectwiththeimmediateandsubsequentstreamsofearningfromaproject,withtheimmediateandsubsequentstreamsofexpenditure.”

4.2NeedsandImportance

Sinceforcapitalexpendituresfirms’resourcesarebeingallocatedwhichisscarceinnaturesothereisaneedtounderstandthecriticalitythatisbeinginvolvedincapitalbudgeting.1. Hugeinvestments:Capitalbudgetingrequireshugeinvestmentsoffunds,buttheavailable

funds are limited, therefore the firmbefore investing projects, plan are control its capitalexpenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Thereforefinancial risks involved in the investmentdecisionaremore. If higher risksare involved, itneedscarefulplanningofcapitalbudgeting.

3. Irreversible: Thecapital investmentdecisionsare irreversible,arenotchangedback.Oncethedecisionistakenforpurchasingapermanentasset,itisverydifficulttodisposeoffthoseassetswithoutinvolvinghugelosses.

11VideoLink:https://www.investopedia.com/video/play/capital-budgeting/12VideoLink:https://www.investopedia.com/terms/b/breakevenpoint.asp13VideoLink:https://www.investopedia.com/video/play/sensitivity-analysis/

56

4. Long-termeffect:Capitalbudgetingnotonlyreducesthecostbutalsoincreasestherevenueinlong-termandwillbringsignificantchangesintheprofitofthecompanybyavoidingoverormore investment or under investment. Over investments leads to be unable to utilizeassetsoroverutilizationoffixedassets.

Followingpointsmustbeconcludedfromtheshownvideo:o Beforemaking the investment, it is required carefullyplanningandanalysis of theproject

thoroughly.o If an organization has more than one capital expenditure options then capital budgeting

helpstoevaluatetheoptionsandhowtofinancethem.o Costandrevenueassociatedwitheachoptionmustbecalculatedforbetterreturn.

4.3MethodsofEvaluationofCapitalBudgeting

Therearetwomethodsofevaluationofcapitalbudgetingthatare:1. Traditionalmethods:-ItisalsocalledNon-Discountedmethod.ItincludesPay-backperiod

method,Postpay-backmethodandAccountsrateofreturn.2. Modern methods: - It is also called Discounted methods. It includes Net present value

method(NPV),Internalrateofreturnmethod(IRR)andProfitabilityindexmethods.

SincemostcommonlyadoptedmethodsundertraditionalandmodernapproachisPay-backperiodmethod,Netpresentvalue(NPV)andInternalrateofreturn(IRR)respectivelysotrainer’sfurtherdiscussionwillbefocusedonthebelowlistedthreeevaluationmethodsonly.

4.3.1PaybackPeriodMethod

Pay-back period is the time required to recover the initial investment in a project. Merits anddemeritsofthismethodare:Merits:

§ Itiseasytocalculateandsimpletounderstand.§ Pay-backmethodprovidesfurtherimprovementovertheaccountingratereturn.§ Pay-backmethodreducesthepossibilityoflossonaccountofobsolescence

Demerits:

§ Itignoresthetimevalueofmoney.§ Itignoresallcashinflowsafterthepay-backperiod.§ Itisoneofthemisleadingevaluationsofcapitalbudgeting.

𝑃𝑎𝑦𝑏𝑎𝑐𝑘𝑝𝑒𝑟𝑖𝑜𝑑 =𝐼𝑛𝑖𝑡𝑖𝑎𝑙𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝐴𝑛𝑛𝑢𝑎𝑙𝑐𝑎𝑠ℎ𝑖𝑛𝑓𝑙𝑜𝑤𝑠

Problems:

1. Projectcostis₹.30,000andthecashinflowsare₹.10,000,thelifeoftheprojectis5years.Calculatethepay-backperiod.

57

Solution=��,��,��

=3YearsNote:Theannualcashinflowiscalculatedbyconsideringtheamountofnetincomeontheamountof depreciation project (Asset) before taxation but after taxation. The income precision earned isexpressedasapercentageofinitialinvestment,iscalledunadjustedrateofreturn.Theaboveproblemwillbecalculatedasbelow:

Unadjustedrateofreturn=�zz�y~��}��z�z��|}��z}

∗ 100

= ��,��,��

* 100 =33.33%

2. Certainprojectsrequireaninitialcashoutflowof₹.25,000.Thecashinflowsfor6yearsare₹.5,000,₹.8,000,₹.10,000,₹.12,000,₹.7,000and₹.3,000.

Table31:PaybackPeriodCalculation

Years Cashinflows(₹.) Cumulativecashinflows(₹.)1 5,000 5,0002 8,000 13,0003 10,000 23,0004 12,000 35,0005 7,000 42,0006 3,000 45,000The above calculation shows that in 3 years ₹. 23,000 has been recovered ₹. 2,000, isbalanceoutofcashoutflow.Inthe4thyearthecashinflowis₹.12,000.Itmeansthepay-backperiodisthreetofouryears,calculatedasfollows:

𝑃𝑎𝑦 − 𝑏𝑎𝑐𝑘𝑝𝑒𝑟𝑖𝑜𝑑 = 3𝑦𝑒𝑎𝑟𝑠 +200012000

∗ 12𝑚𝑜𝑛𝑡ℎ𝑠

=3years2months.

4.3.2 NetPresentValue(NPV)Netpresentvaluemethodisoneofthemodernmethodsforevaluatingtheprojectproposals. Inthis method cash inflows are considered with the time value of the money. Net present valuedescribesasthesummationofthepresentvalueofcashinflowandpresentvalueofcashoutflow.

Merits:

§ Itrecognizesthetimevalueofmoney.§ Itconsidersthetotalbenefitsarisingoutoftheproposal.§ Itisthebestmethodfortheselectionofmutuallyexclusiveprojects.§ Ithelpstoachievethemaximizationofshareholders’wealth.

58

Demerits:

§ Itisdifficulttounderstandandcalculate.§ Itneedsthediscountfactorsforcalculationofpresentvalues.§ Itisnotsuitablefortheprojectshavingdifferenteffectivelives.

Problems:

1. Fromthefollowinginformation,calculatethenetpresentvalueofthetwoprojectandsuggestwhichofthetwoprojectsshouldbeacceptedadiscountrateofthetwo.

ProjectX ProjectYInitialinvestment ₹.20,000 ₹.30,000Estimatedlife 5years 5yearsScrapvalue ₹.1,000 ₹.2,000

Theprofitsbeforedepreciationandaftertaxation(cashflows)areasfollows:

Year1 Year2 Year3 Year4 Year5ProjectX 5,000 10,000 10,000 3,000 2,000ProjectY 20,000 10,000 5,000 3,000 2,000

Note:Thefollowingarethepresentvaluefactors@10%p.a.Year 1 2 3 4 5 6Factor 0.909 0.826 0.751 0.683 0.621 0.564

Table32:NetpresentValueCalculation

Year CashInflows(₹.) Presentvalueof₹.1@

10%

PresentValueofNetCashValueof₹.Inflow

ProjectX ProjectY ProjectX ProjectY1 5,000 20,000 0.909 4,545 18,1802 10,000 10,000 0.826 8,260 8,2603 10,000 5,000 0.751 7,510 3,755

4 3,000 3,000 0.683 2,049 2,049

5 2,000 2,000 0.621 1,242 1,242

Scrapvalue 1,000 2,000 0.564 621 1,245

Totalpresentvalue 24,227 34,728Initialinvestment 20,000 30,000Netpresentvalue 4,227 4,728

ProjectYshouldbeselectedasnetpresentvalueofprojectYishigher.

59

4.3.3 InternalRateofReturnInternalrateofreturnistimeadjustedtechniqueandcoversthedisadvantagesofthetraditionaltechniques.Inotherwordsitisarateatwhichdiscountcashflowstozero.

Merits:

§ Itconsiderthetimevalueofmoney.§ Ittakesintoaccountthetotalcashinflowandoutflow.§ Itdoesnotusetheconceptoftherequiredrateofreturn.§ Itgivestheapproximate/nearestrateofreturn.

Demerits:

§ Itinvolvescomplicatedcomputationalmethod.§ Itproducesmultiplerateswhichmaybeconfusingfortakingdecisions.§ It isassumethatall intermediatecashflowsarereinvestedatthe internalrateof

return.

AtIRR,NPVequalstozero.So,𝑃𝑉𝑜𝑓𝑓𝑢𝑡𝑢𝑟𝑒𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠 − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 0𝑜𝑟;

𝐶𝐹11 + 𝑟 � +

𝐶𝐹21 + 𝑟 � +

𝐶𝐹31 + 𝑟 � + ⋯ − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 0

Table33:InternalRateofReturnCalculation

Years CashFlows0 -1000001 200002 300003 400004 500005 30000

Solution:NPVat18%discountrate=1750NPVat19%discountrate=-780HenceIRR=

18% +17502530

∗ 1% = 18.69%

r=IRR

CF1=periodonenetcashinflow

CF2=periodtwonetcashinflow

Andsoon….

60

4.4RiskandUncertaintyinCapitalBudgeting

Capitalbudgetingrequirestheprojectionofcashinflowandoutflowofthefuture.Thefuture is always uncertain, estimate of demand, production, selling price, cost etc.,cannotbeexact.Forexample:Theproductatanytimeitbecomeobsoletetherefore,the future in unexpected. So various evaluation methods are used for risk anduncertaintyincapitalbudgeting.Theseare:

§ SensitivityAnalysis§ Break-evenanalysis

4.4.1 SensitivityTechnique

Takeawayfromthevideoplayedare:o Thistechniquehelpustounderstandhowchangeinoneinputs(whetherchangeincostofraw material, change in finance cost etc.) can affect the overall revenue of theorganization.

o Ithelpsinmakingpredictionamoreappropriate.

Whencash inflowsaresensitiveunderdifferentcircumstancesmorethanone forecastof thefuturecashinflowsmaybemade.Theseinflowsmayberegardedon‘Optimistic’,‘mostlikely’and ‘pessimistic’. Further cash inflowsmay be discounted to find out the net present valuesunderthesethreedifferentsituations.Ifthenetpresentvaluesunderthethreesituationsdifferwidelyitimpliesthatthereisagreatriskintheprojectandtheinvestor’sisdecisiontoacceptorrejectaprojectwilldependuponhisriskbearingactivities.

Problem:MrSelvaisconsideringtwomutuallyexclusiveproject‘X’and‘Y’.Youarerequiredtoadvisehimabouttheacceptabilityoftheprojectsfromthefollowinginformation. ProjectX(In₹.) ProjectY(In₹.)Costoftheinvestment 1,0,0000 1,0,0000Forecastcashinflowsperannumfor5years Optimistic 60,000 55,000Expected 35,000 30,000Pessimistic 20,000 20,000

(Thecut-offratemaybeassumedtobe15%).Solution:Calculationofnetpresentvalueofcashinflowsatadiscountrateof15%.(AnnuityofRe.1for5years).ProjectXEvent Annual cash

inflows(₹.)Discount factor@15%

PresentValue₹. Net PresentValue₹.

Optimistic 60,000 3.3522 2,01,132 1,01,132Mostlikely 35,000 3.3522 1,17,327 17,327Pessimistic 20,000 3.3522 67,105 (32,895)

ProjectY

61

Event Annual cashinflows(₹.)

Discount factor@15%

PresentValue₹. Net PresentValue₹.

Optimistic 55,000 3.3522 1,84,371 84,371Mostlikely 30,000 3.3522 1,00,566 566Pessimistic 20,000 3.3522 67,105 (32,895)

ThenetpresentvaluesoncalculatedaboveindicatethatprojectYismoreriskyascomparedtoproject X. But at the same time during favourable condition, it is more profitable also. TheacceptabilityoftheprojectwilldependuponMrSelva’sattitudetowardsrisk.Ifhecouldaffordtotakehigherrisk,projectYmaybemoreprofitable.

4.4.2 Break-evenAnalysisTakeawayfromthevideotitledas‘SensitivityAnalysis’are:

o The break-even analysis lets you determinewhat you need to sell,monthly or annually, tocoveryourcostsofdoingbusiness—yourbreak-evenpoint.

o Itisfrequentlymistakenforthepaybackperiod,thetimeittakestorecoveraninvestment.

The basic idea behind break-even point is to calculate the point at whichrevenuesbegin toexceedcosts.Break-evenpointdoesnotallowforanincomeforthebusiness,itdoesmeanthecompanyisabletopayalloftheexpenseswithoutgoingindebtorhavingtocloseitsdoors.

𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛𝑝𝑜𝑖𝑛𝑡𝑖𝑛𝑢𝑛𝑖𝑡𝑠 =𝐹𝑖𝑥𝑒𝑑𝑐𝑜𝑠𝑡

𝑃𝑟𝑖𝑐𝑒𝑜𝑓𝑡ℎ𝑒𝑝𝑟𝑜𝑑𝑢𝑐𝑡 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑐𝑜𝑠𝑡𝑝𝑒𝑟𝑢𝑛𝑖𝑡

𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛𝑝𝑜𝑖𝑛𝑡𝑖𝑛𝐼𝑁𝑅 = 𝑆𝑎𝑙𝑒𝑠𝑝𝑟𝑖𝑐𝑒𝑝𝑒𝑟𝑢𝑛𝑖𝑡 ∗ 𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛𝑢𝑛𝑖𝑡

Problem:

1. Janehas justopenedherownshopand is lookingatherprojectedcosts fortheendofthefirstfiscalquarter,tryingtodeterminewhatherbreak-evenpointis.Let'ssayherfixedcostsfor this first quarter, which include vats, delivery trucks, ingredients and the rent for thestorefront, total out to20,000, andher variable costshavebeen calculated tobe1.50perunit.Sheplansonchargingapproximately2.00perunit.Howmanyunitswillshehavetoselltobreakeven?

Solution:

𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛𝑝𝑜𝑖𝑛𝑡𝑖𝑛𝑢𝑛𝑖𝑡 =20,000

2.00 − 1.50= 40,000𝑢𝑛𝑖𝑡𝑠

𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛𝑠𝑎𝑙𝑒𝑠 = 2 ∗ 40,000 = 𝐼𝑁𝑅80,000

§ Budgeting of the capital requirement is important because it is huge investment,irreversibleandforalongerperiodoftime.

§ Sinceitishugeinvestmentsosomekindofriskmustbeassociatedwithitwhichneedtobeanalysedformitigationoftherisk.

§ Payback period, Net present value and Internal rate of return (IRR) is the mostcommonlymethodthatisbeingadoptedforevaluationofcapitalbudgeting.

62

§ Sensitivityanalysisusuallyshowshowsensitivethecashflowsarewithrespectchangeindifferentcircumstance.

§ Every firm must be operate at break-even point, if not then firm will be shut downwithinashortspanoftime.

Chapter5:WorkingCapital

TopicsCovered LearningObjectivesWorkingCapital

• Conceptandcomponentofworkingcapital• Needofworkingcapital(Video:Working

capitalmanagement14)• Effectsofexcessiveandinadequateworking

capital• Factorsdeterminingworkingcapital

requirement• Estimationofworkingcapital

• The meaning of working capital

andwhy it is important toget theclearunderstandingoftheworkingcapitalconcept.

• Different items that constituteworking capital and their effectsonworkingcapitalrequirement.

• How the requirement of theworkingcapitalisbeingestimated.

5.1ConceptandComponentofWorkingCapital

Capitalareoftwotypes.Theyare:

Figure8:TypesofCapital

14VideoLink:https://www.youtube.com/watch?v=bHK77lbdyWA

Capital

FixedCapital WorkingCapital

63

Fixedcapitalmeansthatcapital,whichisusedforlong-terminvestmentofthebusinessconcern.Forexample,purchaseofpermanentassets.Normallyitconsistsofnon-recurringinnature.WorkingCapitalisanotherpartofthecapitalwhichisneededformeetingdaytodayrequirementofthe business concern. For example, payment to creditors,salary paid to workers, purchase of raw materials etc.,normally it consists of recurring in nature. It canbeeasilyconverted intocash.Hence, it isalsoknownasshort-termcapital.5.1.1 ConceptofWorkingCapital

Take away from the video titled as, ‘Working CapitalManagement’are:

o Efficientworkingcapitalmanagementoptimizestheliquidityoftheorganizationo Enhancestheprofitabilityo Itexplainshowbusinessescansuccessfullyuseittoleveragehiddenliquidityreserveswithin

thevaluechain.

Working capital can be classified or understood with the help of the following two importantconcepts.

Gross Working Capital: - Gross Working Capital is the general concept which determines theworking capital concept. Thus, the gross working capital is the capital invested in total currentassetsofthebusinessconcern.GrossWorkingCapitalissimplycalledasthetotalcurrentassetsoftheconcern.

𝐺𝑊𝐶 = 𝐶𝐴NetWorkingCapital: -NetWorkingCapital is thespecificconcept,which,considersbothcurrentassetsandcurrentliabilityoftheconcern.NetWorkingCapitalistheexcessofcurrentassetsoverthe current liability of the concern during a particular period. If the current assets exceed thecurrent liabilities it is said to be positive working capital; it is reverse, it is said to be Negativeworkingcapital.

𝑁𝑊𝐶 = 𝐶𝐴 − 𝐶𝐿

5.1.2 ComponentsofWorkingCapital

Workingcapitalconstitutesvariouscurrentassetsandcurrentliabilities.Thiscanbeillustratedbythefollowingchart.

Figure10:ComponentsofWorkingCapital

Figure9:ConceptofWorkingCapital

64

5.2NeedsofWorkingCapital

Working Capital is an essential part of the business concern. Every business concern mustmaintain certain amount of Working Capital for their day-to-day requirements and meet theshort-termobligations.WorkingCapitalisneededforthefollowingpurposes.

a) Purchase of raw materials and spares: - The basic part of manufacturing process is, rawmaterials. It should purchase frequently according to the needs of the business concern.Hence, every business concernmaintains certain amount asWorking Capital to purchaserawmaterials,components,spares,etc.

b) Paymentofwagesandsalary: -ThenextpartofWorkingCapital ispaymentofwagesandsalaries to labourandemployees.Periodicalpayment facilitiesmakeemployeesperfect intheir work. So a business concern maintains adequate the amount of working capital tomakethepaymentofwagesandsalaries.

c) Day-to-day expenses: A business concern has tomeet various expenditures regarding theoperationsatdailybasislikefuel,power,officeexpenses,etc.

d) Providecreditobligations:Abusinessconcernresponsibletoprovidecreditfacilitiestothecustomer and meet the short-term obligation. So the concern must provide adequateWorkingCapital.

5.3EffectsofExcessiveandInadequateWorkingCapital

A.Effectsofexcessiveworkingcapital.

i. ExcessiveWorkingCapitalleadstounnecessaryaccumulationofrawmaterials,componentsandspares.

ii. ExcessiveWorkingCapitalresultsinlockingupofexcessWorkingCapital.iii. Itcreatesbaddebts,reducescollectionperiods,etc.iv. Itleadstoreducetheprofits.

B.Effectsofinadequateworkingcapital

i. Inadequateworkingcapitalcannotbuyitsrequirementsinbulkorder.ii. Itbecomesdifficulttoimplementoperatingplansandactivatethefirm’sprofittarget.iii. Itbecomesimpossibletoutilizeefficientlythefixedassets.

CurrentAssets

• Cashinhand• Cashatbank• Billsreceivable• Sundrydebtors• Shorttermloanandadvances• Inventories• Prepaidexpenses• AccruedIncome

CurrentLiabilities

• BillsPayable• Sundrycreditors• O/sExpenses• Dividend• Shorttermloanandadvances• BankO/D• Provisionfortaxation

65

iv. TherateofreturnoninvestmentsalsofallswiththeshortageofWorkingCapital.v. Itreducestheoveralloperationofthebusiness.

5.4FactorsDeterminingtheWorkingCapitalRequirement

WorkingCapitalrequirementsdependsuponvariousfactors.TherearenosetofrulesorformulatodeterminetheWorkingCapitalneedsofthebusinessconcern.Thefollowingarethemajorfactorswhich are determining the Working Capitalrequirements.

i. Natureof business:WorkingCapital of thebusinessconcerns largelydependuponthenature of the business. If the businessconcerns follow rigid credit policy and sellgoods only for cash, they can maintainlesser amount of Working Capital. Atransport company maintains lesseramount of Working Capital whileConstruction Company maintains largeramountofWorkingCapital.

ii. Production cycle: Amount of Working Capital depends upon the length of the productioncycle.Iftheproductioncyclelengthissmall,theyneedtomaintainlesseramountofWorkingCapital.Ifitisnot,theyhavetomaintainlargeamountofWorkingCapital.

iii. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the businessconditionanditwillaffecttherequirementsoftheWorkingCapital.In thebooming conditions, theWorkingCapital requirement is larger and in thedepressioncondition,requirementofWorkingCapitalwillreduce.BetterbusinessresultsleadtoincreasetheWorkingCapitalrequirements.

iv. Productionpolicy:It isalsooneofthefactorswhichaffectstheWorkingCapitalrequirementofthebusinessconcern. If thecompanymaintainsthecontinueproductionpolicy, there isaneedof regularWorkingCapital. If theproductionpolicyof thecompanydependsupon thesituation or conditions, Working Capital requirement will depend upon the conditions laiddownbythecompany.

v. Creditpolicy:CreditpolicyofsalesandpurchasealsoaffecttheWorkingCapitalrequirementsofthebusinessconcern.Ifthecompanymaintainsliberalcreditpolicytocollectthepaymentsfromitscustomers,theyhavetomaintainmoreWorkingCapital.Ifthecompanypaystheduesonthelastdateitwillcreatethecashmaintenanceinhandandbank.

vi. Growth and expansion:During the growth and expansion of the business concern,WorkingCapitalrequirementsarehigher,becauseitneedssomeadditionalWorkingCapitalandincurssomeextraexpensesattheinitialstages.

vii. Availability of raw materials: Major part of the Working Capital requirements are largelydependon theavailabilityof rawmaterials. Rawmaterials are thebasic componentsof theproductionprocess.Iftherawmaterialisnotreadilyavailable,itleadstoproductionstoppage.So, theconcernmustmaintainadequaterawmaterial; for thatpurpose, theyhavetospendsomeamountofWorkingCapital.

viii. Earning capacity: If thebusiness concern consistsofhigh level of earning capacity, they cangeneratemoreWorkingCapital,withthehelpofcashfromoperation.Earningcapacityisalso

R

W

F

D

Figure11:OperatingCycle

66

one of the factors which determines the Working Capital requirements of the businessconcern.

5.5EstimationofWorkingCapitalRequirement

WorkingCapital requirementdependsuponnumberof factors,whicharealreadydiscussed in thepreviousparts.NowthediscussionisonhowtocalculatetheWorkingCapitalneedsofthebusinessconcern. Itmayalsodependuponvarious factorsbut someof the commonmethodsareused toestimatetheWorkingCapital.

A.Estimationofcomponentsofworkingcapitalmethod

Workingcapitalconsistsofvariouscurrentassetsandcurrentliabilities.Hence,wehavetoestimatehowmuch current assets as inventories required andhowmuch cash required tomeet the shortterm obligations. Finance Manager first estimates the assets and required Working Capital forparticularperiod.

B.Percentofsalesmethod

Based on the past experience between Sales and Working Capital requirements, a ratio can bedeterminedforestimatingtheWorkingCapitalrequirementinfuture.It isthesimpleandtraditionmethodtoestimatetheWorkingCapitalrequirements.Underthismethod,firstwehavetofindoutthe sales to Working Capital ratio and based on that we have to estimate Working Capitalrequirements.ThismethodalsoexpressestherelationshipbetweentheSalesandWorkingCapital.

C.Operatingcycle

WorkingCapitalrequirementsdependupontheoperatingcycleofthebusiness.Theoperatingcyclebeginswiththeacquisitionofrawmaterialandendswiththecollectionofreceivables.

Operatingcycleconsistsofthefollowingimportantstages:

o RawMaterialandStorageStage,(R)o WorkinProcessStage,(W)o FinishedGoodsStage,(F)o DebtorsCollectionStage,(D)o CreditorsPaymentPeriodStage.(C)

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝐶𝑦𝑐𝑙𝑒 = 𝑅 +𝑊 + 𝐹 + 𝐷 − 𝐶Where,

𝑅 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑠𝑡𝑜𝑐𝑘𝑜𝑓𝑟𝑎𝑤𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙

𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑟𝑎𝑤𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛𝑝𝑒𝑟𝑑𝑎𝑦

𝑊 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑤𝑜𝑟𝑘𝑖𝑛𝑝𝑟𝑜𝑔𝑟𝑒𝑠𝑠𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑐𝑜𝑠𝑡𝑜𝑓𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛𝑝𝑒𝑟𝑑𝑎𝑦

𝐹 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑓𝑖𝑛𝑖𝑠ℎ𝑒𝑑𝑠𝑡𝑜𝑐𝑘𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑐𝑜𝑠𝑡𝑜𝑓𝑔𝑜𝑜𝑑𝑠𝑠𝑜𝑙𝑑𝑝𝑒𝑟𝑑𝑎𝑦

𝐷 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑏𝑜𝑜𝑘𝑑𝑒𝑏𝑡𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑐𝑟𝑒𝑑𝑖𝑡𝑠𝑎𝑙𝑒𝑠𝑝𝑒𝑟𝑑𝑎𝑦

67

𝐶 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑡𝑟𝑎𝑑𝑒𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑐𝑟𝑒𝑑𝑖𝑡𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑝𝑒𝑟𝑑𝑎𝑦

Problem:Fromthefollowinginformationextractedfromthebooksofamanufacturingcompany,computetheoperatingcycleindaysandtheamountofworkingcapitalrequired:

Table34:WorkingCapitalCalculation

Periodcovered 365daysAverageperiodofcreditallowedbysuppliers 16daysAverageTotalofDebtorsOutstanding 48,000RawMaterialConsumption 4,40,000TotalProductionCost 10,00,000TotalCostofSales 10,50,000Salesfortheyear 16,00,000ValueofAverageStockmaintained: RawMaterial 32,000Work-in-progress 35,000FinishedGoods 26,000Solution:Computationofoperatingcycle:

i. Rawmaterialheldinstock:

=32000

440000/365

=32 ∗ 365440

= 26.5 = 27𝑑𝑎𝑦𝑠ii. Work-in-progress:

=35000

10,00000/365

35 ∗ 3651000

= 13𝑑𝑎𝑦𝑠iii. Finishedgoodheldinstock:

=26000

1050000/365

=26 ∗ 3651050

= 9𝑑𝑎𝑦𝑠iv. Creditperiodallowedtodebtors:

=48000

1600000/365

=48 ∗ 3651600

= 11𝑑𝑎𝑦𝑠Totaloperatingcycleperiod:(i)+(ii)+(iii)+(iv)-16=44days

NumberofOperatingcyclesinayear=� ¡¢¢

= 8.30

68

AmountofWorkingCapitalrequired= £x}y~x¤��y}{z¥¦x|}�x.x§x¤��y}{z¥¦¨¦~�|{zy¨�y�

=10,5008.3

= 1,265𝐼𝑁𝑅§ Awellunderstandingabouttheworkingcapitaloftheorganizationwillreduceleadtoefficient

inventorymanagement,receivablesmanagementandcashmanagement.§ Knowledgeaboutworkingcapitalcyclewillhelpinfurtherforecastingandprojections.§ Finances of working capital can be done through long term sources (like share capital,

debentures,bonds,retainedearnings,venturecapital)andshorttermsources(liketransactioncredit,advancesfromcustomers,overdrafts,commercialpapersetc.)

69

Chapter6:FinancialPlanningandForecasting


FinancialPlanningandForecasting• Whatisfinancialplanningandwhythereisa

needforfinancialplanning(video:‘whatisfinancialplanning?Howcanyoustart?’15)

• Valuationofenterprise• MeaningofForecasting• Methodsofforecasting(video:forecasting16)

- FinancialmodellingusingspreadsheetProformastatementofP&Landbalancesheet

• Describe certain common

elementsoffinancialplans• Calculatetheamountofadditional

fundneeded• Explainthemeaningofsustainable

growthrate

6.1WhatisFinancialPlanningandNeedofFinancialPlanning

Afinancialplanrepresentsablueprintofwhatafirmproposestodointhefuture.Typicallyitcoversaperiodofthreetotenyears–mostcommonlyitspansaperiodoffiveyears.Mostfinancialplanshavecertaincommonelements.Theseare:

§ Economic assumptions – the financial plan is based on certain assumptions about theeconomicenvironmentlikeinterestrate,taxrate,inflation,growthrateetc.

§ Sales forecast – it is the starting point of financial forecasting exercise. Most financialvariablesarerelatedtosalesfigures.

§ Proformastatements–theheartofafinancialplanaretheproforma(forecast)statementofprofit&Lossandbalancesheet.

§ Asset requirements – firmsneed to invest in plant&equipment andworking capital. Thefinancialplansspellsouttheprojectedcapitalinvestmentsandworkingcapitalrequirementsovertime.

§ Financialplans–suitablesourcesoffinancinghavetobethoughforsupportinginvestment.Thefinancialplansdelineatestheproposedmeansoffinancing.

Thebenefitsoffinancialplanningare:

§ Identifiesadvanceactionstobetakeninvariousareas§ Seekstodevelopanumberofoptionsinvariousareasthatcanbeexercisedunderdifferent

conditions§ Facilitates a systematic exploration of interaction between investment and financing

decision.§ Clarifiesthelinkbetweenpresentandfuturedecision.§ Forecastswhatislikelytohappeninfutureandhencehelpsinavoidingsurprises.§ Ensurethatthestrategicplanofthefirmisfinanciallyviable.

15VideoLink:https://www.youtube.com/watch?v=HMmZEgVpAK016VideoLink:https://www.youtube.com/watch?v=2OUtRu7jb6M

70

§ Providesbenchmarkagainstwhichfutureperformancemaybemeasured.

6.2ValuationofEnterprise

Figure12:ValuationofEnterprise

6.2.1ComparableCompanyAnalysisComparablecompanyanalysis isavaluationmethodologythat looksat ratiosof similarcompaniesandusesthemtoderivethevalueofanotherbusiness.Comparablecompanyanalysis isarelativeform of valuation, unlike a discounted cash flow (DCF) analysis, which is anintrinsic form ofvaluation.Stepsinperformingcomparablecompanyanalysis

#1Findtherightcomparablecompanies

Thisisthefirstandprobablythehardest(ormostsubjective)stepinperformingratioanalysisofcompanies.Thenextstepistosearcheitherofthosedatabasesforcompaniesthatoperateinthesameindustryandthathavesimilarcharacteristics.Thecriteriawouldincludethefollowing:

1. Industryclassification2. Geography3. Size(revenue,assets,employees)4. Growthrate5. Marginsandprofitability

#2Gatherfinancialinformation

Theinformationwillvarywidelybyindustryandthecompany’sstageinthebusinesslifecycle.Formaturebusinesses,youwilllookatmetricslikeEBITDAandEPS,butforearlierstagecompaniesyoumaylookatGrossProfitorRevenue.

ValuationofEnterprise

CostApproachCosttoBuild

ReplacementCost

MarketApproach(RelativeValue)

CompanyComparablesPrecedentTransactions

DiscountedCashFlow(intrinsicvalueapproach)Forecastfuturecashflows

71

Theinformationcanbegatherthroughanypaidportalsormanuallygatherthisinformationfromannualandquarterlyreports.

#3Setupthecomparablecompanyanalysistable

InExcel,younowneedtocreateatablethatlistsalltherelevantinformationaboutthecompaniestobeanalysed.Themaininformationincomparablecompanyanalysisincludes:

• Companyname• Shareprice• Marketcapitalization• Netdebt• Enterprisevalue• Revenue• EBITDA• EPS• Analystestimates

Theaboveinformationcanbeorganizedasshowninourexamplecomparablecompaniesanalysisshownbelow.

#4Calculatethecomparableratios

Withacombinationofhistoricalfinancialsandanalystestimatespopulatedinthecomparablecompanyanalysistable,thevariousratiosneedstobecalculatedthatwillbeusedtovaluethecompany.Themainratiosincludedinacomparablecompanyanalysisare:

• EV/Revenue• EV/GrossProfit• EV/EBITDA• P/E• P/NAV• P/B

6.2.2DCFModelA DCF model is a specifictype of financial modelis used to value a business. DCF standsforDiscountedCashFlow, so a DCF model is simply a forecast of a company’s free cash flowdiscountedbacktotodays/currentvalue,whichiscalledtheNetPresentValue(NPV).

Eventhoughtheconceptissimple,thereisactuallyquiteabitoftechnicalbackgroundrequiredforeachofthecomponentsdescribedabove.ThebasicbuildingblockofaDCFmodelisthe3statementfinancialmodel,whichlinksthefinancialstogether.

HowtobuildacashflowforecastinaDCFmodel

In simple terms, it is aboutmakingmost informed prediction about how each of the drivers of abusinesswillimpactitsresultsinthefuture.

Typically,aforecastforaDCFmodelwillgooutapproximately5years,exceptforresourceorlong-lifeindustriessuchasmining,oilandgas,andinfrastructurewhereengineeringreportswillbeused

72

to build a long-term “life of resource” forecast. For an example of this, please see ourminingfinancialmodellingcourse.

#1Forecastingrevenue

There are severalways to build a revenue forecast, but broadly speaking they fall into twomaincategories:growthbasedanddriverbased.

Agrowth-basedforecastissimplerandmakessenseforstable,andpossiblymaturebusiness,whereabasicyearoveryeargrowthratecanbeused.FormanyDCFmodels,thiswillbesufficient.

A driver-based forecast is more detailed and challenging to develop. It requires disaggregatingrevenue into its various drivers, such as price, volume, products, customers, market share, andexternal factors.Regressionanalysis isoftenusedaspartofadriver-based forecast todeterminetherelationshipbetweenunderlyingdrivers,andtop-linerevenuegrowth.

#2Forecastingexpenses

Buildinganexpenseforecastcanbeaverydetailedandgranularprocess,oritcanalsobeasimpleyear-over-yearcomparison.

Themost detailed approach is called aZero-Based Budgetand requires building up the expensesfrom scratch, without giving any consideration to what was spent last year. Typically, eachdepartment in the company is asked to justify every expense they have, based on activity. Thisapproachisoftenusedinacost-cuttingenvironment,orwhenfinancialcontrolsarebeingimposed.

Zero-basedbudgeting(ZBB)isabudgetingtechniquethatallocatesfundingbasedonefficiencyandnecessity rather than onbudget history.Management starts from scratch and develops a budgetthatonlyincludesoperationsandexpensesessentialtorunningthebusiness;therearenoexpensesthatareautomaticallyaddedtothebudget.

#3Forecastingcapitalassets

This typically include balance sheet items such asproperty plant and equipment (PP&E),technology,researchanddevelopment(R&D)andworkingcapitalincludingaccountsreceivableandinventory.

PP&E is often the largest balance sheet item andcapital expenditures(capex), as well asdepreciation,needtobemodelledinaseparateschedule.ThemostdetailedapproachistohaveaseparatescheduleintheDCFmodelforeachofthemajorcapitalassets,andthenconsolidatetheminto a total schedule. Each capital asset schedulewill have several lines: opening balance, capex,depreciation,dispositions,andclosingbalance.

#5TerminalValue

TheterminalvalueisaveryimportantpartofaDCFmodel.Itoftenmakesupmorethan50%ofthenetpresentvalueofthebusiness,especiallyiftheforecastperiodis5yearsorless.Therearetwoways to calculate the terminal value: the perpetual growth rate approach and the exit multipleapproaches.

73

Theperpetualgrowthrateassumesthatthecashflowgeneratedattheendoftheforecastperiodgrowsataconstantrateforever.So,forexample,thecashflowofthebusinessis₹.10millionandgrowsat2%forever,withacostofcapitalof15%.Theterminalvalueis₹.10million/(15%–2%)=₹.77million.

Withtheexitmultipleapproach,thebusinessisassumedtobesoldforwhata“reasonablebuyer”wouldpay for it. This typicallymeansanEV/EBITDAmultipleatornear current tradingvalues forcomparable companies. As you can see in the example below, if the business has ₹. 6.3millionofEBITDAandsimilarcompaniesaretradingat8xthentheterminalvalueis₹.6.3millionx8=₹.50million.ThatvalueisthendiscountedbacktothepresenttogettheNPVoftheterminalvalue.

#6Timingofcashflow

It’s important topaycloseattentionto the timingofcash flow inaDCFmodelasnotall the timeperiodsarenecessarilyequal.There isoftena“stubperiod”atthebeginningofthemodelwhereonly a portion of the year’s cash flow is received by the investor. Additionally, the cash outflow(makingtheactualinvestment)istypicallyaspatetimeperiodbeforethestubisreceived.

NPVandIRRare easy ways to be very specific with the timing of cash flowwhen building a DCFmodel.

#7DCFEnterprisevalue

WhenbuildingaDCFmodelusingunleveredfreecashflow,theNPVthatyouarriveatisalwaystheenterprise value (EV) of the business. This is what you need if you’re looking to value the entirebusinessorcompareitwithothercompanieswithouttakingintoaccounttheircapitalstructures(i.e.an apples-to-apples comparison). Formostinvestment bankingtransactions, the focus will be onenterprisevalue.

#8DCFEquityvalue

If you’re looking for theequity valueof thebusiness, you take thenetpresent value (NPV)of theunleveredfreecashflowandadjustitforcashandequivalents,debt,andanyminorityinterest.Thiswillgiveyoutheequityvalue,whichyoucandividebythenumberofsharesandarriveattheshareprice.Thisapproachismorecommonforinstitutionalinvestorsorequityresearchanalysts,bothofwhomarelookingthroughthelensofbuyingorsellingshares.

6.3MeaningofForecasting

Aplanningtoolthathelpsmanagementinitsattemptstocopewiththeuncertaintyofthefuture, relying mainly on data from the past and present and analysis of trends.Forecasting starts with certain assumptions based on the management's experience,knowledge,andjudgment.Theseestimatesareprojectedintothecomingmonthsoryears.

Note:ForecastingandBudgetingarenot the same.Abudget isanoutlineofwheremanagementwantstotakethecompany.Afinancialforecastisareportshowingwhetherthecompanyisgettingtoitsbudgetornot,andwherethecompanyisheading.

74

Budgeting represents a company’s financial position, cash flows and goals. It is re-evaluatedperiodicallywhereas forecasting estimates the company’s future financial outcomes by examininghistoricaldata.

Forecastingandbudgetingshouldworkintandemwitheachother.

6.4MethodsofForecasting

Therearecommonlytwomethodsthatareusedforforecasting.Theyare:

1. Percentage sales methods – The Percentage of Sales Method is a Financial Forecastingapproachwhich is based on the premise thatmost Balance Sheet and Income StatementAccountsvarywithsales.Therefore,thekeydriverofthismethodistheSalesForecastandbasedupon this, Pro-FormaFinancial Statements (i.e., forecasted) canbe constructedandthefirmsneedsforexternalfinancingcanbeidentified.

2. Budgetedexpensemethod– It calls forestimating thevalueofeach itemon thebasisofexpected developments in the future period for which the pro forma profit & loss a/c isbeingprepared.

6.4.1 CaseStudy

XYZ India-Statement of Profit and Loss

Particulars March31,2017 March31,2018Revenuefromoperations(Net) 1,200.00 1,280.00OtherIncome 8 10TotalRevenue 1,208.00 1,290.00Expenses:

Materialexpenses 547.00 590.00Employeebenefitsexpense 274 295Financecosts 60 65Depreciationandamortisationexpense 75 80Otherexpenses 98 103

Totalexpenses 1,054.00 1,133.00Profitbeforeexceptionalitemsandotherincome 154.00 157.00Exceptionalitems 30.00 32.00

XYZIndiaCaseStudy:

XYZIndia isaforprofitorganizationwhichis involveinthedistributionofsolarhousesysteminthetwostatesnamelyManipurandAssam.Nowtheorganizationisplanningtoexpanditsworkareainthenextyeari.e.2019.Thestrategiccommitteewantedtoknowwhatwouldbetheeffectoftheirthisplanontheoperatingvariablelikeamountofextrafundthatwillberequired,howthatfundwillberaised, operative expenses effect and income etc. Since organization is notwell equippedwith thetechniques thatwouldhelp in financial forecast,hiresyouasaconsultantof theorganization for2months and have been asked to project the effects in the next strategic meeting. Now Being aConsultantpreparetheFinancialProjectionofXYZ Indiaonthebasisofthe lasttwoyearshistoricaldataofprofitandlossa/candbalancesheetthatyouhaveretrievedfromfinancedepartment.

75

profitbeforeextraordinaryitemsandtax 184.00 189.00extraordinaryitems 0 0profitbeforetax 184 189.00taxexpenses 82 90

profit(Loss)fortheperiod 102.00 99.00

Particulars March31,2017 March31,2018

Dividends 60.00 63.00Retainedearnings 42.00 36.00

XYZ India-Balance Sheet Particulars March31,2017 March31,2018Revenuefromoperation 1200 1280EquityandLiabilities Shareholders’funds

ShareCapital(pervalueINR10) 300 300ReservesandSurplus 250.00 286.00

550.00 586.00

Non-currentLiabilities Longtermborrowing 500 505

Deferredtaxliability(net) 45 50Long-termProvisions 55 50

600 605

CurrentLiabilities shorttermborrowings 200 200

TradePayables 100.00 112.00OtherCurrentLiabilities 20 30Short-termProvisions 30 17

350.00 359.00

TOTAL 1,500.00 1,550.00

Assets Non-currentAssets FixedAssets TangibleAssets 750.00 775

IntangibleAssets 0 0CapitalWork-in-progress 0 0

DeferredTaxAssets(Net) 0 0Non-currentinvestment 40 40Long-termLoansandAdvances 60.00 60.00

850.00 875.00

CurrentAssets currentinvestment 30 33

Inventories 375.00 380TradeReceivables 200.00 212.00CashandBankBalances 25.00 28.00Short-termLoansandAdvances 20 22

76

OtherCurrentAssets 0 0

650.00 675.00

TOTAL 1,500.00 1,550.00

CaseStudySolution:E:\Work_office\CLEANProject\Financialmodellingusingspreadsheet.xlsx

§ For the accomplishment of future goals it is necessary to do the planning in advanceespeciallythefinancialplanning.

§ Financialplanningwillhelptoknowthepre-definedactivities/actionsthatmustbetakeninadvance.

§ Risksareuncertainbutonecanmakeanattempttominimizetheriskand forecasting isatool which helps to foresee the financial effects and help tominimize the uncertainty ofrisks.

77

Chapter7:FundraisingforaDREEnterprise


FundraisingforaDREEnterprise • Sourcesoffinance• MajorSchemesforenergyprogrammes• Factorstobeconsiderationbefore

borrowing• ApplicationandDocumentsRequired• Criteriaconsideredfordue-diligence

• Understanding the major sources ofraising finance and major schemes theDREEnterprisecouldexplore

• Essential factors that need to beconsidered before applying for loan,application process and documents to besubmitted.

• Preparingforthedue-diligenceprocess

7.1 Sourcesoffinance17

Table35:SourcesofFinance

Typeoffinance Keyfeatures ChallengesinaccessingGrantsbybilateral/multilateraldonoragencies,philanthropicorganisations

- Signifies one of themost soughtafter source of financing forenterprisesinthissector

- Financed early-stage enterprisestechnology development andprojects

- Interviews indicated thatenterprises/grassrootsorganisations cited lack of grantproposal writing skills andnetworking opportunities as ahindrance to accessing grantfunding

Grantschannelledthroughcompetitions

- Enterprises havebenefitted fromcompetitions organised by stategovernmentorprivateentities

- Only a handful enterprises canaccess grants through suchcompetitions

- Often, small scale regionalenterprises do not have thebandwidth to gain from suchevents

Debtfinancethroughbanks(publicsectorbanks,regionalruralbanks,commercialbanks)

- Debt financing echoed as theprimary financing need acrossenterprises

- Off-grid RE falls under RBI’sprioritysectorlendingnorms

- Banks charge 80%-100%collateral;

- Lack of sufficient collateral and 3years of proven track record is amajor challenge regardless of thetechnologyandenterpriseage.

- Administrative delays in loandisbursal (enterprises havereported delays of up to 2 yearsandmore)

- Lending rates of 12.5% - 14%andabove consideredunaffordablebyenterprises

17Source:UnlockingAccessToFinanceForDecentralisedEnergySolutionsunlocking,CleanEnergyAccessNetwork,2015)

78

- Difficultforsmallscaleenterprisesto avail loans above ₹. 50 lakhs(insufficientcollateral)

- Priorconnectionwithbank/branchmanagerholdsthekeywhichmaynotalwaysbethecase

- Uncertain revenue inflow andrelianceon subsidies (whichagainis a dicey proposition) detersbanks’confidence

- Branch manager is the finaldecision maker when it comes togivingloans

Venturedebt - Offers customised loans to smalland medium scale businessesthatlackaccesstosufficientdebtfinanceforworkingcapitalneeds

- Interest rates at a premium tocommercialbankrates

- Lendingrangesfrom18%-20%- Can offer collateral-free loans;lendingratesincreasewithrisk.

- Few enterprises pointed out highcostofdebt(highlendingrates)of18%-20%(+riskof5%orso)asthekeyproblem

DebtfinanceundertheCGTMSEscheme

- Not specific for off-grid REenterprises,meantforMSMEs

- AdministeredbySIDBI- Offerscollateralfreeloans- Loans are availed through PSUsandthebankshavetotakea25%risk and the government takes75%risk

- Theupperlimitofloansizeis₹.2crore

- Accessing loan under the schemeis a lengthy process withadministrativehurdles

Equityfinance/venturecapital/socialimpactinvestment

- Various equity investorsinterested in this space primarilyinclude social impact investorsAccessing equity investmentthrough social impact investorsrequires strong networks whichseveralenterpriseslack

- Equity investors have high returnexpectations.

Debt/equityraisedthroughprojectcallfacilitiesorganisedbyvariousinvestmentenablers

- Annual project call facilitiesprovide early stage support toshortlistedenterprises

- Canalsocoversoftcosts- Theprojectcall facilitiesmaynotfocussolelyonIndianenterprisesoronoff-gridREtechnologies

- The project call facilities arebackedbyfinancierssuchassuchas ADB, internationalgovernments,etc.

- As few of these investment-enabling organisations or eventsspend on advertising,enterprises/start-ups are oftenunaware of the existingopportunities that such initiativeshavetooffer.

79

Capitalsubsidies - Provided under MNRE’s JNNSMscheme for a gamut ofdecentralised RE solutions suchas solar lighting (lanterns, SHLS)solutions, 14 micro/mini grids(solar, biomass and small wind),wind watermills, biogasinstallations (NationalBiogasandManure ManagementProgramme,NMBPP),solarwaterpumps, and improved biomasscook stoves (Unnat ChulhaAbhiyan)havebeen instrumentalindiffusionofthesetechnologies.

- Untimelydisbursalofsubsidieshasproved to be a huge setback forsolarlightingenterprises.

Centralsubsidies - Capital subsidy offered byMNREon various technologies underdifferentprogrammes.

- Uncertain disbursal of subsidies,hugebacklogwithMNRE

- Subsidiesstifleproduct innovationdue to which costs don’t comedown

Projectfinancethroughgrants(projectaggregationmodel)

- Enterprises find it difficult tosource finance for setting upcapitalintensivemicro/minigrids

- Mostmicro/minigridsusegrantstocovercapitalcosts

- Aggregating projects can spreadriskovermultipleprojects

Crowdfunding

- Crowdfundingisyettopickupincountry’soff-gridREspace

- Online crowd fundingplatform/agencies help raisefinance

- Regular repayments (withinterest)needstobereturnedtothecrowdfundingagency

- Interviews pointed out thatenterprises were unaware ofcrowdfundsasasourceoffinance

CSR - CSR funds used not just for themore established off-grid REtechnologies but also nascentapplications

- CSRfundsfromcorporates,PSUs,public sector banks have beenmobilisedthusfar.

- Insufficient awareness amongstenterprisesonhowCSRfundscanbe used for energy accessinitiatives; lack of knowledgeabout technologies, theirapplications, sustainability andimpact.

Carbonfinancing(CDM)

- Organisations received carbonprice for per ton reduction inGHGemissions

- Marred by uncertainty aroundKyoto Protocol and decline incarbonprices

Source:(CleanEnergyAccessNetwork,2015)

80

End-userFinanceProviders18

Table36:EndUserFinance

End-userFinanceProviders

Details

MicrofinanceInstitutions Financialplayerslikelytohavehighlevelsofengagementintheshort-term.Theseincludesfinancialplayerswhopresentlyprovideconsumerfinancing for RE products and have the potential to increase theirfootprintinthesectorintheshort-term.

RegionalRuralBanksNABARDloansCSRdonationsPhilanthropicFoundationsREproductSupplier Financialplayersexpectedtohavehigher levelsofengagement inthe

medium-long term. This category includes two actors who could beleveraged,

MobileserviceProvidersPublicsectorbankPrivatesectorbank Financialplayersexpectedtohavelittleornoengagementeveninthe

longterm.Thiscategory includesplayerswhodonothaveafootprintinthesectorandareunlikelytoengageeveninthelongterm.

Foreignbank

7.2MajorSchemesforenergyprogrammes

Applicablelimit&purposeforloansforREunderprioritysector

• Bank loans up to a limit of ₹ 15 crore to borrowers for purposes like solar based powergenerators, biomass based power generators, wind mills, micro-hydel plants and for non-conventional energy based public utilitiesviz. street lighting systems, and remote villageelectrification.

• Forindividualhouseholds,theloanlimitwillbe₹10lakhperborrower.

• Source:https://rbi.org.in/scripts/bs_viewmascirculardetails.aspx?id=9857#C7

Category Manufacturing ServicesInvestmentinP&M CostofEquipment

Micro UptoINR25Lakhs UptoINR10LakhsSmall >INR25LakhsuptoINR5Crores >INR10LakhsuptoINR2CroresMedium >INR5CroresuptoINR10Crores >INR2CroresuptoINR5Crores

PradhanMantriMudraYojana(PMMY),MUDRA

Withintheframeworkandoverallobjectiveofdevelopmentandgrowthofmicroenterprisessectorunder Shishu, Kishor and Tarun, the products being offered byMUDRA are so designed, tomeetrequirementsofdifferentsectors/businessactivitiesaswellasbusiness/entrepreneursegments.This signify the stageof growth / development and funding needs of the beneficiarymicro unit /entrepreneurandalsoprovideareferencepointforthenextphaseofgraduation/growthtolookforwardto:

18AccesstoFinanceforMSMEsintheRenewableEnergySectorinIndia,TheDeutscheGesellschaftfürInternationaleZusammenarbeit(GIZ)

81

Undertheaegisofhascreatedproducts/schemes.

• Shishu:coveringloansupto50,000/-• Kishor:coveringloansabove50,000/-andupto5lakh• Tarun:coveringloansabove5lakhandupto10lakh

ThefundingsupportfromMUDRAareoffourtypes:• RefinanceSchemeforCommercialBanks/RegionalRuralBanks(RRBs)/ScheduledCo-

operativeBanks• WomenEnterpriseprogramme• Securitizationofloanportfolio

Security• AssetscreatedoutoftheBank’sfinance.• Nocollateralsecurity

Eligibility• All“Nonfarmenterprises”• under“MicroEnterprises”and“SmallEnterprises”segment• engagedin“incomegeneratingactivities”• engagedin“manufacturing,tradingandservices“and• whose“creditneedsareuptoRs.10.00lacs”• NowalliedagricultureactivitieshavealsobeenincludedunderPMMYschemew.e.f.

01.04.2016.

PrimeMinisterEmploymentGenerationProgramme(PMEGP)

• AttheNationallevel,ImplementedbyKhadiandVillageIndustriesCommission(KVIC),asthenodalagency.

• AttheStatelevel,theSchemeisimplementedthroughStateKVICDirectorates,StateKhadiandVillageIndustriesBoards(KVIBs)andDistrictIndustriesCentres(DICs)andbanks.

• TheGovernmentsubsidyundertheSchemeisroutedbyKVICthroughtheidentifiedBanksforeventualdistributiontothebeneficiaries/entrepreneursintheirBankaccounts.

• Objective: To generate employment opportunities in rural as well as urban areas of thecountrythroughsettingupofnewself-employmentventures/projects/microenterprises.

• QuantumofMarginMoneySubsidyisgivenasfollows:Themaximumcostoftheproject/unitadmissible(https://my.msme.gov.in/MyMsme/Reg/COM_PMEGPForm.aspx)manufacturingsector INR.25lakhbusiness/servicesector INR.10lakhPercapitainvestmentshouldnotexceed₹1.00lakhinplainareasand₹1.50lakhsinHillyareas.

CategoriesofbeneficiariesunderPMEGP Beneficiary’sowncontribution(ofprojectcost)

RateofSubsidy

Area(locationofproject/unit) Urban RuralGeneralCategory 10% 15% 25%Special(includingSC/ST/OBC/Minorities/Women,Physicallyhandicapped,Ex-Servicemen,NER,HillandBorderareasetc.

05% 25% 35%

82

StandupIndia

TitleoftheScheme-Stand-UpIndiaSchemeforfinancingSC/STand/orWomenEntrepreneurs.

Objective

§ Facilitatebankloans(termloans&workingcapital)between10lakhand1CroretoatleastoneScheduledCaste(SC)orScheduledTribe(ST)borrowerandatleastonewomanborrowerperbankbranchforsettingupagreenfieldenterprise.

§ Thisenterprisemaybeinmanufacturing,servicesorthetradingsector.

§ Incaseofnon-individualenterprisesatleast51%oftheshareholdingandcontrollingstakeshouldbeheldbyeitheranSC/STorWomanentrepreneur.

Eligibility

§ SC/STand/orwomanentrepreneurs,above18yearsofage.§ Loansundertheschemeisavailableforonlygreenfieldproject.Greenfieldsignifies,inthis

context,thefirsttimeventureofthebeneficiaryinthemanufacturingorservicesortradingsector.

§ Incaseofnon-individualenterprises,51%oftheshareholdingandcontrollingstakeshouldbeheldbyeitherSC/STand/orWomenEntrepreneur.

§ Borrowershouldnotbeindefaulttoanybank/financialinstitution.Security

Besidesprimarysecurity,theloanmaybesecuredbycollateralsecurityorguaranteeofCreditGuaranteeFundSchemeforStand-UpIndiaLoans(CGFSIL)asdecidedbythebanks.

Repayment-Theloanisrepayablein7yearswithamaximummoratoriumperiodof18months.

OperatedbyallthebranchesofscheduledcommercialbanksinIndia

Source:https://www.standupmitra.in/Home/SUISchemes

CreditGuaranteeFundTrustforMicroandSmallEnterprises(CGTMSE)

• ItisadministeredbySIDBIandofferscollateralfreeloans

• ME&SEareeligible

• CreditguaranteecoveruptoINR2CroresforMSEloanswithoutcollateralsecurityandthirdpartyguarantee

• Bothmanufacturingandservicesectorareeligible

Category MaximumextentofGuaranteewherecreditfacilityis Upto5lakh Above5lakhupto50

lakhAbove50lakhupto200lakh

MicroEnterprises 85%oftheamountindefaultsubjecttoamaximum

75%oftheamountindefaultsubjecttoamaximumof37.50lakh

75%oftheamountindefaultsubjecttoamaximumof150lakh

83

of4.25lakhWomenentrepreneurs/UnitslocatedinNorthEastRegion(incl.Sikkim)(otherthancreditfacilityupto5lakhtomicroenterprises)

80%oftheamountindefaultsubjecttoamaximumof40lakh

Allothercategoryofborrowers

75%oftheamountindefaultsubjecttoamaximumof37.50lakh

PUBLICSECTORBANKS(21nos.)

PRIVATESECTORBANKS(20nos.)

FOREIGNBANK(5nos.)

FINANCIALINSTITUTIONS(9nos.)

REGIONALRURALBANKS*(51nos.)

AllahabadBank CatholicSyrianBank

BankofBahrainandKuwait

AndhraPradeshStateFinancialCorporation

AllahabadUPGraminBank

AndhraBank CityUnionBank. BarclaysBankPLC

DelhiFinancialCorporation

AndhraPradeshGrameenaVikasBank

BankofBaroda DevelopmentCreditBankLtd.

DBSBank ExportImportBankofIndia

AndhraPragathiGrameenaBank

BankofIndia HDFCBankLtd. DeutscheBank

Jammu&KashmirDevelopmentFinanceCorporationLtd

AssamGraminVikashBank

BankofMaharashtra

ICICIBankLtd.* StandardCharteredBank

KeralaFinancialCorporation

BangiyaGraminVikashBank

CanaraBank IDFCBankLtd. NationalSmallIndustriesCorporationLtd.

BarodaGujaratGraminBank

CentralBankofIndia

IndusIndBankLtd.

NorthEasternDevelopmentFinanceCorporationLtd.

BarodaRajasthanKshetriyaGraminBank

CorporationBank

KarnatakaBankLtd.

SmallIndustriesDevelopmentBankofIndia

BarodaUttarPradeshGraminBank

DenaBank KotakMahindraBankLtd.*

TheTamilNaduIndustrialInvestmentCorporationLtd.

BiharGraminBank

IDBIBankLimited

LakshmiVilasBank

CentralMadhyaPradeshGraminBank

IndianBank TamilnadMercantileBankLtd.

ChaitanyaGodavariGrameenaBank

IndianOverseasBank

TheDhanalakshmi

ChhattisgarhRajyaGraminBank

84



FOREIGNBANK(5nos.)



BankLtd.

OrientalBankofCommerce

TheFederalBankLtd.

DenaGujaratGraminBank

Punjab&SindBank

TheJammu&KashmirBankLtd.

GraminBankOfAryavart

PunjabNationalBank

TheKarurVysyaBankLtd

HimachalPradeshGraminBank

StateBankofIndia*

TheNainitalBankLtd.

J&KGrameenBank

SyndicateBank TheRatnakarBankLtd.

JharkhandGraminBank

UCOBank TheSouthIndianBankLtd.

KarnatakaVikasGrameenaBank

UnionBankofIndia

YESBankLimited KashiGomtiSamyutGraminBank

UnitedBankofIndia

KaveriGrameenaBank

VijayaBank KeralaGraminBank

LangpiDehangiRuralBank

MadhyaBiharGraminBank

MadhyanchalGraminBank

MaharashtraGraminBank

MalwaGraminBank

MeghalayaRuralBank

MizoramRuralBank

NarmadaJhabuaGraminBank

OdishaGramyaBank

PallavanGramaBank

PandyanGramaBank

85



FOREIGNBANK(5nos.)



PragathiKrishnaGraminBank

PrathamaBank

PuduvaiBharathiyarGramaBank

PunjabGraminBank

PurvanchalBank

RajasthanMarudharaGraminBank

SaptagiriGrameenaBank

SarvaHaryanaGraminBank

SarvaU.P.GraminBank

SaurashtraGraminBank

SutlejGraminBank

TelanganaGrameenaBank

TripuraGraminBank

UtkalGrameenBank

UttarBangaKshetriyaGraminBank

UttarBiharGraminBank

UttarakhandGraminBank

VananchalGraminBank

VidharbhaKonkanGraminBank

*Note:1.ConsequentuponamalgamationofnumberofRegionalRuralbanks (RRBs)beginningFY2012-13 at the instance ofMinistry of Finance,Govt. of India, the total number of RRBs reducedfrom66to56bytheendofcurrentFY2. All six Associate banks of State bank of India havemergedwith it.(BharatiyaMahila Bank Ltd.,

86



FOREIGNBANK(5nos.)



SBBJ,SBP,SBM,SBH,SBT)3.INGVysyaBankLtd.mergedwithKotakMahindraBankLtd.4.TheBankofRajasthanLtd.mergedwithICICIBankLtd

DifferentialRateofInterest(DRI)SchemeBankLoan

Provides bankloan at a concessional rate of interest of 4% per annum for productive / selfemploymentventures.SC/ST,minoritiesandphysicallyhandicappedpersonsaretargetedunderthisschemetoboostfinancialinclusion.

Categoriesofpersonseligible:

• ScheduledCases/ScheduledTribesandothersengagedonaverymodestscaleinAgricultureand/oralliedagriculturalactivities.

• Peoplewhothemselvescollectordoelementaryprocessingofforestproductsandpeoplewhothemselvescollectfodderindifficultareasandsellthemtofarmersandtraders.

• Peoplephysicallyengagedonamodestscaleinthefieldsofcottageandruralindustries• Physicallyhandicappedpersonspursuinggainfuloccupation.Inadditiontotheabove,theapplicantmustmeetthefollowingeligibilitycriteria:

• FamilyincomenotexceedingRs.18,000/-p.a. inruralareasandRs.24,000/-p.a.urban/semiurbanareas.

• Landholdingdoesnotexceed1acreirrigatedor2.5acresincaseofun-irrigatedland.• SCs/STs are eligible for loan irrespective of their land holding, provided they satisfy other

eligibilitycriteria.• Thebeneficiarylargelyworksonhisownandwithsuchhelpasothermembersofhisfamily.• ThebeneficiaryshouldnothaveanothersourceoffinancewhileDRIloanexists.

7.3 Factorstobeconsiderationbeforeborrowing

Bank'sLendingCriteria

Banksandotherlenderstendtosettheirowninternalrules.Nevertheless,allfinancialinstitutionsareboundbygeneralregulationsandguidelinesestablishedbytheirnationalfinancialauthorities(forinstance,thecentralbank).

• Good Cash Flow :As a borrower, youmust show that your performance is positive and thatoperationarenotonlyprofitablebutalsogeneratesufficientcashtocoverallcommitments.

• Adequate Shareholders' Funds: In other words, youmust not be already over-committed tootherlenders,buthaveareasonableproportionofyourowncapitalinthebusiness.

• AdequateSecurity:Youwillnotobtaincreditfromabankifallyourassetsarealreadypledgedtootherlenders.

• ExperienceinTrading:Mostinstitutionlikestoknowthatyouhaveagoodrecordofsuccessfultrading.Itisdifficulttoconvinceabankertolendyoumoneyifyouarecompletebeginner,orif

87

you are starting a completely new trading activity with untried products and unknowncustomersorsuppliersincountriesyouhaveneverdealtwithbefore.

• GoodReputation:Your referencesandcredentialsmustbeacceptable to lenders.Theywouldnodoubtfinditdifficulttoconvincetheirloanscommitteeorboardtoapproveanadvancetoabankruptcompanyoraknowncrook!But,evenassumingthatyourpastiswithoutblemish,itishelpful to have the backing of a reputable sponsor. This could be a well-known person inbusiness,yourtradeassociationorevenyourcustomerorsupplier.

• Specific Purpose:Although some lenders grantoverdraft facilitieson thebasis of the securityyouoffer,mostinstitutionsprefertolinktheirloanstospecifictransactions.Transactionsmustbeexplainedinfulldetailandshowntobeprofitableandself-liquidating(moneyborrowedwillberepaidfromproceedoftransactionstobefinanced).

RatingParameters

The lenders (Banks/ Venture Capitalists, etc.) carefully assess your credit worthiness and assignratings by analysing your business information with respect to various parameters. The mainparametersthataregenerallyusedtoratebusinessentitiesareprovidedbelow

Management Financial Operational

Industry PastLoanPerformance

Background Currentratio Proximitytobranch

Natureofindustry–cyclical/seasonal

Prepayments

Industryexperienceandknowledge

Debtequityratio Locationofunit

Eligibilityunderassistancescheme,ifany

Re-paymenthistory

Pastconductofborrowerwithbanks

Averageturnover Borrowersproximitytomarket

Competitiveadvantage Missedinstallments

Qualifications Netprofits Typeoftechnology

Brandingofproduct Revisionininterestrates/period

BackgroundandCapabilityofthePromoters

Incomegrowth Equipmentsupplier

Numberofapplicationsofproduct/machinery

DefaultsMonthofdefaultAmountofdefaultReasonofdefault,ifprovidedSecurityre-salevalueCapitallosstobank

Organisation'sPreparednessformeetingChallenges

Netcashaccruals Qualitycertifications

Combinednetworthofpromoters

FinancialProjectsandDebtServicingCapabilities

Associateconcerns

Provisionofsecurityforproposedassistance/Qualityofcollateralsecurity

88

1.LiquidityTheterm‘liquidity’impliestheabilitytoproducecashondemand.Abankmainlyutilizes‘itsdepositsforthepurposeofgrantingadvances.Thesedepositsarerepayableondemandorontheexpiryofaspecifiedperiod.Tomeetthedemandofthedepositorsintime,banksshouldkeeptheirfundsintheliquidstate.Moneylockedupinlong-termloanscannotbereceivedbackintimeandsoarelessliquid.

2.ProfitabilityLike all other commercial institutions, banks are run for profit. Even government-owned‘banksarenoexceptiontothis.Banks earn profit to pay interest to depositors, declare a dividend to shareholders, meetestablishment charges and other expenses, provide for reserve and for bad and doubtfuldebts, depreciation, maintenance and improvements of property owned by the bank andsufficientresourcestomeetcontingentloss.Soprofitisanessentialconsideration.Abankeremployshis/herfundsinsuchawaythattheywillbringhim/heradequatereturn.

3.SafetyandSecurityThebankerwouldensurethattheborrowerhastheabilityandthewillingnesstorepaytheadvancesasparagreement.Closely allied to this point is that before granting a secured advance, he should carefullyconsiderthemarginofsafetyofferedbythesecurityandpossibilitiesoffluctuationsinvalue.If it is an unsecured advance, its repayment depends on the creditworthiness of theborrower,andthatoftheguarantor.As such, the cardinal principles which the banker should consider in case of unsecuredadvancesarea character, capacity,andcapital (popularlyknownas the3C’s)or reliability,responsibility, and resources (popularly known as the 3 R’s) of the borrower and theguarantor.

4.PurposeThebankercarefullyexaminesthepurposeforwhichtheadvancehasbeenappliedfor.Incasetheadvance is intendedforproductivepurposes, itcouldbereasonablyanticipatedthatcashflowsarisingforproductiveactivitieswillresultinpromptrepayment.Thebankeriscarefultomonitortheexactpurposeforwhichtheadvanceisactuallyutilized.

5.SourcesofRepaymentBeforegivingfinancialaccommodation,abankerconsidersthesourcefromwhichrepaymentispromised.Insomeinstances,debentureswhicharetoberedeemedinfewmonths’timeoralifeinsurancepolicywhichistomatureinnearfuturemaybeofferedassecurity.Advancesagainstsuchsecuritygivenotrouble.Sometimes customersmay apply for loans for additionalworking capital for their businessandundertaketorepayoutoftheprofitsoveraperiod.In such cases, the rate at which the customer can reasonably hope to repay should beascertained.A lenderwill lookatwhetherthebusiness ismakinganymoneyorwhetheryouhaveothermeans to pay the bank back. If this is a new business, then you will need to provideinformationtothebankonwhethercollateral,orsomeothermeans,willbeusedtherepaytheloan.

6.DiversificationofRisk

89

Thesecurityconsciousnessofabankerandthe integrityoftheborrowerare ‘notadequatefactors tokeep thebankeron thesafeside.What isalso important is thediversificationofrisk.Thismeansthebankershouldnotlendamajorportionofhis/herloan-ablefundtoanysingleborrowerortoanindustryortooneparticularregion.Otherwise,anadversechangeintheeconomymayaffecttheentirebusiness.In such a case repayment will be highly difficult and the survival of the bank becomesquestionable.Thereforeabankshouldfollowthewisepolicyof“donotputalltheeggsinasinglebasket.”Thebankmustadvancemoderatesumstoalargenumberofcustomersspreadoverawideareaandbelongingtodifferentindustries.

7.SocialResponsibilityWhileadmittingthatbanksareessentiallycommercialventures,abankshouldnotforgetthefactthatitisnotenoughthatonlypeopleofmeansaregivenbankfinance.Through productive effort, bank finance shouldmake people creditworthy, and turn themintopeopleofmeans.Technicalcompetenceof theborrower,operational flexibility,andeconomicviabilityof theproject, rather than the security which the borrower can offer, should be considered inevaluatingaloanproposal.The identification of priority sectors for the purpose of extending bank credit should beconsideredasapositivedevelopmentinthebankingsystem,aimedateffectivelydischargingitsresponsibilitytowardssociety.

7.4 LoanApplicationandDocumentsRequired

A good business plan (annexure I) is built on solid information (a specimen of loan application isshowedinannexureII).Thatinformationcanbeorganizedinmanydifferentwaysbuttheessentialingredientsremainthesame:

• LocationandTechnology• Agreements• SponsorsandAdvisors• Market• Implementation• Finance• Impacts• Risks

• LocationandtechnologyIn this section of a business plan the project is introduced by its location and the proposedtechnology to be employed. This description includes the inputs (fuels, labour, etc.), the process(equipmentconfiguration)andtheoutputs(steam,electricity,etc.)oftheproject.• AgreementsThissectionofthebusinessplandescribesallofthelegalagreements,includingpermits,requiredtoconstructandoperatetheproposedproject.

90

• SponsorsandadvisorsThis section describes the project’s sponsors, their commitment to the project, the form of theproposedProjectCompanyandtheadvisorsassistingintheproject’splanningandimplementation.• MarketThissectiondescribesthecountry,itslegalandregulatorystructureandthecustomerstowhomtheoutputoftheprojectwillbesold,includingtheircapacityandwillingnesstopay.• ImplementationThissectiondescribesthespecificstepsandscheduletoprogresstheprojectfromitspresentstatustocompletionandoperation.• FinanceIn this section all of the financial features of the project are presented. The most importantfinancial assumptions of the project are shown, the proposed financial plan is described and ananalysisismadeoftheimpactofvariouschangestothebasicfinancialassumptions.• ImpactsSocial and environmental benefits, and any other special features regarding the project arepresentedhere.• RisksThissectiondescribestherisksthattheprojectfacesandhowtheprojectplanstodealwiththeserisks.

• Inadditiontotheseelements,abusinessplancontains:

- CLOSING, which describes the project’s proposed capitalization plan and what is beingrequestedfromlendersandinvestors;

- COVER, which provides simple but crucial information to help readers understand thedocumentandlocatetheentrepreneur;

- AnexecutiveSUMMARY,whichtriestotelltheproject’s“story”inoneortwopages;- AsetofATTACHMENTS,whichprovidedetails concerningsomeof thepointsmade in the

businessplan.KindlyrefertotheAnnexure-I,whereinhavesharedthespecimenofloanapplicationformandCMAsheetofIDBIBankwhichismorerelevantforSMEs.DocumentsRequired-CHECKLISTofDocumentsrequiredalongwiththeproposal

1. Proof of Identity: Voter’s ID Card / Passport / Driving License / PAN Card / Signatureidentificationfrompresentbankersofproprietor,partnerofdirector(ifacompany)

2. Proof of residence: Recent telephone bills, electricity bill, property tax receipt /Passport /voter’sIDCardofProprietor,partnerofDirector(ifacompany)

3. ProofofbusinessAddress4. ApplicantshouldnotbedefaulterinanyBank/F.I.5. Last threeyearsbalance sheetsof theunits alongwith income tax / sales tax returnsetc.

(Applicable for all cases from ₹. 2 lakh and above) However, for cases below fund based

91

limits of ₹. 25 lakh if audited balance sheets are not available, then un audited balancesheetsarealsoacceptableasperextantinstructionsofthebank.

6. MemorandumandarticlesofassociationoftheCompany/PartnershipDeedofpartnersetc.7. Assets and liabilities statement of promoters and guarantors alongwith latest income tax

returns.8. RentAgreement(ifbusinesspremisesonrent)andclearancefrompollutioncontrolboardif

applicable.9. SSI/MSMEregistrationifapplicable.10. Projectedbalancesheetsforthenexttwoyearsincaseofworkingcapitallimitsandforthe

periodoftheloanincaseoftermloan(Forallcasesof₹.2lakhandabove).11. In case of takeover of advances, sanction letters of facilities being availed from existing

bankers/FinancialInstitutionsalongwithdetailedtermsandconditions.12. Photocopiesof leasedeeds/ titledeedsof all thepropertiesbeingofferedasprimaryand

collateralsecurities.13. Position of accounts from the existing bankers and confirmation about the asset being

standardwiththem.(incaseoftakeover).

ForCasesWithExposureabove₹.25Lakh(Additionaldocuments)

14. Theauditedbalancesheetsarenecessary.15. Profileoftheunit(includesnamesofpromoters,otherdirectorsinthecompany,theactivity

beingundertakenaddressesofallofficesandplants,shareholdingpatternetc.16. LastthreeyearsbalancesheetsoftheAssociate/GroupCompanies(ifany).17. Projectreport(fortheproposedprojectiftermfundingisrequired)containingdetailsofthe

machinery tobeacquired, fromwhom tobeacquired,price,namesof suppliers, financialdetails like capacity of machines, capacity of utilization assumed, production, sales,projectedprofitandlossandbalancesheetsforthenext7to8yearstilltheproposedloanisto be paid, the details of labour, staff to be hired, basis of assumption of such financialdetailsetc.

18. Review of account containing month wise sales (quantity and value both), production(quantityandvalue), imported rawmaterial (quantityandvalue), indigenous rawmaterial(quantityandvalue),valueofstocksinprocess,finishedgood(quantityandvalue),debtors,creditors,bank’soutstandingforworkingcapitallimits,termloanlimits,billsdiscounted.

19. Manufacturingprocessifapplicable,majorprofileofexecutivesinthecompany,anytie-ups,detailsaboutrawmaterialusedandtheirsuppliers,detailsaboutthebuyers,detailsaboutmajor-competitors and the company’s strength and weaknesses as compared to theircompetitorsetc.

(Thecheck list isonly indicativeandnotexhaustiveanddependingupon the local requirementsatdifferentplacesadditioncouldbemadeasper(necessity).

7.5 Criteriaconsideredfordue-diligenceLenderslookatthefollowingfiveareasindeterminingwhetherornotaloanapplicantqualifiesforaloan:

1. Canyourepaytheloan?2. Whatdoesthecredithistorylooklike?3. Doyouhaveanyequityinthebusiness?

92

4. Whatissecuringtheloan?5. Howmuchexperiencedoyouhaveinrunningthisbusiness?

1.Canyourepaytheloan?

Yes, banks do want to know that they aren’t just giving money away. So what can you do todemonstrate that you pay them back? A lender will look at whether the business is making anymoneyorwhetheryouhaveothermeanstopaythebankback.Ifitisanewbusiness,thenyouwillneedtoprovideinformationtothebankonwhethercollateral,orsomeothermeans,willbeusedtherepaytheloan.

2.Whatdoesthecredithistorylooklike?

Itisimportanttoknowwhatthecreditscoreis.Requestacopyofthecreditreportwellinadvanceofsubmittingtheloanapplication,sothatitcanbereviewedandanyerrorsmaybecorrected.Ifthebusinesshasalsoestablishedcredit,boththepersonalandbusinesscreditscore.

3.Doyouhaveanyequityinthebusiness?

Theamountofequitywillbereflectedinthecompany'sbalancesheet,andisusuallyduetoeitheran investmentof fundsor throughearnings thathavenotbeenre-invested.The lendersgenerallypreferthatabusinessdebtnotexceedfourtimestheamountofequity.Shouldthebalancesheetnotreflectthisstandard,itmaybenecessarytoseekoutadditionalsourcesoffunding.

4.Whatissecuringtheloan?

Collateralareassetsthatcanbesoldtopaybacktheloan,andcanbepledgedbytheborroweroraco-signortotheloan.Thevalueofthecollateralisgenerallydiscounted.

5.Howmuchexperiencedoyouhaveinrunningthisbusiness?

Itwillbedifficulttoobtainaloanwithoutanyexperienceinthelineofbusinessforwhichtheloanapplicant is seeking a loan. The loan applicant should be able to demonstrate that she or he hasexperience,orthattheyarehiringorpartneringwithpeoplethathaveexperience.

It is essential that the organisation has adequately prepared a business plan, as well as the loanapplication.Alsotheweaknessesshouldbeidentifiedandaddressed.

93

Chapter8:IntroductiontoBusinessandFinancialRisk

Topics LearningObjectives

IntroductiontoBusinessandFinancialRisk• Riskanditsdifferenttypes• RiskManagement• RiskMeasurementandmonitoringtool• RiskMitigationstrategies

• Participantswillunderstandaboutthemeaningofriskanditsdifferenttypes.

• Theywilllearntheimportanceofmanagementofriskinthesectoranddifferentwaystomitigateandmonitorrisk.

8.1Riskanditsdifferenttypes

MeaningofRisk:Riskimpliesfutureuncertainty,aprobabilityofthreatorlossthatiscausedbyexternalorinternalvulnerabilitiesandthatmaybeavoidedthroughpre-emptiveaction.DifferenttypesofRiskprevailinginthesector

1. Product/TechnologyRisk2. Management/GovernanceRisk3. OperationalRisk4. ClientRelatedRisk5. FinancialRisk6. PolicyandRegulatoryenvironmentRisk7. HumanResource

Theseriskarefurtherdividedintotwocategoriesi.e.externalandinternalrisk.Somerisksmaybeunpredictableandlinkedtolarge-scalestructuralcausesbeyondaspecificactivity(forinstance,financialrisks).Othersmayhaveexistedforalongtimeormaybeforeseentooccurinthefuture.Thus,toachieveastructuredandmanageableoverviewofallrisksfacinganorganization,ithelpstoclassifythemincategories.Thefollowingisonepossiblecategorizationsystem

• Riskslinkedtotheinternalenvironment,e.g.operationalrisks.Theseriskswilllargelybewithinthesphereofinfluenceoftheorganization,andneedtobeproactivelymanaged

• Riskslinkedtotheexternalenvironment,e.g.politicalrisksassociatedwithMemberStates’homeagendas.Theseriskswilllargelybeoutsidethesphereofinfluenceoftheorganization,andmayrequirerobustcontingencyplanning

• Riskslinkedtotheinterfacebetweenoneormoreorganizations(internalandexternalrisks),e.g.Relationshipsandpartnership.Managingtheserisksrequireclosecooperationwithpartnerorganizations.

94

Figure13:TypesofRisk

1. ProductandTechnologyRisk:a. Productsarenotofgoodqualityandtherearecomplainsofbreakdownand

requirementofaftersalesserviceb. Newtechnologiesaredevelopedandclientsfeeldissatisfiedwithenergyproduct

providedtothemc. Aftersalessupportandservicesnotadequated. Reliabilityofdesign,installationandmaintenanceofenergyproductsmaybeproblem

areasforDREenterprisesandthecustomers2. Management&GovernanceRisk

a. Board/investors/lenders/seniormanagementisnotfullycommittedornothaveconsensusonroadmapofenergylendingprogram.

b. Energyleadleaves3. OperationalRisk

a. Inventorymanagementb. Clientdecliningtheorderatthetimeofdeliveryoftheproductsc. Informationflow,reportingtemplate,structureandprocessarenotdesignedcarefully

andthereforedifficulttotrackstatusoftheprogram.4. ClientRelatedRisk

a. Clientsarenotusingproductsproperlyornotusingproductsatallb. Clientshavemisplacedexpectationsaboutproductperformanceandaftersalessupportc. Clientsdonotknowhowtoregisterforanduseaftersalesservicesd. Clientsunwillingtoinvestintechnicalproductsthatrequireahighinitialinvestment

suchassolar5. FinancialRisk

Internal Risk•Operational•Human Resource•Financial•Governance & Management•Client Related

External Risk•Product/Technology•Policy & Regulatory environment

95

a. Cashflowmanagementbetweenstreamsofcashinflows(advancepaymentfromclients,loanrepayment,processingfees,cashsalesproceed)andcashoutflow

b. Financialinstitutionsotherthanbankhavehigherrateofinterest.6. Policy&RegulatoryEnvironmentRisk

a. Suddenchangeinthecentralgovernmentpoliciesb. Lackofclarityonthesubsidyapplicationandapprovalprocess

7. HumanResourcea. Staffinabilitytomarketenergyproductsb. LackofinternalorganizationalcapacityandincentivestomarketREproductsand

recommendappropriateproducttoclients.

8.2RiskManagement

Definition: Risk managementis a systematic approach tomanagingrisksthroughoutthewhole organization byidentifying, assessing,understanding, acting on andcommunicatingriskissues.Systematic management ofrisk at all levels of theOrganizationandateachstageof programming will improveplanningefficiencyandservicedelivery, andwill allow betterand more reliable decision-making.

Figure14:RiskManagementprocess

Lackofinnovativefinancingandfinanciercapacitybuilding

DRE

Lowcostworkingcapital

Creditfromsuppliers

EndUsers

Lowcostfinance

Collateralfreeloans

96

Importance of Risk management: In the process it is an integral part of strategic planning andresults-basedmanagement.

I. It helps the management: Risk management will help senior management to planstrategically, allocate resources more wisely, and reform. It enables more responsibledecision-makingandhelpstoconstrainthreatstotheorganization.Monitoringtheresultsofriskmanagementwillbecomeapartofperformanceauditingensuringacloserlinkbetweenexpectedoutcomes,resultsandevaluation.Existingmanagementandreportingmechanismswillbeusedinordernottoincreasestaffworkload.

II. Itincreasesefficiency:Tomaximizeitsimpact,anorganizationhastotakerisks.Managingrisk enables organization to take the lead in its fields of competence and achieve betterresults especially working in adverse or unreliable environments. Risk managementfacilitates decision making and priority-setting and thus contributes to achieving theorganization’sgoalsmoreefficiently.

III. Itfacilitatesinnovation:Tobeinnovativeimpliestakingrisks.Riskmanagementencouragesstafftotakeriskswisely,whichmeansitsupportsinnovationwhileinsuringprudentdecisionmakingandmaintainingstakeholdertrust.

IV. It fostersa supportiveworkenvironment for self-reliance: Riskmanagement servesasatool for analysing causes and consequences of difficult situations rationally andsystematically. This enables staff to account for riskmanagement decisions by explainingreasons and evidence on which they are based and thus increases confidence and self-reliance. It is a tool for proactive thinking, learning from experience and for improvingteamwork.Itleadstoimprovedstewardshipandaccountability.

V. Itincreasesthecredibilityoftheorganization:Riskmanagementimprovesresultsandgivesassurance to member states and other stakeholders that goals will be met and thusimprovestheorganization’scredibilityandreputation.Effectiveriskmanagementenablesustoavoidcostlysurprisesbothintermsofspendingandcredibilityorreputation.(GIZ,2016)

8.3RiskMeasurementandMonitoringtool

NeedofMeasuringRisk

• Itisnotpossibletoknowthegravityofrisksunlesswemeasureandquantifythem.• Thecriticalityofariskisthefactorthatobligesresourceunitsandforcescoststobespentonit.• A tool is created based on the potential and features of a risk in an organization. It helps in

reviewingsuccess,failureordevelopments,andanalysetheefficiencyofriskcontrolmeasures.• Measuring risks provides clarity on the choice of actions and decisions that should enforce

balance in the risk-reward trade-off (wherein the degree of risk, high or low, is directlyproportionaltothereturn).

WaystomeasureriskTherearetwowaystomeasurerisk

1. QualitativeriskassessmentthroughSWOTanalysis,Historicaldataanalysis2. Quantitativeriskassessment:Itisadetailedamount/numberbasedanalysisonthetop

risks found during the Qualitative assessment. The top risks from the Qualitativeassessments are picked and then the assessment is done on them in terms of Cost,

97

Schedulebasedhitsetc.Oncetheassessmentiscompleted,therisksarethenregisteredin the system and thenmonitored throughout the project span. If they occur in realtime,corrective/necessaryactionshavetobetaken.

Figure15:Systemtomeasureriskintheorganisation

i. Attheapexliestheresponsibilitiesforriskgovernance,includingstrategicguidanceandriskoversight,whichrestswiththeboardofdirectors.

ii. In the middle lies the responsibility for risk infrastructure and management includingdesigning, implementing and maintaining an effective risk programme, led by executivemanagement.

iii. At the base lies the responsibility for risk ownership, including identifying, measuring,monitoringandreportingonspecificrisksledbythebusinessunitsandfunctions.

Table37:MeasuringofRisk

Riskculture

Riskstrategyandappetite

Riskgovernance

Riskresources/Infrastructure

Externaldisclosure

Riskmonitoringandreporting

Riskidentification

Riskassessment

Riskmanagement

Sr.No

TypesofRisk Informationrequiredtomeasurerisk Measuresofrisk

1 Institutional&GovernanceRisk–MissionDrift

Whoareyoureaching?-howmanyclients-profileofexistingclients

Numberofclientsservedtarget,actualprofileofclientsv/stargetprofileofclients

2 OperationalRisk–CreditRisk

Outstandingprincipalofallloanswithanoverdueandtotaloutstandingportfoliooftheorganisation

PARRepaymentrateDSCR

3 FinancialManagement-liquidityrisk

Valueofcurrentassetsandcurrentliabilities,cashandbankbalances

CurrentRatio,Cashflowstatements

4 ExternalRisk–foreignexchangerisk

CurrencyRates,trendsincurrencyrates

Exchangegainandlosses

OversightTonefromthe

Top

SystemsPeople-Process-Technology

ProcessIdentify->Measure>Respond->control-

>MonitorProcess

Oversight

System

s

98

8.4RiskMitigationStrategies

Below mention table contain different mitigation strategies to cover different types of the risksprevailinginthesector.(Sonntag-O’Brian&Usher,2004)

Table38:RiskMitigationStrategies

TypeofRisk MitigationstrategiesProductandTechnology

• Revisitexistingpartnershiparrangementsimmediatelyfollowingthepilottofocuscloselyonaftersalesserviceprovisions.

• Agreementtoincludebufferstockarrangementforservicingreplacementguarantee

• Ifnecessarybuildlinkageswithotherenergycompaniesthatofferstrongermaintenanceandaftersalesservices

• Insomesituationscollaboratingwithaninsurancecompanytocoverthetechnicalriskprovidesthebestcoverage.

• Researchanddevelopment

Management&GovernanceRisks

• Awareness,education,exposuretrips,clientvisits,visioningsessionswithallrelevantstakeholderstodevelopagreeduponplanofactionandbusinessplan.

• Timelyreportingandfeedbacksessionstodevelopconfidenceamongallstakeholders.

OperationalRisks

• Detailedenergyprogrammanualwithcarefullydocumentedprocesses,structure,rolesandresponsibilities,approvalmechanism,trainingandauditfunctionsandinformationflow.

• Monitoring,auditandfeedbackloopsareinplace.HumanResources

• Stafftrainingonsales,marketingandproductfeatures.Followupwithrefreshertraining.

• Salesprocessaudit• Designingincentivesinconsultationwithstaffearlyiterationsinorderto

settleonappropriateincentivestructure• Developtalentpoolforturnoverrelatedissues

ClientRelatedRisks

•Emphasisonrightsetofsalesstrategies•Adequateandeffectivecommunicationmaterialonproductfeatures,aftersalessupportandensuringthatclientacknowledgethesebeforepurchase•Auditofsalesprocessesandsatisfactionsurveys•Highqualityclientassessment,solidloantrackingandmonitoringsystemsandstrongandsoundcreditmanagementpolicies.

FinancialRisk •Designandmaintainacashflowmanagementsystem•Workingcapitalfinancinginplace•Currencyhedging•Properreviewandadherencewithpolicyandregulations

Policy&RegulatoryEnvironmentalRisks

• Understandregulatorylandscapeanddesigninnovatingmodels,ifpossible,forenergylendingprogramsexampleenergysubsidiarycompanymodel,productcompanyinvoicingclientdirectly

• Advancesshouldbetakenfromclients

99

References

Clean Energy Access Network, C. (2015). Unlocking access to finance for decentralisedenergysolutions,(April),1–40.

GIZ,D.G.für I.Z.(2016).AccesstoFinanceforMSMEsintheRenewableEnergySector inIndia.

National Institute forMicro, S. andM. E. (2015).MSME Schemes, 1–240. Retrieved fromhttp://msme.gov.in/WriteReadData/eBook/MSMESchemesNew.pdf

Sonntag-O’Brian, V., & Usher, E. (2004). Mobilising Finance for Renewable Energies.ThematicBackgroundPaper,(January).

Yadav,R.J.(2015).IssuesinSMEFinancing,1–62.

VideosLink:

1. IntroductiontoIncomeStatements:https://www.investopedia.com/terms/f/financial-statements.asp

2. BalanceSheetIntroduction:https://www.investopedia.com/terms/b/balancesheet.asp3. CashFlow:https://www.investopedia.com/video/play/what-is-cash-flow/4. IntroductiontoFreeCashFlow:https://www.investopedia.com/terms/f/freecashflow.asp5. IntroductiontoUnleveredCashFlow:https://www.investopedia.com/terms/u/unlevered-

free-cash-flow-ufcf.asp6. CapitalBudgeting:https://www.investopedia.com/video/play/capital-budgeting/7. SensitivityTechnique:https://www.investopedia.com/video/play/sensitivity-analysis/8. Breakevenanalysis:https://www.investopedia.com/terms/b/breakevenpoint.asp9. Whatisfinancialplanning?Howcanyoustart?:

https://www.youtube.com/watch?v=HMmZEgVpAK010. Forecasting:https://www.youtube.com/watch?v=2OUtRu7jb6M11. WorkingCapitalManagement:https://www.youtube.com/watch?v=bHK77lbdyWA

Annexure–I

TemplateforADB-UNESCO-IHEprojectproposals

RETA6498:KnowledgeandInnovationSupportforADB’sWaterFinancingProgram

KNOWLEDGEPARTNERSHIPBETWEENADBANDUNESCO-IHE

Date: __________________

ADB UNESCO-IHE

To: Director,RSID

Through: Director

From: Project/ActivityOfficer

To: Director,RSID,ADB

Through: UIHERectorate

UIHEPartnershipManager

From: ProjectLeader

PROJECTPROPOSAL

Whatisbeingrequested Pleasecheckoneormore

o Expertsforprojectpreparationandimplementationo Operational researchand jointstudies,bymakinguseof

PROJECTTITTLE:..............................................(Max50characters)

M.ScandPhDresearchstudentso Peerreviewofcomplexprojectso PromotingnetworkingamongclientsandK-hubso Contribution to ADB related sessions in workshops,

seminarsandforumso Educationandcapacitybuildingactivities (i.e.support to

capacity development of key sectororganizations/agencies in DMC; support to refresh theknowledge of staff from DMC country offices andknowledgesharingactivitieswithADBstaff)

o Support countryWaterAssessments, FutureofWater inAsiastudy,AsianWaterInfoSystem,etc.

Country

Projecttimingandduration

ProjectSize

- ForExpertinput:expressinperson-days/months- Forallotheractivities:provideanindicationofthenumberof

missions,ifapplicable

NatureofActivity Pleasecheckoneormore

o Linkedtoon-goingorplannedTAo Linkedtoanon-goingloano Linkedtoaplannedinvestmentprojecto Linkedto(sub)regionalcooperation

Withinwhichpriority theme(s) doesyourproposalfit?

Pleasecheckoneormore

o Government-corporate-societypartnerships,o Corporatizationofpublicutilitieso Partnershipswithknowledgeinstituteso Waterandclimatechangeo Waterandfoodsecurityo Water,environmentandecosystemso Sanitationandwastewatermanagemento Watergovernance

Isclimatechangebeingaddressedbytheproject?

Ifyes,pleaseprovidebriefexplanationhow

BRIEFDESCRIPTIONOFTHEACTIVITY(nomorethan2-3pages)

• Describetheactivityintermsofitsobjectivesandtheissuesorproblemsitseekstoaddress• IftheactivityislinkedorsupportingaspecificloanorTA,describebrieflywhataddedvaluedoes

thisactivityprovidetotheloanorTA.• Ifitisastand-aloneactivity(notlinkedtospecificloanorTA),describewhataddedvaluedoes

thisactivityprovidetoADB’soverallwatersectoroperationsinthatcountry.

ATTACHMENTS

• TermsofReferenceiftheproposalisforrequestingexpert/s• CopyofTAorProjectdocumentsifactivityislinkedtoaTAorloan• Otherrelevantdocuments

Annexure-II

Specimen-ApplicationforMSMELoan

Branch-CGRoad,Ahmedabad

SolId________________

APPLICATIONFORMFORMICRO,SMALL&MEDIUMENTERPRISES(MSMEs)

TobesubmittedalongwithdocumentsasperthechecklistApplicationforMSMELoan

Date:

1.NameoftheEnterprise*

2.Regd.OfficeAddress*

3.AddressofFactory/Shop*

4.WhetherBelongstoSC/ST/OBC/MinorityCommunity:NotApplicable

IfYes,thenPleaseSelect:SC/ST/OBC/MinorityCommunity

5.TelephoneNo.*

6.EmailAddress*

7.MobileNo.*

8.PANCardNo.

9.Constitution(PleaseSelect)*Individual/Joint/Prop.Concern/Partnership/Pvt.Ltd.Co/LimitedCo/Trust/others-Trust

10.DateofEstablishment*

11.State*

12.Citywhereloanisrequired*

13.Branchwhereloanisrequired.(Ifany)

14.NameofBoardofTrusteesandtheirAddresses:*Enclosure1

SN Name DateofBirth Father/Spouse AcademicQualification MobileNo1. 2.

Photographtobepastedatthetimeofsigningoftheapplicationinthedesignatedbranch.

3.

SN PANNo. ResidentialAddress TelephoneNo.(Residence)

Experienceinthelineofactivity(Years)

1. 2.

3.

15.1)Activity*

Proposed#_________

#ifadifferentactivityotherthanexistingactivityisproposed.

16.NamesofAssociateConcernsandNatureofAssociation:

NameofAssociateConcerns

AddressofAssociateConcerns

PresentlyBankingWith

NatureofAssociation

ExtentofInterestasaProp./Partner/DirectororJustInvestorinAssociateConcern

RelationshipofProprietors/Partners/DirectorswiththeofficialsoftheBank/DirectoroftheBank:Pleaseselect(Yes/No)_____

17.Banking/CreditFacilities(Existing)(Rs.inlakh)

TypeofFacilities

Limit(inlakh)

Outstandingason31stDec,2017

PresentlyBankingWith

Securities RateofInterest

RepaymentTerms

CurrentAccount

CashCredit TermLoan LC/BG Others Total

IfbankingwithourBank,customerIDbegivenhere:__________

18.CreditFacilities(Proposed)*

TypeofFacilities Amount(inlakh)

PurposeforwhichRequired

SecurityOfferedPrimarySecurity(Detailswithapprox.valuetobementioned)

WhetherCollateralSecurityOffered(If,yes,thenprovidedetailsoncolumn20)(Yes/No)

CashCredit** TermLoan LC/BG Others Total *MandatoryFields

**BasisofCashCreditLimitapplied

CashCredit

ProjectedSales Working

Cycleinmonths

Inventory Debtors Creditors Othercurrentassets

PromotersContribution

NotApplicable

19.Incaseoftermloanrequirements,thedetailsofmachinerymaybegivenasunder:

TypeofMachine/Equipment

PurposeforwhichRequired

WhetherImportedorIndigenous

NameofSupplier

TotalCostofMachine(incaseofimportedmachine,thebreakupofbasiccosts,freight,insuranceandcustomsdutymaybegiven)

Contributionbeingmadebythepromoters

LoanRequired(Rs.)

20.DetailsofCollateralSecuritiesOffered,ifany,includingthirdpartyguarantee

(AsperRBIguidelinesbanksarenottotakecollateralsecurityforloansuptoRs.10LakhstoMSMEUnits)

a)ThirdPartyGuarantee:

S.No NameofGuarantor

ResidentialAddress

TelephoneNo.(Residence)

MobileNo

Networth(Rs.inlakh)

PANNo

1. 2. 3.

b)OtherCollateralSecurity:

SN NameofownerofCollateral CollateralSecurity Nature Details Value(Rs.inlakh

1. 2. 3.

21.PastPerformance/FutureEstimates-

PastPerformance/FutureEstimates(Actualperformancefortwopreviousyears,estimatesforcurrentyearandprojectionsfornextyeartobeprovidedforworkingcapitalfacilities.Howeverfortermloanfacilitiesprojectionstobeprovidedtilltheproposedyearofrepaymentofloan)Rs.inlakh PastYear1

(Actual)PastYear2(Actual)

PresentYear(Estimate)

NextYear(Projection)

NetSales NetProfit Capital(NetWorthincaseofCompanies)

22.StatusRegardingStatutoryObligations:

StatutoryObligation:Remarks(AnydetailsinConnectionwiththerelevantobligationtobegiven)

WhetherCompliedwith(selectYes/No).IfnotapplicablethenselectN.A.1.RegistrationunderShopsandEstablishmentACT Yes/No/NA 2.RegistrationunderMSME(Provisional/Final) Yes/No/NA 3.DrugLicense Yes/No/NA 4.LatestSalesTaxReturnFiled Yes/No/NA 5.LatestIncomeTaxReturnsFiled Yes/No/NA 6.AnyotherStatutoryduesremainingoutstanding Yes/No/NA

22. a.)IDProof(Anyoffollowing):

Passport/VoterIdentityCard/PANCard/DrivingLicence/JobCard/AadhaarCard/IdentityCard(subjecttothesatisfactionofbank)

IDProofNo.PANCard-

b.)AddressProof(Anyoffollowing:

ElectricityBill/TelephoneBill/BankAccountStatementofanyotherbank/Letterfromreputedemployer/Letterfromrecognizedpublicauthorityverifyingtheaddressofthecustomertothesatisfactionofthebank/RationCard

AddressProofNo:_______________________________

Declaration:

I/We hereby certify that all information furnished by me/us is true; that I/We have noborrowing arrangements for the unit except is in the application; that there is no over dues/statutory dues against me/us/promoters except as indicated in the application; that I/We shallfurnishallotherinformationthatmayberequiredconnectionwithmy/ourapplicationthatthismayalso be exchanged by you with an agency you may deem fit and you, your representatives orReserveBankof Indiaor anyother agency as authorisedby you,mayat any time, inspect/ verifymy/ourassessmentofaccountetc.inourfactory/businesspremisesasgivenabove.

Signature:

(Tobesignedatthedesignatedbranchonly)

CHECKLIST

1. Proof of Identity: Voter’s ID Card / Passport / Driving License / PAN Card / Signatureidentificationfrompresentbankersofproprietor,partnerofdirector(ifacompany)

2. Proof of residence: Recent telephone bills, electricity bill, property tax receipt /Passport /voter’sIDCardofProprietor,partnerofDirector(ifacompany)

3. ProofofbusinessAddress4. ApplicantshouldnotbedefaulterinanyBank/F.I.5. Last three years balance sheets of the units along with income tax / sales tax returns etc.

(Applicableforallcasesfrom₹.2lakhandabove)However,forcasesbelowfundbasedlimitsof₹.25lakhifauditedbalancesheetsarenotavailable,thenunauditedbalancesheetsarealsoacceptableasperextantinstructionsofthebank.

6. MemorandumandarticlesofassociationoftheCompany/PartnershipDeedofpartnersetc.7. Assets and liabilities statement of promoters and guarantors along with latest income tax

returns.8. Rent Agreement (if business premises on rent) and clearance frompollution control board if

applicable.9. SSI/MSMEregistrationifapplicable.10. Projected balance sheets for the next two years in case ofworking capital limits and for the

periodoftheloanincaseoftermloan(Forallcasesof₹.2lakhandabove).11. In case of takeover of advances, sanction letters of facilities being availed from existing

bankers/FinancialInstitutionsalongwithdetailedtermsandconditions.12. Photocopies of lease deeds/ title deeds of all the properties being offered as primary and

collateralsecurities.13. Positionofaccountsfromtheexistingbankersandconfirmationabouttheassetbeingstandard

withthem.(Incaseoftakeover).

ForCasesWithExposureaboveRs.25Lakh(Additionaldocuments)

14. Theauditedbalancesheetsarenecessary.15. Profileof theunit (includesnamesofpromoters,otherdirectors in thecompany, theactivity

beingundertakenaddressesofallofficesandplants,shareholdingpatternetc.16. LastthreeyearsbalancesheetsoftheAssociate/GroupCompanies(ifany).17. Project report (for theproposedproject if term funding is required) containingdetails of the

machinery to be acquired, from whom to be acquired, price, names of suppliers, financialdetails like capacityofmachines, capacityofutilizationassumed,production, sales,projectedprofitandlossandbalancesheetsforthenext7to8yearstilltheproposedloanistobepaid,thedetailsoflabour,stafftobehired,basisofassumptionofsuchfinancialdetailsetc.

18. Reviewofaccountcontainingmonthwisesales(quantityandvalueboth),production(quantityandvalue),importedrawmaterial(quantityandvalue),indigenousrawmaterial(quantityandvalue),valueofstocksinprocess,finishedgood(quantityandvalue),debtors,creditors,bank’soutstandingforworkingcapitallimits,termloanlimits,billsdiscounted.

19. Manufacturing process if applicable,major profile of executives in the company, any tie-ups,details about raw material used and their suppliers, details about the buyers, details aboutmajor-competitors and the company’s strength and weaknesses as compared to theircompetitorsetc.

(Thecheck list isonly indicativeandnotexhaustiveanddependinguponthe local requirementsatdifferentplacesadditioncouldbemadeasper(necessity).

IDBIBankLtd

Branch………………..

ACKNOWLEDGEMENTOFLOANAPPLICATION

To ________________________________________

YourLoanApplicationdated:-_______________________

DearSir,

WeacknowledgereceiptofyourapplicationforLoanofRs._________on__________________.Theapplication isbeingtakenupforprocessing.Weshallget intouchwithyoushortlyforanyfurtherinformation if required in this regard and shall communicate disposal of the application in duecourse.

YoursFaithfully

BranchManager

NOTE:-1. Processingofapplicationissubjecttosubmissionofallnecessaryinformation/documentsrequired

forprocessingtheapplication.2. Sanctionof loan is subject to conformitywithBank’s policy andprocedures and is an entirely at

Bank’sdiscretion.3. Youmaypleasecontactthebranchmanagergivingtheaboveapplicationno.anddateofreceiptfor

anyfurtherinformation/clarifications.

…………………………………………………………….Pleasetearofffromhere………………………………………………………IDBIBankLtd

Branch………………..

COUNTERFOILFORACKNOWLEDGEMENTISSUED

Acknowledgementissuedto…………………………………………………………….forhis/her/theirloanapplicationdated…………………withapplicationNo._______________dated_______________.SignatureoftheApplicant BranchManager

ApplicationNo:__________ApplicationReceiptdate:_________

Friends of Women's World Banking, India 101, Sakar- I Building, Opp. Gandhigram Station,

Ashram Road, Ahmedabad -380009

A: A-23, 2nd Floor, Behind Green Park Free Church, Aurobindo Marg, Green Park Main, New Delhi- 10016 P: +91-11-41601543 W: thecleannetwork.org