Banking Strategy, Credit Appraisal, and Lending Decisions A Risk-Return Framework Second Edition Hrishikes Bhattacharya UNIVERSITY PRESS
Contents List ofappendices xi List ofannexures xii Preface to the Second Edition xiii Acknowledgements xv Introduction xvii 1. Capital Regulation and Risk Management Strategy 1 Introduction Inter-relationship among capital, assets, ROA, and ROE Competition for funds» Rise in losses <> Risk management: A strategic issue 2. Liquidity Management and Assets-Liabilities Strategy 32 Introduction Liquidity management theories Fluctuations in the economy Liquidity planning > Liquidity ratios Balance sheet approach > Deployment strategies Maturity matching strategy 3. Banking Strategy 65 Introduction Financial sector reforms Decline of traditional banking > Changing savings and investment behaviour Liquidity newly denned Securitisation Strategic planning Capital planning Growth model Banking strategy: The case of ABC Bank Strategic planning exercise of ABC Bank Cost allocation < Risk component Asset allocation Cost of funds Operational plan forfiveyears <> Concluding remarks 4. Lending Strategy and Loan Policy 105 Introduction Need for a loan policy Credit-deposit ratio The threat of dilution in the quality of loans Policy emphasis on non-fund business «Interest rate policy Loan portfolio and exposure policy» Loan-to-value ratio Repayment policy
viii Contents 5. Fixed Assets 125 Introduction Definition > Land and buildings > Factory shed location Plant and machinery» Depreciation Appreciation Capital work-in-progress Furniture and fixtures Motor vehicles 6. Working Capital: A Techno-Financial Approach 133 Introduction <> Should we hate current assets? <> Currentness concept and operating cycle theory <> Natural business year Negative operating cycle <> Limitations of operating cycle theory«mathematical fallacy«reversibility test An alternative theory of working capital o Discrete operating inventories Other discrete current assets Techno-financial approach Core working capital Projection of working capital Characteristics of Core Working Capital Control mechanisms 7. Current Assets and Fictitious Assets 152 Introduction Cash and bank balances Sundry debtors/receivables Inventory Valuation of inventories Various types of stocks/inventories Loans and advances Intangible and fictitious assets Fictitious assets 8. Long-term Liabilities 165 Introduction Definition Equity or share capital Contribution of promoters Authorised capital Issued and paid-up capital Fear of takeover Reduction of capital Limited liability: Banker s problem «Preference share capital Financing the redemption Share premium Dividend versus reserves Free reserves: The problem Bonus shares Capital reserve Banker's viewpoint Debentures» Term loan Loans from friends and relatives Loans from subsidiaries Modern financial instruments 9. Current Liabilities 190 Introduction Origination Danger of overtrading Safety margin «Trade creditors Deposits from customers and public Inter-corporate loans and investments «Bridge loans Commercial paper Registration of charges «Concluding remarks 10. Profit and Loss Account 207 Introduction Accounting concepts Nature of costs Wages Production overheads Maintenance and repairs Administrative costs Marketing and distribution costs Controllable versus uncontrollable cost Trading, manufacturing, and profit and loss account Gross profit Operating profit PBIT versus PBT «Trading companies Manufacturing companies Absorption costing versus direct costing Difference in profit measurement» Cost of goods sold Operating profit approach o Unusual incomes Concluding remarks
Contents ix 11. Understanding the Balance Sheet 230 Introduction Trial balance Treatment of closing stock Classification of accounts Balance sheet Net worth» Gearing of capital Shareholders versus banker o Format of a balance sheet Non-corporate borrowers Percentage balance sheet > Preliminary observations A business with no formal accounting system 12. New Era of Lending:Tandon Committee and Its Aftermath 267 Introduction I. TANDON COMMITTEE The norms Methods of lending» System mechanics End-use t Classifications of current assets and current liabilities II. CHORE GROUP Review of the lending system Cash credit system <> Loan system» Bill system Proposed scheme Drawee bill system <> Restructuring of financial statements, credit appraisal, and lending decisions Lending decision: An example «Credit appraisal Lending decisions: Problems with the MPBF system 13. Business Forecasting and Credit Decisions 323 Introduction The basic theory Variables «Regression analysis «Standard error of estimate t-distribution Coefficient of correlation Illustration Checking the assumptions Projection of sales Projected operating expenses «Projection of gross working capital t Projection of trade and expense liabilities Bank finance for working capital 14. Funds Flow and Cash Flow Analysis 341 I. FUNDS FLOW ANALYSIS Introduction Financing the total operation: Fourth concept Sources and uses of funds Generation of funds from operations Recommendations of IAS C <> Acquisition or disposal An illustration Suggested approach <> Calculation of bank finance for working capital II. CASH FLOW ANALYSIS Clearing the ground Value and obligation Cash and funds flow Cash book summary Detailed cashflowstatement Cash inflows o Motives for holding cash Cash outflows 15. Cost, Profitability, and Break-Even Analysis 383 Introduction Dilemma of an entrepreneur Full cost versus marginal cost Variable cost Fixed cost Semi-variable cost» Margin of safety Profit-volume ratio - Further problems of Pankaj Verma Problem of multiple products A simple method for a break-even analysis Financial break-even point Financial margin of safety Limitation and laws of marginal analysis
x Contents 16. Appraisal and Monitoring through Ratios 403 Introduction» Presentation and uses of ratios Manipulability of ratios» Objectivity in ratio analysis» Difficulties with ratios «Classification of ratios «Efficiency of operational management Efficiency offinancialmanagement Net working capital A situation with zero net working capital Implicit credit Treatment of contingent liabilities Efficiency of debt-service management <> Standards of comparison <> Concluding remarks 17. Project Appraisal: Methods and Techniques 433 Introduction «Banks' involvement in project financing > Policy changes > Non-financial appraisal Technical and managerial viability Financial appraisal Cost structure Depreciation Taxation <> Interest Discounted cash flow» Risk element Net present value Opportunity cost Internal rate of return Payback method «Average and effective rate of return Profitability index Repayment capacity«concluding remarks 18. Project Appraisal and Lending Decisions 463 Introduction Summary of the project Financial analysis of the project Cost structure Life of the project Salvage value» Estimating projected revenue Relevant cash flows Working capital and term loan > Cash flow from operations «Profitability index and internal rate of return NPV versus IRR Break-even point Debt-service coverage ratio 19. Small Business Loan 486 Introduction The case The need of the borrower Appraisal Alternative scenarios 20. Credit Risk Analysis 491 Introduction Business risk Measurement of sales risks Coefficient of variation Evaluation of sales forecast«sales risk index <> Measurement of operating risks o Measurement offinancialrisks Measurement of industry risk Methodology and results of analyses Industry risk category > Borrower risk «Character Lending decisions based on Cs Comprehensive borrower risk analysis Determination of final risk category Interest rate determination and margin requirement Bibliography 536 Index 541