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Analysis of Credit Appraisal






MBF 2008-2010


Mr. Ramesh Vege

Senior Manager, UBI, Bhopal


I hereby declare that the project report titled “Analysis of Credit Appraisal in Union
Bank of India” has been prepared by under the guidance of Mr. Ramesh Vege,
(Senior Manager), Mr. K.D. Lalwani(Senior Manager), Mr. Vinod Mathur,
Assistant Manager, Credit Division, Union Bank of India and Prof.
J.D.Agarwal, Director, Indian Institute of Finance, New Delhi.

I also declare that this project has not been submitted nor shall it be
submitted in future to any other University or Institution for the award of any
other Degree or Diploma.

Dated: 12/06/2009

(Apoorva Ghosh)

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This project is the result of my deep interest in the Banking sector. First of all, I would like to
thank Mr. Raman (General Manager, Zonal Office, Union Bank of India, Bhopal) for giving me
this opportunity and allowing me to work in the Finance Division of Regional Office of Union
Bank of India.

I would express my gratitude to my guide Mr. Ramesh Vege(Senior Manager,

Regional Office, Union Bank of India, Bhopal), for giving me an opportunity to undertake this
project, as a part of my requirement of Summer Training during my MBF Program. His valuable
advice and guidance has been a major factor in completion of this project.

I am also indebted to Mr. Khushal D. Lalwani (Asst. Manager, Union Bank of India,
Bhopal Branch), for giving his precious time in making me understand the practical difficulties
in Credit Appraisal and its management.

I would also thank Mr.Ramnathan (Assistant General Manager, Regional Office,

Bhopal), Mr. Rakesh Khare (Chief Manager, Regional Office, Union Bank of India) and Mr.
Vinod Mathur (Assistant Manager, Regional Branch), for lending out their helping hand in
making me understand the basics of Credit appraisal.

My deep sense of obligation goes to Prof. J. D. Agarwal, Chairman, Indian Institute of

Finance, and Prof. Aman Agarwal, Director, IIF, whose words of wisdom and motivation has
inspired me to come this long way.

Last but not the least, I would thank the faculty and staff members of Indian Institute
of Finance, who have extended their helping hand by sharing their knowledge and experiences.

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Date: 21/07/2009

Apoorva Ghosh

Project title : Credit Appraisal

Duration : 20th April to 13th June

Place of work : Bhopal

Institution : Union Bank of India

Project Guide : Mr. Ramesh Vege

Senior Manager,Union Bank of India


As a part of MBF programme, a student has to pursue a project duly approved by the Director of
the institute . I had the privilege of undertaking the project on Credit Appraisal. Credit Appraisal
is a process through which institutions like banks etc. try to continue giving quality loan to its
customers. One of the basic tenets of the loan policy is to ‘ensure continuous growth of loan
assets while endeavouring that they remain secure, performing and standard’. Loans and
advances constitute significant portion of a banks Balance Sheet. But lending activity is
associated with various risks, the most predominant being default risk. While default risk is
unavoidable/inescapable, risk mitigation is recognized as a significant technique.

This report also compares the strategies to deal with Credit Appraisal and to check the credit
worthiness of the customers. It further looks into the effect of the different techniques used for
Credit appraisal and suggests mechanisms to handle the problem by drawing on experiences
from different techniques used.
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My project is divided into 5 chapters.

The first chapter deals with the introduction to the organization I have worked with and the
current scenario of retail loans.

The second chapter deals with the review of literature related to credit appraisal.

The third chapter gives a brief account of the objective of the study, research methodology and a
brief review of other related literature.

Chapter four has all the analysis and interpretations.

Chapter five deals with the summary of major findings, discussions of results, suggestions and
limitations of the study.

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 About Union Bank of India Pg 8
 The Genesis of Banking in India Pg 13
 Retail Loans Offered By Union Bank Pg 17
- Union Home
- Union Top Up
- Union Miles
- Union Comfort
- Union Education
- Union Mortgage
- Union Smiles
- Union Shares


 Review of Literature Pg 49

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 Risk Management Pg 51
 Significance Pg 54
 Credit Risk Pg 57
 Credit Risk Management Pg 60

 General procedure to Compile a credit report Pg 63

 Sources of Information Pg 68


 Objective Pg 71

 Asset Liability Management Pg 72

 Computation Of Net Worth Pg 75

 Compliance with Accounting Standards Pg 77

 Balance Sheet Analysis Pg 81

 Profit and Loss Analysis Pg 99

 Common Window Dressing Techniques Pg 117

 Ratio Analysis Pg 118

 Break Even Point Pg 128

 Fund Flow Analysis Pg 134

 Cash Flow Analysis Pg 142

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 Term Loan Assessment Pg

 Technical Appraisal Pg 156

 Project report Analysis Pg 166

 Working Capital Assessment Pg 172

 Letter Of Credit Pg 175

 Letter Of Guarantee Pg 176


 Analysis Pg 178


 Findings Pg 196
 Limitations Pg 197

 Suggestion Pg 198

 Conclusion Pg 198


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• Bank of India Pg 17

• Balance sheet as per schedule vi Pg 83

• Balance Sheet for non- corporate entity Pg 85

• Proforma of P and L Pg 89

• Working Pool of Sources Pg 142

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The dawn of twentieth century witnesses the birth of a banking enterprise par excellence-
UNION BANK OF INDIA- that was flagged off by none other than the Father of the Nation,
Mahatma Gandhi. Since that the golden moment, Union Bank of India has this far
unflinchingly traveled the arduous road to successful banking........ A journey that spans 88
years. The Union Bank of India, reiterates the objective of their inception to the profound
thoughts of the great Mahatma... "We should have the ability to carry on a big bank, to
manage efficiently crores of rupees in the course of our national activities. Though we have
not many banks amongst us, it does not follow that we are not capable of efficiently
managing crores and tens of crores of rupees."

Union Bank of India is firmly committed to consolidating and maintaining its identity as a
leading, innovative commercial Bank, with a proactive approach to the changing needs of the
society. This has resulted in a wide gamut of products and services, made available to its
valuable clientele in catering to the smallest of their needs. Today, with its efficient, value-added
services, sustained growth, consistent profitability and development of new technologies, Union
Bank has ensured complete customer delight, living up to its image of, “GOOD PEOPLE TO
BANK WITH”. Anticipative banking- the ability to gauge the customer's needs well ahead of
real-time - forms the vital ingredient in value-based services to effectively reduce the gap
between expectations and deliverables.

The key to the success of any organization lives with its people. No wonder, Union Bank's
unique family of about 26,000 qualified / skilled employees is and ever will be dedicated and

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delighted to serve the discerning customer with professionalism and wholeheartedness.

Union Bank is a Public Sector Unit with 55.43% Share Capital held by the Government of India.
The Bank came out with its Initial Public Offer (IPO) in August 20, 2002 and Follow on Public
Offer in February 2006. Presently 44.57 % of Share Capital is presently held by Institutions,
Individuals and Others.

Over the years, the Bank has earned the reputation of being a techno-savvy and is a front runner
among public sector banks in modern-day banking trends. It is one of the pioneer public sector
banks, which launched Core Banking Solution in 2002. Under this solution umbrella, All
Branches of the Bank have been 1135 networked ATMs, with online Telebanking facility made
available to all its Core Banking Customers - individual as well as corporate. In addition to this,
the versatile Internet Banking provides extensive information pertaining to accounts and facets
of banking. Regular banking services apart, the customer can also avail of a variety of other
value-added services like Cash Management Service, Insurance, Mutual Funds and Demat.

The Bank will ever strive in its Endeavour to provide services to its customer and enhance its
businesses thereby fulfilling its vision of becoming “THE BANK OF FIRST CHOICE IN

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The Vision Statement

To become the bank of first choice in our chosen area by building beneficial
and lasting relationship with the customers through a process of continuous

The Mission Statement

 A logical extension of the Vision Statement is the Mission of the Bank,which is

to gain market recognition in the chosen areas.

 To build a sizeable market share in each of the chosen areas of business

through effective strategies in terms of pricing, product packaging and
promoting the product in the market.

 To facilitate a process of restructuring of branches to support a greater

efficiency in the retail banking field.

 To sustain the mission objective through harnessing technology driven banking

and delivery channels.

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 To promote confidence and commitment among the staff members, to address
the expectations of the customers efficiently and handle technology banking
with ease


Chairman & Managing Director


Executive Director

SHRI S.Raman
Executive Director Government of India Nominee


Government of India nominee on the recommendation of RBI.


Chartered Accountant Director


Director representing Workmen Employees


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Director representing Officer Employees


Government Nominee Director under General Category


Government Nominee Director under General Category


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Genesis of banking in India

Banking in India organized in the first decade of 18th century with The General bank of India
coming into existence in 1786. This was followed by Bank of Hindustan. Both these banks are
now defunct. The oldest bank in existence in India is the State Bank of India being established as
“The Bank of Calcutta” in Calcutta in June 1806. Couple of decades later, foreign banks like
HSBC and Credit Lyonnais started their Calcutta operations in 1850s. At that point of time,
Calcutta was the most active trading port, mainly due to the trade of the British Empire, and due
to which banking activity took roots and prospered. The first fully Indian owned bank was the
Allahabad Bank set up in 1865.

By the 1990s, the market expanded with the establishment of banks like Punjab National Bank,
in 1895 in Lahore; Bank of India in 1906, in Mumbai- both of which were founded under private
ownership. Indian banking sector was formally regulated by Reserve Bank of India from 1935.
After India’s independence in 1947, the Reserve bank of India was nationalized and given
broader powers.

Structure of the organized banking sector in India. Number of banks is in brackets.

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Central bank and supreme monetary authority

Scheduled banks

Commercial banks Cooperatives

Foreign Banks[40] Regional Rural Bank[196]

Urban Cooperatives[52] State Co-Op[16]

Public Sector Banks [27] Private Sector Banks [30]

Old [22] New [8]

State Bank of India & Associate banks[8] Other nationalized banks [19]

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SBI Group

The Bank of Bengal, which later became the State Bank of India. SBI with its seven associate
banks command the largest banking resources in India, SBI and its associates banks are :

• State Bank of India

• State Bank of Bikaner and Jaipur

• State Bank of Hyderabad

• State Bank of Indore

• State Bank of Mysore

• State Bank of Patiala

• State Bank of Saurashtra

• State Bank of Travancore


The next significant milestone in Indian banking happened in the late 1960s when the then Indira
Gandhi Government nationalized, on 19th July, 1964. 14 major commercial Indian banks,
followed by nationalization of 6 more commercial Indian banks in 1980. The stated reason for
the nationalization was more control of credit delivery. After this, until the 1990s, the
nationalized banks grew at a leisurely pace of around 4% also called as the Hindu growth of the
Indian economy. Currently there are 19 nationalized banks.

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In the early 1990s the then Narsimha Rao government embarked on a policy of liberalization and
gave license to a small number of private banks, which came to be known as New Generation
tech-savvy banks, which included banks like ICICI Bank and HDFC Bank. This move along
with the rapid growth with strong contribution from all the three sectors of banks, namely,
government banks, private banks and foreign banks. However, there had been a few hiccups for
these new banks with many either being taken over like Global Trust Bank have found the going

The next stage for the India banking has been setup with the proposed relaxation in the norms for
Foreign Direct Investment, where all Foreign Investors in banks may be given voting rights
which could exceed the present cap of 100%.

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Retail loans Offered by the Union Bank of India

Union Home:


• Indian Citizen - 21 years and above.

• Either single account or joint account with other family members viz., father, mother,
wife, son or daughter with regular source of income.
• Individuals who may be employed/self-employed in business having regular income.
• A minimum of 40% marks as per investment grade scoring chart.


• Purchase of independent house/flat.

• Construction of independent house/flat.

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• Repair/Improvement/Extension.
• Repayment of loan availed from another agency/Bank/NBFC.
• For purchase/ construction of 2nd property (independent house/flat)
• Plot sold by a Government-recognized agency viz., HUDA, HOUSEFED and such


• Max. Rs. 100 lacs for major 'A' class cities; for other cities Rs.50 lacs
• Max. Rs. 10 lacs for repair.


• For purchase/construction, 20% of the value of independent house/flat.

• For repairs, 20% of total cost of repair.
• For purchase of plot, 20% of the value of the plot.


• Moratorium up to 18 months wherever loan is taken for under construction flat or

• By EMI.
• The maximum repayment period should not exceed 20 years for construction / purchase
of house/ flat and 10 years for repair.
• Option of Flip/Step-up/Balloon methods of repayments for the convenience of the

Special Package (w.e.f. 16.12.2008)

Free Life Insurance Coverage for outstanding loan

No processing Charges
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No Prepayment Charges

Loan up to 5 Lac : 8.50% (reset After 5 year)

Margin : 10% by borrower

Loan from 5 Lac to 20 Lac : 9.25% (reset After 5 year)

Margin : 15 % by borrower

Special Combo Offer for Home Loan effective from 15.05.2009 to 30.09.2009

Special Combo Offer is applicable for loan upto 50 lacs

Loan upto Rs. 30 Lacs

Tenor Upto 5 year >5 Year to 10 >10 Year to 20 Year


Ist Year 8.00% 8.00% 8.00%

2nd Year till final BPLR - 2.75% BPLR - 2.50 % BPLR - 2.25 %
i.e . 9.25 % I .e. 9.50 % i.e 9.75 %

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Loan over Rs 30 Lacs upto 50 Lacs

Tenor Upto 5 year >5 Year to 10 >10 Year to 20 Year


Ist Year 8.00% 8.00% 8.00%

2nd Year till final BPLR - 2.50% BPLR - 2.25 % BPLR - 2.00 %
i.e . 9.50 % I .e. 9.75 % i.e 10.00 %


Applicable for the borrowers who availed loan up to Rs. 50 lacs only.

Free life insurance policy will not be availed to the


No takeover account from other bank/ institution to be permitted.

All other terms and conditions of Union Home Loan scheme will remain unchanged

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Rate of Interest (w.e.f. 01.04.2009 )

Up to Rs 30 Lacs Above Rs 30 lacs upto Rs 50 Lacs Above Rs 50 lacs

As on 01.04.2009 As on 01.04.2009 As on 01.04.2009

Floating Floating Floating

Upto 5 Yrs. Upto 5 Yrs. Upto 5 Yrs.

BPLR-2.75% = 9.25% BPLR-2.50% =9.50% BPLR-2.25% =9.75%

>5 Yrs to 10 Yrs >5 Yrs to 10 Yrs >5 Yrs to 10 Yrs

BPLR-2.50% = 9.50% BPLR-2.25% =9.75% BPLR-1.75% =10.25%

>10 Yrs to 15 Yrs >10 Yrs to 15 Yrs >10 Yrs to 15 Yrs

BPLR-2.25% = 9.75% BPLR-2.00% =10.00% BPLR-1.50% =10.50%

>15 Yrs to 20 Yrs >15 Yrs to 20 Yrs >15 Yrs to 20 Yrs

BPLR-2.25% = 9.75% BPLR-2.00% = 10.00% BPLR-1.50% = 10.50%

Fixed rates - upto Rs 30 lacs - 9.75% (upto 5 years)

Above Rs 30 lacs - 10.75% (upto 5 years)

BPLR = 12.00% with effect from 01.04.09

Processing Charges inclusive of applicable service tax

• 0.50% of loan amount subject to a maximum of Rs.15000/- plus service tax as applicable
• 0.25% of the loan amount at the time of application plus service tax as applicable
• 0.25% of loan amount on acceptance of sanction plus service tax as applicable

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• Free Building Insurance.
• Natural Death (other than accidental death) may be covered under Union Home Plus,
which is optional and additional loan can be sanctioned.
• Free Personal accident coverage (in case of death).

Value Added Services

• Credit Card will be issued (free of admission fees and annual fees during first year)
• Triple Insurance benefit
• No hidden or built-in costs
• Quick processing and disposal of loan applications
• Flexible repayment options

Guarantee Third party guarantee is not mandatory. HOME LOAN FOR PURCHASE OF 2nd

• Prospective borrower can include spouse or any other co-owner as a co-applicant.

• To enhance the loan amount, co-applicant's income can be taken into account while
calculating repayment capacity.


• Loan can be availed for the second property even while the existing house/flat is under
mortgage to Banks/Financial Institutions (subject to conditions).


• Depends on the repayment capacity as well as the cost of the property.

• 80% of the cost (cost will include cost of house, stamp duty, registration fees, transfer
fees, if any, and all such charges.) subject to maximum of Rs.50,00,000 or 4 times the
gross annual income, whichever is less.

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• Maximum repayment period is 20 years (including moratorium) OR permissible up to the

retirement age of the borrower OR 65 years (in case of professionals/businessmen)
whichever is earlier.
• The existing house to be disposed off in 12 months time (optional) and sale proceeds to
be deposited in the loan account.
• The EMI would be fixed on balance amount outstanding in the account.


• If money from the sale proceeds of the existing house is deposited in the account, the
same would be treated as margin.


• Similar to Home Loan.

Processing Charges ( Processing charges excluding applicable service tax ) 0.50% of loan
amount subject to a maximum of Rs.15000/- and payable -

• 0.25% of the loan amount at the time of application plus service tax as applicable
• 0.25% of loan amount on acceptance of sanction plus applicable as applicable

Other Attractive Features

• No prepayment penalty
• Free Insurance facility against Fire, allied perils including Earthquake, Personal Accident
• Flexible repayment schedule

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• Easy and convenient EMIs
• Loan sanctioned within 72 hours of receipt of application in full as per requirement.
• Option to pay interest on a daily reducing balance basis.

Other Conditions: No Prepayment penalty if the loan is adjusted by the borrower from his own
verifiable legitimate sources or genuine sale. However, 2% charged on an average o/s. balance of
last 12 months if loan is closed on take over by other Banks / Financial Institutions.

Union Top up:


Existing home loan borrowers (Standard Assets with regular EMI repayment) who

 Are salaried/professional & self employed, agriculturists or business men having regular
source of Income.

 Have repaid minimum 24 EMIs in Home loan account and

 Where net take home pay/monthly income is not be less than 35% of gross monthly
income/earnings after considering all deductions including the EMI of the proposed TOP-up


To meet any type of expenditure in respect of the House viz. repairs/renovation/ remodeling /
furnishing etc.
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Term Loan (Floating)


The maximum amount of loan can be extended upto 50% of EMIs repaid subject to minimum of
Rs.50,000/- to Maximum of Rs.5,00,000/-

RATE OF INTEREST (w.e.f. 01.04.2009)

Union (Original Housing Loan (Original Housing Loan

Top-Up Limit upto Rs.30 lacs) Limit Above Rs.30 lacs)

Term BPLR – 1.75% i.e. 10.25% BPLR –1.00% i.e. 11.00%

Loan (Floating) (Floating)


50% [i.e. only 50% of the amount already repaid will be considered as top-up loan
subject to maximum cap].


0.50% of the Top-up Loan amount.


Existing Mortgaged House will continue as security (the house for which housing loan is
extended and is secured by EM.).


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Guarantee is applicable wherever guarantee is taken in the existing Home Loan.


The maximum repayment period is of 5 years or left over period for the borrower before he
attains retirement or 60 years of age which ever is earlier. Term loan is subject to review every


Accrued interest on Top-up loan is eligible for exemption under section 24 of Income Tax Act,
provided the loan is granted for the purposes of renovation, additions, repairs or reconstructions
of house property. However, if the loan is granted for furnishing of house, such exemption is not
available. (The Installments towards repayment of Principal is not eligible for exemption under
Income Tax).

Union Miles:

Union Miles Scheme is offered to individuals /frims for vehicle finance for thier personal use.


• Individuals of the age 18 years and above

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• Permanent employee of Central/State/Defence/Police Force/Public or Joint Sector
Undertaking/reputed firms/ established Educational Inst.
• Professional/Businessmen having regular income.
• Borrower has at least minimum services to liquidate the loan 1 year prior to retirement.
• Firms / Companies.

A Minimum of 40% marks as per investment grade scoring chart


• For Purchase of new two/four wheelers, for personal or professional use

• Second hand vehicles upto 3 years old also eligible.


4 Wheeler- 4 times the net income /net annual salary subject to a maximum loan of Rs 25 lacs
for new vehicle and Rs 10 lacs for old vehicle
2 Wheeler- 4 times the net income /net annual salary
subject to a maximum loan of Rs 1 lacs for new vehicle


• 15% of cost of vehicle.

• 50% of old vehicle.
• Under tie-up - 10%. or agreed upon


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• 4 Wheelers - A Maximum of 60 months in Equated Monthly Installments(EMIs).
• 2 Wheelers - A Maximum of 36 months in Equated Monthly Installments(EMIs).

Under Tie-up

4 Wheelers - A Maximum of 84 EMIs (Ford India)

2 Wheelers - A Maximum of 60 EMIs (Bajaj Auto Ltd.)

RATE OF INTEREST (w.e.f. 01.04.2009)

Period Rate Of Interest

4 wheelers

Upto 3 Years 11.00% p.a

Above 3 Years 11.25% p.a

Rate of Interest (w.e.f 01.04.2009)

2 Wheelers

Upto 3 Years 12.75% p.a

Above 3 Years 13.25% p.a

Old Cars(< 3 Years) 13.25% p.a


• Two Wheelers Rs. 250

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• Four Wheelers Rs. 500 per vehicle for Loan upto Rs. 2 Lacs.
• Four Wheelers Rs. 1000 per vehicle for Loan over Rs. 2 Lacs.


• Hypothecation of vehicle financed by the Bank.

• Bank's lien to be got noted with the Transport Authorities.


Guarantee of the spouse. In case unmarried, third party guarantee with sufficient means.


• No Pre-Payment penalty if the loan is adjusted by the borrower from his own verifiable
legitimate sources or genuine sale. However, 2% charged on an average o/s. balance of
last 12 months if loan is closed on take over by other Bank/Financial Institutes
• Comprehensive Insurance with Bank Clause.
• Salary Certificate/proof of income and proof of residence to be obtained and held on

Union Comfort:


• Age 18 yrs completed.

• Permanent employee of Central Government / State Government/ Defence / Police
Force / Autonomous bodies / Public / Joint Sector undertaking / Corporations / Limited
Companies / Firms / Established Educational Institutions.
• Individuals having regular income.

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• Tax payers, Non-I-T permissible if annual pay Rs.1 lac or more and net take home annual
pay Rs.0.40 lac - after deducting EMI of present loan.
• Salary accounts with financing branch.
• Min. 40% marks as per investment grade scoring chart.


To meet personal expenses or purchase of consumer durables.


• 6 months net salary not exceeding Rs. 1 lac for salaried class.
• For others, 50% of annual income as per last 2 IT returns (not exceeding Rs.1 lac.)



In 36 Euated Monthly Instalments(EMIs). Repayment starts from the nest month of

disbursement of loans.

RATE OF INTEREST (w.e.f. 01.04.2009)

• 15.00%.
• Concession in the rate of interest can be considered by Regional Head in case of group
• 10% under HCL Tie-up scheme for purchase of PCs.


• Rs. 100 upto Rs. 10,000/-

• Rs. 250 upto Rs. 50,000/-

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• Rs. 500 above Rs. 50,000/-


One Guarantor having means equivalent to the loan amount, Hypothecation Of Asset wherever


• Proof of Income (Salary Certificate).

• Proof of Residence (latest Tel. Bill/Electricity Bill/Employer's Certificate)
• Irrevocable undertaking letter from the employer for recovery of installment from salary
every month and to remit to bank directly.
• Irrevocable undertaking by the borrower authorising the Bank to recover the loan
installments from his/her salary A/c./SB A/c. with the Branch.

* Prevailing Rate of Interest will be applicable as on date of sanction.

Union Education:

The scheme aims at providing financial assistance on reasonable terms:

• To the poor and needy students that they may undertake basic education
• To meritorious students that they may pursue higher or professional or technical


The student applying for UNION EDUCATION Loan ought to:

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• Be an Indian National
• Has secured admission to professional or technical courses through an appropriate
Entrance Test or selection process
• Has secured admission to a foreign University
• Has passed an appropriate qualifying examination

a. Studies in India
 School education up to +2
 Graduation/Post-Graduation
 Professional course
 Management course
 Special Education Loan Scheme for Students pursuing courses from
approved institutions like IITs/IIMs/ /NIT XLRI/BITS/VIT/IISc/S.P. Jain
Institute Of Management/Symbiosis Institute Of Management and T.S.
Chanakya, Navi Mumbai- Nautical Science and MERI, Calcutta, Marine
Engineering, MERI, Mumbai, Maritime Science.

b. Studies Abroad :
 Graduation: For job-oriented professional or technical courses offered by
reputed universities
 Post-Graduation: MCA, MBA, MS and such other courses

Courses conducted by CIMA, London, CPA, USA., and such other institution


To the poor and needy students to undertake basic education. To meritorious students to pursue
higher or professional or technical education.

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• The Parent/Guardian of the student who is availing loan from our bank shall be made co-
obligator/joint borrower irrespective of the age of such students.
• The Loan Accounts of students applying through college/institutions will be
sanctioned/disbursed at the branch nearest to permanent residence/place of domicile of
the borrower student.
• Loan will be disbursed directly to the college/institute.
• Student to produce mark list of previous term/semester before availing next installment.
• Student /Parent to provide latest mailing address before availing next installment.

In case of parents with transferable job, new address to be provided before availing installments.


Need-based finance subject to repayment capacity of the parent or student with margin and upto
the following ceilings

For studies in India - Up to Rs. 10 lacs

For studies abroad - Up to Rs. 20 lacs


No margin for loans up to Rs. 4.00 lacs . However, for loan of higher amounts, the margin
requirement is 5% for inland studies and 15% for studies abroad.

Scholarship/assistance to be included in margin.

Margin maybe brought in on pro-rata basis as and when disbursement is made


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Repayment holiday or Moratorium on loan: Course period + 1 year OR 6 months after job
placement, whichever is earlier. Starting from this point, the loan is to be repaid in 5-7 years
after completion of course period/moratorium.

RATE OF INTEREST(w.e.f 01.04.2009)

For Male Student :

Up to Rs. 4.00 lakhs : 11.75% (Fixed)

Above Rs. 4.00 lakhs upto Rs.7.50 lakhs : 12.50% (Fixed)

Above Rs. 7.50 lakhs : 12.00% (Fixed)

For Female Student:

Up to Rs. 4.00 lakhs : 11.25% (Fixed)

Above Rs. 4.00 lakhs upto Rs.7.50 lakhs : 12.00% (Fixed)

Above Rs. 7.50 lakhs : 11.50% (Fixed)

For Special Education Loan Scheme :

Special scheme For IIM students : 10.50% for Male

: 10.25 % for Female

Special Scheme for BSc in Nautical Science,Marine Engg,Maritime Science : 11%

Special Scheme IIT/NIFT students: 10.50% for male

: 10.25% for Female


Special Scheme for students of ISB(Indian School of Business) only for Hyderabad :

10.50% for male

10.00% for Female

Special scheme for students of Asian Institute of Management : 11.00%

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Simple interest will be calculated during repayment holiday/moratorium period.Interest rate is
fixed and will not undergo any change till the loan amount is repaid in full



Upto Rs. 4 lakh : No security

Above Rs 4 Lakh & upto Rs 7.5 lakh : a suitable third party / personal guarantee

However for loans above Rs 7.5 lakh, Collateral security of suitable value along with co-
obligation of parents / guardian / third party / accompanied by assignment of future income of
student for the payment of installments is required. A Life insurance policy from Insurance
company for a sum not less than the loan amount is required to be taken in the name of the
student and duly assigned in favour of Union Bank.


Loans can be considered for eligible students in case they approach the Bank in the subsequent
year of the commencement of the course. Branches can issue Bank Guarantee, for payment seats
wherever required.

No Prepayment penalty if the loan is adjusted by the borrower from his own verifiable legitimate
sources or genuine sale. However, 2% charged on an average o/s. balance of last 12 months if
loan is closed on take over by other Banks / Financial Institutions. The Loan Accounts of
students applying through college/institutions will be sanctioned/disbursed at the branch nearest
to permanent residence/place of domicile of the borrower student.

No Pre-Payment penalty for self-closure. However, 2% charged on an average o/s. balance of

last 12 months if loan is closed on take over by other Bank/FIs.

MBF 2008-2010 38
Union Education Scheme for Commercial Pilot Training Programme / Course Nature of
course/training programme Commercial Pilot Training / Course Eligibility Should be
Indian National.
Should have secured admission to the relevant course through admission test.

Should have secured admission to the foreign institutions for studies abroad. Duration of the
Course 12-24 months Type Of Institution

1. For Course / Training programme in India:

Government or recognized Private Institute approved by Director general Of Civil aviation,
Government Of India.

2. For course/training programme abroad:

The course/ training programme should have been offered by recognized institutions abroad
approved by competent authority in that country eg. in U.S.A the Federal Aviation
Administration, Govt. Of U.S.A.

The licenses issued by such institution should be convertible into corresponding Indian Licences
in case the applicant desires to take up employment in India after completion of course/ training
abroad, as per directives of Director General Of Civil aviation, Government of India.

Quantum Of Loan

Nil margin up to Rs.4 lacs.

Min.5 % margin for loans above Rs. 4.lacs in India.
Min.15% Margin for loans above Rs. 4 lacs for studies abroad.

MBF 2008-2010 39
Scholarships/ assistance to be included in Margin.
Margin to be brought in year to year whenever disbursement made on pro rata basis.

Rate Of Interest

Male Female

For loans up to Rs. 4 lacs 11.75% 11.25%

For Loans above Rs.. 4 lacs and Below 7.5 lacs 12.50% 12.00%

For Loan above Rs. 7.5 lacs 12.00% 11.50%

(1% concession if interest is serviced during moratorium period) Security

No security up to Rs. 4 lacs.

Loan above Rs. 4 lacs and upto Rs. 7.50 lacs- personal guarantee to the satisfaction of the bank.
For loans above Rs. 7.50 lacs- suitable collateral security/third party guarantee acceptable to the
Life insurance policy for a sum not less than the loan to be taken on the life of the student/
applicant and assigned in favor of the BanK.

Union Mortgage:


Any qualified medical practitioner / Dentist in the age group of 25 to 60 years with minimum
three years experience and in the age group of 25 to 60 years.
Firms / Companies engaged in medical profession in which Doctors / Dentist are Partners or
Directors or the Proprietor.


MBF 2008-2010 40
An amount equivalent to 75% of the equipment cost and other Assets to be


Minimum 25% of cost of equipments and other assets to be financed.


Maximum 7 years including initial moratorium period of 3/6 months - By Equated Monthly

RATE OF INTEREST (w.e.f. 01.04.2009) (BPLR=12.00%)

A Fixed Interest rate of 12.50% for Individuals and 12.50% for others. Interest rate will not
undergo any change till full repayment of the loan .


0.50% of loan amount.


Hypothecation of equipment / items purchased out of Bank finance.

Collateral security 50% of loan amount.
EM of premises in case the loan is for acquiring premises


Third Party gurantee is not mandatory

No Prepayment penality if the loan is adjusted by the borrower from his own verifiable
legitimate sources or genuine sale. However, 2% charged on an average o/s. balance of last 12
months if loan is closed on take over by other Banks / Financial Institutions.
MBF 2008-2010 41
* Rate of Interest prevailing on the date of sanction shall be applicable.

Union Mortgage Scheme

[Scheme for financing against Mortgage of immovable property] ELIGIBILITY

Any Individual in the age group of 18-60 years of age owning residential/ commercial property
(land/plot/ building) and who are Income-Tax assesses having net monthly income of
Rs.10,000/- pm in the case of salaried persons and an annual income of Rs.1.20 lacs p.a. in the

case of non salaried perosns. Earning family members income can also be clubbed to arrive the
eligibility criteria.

Individuals who are not Income Tax assessees also eligible for this scheme, subject to production
of proof of income acceptable to the Bank.

A minimum 40 points as per investment grade scoring chart.


To meet any personal expenditure of varied needs like marriage of children, higher education,
medical expnses or any unforeseen expnses and also as liquidity finance.


Metro/Urban Semi Urban

- Minimum Rs. 1 lac. Rs.1 lac
- Maximum Rs. 50 Lac. Rs.25 lacs
subject to 36 times of gross monthly income of salaried persons(Net of all deductions including
TDS etc.) whichever is less

MBF 2008-2010 42
- 2 times the Net annual Income in case of others (Income as per the latest IT return less taxes
payable) whichever is lesser.


Facility can be given in the form of Term Loan or Secured Overdraft. However, SOD Facility
will not be considered for salaried persons


50% of the fair market value of the property mortgaged as per the latest valuation report not
older than six months from an approved valuer of the Bank.

Fresh valuation at the cost of the borrower(s) once in three years required during currency of


Loan amount together with interest is to be repaid in maximum 60 equal monthly installments.
Post-dated cheques fot the 60 EMIs will be collected up-front.
Subject to closure of the loan with full adjustment prior to the retirement in case of salaried class


- Fixed Rate ---- 15.25%

- Floating rate ---- BPLR + 2.50% i.e.. 14.50%
- 2% penal interest to be levied on overdue installment.
[ Present BPLR is 12.00% ]
MBF 2008-2010 43

One time fee of 0.50% of the loan amount, collected up front.


Equitable Mortgage of non-encumbered residential house/flat, commercial or industrial property

situated in Metro, Urban & Semi-urban centres only in the name and possesion of the borrower
and/or his/her family member.

SOD limit is subject to review/renewal every year.

SOD interest to be serviced every month


No Prepayment penalty if the loan is adjusted by the borrower from his own verfiable legitimate
sources or genuine sale. However, 2% charged on an average outstanding balance of last 12
months if loan is closed on take over by other Banks/Financial Institutions.



Individuals holding shares/debentures/bonds either in their name or jointly.


Personal purposes like Education, Housing, Consumer Goods and such other needs.


MBF 2008-2010 44
The maximum amount that can be granted is up to Rs.20.00 Lacs for security held ONLY in


3 years for Loan repayable in installments.

SOD facility to be renewed/reviewed every year.

RATE OF INTEREST (w.e.f. 01.04.2009) (BPLR = 12.00%)

Rate of Interest BPLR+4.50% i.e. 16.50%


Pledge of shares of those companies approved by the Bank (Please refer to nearest branch of
Bank for the list of approved companies)


No PrePayment penalty for self-closure. However, 2% charged on an average o/s. balance of last
12 months if loan is closed on take over by other Bank/Financial Insitutions

Union Cash


Retired employees of Government / Semi Government undertakings, Banks and other reputed
private organisations etc. who draw fixed income / pension through our Bank.


To meet financial requirements.

MBF 2008-2010 45

• Demand Loan repayable in installments with a maximum repayment tenure of 36 months

• Term Loan with repayment tenure of above 36 months and maximum upto 48 months.


Upto Rs.1,00,000/- or 12 times the monthly pension, whichever is less.


25% in case of Deposit Receipts / NSC / Bonds issued by Government of India / Financial
50% in case of Shares & Debentures.


12 – 36 EMIs in case of Demand Loan repayable in Installments

Above 36 to 48 EMIs in the case of Term Loan

RATE OF INTEREST (w.e.f. 01.04.2009)

A fixed interest rate of 13.75% (Fixed)


NO Processing charges.


Pledge of Deposit Receipts / Shares / Debentures of corporates of good standing, NSCs Bonds
issued by Government of India / Financial Institutions etc.
Where sufficient security is not available, personal guarantee of spouse or a person who is the
MBF 2008-2010 46
nominee under pension scheme is to be obtained.
In genuine cases, the Bank may consider this facility on a clean basis.


Declaration is required from the spouse who is eligible for family pensio


Pensioners & salaried class who are drawing their pension/ salary throu

gh Union Bank of India.


To meet unforeseen medical expenses, timely payment of dues to State Electricity Board,
Telephone, School fees and water charge and other such needs.


Maximum 90% of one month’s pension/salary credited in the account



Entire amount of overdraft and interest should be recovered while crediting next pension/salary.
Otherwise, it can be recovered in installments within a period of 3 months, if so required by

RATE OF INTEREST (w.e.f. 01.04.2009) (BPLR=12.00%)

MBF 2008-2010 47
2% of the amount of overdraft in the account every month.
Interest to be recovered as and when the pension /salary is credited.




The facility can be allowed on an ongoing basis by liquidating earlier dues. Pensioners of Union
Bank of India are also eligible.

MBF 2008-2010 48


MBF 2008-2010 49
This chapter basically deals with all the important research works done in the same field as that
of the projects topic. Credit appraisal is not something new, right from the olden days, men has
appraised people, places etc. so that he can bring them to his own personal use and profit from
them. Behavioral science explains rating scales used to measure if not gauge the human psyche
to a certain extent. The same way credit appraisal too has its own procedure. Some of the
important findings and researches are…

This study was conducted to evaluate the effectiveness of a decision support system
(DSS) for credit management. This study formed a part of a larger initiative to assess the
effectiveness of IT-based credit management processes at the State Bank of India (SBI). Such a
study was necessitated since credit appraisal has emerged to become a critical sub-function in
Indian banks in view of growing incidence of non-performing assets. The DSS that we assessed
was a credit appraisal system developed in Quattro Pro® at SBI. This system helps in the
analysis of balance sheets, calculation of financial ratios, cash flow analysis, future projections,
sensitivity analysis and risk evaluation as per SBI norms. We used a strong quasi-experimental
design, called the Solomon's four-group design, for our assessment. In our experiment, managers
of SBI who attended training programs at the SBI training college, were the subjects. The
experiment consisted of measurements that were taken as pre- and post-tests. An experimental
intervention was applied between the pre-tests and the post-tests. The intervention, or stimulus,
consisted of DSS training and use. There were four groups in our experiment. The stimulus
remained constant as we took care to ensure that the course contents as well as the instructors
remained the same during the course of our experiment. Two were experimental groups and two
were the control groups. All four groups underwent training in credit management between the
pre- and post-tests. Results from our research show that while the DSS is effective,
improvements need to be made in the methodology to assess such improvements. Moreover,
such assessment frameworks, while being adequate from a DSS-centric viewpoint, do not
respond to the assessment of a DSS in an organizational setting. In our concluding section, we
have discussed how this evaluative framework can be strengthened to initiate an activity that will
allow the long-term, and possibly the only meaningful, evaluation framework for such a system.

MBF 2008-2010 50
Pension fund industry in India grew at a CAGR of 122.44% from 1999-00 to 2006-07.In terms
of ownership, debit cards are more in number than credit cards but in terms of transactions, use
of credit cards is more prevalent than debit cards.

The ATM outlets in India increased at a rate of 28.09% from March 2006 to March
2007.Outstanding Education loan segment is expected to grow at 36.41% till March 2009 from
March 2007 onwards to cross Rs. 27000 Crore Mark.Two-wheeler finance industry is projected
to forge ahead at a CAGR of 14.21% till 2009-10 from 2005-06.Indian Mutual Fund industry
witnessed a growth of 49.88% from May 2006 to May 2007, and a higher 215.61% growth was
recorded in closed ended schemes. Increasing number of millionaires in India is increasing the
scope of Wealth Management Services. Bankable households in India are estimated to move up
at a CAGR of 28.10% during 2007-2011.

Information Sources
Information has been sourced from books, newspapers, trade journals, and white papers, industry
portals, government agencies, trade associations, monitoring industry news and developments,
and through access to more than 3000 paid databases.

This section covers the key facts about the major players (including Public, Private, and Foreign
sector) in the Indian Banking Industry, including Bank of Baroda, State Bank of India, Canara
Bank, Punjab National Bank, HDFC Bank, ICICI Bank, Kotak Mahindra Bank, Citibank,
Standard Chartered Bank, HSBC Bank, ABN AMRO Bank, American Express, etc.

MBF 2008-2010 51


MBF 2008-2010 52
In today’s scenario, it is very important to understand that every industry needs to brace itself
and hedge itself against risks. Risks are of various kinds and in different magnitude. No matter
which industry or sector the company belongs it needs to update every day itself to the various
things happening all over the world which may directly or indirectly affect its business, growth
and potential in the market.

With banks the scene is no different, whenever there comes some slowdown or the market
slouches the banks are effected too. Banks are directly related to people and industry and market.
In the recent times, we have seen that the retail loan section of the banks have come up as one of
the important areas. All the big industry, small and medium enterprises and individuals, avail
loans for all their purposes.

The important thing in this case is that, banks can’t give loans to everyone. They need to check
the credit worthiness of the borrower. To rate the worthiness of an individual to that of a
company there are various methods. From checking their market image, their past record,
potential and security provided, it is decided whether they are worthy enough or not. To talk in
more financial terms, for corporate loans there are various methods like balance sheet analysis,
fund flow and cash flow analysis, working capital management, ratio analysis etc.

Every bank also has their own credit rating system; they take into consideration a number of
things, apart from financial workings. All this and more is discussed at length in the coming

MBF 2008-2010 53

Introduction :

Risk is an integral part of any business environment, more so in the case of Banks, which are in
the business of financial intermediation. The word Risk is derived from the Italian word
‘Risicare’ which means to dare. Risk can be identified, measured and managed while uncertainty
remains altogether unknown and hence unmanageable.

The first step to be recognized is that risk has two distinct phases : risk as opportunity and risk as
hazard. Risk as opportunity is implicit in the relationship that exists between risk and return.
Risk as hazard is what most of us mean by the term.

The second characteristic is that risk is always in future. It always pertains to what can happen
but not what has happened.

The third characteristic of risk Is that it keeps changing with time. Risk management tus is a
process which manages and controls all the three activities.

How does risk matter to the bank?

Banks and Financial Institutions perform the essential function of channelizing funds from those
with surplus funds to those with shortage of funds. Broadly, the risks by the banks today can be
classified as under:

I. Credit Risk : it’s one of the major risks faced by the banks on account of the nature of
their business activity, which includes dealing with or lending to a corporate, individual,
another bank, financial institution or a country. Credit risk includes borrowers risk and

MBF 2008-2010 54
portfolio risk. Borrower risk may be defined as the possibility that a borrower will fail to
meet his obligations in accordance with agreed terns. It may also be reflected in the
downgrading of the standing of the borrower making him more vulnerable to possibility
of defaults. Portfolio risk arises due to credit concentration/investment concentration etc.

II. Market Risk : market risk is the potential of erosion in income or market value of an
asset arising due to changes in market variables, such as interest rate, foreign exchange
rate, equity prices and commodity prices.

a) Transaction Rate Risk : The risk in the erosion of earnings due to variation in
interest rate within a given time zone is referred to as interest rate risk. Interest rate
risk may itself arise on account of gap or mismatch risk, basis risk, embedded
options risk, yield curve risk etc.

b) Exchange Rate Risk : this risk is of two types viz. transaction risk and translation

Transaction risk – it is observed when movements in price of a currency, upward or

downward, results in a loss of a particular transaction. Transaction risk also
destabilizes the anticipated cash flows.

Translation risk – in a situation of translation, the Balance Sheet of a Bank, when

converted in home currency, undergoes a drastic change, chiefly owing to exchange
rate movements and changes in the level of investments or borrowings in foreign
currency even without having translation at a particular point of time.

Forex risk arises when a bank is holding foreign exchange assets or liabilities that have not been
hedged against movement in exchange rates. This position is referred to as open position. Forex
risk affects both spot and forward position of the bank. Banks are also exposed to movement in
MBF 2008-2010 55
forward premium rates, which is a manifestation of interest rate movements, when there is a
mismatch in the maturity pattern of forward transactions.

c) Equity Price Risk : the risk arises from the potential of an institution to suffer
losses on its exposure to capital markets, from adverse movements in prices of

d) Commodity Price Risk : the risk arises from the potential of movements in prices of
physical products, which are or can be traded in the secondary market. These
products include agricultural products, minerals, oils and precious metals.

III. Liquidity Risk : it arises due out of the possibility that a bank maybe unable to meet its
liabilities as they become due for payment or may be to find the liabilities at a cost much
higher than normal cost. The risk arises due to mismatch in the timing of inflows and
outflows of funds, and from funding of long term assets by short- term liabilities.
Surplus liquidity could also represent a loss to the bank in terms of earnings missed and
hence an earning risk.

Operational Risk – it arises out of malfunctioning of information systems or service delivery

process or internal sabotage. In all these cases, the losses are similar and even can generate
losses of unknown magnitude.

Systemic Risk – banks are highly inter-related with mutual commitments. Hence the failure of
one institution generates a risk of failure for those other banks which have committed funds with
defaulting bank.

Solvency Risk – it occurs when the bank is landed in a chronic situation of not able to meet its
obligation. This type of risk gives the ultimate impression that the bank has failed.

Other Risks – there are some other categories of risks also such as compliance risk, tax risk etc.

MBF 2008-2010 56
Risk Management is not new to bank, as banking has always been associated with risk. But risk
environment that was prevalent in pre- reform period was much different than what it is today.
The emphasis then was on achieving ‘reasonable’ level of profits instead of maximizing profits
and share holder value. In other words, risks in the normal course of business were taken by
banks, but without much emphasis on managing them. Interest rates then were totally
administered; credit ceilings were in place and allocation of credit was done as per the directives.
All these practically ensured that the banks had no incentives whatsoever in risk management.
However the ongoing financial sector reforms have changed the ball game of banking today. As
compared to the practice of focusing only on achieving higher deposit growth, in the current
context the need for proper management of assets and liabilities has gained importance,
heightened by the need for containment of non – performing assets and attendant provisioning.
Generating internal surplus has assumed critical importance as meeting the prescribed capital,
standard has become inevitable. This calls for allocating the resources optimally and managing
the attendant risk suitably. Here lies the major change in the risk environment for banks.

With tighter prudential accounting norms and higher capital standards, banks have to reckon the
risks they are assuming and returns there on. In other words, while funding costs will have to be
reduced by sourcing funds at the lowest cost, income has to be maximized by allocating the
MBF 2008-2010 57
resources optimally between various assets depending upon the risk return trade off and taking
into account the constraints in maintaining and improving the capital standard. In other words,
the sources and uses of funds will have to be seen in a holistic manner and not in isolation as

Besides, the paradigm shifts, in the operating environment, the major and minor banking failures
during the last decade, has brought into sharp focus the need for risk management. The east
Asian melt down has especially proved that banks have to per se relate their profitability to risks

being assumed and managed by them and sustain a prescribed level of capital standard. The
focus has further shifted to generating adequate level of profits, so that it will ensure not only
future growth but also lead to increase in capital which is critical in ensuring the confidence of
depositors and other stake holders.

In essence, the foundation of risk management lie in the following –

- Banks should exercise control on their assets and liabilities, on the return and costs, to
achieve the desired goal.

- Such controls in turn, should be coordinated and integrated so as to accommodate

attendant priorities and risks and should help in maximizing interest rate spread.

- Cost and yield arise from both the sides of the balance sheet and our policies should be to
maximize the spread and minimize the burden.

Management of risk and profitability are therefore inextricably linked. As various risks are
interdependent, an integrated approach to all the risks faced by a bank is considered most

Initiatives by Reserve bank of India

MBF 2008-2010 58
In a view of the important role banks play in the economy and in the payment and settlement
system, banks are always subject to more regulation by the Central Bank.

RBI has taken various supervisory initiatives to induce better operating standards in banks,
greater transparency and sensitivity towards risk management. Various guidelines, on the subject
matter are outlined below:

• Guidelines on Asset Liability Management in banks which includes February 1999

Liquidity and Interest Rate Risk
• Guidelines on Risk Management Systems in Banks October 1999
• Guidelines Notes on Credit Risks and Market Risks March 2002
October 2002
• Discussion paper on ‘Move towards Risk Based Supervision’ August 2001
• Detailed risk profile template to assist banks in undertaking self July 2002
assessment of risks.
• Guidelines on Risk based Internal Audit December 2002

Action points include :

- Identifying gaps in existing risk management practices and procedures and chart out
policies and strategies and road map for addressing the gaps.

- Putting in place required Organization Structure.

- Articulate “Risk Management philosophy, policy and risk limits.

- Put in place robust credit rating system covering all risk issues for rating the borrower.

- Inter Bank limits and exposures.

- Country and transfer risk management.

- System to measure and monitor liquidity and interest rate risk.

MBF 2008-2010 59
- Policy and limits for operational risks. Develop internal processes and expertise in risk
aggregation and capital allocation.

- Develop methodology for estimating and maintaining economic capital.

RBI is closely monitoring the progress in implementation of risk management systems in banks
through periodical review, individual assessment, meetings with management etc.

Credit Risk

Lending involves a number of risks. In relation to the risks related to credit worthiness of the
counter party, the banks are also exposed to interest rate, forex and country risks.

What is credit risk?

Credit Risk is the possibility of losses associated with changes in the credit profile of the
borrowers or counter parties. These losses could take the form of outright default or
alternatively, losses from changes in portfolio value arising from actual or perceived
deterioration in credit quality, short of default.

Credit Risk of a bank has two distinct facts i.e. risk inherent to the individual business unit/loan
account and risk from macro credit portfolio perspective. Credit Risk emanates from banks
dealings with an individual, corporate, bank, financial institution or a sovereign. Credit Risk may
take the following forms:

 In the case of direct lending : principal/and or interest amount may not be repaid;

MBF 2008-2010 60
 In the case of guarantees or letters of credit : funds may not be forth coming from the
constituents upon crystallization of the liability;

 In the case of treasury operations : the payments or series of payments due from the
counter parties under the respective contracts may not be forthcoming or cease;

 In the case of securities trading business : funds/securities settlement may not be


 In the case of cross – border exposure : the availability and free transfer of foreign
currency funds may either cease or restrictions may be imposed by the sovereign.

How to quantify Credit Risk?

Credit Risk has got two components : ‘quantity of risk’ which is nothing but the outstanding loan
balance as on the date of default and the ‘quality of risk’ i.e. “severity of losses” which is defined
by both default probability and the receivers that could be effected in the event of default.

Credit Risk is therefore, a combined outcome of –

Default Risk – it is the probability of the event of default i.e. missing a payment obligation. In
today’s parlance, payment default is declared when a scheduled payment has not been made
within regulatory time from laid down.

Exposure Risk – the outstanding balances at the time of default are not known in advances
particularly under facilities like committed lines of credit, ODs, project financing, off balance
sheet items like guarantees/LC facilities etc. this uncertainty prevailing with future amounts at
risk, generates exposure risk.

Recovery Risk – the losses in case of default is the amount outstanding at default time less
recovery. Normally, once a borrower defaults, banks resort to enforcement of security. But
recoveries are not predictable as they depend upon the type of default, availability of risk
MBF 2008-2010 61
mitigators like guarantors, collaterals etc. and their nature/worth besides the prevailing legal
system. It thus involves great amount of uncertainties. These uncertainties can be traced to :

Value of Collateral Security :

Recovery risk depends on the nature of charged assets, their location and possession,
marketability/appeal, legal status etc. At times, the economic value of assets charged may erode
over a period and may even go below the value of outstanding debt. Contrarily, where collaterals
are of high value and are capable of generating buyer’s interest may even cancel the loss.

Guarantor’s value : the net worth of guarantors and in turn their ability to discharge liabilities
upon invocation of guarantee may undergo changes affecting the ultimate realization amount.

Enforceability of Securities : the very ability of a bank to access the securities/collaterals charged
to a bank in order to dispose them off may itself be doubtful. Secondly, enforcement of
securities/contracts is also defined by the prevailing legal system.

In view of this, it becomes difficult to predict the recoverable amount in advance.

The combine outcome of all three elements ultimately defines the credit risk of a bank. Once
these estimates are made, the loss in case of default can be measured by using the formula –



EL= Expected Loss

PD= Probability of Default

EAR= Exposure at Risk

LGD= Loss Given Default i.e. (1-Recovery Rate)

Now the moot question is how to assign values to the formulae and that is where ‘risk’
identification and measurement assumes greater significance.
MBF 2008-2010 62
What is Credit Risk Management?
Credit Risk Management covers the systems and processes in place to

• Identify and measure the risk involved both at the individual transaction level and portfolio

• Evaluate the impact of exposure on Banks balance sheet/profit.

• Assess the capacity of risk – mitigators.

• Design an appropriate strategy to arrest risk – mitigators leading to deterioration in credit

quality/default risk.

It is to be emphasized that Credit Risk Management is not NPA management. NPAs are a legacy
of the past in the present. Credit Risk management is action in present for the future. In an NPA
account, the Credit Risk has crystallized. Credit Risk Management is more concerned with
quality of credit portfolio before default. The Credit Risk approach monitors worsening credit
MBF 2008-2010 63
quality by tracking migration of assets down the rating ladder, with each rating downgrade
representing a higher Credit Risk. This approach enables bank management to take timely action
to stem deterioration in credit portfolio quality much before actual default, which is the last step
in the rating ladder.

Credit Risk Management is also not merely credit management. Credit Management, as is
understood conventionally, is confined to selection, limitation, and diversification and includes
management of NPAs also. In selection i.e. granting a loan or making an investment, borrower’s
financial condition, profitability, cash flows, nature of borrower’s industry, his competitive
position therein, quality of management, presences of collaterals etc. are assessed to ascertain the
repaying capacity. Limitation ensures that individual or group borrower concentrations are not
very large and is within the prescribed exposure limit. Diversification is related to limitation and
is based on the age-old principle of not putting all the eggs in one basket. This age-old concept
of Credit Management is necessary and would continue to hold good but it is not proving
adequate for management of credit risk in today’s deregulated environment.

It may be appreciated that the traditional Credit Management focuses on probability of

repayment. Credit Risk Management, on the other hand, focuses on probability of default. It is
more sophisticated than the simple credit management techniques. Some of the differences in the
existing Credit Management approach and the Credit Risk management. Approach as envisaged
by RBI are given in the following table:


It is based on Asset-by-Asset or Stand-alone It is based on Portfolio approach to risk.
approach to credit management. The risks in
the portfolio as a whole are not captured.
Expected Loss [EL] and Unexpected Loss Measurement of EL and UL is carried out as an
[UL] are not measured. Losses are recognized integral credit risk management process.
in the accounting sense or as per the regulatory

MBF 2008-2010 64
The concentration risks are identified on the The concentration of risks are measured in
basis of owned funds/industry/geographical terms of additional portfolio risk arising on
area etc. account of increased exposure to a
borrower/group of correlated borrowers.

The correlations among constituent assets are

captured to arrive at a measure of Portfolio.
The strategy under this approach is to originate Credit risk management techniques allow
The loan and hold the loan till maturity. active credit risk through securitization/credit
derivatives etc.

RBI in its Guidelines of 1999 and the subsequent Guidelines Note on Credit risk management
has outlined the broad framework on various facets of Risk Management. It includes, in main,
the framework of following instruments of Credit Risk Management:

1. Organizational Structure

2. Credit Risk Measurement that includes appraisal, rating and pricing.

3. Appropriate Credit Administration

4. Limit Structure

5. Documentation Standards

MBF 2008-2010 65
6. Loan Review Mechanism

7. Portfolio Management and System Infrastructure


While compiling a credit report there are certain things one has to include, which are very
necessary for any bank to process a loan or advance. Every bank requires the borrower to
submit all the legal documents with the report, this makes the banks work considerably easy, in
order to process a loan. The following are the steps required to file a credit report;

MBF 2008-2010 66
1. Take the party’s letter head.

2. Take the visiting card of the person is interviewed.

3. Constitution : Whether it is a worthy partnership or proprietorship.

Date of being established – at which place

♦ Any changes thereafter due to entry/exit

Of some partners.

4. Capital : Authorized Capital :

Paid-up Capital :

Reserve & Surplus :

5. Partners /Directors : Name :

Address Residential :

Bio-data in brief.

6. Establishment : Name & Address of Head Office or Registered Office. Also of

branches/ offices, if any.

7. Banking with which branch. Limits enjoyed. Address of that branch.

Materials required : Name of the materials and policy of purchase.

8. Nature of Business : Credit given to buyers for how many days – credit received for
how many days.

9. Factory : Location/ Address

Household /Freehold – Ownership in whose name

MBF 2008-2010 67
Rent / Outgoing paid (amount and to whom)

10. Associate concern

11. Residential details : Address – Area – ownership/rental details in whose name – any
other property.

12. Godown : Details address – Area – ownership/rental – keys with

13. Other bankers details : Name – address – limits enjoyed at present

14. Bio-data of partners: They are partners/director in other companies/firms, if any and
qualifications – educational, previous experience.

15. Market opinion

16. Capital reserve – (advance tax paid on asset side, miscellaneous exp.)

17. Balance Sheet : Latest completed year- should be audited, , if not provisional.

Amount Paid to directors/partners.

18. Profit & Loss : stock, purchase, gross profit, closing stock, sales.

19. Observations on final Accs : Capital loan to/from sister concerns – interlocking of
funds – major items of expenses

20. Income declared/ assessed.

21. Wealth Tax: Copy sheet of wealth of partners – also assessment orders of WTO

(1)Exempted (2)Taxable (3)Total

22. Enclosures 1) Final Accs (audited)

2) Assessment orders of income of firm/partners and of wealth of


MBF 2008-2010 68
3) Sales/ purchases monthly figures of latest years.

4) Copies of Challan of income tax/ wealth tax.

23. Information given by whom?

24. Reference given by whom?

25. Mention what specifically could not be obtained to help forming or compiling the
credit report.

The procedure relating to submission of data is explained below:


For submission of data relating to time deposits Union bank Branches have been classified into following


a) PBA BRANCHES WHERE TERM The ALM program which has been supplied by
DEPOSIT PACKAGE IS RUNNING the central accounts department facilitates
LIVE AND TBA BRANCHES transfer of data directly from the deposit
package to ALM system. Therefore, branches
are only required to transfer the data to ALM
system at the month end and forward the same
to their RCCs by email latest by 5th working
MBF 2008-2010 69
day of the next month.

Branches where cumulative deposit is not line

on the deposit package should update the
details relating to these in ALM data entry
module and forward the relevant (soft copy) to

b) PBA BRANCHES WHERE TERM These branches would continue to update the ALM
DEPOSIT PACKAGE IS NOT LIVE data through the data entry program supplied
by central accounts department. Ideally, details
of deposits accepted, renewed and closed
should update on the daily basis to avoid delay
in reporting. The data base should be
forwarded to respective RCC by e-mail latest
by 5th working day of the next month.

c) MANUAL BRANCHES These branches are not required to update the

data base on monthly basis. Therefore, RCC
would continue to generate turn around
statements for these branches on a quarterly
basis. The turnaround sheets will be updated by
these branches and submitted to RCCs on a
quarterly basis.




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a) PBA/TBA BRANCHES The data entry packages for term loans has
already been installed at these branches by
RCCs. The data base has been created for all
loans as of 31st march, 2001. Therefore, these
branches are only required for new accounts
and pre payments, if any, in the system. The
accounts which have been adjusted are also
required to be updated in the system.

b) MANUAL BRANCHES These branches are not required to update the

data base on monthly basis. Therefore, RCC
would continue to generate turn around
statements for these branches on a quarterly
basis. The turnaround statements will be
updated by these branches and submitted to
RCCs on quarterly basis.


Maturity profile of bills will continue to be worked out branches on quarterly basis.


This statement will also be submitted at quarterly intervals by the branches which are controlling
the refinance from SIDBI and RBI.

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MBF 2008-2010 72




11. CREDIT AGENCIES (EG. CRISIL), Cybercline 2000 etc.

MBF 2008-2010 73
MBF 2008-2010 74


MBF 2008-2010 75
• The basic objective behind joining UBIs Credit department was to learn about how retail
loans are sanctioned.

• The process behind every small and big loan

• The credit rating system and the methodologies applied.

• The way balance sheet and other financial techniques are used in deciding whether or not
to approve the loan.

• The other important aspects apart from the financial techniques which are of equal

MBF 2008-2010 76

 ALM can be defined as the management of Net Interest Margin (NIM is ratio of net
interest income or spread to total earnings) to ensure that its level and riskiness are
compatible with the risk – return objective of the institutions.

 ALM is more than just managing asset and liability categories. It is an integrated
approach to financial assets and liabilities both mix and volume with the complexities of
the financial markets in which the institution operates.

 ALM function informs the management as to what the current market risk profile of the
bank is and the impact that various alternate business decisions would have on the future
risk profile.

Assume that the structure of the existing assets and liabilities is such that at the aggregate,
the maturity of assets is longer than the maturity of liabilities. This would expose the bank to
interest rate risk as the interest rate can increase or decrease. Thus the interest income can suffer
in the process. This has to be set right either by reducing the maturity of assets or increasing the
maturity of the liabilities.

MBF 2008-2010 77
Importance of ALM in the present scenario:

Prior to introduction of financial sector reforms all activities undertaken by the bank were
subjected to RBI regulations, which included,, minimum lending rates, regulated deposit interest
rates etc. The products available to the users were also limited and banks had wide spreads. The
introduction of reform process however brought phased deregulation, new market players with
new products at competitive rates. With all these came a number of risks which include credit
risk, liquidity risk, foreign exchange risk, market risk etc. in view of these developments
necessity was felt to develop some system which should help achieve the organizational
objectives while effectively managing the assets and liabilities. ALM is that system to take care
of the above.

ALM Process:

 Data is the key raw material for ALM and hence the system should be able to provide
accurate and reliable information.

 ALM is a comprehensive and dynamic frame work for (a) measuring (b) monitoring and
(c) managing the market risk which is required to be built around a foundation of sound
methodology, human and technological infrastructure and risk philosophy.

 ALM has to be closely integrated with the bank’s business strategy as this affects the
future risk profile of the bank.

Constituents of a sound ALM system:

 ALM information system

 ALM organization (ALCO, Board and ALM desk)

 ALM process i.e. risk parameters, risk identification, risk management, risk
measurement, risk policies and tolerance levels.
MBF 2008-2010 78

The Asset Liability Management system in the bank has fairly stabilized. Union Bank is one of
the few public sector banks who are leading in implementation of ALM and risk management
guide lines of reserve bank of India. Apart from the regulatory requirements, ALM information
is frequently used by the top management and Assets and Liability Committee (ALCO) for
taking strategic decisions with regard to pricing of assets liabilities , investments, funding etc.
We describe below some of the major functions of ALCO. The decisions of ALCO are based on
data furnished by branches with regard to maturity profile of major items of assets and liabilities
like term deposits, term loans, bills etc.

Functions of ALCO

• Fixation of interest rates on deposits and advances

• Strategy for business growth and desired maturity profile of such incremental assets and

• Funding plan including source and mix of such funds

• Hedging of ALM gaps based on interest rate view.

At present the following details are captured from branches under the ALM information system:

a) Details of time deposits including cumulative deposits

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b) Details of all standard term loan

c) Maturity profile of bills

d) Maturity profile of borrowings




1. Individual/Proprietary Concern

Following factors may be taken into account for computing the “Net Worth” or “Means”

a) Capital investment in the business including investment in other partnership firms

b) Moveable assets such as Bank Deposits, Gold Ornaments/ Jeweleries, Investment in

shares/ debentures/Securities, Company Deposits etc.

c) Personal unencumbered immovable properties

♦ Self – acquired properties of an individual

♦ The share in the ancestral properties acquired on division of HUF

2. Partnership Firms/ Joint Hindu family Concerns:

Following factors may be taken into account for computing the “Net Worth” or “Means”

MBF 2008-2010 80
♦ Capital invested in the business by all the partners (figures to be obtained
from Balance Sheet of the firm)

♦ Undivided profits

♦ Drawing by the partners

♦ Investment in subsidiary firms

♦ Accumulated losses

Net estimated worth of the firm will be :-

Total of (a) & (b) less total of (c), (d) & (e).

3. Limited Liabilities Companies

Following factors may be taken into account for computing the “Net Worth” or “Means”

a) Paid-up capital

b) Free Reserve (including balance in share premium account, capital and other
debenture redemption reserves and any other reserves not being one created for
repayment of any future liability or for depreciation in assets or for bad debts or a
reserve created by revaluation of the assets)

c) Accumulated balance of loss, balance of deferred revenue expenditure as also other

intangible assets

d) Investments in subsidiary or branch companies and loans/advances due from

subsidiary companies/affiliates, other than those of a trading nature.

Net estimated worth of the company will be:-

Total of (a) & (b) less total of (c) & (d).

MBF 2008-2010 81

MBF 2008-2010 82
Accounting as a ‘language of business’ communicates the financial results of an enterprise to
various interested users by means of financial statements. Financial statements summarize the
financial results and activities of an enterprise during an accounting period. Financial activities
should be presented in such a manner so that there is an optimum flow of information. Therefore,
how to present it in financial statements is a significant issue at a point of time. In today’s
complex business environment, the measurement and presentation of financial information is
critical. Like any other language, accounting has its own set of rules that have been developed on
the basis of general acceptance and experience of the users of the financial statements.

Accounting standards are formulated with a view to bring uniformity in the treatment of various
accounting policies and practices existing for the preparation and presentation of the financial
statements. The objective of accounting standards Is to make financial statements of different
enterprises comparable to provide meaningful information to various users of financial
statements. Accounting standards make the information provided by the financial statements
useful, transparent and comparable for the users if the financial statements.

In our country, the Institute of chartered Accountants of India [ICAI] issues the accounting
standards to harmonize the diverse accounting policies and practices at present use in India. The
ICAI constituted the Accounting Standards Board [ASB], the composition of which is broad
based with a view to ensuring wider participation of all interest groups in the standard setting

It needs to be understood that the Accounting standards cannot be absolutely rigid like those of
the physical sciences. These rules, accordingly, should provide a reasonable degree of flexibility
in line with the requirements and technological developments. It may also be noted that the
treatment as specified by the Accounting standards.

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Every business enterprise needs money constantly for its operations and such money is provided
by the owners themselves, the gap, if any, being bridged by outsiders, viz., creditors. These
funds are constantly in movement, involved in various financial transactions, thus continuously
altering their form and content. A periodical assurance about their safety is, therefore, required
by both the owners and the creditors. Further, if the enterprise happens to be limited company-
the owners are the shareholders who do not exercise any direct control over the day-to-day
affairs or administration of the Company, this being entrusted to the Board of Directors or the
Management team. The management is, therefore, bound by law as well as contractual
obligations to use such funds in accordance with the mandate of the purveyors of funds and
produce evidence of having done so at periodical intervals. Financial Accounting is the manner
of recording all financial transactions so as to enable extraction of the evidence mentioned

Financial Accounting is the “art of recording, classifying and summarizing, in a significant

manner and in terms of money, transactions and events, which are, in part at least, of a financial
character and interpreting the results thereof. Financial Accounting, therefore produces a
significant summary of all recorded financial operations for the purpose of interpreting the end-
result of such operations. Such a summary is called the Financial Statements, which comprise the
Balance Sheet and the Profit and Loss Statement.

American Institute of Public Accounts describes Financial Statements as under:

“Financial Statements are prepared for the purpose of presenting a periodical

review or report on the progress by the Management. They deal with the status of
investment in the business as also with the results achieved during the period. They
reflect a combination of recorded facts, accounting conventions and personal judgments.
And, the judgments and conventions applied affect them materially. The soundness of
judgment necessarily depends upon the competence and integrity of those who make
them and on their adherence to generally accepted accounting principles and

MBF 2008-2010 84
This definition is very appropriate as it succinctly but nonetheless effectively brings out the
characteristic features of Financial Statements, their strengths and weaknesses and their
reliability and limitations. This understanding is very important to us since the reliability or
authenticity of the Analysis of the Financial Statements would, it will be appreciated, be just as
much as that of the Financial Statements themselves. This definition indicates the following
characteristic features of the Financial Statements:

I) They are periodical review of the status of investment and progress made by the

ii) They contain facts recorded on the basis of accounting conventions and exercise
of personal judgments.

iii) Integrity and competence of accountants who prepare them have a vital bearing
on the ultimate results furnished by them.

A major weakness of Financial Statements is its lack of objectivity, being influenced largely by
subjective exercise of judgments. For instance, in the hands of unscrupulous management with
fraudulent intentions, manipulations are possible, which could distort, to a large extent, the
ultimate results, thus camouflaging the real picture. Nevertheless, if the accountant compiles the
statements diligently and without personal bias and on the basis of established and generally
accepted accounting conventions, the Financial Statements do reflect the financial conditions of
the limited companies to examine, among others, the accounting practices, and procedures and
comment on whether the Financial Statements give a ‘true and fair view’ of the state of affairs
and the net result. The Auditor’s Report is, therefore, an independent professional guarantee for
compliance with the generally accepted accounting principles and to that extent, takes care of
lack of objectivity, and an intelligent scrutiny of the Annual Report is bound to bring out
Auditors reservations, if any, on this subject.

MBF 2008-2010 85
To ensure the genuineness of the financial statements and that of the signatures of the chartered
accountants therein, in case of large borrowers, viz. borrowers whose fund based limits are Rs.1
cr and above, a confirmation is to be obtained by sending a letter by Post/ e-mail regarding
certification of financial statements from the Chartered Accountant who has signed the balance
sheet / financial statements of the borrowers and this confirmation will be kept with the files of
correspondence pertaining to the borrower.

MBF 2008-2010 86
Balance Sheet Analysis

Balance Sheet, as the name indicates, is a statement of balances, depicting the state of affairs or
position of a business enterprise. Since it is an aggregation of balances, it pertains obviously to a
particular date. As on the date of reckoning, it discloses to the user of the statement of the
investment of funds made by the enterprise on various classes or categories of assets and the
various sources from which funds have been drawn to enable such investment. It would be useful
to visualize a Balance Sheet essentially in terms of the resources of an enterprise and claims held
against such resources provided to it. Clearly every person or organization providing funds to the
enterprise (either directly as investors and lenders or indirectly by providing credit or deferring
payments due to them) will have claims against the assets or resources of the enterprise and will
expect such claims to be met at appropriate times, inevitably there is a cost attached to claims,
which needs to be reimbursed to all outsiders either in a Lump sum at the time of repayment of
the principal amount of the claim or in installments at the option of the providers of funds. Thus,
it behaves of the manager of the enterprise to conduct the affairs of the business in such a way
that the following objectives are met

i) the funds provided to the manager by the owners/shareholders and lenders/other

creditors are judiciously invested to create certain assets,

MBF 2008-2010 87
ii) the assets so created should be capable, through their operation and use by the
manager, of yielding the highest return in terms of the net income after meeting
all expenses and charges incurred in earning that income.

iii) the net income so earned should be adequate to service the cost of funds, viz,
interest on loans and dividend on capital, in addition to redemption of the capital
funds (principal) where stipulated, and to leave a surplus for future growth.

iv) the surplus funds should be so invested as to enable their prompt and ready
encashment to meet maturing claims against the enterprise.

The Balance Sheet of an enterprise is basically analysed to test the above hypotheses and can,
therefore, be deemed to reflect the financial condition of the enterprise. It was for this reason that
some of the U.S. accountants and business organisations refer to Balance Sheet as ‘ A Statement
of Financial Condition’. While this is so, the Balance Sheet has certain limitations and cannot be
treated as the sole indicator of financial position of a unit.

Format of Balance Sheet:

The Balance Sheet can be presented either in a ‘ T’ form or in a vertical order, beginning with
assets. While the Companies Act, 1956, prescribes the form in which the Balance Sheet has to be
presented by the limited liability corporations, there is no such standard form for non-corporate

Schedule VI Companies Act, 1956 contains the format in which limited companies should
present the Balance Sheet to the shareholders. The format has been devised by the framers of the
Act, keeping essentially the interests of the shareholders in view, though there are provisions in
the Act to protect the interests of all classes of persons or organisations who transact business
with the Company.

The grouping of the various assets and liabilities in Schedule VI follows the familiar dictum that
assets and liabilities should be detailed in their order of permanence. For instance, assets start

MBF 2008-2010 88
from fixed assets-the near permanent assets - and go down to current assets, loans and advances
which are regarded as being closest to cash in terms of their convertibility to cash within a short
period. Similarly, the liabilities start with share capital - the near permanent source of funds to an
enterprise - and travel through long term loans down to current liabilities and provisions, the last-
mentioned items requiring layout of funds by the enterprises at short notice.

In accountant’s parlance, current assets, could, therefore, be converted into cash within a period
of 12 months and current liabilities are those liabilities that mature for payment within 12
months. Thus “advances to staff and group companies” for instance can be a current asset, if they
satisfy the test of conversion to cash within one year.

Balance Sheet: Format As Per Schedule VI Of Company’s Act,


For Corporate Entities



- Authorized Capital (Preference and - Gross Block
Equity Separately ) - Less: Depreciation
- Issued Capital Net Block
- Subscribed Capital - Capital working in progress
- Paid- up capital - Distinguishing as far as possible
- Less: Calls Unpaid between various items of
Add: Forfeited Shares expenditure i.e. goodwill, land and
(Only Paid-up Capital is added into building etc.
the total of the liabilities) 2 INVESTMENTS
Add: Share Application Money - Investment in Govt. or trustee
- General reserves - Investment in shares/debentures of
MBF 2008-2010 89
- Share Premium Amount subsidiary companies
- Other reserves - Investment of capital of partnership
- Sinking Funds firms
- Retained Profits 3 CURRENT ASSETS
3 SECURED LOANS - Cash and Bank Balances
- Cash Credits - Stock
- Term loans - Sundry Debtors
- Debentures a) O/s for a period exceeding 6
- Loans from Associates and b) Other debts
- Fixed Deposits - Advances for capital goods
- Other Loans and Advances - Advances to staff
5 CURRENT LIABILITIES AND - Loans to sister concern
- Acceptance - Preliminary expenses
- Sundry Creditors - Expenses including commission,
- Unclaimed dividends brokerage etc.
- Subsidiary Companies - Discount on shares and debentures
- Interest Accrued but not due - Interest paid out of capital during
PROVISIONS construction
- For Taxations - Development expenditure not
- For Providend Funds adjusted
- For Proposed Dividend 6 PROFIT AND LOSS ACCOUNT
- For Contingencies - Debit balance of profit and loss
- For Other Provisions account carried forward

MBF 2008-2010 90


Name of Entity/Entities
Balance Sheet as at
Figures for Capital and Figures for Figures for Properties Figures For
Previous year liabilities Current year Previous year and Assets Current Year

1. CAPITAL (In case of partnership, these 1. FIXED ASSETS

particulars to be given separately for each Under each head the original cost the
partner and if possible the fixed capital addition thereto, deductions three from
accounts may be segregated from the the year and the total depreciation
current accounts) as at the beginning written off or provided up to the end of the
of the year. Year to be stated.
Where the assets have been revalued, the
Add/ Deduct net profit /Net Loss during revalued figures to be shown. Each balance
the year. Sheet for the first five years. Subsequent to
MBF 2008-2010 91
Interest on Capital the date of revaluation to state the amount
Drawings of revaluation.
Any other items (give details) distinguishing as far as possible between
Expenditure upon.
a) Goodwill
b) Land
c) Building
d) Leasehold
e) Railway sidings
f) Plant and machinery
g) Furniture and fittings
h) Development of property
i) Patents, trademarks and designs
j) Livestock
k) Vehicles etc.
1. Cost
2. Less : depreciation
2 RESERVES (give details under each head) 2 ADVANCES AND DEPOSITS ON
Capital reserves (if any) CAPITAL ACCOUNT
1. Other reserves (including retained profits
To the extent not already added to the
Capital, given details )


Interest accrued and due on each category Investments in shares, debentures or bonds
To be shown separately. In case of secured (Note: Investments in concerns wherein
Loans the bature of security to be specified. Proprietor, partner or their relatives are
Amounts due for payments within one year interested to be shown separately)
MBF 2008-2010 92
From the balance sheet date to be shown Immovable properties
Separately. Loan from partners, relatives of Investments in the capital of partnership
The proprietor or partners to be shown separately firms.
Loans from financial institutions. Other Investemnts.
Loans and borrowings from banks (specify the
Name of the nature of the borrowing e.g. cash
Credit term-loans, overdraft, packing credit etc.)
Fixed deposits (from public and others)
Others (give details)
a) Investories
Stock in trade.
Supplies and sundries (if the trading
Organization is also involved in any
processing activity/ies other
categories of inventories e.g. raw
material and work in progress
should be separately disclosed.
b) Recievables
Debts due and outstanding for a
period exceeding six months
Installments of deferred recievables
due within one year to be shown
Amount due from proprietors,
partners or associated concerns
On account of sales deferred
payment basis.
On account of exports
MBF 2008-2010 93
Total receivables
Less : provision for bad and
doubtful debts
c) Bills of exchange
d) Advances on current Account
Advances of suppliers of raw
material and
Advance payment of taxes
Pre-paid expenses
e) Cash and bank balance
Fixed deposit account
Current and saving account
Cash in hand
f) Miscellaneous expenditure
To the extent not written off or
g) Accumulated losses
If any before depreciation

MBF 2008-2010 94

Name of the entity

Profit & Loss Account for the year ending……
Last year
Rs. Rs.


(income for services may be shown separately)

2. Cost of goods sold

I) Opening stock
Add: Purchases (less returns)
Less: Closing stock
II) Other Direct expenses
3. Gross Profit (1-2)
4. sales and administrative expenses
5. Other Income expenses* net (+)
6. interest
7. Profit before depreciation and tax
[item 3 minus item (4+5+6)]
8. Depreciation
9. Taxation (for example for registered firms)
10. Profit after depreciation & taxation item minus item (8+9)

MBF 2008-2010 95
NOTE: Any item which forms a significant proportion, say 5% or more of the total sales or has
special significance otherwise should be shown separately under appropriate heads for example
(I) salary (II) commission (III) perquisites and money value thereof.
**registered firms are subject to tax, before the profit is apportioned amongst partners.

MBF 2008-2010 96


CURRENT ASSETS: Also called Liquid Assets/ Circulating Assets/ Floating Assets/ Gross
Working Capital

Definition: those assets which are reasonably expected to be converted into cash during the
operating cycle of the business. Assets however liquid which do not form a part of operating
cycle are not classified as current assets by bankers.

Three categories:

 Inventories (stock in trade)

 Receivables (trade debtors)

 Other current assets



a) Stock of raw materials on hand-indigenous, imported

b) Stock of work-in-process (semi finished goods)

c) Stock of finished goods on hand

d) Goods at stores and spares – indigenous and imported


a) Sundry debtors (trade debts/book debts)

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b) Bills receivables (bills accepted by sundry debtors)

- Inland bills up to 6 months, including deferred receivables maturing within one year.

c) Export


a) Cash & Bank balance

b) Investment

- In government and trustee securities

- Investment in fixed deposits with banks/MMFS/CPS/CD

Investment in quoted securities

c) Advance Tax Payment after adjusting reserves for taxation

d) Advance given to suppliers

e) Advance recoverable in cash or kind

f) Advance accrued on investment

g) Pre-paid expenses

h) Cash margin on LG/LC


These assets cannot be included in Current assets as they are slow moving or as they are not
acquired for normal business purpose.

1) Dead inventory – slow moving inventory – obsolete items/slow – moving items not
readily realizable.

MBF 2008-2010 98
2) Deferred receivables – other than those maturing beyond/after one year

3) Amounts due from Associates/subsidiaries/affiliates

4) Other loans and advances

5) Security deposits- balance/deposit with govt. Dept./Statutory Bodies/Tender deposit

irrespective of their maturity period.

6) Receivables not related to trade-

a) Advances given to staff members

b) Advances given to directors, partners.

c) Advances given to companies not connected with business

d) Advances for purchase of fixed assets or advance to supplier or contractor for capital

e) Investments in companies not related to trade.

7) Unquoted investments/ gratuity funds/ sinking funds for long term purpose.

8) Other Miscellaneous assets/CD etc.


Also known as block assets/capital asset/Capital goods/Productive assets/tolls of business.

Definition: Assets which are acquired for long term use and are not meant for sale in the normal
course of business. They are least liquid.


1) Land

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2) Building

3) Plant and machinery

4) Furniture, fixtures & vehicles etc.

5) Construction – awaiting completion

6) Other assets of long term nature

7) Other fixed assets

Gross Block- The total value of all fixed assets before depreciation.
Net Block- Value of fixed assets after depreciation.
Net Block= Gross block – Depreciation

Valuation of fixed assets = Fixed assets are valued at original cost less depreciation.
Revaluation – Where assets have been revalued the increase in their value due to revaluation
should be set off with revaluation reserve to make comparisons meaningful.

Depreciation – A company is free to charge depreciation on straight line method or written down
value method or any other method. The depreciation amount in straight-line method is higher
compared to that in W.D.V. method. The income tax liability of the company is calculated after
providing depreciation in W.D.V. method at rates given in the I.T. act


Definition: Assets which have no tangible existence or certain fictitious assets which are in fact
capitalized expenses are classified as intangible assets.

Good Will (value of reputation associated to a business)
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Copyright (amount paid to the author to obtain copy right of a book)
Patents (amount paid towards obtaining patent over a new product)
Trade Mark
Franchise (amount paid towards getting exclusive right for using a brand)
Preliminary expenses (company formation expenses capitalized)
Deferred Revenue Expenditure
Debit Balance in profit and loss account (adverse profit & loss account)
Drawings by partners (withdrawal of capital) in partnership firm
Bad & Doubtful debts not provided for
Pre – operative expenses/developments expenses etc. to the extent not written off.

Nature of these assets –

A banker presumes that these assets are a drain on the capital. The assets are not available for
payment of debts as long as the business runs and they are not realizable at the time of



• Net Worth
• Term Liability
• Current liability

Net worth - Also known as Share holders, funds or owners equity.

Items are almost permanent source of fund (need not be paid back as long as the business runs)
Items represent the amount of funds (resource) given (or not drawn) by the owner (share holders)
of the business.
MBF 2008-2010 101
They are permanent source of funds.
They represent the owners’ stake in the business.
They do not carry any fixed charge by way of interest.
They are not outside liabilities.


Paid up capital [equity & preference]

Free Reserve
Ordinary share capital [paid up]
General Reserves
Revaluation reserves
Share premium amount
Balance of profit
Preference share capital maturity after 12 years
Other reserves

TERM LIABILITY – also known as long term liability or Deferred Liability

Definition: Liabilities which mature for payment after a period of one year from the date of
balance sheet are called term/deferred liabilities.
Examples :
Term loan from financial institutions, bank [excluding installment payable within one year]
Debentures payable after one year [not maturing within one year but maturing within 12 years]
Deferred payments credits[excluding installments payable within one year]
Term deposits payable after one year.
Preference Share redeemable after one year but before 12 years
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Working Capital Term Loan
Deposits from dealers – which are refundable only on termination of dealership are to be treated
as term liability.
Other term liability [including ECB/ADR/GDR/FCNR, loans etc.]


Definitions: liabilities payable in short term (within a year) from the date of balance sheet are
classified as current liabilities. They represent short term source of fund and should be utilized
for financing current assets.

Short term bank borrowing against stock, stores etc. (cash credits, overdrafts)
Sundry creditors for trade (creditors on account of supply of raw materials)
Advance/ progress payment from customers for supply of finished goods.
Sundry creditors for expenses
Bills payable (bill accepted on account of sundry creditors)
Outstanding/Accrued expenses (expenses like rent, insurance due/accrued but not paid)
Provisions (made towards payment of taxed, bonus etc.)
Dividend payable within one year of provision
Deposits from dealers (not accepted with a condition to be repayable on cancellation of
dealership or agency)
Other statutory liability like PF dues etc.
Installment of term loan, debentures, deferred payment, deposits or preference share capital,
DPG/DEB/RP shares/ECB/ADR/GDR due within one year.
Working capital term loan – term liability
Unsecured borrowings from the bank including bills discounted.

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Unsecured borrowings from others, where no period of repayment is mentioned. Deposits
maturing within one year.
Interest and other charges accrued but not due for payment.
Other current liability/provision, such as gratuity liability due within one year of provision.



Limitations of a Balance Sheet

While the above analysis of the Unit’s Balance Sheet does disclose certain important indicators
to the analyst, he will do well to remember that conclusions based purely on the Balance Sheet
may quite be misleading, due to its inherent limitations. The Balance Sheet is often likened to a
snapshot of a moving train and hence reveals just as much about the financial condition as the
photograph does of the moving train, capturing only a particular position. Hence, any undue
reliance on Balance Sheet is fraught with risks. The limitations of balance sheets are four-fold.

i) Exactness owing to personal bias of the accountant in exercise of his judgment:

e.g. valuation of stocks, provision for bad debts etc.

ii) Non-recognition of diminishing value of rupee and treating all assets only in terms of their
recorded rupee value: inflation accounting is the answer

iii) Exclusion of all non-monetary transactions and factors, howsoever important they may be.

iv) Pertains to a date and hence liable to abuse like window-dressing.

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In order to eliminate at least some of these limitations, the analyst could examine a series
of balance sheets and discern a trend of the various financial and performance indicators. Such a
comparison could be internal i.e. with past performance or external i.e., with those of similar
units. A Balance Sheet analysis, it will be appreciated, is only the first step in the whole analysis,
an indicator ordering a further probe, but definitely not the final conclusion.


Importance of the Profit and Loss Statement

The profit and loss statement summarises the transactions which together result in a profit (or
loss) for a specific period of time. This profit or loss is shown on the balance sheet as an increase
or decrease in owners’ equity. People who invest in securities believe that a study of the profit
and loss statement of a business enterprise will give them information regarding future
expectations of profits and dividends. It is in this context that the profit and loss statement has
gained importance.

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The profit and loss statement reports the results of operations and indicates areas
contributing to profitability or otherwise of the business enterprise. Analysis of profit and loss
statements for several years may reveal desirable or undesirable trends in the profit earning
capacity of a business enterprise.

Revenues, Expenses and Changes in Owners’ Equity

Defined more precisely, revenues are increases in owners’ equity that result from
operations of a business enterprise while decreases in owners’ equity are expenses. Revenues
take the form of an inflow of assets like cash and sundry debtors from customers or clients to
whom products have been sold or services rendered. Revenues might also be earned from
investments, for instance, interest on Govt. securities or dividends. It should be noted that
revenues are not the only source for increase in owners’ equity. An inflow of capital funds
invested by owners increases owners’ equity but it is not revenue.

Expenses connote “sacrifice made”, “cost of services or benefits received”, or

’resources consumed’ during a specified period. Expenses are costs incurred for generating
revenue and are therefore related to the operations of a business enterprise. As stated earlier,
expenses decrease owners’ equity, however they are incurred in the expectation that the revenues
generated will more than offset the decrease in owners’ equity. The excess of earned revenues
over the incurred expenses in a specific period is called profit or income. If expenses exceed
revenues the difference is called a loss resulting in net decrease in owners’ equity.

The Format of the Profit and Loss Statement can be seen from the Exhibit A furnished

Exhibit ‘A’


Profit and Loss Statement for the year ended March 31, 2006

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Sales of goods and service 1,44,73,526

Cost of goods sold 79,88,956

Gross Profit 64,84,570

Operating Expenses

Staff Expenses 31,64,830

Sales and Administration Expenses 18,64,390

Depreciation 3,56,971

Managerial remuneration 80,169

Operating Profit 10,18,210

Other Income 4,35,326

Net Profit before taxes 14,53,536

Provision for Taxes 7,90,000

Net Profit after Taxes taken to General 6,63.536


Exhibit A’ is a profit and loss statement for Dhrupad Company. The statement shows the results
(in Rupees) of operations of this company for the year ended March 31,2006.

As seen from the exhibit “A”, Dhrupad Company made a profit of Rs.6,63,536. This profit will
be included as a net increase under ‘general reserve’ in owners’ equity section of the balance
sheet of Dhrupad Company.

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Instead of the format outlined in Exhibit ‘A’, some published annual statements in India follow
the practice of listing revenues on the right hand and expenses on the left hand side of the profit
and loss statement. This format is an outcome of the practice to represent the profit and loss
account as it appears in the detailed accounting records (ledgers). Generally, additional schedules
giving details of cost of goods sold and operating expenses are appended to a published profit
and loss statement. Generally the format given in the exhibit facilitates easy analysis of the profit
and loss statement. Comparison of results of operations for several years and calculation of ratios
and percentages is easily done if the vertical format is followed.

The first item on the profit and loss statement in Exhibit “A” is sales of goods and services. This
item represents the revenues from operations for Dhrupad Company. Revenue might also be
derived from exchange or sale of assets, interest on dividends from ‘other investments’. The
usual practice however is to distinguish the two kinds of revenues. Revenue arising out of
normal operations is designated as sales revenue whereas revenue arising out of investments and
sale or exchange of assets is called ‘other income’

The second item of the profit and loss statement is cost of goods sold. Cost of goods sold is an
item of expense and results in a decrease in owners’ equity. The difference between ‘sales and
cost of goods sold’ is called ‘gross profit’ which in our case amounts to Rs.64,84,570. From
gross profit several other items of expenses called operating expenses are deducted, the
difference between gross profit and operating expenses is called operating profit. The operating
profit figure is very important since it discloses the profitability and operating efficiencies of
Dhrupad Company.

The next item on the profit and loss statement is ‘other income.’ Other income is a net figure and
includes interest on investment and securities paid or received, and profit or loss on sale and
exchange of assets, etc. The total of operating profit plus other income gives the figure of net
profit before taxes. Provision for taxes calculated according to income tax rules is deducted
leaving a figure for net profit after taxes. Net profit after taxes represents the net increase in
owners’ equity for Dhrupad Company during the year ended March 31, 2006.

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The accounting period:

The profit and loss statement illustrated in Exhibit ‘A’ pertains to one year’s operations of
Dhrupad Company. Ideally, an exact measurement of the net profit or loss of a business
enterprise can only be made after the enterprise has ceased doing business and sold all its assets
and paid off its liabilities. Management however cannot wait until the business operations have
ended to determine the profit or loss from operations. In practice, therefore, accountants attempt
to determine profits or losses for intervals of time shorter than the total life of a business entity.
Accounting transactions that have occurred during a specified period of time are collected,
summarised and a report is made of all the material changes in owners’ equity during this
specific period. This specific period which is chosen to report profits or losses is called the
Accounting period.

Although published statements for reporting to owners and outside agencies are prepared at
annual intervals (quarterly performance reports should be furnished to stock exchange by the
listed companies), management often needs interim profit and loss statements prepared for
shorter intervals of time. This interval might be a quarter, a month, a week or even daily. Over
the life of a business enterprise, a profit and loss statement and balance sheet are prepared at the
end of each accounting period. The profit and loss statement presents the results of operations
during an accounting period. It might also be said that a profit and loss statement covers the
period between two balance sheet dates and explains the changes in owners’ equity during the
accounting period.


Cost of Goods Sold and Operation Expenses:

Profit and loss statement will give the figure of gross sales. Net sales is arrived at by deducting
from gross sales, sale returns and allowances and sales discounts, excise duly and Sales tax.

Gross Sales

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Gross Sales is total sales revenue measured by multiplying goods delivered into unit price per
item. State and local sales taxes and octroi and excise duties charged to a consumer are to be
excluded from net sales as they are not revenue for the unit but are collected by a business
enterprise on behalf of the Central, State and Local authorities. Until such time as they are
passed on to the government, they represent a liability of the business enterprise to Government.

Sales returns are part of goods sold to customers but returned by them to the business because
the goods are not of a kind of quality ordered by a customer. Goods returned are called sales
returns. Instead of returning the goods customers may sometimes claim an allowance on the
price. In such a case, the allowance on price is called sales allowance.

Sales discounts are deductions from sale price allowed to customers to induce them to pay
promptly. For example, a business may sell goods on terms 2/15, n/45 which means that
customer will get a 2 percent deduction from the billed amount if payment is made within 15
days, after 15 days no discount will be given but the customer will be required to pay the billed
amount within 45 days. Since sales discounts reduce the revenues received from sales it is
deducted directly from gross sales instead of being shown as an expense item. Another kind of
discount, trade discount does not appear on the profit and loss statement at all, trade discount is
the amount deductible from published or catalogue price in order to arrive at actual sales price.

Sales Revenue and the Realisation concept

The realisation concept is one of the most important concepts influencing modern day
accounting practices. This concept states that as a general rule, sales revenue is recognised in the
accounting period in which revenue is realised. Realisation occurs when goods are shipped or
delivered to the customers. For services, revenue is recognised in the period in which services
are rendered. It is important to emphasise that revenue recognition occurs not when a sales order
is received, not when a contract is signed but when the goods are shipped or delivered. Payment
for goods shipped or services rendered may be made immediately or after a period of time, the
timing of payment is quite immaterial to the realisation concept. The crux of revenue recognition

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is performance of the contractual obligation through shipment or delivery of goods or rendering
of services.

Cost of Goods Sold and Operating Expenses

At the same time as owners equity is increased by the sales value of goods shipped or delivered
or services rendered it is also reduced by the cost of goods sold and operating expenses. In this
section we shall explain how cost of goods sold and operating expenses are measured but before
we do so it should be emphasised that cost of goods and operating expenses are both expenses
and have the same effect on owners’ equity, a decrease. But a distinction is made between these
two items since gross profit (difference between sales revenue and cost of goods sold or services
rendered) constitutes very important and useful information to management and other users of
financial statements. Published statements are required to state all three items, that is, sales
revenue, cost of goods sold and gross profit.

Measuring Cost of Goods Sold

The problem of measuring cost of goods sold arises because a business does not sell all the
goods that it purchases during an accounting period. For example, a business may purchase
10,000 units of a product at Rs.5 per unit during an accounting period. If 5,000 units are sold
during the accounting period at Rs.6 per unit, what is the cost of goods sold? The problem can be
explained as follows: The purchase of 10,000 units can be regarded as inventory of Rs.50,000,
an asset available for sale during the accounting period. Since only 5,000 units were sold, the
cost of goods sold is Rs.25.000 (5,000 units x Rs.5 per unit), the balance of 5,000 is inventory
available for sale during the next accounting period. If during the next accounting period another
3,000 units were purchased at Rs.5 per unit and 7,000 units were sold at Rs. 6 per unit partial
profit and loss statements and balance sheets for operations for the two accounting periods would
be -

Profit and Loss statement Balance Sheet at the end

for Account Period 1 of Accounting Period 1

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Sales 30,000 Assets

Cost of Goods sold 25,000 Current Assets


Gross Profit 5,000 Inventories 25,000


Profit and Loss Statement Balance Sheet at the end

for Accounting Period 2 of Accounting Period 2

Sales 42,000 Assets

Cost of Goods sold Current Assets

Opening Inventories 5,000

Inventory 25,000

Purchases 15,000

Goods available for sales 40,000

Less Closing Inventory 5,000

Goods sold 35.000

Gross Profit 7,000

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During the two accounting periods, a total of 13,000 units were purchased at Rs.5 per unit of
which 12,000 units were sold leaving a balance of 1,000 units at the end of the second
accounting period. The cost of this inventory which is the closing inventory is Rs.5,000.

In the above example, we were concerned with measuring cost of goods sold in a business which
was primarily engaged in buying and selling goods without any processing. In manufacturing
businesses, where materials are processed and converted into finished goods before sale, the
measurement of cost of goods sold is slightly more complicated.

There are two distinct methods of calculating cost of goods sold. The first method called the
perpetual inventory method is commonly used by businesses which are buying and selling high
unit price, low volume items (like refrigerators and air conditioners.) In such businesses, a record
is kept of the cost of each item sold, and cost of goods sold is determined by simply adding up
the cost associated with individual items sold. The total cost of goods sold is subtracted from the
asset inventory so that at all times the asset inventory represents cost of goods still available for

The other method called the physical inventory method is generally used by businesses engaged
in buying and selling high volume low unit price items (like provision stores). In this case, no
track is kept of costs associated with each item that has been sold, but a physical inventory of
goods remaining unsold is taken at the end of each accounting period. Costs are associated with
the physical inventory on hand which results in the value of inventory not yet sold. The cost of
goods sold is then determined through a process of deduction. To the inventory available for sale
at the beginning of an accounting period (or remaining unsold at the end of the previous
accounting period) is added the value of purchases made during the accounting period for which
the profit and loss statement is being prepared. From this, the value of physical inventory not yet
sold is deducted, giving the cost of goods sold during the current accounting period.

Until now the figure used for “purchases” represented the gross value of purchases. To
determine the net purchases during an accounting period certain adjustments to gross purchases
are necessary. A part of the purchase may be returned to the supplier because the goods supplied
MBF 2008-2010 113
were not of the kind or quality ordered. Purchases returns will thus be deducted from gross
purchases. Similarly, where an allowance on purchase price is claimed for non-standard goods,
purchase allowance is also deducted from gross purchases. Purchase discount is next deducted
from gross purchases. If any freight charges are incurred on the purchases of goods, this is added
to gross purchases. To summarise by using an example, cost of goods sold for an accounting
period will be calculated thus,

Opening Inventory Rs. 500

Purchases Rs. 300

Add : Freight in Rs. 30

Rs. 330

Less : Purchases Return

and allowances. Rs. 50

Less : Purchase Discounts Rs. 20

Add : Net purchases Rs. 260 As. 260

Goods available for Sales Rs. 760

Less : Closing Inventory Rs. 250

Cost of goods sold Rs. 510

It should be noted that under the physical inventory method, we are assuming that if goods are
not found in physical inventory at the end of an accounting period, they must have been sold.
This is perhaps an erroneous assumption, since goods might have been pilfered or lost instead of
being sold. Unless steps are taken to determine such shrinkages in physical inventory, the cost of
goods sold calculation might be misleading. On the other hand, in the perpetual inventory

MBF 2008-2010 114
method an actual count of inventory on hand can be made to check the accuracy of perpetual
inventory records.

Measuring Operating Expenses

Earlier in this note, we defined expenses as ‘sacrifice made’, ‘cost of services or benefits re-
ceived’, or ‘resources consumed’ during a specific accounting period. It might now be useful to
distinguish between expenditures and expenses. An expenditure takes place when an asset, re-
source or service is acquired in exchange for cash, another asset or by incurring a liability.
Expense is incurred only when the asset, resource or reserves is used or consumed. During the
total life of a business all expenditures must become expenses. Within a single accounting period
however, there is no necessary correspondence between expenditures and expenses. The
relationship between expenditures and expenses is illustrated with examples in the next few

Expenditure incurred during an ‘accounting period’ which become expenses in the same
‘accounting period.’

If a resource, service or asset is acquired and consumed during the same accounting period, it is
both an expenditure and expenses for that accounting period. There is an exact correspondence
between expenditure and expense in the current accounting period in so far such items are

Illustration: In Dec 2005, goods worth Rs.5,000 were purchased for cash. There was thus an
expenditure of Rs. 5,000. One asset ‘inventory’ or ‘stocks’ being acquired in exchange for
another asset ‘cash’. Out of this amount of Rs 5,000, how would be accounted for as expense for
the year ended 31 March 2006? If all these goods were sold before 31 Mar 2006, there was an
expense of Rs.5,000 in the year 2005-06. If none of the goods were sold in 2005-06, there was
no expense in 2005-06. If the goods were sold subsequently in April 2006, there was an expense
of Rs.5,000 in the year ending 31 March 2007. If only Rs,3,000 worth of goods were sold in
2005-06, there was an expense of only Rs.3,000 in 2005-06.

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Expenditure incurred during an accounting period that become expenses in that same accounting
period are the simplest types of accounting transactions. However, as can be seen from the next
three sections, not all expenditures become expenses in the same accounting period in which
they are incurred,

Expenditures incurred in previous accounting periods that will become expenses in ‘current ac-
counting period’.

In the last part of the previous illustration we saw that out of an expenditure of Rs.5,000 in 2005-
06 only Rs.3,000 became an expense during the same year. What happened to the difference of
Rs. 2,000? The expenditure of Rs.2,000 would have been shown as an asset on the balance sheet
as on March 31, 2006 and may be used up and transformed into expenses in 2006-07 in or future
years. Three major types of such assets are described below:

Current assets include inventories of products which have not been sold at the end of the
previous accounting period- these will become expenses in the ‘current accounting period if the
products are sold in this period.

Another kind of asset is prepaid expenses and deferred charges. These assets represent cost of
services purchased in previous accounting periods but not used up until the commencement of
the current accounting period. Such assets become expenses in the period in which they are used
up or consumed. Insurance premium provides an example of prepaid expense. Premiums on
most insurance policies are payable in advance and the amount paid as premium remain as assets
until the accounting period in which the protection becomes effective at which time the
proportionate premium is treated as expense.

Illustration: - A company paid Ps,3,000 for rent in advance for 3 years on March 31, 2006. The
balance sheet prepared on March 31, 2006, should show an asset ‘prepaid rent’. However, in the
next three years, one-third of the prepaid rent, that is, Rs.1,000 would be regarded as an expense
each year..
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The third type of assets that become expenses are Long-lived assets. Fixed assets are acquired by
a business enterprise in the expectation that they would be used in generating revenue over a
period of time. Fixed assets would therefore, become expenses in future accounting periods
when the assets are used. The conversion of fixed assets into expenses parallels the examples of
insurance premium. One important difference is that in case of insurance premium the life of the
policy is definite whereas in case of fixed assets, like plant and machinery, the asset life has to be
estimated. Because of the estimation involved, the process of determining the portion of the plant
and machinery cost that will be regarded as an expense for the current accounting period is quite
a difficult task. Although difficult, the concept of depreciation has been devised to estimate the
expense for each accounting period.

Expenditure incurred in “current accounting period” that are not yet expenses

In the preceding section, it was described how assets become expenses in the current accounting
period. Using the current accounting period as our reference point, there are some expenditures
incurred in the “current accounting period” which are not expenses in the “current accounting
period” but will become so in future accounting periods when the assets or resources are
consumed or used up. Such expenditures include not only assets that are purchased for future use
but also expenditures on the manufacture or purchase of products that are to be sold in future
accounting periods. Thus using the illustration from the preceding section, the expenditure of
Rs.3,000 in March 2006 on insurance premium, is an expenditure that is not yet an expense in
the accounting period for the year ended March 2006.

Expense for ‘current accounting period’ that will be paid for in subsequent accounting periods:

This category of operating expense is called accrued expense. The characteristic of accrued
expense is that although services might have been used or benefits received in the current
accounting period, payment for these services or benefits will be made in future accounting
period. Owners’ equity is reduced when these expenses are incurred. Subsequent payment of the
liability does not affect ‘owners’ equity’

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An example, of this type of expense is wages and salaries that are earned by employees but have
not yet been paid. Some firms follow the practice of paying wages and salaries for a month in the
first week of the following month, that is, wages and salaries for March 2006 are paid by the first
week of April 2006. So far as the accounting period for the year ending March 2006 is
concerned, wages and salaries for March 2006 are expenses for the period, although they will be
paid only in April 2006.

Another example of accrued expense is interest expense. Interest is the cost of borrowed money
and is an expense for the accounting period in which borrowed money is used. Quite often,
interest is payable quarterly. If the annual accounting period ends on March 31, interest for the
period Jan to March 31 has been incurred, although the obligations to pay will arise only in
April. The obligation to pay interest is shown as a liability in the balance sheet prepared on
March 31.

For all expenses of this type, transactions involved are essentially the same, the expense is
shown as operating expense in the accounting period in which the services were used or benefits
received. The obligation which results from this expense is shown as a liability in the balance
sheet at the end of the current accounting period.

The ‘Accrual concept’ - Cash Versus Accrual Accounting

The essence of the accrual concept is that net profit (or net loss) arises from revenue and
expenses transactions during an accounting period and that net profit (or net loss) is not synony-
mous with cash increase or cash decrease.

Earlier we have seen that the process of revenue recognition is not necessarily associated with
the collection of cash. For example when products or services are sold on credit the increase in
revenue leads to a corresponding increase in the asset, sundry debtors. At a later date when cash
is collected from customers, increase in asset ‘cash’ is offset by decrease in the asset ‘sundry

MBF 2008-2010 118
debtors’, revenue is not increased at the time of collection but rather at the time when the
products or services were delivered and billed on credit terms.

Occasionally, customers make advance payments for products or services to be delivered or sold
in future years. Revenue is not recognised at the time of receipt of advance payment, although a
liability to sell products or render services in future periods has been created at the time of
advance payment. Revenue will be recognised only when products or services are actually
delivered and billed. The liability would be removed at the time when revenue is recognised.

In a like manner, expenses are not necessarily represented by cash transactions. Expenses occur
when benefit is received from or use is made of an expenditure or asset. The payment for the
expenditure or asset may be in quite a different period than the one in which the expense is
recognised. For example when supplies are purchased on credit, an asset account is created and
liability to the creditor is recorded. Expense is recognised in the accounting period in which
these supplies are used or consumed. When payment is made to the creditor, the liability is
reduced but it does not affect expense recognition.

It is extremely important to recognise that net profit or loss is associated with changes in
owner’s equity through revenue and expense transactions and that net profit or loss is not
necessarily synonymous with cash increase or decrease. Generally speaking, the larger the net
profit, the better off are the owners. An increase in cash, however, is no indication that the
owners are better off. The increase in cash may merely be offset by a decrease in another asset or
by an increase in a liability, with no effect on equity at all. Net profit will exactly correspond
with net cash increase only if the following four conditions are met

a) All sales are made for cash during the current accounting period.

b) Any sales made on credit terms during the current accounting period are realised
in cash in the current accounting period itself.

c) All cash expenditures become expenses during the current accounting period, and

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d) All expenditures made on credit terms are paid off during the current accounting
period, such expenditures being transformed into expenses during the current
accounting period.

In short, for net profit to be synonymous with net cash increase, there must be complete
correspondence between sales revenue and cash receipts, between cash payments and
expenditures and between expenditures and expenses.

It is rare indeed for all the four conditions to be fulfilled in any business enterprise. Accrual
accounting based on the accrual concept ignores the timing of cash receipts and payments in
determining net income for an accounting period, the timing of revenue realisation and expense
incurrence is the fundamental basis of accrual accounting.

Matching Expenses with Revenues

An accurate measurement of net profit or net loss during an accounting period depends consid-
erably on the proper matching of expenses with revenues. The matching concept means that in
determining net profit for an accounting period, all expenses associated with revenue generation
should properly be regarded as expenses for that period. If revenue is recognised on the billing
and delivery of a particular product, then the cost of products sold should include all expenses
associated with the sale of that product.

Similarly costs incurred for manufacturing a product that has not been sold but remains as
closing stock at the end of the accounting period should not be included in operating expenses.

Quite often the expenses to be matched with revenues need to be estimated. For example,
products are sometime sold under a repair and service guarantee scheme. The concept of
matching expenses with revenues gives rise to the problem of estimating the portion of the future
repair and service guarantee costs.

Sometimes the expenses needed to earn revenues are quite certain, but the likely revenues are
uncertain. Taking another example, a company might spend a considerable sum of money on
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development of a new product to be launched. Over how many years should the cost of
development be spread? This would depend amongst other factors on product life and its ability
to generate revenues over a number of years.

For practical reasons, accountants are sometimes forced to relax the concept of matching
expenses with revenues. One reason is that a very exact matching of revenues and expenses may
not be significantly useful and also the work and cost involved in achieving accuracy may not
justify the results achieved.

The profit and loss appropriation statement

The profit and loss appropriation account shows how the net profit for the current accounting
period has been disposed of. The statement starts with the balance in the P&L appropriation
account at the end of the previous period, to which is added the net profit of the current
accounting period. From this sum any dividends that might have been declared or any specific
appropriations from the P&L appropriation account are deducted and any excess left over is
added to the general reserves.

Sometimes the net profit in an accounting period might be less than the profits required for
declaration of dividends. In such a case the general reserve available at the end of the previous
accounting period is used to cover the deficit between declared dividends and net profit. The
profit and loss appropriation statement would then show general reserve available at the end of
the previous accounting period., to which is added the net profit for the current accounting
period. In other words there would be a reduction in the general reserves by an amount equal to
the deficit between dividends and net profit.

The profit and loss appropriation statement forms the link between the profit and loss statement
and the balance sheet. This is done through the process of additions to and subtractions from
general reserves.

The profit and loss statement and the accounting equation

MBF 2008-2010 121
It must be emphasized that all transactions shown on the profit and loss statement can be
represented in terms of the accounting equation. When revenue from sales is received, owners’
equity increases by the amount of revenue from sales, this increase is offset by an increase either
in cash or sundry debtors or some other asset. Similarly when an expenditure is incurred on
purchase of products for sale and asset stock increases this increase is offset either by a decrease
in cash or by an increase in liability to a creditor. When the products are sold owner’s equity
decreases to the extent of the use of products for sale and stock of products for sale decreases

You will therefore see that revenues and expenses result in increase and decrease in owner’s
equity and that such increase and decrease is accompanied by a corresponding change in another
asset or liability item. So far as the balance sheet is concerned one could directly record the
revenue and expense transactions in terms of their effect on owner’s equity, however, for
management information purpose it is quite useful to separate the increases and decreases in the
owner’s equity in the form of revenues and expenses.

In some cases business enterprises report to owners a net profit figure which is quite different
from the one reported for tax purposes. There is nothing unethical about this practice since
income tax regulations might in some cases prescribe a treatment for certain revenues and
expenses which is quite different from that justified by sound business management policies.
For example, income-tax regulations require companies to use the Written Down method of
depreciation for tax reporting purposes. However, the Companies Act and Accounting Standards
permit companies to choose either the written down method or the straight line method of
depreciation for purposes of reporting to owners. In fact, some companies do follow straight line

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method of depreciation resulting in different net profit figures for tax returns and reporting to

Almost every business enterprise attempts to pay the least amount of tax on its taxable profit
both in the short and long runs. A company will hire experts to advise management in how best
to comply with tax laws, and pay the least amount of tax. This aspect of management policy may
be more properly designated as tax avoidance rather than tax evasion. Tax avoidance is perfectly
legal and ethical provided it is done in compliance with tax laws.

In actual practice, several companies pattern their accounting policies for reporting to owners on
the same line as the tax provisions. This is a very convenient procedure since it obviates the
necessity of having separate accounting records for the two purposes. However, complete depen-
dence on tax regulations for reporting to owners might result in serious distortion of financial
reports presented to them. Tax regulations should not be substituted for clear and sound thinking
on profit reporting practices.

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• Date of Balance Sheet - If coinciding with end of season, the balance sheet size and
liabilities may be smaller than during peak season.

• Indicating Current expenses as Capital in Balance Sheet.

• Resorting to heavy billing of sales on date of Balance Sheet – leading to increased sales
& increased profit.

• Preparing Balance Sheet on different dates for associate concerns. (making it difficult to
ascertain the extent of interlocking of funds/stocks)

• Temporary reduction in CL (for a day or so); Setting off CL against CA, Issuing cheques
in payment of CL but not despatching them (reduces

• S.Crs. and shows a better current ratio)

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• Maximising collection of receivables on Balance Sheet date thus showing a large cash
balance (including cheques yet to be realised)

• Resorting to heavy billing of sales on the date of Balance Sheet, leading to increased
sales and profits

• Changing the method of Valuation of Stocks

(In an inflationary situation change from weighted average cost of current assets to First in
First out method (FIFO) leads to increase in profit).

• Changing the method of Depreciation - particularly with retrospective effect

• Booking unrealised income as revenue.


Ratio is the relationship between two variables. It can be expressed as ratio or as a percentage or
so many times. The purpose of ratio analysis is to facilitate comparisons with reference to time
periods or with the average of industry. An investor who is intending to invest money in a
company may like to know the risk and returns associated with the investment. As this involves
future activity, a doubt may arise as to how the analysis of the statements based on past
performance will be useful. However, past performance and trend do play a part, rather a
significant part in the future performance also.

The various ratios may be grouped under the following categories:

Liquidity Ratios
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Activity or Efficiency Ratio
Leverage or Stability Ratio
Profitability Ratio
Although it is possible to calculate a number of ratios under each category, we shall discuss only
some of the important ratios both from the management and bankers.

Liquidity Ratios:
1) Current Ratio = Current Asset/ Current Liability

In a balance sheet it Is very important that the assets and liabilities be correctly identified.
It is necessary that current assets should be sufficient to meet the current liabilities.
Another question is whether a current ratio of 1:1 is adequate. Here it is to be seen that
the value given to the assets in the balance sheet is matter of estimate. Although the
current assets valued at the realizable cost unlike fixed assets, it is possible that the
estimates may go wrong and the realizable value may be less than the estimated one. It is
therefore, desirable that CA are more than CL to keep a good margin of safety for the
current creditors. Another question may arise, namely , what is the need to have more CA
in relation to CL as long as total assets are more than the total outside liabilities. This can
be easily answered considering the fact that fixed assets are intended for long term use in
business and if companies were to pay its current creditors from the sale proceeds of
fixed assets, it will be virtually in a state of bankruptcy – liquidation. Commercial
solvency of the company depends upon the adequacy of current assets in relation to
current liabilities. To what extent CA should exceed CL depends on the operating cycle
of the company. If it has a faster turnover, it may be able to manage with a high margin
of safety. Bankers now insist that current ratio should be at least 1.33:1. However, a very
high current ratio also does not indicate a very healthy management pattern.

Ways of improving current ratios

Sale of fixed assets to pay CL
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Sale of fixed assets for investments in CA
Long term borrowing to pay CL
Long term borrowing to invest CA

2) Quick Ratio or Acid test Ratio = CA- Inventory/ CL- Short term bank borrowing

It has to be recognized that some assets are more liquid than others. Inventory is the most
illiquid of the CA because it might have to be firstly, converted into receivables. It is
therefore, deducted from the CA. Similarly, short term bank borrowings though legally
payable on demand, are generally renewed if the company is doing alright and hence is
treated as long term liability. The acid test ratio will indicate whether liquid current assets
are adequate to meet current liabilities. Here again, the duration of the operation cycle is
a crucial factor to examine the magnitude of the standard ratio which is 1:1.

Activity Ratios:
1) Inventory Turnover Ratio = cost of goods sold/ Average inventory
Inventory comprises of raw material, work-in-progress, finished goods and consumable
stores and packaging materials. Inventory turnover ratio indicates how fast production
cycle operates. If the ratio is high, it indicates higher volume of sales per rupee invested
in inventory. If for example, this ratio is going down, it means that the company’s
production operation is being lengthened and inventory is getting accumulate. In such a
situation, it is necessary to examine the portfolio further. If there is accumulation of
finished goods, it required a careful analysis of the reasons for this build up. It may be the
result of a decline in the demand for the product of the firm resulting from price,
competition, availability of substitute or changes in tastes, fashions, etc. the situation may
not be so alarming if it is arising from the buildup of raw materials inventory unless it is
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Inventory buildup entails several costs-interested, rent, insurance, salaries and loss due to
obsolescence and pilferage. All these costs can be avoided if there is no inventory.
However, business cannot run without a minimum of inventory. To ensure uninterrupted
production and sales, a reasonable amount of inventory has to be maintained. The
inventory turnover further is sub-divided into the three following categories with a
different pattern.

Raw Material Storage Period:-

Average Inventory of R.M./R.M. consumption x 365

This will indicate, on an average, how many days consumption of raw material is held by
the company.

Work in progress period:

Average work in progress/cost of production x 365

This will indicate the amount of money involved in the semi finished goods by giving the
number of days inventory is held in the form of semi finished goods.
Finished goods storage period:
Average inventory of finished/cost of sales x 365

This ratio maybe used to find out the period for which the company before sale holds
finished goods.

2) Accounts Receivable (Debtors) Turnover Ratio = Total sundry debtor + bills

+ Bills Discounted outstanding/Credit sales x 3665

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The accounts receivable turnover ratio indicates at what interval the debtors of the
company pay the amounts due by them to the company. If a company is extending credit
for sixty days against the industry average of 30 days, it may imply anyone of the
The company has liberal credit policies to increase its sales.
Its customers are not having high credit rating and hence are not prompt in meeting their
The realization department of the company is not efficient to realize the debts in time.
The company’s products are inferior so that they are forced to extend credit to buyers.
The company is facing customers who can dictate terms to the company.

The age of the debts is also a significant consideration. The older the age of the debt,
farther it will be from being realized and hence the profits of the company may be

3) Payables or Creditors Turnover Ratio = Bills Payable + Sundry Creditors for

purchases x 365

This ratio indicates the time taken by the company to pay off the creditors. If the credit
period increases it means that the company is taking longer time to pay the creditors. It
may be strength of the company. If it is a strong and reputed company, many may be
willing to extend credit longer and therefore, the company is enjoying the cost free
finance for a longer period.

On the other hand, it may be a weakness of company. The longer period of credit may be
owing to the inability of the company to meet its obligations at the appropriate time
because of liquidity problems. Specially, if the current ratio is poor and the debtors and
inventory period is declining. This situation may arise following the investment of
current funds for acquisition of fixed and non-current assets.
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4) Assets Turnover Ratio = Sales/ Net Operating Assets

The assets turnover ratio will indicate the efficiency with which the assets are used. If the
ratio is increasing, it will mean increasing efficiency and vice versa. An enterprise invests
in assets with a view to increase the turnover. In case of growth of turnover to less than
marginal increase in assets, the ratio will come down which will indicate that the
performance has been less than budgeted
5) Expense Ratio

Another measure for efficiency of an enterprise may be the way various expenses are
The following may be more pertinent:
Raw material to cost of production: This will indicate the efficiency of raw material
usage. If it is increasing it may be either because of more wastage, rejection etc. or
because of a rise in raw material price. In the former case, there is a decline in efficiency.
Cost of production to sales: This will indicate the overall production efficiency.
Selling and distribution expenses to sales: This will indicate the efficiency of the selling
and marketing wing of the enterprise.
Administrative expenses to sales: The will indicate the efficiency of general

6) Leverage Ratios

1] Debt /Equity Ratio = Debt / Tangible net worth

Debt represents the long term liabilities and preference share capital due for payment
Within the next 12 years. Another concept of debt is both short term and long term debt.
Equity on the other hand, refers to the tangible net worth.

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The ratio indicates the proportion in which the financing of the company has been done.
If it works to 2:1, it means that the long term creditors have provided Rs.200 for every
Rs.100 of the owners contribution. If a company has more of debt and less of capital, it
May face problems with regard to repayments of installments and payments if interest
when it does not have enough profits. On the other hand, if the entire amount is in the
form of equity the return (dividend) to shareholders will be on the basis of profits.
However, by borrowing a part the funds, the shareholders stand to gain if the rate of
return in the business is higher than the rate of interest on borrowings.

2] Fixed Assets Coverage Ratio = net fixed assets/ long term debt secured by fixed

The fixed assets coverage ratio indicates to what extent the funds of the long term
Creditors secured by fixed assets. If it is 2:1, it means that even if the fixed assets are
sold for half their book value.

3] Debt service coverage ratio = interest + PAT + Depreciation + Other non-cash

Expenses/ interest + installment of term loan

If an enterprise has borrowed funds, it is required to repay the same and also pay the
Interest . For this, the company has opening profits; in addition, it also has funds from
Depreciation and other non-cash expenses, which are not cash outflows. Some
Authorities exclude depreciation from the numerator arguing that, after all, it is an
Expense for fixed assets and should not be included here. The above formula is based
On the concept that while interest rate is an admissible deduction, principle repayment
will be done only after payments of tax. The ratio therefore shows to what extent the
profits of the company will be adequate to meet the fixed charges of the interest and
repayment of the borrowed funds. If this ratio works out to 2:1, it will mean that even
if there is 50% fall in profits, the company will still be able to meet its commitments.
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However, if it were very near to 1:1, then even a slight fall in profits may result in the
Inability of the company to meet the obligations. Before comparing the debt service
coverage ratio, the various items should be consolidated into aggregates as

Net Funds Generated 1st Year 2nd Year 3rd Year……… etc.

(a) Net profit after Tax

(b) Interest on Term Loans

(c) Depreciation Charged

Net Funds Generated


Term Debt 1st Year 2nd Year 3rd Year.. .. .. etc.


SBI Others Total SBI Others Total SBI Others Total

(a) Term Loan


(b Instalments under
) DPGs

(c) Interest on Term

Loans/ DPGs

Total Term

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Debt Service Coverage Ratio (Gross DSCR):

1st Year 2nd Year 3rd Year………. etc.

A Net Funds Generated

B Maturing term obligations

Gross DSCR ( ‘A’ divided by ‘B’ )

A debt service coverage ratio (Gross DSCR) of 1.75 is taken as the bench mark.

Net Debt service coverage ratio (Net DSCR):

1st Year 2nd Year 3rd Year………. etc.

A Net Funds Generated less

Interest on term debt

B Maturing term obligations

Less interest on term debt

Net DSCR ( ‘A’ divided by ‘B’ )

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An ideal position would be a uniform pattern of the net debt service coverage ratio of 2 : 1
during the entire repayment period. A ratio more than 2 :1 will indicate surplus servicing
cushion available. The level of the ratio between 1.7 5 : 1 to 2 : 1 will be the moderate risk
range. The level of the ratio below 1.75 : 1 will indicate that the element of risk is on the high

Finally, comment on the pattern of the debt service coverage ratios available during the
repayment period as worked out above and state whether the margin of safety and the extent of
risk coverage available in the debt servicing capacity of the project are satisfactory and

7) Profitability Ratio

1] Gross profit ratio = gross Profit / sales x 100

It is an indicator of the production efficiency as discussed earlier with slight difference.

In the production efficiency, we had taken the percentage of cost of production to sales
Whereas share we have deducted from the sales the cost of sales to arrive to gross profit.
A low ratio may high manufacturing expenses, low price or inability to push up sales.
increasing ratio, on the other hand may indicate a higher sales volume, low
manufacturing expenses or ability to increase the selling price.

2] Operating Ratio (Net Sales Margin) = PAT/ Net Sales x 100

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This ratio indicates the net margin on sales after taking into account all expenses, except
financial expenses (interest) and taxes. A higher margin will indicate that the company
has higher percentage of profit on sales to meet the payment of interest, dividends and
other corporate needs
3] Return on investment (ROI) = Return/ Investment x 100

This is the most widely used ratio to measure the profitability of a company specially by
The management and creditors. Here the return is not profit before tax, interest on term
Loan and interest on debenture and investment means net worth of the shareholders and
term liabilities.

Return on Tangible net worth : Return on owners fund

Net Profit After taxes/ Net worth of share holders funds x 100


Definition of BEP

Break – even point is the amount of sales at which a unit makes no profit no loss. In other words
it is the level of sale at which sales revenue is equal to the costs of units sold. A unit can earn
profit only if its level of sale is above the break – even point.

Why is BEP calculated?

A term loan should be serviced out of profits. If the unit functions at a level of sale at which
there is no profit, it is natural that it cannot repay the term loan installments. This brings the
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necessity for calculating the level of sale above which profits are earned by the unit. In other
words we need to calculate Break – even point.

Once the BEP is calculated, the sale projection made at the profitability statement is compared
with BEP sale. In case the difference between the projected sale and BEP sale is very low, it is
risky to finance the project. A minor deviation in some elements of projected cost may result in a
loss and thus non – payment of the term loan.

On the other hand, where the projected sale is appreciably higher than the BEP, the probability
of earning some profit is still there even if there are some deviations in projections. A unit with
comparatively low BEP is generally preferred for finance. The difference between projected sale
and BEP sale is known as margin of safety. Banks for finance generally prefer a unit with higher
Margin of Safety.

Step by step procedure for calculating BEP

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Optimum Capacity

Where projected profitability statements for many years are given, one should chose the first
year of optimum capacity utilization for calculating BEP.

Classification of costs

All costs relevant to this year should be taken into consideration and they should be classified

Fixed Cost: is one which is incurred irrespective of the level of production. It is there, even if
there is no production or sale. It is a sort of PERIOD COST – a cost be compulsorily incurred
Whether there is sale or no sale. Examples of fixed cost are depreciation, rent, manager’s salary,
interest on term loan etc.

Variable Cost: it is one with directly varies with Sales/ Production. Sales / production increases
thus cost also increases. If there is NIL Sales/Production then cost should also be NIL. Examples
of variable cost are raw material, wages, fuel, interest on working capital etc.

Semi variable cost: there are certain costs which cannot be classified strictly as fixed or as
variable cost. They increase with increase in volume of sales/production increase is not directly
proportional to the increase in sales/production. Examples, semi variable costs are – telephone
charges, selling expenses, power/electricity etc. For banks consider Semi- variables costs as
fixed costs.

Items of fixed and variable cost

Raw material – Variable

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Consumable stores – variable
Power and Fuel – Consumption
Generally varies with output however minimum charges on power consumption should be
treated as fixed cost.
Labor and Supervision Cost- Normally labor is a variable expense. But distinction is to be made
as regards permanent direct labor and other workers whose number varies with production.
Repairs and maintenance – Semi variable / fixed
Salaries and wages – fixed
Interest – A distinction would require that while interest on term borrowings and bank
borrowings for core working capital should be treated as fixed cost, Interest on working capital
borrowing which varies with production should be variable cost.
Depreciation – Fixed
Selling Expenses, sales commission etc related to unit of sale is variable but expenses like
advertising, sales promotion etc. may semi variable or fixed.


After classifying the cost one should find out the contribution which is done by deducting the
total variable cost from sales.

Contribution = Sales – Variable Cost

Contribution per unit is calculated by deducting variable cost per unit from sales per unit.
Contribution per unit of product = Sale price per unit – Variable cost per unit
Contribution (as the name suggests) means the surplus left from sales, revenue meeting variable
Cost and which is contributed towards the recovery of fixed cost.
[Note: contribution increases as sale increases and falls down as sale fails. At zero of sale, the
amount of loss is equal to fixed cost as there is no contribution.]
Calculating of BEP
BEP can be expressed in three ways:
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1) In terms of number of units of sale
2) In terms of amount of sale in rupees
3) In terms of capacity utilization
Depending upon the requirement in which BEP is to be expressed, different formulae are used
for calculating BEP.
BEP in units of sale: Anyone of the three formulae can be used depending on the availability of

(I)BEP in units = Fixed cost or

Contribution per unit

BEP in units = Fixed Cost or

Sale price per unit – Variable cost per unit

(II) BEP in rupees: Any one of the following two formulae can be used.

BEP in rupees = BEP in units X sales Price per unit

BEP in rupees = Fixed Cost X Total sale in Rs.

Total contribution

(III) BEP in terms of capacity utilization

BEP in capacity = No. of units at BEP X 100
Total Capacity
Calculation of BEP when PV ratio is given

PV ratio [profit volume ratio] is equal to Total contribution

Total sales
Break Even point = Fixed Cost
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P/V Ratio

Margin of safety = actual Sale – BEP (Sales)

It is the measure of cushion available in the given level sale. More the margin of safety, stronger
is the unit. Where the margin of safety is low, the possibility of the unit coming to loss is quite
high and banks avoid financing such units.

Margin of safety is also calculated in the form of ratio as given below

Margin of safety = Actual sale – BEP (sale) X 100
Actual sale

Uses of Break Even Point Analysis

To study the viability of the project – (projects having BEP above 75% of capacity utilization
should not be accepted for finance)
To decide the optimum product mix, products with higher contribution should be chosen.
To decide the required level of production in order to attend a desired level of profit.

Cash – Break Even Point

It is the point of sale at which the unit does not incur cash loss or cash profit. While calculating
costs non cash expenses like depreciation are not taken into account.

Significance of BEP
One of the tools of profitability analysis along with DSCR.
Determines the lowest production and price levels at which the project would cover all its costs.
Helps at realistic fixation of repayment schedule.

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Tells how sensitive is the project towards adverse situations like decline in sales/profit /capacity
Utilized to determine the volume of sale, necessary to achieve the target profit.
Determines ‘product mix’ and ‘make or buy’ decision.

Limitations of BEP
Based on many unrealistic assumptions.
It assumes that volume of sales and volume of production are equal. In reality this situation
seldom happens.
It assumes that all revenues are perfectly variable with the physical volume of production.
It assumes that all the costs are neither perfectly variable or absolutely fixed over the entire range
of volume of production.


According to Roy A. Foulka, Funds Flow Statement is “a statement of the sources and
application of funds, is a technical device designed to highlight the changes in the financial
condition of a business enterprise between two dates”. In India, the funds flow analysis, in its
present form, was not extensively used by the commercial banks for their working capital
appraisal, until late sixties, when the National Credit Council Study Group No.11, popularly
known as Dehejia Committee came out with its report.. This committee, asked to determine “to
what extent credit needs of the industry are likely to be inflated”, pointed out that the banks did
not seek to link credit with industrial output, with the result that end-use of bank credit was not

MBF 2008-2010 141
property followed up. As a sequel to this the commercial banks and RBI started looking into
their appraisal procedures and thus the funds flow statement came to be regarded as an important
component of appraisal for working capital advances.

Stated simply, a funds flow statement captures movement of funds to and from the company’s
coffers. Thus, sources include cash generated by the business after meeting the expenses,
increase in owners’ equity, contracting of additional debt, sale of assets or reduction thereof.
Increase in assets, liquidation of loans/other liabilities and reduction in owners’ equity denote
uses. As a management tool for decision making, it discloses to the management, at a glance, as
to what its committed outlays are in a given period of time and what the funds availability is for
meeting such outlays. It is quite essential for the management to have an idea of the funds flow
as, without which, management of capital expenditure and operational expenditure will become a
haphazard exercise, leading to defaults in payment obligations of the business or sub – optimal
utilisation of funds.

It is pertinent to mention here about the confusion that may arise about profit and liquidity.
Many presume that adequacy of profit is tantamount to an automatic liquidity and vice versa.
Nothing can be farther from reality.

If maximisation of profit is the corporate goal or objective, the consistency of flow of funds into
the system can be regarded as a precondition for reaching the goal. While profit generates
additional funds, optimum deployment of funds forms the nucleus of the operating cycle in a
business which generates additional profits. Despite good amount of profits, a situation of
disequilibria can still arise due to wrong financial management decisions affecting the inflow
and outflow of funds. A surfeit of this liquidity (funds) affects also the profitability, no doubt,
due to non-utilisation, but if the ‘funds tank’ gets dry, it leads to potential dangers, which, in
turn, are capable of forcing the business eventually to insolvency. Thus, sound or prudent man-
agement principles dictate measures aimed at optimising profit, but simultaneously, they also
enjoin upon the management to properly use the funds such that sufficient liquidity is available
MBF 2008-2010 142
to the unit to meet its creditors in time, with neither an overdose of liquidity nor a depletion
thereof with all the attendant difficulties.

What are funds?

Very broadly, funds are described as total resources. However, most commonly funds are
defined as working capital or cash.

Working capital [here refers to] = Current Assets – Current liabilities


The preparation of funds flow statement on total resource basis is fairly simple. The successive
balance sheets are compared and changes in each of the balance sheet items are noted and
classified as sources of funds.
Increase in owner’s equity Decrease in owner’s equity
Increase in a liability Decrease in liability
Increase in an asset Decrease in an asset

Funds flow on total resource basis is prepared on two parts – part A shows the changes under
various balance sheet items & part B classifies these changes into sources of funds and uses of
funds. It may be noted that when funds are defined as total resources, the sources of funds are
equal to the use of funds due to the double entry principle of book keeping. It may also be
appreciated that under the total resources method, only the successive balance sheets are used
and the income statements/ profit and loss account are not put to use.

Amplified Funds flow

The statement of sources and use of funds shown in the above table may be amplified, drawing
on the information contained in income statement. The amplification consists of providing

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details of underlying changes in (I) reserves and surplus and (II) net fixed assets. This is done as

Changes in reserves and surplus is essentially out of retained earnings as shown below :-\
Profit before tax and interest
- Interest
- Taxes
- Dividends

Now, profit before tax and interest is shown as source of funds while taxes, interest and
dividends are shown as use s of funds.

Now the funds flow statement on a working capital basis presents

1) Sources of working capital
2) Uses of working capital
3) The net change in working capital
These can be depicted as under




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Sources of Working Capital

1. Operations

The operations of the business generates revenues and entail expenses. While revenues
augment working capital, expenses other depreciation and other amortization decreases
working capital. Hence, the working capital increases on account of operations is equivalent

Net Income + Depreciation

2. Issue of share capital

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As issue of share capital results in an inflow of working capital because it brings a cash

3. Long – term Borrowings

When a long term loan is taken, there is an increase in working capital because of cash
inflow. The short term loan, however, does not have any effect on working capital. The
reason being a short term loan increases a current asset (cash) and a current liability (short
term loan) by the same amount, leaving the working capital position unchanged.

4. Sale of Non-current asset

When a fixed asset or a long term investment or any other long term asset is sold, there is
working capital inflow represented by cash or short term receivables.

Uses Of Working Capital

I) Payment of taxes, dividends, interest etc.

These transactions result in cash (working capital) outflow.

II) Repayment of long term Liability

The repayment of long term loan, debentures and other long term liabilities involves cash
outflows and hence a use of working capital. The repayment of a current liability, it may be
noted does not affect the working capital position because It entails an equal reduction in
current liabilities and current assets.

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III) Purchase of non-current assets

When a firm purchases fixed assets, long term investments or other non-current assets; it
pays cash or incurs a short term debt. Hence, working capital decreases.

The funds flow statement – on working capital basis shown at the above table Part A shows
the sources, uses and net change in working capital and Part B shows the changes in the
internal content of working capital.

Funds Flow Statement : Cash Basis shows,

a) Sources of cash

b) Uses of cash and

c) Net change in cash.

The sources of cash are the sources of working capital plus changes within the working
capital account which augment the cash resources of the business. The change in working
capital which augment the cash flow of the business are accounted for by decrease in
current assets other than cash. The uses of cash are changes that use working capital plus,
changes within the working capital account, which depletes the cash resources of the
business. These latter changes are simply increase in current assets other than cash.

These sources and uses of cash are illustrated below:

Sources of cash

- Operations net income, depreciation

- Issue of share capital

- Long term borrowings

- Sale of non-current asset

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- Increase in current liabilities

- Decrease in current assets other than cash

Uses of cash

- Payment of dividend

- Purchase of non-current assets

- Repayment of long term borrowings

- Decrease in current liabilities

- Increase in current assets other than cash

The net effects of the movements of funds is easily discernible in each of the three methods
under which funds flow statements have been prepared. The funds flow system in a business
is often likened to a hydraulic system. The concept of flows implies an inflow, an outflow and
storage where the level is determined by the rate of inflow and outflow.

To summaries, the funds flow statement we observe, is very closely related to the financial
statements, the balance – sheets and profit and loss accounts, the funds flow statement is
related to a time span say one year or six months as the case may be. Thirdly, the funds flow
analysis is very closely related to the normal decision making process in the business –
decisions relating to investment, operations and finance.

Projected Fund Flow Statement

A fund flow statement can be prepared either on the basis of the past data or for a future
period of time provided the time span is specified. All the questions for which the answers are
sought on the basis of past data can also be answered for future period of time provided the
projections are based on realistic assumptions. In fact, projected funds flow statement is of
great practical relevance to bankers, as some of the important questions pertaining to the

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financial position, profitability and servicing of working capital/ term loan etc. extended by
banks can be answered with a fair degree of reliability. This to a great extent relives the
banker of his anxiety as to whether a credit decision to be taken at present is worth while from
a commercial point of view.

As bankers funds flow analysis is used mainly to find answers to:

a) How the long term and short term resources will be raised and used?

b) When and how much finance the unit will require?

c) When and how the business will repay the loans?

d) Are the financial policies followed by the unit proper and financial planning

e) What is the dividend policy of the company?

f) What is the contribution of funds provided by internal sources to the growth of

business? (in the past and in future)

A funds flow statement as a third financial statement in addition to the balance sheet and
profit and loss account has a distinct role to play in evaluating the use of resources and the
pattern of financing them.

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The following I the text of the revised Accounting Standard (AS) 3, ‘Cash Flow Statements’,
issued by the Council of the Institute of Chartered Accountants of India. This standard
supersedes Accounting Standard (AS) 3, Changes in financial position’, issued in June, 1981.

In the initial years, this accounting standard will be recommendatory in character. During this
period, this standard is recommended for use by companies listed on a recognized stock
exchange and other commercial, industrial and business enterprises in the public and private

MBF 2008-2010 150
Information about the cash flows of an enterprise is useful in providing users of financial
statements with a basis to assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the enterprise to utilize those cash flows. The economic decisions
that are taken by the users require an evaluation of the ability of an enterprise to generate cash
and cash equivalents and the timing and certainty of their generation.

The statement deals with the provision of information about the historical changes in cash and
cash equivalents of an enterprise by means of a cash flow statement, which classifies cash flows
during the period from operating, investing and financing activities.


• An enterprise should prepare a cash flow statement and should present it for each
period for which financial statements are presented.

• Users of an enterprise’s financial statement are interested in how the enterprise

generates and uses cash and cash equivalents. This is the case regardless of the
nature of the nature of the enterprise’s activities and irrespective of whether cash
can be viewed as the product of the enterprise, as may be the case with financial
enterprise. Enterprises need cash for essentially the same reasons, however
different their principal revenue producing activities might be. They need cxash
to conduct their operations, to pay their obligations , and to provide returns to
their investors.

Benefits of Cash Flow Information

A cash flow statement in conjunction with other financial statements provides information that
enables users to evaluate the changes in net assets of an enterprise, its financial structure and its
ability to affect the amounts and timing of cash flows in order to adapt to changing
circumstances and opportunities. Cash flow information is useful in assessing the ability of the
enterprise to generate cash and cash equivalents. It also enhances the comparability of the

MBF 2008-2010 151
reporting of operating performance by different enterprises because it eliminates the effects of
using different accounting treatments for the same transactions and events.

Historical cash flow information is often used as an indicator of the amount, timing and certainty
of future cash flows. It is also useful in checking the accuracy of past assessments of future cash
flows and in examining the relationship between profitability and net cash flow and the impact
of changing prices.


The following statements are used in this statement with the meanings specified:

Cash comprises of cash in hand and demand deposits with the bank.

Cash equivalents are short term, highly liquid investments that are readily convertible into
known amounts of cash and which are subject to insignificant risk of changes in value.

Cash flows are inflows and outflows of cash equivalents.

Operating activities are the principal revenue – producing activities of the enterprise and other
activities that are not investing or financing activities.

Investing activities are the acquisition and disposal of long term assets and other investments not
included in each equivalents.

Financing activities are activities that result in changes in the size and composition of the
owner’s capital (including preference share capital in the case of a company) and borrowings of
the enterprise.

Cash and Cash Equivalents

Cash equivalents are held for the purpose of meeting short term cash commitments rather than
for investments and other purposes. For an investment to qualify as a cash equivalent, it must be
readily convertible to a known amount of cash and be subject to an insignificant risk of changes

MBF 2008-2010 152
in the value . Therefore, an investment normally qualifies as a cash equivalent only when it has
short term maturity of, say, three months or less from the date of acquisition. Investments in
shares are excluded from cash equivalents unless they are, in substance, cash equivalents; for
example, preference shares of a company acquired shortly before their specified redemption date
(provided there is only an insignificant risk of failure of the company to repay the amount at

Cash flows exclude movements between items that constitute cash or cash equivalents because
these components are part of the cash management of an enterprise rather than part of its
operating, investing and financing activities. Cash management included in the investment of
excess cash in cash equivalents.

Presentation of Cash Flow Statement

The cash flow statement should report cash flows during the period classified by operating,
investing and financing activities.

An enterprise presents its cash flows from operating, investing and financing activities in a
manner which is most appropriate to its business. Classification by activity provides information
that allows users to assess the impact of those activities on the financial position of the enterprise
and the amount of its cash and cash equivalents. This information may also be used to evaluate
the relationships among those activities.

A single transaction may include cash flows that are classified differently. For example, when
the installment paid in respect of a fixed asset acquired on deferred payment basis includes both
interest and loan, the interest element is classified under financing activities and the loan element
is classified under investing activities.

Operating Activities

MBF 2008-2010 153
The amount of cash flows arising from operating activities is a key indicator of the extent to
which the operations of the enterprises have generated sufficient cash flows to maintain the
operating capability of the enterprise, pay dividends, repay loans and make new investments
without recourse to external sources of financing. Information about the specific components of
historical operating cash flows is useful, in conjunction with other information, in forecasting
future operating cash flows.

Cash flows from operating activities are primarily derived from the principal revenue producing
activities of the enterprises. Therefore, they generally result from the transaction and other
events that enter into the determination of net profit or loss.

Examples of cash flows from operating activities are;

• Cash receipt from sale of goods and the rendering of services;

• Cash receipts from royalties, fees, commissions and services;

• Cash payments to suppliers for goods and services;

• Cash payments to and on behalf of employees

• Cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities, and other policy benefits;

• Cash refunds or payments of income taxes unless they can be specifically identified with
financing and investing activities; and

• Cash receipts and payments relating to futures contract, forward contracts, option
contracts and swap contracts when the contracts are held for dealing or trading purposes.

Some transactions, such as the sale of an item of plant, may give rise to gain or loss which is
included in the determination of net profit or loss. However, the cash flows relating to such
transactions are cash flows from investing activities.

MBF 2008-2010 154
An enterprise may hold securities and loans for dealing on trading purposes, in which case they
are similar to inventory acquired specifically for resale. Therefore, cash flows arising from the
purchase and sale of dealing or trading securities are classified as operating activities. Similarly,
cash advances and loans by financial enterprises are usually classified as operating activities
since they relate to the main revenue – producing activity of that enterprise.

Investing Activities

The separate disclosure of cash flows arising from investing activities is important because the
cash flows represent the extent to which expenditures have been made for resources intended to
generate future income and cash flows. Examples of cash flows arising from investing activities

a) Cash payments to acquire fixed assets (including intangibles). These payments include
those relating to capitalized research and developing costs and self – constructed fixed asset.

b) Cash receipts from disposal of fixed assets (including intangibles);

c) Cash payments to acquire shares, warrants or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be cash
equivalents and those held for dealing or trading purposes) ;

d) Cash receipts from disposal of shares, warrants or debt instruments of other enterprises
and interests in joint ventures (other than receipts from those instruments considered to be
cash equivalents and those held for dealing or trading purposes);

e) Cash advances and loans made to third parties (other than advances and loans made by a
financial enterprise);

f) Cash payments for future contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the
payments are classified as financing activities; and

MBF 2008-2010 155
g) Cash receipts from futures contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the receipts
are classified as financing activities; and

h) Cash receipts from futures contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the receipts
are classified as financing activities.

When the contract Is accounted for as an hedge of an identifiable position, the cash flows of the
contracts are classified in the same manner as the cash flows of the position being hedged.

Financing Activities

The separate disclosure of cash flows arising from financing activities is important because it is
useful in predicting claims on future cash flows by providers of funds (both capital and
borrowing) to the enterprise.

Reporting Cash Flows from Operating Activities

An enterprise should report cash flows from operating activities using either;

• The direct method, whereby major classes of gross cash receipts and gross cash payments
are disclosed; or

• The indirect method, whereby net profit or loss is adjusted for the effects of transactions
of non-cash nature, and deferrals or accruals of past or future operating cash receipts or
payments, and items of income or expense associated with investing or financing casgh

MBF 2008-2010 156
The direct method provides information which may be useful in estimating future cash flows and
which is not available under the indirect method and is, therefore, information about major
classes of gross cash receipts and gross cash payments may be obtained either.

a) From the accounting records of the enterprise; or

b) Bu adjusting sales, cost of sales, (interest and similar income and interest expense and
similar charges for a financial enterprise) and other items in the statement of profit and loss for:

• Changes during the period in inventories and operating receivables and payables;

• Other non-cash items; and

• Other items for which the cash effects are investing or financing cash flows.

Under the indirect method, the net cash flow from operating activities is determined by
adjusting net profit or loss for the effects of:

a) Changes during the period in inventories and operating receivables and payables;

b) Non – cash items such as depreciation, provision, deferred taxes, and unrealized foreign
exchange gains and losses; and

c) All other items for which the cash effects are investing or financing cash flows.

Alternatively, the net cash flow from operating activities may be presented under the indirect
method by showing the operating revenues and expenses excluding non – cash items disclosed in
the statement of profit and loss and the changes during the period in inventories an doperating
receivables and payables.

Reporting Cash Flows from Investing and Financing Activities

An enterprise should report separately major classes of gross cash receipts and gross cash
payments arising from investing and financing activities, except to the extent that cash flows
described above are reported on a net basis.
MBF 2008-2010 157
Reporting Cash Flows on a Net Basis

Cash flows arising from the following operating, investing or financing activities may be
reported on a net basis.

a) Cash receipts and payments on behalf of customers when the cash flows reflect and the
activities of the customer rather than those of the enterprise; and

b) Cash receipts and payments for items in which the turnover is quick, the amounts are
large, and the maturities are short.

Examples of cash receipts and payments referred to in above are:

a) The acceptance and repayments of demand deposits by bank;

b) Funds held for customers by an investment enterprise; and rents collected on behalf of, and
paid over to, the owners of properties

Examples of cash receipts and payments referred to in above paragraph are advances made for,
and the repayments of:

MBF 2008-2010 158
a) Principal amounts relating to credit card customers;

b) The purchase and sale of investments; and

c) Other short – term borrowings, for example, those which have a maturity period of three
months or less.

Cash flows arising from each of the following activities of a financial enterprise may be
reported on a net basis:

a) Cash receipts and payments for the acceptance and repayment of deposits with a fixed
maturity date;

b) The placement of deposits with and withdrawal of deposits from other financial enterprises;

c) Cash advances and loans made to customers and the repayment of those advances and loans.

Thus, along with fund flow, the cash flow statements gives us a very broad and explicit idea of
the state of an enterprise.



Funds required for –

 Acquisition of land and its development

 Constitution of building

 Acquisition and erection plant & machinery

 Acquisition of other assets

MBF 2008-2010 159
 Preliminary & pre – operative expenses

 Margin for working capital

Project cost – sources

 Own funds (capital and reserve)

 Unsecured long term loans from friends, relatives and others

 Term loans from banks and financial institution

 Subsidies from government if any


 Is the location suitable for the project?
 How land is acquired?
 Is it adequate for the project?
 Is it planned for future expansion?
 How is it valued, excessive or reasonable?
 In case of loan the cost to be released along with the borrowers margin
 Is it developed or to be developed; if so, whether cost properly assessed?
 Whether required infrastructure available or not?

 Are the buildings needed for the actual productions justified?
 Are there any unnecessary constructions like guest houses?
 Are the estimates enclosed from an authorized architect?

MBF 2008-2010 160
 Does the cost assessed is reasonable and justified?

Plant and machinery:

 Are these really needed for actual production?

 Are they brand new or second hand?
 Are all quotations given for new machineries which are latest and relevant
 If second hand, any competent authority assessed the value?
 Are the prices reasonable and realizable with similar types?
 If the technical knowhow is to be acquired from outside is the cost included in
 Margin is normally @ 25%

Miscellaneous Assets:
 What are included miscellaneous assets?
 Do these items are genuinely required or provided for future contingencies?
 Are quotations given or these are assessed approximately?
 Are all electrical fittings and fixtures properly and reasonably assessed with relevant

Preliminary / pre- operative expenses:

 What are they?
 Are they properly classified?
 Whether all these are justified?
 Is interest cost during construction period arranged for by borrower?
 What is their accounting system to capitalize/ absorb the expenditure?

MBF 2008-2010 161
Margin for working capital:
 Is it properly assessed?
 Is there enough NWC in the system as on date and on projected basis?
 What are the sources? Are they really on long term basis or arranged or on short term
 Whether undertakings can be obtained from contributors that they shall not be withdrawn
during currency of banks finance?

Sources of finance:
 Capital – is it properly arrived at?
 Whether personal balance sheets are given to know actual capital contribution?
 Whether the capital investment in the project is correctly related to the credit reports of
the individuals?
 Are the unsecured loans properly planned?
 Is there any interest and at what rate and interest?

Management Appraisal:
 Proprietary concern – one man show
 Partnership firm – more than one person could be at the helm of the affairs
 Joint stock companies – public or private
 Board of directors
 Managing directors
 Committee of board of directors
 Middle level officers
 Line officers
 Functional Management
MBF 2008-2010 162
 Planning
 Organizing
 Directing
 Coordinating
 Controlling
 Reviewing

MBF 2008-2010 163
Other things to be kept in mind are that there are certain factors to judge integrity, managerial
capacity, and judgment of borrowers’ vision and mission. This is a very crucial factor and one
should always keep in mind the role that they play and their importance. The diagram below will
help in throwing light over the issue;

MBF 2008-2010 164

1) LOCATION : The location of a project is highly relevant to its technical feasibility and
hence special attention will have to be paid to this feature. Projects whose technical
requirements could have been well taken care of in one location sometimes fail because
they are established in another place where conditions are less favourable. One project
was located near a river to facilitate easy transportation by barge but lower water level in
certain seasons made essential transportation almost impossible. Too many projects have
become uneconomical because sufficient care had not been taken in the location of the
project, e.g. a woollen scouring and spinning mill needed large quantities of good water
but was located in a place which lacked ordinary supplies of water and the limited water
supply available also required expensive softening treatment. The accessibility to the
various resources has meaning only with reference to location. Inadequate transport
facilities or lack of sufficient power or water for instance, can adversely affect an
otherwise sound industrial project

2) INFRASTRUCTURE FACILITY: confirm that the needed infrastructure facilities are

available in the area. Power, water , fuel required are available or not. Sources of water

3) LAND AND BUILDINGS: whether owned or rented or leased. Scope of future

expansion, is the building adequate, is it well protected etc.

4) MANUFACTURING PROCESS: study the flow chart and identify the critical process on
which quality of finished products rely. Duration of the process, input and output, is it
mechanized or labor intensive? Etc.
MBF 2008-2010 165
5) TECHNICAL KNOW HOW: important feature of the feasibility relates to the type of
technology to be adopted for the project. A new technology will have to be fully
examined and tried before it is adopted. It is equally important to avoid adopting
equipment or processes which are obsolete or likely to become outdated soon. The
principle underlying the technological selection is that “a developing country cannot
afford to be the first to adopt the new nor yet the last to cast the old aside”. Is it
indigenous or imported? Can it be easily adopted?

6) PLANT AND MACHINERY: is it appropriate to the production process? Condition of

machinery, installation process, servicing etc.

7) LICENSES AND PERMITS: are they current and valid? Any restrictions imposed, if yes
then why?

8) PRODUCTIVITY CAPACITY: licensed capacity, installed capacity, any expansion

undertaken etc.

9) TYPE OF PRODUCT: product and its uses, who are going to use it, is it in demand etc.

10) RAW MATERIALS: what are the raw material? Their availability, supply, time needed
for arranging supply, payment terms etc.

11) STORAGE FACILITIES: has provision been made for future or not?

MBF 2008-2010 166
12) MARKETTING ARRANGEMENTS: by whom is it done? Any permanent
arrangements, is their any volatility in their prices etc.

13) MANAGEMENT /LABOR ARRANGEMENTS: who manages it, are they qualified, is
it labor oriented, any unresolved problem till now etc. The labour requirements of a
project, need to be assessed with special care. Though labour in terms of unemployed
persons is abundant in the country, there is shortage of trained personnel. The quality of
labour required and the training facilities made available to the unit will have to be taken
into account.

14) COSTING AND PROFITABILITY: how well the profitability has been assessed based
on the cost.

15) OTHERS: specific benefits available like in the case of 100% EOU, units located in EPZ.

MBF 2008-2010 167



Payback Method

The method determines the period needed to recover the initial cash investment through annual
cash flows estimated to be generated.

Payback period = Cash investment/ Annual cash inflow

Cash Inflow = net PAT + Depreciation + Other non-cash write offs (intangible)

Term Loan Appraisal

Term loan characteristics

• For acquiring assets
• Repayable in installments
• Repayment out of profits

MBF 2008-2010 168
Term loan appraisal
Term loans can be granted for:
• Working capital/ fixed assets under schematic finance
• Bank’s branded loan products
• Industry or any other projects

Schematic Loans

Appraisal of term loan in schematic finance and our products is purely depending on DSCR and
the repaying capacity respectively.
Economics is required to be prepared for viability study in cases other than the bank’s brand

Quantum of loan is the cost of asset less margin subject to repaying capacity.
Repayment Schedule

Repayment schedule may be planned considering DSCR.

Repayment period

Repayment period may be decreased in case of high DSCR and increased in deserving cases
Where DSCR is below 1.5 subject to maximum period permitted in the scheme after keeping a
cushion for delay/default for reason beyond control.
Repayment should start immediately after cahs generation.
Delay in starting of repayment will affect adversely.
Appraisal of term loans in cases of an industry or a project is long term investment decision. It
requires detailed study/appraisal.
MBF 2008-2010 169
Project Appraisal

Assessment of project
 Study of project report
 Feasibility study
 Financial viability
 Cost of project
 Sources of finance

Project Report
 Cost of the project
 Sources of finance
 Proforma balance sheet and projections
 Financial highlights with ratios
 Cash flow and fund flow statements
 Project implementation schedule
 Debt service coverage ratio
 Cost of production and profitability
 Technical report

Feasibility Study

Generally the entrepreneurs submit a project report & it is duty of appraising officer to cross
check the reliability of assumptions made in the project report.

 Managerial Competence

MBF 2008-2010 170
 Technical Feasibility
 Commercial Viability
 Ecological Analysis

Managerial Competence

Capability of the entrepreneur in implementing & managing the project.

Technical Feasibility

Study of aspects relevant to production of finished goods of proper quality like permits,
machinery, availability of spare parts, infrastructure facility, power, water, fuel etc.

Commercial Viability

Whether the goods can be sold in the quantity and prices as projected. Projection and
forecasting, capacity utilization, price levels etc.

Ecological Analysis

 Environmental damage
 Restoration measures

Sources of finance
 Capital / equity
 Reserves/ subsidies
 Unsecured loans
 Term loans from financial institution

MBF 2008-2010 171
Cost of project
 Land and site development
 Building
 Plant and machinery
 Miscellaneous assets
 Consultancy fees
 Contingencies

Financial Viability
 Financial projections
 Fund flow and cash flow statements
 Ratio Analysis
 Non discounted cash flow technique
 Discounted cash flow technique

Debt Service Coverage Ratio (DSCR)

DSCR = NPAT +Intt on TL + Depreciation/ Intt on TL + installment of TL

Ideal DSCR is 2:1
For SSI it is 1.5:1
Repayment period can be reduced where DSCR is high.
Repayment period can be increased up to permissible limit where DSCR is low.

Average Rate of Return

ARR = Average profit after tax/Average book value of investment x 100

MBF 2008-2010 172
It is comparable with the rate of return in market in other investments

Discounted Cash Flow Techniques

Net Present Value [NPV]

Cost Benefit Ratio [CBR]
Internal Rate of Return [IRR]

• The entire cash inflow is discounted at the rate of interest to arrive at present value of
• NPV = present value of cash inflow minus present value of cash outflow.
• The project Is accepted if NPV is positive and rejected if NPV is negative.

• The entire cash inflow is discounted at the rate of interest to arrive at present value of
• BCR = Present worth of benefit/ Present worth of costs
• The project is accepted if BCR is more than one and rejected if less than one.

• IRR is the rate of discount at which present value of cash inflows is equal to the present
value of cash outflows.
• The project is accepted if IRR is more than the expected rate of return.
• Higher the IRR, better is acceptability of the project.

MBF 2008-2010 173
Working Capital Assessment

Working capital, also known as net working capital, is a financial metric which represents
operating liquidity available to a business. Along with fixed assets such as plant and equipment,
working capital is considered a part of operating capital. It is calculated as current assets minus
current liabilities. If current assets are less than current liabilities, an entity has a working
capital deficiency, also called a working capital deficit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted into cash. Positive working capital is required to ensure that a firm is able to
continue its operations and that it has sufficient funds to satisfy both maturing short-term debt
and upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable and cash.

Current assets and current liabilities include three accounts which are of special importance.
These accounts represent the areas of the business where managers have the most direct impact:

• accounts receivable (current asset)

• inventory (current assets), and
• accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-
term claim to current assets and is often secured by long term assets. Common types of short-
term debt are bank loans and lines of credit.

An increase in working capital indicates that the business has either increased current assets (that
is received cash, or other current assets) or has decreased current liabilities, for example has paid
off some short-term creditors.

MBF 2008-2010 174
Implications on M&A: The common commercial definition of working capital for the purpose
of a working capital adjustment in an M&A transaction (ie for a working capital adjustment
mechanism in a sale and purchase agreement) is equal to:

Current Assets - Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus
assets and/or deposit balances.

Cash balance items often attract a one-for-one purchase price adjustment.

Decisions relating to working capital and short term financing are referred to as working capital
management. These involve managing the relationship between a firm's short-term assets and its
short-term liabilities. The goal of working capital management is to ensure that the firm is able
to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term
debt and upcoming operational expenses.


Gross Working Capital [GWC] = Total of Current Assets

Net Working Capital [NWC] = CA - CL
Working Capital Gap [WCG] = [CA –CL {Excl STBB}]
Permissible Bank Finance [PBF] = WCG – [Higher of stipulated NWC or available NWC]


MBF 2008-2010 175
TURNOVER METHOD : under this method, the WC limit shall be computed at 20% of the
projected sales turnover accepted by the Bank. 5% of projected sales should be available as
margin. In the case of SSI borrowers seeking/enjoying fund based working capital facilities up to
Rs. 5 Lacs, the limits shall be assessed on the basis of turnover method.

FLEXIBLE BANK FINANCE METHOD: it is an extension of Maximum Permissible Bank

Finance [MPBF] with customer friendly approach in as much as the scope of current assets is
made broad based and for evaluating projected liquidity, acceptable level of current ratio is taken
at 1.17:1 against benchmark of 1.33:1. this method is applicable for accounts with credit limits of
more than Rs. 5 crores.

CASH BUDGET METHOD : this method may be adopted in case of specific

Industries/Seasonal activities such as software, construction, film, sugar, fertilizers etc. the
required finance is arrived at from the projected cash flows and not from the projected values of
assets and liabilities.

NET OWNED FUNDS METHOD: the credit needs of NBFCs shall be assessed based on this
method, rescribed by the RBI.

Dangers of inadequate Working Capital

1. It stagnates growth
2. Fixed assets remain underutilized
3. operating inefficiencies creeps in
4. Difficulty in achieving targets of business for production and profit
5. Business reputation at stake
6. Situation of tight credit terms
7. Difficulty in meeting payment commitments

MBF 2008-2010 176
Letter of Credit

The customers in the course of their business, to run business transactions smoothly, have to
make efforts like participation in tenders for expanding market, deposit security deposits for
participation in tenders, give guarantees for their capacity to perform contracts, avail concessions
in duty on imports when tagged to some exports obligations etc. These business requirements for
goods and services can be met by them with the help of non-fund based facility known as
‘guarantees’ given/issued by the banks.

Sec. 126 of Indian Contract Act, 1872 defines guarantees as a contract to perform the promise or
discharge the liability of a third person in case of his default. During the course of business,
banks are often required to furnish guarantee on behalf of their own customers in lieu of their
obligations, performance or engagement.

The parties involved:

• Beneficiary, creditor, lendor

• Borrower, debtor

• Guarantor, surety

There are different types of guarantees, depending upon the kind of financial favor the customer
is asking from the bank. But certaing issues should be kept in mind, precaution should be taken
while accepting a guarantee or guaranteeing on some other parties behalf. Expiry of guarantee
should be kept in mind and accordingly the acknowledgement should be given. In a letter of
guarantee clarity should be maintained, as far as the amount and dates are concerned, the name
of the customer etc.
MBF 2008-2010 177
Letter of Guarantee

Traders are required to acquire fixed assets and purchase different types of raw materials and
finished goods or make payments for services availed in the course of business. Some of the
purchases of goods and services are possible only if the buyer makes payment in advance.
However, the suppliers in such circumstances also allow the buyers to make purchases with the
help of letter of credit issued by the banker.

The letter of credit is a commercial instrument of assured payment and widely used by the
business community for its various advantages. All parties to credit deal only with the
documents and not the goods. It is an instrument by which a bank undertakes to pay a seller for
his goods, provided he complies with the conditions laid down in the credit. The credit specifies
as to when payment is to be made which maybe either when the documents are presented to the
paying bank or at some future date, depending upon the use of draft as stipulated in the creit.

There are different types of credit like revocable an irrevocable credits, transferable, back to
back, red clause, standby etc. and the letter of credit proves to be a very useful and helpful
facility for the customers.

MBF 2008-2010 178



MBF 2008-2010 179
The whole project is based on the process of advancing loans to a company or an organization,
which has now become a very crucial part of every bank. I had learned how to advance loans of
various kinds, right from comfort loans, vehicle loans, housing loans, education loans etc. to
corporate lending. Corporate lending play important role because these are huge lending and so
they need to be taken care of. As in, when a company or an organization asks for loan then the
bank needs to check a number of things. There is a long process, at the end of which the bank
decides whether to lend the money or not.

In this chapter, I would like to analyze the complete process with the help of a case study.
Taking a hypothetical company and its balance sheet as used by the bank, I would like to analyze
whether or not the company should be given the loan or not.


The firm was established in 1991 by the proprietor Mr. G H Pal. The unit is engaged in
processing of cotton seed oil and trading of soyabean, groundnut and various grains according to
season. Initially, the unit was started with three oil expellers. Thereafter they installed three more
oil expellers in the year 2004. Again they installed six more high capacity machines in 2006.
Therefore, presently they are working with 12 expellers/machines. Now they proposed to install
12 new machines in the newly constructing building. However, they proposed to sell the oldest
six machines within very short time. Mr. Sumit Pal S/o Shri G H Pal has recently completed
MBA and looking after financial matters of the firm. The account was taken over in August 2003
from XYZ Bank where they were enjoying credit facilities at lower level.

MBF 2008-2010 180

( Rs. In Lac)

31.3.05 31.3.06 31.3.07 31.3.08 31.3.08 31.3.09

Year Ending (Aud.) (Aud.) (Est.)

(Aud.) (Aud.) (Proj.)

Paid up Capital 31.63 33.19 37.09 47.54 66.50 161.01

Reserves & Surplus - - - - - -

Intangible Assets - - - - - -

Tangible Net Worth 31.63 33.19 37.09 47.54 66.50 161.01

Long Term Liabilities 81.87 85.48 121.10 89.45 137.00 230.00

Capital Employed 113.50 118.67 158.19 136.99 203.50 391.01

Net Block 16.15 18.93 33.70 33.34 26.64 220.00

Investments 6.47 7.61 13.70 15.10 10.00 15.10

Non Current Assets 11.35 3.01 4.37 5.92 9.37 8.83

Net Working Capital 79.53 89.12 106.42 82.63 157.49 147.08

Current Assets 206.38 267.52 571.58 573.98 712.49 684.08

Current Liabilities 126.85 178.40 465.16 491.35 555.00 537.00

Current Ratio 1.63 1.50 1.23 1.17 1.28 1.27

D E Ratio (TL/TNW) 1.12 3.23 3.26 1.89 2.96 1.43

DER (TOL/TNW) 6.58 7.95 15.81 12.22 10.40 4.76


U/sec. loans as quasi-
capital 1.50 3.28 3.59

Net Sales 200.99 600.46 1720.71 2097.75 2500.0 2600.00

MBF 2008-2010 181
Other Income 0.43 0.52 1.28 3.19 1.00 8.00

Net Profit Before tax 1.72 2.67 4.73 11.01 12.22 40.78

Net Profit After Tax 1.71 2.67 4.02 9.35 10.72 29.80

Depreciation 2.17 2.06 4.60 4.28 3.75 9.70

Cash Accruals 3.88 4.73 8.62 13.63 14.47 39.50

 Capital of the firm is showing increasing trend due to retention of part of net profits in the
system. The proprietor has infused additional funds of Rs. 3.45 lacs as capital apart from
balance net profits of Rs. 7.00 lacs as of 31.03.2008, which resulted it has increased from Rs.
37.09 lacs as of 31.03.07 to Rs. 47.54 lacs as of 31.03.08. The proprietor has estimated to
induct Rs. 100.00 lacs additional funds apart from plough back of profit to raise the capital to
Rs. 161.01 lacs as of 31.03.2009.
 Unsecured loans are continuously increased year after year. The same are mainly raised from
family members/relatives. An undertaking from the party should be obtained that these
unsecured loans will be retained in the system till currency of bank finance, as NWC and
DER are depend upon these loans.
 NWC in the system as of 31.03.08 stands at Rs. 82.63 lacs, which provide the margin (25%)
for availing the fund based limit upto Rs. 380.00 lacs.
 CR of 1.17 as of 31.03.08 has come down from 1.23 as of 31.03.07, which is due to
repayment of T/L and reduction in unsecured loans i.e. short term sources are used for long
term uses, which is internal diversion of funds and should be avoided by the firm. Though it
is still within the acceptable level.
 DER in normal condition is above the bench mark level, showing the firm’s high dependency
on outside liabilities. The firm should reduce the outside liabilities or raise capital/family
deposits. However, if unsecured loans raised from family members/relatives are taken as
quasi-capital, the DER as of 31.03.08 is worked out to 3.59, which is within acceptable level.

MBF 2008-2010 182
An undertaking from the party to be obtained that these unsecured loans will be retained in
the system till currency of bank finance.
 Sales turnover of the firm has increased substantially from Rs. 600.46 lacs as of 31.03.06 to
Rs. 1741.28 lacs (190%) as of 31.03.2007 and Rs. 2097.75 lacs (21.91%) as of 31.03.08
reflecting the good progress of the unit during last two years. The same are estimated at Rs.
2600.00 lacs as of 31.03.09 with the growth of 24%, which looking to their past
performance, can be considered achievable.
 The firm is earning net profits continuously. As of 31.03.08 the firm has registered 132%
growth in net profit as against 21.91% growth in net sales over the last year. The firm has
estimated much improved profit margin due to reduction in manufacturing/power expenses
on account of installation of new plant & machinery.
 Cash accruals are sufficient to service the interest on WC.

Overall financials can be considered as satisfactory as of 31.03.2006.




MBF 2008-2010 183
MAR-05 200.99

MAR-06 600.46

MAR-07 1720.71

MARCH 2008 2097.75

Sales turnover of the firm is showing increasing trend. The firm has achieved sales
turnover of Rs. 2097.75 lacs against projected sales of Rs. 2500.00 lacs i.e. 84%. The
firm has achieved 22% growth in sales from Rs. 1720.71 lacs to Rs. 2097.75 lacs as of
31.03.08. During this fiscal, the firm has projected sales of Rs. 2600.00 lacs. From April
to September 08, the firm has registered sales of Rs. 595.25 lacs, which is slightly
decreased by 3.2% as compared to last year correspondence period sales of Rs. 614.90
lacs. However, it is marginal difference, which can be filled during peak season starting
from October to May. Looking to their last 3 years performance and proposed expansion
of unit, we may consider sales of Rs. 2500.00 lacs during 2008-09 achievable with about
20% growth over the previous year.


The major raw material of the unit is cotton seeds, soya seeds, etc., which are processed
and converted into oil. These raw materials are purchased from Mandi and Cotton
Ginning & Processing Mills. During last 3 years, the actual stock holding & receivables
level remained as under:

Particulars 2005-06 2006-07 2007-08

MBF 2008-2010 184
Total Inventory 173.22 356.69 447.13

Receivables 91.97 183.25 92.93

Sundry Creditors 108.61 236.61 88.85

The level of stock holding and debtors as of March 2006, March 2007 and March 2008
indicate working capital cycle of peak season of 8 months. In view of the fact that it is a
seasonal unit and the firm is required to make bulk purchases of cotton/soya seeds during
the crop season to ensure regular production/working of the unit, the holding can be
considered reasonable. Looking to the situation, it is required to make Peak Level and
Non-Peak level limits i.e. during the peak season & off-season of the crop.


Based on projected sales of Rs. 2500.00 lacs for 2008-09, the WC requirement of the
party as per turnover method can be worked out as under:

 Projected Sales achievable during 2008-09 : 2500.00

 25% of Sales : 625.00
 5% of sales as margin : 125.00

MBF 2008-2010 185
 Available margin (NWC) : 82.63
o MPBF : 500.00

Further, based on FBF method of assessment, the WC requirement is worked out as


(Rs. in lacs)

MAR-07 MAR-08

Total Current Assets. 581.26 712.49

Less: Current Liabilities 241.90 150.00

(Other than Bank Borrowings)

Working Capital Gap 339.36 571.86

NWC 95.21 157.49

Flexible Bank Balance (FBF) 244.15 414.37

Net Sales 1741.28 2500.00

NWC to TCA % 16% 22%

Flexible Bank Finance to TCA % 42% 58%

Sundry Creditors to TCA % 40% 21%

Therefore, C.C.(Hyp) limit of Rs. 380.00 lacs as recommended by the branch, can be
considered. However, looking to past trend and seasonal business – crop season from
October to May, it will be justified to renew Peak-Season & Non-Peak Season limits at
25% margin as under:

 Rs. 380.00 lacs – From October to May.

MBF 2008-2010 186
 Rs. 135.00 lacs – From June to September


The firm was sanctioned T/L of Rs. 17.90 lacs for purchase/installation of 6 jumbo
expellers to expand the capacity of the unit in June 2006. Presently they are working with
12 expellers/machines. Also they proposed to sell the oldest six machines within very
short time. Expected sale proceeds of six old machines about Rs. 18.00 lacs will be
utilized for adjustment of existing Term Loan and other long term uses.

The firm has now proposed to construct new building shed and to install advanced
technology 12 new oil expellers alongwith remaining 6 existing expellers out of 12.
Therefore, the firm intend to work with total 18 expellers to increase the production with
improved quality at reduced cost.

The cost of project & means of finance as per Technical Inspection Report dated 30.09.2008
are as under:

Cost of project Means of funding

Land & Site development owned by the 0.00 Promoter’s contribution 61.00
Construction cost of shed& building 106.28 Term Loan from Bank 118.80
Electric Installation 14.62
Plant & Machinery 58.52
Misc./Sundry exp. 0.38
TOTAL 179.80 TOTAL 179.80


MBF 2008-2010 187

The firm has obtained construction permission from the competent authority. Out of own
contribution, the firm has already started/completed construction of building & civil works as

Particulars Construction area Works completed till

(In sq.ft.)

Oil Mill Shed 4300 90%

Raw Material godown 4300 90%

Finished material godown 4300 90%

Shed for overhead tank 2800 60%

Platform No.1 10500 25%

Platform No. 2 10500 25%

As per abstract dtd. 21.04.08 & 23.04.08 obtained from M/s abc, Chartered Engineer, xyz city,
estimated construction cost are given as under:

 Oil Mill Shed : Rs. 2589800

 Overhead Water Tank : Rs. 917500
 Khal Godown Shed : Rs. 2109800
 Sarki Godown Shed : Rs. 2109800
 Cotton Seed drying platform No.1 : Rs. 1450600
 Cotton Seed drying platform No.2 : Rs. 1450600
TOTAL : Rs. 10628100 (Say Rs. 106.28 lacs)

MBF 2008-2010 188
As per certificate of Chartered Engineer, xyz city, the construction works of around Rs.85.75
lacs are already completed. The technical inspecting officials have also confirmed the above
stage of completion. The construction cost is varied from Rs. 150/- to Rs. 600/- depending upon
the works, which is considered reasonable and justified.


Electric installation is mainly consisting of 14 TEFC Motors, 36 pieces Start Delta starter, main
switch, other accessories, etc. These items will cost Rs. 10.20 lacs as per quotation obtained from
Allied Electric Stores, xyz city. Transformer of 500 KVA costing Rs. 4.42 lacs as per quotation
of M.P. Transformer Pvt. Ltd. is to be installed for smooth and adequate supply of power.


The firm has been working with 12 oil expellers with about 100% capacity utilization. To
improve the quality and enhance the capacity, they have decided to purchase 12 new expellers
and install them alongwith existing 6 out of 12 expellers in a new building adjacent to existing
one. Particulars of P&M, cost & manufacturers/suppliers are proposed as under:

(Rs. in lacs)

PARTICULARS Manufacturer/Supplier No. Rate Total Cost

‘Sona’ Oil Expellers M/s xyz 1 12 2.50 30.00

Chainlink convear with M/s xyz 2 1 6.65 6.65

gearbox & chin fitting

Wash Tank 7 ton with 3 1 1.05 1.05

HP Motor

Filter with pump 1 1.65 1.65

MBF 2008-2010 189
Elevator 30’ 1 1.05 1.05

Dicordicator complete 1 7.50 7.50

automatic plants

Underground tank with 1 0.40 0.40

cover & partition

Storage tank 10 0.264 2.64

Motor stand (6 no.), 0.56

foundation bolt (6 no.) &
pipe fitting,

VAT 2.68

Expeller Spare parts Xyz 3 - - 4.34

TOTAL 58.52

12 pieces of are to be purchased from @ Rs. 2.50 lacs each total costing Rs. 30.00 lacs as per
their quotation dated 14.04.2008. Other supporting items like, wash tank, filter, elevator,
dicordicator complete automatic plant, etc. are proposed to be purchased from.

Keeping in view the volume of project, projected misc./sundry expenses of Rs. 0.38 lac are
reasonable. Therefore, total cost of project Rs. 179.80 lacs is acceptable.

The firm has proposed to contribute 40% margin towards construction of building and 25%
margin for plant & machinery.

MBF 2008-2010 190
As per technical report, the firm has acquired 6 new machines, elevator and conveyor and these
machines are installed in new mill shed alongwith 12 old machines. When in near future 6 more
new machines are supplied, old 6 machines will be sent back to the supplier under buyback
arrangement. The other items are also expected to receive very soon. With the installation and
implementation of all the plant & machinery as proposed herein above, the quality and capacity
of the unit are expected to increase. The capacity will be increased from 80000 quintal to 129000
quintals per season i.e. 540 quintals per day for 240 days working in 2 shifts of 12 hrs. During
the current year i.e. 2008-09, capacity utilization is projected at 75% i.e. 90000 quintals with
working of 18 oil expellers (12 new & 6 existing).

The firm has requested for Term Loan of Rs. 130.00 lacs for the above project. But due to
totaling mistake in one quotation and repeatation of some electrical parts & machineries, total
project cost has been assessed at reduced level of Rs. 179.80 lacs instead of Rs.194.63 as per
technical report dated 30.09.2008. Accordingly, the term loan of Rs. 118.80 lacs can be taken for
financial assistance. The loan is proposed in 6 years after moratorium period upto March 2009.

The following details & analysis are given as per the project report submitted by the Society:



08-09 09-10 10-11 11-12 12-13 13-14 14-15

Net Sales 2097.75 2600 2725 2850 2975 3100 3225 3300


MBF 2008-2010 191
Raw material 1937.16 2388. 3025
consumption 03 2500 2615 2725 2840 2955

Purchase & 87.95 100.0 103.0 107.0 110.0 110.00

Processing exp 95.00 97.00 0 0 0 0

Selling & Admn. 9.69 21.00

Exp. 15.00 16.00 17.00 18.00 19.00 20.00

2034.8 2498. 3156

Total Expenditure 03 2613 2732 2846 2966 3085

Profit Before Dep. 62.95 106.9 117.0 123.0 134.0 139.0 145.0 149.00
Int. & Tax 7 0 0 0 0 0

Interest on Proposed
T/L @ 12% 6.19 13.09 10.61 8.16 5.71 3.26

Interest on CC 38.33 40.00 40.00 40.00 40.00 42.00 44.00

Existing T/L 1.91 132 0 0 0 0 0

Intt. to others 10.62 10.50 10.50 10.50 10.50 10.50 10.50

Total Interest 50.86 58.01 63.59 61.11 58.66 58.21 57.76

Depreciation 4.22 9.70 16.46 15.71 14.14 12.72 11.45

55.08 67.71 80.05 76.82 72.8 70.93 69.21

Profit Before Tax 5.77 12.04 15.95 21.18 30.20 39.07 45.79

Income Tax Provn. -1.25 -1.99 -2.34 -3.11 -4.45 -5.78 -6.78

Profit After Tax 4.52 10.05 13.61 18.07 25.75 33.29 39.01

Interest calculated @ 12% p.a.

MBF 2008-2010 192
As per IC 8088 dtd. 26.08.08 interest rate for food & agro based processing units with
investment in plant & machinery upto Rs. 10.00 crores for the amount of advance above Rs. 1.00
crore with CR-5 will be applicable @ BPLR-1.75% i.e. 12.25% at present.


(Rs. in lacs)

Year 08-09 09-10 10-11 11-12 12-13 13-14

PAT 10.05 13.61 18.07 25.75 33.29 39.01

Depreciation 9.70 16.46 15.71 14.14 12.72 11.45
Interest 58.01 63.59 61.11 58.66 58.21 57.76

Sub total (A) 77.76 93.66 94.89 98.55 104.22 108.22

Interest 58.01 63.59 61.11 58.66 58.21 57.76

Installments 0 19.80 19.80 19.80 19.80 19.80

Sub total (B) 58.01 83.39 80.91 78.46 78.01 77.56

DSCR 1.34 1.12 1.17 1.26 1.34 1.39

Average DSCR


N. A.

MBF 2008-2010 193
N. A.




Year Previous yr. Current yr.

Total score obtained 72% 71%

Grade CR-5 CR-5


Parameters Marks obtained

Previous yr. Current yr.

Max. Obtained Max. Obtained

Borrower rating 67 48 46 34

Facility rating 21 16 29 22

Risk Mitigators 5 5 20 12

Business aspects 4 1 5 3

Total Marks with grade 97 70 100 71

As per Rating Model-II, the firm has secured 71% marks, which comes under investment grade
with acceptable risk.

MBF 2008-2010 194
Thus we can see, that in terms of financial assessment this is what is done in a broad scale.
Although banks use many different models and ways to assess a borrower. Another important
thing to keep in mind is that credit appraisal consists of many different kinds of appraisal that is
the borrowers market worth and the like, which are also very crucial part.

MBF 2008-2010 195

MBF 2008-2010 196
• That the banks have their own credit rating system and that they try to update it with the
latest method available.

• The ratios have a very important role to play; a thorough understanding of them leads one
to the future prospects of the borrower and also tells a lot about its financial soundness.

• Another important thing is the balance sheet, its break up and the study of it, tells a lot
about any organization.

• Retail loan sector in india has a long way to go, a steady growth is projected in the
coming years.


• The time given for the summer internship i.e. 8 weeks, was not sufficient enough to study
and understand the retail loans approval process of the Union bank of India.

• The banks have their own confidential information and it was very difficult to make the
project and analyze it on the basis of hypothetical information.

MBF 2008-2010 197
• UBI has this time ranked 5th among all the Nationalized banks. The reason for its ranking
was the number of NPAs it had. It was found that a number of retail loans ended up in
NPAs . UBI needs to develop a competitive edge and the managers and the assistants
need to keep a tab on the loans given.

• Usually the managers would only fulfill their required target and then would forget about
more borrowers. They need to have more borrowers both for small and big loans.

• Many times they pass a loan without the proper appraisal, i.e. the client may lack either
the projected and estimated balance sheet or the proper documents. In such cases there
should be a strict protocol followed.


As discussed in the project above, Credit Appraisal appears to be the back bone of the banking
institution. It is equally important and dangerous, as there is always the chance of default or
some other risk. After dealing with almost every aspect of loans and advances one can
summarize that with a little bit of strict measures and a keen eye and understanding of a
company’s balance sheet one can very well save the institute the risk other than the default risk.
Even the default risk can be to a certain limit mitigated, if we before sanctioning the amount
check the profile of the customer. Industry Report, bank’s own experiences and the ability of the
borrower to run his enterprise professionally are certain things one can check.

A very crucial aspect of credit appraisal is the credit rating, Union bank has introduced their
own Internal Rating system of all borrowers enjoying/seeking credit limits above Rs. 2 lacs. The
rating grades range from CR1 to CR8. Credit ratings up to CR5 are investment grade. CR6 to
CR8 are non-investment grade as per the loan policy of the bank. Migration in credit rating,
MBF 2008-2010 198
especially downward migration should be discussed in detail and road map to improve the credit
rating has to be drawn up/implemented. A lot of times for some reasons, credit report is not
submitted and the submission of the proposal and its sanctioning is done without it, while
keeping in mind other necessary factors. It is to be seen and made mandatory that the credit
report must accompany the proposal as it gives a very clean and clear picture of the borrowers
credit worthiness.

In order to potential NPAs it is significant to have a fair understanding of the borrower’s

financial health. Thus, at least last three years balance sheet and Profit and loss accounts should
be obtained, in addition to projections of next 2 years. Now, most of the time customers to prove
their credit worthiness make the estimated balance sheets unrealistic, such areas should be
stressed and it should be checked whether the borrower has the ability to go as per the projected
Balance Sheet. The important factors which should be given special consideration are trend in
sales, both quantity and quality, it should be positive with the industry trend. Disparities in the
sales pattern should be analyzed properly. Profitability should be critically analysed, it should be
checked with the existing norms of the balance sheet.

The distribution of profits and its impact at the reserve and surplus along with the tangible net
worth should be seen. Increase/decrease in the term liabilities and its effect on capital employed
should be scrutinized too. Increase or decrease in the investments of the borrower also needs to
be looked at, it should be seen that the investments that the borrower is making should yield
some income. The non – current assets is another important aspect, it should be seen and
commented upon. The debt equity ratio should be seen, if the debts are increasing and equity
decreasing then such case should be discussed.

Working Capital and its assessment should be done before taking a decision about the borrower.
Credit rating is a very important step in deciding whether to sanction or decline a proposal. All
the stages should be vetted and the necessary action should be taken while making any decision.

MBF 2008-2010 199
The other important things to be kept in mind is the security offered, the documents submitted
and the market reputation of the borrower.

It is true that the fear of NPAs looms large whenever a borrower new or old comes for the loan,
but if the all the steps are properly followed and all the aspects looked at, then the banks should
not have any problem in giving out loans and advances of any kind.


MBF 2008-2010 200
 Bessis Joel, ‘Risk Management in Banking’
 RBI guidance notes on Credit Risk Management.
 Credit Risk Models and Management, 2nd edition by David Shimko.
 Credit scoring and its applications by Lync.Thomas, David B. Ederman and Jonathan N.
 Credit Risk Valuation: Methods, Models and applications by Manuel Ammann.
 M.Y.Khan’s, Corporate Finance and its basic usage.
 Credit Appraisal, Risk Analysis And Decision Making book, by DD Mukherjee
 Banking Strategy, Credit Appraisal and Lending Decisions: A Risk-Return Framework.
By Bhattacharya, Hrishikesh
 Financial Statement Analysis: A Practitioner's - by Martin S Fridson, Fernando Alvarez
 Analysis of Financial Statements - by Leopold A Bernstein, John J Wild
 Financial Analysis: Tools and Techniques a ... - by Erich A Helfert
 Credit Risk Management & Basel II - An Implementation Guide. . Mohan Bhatia.

 Credit Risk Management by Andrew Fight

 The Essentials of Risk Management by Michel Crouhy, Dan Galai, Robert Mark

 Framework for Credit Risk Management: Credit by Alastair Graham, Brian Coyle

 Risk management and capital adequacy by Reto R.


 The risk management process: business strategy and tactics by Christopher L. Culp

 Credit and collection principles and practice by Albert Franklin Chapin, George

 The Appraisal journal by American Institute of Real Estate Appraisers, Appraisal

Institute (U.S.)

MBF 2008-2010 201
 Financial statement analysis: a practitioner's guide by Martin S. Fridson,
Fernando Álvarez –
 Finance and accounting for nonfinancial managersby William G. Droms

 Corporate Finance by Scott B Smart, William L Megginson

 The analysis of financial statements by Harry George Guthmann, Harry Lewis

 Financial statement analysis: a new approach by Baruch Lev

 Principles of corporate finance by Richard A. Brealey, Stewart C. Myers

Sites Referred:
 www.unionbankofindia/
 www.unionbankofindia/retailloans/
 www.unionbankofindia/retailoans/
 www.unionbankofindia/retailloans/
 www.unionbankofindia/retailloans/
 www.unionbankofindia/retailloans/
 www.unionbankofindia/retailloans/

Inter – office and Intra- Office Circulars.

MBF 2008-2010 202
MBF 2008-2010 203