07/02/2024

CREDIT
ANALYSIS
OCT, 2023
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OVERALL OBJECTIVES

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 To help and expedite the HRD strategy

 To enable all performers to have uniform understanding of the

credit processing based upon the credit culture of the bank.

 To enhance efficiency and effectiveness of Credit process,

especially credit appraisal and follow-up.

 To enhance adherence to an established principles on Know

Your Customer (KYC), credit policies and Procedures.

 To maximize quality credit portfolio.

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OBJECTIVES CONT……..

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 To create, cultivate and promote professional and healthy credit
culture.

 To establish lifelong relationship between the Bank and its customers

through satisfying the actual need of the later.

 To make the Bank’s credit operation as well as decision prudent.

 Meet the credit needs of customers through providing proper advice

and consultancy on the credit standards of the Bank and proper
business management and book of recording.
 To bring a paradigm shift in the attitude - Helpful and friendly
banker, usually Banker considered as risk averter- So in our current
situation need to have wide risk appetite 3
 To help realize the mission and vision of the Bank.
OBJECTIVES CON…

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 To start a new era of Lending where there is a need to:
 Assess the need-Based Credit of a borrower on a RATIONAL Basis-
Based on their business plan or financial statement.
 To ensure proper end-use of Bank credit- Bring Rational Mgt of

Fund by customers
 To improve the financial discipline of a borrower, Bank Credit is a

supplement, 100% finance is not recommendable

 Banker has a role to improve the operational efficiency of

Borrowers, and at National wide also

 To develop healthy Banker-Borrower R/ship(KYC)

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Getting the Big Picture

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 Themes &
Perspectives Strategic Objectives
Results
Ensure Sustainable Profitability
Financial Increase Financial Resource
Mobilization

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Business and
Growth: Enhance Developmental Financing
Developmental
Ensure Financial Soundness
Sustainable
profit and Increase Customer Satisfaction
Customer
Enhanced Expand the Customer Base
Role towards
Enhance Accessibility of Services
National
Internal Business Improve process efficiency and
Development
Process effectiveness
Improve Risk Management
Operational
Improve Employee Satisfaction and
Excellence :
Engagement
Satisfied Enhance Information Systems
Learning &
Stakeholders Growth Enhance Human Resource
Development
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Enhance Internal and External
Communication
CONT..

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Vision
To Be a World Class Commercial Bank by the year 2025.

Mission
We are committed to realizing the needs of stakeholders
through enhanced financial intermediation globally, and
supporting national development priorities by deploying
highly motivated, skilled and disciplined employees as well as
state-of-the-art technology. We strongly believe that winning
the public confidence is the basis of our success.

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CONT..
Values
Integrity

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Customer Satisfaction

Employee satisfaction

Learning Organization

Teamwork and Collaboration

Public Trust

Value for Money

Decentralization
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Corporate Citizenship
CREDIT ANALYSIS

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 critical assessment of creditworthiness of a borrower;

 identification of anticipated risks and setting risk mitigating

measures

 depth of the credit analysis depends on nature of the request,

type of business and the associated credit risk;

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 General Eligibility Criteria for a Loan

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 All persons engaged in lawful trading activities.
 Non-trading government/public institutions will be eligible
depending on their nature and strategies.
 All persons who have defined and sustainable source of income
are eligible to borrow consumer loans.
 The business/credit applicant should present renewed trade
license for the current fiscal year or investment license and
principal registration certificate for new projects.
 All applicants who are engaged in business must present a tax
identification number /TIN/ or tax exemption certificate for all of
their income.
 The applicant and/or any of its shareholders/subsidiaries shall
fully settle any previous loss loan to the Bank, if any. To this 10
effect, internal records shall be thoroughly checked
CONT..

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 The applicant must have never been engaged in tax
evasion;
 The applicant must not have any record of mal-operation
of the checking account ;
 The applicant shall fulfil at least the required minimum
equity contribution;
 The applicant has to present all the
documents/information demanded by the Bank.
 The applicant’s business must be financially viable,
legally acceptable, technically feasible and
environmental friendly;
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 The Credit Process

For regular loans,

 Credit Origination

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 Interview

 Collecting Credit Processing Documents & Information

 Collateral Estimation

 Credit Analysis & Approval

 Decision Communication, Contract Preparation & Loan

Disbursement
 Documentation & Regular Follow-up

 Filing of loan and security documents/information.

 Monitoring of periodic loan

repayments/amortizations/utilizations. 12
CONT

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 For loans that show irregular pattern of repayment, the
following additional steps are applied:
 Following-up the end use of disbursed loan, debt servicing
and early warning signals.
 Preparing early intervention/remedial action proposal on
problem loans.
 Making decision on early intervention/remedial action
proposal.
 Communicating the decision to customer.
 Amending loan/mortgage contract.
 Following-up the performance of the customer's business and
loan account. 13

 Ensuring full collection of loans and advances.

CONT

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 For loans that are categorized as “Non Performing Loan” as per
relevant directive of National Bank of Ethiopia, the following
additional steps are applied:
 Transferring problem loans to Loan Recovery Team.
 Setting of negotiation and resolution strategies.
 Negotiating with customer.
 Searching for attachable properties.
 Preparing and presenting loan recovery resolution proposal.
 Checking and commenting on the loan recovery resolution proposal.
 Making decision on loan recovery resolution proposal.
 Amending loan/mortgage contracts.
 Foreclosing and collecting of sales proceeds.
 Instituting litigation against defaulter and selling property through court. 14
 Following-up of loan recovery/settlement.
CONT

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 Re-transferring cases to regular loans category.
 Preparing write-off proposal on impaired loan.

 Making decision on write-off of impaired loan proposal.

 Communicating the write-off decision to concerned

branch.
 Adjusting accounting records.

 Conducting post write-off follow-up.

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 CHAPTER TWO
CREDIT ANALYSIS

 Credit and Risk Analysis refers to a critical assessment

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of a business entity to see whether it is strong enough to
warrant lending of money to it, and related risks.
 It is generally done to assess the creditworthiness of a
borrower and involves examining the ability of a
borrower to repay debt of some kind.

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CREDIT ANALYSIS SOURCE DOCUMENTS
 Due diligence report of the CRM;

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 Credit Application Form (CAF) and Customer’s application;
 Financial statements;
 Credit database of the Bank and/or market data (to be collected by
the credit analyst), such as industry-wide profitability, liquidity and
leverage ratios, portfolio concentration (by sector, ownership,
product and geographic area), macro- and micro-economic data,
market situation, market share, where applicable, intensity of
competition, industry characteristics, business cycle, etc.;
 Supporting documents;
 Range of accounts/overdraft utilization/ account performance;
 Credit information report;
 Legal opinion; and
 17
Other pertinent sources.
DEPTH OF CREDIT ANALYSIS/APPRAISAL:
…
 Intensity of the credit and risk analysismay vary based on the

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nature of credit request; type of the business the customer is
engaged in; and level of associated credit risk;
 In case of existing borrower(s)/customer(s), the Credit Risk
Analysis Report shall concentrate on new developments of the
business and summarized on a few pages as far as possible;
 To properly analyze/appraise the credit request the lending
officer shall gather adequate information;
 The CRM is responsible to gather the required
documents/information;

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CREDIT NEGOTIATION BEFORE FINAL PPROVAL
 The CRM can negotiate with the customer on items like

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tenure, disbursement arrangements, repayment terms, collateral
issues and covenants etc... prior to final decision by the
approving team.

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CONTENT OF CREDIT ANALYSIS

 The content of the credit analysis/appraisal shall follow the

analysis format of the Bank to ensure a standardization and

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uniformity.
 The basic components of the analysis format are explained
below:

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APPLICANT
 Customer Name and address;

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 Date of Business establishment;

 Date of relationship established with the Bank;

 Customer classifications;

 Ownership or Business Formation;

 Economic sector;

 Business type;

 Type of financial statement presented;

 Customer’s Credit Grade Risk;

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CREDIT RISK GRADING /RATING
 The Credit Risk Grading – CRG is collective definition based
on the pre-specific scale and reflects the underlying credit-risk

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for a given exposure;
 Used to develop credit risk management system;

 The system should define the risk profile of borrower’s to

ensure that account management, structure and pricing are
commensurate with the risk involved;

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PURPOSE OF THE RATING/GRADING

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 To assist credit decision making process,
 To help in monitoring and controlling the quality of
loans and advances;
 To timely manage early warning signals;

 To maintain application of uniform credit risk

rating/grading standards;
 To help in setting loan pricing and maintain appropriate
level of loan provisioning.

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CONTENT OF CREDIT RISK GRADING

 Financial Risk/ strength of financial management system – to

determine the adequacy of the financial management and

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financial position, measured in parameter of
 Leverage - Liquidity
 Profitability - Debt service coverage

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CONTENT.....
 Quality of the financial statement

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 Composition of the recent three years financial statement
provided with respect to the credit exposure
 Negative value ( auditor’s qualified opinion either as major or
minor discrepancies)

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CONT....

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Business/Industry risk
 Business/industry outlook

 Market competition/market share

Management risk
 Experience of the management

 Qualification of the management

 Succession plan

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CONT...
Account performance risk

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 Overdraft( highest debit, lowest balance and turnover)

 Term loan (settled and existing term loans)

 Facility-ML,OD, Pre-shipment, Revolving export credit

(turn over and settlement condition)

 Letter of guarantee( settlement without claim or after claim)

 Negative value

 Settled by converting to other forms of loan or selling of

collateral or loan sell out

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CONT....

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Customer relationship risk
 Length of borrowing relationship

 Integrity honesty and co-operation

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LINKED LENDING

 Shareholders in the applicant company having 50% or more

stakes in a related/sister company or having shareholders of

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first degree consanguinity a major shareholders, shall take the
credit risk rating of the parent company, or the related/sister
company, or company being graded/rated (the applicant),
whichever is the worst grade/rate.

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CREDIT EXPOSURE
• The credit exposure of the applicant with Siinqee

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Bank is computed by taking the outstanding balances
of term loans and the limit of the credit facilities.
Similarly of the sister company’s credit exposures
should be clearly computed.
• The grand exposures calculated as a summation of the
applicant’s and sister company exposure. The grand
total exposure should be within a single borrower
limit, as stipulated in NBE directive SBB/53/2012.

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CONT…
Auditor: the auditor must have a license and among
registered auditors and should be in the list of

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acceptable auditors by government body
Procedure exception: the loan approved by the variation
from the Credit Process Procedure but within the spirit
of the credit policy and procedure.
Approving Team: The processed credit request shall be
forwarded to approving team based on the discretion
limit assigned to respective team. If the request is an
appeal or have exception component, the case will be
forwarded to one committee higher of the discretion
limit of the committee.
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 CREDIT REQUEST

 Content of the credit request

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The content of the credit application varies depending on the
nature of requests. For instance, the request of the applicant
shall either be for a fresh term loan- or credit facilities like an
O/D facility, L/C facility, pre-shipment export credit facility,
L/G facility or renewal of credit facilities.

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THE CONTENT OF THE CREDIT APPLICATION
The content of the credit application shall at least include

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 The type of the credit product requested

 The amount requested

 Period of borrowing and repayment term

 The type of collateral and the owner of collateral offered

 Purpose of the credit request

 Grace period, if necessary

Source :( Credit application, CAF, business plan and feasibility
study) 33
ELABORATION OF TERMS

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 Type of loan: refers to type of credit products such as
term loan, overdraft, pre-shipment export credit facility,
letter of credit, letter of guarantee, or other credit related
request.
 Amount requested: refers the loan amount requested
which is directly taken from the application letter and
CAF filled by the applicant. There are requests which do
not involve amount such as, collateral release, collateral
replacement, lifting of conditions etc…
 Period of borrowing; this is the time required by the
borrower to repay the loan or the renewal period. It can
be inferred from the application letter and/ or CAF filled 34

by the borrower.
CONT...
 Repayment term: this refers to mode of repayment of the loan

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and it varies depending on the nature and cash flow generation
of the business from the business. Repayment term could be on
monthly, quarterly, semi annually, annually or at maturity
(lump sum).
 Grace period: depending on the cash flow pattern of the
borrower, the bank may consider the grace period, in the light
of the cash generating lag.

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PURPOSE OF THE REQUEST
 The purpose of the request is deduced directly from the

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applicant’s credit application letter (such as working capital,
project financing, change or replace or release collateral etc).
The applicants shall clearly and concisely indicate the end use
of request and reason for choosing the specific credit products.
The purpose should be substantiated by business plan with the
breakdown of working capital need or feasibility study or other
relevant document depending on the nature of the request.
(Source: Credit application, CAF, business plan and feasibility
study)

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COLLATERAL

Key components:

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 description of the type,

 name of owner,

 location,

 type of evidencing document (like LHC, booklet) with

ownership certificate number ,plate number, value estimating
body, estimation date, year of make (machinery and vehicle)
 gross estimation value,

 net estimation value( if there is remark on the building

estimation or discounted/deduct the depreciation)
Source: from estimation format, letter of guarantee, authenticated
foreign bank guarantee, bond certificate and other documents. 37
 TYPES OF COLLATERAL

 The type collateral offered should be acceptable per the bank’s

Credit Process Procedure. Some of the acceptable collateral are

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building, vehicles, machinery, construction machinery, agricultural
machinery, bank guarantee, negotiable instrument (Treasury bill,
government bond), cash deposit, merchandise, business mortgaged,
land lease right, coffee plantation and other form of collaterals.
 If building is offered as collateral, it can be of private or public and
it can be with the state of use of residence, office, store, factory
building or others.
 If vehicles, it can also be automobile, trucks, trailers, bus and so
on, the bank also accepts construction machinery like excavator,
dozer, grader, loader, roller, crusher and others as well agricultural
machinery like tractors, combine harvester, coffee pulping and
others.
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 TYPES OF COLLATERAL
 Merchandise shall be held as collateral only when credits are to be
extended in the form of merchandise loans its value must be

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determinable; easily marketable/fast moving, the price must be
relatively stable; the product should not be perishable; and the
product must be insurable.
 Business mortgage is a security arrangement whereby loans and
advances are approved against security of the corporeal and
incorporeal element of business entity. The corporeal elements of
a business mortgage are those that are tangible and may consist of
building, motor vehicles, equipment, machinery, goods and other
movable items. The incorporeal elements of a business mortgage
include goodwill, trade name, and trademark, the right to lease the
premises in which the trade is carried on, patents, copyrights, and
other special rights attached to the business itself. 39
TYPES OF COLLATERAL
 The bank shall accept the coffee plantation and the land lease right
of the applicant to be held as collateral.

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 A Foreign Bank Guarantee refers to a written undertaking issued by
a foreign bank as a guarantor of the borrower, stating its legally
binding commitment to pay on demand and without any
contestation a sum equal to the value of the guarantee to the bank in
the event of default by the borrower. While accepting the bank
guarantee, legal advice or opinion should be obtained from Attorney
of the Bank;
 Cash in form of saving deposits, demand deposits and time deposits
in any branch of the Siinqee Bank. A letter of consent from the
customer that authorizes the Siinqee Bank to have all rights on the
account must be filled and presented as per the standard format of
the Bank. Such deposits shall be blocked until the loan is fully
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settled.
 TYPES OF COLLATERAL
 Negotiable Instruments including treasury bills and

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government bonds. Treasury bills represent short-term
financial papers/instruments commonly issued at defined
denominations by Government Treasuries. Government Bonds
Government Bonds represent interest bearing certificates
issued (sold) by government.

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VERIFICATION OF PERTINENT POINTS
IN COLLATERAL
 The Siinqee Bank’s lending system is cash flow oriented,

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however, if the applicant fails to meet his/her/its
obligation, collateral is deemed as a second way out.
 Exhaustive List of collateral corresponding to the type of
loan mortgaged must be indicated and the completeness
of the document must be ensured
 The name of the owner of the collateral, the state of the
present use shall be deduced from provided evidencing
document, the genuineness and completeness of the
evidencing document (ownership certificate, title deed,
approved plan, lease agreement and other relevant
document) need verified by the bank engineer.
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 VERIFICATION CONT....

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 The analyst also needs to go through the physical
condition, instalment and technical condition assessment
of the machinery and vehicles.
 If the offered collateral is the lease right, the analyst
should go through the lease agreement and inquire legal
comment, if necessary
 The offered collateral shall be registered with legal
empowered governmental body, however, not all
acceptable collaterals are registered like bank deposit,
financial instrument, merchandise, bank guarantee, and
written undertaking from the Federal Government,
Corporate/personal guarantee and others shall not be 43
registered.
 VERIFICATION CONT...
 Second degree mortgage is not acceptable by the bank;

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 The analyst shall cautiously go through the remark stated by
the bank engineer like
 The name of ownership on the LHC vary from the name
on the approved plan,
 The building construct out of the LHC

 If approved plan is not presented

 The implication of the bank’s engineer remark given on

property estimation on collateral should thoroughly assess.

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VERIFICATION CONT.....
 Assess the location of the collateral in terms of effect on

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Market value of the collateral ( the bank engineer indicates
this condition in the market condition factor) and stability of
the realizable value and convertibility to cash when desired;
 The analyst should inquire legal opinion about collateral like
bank guarantee, and for other collateral ,if necessary
 Status of stock( for merchandise loan) as checked by the
CRM;
 If the collateral is foreign Bank Guarantee must be
authenticated by Trade service, Bank Risk grade should be
checked based on Standard and Poor rating or equivalent of
Moody’s or Fitch latest rating (source latest Banker Almank
and confirmed by the Trade Service) and the analyst make
sure that the guarantee fulfil the grade that the CPP as well 45

the NBE require;

VERIFICATION CONT....

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 The analyst should verify the timely revaluation of the
collateral per the credit Process Procedure;
 The analyst shall verify the vulnerability to
obsolescence, especially machinery;
 Insurability, registration and transferability are checked
based on the CRM information;

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VALUE OF COLLATERAL
Gross Collateral Value

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 The Gross value of the building, machinery and vehicle
from the bank engineer estimation, which is made per
the collateral Valuation Procedure;

 If the building under construction offered as collateral, it

can be considered only if 50% and more is completed;

 For the machinery and vehicles, at the first year of

estimation gross value is considered, but for the
following years the value should be adjusted by the level
of depreciation;
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VALUE CONT...
 If the motor vehicles and machinery are imported final
invoice of cost and CIF value, custom clearance cost,

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inland transportation shall be considered;
 For cash deposit, the value will be deduced from the
certificate of deposit;
 For the guarantee, the value shall be taken from the letter
of guarantee issued by the guarantor;
 For the financial instrument, the face value of the
instruments are considered;
 For the merchandise (imported goods, locally
manufactured goods and agricultural products) and other
forms of collateral based Credit Process Procedure;
 Other form of collateral based collateral like business 48

mortgage,
VALUE CONT....
 The collaterals, requires to be estimated by the bank
engineer;

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 If the loan is unsecured by the offered collateral, the
analyst should check the eligibility for the unsecured
loan;
Net Collateral Value
 The net collateral value of the collateral will be adjusted
as follows
 For computation of the net collateral value of the
collateral, the remark pointed out and the engineer and
the implication are used, based on the effect, the analyst
compute the net collateral value;
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VALUE OF COLLATERAL
 For the vehicles, machinery and corporal element of the

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business mortgage, the value should be adjusted
considering of the depreciated value effective the date of
estimation;
 Based on year of manufacturing , the value of
automobile and truck will be excluded, as per the bank’s
credit procedure.
Security to loan ratio
 The strength of the collateral offered to extent of loan
coverage measured by the security to loan ratio;
 For the existing loans, the outstanding balance of the
term loan and the facility limit shall be taken to calculate
the loan amount; 50
VALUE CONT...
 The analyst compute this ratio by considering the gross
as well the net value of the collateral, these collateral

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value with respect to the existing loans, including his/her
recommendation and considering of the applicant request
in different scenarios;
 The analyst shall examine the minimum collateral
coverage requirement for the respective Credit Risk
grade per the CPP;

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ESTABLISHMENT, MANAGEMENT AND NATURE OF THE BUSINESS

Establishment

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 The date of establishment;

 The owner of the business, if it is a company and

partnership, from the registered article and memorandum
of the company and the respective share contribution;
 Background information of the owner of the business and
experience on the line of business and qualification.
 The role of the owner in the business and plan on the
successor of the ownership.
 Profile of the sister company:

 The owners of the sister company with their respective

share value
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 Line of business
ESTABLISHMENT, CONT…
 Profile of the major shareholder of the company and

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other related companies:
 The major shareholder share profile of in other related
company
 Line of business it engages

Source: business license, Article and Memorandum of

Association, business plan and due diligence report.

53
LEGAL AND OTHER ISSUE
 The legal personality and related issues shall be checked

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by the legal attorney;
 The empowerment of the appointed person/persons to
enter loan and mortgage contract shall also be collected
from the legal attorney;
 The analyst can also inquire opinion legal comment
collateral related issues, including of bank guarantee,
lease right, and other collateral related cases, if it needs
to be supplemented by the attorney legal opinion.
 The analyst shall also inquire legal comment on tax
clearance as well tax exemption condition, if necessary.
 Depending of the nature of request, the analyst can
inquire on the issues which demands legal comments. 54
MANAGEMENT OF THE BUSINESS
 The management issue includes at least the following points:
 The profile of the Board of the management, if the company

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has such form of supervising authority.
 The authority and delegation role of the Board of Management,
like appointment of a person who enter loan and mortgage
contract and issues need to be asses based on the registered and
authenticated Article and Memorandum of Association;
 Registered and authenticated Minute of Board of Management
on the amendment of Article and Memorandum of association, on
the delegation of authorized person to run the business and other
related issues;
 The profile of the management supported with evidentiary
document on the qualification and level of experience, should be
part of the applicant document along with the summery of the
management list with respective position. The analyst reproduces 55
into the profile based on the presented document.
MANAGEMENT WITH 5 C’S

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56
NATURE OF THE BUSINESS
 The business purpose is inferred from authenticated and
registered Article and memorandum of association, if the

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applicant is a PLC or share company.
 The specific line of business which the applicant currently
engages is considered, based on the trade license and/or
investment permit business field.
 The nature and background information of the business, location,
overall performance (like total export performance), type of the
machinery and equipment, capacity (ideal and current operation
capacity of the machinery), trend of production and shift of
operation, the number of staffing and other related information
related with business can be included in this section.
 The availability of side business, the overall performance of
these side business, the link either as forward or backward
linkages, complimentarily or independence and other related 57
issues are also review.
NATURE OF THE BUSINESS
 If there is sister companies, the business line and the
overall business performance should be assessed in brief.

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 The analyst also needs to identify the current market
situations of the specific business and overall economic
sector.
 Factors which affect the business condition and any
challenges on the business operation (like problem of
infrastructure, access to market, sustainability raw materials
and availability of trained and skilled manpower) shall be
incorporated in business analysis.
 The analyst also expects to include any possible business
risk.
 Source: business license, Article and Memorandum of
58
Association, business plan, due diligence report and other
internal and external information source.
KEY CUSTOMERS AND SUPPLIERS OF
THE BUSINESS:

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 Identify the main customers and suppliers of the business
and comment on the availability of sufficient suppliers
and buyers based on the information obtained from CAF
and file (like sales agreement and purchase agreement).

59
CREDIT EXPOSURE
 The credit exposure of the applicant both with Siinqee Bank
and other banks shall be taken from the LAF, statement of

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loan accounts and credit information response.
 Similarly, the credit exposure of the sister company, the
major shareholders and other affiliated companies with
Siinqee Bank and other banks are also incorporated in this
section based on the due diligence report and credit
information response
 The key components in analysis of the credit exposure are
the approved amount/limit, outstanding balances, date
granted, due date and the status.
 The analyst should critically assess the status, repayment
habit, utilization of the facility based on the presented
document and verify whether the performances are in line 60
with the bank’s credit process procedure and NBE directives.
CREDIT EXPOSURE
 If company, the credit exposure of the sister
company( the sister company definition based on the

07/02/2024
NBE directive) should be added to indicate the total
credit exposure and to check whether it is within the
single borrower limit per the NBE directive.
 The analyst should check whether the major
shareholders/subsidiaries fully settle the previous loss
loan, if any
 The analyst should check whether the major
shareholders/subsidiaries have non- performing loan
 Source: information statement of loan account, MIS
report, LAF, CAF and due diligence report
61
BORROWER’S LOAN ACCOUNT
PERFORMANCE
 Each loan account performance shall be assessed

07/02/2024
separately and in detail; some of the credit products
performances are measurement of performance are
presented beneath with the respective type of the credit
products:

62
TYPES OF THE CREDIT PRODUCTS:

Term loan,
 A Term Loan is a loan granted for working capital and/or

07/02/2024
project finance to be repaid within a specific period of
time with interest. The loan is repaid in a lump sum on
maturity, or in periodic instalments (i.e. monthly,
quarterly, semi-annually, or annually), depending on the
nature of the business and its cash flow. The Bank
extends Short-Term Loan, Medium-Term Loan and
Long-Term Loan;

63
TYPES OF THE CREDIT PRODUCTS
 Short-Term Loan: Short-Term Loan is a loan extended

07/02/2024
by the Bank to finance the working capital needs and/or
to address other short-term financial constraints of the
borrower’s business. Short-Term Loan could be granted
up to a maximum of three years.
 Medium Term loan: A Medium-Term Loan is a loan
which has a maturity period longer than three years, not
exceeding a maximum period of seven years,
 Long term loan: A Long-Term Loan, on the other hand,
is a loan which has a maturity period longer than seven
years but not exceeding a maximum period of 15 years.

64
TYPES OF THE CREDIT PRODUCTS
 Medium- or Long-Term Loans for projects/businesses
whose nature justify, or require, such periods of time for

07/02/2024
implementation and repayment of the loan.

 These types of loan are intended for the financing of the

acquisition and/or leasing of fixed business assets
(leased land, buildings, machinery, equipment, vehicles,
trucks and trailers, etc.), the establishment of a new
project and the expansion of an existing business—all of
which must be justified by a project feasibility study

65
CONT…
 Grace period is a period during which the borrower is

07/02/2024
relieved from principal repayments. Depending on the
nature and cash flow of the business, the Bank may
provide a different grace period.

 In measuring of the performance of term loans, the

analyst approached as settled and existing term loans:

66
CONT…
 Settled term loan -the different term loan granted and
settled shall be measured taking into account the range

07/02/2024
of amount granted and settlement condition, either
settled with regular repayment, settled timely but with
element irregularity, settled within thirty days after the
due date, settled between 30 to 89 days after the due
date, settler after NPL/through legal action etc...

67
CONT…
 Existing term loan-here only term loans that have
currently outstanding balance are assessed. The analyst

07/02/2024
expected to include the amount granted, purpose, date
granted, due date, status of the loan per the NBE
directive, and measure the performance as the regularly
repaid, if the loan incur arrears, categorize the arrears as
1-30 days arrears, 31-60days arrears and more than
60days arrears.

Source: information statement of loan account, MIS

report, LAF and due diligence report

68
CONT..
Overdraft (O/D)
 An Overdraft is a form of credit facility by which a

07/02/2024
customer may be allowed to draw beyond the deposits of
its current accounts for the sole purpose of the day-to-
day operational needs of a viable and ongoing
businessman Overdraft facility is repayable on demand.
The facility has pre-determined limit and renewal.
 The Bank shall call-back the outstanding Overdraft loan
balance at any time when its performance is
unsatisfactory. In the case of measuring the performance
of an O/D the following parameters should be assessed:

69
CONT..
 Turnover, the frequency of the facility turned over, it is
computed dividing of the summation of the debit balance

07/02/2024
of a month to the limit of the facility, and add the
monthly turnover to get the annual turnover. High
turnover implies good utilization of the facility.
 Highest debit swing of an O/D account- take the highest
value of the facility utilized for the tenure under
consideration and put in terms of percentage of the ratio
of the facility limit.
 Lowest debit of an O/D account or highest credit balance
- showing how the facility is stretched to lowest debit
balance or credit balances, the lowest debit balance
computed by taking the lowest debit balance of the
70
facility as the ratio of the facility limit
CONT..
 The analyst should also check the fulfilment of the NBE
directive in terms of lowest debit balance.

07/02/2024
 The analyst should critically assess whether the
performance of an O/D is in line with cash flow of the
business.
 The analyst should critically assess existence of hard core
or not, inquire justification if there is of hard core(like
diversion of an O/D or the change in business condition)
and resolving mechanism
 If the facility is not satisfactorily utilized, suggest on the
possibility of reduction of the limit or if totally or hardly
utilized comment on the possibility of cancellation of the
limit
71
 Source: Range of Account/Overdraft Utilization
Worksheet).
CONT.
Letter of credit (L/C)
 The import letter of credit facility is a credit product that

07/02/2024
the bank extends to applicants engaged in the import
business, or other applicants who import for various
purposes on payment of a certain percentage of the value of
the document while opening a L/C.
 It is form of payment promise of the bank to the exported
made by a bank on behalf of the importer who pays certain
margin of the value of goods against the receipt of import
documents. The bank transfer the ownership the import
document upon collecting the remaining amount and
interest there on from the importer.
 The L/C facility can either be of one time (non renewable)
or revolving which can be utilized by turning over of the 72
limit and renewable.
CONT…
 The important points to be considered in L/C
 Key components to be included for measuring the

07/02/2024
performance of L/C are L/C opening and settlement date,
advised date, the L/C opening balance both in terms of
foreign currency and local currency, nature of imported
items.
 The analyst should critically assess the purpose of the
L/C and check whether the facility has been utilized only
for the intended purpose.
 To show the utilization of the facility, the analyst shall
assess the total amount of L/C opened during the
reviewed period with respect to the facility limit in order
to measure the utilization and turnover.
73
CONT..
 The number of L/C opened and settled, disregarded the
cancelled L/C.

07/02/2024
 The settlement condition of each L/Cs as settled within a
week, within three weeks, within a month and after a
month, if there are L/C settled after weeks or being
outstanding for the long period, the analyst should inquire
justification and comment on the settlement condition
 Source: Trade service, the branch report and MIS

74
CONT…
Merchandise loan
 Merchandise refers to a specific product or group of

07/02/2024
products or goods manufactured or acquired by a trading
business for the purpose of sale. A Merchandise Loan is
a short-term credit facility provided by the Bank against
which the merchandise or documentary evidence.

 The merchandise loan can be for one time and revolving

merchandise loan. The revolving M/L renew periodically
prior to maturity where as the one time avail only up to
the facility mature.

75
CONT..
 The performance of the M/L is measured in terms of
turnover, which is computed by dividing by summation

07/02/2024
of the amount of settled M/L at the review period to the
facility limit.
 The sum of each advance at a time can be stretch up to
the approved facility limit.
 The analyst expect to put in as summery, each advances,
date grant and settlement date and check the sum
advances is not over the granted limit
 The settlement condition of each advance should be also
need to assess.
 The analyst assess the physical condition of the stock
based on the CRM due diligence report
 Source: statement of merchandise loan facility 76
CONT…
Pre-shipment Export Credit Facility
 Pre-Shipment Export Credit Facility is a loan extended for

07/02/2024
purchase of raw materials, processing and converting them into
finished goods, warehousing, packing and transporting the
goods until the time of shipment.
 The pre-shipment export credit facility can be one time or
revolving, and it is granted against sales contract.
 The sum of advance shall not exceed the approved limit

 The performance of the pre-shipment is measured in terms of

turnover of the facility which is computed by dividing the sum
of advances during the tenure by the facility’s limit.
 Compare the proceeds to total value credited to loan account for
the settlement of different advances
 The settlement condition of each advance should be assessed.

 Source: (the statement of facility MIS and credit advices of 77

receipt of proceeds)
CONT…
Revolving Export Credit Facility
 Revolving Export Credit Facility is an advance extended

07/02/2024
to exporters after the shipment of export items and it is
advanced upon presentation of acceptable export
documents, except a bill of lading.

 The facility should be advanced against valid export

documents and will be settled from the proceeds of the
export.

78
CONT..
Letter of guarantee
 A letter of guarantee facility issued by a Bank is a written promise/

07/02/2024
irrevocable obligation by the Bank to compensate (pay a sum of
money) to the beneficiary (local or foreign) in the event that the
obligor fails to honour his/her/its obligations in accordance with
the terms and conditions of the guarantee/agreement/contract.
 There are different forms of letter of guarantee such as Bid bond,
Performance Bond, Advance Payment, Supplier’s Credit, Retention
Guarantee, Custom Duty Guarantee and Steamers Guarantee.
 The Letter of Guarantee either be one time or renewable

 The duration of the guarantee instrument depend on the contractual

agreement signed by the parties involved in guarantee contract.
 The analyst should check whether settlement of the letter of
guarantee, as a beneficiary has claimed or not for issued guarantee
during the given period.
 Source: due diligence report and LAF 79
CONT..
Customer’s Deposit Performance
 Creation of integration between credit and resource

07/02/2024
mobilization efforts of the Bank is one of the major
recent focus areas of our Bank. Among the methods for
creation of this integration is to ensure that credit
customers of the Bank transact their sales through our
Bank’s branches.
 Hence, existing borrowers of the Bank are expected to
channel at least 95% of their sales through our Bank if
the customer has credit relationship only with our Bank
or proportional amount thereof if the customer has also
credit relationship with other banks.
 Source: Deposit account transaction summary from
80
branches, financial statements (for sales)
CONDITION OF FIXED ASSETS
 Analyze the age and condition of fixed assets (Buildings,
Machinery, equipments, etc.) owned by the business.

07/02/2024
Any addition or disposal of asset based on the financial
statement.

 Identify any plans for asset replacement or expansion

over the next years. This information shall be gathered
from due diligence report and business plan.

81
FINANCIAL STATEMENT ANALYSIS
Financial Analysis Meaning and Importance
 Financial statement analysis is a process of synthesis and

07/02/2024
summarization of financial statements and operative data
(presented in financial statements) with a view to getting
an insight into the operative activities of a business
concern;
 Financial statement analysis is a technique of
investigating the financial positions and progress of the
unit, by establishing some relationship between balance
sheet and income statement. It is also an attempt to
reveal the meaning and importance of various items
contained in the financial statements. An analysis of
financial statements gives a general picture of business
operations and their impact on the financial health of the 82

business.
CONT..
 Generally, financial analysis using financial statement of a
business entity is one of the integral parts of credit

07/02/2024
processing and analysis. It is the process of selection and
evaluation of financial information;
 Selecting from among the total information available
about a business enterprise;
 Arranging the information in a way that will bring out
significant relationship;
 Studying these relationships and interpret the result;

83
IMPORTANCE OF FINANCIAL STATEMENTS
 Financial statements are the index of the financial affairs of a
company.

07/02/2024
It can be viewed differently by various users;
 To the management of the business - can use as means of self-
evaluation.
 To the bank -assess the liquidity positions of the client firm and
determine the credit worthiness;
 To investor in knowing the safety of his/her funds and the
possible returns of same.
 To the economist can gauge the extent of concentration of
economic power and lapses in the financial policies.
 The employees and trade unions can know how the firm stands
in relation to labour and its welfare.
 To the Government relating to licensing controls, price fixation,
84
ceiling of profits, dividend freeze, tax subsidy and other
concessions.
PROCEDURES FOR FINANCIAL ANALYSIS
Re-organizing financial data
 For the purpose of financial analysis, we have to re-
organize and re-arrange the data contained in financial

07/02/2024
statements. The data may be grouped and re-grouped on
the basis of resemblances and affinities into categories of
a few principal elements;
 Through such classification and re-classification the
financial statements will be recast and presented in a
condensed form. The changed arrangement of items will
be different from the original financial statements;
 The analysis of financial data i.e., classification of the
data into groups and sub-groups and establishment of
relationships among them, is followed by interpretation;
85
CONT...
Interpretation
 The term interpretation means explaining the meaning

07/02/2024
and significance of data, so simplified. It involves
drawing inferences from the analyzed data about the
different aspects of the operational and financial results
of the business and its financial health;
 Analysis and interpretation are closely inter-linked. They
are complementary to each other. Analysis without
interpretation is useless and interpretation without
analysis is impossible. But, generally, the term analysis
is used to include synthesizing, summarizing as well
interpretation, since, analysis is always aimed at
interpretation of the relationships that are established in
the course of analysis; 86
CONT…
Points to be considered by the analyst:
 Accordingly, during financial analysis, analysts should

07/02/2024
understand the following features of financial statements.
 Financial statements are organized summaries of detailed
information. Therefore, the document provides full
information about the business entity;
 Items in the statements and their standard of disclosure are
influenced by the issuers’ desire to provide complete
information or not;
 Analysts should concentrate on essential or key amounts
and relationships to find out why the conditions revealed
by the financial statements existed.
87
CONT…
 Apart from the above, it is crucial to know the following
facts in order to understand financial statement. The facts

07/02/2024
are: -
 Accounting policies;
 Subjectivity of assets valuation;
 The underlying business and the non – financial
information.
 Likewise, financial statements are prepared based on
some assumptions; and are subjected to judgments and
estimates. At the same time, they provide valuable
information about the business entity that is relevant to
financial analysis and decision making.

88
CONT…

 There are five fundamental concepts followed in

preparing financial statements and need to be

07/02/2024
understood by users of the statements.
 The business entity concept: - Business financial
information is recorded and reported separately from the
owner’s personal financial information;
 The going concern concept: - Financial statements are
prepared with the expectation that a business will remain
in operation indefinitely;

89
CONT…
 The accrual concept (matching principle): - Revenue
from business activities and expenses associated with

07/02/2024
earning that revenue are recorded in same accounting
period;
 The consistency concept: -In the preparation of financial
statements, the same accounting concepts are applied in
the same way in each accounting period; and
 The concept of prudence (conservative principle): when
there are alternative accounting methods that could be
applied to a transaction or an account balance, it is
generally recommended to apply the one that leads to
lower income or lower asset value. For example, lower
of cost and net realisable value for inventory valuation.
90
CONT…
Objective of Financial Analysis
 The main objective of financial analysis is-

07/02/2024
 To reveal the fact and relationships among the
managerial expectations and the efficiency of the
business unit;
 To measure a financial strengths and weaknesses, its
credit worthiness can also be known through such an
analysis;
 To identify the safety of funds invested in the firm, the
adequacy or otherwise of its earnings, the ability to meet
its obligations etc.
 Prediction has to be made based on past trend;

91
FINANCIAL ANALYSIS METHODS
 The analysis make use of various instruments at the time
of financial analysis. Among these instruments, ratio
analysis is the first in the priority list. Trend analysis,

07/02/2024
cross section analysis and common size statements are
also most widely used methods.
 Using the financial statement the Lending Officers must
assess the repayment capacity of a business to meet its
loan and identify the source of repayment. The Lending
Officer must also have done a ratio analysis in order to
assess the customer ability to repay his/her/its debt;

92
CONT…
 Analyze and interpret the cash-flow and the financial
ratios from the historical financial accounts of the

07/02/2024
business using Siinqee Bank’s Financial Analysis
Spreadsheet.

 The spread sheet should be filed properly with maximum

care and should be attached with the report to be
produced.

93
 Ratio Analysis

 Ratios are the main tools of financial analysis. There are

an endless number of ratios that could be established

07/02/2024
between the figures in a set of financial statements.

 The Credit performer must also compare each ratio from

the previous periods. The reason for any major changes
from one period to another must be ascertained through
discussion with the customer.

94
CONT…
 It is well known that, normally ratios provide us with a
way to express the relationship between figures and are

07/02/2024
useful tool of analyzing. In practice, there is no “correct
or perfect ratio” for any particular business in ratio
analysis. Still, there are two instruments useful in
deriving meaningful information from ratios.
These are: -
 Comparison against industry average (vertical analysis);

 Trend in ratio over time (horizontal analysis).

95
CONT..
 In practice, horizontal analysis involves comparison of
ratio of the same company over time in order to identify

07/02/2024
trends. Whereas vertical analysis is comparing ratios of a
particular company with the industry average, average of
similar companies in the industry, etc.
 Ratios are warning signals, which assist in identifying
areas that need further investigation. Valid conclusions
as to cause and effect of changes could only be made
after obtaining further information.

96
COMMON PROBLEM OBSERVED OF RATIOS:
Ratios do have a number of failings and the lists below are

07/02/2024
few among many.
 Analysis tend to rely too much on figures produced, but
the figures are only as good as the information in
financial statements;
 Balance sheet is a one moment in time picture;

 Seasonal nature of some business;

 Cyclical nature of the business; and

 Accounting policy (asset valuation) etc

 It is worthwhile to note that the final three points are

very important particularly when undertaking a vertical
analysis. 97
 Classification of ratios

Ratios can be classified in to three major types: -

 Static Ratio: - these are ratio that compare one balance

07/02/2024
sheet figure against another, e.g. current ratio;
 Dynamic ratio: - These are ratio, which compare one
figure from the profit and loss accounts with another in
the same statement, e.g. profit margin;
 Hybrid Ratio: - this compares balance sheet figure to
income statement figure or vice versa. However, these
ratios will be distorted as they compare a one – moment
figure with a figure representing a full year total.
Therefore, extreme care should be taken with the
interpretation of hybrid ratios.

98
 Types of Ratios

 The most widely used ratios included

 activity ratios,

07/02/2024
 Leverage ratios or capital structure ratios,

 coverage ratios,

 liquidity ratios and

 Profitability ratios.

99
 Activity Ratios

 The finances obtained by a firm from its owners and

creditors will be invested in assets. These assets are used

07/02/2024
by the firm to generate sales and profits. The amount of
sales generated and the obtaining of the profits depend
on the efficient management of these assets by the firm.
 Activity ratios indicate the efficiency with which the
firm manages and used its assets. That is why these
activity ratios are also known as ‘efficiency ratios’. They
are also called ‘turnover ratios’ because they indicate the
speed with which assets are being converted or turned
over into sales.
 Thus, the activity or turnover ratio measures the
relationship between sales on one side and various assets
on the other. 100
CONT…
 The underlying assumption here is that there exists an
appropriate balance between sales and different assets.

07/02/2024
 A proper balance between sales and different assets
generally indicates the efficient management and use of
the assets.
 Many activity ratios can be calculated to know the
efficiency of asset utilization. In addition, the ratio refers
to the sales activity of the business.
 The ratio reflects the increase or decrease in sales levels
for the business from one period to another.

101
CONT…
 Activity Ratio = Sales Current Period – Sales previous Period

07/02/2024
Sales Previous Period
 The Lending Officer should note that changes in sales
levels are made up of two basic components: price and
volume.

 The breakdown of sales (i.e. price and volume) will not

be evident from the financial accounts and must be
ascertained through discussion with the customer.

102
CONT…
The following are some of the important activity ratios or
turnover ratios:

07/02/2024
 Total Assets Turnover Ratio

 This ratio measures the overall performance and

efficiency of the business enterprise.
 It points out the extent of efficiency in the use of assets
by the firm. This ratio is calculated by dividing the
annual sales value by the value of total assets.
Normally, the value of sales should be considered to be
twice that of the assets.

103
CONT…
A lower ratio than this indicates that: -
 The assets are lying idle;

07/02/2024
 While a higher ratio may mean that there is overtrading.

 Sometimes, intangible assets (goodwill, patents, etc) are

excluded from the total assets and the total tangible
assets-turnover ratio is calculated. For calculating this
ratio fictitious assets (P & L A/c debit balance, deferred
expenditure, etc) should be ignored.

104
Capital Employed Turnover

07/02/2024
 This is also known as ‘Sales-Net worth Ratio’. The
capital employed is equal to the non-current liabilities
plus the owners’ equity.

 This represents the permanent capital or long term funds

entrusted to the firm for use by the owners and creditors.

 The capital employed can be treated as equivalent to the

net working capital plus the non-current assets. This ratio
examines the effectiveness in utilizing the capital
employed.
105
CONT…

 It is calculated by dividing the sales value by the

capital employed. Thus the ratio indicates the firm’s

07/02/2024
ability to generate sales per unit of the capital employed
(long term funds). The higher the ratio, the more
efficient the utilization of the owners’ and the long term
creditors’ funds.

 The efficiency of the operations of a firm need not be

ascertained solely on the basis of this ratio. Other ratios
which are related to it also should be considered.

106
CONT…
Fixed Assets – Turnover Ratio

07/02/2024
 This ratio measures the firm’s efficiency in utilizing its
fixed assets. Firms which have large investments in fixed
assets usually consider this ratio;
 It indicates the extent of capacity utilization in the firm.
The ratio is calculated by dividing the total value of
sales by the amount of fixed assets invested.
 A high ratio is an indicator of overtrading while a low
ratio suggests idle capacity or excessive investment in
fixed assets. Normally, a ratio of five times is taken as
a standard.

107
CONT…
Current Assets Turnover
 This ratio is calculated by dividing the net sales value

07/02/2024
by that of the current assets.

 It indicates the contribution of current assets to the sales.

108
CONT…
Working Capital Turnover
 This ratio indicates the efficiency of the employment of

07/02/2024
working capital. If supplemented with the net worth
turnover ratio, it indicates the under capitalization of the
overtrading of the concern.
 A firm is said to be undercapitalized if its return on
capital is unusually high when compared to similarly
situated firms. This ratio is calculated by dividing the
net sales value by the net working capital.
 There is no standard norm for this ratio. It can only be
stated that the firm should have adequate and appropriate
working capital to justify the sales generated.
109
CONT…
Stock Turnover or Inventory Turnover

07/02/2024
 This ratio indicates the efficiency of the firm’s inventory
management. It is calculated by dividing the Cost of
Goods Sold by the average inventory.
Stock Turnover = Cost of goods sold
Average Stock

 Cost of goods sold = Sales – Gross Profit or

 Opening Stock + Purchases + Mfg. Costs – Closing
Stock.
 Average Stock = (Opening Stock + Closing Stock) 2.

110
CONT…
 This ratio indicates the rapidity with which the stock is
turning into receivables through sales. Generally, a high

07/02/2024
inventory turnover is an index of good inventory
management and a low inventory turnover indicates an
inefficient inventory management.
 Low stock turnover implies the maintenance of
excessive stocks which are not warranted by production
and sales activities. It also may be taken as an indication
of slow moving or non-moving and obsolete inventory.
 A too high inventory turnover also is not good. It may be
the result of a very low level of stocks which may result
in frequent stock-outs. The stock turnover should be
neither too high nor too low.
111
CONT…
Debtors Turnover
 Credit sales are not an uncommon feature. When the

07/02/2024
firm sells goods on credit, book debts (receivables) are
created. Debtors are expected to be converted into cash
over a short period and hence are included in current
assets.
 To a great extent the quality of debtors determines the
liquidity position of the firm. The quality of debtors can
be judged on the basis of debtors’ turnover and average
collection period.
 Receivable turnover is calculated by dividing credit sales
by average receivables: -

112
CONT…
 Receivables turnover = Credit Sales
Average Receivables

07/02/2024
 This ratio indicates the number of times on an average
the debtors or receivables turnover.

 The higher the value of debtors’ turnover, the more

efficient is the management of assets.

113
CONT…
 If the information about credit sales opening and closing
balances of receivables is not available in the financial

07/02/2024
statements, the receivables turnover can be calculated by
taking the total sales and closing balance of receivables
 Debtors Turnover = Total credit Sales
Receivables

114
CONT…
Average Collection Period
 As stated earlier the average collection period ratio is

07/02/2024
another device for indicating the quality of receivables.
This ratio shows the nature of the firm’s credit policy
also.
 The average collection period is calculated by dividing
days (or months) in a year by the receivables’ turnover.
 Average Collection Period = Days in a year/12 months
Receivables’ Turnover
 The average collection period and the receivables’ turnover are interrelated. The receivables
turnover can be calculated by dividing days in the yare by the average collection period.

115
CONT…
Inventory Turnover (in days) or Number of days in
Inventory

07/02/2024
 It indicates how long the company carries its inventories
in warehouse on the average. It is calculated using the
following formula: -
Number of days in Inventory = Average Inventory X 360
Cost of goods sold

 In the formula inventory is compared to cost of goods

sold, not to sales, because sales includes profit margin.

116
CONT…
Quick inventory turnover can indicate: -
 Higher demand for commodity;

07/02/2024
 Seasonal movements;

 Insufficient purchase;

 Changed production methods (contract out);

 Fall in price of raw materials;

 Methods of inventory valuation used;

 Shortage or difficulty in obtaining supplies (raw

material:

117
CONT…
Slow inventory turnover indicates one or more of the
following: -

07/02/2024
 Difficulty in selling;

 Seasonal movement;

 Speculative buying;

 Inventory obsolescence;

 Over – buying in relation to need of the business;

 Deterioration of some inventory;

 Production not matching to falling sales;

 Raw material price increase etc

118
CONT…
Possible distortion include: -

07/02/2024
 The ratio indicates for the whole inventory but different
line of products may have different periods;
 Method of pricing for closing inventory and cost of
goods sold could differ and it can distort the ratio if the
method is changed;
 If inventory and payables (creditors) are large, it could
indicate recent purchase.
 Given the above stated points interpretation of inventory
turnover both too small below the industry average and
too high above the industry average should be cautiously
observed.
119
CONT…
Average Collection period (in days)
Average Collection Period = Average AR X 360

07/02/2024
Net Credit Sales
 The ratio shows the company’s internal collection
efficiency of its receivables provided that, sales are
evenly spread throughout the year.
 The speed at which debts are collected is an important
indicator of liquidity. The result shows the number of
days receivables remain outstanding.

120
CONT…
Credit Taken (In days)

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 This ratio shows how fast or slow a company pays its
debts. It indicates the number of days a company takes to
settle its trade creditors. It is calculated using the
following formula: -
Creditors day = Average trade creditors X 360
Credit purchase
 This ratio gives company’s reliance on creditors to fund
operations, if purchase is evenly spread throughout the
year.

121
CONT…
Increase in number of creditors’ days may indicate:
 More reliance on creditors for financing company

07/02/2024
operation;
 Company is strong that is can dictate its own terms;

 Company is short of cash and cannot afford to pay its

creditors etc
Decrease in number of creditors’ days indicates: -
 Creditors are refusing to allow trade credit or they are
pressing for payment;
 Company is failing to take advantage of available credit
terms;
 Taking advantage of discounts for early payment.
122
CONT…
Profitability Ratios
 Profitability means the ability to make profits.

07/02/2024
Profitability ratios are calculated to measure the
profitability of the firm and its operating efficiency.
They relate profits earned by a firm to different
parameters like sales, capital employed and net
worth.
 From the management point of view, profitability
ratios are calculated for measuring the efficiency
of operations. There are two types of profitability
ratios calculated for this purpose. They are:
1. Profitability in relation to sales, and
123
2. Profitability in relation to investment.
CONT…
 Every firm should generate sufficient profit on each Birr
of sales otherwise it would be very difficult for the firm

07/02/2024
to recover operating expenses and non-operating
expenses like interest charges.

 Similarly, if the firm’s earnings are not adequate in terms

of its investment in assets and in terms of capital
employed (contributions by owners and creditors) its
very survival will be at stake.

124
CONT…
Profitability in relation to sales

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 Under this category many profitability ratios are
calculated relating different concepts of profit to the
sales value. Some such ratios are:

 Gross Profit margin or Gross Profit to Sales

 This ratio is calculated by dividing gross profit by sales
value.

Gross profit margin = Gross Profit = Sales – Cost of goods sold

Sales
125
CONT…
 In a steady situation, this ratio is expected to remain stable
irrespective of the level of production or sales.

07/02/2024
 If there is change in gross profit margin, the analyst has to
investigate further to identify the cause. As mentioned
above, a steady and adequate rate of Gross Profit is the
most reliable evidence of efficient management.
 The ratio indicates the efficiency of operations and firm
pricing policies

126
CONT…
The following can cause declining Gross Profit.
 Lack of stocking;

07/02/2024
 Incorrect stock valuation;

 Competence of management – pilfering by employees,

bad buying etc;
 Poor quality control – goods being returned

 High cost of goods sold.

127
CONT…
Gross Operating Margin

07/02/2024
 This ratio is calculated by dividing gross operating
margin by sales.
 Gross operating margin = Gross profit minus operating
expenses except depreciation.

This ratio indicates the extent to which the selling price

per unit may decline without incurring any loss in the
business operations.
 It is rather difficult to evolve a standard norm for this
ratio. But it should not be lower than that of similar
concerns.
128
CONT…
Net Operating Margin

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 This ratio is calculated by dividing the net operating
profit by (net) sales. The net operating margin may be
calculated as follows:
Net Operating Margin = Gross Operating margin – DepreciationX100
Sales

 For this ratio no standard norm is evolved. The ratio of a

firm may be compared with that of sister concerns to
measure the relative position.

129
CONT…
Net Profit Margins or Net Profit to Sales
 This is one of the very important ratios and measures the

07/02/2024
profitableness of sales. It is calculated by dividing the net
profit by sales.

 The Net profit is obtained by subtracting operating expenses

and income tax from the gross profit. Generally, non-operating
incomes and expenses are excluded for calculating this ratio.

 This ratio measures the ability of the firm to turn each Birr of
sales into net profit. It also indicates the firm’s capacity to
withstand adverse economic conditions. A high net profit
margin is a welcome feature to a firm and it enables the firm
to accelerate its profit at a faster rate than a firm with a low 130
net profit margin.
CONT…
 In order to have a more meaningful interpretation of the
profitability of a firm, both gross margin and net margin

07/02/2024
should jointly be evaluated.
 If the gross margin has been on the increase without a
corresponding increase in net margin, it indicates that the
operating expenses relating to sales have been increasing.
 The analyst should further analyze in order to find out the
expenses which are increasing. The net profit margin can
remain constant or increase with a fall in gross margin
only if the operating expenses decrease sufficiently.

131
CONT…
 As that of Gross Profit, net profit margin is a measure of
profitability except it is computed after deducting

07/02/2024
expenses.
 This ratio could be computed from two figures, profit
before or after tax.
 Net Profit Margin = NIBT x 100

Sales
Or
 Net Profit Margin =NIAT X 100

Sales

132
CONT…
 It is important to note that deterioration in this ratio may

07/02/2024
be caused, among other things, by the factors listed
below:
 Decreased Gross Profit;

 Increase in cost and expense

 As a normal practice, profit margins should be analyzed

vertically in evaluating
 Generally, it indicates the firm’s profitability after taking
account of all expenses and income taxes.

133
CONT…
Operating Ratio

07/02/2024
 The ratio is an index of the operating efficiency of the
firm. It explains the changes in the net profit margin.
 This ratio is calculated by dividing all operating
expenses (i.e., cost of goods sold plus administration and
selling expenses) by sales.
Operating ratio = Cost of goods sold + Operating Expense
Sales
 This ratio is also expressed as a percentage.

134
CONT…

07/02/2024
Profitability in Relation to Investment
 Profitability of a firm can also be measured in terms of
the investment made. The term, ‘investment’, may refer
to total assets, total operation assets, capital employed or
the owners’ equity.
 Accordingly, many profitability ratios in relation to
investment can be calculated. The important ratios are
discussed here under:

135
CONT…
Return on assets

07/02/2024
 This ratio is calculated by dividing net profit after tax by
total assets:
Return on assets (ROA) = Net Profit after tax
Total assets

 There are many variations on the return on assets ratio

mix depending on the particular concept of net profit and
assets used. The different concepts of net profit used
include net profit after tax, net profit after tax plus
interest (on loans), net operating profit, and net profit after
taxes plus interests minus tax savings.
 Similarly, the concept ‘assets’ may indicate total assets, 136

fixed assets, tangible assets, operating assets, etc.

CONT….
The different variants of the Return on assets may be as
under:

07/02/2024
Return on Assets = Net Profit after tax
Total assets
= Net Profit after tax + interest
Total assets
= Net Profit after tax + interest
Tangible assets
= Net Profit after tax + interest
Fixed assets
= Operating Profit
Operating assets 137
CONT…
 Operating assets are the assets which are used in the

07/02/2024
regular conduct of the business operations. They include
mostly tangible fixed assets and current assets.
Investments are generally excluded when calculating the
operating assets.
 This Return on Assets ratio measures the profitability of
the total assets (or investment) of a firm. But this ratio
does not throw any light on the profitability of the
different sources of funds which have financed the total
assets. This aspect of profitability is covered by Return
on capital employed.

138
CONT…
Return on Capital Employed

07/02/2024
 This is a similar to ROA except that in this ratio profits are
related to the capital employed. The term, ‘capital’, employed
refers to the long-term funds supplied by creditors and owners of
the firm. This ratio indicates how efficiently the management of
the firm has used the funds supplied by creditors and owners.

 The Capital Employed can be ascertained in two ways by taking

the non-current liabilities plus owners’ equity or by considering
the net working capital plus net fixed assets. The higher the ratio
ROCE, the more efficient has been the use of capital (long term
funds) employed.

 The Return on capital employed (ROCE) can be calculated by 139

using different concepts of profit and capital employed.
CONT…
 ROCE = Net Profit after Tax

07/02/2024
Total Capital Employed
Or
= Net Profit after Tax
Total Capital Employed
= Net Profit after Tax
Total Capital Employed

140
CONT…
Short-term Liquidity Ratios

07/02/2024
 Short – term liquidity is measured or assessed by
comparing current asset against its counterpart liability.
There are two most commonly used ratios discussed
next.
Current Ratio
 It measures the margin of safety for paying
current debts as they fall due. It is an indicative
of the short – term solvency of the company.
 current ratio (%) = Current Assets X 100

Current Liability
141
CONT…
 Trends of current ratio are different to analyze and
probably could mislead. An increase may reflect an

07/02/2024
increase solvency – positive.
 In the contrary, high level not saleable stock or overdue
receivable, which are hardly collectible may give higher
current ratio but negative.
 Likewise, decrease in current ratio may emanate from
greater efficiency or actual worsening liquidity – real
problem. Therefore, when interpreting this ratio, the
following points should be taken in to account: -

142
CONT…
 This ratio requires qualitative analysis (especially for
stock and debtors);

07/02/2024
 It is dependent upon classification of assets into current
and long term that could be biased and doubtful;
 It could be affected by accelerated year – end transaction
creating room for manipulation;
 It is dependent upon, quality of assets, their composition
and nature of the business;
 Asset concision cycle should be taken in to account.

143
CONT…
Quick Ratio

07/02/2024
 It shows the ability of a company to meet its current
obligations using funds from quick assets.
Quick ratio= Cash + short term inv. + Debtors X 100
Current Liability

 It gives more stringent/strict test of short – term liquidity

144
CONT…
Financial Leverage Ratios
Successful use of debt enhances earnings for the owners of

07/02/2024

the business, because the returns earned on these funds—
over and above the interest paid—belong to the owners, and
thus will increase the return on owners’ equity.
 From the lender’s viewpoint, however, when earnings do
not exceed or even fall short of the interest cost, fixed
interest and principal commitments must still be met.

 The owners must fulfil these claims, which might

severely affect the value of owners’ equity. The positive and
negative effects of leverage increase with the proportion of
debt in a business. With higher leverage, the risk exposure
of the providers of debt grows, as does the risk exposure of 145
the owners.
CONT…
Debt to Assets

07/02/2024
 The first and broadest test is the proportion of total debt,
both current and long- term, to total assets, which is
calculated as follows:
Total Debt= Total Debt
Total Asset
 This ratio describes the proportion of “other people’s
money” to the total claims against the assets of the
business. The higher the ratio, the greater the risk for the
lender.
 This is not necessarily a true test of the ability of the
business to cover its debts, however.
146
CONT….
Debt to Capitalization
 A more refined version of the debt proportion analysis

07/02/2024
involves the ratio of long- term debt to capitalization
(total invested capital/Capital employed).
 when the current portion of long-term debt, long-term
liabilities, and deferred taxes are included in the debt
total:

147
CONT…
Debt to capitalization= Long term Debt

07/02/2024
Capitalization (Net Asset)

 The ratio is one of the elements that rating companies

such as Moody’s take into account when classifying the
relative safety of debt. Another definition of debt is
sometimes used, which includes
(1) short-term debt (other than trade credit),

(2) the current portion of long-term debt, and

(3) all long-term debt in the form of contractual

obligations.
148
CONT…
Debt to Equity

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Debt to equity= Total Debt
Shareholders’ Investment

 A third version of the analysis of debt proportions

involves the ratio of total debt, frequently defined as the
sum of current liabilities and all types of long-term debt,
to total owners ’ equity, or shareholders’ investment.
 The debt to equity ratio is an attempt to show, in another
format, the relative proportions of all lenders’ claims to
ownership claims, and it is used as a measure of debt
exposure. The measure is expressed as either a
percentage or as a proportion. 149
CONT…
Debt to equity (alternate) = Long-Term Debt

07/02/2024
Shareholders’ Investment (Equity)

 The various formats of these relationships imply the care

with which the ground rules must be defined for any
particular analysis, and for the covenants governing
specific lending agreements. They only hint at the
risk/reward trade-off implicit in the use of debt.

150
CONT…
Debt Service
 Regardless of the specific choice from among the several

07/02/2024
ratios debt proportion analysis is in essence static, and
does not take into account the operating dynamics and
economic values of the business. The analysis is totally
derived from the balance sheet, which in itself is a static
snapshot of the financial condition of the business at a
single point in time.
 company’s ability to pay both interest and principal on
schedule as contractually agreed;

151
CONT…
Interest Coverage
 One very frequently encountered ratio reflecting a

07/02/2024
company’s debt service uses the relationship of net profit
(earnings) before interest and taxes (EBIT) to the amount
of the interest payments for the period.
 This ratio is developed with the expectation that annual
operating earnings can be considered the basic source of
funds for debt service, and that any significant change in
this relationship might signal difficulties. Major earnings
fluctuations are one type of risk considered.

152
CONT…
Interest coverage= Net profit before interest and taxes (EBIT)
Interest

07/02/2024
Burden Coverage
 A somewhat more refined analysis of debt coverage
relates the net profit of the business, before interest and
taxes, to the sum of current interest and principal
repayments, in an attempt to indicate the company’s
ability to service the burden of its debt in all aspects.

153
CONT…
 One correction often used involves converting the
principal repayments into an equivalent pre-tax amount.

07/02/2024
This is done by dividing the principal repayment by the
factor “one minus the effective tax rate.”
Burden coverage = Net Profit before interest and taxes (EBIT)
Interest + Principal Repayments/ (1-Tax rate)]

154
STATEMENT OF CASH FLOW
Introduction

07/02/2024
 A financial statement that shows how change in balance
sheet account and income affects cash and cash
equivalents, and breaks the analysis down to Operating,
Investing and financing activities;

 Concerns with the flow of cash in and out of the

business;

 determine the short-term viability of company ,

particularly its ability to pay bills,

155
CONT…
 The cash flow statement reflects a firm's liquidity. The
balance sheet is a snapshot of a firm's financial resources

07/02/2024
and obligations at a single point in time, and the income
statement summarizes a firm's financial transactions over
an interval of time.
 These two financial statements reflect the
accrual basis accounting used by firms to match
revenues with the expenses associated with generating
those revenues.

156
CONT…
 The cash flow statement includes only inflows and
outflows of cash and cash equivalents; it excludes

07/02/2024
transactions that do not directly affect cash receipts and
payments.
 These non-cash transactions include depreciation or
write-offs on bad debts or credit losses to name a few.
 The cash flow statement is a cash basis report on three
types of financial activities: operating activities,
investing activities, and financing activities. The cash
flow statement is thus intended to;

157
CONT…
 provide information on a firm's liquidity and solvency
and its ability to change cash flows in future

07/02/2024
circumstances;

 provide additional information for evaluating changes in

assets, liabilities and equity;

 improve the comparability of different firms' operating

performance by eliminating the effects of different
accounting methods;

 indicate the amount, timing and probability of future

cash flows; 158
CONT…
Parts of Cash flow statement

07/02/2024
 As briefly discussed above, the cash flow statement is
partitioned into three segments namely:
 Cash flow resulting from operating activities

 Cash flow resulting from investing activities and

 Cash flow resulting from financing activities.

159
CONT…
Operating activities
 Operating activities include the production, sales and

07/02/2024
delivery of the company's product as well as collecting
payment from its customers.

 This could include purchasing raw materials, building

inventory, advertising and shipping the product.
Operating cash flow includes:

160
CONT…
 Receipts from the sale of goods or services;
 Receipts for the sale of loans, debt or equity instruments

07/02/2024
in a trading portfolio;
 Interest received on loans;

 Payments to suppliers for goods and services;

 Payments to employees or on behalf of employees;

 Interest payments;

 buying merchandise;

 Others

161
CONT…
Investing activities
 Purchase or sale of an asset (assets can be land, building,

07/02/2024
equipment, marketable securities, etc.)
 Loans made to suppliers or received from customers;

 Payments related to mergers and acquisition;

 Proceeds from issuing short-term or long-term debt;

 Repayment of debt principal, including capital leases;

162
CONT…

Financing activities
 Financing activities include the inflow of cash from

07/02/2024
investors such as banks and shareholders, as well as the
outflow of cash to shareholders as dividends as the
company generates income.

 Other activities which impact the long-term liabilities

and equity of the business are also listed in the financing
activities section of the cash flow statement.

163
CONT…
Methods of Preparing Cash flow Statement
 Basically, there are two ways to prepare cash flow

07/02/2024
statement namely the direct and indirect method.

 The direct method of preparing a cash flow statement

results in a more easily understood report. The indirect
method is almost universally used.

164
DIRECT METHOD

 The direct method for creating a cash flow statement

reports major classes of gross cash receipts and

07/02/2024
payments.

 If taxes paid are directly linked to operating activities,

they are reported under operating activities; if the taxes
are directly linked to investing activities or financing
activities, they are reported under investing or financing
activities.

165
INDIRECT METHOD

 The indirect method uses Net-Income as a starting point,

07/02/2024
makes adjustments for all transactions for non-cash
items, then adjusts from all cash-based transactions.

 An increase in an asset account is subtracted from net

income, and an increase in a liability account is added
back to net income.

 This method converts accrual-basis net income (or loss)

into cash flow by using a series of additions and
deductions.
166
CONT…
Rules (operating activities)
 The following rules can be followed to calculate cash

07/02/2024
flows from operating activities when given only a two-
year comparative balance sheet and the net income
figure.
 Cash flows from operating activities can be found by
adjusting Net Income relative to the change in beginning
and ending balances of current assets, current liabilities,
and sometimes long term assets.
 When comparing the change in long term assets over a
year, the accountant must be certain that these changes
were caused entirely by their devaluation rather than
purchases or sales (i.e. they must be operating items not
providing or using cash) or if they are non-operating 167

items.
CONT…
 Decrease in non-cash current assets are added to net
income

07/02/2024
 Increase in non-cash current asset are subtracted from net
income
 Increase in current liabilities are added to net income
 Decrease in current liabilities are subtracted from net
income
 Expenses with no cash outflows are added back to net
income (depreciation and/or amortization expense are the
only operating items that have no effect on cash flows in
the period)
 Revenues with no cash inflows are subtracted from net
income
 Non operating losses are added back to net income 168

 Non operating gains are subtracted from net income

CONT…
Sources of Cash

07/02/2024
 Cash sales – Debtor payments;

 Increase in borrowings or overdraft (Bank or other);

 Usage of funds on current or saving accounts generated

in previous periods;
 Sale of fixed assets;

 Investment in the business by directors or others;

 Reduction in working capital;

169
CONT…
Cash sales/debtor payments
 Sales would be regarded as the primary source of funds to a

07/02/2024
business.
 The main purpose of a business is to generate sales at a
sufficient level to fund all of their costs and provide an
adequate return to the owners or shareholders.
 Given a preference the management would sell only on cash
terms, as this eliminates the possibility of bad debts and the
timing differences that arise while awaiting payment from
debtors.
 However if the nature of the business or the competition
demands that credit terms are given, then the cash inflow
from sales will only occur when payment is received from
170
debtors.
CONT…
Increase in borrowings or overdraft
 Banks and other lenders are a secondary source of

07/02/2024
funding to a business.
 The funding provided from these sources is temporary as
any advances must be repaid in accordance with the
agreed terms of repayment.
 Overdraft finance for example can fund the short term
timing gaps that arise between sales and receipt of
payments from debtors.
 If the overdraft is not repaid in the short term, then
difficulties will arise when the company next needs to
finance a short term timing gap in cash-flow
171
CONT…
 Medium and long term loans will provide immediate
funding to purchase fixed assets and enable the business to

07/02/2024
make repayments over a number of periods, and thus
reduce the immediate demands on the cash-flow of the
business.

 However if bank borrowings are continually used to

finance shortages in the business cash flow, this will create
difficulties when the Bank refuses to extend additional
credit and demands repayment of past loans.

172
CONT…
Usage of funds generated in previous periods
 If a business has generated more funds in previous periods

07/02/2024
than it has used, the additional funds will generally be
reflected in credit balances on bank current account or
deposit.

 These funds will be available in subsequent periods if cash-

flow is not sufficient to meet all requirements.

173
CONT..
Sale of fixed assets

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 Obviously a business will not resort to selling its core
fixed assets to prop up temporary cash shortages;

 However, if replacement assets are required and the assets

being replaced have a disposal value, then the business can
fund part of the new capital expenditure from the sale
proceeds of the surplus assets;

174
CONT…
Investment by directors or others
 Basically, when a business is unable to generate sufficient

07/02/2024
funds to meet requirements, the additional funding required
should be applied either temporally or permanently by the
owners of the business;
 This is a far safer source of funding than borrowing from
banks, as the repayment terms (if required) can be geared to
the cash generation ability of the business;
 The funding might be introduced in the form of permanent
capital to the business. Unfortunately most directors are
either unwilling or unable to provide funding to their
businesses when called upon to do so;

175
CONT…
Decrease in stock
 Stock is an asset that a majority of businesses are

07/02/2024
required to carry to meet the needs of their customers.
Although designated as a current asset, it is not true to
say that it is a temporary requirement within a business.
 Generally, stock will turn over regularly in line with the
sales pattern of the business. However all business have
a core level of stock that must be carried permanently.
 When sales reduce stock levels to below that of the core
value, replacement stock is purchased to keep the stock
at a level sufficiently high enough to match customer
demand.
176
CONT…
Decrease in debtors
 Debtors are another asset being carried by a business

07/02/2024
through necessity. As explained above, debtors are a
regular source of funding to a business when payments
are received;

 However, similar to stock, there is a core level of debtors

that must permanently be carried by the business;

177
CONT…
 Timing differences between sales and payment result in
further credit sales being made in the period between

07/02/2024
sales and payments from debtors.
 The longer that gap is, the higher the level of core
debtors that the business will have to carry. Similarly to
stock, as debtors are turned into cash on a regular basis,
they are in turn being replaced by new debtors.
 If the business can reduce the time gap between sales
and receipt of payment from debtors it will reduce the
core level of debtors being carried. The funds being
released by this reduction can be used elsewhere in the
business.

178
CONT…
Increase in creditors
 A business must purchase its stock from its suppliers. If

07/02/2024
the business can obtain credit terms from suppliers, this
creates a timing gap between purchase and payment.
 Similarly to the illustration on debtors above, as payment
is made to creditors new goods are being purchased,
keeping a core level of creditors that helps to fund the
stock being carried by the business.
 The longer the business can delay making payment to
creditors, the higher the funding provided from that
source. However, there are limitations in extending
credit terms beyond those agreed with suppliers.

179
CONT…

Uses of Cash
 Cash purchases – Creditor payments

07/02/2024
 Loan repayments – Permanent reductions to overdrafts

 Payment of wages/salaries

 Payment of other expenses

 Payment of taxes

 Purchase of fixed assets

 Payment of dividends to director shareholders

 Increases in working capital.

180
CONT…
 All businesses generally have high requirements for cash.
Only a few businesses are in the fortunate position of

07/02/2024
regularly generating more cash than they can use.
 Cash is therefore, a scarce resource and must be managed
carefully to ensure that there is a constant availability to
fund the continuing operations of the business.
 Sources must be matched with uses to ensure that timing
differences do not result in an inability to fund essential
activities of the business.
 The sources and uses of cash is known as the cash cycle
of the business and it is vital to the continued success of a
business that it generates sufficient cash from its
operating sources to meet operating uses including loan 181
repayments.
SUMMARY

 Good credit management does not consider collateral to be

a substitute for creditworthiness, which is the existence of

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cash flow adequate to repay the loan;

 Any proposed borrowing is closely related to both amount

and payback. Hence, the performer should always assess
how the additional borrowings requested will enhance the
business;
 Will the borrowings generate additional funds or reduce
existing overheads. (e.g. The purchase of new machinery
may result in saving on repairs to obsolete machinery or
may improve quality standards or increase production);
182
CONT…
 Assessment of repayment capacity is at best a rough
estimate of the ability of a business to meet loan repayments

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in the future. It is an inexact science and therefore margin
must be allowed for unexpected contingencies.
 Accounts provided by customers are not always an accurate
reflection of business operations and such that a performer
needs to have a good knowledge of business and finance in
order to extract sufficient information from the customer to
make a reasonable assessment;
 These skills come from practise and it is generally possible
to spot deficiencies in information;

183
CONT…
 There might be instances when there is reduced operating
cash-flow occurs. This may be as a result of:

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 Reduced turnover (market/economic conditions – competition –
customer demand)
 Increase in overheads (possibly poor cost control)
 Large financing charges (business over borrowed)
 Working capital management problem:
 High levels of stock
 Slow collection of Debtors/credit terms too generous to
customers/ over reliance on a small number of customers who
can dictate credit terms.

184
WORKING CAPITAL DETERMINATION

Meaning of Working Capital

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 In financial management, two important investment
decisions are vital. They are decisions regarding
investment in fixed assets/fixed capital and working
capital (current assets);

 Whereas working capital refers to funds locked up in

current assets and liabilities such as inventory (raw
materials, work-in-process and finished goods), supplies,
receivables, cash, payables etc;

185
CONT…
 Working capital is required for the smooth running of
day to day operation of the business. Mismanagement of

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working capital will lead to failure of a business.

 Working capital is like blood circulation in our body. If

there is no circulation of blood, we know we would
almost be dead or if some clot in the blood happens in
one part of the body, then that part becomes numb and
not in a position to use;

186
CLASSIFICATION OF WORKING CAPITAL

Gross working capital

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 It is simply called as working capital and it refers to the
firm’s investment in current Assets. Current Assets
represent:
 Cash,
 Short term securities,

 Debtors,

 Stocks, etc.

187
CONT…
Net Working Capital

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 It refers to the difference between Current Assets and
Current Liabilities.;
 That is equal to the value of raw materials, work in-
progress, finished goods inventories and accounts
receivable less accounts payable
 Current Assets refer to those assets which can be
converted in to cash within the accounting year.
 Current Liabilities refers to those claims of outsiders
which are expected to mature within the accounting year.

188
CONT…
 Thus net working capital indicates the liquidity position

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of the firm and suggests the extent to which working
capital needs may be financed by permanent sources of
funds (i.e. going to be financed by owner’s capital, long
term debt or retained earnings.)
 Working capital requirement of a firm can be classified
into Permanent/Fixed/Regular working capital and
Temporary/Fluctuating/Seasonal/variable Working
capital.
 The distinction between permanent and temporary
working capital attains importance because the source of
funds for permanent WC should come from long-term
sources while that for temporary WC from short-term 189
sources;
CONT…
Permanent WC

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 The magnitude of current assets needed is not always
same, it increase and decreases over time. The minimum
level of current assets which is continuously required by
the firm to carry on its business operations is referred as
permanent, or fixed, working capital
Variable WC
 The extra working capital needed to support the
changing production and sales activities as well as for
meeting seasonal requirements and execution of special
orders are referred as fluctuating, or variable or
temporary, working capital;
190
DETERMINANTS OF WORKING CAPITAL REQUIREMENT
 Nature of business

07/02/2024
 Size of business
 Manufacturing cycle
 Business fluctuation
 Production Policy
 Credit policy
 Growth and expansion activities
 Price level changes

191
DETERMINATION OF WORKING CAPITAL

 Investment in current assets should be just

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adequate/accurate, not more nor less, to the needs of the
business firm;

 Excessive and inadequate investment in current assets is

dangerous for the business;

 Hence, it should be optimal. A firm should achieve balance

between having sufficient working capital to ensure that
the business is liquid but not too much that the level of
working capital reduced its profitability;

192
 OPERATING CYCLE METHOD

 There is no specific way in which current assets should

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be financed;
 In general Investment in current asset is realized during
the firms operating cycle which is usually less than a
year;
 Since working capital is represented by the sum of
current assets, the investment in the same is determined
by the level of each current asset item;
 The size of investment in each component of working
capital is decided by the length of OC;

193
CONT…

 The operating cycle of manufacturing company involves

three phases.

07/02/2024
 Acquisition of resources such as raw material, Labour, fuel,
etc.
 Manufacture of the product which includes conversion of
raw material in to work in progress in to finished goods
 Sales of products either for cash or on credit. Credit sales
create books debts for collection.

194
CONT…
Determining Operating Cycle (Working Capital Cycle)

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 How is the operating cycle determined?

 The length of operating cycle of manufacturing firm is the

sum of:
1. Inventory conversion period (ICP or stock days)
2. receivables conversion period (RCP or Accounts
Receivable/debtors days)
minus the payable deferral period (PDP or Accounts
Payable/creditor days).
 Inventory conversion period is the total time needed for
producing and selling the product.
 Payable deferral period (PDP or Accounts Payable/creditor
days) is the length of time the firm is able to defer payments 195

on various resource purchases

CONT…
Inventory conversion period = Raw material conversion +
Work in process conversion period + finished goods

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conversion period;

 The difference between the gross operating cycle and

payables deferral period is net operating cycle.

196
 Description Formula* Information Required from
customers
CURRET ASSETS Stock of Raw Materials (a)
RM Days x Annual RM cost / -minimum RM holding period
working days in a year

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Work-in-process (b WIP Days (annual RM cost + - Average production process time
Annual DL cost+ Annual FOH) /
working days in a year

Stock of finished Goods (c) FG Days (Cost of finished Goods -holding period of finished goods in
produced + general expenses days
(exclude depreciation and finance
costs /Working days in a year)

Debtors (d) Credit sales X AR Days)/ Annual - credit policy (average debt
working days collection period)
Cash and Bank Balance (e) Minimum cash balance required -minimum petty cash requirement
to be maintained

Current Assets- TOTAL a+ b+ c+d+e

Annual Cost of Goods sold

(purchase) X AP Days)/ Annual Accounts Payable Policy (average
Trade Creditors (f) working days trade payable period)
Less: CURRENT
LIABILITIES Current Liabilities- Total f 197
Working Capital Current Assets – Current
Requirement Per Cycle Liabilities
CONT…
Illustration of the length operating cycle

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Items……………………..Value…………….Total
Raw material………………….68
Work in process………………23
Finished goods………………. 38…….…………..129
Receivable Conversion period……………………50
Gross operating cycle…………………………….179
Payment deferral period…………………………(35)
Net operating cycle…………….………………….144

198
THE COST OF GOODS SOLD METHOD
Key Description

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A. Forecasted Total sales
Average of Ratio of cost of Goods sold to net sales of at least for
B. three years (in percentage)

C. Cost of Goods Sold (A*B)

D. Average working capital cycle ( as determined by industry)

E. Working capital requirement per one cycle (C/D)

F. Net current asset

G Limit of the existing facilities like Overdraft , Pre-shipment

H. Net Working capital requirement for one cycle ( (E-(F+G))

199
CONT…
 There are three approaches to estimate the coming full year
sales figures such as

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 Forecasted sales: As product of the base year sale and
growth rate computation approach

 Forecasted sale = Base year sale * (1+Growth rate of the

sales)
 Forecasted sale: an amount of sales for which the working
capital requirement is going to be determined;

200
CONT…
 Base year sale The base year is the sales amount which used
as a basis to forecast the next year sales;

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 Growth rate: a rate at which the base year sales is augment
to obtain the forecasted sale;

 Base year sale and growth rate are employed for the
computation of the forecasted sale. These factors can be
approached in different ways. The different options of
approaching the factors are presented as follows:

201
CONT…
Base year Sale computation
 Base year sale can be computed in various ways depending on

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the nature of the business, trend of financial condition and
external factors affecting the business. The common
approaches of calculating base year’s sales are the following:
 Taking an average of the latest three preceding years actual
sales figure,
 Disregard exceptional minimum and/or maximum sales figures
and compute the average sales figure,
 If the sales performance is consistent, the performer can take
the latest full year sales performance as the base year figure,
 If there is any strong justification for the proxy of base year
sale, the performer can use any alternative approach for
202
calculation of the base year sale other than the above three
approaches,
CONT…
Growth rate
 The forecasted sale is computed by projecting the base year

07/02/2024
sale by the possible growth rate. The rate of growth can be
approached in the following alternatives:
 Average of at least the preceding three years sales growth
rate;
 Disregard exceptional minimum and/or maximum sales
growth rate and compute the average growth rate;
 If there is any strong justification the performer can use any
other sales growth rate other than the above approaches ;

203
CONT…
Average Margin Of Cost Of Goods Sold

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 To calculate the average margin of cost of goods sold, one of
the following options shall be considered:
 Average of at least the previous three years cost of goods
sold margin,
 Disregard exceptional minimum and /or maximum cost of
goods sold margin and calculate the average based on the
remaining year cost of goods sold margin,
 If the cost of goods sold margin is consistent, the performer
could take the latest full year cost of goods sold margin,
 if there is any strong justification the performer can use
any alternative method for computing cost of goods sold
margin other than the above three approaches . 204
CONT…
Net current asset
 Calculate the balance of net current asset by summing the

07/02/2024
stock, Trade debtors and deduct the trade creditors from the
summed value;

 The latest balance of net current asset;

 Long outstanding debtors;

 Dead or obsolete stocks and others;

205
CONT….

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Sector Recommended turnover
2.5 times
Export-Coffee average
3 times
Export-Others average
1.5 times
Manufacturing- Leather

Manufacturing- Steel 2 times

2.5 times
Manufacturing-Others average
3 times
Import Average
4 times
DTS Average 206
 WORKING CAPITAL REQUIREMENT PER BIRR
OF SALE
Steps of calculating the working capital

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1. Calculate the forecasted sale
2. Compute the working capital requirement based on the
working capital requirement per Birr of sale, say if it is
0.30, the working capital need to generate one Birr of
sale is 30 cents.
3. In this computation, we get the overall working capital
requirement for the total forecasted sale, so first we need
to compute the working capital requirement per single
cycle by dividing the yearly working capital by the
number of turnover.

207
CONT….

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Working capital requirement per birr of sale
Description

A Forecasted Total sales

Average/computed working capital required per one birr of
B sale
C Working Capital Requirement Per Cycle(A*B)
D Net current asset
E Total Bank financing required (=C-D)
F Existing facilities limit
G Additional Bank finance required (E-F)
208
LC FACILITY LIMIT DETERMINATION
Step 1: Compute the import figure from the total actual Cost

07/02/2024
of Goods Sold
 Determine annual import figure based on the average growth rate of
actual import figure ( at least three years data) from the total cost of
goods sold.
Step 2: Considering working capital cycle
 For simplicity purpose assumes there are three working capital cycle
in a year. However, depending on the nature of the import (bulk
import, country of shipment of imported goods and other based on
previous year experience), the performer may change the working
capital cycle.
Step 3: Deduct the margin to be paid by the customer (i.e.
customer’s equity) from the additional working capital
Step 4: Determine Import facility Limit 209
 Deduct the existing L/C facilities with our bank and other banks while
determining the working capital need.
SUMMARY FOR IMPORT L/C

Description

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A Total yearly import purchases ( forecasted based on trend)

B. No. of working capital cycles

C Working capital requirement per one cycle (A/B)

E Margin to be paid by the customer

E Existing Facility Limit

F. Net Working capital requirement for one cycle (C-D-E)

210
For Applicants Who Have No Experience in Import Business

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 For applicants who have no experience in the import
business, the performer should set the working capital
need/L/C facility limit based on the nature of the business,
its production capacity and likely volume of import,
financial strength of the customer, marketability of imported
item, its importance to the country, the business plan of the
customer and other issues related to the case.

211
Pre-shipment Export Credit Facility Limit determination ( for new)

Step 1: Set achievable export sales limit

07/02/2024
 Assume the maximum export sales of the planned year as USD
300,000 or equivalent of other currencies. However, if the
customer justifies its ability to export more than 300,000 USD ,
the customer’s plan could be considered.

 The ability of the customer shall be critically assessed in terms of

availability of adequate logistics- raw material availability,
processing machineries, storage facilities etc.

212
CONT…
Step 2 - considering working capital cycle

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 Refer the points mentioned in Step 4 of the Cost of Goods
Sold Method above regarding working capital
cycles/turnover.

Step 3- Set the limit of the pre-shipment facility

 The facility’s limit shall be set by dividing the total annual
estimated export sales by the number of working capital
cycles;

213
CONT…
 Summary of the steps:

07/02/2024
Description

A. Forecasted export sales

B. No. of working capital cycles

Export sales in one cycle (the facility’s limit to be set)

C. (=A/B)

214
NON-FINANCIAL ANALYSIS

Scope & Methods of Non-Financial Analysis

07/02/2024
 As financial assessment is very critical in credit analysis,
assessment of Non-Financial issues of any applicant is very
essential part of analysis and for better decision making as
well;

 Considering the Non-Financial aspects of the applicant is

mainly depends on the willingness of the applicant to
provide the data, availability of specific type of non-
financial data , the general knowledge of the business sector
that the customer is engaged in and to the extent that we as
credit performer value non-financial aspect;
215
CONT…
Assessment tools for non-financial analysis:

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 SWOT
 Business plan analysis

 5 C’s

 PESTEL

 Market Analysis(Porter’s Five forces Models, Competitor

analysis)
 Industry Analysis

 Production Analysis

 Product analysis

216
Risk Analysis
Management risk

07/02/2024
 Management quality and competence are measured in
terms management’s ability to administer a business or a
project effectively and efficiently, the strength of the
management in finical administration, proper
management the business, their relation with the labour
and other management related issues.
 Deterioration of business may arise due to poor
management quality, which makes going concern of the
business to be questionable. High turnover of
management and adverse relation with labour are also
indicators of management risk,
217
CONT…
Business risk
 It refers to the extent of the business’s exposure to

07/02/2024
operational risk. It is examined in terms of
Business/industry outlook Market competition/market
share, business plan, life of business, sales trend,
variance in net income before tax(NIBT) and net profit,
sales/ total sales, NIBT/sales inventory turnover, ROA,
ROE and earnings before interest and tax;

218
CONT…

Collateral risk
 This risk is identified by measuring the strength of the

07/02/2024
collateral backing the loan, marketability, extent of
depreciation, traceability in the case of default,
incompleteness and genuineness of the document.

219
 07/02/2024
Thank you

220