Financial sector reform in India has progressed rapidly on aspects like interest rate

deregulation, reduction in reserve requirements, prudential norms and supervision of

risk. Though the progress on the structural institutional aspects have been
comparatively slower, major changes required to take the Loans and Advances problem
has gained importance. The report deals with a clear understanding of the lending
procedures followed by Indian Overseas Bank to the S.M.E. units as working capital.. It
not only explains the basic concepts and the terminologies used in the banking sector
but also gives an insight into the legal aspects and the paper work required for final
sanction of a loan proposal. Method of assigning credit limit to the business units has
been a part of the study during the internship period. The credit rating methods applied
by the banks to rate the credibility of the prospective clients, securities accepted against
lending,etc have also been discussed to give an overview of the lending concept of the
bank. The most important part of the study includes case analysis of XYZ Pvt. Ltd. This
explains the significance of financial ratios and credit rating of the client in a precise
manner. The forecasting of financial status of the prospective borrower is shown by the
study of balance sheets sand other financial details furnished by the borrower and the
bank.
A bank is a financial intermediary that accepts deposits and channels those deposits into
lending activities. Banks are a fundamental component of the financial system, and are
also active players in financial markets. The essential role of a bank is to connect those
who have capital (such as investors or depositors), with those who seek capital (such as
individuals wanting a loan, or businesses wanting to grow).

Banks are the financial backbone of any country‟s economy.

Without a sound banking system a country cannot have a healthy economy. A bank is a
financial institution which deals with money and credit. It accepts deposits from
individuals, firms and companies at a lower rate of interest and gives it at a higher rate of
interest to those who need them. The difference between the terms at which it borrows
and which it lends forms the source of profit, thus bank being a profit earning
institute.

For the past three decades India‟s banking system has several
outstanding achievements to its credit. The most striking is its extensive reach to
customers. It is no longer confined to only metropolitans or cosmopolitans in India. In
fact the Indian banking system has reached even to the remote corners of the country.
This is one of the main reasons for the India‟s growth process. The first bank in India
though conservative, was established in 1786. From 1786 till today, the journey of Indian
banking system can be segregated into three distinct phases. They are:

PHASE 1: early phase from 1786 to 1969 of Indian banks.

PHASE 2: nationalization of Indian banks and up to 1991 prior to Indian banking sector
reforms.

PHASE 3: new phase of Indian banking system with the advent of Indian banking and
financial reforms after 1991.

The Indian banking can be broadly categorized into nationalized

(government owned), private banks and specialized banking institutions. The RBI acts as
a centralized body monitoring any discrepancies and shortcomings of the system. It is the
foremost monitoring body in the Indian financial sector. Since the nationalization of
banks in 1969, the public sector banks have realized the need to become highly customer
centric that forced the slow moving public sector banks to adopt a fast track approach.

Banking is generally a highly regulated industry, and government

restrictions on financial activities by banks have varied over time and location. The
current set of global standards is called Basel II.
• Indian Overseas Bank (IOB) was founded on 10th February 1937 and had
distinction of three branches at Chennai, Kasaikudi and Rangoon
simultaneously commencing business on the inaugural day.
• The founder Chairman was M.Ct.Chidambaram Chettiyar. It was started with
a vision to specialize in foreign exchange and overseas banking business in India.
• Before 1969, it had ventured into consumer credit, had begun with
computerization and had 195 branches in India.
• In 1969, when it was nationalized, the bank had 208 branches and business mix
of Rs 156 crores.
• IOB has gained AA rating by CRISIL for its primary issue and a rating of P1
for its term deposits.
• IOB is currently one of the major banks based in Chennai, with 1845 domestic
branches and 12 branches overseas.
• IOB also has an ISO certified in house information technology department,
which has developed the software that most of its branches use to provide
online banking to customers.
• IOB has a network of more than 500 ATMs all over India and IOB’s
international visa debit card is accepted at all the ATMs.
• IOB offers internet banking (E-see banking) and is one of the banks that the
government of India has approved for online payment of taxes.
• IOB provides various banking services, including saving bank, current
account, credit facilities and other services. IOB also provides non-
residential Indian (NRI) services, personal banking, foreign exchange
reserves (FOREX) collections services, agri-business consultancy, credit
card and e-banking services. The bank is also engaged in merchant banking.
• IOB is the first public sector bank in the country to introduce mobile
banking services using wireless application protocol (WAP).
• It was also the first public sector bank to introduce anywhere banking at its 129
branches in the four metros and is extending the connectivity to 100
other branches in Hyderabad, Bangalore, Ahmadabad and Ludhiana.
• In year 2000, it came out with a public issue of 11,12,00,000 shares of Rs 10
each for cash at par aggregating Rs 111.20 crores. It also raised Rs 125
crores through bonds issue in year 2001. It gained the rating of AA for the
issue.
• Being ranked as the best public sector bank in India in 2007, it’s key
trade centers now include Singapore, Seoul, Hong Kong, Bangkok and Germany.

WORKING CAPITAL
There are two concepts of working capital: Gross Working Capital
Net Working Capital

Gross working capital is the total of all current assets. The constituents of current
assets are shown below:

CURRENT ASSETS:
Inventories
Raw materials and Components
Work- in Process
Finished goods
Others
Trade Debtors
Loans and Advances
Cash and Bank Balances

Net Working Capital is the difference between current assets and current liabilities.
The constituents of current liabilities are shown below:

CURRENT LIABILITIES:
Sundry Creditors
Trade Advances
Borrowings (short term)
Commercial Banks
Others
Provisions

FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS:

The working capital needs of a firm are influenced by numerous factors. The
important ones are:

• Nature of Business : The working capital requirement of a firm depends on the

nature of its busuness. The table below shows the relative proportions of
investmentin current assetsand fixed assets for certain industries:

PROPORTIONS OF CURRENT ASSETS AND FIXED ASSETS

CURRENT ASSETS FIXED ASSETS INDUSTRIES
(%) (%)
10-20 80-90 Hotels and restaurants
20-30 70-80 Electricity generation and distribution
30-40 60-70 Aluminium, Shipping
40-50 50-60 Iron and steel, basic industrial chemicals
60-70 30-40 Cotton textiles, sugar
70-80 20-30 Edible oils, tobacco
80-90 10-20 Trading , construction

• Seasonality of Operations: Firms which have marked seasonalityin their

operations usually have highly fluctuating working capital requirements. For
example
• Production Policy
• Market Conditions
• Conditions of supply
Financial analysis is the systematic examination and interpretation of financial data
to evaluate the past performance of a business, its present conditions and its future
prospects. It refers to an assessment of the viability, stability and profitability of a
business, sub-business or a project. Essentially, financial analysis moves from a
preliminary investigation of the client to an in depth examination of operating
performance, as interpreted from historical and projected financial statements.
With financial analysis, the advances manager assesses the company’s financial
performance to arrive at a conclusion about the future prospects of the loan
repayment.

FINANCIAL ANALYSIS ASSESES THE FIRM’S:

1. Profitability - its ability to earn income and sustain growth in both short-term
and long-term. A company's degree of profitability is usually based on the income
statement, which reports on the company's results of operations;

2. Solvency - its ability to pay its obligation to creditors and other third parties in
the long-term;

3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate
obligations;

4. Stability- the firm's ability to remain in business in the long run, without
having to sustain significant losses in the conduct of its business. Assessing a
company's stability requires the use of income statement and balance sheet, as well
as other financial and non-financial indicators.
STEPS INVOLVED IN FINANCIAL ANALYSIS OF LENDING

Step 1: Company’s financial statement for at least 3 to 5 years is acquired.

The financial statement must include the following:
• Balance sheets
• Income statements
• Cash flow statement

Step 2: A quick scanning of all the statements is done to look for large movements
in specific terms from one year to the next. If there is something suspicious,
relevant research about the company is done from the information available to find
out the reason. Notes accompanying the financial statements are also reviewed
for additional information that may be significant to analysis.

Step 3: This stage calls for an exhaustive scrutiny of the balance sheet. While
examining, the advances manager looks for the large changes in overall
components of company’s assets and liabilities of equity. For example, have fixed
assets grown rapidly in one or two years, due to acquisitions or new facilities? Has
the portion of debt grown rapidly, to reflect a new financial strategy?

Step 4: This level relates to an assessment of the income statement as furnished

by the client. The advances manager looks for the trends overtime. Graphs and
growth of the following entries over the past several years are calculated:
• Revenue (sales)
• Net income (profit, earnings)
For each key expense components on the income statement, percentage of sales of
each year is calculated. For example, percentage of cost of goods sold over sales,
general and administrative expenses over sales and development over sales are
computed. Favorable and unfavorable trends are highlighted. Manager determines
whether the spending trends support the company’s strategies.

Step 5: The very phase pertains to an evaluation of the cash flow statement. It
gives information about the cash inflows and outflows from operations, financing and
investing. While the income statement provides information about both cash and
non-cash items, the cash flow statement attempts to reconstruct that
information to make it clear how cash is obtained and used by the business, since
that is what investors really care about.

BALANCE SHEET ANALYSIS:

The balance sheet tells how much money the company has, how much it owes, and
what is left for the stockholders. A balance sheet is divided mainly into to parts:
a) ASSETS
b) LIABILITIES
Assets are referred to as uses of funds , while liabilities are referred to as sources of
fund.
SOURCES OF FUND USES OF FUND

• Capital • Fixed Assets

1) Authorized Capital 1)Infrastructure like land & building
2) Issued Capital 2)plant & machinery
3) Subscribed Capital 3)Vehicles
4) Paid-up Capital 4)Furniture & fixtures
• Reserves • Investments
1) Subsidy Received From The Government 1) Shares And Securities
2) Development Rebate reserve 2) Associate Companies
3) Revaluation of fixed assets 3) Fixed deposits with banks/finance
4) Issue of Shares at Premium companies
5) General Reserves • Current Assets
• Surplus 1)Raw materials, work-in-progress, finished
The credit balance in profit and loss goods, spares and consumables
account 2)Sundry debtors and receivables < 6
• Term Liabilities months
1)Redeemable preference shares 3)Advances paid to suppliers of raw
2)Debentures materials
3)Deferred payment guarantees 4)Cash and bank balances
4)Public Deposits(Repayable after 5)Interest receivables
12months) • Non Current Assets
5)Term loans and unsecured loans from 1)Deferred receivables/Overdue
friends, relatives, directors repayable over receivables(like disputed amounts and Over
a period of time Due > 6 months)
• Current Liabilities 2)Non moving stocks/inventory/un usable
1)Working capital bank borrowings spares
2)Term loans deferred credit inst falling 3)Investment/Lending to associate concern
due in 12 months 4)Borrowing of the directors from the
3)Public deposits maturing within 12 company
months 5)Telephone deposits/ ST deposits etc
4)Unsecured loans, unless the repayment • Intangible Assets
is on deferred terms 1)Preliminary & Preoperative expenses
5)Sundry creditors 2)Deferred Revenue Expenditure
6)Advances from dealers and customers 3)Goodwill
7)Interest accrued but not paid 4)Trade mark
8)Tax provisions 5)Patents
9)Dividend declared and payable

Balance Sheet Analysis is not only quantitative but has to be qualitative. It gives
the idea about the financial position of the company. Minimum three years
balance sheet is needed for a meaningful analysis.
PROFIT & LOSS ACCOUNT
It is a summary of revenue earned and expenses incurred which ultimately
results in profit or loss of to the company

Operating revenue = Sales revenue

Non_operating revenue = Other income ( out of sale of investments, interest,

commission and discount etc).
Hence operating profit is a yard stick for operating profit of the company

Operating profit = Sales Revenue- Operating Cost

Gross Sales
Gross sales includes excise duty to be charged to the customer, central sales tax
applicable, state sales tax applicable, the discount o be allowed to
distributors/dealers/customers. The gross sales appear in the Profit & Loss
account comprises of all the above part from the basic unit price.

Net Sales
The sales figure excluding all the factors explained above are the net sales.

Cost of production
This is the cost incurred right from the procurement of raw material to the
finished good.

Selling And General Administrative Expenses

All the expenses which are not directly connected to manufacturing are classified
as selling and/or general expenses.
It includes: a)Maintaining office staff for administration & accounting
b)Marketing effort
c)Payment of salaries to marketing personnel

Cost of goods sold

Cost of goods sold includes all manufacturing expenses and the adjustments for
opening and closing stock

Cost of Goods sold = Opening stock + Purchases +

Manufacturing expenses - Closing stock

Gross Profit
It is arrived deducting figure of cost of goods sold from the sales figure

Gross profit = Sales - Cost of goods sold

Operating Profit
It is arrived deducting selling, administrative and general expenses, provision for
bad debts, interest and miscellaneous expenses from the gross profit.

Operating Profit = Gross Profit- (Selling & administrative

expenses + Provision for bad debt + miscellaneous expenses)

Profit Before Tax

 When other income is added and other expenses are deducted from the operating
profit we get profit before Tax

PBT = Operating Profit + other Income - other expenses

Net Profit
When provision for taxes is deducted from the Profit Before Tax we get Net profit.

Net Profit = PBT – taxes

Non Operating Income/Expenses

The income earned by the unit from other than manufacturing and selling
operations is classified under this head . i.e.
a) Interest earned on fixed deposits
b) Dividends and profit earned by sale of assets and share.

All those expenses which are not directly connected with operations of the unit
are classified under this head. i.e.
a) Preliminary expenses written off
b) Loss suffered due to sale of assets & share

CALCULATION OF FINANCIAL RATIOS

Ratio analysis is a powerful tool of financial analysis. In financial analysis, a ratio is

used as a benchmark for evaluating the financial position and performance of the
firm. A ratio in itself has no meaning. It should be compared with some standard.
Standards of comparison may consist of:
• Past ratios
• Competitors ratios
• Industry ratios
• Projected ratios

The most frequently used ratios by bank and financial analysts are:

• Liquidity Ratio
• Degree of financial leverage of debt
• Profitability
• Efficiency
• Value
a)ANALYZING LIQUIDITY: Liquid assets are those that can be converted
into cash quickly. The short-term liquidity ratios show the firm‟s ability to meet its
short-term obligations. Thus a higher ratio (#1 and #2) would indicate a greater
liquidity and lower risk for short-term lenders. The Rules of Thumb for acceptable
values are: Current Ratio (2:1), Quick Ratio (1:1).

1. Current Ratio = Total Current Assets / Total Current Liabilities

2. Quick Ratio = (Total Current Assets - Inventories) / Total Current

Liabilities

In the quick ratio, we subtract inventories from total current assets, since they are
the least liquid among the current assets.

b) ANALYZING DEBT: Debt ratios show the extent to which a firm is relying
on debt to finance its investments and operations, and how well it can
manage the debt obligation, i.e. repayment of principal and periodic interest. If
the company is unable to pay its debt, it will be forced into bankruptcy. On the
positive side, use of debt is beneficial as it provides tax benefits to the firm, and
allows it to exploit business opportunities and grow.
Note that total debt includes short-term debt (bank advances + the current portion
of long-term debt) and long-term debt (bonds, leases, notes payable).

1. Leverage Ratios
1a. Debt to Equity Ratio = Total Debt / Total Equity
This shows the firm‟s degree of leverage or its reliance on external debt for
financing.
1b. Debt to Assets Ratio = Total Debt / Total assets
In general, with either of the above ratios, the lower the ratio, the more
conservative (and probably safer) the company is. However, if a company is not
using debt, it may be foregoing investment and growth opportunities. This is a
question that can be answered only by further company and industry research.

2. Interest Coverage (or Times Interest Earned) Ratio = Earnings before

Interest and Taxes / Annual Interest Expense
This shows the firm‟s ability to cover fixed interest charges (on both short-term and
long-term debt) with current earnings. The margin of safety that is acceptable
varies within and across industries, and also depends on the revenue
generation history of a firm (especially the consistency of earnings from period
to period and year to year).

3. Cash Flow Coverage = Net Cash Flow / Annual Interest Expense

Net cash flow = Net Income is either subtracted from or added to non-cash items,
as applicable (e.g. -equity income + minority interest in earnings of subsidiary +
deferred income taxes + depreciation + depletion + amortization expenses)
Since depreciation is usually the largest non-cash item in most companies,
analysts often approximate Net cash flow as being equivalent to Net Income +
Depreciation.
Cash flow is a “critical variable” in assessing a company. If a company is showing
high profits but has poor cash flow, one should investigate further before passing a
favorable opinion on the company. Analysts prefer ratio #3 to ratio #2.
c) ANALYZING PROFITABILITY: Profitability is a relative term. It is hard to
say what percentage of profits represents a profitable firm, as profits depend
on factors such as the position of the company and its products on the
competitive life cycle (for example profits will be lower in the initial years when
investment is high), on competitive conditions in the industry, and on borrowing
costs. For decision-making, bank is mainly concerned with the present value of
expected future profits. Past or current profits are important only as they help us to
ascertain future profits, by identifying historical and forecasted trends of profits and
sales.

1. Net Profit Margin = Profit after taxes / Sales

2. Return on Assets (ROA) = Profit after taxes / Total Assets

3. Return on Equity (ROE) = Profit after taxes / Shareholders‟ Equity (book

value)

4. Earnings per Common share (EPS) = (Profits after taxes - Preferred

Dividend) / (# of common shares outstanding)

5. Payout Ratio = Cash Dividends / Net Income.

d) ANALYZING EFFECIENY: These ratios reflect how well the firm‟s assets
are being managed. The inventory ratio shows how fast the inventory is being
produced and sold.

1. Inventory Turnover = Cost of Goods Sold / Average Inventory

This ratio shows how quickly the inventory is being turned over (or sold) to generate
sales. A higher ratio implies the firm is more efficient in managing inventories
by minimizing the investment in inventories. Thus a ratio of 12 would mean that
the inventory turns over 12 times, or the average inventory is sold in a month.

2. Total Assets Turnover = Sales / Average Total Assets

This ratio shows how much sales the firm is generating for every dollar of investment
in assets.
The higher the ratio, the better is the performance of the bank.

3. Accounts Receivable Turnover = Annual Credit Sales / Average

Receivables

4. Average Collection period = Average Accounts Receivable / (Total

Sales / 365)
Ratios #3 and #4 show the firm’s efficiency in collecting cash from its credit sales.
While a low ratio is good, it could also mean that the firm is being very strict in its
credit policy, which may not attract customers.

5. Days in Inventory = Days in a year / Inventory turnover

Ratio #5 is referred to as the “shelf-life” i.e. how quickly the manufactured product
is sold off the shelf. Thus #5 and #1 are related.

e) VALUE RATIOS: Value ratios show the “embedded value” in stocks, and
are used by investors as a screening device before making investments.
1. Price to Earnings Ratio (P/E) = Current Market Price per Share / After-
tax Earnings per Share

2. Dividend Yield = Annual Dividends per Share / Current Market Price per
Share

f) DEBT SERVICE COVERAGE RATIO: The debt service coverage ratio (DSCR)
is the ratio of cash available for debt servicing to interest, principal and lease
payments. It is a popular benchmark used in the measurement of an entity's
(person or corporation) ability to produce enough cash to cover its debt
(including lease) payments. The higher this ratio is, the easier it is to obtain a loan.
The phrase is also used in commercial banking and may be expressed as a minimum
ratio that is acceptable to a lender; it may be a loan condition.

In general, it is calculated by: NET OPERATING INCOME/ TOTAL DEBT SERVICE

A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1 say
0.95 would mean that there is only enough net operating income to cover 95% of
annual debt payments. For example, in the context of personal finance, this would
mean that the borrower would have to delve into his or her personal funds every
month to keep the project afloat. Generally, lenders frown on a negative cash flow,
but some allow it if the borrower has strong outside income.
After a detailed financial analysis of the proposal given by the client, rating is done
for risk analysis. Every proposal has its pros and cons. Therefore proper assessment
of credit risks has to be done. It helps in establishing credit limits. In assessing credit
risks , errors can occur. To avoid or mitigate the occurnce of risks proper credit
evaluation is done. Two broad approaches are used here for credit evaluation:
a) Traditional credit analysis
b) Numerical credit scoring
TRADITIONAL CREDIT ANALYSIS:

The traditional approach to credit analysis calls for assessing a prospective customer in
the terms of “five C’s of credit”.
1. Character – The willingness of the customer to honour his obligations. It reflects
integrity, a moral attribute that is considered very important by credit managers.
2. Capacity – The ability of the customer to meet credit obligations from the
operating cash flows.
3. Capital – The financial reserves of the customer. If the customer has difficulty in
meeting his credit obligations from its operating cash flow, the focus shifts to its
capital.
4. Collateral – The security offered by the customer in the form of pledged assets.
5. Conditions – The general economic conditions that affect the customer.

To get information on the five C’s, a firm may rely on the following:

1. Financial Statements – Financial statements contain a wealth of information. A

searching analysis of the customer’s financial statements can provide useful
insights into the creditworthiness of the customer. The following ratios seem
particularly helpful in this context: current ratio, acid-test ratio, debt-equity ratio,
EBIT to total assets ratio, and return on equity.
2. Bank References – The banker of the prospective customer may be another
source of information. To ensure a higher degree of candour, the customer’s
banker may be approached indirectly through the bank of the firm granting credit.
3. Experience of the Firm – Consulting one’s own experience is very important. If
the firm has previous dealings with the customer, then it is worth asking: How
prompt has the customer been in making payments? How well has the customer
honoured his word in the past? Where the customer is being approached for the
first time, the impression of the company’s sales personnel is useful.
4. Prices and Yeilds on Securities – For listed companies, valuable inferences can
be derived from stock market data. Higher the price-earnings multiple and lower
the yield on bonds, other things being equal, lower will be the credit risk.

NUMERICAL CREDIT SORING:

In traditional credit analysis, customers are assigned to various risk classes somewhat
judgementally on the basis of five C’s of credit. Credit analysis may, however, want to
use a more systematic numerical credit scoring system. Such a system may involve the
following steps:
1. Identify factors relevant for credit evaluation.
2. Assign weights to these factors that reflect their relative importance.
3. Rate the customer on various factors, using a suitable rating scale(usually a 5-
point scale or a 7-point scale is used).
4. For each factor, multiply the factor rating with the factor weight to get the factor
score.
5. Add all the factor scores to get the overall customer rating index.
6. Based on the rating index, classify the customer.

In the bank, internal rating as well as external rating is done for risk analysis.
Internal rating is done for every proposal the bank gets. While external rating is
done by the credit rating agencies such as CRISIL, ICRA, etc. for advances above 10
crores.

RAM RATING:
 It is a type of internal rating done for the proposals for advances upto Rupees 10
crores. It is done by filling up a questionnaire by the managers. The questionnaire
includes the detailed study of the company which needs the advances.
In this type of rating, four types of risks are evaluated. They are:
• Business Risk
• Financial Risk
• Industry Risk
• Management Risk

BUSINEES RISK:

It is the risk associated with the type of business the client is pursuing.
It includes: a) Market position
b) Operating efficiency

Market position includes: -> Geographical reach of the entity,

-> Proximity to customers,
-> Marketing and selling arrangements,
-> Presence of export activities, etc.

Operating efficiency includes : -> Availability of skilled manpower

-> Environment risk
-> Capacity utilization
-> Availability of raw materials, etc.

FINANCIAL RISK :

Financial risk is evaluated to learn about the financial position of the company. It is
verified whether the company has a sound financial management. Financial risk
includes : a) Financial flexibility
b) Past financials
c) Future financials

Financial flexibility includes : -> Ability to raise debt

-> Ability to raise equity , etc.

Past financials include : -> Interest Coverage ratio (Past)

-> Current Ratio (Past)
-> TOL/TNW (Past)
-> Net Profit Margin (Past), etc.

Future financials include : -> Interest Coverage ratio (Projected)

-> Current Ratio (Projected)
-> TOL/TNW (Projected)
-> Net Profit Margin (Projected), etc.

INDUSTRY RISK :
SWOT analysis is a strategic planning method used to evaluate
the Strengths, Weaknesses, Opportunities, and Threats involved in a project or in
a business venture. It involves specifying the objective of the business venture or
project and identifying the internal and external factors that are favorable and
unfavorable to achieve that objective.

There are different methods used in the bank for calculating the permissible banking
finance according to the amount of advances needed for working capital.

1. When the advances for a SME unit is up to 7.5 Crores:

In this situation, Nayak Committee Method is used. According to this method,

the cash credit limit or the working capital to be granted should be 25% of the
Turnover. This is called the minimum permissible banking finance.

2. When the advances for a SME unit is above Rupees 7.5 Crores:

In this situation