-201 Term

Term loan, Assessment of term loan

for asset financing. Regulatory
guidelines for asset financing
through Term loan

7)
National Institute of Banking Studies & Corporate Management
A-30, Sector 62, Institutional Area, Noida—201307
Phone: 0120-2975208/09, E-mail nibscom@nibscom.in, http://nibscom.in
Contents
1. Sound Principles of Lending, Credit Investigation & Selection of
Borrowers.......................................................................................... 2
2. Basic Concepts of CMA Data ............................................................. 6
3. Credit Analysis Process ....................................................................... 7
4. Financial Ratio Analysis relevant to Bankers ................................... 10
5. Analysis of Fund Flow and Cash Flow .............................................. 26
6. Project Appraisal ............................................................................. 49

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1. Sound Principles of Lending, Credit
Investigation & Selection of Borrowers
Sound Principles of Lending: It is a fundamental precept of banking everywhere that advances
are made to customers in reliance on his promise to repay, rather than the security held by the
banker. Although all lending involves some degree of risks, it is necessary for any bank to
develop sound and safe lending policies and new lending techniques in order to keep the risk to
a minimum. As such, the banks are required to follow certain principles of sound lending.
• Safety
• Liquidity
• Purpose
• Profitability
• Security
• Spread/ Diversity

Safety: Advances should be expected to come back in the normal course. The repayment of the
loan depends upon the borrower’s capacity to pay and willingness to pay. The capacity depends
upon the tangible assets of the borrower. The willingness to pay depends upon the honesty and
character of the borrower.
Liquidity: Liquidity is the availability of bank funds on short notice. The borrower must be in a
position to repay within a reasonable time. Liquidity also signifies that the assets should be
salable without any loss.
Profitability: A banker has to see that major portion of the assets owned by it are not only liquid
but also aim at earning a good profit. The difference between the interest received on advances
and the interest paid on deposits constitutes a major portion of bank’s income. Besides, foreign
exchange business is also highly remunerative.
Purpose: A banker would not throw away money for any purpose for which the borrower wants.
The purpose should be productive so that the money not only remains safe but also provides a
definite source repayment.
Security: Security serves as a safety valve for an unexpected emergency. The security offered for
an advance is a cushion to fall back upon in case of need. An element of risk is always present in
every advance however secured it might appear to be.
Spread/ Diversity: The advances should be as much broad-based as possible and must be in
keeping with the deposit structure. The advances must not be in one particular direction or to
one particular industry. Again, advances must not be granted in one area alone.
National Interest: Bank has significant role to play in the economic development of a country.
The banker would lend if the purpose of the advance is for overall national development.

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Credit Investigation: Different phases of Credit Investigation:
1. Collection of information of the entrepreneur
2. Preparation and analysis of this information in order to determine creditworthiness of
the borrower/ entrepreneur
3. Making decisions and recommendations about the borrower
4. Furnishing credit information to other bankers
5. Retention of the information for future use
Sources of information for credit investigation:
A. Personal Interview:
The first and most obvious information that can be derived from the borrower by personal
interview in the following manner:
B. Refreezing:

Try to get introduced with the entrepreneur

Be informal with him

Know him personally and earn his acceptance

Be frank, upright and sincere

C. Assessing achievement need:

Ask about his past experiences during student life and afterwards and try to assess
whether he is a winner character or loser

Mark his enthusiasm when the entrepreneur describes his achievement/ success

Try to assess the extent of optimism and pessimism

Make notional rating about his achievement need (positive/neutral/negative)

D. Assessing attitudes of the entrepreneur:

Try to note entrepreneur’s responses indicating his inclination to literature, business,
economics, history etc.

Check and recheck if his attitude is proper towards business management

Examine his responses and deliberations to find out whether trend of response is positive
or negative

Try to assess his attitudes on the above lines and rank him accordingly
(High/average/low)
E. Assessing overall knowledge about the project:

Discuss about the project the entrepreneur has submitted

Check if he is familiar with the project that contained in the profile

Check the information given by the entrepreneur contained in the profile

Rank his project knowledge according to the correctness of project information
(high/modest/low)
F. Assessing management skill:

Try to assess entrepreneur’s skills in managing people, material resources and financial
resources

Try to know his capability about assessing others

Note if he is critical about others

Note his appreciation about others

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Assess his knowledge about the product/service

Assess his knowledge about the competitors

Assess his knowledge about the price, consumer group and consumer behavior

Assess his knowledge about actual market where his product is likely to be marketed

Assess his knowledge about demand gap

Rank his management skill on the basis of above discussion (high/average/low)

Borrower’s Loan Application:

1. Loan application entails a detailed questionnaire where from borrowers answer provide
some basic information
2. Bank’s own record: Bank’s own record provides applicant’s transaction behaviour. In case
of old borrower information are available regarding previous borrowings and the
repayments were made as per sanction stipulation.
3. Reports obtained through friends or rivals: Banks may obtain information about the
borrowers in the same line of trade or business.
4. Confidential Report/ Status Report from fellow bank
5. Spot verification
6. Market reports
7. Financial statement of the applicant
8. Income Tax statement
9. Report from CIB
10. Trade checking
11. Reports from Chamber of Commerce and Industry
12. Reports from Registrar of Joint Stock Company in case of Limited Company
13. Personal visit to the applicant’s business, plant or trade center
14. Other sources:
a). Press reports regarding purchase, sale, auction of property
b). Registration records, municipal records etc.

4. Preparation of Credit Report: On the basis of credit investigation, bankers prepare a credit
report for the applicant usually as per proforma used by the respective bank. The report
generally includes the following under different ownership:
1. Name
2. Worth
3. Date
4. Registered Office
5. Address (present, permanent and business)
6. Nature of business
7. Constitution of the firm
8. Date of establishment
9. Incorporation and Commencement certificate
10. Associates and allied concerns with details of assets and liabilities
11. Manufacturing and Trading Account
12. Profit & Loss Account

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 13. Analysis of Balance Sheet
14. Facilities requested
15. Ability to furnish equity and collateral
16. Other bank report
17. Manager’s opinion
5. Credit Report Analysis:
An analytical study is required whether a particular project is accepted or rejected:
1. Managerial Aspect
2. Organizational Aspect
3. Technical Aspect
4. Marketing Aspect
5. Financial Aspect
6. Economic Aspect

Selection of Borrowers
Selection of borrowers is to be considered as per lending principles and Bangladesh Bank
Guidelines.

Borrower Selection Criteria: The following points should be taken into consideration:
1. The borrower must be a real entrepreneur
2. He must be resident of the project area
3. He should have at least 20% of the total project value as his equity
4. He should have the ability to offer collateral security acceptable to the lending bank

Methods of Selection:
In selecting the borrower, the following aspects should be considered
1. Past behaviour of the borrower requires to be studied. Enquiry should be made whether
the applicant has availed of any loan previously from other bank and whether his dealings
with that bank are regular or not.
2. Work experiences of the intending borrower—what are the activities undertaken by
him—his successes and failures along with analysis of the underlying factors.
3. Whether the work area has any relevance to the project proposed to be undertaken y
him.

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2. Basic Concepts of CMA Data
Credit Monitoring Arrangement (CMA) data is a very important area to understand by a person dealing
with finance in an organisation. It is a critical analysis of current & projected financial statements of a loan
applicant by the banker. CMA data is a systematic analysis of working capital management of a borrower
and objective of this statement is to ensure the usage of long term and short term fund have been used
for the given purpose. In this article I want to discuss about the basic contents of the CMA data. Basically
CMA data contains the 7 statements which as follows.

1. Particular of Existing & proposed limits:

This is the first statement in the CMA Data which contains the present fund & non fund based credit limits
of the borrower and their usage limits and history. Along with present fund limits what is the proposed or
applied limit of the borrower will be mentioned in this statement, this is an basic information document
which provided by the borrower the banker.
2. Operating statement:
This is the second statement which provided by the borrower, this indicates the business plan of the
borrower which gives the Current Sales, Direct & indirect expenses, Profit before & after tax along with
the projections of sales, expenses and profit position for the 3 to 5 years based on the borrower working
capital request. This statement is a scientific analysis of current & projected financial and profit
generating capacity of the borrower.
3. Analysis of Balance sheet:
Balance sheet analysis for the current & projected financial years is the third statement in CMA data. This
statement gives the detailed analysis of Current & noncurrent assets, fixed assets, cash & bank position,
current & noncurrent liabilities of the borrower. Also this statement indicates the net worth position of
the borrower for the projected years. Balance sheet analysis gives a complete financial position of the
borrower and cash generating capacity during the projected years.
4. Comparative statement of Current Asset & liabilities: Fourth statement which gives the comparative
analysis of current assets & current liabilities movement of the borrower. This basically decides the actual
working capital cycle for the projected period and the capacity of the borrower to meet their working
capital requirements.
5. Calculation of MPBF: This is a very important statement and calculation which indicates the Maximum
Permissible Bank Finance. This statement which calculates the borrower working capital GAP and
permissible finance in two lending methods, first method of lending will allow the MPBF 75% of the net
working capital GAP which is Current assets less current liabilities, Second method of lending will allow
the MPBF 75 % the current assets less current liabilities. So only the MPBF limit is the cash credit
component of the borrower which generally known Drawing power (DP Limit). So this is very important
statement which decide the borrower`s borrowing limit from the bank.
6. Fund flow statement: Fund flow statement analysis for the current & projected period is one of the
statements in CMA data. This statement analysis borrower fund position with reference to the working
capital analysis given in MPBF calculations & projected balance sheets. Basic objective of this statement
capture the funds movement of the borrower for the given period.
7. Ratio analysis: This is the last statement which gives the key ratios to the banker based on the CMA
data prepared and submitted to the bank for finance. Basic key ratios are Gross profit ratio, net profit
ratio, current ratio, DP limit, MPBF, Net worth, ratio of net worth with Liabilities, quick ratio, stock
turnover, asset turnover, fixed asset turnover, current asset turnover, working capital turnover, Debt
Equity ratio etc.

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3. Credit Analysis Process
Below diagram shows the overall Credit Analysis Process.

The 5 C’s of Credit Analysis

CHARACTER
• This is the part where the general impression of the protective borrower is analysed. The
lender forms a very subjective opinion about the trust – worthiness of the entity to repay
the loan. Discrete enquires, background, experience level, market opinion, and various
other sources can be a way to collect qualitative information and then an opinion can be
formed, whereby he can take a decision about the character of the entity.

CAPACITY
• Capacity refers to the ability of the borrower to service the loan from the profits
generated by his investments. This is perhaps the most important of the five factors. The
lender will calculate exactly how the repayment is supposed to take place, cash flow from
the business, timing of repayment, probability of successful repayment of the loan,
payment history and such factors, are considered to arrive at the probable capacity of the
entity to repay the loan.

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CAPITAL
• Capital is the borrower’s own skin in the business. This is seen as a proof of the
borrower’s commitment to the business. This is an indicator of how much the borrower is
at risk if the business fails. Lenders expect a decent contribution from the borrower’s
own assets and personal financial guarantee to establish that they have committed their
own funds before asking for any funding. Good capital goes on to strengthen the trust
between the lender and borrower.

COLLATERAL (OR GUARANTEES)

• Collateral are form of security that the borrower provides to the lender, to appropriate
the loan in case it is not repaid from the returns as established at the time of availing the
facility. Guarantees on the other hand are documents promising the repayment of the
loan from someone else (generally family member or friends), if the borrower fails to
repay the loan. Getting adequate collateral or guarantees as may deem fit to cover partly
or wholly the loan amount bears huge significance. This is a way to mitigate the default
risk. Many times, Collateral security is also used to offset any distasteful factors that may
have come to the fore-front during the assessment process.
CONDITIONS
1. Conditions describe the purpose of the loan as well as the terms under which the facility
is sanctioned. Purposes can be Working capital, purchase of additional equipment,
inventory, or for long term investment. The lender considers various factors, such
as macroeconomic conditions, currency positions, and industry health before putting
forth the conditions for the facility.

Step by step approach towards Analysis, Assessment & Sanction

Quantitative Data of the Clients

• Borrower’s history – A brief background of the company, its capital structure, its
founders, stages of development, plans for growth, list of customers, suppliers, service
providers, management structure, products, and all such information are exhaustively
collected to form a fair and just opinion about the company.
• Market Data – The specific industry trends, size of the market, market share, assessment
of competition, competitive advantages, marketing, public relations, and relevant future
trends are studied to create a holistic expectation of future movements and needs.
• Financial Information – Financial statements (Best case/ expected case/ worst case), Tax
returns, company valuations and appraisal of assets, current balance sheet, credit
references, and all similar documents which can provide an insight into the financial
health of the company are scrutinized in great detail.
• Schedules and exhibits – Certain key documents, such as agreements with vendors and
customers, insurance policies, lease agreements, picture of the products or sites, should
be appended as exhibits to the loan proposal as proofs of the specifics as judged by
above mentioned indicators.

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Judgment: After collating all the information, now the analyst has to make the real
“Judgement”, regarding the different aspects of the proposal which will be presented to the
sanctioning committee:
• Loan – After understanding the need of the client, one of the many types of loans, can be
tailored to suit the client’s needs. Amount of money, maturity of loan, expected use of
proceeds can be fixed, depending upon the nature of the industry and the credit
worthiness of the company.
• Company – Market demand for the products and services offered, major suppliers,
clients and competitors, should be analysed to ascertain its dependency on such factors.
• Credit History – Past is an important parameter to predict future, therefore, keeping in
line with this conventional wisdom, client’s past credit accounts should be analysed to
check any irregularities or defaults. This also allows the analyst to judge the kind of client
we are dealing with, by checking the number of times late payments were made or what
penalties were imposed due to non compliance with stipulated norms.
• Analysis of market – Analysis of the concerned market is of utmost importance as this
helps us in identifying and evaluating the dependency of the company on external
factors. Market structure, size and demand of the concerned client’s product are
important factors that analysts are concerned with.

Credit Rating & Pricing: Credit rating is a quantitative method using statistical models to assess
credit worthiness based on the information of the borrower. Most banking institutions have
their own rating mechanism. This is done to judge under which risk category the borrower falls.
This also helps in determining the term and conditions and various models use multiple
quantitative and qualitative fields to judge the borrower. Many banks also use external rating
agencies such as CRISIL, CARE, Fitch, etc. to rate borrowers, which then forms an important basis
for consideration of the loan. The pricing is decided based on the risk rating of the account as per
the guidelines of the bank in force.

Recommendation & Sanction: Credit Analysis is about making decisions keeping in mind the
past, present and the future. As a Credit analyst, two days in life are never the same. The role
offers a plethora of opportunities to learn and understand different types of businesses as one
engages with a multitude of clients hailing from different sectors. Not only is the career
monetarily rewarding but also helps an individual grow along with providing good opportunities
to build one’s career. Once the process of the note is complete and quantum of loan to be
recommended is arrived at, the analyst undergoes an important process of proposing suitable
covenants taking into account, the typicality of the proposal, the strength and weekness,
Industry scenario, company scenario and other relevant factors. Such covenants form part of
the sanction as accepted by the sanctioning authority.
The covenants are generally divided into
a. Pre –Disbursement covenants
b. Other General covenants to be applied during the life cycle of the asset.

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4. Financial Ratio Analysis relevant to
Bankers
Financial Ratios
A company’s financials contain the exact picture of what the business is going through, and this
quantitative assessment bears utmost significance. Analysts consider various ratios and financial
instruments to arrive at the true picture of the company.
1. Liquidity ratios – These ratios deal with the ability of the company to repay its creditors,
expenses, etc. These ratios are used to arrive at the cash generation capacity of the
company. A profitable company does not imply that it will meet all its financial
commitments.
2. Solvability ratios – These ratios deal with the balance sheet items and are used to judge
the future path that the company may follow.
3. Solvency ratios – These ratios are used to judge the risk involved in the business. These
ratios take into picture the increasing amount of debts which may adversely affect the
long term solvency of the company.
4. Profitability ratios – These ratios show the ability of a company to earn satisfactory profit
over a period of time.
5. Efficiency ratios – These ratios provide insight in the management’s ability to earn a
return on the capital involved, and the control they have on the expenses.
6. Cash flow and projected cash flow analysis – Cash flow statement is one of the most
important instruments available to a Credit Analyst, as this helps him to gauge the exact
nature of revenue and profit flow. This helps him get a true picture about the movement
of money in and out of the business
7. Collateral analysis – Any security provided should be marketable, stable and
transferable. These factors are highly important as failure on any of these fronts will lead
to complete failure of this obligation.
8. SWOT analysis – This is again a subjective analysis, which is done to align the
expectations and current reality with market conditions.
LIQUIDITY RATIOS:
Liquidity ratios are the ratios that measure the ability of a company to meet its short term debt
obligations. These ratios measure the ability of a company to pay off its short-term liabilities
when they fall due.
The liquidity ratios are a result of dividing cash and other liquid assets by the short term
borrowings and current liabilities. They show the number of times the short term debt
obligations are covered by the cash and liquid assets. If the value is greater than 1, it means the
short term obligations are fully covered.
Generally, the higher the liquidity ratios are, the higher the margin of safety that the company
posses to meet its current liabilities. Liquidity ratios greater than 1 indicate that the company is
in good financial health and it is less likely fall into financial difficulties.

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Most common examples of liquidity ratios include current ratio, acid test ratio (also known as
quick ratio), cash ratio and working capital ratio. Different assets are considered to be relevant
by different analysts. Some analysts consider only the cash and cash equivalents as relevant
assets because they are most likely to be used to meet short term liabilities in an emergency.
Some analysts consider the debtors and trade receivables as relevant assets in addition to cash
and cash equivalents. The value of inventory is also considered relevant asset for calculations of
liquidity ratios by some analysts.

The concept of cash cycle is also important for better understanding of liquidity ratios. The cash
continuously cycles through the operations of a company. A company’s cash is usually tied up in
the finished goods, the raw materials, and trade debtors. It is not until the inventory is sold, sales
invoices raised, and the debtors’ make payments that the company receives cash. The cash tied
up in the cash cycle is known as working capital, and liquidity ratios try to measure the balance
between current assets and current liabilities.
A company must possess the ability to release cash from cash cycle to meet its financial
obligations when the creditors seek payment. In other words, a company should posses the
ability to translate its short term assets into cash. The liquidity ratios attempt to measure this
ability of a company.
Acid-Test Ratio
The term “Acid-test ratio” is also known as quick ratio. The most basic definition of acid-test
ratio is that, “it measures current (short term) liquidity and position of the company”. To do the
analysis accountants weight current assets of the company against the current liabilities which
result in the ratio that highlights the liquidity of the company.
The formula for the acid-test ratio is:
• Quick ratio = (Current Assets – Inventory) / Current liabilities
• This concept is important as if the company’s financial statements ( income statement,
balance sheet) get through the analysis of the acid-test ratio, then the short term debts
can be paid by the company.
Current Ratio
Definition: The current ratio is balance-sheet financial performance measure of company
liquidity.
The current ratio indicates a company's ability to meet short-term debt obligations. The current
ratio measures whether or not a firm has enough resources to pay its debts over the next 12
months. Potential creditors use this ratio in determining whether or not to make short-term
loans. The current ratio can also give a sense of the efficiency of a company's operating cycle or
its ability to turn its product into cash. The current ratio is also known as the working capital
ratio.
Calculation (formula)
The current ratio is calculated by dividing current assets by current liabilities:
• The current ratio = Current Assets / Current Liabilities
• Both variables are shown on the balance sheet (statement of financial position).

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Norms and Limits
The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's
a comfortable financial position for most enterprises. Acceptable current ratios vary from
industry to industry. For most industrial companies, 1.5 may be an acceptable current ratio.
Low values for the current ratio (values less than 1) indicate that a firm may have difficulty
meeting current obligations. However, an investor should also take note of a company's
operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be
supported by a strong operating cash flow.
If the current ratio is too high (much more than 2), then the company may not be using its
current assets or its short-term financing facilities efficiently. This may also indicate problems in
working capital management.
All other things being equal, creditors consider a high current ratio to be better than a low
current ratio, because a high current ratio means that the company is more likely to meet its
liabilities which are due over the next 12 months.
PROFITABILITY RATIOS:

Profitability ratios measure a company’s ability to generate earnings relative to sales, assets and
equity. These ratios assess the ability of a company to generate earnings, profits and cash flows
relative to relative to some metric, often the amount of money invested. They highlight how
effectively the profitability of a company is being managed.
Common examples of profitability ratios include return on sales, return on investment, return on
equity, return on capital employed (ROCE), cash return on capital invested (CROCI), gross profit
margin and net profit margin. All of these ratios indicate how well a company is performing at
generating profits or revenues relative to a certain metric.
Different profitability ratios provide different useful insights into the financial health and
performance of a company. For example, gross profit and net profit ratios tell how well the
company is managing its expenses. Return on capital employed (ROCE) tells how well the
company is using capital employed to generate returns. Return on investment tells whether the
company is generating enough profits for its shareholders.

For most of these ratios, a higher value is desirable. A higher value means that the company is
doing well and it is good at generating profits, revenues and cash flows. Profitability ratios are of
little value in isolation. They give meaningful information only when they are analyzed in
comparison to competitors or compared to the ratios in previous periods. Therefore, trend
analysis and industry analysis is required to draw meaningful conclusions about the profitability
of a company.
Some background knowledge of the nature of business of a company is necessary when
analyzing profitability ratios. For example sales of some businesses are seasonal and they
experience seasonality in their operations. The retail industry is example of such businesses. The
revenues of retail industry are usually very high in the fourth quarter due to Christmas.
Therefore, it will not be useful to compare the profitability ratios of this quarter with the

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profitability ratios of earlier quarters. For meaningful conclusions, the profitability ratios of this
quarter should be compared to the profitability ratios of similar quarters in the previous years.

Earnings Before Interest After Taxes (EBIAT)

Earnings before Interest and after Taxes is used to measure the ability of a firm to generate
income through various operations during a specific course of time. The following formula is
used to calculate it:

• Earnings Before Interest and After Taxes = Revenue - Operating Expenses + Non-
operating expenses.
• Earnings Before Interest and After Taxes represents the availability of cash in a
company’s account that may be used to pay off the amounts of the creditors during
liquidation. It is proves to be useful when the company incurs amortization of the assets.
If Earnings Before Interest And After Taxes is compared with the earnings before interest
and taxes, then it must be said that it is a less common measure.
The financial analysts use Earnings Before Interest And After Taxes when they want to take a
look at the performance of the company in the particular accounting cycle in which it is currently
operating. We all know that taxes are set by the government and a person who is running a
company cannot influence them according to his own will like the way he can take decisions
regarding the operations of his company. Therefore, with the use of Earnings Before Interest And
After Taxes, the financial analysts consider taxes as a cost of doing business. The reason for this
is that a company is legally bound to pay the taxes otherwise it cannot operate.
Earnings Before Interest And After Taxes helps to reduce the financing effects which in turn
enables the investors to see that whether the company is profitable or not and what is the status
of its financial performance.

Whenever a company’s Earnings Before Interest And After Taxes is being analyzed, it must be
done with the combination of other things too like working capital, debt payments, net income
and capital requirements.

EBITDA
Definition: EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is an
indicator of a company's financial performance. It measures a company’s financial performance
by computing earnings from core business operations, without including the effects of capital
structure, tax rates and depreciation policies. EBITDA is a rough approximation for cash flow; it
ignores many factors that impact on true cash flow, such as debt payments. Even so, it may be
useful for evaluating firms in the same industry with widely different capital structures, tax rates,
and depreciation policies.
EBITDA is a "calculated" indicator which is not defined under GAAP. EBITDA is often used in
various evaluating ratios, such as EV/EBITDA and EBITDA margins. EBITDA demonstrates to
investors the ability to have a return on their investments.
Calculation (formula)
EBITDA = Revenue – Expenses (excluding tax, interest, depreciation, amortization)

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Effective Rate of Return

The effective rate of return is the rate of interest on an investment annually when compounding
occurs more than once.
It is calculated through the following formula:
Effective Rate Of Return = (1 + i/ n) n-1
Here; i stands for the annual interest rate
N stands for the number of compounding periods
It can be said that the Effective Rate Of Return determines the effect of compounding for the
annual interest rate.
It can be better explained this way that if an investment pays 5 percent per year but without any
compounding than the effective rate of return will be 5 percent. On the other hand, if an
investment is compounded monthly then the effective rate of return will be greater than 5
percent.
If we move on to the importance of the effective rate of return then it is said to be important for
2 reasons. First one is that it is accurate. It is much more than estimating returns only. It helps in
determining all the details that might be needed for compounding. Secondly, it is being popularly
used as it is based on simple calculations of interests.
The effective rate of return helps to determine the return that will be gained on each investment
and it covers up a number of marketing instruments, loans and investments.
It can be said that effective rate of return is useful in determining what amount of money will be
gained or lost on an investment during a given course of time. The amount that can be lost or
gained might be profit, net income, interest or loss. In this way, the financial analysts are able to
calculate what amount of gain or loss they will be born over the amount of money that they
have invested in a particular thing over a certain time period.
Gross Profit Margin
Definition : Gross profit margin (gross margin) is the ratio of gross profit (gross sales less cost of
sales) to sales revenue. It is the percentage by which gross profits exceed production costs. Gross
margins reveal how much a company earns taking into consideration the costs that it incurs for
producing its products or services. Gross margin is a good indication of how profitable a
company is at the most fundamental level, how efficiently a company uses its resources,
materials, and labour. It is usually expressed as a percentage, and indicates the profitability of a
business before overhead costs; it is a measure of how well a company controls its costs.
Gross margin measures a company's manufacturing and distribution efficiency during the
production process. The higher the percentage, the more the company retains on each dollar of
sales to service its other costs and obligations, the better the company is thought to control
costs. Investors use the gross profit margin to compare companies in the same industry and also
in different industries to determine what are the most profitable. A company that boasts a
higher gross margin than its competitors and industry is more efficient.
Calculation (formula)

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Gross margin is calculated as gross profit divided by total sales (revenue).
Gross profit margin = Gross profit / Revenue
Both variables are shown on the income statement or statement of comprehensive income.

Net Interest Margin

Meaning and definition of Net Interest Margin: The net Interest margin can be expressed as a
performance metric that examines the success of a firm’s investment decisions as contrasted to
its debt situations. A negative Net Interest Margin indicates that the firm was unable to make an
optimal decision, as interest expenses were higher than the amount of returns produced by
investments. Thus, in calculating the Net Interest Margin, financial stability is a constant concern.
Calculating the Net Interest Margin
The Net Interest Margin is calculated as:
Net Interest Margin = (Investment Returns – Interest Expenses) / Average Earning Assets
Applications of Net Interest Margin
The use of net interest margin is helpful in tracking the profitability of a bank’s investing and
lending activities over a specific course of time. Besides, a period end balance sheet, average
balance sheet published by the banks indicating the breakdown of bank’s loans, deposits,
investments, and borrowed funds, and their related interest rates provides more insight to
investors seeking for more info on the fluctuation of Net Interest Margin.
Limitations of Net Interest Margin
One of the drawbacks of Net Interest Margin is that it does not measure the total profitability of
the bank as most of them earn fees and other non-interest income through services like
brokerage and deposit account services, without taking account operating expenses, such as
personnel and facilities costs, or credit costs. Besides, net interest margin of two banks can’t be
contrasted as both the banks are poles apart in their own way, like in the nature of their
activities, composition of customer base, and similar more.

Profit Analysis
Introduction to Profit Analysis
In managerial economics, profit analysis is a form of cost accounting used for elementary
instruction and short run decisions. A profit analysis widens the use of info provided by
breakeven analysis. An important part of profit analysis is the point where total revenues and
total costs are equal. At this breakeven point, the company does not experience any income or
any loss.
Components of Profit Analysis
The key components involved in profit analysis include:
• Selling price per unit
• Level or volume of activity
• Total fixed costs
• Per unit variable cost
• Sales mix
Assumptions in Profit Analysis

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The profit analysis incorporates the following assumptions:
• Unvarying sales price,
• Unvarying variable cost per unit,
• Unvarying total fixed cost,
• Unvarying sales mix,
• Units sold equal units produced.
These are largely linearizing and simplifying assumptions, which are frequently presumed in
elementary discussions of costs and profits. In more advanced accounting treatments, costs and
revenue are non linear thus making the analysis more complicated.
Applications of Profit Analysis
The profit analysis is helpful in simplifying the calculation of breakeven in breakeven analysis.
Besides, it is generally helpful in simple calculation of Target Income Sales. Moreover, it also
simplifies the process of analyzing short run trade-offs in operational decisions.

Method adopted for Profit Analysis

The main method adopted to carry out profit analysis is the profit volume ratio which is
calculated by dividing the shareholders contribution by the sales and then multiplying it by 100
as follows:
Profit Volume Ratio = (Shareholders contribution / Sales) * 100

Limitations of Profit Analysis

The profit analysis is a short run and marginal analysis which presumes the unit variable costs
and the unit revenues to be constant. This is, however, appropriate for small deviations from
current production and sales. Besides, the profit analysis also presumes a neat division between
variable costs and fixed costs, though in the long run, all costs are variable. Therefore, for longer
term profit analysis considering the complete life-cycle of a product it is preferable to carry out
activity-based costing or throughout accounting.

Return On Assets (ROA)

Definition : Return on assets (ROA) is a financial ratio that shows the percentage of profit that
a company earns in relation to its overall resources (total assets). Return on assets is a key
profitability ratio which measures the amount of profit made by a company per dollar of its
assets. It shows the company's ability to generate profits before leverage, rather than by using
leverage. Unlike other profitability ratios, such as return on equity (ROE), ROA measurements
include all of a company's assets – including those which arise from liabilities to creditors as well
as those which arise from contributions by investors. So, ROA gives an idea as to how efficiently
management use company assets to generate profit, but is usually of less interest to
shareholders than some other financial ratios such as ROE.

Return on assets gives an indication of the capital intensity of the company, which will depend
on the industry. Capital-intensive industries (such as railroads and thermal power plant) will yield
a low return on assets, since they must possess such valuable assets to do business. Shoestring
operations (such as software companies and personal services firms) will have a high ROA: their

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required assets are minimal. The number will vary widely across different industries. This is why,
when using ROA as a comparative measure, it is best to compare it against a company's previous
ROA figures or the ROA of a similar company.

Calculation (formula)
Return on assets is calculated by dividing a company's net income (usually annual income) by its
total assets, and is displayed as a percentage. There are two acceptable ways to calculate return
on assets: using total assets on the exact date or average total assets:

ROA = Net Income after tax / Total assets (or Average Total assets)
Instead of net income, comprehensive income can be used as the formula's numerator

Return on Average Capital Employed (ROACE)

Meaning and definition of Return on Average Capital Employed

The return on average capital employed (ROACE) is a ratio that reveals the profitability against
the investments made in the company. The ROACE is different from the return on capital
employed for it counts the average of the opening and closing capital for the specific period
contrasting to only the capital figure at the end of a period.

The return on average capital employed is helpful for analyzing businesses in capital-intensive
industries, oil for example. The businesses capable of squeezing higher profits from a smaller
amount of capital assets will feature a higher ROACE as compared to those which are not
efficient in transforming capital into profits.

Formula used for computing return on average capital employed

The ROACE is calculated as:
ROACE = EBIT / (Average Total Assets - Average Current Liabilities)
i.e. Capital Employed = Total Assets – Current Liabilities = Equity + Non-current Liabilities

Calculating Return on Average Capital Employed

The key steps involved in calculating the Return on Average Capital Employed include:
1. Deduct the operating expenses from the revenue to obtain the company’s earnings before
interest or tax (EBIT).
2. Deduct the value of liabilities from the value of total assets to obtain capital employed at the
begging of the period plus at the end of the period and divide it by 2.
3. Divide the EBIT by the result obtained as capital employed to obtain the ROACE.

1. Asset Coverage Ratio

Definition:
Asset coverage ratio measures the ability of a company to cover its debt obligations with its
assets. The ratio tells how much of the assets of a company will be required to cover its
outstanding debts. The asset coverage ratio gives a snapshot of the financial position of a

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company by measuring its tangible and monetary assets against its financial obligations. This
ratio allows the investors to reasonably predict the future earnings of the company and to assess
the risk of insolvency.

Usually a minimum level of asset coverage ratio is defined in the covenants so that a company
does not overextend its debts beyond a certain limit. The company would not be tempted to
take too much loans; therefore chances of its insolvency are less. As a rule of thumb, industrial
and publicly held companies should maintain an asset coverage ratio of 2 and utilities companies
should maintain an asset coverage ratio of 1.5.

Calculation (formula)
The asset coverage ratio is calculated in three steps:
• Step 1: The current liabilities are added up and short term debt obligations are subtracted
from this sum.
• Step 2: The book value of tangible and monetary assets of a company is calculated by
subtracting the value of intangible assets (such as goodwill) from the book value of total
assets. The figure calculated in Step 1 is subtracted from this figure.
• Step 3: The resulting figure of Step 2 is divided by the total outstanding debt of the
company.

All of these three steps can be expressed in the following formula for asset coverage ratio.
Asset Coverage Ratio = ((Total Assets – Intangible Assets) – (Current Liabilities – Short-term
Debt)) / Total Debt Obligations
Norms and Limits
Asset coverage ratio should be used in conjunction with other financial ratios to have clearer
picture of the company’s financial strengths and weaknesses. A negative point of asset coverage
ratio is that it uses the book value of the assets. The book value may vary significantly from the
actual liquidation value of the asset. In such a case the asset coverage ratio will give misleading
results.
2. Capitalization Ratio
Definition
The capitalization ratio compares total debt to total capitalization (capital structure). The
capitalization ratio reflects the extent to which a company is operating on its equity.

Capitalization ratio is also known as the financial leverage ratio. It tells the investors about the
extent to which the company is using its equity to support its operations and growth. This ratio
helps in the assessment of risk. The companies with high capitalization ratio are considered to be
risky because they are at a risk of insolvency if they fail to repay their debt on time. Companies
with a high capitalization ratio may also find it difficult to get more loans in the future.

A high capitalization ratio is not always bad, however, higher financial leverage can increase the
return on a shareholder’s investment because usually there are tax advantages associated with
the borrowings.

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Calculation (formula)
The capitalization ratio is calculated by dividing the long-term debt by the total shareholder’s
equity and long–term debt. This can be expressed as:
• Capitalization Ratio = Long-Term Debt / (Long-Term Debt + Shareholder’s Equity)
• The capitalization ratio is a very meaningful debt ratio because it gives an important
insight into the use of financial leverage by a company. It focuses on the relationship of
long-term debt as a component of the company's total capital base. The total capital is
the capital raised by the shareholders and the lenders.
• The company’s capitalization (it should not be confused with the market capitalization)
explains the make-up of the long-term capital of the company. Capitalization is also
known as capital structure. A company’s long term capital consists of long - term
borrowings and shareholder’s equity.
• There is no standard or benchmark for setting the right or optimum amount of debt.
Leverage will depend on the type of industry, line of business and the stage of
development of the company (and its products). However, it is commonly understood
that low debt and high equity levels in the capitalization ratio indicates good quality of
investment.

3. Debt Service Coverage Ratio

Definition: The debt service coverage ratio (DSCR) has different interpretations in different
fields. In corporate finance, for example, the debt-service coverage ratio can be explained as the
amount of assessable cash flow to congregate the annual interest and principal payments on
debt, not forgetting the sinking fund payments. On the other hand, as explained in Government
finance, the debt-service coverage ratio refers to the requisite amount of export earnings for
meeting up the annual interest and principal payments on the external debts of a country.
Personal finance, on the contrary, explains it as a ratio which is used by bank loan officers to
determine income property loans. The ratio is considered to be ideal if it is above 1 thus
indicating that the property is producing income which is sufficient to pay back its debts.
Calculation (Formula)
The formula used for calculating the debt service coverage ratio is:
• DSCR = Net Operating Income / Total Debt Service
• Generally, the debt service coverage ratio is calculated as -
• DSCR = (Annual Net Income + Interest Expense + Amortization & Depreciation + Other
discretionary and non-cash items like non contractual provided by the management)/
(Principal Repayment + Interest Payments + Lease Payments)
• Thus, to calculate the debt service coverage ratio of a company or business entity, it is, at
the first point, essential to calculate the net operating income of the company.

Interpretation
A debt service coverage ratio which is below 1 indicates a negative cash flow. For example, a
debt service coverage ratio of 0.92 indicates that the company’s net operating income is enough
to cover only 92% of its annual debt payments. However, in personal finance context, it indicates
that the borrower would have to look into his/her personal income and funds every month so as

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to keep the project afloat. The lenders, however, usually frown on a negative cash flow while
some might allow it if, in case, the borrower is having sound income outside.

The debt service coverage ratio is, therefore, a benchmark used to measure the cash producing
ability of a business entity to cover its debt payments. A higher debt service coverage ratio
makes it easier to obtain a loan.

4. Debt-to-Equity Ratio

Definition: The debt-to-equity ratio (debt/equity ratio, D/E) is a financial ratio indicating the
relative proportion of entity's equity and debt used to finance an entity's assets. This ratio is also
known as financial leverage.

Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a company's
financial standing. It is also a measure of a company's ability to repay its obligations. When
examining the health of a company, it is critical to pay attention to the debt/equity ratio. If the
ratio is increasing, the company is being financed by creditors rather than from its own financial
sources which may be a dangerous trend. Lenders and investors usually prefer low debt-to-
equity ratios because their interests are better protected in the event of a business decline.
Thus, companies with high debt-to-equity ratios may not be able to attract additional lending
capital.
Calculation (formula)
A debt-to-equity ratio is calculated by taking the total liabilities and dividing it by the
shareholders' equity:
• Debt-to-equity ratio = Liabilities / Equity
• Both variables are shown on the balance sheet (statement of financial position).

Norms and Limits

Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is
very industry specific because it depends on the proportion of current and non-current assets.
The more non-current the assets (as in the capital-intensive industries), the more equity is
required to finance these long term investments.

For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large
public companies the debt-to-equity ratio may be much more than 2, but for most small and
medium companies it is not acceptable. US companies show the average debt-to-equity ratio at
about 1.5 (it's typical for other countries too).

In general, a high debt-to-equity ratio indicates that a company may not be able to generate
enough cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also indicate
that a company is not taking advantage of the increased profits that financial leverage may bring.

5. Debt-to-Income Ratio

Meaning and definition of Debt-to-Income Ratio

The debt-to-income ratio can be expressed as a personal finance measure that is helpful in
comparing an individual’s debt payments to the income generated by him/her. This measure is

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important in the lending industry for it provides the lenders with an idea about the possibilities
of the borrower repaying the loan. As explained by the Investopedia, a higher debt-to-income
ratio indicates more burden on the individual for making payments on his/her debts. Besides, if
the ratio is too high, the individual will experience a hard time accessing other forms of
financing.

Importance of Debt-to-Income Ratio

It is really important to know about what the debt-to-income ratio number indicates.
Apparently, this is a number that needs to be as low as possible. The less debt relative to the
income indicates an individual being financially better off because of having extra money to
apply towards other goals.

When it comes to mortgages, the lenders tend to look at two key debt-to-income ratios. First,
they consider the front ratio, which is the debt to income ratio consisting of all housing costs.
Then, there is the back ratio, which considers the non-mortgage debt to income ratio. Usually,
the lenders prefer a front ratio of 36% or less and a back ratio of 28% or less.

Calculating the Debt to Income ratio

Calculating the debt-to-income ratio is as simple as toting up all of your debt and deducting it
from your income. Some calculations might exclude items like mortgage payments and property
taxes, but to actually get a complete picture, it is better to include everything.
As the first step of calculation, congregate all of your monthly debt obligations. This will include
monthly payments like:
• Car payments
• Mortgage payments
• Student loans payments
• Minimum credit card payments
• Child support
• Any other monthly debt obligations
After adding these all up, you will get the total monthly debt payments. Thereafter, calculate
your monthly income counting your monthly salary and additional bonuses (if any). Then add up
any additional income received through dividends, or a side business. Add up all these to get
your monthly income.
As a final step, determine the debt-to-income ratio by dividing the total debt payments by total
monthly income.
6. Debt/EBITDA Ratio
Debt/EBITDA ratio is the comparison of financial borrowings and earnings before interest, taxes,
depreciation and amortization. This is a very commonly used metric for estimating the business
valuations. It is a good determinant of financial health and liquidity position of an entity. It is a
measure of the ability of a company to pay off its debts. It compares the financial obligations of a
company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-
cash expenses.

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Debt/EBITDA ratio can be used compare the liquidity position of one company to the liquidity
position of another company within the same industry. A lower debt/EBITDA ratio is a positive
indicator that the company has sufficient funds to meet its financial obligations when they fall
due. A higher debt/EBTIDA ratio means that the company is heavily leveraged and it might face
difficulties in paying off its debts.

Debt/EBITDA is one of the common metrics used by the creditors and rating agencies for
assessment of defaulting probability on an issued debt. In simple words, it is a method used to
quantify and analyze the ability of a company to pay back its debts. This ratio facilitates the
investor with the approximate time period required by a firm or business to pay off all debts,
ignoring factors like interest, depreciation, taxes, and amortization.
A high debt-EBITDA ratio might result in a lower credit score for the business. On the contrary, a
lower ratio implies the firm’s desire to take on more debt, if required, thereby warning with a
comparatively high credit rating.

Calculation (formula)
The debt/EBITDA ratio is calculated by dividing the debts by the Earnings before Interest, Taxes,
Depreciation, and Amortization (EBITDA).

Debt/EBITDA ratio = Liabilities / EBITDA

The main target of this ratio is to reflect the cash available with the company to pay back its
debts, and not how much income is being earned by the firm.
Norms and Limits
The debt/EBITDA ratio is popular with financial analysts because it relates the debts of a
company to its cash flows by ignoring non-cash expenses. Ultimately it is the cash flows (as
opposed to profits) that will be used to pay off debts. Entities in normal financial state show
debt/EBITDA ratio less than 3. Ratios higher than 4 or 5 usually set off alarms because they
indicate that a company is likely to face difficulties in handling its debt burden, and thus is less
likely to be able to raise additional loans required to grow and expand the business.

Debt/EBITDA ratio is not usually appropriate for comparison of companies in different industries.
Capital requirements of other industries are different. Capital structure is different for
companies operating in different industries. Some industries are capital intensive and require
larger amounts of borrowings to finance their operations. Therefore, debt/EBITDA ratio may not
give reliable conclusions when comparing different industries.
Usage of Debt/EBITDA ratio
This ratio is helpful in management decisions and can be used by a company interested in
investing in a takeover bid. Besides, the ratio is also helpful for the potential buyer in estimating
the profitability of the company without the aggressive spending of the current manager. If, in
case, the company does not spend much on purchase of new equipment or opening up new
stores, it will have a lower depreciation and amortization costs thereby making the company
profitable, not including these extra costs.
However, it is a risky process to use the debt/EBITDA ratio for analyzing the debt repayment
ability of a company. A company can spend huge amount of money on new offices, retail stores,
and factories in spite of having a high EBITDA. Besides, EBITDA also presumes that the company

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collects whole of the revenue earned from its customers thereby not counting the uncollectible
customer returns and accounts receivable. Moreover, a higher debt-EBITDA ratio is taken to be
more risky as the company might come prove to be a default.
7. Fixed Assets to Net Worth
Fixed assets to net worth is a ratio measuring the solvency of a company. This ratio indicates the
extent to which the owners' cash is frozen in the form of fixed assets, such as property, plant,
and equipment, and the extent to which funds are available for the company's operations (i.e.
for working capital).
Calculation (formula)
Fixed assets to Net Worth = Net fixed assets / Net worth

Norms and Limits

Fixed assets to net worth ratio 0.75 or higher is usually undesirable, as it indicates that the firm is
vulnerable to unexpected events and changes in the business climate. But the term "fixed
assets" (non-GAAP term) has different interpretations so it's difficult to use and compare this
ratio. That is why we prefer to use similar ratio "Non-current assets to net worth" implicating
IFRS term "Non-current assets".
Breakeven Point (BEP) :
4
The breakeven point is the level of production at which the costs of production equal the
revenues for a product. In investing, the breakeven point is said to be achieved when the
market price of an asset is the same as its original cost.
The breakeven point formula is determined by dividing the total fixed costs associated with
production by the revenue per individual unit minus the variable costs per unit. In this case,
fixed costs refer to those which do not change depending upon the number of units sold. Putting
it differently, the breakeven point is the production level at which total revenues for a product
equal total expenses.
The breakeven formula for a business provides an sales figure /quantity they need to break even.
This can be converted into units by calculating the contribution margin (unit sale price less
variable costs). Dividing the fixed costs by the contribution margin will provide how many units
are needed to break even.

Fixed Costs
Business Breakeven =
Gross Profit Margin (i.e. contribution per unit)

Contribution per unit = Sale price per unit – Variable Cost per unit

Payback Period :

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The payback period refers to the amount of time it takes to recover the cost of an investment or
the length of time an investor needs to reach a break-even point. Shorter paybacks mean more
attractive investments, while longer payback periods are less desirable.

The payback period is calculated by dividing the amount of the investment by the average
annual net cash flow.

Account and fund managers use the payback period to determine whether to go through with an
investment. One of the downsides of the payback period is that it disregards the time value of
money.

Internal Rate of Return (IRR) :

The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability
of potential investments. IRR is a discount rate that makes the net present value (NPV) of all
cash flows equal to zero in a discounted cash flow analysis.

The internal rate of return (IRR) is the annual rate of growth that an investment is expected to
generate.

IRR is calculated using the same concept as net present value (NPV), except it sets the NPV equal
to zero.

IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates of
annual return over time.
Formula and Calculation for IRR : The formula and calculation used to determine this figure are
as follows:

where:
Ct=Net cash inflow during the period t
C0=Total initial investment costs
IRR=The internal rate of return
t=The number of time periods

How to Calculate IRR

1. Using the formula, one would set NPV equal to zero and solve for the discount rate,
which is the IRR.
2. The initial investment is always negative because it represents an outflow.
3. Each subsequent cash flow could be positive or negative, depending on the estimates of
what the project delivers or requires as a capital injection in the future.

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 4. However, because of the nature of the formula, IRR cannot be easily calculated
analytically and instead must be calculated iteratively through trial and error or by using
software programmed to calculate IRR (e.g., using Excel).

IRR is generally most ideal for use in analyzing capital budgeting projects. It can be misconstrued
or misinterpreted if used outside of appropriate scenarios. In the case of positive cash flows
followed by negative ones and then by positive ones, the IRR may have multiple values.
Moreover, if all cash flows have the same sign (i.e., the project never turns a profit),
then no discount rate will produce a zero NPV.

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5. Analysis of Fund Flow and Cash Flow
INTRODUCTION:
One of the most fundamental objectives of business is to make a profit. Long run survival
requires that the business must be able to deal with any liquidity problems which arise in the
short term. Basically any business must be concerned with making a profit and marinating a
solvent financial position. The financial statement of the business indicates assets, liabilities and
capital on a particular date and also the profit or loss during a period. But it is possible that there
is enough profit in the business and the financial position is also good and still there may be
deficiency of cash or of working capital in business. If the management wants to find out as to
where the cash is being utilized, financial statement cannot help.

In the other words, the profit and loss account and balance sheet statements are the common
important accounting statements of a business organization. The profit and loss account
provides the financial information relating to only a limited range of financial transactions
entered into during an accounting period and which have impact on the profits to be reported.
The balance sheet contains information relating to capital debt raised or assets purchased. Along
with the information about the assets and liabilities as well as the profit and loss, it is equally
important to know what funds became available during the accounting year and how such funds
were applied. This information may be obtained by preparing a statement of source and
application of funds. This statement demonstrates the movement of funds into and out of the
business during the course during the accounting period.

CONCEPT OF “FUND’’:
The term ‘fund’ has been defined and interpreted differently by different experts. Broadly the
term ‘fund’ refers to all the financial resources of the company. On the other extreme, fund has
been understood as ‘cash’ only. According to the International Accounting Standard No. 7, the
term generally refers to cash, to working capital and to cash and cash equivalents (long term
financial sources).

1. Fund means cash: Under this concept, the term “funds” is used only in the sense of cash
and bank balance. Here, only the changes in cash and bank are considered. Hence, the
statement is called “Cash Flow statement.

This statement aims at listing the various items which bring about changes in the cash
balance between two balance sheet dates. Cash planning becomes useful for control
purposes. Since cash is considered as short term assets, they are subjected to short term
fluctuations. A delay in making payment to suppliers and a provision of one month’s credit
for making a payment of land purchases may show sufficient cash flow. They may reflect a
satisfactory position, but it is not a reality. Therefore, cash equivalent concept of fund is
useful only for short term financial planning and not for long term. Thus cash and bank is
one part of fund.

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 2. Fund means Working Capital: Working capital is the excess of current assets over current
liabilities. It means working capital = Current asserts - current liabilities. It is an
alternative measure of the changes in the financial position. All those transactions which
increase or decrease working capital are included in this statement. It excludes all such
items which do not affect the working capital. The working capital concept of funds is in
conformity with normal accounting procedures. Hence, a funds flow statement based on
this concept fits well with the other statements. Moreover, working capital is also a
measure of short term liquidity of the firm. Therefore, an analysis of factors bringing
about a change in the amount of net working capital is useful for decision making by
shareholders, creditors and management. Due to these reasons, the working capital
approach to funds is more useful than the cash approach.

The operating cycle of working capital (working capital flow) is as follow:

3. Fund means total financial resources:

The term “funds” is very often used in the sense of useful financial resources also. Cash
approach and working capital approach both are incomplete and inadequate to the extent
that they omit a few major financial and investment transactions. Such items do not affect
net working capital. But, if they are included, they would certainly provide qualitative
information for the decision making, For example issuing equity shares and debentures for
purchase of buildings or assets shall not have any effect on the working capital. But it is a
significant financial transaction that should be disclosed. Therefore, this concept seems to be
the best approach to disclose the changes in the financial position as compared to other
concepts. It is in conformity with the statutory regulations and legal requirements.
CONCEPT OF FUND FLOW:
The term "Flow of Funds" refers to changes or movement of funds or changes in working capital
in the normal course of business transactions. The changes in working capital may be in the form

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of inflow of working capital or outflow of working capital. In other words, any increase or
decrease in working capital when the transactions take place is called as "Flow of Funds." If the
components of working capital results in increase of the fund, it is known as Inflow of Fund or
Sources of Fund. Similarly, if the components of working capital effects in decreasing the
financial position it is treated as Outflow of Fund. For example, if the fund raised by way of issue
of shares will be taken as a source of fund or inflow of fund. This transaction results in increase
of the financial position. Like this, the fund used for the purchase of machinery will be taken as
application or use of fund or outflow of fund, because it stands to reduce the fund position.
Increase the funds while others decrease the funds. Some may not make any change in the funds
position. In case a transaction results in increase of funds, it will be termed as a “sources of
funds”. In case a transaction results in decrease of funds it will be taken as an application or use
of funds. In case a transaction does not make any change in the funds position, it is said that it is
a non-fund transaction.

According to R.N. Anthony, “Fund Flow is a statement prepared to indicate the increase in cash
resources and the utilization of such resources of a business during the accounting period.”

According to Smith Brown, “Fund Flow is prepared in summary form to indicate changes
occurring in items of financial condition between two different balance sheet dates.”

No Flow of Funds:
Some transactions may not make any movement or changes in the fund position. Such
transactions are involved within the business concern. Like the transaction which involves both
between current assets and current liabilities and between non-current assets and non-current
liabilities and hence do not result in the flow of funds. For example, conversion of shares in to
debenture. Such transaction involves between non-current accounts only and this activity does
not effect in increase or decrease of the working capital position.
CONCEPT OF FUND FLOW STATEMENT:
It is a statement showing the movement of funds into and out of business. In other words it is a
statement showing sources and application of fund. A fund flow statement deals with the
financial resources required for running the business activities. It explains how were the funds
obtained and how were they used.
A fund flow statement matches the funds raised and funds applied during a particular period.
The sources and applications of fund may be of capital as well as of revenue nature. A fund flow
statements provide a meaningful link between the balance sheets at the beginning and at the
end of the period and profit and loss account of the period. In view of recognized importance of
capital inflows and outflows which often involve large amount of money should be reported to
stake holders, the fund flow statement is devised.
In the words of Dr. Shailesh Ransariya, “Funds flow statement is a modern technique of
analyzing financial statement. Fund flow statement shows as to where have the funds come from
and where have they been used during the accounting period. It helps in analyzing the movement
of funds of a firm between the two balance sheet dates.”

28 NIBSCOM Course Material for Internal Circulation Only

As per Foulk point of view “A statement of sources and applications of fund is a technical device
deigned to analyze the changes in the financial condition of a business enterprise between two
dates.”
In the words of Anthony, “The fund flow statement describes the sources from which additional
funds were derived and the uses to which these sources were put.”
The I.C.W.A. in glossary of management accounting terms defines fund flow statement as “a
statement prospective or retrospective, setting out the sources and applications of the funds of
an enterprise. The purpose of this statement is to indicate clearly the requirement of funds and
how they are proposed to be raised and the efficient utilization and application of the same.”
OBJECTIVES OF FUNDS FLOW STATEMENT:
The main objectives of the fund flow statement are:
1. Helpful in finding the answer to some important financial question:-A fund flow statement
is prepared to give satisfactory answer to the following question:-
(a). What have been the main source and application of funds during the period?
(b). How much funds have been generated from business operations?
(c). Where did the profits go?
(d). Why where dividends not larger?
(e). How was it possible to distribute dividends in excess of current earning or in the presence
of net loss for the period?
(f). Why the net current assets are up even though there is a net loss for the period?
(g). How was the expansion in plant and equipment financed?
(h). How was the repayment of long term debt accomplished?
(i). How was the increase in working capital financed?
2. Helpful in financial analysis:- A fund flow statement provides a complete analysis of the
financial position of a firm.
3. It provides more reliable figures of profit and loss of the business:- It gives much more
reliable figure of the profits of the business than the figures shown by P/L account because
the figure of profit shown by P/L account is affected by the personal decision of
management in deciding the amount of depreciation and other adjustments regarding the
writing off preliminary expanses etc.
(4) It enables to know whether the funds have been properly used:- The funds flow
statement enables the management to know whether the funds have been properly used
in purchasing various assets or repaying loans etc.
(5) Helpful in proper management of working capital:- While managing working capital in a
business, it becomes essential to ensure that it should neither be excessive nor
inadequate. A fund flow statement indicates the excessiveness or inadequacy in working
capital.
(6) Helps in preparation of budget for the next period:- A fund flow statement is prepared
for next year, it will enable the management to plan its financial resources properly. The
firm will know how much funds it requires, how much the firm can manage internally and
how much it should arrange from outside source. This is helpful in preparing the budgets
for the future period.

29 NIBSCOM Course Material for Internal Circulation Only

 (7) It helps a firm in borrowing operations:- A fund flow statement prepared for the future
period indicates whether the company will have sufficient funds to repay the interest &
loans in time.
(8) Helpful in determining dividend policy: - Sometimes, there may be sufficient profit but
the distribution of dividend may not be possible due to its adverse effect on the liquidity
and working capital of the business. in such cases a funds flow statement help in leading
whether to distribute the dividend or not because a funds flow statement will reveal
from where and how much funds can be managed for distributing the dividends.
(9) Useful to shareholders:- Shareholders also get information about the financial policies of
the enterprise with the help of fund flow statement.
SOURCES AND USES (APPLICATIONS) OF FUNDS:
Since a fund flow statement describes the varies sources and uses of funds, it is imperative that
one should know the varies sources and uses of funds:

Sources of funds:
Generally funds are derived from:
1. Operating of business i.e. operating income
2. Income from investment
3. Sale of assets
4. Sale of long term investments
5. Contribution of share holders
6. Increase in long term liabilities, e.g., issue of debentures
7. Gifts, damages awarded in legal action etc.
Uses (Applications) of funds: Generally funds are utilized to:
8. Operating loses
9. Repayment of long term loan and debentures
10. Redemption of preference share capital
11. Payment of cash dividends
12. Purchase of fixed assets
13. Purchase of long term investments
Importance/Significance of Fund Flow Statement:
Fund flow statement is a useful tool in the financial managers’ analytical kit. The basic propose of
this statement is to indicate where funds came from and where it was used during certain
period. Following are the uses of this which show its importance:
[1] Fund flow statement determines the financial consequences of business operations. It
shows how the funds were obtained and used in the past. Financial manager can take
corrective actions.
[2] The management can formulate its financial policies – dividend, reserve etc. on the basis of
the statement.
[3] It serves as a control device, when comparing with budgeted figures. The financial manager
can take remedial steps, if there is any deviation.
[4] Other points:
1. It points out the sound and weak financial position of the enterprise.
2. It points out the causes for changes in working capital.

30 NIBSCOM Course Material for Internal Circulation Only

 3. It enables the Bankers, creditors or financial institutions in assessing the degree of risk
involved in granting credit to the business.
4. The management can rearrange the firm’s financing more effectively on the basis of the
statement.
5. Various uses of funds can be known and after comparing them with the uses of previous
years, improvement or downfall in the firm can be assessed.
6. It provides a basis for preparation budgets for the future.
7. The statement compared with the budget concerned will show to what extent the
resources of the firm were used according to plan and what extent the utilization was
unplanned.
8. It tells whether sources of funds are increasing or decreasing or constant.
9. It points out the financial strengths and weaknesses of the business.
10. It helps in working capital management of the company.
11. It appraises the shareholders regarding the uses of funds in the business.
Limitation of Fund Flow Statement:
The main limitations of fund flow statement are as under:
(1) The statement lacks originality because it is only rearrangement of data appearing in
account books
(2) It indicates only the past position and not future.
(3) It indicates Fund flow a summary form and it does not show various changes which take
place continuously.
(4) When both the aspects of a transaction are current, they are not considered.
(5) When both the aspects of a transaction are non- current, even then they are not included in
this statement.
(6) It is not an ideal tool for financial analysis.
(7) It is not an original statement but simply a rearrangement of two statements or financial
data.
(8) It is not a substitute of income statement or a balance sheet. It is only a supplement to
them.
Components of Flow of Funds:
In order to analyze the sources and application of funds, it is essential to know the meaning and
components of flow of funds given below:
(1) Current Assets
(2) Non-Current Assets (Fixed or Permanent Assets)
(3) Current Liabilities
(4) Non-Current Liabilities (Capital & Long-Term Liabilities)
(5) Provision for Tax
(6) Proposed Dividend
1. Current Assets: The term "Current Assets" refer to the assets of a business of a transitory
nature which are intended for resale or conversion into different form during the course of
business operations. For example, raw materials are purchased and the amount unused at
the end of the trading period forms part of the current as stock on hand. Materials in
process at the end of the trading period and the labour incurred in processing them also
form part of current assets.

31 NIBSCOM Course Material for Internal Circulation Only

2. Non-Current Assets (Permanent Assets): Non-Current Assets also refer to as Permanent
Assets or Fixed Assets. These classes of asset include those of tangible and intangible nature
having a specific value and which are not consumed during the course of business and trade
but provide the means for producing saleable goods or providing services. Land and
Building, Plant and Machinery, Goodwill and Patents etc. are the few examples of Non-
Current assets.
3. Current Liabilities: The term Current Liabilities refer to amount owing by the business which
are currently due for payment. They consist of amount owing to creditors, bank loans due
for repayment, proposed dividend and proposed tax for payment and expenses accrued
due.
4. Non-Current Liabilities: The term Non-Current Liabilities refer to Capital and Long-Term
Debts. It is also called as Permanent Liabilities. Any amount owing by the business which are
payable over a longer period time, i.e., after a year are referred as Non-Current Liabilities.
Debenture, long-term loans and loans on mortgage etc., are the few examples of non-
current liabilities.
5. Provision for Taxation: Provision for taxation may be treated as a current liability or an
appropriation of profit. When it is made during the year it is not used for adjusting the net
profit, it is advisable to treat the same as current liability. Any amount of tax paid during the
year is to be treated as application of funds or non-current liability. Because it is used for
adjusting the net profit made during the year.
6. Proposed Dividend: Like provision for taxation, it is also treated as a current liability and
noncurrent liability, when dividend may be considered as being declared. And thus, it will
not be used for adjusting the net profit made during the year. If it is treated as an
appropriation, i.e., an non-current liability when the dividend paid during the year.
7. Provisions Against Current Assets and Current Liabilities: Provision for bad and doubtful
debts, provision for loss on inventories, provision for discount on creditors and provision
made against investment etc. are made during the year, they may be treated separately as
current assets or current liabilities or reduce the same from the respective gross value of
the assets or liabilities.

Analysis of Fund Flow:

32 NIBSCOM Course Material for Internal Circulation Only

Analysis: The above table no.6.1 presents the fund flow statement of DGVCL during the study
period of 2010-11 to 2013-14. It would provide the valuable information about the changes in
the long-term sources of funds and in the quantum of working capital. First part of the statement
shows the sources of funds. Profit from operations shows the mixed trend during the study
period. It is ranged between 146.05 in 2012-13 and 195.87 in 2013-14. The company has sold the
investments during last two years of the study period. Company has issued additional share
capital 1.66 crore in 2013-14. Again it shows that company has taken a secured loan of 52.86 in
the year 2012-13. Company has borrowed huge amount in form unsecured loan in the year
2011-12, 2012-13 and 2013-14. 824.97% increase in unsecured loan in 2011-12 as compare to
2010-11. Amount in working capital was also decreased in the year 2010-11, 2012-13 and 2013-
14.
Second part of the statement shows the application of funds. Company has purchased the fixed
assets of Rs.204.48 crore, Rs.285.61 crore, Rs.532.55 crore and Rs.625.42 crore in the year 2010-
11, 2011-12, 2012-13 and 2013-14 respectively. It shows the progressive trends during the study
period. 86.46% increase in fixed assets in 2012-13 as compare to the year 2011-12. Company has
repaid the secured loans in the year 2010-11, 2011-12 and 2013-14. Company’s working capital
was increased of Rs.768.02 crore in the year 2011-12. Company has invested Rs.85.78 crore in
investments in the year 2011-12.

33 NIBSCOM Course Material for Internal Circulation Only

Analysis:
The above table no.6.2 shows the fund flow statement of MGVCL during the study period of
2010-11 to 2013-14. It would provide the valuable information about the changes in the long-
term sources of funds and in the quantum of working capital of the MGVCL. First part of the
statement shows the sources of funds. Profit from operations shows the mixed trend during the
study period. It is ranged between 125.92 in 2010-11 and 151.46 in 2013-14. The Company has
issued additional share capital 7.07 crore in 2013-14 and increased in Share
warrants/outstanding of 42.42 crore in the year 2012-13. Again it shows that company has taken
a secured loan of 1.61 crore in the year 2012-13. Company has borrowed huge amount in form
unsecured loan of Rs. 467.88 crore, Rs. 36.42 crore, Rs. 58.33 crore and Rs. 30.47 crore in the

34 NIBSCOM Course Material for Internal Circulation Only

year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. Amount in working capital was also
decreased in the last two years of study period by Rs. 19.51 crore and Rs. 199.54 respectively.
Moreover company has received funds in form of other sources by Rs. 57.82 crore, Rs. 200.16
crore, Rs. 86.03 crore and Rs. 138.66 crore in the year 2010-11, 2011-12, 2012-13 and 2013-14
respectively. It is increased by 246.18 % in the year 2011-12 as compared to year 2010-11.
Second part of the statement shows the application of funds. Company has purchased the fixed
assets of Rs.20548 crore, Rs.287.69 crore, Rs. 327.12 crore and Rs. 426.30 crore in the year 2010-
11, 2011-12, 2012-13 and 2013-14 respectively. It shows the continuously progressive trends
during the study period of 2010-11 to 2013-14. 30.32% increase in fixed assets in 2013-14 as
compare to the year 2012-13. Company has repaid the secured loans in the year 2010-11, 2011-
12 and 2013-14. Company’s working capital was increased of Rs. 363.39 crore and Rs. 30.66 in
the year 2010-11 and 2011-12 respectively. Company has purchased investment of Rs. 43.30,
Rs.4.13, Rs.16.05 and Rs.18.11 crore in the year 2010-11, 2011-12, 2012-13 and 2013-14
respectively.

35 NIBSCOM Course Material for Internal Circulation Only

Analysis:
The above table no.6.3 indicates the fund flow statement of PGVCL during the study period of
2010-11 to 2013-14. It would provide the valuable information about the changes in the long-
term sources of funds and in the quantum of working capital of the PGVCL. First part of the
statement shows the sources of funds. Profit from operations shows the mixed trend during the
study period. It is ranged between 216.84 in 2010-11 and 385.40 in 2013-14. The Company has
issued additional share capital of Rs. 324.00 crore and Rs.440.12 crore in 2012-13 and 2013-14
respectively and increased in Share warrants/outstanding of Rs.2.38 crore in the year 2011-12.
Again it shows that company has taken a secured loan of Rs. 36.61 crore, Rs. 164.32 crore and
Rs. 20.09 crore in the year 2010-11, 2011-12 and 2013-14 respectively. Company has borrowed
huge amount in form unsecured loan of Rs. 41.75 crore, Rs. 10.78 crore and Rs. 319.52 crore in
the year 2010-11, 2011-12 and 2012-13 respectively. It is increased by 2864% in the year 2012-
13 as compared to 2011-12. Amount in working capital was also decreased by Rs. 265.43 crore,
Rs. 495.72 crore, Rs. 93.74 crore and Rs. 352.80 crore in the year 2010-11, 2011-12, 2012-13 and
2013-14 respectively. Moreover company has received funds in form of other sources by Rs.
394.25 crore, Rs. 372.52 crore, Rs. 231.64 crore and Rs. 169.65 crore in the year 2010-11, 2011-
12, 2012-13 and 2013-14 respectively.
Second part of the statement shows the application of funds. Company has purchased the fixed
assets of Rs. 911.25 crore, Rs. 1115.67 crore, Rs. 1381.90 crore and Rs. 1196.22 crore in the year
2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows the mixed trends during the study
period of 2010-11 to 2013-14. Company has repaid the secured loans in the year 2011-12 by Rs.
18.68 crore. Company has purchased investment of Rs. 36.84, Rs. 6.21 and Rs. 3.42 crore in the
year 2010-11, 2011-12 and 2013-14 respectively.

36 NIBSCOM Course Material for Internal Circulation Only

Analysis:
The above table no.6.4 indicates the fund flow statement of UGVCL during the study period of
2010-11 to 2013-14. It would provide the valuable information about the changes in the long-
term sources of funds and in the quantum of working capital of the UGVCL. First part of the
statement shows the sources of funds. Profit from operations shows the progressive trend
during the study period. It is ranged between 132.16 crore in 2010-11 and 187.39 crore in 2013-
The Company has issued additional share capital of Rs. 29.56 crore in the year 2013-14. It shows
that the amount increased in Share warrants/outstanding of Rs. 168.50 crore in the year 2012-
13. Again it shows that company has taken a secured loan of Rs. 29.38 crore in the year 2013-14.

37 NIBSCOM Course Material for Internal Circulation Only

Company has borrowed huge amount in form unsecured loan of Rs. 282.21 crore in the year
2012-13. Amount in working capital was also decreased by Rs. 126.37 crore, Rs. 113.52 crore and
Rs. 296.08 crore in the year 2010-11, 2011-12 and 2013-14 respectively. Moreover company has
received funds in form of other sources by Rs. 43.62 crore, Rs. 59.43 crore, Rs. 120.27 crore and
Rs. 261.12 crore in the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively.

Second part of the statement shows the application of funds. Company has purchased the fixed
assets of Rs. 272.31 crore, Rs. 293.70 crore, Rs. 544.95 crore and Rs. 541.55 crore in the year
2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows the fluctuated progressive trends
during the study period of 2010-11 to 2013-14. Company has repaid the secured loans of Rs.
34.98 crore, 29.04 crore and Rs. 8.28 in the year 2010-11, 2011-12 and 2012-13. Company has
purchased investment of Rs. 0.99 crore in the year 2012-13.
Analysis of Cash Flow
INTRODUCTION: The separation of management from ownership in modern business calls for
the use of some form of connection between the managers and the owners and other interested
parties. Financial reporting is the most efficient and extensively used medium of communicating
the operating results as well as latest financial position of a concern for the management.
Constancy and achievement of any business largely depend on its capacity to generate enough
cash. As part of conveying an end result of companies operation managements use financial
statement as an important vehicles through which financial information is furnished to the
stakeholders. But the three basic financial statements present only fragmentary information
about a company’s cash flows (cash receipt and cash payments).
The balance sheet is a snapshot of a firm's financial resources 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.
Concept of Cash Flow: A cash flow statement is a financial report that describes the sources of a
company's cash and how that cash was spent over a specified time period. It does not include
non-cash items. The cash flow statement is a cash basis report on three types of financial
activities: operating activities, investing activities, and financing activities. Non-cash activities are
usually reported in footnotes. This makes it useful for determining the short-term viability of a
company, particularly its ability to pay bills. Because the management of cash flow is so crucial
for businesses and small businesses in particular, most analysts recommend that an
entrepreneur should study a cash flow statement at least every quarter. The cash flow statement
is similar to the income statement in that it records a company's performance over a specified
period of time. The difference between the two is that the income statement also takes into
account some non-cash accounting items such as depreciation. The cash flow statement strips
away all of this and shows exactly how much actual money the company has generated. Cash
flow statements show how companies have performed in managing inflows and outflows of
cash. It provides a sharper picture of a company's ability to pay creditors, and finance growth.
The Cash Flow Statement (CFS) provides relevant financial information about the cash receipts
and cash disbursements of a firm during a fiscal year. This information is especially important to
shareholders and creditors. As part of their investment return, shareholders often expect to
receive dividends, and the ability to pay cash dividends depends on the availability of cash flows.

38 NIBSCOM Course Material for Internal Circulation Only

Creditors are concerned about a firm’s ability to make interest and principal payments on loans
they have made to the firm. Other stakeholders such as employees and suppliers are also
concerned about a firm’s ability to meet its financial obligations.
It is perfectly possible for a company that is shown to be profitable according to accounting
standards to go under if there isn't enough cash on hand to pay bills. Comparing amount of cash
generated to outstanding debt, known as the "operating cash flow ratio," illustrates the
company's ability to service its loans and interest payments. If a slight drop in a company's
quarterly cash flow would jeopardize its ability to make loan payments that company is in a
riskier position than one with less net income but a stronger cash flow level.
Unlike the many ways in which reported earnings can be presented, there is little a company can
do to manipulate its cash situation. Barring any outright fraud, the cash flow statement tells the
whole story. The company either has cash or it does not. Analysts will look closely at the cash
flow statement of any company in order to understand its overall health. Statement of cash
flows provides the answer to the following simple but important question about an enterprise.
(Keiso and Weygand, 1998: 1275-76)
i. Where did cash come from during the period?
ii. What was the cash used for during the period?
iii. What was the change in the cash balance during the period?

The use of cash flow information is gaining value in the analysis of financial statements. Cash
flow information is measured less open to manipulation than information on earnings, because it
is based on the actual receipt and payment of cash only and not on the accrual and other
accounting principles. However, the literature on the cash flow statement indicates that there
are grey areas in cash flow reporting that are open to various interpretations. The perceived
simplicity of the cash flow statement may therefore create synthetic confidence in the reliability
of companies‟ cash flow reporting and the comparability of various companies’ cash flow
information. The acceptance of AS-3: The Cash Flow Statement has added a new dimension to
the preparation and presentation of financial statements in Bangladesh. This paper is an effort to
investigate into the state of cash flow reporting by the listed Bangladeshi non-banking financial
companies in general. The focal point is not on the quality of the reporting of the companies but
rather on what the reporting levels are in general.

IMPORTANCE OF CASH FLOWS

Investors, creditors, and managers use cash flow information to make decisions about a
company’s ability to meet obligations, or to take advantage of business opportunities.
Information about a current period’s cash flows provides a basis for predicting the amount,
timing, and certainty of future cash flows. Cash flow information is also useful in evaluating the
liquidity, solvency, and financial flexibility of a company. Liquidity refers to the ability of a
company to pay its current liabilities with existing liquid assets. Solvency is the ability to pay all
debts as they come due. A company may wish to raise money by issuing shares, for instance.
Financial flexibility relates to the ability of a company to use its resources to adapt to change and
take advantage of business opportunities as they arise.

A cash flow statement (formerly known as a statement of changes in financial position) is

designed to help a user make these evaluations and to answer specific questions such as

39 NIBSCOM Course Material for Internal Circulation Only

 • What accounts for the difference between cash and cash equivalents at the beginning of
the year and at the end of the year?
• What was done with the cash raised from the sale of bonds or shares?
• How did the business finance its purchases of machinery or other capital assets?
• How was it possible to pay dividends when the business reported a net loss on its income
statement?
• Does the firm have the ability to pay off the mortgage on its office building?

Cash Flow Statement:

In 1998, the CICA revised section 1540 of the CICA Handbook, changing the “statement of
changes in financial position” to “cash flow statement.” This does not affect the preparation of
the cash flow statement, which is still based on cash and cash equivalents. This applies to all
businesses unless a business has relatively simple operations, with few or no significant financing
and investing activities, and their effects on cash flows are apparent from the other financial
statements or are adequately disclosed in the notes to the financial statements. For example,
the cash flow statement does not apply to pension plans or not-for-profit organizations.

The CFS is similar to an income statement in that it summarizes the activities of a company
during a given period. An income statement, however, only reports on operating activities. The
CFS not only reports on operating activities, but also on investing and financing activities.
Another key difference between the income statement and the CFS is that the income statement
is prepared using the accrual basis of accounting, but the CFS includes inflows and outflows of
cash or cash equivalents, thus it is prepared on a cash basis.

Classification of Cash Flow Transactions: Cash flows result from operating, financing, and
investing activities. You must be able to distinguish among these types of cash flows. These
activities are explained as follows:

1. Operating activities: Cash flows from operating activities include all cash flow transactions
that are not classified as investing or financing activities. Operating activities are related to
the primary operations of the company in generating revenues and incurring related
expenses. Companies expect to generate more cash inflows from selling goods and services
than they spend in doing so. As you know, revenues are recorded when they are earned and
expenses are recorded when incurred. Revenues and expenses therefore seldom match
perfectly with their corresponding cash flows. For example, of $20,000 sales during the
current fiscal period, perhaps only $10,000 are collected in the same period as the sales. The
income statement also includes noncash expenses such as amortization. Amortization
expense reduces income without a corresponding reduction in cash. You should think of
operating cash flow activities as those that affect net income as well as current assets and
current liabilities (the working capital accounts or operating accounts). Changes in working
capital accounts are very much affected by a company’s rate of growth. Expanding
businesses will usually report significant increases in accounts receivable and inventories. If a
business uses suppliers to finance these increases, you will see an upward change in accounts
payable. Some changes in current liabilities, however, are not usually classified as operating
activities. For instance, changes in dividends payable and interest charged to retained

40 NIBSCOM Course Material for Internal Circulation Only

 earnings are classified as financing activities. In the previous example, a business may finance
increases in accounts receivable and inventory with borrowing or equity financing. However,
borrowing and equity financing are not considered to be operating activities.
2. Investing activities: In general, investing activities are transactions for purchasing and selling
capital assets and other productive assets. Capital assets are acquired in order to increase
productive capacity. Cash needed for this expansion may come from the sale of existing
assets that are less productive. Usually this section of the CFS shows a net cash outflow
because companies typically spend more cash than they receive from the sale of non-current
assets. Additional cash, therefore, has to come from operations or other sources to finance
capital expansion. Investing activities also include purchasing and selling of long-term
investment securities such as bonds or shares of other companies.
3. Financing activities: Financing activities affect a business’ capital structure, its debt and
equity. This includes a company’s transactions with its owners and creditors but does not
include cash payments to settle credit purchases of merchandise, which are operating
activities. Financing activities include the use of cash to pay dividends to shareholders, the
borrowing or payment of debt, and the issue or repurchase of shares. Do not confuse
dividends declared and paid with dividends received from investments. Dividends paid are a
cash outflow that is a financing activity, but dividends received are a cash inflow reported on
the income statement. Dividends received are therefore classified as an operating activity.

41 NIBSCOM Course Material for Internal Circulation Only

 Comparison of Fund Flow Statement & Cash Flow Statement

ANALYSIS OF CASH FLOW:

Cash flow analysis is primarily used as a tool to evaluate the sources and uses of funds. Cash flow analysis
provides insights into how a company is obtaining its financing and deploying its resources. It also is used
in cash flow forecasting and as part of liquidity analysis. The cash flow statement was previously known as
the flow of Cash statement. The cash flow statement reflects a firm's liquidity. The balance sheet is a
snapshot of a firm's financial resources 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. The cash flow statement includes only inflows and outflows
of cash and cash equivalents; it excludes 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

42 NIBSCOM Course Material for Internal Circulation Only

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. Noncash activities are usually reported in footnotes.
The cash flow statement is intended to
1. Provide information on a firm's liquidity and solvency and its ability to change cash flows in future
circumstances
2. Provide additional information for evaluating changes in assets, liabilities and equity
3. Improve the comparability of different firms' operating performance by eliminating the effects of
different accounting methods
4. Indicate the amount, timing and probability of future cash flows.

The cash flow statement has been adopted as a standard financial statement because it eliminates
allocations, which might be derived from different accounting methods, such as various timeframes for
depreciating fixed assets.

43 NIBSCOM Course Material for Internal Circulation Only

Analysis:
The above table no.6.5 shows the cash flow statement of DGVCL during the study period 2010-
11 to 2013-14. Cash flow after changes in working capital was Rs. 433.16 crore, Rs.253.10 crore,
Rs.383.63 crore and Rs.611.91 crore in the year 2010-11, 2011-12, 2012-13 and 2013-14
respectively. It shows progressive trend during the year 2011-12 to 2013-14. It was increased by
85.57 % in 2013-14 as compare to 2012-13. Cash flow from operating activities was Rs. 376.24
crore, Rs.221.54 crore, Rs.380.59 crore and Rs.619.44 crore in the year 2010-11, 2011-12, 2012-
13 and 2013-14 respectively. It shows fluctuated and progressive trend during the study period.
It was increased by 62.76 % in 2013-14 as compare to 2012-13. Cash flow from investing
activities was Rs. -205.52 crore, Rs.-286.11 crore, Rs.-532.61 crore and Rs.-628.54 crore in the
year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows progressive trend during the
study period. It was increased by 86.16 % in 2012-13 as compare to 2011-12. Cash flow from
financing activities was Rs. -146.40 crore, Rs.115.56 crore, Rs.169.56 crore and Rs.47.95 crore in
the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows fluctuated trend during
the study period. Closing balance of cash and equivalent was Rs.83.50 crore, Rs.134.59 crore,
Rs.152.03 crore and Rs.190.88 crore during the year 2010-11, 2011-12, 2012-13 and 2013-14
respectively. It shows the progressive trend during the study period.

44 NIBSCOM Course Material for Internal Circulation Only

Analysis:
The above table no.6.6 shows the cash flow statement of MGVCL during the study period
2010-11 to 2013-14. Cash flow after changes in working capital was Rs. 229.98 crore,
Rs.225.75 crore, Rs.238.99 crore and Rs.379.16 crore in the year 2010-11, 2011-12, 2012-13
and 2013-14 respectively. It shows fluctuated and progressive trend during the study
period. It was increased by 58.65 % in 2013-14 as compare to 2012-13. Cash flow from
operating activities was Rs. 230.01 crore, Rs.218.73 crore, Rs.238.91 crore and Rs.376.29
crore in the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows fluctuated
and progressive trend during the study period. It was increased by 57.50 % in 2013-14 as

45 NIBSCOM Course Material for Internal Circulation Only

compare to 2012-13. Cash flow from investing activities was Rs. -227.36 crore, Rs.-289.35
crore, Rs.-345.57 crore and Rs.-433.43 crore in the year 2010-11, 2011-12, 2012-13 and
2013-14 respectively. It shows progressive trend during the study period. It was increased
by 25.43 % in 2013-14 as compare to 2012-13. Cash flow from financing activities was Rs.
4.43 crore, Rs.84.41 crore, Rs.117.63 crore and Rs.55.14 crore in the year 2010-11, 2011-12,
2012-13 and 2013-14 respectively. It shows fluctuated trend during the study period.
Closing balance of cash and equivalent was Rs.35.87 crore, Rs.49.65 crore, Rs.60.61 crore
and Rs.58.62 crore during the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It
shows the mixed trend during the study period.

46 NIBSCOM Course Material for Internal Circulation Only

Analysis: The above table no.6.7 presents the cash flow statement of PGVCL during the study
period 2010-11 to 2013-14. Cash flow after changes in working capital was Rs. 716.32 crore,
Rs.723.04 crore, Rs.41.42 crore and Rs.1494.44 crore in the year 2010-11, 2011-12, 2012-13 and
2013-14 respectively. It shows fluctuated and progressive trend during the study period. There
was sharp decline in the year 2012-13 in cash flow after changes in working capital by 681.62
crore. It was increased by 3508 % in 2013-14 as compare to 2012-13. Cash flow from operating
activities was Rs. 701.20 crore, Rs.699.02 crore, Rs.38.32 crore and Rs.1419.42 crore in the year
2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows fluctuated trend during the study
period. It was increased by 3604 % in 2013-14 as compare to 2012-13. Cash flow from investing
activities was Rs. -666.48 crore, Rs.-1127.65 crore, Rs.-1384.24 crore and Rs.-1194.15 crore in
the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows progressive trend during
the year 2010-11 to 2012-13. Cash flow from financing activities was Rs. -25.53 crore, Rs.415.14
crore, Rs.1403.89 crore and Rs.-265.70 crore in the year 2010-11, 2011-12, 2012-13 and 2013-14
respectively. It shows fluctuated trend during the study period. Closing balance of cash and
equivalent was Rs.79.27 crore, Rs.66.37 crore, Rs.124.34 crore and Rs.83.91 crore during the
year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows the fluctuated trend during
the study period.

47 NIBSCOM Course Material for Internal Circulation Only

Analysis:

The above table no.6.8 presents the cash flow statement of UGVCL during the study period
2010-11 to 2013-14. Cash flow after changes in working capital was Rs. 558.37 crore, Rs.504.21
crore, Rs.171.73 crore and Rs.537.95 crore in the year 2010-11, 2011-12, 2012-13 and 2013-14
respectively. It shows fluctuated trend during the study period. There was sharp decline in the
year 2012-13 in cash flow after changes in working capital by 332.48 crore as compare to year
2011-12. It was increased by 213.25 % in 2013-14 as compare to 2012-13. Cash flow from
operating activities was Rs. 530.81 crore, Rs.501.28 crore, Rs.171.16 crore and Rs.536.37 crore in
the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows fluctuated trend during
the study period. It was increased by 213.37 % in 2013-14 as compare to 2012-13. Cash flow
from investing activities was Rs. -222.05 crore, Rs.-293.09 crore, Rs.-549.74 crore and Rs.-545.57
crore in the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows progressive
trend during the year 2010-11 to 2012-13. Cash flow from financing activities was Rs. -301.05
crore, Rs.-148.95 crore, Rs.374.74 crore and Rs.-44.68 crore in the year 2010-11, 2011-12, 2012-
13 and 2013-14 respectively. It shows sharp fluctuated trend during the study period. Closing
balance of cash and equivalent was Rs.72.64 crore, Rs.131.87 crore, Rs.128.04 crore and
Rs.74.16 crore during the year 2010-11, 2011-12, 2012-13 and 2013-14 respectively. It shows the
fluctuated trend during the study period.

48 NIBSCOM Course Material for Internal Circulation Only

6. Project Appraisal
The following points highlight the four main aspects project appraisal by financial institutions.
The aspects are:

1. Financial Feasibility
2. Technical Feasibility
3. Economic Feasibility
4. Management Competence.

1. Financial Feasibility:
The basic data required for a financial feasibility analysis can be grouped as under:
(i) Cost of project and means of financing,
(ii) Cost of production and profitability,
(iii) Cashflow estimates during the period of loans outstanding, and
(iv) Proforma balance sheets as at the end of each financial year during the period of loan.

A. Cost of Project:

The cost of the project can be broadly classified into the following:
(a) Land and Site Development:
It includes the cost of the land, conveyance expenses, premium payable on leasehold land, cost
of levelling the site and other site development expenses, cost of internal roads, cost of fencing
and compound wall and cost of providing gates etc.

(b) Buildings and Civil Works:

It includes construction cost of main factory building, building for auxiliary services, factory
administrative building, storehouse, workshops, godowns, warehouses, open yard facilities,
canteen, workers rest rooms, sanitary works, staff quarters etc.

(c) Plant and Machinery:

It includes the cost of main plant and machinery, stores and spares, auxiliary equipment,
transportation cost, installation cost, cost of test runs, foundation cost, cost of erection and
commissioning,

(d) Technical know-how and Engineering Fees:

It includes fees payable to provide the technology and know-how and travelling expenses
payable to technicians and foreign collaborators etc.

(e) Miscellaneous Fixed Assets:

It includes the cost of office furniture and equipment like tables, chairs, air-conditioners, water
coolers, miscellaneous stores items etc.

(f) Preliminary and Pre-Operative Expenses:

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The preliminary expenses includes the cost of raising finances like public issue expenses,
commission and fees payable to brokers and consultants in raising term-loans, expenses incurred
for incorporation of the company, legal charges, underwriters commissions, cost of advertising
the public issue etc.

The pre-operative expenses include salaries, establishment expenses, rent, trail-run expenses
and other miscellaneous expenses incurred before the commercial production.

(g) Provision for Contingencies and Escalation:

It includes the provision for meeting the unforeseen expenses and costs not provided in the
other heads of the cost of the project. It also includes the cost of escalation of the major heads
of cost like land and site development, building and civil works, plant and machinery, technical
knowhow fees etc.

(h) Working Capital Margin:

The working capital margin required for the project, which is not being financed by the banks,
will also be included in the cost of project.

Though machinery cost often constitutes a major element in the total project cost, its estimation
need not pose major problems since this can be based on competitive quotations. On the other
hand, cost of items such as land, site development expenses, ancillary facilities like power and
water connections, intangibles like preliminary expenses and preoperative expenses, necessitate
a careful inquiry and assessment.

A realistic assessment of project cost with built in cushions (say a reasonable contingency
margin) for absorbing normal cost escalations, could take care of the ‘ consequences of delay
and cost overrun.

B. Means of Financing:
There is no ideal pattern concerning means of financing for a project. The means of financing is
determined by a variety of factors and considerations like magnitude of funds required, risk
associated with the enterprise, nature of industry, prevailing taxation, laws etc.

The following are the sources of finance:

(a) Share capital,
(b) Subsidies,
(c) Long-term borrowing from financial institutions and banks,
(d) Loans from friends and relatives,
(e) Retained earnings, and

Financial institutions specify certain debt-equity ratios and promoters will have to raise own
finances to match these ratios.

Cost of Production and Profitability:

50 NIBSCOM Course Material for Internal Circulation Only

The next step is the assessment of the earning capacity of the project. The unit should be in a
position to manufacture the product at a reasonable cost and sell them at a reasonable price
which would allow adequate profit margin even in a competitive market.
The profitability of an enterprise depends on the total cost of production and the aggregate sale
price of the output. The cost of production and sale estimates are also useful in working out the
break-even point, the point at which the income from sales would cover the working costs of the
project. At this point the unit begins to make profit.

Cashflow Estimates:
The cashflow estimates are essential to ensure availability of cash to meet the requirements of
the project from time to time. The cashflow estimates will show the sources of funds including
those arising from depreciation and profits as well as uses of funds including repayment of term
loan instalments.

The debt service coverage ratio is arrived at by dividing cash accruals comprising net profits
(after taxes, interest on term loans and depreciation added back) by total interest charges and
instalments. This will indicate whether the cashflow would be adequate to meet the debt
obligations and also provide sufficient margin of safety, the repayment of term loans being
drawn taking into consideration the above aspect.

Proforma Balance Sheets:

Proforma balance sheets are drawn for existing concerns going for expansion, as well as, for new
projects. However in the case of existing concerns going for expansion, the balance sheets for
the past three years are also analyzed and compared, with the projections.
The projected balance sheets can be drawn for the cashflow estimates and profitability
projections. Various ratios are derived from the balance sheets and inferences drawn therefrom.

2. Technical Competence:
The technology may be indigenous or imported through foreign collaboration. In the case of
indigenous technology it should be ensured that suitable technical personnel are available.
For technology acquired through collaboration tie-ups, the key areas to be probed are:

(a) The standing of the collaborators and past experience concerning tie-up arrangements with
them.
(b) Adequacy of the scope and competitiveness of the terms of the collaboration in relation to
the requirements of the project, project engineering, equipment specifications, drawings,
process know-how, erection and commissioning of the plant, trial-run operations and
performance test, training facilities etc.
(c) Performance guarantee and it’s adequacy in relation to rated capacity of plant and
machinery.
(d) Reasonableness of financial and other costs by way of down payment, royalties etc.
The cost of the project should provide for the know-how fee, training expenses, foreign trips etc.

51 NIBSCOM Course Material for Internal Circulation Only

The project needs to be examined with particular reference to the following points regarding the
technical feasibility:

Location:
The success of a project generally depends on its proper location yielding the advantages of
nearness to the sources of raw material, labour; availability of power and transport facilities and
market. The subsidies and other concessions available at certain specified areas are to be
compared with these basic infrastructure aspects.

Land and Building:

The land should necessarily be sufficient to take care of future expansion. If the land is on lease,
the terms and conditions of the lease to be verified and so also whether the municipal laws
regarding construction of building are complied. Actual plant lay out is to be studied before
deciding on the size of the building.

Plant and Machinery:

The important aspect to be noted in examining the list of plant and equipments is to ascertain
the appropriateness of the process of technology, capacity and the related sectional balances
amongst various assembly lines.

It has to be ensured that the cost of equipment is based on proper quotations from suppliers and
that suitable provisions have been made for insurance, freight, duty and transportation to site,
erection charges and allied expenses. Adequate provision for spare parts is also essential
especially if the same have to be imported.

3. Economic Feasibility:
The economic feasibility basically deals with the marketability of the product. Basic data
regarding demand and supply of a product in the domestic market so also marginal and also
artificial.

Manmade shortages are not to be reckoned as genuine demand and the market analysis is an
essential part of a full appraisal. Projection or forecasting of demand is no doubt a complicated
matter but is of vital importance. Equally important is to examine the sales promotion proposed
by the enterprise and its adequacy.

4. Managerial Competence:
The success of a business enterprise depends largely on the resourcefulness, competence and
integrity of its management. However assessment of managerial competence has to be
necessarily qualitative, calling for understanding and judgment. The managerial requirements
are the experience and capability of the principal promoters to implement and run the project.

The adequacy of the management set up for day-to-day operations like production,
maintenance, marketing, finance etc. and also the homogeneity of the management set up.

52 NIBSCOM Course Material for Internal Circulation Only

For a new entrepreneur it will always be advisable to build up a competent team of specialists in
the required discipline to join hands with an entrepreneur who has the requisite organizational
and managerial expertise in the implementation and operation of the project.

Project Appraisal under Inflationary Conditions:

The project cash flows will arise over a period of time in future. Normally the cash flows are
estimated and projected income statement and balance sheet are prepared without considering
the uncertainty in projections due to inflation factor. But inflationary situation over the period of
projections will make us to take wrongful investment and financing decisions.

Therefore it is necessary to consider the following factors while project appraisal is made
under inflationary conditions:

(a) During periods of inflation all the input costs like raw material, wages, power, establishment
expenses will be escalated.
(b) Simultaneously the sales realization will also be higher, even though there is no increase in
the capacity utilization.
(c) The value of opening and closing stock of finished goods will also be required to show at
escalated cost due to increase in cost of production.
(d) The amounts shown in receivables will also have increase due to increase in sales, in
proportion to credit sales.
(e) The projected profitability may not be correct if calculations are made without considering
the inflation.
(f) During inflation, the working capital requirements of the concern will also be much higher
than what is projected under normal circumstances.
(g) The discount factor selected for calculation of NPV, to be fixed at a higher rate, by adding
the risk premium to normal discount rate.
(h) During the periods of inflation, the project should be selected on the basis of early payback
period. The longer the payback period means higher the risk carried with the cash flows.
(i) A provision is to be included in the cost of project to meet the escalation in project cost and
contingencies due to unforeseen circumstances during periods of implementation of the
project.
(j) The financial institutions take great care in fixing the interest rates for long-term financing.
They will put a covenant in the loan agreement to revise the lending rates of interest in
future considering the inflation factor.
(k) The borrower is required to carefully select the sources of finances to see that the cost of
capital is minimized and at the same time the financial risk of the concern to be within the
manageable limits.
(l) Proper adjustments are to be carried in the financial projections to give consideration for
influence of inflation on the profitability and cash flows.
(m) The desirable rate of return is to be determined keeping in view the inflationary pressures on
the cash flows. Such rate must be above the overall cost of capital of the firm and earn a
surplus profit for the growth of the concern.
(n) The inflation will erode the purchasing power of money and ultimately the consumers may
prefer to cheaper varieties of products or may switch over to other products which are

53 NIBSCOM Course Material for Internal Circulation Only

 cheaper. Therefore selling prices cannot be much inflated while preparation of projected
cash flow and profitability statements.

There is no specific approach prescribed for preparation of projected profitability and cash flow
statements, in conditions of inflation. But as a precautionary measure and to reduce the
uncertainty of the estimates, it is to be adjusted to inflationary conditions. The financial
institutions will appraise and finance the project only when the inflationary tendencies are
considered and incorporated into the financial projections.

Restrictive Covenants in Long-Term Loan Agreement:

Once the appraisal of the project has been undertaken by the financial institutions and the
competent sanctioning authority has approved the case for the necessary financial assistance,
the institution communicates its decision about the sanction of financial assistance giving
broadly the terms and conditions of the sanctions. This is known as ‘letter of intent’ or ‘letter of
sanction’.

Normally, the institutions have two sets of conditions:

• Standard conditions of the institution which are normally applied to all the sanctions.
• Specific conditions which are applied to the particular sanction.

The institutions have standardized the format and have got them printed so far as the standard
conditions concerned. Before the institutions take up the case for financing, one of the
important requirements is completion of the legal documentation.

The important covenants of the loan agreement would be as follows:

1. Amount of Loan:
The agreement will specify the amount of term loan sanctioned by the institution, and agreed to
borrow by the borrower.

2. Interest:
The borrower shall pay interest to the institution at a specified rate on the amounts of loans
outstanding from time to time, generally quarterly in each year.

3. Additional Interest:
The loan agreement may also contain a convent for the payment of additional interest in
specified circumstances.

4. Commitment Charges:
The commitment charge payable by the borrower to institution on the principal amounts of the
loans which have not been drawn by the borrower from time to time or have not been cancelled
by the institution.

5. Reimbursement of Costs etc.:

54 NIBSCOM Course Material for Internal Circulation Only

The borrower would be required to pay and reimburse all taxes, duties, costs, charges and
expenses in connection with or relating to the loan transaction including costs of investigation of
title and protection of institutional interests.

6. Last Date of Withdrawal:

The loan agreement will contain a covenant unless the institution otherwise agrees, the right to
make drawls from loans will cease on specified date.

7. Repayment:
The borrower will undertake to repay the principal amounts of loans in accordance with the
amortisation schedule specified in the loan agreement.

8. Conversion Right:
Reservation of right by the institution to convert loan into fully paid up equity shares in the
borrower company and the rate of conversion and events on which the Institution can exercise
such conversion right viz., (i) Default in payment of principal and interest, (ii) Mismanagement in
borrowing company affecting the Institution’s interest, (iii) In case of closure of the unit, will also
be mentioned in the loan agreement.
9. Security for the Loans:
The loans together with all interest, liquidated damages, commitment charges, premium for
prepayment or on redemption, costs and expenses and other monies shall be secured by first
mortgage on all borrowers’ property, both present and future.

10. Nominee Directors:

The institution will have a right to nominate a director on the board of directors of the borrower
company who will not be liable to retire by rotation or removal.

11. Restriction on Payment of Dividends:

The borrower shall not declare any dividends unless it has paid the principal and interest dues to
the institution or has made satisfactory provision for this purpose.

12. Expansion or Diversification:

The borrower shall not undertake any new project or expansion without the prior approval of
the institution during the period of loan.

13. Inspection of Books and Property:

The institution can carry out periodically technical and financial inspection of the factory both
during construction and operating periods of the project and inspection of books of account and
records.

14. Investment of Funds:

The borrower shall neither lend its funds to any one, nor invest the same for purchase of shares
etc.

15. Change in Scheme:

55 NIBSCOM Course Material for Internal Circulation Only

The borrower shall not make any alterations or modifications in the scheme submitted by it and
as approved by the institution without its prior approval.

16. Managing Director:

The appointment of M.D. or any whole time director and the terms of such appointment or
reappointment and any changes therein shall be subject to prior approval of the Institution.

17. Changes in Memorandum and Articles of Association:

The borrower shall not make any amendment to its memorandum of association and articles of
association during the period when the loan is outstanding, without prior permission of the
institution.

18. Unsecured Loans:

The borrower shall undertake not to repay the unsecured loans from the directors during the
tenure of loan. The loans from the directors shall not bear any interest.

19. Raising of Resources:

The borrower shall arrange to bring in resources by way of internal generation for
implementation of the scheme. In case of any deficit in meeting this requirement or in case of
cost overrun in implementation of the project, the directors shall arrange to meet the same from
non-interest bearing sources.

20. Physical and Financial Progress:

The borrower shall intimate the institution periodically about the physical progress as well as
expenditure incurred on the project and agrees and undertakes to furnish the institution such
information or data as may be required.

21. Review of Project Cost:

The institution shall have the right to review the cost of the project before the final
disbursement of loans.

22. Withhold Disbursement:

The institution have power to withhold disbursement of the amount of loan equivalent to the
provision against margin money for working capital in the cost of the project till such time as the
project is completed and build up of working capital commences.

23. Change in Contacts:

The borrower shall obtain prior concurrence of the institution to any modification or cancellation
of the borrower’s agreement with its various suppliers.

24. Maintenance of Property:

The borrower shall ensure proper maintenance of the property and is properly insured.

25. Merger Compromise:

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The borrower shall not undertake or permit any merger, consolidation, reorganization or
amalgamation scheme or compromise with its creditors or shareholders.

26. Material Happenings:

The borrower shall promptly inform the material happenings like strike, lockout, winding up
petition, decline in profit, sales, production etc. to the institution.

27. Creation of Subsidiary:

The borrower shall not create any subsidiary or permit any company to become its subsidiary.

28. Raising of Funds:

The borrower shall not issue any debentures, raise any loans, accept deposits from public, issue
of equity or preference capital, change its capital structure or create any charge on its assets or
give any guarantee without prior approval of lead institution.

The basic objective for incorporating the above covenants in the long-term loan agreement is to
protect the interest of the financial institution.

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