Our last instalment had ended
with the resolution “we propose to write on how close we could allow the
client to get to us at a personal level.” However after we discussed the
issues with two young friends and with the analyst who had mooted the topic in
the first place, we decided that this could be well sorted out individually. In
fact the writer was already feeling something of a psychiatric counsellor in
the role. Yes, it is an important practical ‘conceptual’ issue, but obviously
the ‘subjectivity index’ is rather high. We’ll run a re-check on another date. Time
we turned to something technical.
There is a very
significant issue which has always exercised the minds of many. It is the unreality
or artificiality of ‘Financials’ especially in the Indian scenario. You find
this subject commonly discussed in the chapter called “Limitations of the
Balance Sheet” or something. The Chapter usually talks about aberrations in Valuation,
Intangibles, Subjectivity and ‘inclusion only of elements which can but be
assessed in terms of money’. But then
books all over the world blame the same factors, whereas as any analyst will
vouch, the figures are more fictitious in India than anywhere else. In fact,
many Annual Reports deserve to be kept under ‘Fiction’ and not under ‘Business’
in the Library. Hence, if it is to be of practical use, the discussion should
be in the Indian context.
As a credit analyst, the major
factor for the unreliability of published financials we can cite is sheer
‘Hypocrisy’ amongst sections of our great Civilisation. All those who matter
indulge in tax evasion, or filing inflated Export Incentive claims, or angling
for undeserved Subsidies or a host of other things on which several major and
respectable professions in India thrive.
We have attended many a
Consortium meeting, where the members, particularly of a Bank the name of which
begins with an ‘A’, and in the past used to begin with a ‘U’, ask innumerable
theoretical questions. There is something to be said for their touching faith
in the Written Word, or there being so wedded to, or being so keyed up of the
theoretical aspects of Ratio Analysis. Problem here is that the querying
analyst is exposed as a ‘theoretical’ person, a greenhorn with little practical
experience in his blood, and someone who will be contented with a theoretical
nostrum and can be lulled with Theory, which is what the ‘consultant’ wants in
order to have unreasonable demands cleared.
Any expert engaging in
the analytical part of credit appraisal strongly protests, when one mentions the
sheer futility of endless discussions on current ratio or CRR or the other, and
many will say “ if we cannot rely upon these statements which were handed over
to us by our Gurus, what do we analyse then?”, how can anyone say “financial
analysis is futile”? Try telling this to an analyst at CRISIL or Moody’s. Our
answer is that most analysts will rarely handle listed and highly regulated
entities, following Corporate Governance, such as BHEL or Tata Steel or MMTC.
For the usual analyst, the playing field will rarely be ‘level’.
Even then, so far as the
units we contend with are concerned, we grant it, or can again unequivocally affirm the
utility of the study, and acknowledge the importance of these figures. The only
problem according to the writer is the way the statements are to be studied and interpreted,
the angles of looking, so to say, and the importance of reading between the
lines. These are lessons we have learned after years of disappointment and handling
the machinations of the pimps of the Indian Financial World, namely the
‘Consultants’! Many of these people can’t differentiate between an asset and a
liability! Sure, they cannot be wished away!
To illustrate the mistaken
assertions the analyst frequently makes, exposing their ignorance of the
peculiar Indian circumstances, here is a hilarious exchange (we swear it really
happened):
We were attending the
Consortium meeting for assessing the new ABF (Assessed Bank Finance) of LDPL, a
leading diamond company, a DTC sight-holder, and obviously a Kathiawari.
ABF was around Rs. 500 crore. In diamond, the limits tend to be roughly half of
projected sales. The promoter VBG, whose name is a household name in Surat,
number of rotaries and gardens named after him for pecuniary reasons, was
attending the meeting- that’s one meeting the promoter invariably attends. One
banker friend roared: “Mr. G....., why has your current ratio fallen from 1.35
to 1.28 as the end of so-and-so?” Furious, VBG glowered at his Director Finance
who is paid ten times the banker, and said “ what is this chap saying, do you
understand? The “what-he-says”- (turning to the dealing officer-kitna
(kiman) hona apko saab, is less good or more?) should be more than 1.35 by
tomorrow, otherwise considered yourself fired!”
More on Current Ratio:
M/s PCL was a major
manufacturer of Roto Water Tanks in what is now Chhatisgarh- they are what we
loosely call ‘sintex’ tanks. The promoter was NS, an IITian, topping the degree
with a PGDM from IIM Ahmedabad. Their working capital enhancement proposal was
rejected because their current ratio as at the end of the past FY was less
1.33. In response NS just laughed and said something to the effect- “Sir, I can
pull on with the same limits, but you must seriously reconsider this 1.33
fetish, it will cost you business..you’ll lose clients! Now Sir tell me- during
the past year- have I once approached for overdrawing, or was my account ever
irregular due to LC devolvement, or did you find my liquidity strained? I’ll
bet, if anyone manages to show the ratio as 1.33, you’d ignore all symptoms of
strained liquidity in the actual account, if any.”
The lessons from the
above are:
(i)
The current ratio figure
has to be read in conjunction with other events in the actual bank account over
the recent past.
(ii)
The current or CC account
statement of account is more important than the number crunching. It can throw
up all kinds of surprises- irregularities, suspicious round sum payments and
receipts, cheque returns etc. etc.- the proof of the pudding is the statement
of accounts- do collate all of them in case of multiple banking. A senior
banker calls it the ‘Janam Patri’, i.e., the horoscope of the unit.
(iii)
What matters is not just
the figure of the ratio, but also the quality of the asset, as well as proper
classification of the assets. Take the example of Mafia- whatever the period or
circumstances- all receivables are current asset- recoverable at the drop of a
hat! Do read the book ‘Freakonomics’ by Steven D. Levitt and Stephen J. Dubner, which
likens the management procedures of the Mafia to those of any major American
Corporate!
(iv) So far as classification
is concerned, the definition should not be rooted in ‘time-period’. The correct
definition is that the asset should form part of the working cycle of the unit.
Thus, a ship, in the books of the dock building the same, will be classified as
a CA even if the realisation of expenses takes 2 years. If realisation of a 2
month old debt is doubtful, we’ll treat as outside current asset. An example
about inventory was one YE of Shillong- they procured cheap tablet cell-phones
from China, good quality but economical cost-wise, and just then HCL launched
the excellent HCL ME tablet costing Rs. 14,000/-. Imagine the ‘currency’ of the
new Chinese stock! In general, any techno-intensive industry deserves to be
looked at very closely from the angle of obsolescence. You know how they reap
the prices and dump them in free fall. In fact facilities to these high
risk-high return businesses are usually treated as clean, and the collateral
factor counts for more, than the current ratio. The common-sense about security
in India- primary security is less sacrosanct than collateral, because primary security
is in the custody of the borrower, whereas the collateral security is in the
custody of the lender! You can have endless discussions about validity of a title,
what the bania believes is- kabja sachha, baaki jhoot- possession
is everything, forget the paper work!
(v)
Striking off an
equivalent sum from both the numerator and denominator – CA and CL- boosts the
current ratio. (for example removing bills discounted from limit availed and
receivables, as is commonly done, enhances the ratio.)If CA= 210 and CL= 201,
the current ratio is 1.05, and deducting 200 both from numerator and
denominator, it becomes 10! Therefore please do remember to factor in all the
CAs and CLs.
(vi)
Some theoretical
misconceptions:
- The remark in many appraisals: the NWC has gone down as the sundry creditors have shot up: remember NWC= CA-CL is a non-causative identity, while NWC is ‘the amount of long term fund that goes into funding of CAs’. So, the changes in CA and CL will not affect NWC, it’s independent of CA and CL, being a part of long term funding. Please think into this- it’s very important.
- The higher the current ratio, the better: the current ratio of a defunct unit always shows an increasing trend as both numerator and denominator go down as the business is winding up.
- How important is the arithmetical figure as at the end of the year: the current ratio in the closing balance sheet is less important than the situation on the ground you have to watch, physically inspecting the unit. You’ll know more about the current ratio from a mere look at the unit itself.
We return to the same
topic next week, taking up the net profit/ production ratio, how it is to be
handled in the Indian circumstances. That’s another very interesting topic
which we reserve for now!
(your queries may be addressed to carlvonaldrich@gmail.com- do name
your institution)
*A MERRY CHRISTMAS AND A HAPPY NEW YEAR TO
ALL!*
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