Wednesday, December 26, 2012


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’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 do name your institution)


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