Wednesday, January 16, 2013


Last, we had discussed current ratio, and had signed off with a reference to another much misunderstood ratio, namely the net profit to production or net profit to sales ratio. Normally, unless we make it explicit, kindly assume we are talking about a manufacturing concern. In business environments where all is disclosed, it is a ratio that can be rationally discussed and argued about. In the context of the Indian Economy, talking about the ratio is like telling ghost stories. However, to place the entire blame on businessmen, and treat them with suspicion is also not justified. In the post we attempt to take a perspective on these twin issues- the ratio and the people behind the ratio.

So, in a large Consortium of say 10 or 12, there will be 1 or 2 officials who’ll have the (misplaced) guts to broach the subject of ratios in the open, even if financials are not there on the meeting agenda. Others will have some curiosity, but will wait for someone else to speak-up. The lead official will be tense and would be involved in his/her own agenda. So, it will go like this  (let’s name the rookie, pushy analyst Sankar, for the sake of convenience).

SANKAR: “Why has the net profit/ production ratio gone down from 2.45% to 2.10% in the last FY?
DF that is Director Finance (he’s senior and is more into wheeling dealing and no longer technically upto date): Well, I would remind the house that the Govt. has raised oil prices thrice last year. This year depreciation and interest were higher due to expansion and the term loan taken from IDF. You add back depreciation and see.

SANKAR: Why should anybody add back depreciation? You have not been able to pass on the price hike to the customer which shows that you are buyer dependent and your product demand is too price elastic. Our other client XYZ in the same line has shown a 10% rise in the ratio. The industry average is also higher than this as per CMIE- don’t you read those?
DF: Arre boss, that’s a small company, how can you compare the two? When we were of that size, our profitability was double. Why has CRISIL continued our credit rating then?

SANKAR (looks at other officials for support, the others, though silent, nod in assent, for propriety demands supporting the fellow lender): I know how these agencies work yaar...Do you say you have not derived benefit of scale of operation?
DF: Boss, now what to say, the reality is that XYZ has this tax benefit and that tax benefit, being less than 7 year old, actually our profit is 10%, but why to pay to the Govt., etc.etc.etc., otherwise how will pay the FIs/Banks...

PROMOTER: (relieved, so is the Lead Bank official, whose home-work is lacking, he has to attend so many meetings, always late): Ha, ha, ha! That’s the problem in this country, no one can do honest business, etc.etc.etc..  Chalo bhai, dinner is waiting, cocktail bhi hai...!
SANKAR to LB: (feels his remarks should be preserved for posterity) Sir, don’t forget to include this issue in the minutes.

LB:  Yes, yes, before circulating the minutes we’ll show them to you, ok (he’s not going to draft the minutes till the next meeting is imminent)
Due to external factors like absence of identical playing field for all, propensity to avoid  tax, or the sheer temperament of businessmen in India, this ratio loses much of its significance. We can’t blame the entrepreneurs too much. You have to look at business compulsions from their angle also. As we remarked on an earlier occasion, credit analysts are mostly from a service background and have not ‘lived’ business. You’ll be better placed to arrive at decisions related to lending, especially handling stressed assets well, if you have some means of having a first-hand and inside view. To appreciate the nuances of business the best course is you start a business yourself !!!, but that is a rare possibility. You could associate yourself with a close friend or relative doing business, do some apprenticeship, or keep chatting with the friend regularly. ‘Strong handling’ and SARFAESI threats are often destructive and against equity. You end up harming national wealth and human resources and this approach shows one’s lack of experience, callousness and lack of sensitivity towards the assets that nature and people have built up.

What business-people sometimes say about SARFAESI is true. Officials esp of Banks will stay at a centre for 3-4 years only. Therefore they tend to take short-term measures, esp. in the second half of their tenure. In a scenario of rising NPAs, a one-size-fits-all approach is adopted and targets given for SARFAESI notices. The approach that prevailed in pre SARFAESI days like rehabilitation and restructuring has been forgotten because BIFR days are over. This is sheer stupidity and has brought the banking industry to the brink of disaster. We would draw the readers’ attention to what the Japanese believe. The Japanese banking philosophy holds that Banks exist for ensuring economic growth, while we believe the other way round. This post is not about Banking theories, but one would do well to know that alternate ways of thinking are there. We don’t feel this Japanese banking suits our countrymen, but being a matter of interest, we are giving excerpts in a box. It may be noted that Japanese Banks’ NPAs were 20% of their total loans at some point of time, which was taken care of by the Govt. This is also not to say that we detest SARFAESI, and infact we were present at the IBA meeting in 2002 when the father of the Act, Dr. Umarji, unveiled it in Mumbai.

There are some businesses in our family, honest businesses. The business-person has no pension or gratuity to fall back upon, and has to face the full blast of economic and commercial risk. It’s not surprising, they will now and then withdraw money from the firm, which no one should object to if it’s over and above the stipulated NWC. They are also justified in substituting with Institutional funds, the money they had to raise from relatives, because the Institutions were taking months to decide, and business had to carry on. Then, the business will make every attempt to charge a price which can be squeezed out of the customer, while our middle class profit mentality cries ‘cheating’, for we  think on cost+ lines, forgetting our earlier observation regarding risk borne by the business person.

Profit/Production Ratio and PBDIT:
By just reeling out the percentages, one only exposes oneself. As we said above, the factors behind the changes would in all likelihood be external to the unit, having nothing to do with the operations of the unit, a fact about which the analyst should be aware. The relevant profitability ratio in the context of our situation, namely taking up a new project, is the PBDIT (profit before depreciation, interest and taxes), and you can question the Company on changes in the figure. The ratio correctly reflects the efficiency of the operations of the unit, by performance we mean the entire process of conversion, cash to cash. The significant properties and advantages of analysing PBDIT are as under:

(i)            The ratio is immune to plant age (excludes depreciation),and capital structure (i.e. debt vs equity) which would differ unit to unit, but the mix would affect the working results only to the extent of interest, which is irrelevant  in this ratio. The tax part which was posing problems in the first place is also excluded.

   (ii)     The ratio reflects the efficiency of the technology, RM or power position in                    general, the manpower, entrepreneurship, competition factors, forex rates etc.
                      (we’ll call this ‘hypothesis @’ and will test it later).
(iii)          This is the ratio you are to look at when you approve a project, based on a certain technology, location, scale and markets. Other ratios could be important, but for project selection, we find in the light of our experience, this is the best ratio to be used. For instance, IRR sounds s**y, but is basically used for computing real returns from a project.

Suppose the PBDIT is projected at a level lower than another local unit in same line operating on similar scale, and the promoter says that the technology is different, the question to be asked is why the costlier technology,  for the market risks the product will face are the same. Are there any other risks (e.g. regulatory risks, say environment concerns which will demand higher investment in pollution control), due to which the previous technology will be outdated soon ?

(iv)         Before arriving at a credit decision, you need to compare the ratio of other similar units operating the area, if available of course. The project report will always assume a high ratio, which may or may not be realistic. Of course in case of deviation you will ask the promoter to explain. This ratio will be jealously guarded by the unit, lest it benefit the rivals. We remember, when someone wanted to set up a computer stationery unit in Chhatisgarh, we engineered a break-in at another local unit, because their CA could not ‘incentivised’ by the client into parting with the figures.

(v)          What is the ideal level? It naturally depends upon the risks faced by the unit, particularly the risk or obsolescence that the product or technology face. Higher risk is associated with higher returns and vice versa. Thus it should be high in case of say a unit manufacturing mobile sets. Following are PBDITs rounded-off to nearest whole, for some well known companies (from moneycontrol: three year running averages for year ended 31.03.2012, save ACC-one year behind)

STEEL:   Tata Steel: 31 %, Steel Authority:22%:Essar Steel: 19%:

CEMENT:   ACC 26%: Ultratech: 24%: Ambuja Cements: 28%

SOFTWARE:   Infosys:40%: TCS: 60%: WIPRO: 30%

Thus players in similar industries are likely to have similar PBDITs, a few    exceptions will always be there. Further, the variations in each of the industries faithfully reflect the general perception about the groups- Tatas highest, Essar lowest, Infosys in between. This vindicates our hypothesis labelled @ above.

(For the purposes of the analyst, usually he/she will be able to locate a company of similar size, say in CMIE Database, when you seek a benchmark. If you are not able to find a benchmark, just remember the Lord and assume it as 20%, for a normal risk company.)

COMPUTING THE RATIOS:The CMA format is not conducive to computing ratios readily and those given by the Company may not be reliable. Better fill up the form A (below). Note that the first thing you need to do when a new loan file comes to you for appraisal is to check CMA and fill up the form A and the form E, which are nothing but CMAs condensed on one page and tweaked a bit (in form A, we bring inventory changes to the top in order to get the production figure which is required for ratio analysis). Normally our analysts pounce upon the file and start filling the internal format. Then they raise queries in order to fill up the gaps. Once the replies to the queries are ‘in place’, they start filling up the financials, and run into further questions the commonest one being the first year net inventory, that is the increase/decrease in finished goods+stock-in-process, which is required to arrive the figure of production in the first year analysed, and require financials another year back. After ratios are computed, there are further queries on variations, and this goes against the principle of avoiding piecemeal queries. So filling up forms A and E should be the first task.

The    Japanese   way   of   doing   Banking   is   said  to  be different. These are  excerpts from  an article in Nikkei Shimbun, leading Japanese daily: the writer states:
“I don’t think that the Western way is in International Banking should develop. I think that much of the Japanese Philosophy of relationships is for the long term, of honour and not getting a profit for every deal. The Japanese Bank sees  itself as a citizen within a community in which it works. ..It wants to give back to the community as well. “
Cracking the Japanese Markets by  James Morgan:
“Japan’s giant financial institutions have played an important role in development of industrial Japan...Japanese companies, more than their international competitors rely on their close banking relationships and are highly leveraged to fund rapid plant expansion and large overseas domestic projects.”
Japanese Banking author N.G.Kiyohiko writes in his 2002 research paper:
“The bank tries to honour past pledges even if they are no longer optimal when market conditions change. In arm’s length transactions, the bank is likely to call in firms’ loans if they fail to repay their debts. Although we do not examine such cases explicitly in our formal model, rational rigidity results suggest that a bank maintaining long-term relationships with many entrepreneurs is not likely to take such an immediate disciplinary strategy, but to keep a distressed firm alive for a while to give it time to recover and to offer managerial advice; the firm may recover from a temporary downturn and begin to repay its debts. And even if it eventually fails, the bank will have honoured its long-term pledge not to let the firm down, so it does not antagonise its current and potential small trading partners. Consequently, the rate of bankruptcy is substantially lower than in arm’s length banking.”

In our next post, we examine some more ‘theoretical’ issues from a ‘practical’ angle. So long...!
            For Annexures A and E:

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