The framework is as follows
Application to Non-Banking Finance Companies
The NBFC industry includes MNC players, captive finance companies and a few large, stand-alone finance companies.
The companies within the universe of analysis were typically retail-financing companies, with particular emphasis on auto and consumer durables. While some were independent NBFCs, like Cholamandalam Investment and Finance, Lakshmi General Finance, others were captive financing companies with strong parentage such as Bajaj Auto Finance Ltd. and Ashok Leyland Finance Ltd.
Critical Factors:
- Market Position
A company’s distribution network, in terms of a branch or direct sales/marketing agent network, together with the company’s brand equity, service standards, customer relationships and product portfolios are significant in determining an NBFC’s market position.
Particularly in vehicle/ consumer goods financing, tie-ups with manufacturers and dealer relationships are critical. In this respect, captive financing companies can be assumed to enjoy an advantage stemming from the manufacturers’ brand equity, lower establishment costs, preferred financier status and asset quality support from various forms. This ultimately impacts the business growth and profitability of a captive finance company.
- Asset Quality
This is critical for determining the credit worthiness of the organisation and entails knowledge of asset diversity in terms of classes and geographical distribution, NPA levels and provisioning norms.
- Capital Adequacy
This reflects the level of cushion or protection available to company’s creditors to absorb losses from credit and other risks. For the purpose of the analysis, due to the limited time available, the Capital Adequacy Ratio and the ability of the company to raise resources internally as reflected in the growth in reserves and the dividend payouts was used as a yardstick.
- Resource Raising Ability
The diversity of the funds tapped, renewal rates of fixed deposits, ratings enjoyed by instruments from accredited rating agencies are a measure of this factor.
Company Performance: CAMEL Model
A finance company is distinctly different from a manufacturing company. These differences emerge in several contexts. Understanding these differences is critical because without a clear idea of the way the financials are classified, presented and analyzed, it is not possible to assess the company for the purpose of the project.
Some of these differences are:
- Components of Financial Statements
- Importance of working capital
- Provisioning norms
- Accounting policies, especially with respect to recognition of interest, NPAs, etc.
- Nature of Financing
- Marketing and Distribution
- Parentage and its criticality
Having identified these differences, the process of capturing company performance becomes significantly simpler.
The following model can then be used to ascertain the favourability or unfavourability of the performance of the finance company being studied.
Capital Adequacy
Asset Quality
Management
Earnings
Liquidity
This model specifies not even the criteria that can be used to assess the company, but also specifies the order of importance of the criteria, with capital adequacy and asset quality considered most critical to the assessment.
Capital Adequacy
Capital adequacy is of critical importance to a fixed income investor, for it represents the extent of safety he enjoys with respect to the company, in the event that there is a default on account of payments. It symbolizes the cushion of protection to impaired assets, the ability of the company to raise resources and the strength of its reserves position.
Capital Adequacy may be reflected by:
a) Capital Adequacy Ratio
b) Increase in Net Worth
c) Market-tapping ability
d) Access to diversified sources of capital
e) Gearing
In practice, a financing company makes repayments on commercial paper, fixed deposits etc, not out of their cash flows but by approaching the market for fresh funds to repay the existing dues. Thus, the reputation and ability of the company to tap the market, especially at short notice for fresh funds is an important criteria.
Asset Quality
A financing company’s critical assets would be the disbursements it carries out to its clients. The credit-worthiness of the clients is of extreme importance, and thus the need for having an efficient credit risk management system. Here, the following give an idea of the asset quality:
- Distribution of disbursements basket – i.e. the segment- wise classification of disbursements. Certain segments of retail financing are riskier than others due to the nature of clients involved, the size of individual disbursements. For example, consumer durables are the highest-risk category of disbursements, and 2 wheeler loans are riskier than car and Commercial Vehicle loans.
- Non-Performing Assets- Level and Classification
The delinquency ratio of assets as depicted by NPAs is a useful reflector of asset quality. However, here again the segment of the portfolio in which the NPAs are higher, the extent of provisioning determining the difference between gross and net NPAs need to be kept in mind.
- Collection Efficiency
This reflects the company’s ability to recover its dues from customers on due dates, and thus impacts the NPA levels indirectly. Number of days of debtors is a critical measure here.
- Recognition of NPAs and provisioning requirements
Fund managers have evaluate the management of the company that he or she is looking to invest in. They have to assess the credibility of those who are at the helm of affairs, who determine strategies and policies followed by the company. This assessment typically ranges from word of mouth opinions about the company in the industry, the reputation enjoyed by it and also detailed meetings with the management.
In this evaluation, the parentage of the organization is also important. This was especially relevant for captive financing companies like Bajaj Auto Finance, Ashok Leyland Finance etc. Determining the synergies between the promoters and the company, as also the strategic importance of the financing company to the parent was useful in assessing the extent of support that could be expected to be enjoyed by the company. Captive companies with strong parentage can draw comfort from the positive credit ratings enjoyed by their parents.
Earnings
Earnings can be captured not only in gross terms but also as ratios to determine return on assets, profitability, yields on funds deployed etc. Further, earnings are also a function of the volume of disbursements, i.e. the ability to enhance credit levels, increase clientele, etc. This is often a management-driven decision, and because it can be amended to suit management goals, it is not as critical as the factors mentioned above. For example, volume of disbursements can be enhanced by opening up new branches in new locations, adding dealerships, etc.
- Gross measures
This includes the different components of income, classified appropriately. For example, the proportion of income earned from leasing as against that earned from hire purchase business, the portion of earnings contributed by bill discounting, the percentage increases therein, the extent of other income and its components, the change in earnings profile, etc. Further, the changes in expenditure levels, provisioning increases or decreases and the improvements in Profit after Tax, EBIDTA, etc.
- Relative measures
These are numerous and can be used to compare performance not only year on year, but also across peer group members. Some of these measures include:
a) Return on Net worth
b) Yield on funds deployed
c) PAT to total income
d) PAT to operating income
- Diversity in Earnings profile
A diverse earnings profile ensures lower risk of dependence on one particular segment and serves as a measure of safety. Thus captive companies that depend essentially on their parents for business, or financing companies that have too large a presence in one segment (say, 2 wheeler financing) and too small a presence in another (say car financing) may be liable to viewed negatively.
Liquidity
This is the least important of the five criteria on a relative basis, because of the fact that most financing companies do not use their daily cash flows to repay debts. They mostly adopt the fresh-funds route to repay their dues. However, it is important to view liquidity to the extent that the interest coverage should be reasonably adequate. Measures of liquidity include:
a) OPBDIT/ Interest and finance Charges
b) OPBIT/ Interest and finance Charges
c) PAT/ Interest and finance charges
d) Net cash accruals to total debt
e) PAT less dividend to total debt
f) Debtors as days of income
Interest coverage of less than 2:1 is unfavourable and should be viewed with caution.
Peer Group Comparison
Some formulae more frequently used by fund managers are as follows:
(Net Worth – Non-Performing Assets)
Provisioning
(Market Capitalization – NPA)
Provisioning
NPA as a percentage of Net Worth
This article substantially utilizes the material in the student project report prepared by Sakshi Budhiraja under my guidance.
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