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Case Study 4: Assessment of Credit Worthiness and Grant of Credit Limits

Bharat Refineries Ltd., which is operating for the last 6 years. It has approached Moon Organic
Chemicals Ltd. for grant of credit limit on account of goods bought from the later. Bharat Refineries Ltd.
Has submitted its Balance sheet and Income statement for last 2 years to the later for analysis and grant
of credit.

Bharat Refineries Ltd. Balance Sheet (Rs. In Lakhs)

Current Last Current Last


Liabilities Years years Assets Years years
Share Capital Equity (Rs.10) 600 600 Plant & Equipment
Share Premium 400 400 (Less Dep.) 1500 1400
Retained Earnings 900 700 Land 750 750
Total Equity 1900 1700 Total Fixed Assets 2250 2150
First Mortgage 200 300 Inventories 580 300
Second Mortgage - 200 Account Receivalbles 350 200
Marketable
Bonds 300 300 Securities 120 120
Long Term Liabilities 500 800 Cash 100 80
Account Payable 300 60 Total current assets 1150 700
Notes Payable 600 220
Secured Liabilities 100 70
Total Current Liabilities 1000 350
3400 2850 3400 2850

Bharat Refineries Ltd., Income Statement (Rs. In Lakhs)


Particulars Current Years Last Years
Sales 5980 5780
Income from Investments 20 6000 20 5800
Opening Inventory 300 400
Total Manufacturing cost 4200 3200
Ending Inventory -580 3920 -300 3300
2080 2500
General & Admin. Expenses 950 750
Operating Income 1130 1750
Interest Expenses 60 62
EBT 1070 1688
Income Tax 480 674
Net Income After Taxes 590 1014
Dividend declared and Paid 250
Case Study 4: Assessment of Credit Worthiness and Grant of Credit Limits

Moon Organic Chemical Ltd., has established the following broad guidelines for granting credit limits to
its customers:

I. Limit Credit Limit to 10% of net worth and 20% of the net working capital.
II. Not to give credit in excess of rupees one crore to any single customer.
Case Study 4: Assessment of Credit Worthiness and Grant of Credit Limits

Analysis of Bharat Refineries Ltd. Financial status

Current Last
Working Notes Year Year
a) Liquidity Ratios
1 Current Ratio
Current Assets 1150 700
Current Liabilities 1000 1.15 350 2

2 Acid Test Ratio


Current Assets- Inventory 570 400
Current Liabilities 1000 0.57 350 1.142857

3 Inventory Turnover
Cost of Goods Sold 3920 3300
Inventory 580 6.758621 300 11

4 Debtor Turnover
Sales 5980 5780
Receivables 350 17.08571 200 28.9

b Profitability Ratio
1 Profit Margin
EBIT 1130 1750
SALES 5980 18.89632 5780 30.27682

2 Return on Investment
EBIT 1130 1750
Total Assets 3400 33.23529 2850 61.40351

3 Return on Equity
EAT 590 1014
Equity 1900 31.05263 1700 59.64706
Case Study 4: Assessment of Credit Worthiness and Grant of Credit Limits

© Composition of Current Assets


Particulars Current Year Last Year
Rs. Rs.
Lakhs % Lakhs %
Inventories 580 50.43478 300 42.85714
Account receivable 350 30.43478 200 28.57143
Market Securities 120 10.43478 120 17.14286
Cash 100 8.695652 80 11.42857
1150 100 700 100

(d) Working capital


Current Last
Particulars Year year
Current Assets 1150 700
Less: Current Liabilities 1000 350
Working Capital 150 350

Analysis of Bharat Refineries Ltd. Creditworthiness

1. The cost of goods sold has increased by Rs.620 lakhs (3920-3300) but the corresponding sales
increase amounted to Rs.200/- lakhs only.
2. The current ratio and quick ratio gives an indication of adverse liquidity position.
3. Inventory turnover ratio has slipped from 11 times to 6.76 times, is an indication of poor sales
and ineffient inventory control system.
4. Debtor turnover ratio has declined from 28.9 to 17.09 indicates liberal credit policy extended to
customers and mounting of debtors balances.
5. Profit margin has declined from 30.28 to 18.9
6. Return on Investment has declined from 61.40 to 33.24
7. Return on equity has also drastically declined from 59.65 to 31.05
8. Current liabilities have substantially been increased by Rs. 650 Lakhs (1000-350) during the
current year.
9. The composition of current assets gives an indication of locking up of working capital in
inventories.
10. The quick assets viz. marketable securities and cash balances have declined during the current
year.
11. The long term liabilities have reduced from Rs.800 lakhs to Rs.500 lakhs short term funds might
have used for repayment of long term liabilities.
12. The company has skipped the payment of dividend for the current year.
13. General and administration expenses have increased by Rs.200 lakhs (950-750) during the
current year.
Case Study 4: Assessment of Credit Worthiness and Grant of Credit Limits

Moon Organic Chemical Ltd., has established the following broad guidelines for granting credit limits to
its customers:

I. Limit Credit Limit to 10% of net worth and 20% of the net working capital.
II. Not to give credit in excess of rupees one crore to any single customer.

Credit Limits to Bharat Refinaires Ltd.

i Net worth of Bharat Refinaries Ltd. 1900


Credit Limit - 10% of Net Worth (Rs. 1900 lakhs * 10/100) 190

ii Net Working Capital of Bharat Refinaries Ltd. 150


Credit Limit -20% of Net Working Capital (Rs.150 lakhs*20/100 30

iii Maximum Credit Limit to any single Customer 100

Analysis: Bharat Refineries Ltd. May be allowed a credit limit of Rs.30 lakhs with constant
appraisal of it performance and financial position.