A merchant bank's toying with financial ratios

Merchant banks' functioning is multi-dimensional. They cater to unbridged gap between supply and demand of investible funds. The banks help enterprises in raising funds and investors to invest their money. In new securities offerings and managing funds, merchant banks play an important role. These are also referred as investment banks.
The role of a merchant banker is dynamic in the wake of diverse nature of services offerings. A merchant banker has to devise instruments of financing for commercial propositions in accordance with the requirements of his customers. Merchant banks do not accept deposits from the public like ordinary commercial banks.
The role of merchant banks in equities and debt instruments' private placements, market making, mergers, acquisitions and corporate structuring is pervasive. Also acting as underwriters of both listed and non-listed securities, the banks assist individuals, companies, institutions and governments in raising funds. The sales force of the banks call on high-net-worth investors to suggest trading ideas. To fit specific requirements, trading desks in merchant banks price and execute trade, structure new products.
Merchant banks operations extend beyond issue management to project and corporate counselling, portfolio management, consultancy on sick units, providing and procuring venture capital, leasing financing, trusteeship for instruments of redeemable capital, arranging international finances etc. At times, as divisions of commercial banks, non-banking financial institutions, financial and corporate consultants, merchant banking activities thrive.
A merchant bank in the US is subject to the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) regulations. In Pakistan they are under the discipline of Securities and Exchange Commission of Pakistan (SECP) in terms of Non-Banking Financial Companies Rules and Regulations (NBFIs Rules). In India, Securities and Exchange Board of India (SEBI) regulates these banks. The UK has the Securities and Investment Board (SIB), under the Financial Services Act, 1986, with wide powers to put in place fair practices on the part of all those engaged in investment or merchant banking business like stock brokers, jobbers, unit trust managers, life insurance agents, pension funds managers and financial consultancy.
In common day to day reference, terms like 'take-overs', 'mergers', 'amalgamations', 'acquisitions' etc are considered synonyms to exchange. Acquisitions and Mergers (AM) involve the transfer of an entire undertaking for shares of the transferee company-given in exchange to subsisting shareholders in the ratio of their holding. AM are strategic decisions that can introduce a paradigm shift of business. On rejuvenations of enterprises AM have volumes to tell. They help usher rejuvenation at a pace and volume internal developments would normally not. Of the activities merchant banks get into, AM is a core activity.
In the melee, as a matter of course, AM appear great on paper. However, the real test is after these are put in place, when people from different organisations collaborate to turn the plans into action and finally into results. Value is not created until after the combinations. Due to this, despite pressure for a quick secretive go that surrounds almost all AM decisions, managers of the game, which include consultants and advisers of the exercise, do not make their decisions lightly.
Financial statements present a condensed position of a date and summarised operating results for a period. Personal judgement is enshrined in financial statements with conventions in deciding:
--- A particular method or combination of methods to estimate depreciation, depletion, amortisation or provision for receivables no longer collectible.
--- Compile merchandise inventory figures.
--- Choose the method of inventory valuation for purposes of charge to cost.
--- Record certain expenditure as capital instead of revenue and vice versa.
Operations presented by financial statements are historical in nature which can hardly be used for analysis of segments and phases of business during the operating period. For an AM exercise relatively deeper information and segmental data, both with regard to financial position and operations would be called for. Financial Ratios are used to compare return relationships. Through these, risk and returns of different entities can be compared by investors and creditors. A merchant bank needs these to make intelligent investment and credit decisions. To gauge feasibility or efficacy of a proposition, merchant banks engrossed in AM exercises apply many tests, based on techniques drawn from different disciplines.
Analysis of financial ratios would always be there. The ratios categorised from different angles provide the profile of a company's economic properties, its strength and its operating, financial and investment characteristics. These normally are:
1. Activity analysis.
2. Liquidity analysis.
3. Term-debt and solvency analysis.
4. Profitability analysis.
Knowledge gained through accounting ratios is used to the end of:
--- testing efficiency of operations,
--- determining investment value of the enterprise concerned, and
--- deciding whether financial and operating policies, methods or practices should be continued or altered.
The process of evaluation can not possibly be reduced to inflexible arithmetical exercises. Too much reliance on mechanical means may not be good. All ratios or indicators have their limitations. Ratios do not always have something definite to say. Technical analysis may not be effective where capital is small.
Accounting ratios and equations do not have to be used in isolation. Judgement will have to be based on judicious discretion taking into account all the relevant factors. Such factors would include quality and integrity of the management, present and prospective competition and yield on a scrip comparable with share of the company being analysed. Not to be overlooked will be the possibilities of 'window dressing' of accounts being examined.
Going into financial ratios by merchant banks would also be with the viewpoint of exploring their alteration, given the identified 'dose of change' after AM. For example, the doers of an AM exercise would consider steps which go to alter the gross profit margin. They could look into reducing the operating profit percentage through pegging-up percentage allocations for marketing overheads by pushing-up incentives for the marketing force. This process may be to target increase in volume of operating profit.
An expert assisting an AM exercise cannot afford to ignore state of: production and marketing strategies; changing price levels; and fixed and variable costs complexions on profitability and financial health of the enterprise. He can not be oblivious of similar ratios obtaining in other (competitive) business concerns. It is study on this pattern which decides whether sales should be augmented, production pattern reshuffled and capacity should be increased to bring down cost, particularly fixed component of cost, and whether outside financing would be required to push-up the level of operations.
In the planning process prices and/or sorts of costs are projected at the desired points with a view to put in place machinery to achieve the targets.
Hereinafter are cited some ratios, projection of change in which may be in pursuance with an AM plan. What follows is neither a scientific outline for ratios modification nor enumerated are all the steps under each head. Engaging the attention of the AM team, this is listing of ideas for probe under each heading. This scribe is aware that information on a number of points hereinabelow, the AM team may not eventually be able to have.
Gross profit to sales
--- Whether service industry, industrial or commercial activity.
--- Graph of market share enjoyed by the entity.
--- Effect of changes in duties and taxes on gross profit margin.
--- Competitive strength of the company and obsolescence.
--- Stability of the company - % decline in sales to erode gross profit.
--- Reliance on associated/group companies for business.
--- Prospects of increase in gross profit margin.
--- Depreciation, depletion and amortisation methodology.
--- Weightage and segment to sales and gross profit.
--- Sensitivity associated with governmental policies.
--- Strategic depth of sales revenue.
--- Cyclical trends associated with business of the entity.
Operating profit to sales
--- Sensitivity of marketing overheads in relation to sales.
--- Efficacy of subsisting marketing-related incentives.
--- Trends of administration and marketing overheads ratio to sales.
--- Factors leading to variation in marketing expenses, fixed and variable components of marketing expenses.
Net profit to sales
--- Spread between operating and net profit margins.
--- Percentages of cash and credit sales in total sales and terms for credit sales.
--- Impact of increase or decrease of days allowed to pay for sale on credit.
--- Amount of interest against short-term borrowing charged to operations.
--- Net profit if there were no financial overheads.
Financial overheads as % sales and capitalisation
--- Purposes for which term loans utilised and such loans in the pipeline.
--- Term loans as percentage of fixed assets, cushion existing for further borrowing and impact of such borrowing on profitability.
--- Possibilities of utilisation of short-term loans as term loans and vice versa.
--- Impact of cash dividend in view of the related tax shield missing, particularly when the funds are borrowed for such payment
--- Chances of swapping between types/forms of financing.
--- Implications of further issue of instruments of redeemable capital/debentures.
--- Evaluating impact of:
--- decrease in credit sales.
--- increase in credit sales on financial overheads, cash flows and profit.
Profit after tax profit to equity
--- Characteristics of shares and instruments of redeemable capital issued:
(a). for consideration other than cash, wholly or partly.
(b). traded at a premium or discount.
(c). option for conversion or otherwise.
--- Tax concessions available or existing and timeframe for such availability.
--- Post re-organisations, reconstructions, amalgamations or changes otherwise in capital structure.
--- Current and previous liabilities included in tax computations and tax-related contingencies.
--- Impact of tax in relation to segment-wise profit.
--- Profit arising from normal operations and tax shields associated with different income categories.
--- Possible changes in accounting policies and their effect on profitability.
--- Tax holidays existing or possible and other tax incentives.
--- Deferred tax/tax rebates available and availed.
--- Claims on equity eg conversion of redeemable or preferred capital into ordinary shares, stock options to employees and right options released or to be released to shareholders.
--- Prospects for reduction in tax with change in corporate structure or presentation of tax information.
Earning per share
--- Past years' trend.
--- Past years' trend of other companies in the same business.
--- EPS of companies in general.
--- EPS with all financial overheads written back.
--- EPS with cost of long-term borrowings written back.
--- Major shareholders of the company, nature of their business and support flowing from them to the company.
--- Sensitivities associated with earnings - comparison with industry averages and impediment with removal of which earning could improve.
--- Effective rate of the company's EPS in view of right issues made and stock dividends declared.
--- High and low stock market quotations for shares and debentures of the company and their average prices during last six months.
--- Management's perception of risk factors.
--- Material contracts in force and in offing.
--- Review of capital available - additions or surplusage.
Debt equity ratio
--- Industry relevance:
--- Conventional or non-conventional industry.
--- Consumption goods or capital goods relevance.
--- Production or service industry, fragility associated with production and delivery.
--- Whether licence required for setting-up a project likewise and effective cost of licence.
--- Total loans in relation with total assets and assets under lenders' lien.
--- Sale prospects of assets and their estimated (sale) value in relation with the investment proposed.
--- Soundness of lenders, prospects of postponement/rescheduling/restructuring of debts.
--- Status of debt servicing.
--- Debt service coverage computation and determining debt servicing capacity.
Break-even
--- Break-even point in units and value AM.
--- Break-even point as % of enterprise's capacity subsisting and capacity utilised.
--- Investment required to lower the fixed cost per unit by:
--- Increasing capacity operations.
--- Upgradation etc of production process.
Current Assets
--- Complexion of current assets.
--- Characteristics associated with inventories forming current assets of the business:
--- Seasonal availability.
--- Perishability.
--- Obsolescence.
--- Price variation associated with purchase timings.
--- Storage cost and delicacies associated with storage.
--- Stocks consumption as % of cost and cost as % of sales.
--- Do the stocks consist of items of daily use? Whether the stocks are commonly traded and used.
--- Peculiarities with accounts receivables:
--- Uncollectibles as % of all receivables booked, position obtaining and trend in the past.
--- Cost of receivables collection as % of receivables booked.
--- Receivables' likely quantum when incentives are associated with sale against cash.
--- Availability of finance against receivables from commercial banks and otherwise.
--- Possibilities of securitization of receivables.
Short-term investments
--- Possibilities of conversion into spot cash, effectiveness of discount offer for early cash realisation and availability of credit against pledge of instruments of investment.
Current liabilities
--- Forms of availability of short-term credit and terms thereof.
--- Terms associated with accounts payable, implications of extension in the credit period and availability of credit for payables' settlement.
--- Instalments of term loans and interest forming part of current liabilities:
--- Debt servicing obligations as % of current liabilities and as % of resources generation.
--- Possibilities of down shift in impact of debt servicing.
(The writer is a corporate and sales tax counsel and is former chairman of ICAP and ICMAP Joint Committee and Development Banker)