Financial Investments in BASIX - Research Paper Example

Financial Investments Table of Contents Introduction 1 Financial Ratios 3 Conclusion 12 Bibliographies 13 Introduction BASIX was founded in 1996, by Vijay Mahajan and mainly aimed at advancing loans to the rural poor who had very little access to the commercial banks for loans. They found the commercial loans very risky and the procedure of getting loans very tedious. BASIX came up with the idea of microfinancing where a group of farmers could take loan collectively and the risk quotient also was very low as it was divided among the entire group. Everyone stood liable equally for the repayment of debts. This idea was particularly liked by the farmers who had very little means to guarantee a repayment. Thus, BASIX took off its business starting its operations from the rural areas of Andhra Pradesh, India. Since, at the time it begun its journey, this idea was very unpopular in the country, so BASIX managed to bag its clients in over 4000 villages of Andhra Pradesh. But, BASIX besides indulging itself in advancing of loans also started offering other services to its clients like, various insurance products. Now, no insurance comes for free and requires a premium against it. But the poor farmers with a very little outlook were very skeptical about such offers and started demanding their premiums back after one year if the incident that is insured did not take place. The weather insurance project, initiated in 2001, for example had expected a huge popularity among farmers especially in a region where rainfall is very unpredictable. However, its utter failure rocked the bank. It had expected a huge turnover, but the reverse was found to be true as is clear from the ratio analysis done below. Financial Ratios Before making any financial investment decision, it is important for a firm as well as investors to evaluate the firm’s position, using financial ratio analysis. Financial ratios help not only in assessing a firm’s present financial condition, but also forecast its probable position in the future. The better the signals sent by the financial ratios about a firm’s position, the better are the investment decisions said to be taken by the firm. This paper tries to explore how far the investment decisions are feasible in the case of BASIX. The financial ratios use components from the income statement and the balance sheet of a firm for calculation. The various financial ratios along with their importance in judging a firm’s position is described below. 1. Short Term Solvency Short term solvency helps in finding out how far a particular firm is financially sound in the short run. Financial soundness implies a firm’s ability to avoid financial distress in the short-run. The more financially sound or liquid a firm is in the short run, the lesser is its chance of facing any financial distress. The financial soundness of a firm can be analysed through calculating the following ratios. (i) Current Ratio Current Ratio shows how far the firm is able to prevent any financial problem in the short run, which could crop up any time in a business. The higher the current ratio is the better is the firm’s position, since that would indicate that the firm’s current assets exceed its current liabilities and thus the firm is indeed in a position to pay off its current liabilities in the short run if the need arises. Here, Current Ratio = Total Current Assets, Loans and Advances / Total Current Liabilities and Provisions The best case is when the ratio is greater than 1. (ii) Quick Ratio Quick Ratio is a more advanced version of Current ratio and shows how far the firm is capable of paying off its liabilities immediately. For this reason, it excludes all those assets which although are receivable in the short run, but not immediately if the need arises. The term quick assets refer to all such assets In this case, Quick Ratio = Quick Assets / Total Current Liabilities and Provisions Where, Quick Assets = Current Assets, Loans and Advances – Net Loans Owned. Similar to current ratio, the higher the quick ratio is, the more financially sound the company will be. (iii) Liquidity Ratio Liquidity Ratio takes into account only quick liabilities, rather than current liabilities. Here, Liquidity Ratio = Quick Assets / Quick Liabilities where Quick Liabilities = Current Liabilities – Provisions for Taxes. This is because taxes need not be paid immediately, but only at the end of the current year. And Quick Assets are as described above. The higher the ratio is, the more liquid is the firm. 2001 2002 2003 2004 Current Ratio = 16.7301 13.58335 8.960403 6.919118 Quick Ratio = 3.518151 5.146709 1.71915 1.599204 Liquidity Ratio = 3.814154 5.456677 1.790732 1.83138 Position of BASIX The ratios that indicate short-term solvency for the firm are all above 1 for four years consecutively. This is a good indicator of the firm’s financial soundness in the short-run. All these ratios indicate that BASIX indeed is liquid enough to meet its immediate expenses and thus has a very low chance of getting bankrupt. However, the alarming fact is that, the ratios, although are quite high above 1, are falling over the years, thus implying that the firm’s capability to meet an immediate financial need is falling over the years. 2. Activity Activity of a firm implies how active a firm, i.e., how good a firm is in making its investment decisions, i.e., are the investments made by the firm really profit-earning ones or not. This factor too can be analysed through a number of ratios found by considering components from both the firm’s balance sheet and income statement. (i) Total Asset Turnover A high TAT indicates good activity on part of the firm. For BASIX, Total Asset Turnover = Total Income from Operations / Total Assets Where, Total Assets = Total Current Assets + Total Fixed Assets + Investments It shows how much income a firm is yielding for each unit of asset owned by it. (ii) Receivable Turnover = Total Operating Revenue / Total Receivables Receivable Turnover indicates the rate at which the firm’s borrowers are repaying back their loans. Hence, the better is the firm’s position since that would indicate that the firm’s borrowers are fast in repaying back their loans and thus, a very small proportion of the firm’s advanced loans are probable to become bad debts. In this case, Receivable Turnover = Total Operating Income / Total Receivables Where, Total Receivables = Net Loans Owned + Interest Receivable + Advances Recoverable. 2001 2002 2003 2004 Total Asset Turnover = 0.150042 0.111903 0.151281 0.189176 Receivable Turnover = 0.183657 0.192659 0.200714 0.242096 Position of BASIX The firm has not been making very good investment decisions over the years as is indicated by the ratios indicating the firm’s activity over the years. The ratios all are well below 1. Individually, from the Total Asset Turnover ratio, it is clear that the firm’s assets are not being able to yield enough revenue as it should ideally. Again, the low Receivables Turnover ratio indicates that most of the loans advanced by the firm turn out to be a bad debt. However, before making an analysis regarding the investment decisions that the firm takes, it must be kept in mind that BASIX is a microfinance institution operating in the rural parts of India. The people who they advance loans to are but poor farmers and most often they fail to repay back their loans. When BASIX started off, it did not intend to become a profit earning firm, but rather a purely experimental one that wanted to see the factors that the Indian farmers are most compatible to while deciding to take a loan. 3. Financial Leverage This ratio finds out how far a firm relies on debts to finance its investments. The higher the debts, the greater are the chances of facing financial distress. Again, the higher the equity, the more will be the number of share-holders and the more chaotic will be the situation. Thus, there must always be a balance. (i) Debt-Equity Ratio The value of this ratio shows the capital structure of a firm. In this case, Debt Equity Ratio = Total Loan Funds / Total Shareholders’ Share Capital The best possible situation is when the Debt-Equity ratio is just equal to or close to 1. For growth stocks, although this ratio is likely to be less than 1, since such firms depend more on venture capital that comes up through equity financing. However, BASIX is (ii) Debt Ratio This ratio shows the amount of debt-financing that a firm depends upon. In this case, Debt Ratio = Total Loan Funds/ Total Assets, where Total Assets = Total Current Assets, Loans and Advances + Fixed Assets + Investments. The higher the ratio is, the more a firm is dependent on loans from creditors and thus more is it prone to facing financial distress. (iii) Equity Multiplier It shows a firm’s dependence on equity financing. In this case, Equity Multiplier = Total Assets / Total Shareholders’ Share Capital where, Total Assets is defined as before. The higher the ratio is, the lesser is the firm’s chance of facing financial distress. (iv) Interest Coverage Whenever an investor takes loans he has to keep on making some interest payments at regular intervals of time. This ratio shows a firm’s ability to pay its interest expenses. In this particular case, Interest Coverage = Total Income / Interest on Borrowed Funds. Where, Total Income = Income from Operations + Income from Investments + Other Income. The higher the ratio is, the better is the firm’s position as the more capable the firm is in paying its interest expenses. 2001 2002 2003 2004 Debt-Equity Ratio = 3.527201 0.824210 0.818409 0.964164 Debt Ratio = 0.721708 0.416598 0.394985 0.400068 Equity Multiplier = 4.887295 1.978427 2.07199965 2.410003 Interest Coverage = 2.81558 3.183926 4.586009 5.654139 Position of BASIX From the ratios calculated above it could be ensured that the firm strongly depends on debt financing for its investment decisions. The debt-equity ratios over the years are quite high. Moreover, the debt ratio and equity-multiplier both are high as well implying that the firm is able to manage its investment decisions well, since each unit of debt (from debt ratio < 1) and each unit of equity (from equity multiplier > 1) yield more than 1 unit of assets. In fact, the firm’s higher dependence on debts is actually playing a major role in enhancing the asset position of the firm. The increasing dependence is implied by the debt-equity ratio growing higher and higher, and the rise in acquiring of asset per unit of debt is indicated by the falling debt ratio. Again, the firm is also able to pay back its interest expenses on the loans it has taken, as is signaled by the Interest Coverage Ratio which is well over 1, and is actually on a rise over the years. 4. Profitability (i) Profit Margin The profit margin is the true indicator of how profitable the firm is for investment. It is found with the help of the following ratios. Gross Profit Margin This shows the gross profit per unit of operating revenue earned. In this case, Gross Profit Margin = Total Income / Total Operating Income Where Total Income is defined as above. Higher the ratio is, it indicates that the firm profits more for each unit of revenue it is earning. Hence, it implies a better position for the firm. Net Profit Margin This shows the net profit per unit of operating revenue earned. In this case, Net Profit Margin = Total Profit / Total Operating Revenue Higher the ratio is, it indicates that the firm profits more for each unit of revenue it is earning, even after it has met all its expenses. Hence, it implies a better position for the firm. Gross Return on Assets This ratio shows the amount of gross income yielded by each unit of asset. In this case, Gross Return on Assets = Total Income / Total Assets Where, Total Assets has been defined before. The higher the ratio is, the better are the investment decisions made by the firm, indicating a more profitable business. Net Return on Assets This ratio shows the amount of net income yielded by each unit of asset. It is similar to gross profit margin with the only difference that this ratio takes care of the firm’s expenses as well. So, it could be said that this ratio is a better indicator of the firm’s position. In case of BASIX, Net Return on Assets = Total Profit / Total Assets Where, Total Assets has been defined before. The higher the ratio is, the more profitable are the firm’s investment decisions. (ii) Return on Equity Indicator This ratio is a good indicator of the sustainable growth rate of a firm. The sustainable growth rate of a firm depends upon its own performance and is deduced from the funds that the firm has in its hands. In case of BASIX, Return on Equity Indicator = Total Profit / Total Shareholders’ Share Capital The higher the ratio is, the more profit will each unit of equity capital yield. 2001 2002 2003 2004 Gross Profit Margin = 1.096649 1.090118 1.152326 1.085595 Net Profit Margin = 0.042937 0.051023 0.066778 0.033293 Gross Return on Assets = 0.164544 0.121988 0.174325 0.205369 Net Return on Assets = 0.006442 0.00571 0.010102 0.006298 Return on Equity Indicator = 0.031485 0.011296 0.020932 0.015179 Position of BASIX The firm’s net profitability is very low as is indicated by the net profit ratios. However, the gross profit ratios are well above 1, implying that the firm’s expenses are probably very high; in fact, the expenses are on a rise over the years, as is obvious from the falling net profit ratios. Again, the return to equity indicator also suggests that the firm’s profits are falling over the years. This is because, it has already been found from the rising debt equity ratio that more and more of the firm’s investments over the years are depending upon equity financing. So, it cannot be said that the firm’s capital raised from equity is rising. However, once again it must be noted that the firm is a non-profit-making institution and thus the ratios are at par with the firm’s objectives. Conclusion As was found practically, theoretically too the results from the financial ratio analysis indicate a poor progress of the firm over the span of four years that it had allowed the project to gain popularity among the people. The project came out to be one of the worst ones that the company had undertaken, with its expenses rising and profits falling over the years. The main reason why its expenses rose, were the increasing number of Customer Service Agents that it recruited to make the farmers understand the mechanism and the importance of the project. But, the farmers were very skeptical about it and did not want to take the plunge without the guarantee that they would be paid back their premiums if any oddities in the weather conditions did not affect the crops. Only 144 farmers in 4000 villages bought the weather insurance but the revenue from that was very poor and after paying away the expenses, the profits were negligible. This is what made the bank withdraw the scheme and continue with its microfinancing business. Bibliographies Troy Leo, 1983, Almanac of business and industrial financial ratios, Prentice-Hall Publishers. Read More