Lending has been a way of life in India. It is routine for us to lend money to businesses run by our relatives, friends or their friends. However, many of us have also been burnt in the process. Whether you would like to lend again or not is your call. But if you do, a little research about the borrower can ensure better safety of your funds. Here are three essential things you should look at before lending. None of these require you to ask any details from the business itself:
- Financial strength: The financial health of the company over the last 3-5 years
- Leverage: Existing debt burden on the company
- Existing industry conditions: The health of the overall industry and its main players
In this part (1) of the article, we will discuss assessing the financial strength. Assessing the financials of a company is a nuanced field. These are a few things you can begin with:
- Operating revenues: Check if the operating revenues have grown or declined over the last 3 years? Growing revenues is definitely a comfort but do compare them with days receivables outstanding (DRO). DRO indicates the number of days for which the payment against sales is yet to be received. For example, if an SME has days receivables outstanding of 45 days, it means it is yet to receive payment against its 45 days worth of sales. So, if sales are increasing and so is DRO, then it raises suspicion on the quality of sales. Perhaps, they are low-quality sales made in desperation and payment is yet to be received (or might not be received). Or they could be a case of fake billing to inflate revenues to show a better picture to lenders and customers. The point being, DRO shouldn’t be increasing over time. On the other hand, declining revenues is obviously a sign of caution.
- Profit margins: Look at gross (sales – the cost of goods) and net (sales – all expenses and taxes) profit margins. Are they narrowing, stable or growing? Growing and stable margins is a comfort, however, do check days receivables outstanding. Narrowing margins need a little more research. Try to ascertain the reason for reducing margins by studying the expenses that have increased. You should also look at similar companies in the industry to check if it’s a company-specific concern or industry-wide concern. Any way, narrowing profit margins is a sign of caution.
- Major assets: Check the major assets owned by the company in its ‘fixed assets’ schedule provided in its balance sheet. Are these lands, buildings or plant and machinery for the operations? They should relate to the nature and size of the business. Compare them with other similar companies in the same industry to get an idea. This will give an idea of how efficiently is a company using its funds.
From where do you get the above details?
The financial filings of a ‘company’ can be sourced from the Ministry of Corporate Affairs. You can also source such filings and reports with important financial numbers like revenues, profits, ratios over the last 5 years from tofler.in. However, if it’s a partnership or individual business, then getting such details is almost not possible.