Pre-empt distress in loan accountsIdentifying and managing early signalsFor private circulation onlyJune 2020

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IntroductionIn the recent years, banking sector in India has seen a rise in Non-performing Assets (NPAs) due to various reasons, including economic churn in certain sectors, limited ability of the bank to detect potential repayment failures in the loan portfolio, and rising corporate fraud and insolvencies. The onset of the COVID-19 pandemic is expected to further negatively impact the NPA position in banks.

Moody’s has downgraded India’s growth to 0.2 percent in 2020 after the continuation of the COVID-19 lockdown1. Stock market prices have plunged and there is an atmosphere of fear and anxiety amongst business. Per a survey conducted in March 2020, by the Federation of Indian Chambers of Commerce and Industry2, more than 50 percent of Indian companies have seen a slowdown in their operations and nearly 80 percent have witnessed a decline in cash flows.

Due to the lockdown, many businesses may face a zero-revenue situation, which might have an impact on their ability to service loans. In this situation companies might turn to banks for fresh loans or existing loan extensions. Some companies may resort to

seek further funding through misstated performance or even file for bankruptcy in a worst case scenario. Considering the banking sector is already grappling with significant proportion of NPAs3, alongside ballooning insolvency cases4, banks need to exercise greater caution while monitoring or sanctioning new loans.

In this regard, the Reserve Bank of India’s (RBI) working paper dated December 2016 has mentioned about the use of financial ratios to evaluate the corporate financial distress of companies. Additionally, the Institute of Chartered Accountants of India’s (ICAI’s) Guidance note on ‘Early Signals of Fraud in Banking Sector5’ also mentions continuous monitoring through tracking of certain early warning signals to pre-empt suspicious behaviours and take action before it is too late.

However, to predict some of these behaviours in advance, banks need to be adept at not only identifying signs of potential risks and accounting ratios but also watch out for the risk signals embedded in information outside of financial statements. This document shares some perspectives on how banks can relook at their fraud risk management efforts to better manage their NPAs.

1. https://m.economictimes.com/news/economy/indicators/moodys-slashes-india-growth-forecast-to-0-2-per-cent-for-2020/articleshow/75432876.cms

2. https://economictimes.indiatimes.com/news/economy/indicators/coronavirus-impact-over-50-of-india-inc-sees-impact-on-ops-80-witness-fall-in-cash-flow/articleshow/74726229.cms?from=mdr

3. Non-performing assets (NPA) of public sector banks amounted to INR 7.27 lakh crores as on September 2019. Source - https://economictimes.indiatimes.com/industry/banking/finance/banking/bad-loans-of-public-sector-banks-fall-to-rs-7-27-lakh-crore-at-end-of-sept-2019-nirmala-sitharaman/articleshow/74063961.cms?from=mdr

4. The number of cases admitted to the Corporate Insolvency Resolution Process (“CIRP”) under the IBC is 2542 as on September 2019. Source - https://www.ibbi.gov.in/uploads/publication/cff2db5cfaa42ed5aad9544b04bfac8b.pdf

5. Source - http://kb.icai.org/pdfs/PDFFile5b278991dfbc20.26638858.pdf

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Approaches for banks to identify signs of early distress in loan accounts

Leveraging available dataBanks are in a unique position when it comes to the nature and quantum of information available with them pertaining to their asset portfolio or borrowers. This information can be leveraged while monitoring and making estimates on future loan behaviour or taking a decision to extend credit. Some metrics and analyses that may be relied upon include the following:

01. Comparative analysis of financial statements - Multiple techniques incorporating all components of the financial statements involving assets, liabilities, expenses, and income can be used. i. Vertical analysis involves analysing the relationship

amongst the items of profit and loss statement, balance sheet or cash flow statement by expressing components as percentages of a specified base value. For example, change in other expenses as a percentage of sales may be an indicator of overstatement of profits. Similarly, change in debtors as a percentage of total assets may help in determining the inflated sales of the previous year.

ii. Horizontal analysis involves analysing the percentage change in individual line items of financial statements from one period to the next (year-on-year). Such analysis can monitor an entity’s financial health over a period of time and may provide valuable insights into the strategy and focus of the entity. For example, an increasing payroll cost may be suggestive of expanding operations when looked at together with other metrics like sales, etc.

02. Ratios analysis - Ratio analysis involves measuring the relationship between two different components of the financial statement. i. Traditional Ratios involve analysing one component of the

financial statement with another. Some of the financial ratios that are frequently in use and also recommended by the RBI6 for evaluating corporate distress are mentioned as follows:

• Long-term liability to total assets ratio represents the proportion of a company’s assets financed with long-term liabilities (i.e., debt). The ratio helps to understand how leveraged the company is. Higher value of the ratio indicates higher risk for the company, and consequently

6. RBI Working paper series (WPS (DEPR):10/2016) on “Modelling Corporate Sector Distress in India” of December 2016

Quantitative analysis

Approaches for banks to identify signs of early distress in loan accounts

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7. The Beneish M-Score is a weighted average of the following eight ratios - days’ sales in receivables index, gross margin index, asset quality index, sales growth index, depreciation index, sales, general and administrative expenses index, total accruals to total assets and leverage index.

8. The Altman Z-Score is a weighted average of the following five ratios - working capital to total assets ratio, retained earnings to total assets ratio, earnings before interest and taxes to total assets ratio, market value equity to book value of total liabilities ratio and sales to total assets ratio.

the bank.

• Operating profits to total liability ratio represents the funds from operations available to the company as compared to the total liabilities. It is a measure of the operating performance of the company. Lower value of this ratio indicates delays in making operating payments by the company.

• Current assets to current liabilities represent a company’s ability to meet present obligations from its liquid assets. It is an indicator of short-term solvency. Lower value indicates poor solvency condition. Banks can use this data, in conjunction with other data, to assign risk ratings to the company.

ii. Beneish M-Score7 and Altman Z-Score8 - Though

established, but less frequently used models, they provide an indicator as to whether a company has manipulated its earnings and whether a company is headed for insolvency, respectively. Both these scores are a combination of many ratios that have been given weights to arrive at a score, making it a more reliable method compared to traditional ratio analysis that considers only individual ratios.

An M-Score higher than -2.22 (i.e., a less negative or positive number) shows a probability of profit manipulation. A Z-Score lower than 1.81 shows that a company is in distress with a higher probability of going bankrupt.

We tested both the ratios for 10 random sample companies, which went into insolvency per the Insolvency and Bankruptcy Code (IBC) in 2016. It was observed that the Z-score for all 10 companies calculated two years prior to filing for insolvency was in the ‘distress zone’, i.e., below 1.81. The M-score for six out of these ten companies was more than -2.22 when tested for one or more years in a three-year testing period.

Most of the times, one tends to focus only on financial indicators to ascertain risk, whereas qualitative factors are also equally important. Publically available information, such as auditors’ reports, news articles, market surveys, etc., can also be leveraged while evaluating the performance of a company. One of the factors that can be evaluated is capital market forces, i.e., downgrading of rating done by credit rating agencies, inability to meet listing requirements of SEBI, litigation with private equity shareholders, etc. These adverse capital market forces point towards issues in raising capital and the ability of the company to repay its debts.

Another important qualitative consideration is judgmental accounting. This approach considers other data available with banks, such as periodic debtors’ stock statements, stock audits, receivables audit, site visits, banks statements, projected data, etc., to seek early warning signals. These aspects can point towards financial statements that are likely to be misleading.

Qualitative factors

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Approaches for banks to identify signs of early distress in loan accounts

Identifying the potential fraud risks It is pertinent to note that no individual indicator or analysis can help in identifying a bad-loan problem or a risky portfolio. All of these must be taken into account together to develop an early warning system. Some common fraud risks identified by a combination of one or more of such factors are illustrated below:

Revenue recognition fraud in which sales are inflated by recording them prematurely, and these can be correlated with the following:

• Rapid growth in sales or profitability as compared to previous year using horizontal analysis

• Recurring negative cash flows from operation as compared to previous years using horizontal analysis

• Unusually high receivables turnover ratio due to the increase in sales much more than actual receivables

• Unusually high inventory turnover ratio as the inventory can still be lying unsold

Inventory manipulation Cases where the inventory has been manipulated can be seen from:

• Decrease in the cost of goods sold as a percentage of sales due to increase in closing stock as per the vertical analysis,

• Upward trend in the inventory as compared to previous years without corresponding increase in sales or debtors from the horizontal analysis,

• Unusual decrease in the inventory turnover ratio due to increase in inventory more than sales,

• Irregular upward trend in the gross profit margin,

• Unusual increase in the inventory to total assets per the vertical analysis, etc.

Understatement of expenses particularly done to increase profits can be understood by observing:

• Decrease in expenses trend recorded over the years along with corresponding increase in sales per the horizontal analysis,

• Increase in non-current assets to total assets per the vertical analysis as companies may capitalise some expenses instead of writing them off,

• Negative or declining cash flows per the horizontal analysis,

• High return from capital employed, etc.

Approaches for banks to identify signs of early distress in loan accounts

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Way forwardIn such times of economic and financial distress, continuous monitoring of companies is of crucial importance for banks and other creditors including resolution professionals appointed under IBC, 2016, for the purpose of transaction review. The application of such consolidated analysis involving both quantitative and qualitative factors may possibly point to companies entering a

decline stage. Timely action by banks on rationalising their portfolio based on this information can help reduce NPAs. While the future performance of companies cannot be ascertained accurately, the approaches detailed in this document can help banks in identifying the warning signals early thus, allowing more time to take remedial action.

In addition to the potential fraud risks that can be identified, some of the trend analysis performed over the years can also point towards potential insolvency. These include qualitative analysis of industry trends, decline in operating cash, payables days’ ratio, and increase in leverage and borrowings.

Forensic financial analysis of all early warning signals needs to be performed simultaneously instead of only analysing the position of the company on the basis of one adverse ratio or movement in the financial statements.

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Acknowledgement

Contacts

We would like to acknowledge the contribution of Devanshi Sachdeva in this document.

Nikhil BediPartner and LeaderForensic – Financial Advisorynikhilbedi@deloitte.com

Sumit MakhijaPartnersumitmakhija@deloitte.com

Karthik KVPartnerkvkarthik@deloitte.com

Nishkam OjhaPartnernojha@deloitte.com

Aparna GuptaDirectorapagupta@deloitte.com