By Mukta Malhotra

Evaluating NBFCs is a different ballgame altogether. For, NBFCs are different from manufacturing companies. Cash is not only their raw material, but their finished product too.

The earnings of NBFCs come mainly from the interest spread between loans and borrowings. Spreads are influenced by loan losses and expenses. Fixed charge coverage ratios of NBFCs are thinner compared to those in manufacturing companies and are shown on an aggregate basis taking into account interest on all debts.

Spreads important
How important are spreads while evaluating NBFCs? Says Rajesh Mukherjee, general manager of the credit rating agency CARE: "Since NBFCs are financial intermediaries whose business is to borrow and lend, spreads are one of the important yardsticks."

A rider here. Spreads need to be looked in the context of risk profile and lending risks and returns should be compared. One should not only look at operating spreads, but net spreads of NBFCs as well. Net spreads represent the excess of return on capital over cost of capital. Says Mukherjee: "A high spread is not so much necessary. Even a small spread can be good enough."

Assets are another important area one should look into while assessing the strengths of an NBFC. For instance, CARE looks at the companies an NBFC has been lending to and the credibility of these corporate borrowers.

Provisions made for non-performing assets (NPAs) too need to be studied. It is essential to know whether an NBFC has been able to provide adequately for the non-performing risk in assets and whether such a risk provision has been charged to the Profit and Loss Account. In conjunction, it is necessary to look into the recovery ratios of NBFCs. Recovery ratio is actual recovery made during the year expressed as a percentage of total demand during the year. The ratio of fund-based business to fee-based business is another yardstick that should be looked at while analysing the strengths of NBFCs.

The CAMEL model
Most analysts and credit rating agencies go by the CAMEL model when it comes to evaluating NBFCs. The acronym: C stands for capital adequacy, A stands for asset quality and asset profile in the context of evaluating NPAs, M for management quality of the NBFC, E stands for earnings (spreads) and L for liquidity. As for how good the spreads are can be assessed using the ratio of operating costs to total assets ratio. Higher the operating cost, lower the spread.

CAMEL apart, asset-liability management (ALM) is also a vital indicator of an NBFC's fundamental strength. ALM analysis can throw up mismatches in an NBFC's balance sheet.

Not everyone is using the CAMEL model, though. For instance, RBI is using conventional ratios to track NBFCs and the regulator does not have any specific format for evaluating NBFCs. It is left to the discretion of the RBI inspectors to use a particular ratio while examining an NBFC.

However, RBI seems to be placing too much importance on the capital adequacy ratio of NBFCs. Says Durgesh Tinaikar, head of Societe Generale's Indian investment banking division: "Beside interest cover and asset cover ratios, profitability and liquidity ratios are more important for assessing NBFCs." Adds Thakkar of ALFS: "NPAs as a percentage of assets and the debt-equity ratio are two ratios vital in knowing the financial health of NBFCs." Fine. What is now needed is a set of NBFC indicators based on sources of funds, efficiency in the utilisation of funds, cashflows and deployment of funds.

Measuring credit-worthiness
Thanks to the fact that margins of NBFCs are under constant pressure, it is important to understand how NBFCs source their funds. For, the very survival of NBFCs depend on effective sourcing of funds. The yardstick bank loans as a percentage of owned funds. This yardstick shows the extent to which an NBFC has been able to leverage its assets to obtain bank finance and measures an NBFC's exposure to the banking system.

Since this parameter brings out the relationship of bank loans to owned funds, it can also tell an analyst whether an NBFC has been able to source finance cheaply and whether the NBFC depends on high-cost public deposits excessively. Thus, a higher bank loans to owned funds ratio certainly indicates the credit-worthiness of an NBFC. As a complement to this ratio, one should look at an NBFC's total deposits to working funds ratio. This ratio can tell an analyst the degree to which an NBFC has been able to leverage its assets to raise public deposits.

Measuring efficiency
Among the NBFC efficiency parameters, reported net profit to owned funds assumes greater significance. Provisioning norms are stiff for NBFCs and thus linking operating profit to owned funds would be a better indicator of efficiency. Other efficiency ratios that need attention are: reported net profit as a percentage of working funds.

It is also possible to assess the efficiency of a particular activity of an NBFC. For instance, how efficient are an NBFC's hire-purchase operations can be measured by the finance charges to working funds ratio. Likewise, efficiency of leasing operations can be assessed using the lease income to gross leased assets ratio. Says Tinaikar of Societe Generale: "Lease income to gross leased assets is a significant ratio for analysing an NBFC's strengths".

Another NBFC efficiency ratio whose importance cannot be underestimated is the interest spread to business volume ratio. This indicator tells an analyst whether an NBFC is able to source funds cost-effectively and deploy the funds profitably. This ratio can also tell whether an NBFC has a healthy balance between values and volumes. Says Tinaikar of Societe Generale: "This ratio is important as it indicates the interest-earning component of an NBFC." The interest-earning potential apart, asset-liability management is also critical for the survival and success of an NBFC. An NBFC just cannot afford to be careless with its cashflow.

Meanwhile, short-term solvency of an NBFC can be assessed applying the current liabilities and provisions to owned funds ratio. The cashflow of an NBFC can be assessed by expressing non-cash charges as a percentage of total expenses. A higher ratio here would mean low cashflows and more cash retained for replacement of assets.

Assessing vulnerability
Fund-deployment pattern can tell a lot about the health of an NBFC. That is why the ratio business volume to working funds is important. This ratio can show how vibrant and diversified a company's operations are.

The ratio that relates an NBFC's fund-based business to fee-based business can tell how good an NBFC is as far as deployment of funds is concerned. This ratio can also tell whether an NBFC is vulnerable. For, fund-based business brings along vulnerability: fund sources might dry up, cost of funds might shoot up and public deposit norms might be made more stringent. Anyway, fund-based business is very competitive.

Assessing NPAs too is necessary to gauge the strength of an NBFC. So, it is prudent to use the accounts receivable to business volume ratio to know how good the receivables are, how good are the NBFC's recovery systems and whether the NBFC has an excellent account receivable management in place.

The net NPA ratio which expresses NPA net of provisions to total advances net of provisions too is important in understanding the soundness of accounts receivable management of the company. This ratio can tell an NBFC's top management whether debt restructuring is needed.

The critical tax shelter ratio can tell how efficient an NBFC's leasing operations are. Says Tinaikar of Societe Generale: "Tax shelter, which is the excess of profit before tax over profit after tax, is an important tool to analyse NBFCs."

Tax shelter can be expressed as a percentage of business volume or profit before taxes. Tax shelter has a unique significance for NBFCs and it can tell how efficient the tax planning exercise of the NBFC concerned is and how tax-effectively the NBFC has diversified.