Financial Analysis of Hero Honda

————————————————- Financial analysis of hero honda Submitted By: Luke Thachet [F10026] PraneetaSaboo [F10040] Ruth Sequeira [F10049] Shruthi S [F10052] ACKNOWLEDGEMENT We would like to express our sincere gratitude to Mr. Dwarakanathan for guiding us through to understand the concepts of Commercial and Retail Banking. We would also like to thank him for his constant support that he offered for the successful completion of this project. Working on this project has helped us gain insights into the Automobile Industry. It also aided us in the practical application of the concepts covered in academics.

Table of Contents ACKNOWLEDGEMENT1 OVERVIEW OF THE COMPANY2 ABSTRACT2 1. CREDIT RISK ASSESSMENT2 1. 1. STAGE I: FINANCIAL RATIOS2 1. 1. 1. Current Ratio:2 1. 1. 2. Total Outstanding Liabilities to Total Net Worth:2 1. 1. 3. EBDIT to Interest Coverage Ratio:2 1. 1. 4. PAT to Net Sales:2 1. 1. 5. Return On Capital Employed:2 1. 1. 6. (Inventory + Receivables)/ Sales:2 1. 2. STAGE II: HISTORICAL COMPARISON2 1. 3. STAGE III: INDUSTRY COMPARISON2 1. 4. STAGE IV: CONTINGENT LIABILITIES2 1. 5. STAGE V: INDUSTRY RISK2 1. 5. 1 Competition & Market Risk:2 1. 5. 2. Industry Cyclicality:2 1. 5. 3.

Regulatory Risk:2 1. 5. 4. Technology & Quality Control:2 1. 5. 5. User Profile:2 1. 5. 6. Inputs Profile:2 1. 6. STAGE VI: MANAGEMENT RISK2 1. 6. 1. Integrity:2 1. 6. 2. Expertise, Competence/ Commitment:2 1. 6. 3. Track Record:2 1. 6. 4. Structure and Systems:2 1. 6. 5. Capital Market Perception:2 1. 7. STAGE VII: TOTAL COMPUTATION2 2. NEW MODEL2 2. 1. RELEVANT RATIOS FOR MANUFACTURING COMPANIES2 2. 1. 1 CAPITAL STRUCTURE OF THE COMPANY2 2. 1. 2. INTEREST COVERAGE2 2. 1. 3. DEBT SERVICE COVERAGE RATIO2 2. 1. 4. PROFITABILITY MARGIN2 2. 1. 5. RETURN ON CAPITAL EMPLOYED2 2. 1. 6. CURRENT RATIO2 . 1. 7. FIXED ASSET TURNOVER RATIO2 2. 1. 8. INVENTORY TURNOVER RATIO2 2. 1. 9. OPERATING MARGIN2 2. 1. 10. DEBTORS TURNOVER RATIO2 2. 1. 11. OPERATING CASH FLOW TO LONG TERM DEBT2 2. 2. RATING CRITERIA FOR MANUFACTURING COMPANIES2 2. 2. 1. BUSINESS RISK ANALYSIS2 2. 2. 2. INDUSTRY RISK2 2. 2. 3. GOVERNMENT POLICIES2 2. 2. 4. MARKET POSITION2 2. 2. 5. OPERATING EFFICIENCY2 2. 2. 6. TECHNOLOGY2 2. 2. 7 ACCESS TO RESOURCES2 2. 2. 8. PRICE VOLATILITY OF KEY RAW MATERIAL/INPUTS2 2. 2. 9 HUMAN RESOURCES2 2. 2. 10. CAPACITY UTILIZATION AND FLEXIBILITY2 2. 2. 11. LEVEL OF INTEGRATION2 2. 2. 12.

ACCOUNTING QUALITY2 2. 2. 13. ADEQUACY OF CASH FLOW2 2. 2. 14. FINANCIAL FLEXIBILITY2 2. 2. 15. MANAGEMENT RISK ANALYSIS2 2. 2. 16. PROJECT RISK ANALYSIS2 2. 3. METHODOLOGY FOR SCORING2 2. 4. CALCULATIONS:2 2. 4. 1. FINANCIAL PARAMETERS:2 2. 4. 2. NON-FINANCIAL PARAMETERS:2 CONCLUSION:2 OVERVIEW OF THE COMPANY Hero Honda Ltd. is the world’s largest manufacturer of two – wheelers, based in India. In 2001, the company achieved the coveted position of being the largest two-wheeler manufacturing company in India and also, the ‘World No. 1’ two-wheeler company in terms of unit volume sales in a calendar year.

Hero Honda Ltd. continues to maintain this position till date. The story of Hero Honda began with a simple vision – the vision of a mobile and an empowered India, powered by its bikes. Hero Honda Ltd. , company’s new identity, reflects its commitment towards providing world class mobility solutions with renewed focus on expanding company’s footprint in the global arena. Hero Honda’s mission is to become a global enterprise fulfilling its customers’ needs and aspirations for mobility, setting benchmarks in technology, styling and quality so that it converts its customers into its brand advocates.

The company will provide an engaging environment for its people to perform to their true potential. It will continue its focus on value creation and enduring relationships with its partners. Hero Honda’s key strategies are to build a robust product portfolio across categories, explore growth opportunities globally, continuously improve its operational efficiency, aggressively expand its reach to customers, continue to invest in brand building activities and ensure customer and shareholder delight. Hero Honda two wheelers are manufactured across three globally benchmarked manufacturing facilities.

Two of these are based at Gurgaon and Dharuhera which are located in the state of Haryana in northern India. The third and the latest manufacturing plant is based at Haridwar, in the hill state of Uttrakhand. ABSTRACT This project entails seven important steps: The first step is to calculate the six key ratios including Current Ratio, Total Outstanding Liability to Total Net Worth, Profit Before Depreciation Interest and Tax to Interest, Profit After Tax to Net Sales, Return On Capital Employed and Inventory with Receivables to Sales.

The second step is Historical Comparison where the average for 3 to 5 years is calculated for the above mentioned ratios and the current financial year’s ratios are compared to the calculated averages. The third step is where we compare the company’s ratios with the Industry Averages. Industry Averages are published in prowess are can be calculated by taking the average of ratios for 5 or more companies in the industry. The fourth step to analyse how the company’s Contingent Liability will affect the Net Worth of the Company.

Disputed Taxes, Claims against the Company and Counter party guarantee given by the company are taken as Contingent Liabilities. The fifth step is measuring the Industry Risk faced by the company. Factors like Competition and Market Risk, Industry Cyclicality, Regulatory Risk, Technology and Quality Control, User Profile and Inputs Profile are taken into account. The sixth step is the measurement of Management Risk faced by the company. Factors including Integrity, Expertise, Competence/ Commitment and Track Record are taken into account for this measurement.

The seventh and the final step entail the calculation of the total score for the company following the above mentioned six steps. For calculating the total score the Financial Score, Industry Risk Score and the Management Risk scores are pooled together to get a total of 100. Further a new model was developed and comparison was made. 1. CREDIT RISK ASSESSMENT 1. 1. STAGE I: FINANCIAL RATIOS Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company’s financial statements. Careful financial analysis usually means the extraction of meaningful ratios from the statement.

Ratios are often used to assess performance or as diagnostic tools to point up potential problem areas. Given the extremely varied entities for which financial statements are made and even the extreme variation between industries of an entity type the most productive use of these ratios is probably made either against industry standards or against ratios for previous years of the entity in question. As mentioned in the Abstract, there are six main ratios which this project throws light on. But for the calculation of these ratios we need to weed out some of the figures from the financial reports of the company.

The following table represents the data that has to be used in order to calculate to necessary ratios: [Values in Rs. Crores] S. NO| VALUES| 2010| 2009| 2008| 2007| 1| CURRENT ASSETS| 6,033. 68| 2,514. 70| 2186. 67| 2296. 62| 2| CURRENT LIABILITIES| 4864. 73| 2065. 36| 1878. 25| 1512. 33| 3| TL| 185. 46| 2,274. 44| 2,139. 83| 1,807. 08| 4| TA| 8,659. 29| 6,124. 67| 5,134. 43| 4,292. 13| 5| TNW| 8,473. 83| 3,850. 23| 2,994. 60| 2,485. 05| 6| PBDIT| 3,025. 30| 1,964. 65| 1,572. 60| 1387. 49| 7| INTEREST| 2. 1| 2. 53| 2| 1. 61| 8| PAT| 2,231. 83| 1,281. 76| 967. 88| 857. 89| 9| NET SALES| 15,758. 18| 12,319. 2| 10,331. 80| 9,899. 96| 10| EBIT| 2833. 83| 1783. 99| 1412. 28| 1247. 71| 11| FA| 1,706. 92| 1694. 25| 1548. 7| 1355. 45| 12| TNW-FA| 6,766. 91| 2,155. 98| 1,445. 90| 1,129. 60| 13| INVENTORY| 390. 29| 308. 5| 252. 23| 257. 8| 14| RECEIVABLE| 108. 39| 149. 94| 297. 44| 335. 25| 15| INV+REC| 498. 68| 458. 44| 549. 67| 593. 05| The above mentioned values are that of the corresponding years for which ratios are to be calculated. These are further used to calculate the ratios. The various ratios for the 4 years are as follows: S. NO| RATIO CALCULATED| 2010| 2009| 2008| 2007| 1| CURRENT RATIO| 1. 2403| 1. 2176| 1. 642| 1. 5186| 2| TOL/TNW| 0. 0219| 0. 5907| 0. 7146| 0. 7272| 3| PBDIT/INTEREST| 1440. 6190| 776. 5415| 786. 3000| 861. 7950| 4| PAT/NET SALES| 14. 1630| 10. 4046| 9. 3680| 8. 6656| 5| ROCE| 0. 4188| 0. 8275| 0. 9767| 1. 1046| 6| (INVENTORY+RECEIVABLES)/SALES| 11. 5507| 13. 5830| 19. 4186| 21. 8651| INTERPRETATION 1. 1. 1. Current Ratio: The ratio is mainly used to give an idea of the company’s ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations.

A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt – as there are many ways to access financing – but it is definitely not a good sign. The current ratio can give a sense of the efficiency of a company’s operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations.

The formula used for calculation is: 1. 1. 2. Total Outstanding Liabilities to Total Net Worth: This is a measure of the extent that the net worth of the enterprise can offset the liabilities (Total Liabilities / Liabilities + Equity). A ratio greater than 1. 0 should be avoided since it indicates that the creditors have a greater stake in the business than the owners. 1. 1. 3. EBDIT to Interest Coverage Ratio: A ratio that is used to assess a company’s financial durability by examining whether it is at least profitable enough to pay off its interest expenses or not.

A ratio greater than 1 indicates that the company has more than enough interest coverage to pay off its interest expenses. The formula used for calculation is: 1. 1. 4. PAT to Net Sales: This is nothing but the Net Profit Margin which talks about how much profit is made by the company for every Re. it generated in revenue or sales. Profit margins vary by industry, but all else being equal, the higher a company’s profit margin compared to its competitors, the better. 1. 1. 5. Return On Capital Employed: A ratio that indicates the efficiency and profitability of a company’s capital investments.

ROCE should always be higher than the rate at which the company borrows, otherwise any increase in borrowing will reduce shareholders’ earnings. The formula used got calculation is: 1. 1. 6. (Inventory + Receivables)/ Sales: This ratio shows the proportion in which the inventory and receivables are realised through sales. This ratio is somewhat similar to Days Sales Outstanding only that there the measure is to find out how quickly the cash invested can be realised in order to invest the returns in other available avenues. The Formula used for calculation is . 2. STAGE II: HISTORICAL COMPARISON The historical ratio analysis has been based on the balance sheets for the financial years 2006-07, 2007-08, 2008-09, and 2009-10. The various ratios have been calculated for each of these 4 years. The ratios of year 2009-10 were compared with the average of each ratio of the remaining 3 years. The ratios are as shown in the table below: RATIOS| 2010| AVG OF 3 YRS| COMPARISION| SCORE| CURRENT RATIO| 1. 2403| 1. 3001| 0. 0598| 0| TOL/TNW| 0. 0219| 0. 6775| 0. 6556| 2| PAT/NET SALES| 14. 1630| 9. 4794| -4. 6836| 2|

INVENTORY+RECEIVABLES/SALES| 11. 5507| 18. 2889| 6. 7382| 1| TOTAL SCORE|  |  |  | 5| Of the six ratios we calculated in the first stage we make use of four essential ratios to make the historical comparison. The weightage for each of these are equal and we take it as 1. The maximum score that each ratio can receive is 2 and thus the total maximum marks that can be awarded in the Historical Comparison exercise is 8 only. Depending on the range of difference between the current year and the average of the previous years, 0, 1 or 2 marks are awarded to the ratio. Here as we can see the current ratio which is the first ratio considered has gone down but the difference is only 0. 0598 which is not a significant change. Thus 0 is awarded. * The second ratio that is taken into account is Total Outstanding Liabilities to Total Net Worth, which has to be kept low. In this case the ratio has come down by a huge difference which is in the order of 97%. Thus the maximum score of 2 is awarded. * The third ratio which is Profit After Tax to Net Sales which has to improved year on year has shown a negative comparison value. This means that the ratio has gone up by close to 50%.

Thus the maximum score of 2 is awarded. * The last and the final ratio is (Inventory + Receivable)/ Sales which has been awarded a score of 1. The total score received by the company in Historical Comparison if 5 out of maximum 8 which shows that the company has been doing fairly well. 1. 3. STAGE III: INDUSTRY COMPARISON The third and the crucial stage is the Industry Comparison where the position of the company is gauged with respect to the competitors in the market. Here the ratios for the main competitors like Bajaj Auto, TVS Motors, Mah Scooters and Scooters India are taken and the average is calculated.

Then Hero Honda’s ratios are compared to the industry averages to and scores are allocated for each ratio. A maximum of 2 can be allocated to each ratio. Since there are 4 ratios a total maximum score of 8 can be allocated to in this stage. The table below shows the industry average of the different ratios, the comparison and the scores allocated: INDUSTRY COMPARISION| 2010| INDUSTRY AVG| COMPARISION| SCORE| CURRENT RATIO| 1. 2403| 1. 1642| -0. 0761| 2| TOL/TNW| 0. 0219| 0. 6710| 0. 6491| 2| PAT/NET SALES| 14. 1630| 8. 1475| -6. 0155| 2| INVENTORY+RECEIVABLES/SALES| 11. 5507| 25. 6874| 14. 367| 1| TOTAL SCORE|  |  |  | 7| * The first ratio that is taken for comparison with the industry average is the Current Ratio which is slightly higher than that of the industry average. Thus a score of 2 is given. * The second ratio is Total Outstanding Liabilities to Total Net Worth. As mentioned before the lower the ratio the better it is for the company’s financial health. As compared to the industry’s average, this ratio is very low. Thus the maximum score of 2 is allocated for this ratio. * The third ratio is Profit After Tax to Net Sales which has to be high to deliver maximum benefits to the investors.

As compared to the industry average this ratio is high and thus the maximum score 2 is allotted to this ratio. * The last ratio is Inventory + Receivables to Sales. This ratio is lower compared to the industry ratio and thus a score of 1 is allocated. The total score allotted to Hero Hondas is 7 out of 8 which again shows that the company is performing well in the industry as compared to its competitors. This stands proof to the fact that Hero Honda is a market leader and without the company’s numbers the Indian Two- Wheelers Industry’s Growth would have been marginal. 1. 4. STAGE IV: CONTINGENT LIABILITIES

Contingent liabilities are only considered which might affect the net worth of the company. For eg; disputed taxes, any claims against the company, counter guarantees given by the company. In case of Hero Honda, the only such contingent liability the company has is against excise matters which are subjected to legal proceedings in the normal course of their business. CONTINGENT LIABILITIES|  Rs. (cr)| TNW| % of TNW| In respect to excise matters| 13. 72| 8,473. 83| 0. 161910258| However it can be seen that the contingent liability is only 0. 162% when compared to the total net worth of the company. Since the percentage is far ore less than 1%, we need not deduct any marks for the same. Therefore the score given is 0 (max score is -10). 1. 5. STAGE V: INDUSTRY RISK There are six parameters which are prevalently used to measure the Industry Risk posed on any company. These parameters include: Competition and Market Risk, Industry Cyclicality, Regulatory Risk, Technological and Quality Control, User Profile and Inputs profile. Each parameter is given 4 fours and thus a maximum of 24 marks can be assigned to this risk. The table below shows the scores allocated for each parameter and the total score given to the company: INDUSTRY COMPARISION| SCORE|

Competition & Market risk| 4| Industry Cyclicality| 4| Regulatory Risk| 3| Technological & Quality Control| 4| User profile| 4| Inputs profile| 3| TOTAL SCORE| 22| MAX SCORE| 24| 1. 5. 1 Competition & Market Risk: There are few large market players in the industry like Bajaj and TVS. But, at the same time Hero Honda is a well established brand for over two and a half decades and leads both in the domestic two wheeler industry and motorcycle segments with the shares of nearly 48% and 59% respectively.

The company has a record sale of million units in each quarter and has notched its highest-ever annual revenues, EPS and operating income in the year 2009-10. * 23. 6% growth in sales; from 37,22,000 two wheelers in 2008-09 to 46,00,130 in 2009-10. * 28. 1% increase in total turnover; from 12,565 crores to 16,099 crores. * 74. 1% growth in PAT; to 2231. 83 crores. It has a wide spectrum of bikes; Passion, Passion Plus, Splendor, Super Splendor, Glamour, Hunk, CBZ, Karizma to name a few. It has more than 50 vendors who are connected online.

A high cost of developing production facilities, limited accessibility to new technology and soaring competition can be considered as some of the main entry barriers into the industry. The score thus given is 4. 1. 5. 2. Industry Cyclicality: The long term prospects of the industry are excellent with the two wheeler industry is supposed to easily sustain a growth of 10% and more over the next 10 years. The industry has also had fairly stable industry cycles except for the recession times. The score thus given is 4. 1. 5. 3. Regulatory Risk: In the various policies of govt. inistries, no specific guidelines for two wheelers are mentioned. Two wheelers infact have benefits in terms of road space, cost, mobility and release of green house gases. However, safety, emissions and equality of the problems associated with two wheelers need to be addressed. All the environmental related clearances have been obtained and are updated regularly showing Hero Honda commitment to environment. The Dharuhera-Gurgaon industrial belt remains restive and prone to external influences. IR disruptions, especially during peak season, are a source of concern.

Otherwise, there have been harmonious labour relations at Hero Honda and more or less operations have not been hampered by lack of skilled labour. The score thus given is 3. 1. 5. 4. Technology & Quality Control: Globally benchmarked, state of the art manufacturing facilities, is deployed in the manufacturing segment which maximizes the capacity utilization too. A number of IT initiatives, operational efficiency improvement systems and ISO patents relating quality control taken prove that the company is driven towards best technological and quality control practices.

The score thus given is 4. 1. 5. 5. User Profile: The company has wide area of operations with a customer base of more than 30 million, over 4500 customer touch points and widespread reach in over 100,000 villages. However, there have been consumer complaints (about delivery, quality, servicing, showrooms etc. ) and the company on year to year basis based on total sales and past experience of warranty claims made but puts aside provision for the same but when compared to the total sales it comes up to less than 0. 5% of the total sales of the company.

The product is not season specific and has wide acceptance and usage. The score thus given is 4. 1. 5. 6. Inputs Profile: Raw materials are generally available with more or less steady prices. The company, however, has critical tie ups with suppliers for some parts. There is also additional pressure on supply chain to make quick ramp in a growth market without compromising the supply quantity and quality. The score thus given is 3. The weightage for all the parameters is equal and we take it as 1. For Hero Honda the total score allocated is 22 out of 24.

This shows that the company faces a high level of Industry Risk and must always be on their toes to maintain the edge they have over their competitors. 1. 6. STAGE VI: MANAGEMENT RISK Just like in Industry Risk, Management Risk also has five prominent factors that are used to gauge the level of risk faced by the company. These parameters include Integrity, Expertise, Competence/Commitment, Track Record, Structure and System and Capital Market Perception. The below table displays the scores bagged by Hero Honda for the various factors and the total score obtained by the company: MANAGEMENT RISK| SCORE|

Integrity| 1| Expertise, Competence & Commitment| 4| Track Record| 4| Structure & Systems| 4| Capital Market Perception| 4| TOTAL SCORE| 17| 1. 6. 1. Integrity: In Jan 2011, there was a Citibank scam reported of 300 crores, Shivraj Puri, the relationship manager (Citibank) had diverted the funds from his account to his family’s accounts and then put all the funds into the stock market through various brokerage firms, including the brokerage firm owned by his father, Normans Martin Brokers Private Limited.

Hero Honda’s Vice-President Sanjay Gupta’s involvement in the scam: Sanjay is accused of receiving commission from Shivraj Puri for the investmentsGupta opened two accounts in the name of BG Finances and G2S Management Consultant in Axis Bank in which about Rs 4-5 crore of the Rs 20 crore commission allegedly received from Puri were still lying in these two accounts. The two have been arrested under various sections of IPC for cheating, forgery and criminal conspiracy. Source : http://www. openletters. n/tag/hero-honda-sanjay-gupta/ Thus, there has been one case pertaining to the fraudulent, hence the score given would be 1. 1. 6. 2. Expertise, Competence/ Commitment: Hero Honda has won a number of awards, such as the NDTV Profit Business Leadership Lifetime achievement award 2009 and so on. Many of the senior management have also received many awards such as Pitch Exchange for Media –India’s top Marketers award 2009( Mr Anil Dua- Sr Vice President , Sales, Marketing and Customer Care ), India’s Best CIO award 2009( Mr Vijay Sethi- Vice President – Informations Systems and CIO).

The management has well defined strategy, because to create a larger impact in the product overseas, Hero Honda recently introduced a 20 day sales cum training module for all overseas managers at the Hero Honda National Training Center in Gurgaon. Training centers have also been established in all the export markets. Thus from the above we can say the management is very competent and the score given will be 4. 1. 6. 3. Track Record: The company continues to lead both in the domestic two wheeler industry and the motorcycle segment, with nearly 48% and 59%. Coming to the exports, the company grew internationally at 23%.

Coming to the Financial Performance, we understand that the sales volume of 4,6001,130 units were reported in 2009-2010 as compared to 3,722,000 units in 2008-2009. ICRA Limited, a leading rating agency has reviewed and reaffirmed the rating assigned to the Company for its Non- Convertible Debenture Program and Fund Based Limits from Bankas LAAA [pronounced L triple A] indicating the highest credit quality and A1 + [pronounced A one Plus] for its Non-fund based facilities and LAAA [pronounced L triple A with] to Fund based facilities indicating the highest credit quality rating carrying lowest credit risk.

During the year under review, rating agency CRISIL assigned the bank loan ratings of AAA/Stable and P1 + to the Cash Credit Limit & Letter of Credit Limit Facility respectively to your Company. ( Source: Director Report, FY 2009-2010). Thus, score given is maximum that is 4. 1. 6. 4. Structure and Systems: Hero Honda is the market leader in the two wheeler segment with one of the best and professionally managed company. It has sound reporting system, this can be understood since they have won ICAI award for Excellence in Financial Reporting.

They have achieved multiple key milestones which in turn has resulted in the launch of nine product launches. Thus all the statuary requirements are met. Thus score given is 4. 1. 6. 5. Capital Market Perception: Hero Honda has recorded a top notch financial performance, with highest annual revenues, operating income and EPS. The company continues to lead both in the domestic two wheeler industry and the motorcycle segment, with nearly 48% and 59%. Coming to the exports, the company grew internationally at 23%.

Coming to the Financial Performance, we understand that the sales volume of 4,6001,130 units were reported in 2009-2010 as compared to 3,722,000 units in 2008-2009. 5500% dividend is given and 74. 1% growth in PAT. Thus score given is 4. Each factor can be assigned a maximum score of 4 and a total score of 20 can be allotted. But here the total score given to the company is 17. This means that the company does run under Management Risk and the situation can improve in order to reduce the risk faced by the company. 1. 7.

STAGE VII: TOTAL COMPUTATION The table below shows the total score obtained by Hero Honda out of a total of 100. Instead of taking the maximum scores and the scores obtained as such, in order to round the total up to 100, the Financial scores are taken for 66, the Industry Risk scores for 24 and the Management Risk scores for 10. COMPARISION| SCORE| MAX SCORE| FINANCIAL SCORE| 54. 5| 66| INDUSTRY RISK| 22| 24| MANAGEMENT RISK| 8. 5| 10| TOTAL| 85| 100| Thus the final score for Hero Honda on a total of 100 based on the CRA model is 85.

Once the total score is computed, based on the score obtained by the company, the bank will calculate the spread and finalize on the rate at which it can lend money to the company! 2. NEW MODEL 2. 1. RELEVANT RATIOS FOR MANUFACTURING COMPANIES 2. 1. 1 CAPITAL STRUCTURE OF THE COMPANY A company’s capital structure commonly referred to as gearing, leverage or the debt to equity ratio reflects on the extent of borrowed funds in the company’s funding mix. A company’s funding mix which denotes the gearing level is generally a function of a management’s strategy.

Although high dependence on borrowed funds and thus a high gearing level may result in higher returns for shareholder funds, it translates into high fixed costs and in situations of weak business performance high gearing can aggravate the company’s deterioration in profitability, resulting in pressures on its ability to repay its debt obligations. Gearing: Total Debt/ Net worth 2. 1. 2. INTEREST COVERAGE The interest coverage ratios importance in the model arises from the fact that it reflects the firms ability to fulfil its repayment obligation in a timely manner.

This implies that the company should be generating adequate income so as to help meet its interest obligation. Companies with a higher interest coverage ratio are more likely to meet their debt obligation on time. For businesses that have an intrinsically low level of profit margins, a high gearing level or high cost of funds or high cost of funds may have an adverse impact on the debt repayment. Interest Cover: PBDIT/ Interest and finance charges 2. 1. 3. DEBT SERVICE COVERAGE RATIO The DSCR indicates a company’s ability to service its debt obligation both principal as well as interest from earnings generated from its operations.

A ratio greater than one implies that a company would be able to service its debt obligation (including principal as well as interest from accruals) generated in a year. On the other hand a ratio less than one will be unfavourable for debt repayment. DSCR: Net operating income/ Total Debt Service 2. 1. 4. PROFITABILITY MARGIN A profitability margin broadly indicates both a company’s competitive position in its industry and as well as the industry’s characteristics in terms of extent of competition pricing flexibility and like.

PAT margin is more important from a rating point of view as other ratings OPBDIT margins or OPBT margins because these ratios tend to be more influenced by industry specific characteristics and do not lend themselves to comparison across industries which is not the case with PAT margins. PAT Margin: Profit After tax/ Operating income 2. 1. 5. RETURN ON CAPITAL EMPLOYED The ROCE indicates the returns generated by a company on the total capital employed by the company in the business. This ratio is unaffected by the extent of leveraging of a company and thus comprehensively indicates how well the company is run by its managers.

ROCE: EBIT/ (Total Assets-Current Liabilities) 2. 1. 6. CURRENT RATIO The current ratio indicates a company’s overall liquidity position and is widely used by banks for assessing working capital credit decisions. The current ratio broadly indicates the matching profiles of short and long term assets and liabilities. A healthy current ratio indicates that all long term assets are funded with long term liabilities which will ensure adequate liquidity for the company’s normal operation. Current ratio: Current Assets/ Current Liabilities 2. 1. 7.

FIXED ASSET TURNOVER RATIO A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio measures a company’s ability to generate net sales from fixed-asset investments – specifically property, plant and equipment (PP;E) – net of depreciation. A higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues. This ratio is often used as a measure in manufacturing industries, where major purchases are made for PP;E to help increase output.

When companies make these large purchases, prudent investors watch this ratio in following years to see how effective the investment in the fixed assets was. Fixed Asset Turn Over Ratio: Net Sales/Fixed Asset 2. 1. 8. INVENTORY TURNOVER RATIO A ratio showing how many times a company’s inventory is sold and replaced over a period. A low turnover implies poor sales and, therefore, excess inventory. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall. Inventory Turnover Ratio: Sales/Inventory 2. 1. 9.

OPERATING MARGIN Operating margin is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. Operating margin: Operating Income/Sales Operating Income The amount of profit realized from a business’s operations after taking out operating expenses – such as cost of goods sold (COGS) or wages – and depreciation. Operating income takes the gross income (revenue minus COGS) and subtracts other operating expenses and then removes epreciation. Operating income would not include items such as investments in other firms, taxes or interest expenses. In addition, nonrecurring items such as cash paid for a lawsuit settlement are often not included. Operating income would not include items such as investments in other firms, taxes or interest expenses. In addition, nonrecurring items such as cash paid for a lawsuit settlement are often not included. Operating Income: Gross Income – Operating Expenses – Depreciation 2. 1. 10. DEBTORS TURNOVER RATIO An accounting measure used to quantify a firm’s effectiveness in extending credit as well as collecting debts.

The receivables turnover ratio is an activity ratio, measuring how efficiently a firm uses its assets. By maintaining accounts receivable, firms are indirectly extending interest-free loans to their clients. A high ratio implies either that a company operates on a cash basis or that its extension. A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. Debtors Turnover Ratio: Net Credit Sales/ Average Accounts Receivables 2. 1. 11. OPERATING CASH FLOW TO LONG TERM DEBT

It is an accounting item indicating the cash a company brings in from ongoing, regular business activities. Cash flow from operating activities does not include long-term capital or investment costs. It can be calculated as: Cash Flow From Operating Activities: EBIT + Depreciation – Taxes 2. 2. RATING CRITERIA FOR MANUFACTURING COMPANIES 2. 2. 1. BUSINESS RISK ANALYSIS The analysis begins with the fundamental assessment of the company’s environment in terms of the industry in which it operates, the risk attached to that industry and the government policies affecting the industry. 2. 2. 2. INDUSTRY RISK

Assessing the industry risk is fundamental to evaluating the company’s business risk. For industry risk analysis the size of the industry, its growth prospects, the competitive scenario and demand supply dynamics, vulnerability to technological change, the industry importance to the economy, government policy, entry barrier, profitability and cyclicality are evaluated. 2. 2. 3. GOVERNMENT POLICIES The impact of government policies on various industries is an important parameter in analyzing the business risk. The following factors are considered for evaluating this * The importance of the industry to the Indian economy Tariff barriers both quantitative (import duties) and qualitative (quotas) * Excise duties and taxes ; Domestic price control * Incentive for new investment and incentive for export * Legislation regarding pollution control measures * Laws with respect to foreign exchange and trade like 2. 2. 4. MARKET POSITION Ability to sell what is produced and ability to control selling prices critically determine market position of the company. A detailed analysis of both the degree of competition in each market segment and the dynamics among different players is to be done to evaluate the rated entity’s market position.

Also the company’s ability to pass on the input cost increases to its clients remains crucial for its stable profitability. A wide product mix, offers a stable market position compared to a presence to region specific distribution network and limited product portfolio. Distribution network and brand equity also is an important factor for consideration. 2. 2. 5. OPERATING EFFICIENCY Operating efficiency is an analysis of a company’s ability to produce goods/provide service at competitive costs, on a sustainable manner.

Some of the key factors come across industries aretechnology, access to resources, human resources, capacity utilization, flexibility in manufacturing process, level of integration and research and development. 2. 2. 6. TECHNOLOGY Technology remains a significant factor in maintaining a competitive position in the business. Companies with strong technology oriented business have a fewer competitors since technology provides a significant entry barriers to unorganized sector. 2. 2. 7 ACCESS TO RESOURCES Companies with easy access to raw material and bargaining power with suppliers maintain a healthy operating margins in the long term.

Domestic availability of resources impart flexibility in protecting margins. 2. 2. 8. PRICE VOLATILITY OF KEY RAW MATERIAL/INPUTS In addition to access the volatility of raw material pricing is another key element of analysis. The linkage between the input prices and the pricing of goods sold is analyzed. Strong linkage will imply lower volatility of operating margins. However commodity business where the raw material prices is linked to global prices and not related in final product prices report more volatile operating margins, which is viewed less favourably. . 2. 9 HUMAN RESOURCES Analysis is done on the ability to attract and retain qualified and experienced manpower. Also the depth and diversity of skill sets available in the company and policies regarding training and skill up gradation of employees. The company’s attrition levels are compared with the industry levels. Also the relations with labour unions and workforce in general and history of disruptions in operations on account of labour unrest are evaluated. 2. 2. 10. CAPACITY UTILIZATION AND FLEXIBILITY

Economies of scale achieved through optimum capacity utilization are very important to attain lower per unit cost in production. 2. 2. 11. LEVEL OF INTEGRATION A high level of vertical integration usually results in better cost structure. The flexibility available to a manufacturer to start from various stages in production process in case of adverse price in upstream products is analysed. Also the manufacturer’s ability to market intermediate products in the event of adverse movements in downstream products is evaluated. 2. 2. 12. ACCOUNTING QUALITY

Some of the key areas analyzed include overstatement/understatement of profits, qualifications made by the auditors, method of income recognition and depreciation, inventory valuation policies and off-balance sheet items/contingent liabilities and the like. 2. 2. 13. ADEQUACY OF CASH FLOW Since a credit rating is an assessment of the company’s ability to meet its debt obligations in the future, financial risk analysis primarily revolves around taking a call on the company’s future earning capacity in relation to its debt servicing capability. 2. 2. 14. FINANCIAL FLEXIBILITY

We evaluate a company’s ability to generate funds through alternative sources in case of any financial distress. The company’s contingency plans and its ability to deal with various adverse scenarios are analysed. The company’s ability to raise funds through internal sources and external sources to cover temporary shortfalls is evaluated. Additionally a company’s flexibility to differ its capital expenditure plans in case of a weakening financial position is also analysed. The external support that rated entity can receive from the parent company or group companies is analysed at great length. . 2. 15. MANAGEMENT RISK ANALYSIS Evaluation of company’s management entails understanding the goals philosophies and strategies that drive the company’s business and financial performance. Further, if the company is a part of a larger business group or multinational philosophies or those of the business group are used as pointers to assess managerial responses in the enterprise being evaluated. 2. 2. 16. PROJECT RISK ANALYSIS In the case of companies implementing a project the risks associated with that project is analyzed.

The relative size of the new project compared to the existing operations indicates the significance of the project risk in the overall rating. The projects market risks in relation to the company’s existing product line and the company’s track record in implementing such projects are given adequate importance in assigning the rating. 2. 3. METHODOLOGY FOR SCORING To identify the ratio values based on which the scoring was to be done a sample of 200 companies with ratio values from the year 2002 to 2010 were taken from various websites and the data was normalised by removing all the extremities.

The assumption under which the model was developed was that by taking such a large sample size the ratio values would follow a normal pattern with the most commonly occurring values being the mean and values which were either very good or bad would form the extremities of the normal curve. The test result for the normality test is given below. From the normality test results it is clear that the data fails to be normal therefore a decision was taken to remove all the extremities from the ratio values and try and normalize the data as much as possible.

The result of which is seen in the Normal Q-Q plots of the ratios. For a normal data the points would have been lying on the normal line. Further calculations were done on the data set under the assumption the data was normal. Thus the normal curve was divided into 10 equal areas and the ratio values for each of these points under the normal curve was considered. A sample calculation is shown below for debt equity ratio data. Z value: 1. 2811 (From Chart) Debt to Equity Ratio Mean: 0. 790 (From Data Analyzed) Debt to Equity Ratio SD: 0. 60632 (From Data Analyzed) Z=(X-µ)/SD (Assuming Normal Data)

Therefore X Value: 1. 567. Based on the ratio values got after dividing the normal curve in 10 equal areas a score ranging from 1 to 10 was given for ratio values of companies depending on which region of the normal curve it lay. The scoring was done with respect to 10 being the best value which falls in the top 10% and 1 being for being in the bottom 10% of the ratio values. If it was better for a ratio value to be small than values which were on the extreme left region of the normal curve was given a score of 10 and 1 if the value of the ratio being small signifies poor performance.

The other score were given relative to these scores based on where the ratio value lied. The ratio intervals calculated are given below for various Z values Once the scores were arrived at the weightages for each of the ratios was calculated. This was done by discussions with the debt team and arriving at consensus on the weightages each ratio should have, initially, all the ratios were clubbed into four main categories, Liquidity Ratios, Operational Efficiency, Profitability and Leverage Ratios. The weightages were assigned at first to each of these 4 categories and than individual ratios under each of these headings were given a weightage.

The final list of weightages are given below for all the ratios analyzed. The weightage assigned for non financial parameters was decided to be 10% in this model. All the non financial parameters which were listed above have to be taken into account and a score should be arrived at accordingly based on the judgment and prior knowledge of the person assigning the score. The maximum score will be 10 and the minimum score assigned to it will be 1. Of all the ratios the ratios which were grouped under Leverage was given the highest total weightage of 28%.

Liquidity and Profitability of the company was given equal weightages of 22% each. The ratios which were clubbed under operational efficiency of the company wasgiven a weightage of 18%. Individual ratios weightages were than assigned based on which of the 4 groups itcame under such that their sum equal the group weightage and its importance with respect to the other ratios in the group. The final result of the weightages assigned is given below. Liquidity Ratios| 22%| Operational | 18%| Current ratio| 11%| Fixed Asset| 5%| Cash Flow ratio| 11%| Inventory Turnover| 8%| |  | Debtors turnover| 5%|

Profitability| 22%| Leverage| 28%| O/P profit margin| 12%| Debt/Equity| 9%| Net Profit margin| 6%| LT debt/equity| 6%| ROCE| 4%| Debt Service Cov| 8%| |  | Interest Cover| 5%| Once the weightages were arrived at it was then multiplied by the score got for each of the ratio values based on where the ratio values lied on the normal curve. The final score for each of the company was then arrived by summing up the total score for each of the 12 ratios analyzed along with the score arrived at for the non-financial parameters. 2. 4. CALCULATIONS: 2. 4. 1. FINANCIAL PARAMETERS:

The ratio values for the year 2010 which were used for the scoring model is given below S. No. | Ratios| Hero Honda| Score| Weightage| SCR*WTG| 1. | Debt Equity| 0. 02| 9| 9| 81| 2. | LT Debt Equity| 0. 02| 9| 6| 54| 3. | Current Ratio| 0. 54| 1| 11| 11| 4. | Fixed Asset| 6. 37| 10| 5| 50| 5. | Inventory Ratio| 43. 97| 10| 8| 80| 6. | Interest Cover Ratio| 1349. 44| 10| 5| 50| 7. | ROCE (%)| 76. 48| 10| 4| 40| 8. | Debt Service Coverage ratio| 0. 01| 2| 8| 16| 9. | PAT / Net sales %| 14. 16| 10| 6| 60| 10. | Operating profit margin| 18. 03| 8| 12| 96| 11. | Cash flow ratio| 49. 4| 10| 11| 110| 12. Debtors ratio| 129. 92| 10| 5| 50| | TOTAL|  | 99| 90| 698| These scores obtained when multiplied by the weightages finalized by the team and summed up we get a total score of 698. 2. 4. 2. NON-FINANCIAL PARAMETERS: Hero Honda is the market leader and is a well-established brand for over two and a half decades and leads both in the domestic two wheeler industry and motorcycle segments with the shares of nearly 48% and 59% respectively. Also, the long term prospects of the industry are excellent with the two wheeler industry is supposed to easily sustain a growth of 10% and more over the next 10 years.

The company does face some challenges in terms of sourcing critical parts without compromising on the quality and quantity in the near future. The team thus decided that the non financial parameters of Hero Honda were overall very good based on review of annual report and alternate research and decided the score that should be assigned for the management and the industry risk of the company is 9. When this score is multiplied with the weightage of 10 and added to the financial risk score that we had got the total score that we get for the company is 788.

Thus the final score for Hero Honda on a total of 100 based on the model developed by the team is 78. 8. CONCLUSION: Based on the model provided to us we are getting a score of 85 for Hero Honda and on the model developed by us we have got a score of 78. 8. As the results show the scores are very similar and close to each other. The difference may have come because of the lower weightage assigned to non financial parameters and giving higher weightage to the financial parameters and probably also due to the number of financial rations taken.

In short, models such as these allow Banks and other lending agencies to evaluate the debt repayment capabilities of companies and allow them to set lending limits. The company can be benchmarked with companies from the similar industries to evaluate the company. Additionally, Hero Honda has been given a rating of AAA by CRISIL for the year 2010 so it is safe to assume that the scores obtained by both the models is a good industry score.