How a bank reads your balance sheet before giving a loan
A bank does not read your balance sheet as the auditor presented it. It first rearranges the figures, removing anything that would not help repay a loan, and only then calculates ratios. What it wants to know is simple: how much of the owners' real money is in the business, can the business meet its short-term dues, and is the balance sheet telling the same story as the bank statement and the P&L?
This is why a balance sheet showing a current ratio of 1.35 can become 1.04 on a credit manager's desk. Here is the order banks follow, what they adjust, and a worked example.
The four questions behind the analysis
Every credit note, whatever its format, is trying to answer four things from the balance sheet:
- Stake: how much real money have the owners put in and left in?
- Leverage: how much of the business is funded by outsiders?
- Liquidity: are short-term dues covered by assets that will really turn into cash within a year?
- Quality: are the assets worth what the balance sheet says?
Banks usually take at least three years of audited figures, because the trend answers these questions better than any single year-end.
The order in which a credit manager reads it
1. Net worth
The starting point is capital plus reserves. The credit manager then asks where it came from. Fresh capital and retained profits count fully. A revaluation reserve adds nothing to repayment capacity, so most banks remove it. Intangible assets and accumulated losses come off too. The result is tangible net worth (TNW).
Year-on-year movement matters. If profit was ₹50 lakh but reserves rose by only ₹10 lakh, where did the rest go? In a partnership or proprietorship, the capital account shows this directly: high drawings against thin profits is a common query.
2. Borrowings and other outside liabilities
Next come the loans: who has lent, how much, and how soon it falls due. Banks compare the sanction letters and repayment schedules with the balance sheet, and note any instalments due within 12 months, which belong in current liabilities. Unsecured loans are checked as well. Promoters' loans stay in outside liabilities unless they are subordinated to the bank.
All outside debt together gives TOL/TNW, covered in detail in our TOL/TNW article.
3. Current assets and current liabilities
This is where most adjustments happen. Working capital lenders look at each line:
- Debtors: how old are they? Very old or disputed amounts are not treated as liquid.
- Stock: is it moving, and does it match the stock statements given to the bank?
- Creditors: are they being paid on time, or stretched to fund the business?
- Loans and advances: what are they, and to whom? Advances to group entities are a frequent problem.
- Statutory dues: are GST, TDS, PF and similar dues paid on time, or building up?
The ageing of debtors and creditors is one of the first schedules a credit manager asks for, because it shows what the single year-end figure hides.
4. Fixed assets and investments
Long-term assets should be funded by long-term money. If fixed assets jumped but term debt and net worth did not, short-term funds have probably gone into them. That shows up as a weak current ratio, and it is called diversion of working capital. Investments in group companies get the same scrutiny, because that money is not working in this business.
5. Notes, audit report and contingent liabilities
The balance sheet total does not show everything. Credit managers read the notes for contingent liabilities (guarantees given, disputed tax demands, pending cases), related party transactions, and any qualification or adverse remark in the audit report. A large guarantee given for a sister concern can become a real liability overnight.
A worked example
A typical case: a manufacturer with sales of ₹1,800 lakh applies for higher working capital limits. Its audited balance sheet (₹ lakh):
| Liabilities | ₹ lakh | Assets | ₹ lakh |
|---|---|---|---|
| Share capital | 150 | Net fixed assets (includes ₹60 lakh revaluation) | 430 |
| Reserves (includes ₹60 lakh revaluation reserve) | 210 | Intangible assets | 30 |
| Unsecured loans from promoters | 90 | Stock | 280 |
| Term loan (₹40 lakh due within a year) | 180 | Debtors (₹40 lakh over six months old) | 250 |
| Cash credit | 240 | Loan to a sister concern (shown as a current asset) | 70 |
| Trade creditors | 190 | Other advances | 30 |
| Other current liabilities and provisions | 55 | Cash and bank | 25 |
| Total | 1,115 | Total | 1,115 |
As presented by the borrower:
- Current assets = 280 + 250 + 70 + 30 + 25 = ₹655 lakh
- Current liabilities = 240 + 190 + 55 = ₹485 lakh
- Current ratio = 655 ÷ 485 = 1.35, just above the familiar 1.33
Step 1: put the term loan instalments in current liabilities. Current liabilities become 485 + 40 = ₹525 lakh. Current ratio = 655 ÷ 525 = 1.25.
Step 2: clean the current assets. The loan to the sister concern (₹70 lakh) is not going to fund this business's daily needs, so it moves out. The ₹40 lakh of old debtors is treated as doubtful. Current assets = 655 − 70 − 40 = ₹545 lakh.
Current ratio = 545 ÷ 525 = 1.04, and net working capital is only 545 − 525 = ₹20 lakh.
Step 3: find the real net worth.
| ₹ lakh | |
|---|---|
| Book net worth (150 + 210) | 360 |
| Less revaluation reserve | (60) |
| Less intangible assets | (30) |
| Tangible net worth | 270 |
| Less loan to sister concern | (70) |
| Less doubtful debtors | (40) |
| Adjusted tangible net worth | 160 |
Step 4: leverage. Total outside liabilities = 90 + 180 + 240 + 190 + 55 = ₹755 lakh.
| Basis | Calculation | TOL/TNW |
|---|---|---|
| Book net worth | 755 ÷ 360 | 2.10 |
| Tangible net worth | 755 ÷ 270 | 2.80 |
| Adjusted tangible net worth | 755 ÷ 160 | 4.72 |
A business that looked comfortable at 2.10 now sits at 4.72. If the bank's benchmark for this sector is around 3, the proposal does not fit as it stands.
Step 5: what can fix it? Suppose the ₹70 lakh is recovered from the sister concern and used to reduce cash credit, and the promoters subordinate their ₹90 lakh of loans so the bank treats them as quasi-equity.
- Current liabilities = 525 − 70 = ₹455 lakh, so current ratio = 545 ÷ 455 = 1.20
- TOL = 755 − 90 − 70 = ₹595 lakh
- Adjusted TNW = 160 + 70 + 90 = ₹320 lakh, so TOL/TNW = 595 ÷ 320 = 1.86
Leverage is now comfortable. Liquidity is better but still below 1.33, so the credit manager would look for more long-term money, such as fresh capital, before raising the limit. You can test your own figures in the current ratio and TOL/TNW calculator.
The 1.33 itself comes from the Tandon framework. RBI has withdrawn the MPBF prescription based on it, and banks are free to decide their own minimum current ratio. It remains a common benchmark, not a legal requirement, and each bank's policy decides what it accepts.
Reading the trend: holding periods
Balance sheet items make more sense against the P&L. Continuing the example, with cost of sales of ₹1,440 lakh and purchases of ₹1,400 lakh, and assuming last year's figures were as shown:
| Holding period | Formula | Last year | This year |
|---|---|---|---|
| Debtor days | 250 ÷ 1,800 × 365 | 38 | 51 |
| Stock days | 280 ÷ 1,440 × 365 | 60 | 71 |
| Creditor days | 190 ÷ 1,400 × 365 | 42 | 50 |
Customers are taking longer to pay, stock is sitting longer, and suppliers are being paid later. Each could have an innocent reason, but together they suggest cash is getting tighter, and the credit manager will ask why. These are the same figures that feed the CMA data and, on the stock and debtors side, the drawing power calculation.
Red flags banks look for
- Reserves or capital rising with no matching profit or cash inflow
- Debtors growing much faster than sales
- Round-figure "loans and advances" that stay unchanged year after year
- Creditors high against purchases, with statutory dues pending
- Sales in the financials not matching GST returns or bank credits
- Short-term borrowing rising while fixed assets grow
- Year-end cash balance that is unusually high compared with the bank statement pattern
- Frequent change of auditor, or financials that are not audited when they should be
How to prepare before you apply
- Recover or explain loans to group entities well before the year-end.
- Clean up old debtors and dead stock. It may reduce profit once, but banks trust a clean balance sheet more.
- Show instalments due within a year correctly in current liabilities.
- Keep profits in the business instead of withdrawing them, and subordinate promoters' loans where possible.
- Match your documents. Financials, stock statements, GST returns and bank statements should tell one story.
Frequently asked questions
Which ratios do banks check first? Usually current ratio and TOL/TNW from the balance sheet, then DSCR for term loans. They are calculated after the bank's own adjustments, not on the figures as presented.
Does a bank accept the audited balance sheet as it is? It accepts the figures as the starting point, then reclassifies and adjusts them. Audit does not stop a bank from treating an asset as doubtful or moving it out of current assets.
How many years of balance sheets does a bank need? Usually three years of audited figures, though each bank's policy decides. Proposals for working capital also need estimated and projected figures.
Is a current ratio below 1.33 an automatic rejection? No. It is a common benchmark, not a rule. RBI has left banks free to set their own minimum, and sector, cash flow and security all matter.
Sources
- RBI Master Circular: Management of Advances, UCBs, 2009 (MPBF prescription withdrawn; banks free to decide the minimum current ratio)
All content is for educational purposes only and isn't financial or investment advice.
