Popovic, Milos

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Raiffeisen Bank Jugoslavija AD, Belgrade
Credit Analysis
 
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Beginner’s Guide for
Understanding SME1 Credit Analysis
in FR Yugoslavia
Prepared by: M.Popovic
SUMMARY
This paper will not display any of the standard Corporate Credit Analysis
practices and procedures, which can be found in various instruction manuals in
the field. However we intend to assist in applying of such principles in order
to cope with the reality behind financial reporting of the Serbian body
corporate. Our aim is to provide basis for understanding and restatement of the
local financials in the best possible manner, so as to correspond to both
International Accounting Standards (IAS) and reality. Accounting in FR
Yugoslavia has in fact several peculiarities to be aware of when analyzing
corporate credit, concerning the historic data present in both Balance Sheet
and Income Statement. This paper refers to relatively government independent,
private, medium size corporations (annual sales DEM 3-10 mio) involved in
foreign trade operations.
We will try to inform the reader about why the accounts are not transparent,
as well as where and when they are not transparent. We will also try to point
out the differences between importing and exporting companies, and the
repercussions of these two determinants of the business on the display of local
financial reporting.
The theme is associated to problems of foreign currency in the financials,
doing business and accounting in the environment of high disproportion between
local and hard currency exchange rates (1996-1999), and the relative
consequences on financial reporting and credit analysis. In the end we will
provide you with an overview of some common issues and restatements. We intend
to convey the message that the sense may be found in it all, and that a
meaningful cash flow can be created, for a good number of corporates.
I. INTRODUCTION
Due to adverse economic and political climate present in Serbia throughout
the foregone decade, and reaching climax on Oct 5th last year, the economy is in
a very poor shape. Business is sprinkled across nonviable, suffering Socially
Owned Enterprises (SOE’s), spinning off to dots of new private operations which
just now take solid grounds; these are accompanied with a portion of mid-sized
businesses which found their way to growth since private business was allowed a
decade ago. With the lowered political risk and slow liberalization efforts,
foreign capital is gently entering the ‘market’, and domestic SME's will have
to grow transparent and consolidate in order to have their growth financed and
stay competitive. Externally financed growth, whether supported by raising
equity, forming partnerships, or raising debt, will ask for a move from the
current paranoia into transparency of operations within legal institutions.
This is not a short-term task. There is still a very high political risk,
slowing down the process of FDI. However all sides are very much aware of the
fact that whatever political option is next to come (perhaps stalling the
reforms), there is no turning around of the started transition and building of
market economy.
One of main enemies for credit market development in Serbia is the currently
low quality of financial information and large part of cash settlements,
brought about by the environment of mistrust, lack of right incentives, low
economic freedoms, weak contracting and discipline enforcement (rule of law).
                                                 
1 Small and Medium Enterprises 
Raiffeisen Bank Jugoslavija AD, Belgrade
Credit Analysis
 
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Traded at Belgrade Stock Exchange are only short NBY T-bills and one-to-
three-month commercial notes of the handful of liquid enterprises. EUR 427mio
is total 01-08/2001 turnover on BSE. No rating of domestic corporates is
produced. Enterprise and industry benchmarking is not possible thus due to lack
of institutionalized information and low quality of accounting. It is only
possible to compare the two companies if one has access to insider’s
information.
Audit procedures are obligatory for large enterprises and banks, but are
very superficial and promotion- oriented. Very few SME’s hired audit agencies
during foregone years. In those few cases, opinions of the auditor, although of
great value to an analyst, are to be considered more as ‘PR’ oriented than
reliable source of information. Generally, firms have been audited when they
wanted to address foreign investor, creditor or a particular supplier. It is
broadly believed that auditors simply sold their name against manufatured
reports which would portray and enable a company to evade taxes or to avoid
highly restrictive regulation for disposing over financial assets.
II. BASIC FEATURES OF A DOMESTIC ENTERPRISE
All successful SMEs present on this market stem from the two extreme models
created during the last decade, which we shall refer to as Shells and
Politically Correct ones. Whereas most of firms balanced their business in
between these two ‘stereotypes’, we considered it beneficial to over-simplify
and to generalize, in order to introduce the reader to the roots of the
problem.
A) Shells with nothing to steal from: The Downside Case
Shell forerunners are companies whose capital and profits are out of
books (cash unrecorded sales), or expropriated onto the own affiliates abroad
(out of the country). Similar to their capital, much of the Capital
Expenditures (investment in fixed assets) are often not reflected in the
balance sheet. Shells will often have their own trading & financing
intermediaries outside the country. This model is not to be underestimated,
however, as it defines Serbia’s present and future SME domestic capital base.
These entities, often but recent start-ups, were in the last decade given
strong incentives (forced) to seek alternative business channels for doing
business, in order to protect their substance and growth. Reasons for such move
from legal/domestic institutions to illegal/circumventing business channels,
was the adverse business environment of:
 High to hyper inflation (or inflatory tax)
 Up to five fold disproportion between the fixed official and floating,
illegal market exchange rate
 Scarcity of hard currency in institutions
 Adverse, multi-layer taxation policies and non-tariff barriers
 High government regulation and bureaucracy,
 Low other economic freedoms and
 Frequent property rights violation, often by government itself
For purpose of credit risk assessment, it is important to understand these
issues, as they do explain why the accounts are untransparent as well as where
to look for more information. This sort of climate has to the most negative
extent resulted in weak financial reporting, basic rudiments of which, from the
credit institution’s point of view, are
 Low book sales income and nil profits /due to cash sales, and trade
intermediation through associates, for profits expatriation and tax
evasion/ and thus no book generating ability.
 Low book own funds and hence low book capital adequacy
 High operational leverage, finance on trade credit from own affiliates,
untransparent operations
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Credit Analysis
 
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 Lower working investment valuation than actual (stock, inventory, cash),
and negative working capital
In many cases this type of corporate will have faultless solvency with
satisfactory liquidity, but no investment potential whatsoever : their
turnover, accumulated profits, capital and capital investment (fixed assets)
will often, partially or fully remain outside of the balance sheet (and
sometimes outside of the country).
 These entities are not at all happy about the way they do business.
However, they will remain doing so to the very same extent, until the
stimulating business environment is created for them, in terms of the
already stated factors. Some pre-conditions are already met, one being
the relative stability of LCY- Dinar, availability of hard FCY, and
predictable inflation. However, they will not consolidate their hidden
(parallel channels) capital and retained earnings before they are able to
do it tax-free or with low tax, their private property is guaranteed from
violation, iii. they are allowed to freely move their capital and
profits, and are given greater economic freedoms and trust in contract.
N.B. Balance Sheet from as of end-2000 generally reveals correct working
investment, to the extent that now there are no discrepancies between market
and official exchange rates at year-end. Permanent assets and capital will
still remain outside for many firms, and trade payables may be unreal, due to
the external settlement practice conducted during the period of EU’s white
lists. It was allowed to clear them, during the IQ 2001. The 2000 Income
Statement, however, is not accurate in many ways (see below), and is not to be
taken for granted.
Raiffeisen Bank Jugoslavija AD, Belgrade
Credit Analysis
 
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B) Politically Correct Corporates
Quite often these are founded as spin-offs, the result of the State Owned
Enterprise’s (SOE’s) value-stripping practice, done by high executives. These
have continued to base their strategy on close cooperation with the (former)
governing oligarchy, and are therefore deriving various privileges associated
with the redistribution of public wealth, such as
 Not paying or paying minuscule taxes, tariffs and contributions (no
enforcement)
 Availability of cheap sources of hard currency for imports or just F/X
profits
 Monopolistic position over import/export quotas system
 Arbitrary and cheap (public bank) credit, often with interest negative in
real terms. Such loans often served as a start-up capital, and were not
repaid.
The system created a mafia-like synergy between the business community and
the government, resulting in high level of corruption. The line between the two
types is of course not very clear and they often merge intensively. Although
the latter group has a better starting point considering the initial capital,
former are more in number, smaller in size and turnover, more flexible and more
innovative, thus having greater competitive potential under an opened economy
environment. Both should be targeted, as all companies (even if operated for
fifty years) are considered “newborns” under transition, if and once the
economy is opened. Until then, the latter will still have great advantage to
the former, mainly resulting from the accumulated wealth, good market position
and economies of scale.
III. FOREIGN CURRENCY IN THE FINANCIALS, 1996-2000
For the years 1996-1999 (2000 for P&L), there is a significant distortion in
all categories containing foreign currency. The difference between official
(book) and market (transactions) grew from 1:1 in 1998 (devaluation) to 1:5
near end-2000, when fixed currency was devaluated again. This had an enormous
impact on both accounting and business practice. Main difference and point of
separation is to be made between importers and exporters, although many firms
will combine the two in their regular course of business. We will generalize
again, but only to provide with the two new starting points of evaluating a
domestic enterprise.
a) Net importers, framework:
Net Importers will have their liabilities (trade payables) undervalued in
B/S 1997-1999, showing greater then actual liquidity. Also, for the same
respective period, importers will have lower Cost of Goods Sold (COGS) whereas
their book Sales (in YUM) will be a priori closer to true values, once an
average FCY market rate is applied on the figure. They will thus have their
gross margins inflated, whereas net operating profits will be brought down by
the fictional charges in the following parts and sub-categories of the Income
Statement:
 Operating expenses section of the Income statement (production costs,
nonmaterial expense- consultancy services, etc.), or/and
 Financial section (F/X expenses charges, Other financial expense),
or/and
 Non-business & Exceptionals (off-writing receivables, and other non-
ordinary transactions)
 Revaluation section of the Income Statement (later detailed).
Raiffeisen Bank Jugoslavija AD, Belgrade
Credit Analysis
 
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These tangible and material expenses should be located and identified if are
correlated to cost of obtaining foreign currency on the extensively used black
market (usually the difference between the official and market rates was
settled between companies), or if the transaction is non-cash and related to
biasing net result.
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Credit Analysis
 
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b) Net exporters, framework
On the other hand, net exporters will have, for the same respective period,
 Undervalued trade receivables (booked using the official, undervalued
rate), perhaps displaying liquidity problems.
 Undervalued sales income level, as they were booking sales income
(FCY) using the official, lower rate.
 If they completely followed the accounting principles under this high
currency disparity situation, exporters would have posted severe
losses at end-2000, after the five-fold devaluation of dinar near
end-2000.
Exporters will have used external advance payment (trade credit) in YUM
for export (working capital) finance, whereas trade creditors (importers) will
have used their hard currency inflows to settle their creditor claims.
Therefore, they will have had their sales income undervalued (expressed by the
official rate) and COGS will be real in value, as it is paid in YUM, from the
advances received. Once the inflow from the export receivables is collected and
the settlement with trade creditors (importers) is effected, there may and may
not be extra income (F/X) booked under various categories, depending on if the
settlement is done from non-B/S cash or through B/S (for “intellectual”
services), or mixed. The exporters have had within this framework an
opportunity to balance their Income Statement and show net profit, or net loss,
using this mechanism alone.
IV. OTHER COMMON RESTATEMENTS
a) In FR Yugoslavia, Loss is an Asset
Although profits as retained earnings are normally recorded under
Capital, losses are not. Losses, under the Yugoslav accounting, are displayed
on the assets side as positive. Common practice is to deduct “accumulated
losses” against reserves and then against equity.
b) Labor expense is not transparent
It is very difficult to distinguish the total operating expense related
to Gross Salary, as this is, under FRY accounting, split in several reporting
categories under the Selling, General and Administrative expense (SG&A).
Namely, the Gross salary, Non-material expense and Production services expense
categories in the Inome statement allow for various employee-related payments
and owner withdrawals to be recorded throughout this part of the P&L, thus
making it non-transparent. It is sometimes crucial for a labour intensive
business to identify and separate labor from the other operating costs so as to
correctly assess the partake in costs.
c) “Revaluation” Issue
A “revaluation” part of the Income statement comes after SG&A,
Financials, Non-business and exceptional, and before taxes. These, revaluation
income and expense are meant to be separated from the rest of the Income
statement categories, so as to leave these material categories free from
revaluation impact on their value (non-cash), and thus make the statements more
transparent in the environment of high inflation. This “noble” cause was in
practice twisted terribly, as “revaluation” became everybody’s place of
manipulation with the final, pre-tax Income figure.
There are many businesses, which respectfully apply the accounting
principles in this field. So we will present the basics of how to interpret
this part of the Income statement, which is important to construct a meaningful
cash flow table. Generally speaking, guidelines to keep in mind are:
Raiffeisen Bank Jugoslavija AD, Belgrade
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 Positive revaluation of Assets is a Revaluation Income, while positive
revaluation of Liabilities and Equity is Revaluation Expense. There is no
negative revaluation.
 Fixed Assets and local currency Equity capital are revalued using the CPI
growth indice, more or less, while all Foreign Currency (FCY)- valued
balance sheet categories are revalued according to the official exchange
rate fluctuation.
In terms of that, at end-2000, when Dinar was devaluated five-fold, those
with excess FCY liabilities and Equity would generally have recorded
diminishing losses and a drop in liquidity (importers), while those with excess
FCY assets (exporters) would have recorded enormous profits and liquidity rise.
Of course this is said only to alert to the fact that one must take into
careful consideration all the aspects and implications of the issue of
revaluation in the Income statement, and their effect on cashflows.
In restatement to IAS, we have an impact on all B/S, I/S, and the cash-flow
statement.
- Income statement: revaluation of foreign currency receivables, payables
etcetera should be restated as unrealized foreign exchange (F/X) gain or
loss in the financial section, whereas Revaluation of Fixed Assets and
Equity should be completely excluded from net result.
- Balance sheet: Base equity should be restated to separate revaluation
effect, and total accumulated, inflation-oriented Fixed Assets
revaluation should be is reflected under single equity category as a
monetary gain, or accounting change (non-cash).
- Cashflows: Already restated unrealized F/X gains/losses based on
revaluation of receivables and payables must be recorded under change of
same relative categories in the pre-Net Operating Cash Flow, part of
cashflow statement, as to exclude the non-cash transactions from Change
in Working Investment. Financial result is free of non-cash revaluation
impact here.
V. CLOSING REMARKS
These were just the general points of clarification of what falls under
doing credit analysis and company valuation in FR Yugoslavia. However, we would
like to stress that the context is often all but clear and cohesive, and the
credit analyst must be a valuation consultant as well. Yugoslav accounting
practice not only differs from IAS (especially from IAS-29), but the rules are
loose and financial discipline is not well enforced. Domestic reporting will
not provide the analyst with “data comparable over the course of time” unless
serious efforts are put in audit and restatement. Historic results are not a
good benchmark and the cashflow approach is widely suggested when analyzing
corporate credit. Financial reporting, though of utmost importance, should be
normally used only as a signal light for where to look further. It should be
complemented with carefully crafted questionnaires and personal contact with
the Co’s management, in order to obtain qualitative information.
The State develops restrictive regulation in order to control the
economy, and to prevent an outflow of capital. A decrease to the State’s
interventionism, fighting corruption, gray economy and rent-seeking, along with
an increase to economic freedom, are the only route to creating a better
business environment.
At the moment, creditor’s short-term task on the Serbian market is to
reckognise potential, with strong accent on management and business strategy
evaluation. Bank needs to invest in relationship with such corporates.


Beginners guide for understanding SME credit analysis in FR Yugoslavia

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