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Introduction to Banking and Financial Markets

Prof. PC Narayan
How and Why are Banks Different From Manufacturing
Companies? Part 1

Hello, in todays session, we will look at from a finance perspective how and why are banks different from
manufacturing companies? Banks as you know deal in financial assets: loans, investments and so on.
Manufacturing companies deal in real assets: plants, machinery, land, building and so on. In order for us to
understand the difference between banks and manufacturing companies, we will first look at the financials of a
manufacturing company. We will assume that the manufacturing company goes insolvent and we will gradually
wind it down. And then, we will do the same thing for a bank. The difference in the financial status of a
manufacturing company and a bank when they are completely wound down would tell us why there exists such
a huge difference between banks and manufacturing companies.
Let's first look at a manufacturing company. We have a company whose total balance sheet size is 4,500 currency
units. For ease of understanding by the way and to explain the concepts at hand, I have taken only line items in
the balance sheet that are relevant for our discussion here. Now, let's look at this company's balance sheet in
some detail. The 4,500 which is the balance sheet size comprises of Equity and Retained Earnings of 1,000, Long
Term Borrowings 2,000, Accounts Payables 900, Working Capital 600 adding up to a total of 4,500. On the Assets
side, we have Land and Building of 800, Plant and Machinery 2,200, Receivables 600, Inventories 800, Cash 100,
which adds up to a total of 4,500.
Now, let's assume, this company goes insolvent. What do we mean by a manufacturing company going
insolvent? Well, it's not earning enough even to pay the interest obligations on its loans. In other words, its EBIT
earnings before interest and tax is less than the interest that it has to pay on its loans. That is when we say that
a manufacturing company has gone insolvent. When such an eventuality arises, there is no choice for the
company except to start selling off its assets.
When a company starts to sell off its assets, let's say the company suffers a loss of 400 on the sale of its Plant
and Machinery. On the sale of its Land and Building, the book value is 800, it has recovered 800. On the
Receivables of the outstanding of 600, it is able to recover only 500. So, it suffers a loss of 100. On the Inventories
that it disposes off, the book value is 800. It is able to realize only 600. So, it books a further loss of 200. So, by
virtue of liquidating its assets, the loss suffered by the company is 400 plus 200 plus 100 which works out to 700
currency units. So, the total assets which you have valued at 4500, when disposed off, realized 3800 in Cash and
the company had to book a loss of 700.
If you look at the situation of the company now, after it has liquidated all its assets, its balance sheet is going to
look a little like this. Loss on assets, 700. Cash, 3800 and the balance sheet size continues to remain at 4500.
Remember, all these are the liquidated assets which resulted in a loss of 700. Now, what could the company do
with the 3800 it has realized through the sale of assets? It could pay down its Liabilities, Long Term Borrowings
of 2000, pay down its outstanding Payables of 900 and pay down its Working Capital of 600 which totals up to
3500. Now, as you can see, on the Liabilities side, all that now remains is the Equity Capital of 1000.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for
use only with the course FC201.1x titled Introduction to Banking and Financial Markets- I delivered in the online
course format by IIM Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval
system or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise
without the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Introduction to Banking and Financial Markets


Prof. PC Narayan
How and Why are Banks Different From Manufacturing
Companies? Part 1

From the Cash that the company realized of 3800, it has utilised 3500 to pay off its Liabilities and therefore, it is
left with a net Cash of 300. Let's see what the balance sheet looks like at the end of that exercise. The company
has a Cash position of 300, loss on sale of assets 700, the total is 1000 which is supported on the Liabilities side
by Equity Capital of 1000. All other assets have been sold off and their Liabilities have been paid off. This is the
residual balance sheet of the company.
What does this actually mean? If you had invested 10 currency units in this company, now that the company is
fully wound down, you'll get back only 3 currency units for the 10 currency units that you invested. In other
words, you have absorbed the company's loss to the extent of 7 units per 10 units. Or, for the 1000 units that
was invested by the Equity shareholders, they get 300 and the 700 is the loss that they have to bear.
This is a gradual well-organised winding down of a manufacturing company. In the next video, we will look at an
identical situation in a bank and see how different it would be to wind down a bank which has gone insolvent.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for
use only with the course FC201.1x titled Introduction to Banking and Financial Markets- I delivered in the online
course format by IIM Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval
system or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise
without the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

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