CREDIT WEEK 5 – FINANCIAL STATEMENT ANALYSIS

APPLICATION OF FINANCIAL ANALYSIS

INDIVIDUALS (PERSONAL AND CONSUMER) BUSINESSES (REGISTERED BUSINESSES AND

 Latest 3 months Income Statements/Pay
Slips
 Latest 3 months Bank Statements
 Employment Verifications
 Statement of Assets and Liabilities
COMPANIES)
 3 years Audited Statement of Financial
Performance (P&L Account)
 3 years Audited Statement of Financial
Position (B/S)
 3 years Audited Statement of Cash Flows
 3 years Auditor’s Statement
 3 years Bank Statements
 Project Financial Planning and Projections
 Latest BOD’s Statement of Income and
Expenses, Assets and Liabilities
 Documents: Certificate of Incorporation,
M/A, A/A, Board Resolution to Borrow

WHY LENDERS ANALYZE FINANCIAL STATEMENTS

 Analysed to help determine whether:

o Business has adequate liquidity  Can honour promises in form of short-term obligations
o Business is run efficiently
o Business is run profitably
o Proprietor’s stake in business (Debt vs. Equity)  Margin of Safety

 Analysis answers 2 key questions:

o Should bank give requested loan?
o What’s bank’s remedy if assumptions of loan turn out to be wrong?

ANALYSIS OF FINANCIAL STATEMENTS

 Falls into 3 broad categories
o Cross-Sectional Techniques (E.g.: Ratio Analysis, Common-Size Statements)
o Time Series Techniques (E.g.: Identifying trends in ratios/other measures)
o Combination of the 2 techniques

CROSS-SECTIONAL TECHNIQUES
 Ratios: Financial ratios derived from financial statements fall into 4 main categories:
o Liquidity Ratios
o Efficiency Ratios
o Profitability Ratios
o Leverage Ratios

LIQUIDITY RATIOS
 Used to determine relationship between firm’s ability to pay relative to need to pay its short-term
obligations

Current Assets
CURRENT RATIO =
Current Liabilities
 Quick Assets
QUICK RATIO =
Current Liabilities

EFFICIENCY RATIOS
 Used to determine how efficiently firm used its assets  Determines their productivity

COGS
INVENTORY TURNOVER RATIO =
Inventory

Receivables
AVERAGE COLLECTION PERIOD =
Average Sales Per Day

Accounts Payable
DAYS ACCOUNTS PAYABLE OUTSTANDING =
Average Daily Purchase

PROFITABILITY RATIOS
 Used to assess profitability of sales generated through operations

Gross Profit
GROSS PROFIT-SALES RATIO =
Net Sales

Net Profit
NET PROFIT-SALES RATIO =
Net Sales

LEVERAGE RATIOS
 Used to assess proportions and manageability of debt carried by firm

Debt
DEBT-EQUITY RATIO =
Equity

Earnings Before Interest and Taxes

INTEREST COVERAGE RATIO =
Interest Payable on Loans

Earnings Before Interest and Taxes+Depreciation

FIXED CHARGES COVERAGE RATIO =  Ability relative
Interest on Loan+[Repayment Loan  (1−Tax Rate)]
to need ratio

CASH FLOW ANALYSIS

 Ratio analysis uses accrual accounting
 Cash flow analysis can provide further insights into operating, investing, and financing activities
 Statement will show real position of cash  Lifeline of firm
 All U.S. companies required to include statement of cash flows in financial statements

ANALYSING CASH FLOW INFO

 Operating Activities
o How strong is firm’s internal cash flow generation?
o How well is working capital being managed?

 Investing Activities
o How much cash did company invest in growth of assets?

 Financing Activities
o What type of external financing does company rely on?
 o Did company use internally generated funds for investments?
o Did company use internally generated funds to pay dividends?

CASH FLOW ANALYSIS

 Differences in reporting cash flow info allow for variation across firms that complicate comparisons
 Analysts can make adjustments to net income to arrive at free cash flows (Commonly used metric
for financial analysis)

COMMENTS
 There are 2 primary tools in financial analysis:
o Ratio Analysis: To assess how various line items in financial statements relate to each other
and to measure relative performance
o Cash Flow Analysis: To evaluate liquidity and management of operating, investing and
financing activities as they relate to cash flow

 Both forms of analyses must be evaluated while considering whether firm performance is
consistent with strategic initiatives of management

ANALYSIS OF FINANCIAL STATEMENTS

COMMON-SIZE STATEMENTS
 Express relationships between numbers on financial statements

 E.g.: Following items may be expressed as percentage of total assets:

o Accounts Receivable
o Inventory
o Equity

TIME-SERIES TECHNIQUE
Ratios can be evaluated to detect any improvements/deteriorations in financial position over time

Variability Measures: May be used to determine variability over time where trends not detected  Higher
Value = Greater Risk
Maximum Value − Minimum Value
Mean Financial Ratio
FINANCIAL AND NON-FINANCIAL ANALYSIS

COMBINING FINANCIAL AND NON-FINANCIAL INFO

 Other info that may be incorporated into analysis include:
o Read Auditor’s Statement
o Changes in Market Share
o Changes in key management
o Impact of macroeconomic changes

TECHNIQUES OF ANALYSIS USED IN PROJECT FINANCE

 Payback Period
 Accounting Rate of Return
 Discounted Cash-Flow Techniques

NPV at Lower Discount Rate

IRR = Lower Discount Rate + Difference between 2 Discount Rates ( )
|Sum of NPV of 2 Discount Rates|

Remainig Cost to Recover

Payback Period = Years before Cost Recovery +
Cash Flow During Year
PROJECT RISK ANALYSIS
 Sensitivity Analysis
o Measures impact of changes on key variables (E.g.: Interest rate/Prices of key inputs on
project’s viability)
o E.g.: 10% increase in prices of inputs

 Breakeven Analysis
o Level of sales where Revenue = Expenses, Net Income = 0
o Requires knowledge of fixed and variable costs

o Breakeven = Total Fixed Cost / Contribution Margin

 Contribution Margin = Price – Variable Cost

BREAKEVEN ANALYSIS

PROJECT RISK ANALYSIS

 Margin of Safety: Margin between profitability of current operations and breakeven point

Fixed Costs+Loan Instalment Including Interest−Depreciation

 Cash Breakeven Point =
Contribution Per Unit
  Simulation: Computational approach where parameters of probability distributions for key
variables are specified and used for numerous iterations where outcomes are decision variables
(E.g.: Expected NPV and IRR)

DETECTING WINDOW DRESSING, FRAUDS AND ERRORS

 Overwhelming accounting complexities lead to potential abuses of notion of ‘true and fair’ via
manipulation of:
o Valuation of receivables, inventory, property, marketable securities and other assets
o Liabilities including off-balance sheet items
o Changes to accounting methods

LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS

 Financial statements analysis can’t substitute for sound judgement:
o Problems with benchmarks: What benchmarks should be used for multi-industry firms?
o Window Dressing/Creative Accounting
o Historical Data: Accounting reports reveal only history, not future
o Qualitative Aspects: Changes in management, economy, etc.

HOW DIFFERENT INDUSTRIES REVEAL THEIR CHARACTERISTICS THROUGH FINANCIAL STATEMENTS

 Best place to start: Balance sheet

 Industries tend to differ very often in terms of relative importance of inventory and fixed assets
o E.g.: Some industries have virtually no inventory, i.e. electric utilities, airlines, railroads,
professional services

 In other industries  Inventory is one of most important assets, i.e. retail stores, supermarkets, US
style wholesalers - but not Japanese style trading companies

FINANCIAL FOOTPRINTS
 Turnover of inventory provides important clues
o E.g.: Vegetable and fruit stores/Fish and meat vendors/Sellers of any product with short
“shelf life”  Need fast turnover
o Firms that sell products with long “shelf lives” (E.g.: Jewelry stores, Car dealers)  Can
operate with slower turnover

Within industries  Often considerable uniformity among firms with respect to credit terms

 Credit is more important when customers are themselves businesses, i.e. “business to business” 
Generally longer when product is relatively expensive and isn’t perishable
 Accounts Receivable for professional firms tend to be high percentage of total assets with fairly
long average collection periods
 Some firms are capital intensive  Need many fixed assets (i.e. electric utilities, railroads, airlines)
 Some firms (Especially airlines) lease assets  Some of assets they employ may not appear on their
balance sheets
 In terms of profitability  All firms tend to seek to maximize margins, rates of returns on assets,
ROE  Difficult to use profitability measures to identify industries
 Industries that sell highly differentiated products/services, and firms that have monopolistic power,
have higher margins than the industries that sell homogeneous "commodity" type of products in
very competitive markets
 Firm’s financial structure not very useful for identifying industry it’s in  Different firms within
same industry have quite different capital structures
  High-tech, high-risk firms tend to use much less debt financing
 Low-risk firms that are capital intensive use more debt  Especially if they have highly marketable
fixed assets

FINANCIAL FOOTPRINTS – COMMENT ABOUT BANKS

 Financial intermediaries and banks have somewhat unique asset and financial structures
 Like non-bank firms  Banks extend credit to their customers  Called loans and appears on their
balance sheets
 Loans considered Accounts Receivables
 Banks also acquire considerable quantities of marketable securities