FINANCIAL STATEMENT ANALYSIS 1

FINANCIAL STATEMENT ANALYSIS

[Author Name(s), First M. Last, Omit Titles and Degrees]

[Institutional Affiliation(s)]
FINANCIAL STATEMENT ANALYSIS 2

FINANCIAL STATEMENT ANALYSIS

Part 1: Business Letter

XYZ Corporation
16 Heritage Business Park
Boston, Mass.

2/2/2021

Karl Richland, CFO

Semetell Company
Cincinnati, Ohio

Dear Mr Richland,

Thank you for using our financial consulting services. It has brought to light that
Semetell Company is facing issues vis-à-vis their cash flow. According to the topic at hand, the
working capital cycle is long; there is not enough cash to meet the payroll and pay the vendors
within thirty days.
In most cases, there are different issues that the company faces, which causes cash flow
problems. Sometimes, increased sales do not cause an increased cash flow. It does not mean that
the company does not have any sales; it means an issue with the cash flow. Any company's main
problem is the "cash gap" (Fulmer, Finch, Smythe, & Payne, 2001), which means that it takes
time for inventory to turn into sales. As the sales increase, the inventory cost and account
receivables increase, which causes a decrease in cash. Increased accounts receivables can
negatively affect cash flow, this is the amount that the company needs to collect, and until they
manage it, the cashflow stays low. It is one of the leading causes the issue Semetell Company is
facing. For example, sales revenue contains both credit and cash sales, and cashflow contains
cash related items only. High sales do not necessarily mean that cash flow would be positive as
these sales could be credit-based. According to the matching principle, "revenue is recognized at
the time of sale" which is in turn matched with the accounts payable [ CITATION Par14 \l
1033 ]. Hence, the actual cash received from sales would be after the customers have paid what
they owe.
Another factor that CFO should review is liquidity, inventory, accounts receivables,
accounts payables, assets, and liabilities. These factors give an overall view of the cashflow
and impact the cashflow as well. Accounts receivables, accounts payables, and inventory makes
up a company's working capital and having a positive working capital leads to a positive impact
on the cash flow [CITATION Ser21 \l 1033 ].
Accounts receivables are customers who buy the products on credit and agree to pay the
cash later. The day's cycle tells how much on average it takes for the accounts receivables to pay
back their debt. Hence the account needs to be managed accordingly, and the terms and
conditions of credit sales need to be discussed beforehand so that they know about the payment
terms. The company should stop operating with bad debts or those who have a history of not
paying back their debt or the company's amount. The company should ensure that the accounts
are up-to-date and consistent so that there is no data loss.
FINANCIAL STATEMENT ANALYSIS 3

Inventory is all those items that the company holds to meet customer demands. To ensure
that the excess amount is not used in the storage and purchase of inventory, the company needs
to do a demand analysis. No cash is received if the inventory is not sold, and inventory not
utilized causes cash loss.
Accounts payables are a liability. These are all those accounts which the company needs
to pay back. The lower value of accounts payable would mean that the company is making cash
purchases, which means there is less cash. Mostly, vendors provide their customers with
discounts and different incentives to pay back early.
Assets and liabilities also play their part in impacting the cash flow. Suppose the
company increases sales and buys new assets such as machinery to maintain the increased sales
volume, which will decrease cash inflow as the company would need to pay for the machinery in
cash. Liabilities such as asking for a loan would increase cashflow whereas; interest paid would
decrease some money.
Different accounting transactions have a different effect on the cash balance. These
transactions affect the working capital, which in turn affects the efficiency of the business.
Ensuring better and efficient cashflow is pertinent for the company as it results in higher profits
and growth. Analyzing the company's sales, day sales ratio, working capital cycle, etc. would
help your company develop specific strategies that could help the company work efficiently and
not cause low cash flow.
Moreover, considering the balance sheet and specifically working capital there are two
main components that are used: current assets and current liabilities. Current assets are whatever
the company owns, tangible or intangible. Current liabilities are whatever the company owes.
The company can look at different components of these two accounts to make their working
capital efficient. Apart from the ones already mentioned there are other components as well.
Notes payable or short-term loans can both cause an increase in cash. In order to increase the
overall working capital, you would need to increase the current assets so that they have enough
to pay off what they owe. The cash is already low, hence other components would need to be
looked upon. You can have any short-term investment in a company, earn additional profits, issue
stock, and sell non-current assets on cash basis. The company needs to manage four accounts in
order to have an efficient working capital: cash account, receivable accounts, inventory, and
payables account.
I hope the information provided would be fruitful to you. Please reach out to me if you
require any additional information. You may email me at xyzcorporations@email.com.
We are looking forward to receiving your feedback.

Sincerely,
[Signature]
[Name]
[Corporations]

Bibliography
FINANCIAL STATEMENT ANALYSIS 4

Fulmer, J. G., Finch, J. H., Smythe, T. I., & Payne, T. H. (2001). Growing Sales and Losing
Cash: Assisting Your Small Business Customer with Cash Flow Management. Com.
Lending Rev, 14.
Parrino, R., Kidwell, D. S., & Bates, T. (2014). Fundamentals of Corporate Finance, 3rd
Edition. Wiley.
Sernett, T. L. (2021, February 2). Cash Flow Improvement through Balance Sheet Management.
Retrieved from The Virtual BeanCounters, Inc.:
http://www.thevirtualbeancounters.com/cash-flow-improvement-through-balance-sheet-
management/
FINANCIAL STATEMENT ANALYSIS 5

Part 2: Memo

MEMORANDUM

To: Loan Officer in Charge

From: Loan Review Committee

Date: February 3, 2021

Subject: Re: Loan Request by Bob Smith

It is to inform you that my team and I reviewed the cash flow and financial statements
provided by Mr. Bob Smith and matched them with the Covenants, Conditions & Restrictions of
the company to decide whether we should proceed with his request or not. There were specific
trends that lead to this decision. We will go through these decisions one by one.
One of the main conditions that Mr. Smith had to comply with was to maintain at least
$70,000 in the non-interest-bearing checking. Their cashflow was held to $33,411, which means
that they run short of cash. But there could be various reasons that they do.

A. Balance Sheet Analysis

The first reason is the account receivables. The change is shown in the table below:

2016 $ 16,566
2017 $ 33,411
Cash Outflow $ 16,845

This shows that there has been an increase in the accounts receivable, which can be
deemed as cash outflow. This cash is unearned unless the accounts receivables pay for what they
owe. Mr. Smith's company has made increased sales on a credit basis, but this does not guarantee
that the debtors would pay them back. Various reasons may cause these debtors not to pay Mr.
Smith back. The primary reason is bankruptcy. If the debtors declare bankruptcy, they will turn
into bad debts and not pay Mr. Smith back. This amount would be recessed. But if Mr. Smith
shows that he has a reliable and good day sales ratio, which means that his debtors pay him back
in the given period, it could be considered a good sign. Moreover, an increase in the accounts
receivables puts an adverse effect on the cash flow as well. Maybe this could be the reason that
Mr. Smith could not maintain its cash flow of $70,000.
The second account to consider is the company's closing inventory, which can be seen in
the table below.

2016 $ 352,740
2017 $ 423,819
Cash Outflow $ 71,079
FINANCIAL STATEMENT ANALYSIS 6

Maintaining inventory is very crucial for any organization. This inventory at year-end is
the unsold inventory that acts as an expense. Unless the inventory gets sold off, there would be
no cash inflow. The cash is stuck in inventory and hence why Mr. Smith cannot maintain the
$70,000. This means that the company has made more purchases than it has sold. This is an
additional outflow of cash that Mr. Smith must face. Unless Mr. Smith can sell off this inventory
quickly, this would be an issue.
The third factor is the Property, Plant & Equipment, i.e., the non-current assets.
2016 $ 1,403,220
2017 $ 1,512,675
Cash Outflow $ 109,455
Mr. Smith has bought more property, plant, and equipment, which acts as a cash outflow.
Since Mr. Smith had to make this payment, he was not able to maintain the cut-off amount. A lot
of cash has moved out of the company, and they would not pay back their debts.
The accounts payables have increased, which means that Mr. Smith already needs to pay
back the creditors. Since they are short term, he needs to pay them back following their payback
terms and conditions. They increased by $109,455, which means that they would later have to
pay back their creditors. Apart from this, the wages payables have increased by $ 6,625, which
Mr. Smith would have to pay back eventually. Giving loan interest would be an issue for Mr.
Smith. This may act as a cash inflow as of now, but the payback dates may cause tremendous
outflow for Mr. Smith.
The long-term debt that Mr. Smith has decreased by $ 113,534, which were banknotes.
Even though the loan was reduced, Mr. Smith still has a substantial amount of loan that he needs
to pay ($ 697,981) alongside the interest expense, which would make it tougher to pay back the
interest expense if we agree to give him the loan. Moreover, this reduction and paying back of
banknotes affected the cashflow and reduced it, making Mr. Smith unable to reach the cut-off
amount.

B: Compliance with the Covenants, Conditions & Restrictions

The first and foremost CC&R was that Mr. Smith would have a cut-off amount of $
70,000 in their DDA, which Mr. Smith is short of due to the reasons explained above. The
second condition was that Mr. Smith would have a current ratio of 2:1 and maintain it. In 2016,
Mr. Smith had a current ratio of 2.01:1, which was a reasonably good ratio, but in 2017, it
decreased to 1.83:1. Mr. Smith was not able to maintain the current ratio as it dropped in one
year. The third condition was that the company would hold a quick ratio of 1.5:1. In 2016, it was
1.02:1, which did not meet the requirement, whereas, in 2017, it decreased to 0.81:1, meaning
that most of their current assets are based on unsold inventory. Their salaries increased by 46% in
2017, bringing us to the fourth condition that they would not increase their wages by more than
5% during the loan. Even though the loan is not given, they have other outstanding payables, and
the employees would be expecting an increase in the salaries next year. There is not much
information about bonuses, but Mr. Smith would need to comply with not being able to pay
bonuses without permission.
FINANCIAL STATEMENT ANALYSIS 7

C: Operating Cycle Analysis

In theory, the operating cycle tells the time difference between inventory purchase and
the cash collected from receivables. The operating cycle for Mr. Smith and his company is 583
days, which means that it takes 583 days between purchase and collection. The number of days is
a lot, which means that Mr. Smith would not pay back his loan interest on time, as he could not
have residual cash to pay. This cycle needs to be reduced. Mr. Smith's day sales are 406 days,
which means that, on average, it takes him 406 days to collect from his debtors. This means that
the cash stays stuck with the debtors that Mr. Smith is unable to collect.

D: Common Sized Financial Statement

Mr. Smith's common-sized financial statement is as below:

1. Income Statement
Common Size Income Statement 2017  
Revenue $423,819 100.00%
Less: Cost of Sales ($46,232) 10.91%
Gross profit $377,587 89.09%
Less: SG&A ($14,487) 3.42%
EBIDTA $363,100 85.67%
Depreciation ($109,455) 25.83%
EBIT $253,645 59.85%
Interest 0 0.00%
EBT $253,645 59.85%
Tax ($21,125) 4.98%
Net Income $232,520 54.86%

According to this statement, the net income makes 54.86% of the total revenue, which
means that they successfully change their revenue into income. This is a good sign for Mr. Smith.

2. Balance Sheet

Assets 2017 2016 2016-2017 Difference

Cash $34,111 $16,566 51.44% $17,545
AR $260,205 $318,768 -22.51% ($58,563)
Inventory $423,819 $352,740 16.77% $71,079
Other current assets $41,251 $29,912 27.49% $11,339
Total current Assets $758,686 $717,986 5.36% $40,700
Less: Accumulated depreciation       $212,366
Deferred taxes       $225,700
FINANCIAL STATEMENT ANALYSIS 8

Plant Property and Equipment $1,512,67 $1,403,22 7.24% $109,455

5 0
Goodwill and other assets $382,145 $412,565 -7.96% ($30,420)
Total Assets $2,653,50 $2,533,77 4.51% $119,735
6 1
 
Liabilities and Stockholder Equity       Difference
AP $378,236 $332,004 12.22% $46,232
Wages payable $14,487 $7,862 45.73% $6,625
Accrued income taxes $21,125 $16,815 20.40% $4,310
Dividends paid       $2,966,412
total current liabilities $413,848 $356,681 13.81% $57,167
Long Term Debt $679,981 $793,515 -16.70% ($113,534)
Total Liabilities $1,093,82 $1,150,19 -5.15% ($56,367)
9 6
Total Common Equity $1,559,67 $1,383,57 11.29% $176,102
7 5
Total liabilities and stockholder equity $2,653,50 $2,533,77 4.51% $119,735
6 1

The balance sheet shows that the company is more reliant on equity than liabilities, which
is a good sign considering the company's leverage. But on the other hand, their assets are built up
mostly from their non-current assets, which means their liquidity is not that high. Low liquidity
means that it would be tough for Mr. Smith to pay back his loans. Most of the working capital
was used in accounts payable and inventory. Both are the least liquid accounts and hold in cash.

E: Cash Flow Statement

Assets 2017 2016 Difference

Cash $33,411 $16,566 $16,845
Accounts Receivables $260,205 $318,768 ($58,563)
Inventory $423,819 $352,740 $71,079
Other current assets $41,251 $29,912 $11,339
Total current Assets $758,686 $717,986 $40,700
Less: Accumulated depreciation     $212,366
Deferred taxes     $225,700
$1,512,67 $1,403,22
Plant Property and Equipment $109,455
5 0
Goodwill and other assets $382,145 $412,565 ($30,420)
$2,653,50 $2,533,77
Total Assets $119,735
6 1

Liabilities and Stockholder  2017 2016 Difference

FINANCIAL STATEMENT ANALYSIS 9

Equity
Accounts Payable $378,236 $332,004 $46,232
Wages payable $14,487 $7,862 $6,625
Accrued income taxes $21,125 $16,815 $4,310
Dividends paid     $2,966,412
total current liabilities $413,848 $356,681 $57,167
Long Term Debt $679,981 $793,515 ($113,534)
$1,093,82 $1,150,19
Total Liabilities ($56,367)
9 6
$1,559,67 $1,383,57
Total Common Equity $176,102
7 5
Total liabilities and stockholder $2,653,50 $2,533,77
$119,735
equity 6 1

Net Cash flow for operating $3,634,25

expenses = 5

2017
Cash Flows from Operating Activities
Net Income
3,155,848.00
Add Expenses Not Requiring Cash:
Depreciation
212,366.00
Amortization of Goodwill
30,420.00
Other Adjustments:
Add Reduction in Accounts Receivable
58,563.00
Add Increase in Wages Payable
6,625.00
Add Increase in Accounts Payable
46,232.00
Subtract Increase in Inventory
(71,079.00)
Add Increase in Accured Expenses
4,310.00
Other
(11,339.00)
Net Cash from Operating Activities
3,431,946.00
Cash Flows from Investing Activities
Purchase of New Equipment
(109,455.00)
Net Cash Used for Investing Activities
FINANCIAL STATEMENT ANALYSIS 10

(109,455.00)
Cash Flows from Financing Activities
Payment of Loan
(113,534.00)
Net Cash from Financing Activities
(113,534.00)
NET INCREASE/(DECREASE) IN CASH
3,208,957.00
CASH, BEGINNING OF YEAR
34,111.00
CASH, END OF YEAR
3,243,068.00

The cash flow statement shows the reasons for the increase and decrease in cash. As
stated before, there were many reasons for this, the increase in accounts payable, accounts
receivables, inventory, etc. all these reasons make up for why the cash has not been able to
increase as much.

F: Closing Remarks/Summary

The company could not meet up with the CC and Rs because of the management
decisions. The management decided to increase salaries, make more credit sales, buy more
inventory, make more purchases, etc., which led to them not being able to meet the cut off
amount. The company had set its priorities somewhere else; hence, they could not meet the CC&
Rs.
While focusing on the positive trends, it can be seen that there is a decrease in the
accounts receivable which is beneficial for Mr. Smith’s company. Managing the accounts
payable of the company is highly pertinent as it keeps the company’s rapport and according to
the statements, the company has been paying off loans quicker than they are earning. This did
cause an adverse effect on the company’s cashflow. The company would be able to manipulate
its cashflow till a certain time by not paying back its vendors quickly, but this depends on the
type of the relationship they have. Cash balance was less than 34,111 in 2017 which is one of the
main reasons for the unacceptance of the loan. As soon as the accounts receivables are paid for,
Bob would have to channel the invoice towards the wages that need to be paid, as paying off
wages and loans must be every company’s priority.

G: Recommendations

We can give Mr. Smith several recommendations so that he can comply with the CC and
R's for next time. Many big companies fail to have adequate cash flow; hence, they need to
change their policies and align them accordingly so that their cash flow gets better. The
following recommendations would help Mr. Smith:
i. Leasing instead of buying:
Mr. Smith bought a new property plant and equipment, which took a significant
chunk of his cash. To ensure that this does not happen next time and that Mr.
FINANCIAL STATEMENT ANALYSIS 11

Smith still has some residual cash even after having new non-current assets, he
should lease rather than buy. He would need to pay a specific down payment and
then interest payment according to the lease terms and conditions. This would
lead to his company having residual cash that can be used elsewhere. Hence,
making his cashflow better.
ii. Offer Discounts
Mr. Smith's debtors do not pay him back early, which means that his collection
period is relatively small. To make sure that his clients pay him back early and his
day sales ratio gets smaller, he would need to introduce discount policies.
Discounts on early payments encourage the clients to pay early, and early
payments lead to increased cash flow. They are making him able to comply with
the CC & R's.
iii. Conduct Customer Checks
As stated above, Mr. Smith's customers do not pay him back early, which could be
because his customers are unable to pay. This inability can be due to several
reasons: bankruptcy, low cash flow, low income, high expenses, etc. So, Mr.
Smith should ensure that he does customer checks to ensure that they can pay
back the cash.
iv. Buyers Discount
Mr. Smith has high inventory purchases, which causes his outflow to increase.
But to ensure that the outflow does not increase much, Mr. Smith could ask for a
discount from his suppliers so that his company does not have to pay much.
v. Inventory Checks
Mr. Smith has a high level of inventory, which means that a lot of inventory stays
unsold. This can be due to not checking the market's demand levels. High
inventory also increases storage costs. To make sure that Mr. Smith does not incur
these extra costs, he should keep a check on the demand levels of the market and
make sure that the supply should meet the demand. Using inventory systems like
just in time system or kaizen system could help Mr. Smith in this.
All these recommendations could help Mr. Smith make his cashflow better and comply
with the CC & R's.

H: Final Decision

In conclusion, the committee voted against the renewal of his loan based on the 5 Cs of
credit: character, capacity, capital, collateral, and conditions.
i. Mr. Smith is of good character and is known to pay off his loans (as seen in the
reduction of the long-term loan) and pays off his suppliers early as well. This is a
good trend in favor of Mr. Smith.
ii. The company cannot take another loan since they already have to pay back their
outstanding expenses, taxes, and loans. Moreover, the company already has
incurred high expenses such as capital expenditure. Hence the committee deems
that Mr. Smith's company cannot take another loan.
iii. Mr. Smith has an adequate capital level as more than half of the company is
levered on capital rather than a loan. This seems like a good sign for Mr. Smith.
FINANCIAL STATEMENT ANALYSIS 12

iv. Mr. Smith does not have much to give as collateral, as his company lacks the
assets and amount of capital to keep as collateral in the bank.
v. Lastly, Mr. Smith, as discussed above, is unable to meet the conditions of the CC
& Rs, which means that their company is not compliant with them.
Based on all these, the committee concluded that Mr. Smith should not be given a loan.
But, on the other hand, feedback should be taken by Mr. Smith asking him whether he would be
able to meet these demands in the next accounting period, if yes, then perhaps it can be deemed
that Mr. Smith should be given the loan.