DISCUSSION QUESTION (2)

Full name: Chau Nguyen Hoang Nguyen

Student ID: 110102210019
Class: IBP20D02-1

*Note: There are two parts: "Evidence" and "Answer" for each question. The
first part is the information collected from the Textbook, which is then
summarized and analyzed based on my knowledge in the "Answer" part.

1. What characteristics should a business have before it can be considered to

be financially sound?
Evidence (Page: 47)
“It is less risky for a lender to give a loan to a business that is financially
sound. But how can a lender know whether a particular business is financially
sound? A sound business possesses the following characteristics:
- The business has adequate liquidity so it can honour short-term
obligations easily.
- The business is run efficiently.
- The business is run profitably.
- The proprietor's stake in the business is high; alternatively, the business is
not burdened with too much debt.”
Answer:
Before a business can be considered financially sound, it should possess the
following characteristics:
- Adequate liquidity: The business should have enough liquidity to meet its
short-term obligations easily. This means it should be able to pay off
financial obligations that arise within the next year without difficulty.
- Efficient operation: The business should be run efficiently, indicating that
resources are being utilized effectively to generate profits.
- Profitability: The business should be profitable, meaning it generates
more revenue than expenses over time.
- High proprietor's stake or manageable debt: The proprietor's stake in the
business should be high, indicating a strong commitment to the business's
success. Alternatively, the business should not be burdened with excessive
debt, which could pose a risk to its financial health.
2. What are the various types of financial ratio that lenders use in analysing
the financial position of a firm?
Evidence (Page: 51,52,53,54,55,56,57,58,59,60,61)
By appropriately analysing financial statements (for example, ratio analysis),
the lender can know whether the above characteristics are present. If they
are present, then the business will be considered to be financially sound and
loan approval will not be a problem.
The various ratios that lenders generally use can be grouped into the
following categories:
- liquidity ratios
- efficiency ratios
- profitability ratios
- leverage ratios.
a)Liquidity ratios:
Liquidity refers to the ability of a firm to meet its short-term obligations -- that
is, whether the business is in a position to pay financial obligations that will
arise in, say, the next year. Liquidity is an important aspect to be watched in
any business. The failure of many businesses has been due to lack of adequate
liquidity. Liquidity can be described as the lubricant that helps the business
run smoothly: just as a car needs to have sufficient lubricating oil (engine oil,
breaking oil and so on), a business needs to have adequate liquidity at all
times.
To check whether a firm has adequate liquidity, financial institutions compute
liquidity ratios. Two principal ratios that are commonly used to judge the
liquidity position of any business are:
- The current ratio
The current ratio is the ratio of current assets to current liabilities. Current
assets include cash, marketable securities, debtors, closing stock (ending
inventory), loans and prepaid expenses. Current liabilities are borrowings for
the short term, trade creditors, accrued expenses and provisions.
- The quick ratio
Another measure of liquidity is the quick ratio, also called the acid test ratio. It
is much the same as the current ratio except that inventory is excluded from
its calculation.
The quick ratio is a ratio of quick assets to current liabilities. Quick assets
include all current assets except inventory (raw material, work in process and
finished goods).
b) Efficiency ratios
We stated earlier that one of the characteristics of a financially sound
business is that it is run efficiently. To measure efficiency, financial analysts
calculate the efficiency ratios. The efficiency ratios measure how efficiently
the business has employed its assets. These ratios are based on the
relationship between the level of activity (represented by sales or the cost of
goods sold) and the levels of various assets. Efficiency ratios are also called
turnover ratios, activity ratios or asset management ratios. The important
efficiency ratios are:
- The inventory turnover ratio
The inventory turnover ratio shows the efficiency of management of
inventory. The ratio of net sales to inventory is called the inventory turnover
ratio.
- The average collection period.
This ratio shows the efficiency in collection of receivables. A business that is
efficient in debt collection will face fewer liquidity problems. The average
collection period is the ratio of receivables to average sales per day.
c) Profitability ratios
A financially sound business is likely to be a profitable business. The two
popular profitability ratios are the gross profit-sales ratio and the net profit-
sales ratio.
- The gross profit-sales ratio
This is the ratio of gross profit to net sales, where gross profit is defined as the
difference between net sales and the cost of goods sold.
- The net profit-sales ratio
This ratio captures the profitability of the firm when all the costs (including
the administrative costs) are considered.
d) Leverage ratios
Financial leverage means the use of debt finance. Leverage ratios help us
assess the risk arising from the use of debt capital. It has been found that if a
positive financial leverage could be established, then debt capital is a
preferred source of finance. Analysis of financial leverage generally uses two
types of ratio: structural ratios and coverage ratios. The structural ratios are
the debt-equity ratio, the proprietary ratio and the debt-assets ratio, while
the coverage ratios are the interest coverage ratio and the fixed charges
coverage ratio.”
- The debt-equity ratio
This ratio shows the proportion of amount borrowed by the firm compared
with the proprietor's own investment in the business. It is a ratio of debt to
the equity of the firm. The debt consists of all liabilities of the firm, whether
short term or long term, and the equity consists of capital and reserves.
- The interest coverage ratio
The interest coverage ratio is the ratio of earnings before interest and taxes
on debt interest. It shows whether the firm has sufficient resources to cover
the interest portion of the debt. In the case of a firm having financial
difficulties, the bank may postpone the repayment instalment but would insist
on, at least, payment of the interest on the debt. If a firm is unable to pay
even the interest, then it is in serious financial difficulty.
- The fixed charges coverage ratio
This ratio is the ratio of earnings before interest and taxes plus depreciation
to interest on the loan and the loan repayment instalment. It is used to
measure the debt servicing capacity of the firm.”
Answer:
The various types of financial ratios that lenders use in analyzing the financial
position of a firm are:
a)Liquidity Ratios:
- Current Ratio: Ratio of current assets to current liabilities.
- Quick Ratio (Acid Test Ratio): Ratio of quick assets (current assets
excluding inventory) to current liabilities.
b)Efficiency Ratios:
 - Inventory Turnover Ratio: Measures the efficiency of inventory
management by comparing net sales to inventory.
- Average Collection Period: Indicates the efficiency of receivables collection
by comparing receivables to average sales per day.
c)Profitability Ratios:
- Gross Profit-Sales Ratio: Ratio of gross profit to net sales.
- Net Profit-Sales Ratio: Measures overall profitability by considering all
costs, including administrative costs.
d)Leverage Ratios:
- Debt-Equity Ratio: Shows the proportion of debt to equity in the firm,
indicating the reliance on debt financing.
- Interest Coverage Ratio: Indicates whether the firm has sufficient
resources to cover interest payments on debt.
- Fixed Charges Coverage Ratio: Measures the firm's capacity to service debt
by comparing earnings before interest, taxes, and depreciation to interest
and loan repayment instalments.
3. Explain the advantages and limitations of financial statements analysis.
Evidence (Page: 46-47-48-49 & 87)
“The key financial statements used by a lender for analysing the financial
standing of a business firm are
1. An income statement,
2. A balance sheet, and
3. A statement of cashflows.
The second question of whether the loan will be repaid together with interest
is a bit tricky. Financial statements analysis is essentially a post mortem and
cannot provide an answer to this question. The financial statements belong to
a period that has already elapsed, but the loan is to be repaid in the future
and no-one knows what the future holds. How can a lender find an answer to
the second question? How can the lender predict what will happen?
While a lender cannot predict the future with absolute certainty, a reasonable
guess can be made by analysing the following factors:
dang
1. Trend (time series) analysis. If the business was run profitably for some
years, then it may not be unreasonable to assume the trend will continue.
The past trend and the projected surplus, the past trend and the projected
cash surplus, the trend of various ratios and the likelihood of continuing of
that trend are some factors that need to be examined.
2. Safety buffer. If the business has a large margin of safety (between actual
sales and break-even sales), then some fluctuations in business conditions
in the future may not be a cause for worry.
3. Stress testing. The business can be subjected to sensitivity testing. If the
business continues to remain profitable, then the lender can be
reasonably certain that the business can withstand shocks in the future. 4.
Industry analysis. What are trends and prospects for the firm's industry? If
the industry is growing, then the lender can expect that the firm will also
grow.
4. Economic analysis. The lender can analyse trends in the domestic and
judge international economies to gauge the possible impact on the
business.
The techniques that help the lender in analysing the above factors include: a
projected income and expenditure account, a projected cashflow, margin of
safety analysis, sensitivity analysis, trend analysis, inter-firm comparison,
industry analysis and economic analysis. Predicting the future of the business
is just a 'best guess' by the lender; no-one can predict the future with
absolute certainty.
Given that some amount of risk is always involved, the bank needs some form
of insurance. Such an insurance and thus an answer to the third question--
what is the financial institution's remedy if the assumptions made while giving
the loan turn out to be wrong? --are provided by the following:
1. Collateral. If everything goes wrong, then the banker can fall back on the
security obtained while granting the loan. The bank will sell the security and
use the proceeds to satisfy the outstanding debt.
2. Charge on assets. The lender sometimes prescribes a condition that there
will be a floating charge on all the assets of the business. If the proceeds from
the collateral are insufficient, then the financial institution can stake a claim
over the other assets of the business.
3. Guarantees. The lender will insist on personal guarantees of company
directors so in the case of default the financial institution can recover dues
from the personal property of the directors. Such a guarantee also acts to
deter the company directors from taking actions that are detrimental to
business interests. In sole proprietorships and the partnerships, the owners
are personally liable anyway, so the guarantees may be taken from friends or
relatives of the owners.
4. Conditions. The financial institution may place conditions on a loan, such
as a negative pledge (as explained in Chapter 1), to ensure the business
remains disciplined and does not take any action that may be detrimental to
the lender's interest.
Financial statements may show what kinds of assets are available, their book
value, whether they are unencumbered (that is, not given as security for other
loans), and the likelihood of these assets being used as security for the
proposed loan.
It should be clear to you now that financial statements analysis and other
types of analysis are used to find answers to the earlier three questions that
are repeated here for ready reference:
1. Should the bank give the requested loan?
2. If the loan is given, will it be repaid together with interest?
3. What is the financial institution's remedy if the assumptions about the
loan turn out to be wrong?
Financial statements contain a wealth of information, but it takes skill and
experience to unearth that information. If properly analysed, the financial
statements can provide valuable insights into a firm's performance and
financial condition. In the following section, we will discuss how financial
statements are analysed to unearth their hidden information content.”
Limitations of financial statements analysis
Financial statements analysis can be a useful tool, but it is no substitute for a
lender's judgement. Results of such analysis must be read with care. The
following are limitations of financial statements analysis:
1. Problem with benchmarks. Many firms have product lines that span a range
of industries. The diversity of products makes it hard to develop suitable
benchmarks against which to evaluate firm performance. Average ratios for
firms within the industry may be available, but not Scatter, the dispersion
thereof. This makes the use of benchmarks less reliable
and less useful.
2. Window dressing. The problem of window dressing has been considered
earlier in this chapter.
3. Historical data. Ratios are calculated using historical financial statements.
Unless the figures in the financial statements are marked to market, it is hard
to obtain a true picture. Further, the lender is interested in obtaining a
futuristic view and it may not be correct to predict the future on past trends
alone.
4. Qualitative aspects. This type of analysis ignores qualitative aspects such as
the quality of management, regulatory changes and changes in the domestic
and international economies.
Answer:
Financial statement analysis is a critical tool for assessing the financial health
and performance of a business. It involves examining various financial
documents such as balance sheets, income statements, and cash flow
statements to gain insights into the company's operations, profitability, and
solvency. However, like any analytical method, financial statement analysis
has its advantages and limitations:
1) Advantages:
- Performance Assessment: Provides insights into a company's financial
health and past performance.
- Trend Analysis: Helps identify trends over time, aiding in growth
assessment.
- Industry Comparison: Allows benchmarking against peers for
competitiveness evaluation.
- Strengths and Weaknesses Identification: Pinpoints areas of strength and
weakness for strategic decision-making.
- Forecasting: Assists in making informed predictions for investment and
strategic planning.
2) Limitations:
- Difficulty with benchmarks: Many companies operate across multiple
industries, making it challenging to establish relevant benchmarks for
performance evaluation. While average ratios for the industry may exist,
the dispersion of data (Scatter) makes benchmarks less reliable.
- Window dressing: The issue of window dressing, discussed earlier, can
distort financial statements, misleading lenders about the true financial
health of a company.
 - Reliance on historical data: Financial ratios are based on historical
financial statements, which may not accurately reflect current market
conditions. Without marking figures to market, it's challenging to obtain a
true picture of the company's financial position. Additionally, lenders seek
a forward-looking perspective, and relying solely on past trends may not
predict the future accurately.
- Ignoring qualitative aspects: Financial statement analysis often overlooks
qualitative factors such as management quality, regulatory changes, and
shifts in domestic and international economies, which can significantly
impact a company's performance and future prospects.
4. What is break-even analysis? Why should a lender be interested in break-
even analysis?
Evidence (Page: 68-69-70)
“Break-even analysis
Break-even analysis is a concept from cost accounting. It is a useful concept,
not only for the firm but also for the lender who is trying to assess the
performance and prospects of the firm. It is therefore discussed here in detail.
Break-even analysis involves calculation of the break-even point and the
margin of safety.
"The break-even point is the level of sales at which revenue equals expenses
and net income is zero' (Horngren & Sundem 1994, p. 38). It is a point that
indicates a 'no profit, no loss' position. Beyond this point, the firm starts
earning profits. The break-even point is often expressed in a number of units
and/or in dollar sales. It shows the number of units that must be produced or
sold, to achieve a 'no profit, no loss' position. If the firm produces and sells
more units, then it will make a profit. Multiplying the number of units by the
sales price per unit gives the break- even point in dollar sales.
For calculating the break-even point of any firm, it is necessary to have
information about the fixed and variable costs of producing the units. Variable
costs are costs that vary directly in proportion to the number of units
produced. If 100 units of a certain product are produced and the variable cost
per unit is $4, then the total variable cost is $400. If the production is raised to
200 units, then the variable cost is $800. As the units produced are doubled,
the total variable cost also doubles. It is important to note that the variable
cost per unit ($4) remains the same. The costs of raw materials, wages,
power, fuel and so on are examples of variable cost. If you drive 10 kilometres
and you require 1 litre of petrol (which costs 86 cents per litre), then if you
drive 50 kilometres you will require 5 litres of petrol and your total fuel cost
will equal 0.86 multiplied by 5, or $4.30. The cost per litre remains the same
at 86 cents.
Fixed costs are costs that remain constant whatever output is produced. Rent
is a typical example of a fixed cost. If a firm rents a factory shed and pays $300
as weekly rent, then it continues to pay the rent of $300 per week regardless
of whether it produces 600 units or 1200 units. If the firm produces more
units, then the fixed cost per unit declines. If 600 units are produced, then the
loading of rent cost per unit is 50 cents ($300 divided by 600); if 1200 units
are produced, then the loading of rent cost per unit is 25 cents ($300 divided
by 1200).
The calculation of the break-even point requires information on fixed costs,
variable costs, sales revenue and units produced.
Illustration A
The total cost of producing 10 000 units (say, bottles of coke) is estimated at
$20 000, of which 60 percent is variable and the remainder is fixed. If a coke
bottle is sold at $1.70, then calculate the break-even point.
Solution
Total cost = $20 000
Variable cost = $12 000 (60 percent of $20 000)
Fixed cost = $8000 (Total cost $20 000 - Variable cost $12 000) Variable cost
per unit = $1.20 (Variable cost $12 000 + 10 000) Contribution (to fixed cost)
per unit = $0.50 (Selling price $1.70-
Variable cost $1.20)
Break-even in volume of output = 16 000 units (Fixed cost $8000 +
Contribution $0.50)
The firm must produce and sell 16 000 bottles of coke to break even. At this
level of output, the revenue earned will fully cover the total costs of the firm.
Illustration B
If the firm produces 15 000 bottles of coke, then will it make a profit or a loss?
Using the figures in the above example, let us work it out.
Solution
Fixed cost = $8000
Variable cost 15 000 x $1.20 = $18 000
Total cost = Fixed cost + Variable cost = $8000+ $18 000 = $26 000
Total revenue = $15 000 x $1.70 = $25 500
Loss = $26 000 - $25 500 = $500.
If the firm produces less than the break-even output, then it will incur a loss.
On the other hand, if the firm produces more--say, 20 000 bottles of coke --
then it will make a profit. Once we know the break-even point, we can readily
know whether the firm will make a profit or a loss by producing a certain
volume of output.
Let us assume that the firm cannot raise production of coke bottles beyond 15
000. What will the firm need to do to make a profit? The firm has two options:
cut costs or increase revenue. The firm can cut either variable or fixed costs,
or both. It will be hard to cut variable costs. We saw earlier that these costs
vary directly with the output. Many of the inputs are bought from the market
and the firm has no control over the price. Given the difficulties in slashing
variable costs, the firm is left with the alternative of cutting fixed costs. This
may be possible. If the firm rents a smaller factory shed, then it could reduce
the rent cost (a fixed cost). Alternatively, the firm could cut jobs and save the
administration (say, salary) cost. A third alternative is to raise the price of a
bottle of coke to, say, $1.80. The consumers may not be prepared to pay this
price, however, and may shift to other brands of cold drinks, which would
reduce the volume of coke bottles sold. The firm, therefore, has four choices.
These choices are not mutually exclusive and more than one can be used at
the same time.
1. Cut variable costs.
2. Cut fixed costs.
3. Increase the sale price of coke bottles.
4. Produce and sell more bottles of coke than the break-even level of 16 000
bottles.
The circumstances of every firm are different and the solution depends on
those circumstances. Why should the lender worry about these matters? The
reason is that it would be unwise for the financial institution to approve the
loan if the firm cannot be profitably run. The lender should always put
himself/herself in the shoes of the proprietor of the firm and ask whether the
firm can make a profit. The break-even analysis is a handy tool in this decision.
Margin of safety
One direct use of break-even analysis is for assessing possible business risk.
The concept of 'margin of safety' helps to assess the possible risk that the firm
is likely to face. It refers to the excess of actual sales over the break-even
sales. If the actual sales are $100 000 and break-even sales are $70 000, then
the firm enjoys a margin of safety of $30 000. The margin of safety can be
expressed as a percentage of sales. Here, the margin of safety is 30 percent
($30 000 divided by $100 000). Margin of safety can also be expressed in
terms of the volume of production. If the break-even volume is 20 000 units
and the firm is producing and selling 30 000 units, then the margin of safety is
10 000 units. Margin of safety is like a buffer; if it is high, then the business is
sound and has a comfortable cushion to absorb any shocks. A lender would be
interested in knowing the margin of safety that is available to the firm. If the
margin of safety is large, then the risk in lending is less.
Answer:
- Break-even analysis is a financial concept used to determine the level of
sales at which a company's revenue equals its expenses, resulting in zero
net income, indicating a "no profit, no loss" scenario. It involves
calculating the break-even point, which is often expressed in terms of units
or dollar sales.
- For instance, if a company produces and sells more units than its break-
even point, it starts earning profits. Break-even analysis requires
information on fixed costs (which remain constant regardless of
production levels) and variable costs (which vary directly with production
levels), as well as sales revenue and units produced.
- A lender should be interested in break-even analysis because
1) It provides valuable insights into a company's financial performance
and prospects. By understanding the break-even point, a lender can
assess whether the company can generate sufficient sales to cover its
costs and make a profit. This analysis helps the lender evaluate the
viability and profitability of the company, informing their decision on
whether to approve a loan.
2) Additionally, break-even analysis enables lenders to gauge the level of
risk associated with lending to a particular company. A higher margin
of safety, which represents the excess of actual sales over the break-
even sales, indicates a lower risk for the lender. It serves as a buffer
against potential downturns or shocks in the business environment,
enhancing the lender's confidence in the borrower's ability to repay
the loan.
3) Therefore, break-even analysis provides lenders with valuable insights
into the financial health and risk profile of potential borrowers, aiding
in prudent decision-making regarding loan approvals.
4)
5. What is the difference between indexed analysis and common-size analysis?
Evidence (Page: 61)
“Common-size statements
this dang thinh thail (west)
Common-size analysis came into vogue because inter-firm comparisons were
needed. When firms are of different sizes, it is hard to compare them unless
their financial statements are expressed in a common form. This common
form is created by expressing the components of the balance sheet and
income statement as a percentage of total assets and total revenue
respectively. Table 2.1 illustrates a common-size balance sheet.
Table 2.1 covers only items on the balance sheet; it can similarly be prepared
for all items, expressing them as percentages of total assets. Several
inferences can be. drawn from the data in Table 2.1. Firm C has a very high
equity-total assets ratio compared with that of other firms, while firm B has
the lowest. Firm D has a very high proportion of inventories (possibly due to
slow-moving stocks) compared with that of other firms. Other useful
inferences can be drawn too. In this way, the statement indicates the
directions in which further analysis needs to focus.”
Answer:
Common-Size Analysis:
- In common-size analysis, financial statements are expressed as
percentages of a base value, typically total assets for the balance sheet
and total revenue for the income statement.
- The purpose of common-size analysis is to standardize financial
statements, making it easier to compare companies of different sizes or
industries.
- For example, in a common-size balance sheet, each line item (such as
assets, liabilities, and equity) is represented as a percentage of total
assets.
- Common-size analysis helps identify trends and patterns within a single
company's financial statements, as well as differences between
companies.
Indexed Analysis:
- Indexed analysis involves using a common base year as a reference point
to compare financial data over multiple periods.
 -
Instead of expressing financial data as percentages, indexed analysis
calculates the change in each line item relative to the base year and
expresses it as an index number.
- The base year is assigned an index value of 100, and the index values for
subsequent years are calculated relative to the base year.
- Indexed analysis is particularly useful for analyzing trends and changes in
financial performance over time, highlighting growth rates or declines in
various financial metrics.
6. What is discounted cashflow? What are the various discounted cashflow
methods?
Evidence (Page: 65-66-67)
“Discounted cashflow techniques
There are three discounted cashflow techniques: the net present value (often
abbreviated as NPV), the internal rate of return (often abbreviated as IRR) and
the benefit-cost ratio (also called the profitability index).
- The net present value
To compute the net present value, deduct the present value of net
cashflows from the initial outlay.
- The internal rate of return
'Internal rate of return for a project is the rate of return which equates the
present value of the project's net cashflows with its initial cash outlay'
(Peirson et al. 1998, p. 163). The formula used for calculating the internal
rate of return is the same as that for calculating the net present value,
except that it is equated to 0 and k is replaced by r. The r gives the internal
rate of return, which is then compared with k or the expected rate of
return. If r is greater than k, then the project is accepted.
- Benefit-cost ratio
The benefit-cost ratio is a ratio of the present worth of benefits and the
present worth of costs. To calculate this ratio for our example, add up all
the positive values from the last column of Table 2.4 (the present worth of
benefits) and divide the sum by all the negative values (the present worth
of costs). 'The benefit-cost ratio is used almost exclusively as a measure of
social benefit, that is, for economic analysis... It is almost never used for
private investment analysis' (Price Gittinger 1976, p. 60).”
Answer:
- Discounted cash flow (DCF) is a financial valuation method used to
estimate the value of an investment based on its expected future cash
 flows, discounted back to the present value using a discount rate. The
rationale behind DCF is that the value of money decreases over time due
to factors such as inflation and the opportunity cost of capital, so future
cash flows are worth less in today's terms.
- The various discounted cash flow methods include:
1)Net Present Value (NPV): NPV calculates the present value of future
cash flows generated by an investment, minus the initial investment cost.
It helps determine whether an investment will generate a positive or
negative return after accounting for the time value of money.
2)Internal Rate of Return (IRR): IRR is the discount rate that makes the
present value of an investment's cash inflows equal to the present value of
its cash outflows. It represents the rate of return earned by an investment
and helps assess the attractiveness of an investment opportunity.
3)Benefit-Cost Ratio (or Profitability Index): The benefit-cost ratio
compares the present value of benefits to the present value of costs
associated with an investment project. It helps evaluate the economic
viability of projects, particularly in the context of social or public
investments.
7. What is 'creative accounting'? Explain by giving examples.
Evidence (Page: 75-76-77-78)
“Detecting window dressing, frauds and errors
The collapse of the insurance giant HIH shocked Australians. Even though the
company had a professional management, had its accounts audited by a
reputed accounting firm and was under the regulatory eye of both the
Australian Securities and Investments Commission and the Australian
Prudential Regulation Authority, HIH probably resorted to 'creative
accounting'. The financial statements were made up and did not give a true
and fair view. The provisional liquidator for HIH, Mr Tony McGrath, stated
that 'I think it is fair to say that the accounts that were prepared were
prepared at the aggressive end of the equation.
As to how creative they were I think it is far too early for me to offer any
views on that' (Pascoe 2001a, p. 1).
How can a financial institution guard itself if a firm resorts to creative
accounting? There are several ways in which a lender can detect window
dressing, as listed on pages 74-6. One advantage for the financial institution is
that it need not rely on only publicly available information; it has every right
to seek any further details from the firm as it deems fit. If a firm avoids giving
details, then the financial
institution should be more circumspect in advancing the loan. casections,
prudent
neal
1. Check the details of receivables. Are there any receivables in arrears for
more than sixty or ninety days? If so, then exclude these old receivables from
the calculation of the working capital requirements and the current ratio.
Further, of the receivables in arrears for less than sixty days (called 'eligible
debts'), banks will finance up to 75-80 percent of the value. The bank may
obtain a list of debtors and decide which receivables are to be included in the
'eligible debts'. Some debtors may be customers of the bank, so the bank may
already know their credit history. It is also necessary to ensure receivables are
not concentrated with a few parties. This is because the firm may be in
serious trouble if these debtors go bankrupt. Coastales and Szurovy (1994)
state that a firm may sometimes issue 'fake' invoices (to raise the figure of
receivables) and include these in a statement of receivables submitted to the
bank. If the lending officer is too busy and accepts the statement furnished by
a firm without questioning, the advance will be made against the fake
receivables too. The firm has thus drawn cash against 'ghost' debtors. The
auditors cannot catch this problem because they will give the firm a clean bill
of health based on documents in the file. The fake invoices are paid out of
issuing other fake invoices. Sometimes, the firm may not issue completely
fake invoices, but instead resort to over-invoicing existing parties. This
practice helps raise the sales figure and thus the profit. Watch whether
receivables are genuine, due and enforceable. Any portion of receivables from
related parties is better excluded if it does not
represent bona fide receivables. genuine, heal
2. Check the valuation of inventory. Call for the break-up of inventory-- that
is, raw material, works in process and finished goods. Raw material and
finished goods are generally valued at cost price or market value, whichever is
less. The Australian Accounting Standards Board requires inventory to be
valued using the FIFO method. The valuation of works in process is harder.
Such inventory is generally valued at cost. Banks are prepared to give more
advances against raw material (up to 80 percent), which can be easily sold. If
the finished goods have a good demand, then an advance may be made to the
extent of 80 percent. Only about a 50 percent advance will be given against
works in process, however, because it is hard to sell unfinished goods. Check
the inventory turnover ratio. Is the inventory fast moving? If not, be more
circumspect in your decisions.
3. Check the machinery valuation. Machinery and equipment need to be
valued with care and at cost or market price, whichever is lower. It is possible
that the equipment may have become obsolete
4. Check the real estate valuation. Real estate may be worth much more or
much less than the value appearing in the balance sheet. Real estate should
be valued at a price at which comparable property was sold in recent times.
5. Check the valuation of marketable securities. Securities should be valued
at cost or market price, whichever is lower. Any marketable securities of long-
term nature should be excluded from current assets.
6. Check for other 'creative accounting' techniques, as listed in Figure 2.1.
Figure 2.1 Creative accounting techniques
1. Delay publishing the results for as long as possible. There are limits to
this, legal ones in most nations, but it is rare not to be able to get away
with a delay of at least one and perhaps two years. This is often enough;
beyond that either the company has failed or it has recovered. Delayed
accounts, then, are a useful symptom for outside observers to watch for.
2. Capitalise research costs, either on the basis that these will be written
off against orders already received or against orders expected to be
received.
3.Continue paying dividends even if you have to raise equity or loans to. do
so. (While this may put shareholders off the scent, it may not confuse
investments analysts.)
4. Cut expenditure on routine maintenance until the plant is in such a poor
state of repair that a major renovation is needed. This can be treated as
capital.
5.In many nations, leasing and hire purchase arrangements do not have to
be shown as loans in company accounts. Although they are usually a very
expensive source of capital, their use does reduce apparent gearing
6. Instruct all accounts departments, to treat extraordinary income as
ordinary and ordinary expenditure as extraordinary as far as possible. This
of course improves current profits.
7. Instruct all subsidiaries to increase their dividends to the parent
company. (If you have no subsidiaries, you had better get some if you want
to use this and number 8.)
 8. Year by year bring into your consolidated accounts progressively more
and more results, first from your 100 percent owned subsidiaries, then 75
percent, then 50 percent.
9. Proprietors of small businesses should retain the company's main asset
in their name or that of their wife. If the company fails, most of the debts
will then have to be met by the creditors. Outside observers-especially
creditors-should check this point for any suspect company.
10. Value your assets at whatever figure suits you. Either the auditors will
not notice or, if you elect one of their partners to the board, they will say
nothing
11. It is not only research costs that can be capitalised, so can training
costs, interest charges on loans, the costs of setting up a computer,
advance payments.
12. Inflation has seriously upset many accounting conventions. It should be
possible to use it as a smokescreen in revaluing assets, for example. 13.
Certain of a company's debts can be met out of the proprietor's own
pocket. (This is especially useful to improve apparent profits just before a
proprietor sells his/her shares!)
14. Value stocks of finished products at the current market selling price
rather than at cost.
15. To impress one's bankers, one could hold back a week's output so
when they visit the factory, it appears to be a hive of activity. To mg, tap
16. Set up a Department 99 to invent some customers or some rice or
ammonia or vegetable oil. If you need a ship to transport these goods, or
tanks to store them in, invent these too,
17. Set a sales target for a given area of your business for a year. If sales
fall short of this target by, say, 20 percent, take 20 percent of that area's
expenditure out of the current year's accounts and defer it to next year
18. Do not revalue your assets so, although your provision for depreciation
looks adequate compared to their book value, in fact it is much too low,
Source: Extract from j Argenti 1976, Corporate Collapse: The Causes and
Symptoms, McGraw-Hill, London, pp. 141-2.
7. Check the cooperation of the applicant. When a party is willing to provide
whatever information is requested without any hesitation, or volunteers
information, there is no cause for worry. Where a party avoids or delays
giving information before or after a loan is approved; then be suspicious. In
the matter of HIH, Mr Graeme Thompson of the Australian Prudential
Regulation Authority stated 'the actual trigger for that was the fact that the
company was overdue in providing its December statistics to us and that was
the particular trigger that we had under the Insurance Act to issue a Show
Cause Notice which we did at the beginning of March' (Pascoe 2001b, p. 1)”
Answer:
- Creative accounting refers to the practice of manipulating financial
statements or accounting principles to present a more favorable picture of
a company's financial performance or position than is actually the case.
This can involve various techniques aimed at enhancing reported profits,
inflating assets, or concealing liabilities, often to mislead investors,
lenders, or other stakeholders.
Examples of creative accounting techniques include:
- Delayed publishing of financial results: Companies may postpone the
release of financial statements to hide poor performance or unfavorable
trends.
- Capitalizing research costs: Research and development expenses may be
capitalized as assets, thereby spreading their cost over future periods -
rather than expensing them immediately.
- Continuation of dividend payments: Companies may continue to pay
dividends even when they lack sufficient profits, using loans or equity to
fund these distributions.
- Underinvestment in maintenance: Cutting expenditure on routine
maintenance can defer expenses and artificially inflate short-term profits,
although it may lead to higher future repair costs.
- Misclassification of leases: Lease agreements may be structured to avoid
classification as debt, thereby understating liabilities and improving
apparent financial health.
- Manipulation of extraordinary items: Companies may classify ordinary
income or expenses as extraordinary to distort reported profits.
- Increased intercompany dividends: Subsidiaries may be instructed to pay
higher dividends to the parent company, inflating its reported earnings.
- Progressive inclusion of subsidiary results: Companies may gradually
consolidate more subsidiary results into their financial statements,
selectively improving reported performance.
- Asset valuation manipulation: Companies may overvalue assets to inflate
net worth or understate liabilities.
 - Strategic inventory valuation: Finished products may be valued at market
prices rather than cost, leading to higher reported profits.
- Presentation manipulation: Companies may manipulate the timing or
presentation of financial information to create a more favorable
impression.
- Fictitious transactions: Companies may invent fictitious transactions or
customers to inflate sales or revenues.
- Sales target manipulation: Expenses may be deferred to future periods if
sales targets are not met, artificially improving current results.
- Inadequate depreciation provisions: Companies may underestimate
depreciation expenses, leading to overstated profits.
- Misrepresentation of sales activity: Companies may artificially increase
apparent activity, such as holding back inventory to create a false
impression of demand.
- Fabrication of assets or liabilities: Companies may invent assets or
liabilities to manipulate financial statements.
- Adjustment of expenditure timing: Expenditures may be shifted between
periods to manipulate reported profits.
- Inflation manipulation: Companies may use inflation as a pretext to
revalue assets or manipulate accounting conventions.
8. Which ratios do loan officers generally use in credit assessment?
Evidence: (Page: 81)
 Answer:
- Loan officers generally use ratios that are ranked as having high
importance in credit assessment. Based on the ratings provided:
1. Debt/equity
2. Current ratio
3. Cashflow/current maturities of long-term debt
4. Fixed charge coverage
5. Net profit margin after tax
6. Net interest earned
7. Net profit margin before tax
8. Degree of financial leverage
9. Inventory turnover in days
10. Accounts receivable turnover in days
- These ratios are considered crucial by loan officers for evaluating the
financial health and repayment capacity of a borrower. They provide
insights into various aspects of the borrower's financial position, liquidity,
profitability, and ability to meet debt obligations.
9. Imagine the current assets and current liabilities of a firm are $3200 and
$2000 respectively. How much can the firm borrow on a short-term basis
without reducing the current ratio below 1.5?
Answer:
Summary:
- Current assets: $3200
- Current liabilities: $2000
- Current ratio: 1.5
Solutions:
The borrowing amount will be represented by x. (The increase in cash resulting from
borrowing will lead to an increase in current assets.)

(Page:52)
=> (3200+x) / (2000+x) = 1.5
=> 3200+x = 1.5x + (2000*1.5)
=> 3200+x=1.5x + 3000 => 0.5x=200 => x= 400
 (*) Therefore, the company has the ability to borrow $400 on a short-term
basis without causing the current ratio to fall below 1.5.
10. Read the comparative balance sheet (below) and the income statement of
Imaginary Computers Limited. Prepare a credit assessment report using the
techniques of financial statements analysis as explained in this chapter.
Comment on the financial strengths and weaknesses of the firm.
Imaginary Computers Limited
Balance sheet as at 31 December ($’000)
2011 2012 2013
Share capital 5.3 7.5 8.5
Reserves and surplus 6.7 5.7 7.4
Long-term debt 4.1 3.2 4.2
Short-term bank borrowing 5.6 5.2 7.2
Current liabilities 3.4 6.5 5.6
Total 25.1 28.1 32.9
Net fixed assets 17.4 21.8 26.1
Cash at bank 2.6 0.8 1.2
Receivables 3.5 2.8 2.9
Other assets 1.6 2.7 2.7
Total 25.1 28.1 32.9
Imaginary Computer Limited
Income statement for the year ending 31 December ($’000)
2011 2012 2013
Net sales 29.8 34.9 57.4
Cost of goods sold 24.5 26.2 45.8
Gross profit 5.3 8.7 11.6
Operating expenses 3.7 4.2 7.0
Operating profit 1.6 4.5 4.6
Non-operating surplus/deficit 0.2 0.1 0.4
Earnings before interest and tax 1.8 4.6 5.0
Interest 1.0 0.9 2.0
Profit before tax 0.8 3.5 3.0
Tax 0.6 -
Profit after tax 0.8 2.9 3.0
Dividends 0.6 0.6 1.1
Retained earnings 0.2 2.3 1.9
Answer:
Financial Strengths:
- Increasing Net Sales: The company has experienced steady growth in net
sales over the years, indicating a growing customer base or increased
market share.
- Gross Profit Margin Improvement: The gross profit margin has also
improved consistently, suggesting efficient management of production
costs and pricing strategies.
- Growth in Operating Profit: Operating profit has shown a positive trend,
reflecting effective cost management and operational efficiency.
- Increasing Retained Earnings: Despite paying dividends, the company has
managed to retain earnings, indicating profitability and potential for
reinvestment in business growth.
Financial Weaknesses:
- Rising Long-Term Debt: The long-term debt has been increasing over the
years, which may indicate higher interest expenses and potential financial
strain in the long run.
- Fluctuating Cash Position: The cash at bank has fluctuated significantly,
which may indicate challenges in managing liquidity effectively.
- High Short-Term Bank Borrowing: The reliance on short-term bank
borrowing has increased over time, which could pose liquidity risks if not
managed properly.
- Declining Dividend Coverage: Dividends paid out have increased over the
years, while profit after tax has not shown a corresponding increase,
indicating declining dividend coverage and potential strain on cash flow.
Liquidity Ratios Ratio Formula 2011 2012 2013

Current ratio 0.86 0.54 0.53

Quick ratio 0.68 0.31 0.32

The inventory
18.6 12.93 21.3
Efficiency Ratios

turnover ratio

The average
34 29 18
collection period

The gross profit-

Profitability Ratios

0.178 0.249 0.202

sales ratio

The net profit-sales

0.026 0.083 0.052
ratio

The debt-equity
ratio 1.09 1.13 1.06
Leverage Ratios

The interest
coverage ratio 1.8 5.11 2.5

The fixed charges

coverage ratio
- - -
2011:
1. Current Ratio = (2.6 + 3.5 + 1.6) / (5.6 + 3.4) = 0.86
2. Quick Ratio = (2.6 + 3.5) / (3.4 + 5.6) = 0.68
3. Inventory Turnover Ratio = 24.5 / ((3.5 + 2.8) / 2) = 18.6
4. Average Collection Period = ((3.5 + 2.8) / 29.8) * 365 = 34.44 =34 days
5. Gross Profit-Sales Ratio = 5.3 / 29.8 = 0.178
6. Net Profit-Sales Ratio = 0.8 / 29.8 = 0.026
7. Debt-Equity Ratio = (4.1 + 5.6 + 3.4) / (5.3 + 6.7) = 1.09
8. Interest Coverage Ratio = 1.8 / 1.0 = 1.8
9. Fixed Charges Coverage Ratio = Not enough data provided.
2012:
1. Current Ratio = (0.8 + 2.8 + 2.7) / (6.5 +5.2) = 0.54
2. Quick Ratio = (0.8 + 2.8) / (6.5+ 5.2) = 0.31
3. Inventory Turnover Ratio = 26.2 / ((2.8 + 2.9) / 2) = 12.93
4. Average Collection Period = ((2.8 + 2.9) / 34.9) * 365 = 29.03= 29 days
5. Gross Profit-Sales Ratio = 8.7 / 34.9 = 0.249
6. Net Profit-Sales Ratio = 2.9 / 34.9 = 0.083
7. Debt-Equity Ratio = (3.2 + 5.2 + 6.5) / (7.5 + 5.7) = 1.13
8. Interest Coverage Ratio = 4.6 / 0.9 = 5.11
9. Fixed Charges Coverage Ratio = Not enough data provided.
2013:
1. Current Ratio = (1.2 + 2.9 + 2.7) / (5.6 +7.2) = 0.53
2. Quick Ratio = (1.2 + 2.9) / (5.6 + 7.2) = 0.32
3. Inventory Turnover Ratio = 45.8 / ((2.9 + 2.7) / 2) = 21.3
4. Average Collection Period = ((2.9 + 2.7) / 57.4) * 365 = 17.91=18 days
5. Gross Profit-Sales Ratio = 11.6 / 57.4 = 0.202
6. Net Profit-Sales Ratio = 3.0 / 57.4 = 0.052
7. Debt-Equity Ratio = (4.2 + 7.2 + 5.6) / (8.5 + 7.4) = 1.06
8. Interest Coverage Ratio = 5.0 / 2.0 = 2.5
9. Fixed Charges Coverage Ratio = Not enough data provided.