Chapter Two

Financial statements analysis

12/13/21 978-0-7346-1164-2 1
Learning objectives

1. Explain key financial statements

2. Explain the importance of analysis of financial
statements in lending decisions
3. Describe the various methods of analysis where
project finance is involved
4. Describe the special techniques of analysis where
project finance is involved
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5. Describe how window dressing of financial statements
can take place
6. Explain which of the financial ratios are preferred by
loan officers
7. Outline the limitations of financial statements analysis

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Introduction

• The analysis of financial statements plays a key role in

assessing potential business loans
• Generally consists of:
• Income Statement
• Balance Sheet
• Statement of Cash flows

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Why lenders analyse financial
statements

• Financial statements are analysed to help determine

whether:
• The business has adequate liquidity so it can honour short-term
obligations
• The business is run efficiently
• The business is run profitably
• The proprietor’s stake in the business is high versus the business
carrying excessive debt
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• Analysis helps provide answers to three key questions:
• Should the bank give the requested loan?
• If the loan is given, will it be repaid together with interest?
• What is the bank’s remedy if the assumptions of the loan
turn out to be wrong?

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Analysis of financial
statements

• The analysis of financial statements falls into three

broad categories:
1. Cross-sectional techniques, such as ratio analysis and
common-size statements
2. Time series techniques, such as identifying trends in ratios
or other measures
3. A combination of the two.

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Cross-sectional techniques

• Ratios: Financial ratios derived from the financial

statements fall into four main categories:
• Liquidity ratios
• Efficiency ratios
• Profitability ratios
• Leverage ratios

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Liquidity ratios

• Used to determine the ability of the firm to meet its short-

term obligations

Current Assets
– Current ratio
Current Liabilities
Quick Assets
– Quick ratio
Current Liabilitie s

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Efficiency ratios

• Used to determine how efficiently the firm has used its

assets

– Inventory turnover ratio Net Sales

Inventory

Receivables
– Average collection period
Avg Sales Per Day
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Profitability ratios

• Used to assess the profitability of sales generated

through operations
Gross Profit
– Gross profit–sales ratio
Net Sales

– Net profit–sales ratio Net Profit

Net Sales

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Leverage ratios

• Used to assess the proportions and manageability of

debt carried by a firm

Debt
– Debt–equity ratio
Equity

Earnings Before Interest and Taxes

– Interest coverage ratio
Interest Payable on Loans
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Leverage ratios

• Fixed charges coverage ratio

Earnings Before Interest and Taxes  Depreciati on

Interest on Loan  [Repayment of Loan  (1 - Tax Rate)]

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Common-size statements

• Express relationships between the numbers on the financial

statements
• For example, the following items may be expressed as a
percentage of total assets:
• Accounts Receivable
• Inventory
• Equity

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Time series techniques

• Ratios can be evaluated to detect any improvements or

deteriorations in financial position over time
• Variability Measures: Where trends are not detected, these
may be used to determine the variability over time

Maximum Value - Minimum Value

Mean Financial Ratio

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Combining financial statement and
nonfinancial statement information

• Other information that may be incorporated into the

analysis include:
• Changes in market share
• Market perceptions via share price
• Changes in key management
• Impact of macroeconomic changes

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Techniques of analysis used
in project finance

• Payback period
• Accounting rate of return
• Discounted cashflow techniques
n
Ct
– Net present value

t 1 (1  k )
t
 C0
– Internal rate of
n
Ct
return
 (1  r )
t 1
t
 C0  0
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Project risk analysis

• Sensitivity analysis:
• Measures the impact of changes on key variables, such as the
interest rate or prices of key inputs, on the project’s viability
• Break-even analysis
• The level of sales at which revenue equals expenses and net
income is zero
• Requires knowledge of fixed and variable costs

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• Margin of safety
• The margin between the profitability of current operations and break-even
point
• Cash break-even point
Fixed Costs  Loan Instalment Including Interest  Depreciati on
Contributi on per Unit

• Simulation
• Computational approach where one variable is changed at a time to
determine sensitivities across numerous variables
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Step-by-step approach to
financial statements analysis

• Step 1: Obtain relevant financial statements

• Obtain Statement of Financial Performance, Statement of
Financial Position and Cashflow statements for generally
three years
• Step 2: Check for consistency
• Verify names on financial statements, signatures of
partners, corporate seals etc.

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• Step 3: Undertake preliminary scrutiny of financial
statements
• Statement of Financial Performance
• Statement of Financial Position
• Cashflow Statement

• Step 4: Collect data about industry and general

economic trends
• Strength of economy and relevant industry
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• Step 5: Comparison with industry averages
• How does firm’s financial ratios compare with competitor’s in same
industry
• Step 6: Do supplementary analysis
• Break-even and Sensitivity Analysis
• Step 7: Summarise main features
• Provide an analytical overview from all relevant data obtained

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Detecting window dressing,
frauds and errors

• Overwhelming accounting complexities lead to potential

abuses of the notion of ‘true and fair’ via manipulation
of:
• Valuation of receivables inventory, property, marketable securities
and other assets
• Liabilities including off-balance sheet items
• Changes to accounting methods

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Use of financial ratios by loan
officers

• Top ten ratios of importance in loan assessment

1 Debt/Equity 6 Net Interest Earned

2 Current Ratio 7 Net Profit Before Tax
3 Cash Flow/LT Debt 8 Financial Leverage
4 Fixed Charge Cover 9 Inv T/O in Days
5 Net Profit After Tax 10 A/c Rec T/O in Days

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Limitations of financial
statements analysis

• Financial statements analysis cannot substitute for

sound judgement:
• Problems with benchmarks: What benchmarks should be used for
multi-industry firms?
• Window Dressing/Creative Accounting
• Historical Data: Accounting reports reveal only history, not the future
• Qualitative Aspects: Changes in management, the economy, etc.

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