Financial Statement Analysis Study Notes

Financial Statement Analysis

Introduction

• Financial statements serve as a substitute for personal experience with a company.

• In the past, a banker's credit decision relied heavily on personal assessments of a borrower's character and integrity.

• Current banking practices depend on financial statements to make informed lending decisions.

Financial Statement

• Financial statements are reports prepared by a company's management.

• They present the financial performance and position of the company at a specific point in time.

• A company demonstrating profitability shows that revenues exceed expenses over a period of years.

Components of Financial Statements

• Income Statement: Displays the revenue and expenses over a specific period.

• Balance Sheet: Illustrates the beginning and ending balances of assets, liabilities, and equity at a specific time.

• Statement of Retained Earnings: Shows changes in retained earnings between the beginning and ending of the accounting period.

• Statement of Changes in Financial Position: Reconciles changes in cash from the beginning to the end of the reporting period.

• Notes in Financial Statements: Detail the basis for revenue and expense recognition, along with inventory accounting methods.

Analysis of Financial Statements

• Three essential components are analyzed:
    - Operation Management: Using the income statement to review sales, cost control, and profitability.
    - Asset Management: Analyzing the quality and liquidity of assets (ease of conversion to cash).
    - Liability Management: Examining the company’s record in matching liabilities to its asset conversion cycle.

Importance of Analyzing Financial Statements for Lenders

• Lenders analyze financial statements to answer three critical questions:
    - Should the bank grant the requested loan?
    - If the loan is granted, will it be repaid with interest?
    - What recourse does the financial institution have if the loan assumptions are proven incorrect?

• Financially sound businesses pose a lower risk for lenders, requiring a reliable analysis to ascertain the business’s financial health.

Characteristics of a Sound Business

• Adequate liquidity to meet short-term obligations.

• Efficient management and operations.

• Profitability in business operations.

• High proprietors' stake in the firm; minimal debt burden.

Predicting Future Outcomes for Lenders

• Trend (time series) Analysis: If a business shows consistent profitability, lenders may assume future trends will follow.

• Safety Buffers: A significant margin of safety can indicate stability amidst fluctuations.

• Stress Testing: Evaluating how a business performs under adverse conditions.

• Industry Analysis: Growth potential in the borrower's industry can indicate future business viability.

Insurance Against Risks for Banks

• Collateral: Security provided for the loan to be retrieved if the borrower defaults.

• Charge on Assets: Lender places a floating charge on all business assets for additional security.

• Guarantees: Personal guarantees from directors to recover debts from personal assets in case of default.

Interpretation of Financial Statement Analysis Techniques (Foster, 1986)

• Financial statement analysis can be categorized into:
    - Cross-Sectional Techniques: Analyze financial data at a single point in time.
    - Time Series Techniques: Evaluate data over a range of time.
    - Combination of Financial and Non-Financial Information: Integrate financial data with relevant external factors.

Cross-Sectional Techniques

• Analyze financial statements at a single point in time using:
    - Financial Ratios Analysis: Various ratios that provide insights into financial health.
    - Common-Size Statements: Transform financial statements into percentages for easier comparison.

Ratio Analysis

• Liquidity Ratios:
    - Measures short-term financial obligations.
    - Important Ratios:
      - Current Ratio
      - Quick Ratio

Current Ratio

• Formula:
    $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

• Indicates a firm's ability to cover short-term liabilities.

• Typical Benchmark: 2:1 is considered acceptable.

Interpretation of Current Ratio

• Ideal is typically around 2.
    - A ratio higher than 2 can suggest excessive liquidity; it may indicate lost investment opportunities.
    - A ratio too low brings liquidity concerns, suggesting inability to meet obligations.

Quick Ratio

• Also known as the Acid-Test Ratio.

• Formula:
    $\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$

• Excludes inventory due to its low liquidity.

• Rule of thumb: 1:1 or better, indicating a healthy liquidity position without considering inventory.

Efficiency Ratios

• Analyze how effectively assets are utilized.

• Types of Ratios:
    - Inventory Turnover Ratio
    - Average Collection Period

Inventory Turnover Ratio

• Shows the efficiency of inventory management.

• Formula:
    $\text{Inventory Turnover Ratio} = \frac{\text{Net Sales or COGS}}{\text{Average Inventory}}$

• Days in inventory can be measured as:
    $\text{Days in Inventory} = \frac{365}{\text{Inventory Turnover Ratio}}$

Interpretation of Inventory Turnover Ratio

• No universal benchmark; varies by industry.
    - High ratios indicate demand and efficient management.
    - Caution against over-reliance on high turnover to avoid stock-outs.

Average Collection Period

• Reflects efficiency in receivable collections.

• Formula:
    $\text{Average Collection Period} = \frac{\text{Receivables}}{\text{Average Sales per Day}}$

Interpretation of Average Collection Period

• Should align with or be less than customer credit terms.
    - If calculated period is shorter, efficiency is good.
    - If longer, there are concerns about debt collection efficiency.

Profitability Ratios

• Indicators of a company's profitability, essential for assessing financial health.

• Types of Ratios:
    - Gross Profit-Sales Ratio
    - Net Profit-Sales Ratio

Gross Profit-Sales Ratio

• Formula:
    $\text{Gross Profit-Sales Ratio} = \frac{\text{Gross Profit}}{\text{Net Sales}}$

Interpretation of Gross Profit-Sales Ratio

• There are no specific benchmarks; ratios should meet or exceed industry averages.

Net Profit-Sales Ratio

• Captures overall profitability after all expenses.

• Formula:
    $\text{Net Profit-Sales Ratio} = \frac{\text{Net Profit}}{\text{Net Sales}}$

Interpretation of Net Profit-Sales Ratio

• Ideally reflects industry averages; higher ratios indicate better profitability.

Leverage Ratios

• Indicate the degree of financial risk due to debt financing.

• Types of Ratios:
    - Structural Ratios
    - Coverage Ratios

• Protect creditor interests and leverage utilization.

Structural Ratios

• Include Debt-Equity Ratio, Proprietary Ratio, and Debt-Asset Ratio.

• Debt-Equity Ratio: Shows the proportion of debt to equity funding.

• Formula:
    $\text{Debt-Equity Ratio} = \frac{\text{Total Debt}}{\text{Equity}}$

Interpretation of Debt-Equity Ratio

• Generally, should not exceed 2.
    - Some industries may operate with higher ratios due to business nature (e.g., mining).

Coverage Ratios: Interest Coverage Ratio

• Formula:
    $\text{Interest Coverage Ratio} = \frac{\text{Earnings Before Interest and Taxes}}{\text{Interest Payable}}$

• Indicates ability to cover interest on debt.

Interpretation of Interest Coverage Ratio

• Minimum benchmark is often 2 for adequate financial buffer.

Common-Size Statements

• Provides proportional financial data for easier inter-firm comparisons.

• Components are expressed as percentages of total assets or total revenue.

Time Series Techniques

• Focus on analyzing financial ratios over a period.

• Techniques include Trend Statements and Variability Measures.

Trend Statements

• Index values of financial statement items against a base year to show growth or decline.

Variability Measures

• Measures the volatility of a ratio's value over time to assess firm riskiness.

• Variability Formula:
    $\text{Variability} = \text{Maximum Value} - \text{Minimum Value}$

Combining Financial and Non-Financial Information

• Consider external market factors and performance metrics alongside financial ratios for comprehensive analysis.

Step-by-Step Approach to Financial Statement Analysis

Step 1: Obtain Relevant Financial Statements

• Key statements required: income statement, balance sheet, cashflow statement.

• Obtain three years of statements (latest and two previous years).

Step 2: Check for Consistency

• Ensure names and details match across loan applications and statements.

Step 3: Undertake Preliminary Scrutiny

1. Examine the Balance Sheet: Check total figures and sources of funds.

2. Examine the Income Statement: Evaluate profitability and sales trends.

3. Examine the Cashflow Statement: Assess sources and uses of cash.

Step 4: Collect Industry Data

• Gather information on industry and economic trends affecting the firm.

Step 5: Conduct Comparison with Industry Averages

• Compare firm's ratios against industry averages to identify performance gaps.

Step 6: Supplementary Analysis

• Conduct analysis such as break-even and sensitivity analysis to validate findings.

Step 7: Summarize Main Features

• Compile a summary of firm characteristics based on financial statement analysis.

Importance of Financial Ratios for Loan Assessment

Financial Ratios Ranked by Loan Officers

1. Debt/Equity Ratio: 8.71

2. Current Ratio: 8.25

3. Cashflow/Current Maturities of Long-term Debt: 8.08

4. Fixed Charge Coverage: 7.58

5. Net Profit Margin After Tax: 7.56

6. Net Interest Earned: 7.50

7. Net Profit Margin Before Tax: 7.43

8. Degree of Financial Leverage: 7.33

9. Inventory Turnover in Days: 7.25

10. Accounts Receivable Turnover in Days: 7.08

Financial Ratios Percentage Inclusion in Loan Agreements

1. Debt/Equity: 95.5%

2. Current Ratio: 90.0%

3. Dividend Payout Ratio: 70.0%

4. Cashflow/Current Maturities of Long-term Debt: 60.3%

5. Fixed Charge Coverage: 55.2%

6. Times Interest Earned: 52.6%

7. Degree of Financial Leverage: 44.7%

8. Equity/Assets: 41.0%

9. Cashflow/Total Debt: 36.1%

10. Quick Ratio: 33.3%

• Source: Adapted from G. Foster 1986, Financial Statement Analysis, Prentice-Hall, New Jersey, p. 580.