Lecture 7

Financial Statement Analysis

 Learning objectives
• Explain key financial statements
• Describe the various methods of analysis
where project finance is involved
• Describe how window dressing of financial
statement can take place
• Outline the limitation of financial statement
analysis
 Why lenders analyze
financial statements
• Help answer the following three questions
– Should the bank give the requested loan?
– If the loan is given, will it be paid together with interest?
– What is the financial institution’s remedy if the
assumptions about the loan turn out to be wrong?
• A sound business is characterized as
– Has adequate liquidity so it can honour short-term
obligation easily
– Run efficiently
– Run profitably
– The proprietor’s stake in the business is high, alternatively,
the business is not burdened with too much debt
• For a second question, the answer is a bit
tricky because financial statement analysis
is essentially a post mortem
– Belong to a period that has already elapsed
– The loan is to be repaid in the future
– No-one knows what the future holds
• A reasonable guess can be made
– Trend (time series) analysis: 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
– Safety buffer: Whether there is a large margin of safety
(actual sales vs break-even sales)
– Stress testing: If the business continues to remain
profitable, the business could withstand shocks in the future
– Industry analysis: What are the trends and prospects for
the firm’s industry? Growing?
– Economic analysis: What are the trends in the domestic
and international economies?
• Given some amounts of risk involved, the
banks need some form of insurance
– Collateral
– Charge on assets
– Guarantees
– Conditions: a negative pledge (requires
borrowers to undertake NOT to provide any
further security to another lender, or to do so
only on a restricted basis
Analysis of financial statement
• Cross-sectional techniques
• Time series techniques
• A combination of financial statement
information and non-financial statement
information
 Cross-sectional techniques

• Analyze financial statements at a point in time

• Two commonly used techniques: Financial
ratio analysis and common-size statements
• Ratio analysis
– Liquidity ratios: Current ratio and quick ratio
– Efficiency ratios
– Profitability ratios
– Leverage ratios
• The current ratio = current assets/current liabilities
• Ideally, the ratio is between 1.5 and 2
• A very high ratio
– Excess liquidity, may lose opportunities to make profitable use of
current assets
– The party (borrower) is holding excessive debtor or perhaps
because debtors have not been collected (check the average
collection period of the debtor turnover ratio?)
– The party may have sold some goods just before the date on
which FSs were prepared
– Excessive inventory build-up (check the average inventory
level?)
– The ending inventory figure may be excessive as some goods
were sold just after the date of the balance sheet
– Inventory valuation is a grey area. FIFO vs LIFO. Overvaluation
• The quick ratio (acid test ratio) = quick
assets/current liabilities
• Quick assets= all current assets except
inventory
• Bench mark of 1 is preferred
• Inventories are considered the least liquid
components of current assets
• Efficiency ratios
– The inventory turnover ratio
– The average collection period
• The inventory turnover ratio = net sales/inventory
• The number of days for which inventory is tied up=
days in year/inventory turnover ratio
• No benchmark for this ratio
• Items are fast moving, the ratio could be high
• For the business of producing and selling daily necessities
(perishable goods), the ratio is very high>12
• For the business of producing and selling durable goods, the
ratio is about 4
• Some points when calculating inventory
turnover analysis
– Can be easily manipulated by a change to the
basis of the inventory valuation
– Cost of goods sold could replace net sales
– The year-end inventory figure may be misleading,
the average inventory figure needs using.
– The ratio should be compared with that of
competitor firms or the average ratio for the
industry
• The average collection period= receivables/average sales
per day
• the efficiency in collection of receivables
• Average receivables and average sales should be used
• This ratio hides the age-wise distribution of receivables
– Receivables pending collection for more than three months
– Receivables pending collection for between one and three
months
– Receivables pending collection for less than one month
– The first two categories means the collection management is
slack
• Profitability ratio
– The gross profit - net sales ratio
• Gross profit = net sales- the cost of foods sold
• Measuring the pricing and production costs control
aspect
• The firm may have less control over pricing as market
decides price
• This ratio should be compared with that of other firms
– The net profit - net sales ratio
• Net sale= net profit before/after tax
• Measuring the cost-and- profit structure of the firm
• Leverage ratio (the use of debt finance)
– The debt-equity ratio
• The lower, the better ( < 2), depends on the nature of
business
• The book value of equity may be understated
• Some long-term debts may be secured by a charge on
assets
• A lower this ratio may mean that the firm is not making
use of the leverage to its advantage
– The interest coverage ratio = EBIT/interest
payable on loans
• No benchmark for this ratio
• The higher = the better (>2)
• Interest on the debt is a tax-deductible expense
• Payment of interest comes from cashflow statement
and not from earning
• The cashflow statement should be examined carefully
• Depreciation may be added to the nominator
– The fixed charges coverage ratio
• =(EBIT+ depreciation)/((interest on loan + repayment of
loan/(1-tax rate))
• Repayment of the loan is not tax-deductible
• No benchmark for this ratio: the higher, the better
• Important in project financing
• Common size statements
– Inter-firm comparisons can be used
– The common form is created by expressing the
components of the balance sheet and income
statement as a percentage of total assets and
total revenue
 Percentages of total assets (%)
Firm A Firm B Firm C Firm C
Account receivable 7.6 9.8 3.2 5.4
Inventories 20.5 23.7 35.2 48.1
Account payable 15.9 5.6 6.7 19.2
Equity 36.2 21.5 65.4 49.2
 Time series techniques
• Trend (indexed) statements
• The trend of financial ratios
• Variability measures
• Trend statements
– Choosing one year as the base
– The values of an item for subsequent years
relative to their value in the base year

2015 2016 2017 2018 2019

Sale revenue 56.7 58.4 60.2 62.3 70.1

Indexed sales revenue 100.00 103.00 106.17 109.52 123.98

• The trend of financial ratios
– Computing financial ratios for a series of years
for the same firm and studying their trend
– The cross-sectional financial ratios may not be
adequate because of transitory forces and fail
to show the secular trend
2015 2016 2017 2018 2019

Current ratio 1.12 1.19 1.28 1.47 1.34

Debt-asset ratio 0.52 0.61 0.59 0.93 0.55
Inventory turnover ratio 5.52 5.78 6.15 6.83 6.61

Average collection period ratio 55 59 65 56 61

• Variability measures
– = (maximum value – minimum value)/mean
financial ratio
– The ratio of a firm for a series years is
available
– A higher variability means the firm’s riskiness
with respect to that financial ratio
 Combination of non- and
financial statement information
• Data about the shift in the market share of firms
within an industry
• Changes over time in market capitalization
• A consortium with one or two lenders can be formed
to meet financial requirements of the borrowers, so-
called syndicated loans
– Too risky to finance
– Legal barriers such as exposure regulations (a bank
should not give loans in excess of 30% of its issued
capital to a single borrower)
– Equity participation may be created
 Techniques of analysis
used in project finance
• The payback period
• The accounting rate of return
• Discounted cashflow techniques such as
the net present value, the internal rate of
return and the benefit-cost ratio
 Project risk analysis
• These forecasts from projected finance
may turn out to be incorrect
• Operating costs may be higher expected
or the sales revenue may be lower
• Include sensitivity analysis, break-even
analysis and simulation
• Sensitivity analysis
– Like stress testing
– Compare the optimistic, pessimistic and most
likely predictions
• The net cashflows and net present value under three
situations
– Determine the amount of deviation from
expected values before a decision is changed
• Rejecting a project if the NPV drops below break-even
• Break-even analysis
– Cost accounting, requires information on fixed
costs, variable costs, sale revenue and unit
produced
– Margin of safety
– Cash break-even point
• Simulation
– Change one variable at a time in simulation
– Consider the effect of changing all the variables
with uncertain values
 Step-by-step approach
to financial statement analysis
• Step 1: Obtain relevant financial
statements
– Income statement
– Balance sheet statement
– Cash flow statement
– 3 year statement
– Projected financial statement for the term of
loan
• Step 2: Check for consistency
– The business name and address on the financial statements
are exactly the same as indicated in application form
• Step 3: Undertake preliminary scrutiny
• Step 4: Collect data about industry and general
economic trends
– Financial newspapers, professional journals or specialist
firms
• Step 5: Conduct a comparison with industry averages
– Financial newspapers
– Other sources
• Step 6: Do supplement analysis
– Break-even analysis
– Sensitivity analysis
• Step 7: Summarise the main features
– Prepare a summary of main features from steps 3-6
– Some ratios and trends will be favourable while some
will not
– Ratios do not tell full story, but torture them and they
will confess
– ABC rule: Accept nothing, believe no-one and confirm
everything
 Detecting window dressing
frauds and errors
• Check the details of receivables
– Arrears of receivables
– A list of debtors and decide which receivables
are to be included in the eligible debts
– Fake invoices?
– 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
• Check the valuation of inventory
– Break-up inventory (raw material, works in process and
finished goods)
– Raw material and finished goods are valued at cost price
or market value, whichever is less
– Works in process is valued at cost
– Check inventory turnover ratio, fast moving?
• Check the machinery valuation
– Valued with care and at cost or market price, whichever
is lower
– May the equipment have become obsolete
• Check the real estate valuation
– Real estate may be worth much more or much less than
the value appearing in the balance sheet
– Should be valued at a price at which comparable property
was sold in recent times
• Check the valuation of marketable 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
• Check for other creative accounting techniques (from
J Argenti 1976 Corporate Collapse: the causes and
symptoms, McGraw-Hill, London, pp.141-142)
• Check the cooperation of the applicant
– Whether a party delays or avoids giving
information before or after a loan is approved
then be suspicious
 Limitation of financial
statement analysis
• Problems with benchmarks
– Diversity of products
• Window dressing
• Historical data
• Qualitative aspects
– The quality of management
– Regulatory changes
– Changes in the domestic and international
economies
 Summary
• Know the various methods of analysis of
financial statements
• Know how to prevent window dressing
• Know the limitations of financial statement
analysis