BNFN 404 CREDIT ANALYSIS AND LENDING

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BNFN 404 CREDIT ANALYSIS AND LENDING

• WEEK 5
• Financial Statements Analysis
• Sathye et all (2003), Chp. 2

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Learning Objectives

• Explain key financial statements
• Explain the importance of analysis of financial
  statements in lending decisions
• Describe the various methods of analysis where
  project finance is involved

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Learning Objectives

• Describe the special techniques of analysis where
  project finance is involved
• Describe how window dressing of financial
  statements can take place

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Learning Objectives

• Explain which of the financial ratios are
  preferred by loan officers
• 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 consist of
• Statement of Financial Performance
• Statement of Financial Position
• Statement of Cashflows

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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 proprietors stake in the business is high
  versus the business carrying excessive debt

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Why Lenders Analyse Financial Statements

• 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 banks 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
• Cross-sectional techniques, such as ratio
  analysis and common-size statements
• Time series techniques, such as identifying
  trends in ratios or other measures
• A combination of the two.

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Analysis of Financial Statements

• 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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Analysis of Financial Statements

• Liquidity ratios
• Used to determine the ability of the firm to meet
  its short-term obligations
• Current Ratio
• Quick Ratio

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Analysis of Financial Statements

• Efficiency ratios
• Used to determine how efficiently the firm has
  used its assets

• Inventory Turnover Ratio
• Average Collection Period

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Analysis of Financial Statements

• Profitability ratios
• Used to assess the profitability of sales
  generated through operations

• Gross ProfitSales Ratio
• Net ProfitSales Ratio

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Analysis of Financial Statements

• Leverage ratios
• Used to assess the proportions and manageability
  of debt carried by a firm

• DebtEquity Ratio
• Interest Coverage Ratio

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Analysis of Financial Statements

• Leverage ratios
• Fixed Charges Coverage Ratio

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Analysis of Financial Statements

• 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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Analysis of Financial Statements

• 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

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Analysis of Financial Statements

• 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

• Net Present Value
• Internal Rate of Return

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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 projects 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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Project Risk Analysis

• Margin of Safety
• The margin between the profitability of current
  operations and break-even point
• Cash Break-Even Point
• 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-By-Step Approach to Financial Statements
Analysis

• 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-By-Step Approach to Financial Statements
Analysis

• Step 5 Comparison with Industry Averages
• How does firms financial ratios compare with
  competitors 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

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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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