Financial Statement Analysis

Essentials of Corporate Finance Chapters 2 & 3

Materials Created by Glenn Snyder San Francisco State University

Topics

Who uses Financial Statement Analysis? Banking - Loan Underwriter

Loan Package Financial Analysis

Account Receivable Inventory Financial Ratios Income Statement Projections Balance Sheet Projections

Financial Projections

Cash Flow Analysis

Career Advice for becoming a Bank Underwriter

December 28, 2006

Materials Created by Glenn Snyder San Francisco State University

Who uses Financial Statement Analysis?

Almost Everyone in the Business World

Bankers analyze loans and cash flow Portfolio Managers projections of stock prices Marketing Managers market penetration and impacts to profitability Human Resources compensation analysis Senior Management corporate strategy Sales Managers commission rates on sales Internal Financial Analysts profitability analysis Customer Service Managers efficiency ratios

December 28, 2006

Materials Created by Glenn Snyder San Francisco State University

Banking Loan Underwriter

What is a Loan Underwriter?

A loan underwriter analyzes the loan application and supported materials to determine if the loan should be approved.

Where do Loan Underwriters work?

Commercial Banks Investment Banks (Bond Underwriters) Financing Institutions (Mortgage Companies)

December 28, 2006

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Banking Loan Underwriter

What is a Loan Underwriter looking to do?

Analyze the credit quality of a business Project cash flow and interest coverage Gain an understanding of the business
In the end, a bank is only looking to get paid back and earn interest.

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Loan Package

When a company applies for a loan, any of the following can be requested by the bank:

Loan application 3 years financial statements 3 years personal tax returns of owner (if the company is a small business) Accounts Receivable aging schedule Names of customers and suppliers for references

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Accounts Receivable & Inventory

Almost half of all loan requests are for a working capital line of credit.

A working capital line of credit works like a credit card (only without the card). A company can draw up and down on the line and only pay interest on outstanding balances.

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Accounts Receivable & Inventory

Working Capital Lines of Credit

Most working capital lines of credit are based off of a percentage of accounts receivable and inventory.

For example: A $500,000 line of credit based 80% on accounts receivable and 50% of finished goods inventory.

Therefore, Accounts Receivable and Inventory are two of the most important balance sheet accounts for a banker.
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Financial Analysis Accounts Receivable

Accounts Receivable (A/R) is the fastest non-liquid asset to convert to cash Analysis:
Questions to Ask
What % of sales are returned? Why? What % of sales are sold on credit? What % of sales are written-off? Is there a concentration with one or two sales people? What % of sales are guaranteed (contractually obligated)? What % of sales are foreign?

Reason
Are returns a significant part of the business model? Are returns due to poor quality? How reliant is the company on extending credit? Do they continue to sell to customers who dont pay? What if those sales people leave? What happens when the contract expires? Where is new business coming from? Do they use letters of credit to protect against nonpayment? Foreign customers are hard to collect from. The government is typically slow paying
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What % of sales is to the government?

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Financial Analysis Accounts Receivable

Accounts Receivable Aging Schedule

A schedule of all outstanding receivables grouped both by customer and due date

Analysis:
Questions to Ask
Is there a concentration greater than 10% of any customers?

Reason
What happens if they lose a large customer?

What % of customers are past due?

Are there any receivables over 120 days past due that have not been written-off?

How reliable are their accounts receivable

Typically these will not be collected and should be backed out of the total accounts receivable

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Financial Analysis - Inventory

Inventory is typically the largest current asset and is what the company tries to convert to cash. Inventory includes:

Raw materials inventory Work-in-Process inventory Finished goods inventory

In case of liquidation
Raw materials inventory can be sold back to the supplier (at a fraction of the cost) Finished goods inventory can be sold to customers (at a fraction of the cost)

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Financial Analysis - Inventory

Analysis:
Questions to Ask
How does the company inventory compare with the industry average? Is inventory valued at LIFO, FIFO, or Weighted Average? What % of current assets is made up of inventory? What % of inventory is work-in-process?

Reason
Do they carry too much? Too little? Do they have too much in finished goods inventory? This will impact the cost of goods sold and inventory balance. Could inventory be obsolete? Inventory is typically the hardest current asset to convert to cash This inventory is virtually worthless. What can you do with the frame of a car?

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Financial Analysis - Ratios

Liquidity Ratios Current Ratio:

Current Assets / Current Liabilities Measures a firms ability to meet current obligations

Analysis:
Questions to Ask
Calculate the Current Ratio How does the companys current ratio compare with companies of similar size in their industry? Are liabilities being paid on time? How much is inventory weighted in current assets? Are accounts receivable over 120 days being written off? Exclude Prepaid Current Assets
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Reason
Too low suggests a lack of liquidity, too high suggests financial assets are not used efficiently If they are not in-line with the industry, then the underwriter must find out why. If suppliers and service bills are being stretched, this would decrease the current ratio. Inventory is the most difficult current asset to convert to cash? How quickly is it turning over? These accounts will probably not be collected and should be removed from current assets Cash cannot easily be obtained from a prepaid phone bill or rent
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Financial Analysis - Ratios

Liquidity Ratios Quick Ratio (Acid Test):

(Current Assets Inventory)/ Current Liabilities Measures a firms ability to meet current obligations without liquidating inventory

Analysis:
Questions to Ask
Calculate the Quick Ratio How does the companys current ratio compare with companies of similar size in their industry? Are liabilities being paid on time? How much is inventory weighted in current assets? Are accounts receivable over 120 days being written off? Exclude Prepaid Current Assets
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Reason
Too low suggests a lack of liquidity, too high suggests financial assets are not used efficiently If they are not in-line with the industry, then the underwriter must find out why. If suppliers and service bills are being stretched, this would decrease the current ratio. Inventory is the most difficult current asset to convert to cash? How quickly is it turning over? These accounts will probably not be collected and should be removed from current assets Cash cannot easily be obtained from a prepaid phone bill or rent
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Financial Analysis - Ratios

Leverage Ratios Debt-Equity Ratio:

Total Liabilities / Total Net Worth Measures the funds contributed by owners or shareholders versus creditors.
Reason
Banks generally like to see this ratio below 40% If this ratio was greater than 50%, the company would primarily be financed by creditors The owners would be more likely to declare bankruptcy in the event of a downturn, as they would have less to lose

Analysis:
Questions to Ask
Calculate the Debt-Equity ratio

How much of total liabilities are current liabilities?

Matching Principle: current assets should be financed with current liabilities, long-term assets should be financed with long-term debt

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Financial Analysis - Ratios

Efficiency Ratios Accounts Receivable Turnover:

(Accounts Receivable / Sales) x 365 Measures the average number of days it takes the company to collect their receivables.

Analysis:
Questions to Ask
Calculate the Accounts Receivable Turnover

Reason
The shorter the better The faster a company can collect, the faster they have cash The less time they need to borrow If they sell on 2/10 net 30, one would expect to see a turnover around 30 days. A few days over is ok, but 40 or 45 would be too long These accounts will probably not be collected and should be removed from current assets The turnover should be close to industry averages, if not, the underwriter needs to know why
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Is the accounts receivable turnover relatively close to the companys financing terms? Are accounts receivable over 120 days being written off? How does the companys turnover compare with the industry?

December 28, 2006

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Financial Analysis - Ratios

Efficiency Ratios Inventory Turnover:

(Inventory / Cost of Goods Sold) x 365

Measures the average number of days inventory is on hand

Analysis:
Questions to Ask
Calculate the Inventory Turnover

Reason
The shorter the better The faster a company can sell its inventory, the faster they have cash The less time they need to borrow Which method is standard for the industry? Have they changed valuation methods recently? If so, why? Are some products selling and others not? Are some products becoming obsolete? The turnover should be close to industry averages, if not, the underwriter needs to know why
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Which inventory valuation method do they use? LIFO, FIFO, or weighted average? Is the inventory turnover different for different products? How does the companys turnover compare with the industry?

December 28, 2006

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Financial Analysis - Ratios

Efficiency Ratios Accounts Payable Turnover:

(Accounts Payable / Cost of Goods Sold) x 365 Measures the average number of days the company takes to pay its suppliers

Analysis:
Questions to Ask
Calculate the Accounts Payable Turnover

Reason
This is a sensitive ratio: The longer the turnover, the longer the company has cash If the supplier get stretched to much, they may not sell to the company, which can put the company out of business Is the company taking advantage of discounts? An underwriter will want to call 3 or 4 suppliers to confirm the company is in good standing The turnover should be close to industry averages, if not, the underwriter needs to know why
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What terms to the suppliers offer? Supplier reference check How does the companys turnover compare with the industry?
December 28, 2006

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Financial Analysis - Ratios

Profitability Ratios Gross Profit Margin:

(Sales Cost of Good Sold) / Sales Measures the differential between what it costs to manufacture or purchase the product and how much the product is sold.

Analysis:
Questions to Ask
Calculate the Gross Profit Margin

Reason
The higher the gross profit margin, the more money is available to cover the operating costs of the company This can show the impact of price changes or changes in the cost of inventory. Certain industries may have tighter margins, such as technology retail. The turnover should be close to industry averages, if not, the underwriter needs to know why

Has the gross profit margin changed over time? Understand the industry How does the companys turnover compare with the industry?

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Financial Analysis - Ratios

Profitability Ratios Return on Equity (ROE):

Net Income / Total Equity Measures the relationship between profits and the investment of the owners.

Analysis:
Questions to Ask
Calculate the Return on Equity Has the ROE changed over time? How does the companys turnover compare with the industry?

Reason
This ratio will have a direct impact on the companys ability to raise capital This can show changes in capital structure, infusions of capital, an changes in net income The ROE may be close to the industry, despite low profits, as the company may have higher levels of liabilities

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Financial Projections

Loan underwriters must take their ratios and analysis of the financial statements and project the companys financial statements to show adequate cash flow to repay the loan.

Financials are projected by each account shown on the financial statements.

The method of projections may vary by industry The method of projections may vary based on which accounts are shown on the financial statements

All companies prepare and publish their financial statements in different ways
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Income Statement Projections

Sales (Gross Revenues)

Four approaches:

$ Growth Repeat the dollar growth from the previous period Average $ Growth Average the dollar growths from all of the previous periods and project the average % Growth Repeat the percentage growth from the previous period Average % Growth Average the percentage growths from all of the previous periods and project the average)

Average % Growth is the most common method

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Income Statement Projections

Sales (Gross Revenues)

2004 2,000 2005 2,150 2006 2,400 2007E 2,250 2008 2009

Year Sales

$ Growth Avg. $ Growth % Growth Avg. % Growth

150 150 8% 8%

250 200 12% 10%

(150) 83 -6% 4%

2,100 2,333 2,109 2,347

1,950 2,417 1,978 2,447

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Income Statement Projections

Income Statement Account
Cost of Goods Sold

Projection Method
Cost of Goods Sold Margin

Selling, General & Administrative Margin for Variable Expenses Expenses Average Value for Fixed Expenses Depreciation Interest Expense % of Fixed Assets Interest Rates x Associated Debt

Income Taxes
Dividends

Average of Tax Rates

Previous Period Dividend per Share
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Balance Sheet Projections

Balance Sheet Account
Cash
Accounts Receivable Inventory Prepaid Expenses Other Current Assets Fixed Assets

Projection Method
Project Only Minimum Requirement
Average of A/R Turnover Average of Inventory Turnover Average over Prior Periods Average over Prior Periods Prior Period Balance less Projected Depreciation plus Projected Purchases (if any) Average over Prior Periods

Other Assets
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Balance Sheet Projections

Balance Sheet Account
Working Capital Line of Credit

Projection Method
Used as a Plug to Make the Balance Sheet Balance (if negative, make $0, and move the excess to cash) Average of A/P Turnover Prior Period Balance unless Debt is Fully Retired plus Current Portion of New Debt Average over Prior Periods Average over Prior Periods

Accounts Payable Current Portion of Long-Term Debt

Accrued Liabilities Other Current Liabilities

Long-Term Debt
Deferred Taxes

Prior Period Balance plus New Long-Term Debt less CPLTD

Prior Period Balance unless Expiring

Other Liabilities
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Average over Prior Periods

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Balance Sheet Projections

Balance Sheet Account

Minority Interest Preferred Stock Common Stock Retained Earnings

Projection Method
Average over Prior Periods Prior Period Balance Prior Period Balance Prior Period Balance plus Net Income After Tax less Dividends

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Cash Flow Analysis

Cash Flow Coverage Ratio

Total Cash Available / Total Cash Required Requirements of Cash

Lease Payments (1 tax rate) + + + + + + + Interest (1 tax rate) Dividends Capital Expenditures Current Portion Long-Term Debt Increases in Assets Reductions in Liabilities Proposed Debt Payments (Principal and Interest)

Sources of Cash
Net Profit After Tax + + + + + + Depreciation & Amortization Other Non-Cash Charges Increases in Liabilities Reductions in Assets Interest (1 tax rate) Lease Payments (1 tax rate) Non-Cash Revenues

Total Cash Available

Total Cash Requirements

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December 28, 2006

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Cash Flow Analysis

Analysis of Cash Flow Coverage Ratio

A ratio > 1.00 means sufficient cash to cover requirements Underwriters typically want to see a coverage ratio of at least 1.20

This may vary by industry and type of loan

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Career Advice: Bank Underwriter

Most large banks have management training programs Preferred Skills:

Strong Math / Computational Skills Knowledge of Accounting Knowledge of Finance Experience with MS Excel / Modeling

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