Financial Statement Analysis for Credit Decision

Presented by Rabah ElMasri

Financial Accounting is the process of collecting, recording, summarizing and presenting

past and ongoing business activities. The end result of such process could be practically
referred to as the Financial Statements report that reflects the financial profile of any
business entity. A financial report consists of three main financial statements:

 Balance Sheet that accounts for a business’ net worth on a specific day. It reflects the
company’s assets, liabilities and owners’ equity.
 Income Statement that reports the company’s past financial activities expressed as
revenues and expenses during a specified time period. It calculates the net income or
net loss.
 Cash Flow statement that recounts the inflow and outflow of cash resulting from
operating, investing and financing activities during a given time period.

Key Functions of the financial statements

Information deducted from analysis of financial statements discloses the business

financial status to the concerned stakeholders including potential investors, current
shareholders, lenders, and more. It provides the back ground to attract investors or
business partners, stay solvent and avoid bankruptcy, and highlight strengths and
opportunities vs threats and weaknesses.

Financial Statements report is a tool for sound decisions based on determining the
ongoing business concern, business trends, performance appraisal, resource allocation,
management efficiency, and capital structure. It tackles the following issues:

- Measure the amount of capital invested in the business in terms of assets.

- Highlight the due obligations.
- Determine and interrelate the impact of changes in various components of the
financial statements within specified period of time.
- Link the capital changes to the revenues, expenses, and net income.
- Display where money comes from and where it’s being spent.

Type of Financial Statement Analysis

One type is the Vertical Analysis techniques that measures the percentage of each item
or component of the financial statement and compares it to the principle total
components balance of the same financial statement. Taking the balance sheet for
example as a financial statement, vertical analysis compares each item in the assets
section to total assets or total current assets as the identified base. Thorough observation
of the balance sheet identifies close link between assets and liabilities and the volume of
investments placed into the business. For example, compare outstanding accounts
receivables or ending inventory balances to the current assets or total assets as the
identified base. Stakeholders wouldn’t be satisfied when observing receivables constitute
over 40% of the current assets, similarly to inventory. Even if cash & cash equivalents are
over 30%, this could reflect waste of investment opportunities or improper follow up by
the management. This technique applies to each section of both balance sheet and
income statement. For example comparing accounts payable to the total liabilities to
check management efficiency in obtaining credit from suppliers rather than using bank
facilities to buy stock.

Another technique is the Horizontal Analysis that compares the measured percentage of
each item or component of the financial statement to the same component of the
previous year (or any identified timing). An example would be comparing the current
ending inventory to last year inventory balance. Comparing sales, gross profit, and net
income are other examples when applied to the income statement.

The third technique is an advanced one using both vertical and horizontal methods to
carry out ratio analysis of the financial statement components. An example would be to
check the percentage of this year inventory to the accounts payable (vertically) and
compare it to the percentage of last year inventory to the last year accounts payable
(horizontally). This technique can be utilized to compare one component in the assets
side to another component in the liability side and further compare it to related result
during another specified time period. If the Inventory is high as well as accounts payable,
this could show management piling stock imposing due payments’ burden on the cash
flow. The logic behind that to assess efficiency in management of debt vs stock level and
timing. Similarly, if debt is observed high vs low inventory and low investment in
noncurrent assets, this means the debt has not been utilized into the business.

Hence, financial statement analysis is required to assess areas of potential growth or

highlight threats and weaknesses.

Cash Flow Analysis

The functional components of both balance sheet and income statement provide both
source and use of cash representing the key cash drivers. Cash flow is the movement of
money in and out of the business. In other words, cash is raised from investors in the form
of capital base and/or borrowed from lenders under Accounts/Notes Payable. Then, cash
is used to buy assets namely Inventory & Non Current Assets. The loop continues as assets
and inventory enable company operations to generate cash through revenues/sales,
which pays for expenses and taxes as reflected in the net income statement.
Consequently, the net income is shifted to the balance sheet as retained earnings which
is used to settle obligations and provide dividends to investors. The Cash flow process is
derived from two components:
- Inflow which comes from operations such as the sale of goods and services, loans, lines
of credit, and asset sales. This could be referred to as source of cash.
- Outflow which occurs during operations such as business expenditures, loan payments,
and business purchases. This could be referred to as use of cash.

As per the International Financial Reporting Standards, cash flow statement reflects cash
movement within three clusters namely:
Cash Flow from Operations (CFO).
Cash Flow from Investment (CFI).
Cash Flow from Financing (CFF).

Source of Cash Use of Cash Statement of Cash Flow

Revenues Buy Inventory Cash from Operations:
Depreciation Pay lenders Net Income
Amortization + depreciation & amortization
Allowances + doubtful debts allowance
+ end of service benefits
+ slow moving inventory allowance
- Increase in inventory
- Increase In accounts receivable
- decrease in accounts & other
payable
- paid end of service benefits

Sale of assets Purchase of assets Cash From Investing:

Sale of assets
- Purchase of assets

Borrowing Paying debts Cash From Financing:

Paying dividends Increase in borrowing
+ increase in notes payable
- settled loans
- partners withdrawals

Net Cash Flow= CFO + CFI + CFF

It's crucial to balance the cash flow cycle and maintain a reasonable balance of cash at all
times. Yet, the components of the cash flow should be carefully assessed. For example,
we might observe very minor net cash flow balance that could be the result of the
managerial decision to use its available cash to settle long-term debt. Creditors might end
up thinking the operations are not providing good cash even though operating
performance is strong. Nevertheless, a declining performance company can generate net
cash flow by additional capital investment or by selling assets. In this case, a positive net
cash flow could result irrespective of the actual performance.

The cash flow statement analysis provides relevant information to assess a business’
liquidity, quality of earnings and solvency and ensure a positive cash position is sustained
to finance growth.

Ongoing Business Concern Analysis

It is crucial that a credit analyst and any decision maker should thoroughly examine all
financial figures prior to any conclusion. A company may have revenues (Income
statement) and appear profitable, but high receivables (balance sheet component) could
reflect weaknesses including high pricing compensated by stretched credit policy,
obsolete products, improper credit policy, and slow collection follow up. Such weaknesses
could distress the cash flow and hinder the company’s ability to reinvest in the business
cycle or meet its current financial obligations. Similarly, an increase in accounts and notes
payables (balance sheet component) could reflect increase in obligations due to vendors
and other creditors and can grow to the point of putting the company out of business.
Similarly, the increase in payables could be positive in case of acquisition of machines and
equipment that would enhance the cash flow upon utilization.

Another aspect to consider is the Working Capital Requirement. In essence, the Working
Capital is the difference between Current Assets and Current liabilities. Working Capital
Requirement refers to the cash balance required to be maintained and managed for
ongoing business operations including due obligations and to fund the operating cycle
including inventory and accounts receivable by the time cash is regenerated from
operations. Most suppliers get their money in advance but it takes longer period to stock,
sell and collect the price of the sold items. Hence, the cash conversion cycle could be best
managed by reducing receivables, controlling inventory and extending payment terms to
suppliers.

Critical judgement of ongoing business concern is interrelated to the financial report and
should cover other important issues like employees turnover ratio, business trends, age
and type of available inventory, and management skills and experiences. The credit
decision depends partially on the level of growth and development of the company. The
changes that the company has been through reflects whether management takes its
decisions on reasonable sound decision making, wise understanding of the opportunities,
and well prepared budget based on actual resources and constraints.

This presentation is a summary of the techniques and processes involved in the analysis
of the financial statements. Decision makers should carry out due diligence in assessment
of the variables and components of the financial statements in order to reach a sound
business evaluation.

Rabah ElMasri

Oct 2015.