Ch3. financial statement analysis


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Ch3. financial statement analysis

  2. 2. 2Introduction• 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
  3. 3. 3Why Lenders Analyse FinancialStatements• 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 proprietor’s stake in the business is high versus the business carrying excessive debt
  4. 4. 4Why Lenders Analyse FinancialStatements• 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 bank’s remedy if the assumptions of the loan turn out to be wrong?
  5. 5. 5Analysis 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.
  6. 6. 6Cross-sectional techniques ▫ Ratios: Financial ratios derived from the financial statements fall into four main categories:  Liquidity ratios  Efficiency ratios  Profitability ratios  Leverage ratios
  7. 7. 7Time 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
  8. 8. 8Combining Financial Statement andNonfinancial 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
  9. 9. 9 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.
  10. 10. 10 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
  11. 11. 11 Step-By-Step Approach to Financial Statements Analysis• Step 5: Comparison with Industry Averages  How does firm’s financial ratios compare with competitor’s 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
  12. 12. 12 Use of Financial Ratios by Loan Officers• Top ten ratios of importance in loan assessment 1 Debt/Equity 6 Net Interest Earned 2 Current Ratio 7 Net Profit Before Tax 3 Cash Flow/LT Debt 8 Financial Leverage 4 Fixed Charge Cover 9 Inv T/O in Days 5 Net Profit After Tax 10 A/c Rec T/O in Days
  13. 13. 13SELECTION RISK ANALYSIS• Credit selection is the process of assessing the risk of lending to a business or an individual.• Selection risk has both qualitative and quantitative dimensions. ▫ Qualitative: financial responsibility, true purpose for borrowing funds, economic conditions, degree of commitment. ▫ Quantitative: analysis of historical financial data and the projection of future financial results.
  14. 14. 14SELECTION RISK ANALYSISThe credit selection analysis can be captured infour groups: 1. The borrower’s character and soundness 2. The intended use of loan funds 3. The primary source of loan repayment 4. Secondary sources of repayment
  15. 15. 15SELECTION RISK ANALYSIS1. The borrower’s character and soundness: Dishonest borrowers do not feel morally committed to repay their debts. Intelligence, personal discipline, managerial discipline and instincts are also very important.2. The Intended Use of Loan Funds An understanding of the loan’s intended use helps the analyst to understand whether the loan request is reasonable and acceptable. 3. Primary Source of Loan Repayment Determining the borrower’s ability to repay a loan from its cash flow is very important. The analyst must ascertain the timing and sufficiency of these cash flows. 4. Secondary Source of Loan Repayment If sufficient cash flows fail to materialize, the bank can prevent a loss if it has secured a secondary source of repayment (i.e.collateral). Other secondary sources are guarantors and co-makers.
  16. 16. 16Sources of Credit InformationThere are three fundamental sources of information:1.Customer Interview:Despite the possible lack of objectivity, the loan customerordinarily provides the most important information neededin a credit investigation. 2. Internal Bank Sources:If a loan customer has existing relationships with the bank,a great deal of information is internally available to thebank about the customer’s willingness and capacity toservice the proposed loan. 3.External Sources of Information:Local, regional and national credit bureaus providesinformation about the credit history and businessoperations of the loan applicants.
  17. 17. 17RISK RATING AND MONITORINGEvery bank uses a risk rating system to measurethe risk of their loans. The degree of monitoringrequired for a loan is in proportion to its rated risk.Risk Rating: Every bank uses a risk rating systemto measure the risk of their loans. Risk ratingsforce the loan personnel to quantify the riskperceived in their loans.Watch List: Loans that become rated in the lowercategories of the risk rating system constitute thewatch list. Loans that reach90 days past-dueshould be classified loss and charged off.
  18. 18. 18A Loan Risk-Rating SystemClass I (highest quality)Class II (good quality)Class III (satisfactory quality)Class IV (below-average quality)Class V (poor quality)
  19. 19. 19Question