2. 2
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
3. 3
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 proprietor’s stake in the business is high
versus the business carrying excessive debt
4. 4
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 bank’s remedy if the assumptions
of the loan turn out to be wrong?
5. 5
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.
6. 6
Cross-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
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
8. 8
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
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
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
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
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
SELECTION 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
SELECTION RISK ANALYSIS
The credit selection analysis can be captured in
four 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
SELECTION RISK ANALYSIS
1. 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
Sources of Credit Information
There are three fundamental sources of information:
1.Customer Interview:
Despite the possible lack of objectivity, the loan customer
ordinarily provides the most important information needed
in 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 the
bank about the customer’s willingness and capacity to
service the proposed loan.
3.External Sources of Information:
Local, regional and national credit bureaus provides
information about the credit history and business
operations of the loan applicants.
17. 17
RISK RATING AND MONITORING
Every bank uses a risk rating system to measure
the risk of their loans. The degree of monitoring
required for a loan is in proportion to its rated risk.
Risk Rating: Every bank uses a risk rating system
to measure the risk of their loans. Risk ratings
force the loan personnel to quantify the risk
perceived in their loans.
Watch List: Loans that become rated in the lower
categories of the risk rating system constitute the
watch list. Loans that reach90 days past-due
should be classified loss and charged off.
18. 18
A Loan Risk-Rating System
Class I (highest quality)
Class II (good quality)
Class III (satisfactory quality)
Class IV (below-average quality)
Class V (poor quality)
