Financial Statement Analysis Sumed Bhattarai Manager, Laxmi Bank Limited
Topics to be covered • Importance of Financial statement analysis • Sources of Information • Understanding Income Statement • Understanding Balance Sheet • Ratio Analysis • Risks Associated with Financial Statement Analysis • Optimum Capital Structure • Case Study
Importance • Essential element of evaluating ability to repay • Consider financial conditions and performance of the borrower • Ascertain borrower’s management quality / ability
Sources of Information • Financial statements of the borrower (audited / provisional / management prepared) • Balance sheet • Profit and loss account • Cash flow statement • Projected figures (if available) • Financial statements of other companies within the industry • Conversation with the borrower himself / herself
Understanding Income Statement The income statement is a report of the revenues management has recognized during the period and the expenses management has matched to those revenues. When recognized revenues exceed matched expenses, the result is profit.
Understanding Income Statement Total income: 1,100 Gross profit: 500 PBIT: 250 Profitability: 15%
Recognizing Revenues • When the borrower has performed its obligation • Delivered the goods • Provided the service • When the buyer has agreed to buy product / service and the price has been fixed
Matching Expense to Revenues • Immediate Recognition Overheads / Salaries / Office supplies / Utilities / Facilities etc. • Rational Allocation Fixed Assets / Pre-operating expenses through deprecation and amortization • At the time of revenue recognition
Income statement analysis Common size analysis Common-size income statements express each expense or expense category as a percentage of sales, with sales being 100 percent.
Income Statement Analysis • Sustainable Earnings • Analyzing component of sales • Change in unit volume & change in price • Change in sales mix • Change in market segments • Production locations • Assessing the management of expenses • What is each expenses • How controllable is each expenses • How important is each expenses • How typical is each expense amount for current period
Income Statement Analysis • Operating Leverage • Understanding the business well enough to anticipate how major categories of expense will "behave" if sales rise or fall
Income Statement Analysis • Breakeven sales • Breakeven sales is the level of sales at which a business makes no profit before tax but incurs no loss. • Formula for breakeven sales • Fixed Costs / Contribution margin • Contribution margin: (1-VC/Sales) • The amount of each rupee of sales that is available to pay the fixed costs.
Understanding Balance Sheet This sheet gives the customers’ position in terms of its assets and liabilities at a particular point in time / date . Its also reveals clients networth as on same date. Major Items under balance sheet • Assets • Account receivables • Inventory / Stocks • Plant / Machineries and Equipment • Investments • Intangible Assets • Other Assets
Understanding Balance Sheet Major Items under balance sheet • Liabilities • Current liabilities • Long Term liabilities • Amount owned to insiders • Contingent liabilities
Risks Associated with Financial Statement Analysis • Reliability / Authenticity of the information • Leverage: The extent of company uses its dept to support its assets. • Quality of assets and nature of liabilities • Analyzing working capital cycle and structuring loan to finance working capital • Balance sheet mismatch and its management
Indicator comparison • If your borrower is stronger than the industry average, it has a competitive advantage and is more likely to succeed over the long term. It is, therefore, more likely to be a good credit risk and able to repay loans of appropriate amounts and structures. • If the borrower's industry as a whole has prospered with relatively low standards of liquidity, leverage, or profitability, you may reasonably judge that a well-managed and well-financed company in the industry would prosper
Optimum Capital Structure • Capital structure is important to a company's long-term health and ability to repay debts and is the aspect of a borrower's financial profile that the lender can directly impact. Because of this, lenders should understand what an optimal capital structure would be for a particular borrower.Understanding optimal capital structure goes beyond comparing a borrower to its industry. It requires a synthesis of your industry and business risk analysis and the integration of your financial analysis about Liquidity, profitability and leverage
Optimum Capital Structure • Profitability and cash flow: • Does the company have enough to pay interest on its debt and to keep installment payments current? Is profitability still satisfactory after payment of interest expense? If the business is cyclical, are profits and cash flow sufficient even in years of weaker performance? • Asset quality: • If the company had to be liquidated, could total assets realize enough cash to pay all liabilities, even if owners get nothing? Lenders typically are able to take the risk of the time it takes to convert assets to cash, but cannot afford to take the risk of asset shrinkage and failure to convert to cash in any time. • Asset distribution: • Long-term assets are best financed by either noncurrent liabilities or equity because the long-term assets: • Will be the engine that produces the revenues and profits needed to make installment payments and pay dividends • Will not convert to cash within one year as would be needed to pay current liabilities
Optimum Capital Structure • The higher the quality of assets and more liquidity • The higher the quality of assets and the more liquid a company, the more leveraged it can be without creating undue risk for itself or its lenders. • The higher the profitability as a percent of sales • The higher the profitability as a percent of sales, the greater the portion of debt that is suitable for the capital structure. Because the business will be able to pay the interest expense and still make an appropriate return for its owners. • The less cyclical the company or its industry • The less cyclical the company or its industry, the higher the proportion of liabilities that can safely be in the capital structure. Because there is less need to worry about making payments during "bad years." • The less seasonal a business • The less seasonal a business, the higher the proportion of liabilities that can safely be in the capital structure. Because there is no seasonal surge in liabilities creating high leverage at a peak debt position.
Optimum Capital Structure • The more capital-intensive the business • The more capital-intensive the business (those with a higher percentage of fixed assets), the higher the proportion of long-term debt and equity that is appropriate for the capital structure. To assure that current liabilities do not exceed the amount that can be paid from conversion of current assets to cash. • The higher the company's need for working investment as the seasonal low point • The higher the company's need for working investment at the seasonal low point of the business (those whose core current assets are in excess of their core spontaneous financing), the higher the proportion of long-term debt and equity that is appropriate for the capital structure. Because the core level of current assets is no more able to be converted to cash to satisfy current liabilities than are the bricks and machinery of fixed assets. • The less industry and business risk the company faces • The less industry and business risk the company faces, the higher the proportion of liabilities that can safely be in the capital structure. Because the stability of the business makes it less likely that the company will experience a drop in volume or profits or that it will need to borrow to change its business in response to competition or changing economic and industry conditions.