FINANCIAL STATEMENT ANALYSIS

YOU WILL BE ABLE TO…

Identify the effects that financial accounting methods have on

balance sheets and income statements

Analyze common size financial statements

Assess the quality of assets and profits

Use financial statements as a quantitative assessment of

management performance

1
 Sources of information

• Financial statements provided by the company

• Financial statements of comparable businesses from your bank’s

files or composite statements from other companies in the same
industries

• Conversations with management of the borrower and your

observations of the borrower’s assets and activities

Understanding the Income

Statement

2
 Examine Income Statement for accounting risk
Determine whether  How and when is revenue recognized?
revenue is overstated  How does that revenue-recognition method affect sales and
\
accounts receivable?
 Are sales final?
 Are receivables real and collectible?
 Has a change in accounting methods affected the reported
revenues?
Determine whether
expenses are • How and when are expenses recognized?
understated • How do those expense-recognition methods affect reported profits
and related balance sheet accounts?
• What method is used to account for COGS and inventory?
• Are there inventory profits or holding gains?
• If the company uses LIFO, has there been a LIFO liquidation?
• What methods are used to amortize the costs of long-lived assets?
• Are all expenses necessary to produce the revenues recorded?
• Are there capitalized expenses?
• Can the borrower explain each expense account and provide
breakdowns when needed?
• Has a change in accounting methods affected reported expenses?

Examine Income Statement for accounting risk

Depends on…

Management decisions about revenue recognition

Ex: completed contract or percentage of work completed

Management decisions about expense matching

• Immediate recognition
• Rational allocation
• At the time of revenue recognition

COGS and Inventory management

• Specific identification
• Average cost
• LIFO
• FIFO

3
 Examine Income Statement for accounting risk
\

COMMON SIZE ANALYSIS OF INCOME STATEMENT

Display data to facilitate  Organize the income statement in a consistent hierarchy of
\
comparisons accounts
 Calculate each significant category of expense as a percent of net
sales
 Calculate gross profit margin, operating profit margin, pre-tax profit
margin, and net profit margin
Analyze trends in the  Present the most significant findings
borrower’s performance  Explore the reasons for the most important and largest changes
 Explore the reasons for the instability of things that might have
changed
 Consider how the borrower’s actual performance compares to your
expectations about the borrower’s production risk, value added,
and length of asset conversion cycle
Compare the borrower’s
performance with an industry  Obtain appropriate industry data for current period and prior years
standard  Make sure industry ratios and borrower’s ratios are comparable
 Present the most significant findings
 Explore the reasons for the most important and largest differences

4
 COMMON SIZE ANALYSIS OF INCOME STATEMENT
\

COMMON SIZE ANALYSIS OF INCOME STATEMENT

Expectations of Profitability
\

10

5
 SUSTAINABLE EARNINGS
\

Sales sustainability is examined through:

• Analyze the components of sales

• Assess the management of sales and expenses

• Examine the borrower’s operating leverage

11

SUSTAINABLE EARNINGS
Identify the components of
revenue  What are the trends in unit volume and unit price?
\
 Does the business engage in two or more distinct lines of business?
 By product?
 By customer segment?
 By geographic market?
 By production location?

Assess management’s
performance in sales and  Can the business generate a growing level of sales?
 How does sales growth compare with the rest of the industry?
expense control
 How well has management been able to control costs?
 How well has management been able to maintain healthy profit margins?
 How does the profitability compare with the industry’s?
 How is the borrower’s competitive strategy affecting sales, expenses, and profits?
Evaluate operating leverage
 Which of the company’s expenses tend to be fixed and which tend to be variable?
 What is the company’s approximate contribution margin?
 What is the opportunity for increased profitability if sales rise?
 What is the risk of losses or decreased profitability if sales decline?
 What is the approximate sales level at which the company breaks even?

12

6
 CALCULATING THE CURRENT BREAK EVEN POINT
\

13

PROJECTING THE BREAK EVEN POINT

Given any additional financing banks provide
\

• Simply add the new interest costs and depreciation to the fixed costs basis and divide by
the contribution margin
• If, as a result of the financing, some costs will disappear (the purchase of a new facility or
warehouse could replace rent payments, for ex), then subtract these from the current
fixed or variable cost base as appropriate

Example: A company decides to buy a new warehouse to replace its existing facilities. The
cost is $1.5 million, with a loan of $ 1mi at 10% interest. Depreciation is $30,000 annually.
The original rental payment was $70,000 (fixed).

Prior to this transaction (in $000s)

Sales $5,000
Fixed costs 3,500
Variable costs 1,000
Contribution margin 80%
Break even point $4,375

What is the new break even point?

14

7
 Understanding the Balance Sheet

15

UNDERSTANDING THE BALANCE SHEET

\
Asset quality

• Liquidity risk
• Allocation of assets among various categories (CA and LT assets)
• Suitability of asset mix to the business’s optimal operating cycle
• Valuation of collateral or potential liquidation

Structure of Liabilities and Equity

• Timing and terms of payment

• Allocation of liabilities among various categories (CL and LT liabilities and
equities)
• Suitability of L&E mix to asset conversion cycle, and capital structure

16

8
 Examine Balance Sheet for accounting risk

\
Key areas to examine for potential distortions of net worth:

• Accounts receivable
• Check for the adequacy of an estimated allowance for bad debts

• Inventory
• Check for inventory volume count
• Check for the use of LIFO during times of rising prices
• Write-down, write-off problems due to wear and tear, obsolescence…

• Long-term assets
• Check for decisions about original cost, useful life, and calculation of
amortization or depreciation
• Check for the existence of operating leases that may cause similar
companies to report different asset allocations and leverage
• Capitalizing vs. expensing an intangible asset

17

EVALUATING ASSET QUALITY

Refer to the “Understanding the Balance Sheet” \ handout for a

detailed discussion

• Current assets

• Non current assets

• Fixed assets
• Long-term Investments
• Intangible assets and deferred charges

18

9
 COMMON SIZE ANALYSIS OF ASSET
\

Company-prepared balance sheet:

19

COMMON SIZE ANALYSIS OF ASSET

Bank-formatted common size balance sheet: \

20

10
 COMMON SIZE ANALYSIS OF ASSET
Comparative analysis of Asset Distribution
\

Match the letters with the 4 types of companies:

- A cable TV company (owns the cables and individual hookups)
- Jewelry retailer
- Aircraft parts manufacturer
- Wholesaler of fresh fruits and veggies

21

COMMON SIZE ANALYSIS OF ASSET

Comparative analysis of Asset Turnover
Representative sample of average INVDOH and ARDOH for selected
\ industries (Moody’s
Analytics, updated 2017)

22

11
 COMMON SIZE ANALYSIS OF ASSET
Comparative analysis of Liquidity
\

23

STRUCTURE OF LIABILITIES AND EQUITY

\

• Current liabilities
• Noncurrent liabilities
• Amounts owed to owners or insiders: lenders often reclassify as
current unless they are subordinated to the lender’s claims
• Contingent liabilities and commitments: disclosed in notes to the
FS and are not reported on the balance sheet
o Definite obligations for an uncertain amount
o Amount may be reasonably estimated, but the borrower’s
obligation to pay is not certain
o Uncertainty may exist about both the amount and the
obligation to pay
• Tax liabilities
o Taxes payable
o Deferred taxes

24

12
 COMMON SIZE ANALYSIS OF CAPITAL STRUCTURE

25

COMMON SIZE ANALYSIS OF CAPITAL STRUCTURE

26

13
 Developing Expectations

27

DEVELOPING EXPECTATIONS
General rules – Asset structure and turnover
\

28

14
 DEVELOPING EXPECTATIONS
General rules – Asset structure and turnover
\

How is a grocery store’s profitability

and asset structure and turnover like
and unlike the typical data given for
retailers?

29

DEVELOPING EXPECTATIONS
Example 1
\

Based on your
expectations for
grocery stores, what
questions does Park
financial profile
raise? Does this look
like a grocery store?
Focus on:
- Profitability
- Asset distribution
- Asset turnover

30

15
 DEVELOPING EXPECTATIONS
General rules – capital structure
\

31

DEVELOPING EXPECTATIONS
Example 2
\

Among A,B, and C, which

biz seems to have:
- Highest business risk
- Shortest asset
conversion cycle

32

16
 DEVELOPING EXPECTATIONS
Example 3
\
1. The higher the quality of assets and the more liquid a company, the more/less leveraged
it can be without creating undue risk for itself or its lenders.

2. The higher the profitability as a % of sales, the greater/smaller the portion of debt that is
suitable for the capital structure.

3. The less cyclical the business or its industry, the higher/lower the proportion of liabilities
that can safely be in the capital structure.

4. The less seasonal a business, the higher/lower the proportion of liabilities that can
safely be in the capital structure.

5. The more capital – intensive the business, the higher/lower the proportion of long term
debt and equity that is appropriate for the capital structure.

6. The less industry and business risk the company faces, the higher/lower the proportion
of liabilities that can safely be in the capital structure.

7. The higher the company’s need for working investment at the seasonal low point of the
business, the higher/lower the % of long-term debt and equity that is appropriate for the
capital structure
33

DEVELOPING EXPECTATIONS
The combined effects of leverage and profitability
\

Two tools for evaluating the combined effect of a business’s

leverage and profitability:

• Dupont analysis

• EBITDA and EBITDA coverage ratios

34

17
 DEVELOPING EXPECTATIONS
DUPONT ANALYSIS
\

35

DEVELOPING EXPECTATIONS
EBITDA and EBITDA coverage ratios
\

36

18
 DEVELOPING EXPECTATIONS
EBITDA and EBITDA coverage ratios
\

Refer to the ABC Corporation financial statements handout

Calculate the ratios related to EBITDA and comment on the repayment ability of the
company.

37

19