Financial Statement Analysis Essentials of Corporate Finance Chapters 2 & 3 Materials Created by Glenn Snyder – San Francisco State University

Financial Statement Analysis

Essentials of Corporate Finance

Chapters 2 & 3

Materials Created by Glenn Snyder – San Francisco State University

December 28, 2006

Materials Created by Glenn Snyder – San Francisco State University 2

Topics

Who uses Financial Statement Analysis? Banking - Loan Underwriter

Loan Package Financial Analysis

Account Receivable Inventory Financial Ratios

Financial Projections Income Statement Projections Balance Sheet Projections

Cash Flow Analysis Career Advice for becoming a Bank Underwriter

December 28, 2006


Who uses Financial Statement Analysis? Almost Everyone in the Business World

Bankers – analyze loans and cash flow Portfolio Managers – projections of stock prices Marketing Managers – market penetration and

impacts to profitability Human Resources – compensation analysis Senior Management – corporate strategy Sales Managers – commission rates on sales Internal Financial Analysts – profitability analysis Customer Service Managers – efficiency ratios

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Banking – Loan Underwriter

What is a Loan Underwriter? A loan underwriter analyzes the loan application

and supported materials to determine if the loan should be approved.

Where do Loan Underwriters work? Commercial Banks Investment Banks (Bond Underwriters) Financing Institutions (Mortgage Companies)

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Banking – Loan Underwriter

What is a Loan Underwriter looking to do? Analyze the credit quality of a business Project cash flow and interest coverage Gain an understanding of the business

In the end, a bank is only looking to get paid back and earn interest.

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Loan Package

When a company applies for a loan, any of the following can be requested by the bank: Loan application 3 years financial statements 3 years personal tax returns of owner (if the

company is a small business) Accounts Receivable aging schedule Names of customers and suppliers for references

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Accounts Receivable & Inventory Almost half of all loan requests are for a

working capital line of credit. A working capital line of credit works like a credit

card (only without the card). A company can draw up and down on the line and only pay interest on outstanding balances.

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Accounts Receivable & Inventory Working Capital Lines of Credit

Most working capital lines of credit are based off of a percentage of accounts receivable and inventory. For example: A $500,000 line of credit based 80% on

accounts receivable and 50% of finished goods inventory.

Therefore, Accounts Receivable and Inventory are two of the most important balance sheet accounts for a banker.

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Financial Analysis – Accounts Receivable

Accounts Receivable (A/R) is the fastest non-liquid asset to convert to cash

Analysis:

Questions to Ask ReasonWhat % of sales are returned? Why? Are returns a significant part of the business model?

Are returns due to poor quality?

What % of sales are sold on credit? How reliant is the company on extending credit?

What % of sales are written-off? Do they continue to sell to customers who don’t pay?

Is there a concentration with one or two sales people?

What if those sales people leave?

What % of sales are guaranteed (contractually obligated)?

What happens when the contract expires? Where is new business coming from?

What % of sales are foreign? Do they use letters of credit to protect against non-payment? Foreign customers are hard to collect from.

What % of sales is to the government? The government is typically slow paying

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Financial Analysis – Accounts Receivable Accounts Receivable Aging Schedule

A schedule of all outstanding receivables grouped both by customer and due date

Analysis:Questions to Ask ReasonIs there a concentration greater than 10% of any customers?

What happens if they lose a large customer?

What % of customers are past due? How reliable are their accounts receivable

Are there any receivables over 120 days past due that have not been written-off?

Typically these will not be collected and should be backed out of the total accounts receivable

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Financial Analysis - Inventory

Inventory is typically the largest current asset and is what the company tries to convert to cash.

Inventory includes: Raw materials inventory Work-in-Process inventory Finished goods inventory

In case of liquidation Raw materials inventory can be sold back to the supplier (at a

fraction of the cost) Finished goods inventory can be sold to customers (at a

fraction of the cost)

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Financial Analysis - Inventory

Analysis:

Questions to Ask ReasonHow does the company inventory compare with the industry average?

Do they carry too much? Too little? Do they have too much in finished goods inventory?

Is inventory valued at LIFO, FIFO, or Weighted Average?

This will impact the cost of goods sold and inventory balance. Could inventory be obsolete?

What % of current assets is made up of inventory? Inventory is typically the hardest current asset to convert to cash

What % of inventory is work-in-process? This inventory is virtually worthless. What can you do with the frame of a car?

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Financial Analysis - Ratios Liquidity Ratios – Current Ratio:

Current Assets / Current Liabilities Measures a firms ability to meet current obligations

Analysis:Questions to Ask ReasonCalculate the Current Ratio Too low suggests a lack of liquidity, too high

suggests financial assets are not used efficiently

How does the company’s current ratio compare with companies of similar size in their industry?

If they are not in-line with the industry, then the underwriter must find out why.

Are liabilities being paid on time? If suppliers and service bills are being stretched, this would decrease the current ratio.

How much is inventory weighted in current assets?

Inventory is the most difficult current asset to convert to cash? How quickly is it turning over?

Are accounts receivable over 120 days being written off?

These accounts will probably not be collected and should be removed from current assets

Exclude Prepaid Current Assets Cash cannot easily be obtained from a prepaid phone bill or rent

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Financial Analysis - Ratios Liquidity Ratios – Quick Ratio (Acid Test):

(Current Assets – Inventory)/ Current Liabilities Measures a firms ability to meet current obligations without liquidating

inventory

Analysis:Questions to Ask ReasonCalculate the Quick Ratio Too low suggests a lack of liquidity, too high

suggests financial assets are not used efficiently

How does the company’s current ratio compare with companies of similar size in their industry?

If they are not in-line with the industry, then the underwriter must find out why.

Are liabilities being paid on time? If suppliers and service bills are being stretched, this would decrease the current ratio.

How much is inventory weighted in current assets?

Inventory is the most difficult current asset to convert to cash? How quickly is it turning over?



Exclude Prepaid Current Assets Cash cannot easily be obtained from a prepaid phone bill or rent

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Financial Analysis - Ratios Leverage Ratios – Debt-Equity Ratio:

Total Liabilities / Total Net Worth Measures the funds contributed by owners or

shareholders versus creditors.

Analysis:Questions to Ask ReasonCalculate the Debt-Equity ratio Banks generally like to see this ratio below

40% If this ratio was greater than 50%, the company would primarily be financed by creditors

The owners would be more likely to declare bankruptcy in the event of a downturn, as they would have less to lose

How much of total liabilities are current liabilities? Matching Principle: current assets should be financed with current liabilities, long-term assets should be financed with long-term debt

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Financial Analysis - Ratios Efficiency Ratios – Accounts Receivable Turnover:

(Accounts Receivable / Sales) x 365 Measures the average number of days it takes the company to

collect their receivables.

Analysis:Questions to Ask ReasonCalculate the Accounts Receivable Turnover The shorter the better

The faster a company can collect, the faster they have cash The less time they need to borrow

Is the accounts receivable turnover relatively close to the company’s financing terms?

If they sell on 2/10 net 30, one would expect to see a turnover around 30 days. A few days over is ok, but 40 or 45 would be too long



How does the company’s turnover compare with the industry?

The turnover should be close to industry averages, if not, the underwriter needs to know why

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Financial Analysis - Ratios Efficiency Ratios – Inventory Turnover:

(Inventory / Cost of Goods Sold) x 365 Measures the average number of days inventory is on hand

Analysis:Questions to Ask ReasonCalculate the Inventory Turnover The shorter the better

The faster a company can sell its inventory, the faster they have cash The less time they need to borrow

Which inventory valuation method do they use? LIFO, FIFO, or weighted average?

Which method is standard for the industry? Have they changed valuation methods recently? If so, why?

Is the inventory turnover different for different products?

Are some products selling and others not? Are some products becoming obsolete?



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Financial Analysis - Ratios Efficiency Ratios – Accounts Payable Turnover:

(Accounts Payable / Cost of Goods Sold) x 365 Measures the average number of days the company takes to pay its

suppliers

Analysis:Questions to Ask ReasonCalculate the Accounts Payable Turnover This is a sensitive ratio:

The longer the turnover, the longer the company has cash If the supplier get stretched to much, they may not sell to the company, which can put the company out of business

What terms to the suppliers offer? Is the company taking advantage of discounts?

Supplier reference check An underwriter will want to call 3 or 4 suppliers to confirm the company is in good standing



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Financial Analysis - Ratios Profitability Ratios – Gross Profit Margin:

(Sales – Cost of Good Sold) / Sales Measures the differential between what it costs to manufacture or

purchase the product and how much the product is sold.

Analysis:Questions to Ask ReasonCalculate the Gross Profit Margin The higher the gross profit margin, the more

money is available to cover the operating costs of the company

Has the gross profit margin changed over time? This can show the impact of price changes or changes in the cost of inventory.

Understand the industry Certain industries may have tighter margins, such as technology retail.



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Financial Analysis - Ratios Profitability Ratios – Return on Equity (ROE):

Net Income / Total Equity Measures the relationship between profits and the investment of the

owners.

Analysis:Questions to Ask ReasonCalculate the Return on Equity This ratio will have a direct impact on the

company’s ability to raise capital

Has the ROE changed over time? This can show changes in capital structure, infusions of capital, an changes in net income


The ROE may be close to the industry, despite low profits, as the company may have higher levels of liabilities

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Financial Projections

Loan underwriters must take their ratios and analysis of the financial statements and project the company’s financial statements to show adequate cash flow to repay the loan.

Financials are projected by each account shown on the financial statements. The method of projections may vary by industry The method of projections may vary based on which

accounts are shown on the financial statements All companies prepare and publish their financial statements

in different ways

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Income Statement Projections Sales (Gross Revenues)

Four approaches: $ Growth – Repeat the dollar growth from the previous period Average $ Growth – Average the dollar growths from all of

the previous periods and project the average % Growth – Repeat the percentage growth from the previous

period Average % Growth – Average the percentage growths from

all of the previous periods and project the average) Average % Growth is the most common method

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Income Statement Projections Sales (Gross Revenues)

Year 2004 2005 2006 2007E 2008 2009Sales 2,000 2,150 2,400 2,250

$ Growth 150 250 (150) 2,100 1,950 Avg. $ Growth 150 200 83 2,333 2,417

% Growth 8% 12% -6% 2,109 1,978 Avg. % Growth 8% 10% 4% 2,347 2,447

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Income Statement Projections

Income Statement Account Projection Method

Cost of Goods Sold Cost of Goods Sold Margin

Selling, General & Administrative Expenses

Margin for Variable Expenses

Average Value for Fixed Expenses

Depreciation % of Fixed Assets

Interest Expense Interest Rates x Associated Debt

Income Taxes Average of Tax Rates

Dividends Previous Period Dividend per Share

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Balance Sheet Projections

Balance Sheet Account Projection MethodCash Project Only Minimum

Requirement

Accounts Receivable Average of A/R Turnover

Inventory Average of Inventory Turnover

Prepaid Expenses Average over Prior Periods

Other Current Assets Average over Prior Periods

Fixed Assets Prior Period Balance less Projected Depreciation plus Projected Purchases (if any)

Other Assets Average over Prior Periods

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Balance Sheet Account Projection MethodWorking Capital Line of Credit Used as a Plug to Make the Balance

Sheet Balance (if negative, make $0, and move the excess to cash)

Accounts Payable Average of A/P Turnover

Current Portion of Long-Term Debt Prior Period Balance unless Debt is Fully Retired plus Current Portion of New Debt

Accrued Liabilities Average over Prior Periods

Other Current Liabilities Average over Prior Periods

Long-Term Debt Prior Period Balance plus New Long-Term Debt less CPLTD

Deferred Taxes Prior Period Balance unless Expiring

Other Liabilities Average over Prior Periods

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Balance Sheet Account Projection MethodMinority Interest Average over Prior Periods

Preferred Stock Prior Period Balance

Common Stock Prior Period Balance

Retained Earnings Prior Period Balance plus Net Income After Tax less Dividends

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Cash Flow Analysis

Cash Flow Coverage Ratio Total Cash Available / Total Cash Required

Sources of Cash Requirements of CashNet Profit After Tax Lease Payments (1 – tax rate)

+ Depreciation & Amortization + Interest (1 – tax rate)

+ Other Non-Cash Charges + Dividends

+ Increases in Liabilities + Capital Expenditures

+ Reductions in Assets + Current Portion Long-Term Debt

+ Interest (1 – tax rate) + Increases in Assets

+ Lease Payments (1 – tax rate) + Reductions in Liabilities

- Non-Cash Revenues + Proposed Debt Payments (Principal and Interest)

= Total Cash Available = Total Cash Requirements

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Cash Flow Analysis

Analysis of Cash Flow Coverage Ratio A ratio > 1.00 means sufficient cash to cover

requirements Underwriters typically want to see a coverage

ratio of at least 1.20 This may vary by industry and type of loan

December 28, 2006


Career Advice: Bank Underwriter Most large banks have management training

programs

Preferred Skills: Strong Math / Computational Skills Knowledge of Accounting Knowledge of Finance Experience with MS Excel / Modeling

Documents

Financial Statement Analysis Essentials of Corporate Finance Chapters 2 & 3 Materials Created by Glenn Snyder – San Francisco State University