BUSINESS IV: MANAGEMENT & FINANCIAL ANALYSIS
INTRODUCTION TO FINANCIAL
STATEMENT ANALYSIS
Financial statements are, among other things, a
substitute for personal experience with a company or a company’s
management. A financial statement denotes
a record of the effects of management’s decisions and of management’s success
in completing the asset conversion cycle.
When you first meet a bank prospect, you should immediately begin to
collect financial information to begin a preliminary analysis. This includes physically viewing the
potential customer’s operating facilities, obtaining past years’ financial
statements and/or tax returns, and if applicable SEC documents such as the 10K
and 10Q reports. The 10K is an annual
filing containing all information published in an annual report together with
supplementary documents providing additional detail about plant, equipment,
products, markets, and competition. The
10Q report is filed quarterly and contains similar information for the quarter
just ended (good for assessing seasonality of a business).
There are five major components of financial statement
analysis that enables you to “check management’s story”. The first of these is operations management; using the income statement, you assess the company’s sales, cost control,
and profitability. Next we discuss asset management, an analysis of the
quality and liquidity of assets (ease of conversion to cash) and the asset mix
(relative investments in inventory, fixed assets, etc.). Liability
management constitutes the third component that analyzes the company’s
record of matching liabilities to the asset conversion cycle. The fourth element, cash flow, is an analysis of the company’s cash; where it came from
and how it was employed. The last component
deals with projections and sensitivity
analysis. Using this analysis, you
will first develop and interpret a forecast or projection of the company’s
ability to repay the loan. Next you
will test the forecast by using various assumptions to determine what risks
affect the profitability, and hence the loan repayment, of the company--this is
sensitivity analysis. Projections and
sensitivity analysis will enable you to structure the loan.
ASSESSING OPERATIONS
MANAGEMENT
The first step in analyzing operations management is to
examine the income statement for accounting risk. Accounting risk stems from the possibility that your impressions
of a business can be influenced by the various methods a company might legitimately
choose in presenting accounts in financial statements. The accountant’s letter and the endnotes or
footnotes to the financial statement are usually and excellent and reliable
source of information regarding the methods employed to arrive at the figures
they contain.
Revenue Recognition
Management must decide when and in what amount to
recognize revenue. GAAP has developed
several methods of recognizing revenue that reduce accounting risk. These techniques include:
1. At the time of sale (i.e. when
goods/services are delivered--most companies use this method).
2. At the time of cash collection.
3. Percentage of completion (using estimates
of final costs, profits, etc to determine current
percentage completed).
4. At the completion of production (i.e. when
the product/service is readily marketable).
This information is generally found in a footnote to the
financial statements
Expense Recognition
In the ideal financial statement, expenses directly
correspond with the particular revenues they generate. The timing difference between expense
recognition and actual cash outlay creates an area over which management can
exercise excess discretion, be it a conservative or aggressive policy or
somewhere in the middle.
There are three methods of expense recognition. They are:
1. At the time of revenue recognition (the
usual recognition method).
2. Immediate recognition (an expense appears
on the income statement as soon as it
is incurred--known as period expenses).
3. Rational allocation (an expense is
allocated over several time periods).
The second step of operations management evaluation
deals with modifying the income statement format. This step may not always be necessary, however occasionally you
will be required to complete a preliminary reorganization or reformatting of
the income statement prior to analyzing them.
This exercise includes combining certain accounts because the breakdown
is to detailed, isolating certain accounts--depreciation, amortization--that
are not shown separately on the income statement, or changing the sequence in
which accounts are presented. The
income statement model you will want to use is presented below:
Net
Sales
- Cost of Goods Sold
= Gross Profit (Loss)
- SG&A Expenses (Selling, General & Administrative)
= Operating Profit (Loss)
+ Nonoperating Income
- Nonoperating Expenses
= Profit Before Interest & Taxes
- Interest
= Net Profit (Loss) Before Taxes
- Income Tax Expense
= Net Profit Before Extraordinary Items
+ Extraordinary Gains
- Extraordinary Losses
= Net Profit (Loss) after Extraordinary Items
The third step involves common-size or vertical
analysis. The object of this activity
is to identify red flags or clues that the company’s operations are not
consistent. In preparing for this step,
each item on the income statement is expressed as a percentage of sales. This is accomplished for several consecutive
years and posted vertically to compare items year-by-year. The purpose of the is exercise is to learn
how management is handling operation by observing increases and decreases in
expense components over several operating periods relative to changes in sales.
Next, ratio analysis can be examined (see BUSINESS
IV-A). Analysis of ratios allows you to
examine trends in profits and costs over time for a particular company. That is, it permits you to compare the
company with itself from year-to-year.
The final step in operations management analysis
consists of comparative analysis. This
involves comparing the company’s management performance against an external
standard. Generally, this entails the
use of industry standards. The
underlying assumption to this comparison is that all companies within the same
industry will have roughly the same asset conversion cycle characteristics and,
therefore should have roughly similar cost structures. Sources of industry data were listed in the
previous section under industry analysis.
When viewing industry standard data, it is important to
ascertain the sample size and composition to ensure the cross section is
statistically reliable. For this
reason, we will use Robert Morris Associates (RMA) Annual Statement Studies
since it provides a division by asset size and lists the number of companies
comprising the sample.
The following are the steps involved in comparative
analysis:
1. Determine the Standard Industrial
Classification (SIC) codes.
At the end of this section,
an unabridged catalog of SIC codes can be found.
2. Determine
the comparability of ratios. Always
check the notes or introduction to your source of industry data for details on
how ratios are defined and computed. An example of differences between industry
source data is the contrast between how D&B and RMA calculate inventory
turnover; D&B uses sales and RMA uses cost of goods sold in the numerator.
3. Display your data vertically comparing the
company’s ratios in one column to that of
the industry in another column for each year.
This will facilitate comparison.
4. Identify
differences between the company and the industry. Do not rush to conclusions; instead, use your findings to
indicate areas of further exploration
ANALYZING ASSET &
LIABILITY MANAGEMENT
In the last unit, we analyzed the income statement. In this unit, you will become familiar with
balance sheet analysis. Because both
asset management and liability management deal with the balance sheet, we will
study the two together.
Topics discussed include operating efficiency (the
ability of a firm to use its assets effectively in producing a given level of
goods/services), capital structure (techniques used to evaluate the appropriate
mix of financing), liquidity (the ability of a company to fulfill its
short-term obligations), and solvency (an indicator of financial strength and
stability).
Again, as in the last section--READ ALL FOOTNOTES CAREFULLY--concerning the balance sheet. Use the 10% rule, i.e. if an asset or
liability composes 10% or more of the total, it is a significant account.
Analyzing Operating
Efficiency
The way a business manages its assets can be evaluated
by analyzing its operating efficiency.
This entails using ratios that measure efficiency. Such ratios include Sales to Assets Ratio,
Receivables and Inventory Ratios, Sales to Net Fixed Assets Ratio (see BUSINESS
II, Asset Utilization Ratios), and Return on Assets Ratio (BUSINESS II,
Profitability Ratios). Let’s look at
these ratios individually.
Sales to Assets Ratio-measures
the firm’s ability to generate sales in relation to its level of assets. The ratio indicates the dollar amount of
sales generated by each dollar of assets.
This ratio is the starting point when evaluating operating
efficiency. If a problem exists,
analyzing the other asset utilization ratios should help pinpoint the problem.
Receivables & Inventory Ratios-changes in these figures may reflect deliberate
management decisions, or they may reflect unplanned delays or disruptions. To ascertain the answer, you will need to
discuss this with the borrower.
Sales to Net Fixed Assets Ratio-indicates how efficiently the company uses its fixed
assets. It reveals the productivity of
a manufacturer’s plant and equipment, or a merchandiser’s floor space, by
showing how many sales dollars are generated by each dollar of fixed
assets. It is important to understand
that recent additions can often depress this ratio; the use of leased equipment
and facilities (operating lease), which do not appear on the balance sheet, can
also distort this ratio.
Return on Assets Ratio-the
relationship between the resources available to a business--its assets--and net
profit is one of the best and most widely used measures of management
performance (actually, second to ROE).
Use this ratio with caution, as a low return on assets might be the
result of recent investment in new fixed assets.
Do not hesitate to ask questions or request additional
financial statements, such as aging schedules, to obtain the specific
information you need to assess operating efficiency.
Capital Structure
Capital structure focuses on liabilities and
equity. Matching financing term to the
purpose of the financing is something at which you must become an expert. In short: short-term financing is used for
short-term needs (flexibility) and long-term financing is employed for
long-term needs (stability). Long-term
financing should be utilized to finance non-current assets, and core current
assets. The company should use
short-term financing for temporary increases in current assets. Additionally, the longer the asset
conversion cycle, the more stable, long-term financing is required; the shorter
the cycle, the more flexible, short-term financing is appropriate.
In determining the optimal capital structure of a
company (the appropriate mix of debt and equity), equity should be large enough
to cover business risk and to provide any long-term financing that should not
be borrowed from a bank.
Net working capital is the amount of long-term financing
used to finance current assets. To
determine if net working capital is adequate, calculate net permanent working
capital at the high point of the company’s cycle--although this concept is
imprecise, it will provide a beginning point.
Analyzing Liquidity
Liquidity is the ability of a business to convert assets
to cash in order to pay its current liabilities. Two indicators commonly used to measure liquidity are Current
Ratio and Quick Ratio (see BUSINESS II, Liquidity Ratios).
Current Ratio-has
several limitations since it fails to take into account the different
proportions of current assets (example-if selling inventory is the problem,
then the ratio improves as inventory builds up), and the ratio is static
measuring only one point in time.
Quick Ratio-of less
than 1 indicates the company’s inability to pay current liabilities as they
mature.
Analyzing Solvency
The larger the proportion of net worth in a company’s
capital structure, the higher the degree of solvency. In general, the shorter the asset conversion cycle, the lower the
risk, and the lower the equity portion of the capital structure is
required. Two analytical ratios measure
solvency: Debt to Assets and Debt to Net Worth (see BUSINESS II, Debt
Utilization Ratios).
Debt to Assets Ratio-indicates
the extent to which assets are supported by outside creditors. A ratio this is high or rising over a period
of time is a red flag.
Debt to Net Worth Ratio-indicates how many dollars of outside financing there
are to each dollar of owners’ equity.
CASH FLOW ANALYSIS
BUSINESS I: AN INTRODUCTION TO CASH FLOW provides the
major points concerning calculation of a company’s cash flow using a cash flow
summary sheet. The main emphasis of
this section is interpreting this cash flow summary.
Cash flow analysis, like all other analysis discussed
thus far, is a method to help you gain insight into a borrower’s
operations. The primary advantage to
the cash flow format is that you can quickly see the cash flow implications of
the firm’s operations to determine cash flow timing differences. Another advantage is that the form is
organized in roughly the same layout as the income statement. As on an income statement, the order of
presentation reflects a banker’s interest in the company--first determining if
the company is making money from its trading activities, then resolving whether
revenues are sufficient to cover selling, general and administrative
expenses. Some of the major heading on
the form should be discussed in greater detail.
Cash After Debt Amortization
As a general rule, a company should be able to generate
enough positive cash flow to cover its financing cost and repayment of
principal. If, at this point, the
figure is negative the company cannot meet these obligations and you as a
commercial banker should be concerned.
Cash flows of growing companies may be unable to internally generate
sufficient cash to cover financing costs and debt amortization. This situation may become even more
pronounced if the company needs to expand its plant, equipment and trading
assets since cash used to finance these could and should be used to repay debt. You may be willing to lend to some of these
companies since ultimately, when the growth slows, they will be able to pay
back the loans by reducing trading assets, generating profits, or selling more
equity. However, if the company cannot
generate enough cash internally to cover debt repayment within an acceptable
period of time, the borrower should plan to seek financing elsewhere than a
bank.
Financing Surplus
(Requirements)
Generally, you should not expect a company to generate
enough positive cash flow in one year to fund additions to fixed assets. Therefore it is not unusual or undesirable
for a company to show negative cash flow after cash used for plant and
investments.
The company’s choices of external financing should tell
you how the company has responded to its financing requirements and whether it
has matched the repayment schedule to the rate that its assets will convert to
cash that can be used for repayment.
Management’s Discretion
As a final note, remember that management ultimately has
discretion over all cash inflows and outflows.
Most cash flows related to production, sales, investment in plant &
equipment, borrowing, and repayment of debt are within management’s control. Since cash flow is the heart of your
analysis and is the basis for repayment of any loan, you should be able to
explain the trends in the cash flow based on what you learned about management
through trend analysis.
PROJECTIONS AND SENSITIVITY
ANALYSIS
There are two types of projections: short-term projections are forecasts of cash flow, long-term projections are forecasts of
financial statements. Projections can
help you at three critical junctures:
1. When you estimate how much cash the
company will need to borrow.
2. When you estimate when and how fast the
company can repay the loans.
3. When you need to manage the loan.
Good hypotheses are fundamental to good
projections. There are two approaches
to developing hypotheses: the straight-line approach and synthesis
approach. The straight-line approach is
quick, simple, and extremely useful when the borrower’s company activities
remain stable from year-to-year. You
simply extend sales at the same growth rate and tie other variables to this growth
rate. Synthesis approach is a more
sophisticated method that will address the changes and allow you to factor in
what you know about the industry and the general state of the economy if the
future is likely to be different from the past. The mechanics of the projection are still the same--you just need
to think in terms of “If...then...” statements. Since you should have already learned about the four basic
components for short-term projections--cash receipts, cash disbursements,
beginning cash balance, and cash required for day-to-day operations--we will
not discuss them here.