Financial Statement Analysis
Essentials of Corporate Finance
Chapters 2 & 3
Materials Created by Glenn Snyder – San Francisco State University
Topics
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Who uses Financial Statement Analysis?
Banking - Loan Underwriter
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Loan Package
Financial Analysis
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Financial Projections
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Account Receivable
Inventory
Financial Ratios
Income Statement Projections
Balance Sheet Projections
Cash Flow Analysis
Career Advice for becoming a Bank Underwriter
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Who uses Financial Statement Analysis?
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Almost Everyone in the Business World
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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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Banking – Loan Underwriter
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What is a Loan Underwriter?
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A loan underwriter analyzes the loan application
and supported materials to determine if the loan
should be approved.
Where do Loan Underwriters work?
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Commercial Banks
Investment Banks (Bond Underwriters)
Financing Institutions (Mortgage Companies)
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Banking – Loan Underwriter
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What is a Loan Underwriter looking to do?
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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.
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Loan Package
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When a company applies for a loan, any of
the following can be requested by the bank:
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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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Accounts Receivable & Inventory
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Almost half of all loan requests are for a
working capital line of credit.
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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.
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Accounts Receivable & Inventory
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Working Capital Lines of Credit
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Most working capital lines of credit are based off
of a percentage of accounts receivable and
inventory.
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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.
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis – Accounts Receivable
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Accounts Receivable (A/R) is the fastest non-liquid asset
to convert to cash
Analysis:
Questions to Ask
Reason
What % 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 nonpayment? Foreign customers are hard to collect
from.
What % of sales is to the government?
The government is typically slow paying
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis – Accounts Receivable
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Accounts Receivable Aging Schedule
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A schedule of all outstanding receivables grouped both by
customer and due date
Analysis:
Questions to Ask
Reason
Is 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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Inventory
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Inventory is typically the largest current asset and is
what the company tries to convert to cash.
Inventory includes:
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Raw materials inventory
Work-in-Process inventory
Finished goods inventory
In case of liquidation
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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)
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Inventory
Analysis:
Questions to Ask
Reason
How 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?
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Liquidity Ratios – Current Ratio:
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Current Assets / Current Liabilities
Measures a firms ability to meet current obligations
Analysis:
Questions to Ask
Reason
Calculate 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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Liquidity Ratios – Quick Ratio (Acid Test):
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(Current Assets – Inventory)/ Current Liabilities
Measures a firms ability to meet current obligations without
liquidating inventory
Analysis:
Questions to Ask
Reason
Calculate 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?
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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Leverage Ratios – Debt-Equity Ratio:
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Total Liabilities / Total Net Worth
Measures the funds contributed by owners or
shareholders versus creditors.
Analysis:
Questions to Ask
Reason
Calculate the Debt-Equity ratio
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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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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
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Efficiency Ratios – Accounts Receivable Turnover:
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(Accounts Receivable / Sales) x 365
Measures the average number of days it takes the company to
collect their receivables.
Analysis:
Questions to Ask
Reason
Calculate 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
Are accounts receivable over 120 days being
written off?
These accounts will probably not be collected
and should be removed from current assets
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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Efficiency Ratios – Inventory Turnover:
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(Inventory / Cost of Goods Sold) x 365
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Measures the average number of days inventory is on hand
Analysis:
Questions to Ask
Reason
Calculate 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?
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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Efficiency Ratios – Accounts Payable Turnover:
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(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
Reason
Calculate 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
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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Profitability Ratios – Gross Profit Margin:
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(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
Reason
Calculate 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.
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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Analysis - Ratios
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Profitability Ratios – Return on Equity (ROE):
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Net Income / Total Equity
Measures the relationship between profits and the investment of the
owners.
Analysis:
Questions to Ask
Reason
Calculate 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
How does the company’s turnover compare with
the industry?
The ROE may be close to the industry, despite
low profits, as the company may have higher
levels of liabilities
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Financial Projections
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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.
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Financials are projected by each account shown on
the financial statements.
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The method of projections may vary by industry
The method of projections may vary based on which
accounts are shown on the financial statements
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All companies prepare and publish their financial statements
in different ways
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Income Statement Projections
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Sales (Gross Revenues)
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Four approaches:
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$ 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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Income Statement Projections
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Sales (Gross Revenues)
Year
Sales
$ Growth
Avg. $ Growth
% Growth
Avg. % Growth
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2004
2,000
2005
2,150
2006
2,400
2007E
2,250
150
150
250
200
(150)
83
2,100
2,333
1,950
2,417
-6%
4%
2,109
2,347
1,978
2,447
8%
8%
12%
10%
Materials Created by Glenn Snyder – San Francisco State University
2008
2009
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Income Statement Projections
Income Statement
Account
Cost of Goods Sold
Projection Method
Cost of Goods Sold Margin
Selling, General & Administrative Margin for Variable Expenses
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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Balance Sheet Projections
Balance Sheet Account
Projection Method
Cash
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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Balance Sheet Projections
Balance Sheet Account
Projection Method
Working 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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Balance Sheet Projections
Balance Sheet Account
Projection Method
Minority 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
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Cash Flow Analysis
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Cash Flow Coverage Ratio
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Total Cash Available / Total Cash Required
Sources of Cash
Requirements of Cash
Net 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
December 28, 2006
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Cash Flow Analysis
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Analysis of Cash Flow Coverage Ratio
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A ratio > 1.00 means sufficient cash to cover
requirements
Underwriters typically want to see a coverage
ratio of at least 1.20
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This may vary by industry and type of loan
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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Career Advice: Bank Underwriter
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Most large banks have management training
programs
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Preferred Skills:
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Strong Math / Computational Skills
Knowledge of Accounting
Knowledge of Finance
Experience with MS Excel / Modeling
December 28, 2006
Materials Created by Glenn Snyder – San Francisco State University
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