Financial Statement Analysis for Credit
by Binam Ghimire
1
Learning Objectives
Session 8
1. Cross Sectional Analysis;
2. Time Series Analysis;
3. Importance of Profitability, Liquidity, and Leverage
Session 9
1. Profitability, Liquidity and Leverage Ratios;
2. Making Credit Decisions;
3. Limitations of Financial Ratios
Introduction
 Throughout the last few sessions we have examined the
Published Financial Statements:
Their content and
Basic evaluation
 In this session, we will take a detailed look at the
Income Statement and Balance Sheet in order to assess
whether organisations are eligible for credit by
undertaking Financial Ratio Analysis
Financial Ratio Analysis
 Financial Ratio Analysis is the process of reviewing and
interpreting financial information for the purpose of
appraising the financial health and operating performance
of a company.
 This may involve:
cross-sectional techniques
time-series techniques
Cross-Sectional Techniques
• The study of relationships within financial statements at
a point in time
• e.g. comparisons of one company with other companies
at the same point in time and
Time-Series Techniques
• The study of trends in relationships within financial
statements over time
• e.g. comparisons of one company at different points in
time
Profitability, Liquidity & Leverage or Gearing
Financial Ratio
Analysis
Profitability
Liquidity
Financial
Leverage or
Gearing
The Importance of Profit
 Businesses exist to make a Profit
 Profit will eventually turn into cash which can fund future
growth and provide a return for the owners
 Without profits you can’t pay Dividends and if investors
don’t receive a return on their investment they will
eventually leave
 Running at a loss will eventually result is cash deficits and
ultimately liquidation
The Assessment of Profit
 Credit analysts need to know:
The ROCE
The Gross and Net Margins
Whether these percentages are being maintained
with increased sales ?
Are they trading profits, as opposed to a 'one-off'
profit from the sale of a land ?
What percentage of past profits have been retained
in the company for future growth ?
The Importance of Liquidity
 Whilst profit is important it is not the same as cash, you
need cash to pay the bills
 Liquidity is a measure of how quickly a company can
turn their assets into cash in order to meet its liabilities
as they fall due
 By assets, we mean Current Assets (Inventory)
 Without cash to pay the bills or interest creditors (and in
particular banks) will eventually force you into
liquidation
The Importance of
Financial Leverage or Gearing
 Businesses need Long Term Finance in order to
purchase Assets and finance growth
 It may well be a combination of:
Equity and Debt
 Financial Leverage or Gearing are terms used to
describe the long-term financing structure of a business
 A company with a lot of debt is said to be have High
Leverage. Is this Good or Bad ?
 Let’s assess this question with reference to
Profitability, Liquidity and Leverage
Profitability Ratios
Gross Margin Gross Profit
Sales
X 100
Net Margin
Net Profit before Tax
Sales
X 100
Expense Ratio
Marketing or Wages
Sales
X 100
ROCE
Net profit before tax
X100
Shareholders Capital Employed
Liquidity Ratios
Current Ratio
Liabilities
or
Working Capital Ratio
Current Assets: Current
Liquidity Ratio
Liabilities
or
Acid Test/Quick Ratio
Liquid Assets : Current
x
x
:
:
Note: Liquid Assets = Current Assets less Stock
1
1
Operational Ratios
Rate of Stock Turnover
or Inventory
Sold
Average Stock X 365
Cost of Goods
Debtors Settlement Period Average Debtors X 365
or Accounts Receivable
Sales
Creditors Settlement Period
Average CreditorsX 365
or Accounts Payable
Purchases
Note: Average = Opening + Closing. In the absence of
data use the Balance Sheet figures i.e. Closing.
Leverage or Gearing Ratios
Debt Ratio
Long-term Liabilities
X 100
Equity or Total Capital Employed
Equity: Debt
Liabilities
Shareholders’
: Long Capital
Capital Employed Term
x
Interest Cover
:
1
Net Profit before Interest & Tax
Interest
Conducting Financial Ratio Analysis
 When conducting Financial Ratio Analysis for Credit you
need to:
Step 1
Calculate the ratios
for 2 – 5 years in
order to establish a
trend
Step 2
Interpret the results
Step 3
Make Credit
Decisions
 We will start with a simple example of a fictitious
company
Poynton Plc
£
Sales
31.12.Y0
31.12.Y1
£
£
200,000
£
400,000
less cost of goods sold
Opening stock
+ purchases
– closing stock
Gross profit
less expenses
General
Marketing
Interest
Wages
30,000
15,000
85,000
165,000
115,000
180,000
15,000 100,000 30,000 150,000
100,000
250,000
13,000
35,000
2,000
30,000
80,000
Net profit before tax
less taxation
Retained profit for the year
+Balance of profits
Retained profits
33,000
100,000
2,000
80,000
215,000
20,000
7,000
35,000
12,000
13,000
27,000
40,000
27,000
40,000
67,000
Poynton Plc
Fixed assets
Current assets
Inventory
A/c Receivable/Debtors
Bank
Cash
less Current liabilities
Taxation
A/C Payable/Creditors
Net Current Assets
less Long-term liabilities
Loan
Issued Share capital
Retained profits
Total Equity
31.12.Y0
31.12.Y1
£
£
£
£
250,000
250,000
15,000
30,000
1,000
1,000
47,000
30,000
65,000
4,000
—
99,000
7,000
30,000
37,000
12,000
50,000
62,000
10,000
37,000
20,000
240,000
20,000
267,000
200,000
40,000
240,000
200,000
67,000
267,000
Conducting Financial Ratio Analysis
 When conducting Financial Ratio Analysis for Credit you
need to:
Step 1
Calculate the ratios
for 2 – 5 years in
order to establish a
trend
Step 2
Interpret the results
Step 3
Make Credit
Decisions
 So Step 1. Have a go at calculating the ratios and
then compare your results with mine
Poynton Plc
Ratio
Sales
A. Profitability ratios
Gross margin
Net margin
Expense ratios
General
Marketing
Wages
Return on Shareholders Capital Employed
B. Liquidity ratios
Current ratio or Working capital ratio
Liquidity ratio
20Y0
£200,000
20Y1
£400,000
50.00%
10.00%
62.50%
8.75%
7.50%
17.50%
15.00%
8.33%
8.25%
25.00%
20.00%
13.11%
1.27 : 1
0.86 : 1
1.60 : 1
1.11 : 1
C. Operating ratios
Rate of stock/inventory turnover
Debtors’ settlement period
Creditors’ settlement period
D. Leverage/Gearing ratios
Debt Ratio
Equity : Debt
Interest Cover
20Y0
20Y1
82 days
55 days
129 days
55 days
59 days
111 days
7.69%
6.97%
12 : 1
13.35 : 1
11 times 18.5 times
Conducting Financial Ratio Analysis
 When conducting Financial Ratio Analysis for Credit you
need to:
Step 1
Calculate the ratios
for 2 – 5 years in
order to establish a
trend
Step 2
Interpret the results
Step 3
Make Credit
Decisions
 So, what do the results/trend mean ?
 Has the company performed well or not and
would you provide them with credit ?
Gross Margin 50% to 62.50%
 This ratio measures gross profit as a percentage of sales.
 Poynton’s return has increased from 50% to 62.5% of sales. In
addition, it is worth noting that not only has the return increased but
the volume of sales (£200,000 – £400,000) has also doubled.
 This shows a considerable improvement in performance; Poynton is
selling twice as much at a better gross profit margin
 It indicates that Poynton has either effectively controlled its cost of
goods sold (purchasing costs or manufacturing costs) and/or
managed to increase its sales price, maybe due to better marketing,
without a corresponding increase in the cost of goods sold.
20Y0
less
Sales
Cost of goods sold
Gross profit
£200
£100
£100
20Y1
100% £400
50%
£150
50%
£250
100%
37.5%
62.5%
 A decrease in the gross margin may be due to a reduction in the
selling price against stable costs, although one would hope that the
reduced price would bring greater volume of sales.
 This measures net profit as a percentage of sales.
 Poynton’s return has reduced from 10% – 8.75% of
sales.
 This shows a decline in performance.
 A declining net margin indicates that Poynton has been
unable to control all of its costs. But which costs in
particular (purchasing/manufacturing or expenses)?
Given the considerable improvement in the gross margin
we know it is not purchasing/manufacturing costs and
can therefore conclude that the reduction in net margin
was due to the company’s failure to control expenses.
20Y0
£
200,000
less
less
20Y1
£
100%
Sales
400,000
100%
Cost of goods sold
100,000
150,000
37.5%
Gross profit
100,000
50%
250,000
62.5%
Expenses
80,000
215,000
53.75%
Net profit
20,000
35,000 8.75%
50%
40%
10%
But are they controllable and/or was the increase
in expenses worth it ?
Let’s look at the expenses ratios to examine the
situation further.
Expenses Ratios
 These measures the particular expense (in our case;
General; Marketing & Wages) as a percentage of sales.
 The improvement in Gross Margin and decline in Net
Margin tells us that expenses have increased
substantially as a percentage of sales but which
expenses in particular. Poynton’s total expenses have
increased from 40% – 53.75% of sales.
 Each category of expense has increased and we need to
ask:
whether this has been for reasons beyond their
control or due to poor management control.
e.g. General Expenses may have increased due to
a rates increase, or higher utility bills as a result of
working longer hours to achieve the higher sales
whether the increase was a cost worth paying
e.g. Marketing and Wages have increase but did they
generate the 100% increase in turnover and the
increase in Net Profit before Tax, from £20,000 £35,000. Net Margin may have reduced but the
actual profit in terms of £ has increased and I don’t
know about you but I would rather have 1% of
£10,000,000 than 50% of £1,000
Return on Capital Employed 8.33% to
13.11%
 This ratio measures the return on the shareholders
funds employed. It measures whether the business is
using the finance effectively and the return that
shareholders are getting in terms of profit.
 Poynton’s return on shareholders capital employed has
increased from 8.33% to 13.11%.
 This shows an improvement in return, indicating that
the funds retained in the business have been utilized
effectively.
Current Ratio or
Working Capital Ratio
1.27 to 1.60: 1
 This shows whether cash and items that can be converted
into cash adequately cover amounts due for repayment
within the next 12 months.
 Our ratio has increased from 1.27: 1 to 1.6: 1.
 There is therefore more cover on the amounts due for
repayment. (We will discuss whether this is an
improvement or not in a moment.)
 Although Creditors have increased from £30,000 to
£50,000 this is more than matched by an increase in
Debtors, Stock and Bank.
Liquidity Ratio
 By deducting Stock from the Current Assets we are able
to compare the most liquid Current Assets with Current
Liabilities to gain a more critical assessment of liquidity.
 Cover has increased from 0.86: 1 to 1.11: 1.
 The company is therefore more liquid.
Negative
Working Capital and Liquidity Ratios
At this stage what do you think of the following
companies ?:
Current Assets : Current Liabilities
Ratio
Company A
£ 5M
: £10 M
0.5 : 1 Company B
£30 M
: £10 M
3.0 : 1
Liquid Assets : Current Liabilities
Ratio
Company A
£ 3M
0.3 : 1 Company B
1.5 : 1
:
£10 M
£15 M
:
£10 M
 You may have said:
 Company A
 They lack liquidity
 They could pay their current liabilities of £10 M with current assets
of only £5M
 They are destined for liquidation
 Company B
 Have adequate cover and have no liquidity worries
 You may be correct BUT you might also be wrong !!
 To examine the adequacy of Working Capital we need to consider the
next set of ratios and the Cash Flow Cycle
Operational Ratios
C. Operating ratios
Rate of stock/inventory turnover
Debtors’ settlement period
Creditors’ settlement period
What do they tell you ?
Let us examine each one in turn
20Y0
20Y1
82 days
55 days
129 days
55 days
59 days
111 days
Rate of Stock/Inventory Turnover
82 days to 55 days
 This measures how quickly (on average) a company is
turning its stock.
 Poynton’s stock is now turning every 55 days instead of
every 82 days.
 This is clearly an improvement. The quicker the turnover
the better, because this will speed up the Cash
Conversion Cycle and ensure that expensive stock is not
sitting idle on the shelves.
 As stated earlier, sales volume has also doubled,
meaning that not only are they selling more but they are
selling it quicker as well.
Debtors Settlement Period
55 days to 59 days
 This ratio measures how long (on average) it takes for
debtors to settle their debts.
 Poynton’s debtors now settle their debts every 59 days
rather than every 55 days.
 An increased settlement period may be the reason for
increased sales, however in our case, the change is not
dramatic. It is certainly no cause for concern; Poynton
appears to be controlling its debtors effectively.
 If the debtors are taking considerably longer to pay companies may
need to chase their debtors. You must also remember that the ratio
only indicates the average settlement period. If some of the sales are
on cash terms, then some debtors are outstanding for longer than 59
days and the debtors’ figure may even include bad debts. As a result
an aged analysis of debtors, showing how much is outstanding
between various periods, would prove useful.
 Aged analysis of debtors
Period
Amount outstanding
0–7 days£15,000
over 7–14 days £10,000
over 14–21 days £6,000
over 21–28 days £2,000
Creditors Settlement Period
129 days to 111 days
 This ratio measures how long (on average) Poynton takes
to pay its creditors.
 Poynton used to take 129 days credit but now takes only
111 days.
 Again not a dramatic change and no cause for concern.
 We might ask why it is paying its bills quicker. It may be
that they have secured new sources of supply that are
demanding quicker payment, that said, they may also be
cheaper as the Gross Margin has improved.
 If the period is getting longer it may be because
management is taking full advantage of credit facilities, or
it could be that it has a cashflow problem.
Cash Flow Cycle
Cash Flow Cycle
Ratio
C. Operating ratios
Rate of stock turnover
Debtors’ settlement period
CASH IN
CASH OUT Creditors’ settlement period
FINANCE PERIOD
20Y0
20Y1
82 days
55 days
137 days
129 days
8 days
55 days
59 days
114 days
111 days
3 days
 Stock is turning faster (55 days), and volume of sales is increasing;
 Debtors are settling around about the same time (59 days) and
 Poynton is still enjoying long periods of credit, although slightly less
than before (111 days);
 The Cash Conversion Cycle is therefore
55 + 59 = 114 days - 111 days = - 3 days
 They only have to pay their Creditors on Day 111 and 3 days later
receive payment from the sale of stock at a profit, (albeit a reduced
margin).
 The creditors are financing the business and hence Poynton would be
foolish to maintain a large amount of working capital. Their cover
would therefore appear adequate, if not a little high
 That said our cycle does not consider expenses !
Negative
Working Capital and Liquidity Ratios
Now we understand the Operating Ratios what do
you think of the following companies ?:
Current Assets : Current Liabilities
Ratio
Company A
£ 5M
: £10 M
0.5 : 1 Company B
£30 M
: £10 M
3.0 : 1
Liquid Assets : Current Liabilities
Ratio
Company A
£ 3M
0.3 : 1 Company B
1.5 : 1
:
£10 M
£15 M
:
£10 M
 In order to assess the adequacy of their Working
Capital/Liquidity we need to consider their Operating
Ratios and Cash Flow Cycle
 IF Company A & Company B are retailers with a fast Cash
Flow Cycle
Company A would appear to have a more appropriate
ratio
Company B would appear to be holding excessive
inventory; selling on credit on not taking advantage of
credit
 That said, IF they were manufacturing companies:
Company A may lack liquidity
Debt Ratio
7.69% to 6.97%
 Borrowed funds now account for 6.97% of the total
capital employed, compared to 7.69% the previous
year.
 From the bank’s point of view this is an improvement.
Where companies are highly geared (e.g. above, say,
55%) they are relying heavily on borrowed funds and
will be faced with high interest charges and may find it
difficult to raise further finance.
 The improvement comes from generating profits without
increasing long-term liabilities (loans).
Equity: Debt Ratio
12 : 1 to 13.35 : 1
 This ratio simply looks at Gearing from a different angle,
i.e. it also examines the extent to which the company
relies on borrowed funds by comparing debt (funds
borrowed long term) with equity (shareholders’ funds).
 The shareholders’ funds employed in the business are
now 13.35 times bigger than borrowed funds employed
in the business, compared to 12 times bigger the
previous year.
 From the bank’s point of view this is good because
Poynton’s stake in the business is substantial.
Interest Cover
11 times to 18.5 times
 This ratio shows how many times the interest paid is
covered by Net Profit before interest and tax and
thereby examines whether interest payments are at risk
 Cover has increased from 11 times to 18.5 times
indicating that profit could reduce by 18.5 times and the
company would still be able to pay their interest.
 Clearly an improvement and one that will please the
finance providers.
Conducting Financial
Ratio Analysis
 When conducting Financial Ratio Analysis for Credit you
need to:
Step 1
Calculate the ratios
for 2 – 5 years in
order to establish a
trend
Step 2
Interpret the results
 Step 3: Would you provide credit ?
Step 3
Make Credit
Decisions
Credit Decision
 Sales had doubled
 Trading Profit (Gross Margin) substantially increased
 Net Margin gas slipped which needs to be watched but
this has financed the growth in sales
 Liquidity cover is adequate given the Cash Flow Cycle
 Leverage is low
 In addition, there are Non Current Assets which may act
as security
 All the signs are favourable however we should
consider the limitations of our analysis
Limitation of
Financial Ratio Analysis
1. The ratios are only averages.
2. Ratios are taken over the whole business, which may hide certain areas of
business, which are performing badly.
3. A ratio of 10 per cent can be good or bad. In isolation ratios mean nothing;
we must compare either the trend or with other companies of a similar nature.
4. Ratios can hide the true monetary gain/loss, e.g. a reduction in the net profit
margin may hide an increase in actual £ profit as in the example above
5. Companies may distort the true picture.
6. Reference should be made to the accounting policies adopted, e.g. different
methods of valuing stock will produce different profit figures.
7. Inflation must also be considered. An increase in sales may not be an
improvement in real terms.
8. Examining the past is no indication of the future prosperity.
9. If we have only one set of accounts, i.e. for one year, we are not able to
examine the direction in which the company is going.
10. Ratios often provide questions rather than answers you must consider why
the trend is increasing or decreasing
Other things to consider..
 Therefore we must critically consider other things as well as the
ratios, e.g.
 cashflow forecasts, considering whether forecast sales and
expenses are realistic;
 forecast trading profit and loss account;
 cashflow statements;
 management capabilities; what are the company’s strengths and
weaknesses?
 trading outlook, consider the market and industry the company is
operating in, what future opportunities and threats it is likely to
face;
 SWOT; PESTLE; Porter (as discussed in Session 1)
Summary
 Financial Ratio Analysis, despite its limitations, is
clearly a useful tool to aid stakeholder's assessment of a
company's performance over a period of time (by
examining the trend) or to compare the performance of
two similar companies.
 It is particularly useful to lenders (banks) who use it as
a pre and post-lending tool but what about shareholders
who may be more interested in share performance ?
 We will examine the needs of shareholders in
next lecture