1 Financial Statement Analysis (Ross)

Financial Statement Analysis
Essentials of Corporate Finance

Chapters 2 & 3
Materials Created by Glenn Snyder – San Francisco State University

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 Materials Created by Glenn Snyder – San Francisco State University 2
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
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)
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.
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
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.
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.
Financial Analysis – Accounts Receivable
 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 What if those sales people leave?
people?
What % of sales are guaranteed (contractually What happens when the contract expires? Where
obligated)? 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
Financial Analysis – Accounts Receivable
 Accounts Receivable Aging Schedule

 A schedule of all outstanding receivables grouped both by
customer and due date
Analysis:
Is there a concentration greater than 10% of any What happens if they lose a large customer?
customers?
What % of customers are past due? How reliable are their accounts receivable
Are there any receivables over 120 days past due Typically these will not be collected and should be
that have not been written-off? backed out of the total accounts receivable
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)
Financial Analysis - Inventory
Analysis:
How does the company inventory compare with the Do they carry too much? Too little? Do they have too
industry average? much in finished goods inventory?
Is inventory valued at LIFO, FIFO, or Weighted This will impact the cost of goods sold and inventory
Average? 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?
Financial Analysis - Ratios
 Liquidity Ratios – Current Ratio:
 Current Assets / Current Liabilities
 Measures a firms ability to meet current obligations
Analysis:
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 If they are not in-line with the industry, then the
with companies of similar size in their industry? 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 Inventory is the most difficult current asset to
assets? convert to cash? How quickly is it turning over?
Are accounts receivable over 120 days being These accounts will probably not be collected
written off? and should be removed from current assets
Exclude Prepaid Current Assets Cash cannot easily be obtained from a prepaid
phone bill or rent
 Liquidity Ratios – Quick Ratio (Acid Test):
 (Current Assets – Inventory)/ Current Liabilities
 Measures a firms ability to meet current obligations without
liquidating inventory
Analysis:
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 If they are not in-line with the industry, then the
with companies of similar size in their industry? 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 Inventory is the most difficult current asset to
assets? 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
 Leverage Ratios – Debt-Equity Ratio:
 Total Liabilities / Total Net Worth
 Measures the funds contributed by owners or
shareholders versus creditors.
Analysis:
Calculate 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
 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:
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 If they sell on 2/10 net 30, one would expect to
close to the company’s financing terms? 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 turnover should be close to industry
the industry? averages, if not, the underwriter needs to know
why
 Efficiency Ratios – Inventory Turnover:
 (Inventory / Cost of Goods Sold) x 365
 Measures the average number of days inventory is on hand
Analysis:
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? Which method is standard for the industry? Have
LIFO, FIFO, or weighted average? they changed valuation methods recently? If so,
why?
Is the inventory turnover different for different Are some products selling and others not? Are
products? some products becoming obsolete?
why
 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:
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
why
 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:
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.
why
 Profitability Ratios – Return on Equity (ROE):
 Net Income / Total Equity
 Measures the relationship between profits and the investment of the
owners.
Analysis:
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 ROE may be close to the industry, despite
the industry? low profits, as the company may have higher
levels of liabilities
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
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
 Sales (Gross Revenues)
Year 2004 2005 2006 2007E 2008 2009

Sales 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
Income Statement
Account Projection Method
Cost of Goods Sold 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
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
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

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
Cash Flow Analysis
 Cash Flow Coverage Ratio

 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
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
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

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Financial Statement Analysis

Essentials of Corporate Finance

Materials Created by Glenn Snyder – San Francisco State University

 Who uses Financial Statement Analysis?

 Almost Everyone in the Business World

 What is a Loan Underwriter?

 Where do Loan Underwriters work?

 What is a Loan Underwriter looking to do?

 In the end, a bank is only looking to get paid back

 When a company applies for a loan, any of

 Almost half of all loan requests are for a

 Working Capital Lines of Credit

 Accounts Receivable Aging Schedule

 Inventory is typically the largest current asset and is

declare bankruptcy in the event of a

 Loan underwriters must take their ratios and

 Financials are projected by each account shown on

 Sales (Gross Revenues)

 Sales (Gross Revenues)

Year 2004 2005 2006 2007E 2008 2009

$ Growth 150 250 (150) 2,100 1,950

% Growth 8% 12% -6% 2,109 1,978

Balance Sheet Account Projection Method

Accrued Liabilities Average over Prior Periods

Balance Sheet Account Projection Method

 Cash Flow Coverage Ratio

 Analysis of Cash Flow Coverage Ratio

 Most large banks have management training

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