Importance of Financial Statement

Credit risk is art and science of determining probabilities (Probability of Default).

Calculating or arriving at PD is heavily dependent on number crunching arising from
financial statement namely, Sales growth, profitability, adequacy of cash flow, operating
leverage, financial leverage, total leverage, breakeven point, debt service coverage,
ROCE, debtor collection period or inventory holding period.

It is difficult to understand and assess a business without financial statement, it makes it

equally difficult to communicate or exchange details with investors, creditors or lenders.

It wouldn’t be a misnomer to call accounting as ‘Language of Business’.

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Financial statement in Overall Business Context

Quality and Quantity of Financial Statement

Wanda A Wallace – three hypothesis, Evolution of Auditor note represent the necessity of
quality required to be maintained in financial statements.

Countries such as India, UK, Australia follow principle-based system, and it is

responsibility if an auditor for implementation of these principles.

The content of audit report usually cover:

a. Audited Financial Statement cover a fixed period.
b. Management’s Responsibility for the financial statement.
c. Auditors’ Responsibility.

In order to study the risk involved, it is a subjective question how many year of balance
sheet should be analysed.
Role of Historical Financial Statements
Historical track record is best guide for future as far as financial analysis is concerned.
Analysing historical financial data enable one to understand the reason for variation in
past performance and provide a strong guidance towards future expectation in context of
external environment, industry trend and other company specific factors.

Financial Analysis

The purpose of financial analysis is to understand the financial strengths and weakness
of the customer and to recognize and identify earlywarning signs of financial risks and
suggest suitable defensive strategies and practical solutions to mitigate the risks and
protect the lender from future/potential problems.

Any financial statement contains following part:

Balance Sheet

It represent/reflect financial position of a business as at a particular date, usually the

end of a period. It usually explains about:

a. Capital Structure.
b. Short Term and Long-Term Liabilities.
c. Credit period from Suppliers.
d. Taxation and other statutory liabilities.
e. Quantum of Fixed asset and extent of their utilization.
f. Inventory Level.
g. Trade Debtors.

Income Statement

It represents revenue from operation, cost of running the business, and usually
profitability of a business is of major concern for any business from credit analysis
perspective.

Cash Flow Statement

Cash Flow statement is the result of attempt by financial community to overcome

drawbacks associated with Balance Sheet and Income statement.

The CFS is critical as for any business Cash outflow is a deciding factor for calculating or
judging its efficiency and effectiveness rather than the accounting profit.

It helps credit executive to form an opinion about the strength, stability and sufficiency
of the cashflow to meet various obligation including interest, dividends, tax liabilities and
repayment of term commitments and loans.
Ratio Analysis

Most powerful and principal tool of financial analysis, enables a credit analyst to look
behind numbers adroitly and link financial numbers to business factors.

Ratio analysis has relevance to creditors such as:

a. Provide useful insights into state of company’s financial health, based on which
further credit due diligence/research may be carried.
b. Ratio analysis enables one to assess a company’s performance, profitability,
efficiency, and financial structure not only against previous year but also vs.
competitors.
c. Ratio analysis will enable lenders to prescribe ‘financial ratio covenants’ which
enhance the creditors ability to manage and monitor credit facility more
effectively as well as to manage credit risk.
Liquidity Ratios

Acid Test or Quick Ratio

A measurement of the liquidity position of the business. The quick ratio compares the cash
plus cash equivalents and accounts receivable to the current liabilities. The primary
difference between the current ratio and the quick ratio is the quick ratio does not include
inventory and prepaid expenses in the calculation. Consequently, a business's quick ratio will
be lower than its current ratio. It is a stringent test of liquidity.

 Formula
Cash + Marketable Securities + Accounts Receivable
Current Liabilities

Current Ratio
Provides an indication of the liquidity of the business by comparing the amount of current
assets to current liabilities. A business's current assets generally consist of cash, marketable
securities, accounts receivable, and inventories. Current liabilities include accounts payable,
current maturities of long-term debt, accrued income taxes, and other accrued expenses that
are due within one year. In general, businesses prefer to have at least one dollar of current
assets for every dollar of current liabilities. However, the normal current ratio fluctuates from
industry to industry. A current ratio significantly higher than the industry average could
indicate the existence of redundant assets. Conversely, a current ratio significantly lower than
the industry average could indicate a lack of liquidity.
 Formula
Current Assets
Current Liabilities

Cash Ratio
Indicates a conservative view of liquidity such as when a company has pledged its
receivables and its inventory, or the analyst suspects severe liquidity problems with inventory
and receivables.

 Formula
Cash Equivalents + Marketable Securities
Current Liabilities

Profitability Ratios

Net Profit Margin (Return on Sales)

A measure of net income dollars generated by each dollar of sales.

 Formula
Net Income *
Net Sales

* Refinements to the net income figure can make it more accurate than this ratio computation.
They could include removal of equity earnings from investments, "other income" and "other
expense" items as well as minority share of earnings and nonrecuring items.

Return on Assets
Measures the company's ability to utilize its assets to create profits.

 Formula
Net Income *
(Beginning + Ending Total Assets) / 2

Operating Income Margin

A measure of the operating income generated by each dollar of sales.

 Formula
Operating Income
Net Sales

Return on Investment
Measures the income earned on the invested capital.

 Formula
Net Income *
Long-term Liabilities + Equity

Return on Equity
Measures the income earned on the shareholder's investment in the business.
 Formula
Net Income *
Equity

Du Pont Return on Assets

A combination of financial ratios in a series to evaluate investment return. The benefit of the
method is that it provides an understanding of how the company generates its return.

 Formula
Net Income * Sales Assets
x x
Sales Assets Equity

Gross Profit Margin

Indicates the relationship between net sales revenue and the cost of goods sold. This ratio
should be compared with industry data as it may indicate insufficient volume and excessive
purchasing or labor costs.

 Formula
Gross Profit
Net Sales

Financial Leverage Ratio

Total Debts to Assets

Provides information about the company's ability to absorb asset reductions arising from
losses without jeopardizing the interest of creditors.

 Formula
Total Liabilities
Total Assets

Capitalization Ratio
Indicates long-term debt usage.

 Formula
Long-Term Debt
Long-Term Debt + Owners' Equity

Debt to Equity
Indicates how well creditors are protected in case of the company's insolvency.

 Formula
Total Debt
Total Equity

Interest Coverage Ratio (Times Interest Earned)

Indicates a company's capacity to meet interest payments. Uses EBIT (Earnings Before
Interest and Taxes)

 Formula
 EBIT
Interest Expense

Long-term Debt to Net Working Capital

Provides insight into the ability to pay long term debt from current assets after paying current
liabilities.

 Formula
Long-term Debt
Current Assets - Current Liabilities

Efficiency Ratios

Cash Turnover
Measures how effective a company is utilizing its cash.

 Formula
Net Sales
Cash

Sales to Working Capital (Net Working Capital Turnover)

Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a
high level implies that the company's working capital is working too hard.

 Formula
Net Sales
Average Working Capital

Total Asset Turnover

Measures the activity of the assets and the ability of the business to generate sales through the
use of the assets.

 Formula
Net Sales
Average Total Assets

Fixed Asset Turnover

Measures the capacity utilization and the quality of fixed assets.

 Formula
Net Sales
Net Fixed Assets

Days' Sales in Receivables

Indicates the average time in days, that receivables are outstanding (DSO). It helps determine
if a change in receivables is due to a change in sales, or to another factor such as a change in
selling terms. An analyst might compare the days' sales in receivables with the company's
credit terms as an indication of how efficiently the company manages its receivables.

 Formula
 Gross Receivables
Annual Net Sales / 365

Accounts Receivable Turnover

Indicates the liquidity of the company's receivables.

 Formula
Net Sales
Average Gross Receivables

Accounts Receivable Turnover in Days

Indicates the liquidity of the company's receivables in days.

 Formula
Average Gross Receivables
Annual Net Sales / 365

Days' Sales in Inventory

Indicates the length of time that it will take to use up the inventory through sales.

 Formula
Ending Inventory
Cost of Goods Sold / 365

Inventory Turnover
Indicates the liquidity of the inventory.

 Formula
Cost of Goods Sold
Average Inventory

Inventory Turnover in Days

Indicates the liquidity of the inventory in days.

 Formula
Average Inventory
Cost of Goods Sold / 365

Operating Cycle
Indicates the time between the acquisition of inventory and the realization of cash from sales
of inventory. For most companies the operating cycle is less than one year, but in some
industries it is longer.

 Formula
Accounts Receivable Turnover in Days
+ Inventory Turnover in Day

Days' Payables Outstanding

Indicates how the firm handles obligations of its suppliers.
 Formula
Ending Accounts Payable
Purchases / 365

Payables Turnover
Indicates the liquidity of the firm's payables.

 Formula
Purchases
Average Accounts Payable

Payables Turnover in Days

Indicates the liquidity of the firm's payables in days.

 Formula
Average Accounts Payable
Purchases / 365

Additional Ratios

Altman Z-Score
The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict
bankruptcy (financial distress) of a business, using a blend of the traditional financial ratios
and a statistical method known as multiple discriminant analysis.

The Z-score is known to be about 90% accurate in forecasting business failure one year into
the future and about 80% accurate in forecasting it two years into the future.

 Formula
Z = 1.2 x (Working Capital / Total Assets)
+1.4 x (Retained Earnings / Total Assets)
+0.6 x (Market Value of Equity / Book Value of Debt)
+0.999 x (Sales / Total Assets)
+3.3 x (EBIT / Total Assets)

Z-score Probability of Failure

less than 1.8 Very High
greater than 1.81 but less than 2.99 Not Sure
greater than 3.0 Unlikely

Bad-Debt to Accounts Receivable Ratio

Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales. An
increase in bad debts is a negative sign, since it indicates greater realization risk in accounts
receivable and possible future write-offs.

 Formula
Bad Debts
Accounts Receivable
Bad-Debt to Sales Ratio
Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad debts is
a negative sign, since it indicates greater realization risk in accounts receivable and possible
future write-offs.

 Formula
Bad Debts
Sales

Book Value per Common Share

Book value per common share is the net assets available to common stockholders divided by
the shares outstanding, where net assets represent stockholders' equity less preferred stock.
Book value per share tells what each share is worth per the books based on historical cost.

 Formula
(Total Stockholders' Equity - Liquidation Value of Preferred Stocks - Preferred Dividends in
Arrears)
Common Shares Outstanding

Common Size Analysis

In vertical analysis of financial statements, an item is used as a base value and all other
accounts in the financial statement are compared to this base value.

On the balance sheet, total assets equal 100% and each asset is stated as a percentage of total
assets. Similarly, total liabilities and stockholder's equity are assigned 100%, with a given
liability or equity account stated as a percentage of total liabilities and stockholder's equity.

On the income statement, 100% is assigned to net sales, with all revenue and expense
accounts then related to it.

Cost of Credit
The cost of credit is the cost of not taking credit terms extended for a business transaction.
Credit terms usually express the amount of the cash discount, the date of its expiration, and
the due date. A typical credit term is 2 / 10, net / 30. If payment is made within 10 days, a 2
percent cash discount is allowed: otherwise, the entire amount is due in 30 days. The cost of
not taking the cash discount can be substantial.

 Formula
% Discount 360
x
100 - % Discount Credit Period - Discount Period
Example
On a $1,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end of the
10 day discount period or wait for the full 30 days and pay the full amount. By waiting the
full 30 days, the customer effectively borrows the discounted amount for 20 days.
$1,000 x (1 - .02) = $980

This gives the amount paid in interest as:

$1,000 - 980 = $20

This information can be used to compute the credit cost of borrowing this money.

% Discount 360
x 
100 - % Discount Credit Period - Discount Period
=    2 360
x =    .3673
      98 20

As this example illustrates, the annual percentage cost of offering a 2/10, net/30 trade
discount is almost 37%.

Current-Liability Ratios
Current-liability ratios indicate the degree to which current debt payments will be required
within the year. Understanding a company's liability is critical, since if it is unable to meet
current debt, a liquidity crisis looms. The following ratios are compared to industry norms.

 Formulas
Current to Non-current = Current Liabilities
Non-current Liabilities
Current to Total = Current Liabilities
Total Liabilities