Consumer Credit Risk Management

Most companies involved in lending to consumers have departments dedicated to the

measurement, prediction and control of losses due to credit risk. This field is loosely referred to
consumer/retail credit risk management; however the word management is commonly dropped.
Scorecards
A common method for predicting credit risk is through the credit scorecard. The scorecard is a
statistically based model for attributing a number (score) to a customer (or an account) which
indicates the predicted probability that the customer will exhibit a certain behavior. In calculating
the score, a range of data sources may be used, including data from an application form, from
credit reference agencies or from products the customer already holds with the lender.
The most widespread type of scorecard in use is the application scorecard, which lenders
employ when a customer applies for a new credit product. The scorecard tries to predict the
probability that the customer, if given the product, would become "bad" within a given
timeframe, incurring losses for the lender. The exact definition of what constitutes "bad" varies
across different lenders, product types and target markets, however examples may be "missing
three payments within the next 18 months" or "default within the next 12 months". The score
given to a customer is usually a three or four digit integer, and in most cases is proportional to
the natural logarithm of the odds (or logit) of the customer becoming "bad". In general a low score
indicates a low quality (a high chance of going "bad") and a high score indicates the opposite.
Other scorecard types may include behavioral scorecards - which try to predict the probability
of an existing account turning "bad"; propensity scorecards - which try to predict the
probability that a customer would accept another product if offered one; and collections
scorecards - which try to predict a customer's response to different strategies for collecting owed
money.
Credit Strategy
Credit strategy is concerned with turning predictions of customer behavior (as provided by
scorecards) into a decision whether to accept their custom.
To turn an application score into a Yes/No decision "cut-offs" are generally used. A cut-off is a
score at and above which customers have their application accepted and below which
applications are declined. The placement of the cut-off is closely linked to the price (APR) that the
lender is charging for the product. The higher the price charged, the greater the losses the lender
can endure and still remain profitable. So, with a higher price the lender can accept customers
with a higher probability of going "bad" and can move the cut-off down. The opposite is true of a
lower price.
Application score is also used as a factor in deciding such things as an overdraft or credit card
limit. Lenders are generally happier to extend a larger limit to higher scoring customers than to
lower scoring customers, because they are more likely to pay borrowings back.
Credit Strategy is also concerned with the ongoing management of a customer's account,
especially with revolving credit products such as credit cards, overdrafts and flexible loans,
where the customer's balance can go up as well as down. Behavioral scorecards are used (usually
monthly) to provide an updated picture of the credit-quality of the customer/account. As the
customer's profile changes, the lender may choose to extend or contract the customer's limits.
Definition
The process of evaluating an applicant's loan request or a corporations debt issue in order to
determine the likelihood that the borrower will live up to his obligation.
Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend
analysis as well as the creation of projections and a detailed analysis of cash flows.
Credit analysis also includes an examination of collateral and other sources of repayment as well
as credit history and management ability.

Credit Analysis is neither entirely a science nor entirely an art. What credit analysis does allow
us to do is gain an accurate profile of a subject at a given point in time by not only considering
the publicly reported accounting statements of the subject but by also considering non financial
items like macro and micro economics of the firm, industry, country and the world.
It also involves study of the structure of the transaction, and whether the Risk/Reward Profile is
accurate and adequate.

Remember, a review of a subject's past performance, even the most recent previous quarter, is
still nothing more than a history lesson. Conversely, it is impossible to predict the future. Thus,
credit analysis does not predict the future of a company or the behavior of markets. Rather, it
indicates what can be expected and anticipated from a company. However, no matter how one
tries there is still going to be a credit that becomes troublesome no matter what the due diligence
revealed about the subject at the time of a transaction resulting in a loan to, or investment in, the
subject.

The "Science" of credit analysis is digging through the facts and presenting them coherently and
accurately. The "Art" of credit analysis is the experience that one gains and gut feeling that one
has about the subject. The past performance of a company is no indication of how it may perform
tomorrow and past earnings will not pay tomorrow's expenses.

What recent events from the mid 1990s to 2001 demonstrated that Credit Analysts exercised a
great deal of power and high public profile in their coverage of companies and financial
institutions? There appears to have been a failure by certain analysts of forgetting that they
served their institution or clients by being overly optimistic or supportive of their target review
subjects.

The failure was that the analysts did not remain objective and professional. Anyone can appear to
be a financial genius during a boom economic period, and that includes the company and the
Analyst. However, one must always be realistic, rational and never be hesitant in being either
critical of or expressing an opinion of the operations of a company, even if it may jeopardize the
business relationship with the management of the subject.

Credit Analysts are being paid to protect the assets of the institution or clients that they work for.
Conversely, Analysts must also always remember that business does not fall from a tree; it has to
be developed and maintained. Finding, evaluating and maintaining acceptable credit risks is the
true role of the Credit Analyst, however it results in a situation where one is caught between the
past and the future of a potential counterparty, between earning a living but perhaps being placed
in the position of jeopardizing one's career by having to challenge the status quo, and of knowing
how to accurately identify and expose outright fraud.

Credit Risk Analysis can provide the credit analyst with the ability for:

Analysis of the Business and the Industry Category
Financial Statement Analysis for Strengths and Weaknesses
Cash Flow Analysis and Projections for Loan Repayment
Collateral Analysis
Analysis of Credit Risk
Adequate Loan Structure and Pricing
Analysis of Loan Documentation for Completeness

In analyzing Consumer Credit one would consider the following:

Has the person declared bankruptcy in the past
Does the person have a good credit record
Does he/she have a stable job
What is the level of education/experience
What is the person earning and what is the earning potential
Stability at the place of residence, whether rented or owned.

In analyzing Commercial Credit one would consider the following:

The size of the operations
The number of years in business
The legal form of the business

By this one means 'Retail', 'Wholesale', 'Service' or 'Manufacturing'. Typically the incidence of
business failures is high in the Retail and Service segments.
Is the business a Parent, Subsidiary or a division?

Does the business have a Holding company?
"The structure of the business
Is the business a Sole Proprietor, Partnership or Corporation?

For Sole proprietor or Partnership type one would further seek personal information on
individual(s) running the business.

The number of employees

There are Industry specific Norms for 'Employees to Sales' ratio, employees to customers ratio.
For example in airline business employees per aircraft ratio

The management record of the company
The location of the company
Any previous evidence of fraud
Any previous Insolvency record?
Any Labor disputes or issues?
Are the products/service sold by the prospect complimenting products/service to the ones
that you may sell?
Is the business practice ethical?
Is the business seasonal/ non-seasonal
Is the business Local/ National or International.

The economy of a business accordingly could depend upon local/ national or international
economy.

Is there a growing or a going market for this business or the business redefining itself and
what would be the impact of the internet on this business.
o See what computer downloads (E.g. Napster) has done to the music industry
How willing is the prospect to share information?
How diligently does the prospect fill your Credit Agreement/Application?
What are the references saying?
Are there too many lay-offs especially of key personnel?
Are there any Law suits pending against the company?
What does the website of the company say and look like?
Is there any recent media coverage about the company?
Is it positive or negative Or are there any rumors floating?
If the company's stock is publicly traded then see how its stock is performing?
One can also check the indices for a particular type of Industry.

There are some universal truths regarding credit analysis:

No one can predict the future. No one knows what is going to happen in the next 45 minutes let
alone what may happen in the next 30 days, 90 days, one year or five years.

Everything changes; the world is always in a constant state of change.
An asset is only worth what it can be sold for.
A loan is only as good as its collateral.
Loans should be self-evident, the facts should not be stretched to make the loan work.

It is easy to decline a loan application. It is harder to approve a loan application. However, you
are in the business to lend money, if you are not lending then you are not earning. Loans do not
drop from trees so the Credit Analyst has to be aware of the business origination / development
aspects and make the effort to get the loan approved.

You are not always going to approve every loan application presented to you for review.
No matter how hard you try, if you are in this business long enough you are going to have a bad
loan.
There is no piece of information that you cannot ask for as long as you do so in a polite and
friendly manner.
Any, and every, statement on a loan application or financial statement should be verified
independently.
Products, companies profits, industries and national economies are cyclical.
There are two words that may not be used in lending and finance: "Never" and "Hope". It is
impossible to say that an event will never happen: anything can happen and everything has
happened. Similarly, one cannot hope that something may happen: an asset, loan or investment
either performs as it was intended or it does not, and part of risk management is being able to
resolve the problem when it occurs. (If you ever use both words in the same sentence, such as "I
hope we never have a problem with this loan", then it is time to get out of this business).

The five "Cs" of Credit Analysis

Credit investigation could get intricate and dense. The information that is being gathered could
be getting strewn and scattered all over the place. The 4 Cs of Credit helps in making the
evaluation of credit risk systematic. They provide a framework within which the information
could be gathered, segregated and analyzed. It binds the information collected into 4 broad
categories namely Character; Capacity; Capital and Conditions. These Cs have been extended to
5 by adding 'Collateral', or extended to 6 by adding 'Competition' to it. How about 'Computer'
being one of the Cs in this day and age? Or mere 'Common Sense'!
No matter how many Cs we come up with, the fundamental question that remains to be answered
by the framework of our analysis is: 'Will I get paid on time?'

Capacity to repay from the cash flow of the business, the timing of the repayment to match cash
flow, and the probability of successful repayment, payment history on existing credit
relationships is an indicator of future performance, contingent sources of repayment. The
prospective lender will want to know exactly how borrower intends to repay the loan. Potential
lenders also will want to know about other possible sources of repayment.

Capital is the money what the owner has invested and what that person(s) have at risk should the
business fail. Interested lenders will expect borrower to have contributed from his own assets and
to have undertaken personal financial risk to establish the business before asking them to commit
any funding.

Collateral or guarantees are additional forms of security provided to a lender as a repayment in
case the loan cannot be repaid under anticipated means, or some other entity agrees to repay the
loan in the event of the primary borrower's default. A guarantee, on the other hand, is just that -
someone else signs a guarantee document promising to repay the loan if borrower can't.

Conditions focus on the intended purpose of the loan, the local economic climate and the
conditions within the industry that may affect the borrower.

Character is the subjective opinion/impression (education, experience references and trust) of
the borrower by the lender. The lender will form an opinion as to whether or not borrower is
sufficiently trustworthy to repay the loan. Your educational background and experience in
business and in your industry will be considered.
JP Morgan, a successful businessman once said that 'I will do business with anyone as long as
he/she is honest!

Credit Application

Request for credit generally begins with the completion of a Credit Application. This information
in most cases is procured by the Sales Representative for the Credit department to make
decisions in setting the credit terms and conditions. It is a direct source of information and its
quality and dependability is directly proportional to the quality of interview with the subject. The
application also extends the information gathering process by seeking the applicant's Bank and
other Trade references. The application can also request financial statements. Financial
statements can contain inaccuracies or questionable information but it also helps in corroborating
information provided by the applicant on the credit application or through the Sales
representative.
Generally all the accounts should be opened after receiving and evaluating a satisfactory Credit
Application. A well-reviewed account will help save valuable time in attempting to either collect
or enforce in the event of a default.

A Credit Application serves the following purposes:

It is an information gathering tool
It is an assessment tool to determine amount and duration of credit
It is a collection tool
It is a legal document that binds the applicant to your terms and conditions
It is an enforcement tool
It is a monitoring tool. Revisit the credit applications of your important customers
It is a marketing tool that markets your loan. In essence a 'loan application'

If you are in the process of designing a credit application or reviewing your existing one, then
here are the important issues to consider.

What is the information that you require from the applicant for you to assess the credit
worthiness after supplementing it with other credit information resources like a credit
report?
What are the terms and conditions of credit and sales that you want the applicant to
adhere to?
What are the legal disclaimers that you would require to conduct the credit investigation?

Does the customer find the process simple and easy to comprehend and at the same time
understands why the information is required?
As a commercial creditor here is a list of factors that would require attention in drafting a Credit
Application:

Legal Name

Ask for the legal name of the applicant first on your Credit Application and then ask for the
'Trade style' or 'doing business as'. The company can operate under different Trade names but
will have only one 'Legal' name. Thus it is important to sign-up the company with its legal name.

Type of Business and Industry

Which industry does the applicant belong to and whether the applicant is in
a) Retail b) Service c) Wholesale d) Manufacturing,

This information will help in evaluating the risk that you are dealing with. Typically there are a
lot more business failures in a particular industry and especially in the area of Retail and Service.

Type of Product or service the applicant supplies

This will also help in determining if the applicant's products will compliment and supplement the
product or product line that the applicant is seeking to purchase from your company.

Style of Business

Whether the business is a) Sole Proprietorship b) Partnership c) Limited liability Corporation. In
the case of a Sole Proprietorship and partnership the liability extends to the individuals running
the business and thus it becomes important that the personal information of the principals along
with their full names, home address and telephone numbers are sought on the credit application.

Number of employees
Estimated Annual Sales

Number of Employees and Estimated Annual Sales not only gives an idea of the size of the
applicant but also helps evaluate the 'sales to employee' ratio that would indicate if they are over
or underemployed.

Number of years in this business

It is important to ask 'in this business'. Obvious reasons being that the applicant could have in
business for a long time but could have only recently started this or the current business.
Credit reference
A credit reference is information, the name of an individual, or the name of an organization that
can provide details about an individual's past track record with credit. Credit rating agencies provide
credit references for companies while credit bureaus provide credit references for individuals.
Other letters of credit reference might be written by banks which would provide basic information
about how long the applicant has held an account, what type of account it was, and whether or not
there were any overdrafts or late payments noted.
How credit references are used
Credit references are used to help lenders quantify the risk of lending to a given applicant, or to
determine overall creditworthiness. For example, if an applicant's credit history indicates proper,
timely payments on all outstanding obligations, a lender may judge it more likely that the applicant
will make timely payments on the requested loan.

Bank Reference

Ask for a 'borrowing account'. Get the account numbers and also the Account Manager's name.
Some even insist on a copy of a void cheque. This helps in a roundabout way to substantiate the
company's legal name.

Trade References

Normally three references are asked for. However, asking for more than three could further test
the credit worthiness of your applicant. If possible ask for one Trade reference from your
industry. This could indicate if the applicant is coming to your company after having
shortchanged another from your industry.

Web site and Email address

Email address is a vital tool of communicating and can aid quick collection and transfer of
documents especially when a customer claims that they have not received the invoice.

Signing officers and accounts payable contacts

Email, telephone and fax numbers

Authorized Signature

The credit application should be signed by someone who is authorized to do so. It should then
bear the person's title the date and place.

Terms and conditions

The credit application should bear the terms and conditions of sale.

Disclaimers

Some of the important considerations in writing your disclaimers would be as follows:
Permission to do a check with the applicant's bank/financial institution and trade references not
just at the time of setting up of the account but from time to time.
If you need to check the personal credit history of any individual or principal then you would
require their permission in writing. If you are making provisions for 'Personal Guarantee' then
make sure that your state/provincial laws do not require that to be notarized and as a separate
addendum. Statement that upon signing the information that has been provided is certified to be
true and correct and that it will be used and based to make the credit decision.
The applicant will be bound by the terms and conditions on the Credit Application whether on
the front or reverse.

That a faxed or computer generated application will be deemed as original
A statement of interest to be charged. Certain jurisdictions
might require this as a separate addendum. The allowable rate could also vary. Check with your
attorney regarding the state/provincial laws

Discounts and the definition of overdue
Discounts and payable dates.
Statement that no oral agreements or modifications will be accepted or effective.
Statement that in the event of dispute the laws of which state or province would apply and in
which state would be the forum for the court proceedings.
A statement whether the attorney fee or collection cost will be added on to collect past due
accounts. Your lawyer should review the final draft of your credit application.

Trade References

Trade references are normally obtained on your credit application and checked at the time of
setting up of a new customer/applicant.

It is a good practice to check references even at a time when an established customer starts to
show signs of financial stress or changes their buying or payment pattern. A periodic check on
trade references is recommended on customers those contribute to the cash flow of your
organization. Do not be surprised if you uncover something unexpectedly!

Moreover it also shows that you care about your exposure and that you monitor it regularly.
Trade references help in analyzing the applicant. It also aids in setting limits and determining your
exposure. Trade references are another avenue to monitor accounts during the course of your business
journey with them. It all depends on how creative you are in using this valuable resource of credit
analysis

The following is a checklist of things to ask and look for while checking the reference provided
by the applicant for credit.

Number

It is a normal practice to ask for three (3) trade references on a Credit Application. Over the ages
this has taught the average customer looking for credit to walk around with their best three
references while applying for credit. What if as creditors we ask for four or more. It is a subtle
way of forcing the applicant to look for and supply you with one or two more suppliers with
whom they have a healthy business relationship.

Primary versus Secondary Supplier
Find out if the reference provided is a primary or secondary supplier to the applicant. Generally
we tend to give preferential treatment to our Primary suppliers on which our business depends.
Thus we also end up paying them first. Checking whether the reference is a primary or secondary
supplier to the applicant might help reduce that particular anomaly.

At least one trade reference from the industry

Ask for at least one reference from your industry. It will help you in ascertaining whether they
have abandoned one to now join the other, the other perhaps being you.

Location of the Trade Reference

Again local suppliers tend to get paid first. Finding out the location of the trade reference could
provide some insight into the payment practices of the applicant.

Related Party transactions

Find out if the references provided are related parties. You might be getting a biased reference.
Also, upon insolvency 'related party transactions' are viewed as 'non-arms length' transactions.
The remedies for these transactions are worth investigating.

What References were provided to the Trade References by the applicant?

When speaking to one or more of the references provided to you on the credit application try
finding out the trade references that were provided to these references by the applicant, at the
time that the applicant filled an application for credit with these trade references. Then call these
references. This will perhaps give you a more meaningful insight into the payment habit of the
applicant.

Questions to be asked

High and Low credit

The amount given as high credit to the applicant displays the exposure and confidence that the
supplier had in the applicant. The figures can also be used to judge and set your own limit with
the applicant. If the amount of credit sought by the applicant is significantly higher than the
amount indicated by the references then perhaps you might want to proceed with caution and the
case might warrant further investigation.

Amount Current

This amount would especially be of significance and concern if during the peak season of the
applicant the amount current were relatively low. This implies that you should also know the
business cycle of the applicant to aid your analysis.

Amount Past due

This will trend the payment habit of the applicant and give you a rough aging analysis against the
terms as discussed next.

Terms

Find out if the applicant has any special terms with the references provided. Also, find out if the
reference gives any special discounts like 2%10 Net 30. If so, then does the applicant avail of
such discounts or abuses it by taking the discount and still paying late.
General Payment experience and habit

How has the payment relationship been over the period of their business partnership?

Slow 30, Slow 45, Slow 60 satisfactory, unsatisfactory excellent etc might be some of the
typical responses.

How long the reference is doing business with the customer

This would indicate the duration of the relationship of the applicant with the reference that you
are checking.

Last Sale

It is important to know if the applicant is a regular customer of this trade reference that is
provided to you. It could be just a one time or a short and sweet relationship that the applicant
had with this supplier.

Credit Limit

Derogatory remarks

Just as a tip, if you were checking references other than the ones that were provided to you on the
credit application a good disclaimer on your credit application would address that condition.
A disclaimer that would indicate that, you will be able to check the references provided to you on
the credit application and others that become available to you or you become aware of during the
credit review process and from time to time. A good idea would be to review your disclaimers on
your credit application in light of the above with your legal counsel.

Other Avenues

The Yellow Pages:

Study the 'heading' under which your applicant is listed in the Yellow Pages and then call some
of the others listed under the same heading to find out more about the applicant. This will be of
special value if the customer is out of town or even in a different country.
Note: Yellow Pages are now available online via the Internet.
Credit Group/Association meetings:
Valuable information regarding the credit worthiness of the applicant can be picked up at Credit
Group or Association meetings.

Bank reference

Plant tour
Customer visit
Management Structure
Management is the administrator and steward of the company on the behalf of the investors /
shareholders. They are hired for their skills and experience to maximize the value of the
company on the behalf of the shareholders. Overall, one is looking for very well experienced
industry professionals. One is also looking for some longevity of the management as employees
of the company. However, there is nothing wrong with the hiring of new persons to replace a
departing employee, or with hiring new persons with desirable skills or experience in order to
improve operations or expand the company's business or product line into a new area.
Corporate governance is the concept of monitoring the effects that the decisions of the senior
management of the company have made with regard to the financial health of the company, the
preservation of the shareholder's investment, the working conditions for lower level employees,
the local natural environment, the customers of the company, and other stakeholders (local
community). Senior management is responsible for providing the Board of Directors with prior
notice and some type of measurement of what may transpire from major decisions management
has made or is planning to make with regard to the operation of the company.
The real success of any company is not just reflected in the stock price or the financial
statements. The real measure is the public perception of the company by many different and
separate groups, and senior management has the responsibility for developing that public
perception.
Legal Issues

It is not unusual for companies to be the plaintiff or defendant in a legal action, and have the
pending litigation reported in the financial statements of the company.
In the United States, federal legislation mandates that class action suits can be moved out of a
state court system to the federal court system. This is viewed as a positive development for
businesses as some state courts / counties were deemed hostile to business.
If a company is publicly traded, and is listed on public equity exchanges in more than one
country, and a legal challenge is filed that the company defrauded its shareholders, then the
company can possibly be sued in any country where its shares are publicly listed.
Industry analysis
Research the industry that the company operates in: you cannot understand the company unless
you understand what its products are, who it sells to, where it fits into the larger world and what
is the future for its product(s) or service.
Similarly, always look at the competitors / peer group of the subject. What is it doing right and
wrong compared to similar companies within the same industry sector?

External forces that may affect the Corporation:

Currency Risk

Corporations incur foreign exchange exposure as a result of:

Export sales invoiced in foreign currencies.
Imported raw material or intermediate components invoiced in foreign currencies.
External debt denominated in foreign currencies.
External investment (direct/portfolio) generating foreign currency interest and dividends
Licensing agreements, etc., denominated in foreign currencies.

Economic Risk

What is the real GDP growth, CPI change, size and composition of savings and investment,
public sector financial balances, public debt and interest requirements, rates of money and credit
growth, exchange rate policy and performance, and central bank objectives and authority?
Companies tend to postpone their investment decisions in an uncertain environment.

What is the situation of the internal labor market?

Political

Form of government, degree of popular participation, orderliness of leadership succession,
economic policy consensus and objective, internal strife, civilian control of the military
Integration in the global trade and financial system
Cultural, social, religious and demographic trends

Hostilities with neighbors

Reliance on commodity economy or diversification?
Sovereign Ceiling suggests that the debt rating of a corporation cannot exceed that of the nation
of domicile although the company's own position and ability, or parent support, or external
guarantees may suggest otherwise. Through some intervention by the government, or simply by
how it manages economic conditions, the corporate entity will have no recourse other than to
mirror the country's actions.

Financial Analysis

Financial Statements normally present two successive years of entries in columns, which makes
a comparison easier.

Work directly and cordially with the Relationship Manager. A relationship with a company must
be nurtured. However, never allow the Relationship Manager to dictate what should be included
in a credit analysis: everything should be included in an analysis.

Similarly, do not be hesitant or afraid to contact the subject directly to get their views and input
on information about them that either you located within the financial documents or is issued in a
public news release. Try to speak directly with those who are responsible for speaking with
analysts or whoever prepared the information that is in your possession. Again, work cordially
with the Relationship Manager but do not give him a list of questions to contact the subject with
and then get his interpretation of the answer from the company. Speak directly, but competently
and cordially, with the company on your own in order to obtain primary data. Be confidential
with, information that is public and that which is non-public.

Never be hesitant in being either critical of or expressing an opinion of the operations of a
company, even if it may jeopardize the business relationship with the management of the subject.
If you are sure you are accurate or the opinion is legitimate, then it is your duty to present the
argument or position. Check, double check, check again and then re-check. The point is that you
had better be sure about the accuracy of your work before you raise any issue or even present an
application or report for review.

One will actually learn more about industries, companies, management and credit analysis during
recessions and restructurings as it is more difficult and challenging to be a success, for all those
involved, during adverse conditions.

Accounting

Credit analysts must be proficient in basic accounting concepts, IAS global common
International Accounting Standards (IAS), guidelines statements and interpretations.
The key for credit analysts is that although the financial statements are a history lesson by the
time one sees them, they do provide data to indicate the trend of a company's earnings and
condition, and the trend indicates as to whether past strategic decisions by management are now
producing positive results.

Financial statements are a record of a company's accounts, financial condition and the results of
its operations at a given point in time. The financial statements include the Balance Sheet,
Income Statement, and the Statement of Cash Flows. Many large companies also include a
Statement of Change in Stockholder's Equity or Statement of Retained Earnings.

The Balance Sheet is divided into three accounts: Assets, Liabilities and Stockholder's Equity.

The Income Statement has 2 major accounts: Revenue and Expenses.

The Statement of Cash Flows has 3 accounts: Net Cash Provided/Used by Operating Activities,
Net Cash Provided/Used by Investing Activities and Net Cash Provided/Used by Financing
Activities.

Accounting is based on the accrual system, which is an estimate of booking income when earned
(not actually received) and expenses when incurred (not actually paid). This requires that a
company accurately estimate any non-cash revenue was earned within a given period (revenue
recognition) and accurately estimate how much in related expenses were incurred in earning that
revenue.

Before approving a commercial loan, a bank will look at all of these factors with the primary
emphasis being the cash flow of the borrower. A typical measurement of repayment ability is the
debt service coverage ratio. A credit analyst at a bank will measure the cash generated by a
business (before interest expense and excluding depreciation and any other non-cash or
extraordinary expenses). The debt service coverage ratio divides this cash flow amount by the
debt service (both principal and interest payments on all loans) that will be required to be met.
Commercial Bankers like to see debt service coverage of at least 120 percent. In other words, the
debt service coverage ratio should be 1.2 or higher to show that an extra cushion exists.

Director or Chairman Report
Auditors Report
Notes to the account
Accounting policies
Current Assets
Cash in banks
Should not be reserved for an acquisition or near-term project, nor locked up in a country where
the ability to repatriate cash is limited. Negative cash should be treated as an overdraft / current
liability.
Cash Equivalents
Short-term, highly liquid securities. These instruments include short-term certificates of deposit,
money-market funds which offer a floating interest rate and unlimited access to funds; and
Treasury bills, which are sold by the U.S. Government.
Marketable securities
Easily (liquid) tradable debt and equity instruments; securities of affiliated companies should be
discounted.
Accounts Receivable
Amounts with trade customers should be examined for quality. Large companies tend to extend
supplier credit to small and medium-sized companies. However, this means that the large
company that extended the credit also has to perform its own credit analysis and monitor of the
small and medium-sized business. During a recession these extended lines of credit or products
sold on 30 to 90 days terms can become suspect. It is also prudent for the large company should
reduce the dollar amount of the credit line / sales terms to the small and medium-sized company.
Check the accounts receivable in days ratio to determine whether the collection period is
lengthening/shortening to determine quality
Accounts Receivable from affiliated companies should be discounted.
Notes Receivable
A note receivable sold at a discount which represents an asset and liability at the same time.
This is usually shown off-balance sheet as a contingent liability or as a reduction to notes
receivable.
I nventory
Raw materials work in progress, finished goods and inventory in transit; finished goods have
greater value in liquidation, raw materials are merely commodities. Supplies used in operations
should not be included in inventory.
Refundable or recoverable income taxes:
Long-term Assets
Notes Receivable
It is hard to determine why a company would hold a long-term note as it is in the business of
selling items and receiving cash. This could be a mortgage the company took back on the sale of
fixed assets or an agreed to long-term financing arrangement.
Net fixed assets
Buildings, furniture, fixtures, and equipment net of depreciation. Leasehold improvements are to
property not owned by the subject thus there is uncertainty of their liquidation value and they
should really be shown as intangibles.

Capitalized leases
Represents property leased rather than purchased; if the asset will be leased for most of its
expected life or has a purchase option at the end of its lease, then it may be capitalized and
depreciated similar as to a purchased asset.
Other assets
If "other" is substantial in relation to the balance sheet, then it should be questioned.
Deferred taxes
Are sometimes related to pension items. This represents taxes paid to the FBR but have not yet
been recognized as an expense.
Loans to/due from officers
Usually have an unspecified amortization.
Pre-paid taxes
Have no definite recovery or liquidation value.
Goodwill (intangible asset of the value of the asset over it actual cash price).

Some UK corps. tend to write off good will directly against reserves at the outset of the
acquisition, whereas companies in other parts of the world tend to amortize goodwill over time
against earnings).

Liabilities
Current Liabilities
Bank overdrafts
Due within the current period
Accounts payable
These could be short-term, supplier / vendor credit lines and favorable sales terms extended by a
large company to a small or medium-sized business. During times of recession these lines / sales
terms tend to be reduced in dollar amount or time, and sometimes they are terminated, which can
place the small or medium-sized business under duress if bank financing is not available (which
it probably will not be in a recession).
Notes payable
Borrowings utilized for working capital purposes.
Current Portion of Long-term debt

Long-term Liabilities
Notes Payable to banks
Bonds
Debentures
TFCs
What is the schedule of repayment of the long-term debt? What is coming due within the next 6
months and 12 months?
Subordinated Debt
Equity
Common share
Preference shares
Retained Profit
Income Statement
Revenue
Cost of Goods Sold
Direct charge(s) against the primary manufacturing/sales process
Gross Profit
Total Income / Net sales minus the Cost of Goods Sold
Operating Expenses
Cash Flow

Sometimes also referred to as EBIT - A company's Earnings Before Interest and Taxes.
Typically is used in presentations by companies to demonstrate cash flow available to fund
operations (considered a non-GAAP financial measure under the SECs rules).

Cash Flow Value - The value of a firm based on the cash flow available for distributing to any of
the providers of long-term capital to the firm. The free cash flows equal operating cash flow less
any incremental investments made to support a firm's future growth.

Depreciation Expense

If a company does not accurately depreciate an asset, either knowingly or unknowingly, then the
net income result is higher or lower than it should be. If the company knowingly takes less
depreciation then it is pumping up the earnings of the company. If the company applies too much
depreciation then it is decreasing earnings. The analyst needs to look at what the historical
depreciation has been and whether there have been any recent capital expenditures (increases
depreciation) or asset sales (decreases depreciation). If the company knowingly applies too much
depreciation then it may be looking to push up earnings in a later period by applying the accurate
(and lesser) amount of depreciation during that period. The amount of depreciation charged
against earnings each accounting period is the based on the assumption of management. In
addition, companies in a growth phase will have higher capital expenditures (actual cash spent,
which reduces earnings) than depreciation (non-cash item, which does not affect actual cash
flow).

Interest Expense

If you are increasing facilities or the company is increasing borrowings to fund an acquisition or
expansion of operations then this figure will be increasing.

Deferred Income

Money received from customers in advance of performance of revenue activities. This amount
will be spent on goods or services, or will be repaid to the customer.

Taxation

Is the rate consistent with the past several years?

Net Income

What is the trend compared to the previous year(s)?
How much is committed to dividends? Is the payout consistent with previous years?
Investing activities include acquiring and selling or otherwise disposing of securities which are
not cash equivalents, and productive assets that are expected to generate revenues over the long
term.
Free cash flow, which is sometimes defined as net cash provided by operating activities of
continuing operations in the period minus payments for property and equipment made in the
period, is considered a non-GAAP financial measure under the SECs rules but is still an
important financial measure for use in evaluating a companys ability to generate additional cash
from business operations.

Profitability

A company's income statement includes non-cash items. The amount of these items is derived by
management's estimate, and whatever the company's auditors will agree to.
How do companies smooth or manage their earnings:
Plan ahead: time store openings or asset sales to show earnings rising.
Aggressively book sales and/or revenue recognition at the end of a weak quarter,
or hold off if the quarter's goal has already been met.
Capitalize expenses (amortization or lengthening a depreciation schedule) as oppose to
expensing it.
Write-off a restructuring in order to lower one quarter to make it easier to meet future earnings
quarters.
Utilize reserves to reduce income by building them up for allowances or potential insurance
losses, and then draw them down to bolster earnings.

Cash Flow Analysis

The statement of cash flows indicates a company's major sources of cash receipts and major uses
of cash payments for a given period.
Operating activities entered into for the purpose of earning net income.
Financing activities include obtaining resources from owners and creditors and providing them
with a return, or return on, such a interest, dividends and payment of principal; proceeds from
issuance of equity securities (preferred and common), bonds and other short-term and long-term
borrowing. Payments of cash dividends, acquisition of treasury stock and repayments of amounts
borrowed.

Investing activities include acquiring and selling or otherwise disposing of securities which are
not cash equivalents, and productive assets that are expected to generate revenues over the long
term.

Free cash flow, which is sometimes, defined as net cash provided by operating activities of
continuing operations
Cash Flow Statement (GAAP)
The Cash Flow Statement has three cash flow accounts:
1) Operating Cash Flow generated by normal business operations.
2) Investing Cash Flow from the purchase or disposal of assets such as plant buildings, real
estate, investment portfolios, equipment.
3) Financing Cash Flow from investors or long-term creditors.

Ratio Analysis
Asset Quality
Average Assets
Total assets (previous year) + Total assets (present year)
-----------------------------------------
2
Profitability / Earnings
Sales Growth Rate
Sales in Period 2 - Sales in Period 1
-----------------------------------------------------
Sales in Period 1
Gross Profit Margin
Gross Profit
------------------ x100
Sales
Operating Profit Margin
Operating Profit
------------------------- x 100
Sales
Pretax Profit Margin
Income before Taxes
------------------------------ x100
Sales
Return on Sales (Net Income Margin)
Net income
--------------------- x100
Sales
Return on Average Assets (ROAA) (measures how effectively an institution utilized its assets)

Net income
----------------------- x100
Total Average Assets

Is the key indicator of a company's profitability? It matches net profits after taxes with the assets
used to earn such profits. A high percentage rate will tell you the company is well managed and
has a healthy return on assets.
Return on Average Equity (ROAE) (measures what an institution earned on its shareholders'
investment)
Net income
---------------------------------------- x100
Total Average Shareholders' Equity

Measures the ability of a company's management to realize an adequate return on the capital
invested by the owners in a company
This ratio is affected by the level of capitalization of the company.
Measures the ability to augment capital internally (increase net worth) and pay a dividend.
Measures the return on the stockholder's investment (not considered an effective measure of
earnings performance from the company's standpoint).
In the long run, a return of around 15% to 17% is regarded as necessary to provide a proper
dividend to shareholders and maintain necessary capital strength in the event of an earnings
decline.
ROAE can be manipulated by increasing net income from asset sales (a one-time event) or by
reducing equity through share buy-backs or write-downs. When a company purchases another
company and creates intangible goodwill, the equity side of the balance sheet also increases.

DuPont ROA

EBIT Tax
-------------------
Assets
DuPont ROE
EBIT - (Taxes + Interest)
-------------------------------
Shareholder's Equity
Cash Flow
Net Income before + Depreciation Expense
Operating Cash Flow
Income before Interest and after Taxes + Depreciation
Interest Coverage
Operating Cash Flow
------------------------------
Interest Expense
Debt Service
Operating Cash Flow
------------------------------
Interest + Principal
Debt Service after Non-discretionary CAPEX (Capital Expenditures)
Operating Cash Flow Net of CAPEX
----------------------------------
Interest + Principal
Working Capital, Liquidity and Funding

Liquidity/Working Capital
Liquidity refers to a company's ability to convert an asset into cash. The faster the conversion the
more liquid the asset. Illiquidity is a risk in that a company might not be able to convert the asset
to cash when most needed. Moreover, having to wait for the sale of an asset can pose an
additional risk if the price of the asset decreases while waiting to liquidate.
Is a measure of how much cash does a company have on hand for immediate use.
A company will have both on balance sheet liquidity and off-balance sheet sources of liquidity.
On balance sheet will be actual issued debt, commercial paper. Off-balance sheet will consist of
committed, unused bank credit facilities to support commercial paper.
What is the mix of debt according to maturity, rate structure (mixed versus floating rate), and
currency?
Key Ratios for Examining Liquidity

Working Capital (measures the amount of cushion that current assets provide)

Current Assets - Current Liabilities
Current Ratio

Measures how well current assets could cover current liabilities if for some reason they all
became payable simultaneously and how much is available for short-term operations over and
above current liabilities. A minimum of 1:1 is required to provide better coverage, the industry
standard is approximately 1.2:1, however as a rule of thumb, at least 2:1 is considered a sign of
sound financial strength.
Current Ratio
Current Assets
---------------------------
Current Liabilities
Quick Ratio / Acid Test Ratio
(Should be greater than 1: 1 to provide better coverage; cash + marketable securities +
receivables)
Current Assets - Inventory
---------------------------
Current Liabilities
Cash + Cash Equivalents+ Receivable / Current Liabilities measures
Measures the extent to which a business can cover its current liabilities with those current assets
readily converted to cash (the ability to cover short-term liabilities without the need to convert
inventory into cash). Only cash and accounts receivable would be included, as inventory and
other current assets would require time and effort to convert into cash. A minimum ratio of 1:1 is
desirable.
Cash Ratio

Cash + Marketable Securities
---------------------------------------------
Current Liabilities

Cash + Marketable Securities
---------------------------------------------
Total Liabilities
Cash Ratio

Cash + High Quality Marketable Securities / Current Liabilities

Efficiency / Turnover
Focus on the operating cycle of the company by examining the cash flow. These ratios give an
indication of the amount of time it takes for cash to move through accounts receivable, inventory
account and accounts payable.
How long does it take for a company to purchase inventory, pay for it, sell it, and collect the
cash for the sales. A company can get squeezed if it has to pay for supplies but not collect for 30
to 90 days.
Accounts Receivable Turnover
Net Credit Sales / Average Accounts Receivable
A receivable is essentially an interest-free loan by the company to the customer. Thus, it is an
asset that is not earning a return (in addition, the company already had to pay for the materials,
sub-assembly or services in order to produce the product or service). Thus, the faster the
receivable is turned over, the faster the company has received the cash plus profit back to cover
the cost of producing the product or service.
Please note: the numerator must be Credit Sales or Net Credit Sales (usually net of returns). If
the company sells a product or service for cash then no receivable was created. Thus, the
numerator cannot be Gross Sales, Net Sales or Sales. It is only when a company extends credit
for 30, 60 or 90 days that a receivable is created.
The higher the turnover of receivable, the shorter the time it takes to convert sales into cash. This
ratio can be divided into 365 days to demonstrate the amount of time it takes to convert $1 of
sales into $1 of cash. Cost of Sales Average Receivables
(Collection Period Ratio) equals Average Accounts Receivable divided by Net Sales, multiplied
by 365 (days) (Accounts Receivable x 365 days Sales) and indicates how quickly a company
collects cash from customers that owe. The sooner it is collected, the sooner the company can put
it to work to purchase more inventory or paying for current orders. It is helpful in analyzing the
collectability of accounts receivable, or how fast a business can increase its cash supply.
Although businesses establish credit terms, customers do not always adhere to them. In
analyzing a business, you must know the credit terms it offers before determining the quality of
receivables. While each industry has its own average collection period (number of days it takes
to collect payments from customers), there are observers who feel that more than 10 to 15 days
over stated terms should be of concern.

Period End Receivables x Days in Period
---------------------------
Sales for Period
Inventory Turnover equals COGS / Average inventory
Another version is annual sales divided by inventory. Low turnover is a sign of excess stocks
and/or poor sales.
Days to Sell Inventory Ratio equals Average Inventory divided by Cost of Goods Sold,
multiplied by 365 (days), and indicates how efficiently a company is in matching its purchases to
its sales. Low inventory days indicate accurate forecasting of demand for the product, which
means that inventory is not accumulating on the shelves and incurring storage costs.

Average inventory x 360
-------------------------------
Cost of Goods Sold

Total Asset Turnover equals Net Sales divided by Average total assets
(Days Purchases in Accounts Receivable) equals Average Accounts Payable divided by Cost of
Goods Sold plus Change in Inventory, multiplied by 365 (days), and indicates how quickly a
company pays its suppliers for inventory purchased. If a company is paying promptly it may be
receiving price discounts.
. Days Payables
Period End Accounts Payables x Days in Period
-------------------------------------------
Cost of Goods Sold for Period

Payables Turnover COGS/ average payables
Days Purchases in Accounts Payables
Equals Average Accounts Payable divided by Cost of Goods Sold, multiplied by 365 (days), and
indicates how quickly a company pays its suppliers for inventory purchased. If a company is
paying promptly it may be receiving price discounts
Dividing this number into 365 days gives you the average number of days it will take to pay for
material(s). In effect, it is the number of days you are financing your sales with your creditor's
money. This should be used in conjunction with the inventory and accounts receivable ratios to
arrive at a more accurate assessment of your cash management policies. For example, if your
payable days figure is considerably less than receivables days, you are probably wasting a
valuable asset - your vendor's permission to use his money. On the other hand, an extended
payback period should be a warning that there is a danger of vendors assessing finance charges,
refusing credit, or refusing to deal with you altogether.
Average Trade Payables x360
Cost of Sales

Cash Conversion Cycle
Days Inventory + Collection Days - Days Payables
Sales to Net Working Capital

Measures the number of times working capital turns over annually in relation to net sales. A high
turnover rate can indicate over-trading (excessive sales volume in relation to the investment in
the business). A high turnover rate may indicate that the business relies extensively upon credit
granted by suppliers or the bank as a substitute for an adequate margin of operating funds.
Sales Net Working Capital
Accounts Payable to Sales
Measures how the company pays its suppliers in relation to the sales volume being transacted. A
low percentage would indicate a healthy ratio.
Accounts Payable Sales
I nterest Coverage
Income Before Taxes + Interest / Interest Expense
Computes the number of times ordinary income before interest and taxes covers interest
payments.
Capitalization
Average Equity

Total stockholder's equity (previous year) + Total stockholder's equity (present year)
-----------------------------------------
2
Book Value per Common Share

Shareholders' Equity at the end of a period
---------------------------------------------------------------
Number of common shares outstanding at the end of that period
Leverage
There are several ways to determine Leverage. One ratio is Total Liabilities to Equity. Overall,
the ratio indicates what proportion of equity and debt the company is using to finance its assets.
The higher the debt/equity ratio is then the greater amount of debt that the company is using to
finance its growth. The credit is that in an economic down turn the company will not generate
sufficient earnings to pay interest or amortizing principal. This ratio can be very high for
financial institutions, however it is important to adjust the liabilities for matched repurchase
agreement / reverse REPO financing.

Debt to Equity
Total Liabilities
---------------
Equity
Another is Total Debt (all short-term and long-term interest bearing debt, including commercial paper,
bonds and bank borrowings) to Equity.

Total Debt
---------------
Equity
Another is Long-term Debt to Equity

Total Long-Term Debt (Total Debt less Short-Term Debt)
-----------------------------------------------
Equity
Another is Senior Debt to Capital

Total Liabilities - Subordinated Debt
-----------------------------------------
Equity + Subordinated Debt

Another is Debt plus Preferred Securities (due to their debt-like interest payments and long-term
maturity feature) to Capital

Total Debt + Preferred Securities
-----------------------------------------
Equity - Preferred Securities

Another is "Gearing", which is the U.K. term for this same ratio. Similarly, a high gearing ratio
indicates a high level of debt as a percentage to equity. The U.K. balance sheet terms may look
something like:

Loan Capital (Debt)
-----------------------------------------
Capital Employed (Shareholders Equity)

Another version of gearing

Total Liabilities / Total Liabilities + Stockholder's Equity
Also called Capital Ratio, indicates how much of capital is borrowed funds.

Debt Service Coverage

Earnings before interest, taxes, depreciation and amortization (EBITDA; or some other cash flow
measure) / Debt Service Costs
Measures annual cash requirements to meet interest and repayment obligations on debt and
provides an indication of the company's ability to pay

Capitalization & Leverage

The company's equity base is considered of high quality if it consists primarily of common
equity, with small/moderate goodwill, and small/moderate preferred equity with high
percentage/dividend rates, and low subordinated debt. Capital formation can be strong if the
company has a high return on equity and modest dividend payout to shareholders resulting
retained earnings growth.
Reliance on debt financing and the nature of the assets being financed; and the relation of debt to
equity capital (the company's use of borrowed funds in relation to the amount of funds provided
shareholders)
Borrowed money carries interest costs and the company must generate sufficient cash flow to
cover interest and principal payments, thus low to moderate leverage is viewed as more
favorable.
Corporate debt is no longer just secured and unsecured creditors. There are now several levels of
debt holders, each earning a specific interest rate to match the level of risk in lending to the
company and being in a subordinated position: senior creditors (first lien), second lien,
mezzanine, senior subordinated, subordinated. Shareholders (equity) are last in the hierarchy of
claims against the assets of a company.

Loan covenants usually specify that financial ratios (for instance, interest coverage or the ratio of
a company's earnings to its interest payments) must be adhered to or the company will be in
breach of the loan agreement.