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

Financial Projections

Account Receivable
Inventory
Financial Ratios
Income Statement Projections
Balance Sheet Projections

Cash Flow Analysis

Career Advice for becoming a Bank Underwriter

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Materials Created by Glenn Snyder San

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

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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)

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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.

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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

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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.

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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.

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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 dont

pay?

Is there a concentration with one or two sales

people?

What if those sales people leave?

What % of sales are guaranteed (contractually

obligated)?

What happens when the contract expires? Where is

new business coming from?

What % of sales are foreign?

Do they use letters of credit to protect against nonpayment? Foreign customers are hard to collect
from.

What % of sales is to the government?

The government is typically slow paying

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Financial Analysis Accounts

Receivable

Accounts Receivable Aging Schedule

A schedule of all outstanding receivables grouped both by

customer and due date

Analysis:
Questions to Ask

Reason

Is there a concentration greater than 10% of any

customers?

What happens if they lose a large customer?

What % of customers are past due?

How reliable are their accounts receivable

Are there any receivables over 120 days past due

that have not been written-off?

Typically these will not be collected and should be

backed out of the total accounts receivable

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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)

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Financial Analysis - Inventory

Analysis:
Questions to Ask

Reason

How does the company inventory compare with the

industry average?

Do they carry too much? Too little? Do they have too

much in finished goods inventory?

Is inventory valued at LIFO, FIFO, or Weighted

Average?

This will impact the cost of goods sold and inventory

balance. Could inventory be obsolete?

What % of current assets is made up of inventory?

Inventory is typically the hardest current asset to

convert to cash

What % of inventory is work-in-process?

This inventory is virtually worthless. What can you do

with the frame of a car?

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Financial Analysis - Ratios

Liquidity Ratios Current Ratio:

Current Assets / Current Liabilities

Measures a firms ability to meet current obligations

Analysis:
Questions to Ask

Reason

Calculate the Current Ratio

Too low suggests a lack of liquidity, too high

suggests financial assets are not used efficiently

How does the companys current ratio compare

with companies of similar size in their industry?

If they are not in-line with the industry, then the

underwriter must find out why.

Are liabilities being paid on time?

If suppliers and service bills are being stretched,

this would decrease the current ratio.

How much is inventory weighted in current

assets?

Inventory is the most difficult current asset to

convert to cash? How quickly is it turning over?

Are accounts receivable over 120 days being

written off?

These accounts will probably not be collected

and should be removed from current assets

Exclude Prepaid Current Assets

Cash cannot easily be obtained from a prepaid

phone bill or rent

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Financial Analysis - Ratios

Liquidity Ratios Quick Ratio (Acid Test):

(Current Assets Inventory)/ Current Liabilities

Measures a firms ability to meet current obligations without liquidating
inventory

Analysis:
Questions to Ask

Reason

Calculate the Quick Ratio

Too low suggests a lack of liquidity, too high

suggests financial assets are not used efficiently

How does the companys current ratio compare

with companies of similar size in their industry?

If they are not in-line with the industry, then the

underwriter must find out why.

Are liabilities being paid on time?

If suppliers and service bills are being stretched,

this would decrease the current ratio.

How much is inventory weighted in current

assets?

Inventory is the most difficult current asset to

convert to cash? How quickly is it turning over?

Are accounts receivable over 120 days being

written off?

These accounts will probably not be collected

and should be removed from current assets

Exclude Prepaid Current Assets

Cash cannot easily be obtained from a prepaid

phone bill or rent

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Financial Analysis - Ratios

Leverage Ratios Debt-Equity Ratio:

Total Liabilities / Total Net Worth

Measures the funds contributed by owners or
shareholders versus creditors.

Analysis:
Questions to Ask

Reason

Calculate the Debt-Equity ratio

How much of total liabilities are current liabilities?

Matching Principle: current assets should be

financed with current liabilities, long-term assets
should be financed with long-term debt

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Banks generally like to see this ratio below

40%
If this ratio was greater than 50%, the company
would primarily be financed by creditors
The owners would be more likely to
declare bankruptcy in the event of a
downturn, as they would have less to lose

Materials Created by Glenn Snyder San

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Financial Analysis - Ratios

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:
Questions to Ask

Reason

Calculate the Accounts Receivable Turnover

The shorter the better

The faster a company can collect, the faster
they have cash
The less time they need to borrow

Is the accounts receivable turnover relatively

close to the companys financing terms?

If they sell on 2/10 net 30, one would expect to

see a turnover around 30 days. A few days over
is ok, but 40 or 45 would be too long

Are accounts receivable over 120 days being

written off?

These accounts will probably not be collected

and should be removed from current assets

How does the companys turnover compare with

the industry?

The turnover should be close to industry

averages, if not, the underwriter needs to know
why

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Financial Analysis - Ratios

Efficiency Ratios Inventory Turnover:

(Inventory / Cost of Goods Sold) x 365

Measures the average number of days inventory is on hand

Analysis:
Questions to Ask

Reason

Calculate the Inventory Turnover

The shorter the better

The faster a company can sell its inventory, the
faster they have cash
The less time they need to borrow

Which inventory valuation method do they use?

LIFO, FIFO, or weighted average?

Which method is standard for the industry?

Have they changed valuation methods recently?
If so, why?

Is the inventory turnover different for different

products?

Are some products selling and others not? Are

some products becoming obsolete?

How does the companys turnover compare with

the industry?

The turnover should be close to industry

averages, if not, the underwriter needs to know
why

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Financial Analysis - Ratios

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:
Questions to Ask

Reason

Calculate the Accounts Payable Turnover

This is a sensitive ratio:

The longer the turnover, the longer the
company has cash
If the supplier get stretched to much, they may
not sell to the company, which can put the
company out of business

What terms to the suppliers offer?

Is the company taking advantage of discounts?

Supplier reference check

An underwriter will want to call 3 or 4 suppliers to

confirm the company is in good standing

How does the companys turnover compare with

the industry?

The turnover should be close to industry

averages, if not, the underwriter needs to know
why

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Financial Analysis - Ratios

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:
Questions to Ask

Reason

Calculate the Gross Profit Margin

The higher the gross profit margin, the more

money is available to cover the operating costs
of the company

Has the gross profit margin changed over time?

This can show the impact of price changes or

changes in the cost of inventory.

Understand the industry

Certain industries may have tighter margins,

such as technology retail.

How does the companys turnover compare with

the industry?

The turnover should be close to industry

averages, if not, the underwriter needs to know
why

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Financial Analysis - Ratios

Profitability Ratios Return on Equity (ROE):

Net Income / Total Equity

Measures the relationship between profits and the investment of the
owners.

Analysis:
Questions to Ask

Reason

Calculate the Return on Equity

This ratio will have a direct impact on the

companys 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 companys turnover compare with

the industry?

The ROE may be close to the industry, despite

low profits, as the company may have higher
levels of liabilities

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Financial Projections

Loan underwriters must take their ratios and

analysis of the financial statements and project the
companys 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

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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

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Income Statement
Projections

Sales (Gross Revenues)

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Income Statement
Projections
Income Statement
Account
Cost of Goods Sold

Projection Method
Cost of Goods Sold Margin

Selling, General & Administrative Margin for Variable Expenses

Expenses
Average Value for Fixed
Expenses
Depreciation

% of Fixed Assets

Interest Expense

Interest Rates x Associated Debt

Income Taxes

Average of Tax Rates

Dividends

Previous Period Dividend per

Share

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Balance Sheet Projections

Balance Sheet Account

Projection Method

Cash

Project Only Minimum

Requirement

Accounts Receivable

Average of A/R Turnover

Inventory

Average of Inventory Turnover

Prepaid Expenses

Average over Prior Periods

Other Current Assets

Average over Prior Periods

Fixed Assets

Prior Period Balance less

Projected Depreciation plus
Projected Purchases (if any)

Other Assets

Average over Prior Periods

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Balance Sheet Projections

Balance Sheet Account

Projection Method

Working Capital Line of Credit

Used as a Plug to Make the Balance

Sheet Balance (if negative, make $0, and
move the excess to cash)

Accounts Payable

Average of A/P Turnover

Current Portion of Long-Term Debt

Prior Period Balance unless Debt is Fully

Retired plus Current Portion of New Debt

Accrued Liabilities

Average over Prior Periods

Other Current Liabilities

Average over Prior Periods

Long-Term Debt

Prior Period Balance plus New Long-Term

Debt less CPLTD

Deferred Taxes

Prior Period Balance unless Expiring

Other Liabilities

Average over Prior Periods

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Balance Sheet Projections

Balance Sheet Account

Projection Method

Minority Interest

Average over Prior Periods

Preferred Stock

Prior Period Balance

Common Stock

Prior Period Balance

Retained Earnings

Prior Period Balance plus Net

Income After Tax less Dividends

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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

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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

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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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