Credit Analysis and Management

for Examiners

Credit Appraisal - Financial Analysis

1
 Financial statements

 Balance Sheet
 Assets
 Liabilities / Equity
 Income statement
 Equity changes statement
 Cash flow statement
 Appendix
 Auditor’s report
 Traditional model

Equity

Fixed assets

Long term debt

Current assets
Short term debt
 Traditional model

Equity

Fixed assets

Long term debt

Current assets
Short term debt

4
 Traditional model

Equity

Fixed assets

Long term debt

Current assets
Short term debt

5
 Traditional model

Equity

Fixed assets

Long term debt

Current assets
Short term debt

6
 Traditional model

Equity

Fixed assets

Long term debt

Current assets
Short term debt

7
 Capital employed
Equity + Long term debt

Equity

Fixed assets

Long term debt

Current assets
Short term debt

8
 Working capital
Current assets – Short term debt

Equity

Fixed assets

Long term debt

Current assets Short term debt

9
 Income statement
Sales
Cost of goods sold
Personnel expenses
Gross profit
Administration
(-) Operating expenses
expenses
Operating income or
EBIT Depreciation

(-) Interest
Income before taxes

(-) Taxes

Net income
 Articulation of Financial Statements

Cash Flow Statement

Cash from operations

Cash from investing

Beginning Balance Sheet Ending Balance Sheet
Cash from financing

Cash Net change in cash Cash

+ Other Assets + Other Assets

Statement of Shareholders’ Equity
Total Assets Total Assets
Investment and disinvestment
- Liabilities by owners - Liabilities
Net income and other earnings
Owners’ equity Net change in owners’ equity Owners’ equity

Income Statement
Revenues
Expenses

Net income

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Ratio analysis
 Ratios
 “Ratios compare two numbers on the financial statements in order to learn
more about the company’s financial position.
 Ratios help organize your analysis and compare the potential borrower to
other companies.
 You can take numbers from the same financial statement or from different
ones.
 Classification
 Profitability ratios
 Asset management ratios
 Solvency ratios
 Liquidity ratios
 Investment ratios
 Profitability ratios

(EBIT or EBIDA) Equity

Equity ROE

Capital
(-) Interest employed
ROCE Long term debt
Income before taxes Total assets
ROA or ROI
(-) Taxes

Short term
Net income
debt
 Profitability ratios

Net profit
Net profit margin = ------------------
Sales
Gross profit
Gross profit margin = ------------------
Sales
Operating profits
Operating profit margin= ----------------------
Sales
Net profit
Return on equity (ROE)= ------------------
Equity
Net profit
Return on capital employed (ROCE)= ------------------
Capital employed
Net profit
Return on assets (ROA)= ------------------
Total assets

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 Analysis of ROA

Net profit Sales

ROA= ------------------ x ------------------
Total assets Sales
Net profit Sales
ROA= ------------------ x ------------------
Sales Total assets
ROA= Net profit margin x Asset turnover

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 Analysis of ROE

Net profit Total assets

ROE= ------------------x ------------------
Equity Total assets
Net profit Total assets
RO?= ------------------x ------------------
Total assets Equity
RO?= ROA x Equity multiplier

Net profit Sales Total assets

RO?= ------------------x ------------------x ------------------
Sales Total assets Equity
RO?= Net profit marginx Asset turnover x Equity multiplier

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 Asset management ratios

A/R
A/R turnover = -----------------x 365
Sales
Inventory
Inventory turnover = ------------------x 365
Cost of goods sold
Sales
Fixed Asset turnover= ------------------
Fixed assets
Sales
Assets turnover = ------------------
Total assets

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 Analysis of ROA

Net profit Sales

ROA= ------------------ x ------------------
Total assets Sales
Net profit Sales
ROA= ------------------ x ------------------
Sales Total assets
ROA= Net profit margin x Asset turnover

Contribution margin = Cost of

goods sold / Sales

Personnel expenses / Sales

Admin expenses / Sales

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 Analysis of ROA
Net profit Sales
ROA= ------------------ x ------------------
Total assets Sales
Net profit Sales
ROA= ------------------ x ------------------
Sales Total assets
ROA= Net profit margin x Asset turnover

A/R turnover

Inventory turnover

Fixed assets turnover

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 Solvency ratios

Debt
Debt ratio= -------------------
Total assets
Equity
Debt to Equity atio
r = --------------------
Debt
EBIT
Times interestearned= ------------------
Interest expenses
EBIT+Depreciation-Taxes
Cash flow coverage ------------------------------
Interest + Principal

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 Analysis of ROE

Net profit Sales Total assets

ROΕ= ------------------ x ------------------ x ------------------
Sales Total assets Equity
ROΕ= Net profit margin x Asset turnover Equity multiplier

Debt ratio

Debt to equity ratio

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 Liquidity ratios

Current assets
Current ratio = -------------------------------
Current liabilities
Current assets - Inventory
Quick ratio = -----------------------------------------------
Current liabilities
Cash
Cash ratio= -----------------------------
Current liabilities

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Payables –Receivables turnover
A/R turnover =
Current liabilities turnover =
A/R
-----------------x 365
Sales
Current liabilities
-----------------------------x 365
Cost of goods sold
 Investment ratios

Net income
Earnings per share (EPS)= ---------------------
# of shares
Price per share
P/E ratio = -----------------------------
Earnings per share
Dividends
Dividends payout ratio= -----------------------------
Net income
Dividend per share
Dividend yield = --------------------------
Price per share
Equity
Book value = -----------------------------
# of shares
Book value
Book value over market value = -----------------------------
Market value

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 Limitations of Financial Statements
 Remember that the production of financial accounts can depend heavily on
the information and records provided by the directors/proprietors,
particularly in the case of small businesses. This means that both the
accuracy of the bookkeeping and the honesty of the proprietors are key
factors in the reliability of the accounts produced.
 In many cases the values attributed to fixed assets/ e.g. vehicles, fixtures
and fittings, are based on the best estimates of the proprietor/directors.
 The balance sheet gives little indication of the sale value of the assets in the
event that the business fails (a break-up situation) or a "forced' sale is
necessary where a fixed asset is being sold quickly to realise liquid funds,
although the business itself may continue trading.
 Limitations of Financial Statements
 When received the figures will already be out of date by at least several months and
often longer.
 The figures may have been manipulated to show the position desired by the
proprietor/accountant (window dressing)
 Inaccuracies may also be unintentional as there may not have been a full audit.
 Typically the stock valuation may be incorrect. If so, this will impact upon the figures,
particularly profit.
 Negative denominator e.g. no profits
 Outliers (mistake ?, true value?, how to treat?)

 Whilst accounts can provide a useful statement of information about a business, do not
over-rely on this. Circumstances can change very rapidly. The current position may be
quite different from that reflected in accounts.
Financial Statements – What they do not tell us

 The quality of the management of the business

 Future demand for the product/service
 The quality of the product/service
 The quality of the customer base of the business, including any undeclared bad or
doubtful debtors
 The future plans for the business and whether the assets are adequate to support these
 Whether the business is reliant on only one product/service
 The accuracy of inventory valuations
 How long monies have been owed to a business. It may be that there are amounts which
are never going to be paid to the business and should therefore be classified as 'bad‘
 Competition
 Analysis
 Time series analysis
 Structural changes
 Change in accounting standards
 Window dressing
 Cross sectional analysis
 Definition of section
 Lack of data
 International comparisons
 Benchmarking
 Different product lines
 Mergers and acquisitions
 Altman Z-score
 The Function
Z  1.2 X 1  1.4 X 2  3.3 X 3  0.6 X 4  1.0 X 5
 X1= Working capital / Total assets
 X2=Retained earnings/Total assets
 X3=EBIT/Total assets
 X4=Market value of equity /book value of long term debt
 X5=Sales/Total assets
 Cut-off points
 Z > 2.99 - “Safe zone”
 1.8 < Z < 2.99 - “Grey zone”
 Z < 1.80 – “Red zone”
Cash flow statement
 Cash flow statement
 Because the income statement is prepared under the accrual basis of
accounting, the revenues reported may not have been collected.
Similarly, the expenses reported on the income statement might not
have been paid. The cash flow statement organizes and reports the cash
generated.
 It distinguishes :
 Operating activities : converts the items reported on the income
statement from the accrual basis of accounting to cash.
 Investing activities : reports the purchase and sale of long-term
investments and property, plant and equipment.
 Financing activities : reports the issuance and repurchase of the
company's own bonds and stock and the payment of dividends.
 Total (positive or negative) cash flow is added to beginning cash balance
and should result in ending cash balance
 Flow from Operating Activities

 Includes:
 Current assets
 Current Liabilities
 Revenue and Expenses (includes interest expense and revenue, and
dividends received)
 Flow from Investing Activities

 Includes:
 Short-term and long-term investments
 Short-term and long term notes receivable
 Property, Plant and Equipment (depreciation affects operating activities)
 Flow from Financing Activities

 Includes:
 Short-term and long-term loans
 Capital
 Retained earnings (net income aspect is operating)
 Dividends Paid
 Rules for Identifying Cash Flows

Balance Sheet

Assets increase Use Financing increases Source

Assets decrease Source Financing decreases Use

Revenues = Source
Expenses = Use

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 Sources = Uses

 Construct two columns for balance sheet changes

 Sources = decreases in assets & increases in financing
 Uses = increases in assets & decreases in financing
 Sources must equal uses
 Construct the CFS.
 Operating Activities - Indirect Method
 Net Income
 + Depreciation (non-cash expense)
 - increases in current assets
 + decreases in current assets
 + increases in current liabilities
 - decreases in current liabilities
 = Net cash from operating activities
 Cash Flow from Investing Activities

 Cash received (sale) or paid (purchase) for:

 short term investments
 long-term investments
 property plant and equipment
 = Net cash from investing activities
 Cash Flow from Financing Activities
 Cash received from:
 sale of stock
 issuance of debt
 Cash paid for
 Payment of debt (principle only, interest is in operating activities)
 Payment of dividends
 = Net cash from financing activities
Example
Example
Example

1.000-900 2.980-780
Cash budget
 What Is Cash Budget?

 The cash budget measures movements of cash in and out of a business

over a period of time.
 It counts only cash income and expenses. It is not interested in any changes
in the business not involving cash.
 Looks at structure of sales and expenses over a period of time.

What is the main reason for

Why is cash flow so important?
business failure and loan default?

• Shows whether the business • Poor cash flow

has the cash to pay its bills management.
AND the bank loan. • Only CASH repays a loan.
• A business cannot function
without cash.
 Cash budget has two parts

• How business has evolved until present day, the past level of cash
from sales and structure of expenses.
Historical • Typical to go back either 1 year, 3 or 6 months.
Data

• Forecast of sales and expenses over time to see if borrowers can

repay the loan.
• You build projections based on historical data.
• Project as many months as loan term (6-12 months, if more then
Projections annual data)
 Cash Budget: Main categories

Beginning Cash

Cash In from Operations (Sales)

Cash Out from Operations (operational costs)

Cash In from Non-Operational Sources (Financing)

Cash Out for Non- Operational Uses (loan repayments, dividends, investments)

Ending Cash
 Ending Cash: What to Watch

Ending Cash – How much is left at the end of

the month after In and Out flows have been
added to beginning cash?

Ending Cash – Cannot be LESS THAN ZERO at

the end of the month.

Ending Cash – Equals the Beginning Cash in

the next month
 (Most) Important Term

Net Operational Cash

Shows how much Shows the Should allow the

cash is being company’s ability company to
generated by the to repay loans on cover repayment
SME from a SUSTAINABLE of loans on a
operations. basis. regular basis.
 Cash budget 1

Menu

September October November December January February March

Sales $34.654 38.000 40.000 43.000 36.000 37.000

Cash Sales (30% of sales) 10.396 11.400 12.000 12.900 10.800

Collections:
One month lag (50% of sales) 17.327 19.000 20.000 21.500 18.000
Two month lag (20% of sales) 6.931 7.600 8.000 8.600 7.200

TOTAL CASH RECEIPTS 37.931 40.500 40.300

 Cash budget 2

CASH DISBURSEMENTS:
Purchases (55% of next mos. sales) 20.900 22.000 23.650 19.800 20.350

Payments:
Cash Purchases (70% of purchases) 14.630 15.400 16.555 13.860 14.245
Lagged one month (20% of purchases) 4.180 4.400 4.730 3.960 4.070
Lagged two months (10% of purchases) 2.090 2.200 2.365 1.980 2.035
Rent 4.000 4.000 4.000
Wages and Salaries 8.000 8.000 8.000
Lease Payments 750 750 750
Interest 15 21 0
Capital purchases 0 0 18.000
Property Taxes 900 0 0
Other Expenses 2.400 2.580 2.160

TOTAL CASH DISBURSEMENTS 39.110 36.141 53.480

 Cash budget 3

FINANCIAL TRANSACTIONS SECTION:

Total Cash Receipts 37.931 40.500 40.300
Less Disbursements 39.110 36.141 53.480

Net Cash Flow -1.179 4.359 -13.180

Add Beginning Cash 2.000 2.000 2.180

Ending Cash Balance 821 6.359 -11.000

Less Minimum Cash Balance 2.000 2.000 2.000

Required Total Financing 1.179 0 13.000

Excess Cash Balance 0 4.359 0

Borrowing Needed This Month 1.179 0 13.000

Repayments on Loan This Month 0 4.179 0
Total Loan Balance 4.179 0 13.000

Ending Cash (After Borrowing) 2.000 2.180 2.000