Introduction
Credit analysis is involved in a wide variety of decision contexts:
If the loan is granted, the banker must later ask: Are we still providing the services, including credit, that this firm need? Is the firm still in compliance with the loan terms?
A commercial bank asks: Should we extend a loan to this firm?
Purpose of Analysis
Financial statement analysis helps users make better decisions.
-Internal Users: managers, officers, internal auditors...
-External Users: shareholders, lenders, customers...
Information for Analysis
-Income Statement
-Balance Sheet
-Statement of Stockholders'Equity
-Statement of Cash Flows
-Notes
Financial Analysis
- Financial analysis is the selection, evaluation, and interpretation of financial data, along with other pertinent information, to assist in investment and financial decision-making.
- Financial analysis may be used internally to evaluate issues such as employee performance, the efficiency of operations, and credit policies, and externally to evaluate potential investments and the credit-worthiness of borrowers, among other things.
Credit Analysis Process
Step 1: Consider the Nature and Purpose of the Loan
Step 2: Consider the Type of Loan and Available Security
Step 3: Analyze the Potential Borrower’s Financial Status
Step 4: Utilize Forecasts to Assess Payment Prospects
Step 5: Assemble the Detailed Loan Structure
Key Analysis Questions
Some of the question to be addressed in analyzing a potential borrower’s financial status including the following:
- Business strategy analysis
How does this business work?
What is its strategy for sustaining or enhancing that value?
How well qualified is the management to carry out that strategy effectively?
Is the viability of the business highly dependent on the talents of the existing management team?
- Accounting analysis
How well do the firm’s financial statement reflect its underlying economic reality?
Are there reasons to believe that the firms’ performance is stronger or weaker than reported profitability would suggest?
Are there sizable off-balance sheet liabilities that would affect the potential borrower’s ability to repay the loan?
- Financial analysis
Is the firm’s level of profitability unusually high or low?
What are the sources of any unusual degree of profitability?
What risks are associated with the operating profit stream?
What is the firm funds flow picture?
What are its major sources and used of funds?
Are funds required to finance expected growth?
How great are fund flows expected to be, relative to the debt service required?
Financial Ratio Analysis
There are six aspects of operating performance and financial condition we can evaluate from financial ratios:
A Liquidity ratio
Liquidity reflects the ability of a company to meet its short-term obligations using assets that are most readily converted into cash.
Asset that may be converted into cash in a short period of time are referred to as liquidity assets, they are listed in financial statements as current assets.
Current assets are used to satisfy short-term obligations, or current liabilities.
Measuring of Liquidity ratio
Liquidity ratios provide a measure of a company’s ability to generate cash to meet its immediate needs.
There are three commonly used liquidity ratio:
The Current Ratio
The Quick Ratio
The net Working Capital to Sales Ratio
A profitability ratio
Profitability ratio compare components of income with sale. They give us an idea of what make up a company’s income and are usually expressed as a portion of each dollar of sales.
Gross profit margin
Operating profit margin
Net profit margin
An activity ratio
Activity ratios are measures of how well assets are used.
Can be used to evaluate the benefits produce by specific assets, such as inventory or account receivable.
A financial leverage ratio
A company can finance its assets either with equity or debt.
Financing through debt involves risk because debt legally obligates the company to pay and to repay the principal as promised.
Financial leverage ratio are used to assess how much financial risk the company has taken on.
A shareholder ratio
The ratios we have explained to this point deal with performance and financial condition of company.
These ratio provide information for managers (who are interested in evaluating the performance of the company) and for creditors (who are interested in the company’s ability to pay its obligation).
Step-by-step approach to financial statement analysis
Financial statement analysis involves the following seven steps.
Step 1: obtain relevant financial statements
Step 2: check for consistency
Step 3: undertake preliminary scrutiny
Step 4: collect data about industry and general economic trends
Step 5: conduct a comparison with industry averages
Step 6: do supplementary analysis
Step 7: summaries the main features
Detecting window dressing, frauds and errors
1 Check the details of receivables
2 Check the valuation of inventory
3 Check the machinery valuation
4 Check the real estate valuation
5 Check the valuation of marketable securities
6 Check for other ‘creative accounting’ techniques
7 Check the cooperation of the applicant
