Financial Statement Analysis
Financial statement analysis is used by a banker to determine a borrower’s capability to repay a loan. A banker will typically review a borrower’s current financial statements and compare them to previous financial statements to see which areas of the business have changed and by how much. Many borrowers will provide the bank with projections and/or pro-forma financial information. The banker will find this information useful and can compare planned performance to actual financial results. Industry comparisons are also used by lenders to compare the business operation results to others in the same industry.
There are numerous balance sheet ratios and statistics; however, five are used frequently in financial statement analysis by lenders. They are: the current ratio, quick ratio, working capital, inventory turnover ratio, and leverage ratio.
The current ratio is widely used to determine financial strength. It is computed by dividing current assets by current liabilities. The higher the ratio equates to a more probable outcome for a borrower to meet its obligations.
The quick ratio concentrates more on liquid assets of the borrower and is calculated by dividing the sum of cash and accounts receivable by current liabilities. This ratio excludes inventory or any other current asset that could have questionable liquidity. Again, the higher the ratio would mean the borrower can meet short-term obligations.
Working capital is very useful to bankers as it deals with cash flow more than a ratio. This calculation is arrived at by taking current assets minus current liabilities. Sometimes bankers incorporate a minimum working capital requirement into the borrower’s loan agreement.
Inventory turnover ratio is used for a business that sells products from its inventory. It tells the banker if inventory is turning over fast enough. This ratio is calculated by dividing net sales by average inventory.
The last balance sheet ratio is the leverage ratio, and is closely monitored by bankers to make sure the borrower continues to be credit worthy. This ratio typically shows the extent that the borrower’s business in reliant upon debt to keep operating. The ratio is calculated by dividing total liabilities by net worth. The higher the ratio would show that the borrower is incurring more risk.
There are three profit and loss ratios that are commonly used in income statement financial analysis. They are: gross profit ratio, EBITDA, and net profit ratio.
The gross profit ratio is the most common to track and is calculated by taking gross profit and dividing it by net sales. This ratio can be compared to others in the borrower’s industry. It can also be compared to projections and pro-forma information to see if the borrower is meeting its benchmarks.
EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) is one of the most important ratios used. This ratio is calculated by dividing EBITDA by net sales and shows how well the borrower’s business is actually running without including non-operating costs.
The net profit ratio is net pre-tax profit divided by net sales. This ratio is of used to track the borrower’s financial profitability trends over time.
Financial statement analysis is not only used by bankers, but other creditors, company management, and regulatory authorities. Creditors are interested in the borrower’s ability to repay loans. Company Management is interested in financial results and return to shareholders while regulatory authorities are interested in conformance with accounting standards and rules.