Business — Banking — Management — Marketing & Sales

The financial situation of a corporation



Category: Corporate Banking

1. The balance sheet

When a credit analyst has to make a credit decision, the first thing he or she will have to analyse is a firm’s balance sheet. The balance sheet analysis alone may often not be sufficient to assess a firm’s creditworthiness, and other factors have to be taken into consideration. These factors, like the qualification of management, may finally be considered more important than the financial figures. But, without looking into the balance sheet, no credit decision must ever be made! This would amount to a violation of the law.

The balance sheet is a statement that shows a firm’s assets and liabilities. So, the banker can see what a company owns and what it owes to its creditors. The structure in which the balance sheet has to be drawn up is regulated in the respective Commercial Laws. Large corporations must present balance sheets that have been audited by an independent auditor. Since the balance sheet is drawn up at the close of the company’s fiscal year, it only represents a true and fair view of the financial situation at this very day. It may not be representative for the firm’s financial position at another time of the year.

The corporate banker’s favourite method of analysing balance sheets is to spread them. Spreading is a standardized method of presenting financial statements in a systematic and consistent manner. As financial statements come in many different formats, it is important that banks organize such data into a standard pattern. This allows the bank to easily compare a firm’s financial performance over a period of years. Important financial details can be easily highlighted. Equally important, it guarantees that a consistent way of financial analysis is followed in all of the bank’s branches. Thus, key ratios can be developed not only for particular balance sheet items but for entire industry sectors giving lending officers a deeper insight into a firm’s standing within its industry. You will find two specimen balance spread sheets at the end of this section.

The most important items on the balance sheet are as follows (For a more detailed, in-depth presentation of all balance sheet items please see the advanced textbook level 2):

a. Assets

These are assets that will probably be converted into cash within 12 months of the balance sheet date or within the normal business cycle of the company. Explanation of the most important current issues are found below.

Cash and bank deposits

This item can be easily manipulated. The firm’s management may have sound reasons to show a particularly high or low amount of cash or bank deposits. Therefore, this figure has to be compared with the previous year’s figure and those of other companies in the same industry sector. If a firm settles all or most of its payments via one bank, this bank should compare the cash and bank deposits statement in the balance sheets with the average amount held in its current account. These items should always be sufficient to meet the firm’s current financial obligations.

Debtors / accounts receivables

Accounts receivables should form a reasonable proportion of total assets. Too many accounts receivables consume funds and may hint at the companies’ inability to make its debtors pay. The more receivables on the balance sheet, the greater is the risk that some amounts are unlikely to be recoverable and have to be written off. Therefore, it is necessary to know who the key debtors are. The company should not be dependent on a single debtor. Since the debtors figure in the balance sheet will represent a number of different items, it should be broken down to its constituent parts (e.g. prepayments, trade debtors, other debtors, etc.). Receivables can be turned into cash by collecting them or by selling them, for example to a factoring company.

Stocks and inventory

Stocks are valued at the initial price paid for the asset plus costs incurred in bringing them to their present condition. Stocks can also be valued at their net realizable value. Finished products must be sold at last: The rate of inventory turnover can indicate whether a firm can quickly sell its products in the market quickly or if its products only collect dust, consuming funds without raising cash.

a.b. Fixed assets

These are assets which the company wants to retain for a long period of time and which it does not intend to resell. They are used in the production of the company’s goods or services. Fixed assets fall into two categories, which are land / buildings and plant / machinery.

Land and buildings

Companies can value these assets at historic cost or at valuation. In any case it is important to know the current market value of the land and buildings of a company. The balance sheet value can be very different from the current market value. In Great Britain, any significant difference between market and book value must be disclosed in the Directors’ report. In Germany, such a difference is not openly disclosed in the annual report. This results in hidden reserves, since many older buildings have already been depreciated and are shown at the books with only a fraction of their current market value. The bank must, therefore, obtain this information from its clients. Whenever land and buildings are needed as collateral, an independent expert’s opinion on the net realizable value of the real estate should be required. This expert’s opinion must then be held in the credit files.

Plant and machinery

The type and quantity of plant and equipment is determined by the type of goods a company produces. It can be useful to compare these fixed assets with those of other firms in the same industry to get a better impression of the appropriateness of its asset structure. Every account manager should visit his corporate clients’ sites to get an impression of his own about the equipment; is it in good shape or hopelessly outmoded? Are there enough machines to produce additional goods in case the management planned for further growth?

Intangible assets

Intangible assets represent values that are ascribed to certain rights or future benefits. These are normally

—          patents, trademarks and licences,

—          goodwill or

—          brand names

Goodwill is created where a business is acquired for more than the net value of its assets. Purchased goodwill is included in the accounts of a group of companies.

Often the price paid for acquiring a company also relates to the value of a brand name. Such firms have included an estimate of the value of the brand name within their balance sheet. Some do not amortize the brand name on the grounds that it does not loose value over time. From the banker’s point of view, it has to be considered that brand names could be the most valuable asset of a company. Brands like Coca Cola or Mercedes Benz are priceless items, although not shown in the balance sheet.

Patents and licences can have substantial value and should be noted when analyzing financial statements.

b. Liabilities

b.a. Current liabilities

These are all amounts owed by the company that are due within twelve months of the balance sheet date.

Creditors — trade

This is the amount the firm has to pay to its suppliers. It should form an appropriate portion of total assets. The amount of creditors shows the degree to which the company is financed by its suppliers. Careful comparisons should be made with other companies of the same industry to see if the level of trade credotors is appropriate. The bank has to consider whether any creditors hold security over goods supplied or other assets of the company.

Bank overdrafts and current loans

These short-term bank facilities are normally provided over a considerable period of time. It is a typical feature of an overdraft facility, however, that it has to be repaid on demand. There is usually no commitment on the part of the bank to advance funds for a longer period of time. Other short-term bank loans are included in this balance sheet item as well. Notes should be made whether these loans are secured or unsecured.

b.b. Medium and long-term loans

It is necessary to know the details of these loans, that is the amount, when they are due for repayment, and whether they are secured or unsecured. The general rule is that long-term loans should be secured, preferably by long-term assets (mortgages). The bank should know when payments are due in order to get a broader picture of the firms solvency. It is important to know whether the company is dependent on only one or two creditors.

Dividends

Dividends may have already been declared but not yet paid. The company must have sufficient cash, or access to cash, to pay the dividends. Uncovered dividends that are paid for by short-term loans are a warning signal.

Provisions

Provisions are reserves established from profits to meet future obligations like pensions. A bank has to consider the size and the time when these obligations must be paid.

b.c. Equity / net worth / shareholders funds

Shareholders’ funds are residual claims of the owners of the company against the company’s assets. Equity falls into two categories, shares and reserves. A company may have different classes of shares, giving different rights to their respective shareholders. The most common type of reserves are retained earnings which represent the balance of the profits and losses made over the years.

A bank has to consider how and why equity has changed over the years. Losses can only be compensated by equity. An appropriate amount of equity is crucial for the firm’s independence and survival. Only sound equity enables a company to survive a number of bad years. An international comparison of equity ratios shows that this ratio is especially low in Germany, in contrast to Anglo-Saxon countries. German small and medium-sized companies have equity ratios that range between 5 % and 15 %. Due to the lack of appropriate equity, 70 % of all start-up companies fail during the first seven years.

Equity ratios and return on sales

c. Profit and loss account / income statement

The profit and loss account records the income and expenses of a company during its fiscal year. It reports the results of a series of transactions over the time of the company’s fiscal year. Just like balance sheets, banks analyse the profit and loss statement by spreading them in a logical and consistent manner. The most important items of the profit and loss account are as follows:

Sales / turnover

The sales of goods or services are normally the primary source of income for a company. Other revenues, e.g. capital gains or extraordinary income generally account for only a tiny friction of total sales. The sales figure in the profit and loss account is one of the most interesting pieces of data for a credit analyst who should examine the following questions related to a company’s turnover:

How — and why — did sales figures change over a period of years? Was the firm able to sell more goods, could it charge higher prices, or both? In any case, total sales should increase at a rate that lies well above inflation, otherwise the company would have stagnant sales. It is always a good sign if a firm grows faster than its industry sector and the markets where it operates.

A disproportionately strong growth of sales can, however, be a warning sign; as growth must be financed in a sound and secure manner, the company must have access to appropriate funding. Otherwise, the additional cash needed to pay for increased raw materials and personnel costs can eventually threaten a company’s solvency.

The company must disclose a detailed breakdown of its sales according to products, regional markets, customer groups etc.

The company’s product range should be well diversified, and the bank should have information on the contribution that each product group makes to the firm’s turnover. A well-established method to gain deeper insight into a company’s product range is the product portfolio analysis which is explained in this book..

To which countries are the goods exported? Is there any danger that funds are not allowed to be transferred from these countries? Has the firm taken care to safeguard against foreign exchange risks? Does it make use of letters of credit?

It is important to know who the most important customers are. What will happen if the most important customer fails to pay its bills? Can other customers make up for this loss, or will the company suffer serious damage?

Raw material and consumables

German accounting principles explicitly show the expenses for raw material, as well as for staff expenditures. Are changes in that figure in line with changes in the company’s  sales over the years? Are prices for raw materials expected to increase? Is the company dependent on one or a few key suppliers?

Personnel / staff expenses

Changes in personnel expenses; should be in line with changes in turnover as well. A comparison with other companies of the same industry shows if sales per employee are appropriate. In smaller companies, the director’s remuneration can make up a large part of total personnel expenses and should be disclosed to the bank.

Other operating expenses

Other operating expenses include payments for electricity, leases, insurance, advertising, legal counsel, auditing etc. If this figure is exceptionally high, the credit analyst must find out its components.

Anglo-Saxon profit and loss accounts

British and American income statements do not explicitly show expenses for raw materials, staff and other operating expenses. These figures are included in the following three items:

—          cost of sales /cost of goods sold

—          administrative expenses

—          research & development and other operating expenses

These three figures may include many different items which a credit analyst has to isolate in order to get a clear view of the company’s cost structure.

Operating profit (before depreciation)

A company’s operating profit is the result of its total revenues minus the above-mentioned items. Then, exceptional (that is non-operating) income and expenses have to be considered, as well as the result of the company’s financial transactions. The largest part of the financial result will normally be made up of interest paid for loans and interest received for bank deposits.

Cash flow

The gross cash flow is the result of all the above-mentioned profit and loss items. The cash flow is one of the most important ratios when analysing financial statements. It shows the actual amount of cash that is available to cover the expenses for interest and principal of loans, for depreciation and for new investments. Generally speaking, the cash flow consists of the net profit plus depreciation. Since depreciations are expenses that are not paid in cash, they, plus the net profit show the amount of cash the company can operate with. So, from the banker’s point of view, the cash flow is even more important than a firm’s net income or loss. A detailed discussion of the cash flow will be given later in this book.

Depreciation

As fixed assets loose value over time, this loss of value has to be charged to the profit and loss account, although there are no cash expenses related to them. Depreciation methods must be disclosed in the annual report. Continued depreciation of long life assets, e.g. buildings, can

result in hidden reserves:-the book value of the asset is then lower than its market value. In German balance sheets, particularly hidden reserves can play a significant part. A bank should know about the net realizable value of a corporate client’s largest fixed assets, such as buildings and machines.

After taxes have been deducted, the final result is the net income or loss of the company in the respective fiscal year. The net income, or a proportion of it, can either be paid as dividends to the shareholders, or it can be transferred to reserves (retained earnings), so that it increases equity in the balance sheet. The use of net income can help distinguish good management from a poor one. As many companies have a thin equity position, a bank normally prefers that its borrowers transfer profits to equity.

d. Case study and worksheets

On the following pages, you will find balance spreads as they are used by a leading German bank. There is a completed form of a company called «Specimen Chemical Ltd.» and an empty spread that can be used for exercise, for example on the financial statements attached. The data are realistic, although the companies are fictional. You will also find spread sheets showing the mathematical formula.


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