Firstly, let us put together the main points considered in this Module and in the previous Module in the series (Module 2) to provide us with a framework for analysing customer credit risk.

Framework for Non Financial Risk Analysis

Non Financial Risk Analysis is the main topic considered in Module 2 of this series. Slide 31 shows a large number of headings that need to be considered by the credit analyst. Any one of these can have a major impact on the future of a business and, hence, on its ability to generate sufficient profits and cash flow to repay bank borrowings. For instance, if the management of a business is poor, almost inevitably its prospects are poor, no matter what other factors are in its favour.

If a credit analyst or relationship manager considers a business under all of these headings he/she will have built up a good knowledge of the business and what may happen to the business over the near future. Of course, the longer the time frame, the greater the uncertainty and, therefore, the greater the credit risk.

Framework for Analysis of Customer Financial Statements

Next shows a framework we might use for analysing the most up-to-date financial information available from the customer. Of course we must always bear in mind the figures themselves are meaningless without reference to trends, industry norms etc.

Analysis of customer financial statements:

-Activity

Sales Growth

- Profitability

Gross Profit Margin

Operating Profit Margin

Net Profit Margin

- Liquidity

Current Ratio

Quick Asset Ratio

- Working Capital Ratios

Debtor Collection Days

Stock Turnover Days

Credit Payment Period

- Gearing

Total Gearing

Bank Gearing

Repayment Capacity

Having considered all of these factors, both financial and non financial, we should be in a good position to make some reasonable assumptions about the immediate future of the business. These assumptions should underlie our calculation of repayment capacity for existing and proposed loans in the manner we looked at near the end of Session 2.

Other Factors

Finally, if we consider there is repayment capacity without unacceptable risk attaching to it, we must consider the other risk factors e.g.

What constitutes acceptable Security, to limit our risk further?

Looking at the proposition in the context of our existing portfolio, does it constitute acceptable risk?

What terms and conditions should apply?

How will we structure debt?

To counteract our inability to predict the exact risk with any one particular credit facility, banks try to keep overall risk within acceptable limits by several means, such as those highlighted on next.

Credit portfolio management:

- Balanced Portfolios

- Designated Credit Decision Making Procedures

- Supervisory and Audit Controls

- Procedures following default

Some of these are considered in detail in further modules in this series, but now we will briefly look at Balanced Portfolios and Procedures following default.

Balanced Portfolios

In the same way as any bank customer takes risks by being over-reliant on one particular client, supplier or market, so a bank must avoid having portfolios which are not balanced. The sort of factors that need to be taken into account in considering the overall balance of portfolios are show in next.

Portfolio balance:

- Location

- Industrial Sector

- Services

- Currencies

Let us look at these in a little more detail

A balanced portfolio with regard to location can be extremely important for a number of reasons:

Banks operating internationally will not wish to be over reliant on one particular country as the quality of their risk in each country can be hugely influenced by political, economic and legal developments there. Diversifying the portfolio between countries will enable the bank to cope better with adverse circumstances in any one location.

Within countries, particular regions may be over-dependant on certain types of industry (e.g. agriculture) which in turn may be dependant on specific factors such as climatic conditions. It is obviously not very prudent banking to have a portfolio which is significantly affected by the weather in any particular location!

Similarly, individual regions can suffer a specific downturn in the local economy. For instance, the major employer in the locality may suffer adverse trading conditions and be forced to reduce its level of activity, or perhaps even close down completely. This would seriously affect local suppliers, service industries, retailers etc.

The need to balance a lending portfolio between different industries and services should be reasonably self evident. Any particular sector can suffer a downturn for any number of reasons. Next lists a few obvious reasons

Some sources of sectoral problems:

- Fashion / Uneven Demand

- Competition

- Obsolescence / Technical Innovation

- Availability of Raw Materials

- Input Prices

- ETC.

Banks which operate internationally need to be particularly careful about currency risk. Movements on currency markets over the past number of years highlight how difficult it can be to forecast future developments. Banks must be extremely careful to balance this exposure and ensure that individual customers are not over-exposed to any particular foreign currency.

This may seem an obvious, and perhaps irrelevant question, but the lending banker must be fully aware of the person or entity to which he is providing credit, and who, or what entity, will have a legal obligation to repay the loan.

For instance, a business customer might be any of the following:

- Sole Trader

- Partnership

- Limited Company

- Unlimited Company

We do not have time here to go into all of the legal distinctions between these borrowers, and indeed these will differ from country to country, but obviously the lending banker must have a clear understanding of who is the debtor and to whom does the Bank have legal recourse. This will not only affect the completion of loan documentation, including security, but also the level of risk attaching to the loan. For instance, lending to a sole trader where the Bank has ultimate recourse to all of the private and business assets of the individual may carry much less risk than lending to a limited company which has been set up with very little capital and has very small net assets.

What might change?

We have already considered how quickly the modern business environment can change. This also applies to the ownership or management of a company. Ask the trainees to give an opinion as to whether credit risk increases or decreases in the following scenarios:

A sole trader forms a limited company and asks for all borrowings to be transferred to the company.

A family business is taken over by a much larger company, perhaps a multinational holding company.

The founder of a successful firm dies and control passes to his sons/daughters/nephews/nieces.

One partner is bought out by the remaining partner(s).

There are several similar scenarios we could illustrate. There is no one right answer with regard to the effect on credit risk of change in ownership etc. The lender or credit analyst must be aware of the possibility of such changes and must be in a position to judge the effect on the safety of the Bank’s lending.

Summary

In this session we have seen that, in addition to a detailed study of the financial position and prospects for a borrower, the prudent lending banker must also give considerable attention to having proper and sufficient security and, also, to structuring the debt properly.

In the final session, we will consider the need to have balance in a bank’s debt portfolio, we will summarise the framework for credit risk analysis we have built up in this training module and the previous one in the series, and will have a look at a comprehensive case study to see if we can put this framework into action

The banker should be aware that particular types of debt introduce different types of financial risk to the business. In particular, time is a significant risk factor. The longer the term of the loan, the greater the risk to the bank. Assessing risk, particularly through evaluation of projections, becomes increasingly difficult as the period of the loan extends and the element of uncertainty becomes greater. Risk on short-term debt is more easily and confidently assessed and controlled.

Because banks generally reflect this risk profile in their pricing, there is a temptation for businesses to seek to reduce financing costs by having higher weightings of short-term debt in their debt structure. However, this may put undue strain on their repayment capacity.

Types of Finance

It is normal to categories types of debt finance by maturity, and while broad definitions may vary from bank to bank and from country to country, next shows a well accepted categorisation.

Types of finance:

- Short Term               Up to 1 or 2 years

- Medium Term           2 to 5 or 7 years

- Long Term                 5/7 years and longer

In deciding which of these types of debt finance to use, the main consideration should be the maturities of the assets for which the finance will be used. Banks and customers should avoid use of short-term debt to finance long term assets. While the short-term debt may be cheaper, it carries considerable financial risk in terms of the inability to meet the debt commitments when they fall due.

In choosing debt structure, the bank and customer should pay particular attention to likely future cash flows and the availability of funds to make capital and interest repayments. Broadly, the following general rules might apply.

Short Term debt is generally only suitable for fluctuations in working capital and for normal trade finance.

Medium Term debt is appropriate for the purchase of most plant and machinery.

Long Term debt is suitable for financing investments in productive assets with a long life, such as land and buildings and heavy plant and machinery.

Working Capital needs contain elements of needs that range from short term to very long term, so, if possible, it should be financed by a combination of all three types of debt.

However, to properly assess repayment capacity we have to examine a huge amount of detail, both financial, as in this module, and non-financial such as Management, Competition etc. Then, even after the most detailed analysis, there can never be any certainty about repayment capacity. When assessing credit risk, and the repayment of loans, we are considering the future, and the future is always uncertain.

It is because of all this uncertainty, banks generally try to reduce their risk from any individual customer by taking Security from that customer. The purpose of the Security is to provide us with a secondary source of repayment if our primary source, normal trading income, is insufficient.

It is important to stress at the outset that the level of Security should never be the principal factor in deciding whether or not a particular loan will be granted. Many banks have found this to their cost over the years. Enforcing security is not always straightforward and it is always preferable to have loans repaid in the normal manner.

Characteristics of Good Security

The type of security we take will depend to a large extent on what is available from the customer. Also, our preferences may be determined by the legal system in our particular country because, ultimately, the effective realisation of security will depend, to a large extent, on the ease with which the legal system allows enforcement of the particular security held.

However, no matter what security we take, next shows the three factors we need to test in order to determine how effective it is likely to be.

Tests of effective security:

- Value

- Realisability

- Title

Value is clearly important. If we do not get repaid from normal trading, we hope that the value of our security will be sufficient, after costs of realisation, to at least cover the full debt. Our problem when taking security is that the only value that is of practical importance is the realisable value at the time we seek to recover our debt. Unfortunately, the value of security can often fluctuate considerably and this makes it difficult for us to make an accurate assessment of how well it covers our risk into the future.

Realisability is a key requirement. Security is of absolutely no practical value if it cannot be realised by the bank. While some forms of security are relatively simple to realise, many require complex legal action and banks often overestimate their ability to realise security in advance.

Title to the security is essential if the bank must be able to get good before realisation, and this in turn depends on the customer having good title and the ability to transfer this to the bank. It is not unknown for banks to find out too late that there are legal complications over ownership of the security provided.

From an overall risk point of view, it is recommended that the lending banker is cautious and prudent when assessing the value of security. It needs to be examined very carefully if the bank is likely to have to rely on the security for repayment. Lending against the perceived value of security is highly dangerous.

Perhaps the most effective use of security is as a means of concentrating the efforts of owners/managers on repayment of loans in the normal course, rather than surrendering the assets given as security.

We will now look at some of the more common forms of security taken by banks. We will look at them under the headings next.

Common types of security:

- Real Estate

- Company Assets / Debentures

- Guarantees / Letters of Comfort

- Assignments

Real Estate

Real Estate or Property is a very common form of security taken by banks. The bank seeks some form of legal charge over the property which allows it, in the event of default, to sell the property and apply the proceeds against the debt. As property is generally good at maintaining its value, the attractions for the bank are obvious.

There are a large number of different types of premises which may be taken as security. These are shown next.

Types of real estate:

- Residential Housing

- Investment Properties

- Retail Premises

- Industrial Buildings

- Agricultural Land

- Land for Building

- Tenanted Property

Each of these types of real estate may have particular points for the banker to bear in mind when considering them as security. In addition, when considering them all for our principal tests of Value, Realisability and Title the banker will need to subject them all to scrutiny under a number of headings. Next shows the sort of checklist that might be used.

Real estate checklist:

- Location

- Type of Land (agricultural, commercial, industrial)

- Government Regulations (e.g. Planning Permission)

- Occupants of Property / Rights of Residence

- Maintenance Costs

- Saleability

Many imposing properties are of little value because of location, legal problems, specialist use etc.

Debentures / Company Assets

When a bank is extending a range of credit facility to a company, financing both its fixed and current assets, it is logical that the bank might seek security over all of the assets of the company, perhaps by means of a debenture. The taking of such security will depend significantly on the laws of the particular country. These will not only affect the bank’s ability to take a debenture, but also the effectiveness of the security in the event of loan default.

In theory, the bank having a hold over all of the assets of the company and being in a position to sell them and apply the proceeds against borrowings, is good, but the reality is often different. The value of the assets may be severely diminished in a break-up situation. Also, there may often be formidable legal obstacles to enforcing the security.

Certainly, where security of this nature is envisaged, it is essential that detailed agreements are entered into between bank and customer, and that very good legal advice is sought in taking the security.

Guarantees and Letters of Comfort

Next, let us consider Guarantees and Letters of Comfort. These are very common forms of security because often the borrowing entity itself does not have sufficient assets to secure its loans. Typically, for instance, a bank may ask the owners of a company to guarantee its borrowings. This give the bank recourse to the personal assets of the owners in addition to the assets of the company. It certainly helps to concentrate the minds of the owners/managers on efforts to repay debts in the normal course from trading.

A similar form of security taken from multinational companies in respect of borrowings by a local subsidiary is a Letter of Comfort. Many multinational companies have a policy of never providing letters of guarantee but they will issue a letter acknowledging they are aware of subsidiary indebtedness and affirming that it is their policy to ensure that their subsidiaries meet their obligations in full. Such a letter probably has limited legal standing but banks take them as security, relying on the reputation of the multinational company.

Assignments

The final type of security mentioned earlier is Assignments. There is potentially a broad range of liquid assets that a bank may seek as security, usually by means of Assignment. The type of assets that are commonly subject to Assignment are listed in next.

Commonly assigned assets:

- Deposits / Account Balances

- Government Bonds

- Marketable Securities

-Life Assurance Policies

Because these assets generally constitute cash or can be quickly turned into cash, and because there is often a considerable degree of certainty about their value, they are particularly attractive to the banker as security.

Summary

To sum up our brief look at security, the banker must be fully aware that while good security may help to reduce credit risk it does not entirely eliminate it. Our primary concern should always be with repayment capacity of the borrower.

When taking security, next shows a number of the more important questions that need to be considered by the banker.

Security check list:

- Has the security intrinsic value?

- Is there a reasonable margin over outstanding debts?

- Has the borrower good title?

- Can the instrument be taken as security?

- Are all legal regulations complied with?

- Is the security easily realised?

- Are their other parties with prior claims (e.g. Revenue Authorities)?

Basically, there are two methods used by bankers:

Estimate Repayment Capacity on the basis of the historical figures and certain assumptions about the future.

Obtain Cash Flow Forecasts from the customer and analyse them to ensure they are reasonable and prudent.

Estimating Repayment Capacity

Bank borrowings are ultimately repaid from the surplus of cash inflows over outflows. We can estimate this starting with our Net Profit figure as next.

The difficulty with this calculation is that we must make certain assumptions to make it meaningful. For example;

We may assume that the business is operating in an extremely stable environment and that the profit figure and the various adjustments will be the same in future years as in the past year, or

We may assume that profit will continue to increase at the same rate as over the past 5 years and make our calculation accordingly, or

We may make alternative assumptions concerning key variables such as Capital expenditure, interest rates etc.

Clearly, because we are dealing with the future, all of the assumptions we may make are open to question.

Cash Flow Forecasts

It makes sense for the banker to request the customer to provide projections showing how the customer estimates future finances will look. In particular, lending bankers usually request cash flow forecasts for the period of the borrowing.

Once again, it is the assumptions underlying these forecasts which must be examined carefully. Next shows some of the key components that must be scrutinised.

Future cash flow assumptions:

- Sales Forecast

- Expenses Forecast

- Debtors Collection Period

- Stock Holding Period

- Credit Payments Period

The Sales Forecast can be particularly difficult to analyse because it can be affected by so many factors.

For example, (These could perhaps be written on a flipchart)

Total Market Size

Market Trends

Competition

Economic Conditions and Outlook

Anticipated Market Share

Potential Production Capacity

Forecast expenses will often follow historical trends, however this cannot be taken for granted. For instance, changes in production volume or product mix may lead to irregular variations. Also, suppliers may impose increased input costs.

Unless we have reasons to believe otherwise, it is often safest to assume that Debtor Collection Period, Stock Holding Period, and Creditor Payment Period will not vary from year to year. However, we must still question the customer to establish that this is a likely scenario. When in doubt, bias should be towards prudence.

We will consider the measurement of repayment capacity in a little more detail shortly, but for the present we will look at the ratios of most interest to the banker under the four headings show next.

Relevant ratio categories:

- Activity

- Profitability

- Liquidity

- Gearing

Activity

Under this heading, we measure the growth in Sales, usually by expressing the increase in Sales between two accounting periods as a percentage of the Sales in the first period.

It may be useful to use a flipchart to illustrate the formula:

It is important for the lending banker to find out what is behind a given increase in Sales.

Has volume increased in addition to price?

In what manner have prices changed?

With general level of inflation?

Change in product mix

Price strategy being pursued to increase volume OR increased competition forcing low prices and low sales.

The major concern for the banker is the likely trend of sales volumes and price in the future. We must examine the past trend from that point of view and try to understand as much as possible what is happening to the market in which the business is operating.

Profitability

As we stated in Session 1, profitability ratios give an indication of the efficiency of the operation of the business. This reflects on management and from the banker’s point of view the better the management the better the prospects for repayment of our loans. While profit is not necessarily cash, the level of profit being earned can be the first indication of cash flow to follow.

Typically, we might calculate Gross Profit Margin, Operating Profit Margin and Net Profit Margin. In each case, we express the relevant profit figure as a percentage of Sales.

Each ratio may give us valuable additional information about the business or, more likely, prompt us to investigate further. We will consider each of them briefly in turn.

Next shows some of the main points to consider about the Gross Profit Margin.

Gross profit margin:

- Comparisons between accounting periods useful

- Varies from business to business

- Several explanations for a drop in the margin.

In normal circumstances it is assumed that this ratio figure should be reasonably constant over time if pricing policy and command over the market is both consistent and proactive. Significant changes between accounting periods should be investigated.

We would expect similar businesses to have similar gross profit margins, and would expect significant variations between different industries. For instance, we would expect many manufacturers with low volume unit sales to have relatively high margins, while retail businesses with high volume unit sales would typically have low margins.

Where gross profit margin falls, the following would be among the possible explanations (Trainees might be asked if they can mention possible explanations before proceeding):

- Prices reduced to maintain or increase market share

- Poor control of direct costs and/or inefficiencies in the production process

- Changes in the mix of products sold

- Increased cost of sales that could not be passed on to customers (because of substitutes, competition etc.)

Next highlights some relevant points to consider about the Operating Profit Margin.

Operating profit margin:

- Measures ability to control overhead costs

- Distinguish between temporary and permanent deterioration

- For explanations, investigate individual expenses.

Operating expenses should be relatively fixed within a certain range of activity. As sales volume increases, we would not expect operating expenses to increase at the same rate. If they do, it may signal an inability or unwillingness of management to control them.

Of course, a deteriorating ratio may be the result of a temporary or non-recurring expense. It is important to isolate any such factors before making any judgment.

To get a very good view on cost control, it is advisable to check any major increases in individual expenses with a view to establishing reason for the deterioration.

Was increase in an individual expense necessary for the survival of the business and/or improved trading performance and/or reflecting deterioration in cost control?

What action is being taken to eliminate unnecessary costs?

Our final measure of profitability, the Net Profit Margin, is the most important but, often, the most difficult to interpret.

It is the most important because it is the best indicator of overall efficiency and, therefore, the firm’s ability to survive and meet all of its obligations.

The difficulty in interpretation comes from the fact that so many factors can affect this “bottom line” performance. Next highlights the principal factors which may negatively influence Net Profit, and the banker must examine the facts to see which are most important.

Factors reducing net profit:

- Disimprovement in gross profit margin

- Increase in Sales, General and Administration expenses

- Increase in Interest costs

- Increase in Tax charge.

Liquidity Ratios

Returning to the Balance Sheet, Liquidity ratios help to determine the ability of a business to meet its day to day obligations. Since these obligations will often include repayment of bank loans, this can be very important for the banker.

Initially, we generally calculate two simple liquidity ratios, as illustrated next, from the balance sheet.

Liquidity ratios:

The current ratio indicates the ability of the business to meet short term obligations from current assets. However, this involves making the broad assumption that current assets can be converted in a relatively short time into cash if required to meet some or all of the current liabilities.

We may find it useful to look at the trend in this ratio over time or compare the ratio from a particular business with an accepted safe norm for the industry. Broadly speaking, manufacturing industries should have a much stronger current ratio (2 is often considered a safe norm) than a cash business such as a retail shop or restaurant.

The Quick Asset Ratio eliminates the reliance on sale of stock in discharging liabilities to short term creditors. A low or deteriorating ratio should at least prompt us to ask questions about the ability of the business to withstand any liquidity problems.

Before drawing any definitive conclusions from an assessment of these primary liquidity ratios, it is advisable to examine Stock, Debtors and Creditors in more detail. These are the main determinants of the need for Working Capital, so ratios involving these items are often called the Working Capital Ratios.

Working Capital Ratios

We can easily calculate three working capital ratios as shown next (based on a financial year of 365 days)

Working capital ratios:

- Accounts Receivable Days = Accounts Receivable / Sales x 365 days

- Inventory Turnover Days = Inventory / Cost of Sales x 365 days

- Accounts Payable Days = Accounts Payable / Cost of Sales x 365 days

Accounts Receivable Days can be a key ratio for interpreting how a business is performing. Not only does it measure how long, on average, it took the business to collect from it’s trade debtors, but it may also be a good indicator of the quality and collectability of the debtors. Generally, the longer that debts are outstanding the more likely they are to be irrecoverable. The banker will be particularly interested in the trend from accounting period to period and, if possible, a comparison with industry norms. A lengthening of debtor collection days may indicate poor administration, individual debtors having cash flow problems, or over reliance on an individual customer who is able to dictate payment terms.

Inventory Turnover Days represents money tied up in stock. Again the banker will, if possible, examine trends and make comparison with industry norms. A lengthening of inventory turnover days may indicate an increase in obsolete or damaged inventory which may ultimately be unsellable, a change in the mix of inventory held, production inefficiencies (a manufacturing firm), or my be for quite innocent reasons (e.g. once off effect such as a special order).

Accounts Payable Period has a beneficial impact on cash flow when increasing, however, it may reflect problems such as inability to pay creditors on time. A shortening of the payment period might indicate increased pressure for earlier payment, disimproved credit terms, or over-dependence on a supplier who can dictate terms.

Gearing

Of major importance to the lending banker is the financial structure, or gearing, of the customer. High gearing can be potentially very rewarding for the owners of a business but it carries with it a much higher risk of failure.

We might calculate three gearing ratios and these are shown next.

Gearing ratios:

- Total Gearing = Total Liabilities / Tangible Net Worth

- Bank Gearing = Total Bank Liabilities / Tangible Net Worth

- Short Term Debt/Working Capital = Short Term Bank Debt / (Stocks + Trade Debtors – Trade Creditors)

All other things being equal, the higher the Total Gearing the less secure the business is in the face of future adversity. However, all other things are never equal and we should not think that there is one level of gearing that is appropriate for all firms in all circumstances.

Firms with a high level of sustainable profits and the ability to generate cash can sustain quite high levels of gearing without undue risk. On the other hand, highly geared firms that are not particularly profitable are in severe danger if creditors withdraw their support.

If Total Gearing increases over time we would hope to see that this was the result of deliberate policy by management of investment in assets that will yield good profits and cash flow in the near future.

The interpretation of Bank Gearing is similar to Total Gearing. It highlights the relative contributions of banks and the owners to financing the business.

Apart from being vulnerable to changes in existing profit and cash generating ability, a company with high Bank Gearing will also be vulnerable to interest rate changes.

As a back up to this ratio, banks often calculate the extent to which operating profit covers interest on borrowing.

The final gearing ratio in Slide?? measures the extent to which bank short term debt is funding net working capital at Balance Sheet date. As a general rule, we would not like to see this ratio too near 100%.

Summary

All of these ratios we have been looking at tell us a little bit more about the business we are analysing. It is almost impossible in advance to know which ratio will be most important for us in any given situation. By calculating the ratios, and asking searching questions which arise as a result, we get a better overall view of the business and the risks involved in lending it money.

By making a systematic analysis of a large number of businesses, a banker usually develops a good sense of judgment about the factors which need most investigation.

The principal method used to interpret financial accounts is Ratio Analysis, which is simply a means of highlighting, in arithmetic terms, the relationship between two figures in the accounts.

Generally, we do not look at ratios in isolation but, rather, at a trend over time or a comparison between a calculated ratio and an accepted norm for the particular industry.

Strengths and Weaknesses

Before we look in more detail at some of the more useful ratios calculated by the lending banker, it is important to stress that, while Ratio Analysis helps us assess risk, it is not an exact measure of that risk.

Next highlights some of the more obvious strengths and weaknesses of Ratio Analysis:

- Helps analysis of trends and meaningful comparisons

- Suggestions questions that need to be answered

- Balance Sheet figures may not be typical

- Figures not always objective

- Financial Analysis is not a comprehensive analysis of a business

Each of these points can be elaborated on:

Ratios are particularly useful in highlighting trends over a period of time. They facilitate comparison between different periods by eliminating the impact of volume changes. Also, they allow comparison with industry or sector norms.

Ratios cannot be used as an authority for making absolute statements. However, they suggest the questions that need to be asked, the answers to which will give us a more detailed knowledge of the business.

Balance Sheet figures reflect the position on a particular day, which may not be a typical one for a number of reasons e.g. seasonality, unusual transaction.

While there are reasonably strict rules for drawing up accounts, it is impossible to eliminate subjectivity e.g. value of premises, stock, bad debts etc.

Analysis of historical figures often tells us little or nothing about the current or future state of the business e.g. management ability, product quality, labour productivity etc.

Also, for other financial analysts (e.g. owners/shareholders, tax authorities, major suppliers etc.) these statements will be their main focus of attention. However, a banker is often more interested in a third financial statement, which does not always get as much attention as the others – the Cash Flow Statement.

The overall aim of the cash flow statement is to identify/eliminate situations where the accounting treatment of specific items obscures the real cash movement that has occurred. The end result should be a clearer profile of the cash that was generated by the business during the accounting period and the manner in which it was used.

The reason why this is of so much interest to the banker is obvious. It is cash rather than profits which repays bank loans. It is possible that a business may generate a profit but experience a cash flow problem, while a business making losses can often survive in the short term.

Contents of Cash Flow Statement

A simple Cash Flow Statement might look something like that illustrated next:

The ‘Non Cash Expenses’ which are added back would include Depreciation and Write off of any Intangible Assets.

The Cash Flow Statement shows us what cash has been generated from the business operations, what other sources of cash have been available (e.g. new share capital, loans, grants), and what other cash commitments have been undertaken (e.g. capital expenditure, repayment of loans). It can give the banker a much broader look at what has happened during the accounting period than a simple analysis of the Profit and Loss Accounts.

Accounts of Different Entities

During the rest of the Module we may assume that the customer we are dealing with is a limited company. Of course, business customers do not always take this form. For example, they may be Sole Traders, Partnerships or Unlimited Companies. However, the basic shape of financial accounts produced will be similar and, therefore, the same sort of analysis will apply.

While a Profit and Loss Account can be for any length of time, we generally look at them for a period of one year.

Different Levels of Profit

In constructing a Profit and Loss Account, expenses are generally grouped into separate categories. As we take away each category of expense from the Sales figure, we get a different level of ‘Profit’. Each level of ‘Profit’ can be analysed to give us a different perspective on the business and how it is operating.

Next shows the outline of how a Profit and Loss Account may be constructed, and the different levels of ‘Profit’.

Gross Profit is the Sales revenue less the direct cost of those sales. In a trading operation, this will effectively represent the ‘mark up’ on the goods sold. In a manufacturing operation, it will represent the margin on production, reflecting the efficiency of the production operation and the appropriateness of the pricing policy.

Operating Profit is a measure of the overall operating efficiency of the business. It is calculated before the interest charge because interest charges are primarily determined by the capital structure of the business and interest rates, neither of which are within the power of anyone on the operating side of the business to influence.

Profit before Tax is a measure of the overall efficiency of the management of the business after taking account of the impact on profitability of the capital structure of the business.

Profit after Tax is the bottom line measure of overall profitability of the business.

Retained Profit shows the amount of additional capital being left in the business to fund future growth.