The analysis of financial statements from a commercial credit professional's point of view is quite different from that of a lending or large institution. Banks and other lenders who in most cases have access to detailed explanations and books and records of the company or firm. Also, bankers have an added advantage of knowledge of the day to day financial dealings of their customers through their banking operations. Most astute bankers are usually the first to identify trouble within their client's operations.
The credit professional on the other hand must rely on conclusions drawn from within their industry, their customer's monthly trading with them and the customer's and financial statements relying on the balance sheet and revenue statement ratios.
Most published comment is regarding the interpretation of financial statements is directed to the large corporation. Usual accounting training is given on "how to read a Balance Sheet" or "Balance Sheets – what do they reveal" are all directed to these large listed corporations who have prepared audited publicly available financial statements. However careful review enables the same concepts of review of the smaller enterprise.
In this article we restrict our discussion to those businesses who are maintaining records and thereby regularly preparing their financial accounts. Discussions with insolvency professionals often reveal a high percentage of their appointments have no suitable books or records. Often the records are prepared sporadically inline with BAS and ATO annual accounts, regulations however, the new one touch payroll superannuation requirements may lead to better record keeping.
The credit professional therefore must examine financial statements in varying degrees of completion and detail. However even the most sophisticated of these statements will be worthless if the numbers cannot be interpreted. Financial statements are not geared to the particular purpose pf any one user. The same statement is prepared for the Australian Tax Office, creditors, banker, shareholders, proprietors and other interested parties.
We hear discussion about several sets of books:
1. ATO – low profit
2. Absent shareholders – low profit and low assets.
3. Creditors – reasonable profit and coverage of debts by assets.
4. Proprietors, directors - True copy
Many small business financial accounts being prepared for the purpose of taxation require adjustments to account for internal transfers to diminish taxable profit. How often have you heard a comment from a proprietor stating that 'that's not the true profit'.
Financial statements are normally prepared on the basis that an enterprise is a going concern. The credit professional must consider whether owners or directors are correct in treating the enterprise as a going concern. In a going concern we use the matching concept (matching costs with revenue by allocating amounts expended to specific accounting periods). If the going concern basis is not appropriate (there is doubt that the enterprise will continue as such) the assets must be shown on a break up basis (estimated realisable values) and liabilities which would include claims for breaking of contracts and other liabilities which would be liable on cessation, must be shown in order of ranking against assets.
Thus before examining financial statements it is vital to get a feeling for the accounts and to correctly classify balance sheet items.
If a "Funds Statement" is not available, then prepare one for yourself. As mentioned above, accounts are not prepared only for the directors or owners, they therefore do not always highlight the best or worse, and therefore a little digging is always necessary.
An example of a balance sheet that doesn't accurately represent risk is when a company rapidly increases size though borrowing without a commensurate increase in profitability. This is usually a sign of weakness which could be being covered up. Take particulate notice of the interest occuring and the need to repay short term loans. The loan length and repayment time frame needs to match the assets involved. Short term borrowings for long term loans is a recipe for insolvency.
A funds statement for a company is very similar to a document that you would prepare for your own finances – sources of cash for a business, just as your income is your source of cash, so with a company it is profit after adding back non-cash items ie depreciation and provisions. When these are added back, we have the cash generated by business during the year. A company also secures cash when it sells assets, borrows, issues shares, reduces debtors. Thus at one glance is the relationship between cash generated by the business and that borrowed.
If a company has large borrowings in relation to cash generated, look closely where was the money spent – this may affect the future.
The expenditure side of the funds statement will disclose information about the enterprise corporate strategy. If a company has a large amount in fixed assets go back and see how it is spending these funds. Unless a business is undergoing big expansion, its cash flow should be able to finance its normal business for stock and debtors.
The funds statement helps determine the level of risk and will alert you to moves in stock and debtors. If these are not accompanied by similar moves in sales, this could be a warning sign.
Once you have a feeling for the company's handling of cash, the next step is to look at the quality of earnings.
Every company dutifully declares a profit or loss, but there is considerable flexibility in accounting standards. This means not all profits are comparable.
This is used when companies take into their profits a share of earnings from entities in which there is held less than 50% equity and they do not have control. If there is a substantial content of equity profit, beware the funds may not be available.
Contribution of capital asset sale
Review the accounts for sale of an asset and surplus funds. Should you sell your residence you will have a surplus funds from the sale, but if you require to purchase another residence it will, all things being equal, cost you just as much. Capital profits can be the same. Inflation enables companies to sell assets above cost and capital profits as extraordinary items, not trading profits.
When a company buys a block of land and develops it, the company does not deduct the cost from the profit and loss but puts in on the balance sheet as an asset. But what about interest? Most companies treat interest as all the same and reduce trading profit – the conservative view. Others add the interest to the book value of the asset being developed, thereby "capitalising" the interest.
This can make an enormous difference to a year's profit. When companies capitalise interest it means when the development is completed its interest burden suddenly hits the account reducing profit if high earnings are not being achieved.
This allows you to assess how good the profit really is – if the provision is low there may be good reason.
We have now looked at cash generation and quality of earnings. The quality of earnings rises if depreciation is over provided but falls if capital profits or low tax provisions are used to boost profits.
Turning now to the balance sheet there are concepts which must be fully understood.
Be on alert if there is a sharp rise in borrowings. Just how serious this can be depends first on the level of earnings and cash generation and second on the value of assets.
Asset valuations on balance sheet
Assets are included in a balance sheet basically at cost, but directors occasionally revalue to near market. This can lead to an amalgam of confusion, complicated further by plummeting values of real estate and probably assets in the books at above their worth. Basically, if a company is trading well, the value of fixed assets is not a vital matter. However, this will be of concern if a take over is considered. If a company gets into trouble, the value of its assets is vital. When survival becomes paramount, the directors may discover the market value of its assets and thereby profit is less than the book value leading to an insolvency event.
The same applies to stocks and debtors. Many an insolvency practitioner and corporate raider has discovered these items taken at book value resulted in unrevealed losses.
Before considering some simple ratios, steps should be taken to correctly classify balance sheet items, that is whether an item is regarded as current or non-current. By examining the classifications of entries other pertinent facts may be revealed.
Debtors or accounts receivable - these should be separated into:
a) Trade Debtors
b) Subsidiary or affiliates loans
c) Shareholders loans
An age analysis of item (a) would also be required. Has factoring of debtors occurred? If debtors items include (b) and (c) any analysis would be distorted.
Work in progress
Question if any gross profit, included in the valuation of work in progress. This item always gives an insolvency professional sleepless nights.
As mentioned earlier, what method is used for valuation – historic or directors value or current cost method ?
This item should be amortised over time. While intangibles may be considered of value to directors, in a winding-up, it is normally valueless. A credit professional should be concerned with net tangible assets not total assets.
Creditors or accounts payable
If your client is a slow payer it is important to examine the age analysis of your client's creditors
Short term liabilities = Current Liabilities
These are liabilities that are due for payment in less than 12 months
Long term liabilities
These are liabilities that are due for payment greater than 12 months
Loans should be dissected into two categories:
- Loans with security should be disclosed as separate liabilities and not deducted from the value of the asset secured
- what are the securities given ?
Related party loans from directors and the like need to be examined closely – why were they given, was it an inability to borrow outside the group, what are their terms, could these loans be considered as capital ?
Provision for Income Tax
Provision for deferred income tax – this is a non current liability. Future income tax benefit arising from previous losses – this is an asset
Future income tax benefit arising from previous losses – this also is an asset
Again the credit professional should be aware of these balance sheet items and care should be taken if they are included in net figures.
These items are not shown on the balance sheet but are usually in a note attached. These contingent liabilities should be referred to by credit professionals when considering net balance sheet figures. Contingent liabilities should include discounted bills or bills receivable, court actions, guarantees
Paid up capital or proprietorship shareholders loans
For a company or firm to examine the capital and current account make sure any amount shown as capital has been in fact contributed and is not an undisclosed loan. Examine the current account of a firm and determine what profit is being withdrawn also what salaries and other benefits the directors and shareholders or proprietors are receiving. These accounts are a clue to the business responsibility of the directors or proprietors
Remember a balance sheet is only a snapshot of a business at a point in time and then it is out of date so question how old are the financial statements. Having classified the data in the financial statements you should have a feel for how the company is operating.
If you find a company is stretched then it may help to explain borrowing problems or slowness in payment. If the converse and cash is held in hand then an opportunity is available to astute entrepreneurs.
Republished with the kind permission of our Life Member Robert Burns.
Robert is a Member if the Institute of Chartered Accountants, a Trustee in Bankruptcy and an Official Liquidator in addition to being a stalwart of the AICM being a past councillor and lecturer on credit.
Robert was the establisher of and key contributor to the Queensland Division's Education Fund the precursor to the AICM's National Education Fund.