Financial Statement Analysis Essentials of Corporate Finance Chapters 2 & 3 Materials Created by Glenn Snyder – San Francisco State University

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 2 Topics Who uses Financial Statement Analysis? Banking - Loan Underwriter  Loan Package  Financial Analysis Account Receivable Inventory Financial Ratios  Financial Projections Income Statement Projections Balance Sheet Projections  Cash Flow Analysis Career Advice for becoming a Bank Underwriter

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 3 Who uses Financial Statement Analysis? Almost Everyone in the Business World  Bankers – analyze loans and cash flow  Portfolio Managers – projections of stock prices  Marketing Managers – market penetration and impacts to profitability  Human Resources – compensation analysis  Senior Management – corporate strategy  Sales Managers – commission rates on sales  Internal Financial Analysts – profitability analysis  Customer Service Managers – efficiency ratios

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 4 Banking – Loan Underwriter What is a Loan Underwriter?  A loan underwriter analyzes the loan application and supported materials to determine if the loan should be approved. Where do Loan Underwriters work?  Commercial Banks  Investment Banks (Bond Underwriters)  Financing Institutions (Mortgage Companies)

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 5 Banking – Loan Underwriter What is a Loan Underwriter looking to do?  Analyze the credit quality of a business  Project cash flow and interest coverage  Gain an understanding of the business  In the end, a bank is only looking to get paid back and earn interest.

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 6 Loan Package When a company applies for a loan, any of the following can be requested by the bank:  Loan application  3 years financial statements  3 years personal tax returns of owner (if the company is a small business)  Accounts Receivable aging schedule  Names of customers and suppliers for references

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 7 Accounts Receivable & Inventory Almost half of all loan requests are for a working capital line of credit.  A working capital line of credit works like a credit card (only without the card). A company can draw up and down on the line and only pay interest on outstanding balances.

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 8 Accounts Receivable & Inventory Working Capital Lines of Credit  Most working capital lines of credit are based off of a percentage of accounts receivable and inventory. For example: A $500,000 line of credit based 80% on accounts receivable and 50% of finished goods inventory.  Therefore, Accounts Receivable and Inventory are two of the most important balance sheet accounts for a banker.

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 9 Financial Analysis – Accounts Receivable Accounts Receivable (A/R) is the fastest non-liquid asset to convert to cash Analysis: Questions to AskReason What % of sales are returned? Why?Are returns a significant part of the business model? Are returns due to poor quality? What % of sales are sold on credit?How reliant is the company on extending credit? What % of sales are written-off?Do they continue to sell to customers who don’t pay? Is there a concentration with one or two sales people? What if those sales people leave? What % of sales are guaranteed (contractually obligated)? What happens when the contract expires? Where is new business coming from? What % of sales are foreign?Do they use letters of credit to protect against non- payment? Foreign customers are hard to collect from. What % of sales is to the government?The government is typically slow paying

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 10 Financial Analysis – Accounts Receivable Accounts Receivable Aging Schedule  A schedule of all outstanding receivables grouped both by customer and due date Analysis: Questions to AskReason Is there a concentration greater than 10% of any customers? What happens if they lose a large customer? What % of customers are past due?How reliable are their accounts receivable Are there any receivables over 120 days past due that have not been written-off? Typically these will not be collected and should be backed out of the total accounts receivable

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 11 Financial Analysis - Inventory Inventory is typically the largest current asset and is what the company tries to convert to cash. Inventory includes:  Raw materials inventory  Work-in-Process inventory  Finished goods inventory In case of liquidation Raw materials inventory can be sold back to the supplier (at a fraction of the cost) Finished goods inventory can be sold to customers (at a fraction of the cost)

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 12 Financial Analysis - Inventory Analysis: Questions to AskReason How does the company inventory compare with the industry average? Do they carry too much? Too little? Do they have too much in finished goods inventory? Is inventory valued at LIFO, FIFO, or Weighted Average? This will impact the cost of goods sold and inventory balance. Could inventory be obsolete? What % of current assets is made up of inventory?Inventory is typically the hardest current asset to convert to cash What % of inventory is work-in-process?This inventory is virtually worthless. What can you do with the frame of a car?

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 13 Financial Analysis - Ratios Liquidity Ratios – Current Ratio: Current Assets / Current Liabilities Measures a firms ability to meet current obligations Analysis: Questions to AskReason Calculate the Current RatioToo low suggests a lack of liquidity, too high suggests financial assets are not used efficiently How does the company’s current ratio compare with companies of similar size in their industry? If they are not in-line with the industry, then the underwriter must find out why. Are liabilities being paid on time?If suppliers and service bills are being stretched, this would decrease the current ratio. How much is inventory weighted in current assets? Inventory is the most difficult current asset to convert to cash? How quickly is it turning over? Are accounts receivable over 120 days being written off? These accounts will probably not be collected and should be removed from current assets Exclude Prepaid Current AssetsCash cannot easily be obtained from a prepaid phone bill or rent

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 14 Financial Analysis - Ratios Liquidity Ratios – Quick Ratio (Acid Test): (Current Assets – Inventory)/ Current Liabilities Measures a firms ability to meet current obligations without liquidating inventory Analysis: Questions to AskReason Calculate the Quick RatioToo low suggests a lack of liquidity, too high suggests financial assets are not used efficiently How does the company’s current ratio compare with companies of similar size in their industry? If they are not in-line with the industry, then the underwriter must find out why. Are liabilities being paid on time?If suppliers and service bills are being stretched, this would decrease the current ratio. How much is inventory weighted in current assets? Inventory is the most difficult current asset to convert to cash? How quickly is it turning over? Are accounts receivable over 120 days being written off? These accounts will probably not be collected and should be removed from current assets Exclude Prepaid Current AssetsCash cannot easily be obtained from a prepaid phone bill or rent

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 15 Financial Analysis - Ratios Leverage Ratios – Debt-Equity Ratio: Total Liabilities / Total Net Worth Measures the funds contributed by owners or shareholders versus creditors. Analysis: Questions to AskReason Calculate the Debt-Equity ratio Banks generally like to see this ratio below 40% If this ratio was greater than 50%, the company would primarily be financed by creditors  The owners would be more likely to declare bankruptcy in the event of a downturn, as they would have less to lose How much of total liabilities are current liabilities?Matching Principle: current assets should be financed with current liabilities, long-term assets should be financed with long-term debt

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 16 Financial Analysis - Ratios Efficiency Ratios – Accounts Receivable Turnover: (Accounts Receivable / Sales) x 365 Measures the average number of days it takes the company to collect their receivables. Analysis: Questions to AskReason Calculate the Accounts Receivable TurnoverThe shorter the better The faster a company can collect, the faster they have cash The less time they need to borrow Is the accounts receivable turnover relatively close to the company’s financing terms? If they sell on 2/10 net 30, one would expect to see a turnover around 30 days. A few days over is ok, but 40 or 45 would be too long Are accounts receivable over 120 days being written off? These accounts will probably not be collected and should be removed from current assets How does the company’s turnover compare with the industry? The turnover should be close to industry averages, if not, the underwriter needs to know why

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 17 Financial Analysis - Ratios Efficiency Ratios – Inventory Turnover: (Inventory / Cost of Goods Sold) x 365 Measures the average number of days inventory is on hand Analysis: Questions to AskReason Calculate the Inventory TurnoverThe shorter the better The faster a company can sell its inventory, the faster they have cash The less time they need to borrow Which inventory valuation method do they use? LIFO, FIFO, or weighted average? Which method is standard for the industry? Have they changed valuation methods recently? If so, why? Is the inventory turnover different for different products? Are some products selling and others not? Are some products becoming obsolete? How does the company’s turnover compare with the industry? The turnover should be close to industry averages, if not, the underwriter needs to know why

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 18 Financial Analysis - Ratios Efficiency Ratios – Accounts Payable Turnover: (Accounts Payable / Cost of Goods Sold) x 365 Measures the average number of days the company takes to pay its suppliers Analysis: Questions to AskReason Calculate the Accounts Payable TurnoverThis is a sensitive ratio: The longer the turnover, the longer the company has cash If the supplier get stretched to much, they may not sell to the company, which can put the company out of business What terms to the suppliers offer?Is the company taking advantage of discounts? Supplier reference checkAn underwriter will want to call 3 or 4 suppliers to confirm the company is in good standing How does the company’s turnover compare with the industry? The turnover should be close to industry averages, if not, the underwriter needs to know why

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 19 Financial Analysis - Ratios Profitability Ratios – Gross Profit Margin: (Sales – Cost of Good Sold) / Sales Measures the differential between what it costs to manufacture or purchase the product and how much the product is sold. Analysis: Questions to AskReason Calculate the Gross Profit MarginThe higher the gross profit margin, the more money is available to cover the operating costs of the company Has the gross profit margin changed over time?This can show the impact of price changes or changes in the cost of inventory. Understand the industryCertain industries may have tighter margins, such as technology retail. How does the company’s turnover compare with the industry? The turnover should be close to industry averages, if not, the underwriter needs to know why

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 20 Financial Analysis - Ratios Profitability Ratios – Return on Equity (ROE): Net Income / Total Equity Measures the relationship between profits and the investment of the owners. Analysis: Questions to AskReason Calculate the Return on EquityThis ratio will have a direct impact on the company’s ability to raise capital Has the ROE changed over time?This can show changes in capital structure, infusions of capital, an changes in net income How does the company’s turnover compare with the industry? The ROE may be close to the industry, despite low profits, as the company may have higher levels of liabilities

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 21 Financial Projections Loan underwriters must take their ratios and analysis of the financial statements and project the company’s financial statements to show adequate cash flow to repay the loan. Financials are projected by each account shown on the financial statements.  The method of projections may vary by industry  The method of projections may vary based on which accounts are shown on the financial statements All companies prepare and publish their financial statements in different ways

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 22 Income Statement Projections Sales (Gross Revenues)  Four approaches: $ Growth – Repeat the dollar growth from the previous period Average $ Growth – Average the dollar growths from all of the previous periods and project the average % Growth – Repeat the percentage growth from the previous period Average % Growth – Average the percentage growths from all of the previous periods and project the average)  Average % Growth is the most common method

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 23 Income Statement Projections Sales (Gross Revenues)

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 24 Income Statement Projections Income Statement AccountProjection Method Cost of Goods SoldCost of Goods Sold Margin Selling, General & Administrative Expenses Margin for Variable Expenses Average Value for Fixed Expenses Depreciation% of Fixed Assets Interest ExpenseInterest Rates x Associated Debt Income TaxesAverage of Tax Rates DividendsPrevious Period Dividend per Share

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 25 Balance Sheet Projections Balance Sheet AccountProjection Method CashProject Only Minimum Requirement Accounts ReceivableAverage of A/R Turnover InventoryAverage of Inventory Turnover Prepaid ExpensesAverage over Prior Periods Other Current AssetsAverage over Prior Periods Fixed AssetsPrior Period Balance less Projected Depreciation plus Projected Purchases (if any) Other AssetsAverage over Prior Periods

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 26 Balance Sheet Projections Balance Sheet AccountProjection Method Working Capital Line of CreditUsed as a Plug to Make the Balance Sheet Balance (if negative, make $0, and move the excess to cash) Accounts PayableAverage of A/P Turnover Current Portion of Long-Term DebtPrior Period Balance unless Debt is Fully Retired plus Current Portion of New Debt Accrued LiabilitiesAverage over Prior Periods Other Current LiabilitiesAverage over Prior Periods Long-Term DebtPrior Period Balance plus New Long-Term Debt less CPLTD Deferred TaxesPrior Period Balance unless Expiring Other LiabilitiesAverage over Prior Periods

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 27 Balance Sheet Projections Balance Sheet AccountProjection Method Minority InterestAverage over Prior Periods Preferred StockPrior Period Balance Common StockPrior Period Balance Retained EarningsPrior Period Balance plus Net Income After Tax less Dividends

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 28 Cash Flow Analysis Cash Flow Coverage Ratio  Total Cash Available / Total Cash Required Sources of CashRequirements of Cash Net Profit After TaxLease Payments (1 – tax rate) +Depreciation & Amortization+Interest (1 – tax rate) +Other Non-Cash Charges+Dividends +Increases in Liabilities+Capital Expenditures +Reductions in Assets+Current Portion Long-Term Debt +Interest (1 – tax rate)+Increases in Assets +Lease Payments (1 – tax rate)+Reductions in Liabilities -Non-Cash Revenues+Proposed Debt Payments (Principal and Interest) =Total Cash Available=Total Cash Requirements

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 29 Cash Flow Analysis Analysis of Cash Flow Coverage Ratio  A ratio > 1.00 means sufficient cash to cover requirements  Underwriters typically want to see a coverage ratio of at least 1.20 This may vary by industry and type of loan

December 28, 2006 Materials Created by Glenn Snyder – San Francisco State University 30 Career Advice: Bank Underwriter Most large banks have management training programs Preferred Skills:  Strong Math / Computational Skills  Knowledge of Accounting  Knowledge of Finance  Experience with MS Excel / Modeling