Analysis of Financial Statements

Analysis of Financial Statements

At the time a borrower, especially a businessmen or an industrialist, approaches a banker with a credit proposal, the banker investigates into all aspects of the borrower’s business and also about his personal character, capacity and capital. In this task of financial appraisal of the credit proposal and the evaluation of the borrower’s creditworthiness, the financial statements of the business are of great value to the banker. The two important financial statements are the balance sheet and the profit loss account of the business. The balance sheet shows the financial position of the business at a particular point of time. The profit and loss account shows the financial result of the working of an enterprise over a period of time. When these statements of the last few year are studied and analyzed, significant conclusions may be arrived at regarding the changes in the financial position, the important polices followed and the trends in profits, etc. analysis and interpretation of the financial statements has now become an important technique of credit appraisal.

Banker’s Approach to analysis:
The financial statements are analyzed and interpreted by different classes of persons from different angles and to serve their respective purposes. The investors, financial experts, management executives and the bankers all analyses these statements. Though the basic technique of appraisals remains the same in all the cases but the approach and emphasis in analysis vary. A banker’s approach to the analysis of these statements is essentially different from that of the investors and the management. As a lender and creditor of his borrower-customer, he is interested in assessing the solvency or the repaying capacity of the borrower as is evident from his financial statements. He is concern with the estimation of the risks, if any, involved in lending to the borrower. The investors approach to the analysis of financial statements is different, as he is interested in assessing the long-term growth prospects of the company. A banker analyses and interprets the financial statements so as to evaluate;

  • The financial soundness and stability;
  • The liquidity position; and
  • The profitability or the earning capacity of the borrowing concern.

Limitation of Financial Statements
Though Balance Sheet and Profit and Loss Account of the borrowing concern are important sources for the above porpoise, but the financial data contained therein have certain limitation. The financial data depict the state of affairs or the operating results, in numerical terms; sometimes wrong or illogical conclusions may be derived from them if regard is not had for other factors not evident from the financial statements. For example, the production of manufacturing concern may fall due to labor strike or non availability of raw materials due to transport bottlenecks, but it should not be considered as decline in the efficiency or profitability of the concern. It is therefore, essential that the banker should go beyond the financial date and make further enquiries regarding the causes for any variation or abnormal trend noted in analyzing the data.
Moreover, exact comparison of certain ratios of a concern with similar ratios of other concern in the same trade or industries is not always accurate and correct because of the difference s in the accounting methods used in various companies. The method of valuation of assets, writing off depreciation, costs expenses, etc. may very form concern to concern. Hence the state of affairs of a company cannot be compared accurately with that of other companies.
Besides, the financial statements depict the performance of the business concern. Any meaningful interpretation of these statements will depend upon the projection of the future trend. Past events are just guides as to what may reasonable be expected to occur in future.
The balance sheet is the most important financial statements prepared annually. It depicts the assets and the liabilities at a stated point of time e.g. 31st March. The figures of the assets and liabilities, as given in the balance sheet, do from the basis of financial appraisals but the banker should check and scrutinize these items in order to assess their dependability. In fact there are two stages in the evaluation of balance sheet:

  • The analysis of balance sheet, i.e., examination of individual item of assets and liabilities and their classification into well-defined categories: and
  • Interpretation of the balance sheet through the Ratio Analysis

The fires step in analysis of balance sheet is the scrutiny and examination of different items of assets and liabilities and their classification into varies categories. The proforma of analysis of balance sheet furnished by the Reserve Bank to the commercial banks.
In the aforesaid proforma the assets are divided into four categories:

  • Current Assets
  • Fixed Assets
  • Other Non-current Assets; and
  • Intangible Assets

Current Assets:  Current assets are those assets which change their form in a short period and are exchanged for cash. In other words, current assets are meant to be liquidated for cash in the near feature. For example, the stock-in-trade is intended to be sold for money and the money is again exchanged for good and so on. These assets are also called the ‘circulating assets,.
The banker attaches great significance to the total amount of current assets because it signifies the liquidity position of the customer in the short period. The larger the quantum of current assets, the greater is the possibilities of the repayment of loans which are repayable on demand or at short notice.

  • Cash and Bank Balances are the most liquid assets. Larger amount of cash and bank balance ensure liquidity and quick paying capacity of the enterprise. But such balances are non-earning assets and may affect the profit of the concern if they are kept beyond a reasonable limit. It should, therefore, be seen that cash balances are adequate keeping in view the requirements of the concern.
  • Marketable Investment and Fixed Deposit. A business enterprise invests its funds in marketable securities such as Government and semi-Government securities or corporate bonds and shares either
  • to employ its surplus fund not required immediately, or
  • to invest the reserves or provisions made out of the profits for specific purposes like depreciation, redemption of debenture, etc. In both these cases investment in securities strengthen the borrower’s liquidity position as these assets are easily and quickly realizable. Fixed deposit with the banks are also refundable before maturity if the depositor so desires.

It is to be noted that only those securities which are easily marketable or saleable in the market are deemed to be the current assets. Investment made in subsidiary companies may not be marketable and are, therefore, placed in the category of other Non-current Assets.
In case of securities the banker should ascertain their market value and also take into account whether they are partly paid-up or fully paid because in case of the former, the investor  is under an obligation to pay the uncalled money.

  • Books Debts and Bills Receivable. According to the Companies Act 1956 debts due and outstanding for more than 6 months are shown separately in the Balance Sheet. Only those debts and bills receivable which are outstanding for not more 6 months are treated as current assets.

The banker should thoroughly scrutinize the book debts of the borrowing concern because they are valuable only if they are realizable. The amount of total debtors should not be unduly large as compared to the total credit sales made. The period for which these debtors have been outstanding and the amount due from them should be investigated to ascertain whether a large number of debtors have been in arrears for a long time. The period of credit granted by the borrowing concern should not be larger than the usual period of credit in the trade or industry. It is also to be enquired whether adequate provision for bad and doubtful debts has been made by the borrower or not.

  • Inventory (stock). The valuation of stock may affect the profit in either way. The banker, however, shall have to rely on the valuation made by the borrower, as no independent valuation by the bankers is possible. Even then the banker should ascertain from the borrower that-
  • The stock of un saleable and useless goods is not included; and
  • The valuation has been made according to the well known principle cost or market price whichever is lower.

The banker should also ascertain that the stocks are not excessive in quantity and they bear a reasonable promotion to the sales. If the stocks-sales ratio is high as compared to other concerns in the same trade or industry, the banker should enquire reasons thereof.
Fixed Assets. Land and building, plant and machinery, fixtures and furniture, automobiles, etc. are the fixed assets of a business enterprise, which are used for carrying on the business and are not meant for sale in the near future. However the banker should ascertain their present realizable value. For this purpose it is essential to examine the location of the land, the condition of the building or machinery and their sale ability. Land should be valued according to ownership right –freehold or leasehold. In case the machinery is of a specialized nature, its marketability and value are greatly reduced. Building must be insured against fire. It is essential that adequate provision for depreciation should be made up to-date.
Intangible Assets.  Intangible assets, called fictitious assets, do not represent any material assets or property. Goodwill represents the amount paid by the purchaser of the business for the reputation earned by the seller. Patents, trademarks and designs, etc. are intangible assets because their value is reduced to nil in case of liquidation of the enterprise. Similarly, preliminary expenses, discount on shares or debentures and debit balance in profit and loss account, though shown on the assets side of the balance sheet, do not represent any tangible assets: they are either deferred revenue expenses or are actual losses which are to be written off over a number of years.